S-1 1 ds1.htm FORM S-1 Form S-1
Table of Contents

As filed with the Securities and Exchange Commission on March 13, 2008.

Registration No. 333-            

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM S-1

REGISTRATION STATEMENT

Under

The Securities Act of 1933

 

 

Salient Surgical Technologies, Inc.

(Exact Name Of Registrant As Specified In Its Charter)

 

Delaware   3845   02-0510461
(State of Incorporation)   (Primary Standard Industrial Classification Code Number)  

(I.R.S. Employer

Identification Number)

One Washington Center

Suite 400

Dover, NH 03820

(800) 354-2808

(Address, including zip code, and telephone number,

including area code, of registrant’s principal executive offices)

 

 

Joseph Army

Chief Executive Officer

One Washington Center

Suite 400

Dover, NH 03820

(800) 354-2808

(Name, address, including zip code, and telephone number,

including area code, of agent for service)

 

 

Copies to:

 

Steven A. Wilcox, Esq.   Marc D. Jaffe, Esq.
Michael D. Beauvais, Esq.   Ian D. Schuman, Esq.
Ropes & Gray LLP   Latham & Watkins LLP
One International Place   885 Third Avenue
Boston, MA 02110   New York, NY 10022-4834
(617) 951-7000   (212) 906-1200

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this registration statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, as amended, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

 

CALCULATION OF REGISTRATION FEE

 

 
Title of Each Class of Securities to be Registered   Proposed Maximum
Aggregate Offering Price(1)(2)
  Amount of
Registration Fee

Common Stock, $0.01 par value per share

  $86,250,000   $3,389.63
 
 

 

(1) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(o) under the Securities Act.
(2) Includes the offering price of shares that the underwriters have the option to purchase to cover over-allotments, if any.

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion, Dated March 13, 2008

             Shares

LOGO

Common Stock

 

 

This is an initial public offering of shares of common stock of Salient Surgical Technologies, Inc. We are offering all of the shares to be sold in the offering.

Prior to this offering, there has been no public market for the common stock. It is currently estimated that the initial public offering price per share will be between $             and $            . Application has been made for listing on The NASDAQ Global Market under the symbol “SLNT.”

See “ Risk Factors” on page 8 to read about factors you should consider before buying shares of the common stock.

Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

     
     Per Share    Total

Initial public offering price

   $                $            

Underwriting discount

   $    $

Proceeds, before expenses, to us

   $    $

To the extent that the underwriters sell more than             shares of common stock, the underwriters have the option to purchase up to an additional             shares from us at the initial public offering price less the underwriting discount.

The underwriters expect to deliver the             shares against payment in New York, New York on                     , 2008.

 

Bear, Stearns & Co. Inc.    Piper Jaffray

 

 

 

Wachovia Securities

Prospectus dated                     , 2008


Table of Contents

LOGO


Table of Contents

TABLE OF CONTENTS

 

     Page

Prospectus Summary

   1

Risk Factors

   8

Special Note Regarding Forward-Looking Statements

   27

Industry Data

   27

Use of Proceeds

   28

Dividend Policy

   28

Capitalization

   29

Dilution

   30

Selected Consolidated Financial Data

   32

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   34

Business

   51

Directors, Executive Officers and Key Employees

   68

Executive Compensation

   73

Certain Relationships and Related Party Transactions

   89

Principal Stockholders

   93

Description of Capital Stock

   95

Shares Eligible for Future Sale

   100

Underwriting

   102

Legal Matters

   106

Experts

   106

Where You Can Find More Information

   106

Index to Financial Statements

   F-1

 

 

You should rely only on the information contained in this prospectus and any free writing prospectus prepared by us or on our behalf. We have not authorized anyone to provide you with different information. We are offering to sell, and are seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus and any free writing prospectus is accurate only as of their respective dates, regardless of their time of delivery or the time of any sale of our common stock. Our business, financial condition, results of operations and prospects may have changed since that date.

For investors outside the United States: neither we nor any of the underwriters have done anything that would permit this offering or possession or distribution of this prospectus in any jurisdiction where action for that purpose is required, other than in the United States. You are required to inform yourselves about and to observe any restrictions relating to this offering and the distribution of this prospectus.

Through and including             , 2008 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription.

 

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PROSPECTUS SUMMARY

This summary highlights information contained elsewhere in this prospectus and does not contain all of the information you should consider before buying shares of our common stock. Before deciding to invest in shares of our common stock, you should read the entire prospectus carefully, including our consolidated financial statements and the related notes and the information set forth under the headings “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in each case included elsewhere in this prospectus.

Overview

We are a medical technology company that develops and markets surgical products based on our proprietary Transcollation technology for the sealing of blood vessels and other collagen-based structures. We believe that our products improve surgical procedures and patient outcomes by enabling surgeons to substantially reduce blood loss during and after surgery. Our Transcollation technology has been used in over 165,000 surgical procedures to date. We focus on selling our products for use in orthopaedic hip and knee reconstructions and multi-level spinal fusions, which are significant markets with over 1.3 million procedures performed in the United States in 2007. Our Transcollation technology is also used in surgical oncology procedures and may be used in other surgical procedures, including trauma, single-level spinal fusions, minimally invasive spine and advanced laparoscopic procedures, which are markets we intend to pursue in the future.

Our principal Transcollation product, the Aquamantys System, was launched commercially in March 2006 and is comprised of single-use handheld devices and a radio frequency, or RF, energy generator system. This system delivers an optimized combination of RF energy and electrically conductive fluid, such as saline, to permanently seal blood vessels and other collagen-based structures in soft tissue and bone. Our Aquamantys System is designed to be easy to use and portable, allowing it to be used in different operating rooms throughout a hospital. Our Transcollation technology and Aquamantys System are based on our internally developed intellectual property, as well as intellectual property we license on a worldwide basis from Medtronic, Inc. Our marketed products have received FDA 510(k) clearance in the United States and equivalent regulatory clearance in targeted international markets.

We believe our Transcollation technology provides clinical and economic benefits to patients, physicians, hospitals and payors by addressing many of the limitations of alternative blood loss management methods currently on the market. Clinical studies comparing our products to alternative blood loss management methods have shown that our products significantly reduce blood loss, the need for blood transfusions and operating time. We believe that the clinical benefits of our Transcollation technology also result in cost savings to hospitals and payors.

Our goal is to establish our Transcollation products as the standard of care for controlling surgical-related blood loss. In the United States, we sell our products through a direct sales organization comprised of approximately 70 sales representatives and eight managers. We intend to significantly expand the size of our direct sales force in the United States in order to grow our customer base and further penetrate existing accounts. As of December 31, 2007, we had 437 active customer accounts in the United States, which represented a 44% increase over the comparable period in 2006. We define an active customer account as an account that purchased products from us in the most recently ended fiscal quarter. Despite our significant growth in the number of customer accounts, our target market remains substantially underpenetrated. We believe our current accounts represent approximately 10% of hospitals in the United States performing our targeted procedures. Internationally, we sell our products through a combination of distributors and direct sales representatives, and we expect to selectively grow our international sales presence. Our revenues for the year ended December 31, 2007 were $29.5 million, a 75% increase over our revenues for the year ended December 31, 2006.

 

 

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Our Strategy

We intend to establish our Transcollation products as the standard of care for controlling surgical-related blood loss by pursuing the following business strategies:

 

Ÿ  

Expand our direct sales force to open new accounts;

 

Ÿ  

Further penetrate existing accounts in the United States;

 

Ÿ  

Continue to launch new products which enhance the value of the Aquamantys System;

 

Ÿ  

Expand the use of our technology into new market opportunities;

 

Ÿ  

Continue to expand and protect our intellectual property position; and

 

Ÿ  

Selectively expand our international sales presence.

In addition, we plan to expand the use of our technology into surgical procedures where our technology may provide surgical benefits beyond reduced blood loss. We also intend to internally develop or acquire new surgical technologies we believe to be of value to our customers.

Our Market Opportunity

It is estimated that more than 32.7 million surgical procedures were performed in the United States in 2006. Bleeding and blood loss are common to all surgeries and represent a significant challenge to the healthcare system, particularly due to medical complications and costs associated with blood transfusions. Bleeding during certain procedures can compromise surgeon visibility, which may impact patient outcomes and extend operative times. Blood loss during and after surgery may lead to sub-optimal clinical outcomes, extended hospital stays and increased costs.

We currently focus primarily on orthopaedic hip and knee reconstructions and multi-level spinal fusions. These procedures represent large and growing market opportunities, driven by an active and aging population and improved surgical techniques. According to Medtech Insight, it is estimated that in the United States in 2007, there were approximately 1.2 million hip and knee reconstructive procedures and 135,000 multi-level spinal fusions, which are projected to grow through 2012 at an annual rate of approximately 6% and 5%, respectively.

Physicians use a variety of methods separately or in combination to limit the amount of bleeding during surgery. The most common method used to manage surgical blood loss is electrocautery, which is often used to control bleeding through high-temperature coagulation. We believe that there are a number of drawbacks to electrocautery, including the length of time required to achieve hemostasis, charring of tissue, noxious smoke and the tearing and re-bleeding caused by electrodes sticking to tissues. In addition, we believe that electrocautery is ineffective when used on large blood vessels or large areas of oozing tissue.

Other alternative blood loss management methods include autologous predonation of blood, surgical sealants, gels, biologics, hypotensive anesthesia, hemodilution, reinfusion of lost blood, erythropoietin (EPO), hemostatic sponges, ultrasound and pharmaceutical agents designed to reduce operative blood loss. We believe that these alternative methods for managing surgical blood loss can have significant drawbacks, including limited effectiveness, high transfusion rates, high cost, lack of suitability for certain patients, difficulty of use and high risk of medical complications.

 

 

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Our Solution

We have developed our Aquamantys System and other products based on our proprietary Transcollation technology platform for sealing of blood vessels and other collagen-based structures. This technology enables physicians to better manage blood loss during and after surgery, which we believe provides clinical and economic benefits to patients, physicians, hospitals and payors.

Our Transcollation technology targets collagen, a protein contained in tissue throughout the body, including blood vessel walls. When collagen is heated between 75°C and 100°C, it shrinks, causing the blood vessel walls to contract, resulting in a permanent seal. Our single-use handheld Transcollation devices deliver RF energy in combination with saline in order to reduce surgical-related blood loss. The saline conducts RF energy from the electrodes of our devices to the treatment area and also acts as a cooling agent, keeping the surface of the tissue below 100°C which prevents it from charring. The saline also acts as a lubricant, allowing surgeons to move the single-use handheld device in a simple painting motion on the surgical site. This enables quick and consistent sealing of the targeted blood vessels and other collagen-based structures. As the tissue is treated, it changes color from pink to light tan which provides a visual cue that sealing is complete.

We believe that our Transcollation technology addresses many of the drawbacks associated with alternative blood loss management methods and that it provides the following benefits:

Benefits to Patients

 

Ÿ  

Reduced Need for Blood Transfusions.    Transcollation reduces the need for transfusions, which can significantly reduce the risk of infections or other post-operative complications.

 

Ÿ  

Reduced Operating Time.    Transcollation reduces operating room time, which can lower the risk of anesthesia-related complications and surgical infection.

 

Ÿ  

Improved Post-Operative Outcomes.    Surgeons report that Transcollation improves post-operative outcomes, including reduced bruising, pain and swelling, which can result in improved range of motion, shorter hospital stays and faster recovery.

Benefits to Physicians

 

Ÿ  

Improved Visibility and Reduced Operating Time.    Transcollation improves surgeon visibility of the operative site by reducing excessive bleeding within the surgical field, which can allow the surgeon to complete surgeries more efficiently and effectively.

 

Ÿ  

Better Patient Outcomes.    Transcollation reduces blood loss, which surgeons report results in less bruising and swelling, allowing for earlier patient mobility and range of motion, which are correlated with improved patient outcomes.

 

Ÿ  

Reduced Need for Post-Operative Care.    Transcollation reduces the need for blood transfusions and surgical blood collection drains, which can result in a reduced need for post-operative care, fewer post-operative complications and less frequent physician follow up.

 

Ÿ  

Ease of Use.    Our Aquamantys RF generator has a simple user interface with pre-defined settings based on a proprietary algorithm that optimizes the relationship between the RF power level and saline flow rate.

 

 

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Economic Benefits to Hospitals and Payors

 

Ÿ  

Reduced Incidence of Blood Transfusions.    Transcollation reduces the need for transfusions, which we believe generates cost savings for hospitals and payors.

 

Ÿ  

Reduced Operating Time.    Transcollation enables more efficient surgical procedures, which potentially allows hospitals to increase the turnover rate of operating rooms.

 

Ÿ  

Reduced Hospital Stay.    Transcollation reduces the post-operative care required and the risk of post-operative complications, both of which can lead to shorter hospital stays.

Risks Associated With Our Business

Our business is subject to numerous risks, as discussed more fully in the section entitled “Risk Factors” immediately following this prospectus summary which you should carefully consider prior to deciding whether to invest in our common stock. Some of the more significant challenges and risks may include the following:

 

Ÿ  

We have incurred losses since our inception and may never achieve or sustain profitability;

 

Ÿ  

We depend on sales of one product family, our Aquamantys System, to derive a majority of our revenues;

 

Ÿ  

We may be unable to generate demand for our products and may have to withdraw our products if future clinical data on the Aquamantys System and further long-term data on all of our products are not consistent with our existing clinical data;

 

Ÿ  

We are dependent on third party suppliers, including a single supplier for our Aquamantys RF generator;

 

Ÿ  

We operate in a highly competitive market and compete against companies that have greater financial resources;

 

Ÿ  

We may not be able to achieve or manage rapid expansion of our sales and marketing organization;

 

Ÿ  

We may become subject to product liability claims related to our products; and

 

Ÿ  

Our intellectual property rights may not provide meaningful commercial protection for our products, and any patent litigation could harm our business.

Corporate Information

We were incorporated in Delaware in August 1999. Our offices are located at One Washington Center, Suite 400, Dover, NH 03820, and our telephone number is (800) 354-2808. Our website is located at www.salientsurgical.com. The information found on, or accessible through, our website is not a part of this prospectus.

We have pending trademark applications in the United States for “SALIENT”, “AQUAMANTYS” and “TRANSCOLLATION.” All other trademarks, trade names and service marks appearing in this prospectus are the property of their respective owners.

 

 

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The Offering

Common stock offered by us

             shares

 

Common stock to be outstanding after this offering

             shares

 

Overallotment option

To the extent that the underwriters sell more than              shares of common stock, the underwriters have the option to purchase up to an additional              shares at the initial public offering price less the underwriting discount.

 

Use of proceeds

We expect our net proceeds from the offering to be approximately $            , assuming an initial offering price of $             per share, which is the midpoint of the range set forth on the cover page of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated fees and expenses payable by us. We intend to use the net proceeds of this offering for sales and marketing expansion, new product development, repayment of certain indebtedness and for working capital and other general corporate purposes. See “Use of Proceeds.”

 

Proposed NASDAQ Global Market symbol

“SLNT”

The number of shares of common stock to be outstanding after this offering is based on 6,472,046 shares of common stock outstanding as of February 1, 2008. The number of shares of common stock to be outstanding after this offering does not include:

 

Ÿ  

7,148,563 shares of common stock issuable upon the exercise of stock options outstanding as of February 1, 2008 with a weighted average exercise price of $0.46 per share;

 

Ÿ  

124,222 shares of common stock issuable upon the exercise of warrants outstanding as of February 1, 2008 with a weighted average exercise price of $0.01 per share;

 

Ÿ  

warrants for 906,208 shares of Series D Convertible Preferred Stock, convertible into warrants to purchase 994,563 shares of common stock upon the consummation of this offering, with a weighted average exercise price of $1.263 per share;

 

Ÿ  

warrants for 1,458,580 shares of Series E Convertible Preferred Stock, convertible into warrants to purchase 1,458,580 shares of common stock upon the consummation of this offering, with a weighted average exercise price of $0.21 per share; and

 

Ÿ  

3,345,138 shares of common stock reserved for future issuance under our equity incentive plans.

Unless otherwise indicated, all information in this prospectus assumes that the underwriters do not exercise the option to purchase additional shares of our common stock in this offering and also reflects:

 

Ÿ  

our amended and restated certificate of incorporation and the adoption of our amended and restated by-laws, which will be filed immediately prior to the completion of this offering, effecting a             -to-1 reverse stock split with respect to our outstanding common stock;

 

Ÿ  

the conversion of all our outstanding preferred stock into 77,606,495 shares of common stock upon the consummation of this offering; and

 

Ÿ  

the conversion of warrants to purchase our preferred stock into warrants to purchase our common stock upon the consummation of this offering.

 

 

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Summary Consolidated Financial Data

The following tables summarize our consolidated financial data for the periods presented. You should read the following financial information together with the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes to those consolidated financial statements, appearing elsewhere in this prospectus. The selected consolidated statements of operations data for the fiscal years ended December 31, 2005, 2006 and 2007, and the selected consolidated balance sheet data as of December 31, 2007, are derived from our audited consolidated financial statements, included elsewhere in this prospectus. Reclassifications have been made to our results from prior years to conform to our current presentation. Historical results are not necessarily indicative of the results to be expected in future periods.

Statements of Operations Data

(in thousands, except shares and per share data)

 

     Year Ended December 31,  
     2005     2006     2007  

Net revenue

   $ 12,528     $ 16,899     $ 29,516  

Cost of revenue

     3,626       5,093       8,292  
                        

Gross profit

     8,902       11,806       21,224  

Operating expenses:

      

Research and development

     3,219       2,407       3,044  

Sales and marketing

     11,316       13,864       24,476  

General and administrative

     2,813       3,575       4,336  
                        

Total operating expenses

     17,348       19,846       31,856  
                        

Loss from operations

     (8,446 )     (8,040 )     (10,632 )

Other income (expense), net (1)

     (616 )     (1,480 )     (4,030 )
                        

Loss before taxes

     (9,062 )     (9,520 )     (14,662 )

Income tax (benefit) provision

     (29 )     13       13  
                        

Net loss before cumulative effect of change in accounting principle

     (9,033 )     (9,533 )     (14,675 )

Cumulative effect of change in accounting principle

     65              
                        

Net loss

   $ (9,098 )   $ (9,533 )   $ (14,675 )
                        

Net loss per common share—basic and diluted

   $ (6.76 )   $ (5.58 )   $ (3.45 )
                        

Weighted average common shares outstanding—basic and diluted

     1,346,542       1,707,365       4,258,863  
                        

Pro forma net loss per common share—basic and diluted (2)

       $ (0.16 )
            

Pro forma weighted average common shares outstanding—basic and diluted (2)

         77,652,525  

 

(1) Other income (expense), net is comprised of the following: foreign currency gain or loss, interest income, interest expense, gain or loss on change in fair value of warrant liabilities, and other income.
(2) Unaudited pro forma net loss per common share gives effect to the conversion upon the closing of this offering of all of our then outstanding shares of preferred stock into shares of common stock at their respective conversion ratios and the conversion of our then outstanding warrants to purchase preferred stock into warrants to purchase our common stock, as if these conversions occurred on January 1, 2007, or their original issuance date, if later.

 

 

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Balance Sheet Data

(in thousands)

 

      As of December 31, 2007
   Actual     As Adjusted (1)

Cash, cash equivalents and marketable securities

   $ 13,280    

Working capital

     10,257    

Total assets

     23,913    

Total liabilities

     20,798    

Convertible preferred stock

     93,863    

Accumulated deficit

     (92,510 )  

Total stockholders’ deficit

     (90,748 )  

 

(1) As adjusted information included above in the consolidated balance sheet data gives effect to the conversion upon closing of this offering of all of our then outstanding shares of preferred stock into shares of common stock at their respective conversion ratios, the conversion of our then outstanding warrants for preferred stock into warrants to purchase common stock, resulting in the reclassification of warrants to purchase shares of our Series D and Series E Preferred Stock from long-term liabilities to equity, and our receipt of estimated net proceeds of $            million from our sale of shares in this offering, based on the assumed initial public offering price of $             per share, the midpoint of the range set forth on the cover page of this prospectus, and after deducting the underwriting discount and estimated offering expenses payable by us.

 

     A $1.00 increase (decrease) in the assumed initial public offering price of $             per share, the midpoint of the range set forth on the cover page of this prospectus would increase (decrease) each of cash, cash equivalents and marketable securities, working capital and stockholders’ deficit by approximately $            million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

 

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RISK FACTORS

Investing in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below, together with all of the other information in this prospectus, including the consolidated financial statements and the related notes appearing at the end of this prospectus, before deciding to invest in shares of our common stock. If any of the following risks actually occurs, our business, financial condition, results of operations and future prospects could be materially and adversely affected. In that event, the market price of our common stock could decline, and you could lose part or all of your investment.

Risks Related to our Business and Operations

We have incurred losses since our inception and anticipate that we will continue to incur substantial losses for the foreseeable future. We may never achieve or sustain profitability.

Since we commenced operations in 1999, we have incurred net losses primarily from costs relating to the development and commercialization of our technology. As of December 31, 2007, we had an accumulated deficit of $92.5 million. We expect to significantly increase our investment in our sales and marketing activities to drive sales growth and market penetration of our products and, therefore, we expect to incur net losses over the next several years. This business strategy may not be successful, and we may not become profitable in any future period. If we do become profitable, we cannot be certain that we will be able to sustain or increase profitability on a quarterly or annual basis. Because we have historically had revenues insufficient to cover our expenses, we have funded our operating activities to date primarily from the sale of securities and the incurrence of debt.

We expect to derive a majority of our future revenues from sales of our Aquamantys System. If surgeons and hospitals do not continue to purchase and use our Aquamantys System and other products, our operating results will suffer.

Our success depends on the sale of our Aquamantys System, and whether physicians and hospitals view our Aquamantys System and other products as clinically effective and economically beneficial. For the year ended December 31, 2007, sales related to our Aquamantys System constituted 79% of our total revenue and we expect it will contribute an increasingly greater percentage of our total revenue over the next several years. We do not have long-term contracts with any of our customers for the purchase of our products. We believe that physicians and hospitals will not purchase and use our Aquamantys System and other products unless they determine, based on experience and other factors, that controlling blood loss improves patient outcomes and reduces the cost of patient care and that our Aquamantys System and other products are an attractive alternative to other available methods. In particular, sales of our products, especially our Aquamantys System, may be limited or delayed due to:

 

Ÿ  

the lack of experience among surgeons with our products and methods and the learning process associated with becoming proficient in the use of our products;

 

Ÿ  

the inability to comply with U.S. and foreign regulatory requirements for the design, development, manufacturing, labeling, advertising, promotion and marketing, among other activities, of medical devices;

 

Ÿ  

the perceived liability risks associated with the use of new technologies or procedures for managing blood loss;

 

Ÿ  

unsatisfactory patient outcomes, patient injury, negative publicity or lawsuits against us resulting from the use of our products, including the misuse of our products by physicians that are not properly trained;

 

Ÿ  

adverse results of any on-going or future long-term clinical studies relating to the effectiveness of our Aquamantys system;

 

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the cost of our Aquamantys RF generator and single-use handheld devices and the reluctance of hospital purchasing committees to invest in the Aquamantys System due to budgetary constraints or its lack of compatibility with the medical devices of other providers; and

 

Ÿ  

the availability of alternative treatments or methods that may be perceived to be more effective, safer, faster, easier to use or less costly than our products.

Hospitals and surgeons generally take a considerable amount of time to evaluate our products before deciding to adopt and purchase them. The typical sales cycle from early engagement by our sales force to actual product sale ranges from three to six months. As a result of this long sales cycle, our products may become obsolete before they ever gain widespread market acceptance since we operate in a rapidly changing technology environment and compete with numerous medical equipment companies in marketing to physicians and for often limited hospital budgets. If we fail to convince surgeons and hospitals to adopt and purchase our products rapidly and in large quantities, we may not achieve revenue growth or generate sufficient revenues to continue our operations.

Future clinical data on the Aquamantys System and further long-term data on all of our products may not be consistent with our existing clinical data, which would adversely affect our revenues and our business and could subject us to liability.

Our clinical results with respect to our Aquamantys System are currently supported by studies based on follow up data taken from patients less than one year after surgery in retrospective, non-randomized limited studies. These results may not be replicated in larger or longer term studies, wider patient populations or in studies initiated by other independent clinicians. If future clinical results are not consistent with our existing clinical data, our business could suffer. In addition, if long-term data or clinical experience with any of our products indicate that our products cause permanent tissue damage, motor impairment or other negative effects, we could be subject to significant liability. Such results would also reduce demand for our products and may cause us to recall or withdraw our products from the market or cause us to lose our marketing clearances or approvals, which would adversely affect our revenues and our business.

We currently rely on a sole supplier of manufacturing services to produce our Aquamantys RF generator. If this supplier, or the suppliers of our other products, fail to manufacture adequate quantities of our products in conformity with our quality control standards, our operating results and revenues would be negatively affected.

We currently rely on a sole supplier to manufacture our Aquamantys RF generators. This supplier is a small, privately held German company. We also rely on two contract manufacturing companies to manufacture our single-use handheld products. Our business constitutes over 75% of overall revenue generated by one of these contract manufacturing companies.

Our manufacturers and suppliers may encounter problems during manufacturing due to a variety of reasons, including failure to follow specific protocols and procedures, failure to comply with applicable regulations, including the FDA’s Quality System Regulations (QSRs), equipment malfunction and environmental factors, any of which could delay or impede our ability to meet demand. Our reliance on these outside manufacturers and suppliers also subjects us to other risks that could harm our business, including:

 

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suppliers may make errors in manufacturing components that could negatively affect the efficacy or safety of our products or cause delays in the shipment of our products;

 

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we may not be able to obtain adequate supply in a timely manner or on commercially reasonable terms;

 

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our anticipated growth may strain our suppliers’ ability to provide for the manufacture of an increasingly large supply of our products;

 

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we may have difficulty locating and qualifying alternative suppliers for our single-use handheld devices or Aquamantys RF generators;

 

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our suppliers manufacture products for a range of customers, and fluctuations in demand for the products those suppliers manufacture for others may affect their ability to deliver components to us in a timely manner;

 

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our suppliers may encounter financial hardships unrelated to our demand for components, which could inhibit their ability to fulfill our orders and meet our requirements or cause us to increase the price we pay for the purchased products. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Operations Overview—Cost of Revenues” for additional information about our suppliers and contract manufacturers; and

 

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products manufactured by our suppliers may contain design or manufacturing defects that may be difficult to detect or may fail to meet our quality control specifications.

We are aware of a limited number of instances in which our Aquamantys RF generator did not complete its pre-operative start up cycle before being used on a patient. When this occurs, the system displays an error code and the system becomes inoperable. Upon a customer notifying us of such an error, we provide a replacement Aquamantys RF generator to the customer at no additional charge if the problem cannot otherwise be corrected. We can provide no assurance that the Aquamantys RF generators manufactured in the future will not experience similar problems, or that the corrective actions required to address the current error codes or future error codes will not be classified as recalls based on the risk assessment of the complaints.

Any interruption or delay in the supply of components or materials, or our inability to obtain components or materials from alternate sources at acceptable prices in a timely manner, could impair our ability to meet the demand of our customers and cause them to cancel orders or switch to alternative methods of managing blood loss. If we lose orders or customers we may not be able to generate sufficient revenues to continue our operations.

To mitigate the risk of supply interruptions from a single-source supplier, we may decide in the future to maintain excess inventory of the products or components they supply. Managing our inventory levels affects our cash position and results of operations. An excessive amount of inventory reduces our cash available for operations and may result in excess or obsolete materials and potential write-offs of inventory. Inadequate inventory levels may make it difficult for us to meet customer product demand, resulting in decreased revenues. An inability to forecast future revenues or estimated life cycles of products may result in inventory write-offs that would negatively affect our gross margins and results of operations.

We may not be able to develop and introduce new products or product enhancements in a timely and cost-effective fashion that will be accepted by the market.

We sell our products in a market that is characterized by technological change, product innovation, evolving industry standards, competing patent claims, patent litigation and intense competition. Our success will depend in part on our ability to develop and introduce new products and enhancements or modifications to our existing products, to do so before our competitors and to do so in a manner that is cost-effective and does not infringe patents of third parties to which we do not have a license. We cannot assure you that we will be able to successfully develop or market new, improved or modified products, or that any of our future products will be accepted by our current customers. Our competitors, who often have substantially greater capital resources than we do, also have product development capabilities that could be more effective than our capabilities, and their new products may get to market before our products. In addition, the products of our competitors may be more effective or less expensive than our products. The introduction of new products by our competitors may drive down our prices, reduce our margins, cause loss of our market share or render our products obsolete or noncompetitive. The success of any new product offering or enhancement or modification to an existing product will depend on several factors, including our ability to:

 

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properly identify and anticipate surgeon, hospital and patient needs;

 

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develop new products or enhancements in a timely manner;

 

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obtain the necessary regulatory approvals for new products or product enhancements;

 

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provide adequate training to potential users of new products;

 

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receive adequate reimbursement approval of third-party payors such as Medicaid, Medicare and private insurers; and

 

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develop an effective marketing and distribution network.

Developing products in a timely and cost-effective manner can be difficult, in particular because product designs change rapidly to adjust to patent constraints and to market preferences. As a result, we may experience delays in our product launches which may significantly impede our ability to enter or compete in a given market and may reduce the sales that we are able to generate from these products. We may experience delays in any phase of a product launch, including during research and development, regulatory clearance, manufacturing, marketing and the surgeon training process. In addition, our suppliers of products or components can suffer similar delays, which could cause delays in our product introductions. If we do not develop new products or product enhancements in time to meet market demand or if there is insufficient demand for these new products or enhancements, it could have a material adverse effect on our business, financial condition and results of operations.

We compete in the field of surgical blood loss management against other companies with much greater financial resources, and competition from existing or new products and procedures may reduce our market potential and cause our revenues to decline.

Our focus markets are highly competitive, subject to change and significantly affected by new product introductions and other activities of industry participants. A number of manufacturers make products or technologies involving the use of both RF and saline, as well as bipolar and monopolar devices. These companies include, but may not be limited to, Angiodynamics, Arthrocare, CONMED Medical, Covidien, Erbe, Gyrus, Integra LifeSciences, Johnson & Johnson, Resect Medical, Smith & Nephew, SurgRx and Synergetics. Some of these companies as well as others make products or technologies for blood loss management or dissection that do not involve the use of RF or saline. These products include, but may not be limited to, Covidien’s Ligasure System, Erbe’s Helix Hydro-Jet product, Haemonetics’ Cell Saver and OrthoPAT systems, Integra Life Sciences’ CUSA Ultrasonic Surgical Aspiration System, and Johnson & Johnson’s Harmonic products. Additionally, we face competition from several companies that provide alternative blood loss management methods such as surgical sealants, electrocautery, hemodilution, cell salvage, reinfusion of lost blood, erythropoietin (EPO), ultrasound and hemostatic sponges, which are established methods for managing surgical blood loss and are supported by companies with greater financial resources and market presence.

Our products face competition from alternative procedures which use different kinds of medical devices or techniques that we do not currently develop, promote or sell. Many of the companies that provide these competitive devices have substantially greater capital resources, larger customer bases, broader product lines, larger sales forces, greater marketing and management resources, products and procedures that are less expensive and take less time to perform, broader blood loss reduction product offerings, larger research and development staffs, larger facilities, established reputations with our target customers and worldwide distribution channels that are more developed and effective than ours. Because of the size of the surgical blood loss management market opportunity, our competitors could elect to devote significant resources to developing directly competing products for the management of bleeding during surgery in our focus markets. Competitors may develop technologies and products that are safer, more effective, easier to use, less expensive or more readily accepted than ours. Their products could cause us to experience price pressure or make our technology and products obsolete or noncompetitive. These companies may also be able to achieve more efficient manufacturing and distribution operations than we can and may offer lower prices than we will be able to offer. Any of these competitive factors could adversely impact our business, revenues and results of operations.

 

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If we fail to properly manage the rapid growth and expansion of our sales and marketing organization, and fail to properly execute on our ambitious sales and marketing plans, our business will suffer.

We are currently pursuing a rapid growth strategy with respect to increasing the number of surgeons and hospitals using our products and the number of states in which we have sales representatives selling our products. Such growth will place significant demands on our managerial, operational and financial resources and systems. Specifically, we intend to significantly increase the size of our direct sales and marketing organization in the United States, and to more efficiently utilize our expanded sales force to increase sales coverage for our products. Expanding our sales and marketing organization nationally in the United States is the key to our growth. In addition, we are in the initial stages of building a direct sales organization in the United Kingdom. Expanding a sales and marketing organization on this scale will be expensive, and there is a significant risk that we will not be able to realize an adequate return on this investment within the near term. We have limited experience in sales and marketing of our products, and are pursuing a strategy of building and greatly expanding our own internal sales and marketing organization to sell our products. We are attempting to do so on our own without collaborating with a large corporate partner that has an established sales and marketing organization with greater experience and resources than we currently possess. There are significant risks involved in building and rapidly expanding our own sales and marketing organization, including:

 

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failure to hire and retain sales representatives who are qualified and able to effectively sell new, pioneering medical devices such as our Aquamantys System and our other products to surgeons and hospitals;

 

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failure to hire and retain qualified regional sales managers with the experience and skills necessary to effectively motivate and manage our sales force;

 

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failure to build the proper infrastructure to support an expanding sales organization in the United States and a developing sales organization in the United Kingdom;

 

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failure to adequately train our sales representatives in the use and benefits of our products; and

 

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failure to formulate and implement effective sales and marketing strategies and programs.

If we become subject to product liability claims, we may be required to spend significant time and money in litigation or engage in product recalls, or otherwise pay significant damages that may exceed our insurance coverage.

The manufacture and sale of our products may expose us to product liability claims and product recalls, including those which may arise from the misuse or malfunction of, or design flaws in, our products, or use of our products with components not manufactured by us. Use of our devices may result in a variety of complications, some of which are potentially serious. Complications related to our products may arise from overtreatment of tissue, burns related to the unsuccessful dissipation of the energy generated from our products and other causes.

Successful results using our devices are dependent upon physician technique. Although we inform physicians of the risks associated with failing to follow proper technique, we cannot assure you that these efforts will prevent complications or injury. Without any recommendation from us, a surgeon may choose to use one of our devices in an application that we have not tested and which may result in harm to a patient or a member of the operating room staff.

We carry product liability insurance which is limited in scope and amount and may not be adequate to fully protect us against product liability claims. We could be required to pay damages that exceed our insurance coverage. Any product liability claim, with or without merit, could result in an increase in our product liability insurance rates or our inability to secure coverage on reasonable terms, if at all. Even in the absence of a claim, our insurance rates may rise in the future to a point where we decide not to carry this insurance. Even a meritless

 

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or unsuccessful product liability claim would be time-consuming and expensive to defend and could result in negative publicity and the diversion of our management’s attention from our business. Any of these events could negatively affect our business, results of operations and financial condition.

Hospitals generally do not receive separate reimbursement for the use of our products from governmental and other third party payors, which could harm our domestic sales and revenues.

Procedures using our products in the United States are generally reimbursed based on fixed payment methodologies. Medicare, for example, pays hospitals a prospectively determined amount for inpatient services under the Medicare hospital inpatient prospective payment system (IPPS). The payment amount for a patient’s stay is determined by the patient’s condition, other patient data and procedures performed during the inpatient stay using a classification system known as diagnosis-related groups, or DRGs. As of October 1, 2007, the Centers for Medicare and Medicaid Services, or CMS, implemented a revised version of the DRG system that uses 745 Medicare Severity DRGs, or MS-DRGs, instead of the approximately 540 DRGs Medicare previously used. The MS-DRGs are intended to account more accurately for the patient’s severity of illness when assigning each patient’s stay to a payment classification. Medicare pays a fixed amount to the hospital based on the MS-DRG into which the patient’s stay is assigned, regardless of the actual cost to the hospital of furnishing services to the patient. Accordingly, hospitals do not receive separate Medicare reimbursement under IPPS for the specific costs incurred in purchasing our products. Rather, reimbursement for these costs is deemed to be included within the MS-DRG-based payments made to hospitals for the services furnished to Medicare-eligible inpatients in which our products are utilized. Accordingly, a hospital must absorb the cost of our products as part of the payment it receives for the procedure in which our product is used. Many other private health insurance plans and Medicaid plans also use a DRG system or a per diem payment system in which the payment amount is fixed in advance and does not vary based on the services furnished to the particular patient, and other private health insurance plans pay hospitals a negotiated percentage of the hospital’s charges for each patient.

We do not know the extent to which hospitals would consider third-party reimbursement levels adequate to cover the cost of our products. Failure by hospitals to receive an amount that they consider to be adequate reimbursement for procedures in which our products are used could deter them from purchasing or using our products and limit our sales growth. In addition, Medicare and other insurance payments may be revised in a manner adverse to our business and may decline over time, which could deter hospitals from purchasing or using our products. If hospitals are unable to justify the costs of our products or are not adequately compensated for procedures in which our products are utilized, they may refuse to purchase or use them, which would significantly harm our business.

Third-party payors that do not pay a fixed amount but instead pay based on a percentage of the hospital’s charges (or that adopt another payment methodology in which a separate payment is made for our products) may deny reimbursement for our products if the payor determines that our products are unnecessary, inappropriate, or not cost-effective. Cost control measures adopted by third-party payors may have a significant effect on the number of surgeries performed using our products or on the levels of reimbursement. Coverage and reimbursement for medical technology can differ significantly from payor to payor. There also can be no assurance that current levels of reimbursement will not be decreased or eliminated in the future, or that future legislation, regulation, or reimbursement policies of third-party payors will not otherwise adversely affect the demand for our products or our ability to sell products on a profitable basis.

In international markets, reimbursement and health care payment systems vary significantly by country, and many countries have instituted price ceilings on specific product lines. There can be no assurance that reimbursements will be available for our products or, if available, that third-party payors’ reimbursement policies will not adversely affect our ability to sell our products.

 

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We sell our products internationally and are subject to various risks relating to such international activities which could harm our international sales and revenues.

We sell our products in select international markets through third-party distributors over whom we have limited control. If these distributors fail to adequately market our products, our international sales could decline or fail to grow. If we or any of our distributors terminate our existing distribution agreements, finding companies to replace them could be an expensive and time-consuming process and sales could decrease during any transition period.

During the year ended December 31, 2007, 9% of our net revenues were attributable to international markets. By doing business in international markets, we are exposed to risks separate and distinct from those we face in our domestic operations. Our international business may be adversely affected by changing economic conditions in foreign countries. Because most of our international sales are currently denominated in United States dollars, if the value of the United States dollar increases relative to foreign currencies, our products could become more costly to an international consumer and, therefore, less competitive in international markets, which could affect our revenues.

In addition, engaging in international business inherently involves a number of other difficulties and risks, including:

 

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costly and lengthy export restrictions and controls relating to technology;

 

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cost and difficulty of complying with foreign regulatory regimes and industry standards;

 

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the lack of availability and reduced level of reimbursement within prevailing foreign health care payment systems;

 

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pricing pressure that we may experience internationally;

 

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required compliance with existing and changing foreign regulations and laws;

 

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laws and business practices favoring local companies;

 

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longer payment cycles;

 

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difficulty enforcing agreements and collecting receivables through certain foreign legal systems;

 

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political and economic instability;

 

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potentially adverse tax consequences, tariffs and other trade barriers;

 

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international terrorism and anti-American sentiment;

 

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difficulty and cost of staffing and managing foreign operations; and

 

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difficulty enforcing intellectual property rights.

Each of these risks may increase our costs, lengthen our sales cycle and require significant management attention. Although only a small percentage of our total sales are currently derived from international markets, this percentage may increase in the future, which would increase our exposure to each of these risks.

Our monopolar products are intended to be used with other manufacturers’ RF generators and patient return electrodes. If one or more of the manufacturers of these RF generators or return electrodes chooses to prohibit the use of their products with our products, our business could suffer.

All of our monopolar devices require that they be plugged into an RF generator to provide the RF energy to produce the desired tissue effect. Use of an RF generator in the monopolar mode requires that a large adhesive-backed electrode pad be attached to the patient and plugged into the RF generator. If an RF generator

 

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manufacturer or electrode pad manufacturer contraindicates use of its products with our products, sales of our products to hospitals that own these RF generators and pads could be adversely affected and we could be subject to regulatory enforcement by the FDA if we continue to market our products for use with the contraindicated products.

The actions of our sales representatives during surgical procedures may subject us to liability.

Our sales representatives are often present in the operating room during surgical procedures, either as observers or to provide technical information to the surgeon regarding the operation of our products. Such interactions with the operating surgeon during surgery may subject us and our sales representatives to potential criminal or civil liability. In an attempt to reduce this risk, we instruct our sales representatives not to have direct or indirect contact with a patient during a procedure and to refrain from handling our products, or any other surgical instrument, during a procedure. There can be no assurance, however, that the standard procedures we have implemented will eliminate such actions by our sales representatives during surgery.

We depend on key employees in a competitive market for skilled personnel and, without additional employees, we cannot grow or achieve profitability.

We are highly dependent on our President and Chief Executive Officer, Joseph Army, and the other principal members of our senior management, including the managers of our finance, sales and marketing, regulatory, quality, operations and research and development activities. Due to the specialized knowledge each of our members of senior management possesses with respect to our technology and operations, the loss of service of one or more of these individuals could significantly and adversely affect our ability to operate and manage our business. We do not have any insurance in the event of the death or disability of any of these key personnel. All of our executive officers may terminate their employment without notice and without cause or good reason. We are currently not aware that any executive officer is planning to leave or retire.

In addition, to succeed in the implementation of our business plan, our management team must execute our sales strategy, achieve market acceptance for our Transcollation technology and further develop products, while managing anticipated growth by implementing effective planning, manufacturing and operating processes. Managing this growth will require us to attract and retain additional management and technical personnel.

We rely on direct sales employees to sell our products in the United States and the United Kingdom and primarily on exclusive distributors in markets outside of the United States and the United Kingdom. We are focused on increasing the size and effectiveness of our sales force, marketing activities, sales management team and corporate infrastructure. We intend to significantly increase the size of our current direct sales and marketing organization in the United States and to more efficiently leverage our expanded sales force to increase sales coverage for our products. In addition, we are in the initial stages of building a direct sales organization in the United Kingdom. We cannot assure you that we will be able to attract and retain the additional personnel necessary to grow and expand our business and operations. In addition, any failure to adequately train our employees in the use and benefits of our products will prevent us from achieving our market share and revenue growth goals. If we fail to identify, attract, retain and motivate these highly skilled personnel, we will be unable to achieve the growth in revenues necessary to support our expanded sales and marketing organization, which would harm the quality of our products, our relationships with physicians and hospitals and our reputation. This would have a material adverse effect on our business, financial condition and results of operations.

Because the environment for qualified personnel in all areas of our operations is extremely competitive, costs related to compensation may increase significantly. If we are unable to attract and retain the personnel we need to support and grow our business, our business will suffer.

 

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Risks Related to our Industry and Regulatory Compliance

If we fail to comply with the extensive government regulations relating to our business, we may be subject to fines, injunctions and other civil or criminal penalties.

Our products are classified under the Federal Food, Drug and Cosmetic Act and similar foreign laws as medical devices. Medical devices are subject to extensive regulation in the United States by the Food and Drug Administration, or FDA, and numerous other federal, state and foreign governmental authorities. The FDA regulations specific to medical devices are wide ranging and govern, among other things:

 

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design, development and manufacturing;

 

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testing;

 

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clinical trials in humans;

 

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electronic product safety;

 

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labeling;

 

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storage;

 

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marketing;

 

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pre-market clearance or approval;

 

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record keeping procedures;

 

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advertising and promotion;

 

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post-market surveillance and reporting of deaths, serious injuries or malfunctions; and

 

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export.

The manufacturing and distribution processes used to produce and market our products are required to comply with the FDA’s QSR, which covers the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, sterilization, storage and shipping of our devices. The FDA enforces the QSR through periodic unannounced inspections. If we or the facilities used to manufacture our products fail an FDA inspection, our operations could be disrupted and the supply of our products interrupted. Failure to take adequate and timely corrective action in response to an adverse inspection could force us to stop shipment or distribution or require us to conduct a product recall.

Compliance with these regulations can be complex, expensive and time-consuming. Our failure, or our suppliers’ failure, to comply with such regulations could lead to the issuance of a warning letter or untitled letter, the imposition of injunctions, suspensions or loss of regulatory clearances or approvals, product recalls, orders for repair, replacement or refund, customer notifications, termination of distribution, product seizures or civil penalties. In the most egregious cases, criminal sanctions or closure of our manufacturing facilities or those of our suppliers are possible. If we are required to shut down manufacturing operations or recall any of our products, we may not be able to provide our customers with the quantity of products they require, and we could lose customers and suffer reduced revenue. If we are unable to obtain sufficient quantities 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.

Our products are regulated in the European Union as medical devices per the European Union Directive (93/42/EEC), also known as the Medical Device Directive. An authorized third party, the Notified Body, must approve our products for sale in the European Union, a process known as CE marking. We cannot assure you that we will be able to obtain the CE mark approval for new products in the future. The CE mark is contingent upon our continued compliance with the applicable regulations and the requirements for quality management systems specific in ISO 13485:2003, which is an international quality system standard designed for medical devices.

 

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We are also subject to medical device reporting regulations, or MDRs, that require us to report to the FDA if our products cause or contribute to a death or serious injury or if they malfunction and, if the malfunction were to recur, it would likely cause or contribute to a death or a serious injury. As of February 1, 2008, we have submitted 18 medical device reporting events and conducted two voluntary product recalls. In December 2007, the FDA requested additional information on three MDR reports we submitted in 2006 and 2007 involving accidental burns to patients. We submitted a response to the FDA and have not received any further follow-up regarding these MDRs. However, we cannot assure you that the FDA will not request additional information about these MDRs in the future.

Our failure to comply with applicable regulatory requirements could result in enforcement action by the FDA, which may include any of the above sanctions. In addition, the identification of serious safety risks could result in product recall or withdrawal of our clearance or approval. The imposition of any one or more of these penalties could have a negative effect on our production, revenues and results of operations.

The majority of our products carry the CE Mark and the Medical Device Directives require that we report to the appropriate Competent Authority any malfunction or deterioration in the characteristics and/or performance of a device, as well as any inadequacy in the labeling or instructions for use which, directly or indirectly, might lead to or might have led to the death of a patient, user or other person or to a serious deterioration in their state of health. As of February 1, 2008, we have submitted nine reportable events to a Competent Authority in the European Union, and all related files have been closed without further action required by us.

Our monopolar products are licensed in Japan, which has similar notification requirements for reportable events. As of February 1, 2008, five reportable events have been submitted in Japan for review. There are currently no open communications with the relevant authority in Japan relating to those reportable events.

Our third-party component manufacturers may also be subject to the same sanctions and, as a result, may be unable to supply components for our products. Any failure to retain governmental clearances or approvals that we currently hold or to obtain additional similar clearances or approvals could prevent us from successfully marketing our products and technology and could harm our operating results. Furthermore, changes in the applicable governmental regulations could prevent further commercialization of our products and technologies and could harm our business.

We must comply with various state and federal anti-kickback, false claims and similar laws, the breach of which could cause a material adverse effect on our business, financial condition and results of operations.

Our relationships with surgeons, hospitals and the marketers of our products are subject to scrutiny under various state and federal anti-kickback, false claims and similar laws, often referred to collectively as health care fraud and abuse laws. Health care fraud and abuse laws are complex, and even minor, inadvertent violations can potentially give rise to claims that the relevant law has been violated. Any violations of these laws could result in a material adverse effect on our business, financial condition and results of operations. We cannot assure you that any of the health care fraud and abuse laws will not change or be interpreted in the future in a manner which restricts or adversely affects our business activities or our relationships with surgeons, hospitals and marketers of our products. Moreover, the relationships between medical device companies and surgeons have come under increasing scrutiny by the federal government, with recent enforcement actions by the Department of Justice and the Office of Inspector General of the Department of Health and Human Services as well as Congressional hearings on the issue.

Federal anti-kickback laws and regulations prohibit any knowing and willful offer, payment, solicitation or receipt of any form of remuneration by an individual or entity in return for, or to induce purchasing, leasing, ordering or arranging for any service or product for which payment may be made by a federal government-sponsored health care program.

 

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Possible sanctions for violation of these anti-kickback laws include monetary fines, civil and criminal penalties, exclusion from Medicare and Medicaid programs and forfeiture of amounts collected in violation of such prohibitions. Certain states in which we market our products have similar anti-kickback laws, imposing substantial penalties for violations.

We have a variety of financial relationships with our surgeon consultants that were structured based on fair market value consideration for educational, training, product development and other consulting services performed, including those few situations where we have provided those consultants with options to purchase our stock. We also have a variety of leasing and discount programs with hospital customers relating to our Aquamantys System.

While these transactions were structured with the intention of complying with all applicable laws, including applicable anti-kickback laws, it is possible that regulatory agencies may in the future view these transactions as prohibited arrangements that must be restructured or for which we could be subject to other significant penalties. We would be materially impacted if regulatory agencies interpret our financial relationships with certain surgeons who use our products to be in violation of applicable laws and we were unable to achieve compliance with applicable laws. This could subject us to reputational damage and monetary penalties for non-compliance, the cost of which could be substantial.

We must comply with a variety of other laws, such as laws prohibiting false claims for reimbursement under Medicare and Medicaid, which can also be triggered by violations of federal anti-kickback laws; the Healthcare Insurance Portability and Accounting Act of 1996, which makes it a federal crime to commit health care fraud and make false statements; and the Federal Trade Commission Act and similar laws regulating advertisement and consumer protections. In certain cases, federal and state authorities pursue actions for false claims on the basis that manufacturers and distributors are promoting unapproved or off-label uses of their products. Pursuant to FDA regulations, we can only market our products for cleared or approved indications.

The scope and enforcement of these laws is uncertain and subject to rapid change, especially in light of the lack of applicable precedent and regulations. There can be no assurance that federal or state regulatory authorities will not challenge our current or future activities under these laws. Any such challenge could have a material adverse effect on our business, financial condition and results of operations. Any state or federal regulatory review of us, regardless of the outcome, would be costly and time consuming. Additionally, we cannot predict the impact of any changes in these laws, whether or not retroactive.

Products we intend to sell to foreign markets must comply with country specific regulations which may include obtaining electrical safety approval to market our applicable products under development.

Sales of our products outside the United States are subject to foreign regulatory requirements that vary from country to country. The time required to obtain approvals from foreign countries may be longer than that required for FDA approval or clearance, and requirements for foreign licensing may differ from FDA requirements. In addition, because physicians who work in countries where the government provides and controls health care may be considered government officials in some circumstances, we may be subject to the Foreign Corrupt Practices Act (FCPA), a United States law that bars certain interactions with foreign government officials. We believe we have structured our relationships with foreign physicians to comply with the FCPA, but given the complexity and the ambiguity surrounding this area of the law, we cannot assure you that the Department of Justice will not scrutinize those relationships in the future under the FCPA.

Our products also require electrical safety testing, and in some cases, electromagnetic compatibility testing, as either a product registration or to gain market acceptance. The electrical safety testing and electromagnetic compatibility testing requirements may change and require us to redesign and retest our products. The complexity, timeframes and costs associated with potential redesign and retesting are unknown.

 

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We may be subject to fines, penalties or injunctions if we are determined to be promoting the use of our products for unapproved or “off-label” uses.

Although surgeons are permitted to use medical devices for indications other than those cleared or approved by the FDA based on their medical judgment referred to as off-label uses, we are prohibited from promoting products for such off-label uses. We market our products and provide promotional materials and training programs to surgeons regarding the use of our products. Although we believe our marketing, promotional materials and training programs for surgeons do not constitute promotion of unapproved uses of our products the FDA may disagree. If the FDA determines that our promotional materials or training constitutes promotion of our products for a use not covered by our FDA clearances, it could request that we modify our training or promotional materials or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalties. It is also possible that other federal, state or foreign enforcement authorities might take action if they believe that the alleged improper promotion led to the submission and payment of claims for an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement.

Product sales or introductions may be delayed or canceled as a result of the FDA regulatory process, which could cause our sales or revenues to decline.

The process of obtaining and maintaining regulatory approvals and clearances to market a medical device from the FDA and similar regulatory authorities abroad can be costly and time consuming, and we cannot assure you that such approvals and clearances will be granted. Pursuant to FDA regulations, unless exempt, the FDA permits commercial distribution of a new medical device only after the device has received clearance under section 510(k) of the Federal Food, Drug and Cosmetic Act or is the subject of an approved pre-market approval application. The FDA will clear marketing of a medical device through the 510(k) process if it is demonstrated that the new product is substantially equivalent to a device legally on the market known as a predicate device with respect to intended use, technology, safety and effectiveness. Clinical data is sometimes required to support substantial equivalence. The pre-market approval application process is typically more costly, lengthy and uncertain than the 510(k) process, and must be supported by extensive data, including data from clinical trials. We cannot assure you that any new products, or any product enhancements that we develop, will be permitted to utilize the shorter 510(k) clearance process. Significant delays in the introduction of any new products or product enhancements may occur, if such products or product enhancements are marketed at all. We cannot assure you that the FDA will not require a new product or product enhancement to go through the lengthy and expensive pre-market approval application process. We cannot guarantee that we will receive clearance or approval of any new products or product enhancements in a timely manner or at all.

Delays or failure to obtain regulatory clearances and approvals may:

 

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delay or eliminate commercialization of products we develop;

 

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require us to seek clearance through the more rigorous pre-market approval process, a process in which we do not have substantial institutional experience;

 

Ÿ  

require us to perform costly clinical studies;

 

Ÿ  

diminish any competitive advantages that we may attain; and

 

Ÿ  

reduce our ability to generate revenues.

Although we have obtained 510(k) clearance from the FDA to market our products, the FDA reserves broad discretion to withdraw product clearances based, among other things, on post-market safety data, and we cannot assure you that the clearance of our products will not be withdrawn or that we will not be required to obtain new clearances or approvals for modifications or improvements to our products.

 

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Existing and future modifications to our products may require new marketing clearances or approvals or require us to cease marketing or recall the modified products until such clearance or approvals are obtained.

Any modification to a 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, design or manufacture, requires a new 510(k) clearance or, possibly, approval of a pre-market approval application. The FDA requires every manufacturer to make this determination in the first instance, but the FDA may review any manufacturer’s decision. We have made modifications to elements of our products for which we have not sought additional 510(k) clearance. The FDA may not agree with our decisions regarding whether new clearances or approvals are required. If the FDA disagrees with us, we may be required to cease marketing or to recall the modified product until we obtain clearance or approval. In addition, we could be subject to significant regulatory fines or penalties. Furthermore, our products could be subject to recall if the FDA determines, for any reason, that our products are not safe or effective. Delays in receipt or failure to receive clearances or approvals, the loss of previously received clearances or approvals, or the failure to comply with existing or future regulatory requirements could reduce our sales, revenues and future growth prospects.

Our business activities involve the use of hazardous materials, which require compliance with environmental and occupational safety laws regulating the use of such materials. If we violate these laws, we could be subject to significant fines, liabilities or other adverse consequences.

Our research and development programs and our manufacturing operations involve the controlled use of hazardous materials. Accordingly, we are subject to federal, state and local laws governing the use, handling and disposal of these materials. Although we believe that our safety procedures for handling and disposing of these materials comply in all material respects with the standards prescribed by state and federal regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of an accident or failure to comply with environmental laws, we could be held liable for resulting damages, and any such liability could exceed our insurance coverage.

We may face significant uncertainty in the industry due to government health care reform.

Political, economic and regulatory influences are subjecting the health care industry to fundamental changes. Reforms under consideration in the United States include strengthening the enforcement powers of the FDA, mandated basic health care benefits, controls on health care spending through limitations on the growth of private health insurance premiums and Medicare and Medicaid spending, the creation of large insurance purchasing groups and significant modifications to the health care delivery system. We anticipate that Congress and certain state legislatures will continue to review and assess alternative health care delivery systems and payment methods. Public debate of these issues will likely continue in the future. Due to uncertainties regarding the ultimate features of reform initiatives and their enactment and implementation, we cannot predict which, if any, of such reform proposals will be adopted, when they may be adopted or what impact they may have on us.

Risks Related to Intellectual Property

If a problem arises with our license agreement with Medtronic, our business could suffer.

The intellectual property covering our products includes intellectual property that has been licensed from Medtronic. See “Business—Intellectual Property—Medtronic License Agreement.” Among other things, we are obligated to pay royalties to Medtronic based on the sales of our products. If we fail to comply with this license agreement, we could lose our license and may not be able to manufacture and sell our products without infringing Medtronic’s intellectual property.

Our license agreement with Medtronic gives us a license to a list of patents and also sets limitations on fields of use for those patents that are defined by anatomical location. However, we cannot prevent a surgeon from using one of our products in a field of use that is not authorized under the license agreement. If we or any of

 

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our sublicensees, including such surgeons, use one of our products in a field of use not authorized under the license agreement and such breach is not timely cured, Medtronic has the right to terminate the license agreement. To date, neither Medtronic nor any other party has claimed that we have breached the license agreement or violated their intellectual property rights in relation to unlicensed anatomical locations; however, it is possible that such a claim may arise in the future.

Under the license agreement, Medtronic has a right of first refusal to prosecute claims that third parties have infringed the underlying intellectual property and will retain a majority of the proceeds from any such successful prosecution. If Medtronic does not exercise its right of first refusal, we may prosecute such infringement claims, but must provide Medtronic with a portion of any proceeds.

We have rights to develop wet electrode products for use in the spine, brain, head and neck surgical spaces that are co-exclusive with Medtronic, meaning that Medtronic may independently develop wet electrode devices for these fields of use. Also, our license to make, use and sell interstitial needle products is co-exclusive with Medtronic. Medtronic has no obligation under the license agreement to notify us if it begins to develop or sell competing devices in these fields of use, and due to the larger size and more established reputation of Medtronic, we may not be able to compete effectively with Medtronic. Our license to make, use or sell RF generators is non-exclusive and does not grant back to Medtronic any rights to any intellectual property we have developed or acquired.

Pursuant to amendments to our license agreement, Medtronic has agreed to allow us to satisfy our payment of royalty obligations in the years 2004 through 2008 in the form of promissory notes and warrants. Starting in 2009, we will be obligated to pay royalties to Medtronic in cash.

The rights we are afforded from the Medtronic intellectual property and our own intellectual property may not provide meaningful legal protection for our business, which could enable third parties to market competitive products which could reduce our ability to compete.

We rely on patent protection, as well as a combination of copyright, trade secret and trademark laws and nondisclosure, confidentiality and other contractual restrictions to protect our business interests and/or proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or business, including permitting us to gain or keep any competitive advantage. Our patent applications, as well as any patent applications licensed from Medtronic, may not issue as patents having claims that will be advantageous to us, and may not issue at all. Our patents, as well as any patents licensed from Medtronic, may be challenged, invalidated, unenforceable or circumvented and may not be of sufficient scope or strength to provide us with any meaningful protection or commercial advantage, all of which could limit our ability to stop competitors from marketing competitive products. Further, we cannot assure you that competitors will not infringe our patents or the patents licensed from Medtronic, and we cannot assure you that either we or Medtronic will have adequate resources to enforce those patents.

Although we have taken steps to protect our intellectual property and proprietary technology, there is no assurance that third parties will not be able to market competing products by designing around any patents we obtain, or the patents licensed from Medtronic, or challenge the validity or enforceability of such patents. Furthermore, although we have entered into confidentiality agreements and invention agreements with our employees, consultants and advisors, such agreements may not be enforceable or may not provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements.

Outside of the United States, we seek patent protection for certain inventions in certain countries of the European Union and Japan, two substantial markets for our products where we believe the benefits of seeking patent protection outweigh the costs. In general, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. Foreign countries generally do not allow patents to cover methods for performing surgical procedures. If our intellectual property does not provide

 

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significant protection against competition, our competitors could compete more directly with us, which could result in a decrease in our market share. All of these factors may significantly harm our competitive position.

We also rely on our trademarks, trade names and brand names to distinguish our products and services from the products and services of our competitors, and have registered or applied to register many of these trademarks. We cannot assure you that our trademark applications will be approved. Third parties may also oppose our trademark applications, or otherwise challenge our use of the trademarks. In the event that our trademarks are successfully challenged, we could be forced to rebrand our products and services, which could result in loss of brand recognition, and could require us to devote resources to advertising and marketing new brands.

The medical device industry in general is characterized by extensive patent litigation and we could become subject to litigation that could be costly, result in the diversion of management’s attention, require us to pay damages and/or require us to discontinue selling our products.

The medical device industry is characterized by extensive litigation over patent and other intellectual property rights. Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. A third party may assert that our products, systems and methods of use thereof infringe its United States or foreign patents. This risk is exacerbated by the fact that there are numerous issued patents and pending patent applications relating to the use of RF energy in the medical technology field. For example, we are aware of at least one company that has a very significant patent portfolio consisting of hundreds of patents directed to monopolar and bipolar RF electrosurgical devices and methods used with electrically conductive fluids, particularly saline. We are aware that this company has asserted several of these issued patents against other third parties, and in one case has successfully obtained a judgment that certain claims of the asserted patents were valid and infringed and was awarded substantial damages and an injunction that required the infringing party to stop selling its infringing products and remove them from the market. The judgment of validity and infringement was upheld on appeal. There can be no assurance that this company will not assert one or more of its patents against us in litigation, or that we would be successful in defending ourselves in any such litigation.

While we have never received a notice of patent infringement from a third party and are not aware of any third party patents that we believe are valid, enforceable and infringed by us, a third party may have such a patent that a judge or jury determines we are infringing and may therefore grant damages and/or injunctive relief against us. Furthermore, because patent applications can be, in many circumstances, maintained in secrecy for a period of time after they are filed, there may be patent applications that we are unaware of which are now pending, which may later result in patents having claims that our products infringe. As the number of issued patents and the number of competitors marketing products similar to our products grow, the possibility of patent infringement by us or a patent infringement claim against us increases.

Any litigation or claim against us for infringement of a third party patent could, regardless of merit, cause us to incur substantial costs, could place a significant strain on our financial resources, divert the attention of management from our business and harm our reputation. Such an infringement suit could also force us to stop or delay research, development, manufacturing, or sales of the product(s) or product candidate(s) that is the subject of the suit. If any such third party patent was upheld as valid and enforceable, and if we were found to infringe that patent, we could be liable for substantial past damages (including treble damages if the infringement is found to be willful), and we could be prevented from selling our products unless we can obtain a license to use the inventions covered by such patent or are able to redesign our products to avoid infringement. A license may not be available on terms acceptable to us or at all, and we may not be able to redesign our products to avoid any infringement. Modification of our products or development of new products could require us to conduct additional clinical trials and to revise our filings with the FDA and other regulatory bodies, which would be time- consuming and expensive. If we are not successful in obtaining a license or redesigning our products, we may be unable to sell our products and our business could suffer. In addition, our patents, as well as the patents licensed from Medtronic, may be subject to various invalidity and unenforceability attacks, which might invalidate or limit the scope of the protection that these patents afford. It is possible that any of the above could have a

 

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material adverse effect on the market price of our common stock, and that you could lose a substantial portion of your investment. Infringement and other intellectual property claims and proceedings brought against us, whether successful or not, could also result in substantial costs and harm to our reputation. Such claims and proceedings could also distract and divert management and key personnel from other tasks important to the success of the business.

We may be subject to damages resulting from claims that we or our employees have wrongfully used or disclosed alleged trade secrets of their former employers.

Some of our employees were previously employed at other medical device companies. Although there are no claims currently pending against us, we may be subject to future claims that these employees, or we, have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of these former employers. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. A loss of key research or sales personnel or their work product could hamper or prevent our ability to improve our products or sell our existing products, which would harm our business.

We recently changed our name, and it could become subject to claims of trade name or trademark infringement and litigation that could be costly, result in the diversion of management’s attention, require us to pay damages and/or require us to discontinue using our name.

We have only recently changed our name to Salient Surgical Technologies, Inc. and intend to use both this trade name, and possibly “Salient Surgical” or “Salient,” when dealing with the public in the future. Although we do not believe that our new trade name, or any associated use of the name as a trademark, infringes a trade name or trademark of a third party, a third party may assert that our name, and an associated use of the name as a trademark, infringes their trade name and/or trademark. Any litigation or claim against us for infringement of a trade name or trademark of a third party may cause us to incur substantial costs, place a significant strain on our financial resources, divert the attention of management from our business and harm our reputation. If we were found to infringe a trade name or trademark of a third party, we may be unable to sell our products until the trade name or trademark is removed from our products, and our business could suffer from the resulting disruption.

Risks Related to this Offering

An active, liquid and orderly market for our common stock may not develop.

Prior to this offering there has been no market for shares of our common stock. An active trading market for our common stock may never develop or be sustained, which could depress the market price of our common stock and could affect your ability to sell your shares. The initial public offering price will be determined through negotiations between us and the representatives of the underwriters and may bear no relationship to the price at which our common stock will trade following the completion of this offering. The trading price of our common stock following this offering is likely to be highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. In addition to the factors discussed in this “Risk Factors” section and elsewhere in this prospectus, these factors include:

 

Ÿ  

our operating performance and the operating performance of similar companies;

 

Ÿ  

the overall performance of the equity markets;

 

Ÿ  

announcements by us or our competitors of acquisitions, business plans or commercial relationships;

 

Ÿ  

threatened or actual litigation;

 

Ÿ  

changes in laws or regulations relating to the sale of medical devices;

 

Ÿ  

any major change in our board of directors or management;

 

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Ÿ  

publication of research reports or news stories about us, our competitors or our industry or positive or negative recommendations or withdrawal of research coverage by securities analysts;

 

Ÿ  

large volumes of sales of our shares of common stock by existing stockholders; and

 

Ÿ  

general political and economic conditions.

In addition, the stock market in general, and the market for medical device-related companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These fluctuations may be even more pronounced in the trading market for our stock shortly following this offering. Securities class action litigation has often been instituted against companies following periods of volatility in the overall market and in the market price of a company’s securities. This litigation, if instituted against us, could result in very substantial costs, divert our management’s attention and resources and harm our business, operating results and financial condition.

Future sales of shares of our common stock by us or our existing stockholders could depress the market price of our common stock.

The market price of our common stock may decline if we or our stockholders sell shares of our common stock after this offering. Our amended and restated certificate of incorporation will authorize us to issue              shares of common stock, of which              shares will be outstanding upon consummation of this offering. This number includes shares that we are selling in this offering (or              shares, if the underwriters exercise their option to purchase additional shares from us in full) and that will be freely tradable immediately after this offering (except for shares purchased by affiliates). The remaining              shares may be sold upon the expiration of lock-up agreements between our current stockholders and the underwriters 180 days after the date of this offering (which period could be extended by the underwriters for an additional 34 days under certain circumstances) under Rule 144 and Rule 701 of the Securities Act, subject in some cases to volume limitations. In addition, as of February 1, 2008, we had outstanding options to purchase 7,148,563 shares of common stock and, upon consummation of this offering, we will have outstanding warrants to purchase              shares of common stock, that, if exercised, will result in these additional shares becoming available for sale upon expiration of the lock-up agreements. A large portion of these shares, options and warrants are held by a small number of persons and investment funds. Sales by these stockholders or optionholders of a substantial number of shares after this offering could significantly reduce the market price of our common stock. Moreover, after this offering, the holders of              shares of our common stock will have rights, subject to some conditions, to require us to file registration statements covering the shares they currently hold, or to include these shares in registration statements that we may file for ourselves or other stockholders.

We also intend to register all common stock that we may issue under our 1999 Plan and 2003 Plan. Upon the completion of this offering, an aggregate of              shares of our common stock will be reserved for future issuance under these plans. Once we register these shares, which we plan to do shortly after the completion of this offering, they can be freely sold in the public market upon issuance, subject to the lock-up agreements referred to above. If a large number of these shares are sold in the public market, the sales could reduce the trading price of our common stock. See “Shares Eligible for Future Sale” for a more detailed description of sales that may occur in the future.

You will experience immediate and substantial dilution.

The initial public offering price will be substantially higher than the net tangible book value of each outstanding share of common stock immediately after this offering. If you purchase common stock in this offering, you will suffer immediate and substantial dilution. At an assumed initial public offering price of $            , the mid-point of the range set forth on the cover of this prospectus, and with net proceeds of $              million, after deducting estimated underwriting discounts and commissions and estimated offering expenses, investors who purchase shares in this offering will have contributed approximately     % of the total amount of funding we have received to date, but will only hold approximately     % of the total voting rights. The dilution

 

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will be $              per share in the net tangible book value of the common stock from the assumed initial public offering price. In addition, if outstanding options to purchase shares of our common stock are exercised, there could be further dilution. For more information refer to “Dilution.”

We have broad discretion in the use of the net proceeds from this offering and may not use them effectively.

We cannot specify with certainty the particular uses of the net proceeds we will receive from this offering. Our management will have broad discretion in the application of the net proceeds, including for any of the purposes described in “Use of Proceeds.” Accordingly, you will have to rely upon the judgment of our management with respect to the use of the proceeds, with only limited information concerning management’s specific intentions. Our management may spend a portion or all of the net proceeds from this offering in ways that our stockholders may not desire or that may not yield a favorable return. The failure by our management to apply these funds effectively could harm our business. Pending their use, we may invest the net proceeds from this offering in a manner that does not produce income or that loses value.

A limited number of stockholders will have the ability to influence the outcome of director elections and other matters requiring stockholder approval.

After this offering, our directors, executive officers and their affiliated entities will beneficially own more than              percent of our outstanding common stock. These stockholders, if they act together, could exert substantial influence over matters requiring approval by our stockholders, including the election of directors, the amendment of our certificate of incorporation and by-laws and the approval of mergers or other business combination transactions. This concentration of ownership may discourage, delay or prevent a change in control of our company, which could deprive our stockholders of an opportunity to receive a premium for their stock as part of a sale of our company and might reduce our stock price. These actions may be taken even if they are opposed by other stockholders, including those who purchase shares in this offering.

As a public company, we will incur increased costs as a result of recently enacted and proposed changes in laws and regulations relating to corporate governance matters.

As a public company, recently enacted and proposed changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules adopted or proposed by the United States Securities and Exchange Commission, or SEC, and by The NASDAQ Global Market, will result in increased costs to us. These laws and regulations will also make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. We cannot estimate the amount or timing of additional costs we may incur as a result of these laws and regulations.

Section 404 of the Sarbanes-Oxley Act of 2002 will require us to document and test the effectiveness of our internal control over financial reporting in accordance with an established internal control framework and to report on our conclusion as to the effectiveness of our internal controls. It will also require an independent registered public accounting firm to test our internal control over financial reporting and report on the effectiveness of such controls for our fiscal year ending December 31, 2009 and subsequent years. In addition, upon completion of this offering, we will be required under the Securities Exchange Act of 1934 to maintain disclosure controls and procedures and internal control over financial reporting. Moreover, it may cost us more than we expect to comply with these control- and procedure-related requirements.

We may in the future discover areas of our internal controls that need improvement. We cannot be certain that any remedial measures we take will ensure that we implement and maintain adequate internal controls over our financial processes and reporting in the future. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet

 

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our reporting obligations. If we are unable to conclude that we have effective internal control over financial reporting, or if our independent registered public accounting firm is unable to provide us with an unqualified opinion regarding the effectiveness of our internal control over financial reporting as of December 31, 2009 and in future periods as required by Section 404, investors could lose confidence in the reliability of our consolidated financial statements, which could result in a decrease in the value of our common stock. Failure to comply with Section 404 could potentially subject us to sanctions or investigations by the SEC, The NASDAQ Global Market or other regulatory authorities.

Provisions in our certificate of incorporation and by-laws or Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock.

Provisions of our certificate of incorporation and by-laws and Delaware law may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares of our common stock. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:

 

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limitations on the removal of directors;

 

Ÿ  

advance notice requirements for stockholder proposals and nominations;

 

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the inability of stockholders to act by written consent or to call special meetings;

 

Ÿ  

the ability of our board of directors to make, alter or repeal our by-laws;

 

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and the ability of our board of directors to designate one or more series of preferred stock and issue preferred stock without stockholder approval.

The affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation. In addition, our board of directors has the ability to designate the terms of and issue new series of preferred stock without stockholder approval. Also, absent approval of our board of directors, our by-laws may only be amended or repealed by the affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote.

In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns, or within the last three years has owned, 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner.

The existence of the foregoing provisions and anti-takeover measures could limit the price that investors might be willing to pay in the future for shares of our common stock. They could also deter potential acquirers of our company, thereby reducing the likelihood that you could receive a premium for your common stock in an acquisition.

We do not currently intend to pay dividends on our common stock and, consequently, your ability to achieve a return on your investment will depend on appreciation in the price of our common stock.

We have never declared or paid any cash dividends on our common stock and do not currently intend to do so for the foreseeable future. We currently intend to invest our future earnings, if any, to fund our growth. Therefore, you are not likely to receive any dividends on your common stock for the foreseeable future and the success of an investment in shares of our common stock will depend upon any future appreciation in its value. There is no guarantee that shares of our common stock will appreciate in value or even maintain the price at which our stockholders have purchased their shares.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that involve substantial risks and uncertainties. All statements, other than statements of historical facts, included in this prospectus regarding our strategy, future operations, future financial position, future revenues, projected costs, prospects and plans and objectives of management are forward-looking statements. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We have based these forward-looking statements on our current expectations and projections about future events. Although we believe that the expectations underlying each of our forward-looking statements are reasonable, these expectations may prove to be incorrect. All of these statements are subject to risks and uncertainties. Should one or more of these risks and uncertainties materialize, or should underlying assumptions, projections or expectations prove incorrect, actual results, performance or financial condition may vary materially and adversely from those anticipated, estimated or expected.

We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. We have included important factors in the cautionary statements included in this prospectus, particularly in the section entitled “Risk Factors” that we believe could cause actual results or events to differ materially from the forward-looking statements that we make. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments that we may undertake. We do not assume any obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

INDUSTRY DATA

The market data and other statistical information used throughout this prospectus are based on government publications, clinical studies and other independent sources. Some data are also based on our good faith estimates, which are derived from our review of internal data, as well as the sources referenced herein. Although we believe these sources are reliable, we have not independently verified the information.

 

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USE OF PROCEEDS

We estimate that the net proceeds to us from the sale of the              shares of common stock in this offering will be approximately $              million at an assumed initial public offering price of $              per share, the midpoint of the range set forth on the cover page of this prospectus, and after deducting estimated underwriting discounts and commissions and estimated offering expenses. A $1.00 increase (decrease) in the assumed initial public offering price would increase (decrease) our net proceeds from this offering by $            , assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same.

The principal purposes of this offering are to obtain additional capital, to create a public market for our common stock and to facilitate our future access to the public equity markets. We currently anticipate that we will use the net proceeds of this offering, together with our cash, cash equivalents and marketable securities, which totaled approximately $13.3 million as of December 31, 2007, to fund our sales and marketing expansion, new product development, for repayment of certain indebtedness and for working capital and other general corporate purposes. We have not determined specific amounts of net proceeds to be used for any of these purposes. For information on our outstanding indebtedness, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Sources of Liquidity.”

The amounts actually expended for these purposes may vary significantly and will depend on a number of factors, including future sales growth, if any, the amount of cash we generate from future operations, the actual expenses of operating our business, opportunities that may be or become available to us and the other factors described under “Risk Factors.” In addition, we will retain broad discretion in the allocation of the net proceeds of this offering. Should we determine to employ cash resources for the acquisition of complementary businesses, products or technologies, the amounts available for the purposes cited above may be significantly reduced. Although we evaluate strategic investments or potential acquisitions in the ordinary course of business, we have no specific understandings, commitments or agreements with respect to any acquisition or investment at this time.

Until we use the net proceeds of this offering for the above purposes, we intend to invest the funds in short-term, investment-grade, interest-bearing securities. We cannot predict whether the proceeds invested will yield a favorable return, if any.

This anticipated use of the net proceeds of this offering represents our current intentions based upon our present plans and business condition. The amounts and timing of our actual expenditures will depend upon numerous factors, including cash flows from operations and the anticipated growth of our business. We will retain broad discretion in the allocation and use of our net proceeds.

DIVIDEND POLICY

We have never declared or paid any dividends on our capital stock. We anticipate that we will retain any earnings to support operations and to finance the growth and development of our business. Therefore, we do not expect to pay cash dividends in the foreseeable future. Generally, any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including earnings, capital requirements, financial condition, prospects and other factors that our board of directors may deem relevant. In addition, the terms of the agreements governing the outstanding indebtedness and any series of preferred stock we may issue in the future may limit our ability to pay dividends on our common stock.

 

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CAPITALIZATION

The following table sets forth our cash and cash equivalents, marketable securities and capitalization as of December 31, 2007:

 

Ÿ  

on an actual basis; and

 

Ÿ  

on an as adjusted basis to reflect:

 

  Ÿ  

the conversion of all of our outstanding preferred stock into 77,606,495 shares of our common stock;

 

  Ÿ  

the conversion of all of our outstanding warrants to acquire shares of our preferred stock into warrants to acquire shares of our common stock; and

 

  Ÿ  

the receipt by us of net proceeds of $              million from the sale of the              shares of common stock offered by us in this offering at an assumed public offering price of $              per share, the midpoint of the range set forth on the cover page of this prospectus, less underwriting discounts and commissions and estimated offering expenses payable by us.

You should read this information together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” our consolidated financial statements and the notes to those statements appearing elsewhere in this prospectus.

 

     As of December 31, 2007
     Actual     As Adjusted
     (in thousands, except share data)

Cash, cash equivalents and marketable securities

   $ 13,280    

Long-term debt, including current portion

   $ 10,959    

Total redeemable convertible preferred stock

   $ 93,863    

Stockholders’ deficit

    

Common stock, $0.01 par value; 68,000,000 shares authorized, 6,472,046 shares issued and outstanding, actual;                  shares authorized,              shares issued and outstanding, as adjusted

   $ 65    

Additional paid-in capital

     1,674    

Accumulated deficit

     (92,510 )  

Accumulated other comprehensive loss

     23    
          

Total stockholders’ equity (deficit)

   $ (90,748 )  
          

Total capitalization

   $ 14,074    
          

The outstanding share information in the table above excludes the following, as of December 31, 2007:

 

Ÿ  

5,395,235 shares of common stock issuable upon the exercise of stock options outstanding with a weighted average exercise price of $0.30 per share;

 

Ÿ  

124,222 shares of common stock issuable upon the exercise of warrants outstanding with a weighted average exercise price of $0.01 per share;

 

Ÿ  

warrants for 906,208 shares of Series D Convertible Preferred Stock, convertible into warrants to purchase 994,563 shares of common stock upon consummation of this offering, with a weighted average exercise price of $1.263 per share;

 

Ÿ  

warrants for 1,458,580 shares of Series E Convertible Preferred Stock, convertible into warrants to purchase 1,458,580 shares of common stock with a weighted average exercise price of $0.21 per share; and

 

Ÿ  

5,098,466 shares of common stock reserved for future issuance under our equity incentive plans.

Each $1.00 increase (decrease) in the assumed initial public offering price of $                 per share, the midpoint of the range set forth on the cover page of this prospectus, would increase (decrease) each of cash, cash equivalents & marketable securities, additional paid-in capital, total stockholders’ equity (deficit) and total capitalization by approximately $                 million, assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same.

 

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DILUTION

If you invest in our common stock in this offering, your interest will be diluted to the extent of the difference between the public offering price per share of our common stock and the pro forma net tangible book value per share of our common stock.

The net tangible book value of our common stock as of December 31, 2007 was ($90.7) million or ($14.02) per share. Net tangible book value per share represents the amount of stockholders’ deficit divided by shares of common stock outstanding at that date. The pro forma net tangible book value of our common stock as of December 31, 2007 was $6.9 million, or approximately $0.08 per share, excluding proceeds from this offering. Pro forma net tangible book value gives effect to the conversion of all shares of outstanding preferred stock into shares of common stock and the conversion of all outstanding warrants to acquire preferred stock into warrants to acquire common stock upon the closing of this offering.

Net tangible book value dilution per share to new investors represents the difference between the amount per share paid by purchasers of common stock in this offering and the pro forma net tangible book value per share of common stock immediately after completion of this offering. After giving effect to our sale of              shares of common stock in this offering at an assumed initial public offering price of $              per share, and after deducting estimated underwriting discounts and commissions and estimated offering expenses, our pro forma net tangible book value as of December 31, 2007 would have been $              per share. This represents an immediate increase in net tangible book value of $              per share to existing stockholders and an immediate dilution in net tangible book value of $              per share to purchasers of common stock in this offering, as illustrated in the following table:

 

Assumed offering price per share

      $             

Pro forma net tangible book value per share as of December 31, 2007

   $                

Increase in pro forma net tangible book value per share attributable to this offering

     

Pro forma net tangible book value per share after the offering

     

Net tangible book value dilution per share to new investors

      $  

A $1.00 increase (decrease) in the assumed initial public offering price of $             per share, the midpoint of the range set forth on the cover page of this prospectus, would increase (decrease) our pro forma net tangible book value per share after this offering by $             per share and the dilution in pro forma net tangible book value per share to investors in this offering by $              per share, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

Assuming the exercise in full of the underwriters option to purchase additional shares from us, our pro forma net tangible book value after this offering at December 31, 2007 would have been approximately $              per share, representing an immediate increase in the pro forma net tangible book value of $              per share to our existing stockholders and an immediate decrease in net tangible book value of $              per share to new investors.

The following table summarizes, on a pro forma basis, as of December 31, 2007, the difference between the number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid by existing stockholders of our common stock outstanding as of December 31, 2007 assuming full conversion of our convertible preferred stock and by new investors at an assumed initial public offering price of $              per share, before deducting estimated underwriting discounts and commissions and estimated offering expenses.

 

     Shares Purchased    Total Consideration    Average Price
Per Share
     Number    Percent    Amount    Percent   

Existing stockholders

         $                   $            

New investors

              
                      

Total

              
                      

 

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The above discussion and tables are based on 6,472,046 shares of common stock outstanding as of December 31, 2007, and excludes:

 

Ÿ  

5,395,235 shares of common stock issuable upon the exercise of stock options outstanding with a weighted average exercise price of $0.30 per share;

 

Ÿ  

124,222 shares of common stock issuable upon the exercise of warrants outstanding with a weighted average exercise price of $0.01 per share;

 

Ÿ  

warrants for 906,208 shares of Series D Convertible Preferred Stock, convertible into warrants to purchase 994,563 shares of common stock upon consummation of this offering, with a weighted average exercise price of $1.263 per share;

 

Ÿ  

warrants for 1,458,580 shares of Series E Convertible Preferred Stock, convertible into warrants to purchase 1,458,580 shares of common stock with a weighted average exercise price of $0.21 per share; and

 

Ÿ  

5,098,466 shares of common stock reserved for future issuance under our equity incentive plans.

Assuming the exercise in full of all vested stock options and vested warrants outstanding as of December 31, 2007, the average price per share paid by our existing stockholders would be reduced by $              per share to $              per share and our pro forma net tangible book value per share as of December 31, 2007 would be $              per share, representing an immediate increase in pro forma net tangible book value per share of $             to existing stockholders and an immediate dilution per share to new investors in this offering of $              per share.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following tables summarize our consolidated financial data for the periods presented. You should read the following financial information together with the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes to those consolidated financial statements appearing elsewhere in this prospectus. The selected consolidated statements of operations data for the fiscal years ended December 31, 2005, 2006 and 2007, and the selected consolidated balance sheet data as of December 31, 2006 and 2007, are derived from our audited consolidated financial statements included elsewhere in this prospectus. The selected consolidated statements of operations data for the years ended December 31, 2003 and 2004, and the consolidated balance sheet data at December 31, 2003, 2004 and 2005, are derived from our audited consolidated financial statements not included in this prospectus. Reclassifications have been made to our results from prior years to conform to our current presentation. Historical results are not necessarily indicative of the results to be expected in future periods.

 

Statement of Operations Data   Year Ended December 31,  
  2003     2004     2005     2006     2007  
    (in thousands, except shares and per share data)  

Net revenue

  $ 5,443     $ 8,872     $ 12,528     $ 16,899     $ 29,516  

Cost of revenue

    1,610       2,449       3,626       5,093       8,292  
                                       

Gross profit

    3,833       6,423       8,902       11,806       21,224  

Operating expenses:

         

Research and development

    3,923       2,915       3,219       2,407       3,044  

Sales and marketing

    13,601       13,120       11,316       13,864       24,476  

General and administrative

    2,197       2,600       2,813       3,575       4,336  

Loss on sales and disposals of fixed assets

    296       49                    
                                       

Total operating expenses

    20,017       18,684       17,348       19,846       31.856  
                                       

Loss from operations

    (16,184 )     (12,261 )     (8,446 )     (8,040 )     (10,632 )

Other income (expense), net(1)

    142       23       (616 )     (1,480 )     (4,030 )
                                       

Loss before taxes

    (16,042 )     (12,238 )     (9,062 )     (9,520 )     (14,662 )

Income tax provision (benefit)

    123       267       (29 )     13       13  
                                       

Net loss before cumulative effect of change in accounting principle

  $ (16,165 )   $ (12,505 )   $ (9,033 )   $ (9,533 )   $ (14,675 )

Cumulative effect of change in accounting principle

                (65 )            
                                       

Net loss

  $ (16,165 )   $ (12,505 )   $ (9,098 )   $ (9,533 )   $ (14,675 )

Net loss per common share – basic and diluted before cumulative effect of change in accounting principle

  $ (14.97 )   $ (10.35 )   $ (6.71 )   $ (5.58 )   $ (3.45 )

Net loss per common share – basic and diluted cumulative effect of change in accounting principle

    —         —       $ (0.05 )     —         —    
                                       

Net loss per share – basic and diluted

  $ (14.97 )   $ (10.35 )   $ (6.76 )   $ (5.58 )   $ (3.45 )
                                       

Weighted average common shares outstanding – basic and diluted

    1,079,779       1,208,655       1,346,542       1,707,365       4,258,863  
                                       

Pro forma net loss per common share – basic and diluted(2) (unaudited)

          $ (0.16 )
               

Pro forma weighted average shares outstanding – basic and diluted(2) (unaudited)

            77,652,525  

 

(1) Other income (expense), net is comprised of the following: foreign currency gain or loss, interest income, interest expense, gain or loss on change in fair value of warrant liabilities, and other income.

 

(2) Unaudited pro forma net loss per common share gives effect to the conversion upon the closing of this offering of all of our issued and outstanding shares of preferred stock into shares of common stock at their respective conversion ratios and the conversion of our then outstanding warrants to purchase preferred stock into warrants to purchase our common stock, as if these conversions occurred on January 1, 2007, or their original issuance date, if later.

 

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Balance Sheet Data    As of December 31,  
   2003     2004     2005     2006     2007  
     (in thousands)  

Cash, cash equivalents and marketable securities

   $ 22,659     $ 11,266     $ 9,985     $ 4,257     $ 13,280  

Working capital (deficit)

     21,880       8,053       9,632       (72 )     10,257  

Total assets

     26,263       15,297       14,469       11,844       23,913  

Total liabilities

     4,883       6,342       14,618       21,324       20,798  

Convertible preferred stock

     67,992       67,992       67,990       67,990       93,863  

Accumulated deficit

     (46,699 )     (59,204 )     (68,302 )     (77,835 )     (92,510 )

Total stockholders’ deficit

   $ (46,612 )   $ (59,037 )   $ (68,139 )   $ (77,470 )   $ (90,748 )

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with our consolidated financial statements, the related notes to those financial statements and the other financial information that appear elsewhere in this prospectus. This discussion contains predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including those set forth in the section entitled “Risk Factors” and elsewhere in this prospectus.

Business Overview

We are a medical technology company that develops and markets surgical products based on our proprietary Transcollation technology platform for the sealing of blood vessels and other collagen-based structures. We believe that our products improve surgical procedures and patient outcomes by enabling surgeons to substantially reduce blood loss during and after surgery. Our Transcollation technology has been used in over 165,000 surgical procedures to date. We believe our Transcollation technology provides clinical and economic benefits to patients, physicians, hospitals and payors by addressing many of the limitations of alternative blood loss management methods. Our Transcollation technology is designed to deliver an optimized combination of RF energy and electrically conductive fluid, such as saline, to permanently seal blood vessels and other collagen-based structures in soft-tissue and bone. We focus on selling our products for use in orthopaedic hip and knee reconstructions and multi-level spinal fusions, which are significant markets with over 1.3 million procedures performed in the United States in 2007. We estimate that our technology was used in approximately 4% of these targeted procedures in the United States in 2007. Our Transcollation technology is also used in surgical oncology procedures and may be used in other surgical procedures including trauma, single-level spinal fusions, minimally invasive spine and advanced laparoscopic procedures, which are markets we intend to pursue in the future.

We were founded in 1999, and initially we devoted the majority of our resources to research and development activities. We launched our first Transcollation product line in 2001 based on the intellectual property licensed from Medtronic that we have further developed and enhanced. This product line is made up of a series of monopolar single-use handheld devices used in solid organ tumor removal for blunt dissection and to control bleeding. These handheld devices are powered by RF generators already in place in hospitals. Since product launch, we have proven the high clinical value of these devices by gaining an estimated 30% share of the liver resection market in the United States.

We launched our second Transcollation product line in 2002 with the introduction of our single-use handheld bipolar devices, which were used to control bleeding in orthopaedic hip and knee reconstructive procedures. We further enhanced our bipolar Transcollation technology and launched our flagship Aquamantys single-use handheld devices and Aquamantys RF generator (collectively, the Aquamantys System) in the first quarter of 2006. As of December 31, 2007, 75,000 procedures have been performed with the Aquamantys System. We discontinued selling our earlier generation bipolar products in September 2007.

Our goal is to establish our Transcollation technology as the standard of care for controlling surgical-related blood loss. In the United States, we sell our products through a direct sales organization comprised of approximately 70 sales representatives and eight managers. We intend to significantly expand the size of our direct sales force in the United States in order to grow our customer base and further penetrate existing accounts.

For the year ended December 31, 2007, we generated net revenues of $29.5 million, of which approximately 91% were generated in the United States. In 2007, we incurred a net loss of $14.7 million and our cumulative losses since inception total approximately $92.5 million. Our net revenues are derived from the sale of our proprietary single-use handheld devices and Aquamantys RF generators, which comprised 96% and 4% of our net revenues, respectively, in 2007. We expect that the percentage of net revenues derived from the sales of our single-use handheld devices and Aquamantys RF generators will remain relatively constant during the next 12 months.

 

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Our objective is to increase the number of Aquamantys RF generators placed in hospitals in order to develop a recurring revenue stream from the sale of our single-use handheld devices. We are focused on increasing the number of direct sales representatives in the United States and the number of active accounts to drive an increase in single-use handheld device revenue generated per account. In order to determine our level of success in achieving these objectives, we continually evaluate the number of our direct sales representatives in the United States, the number of new accounts added, the average amount of single-use handheld device revenue generated per account and the amount of single-use hand held device revenue generated per sales representative on a quarterly basis.

Financial Operations Overview

Net Revenues

We derive a majority of our revenues from the sale of our proprietary single-use handheld devices. Our revenue growth in the past two years has been largely driven by an increase in the sales of our Aquamantys single-use handheld devices and we expect this trend to continue. We offer our customers the opportunity to acquire the Aquamantys RF generator by committing to purchase a minimum number of Aquamantys single-use handheld devices on a quarterly basis over a defined period of time, not to exceed two years. We also offer our customers the opportunity to purchase or rent the Aquamantys RF generator. To date, the majority of our Aquamantys RF generators have been acquired through minimum volume purchase commitments. The minimum purchase commitments can be canceled by our customers for a nominal fee prior to completion, at which point the Aquamantys RF generator would be returned to us. Upon the completion of the purchase commitment, title to the Aquamantys RF generator is transferred to the customer.

Our list price for the Aquamantys RF generator as of December 31, 2007, was $14,500 and our list price for the Aquamantys single-use handheld devices was $525 each, or $475 each when purchased in quantities of five or more. As of March 1, 2008, our list price for the Aquamantys RF generator increased to $17,500, and our list price for the Aquamantys single-use handheld devices increased to $545 each, or $495 each when purchased in quantities of ten or more. The list prices for our monopolar single-use handheld devices range from $800 each when purchased in quantities of five or more to $995 when purchased individually.

Approximately 91% of our revenues in 2007 were generated in the United States through our direct sales channels. Outside of the United States, we utilize a network of nine international distributors to sell our products, and we sell directly into the United Kingdom. We recognize revenue upon shipment to our international distributors.

Cost of Revenues

We outsource the manufacturing, packaging, labeling and sterilization of all of our products. Our cost of revenues represents our third party manufacturers’ selling prices and delivery charges associated with the purchase of single-use handheld devices and the Aquamantys RF generator. Cost of revenues also includes our operations personnel and related costs, the cost of inspecting products prior to sale, depreciation expense, the repair of products during the warranty period and license royalties. Under the terms of our licensing agreement with Medtronic, we pay royalties on product sales at rates ranging from 2.0% to 7.5% of net product sales based on our product sales mix and cumulative volume of sales to date. We have entered into an agreement with Medtronic to finance these quarterly royalty payments through 2008 by issuing promissory notes and warrants to purchase shares of our preferred stock convertible into shares of our common stock upon consummation of this offering. Starting in 2009, we will be obligated to pay royalties to Medtronic in cash.

Because we outsource the manufacturing, packaging, labeling, and sterilization of all of our products, our cost of revenues depends upon the cost at which we can obtain products from third party suppliers. The cost of our Aquamantys single-use handheld devices decreased by approximately 7.5% in 2007. However, in the fourth

 

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quarter of 2007, we agreed to grant our primary contract manufacturer a temporary price increase of approximately 8.0% through 2008, which will be used to scale its manufacturing capacity. In addition, we plan to bring a second contract manufacturer on-line to manufacture our Aquamantys single-use handheld devices in the first quarter of 2008.

Our purchase cost for the Aquamantys single-use handheld devices from this second contract manufacturer will be slightly higher than the purchase cost from our existing contract manufacturer until certain volume levels are attained, which we believe will occur by the end of 2008. We anticipate that cost of revenues as a percentage of sales will increase in 2008 as a result of the temporary price increase granted to our primary contract manufacturer and the addition of a second contract manufacturer, but will decrease thereafter as a percentage of sales once the temporary price increase granted to our primary contract manufacturer expires and our second contract manufacturer has achieved certain volume levels.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of compensation and travel-related expenses for sales, marketing, clinical and customer service personnel. The compensation package for our direct sales force and sales management team in the United States is comprised of a base salary plus commission structured to drive revenue growth. The commission portion of each individual’s compensation package varies and consists of two rate tiers: a lower commission rate paid based on all revenue equal to the prior year revenue and a higher rate paid on incremental revenue over the prior year. Also included in sales and marketing costs are post-commercial clinical activities, trade show exhibits, industry conferences and educational materials. We anticipate that sales and marketing expenses will continue to increase in absolute dollars as we add sales and marketing personnel and broaden our marketing initiatives to increase awareness of our Aquamantys System, but we anticipate that such expenses will decrease as a percentage of sales going forward. In our experience, it generally takes three to six months for a sales representative to begin generating revenues in an amount sufficient to cover their monthly expenses and approximately one year to become break-even. Because of our recent sales force expansion, we have not yet fully realized the potential operating leverage from the United States sales force.

Research and Development Expenses

Research and development expenses consist primarily of compensation and related expenses for research and development, regulatory and quality assurance personnel, as well as costs related to development work conducted by third parties, materials and supplies. We anticipate that research and development expenses will continue to increase in the near term as we seek to develop new products and further enhance our Aquamantys System, expand our intellectual property portfolio and explore new clinical applications.

General and Administrative Expenses

General and administrative expenses consist primarily of personnel expenses for accounting, human resources, information technology and corporate administration, as well as legal fees, accounting fees and facilities expenses. We expect that general and administrative expenses will increase in absolute dollars in the near term due to the cost of being a public company and the increase in our infrastructure to support anticipated revenue growth, but we anticipate these expenses will decrease as a percentage of sales going forward.

Other Income (Expense), net

Other income (expense), net consists of interest expense on our senior debt, notes payables, short-term debt, capitalized leases and the amortization of debt discount and deferred financing fees. In addition, other expenses include realized foreign currency gains or losses, net and gains or losses arising from changes in the estimated fair market value of warrants. Other expense, net is partially offset by interest income earned on cash and cash equivalents and marketable securities.

 

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Results of Operations

The following table sets forth our results of operations, for the periods indicated:

 

     Year Ended December 31,     Year Ended December 31,  
      2005     2006     %
Change
    2006     2007     %
Change
 
     (dollars in thousands)           (dollars in thousands)        

Revenues

   $ 12,528     $ 16,899     34.9 %   $ 16,899     $ 29,516     74.7 %

Cost of revenues

     3,626       5,093     40.5       5,093       8,292     62.8  
                                            

Gross profit

     8,902       11,806     32.6       11,806       21,224     79.8  
                                            

Operating expenses:

            

Research and development

     3,219       2,407     (25.2 )     2,407       3,044     26.5  

Sales and marketing

     11,316       13,864     22.5       13,864       24,476     76.5  

General and administrative

     2,813       3,575     27.1       3,575       4,336     21.3  
                                            

Total operating expenses

     17,348       19,846     14.4       19,846       31,856     60.5  
                                            

Loss from operations

     (8,446 )     (8,040 )   (4.8 )     (8,040 )     (10,632 )   32.2  
                                            

Other income (expense), net(1)

     (616 )     (1,480 )   140.3       (1,480 )     (4,030 )   172.3  
                                            

Net loss before income taxes

     (9,062 )     (9,520 )   (5.0 )     (9,520 )     (14,662 )   50  

Income tax provision (benefit)

     (29 )     13     144.6       13       13     6.0  
                                            

Net loss before cumulative effect of change in accounting principle

     (9,033 )   $ (9,533 )   5.5       (9,533 )     (14,675 )   53.9  
                                            

Cumulative effect of change in accounting principle

     65       —       —         —         —       —    
                                            

Net loss

   $ (9,098 )   $ (9,533 )   4.8 %   $ (9,533 )   $ (14,675 )   53.9 %
                                            

 

(1) Other income (expense), net is comprised of the following: foreign currency gain or loss, interest income, interest expense, gain or loss on change in fair value of warrant liabilities and other income.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

Revenues.    Net revenues increased by $12.6 million, or 75%, to $29.5 million for the year ended December 31, 2007 from $16.9 million for the year ended December 31, 2006. This increase was attributable primarily to an increase in the number of Aquamantys single-use handheld devices sold in the United States as a result of a 79% increase in the number of sales representatives in our sales organization in the United States on a year-over-year basis. We had 68 sales representatives in our United States sales organization as of December 31, 2007 and 38 sales representatives as of December 31, 2006. In addition, as of December 31, 2007, we had 437 active accounts, which represents an increase of 44% as compared to 303 active accounts as of December 31, 2006. Our total single-use handheld device revenue per account in the United States grew from approximately $14,100 per quarter in the fourth quarter of 2006 to approximately $17,500 per quarter in the fourth quarter of 2007. The increase in sales representative productivity was driven primarily by the adoption of our Aquamantys single-use handheld devices in multi-level spinal fusions, increased marketing activities and the publication of post-commercial clinical studies. Our revenues from our single-use handheld devices grew by $12.2 million, or 75% to $28.5 million in 2007 as compared to $16.3 million in 2006. Revenues from our monopolar single-use handheld devices were 17% and 31% of total revenue for the years ended December 31, 2007 and 2006, respectively. Our revenues in the United States grew by $12.1 million, or 81%, in 2007 as compared to 2006, and our revenues outside of the United States grew by $0.5 million, or 28%, in 2007 as compared to 2006.

Cost of Revenues and Gross Profit.    Cost of revenues increased by $3.2 million, or 63%, to $8.3 million for the year ended December 31, 2007 from $5.1 million for the year ended December 31, 2006. This increase was

 

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due primarily to the increased number of single-use handheld devices sold, and to a lesser extent, an increase in our operations and quality control costs. Gross profit increased by $9.4 million, or 80.0% to $21.2 million for the year ended December 31, 2007 from $11.8 million for the year ended December 31, 2006. Gross profit, as a percentage of revenue, increased to 71.9% in 2007 from 69.9% in 2006. Revenue associated with single-use handheld devices, which carry a higher gross margin than our Aquamantys RF generators, accounted for approximately 96% of revenues in both 2007 and 2006. The increase in gross margin percentage on a year-over-year basis was due primarily to favorable product mix resulting from a shift from our earlier generation bipolar single-use handheld devices to our higher-priced Aquamantys single-use handheld devices, improved efficiencies in our operations, and, to a lesser extent, a decrease in the purchase cost of our Aquamantys single-use handheld devices from third party manufacturers. The purchase cost of our Aquamantys single-use handheld devices decreased by approximately 7.5% through the first three quarters of 2007 as compared to 2006.

Research and Development Expenses.    Research and development expenses increased by $0.6 million, or 27%, to $3.0 million for the year ended December 31, 2007 from $2.4 million for the year ended December 31, 2006. Research and development expenses increased as a percentage of sales as a result of our efforts to develop additional products and enhancements for use with our Aquamantys System. The increase in spending levels was attributable to increases in headcount as well as outsourced development services.

Sales and Marketing Expenses.    Sales and marketing expenses increased by $10.6 million, or 77%, to $24.5 million for the year ended December 31, 2007 from $13.9 million for the year ended December 31, 2006. This increase was due primarily to the increase in the size of our sales force in the United States from 38 sales representatives in 2006 to 68 in 2007. In addition, a significant portion of our sales force in the United States over-achieved their quotas in 2007, resulting in an increase in the average overall sales commission rate as a percentage of sales in the United States in 2007 as compared to 2006. All other sales and marketing expenses were consistent between 2007 and 2006.

General and Administrative Expenses.    General and administrative expenses increased by approximately $0.8 million, or 21%, to $4.3 million for the year ended December 31, 2007 from $3.6 million for the year ended December 31, 2006. This increase was primarily the result of an increase in personnel related costs in accounting, technical support and human resources to support the growth in our business.

Other Income (Expense), net.    Other income (expense), net increased by approximately $2.6 million, or 172%, to $4.0 million for the year ended December 31, 2007 from $1.5 million for the year ended December 31, 2006. The increase in other expense, net was attributable primarily to the expense we recorded in connection with the increase in the estimated fair value of warrant liabilities and an increase in interest expense, offset by an increase in interest income recorded in 2007 as compared to 2006 as we maintained a higher average cash and marketable securities balance in 2007 than in 2006.

Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005

Revenues.    Net revenues increased by $4.4 million, or 35%, to $16.9 million for the year ended December 31, 2006 from $12.5 million for the year ended December 31, 2005. This increase was attributable primarily to the introduction of our Aquamantys System in the first quarter of 2006 and the related increase in the number of Aquamantys single-use handheld devices sold in the United States, as well as a 58% increase in the number of sales representatives in our sales organization in the United States on a year-over-year basis. As of December 31, 2006, we had 38 sales representatives in our United States sales organization as compared to 24 as of December 31, 2005. In addition, as of December 31, 2006, we had 303 active accounts, which represents an increase of 22% as compared to 248 active accounts as of December 31, 2005. Total single-use handheld device revenue per account grew from approximately $10,300 per quarter in the fourth quarter of 2005 to approximately $14,100 per quarter in the fourth quarter of 2006. The increase in the sales representative productivity in the United States was aided by increased marketing activities and the publication of post-commercial clinical

 

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research. Our revenues from our single-use handheld devices grew by $3.9 million, or 31% to $16.3 million in 2006 as compared to $12.4 million in 2005. Revenues from our monopolar single-use handheld devices were 31% and 42% of total revenue for the years ended December 31, 2006 and 2005, respectively. Our revenues in the United States grew by $3.9 million, or 35%, in 2006 as compared to 2005, and our revenues outside of the United States grew by $0.4 million, or 28%, in 2006 as compared to 2005.

Cost of Revenues and Gross Profit.    Cost of revenues increased by $1.5 million, or 41% to $5.1 million for the year ended December 31, 2006 from $3.6 million for the year ended December 31, 2005. This increase was due primarily to the introduction of our Aquamantys System in the first quarter of 2006, an increase in the number of single-use handheld devices sold and, to a lesser extent, an increase in our operations and quality control costs. Gross profit, as a percentage of revenue, decreased to 69.9% in 2006 from 71.1% in 2005. The decrease in gross margin percentage on a year-over-year basis was due primarily to the introduction of our Aquamantys RF generator in the first quarter of 2006, which carries a lower gross margin than our single-use handheld devices, a shift in revenue mix from monopolar single-use handheld devices to bipolar single-use handheld devices and, to a lesser extent, an increase in our overhead costs to support our anticipated growth.

Research and Development Expenses.    Research and development expenses decreased by $0.8 million, or 25%, to $2.4 million for the year ended December 31, 2006 from $3.2 million for the year ended December 31, 2005. In 2005, we spent approximately $0.8 million to design and develop the Aquamantys System, which received the FDA 510(k) clearance in the fourth quarter of 2005. There were no comparable project-related expenses in 2006.

Sales and Marketing Expenses.    Sales and marketing expenses increased by $2.6 million, or 23%, to $13.9 million for the year ended December 31, 2006 from $11.3 million for the year ended December 31, 2005. This increase was due primarily to the increase in the size of our sales force in the United States from 24 sales representatives in 2005 to 38 in 2006. In addition, we increased our marketing expenses in 2006 as compared to 2005 due to increased headcount and marketing costs related to the launch of the Aquamantys System in the first quarter of 2006.

General and Administrative Expenses.    General and administrative expenses increased by $0.8 million, or 27%, to $3.6 million for the year ended December 31, 2006 from $2.8 million for the year ended December 31, 2005. This increase was primarily the result of an increase in insurance premiums due to higher annual revenues. In addition, we experienced an increase in accounting and legal fees associated with the liquidation of our two international subsidiaries which began in April 2005.

Other Income (Expense), net.    Other income (expense), net increased by $0.9 million, or 140%, to $1.5 million for the year ended December 31, 2006 from $0.6 million for the year ended December 31, 2005. Other expense, net increased as a result of a full year’s of interest expense and amortization of deferred financing fees and discount on debt associated with $10.0 million of venture debt which we closed in May 2005. In addition, interest expense also increased in 2006 as compared to 2005 due to interest expense and amortization of deferred financing fees and discount on debt associated with a $5.0 million convertible bridge note which was closed in September 2006.

Seasonality

We experience seasonality in the sale of our products. We typically experience lower sequential quarter sales growth in the third fiscal quarter compared to the rest of the year. We anticipate that we will continue to experience relatively lower sequential quarter sales growth in our third fiscal quarter due to the summer holiday and vacation schedules of many surgeons and patients. Such seasonal fluctuations are especially pronounced in Europe. These seasonal factors may lead to a meaningful variability in our quarterly operating results. It is difficult for us to evaluate the degree to which seasonality may impact our revenues in the future.

 

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Liquidity and Capital Resources

 

      As of December 31,  
     2005     2006     2007  
     (in thousands)  

Cash, cash equivalents and marketable securities

   $ 9,985     $ 4,257     $ 13,280  

Working capital (deficit)

     9,632       (72 )     10,257  

Net cash used in operating activities

     (8,439 )     (9,550 )     (9,611 )

Net cash provided by (used in) investing activities

     (4,410 )     3,768       (7,715 )

Net cash provided by financing activities

   $ 7,394     $ 4,698     $ 19,303  

Sources of Liquidity

At December 31, 2007, our cash, cash equivalents and marketable securities totaled $13.3 million. We invest excess cash in commercial paper and money market funds comprised of United States Government securities, CDs, commercial paper, repurchase agreements, reverse repurchase agreements, U.S. dollar denominated foreign-issued bonds and investment-grade bonds issued by corporations in the United States.

At December 31, 2007, our accumulated deficit was $92.5 million. Since inception, we have generated significant operating losses and as a result we have not generated sufficient cash flow to fund our operations and the growth in our business. We have financed our operations primarily through the issuances of $88.2 million of preferred stock, $10.0 million of venture debt and $5.0 million of convertible notes. These issuances of equity and debt were supplemented with financed insurance premiums and equipment financing arrangements.

In June 2004, we amended the payment terms of our royalty-bearing license agreement with Medtronic to settle our quarterly royalty fee obligation through the issuance of promissory notes and warrants to purchase shares of our Series D Convertible Preferred Stock in lieu of cash payment. As of December 31, 2007, the aggregate principal balance due under such promissory notes was $1.8 million, at an interest rate of 11.75%. As of February 1, 2008, we have issued warrants to Medtronic to purchase an aggregate of 114,442 shares of our Series D Convertible Preferred Stock in connection with royalty payments made under the Medtronic License Agreement, or the Medtronic Royalty Warrants. The Medtronic Royalty Warrants are exercisable at a price of $1.263 per share, subject to certain adjustments. Upon consummation of the offering, these warrants will be converted into warrants to purchase 125,600 shares of our common stock at a pre-split exercise price of $1.263 per share. We expect to continue to issue Medtronic Royalty Warrants to Medtronic through 2008, with the principal on such promissory notes becoming due on March 31, 2009. Starting in 2009, we will be obligated to pay royalties to Medtronic in cash.

On May 24, 2005, we entered into a $10.0 million Venture Loan and Security Agreement with Horizon Technology Funding Company LLC. The Horizon Loan Facility was amended on September 1, 2006, at which time the interest rate on the Horizon Loan Facility was increased from 10.79% to 12.25% per annum. Prepayment of the Horizon Loan Facility is subject to a 2.0% prepayment penalty on the outstanding principal balance. We issued ten-year warrants to purchase 395,883 shares of our Series D Convertible Preferred Stock to each of Horizon Technology Funding Company II LLC and Horizon Technology Funding Company III LLC in connection with the initial extension of this loan, and warrants to purchase an aggregate of 324,675 shares of our Series E Convertible Preferred Stock in connection with the amendment of this facility on September 1, 2006. We commenced payments of principal in January 2008 and will make monthly pro-rata payments such that the debt is repaid in full by July 2009. Upon consummation of this offering, these warrants will be converted into warrants to purchase 1,458,580 shares of our common stock at a pre-split exercise price of $0.21 per share. The Horizon Loan Facility is secured by a lien on all of our tangible and intangible assets.

On February 12, 2007 we sold 27,346,379 shares of Series E Convertible Preferred Stock to venture capital investors in a private placement at a price of $0.924 per share, resulting in net proceeds of approximately

 

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$20.0 million after the conversion of approximately $5.3 million of outstanding principal and accrued interest on convertible promissory notes held by insiders and existing investors. We used the proceeds to continue building our direct sales organization in the United States, scale our research and development activities and meet our growing working capital requirements as a result of our sales growth.

Net Cash Used in Operating Activities

Net cash used in operating activities was $8.4 million, $9.6 million and $9.6 million for the years ended December 31, 2005, 2006 and 2007, respectively. Cash used in operating activities was attributable primarily to net losses after adjustment for certain non-cash items including, but not limited to, depreciation and amortization charges, provisions on inventory and gains and losses in the change in estimated fair value of warrants. Our net losses for the years ended December 31, 2005, 2006 and 2007 were primarily driven by investments made to develop and build a direct sales channel in the United States. Over the three year period, we increased the size of our sales force in the United States from 24 sales representatives to 68 sales representatives.

In addition, cash used in operating activities was also used to fund increases in accounts receivable and inventory, which increased as a result of revenue growth over the period. Our accounts receivable and inventory balances grew from $2.6 million and $2.7 million at December 31, 2006, respectively, to $3.8 million and $4.1 million at December 31, 2007, respectively. Over the next 12 months, we expect to continue to utilize cash to fund net losses, build inventory levels in support of our anticipated revenue growth and finance the associated growth in accounts receivable.

Net Cash Provided by (Used in) Investing Activities

Net cash provided by (used in) investing activities was $(4.4) million, $3.8 million and $(7.7) million for the years ended December 31, 2005, 2006 and 2007, respectively. For each of these periods, cash used in or provided by investing activities was driven primarily by our decision to invest excess cash in certain marketable securities and liquidate the investments as needed. Upon closing each of our financing events, we have invested the proceeds in marketable securities and liquidated the investments over time to fund the net cash used in operations. In addition, we also utilized our cash to purchase fixed assets. To date, our fixed asset purchases have consisted primarily of leasehold improvements made to our existing location, tooling and manufacturing equipment utilized to manufacture our products, and IT related equipment.

Net Cash Provided by Financing Activities

Net cash provided by financing activities was $7.4 million, $4.7 million and $19.3 million for the years ended December 31, 2005, 2006 and 2007, respectively. These amounts primarily reflect proceeds received upon our $10.0 million venture debt financing in 2005, $5.0 million in convertible bridge financing in 2006, and net proceeds of $19.8 million upon the sale of preferred stock in 2007. We paid off our asset-based line of credit in April 2005 and subsequently have funded our working capital requirements with cash raised through equity issuances and debt offerings. We have raised these proceeds primarily to fund our operating activities and to date have raised $88.2 million of venture capital and $10.0 million of venture debt and $5.0 million of convertible debt. Upon receipt of the proceeds from these financings, we have invested the proceeds in cash and marketable securities vehicles which we liquidate as needed to fund the operating activities of the business.

Future Liquidity Needs

Our future liquidity and capital requirements will be influenced by numerous factors, including the extent and duration of future operating losses, the level and timing of future sales and expenditures, the results and scope of ongoing research and product development programs, working capital required to support our sales growth, the receipt of and time required to obtain regulatory clearances and approvals, the success and effectiveness of our sales and marketing programs, the continued acceptance of our products in the marketplace, competing technologies and market and regulatory developments. Given our current cash, cash equivalents and marketable securities, we believe that we can fund working capital requirements, capital expenditures, debt

 

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service and operations for at least the next 12 months. We intend to retain any future earnings to support operations and to finance the growth and development of our business, and we do not anticipate paying any dividends in the foreseeable future.

Our ability to fund our longer-term cash needs is subject to various risks, many of which are beyond our control. Should we require additional funding, such as to satisfy our short-term and long-term debt obligations when due, or to make additional capital investments, we may need to raise the required additional funds through bank borrowings or public or private sales of debt or equity securities. We cannot assure that such funding will be available in needed quantities or on terms favorable to us.

As of December 31, 2007, we had federal and state net operating loss carryforwards of $76.7 million and $8.1 million, respectively, available to reduce future taxable income if we become profitable. We expect to utilize our available net operating loss carryforwards to reduce future tax obligations in the event we are successful in achieving profitability. However, limitations on our ability to use net operating loss carryforwards and other minimum state taxes may increase our overall tax obligations.

Subsequent Events

On February 27, 2008, we executed a build-to-suit lease for premises in Portsmouth, New Hampshire. Construction is expected to begin at the end of March 2008, and the building is expected to contain approximately 55,000 square feet and to include office, warehouse, pilot-line capability and cleanroom space. We have no current plans to manufacture our products in-house. We expect to move our headquarters to the new facility after construction is completed, which we currently expect to be in the fourth quarter of 2008. The base term of the lease will be 10 years, with two optional extension periods of 5 years each. We are currently in negotiations with the landlord for the Dover facility to sublet or cancel the existing lease prior to its 2010 expiration. We believe that our current facility will be adequate for our needs until we move into the new space, which will accommodate our growing needs as we expand our business. We also believe we will be able to obtain additional space, as needed, on commercially reasonable terms. We are obligated to deliver a letter of credit in the amount of $2.0 million on or before commencement of construction. The letter of credit will be secured by restricted cash in the same amount.

Off-Balance Sheet Liabilities

As more fully explained in Note 6 to the audited consolidated financial statements included elsewhere in this prospectus, our convertible preferred stock has conversion or other rights which meet the definition of a derivative; however these meet the scope exception within SFAS 133, Accounting for Derivative Instruments and Hedging Activities and accordingly meet the definition of an off-balance sheet liability. Otherwise, we currently have no other off-balance sheet arrangements.

Contractual Obligations and Capital Expenditure Requirements

The following table summarizes our contractual obligations as of December 31, 2007:

 

     Payments Due By Period

Contractual Obligations

   Total    Less than
1 year
   1-3
years
   3-5
years
   More than
5 years
     (in thousands)

Operating lease obligation

   $ 474    $ 160    $ 168    $    146    $     —  

Capital lease obligations

     164      83      79      2      —  

Long-term debt

     11,321      5,712      5,609      —        —  

Purchase obligations(1)

     7,395      7,395      —        —        —  
                                  

Total

   $ 19,354    $ 13,350    $ 5,856    $ 148    $ —  
                                  

 

(1) Purchase obligations include open purchase orders placed and the purchase of unused components from suppliers in the event that the company elects to terminate the agreements with its third-party manufacturers.

 

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Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk of loss related to changes in market prices, including interest rates and foreign exchange rates, of financial instruments that may adversely impact our consolidated financial position, results of operations or cash flows.

Interest Rate Risk

Our exposure to interest rate risk at December 31, 2007 is related to the investment of our excess cash, cash equivalents and marketable securities in money market funds, investment grade commercial paper and debt instruments of the U.S. government. Our investment portfolio maintains an average investment maturity of less than 180 days. Consequently, while the instruments we hold are subject to changes in the financial standing of the issuer of such securities, we do not believe that we are subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments.

Foreign Currency Exchange Rate Risk

A significant portion of our sales and expenses historically have been denominated in U.S. dollars. For the year ended December 31, 2007, approximately 1% of total sales and 2% of total expenses were denominated in currencies other than U.S. dollars. Accordingly, we do not believe that we are subject to material risk from changes in foreign currency exchange rates.

Critical Accounting Policies and Estimates

Our financial statements have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Critical accounting policies are those that are both important to the portrayal of our financial condition and results of operations and require management to make subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. As the number of variables and assumptions affecting the possible future resolution of the uncertainties increase, those judgments become even more subjective and complex. In order to provide an understanding about how our management forms its judgments about future events, including the variables and assumptions underlying the estimates, and the sensitivity of those judgments to different circumstances, we have identified our critical accounting policies below.

Revenue Recognition

We recognize revenues in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue Recognition. Under SAB 104, revenue is recognized when four basic criteria are met:

 

Ÿ  

Persuasive evidence of an arrangement exists.    We use customer purchase orders, and to a lesser extent, contracts to document the existence of an arrangement.

 

Ÿ  

Title and risk of loss has transferred to the customer.    Transfer of title and risk of loss is transferred to the customer upon shipment from us. We use shipping documents and third-party proof of delivery to verify delivery has occurred.

 

Ÿ  

The sales price is fixed or determinable.    All terms are fixed in the customer’s purchase order or contract and do not contain rights of cancellation, return, exchanges or refunds. The company does not offer extended payment terms.

 

Ÿ  

Collection is reasonably assured.    To determine whether collection is reasonably assured, we assess a number of factors including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not reasonably assured at the outset of the arrangement, we defer the recognition of revenue until collection becomes reasonably assured, which is generally upon receipt of payment.

 

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We frequently enter into sales arrangements with customers that contain multiple elements or deliverables, and for these arrangements we apply the provisions of Emerging Issues Task Force, or EITF, Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. We are required to make judgments which impact the timing and amount of revenue recognized in a given period. For example, because the sale of an Aquamantys RF generator and Aquamantys single-use handheld devices is often contemplated in a single arrangement, we make judgments as to the allocation of the proceeds received from the arrangement to the multiple elements of the arrangement and the appropriate timing of revenue recognition. In addition, our ability to establish and maintain objective and reliable evidence of fair value for the elements in our arrangements could affect the timing of revenue recognition.

Under minimum purchase sales arrangements, title to an Aquamantys RF generator passes to the customer upon satisfaction of a minimum number of purchases of single-use handheld devices over a period not to exceed two years, and the cost of the Aquamantys RF generator is capitalized as a component of inventory and amortized to cost of revenues as single-use handheld devices are purchased during the term of the arrangement. We make judgments which impact the timing and amount of cost of revenues recognized in a given period. Our ability to properly match the timing of single-use handheld device revenue to the corresponding use of the Aquamantys RF generator could affect the timing of cost of revenues.

We have not made any material change in the accounting methodology used to record revenue or cost of revenues under multiple element arrangements since the commercial launch of our Aquamantys System in 2006. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions used to record revenue or cost of revenues associated with multiple element arrangements involving the sale of our Aquamantys RF generator and Aquamantys single-use handheld devices. However, the amount and timing of recorded revenues are affected by our estimates regarding the allocation of the proceeds received from the arrangement to the multiple elements of the arrangement and our assessment of the fair value of the elements included in our arrangements.

Our return policy allows customers and distributors to return products to us in the case of warranty issues. All other returns are subject to a restocking fee. We make provisions for estimated returns and allowances based on historical levels. We have not made any material change in the accounting methodology used to establish our estimated returns and allowances during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions used to calculate our estimated returns and allowances. However, if our estimates regarding the estimated returns and allowances are inaccurate, our revenues could be adversely affected. To date, returns and allowances have not been significant.

Shipping and handling costs that are billed to the customer are included as a component of net revenues.

Stock-Based Compensation

Effective January 1, 2006, we began accounting for share-based awards under the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, or SFAS 123(R), which requires the recognition of the fair value of stock-based compensation. Under the fair value recognition provisions of SFAS 123(R), stock-based compensation cost is estimated at the grant date based on the fair value of the awards expected to vest and recognized as expense ratably over the requisite service period of the award. We adopted SFAS 123(R) using the prospective method which requires the application of the accounting standard as of January 1, 2006. In accordance with the prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

Previously, we used the intrinsic method of accounting for employee stock options under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and presented disclosure of pro forma information required under SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123, or SFAS 148. For stock options granted to employees under APB 25, no

 

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compensation expense was recognized unless the exercise price was less than the estimated fair market value of the stock at the date of grant. We apply the provisions of EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods and Services, and use the Black-Scholes option-pricing model to determine the fair value of each option grant to non-employees.

In the absence of a public trading market for our common stock, we relied on our board of directors, the members of which we believe have extensive experience in the medical device market and are accredited venture capital investors, to determine a reasonable estimate of the then-current fair value of our common stock based upon contemporaneous valuations performed by management. Our board of directors exercised judgment in determining the estimated fair value of our common stock on the date of grant based on several factors, including transactions in our preferred and common stock, the rights and benefits that preferred stock holders are entitled to that holders of our common stock are not, key milestones achieved in our business including forecasted revenues and cash flows, product development and market acceptance, our financial condition, equity market conditions, and the likelihood of continuing as a going concern.

The contemporaneous valuations performed by management follow the same fair market value concepts as outlined in the AICPA’s Practice Aid Valuation of Privately-Held-Company Equity Securities Issued as Compensation. In addition to the factors discussed above, our board of directors considered the effects of the withdrawal of refinancing proposals from our existing lender in the second quarter of 2006, a withdrawn 144A financing in late 2006, the estimated pre-money valuation of a financing round among existing investors that closed in February 2007, the departure of our co-founder and Chief Executive Officer in March 2007, and the potential impact that liquidity events would have on us such as an initial public offering, a merger or sale with another company, or our forced liquidation. Based on the contemporaneous valuations performed, the pre-split estimated fair value of our common stock was determined to be $0.25 as of December 31, 2006, $0.35 as of July 6, 2007, $0.58 as of September 30, 2007, and $1.04 as of December 31, 2007.

The procedures performed by our management in connection with the quarterly valuations were based on a probability-weighted combination of the market multiple approach and income approach to estimate the aggregate equity value of the company at specific stock option grant dates.

The market multiple approach is based on revenues, earnings before interest, taxes, depreciation and amortization, or EBITDA, and net income considered to be representative of our future performance, and multiplying these figures by a range of appropriate risk-adjusted multiples. The market multiples were obtained through the market comparison method, where companies having their stock traded in the public market were used as a basis for choosing reasonable market multiples.

The income approach involves applying appropriate discount rates to estimated debt-free cash flows that are based on forecasts of our revenue and costs. The projections used for each valuation date were based on the expected outlook on our operating performance through the forecast periods. The assumptions underlying the estimates were consistent with our board of directors’ approved business plan. The future debt-free cash flows were determined by subtracting from EBITDA taxes and future capital spending and adjusting for future changes in net working capital. The interim debt-free cash flows and resulting terminal value were then discounted at a rate based on the weighted-average cost of capital of comparable companies, as adjusted for our specific risk profile. There is inherent uncertainty in these estimates. If different discount rates or comparable company multiples had been used, the valuations may have been different.

After estimating our average value based on the market multiple and income approaches, we then utilized a probability-weighted expected return method. Under the probability-weighted expected return method, the value of our common stock was estimated based upon an analysis of values assuming various outcomes, such as an initial public offering, merger or sale, forced liquidation, and remaining private, and the estimated probability of each outcome assuming that all preferred stock is converted into common stock.

For financial reporting purposes for the period from January 1, 2005 through December 31, 2005, we recorded stock-based compensation under APB 25 representing the difference between the estimated fair value of

 

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common stock and the option exercise price for options granted to employees. Beginning January 1, 2006, with the adoption of SFAS 123(R), we recorded stock-based compensation for share-based awards made after that date based upon estimated fair values.

The determination of the fair value of our common stock involves significant judgments, assumptions, estimates and complexities that impacted the amount of deferred stock-based compensation recorded under APB 25 and the resulting amortization in future periods. Under SFAS 123(R), we have used the Black-Scholes option-pricing model to estimate fair value of our stock-based awards which requires various judgmental assumptions including estimating stock price volatility, expected life and forfeiture rates. If we had made different assumptions, the amount of our deferred stock-based compensation, stock-based compensation expense, gross margin, net loss and net loss per share amounts could have been significantly different. We believe that we have used reasonable methodologies, approaches and assumptions consistent with the practice aid to determine the fair value of our common stock and that deferred stock-based compensation and related amortization were recorded properly for accounting purposes. If any of the assumptions used change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

The fair value of each option award under SFAS 123 and SFAS 123(R) is estimated on the date of grant using the Black-Scholes option-pricing model using the weighted average assumptions noted in the table below:

 

     Years Ended December 31,
           2005          2006      2007  

Weighted average risk-free interest rate

   4.3%    4.3% - 5.1%    3.4% - 5.0%

Weighted average expected life (years)

   4.5    6.25    6.25

Estimated volatility

   —      70%    70%

Expected dividends

   —      —      —  

The risk-free interest rate for periods within the contractual life of the option is based on the implied yield available on U.S. Treasury constant rate securities with the same or substantially equivalent remaining terms at the time of grant.

For options granted prior to January 1, 2006, and valued in accordance with SFAS 123, the expected life of our stock options was based upon the historical experience of similar awards, giving consideration to the contractual terms of the share-based awards and vesting schedules. We recognized option forfeitures as they occurred as allowed by SFAS 123. Estimated volatility was calculated using the historical volatility of the common stock of comparable medical device companies.

For options granted after January 1, 2006, and valued in accordance with SFAS 123(R), we adopted the simplified method, as permitted by SAB No. 107, to develop an expected life of an employee stock option. Under this approach, the expected life is presumed to be the mid-point between the vesting date and the contractual end of the option term. We estimate forfeitures and only recognize expense for those shares expected to vest. Our estimated forfeiture rate in the 12 months ended December 31, 2007 is based on our historical forfeiture experience. Estimated volatility under SFAS 123(R) is calculated using the trading history of the common stock of comparable medical device companies.

On April 24, 2007, the Board approved the repricing of certain stock options to purchase 5,899,193 shares of common stock at the then current fair value of a share of the company’s common stock. In connection with the repricing of these options, we recorded immediate expense of $369,000 in the year ended December 31, 2007 for these options vested and we will record another $136,000 over the remaining weighted average expected term of those options, or two years.

As of December 31, 2007, we had $1.0 million of unrecognized compensation remaining to be amortized over a weighted-average term of 1.36 years.

 

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Information on employee and non-employee stock options granted in 2007 is summarized as follows:

 

Date of Grant

   Number of
Options Granted
   Exercise
Price
   Estimated Fair
Value per Share
   Intrinsic Value
per Share

February 1, 2007

   321,859    $ 0.124    $ 0.25    $ 0.126

April 24, 2007

   1,246,270      0.124      0.25      0.126

April 25, 2007

   400,000      0.124      0.25      0.126

July 24, 2007

   101,045      0.35      0.35      —  

August 17, 2007

   1,850,000      0.35      0.35      —  

September 11, 2007

   769,000      0.35      0.35      —  

November 6, 2007

   105,504      0.58      0.58      —  

December 11, 2007

   28,500      0.58      0.58      —  

Warrants

Effective July 1, 2005, we accounted for warrants that are exercisable into redeemable preferred shares issued in connection with financing arrangements in accordance with FSP 150-5, Issuer’s Accounting Under FASB Statement No. 150 for Freestanding Warrants and Other Similar Instruments on Shares That Are Redeemable and accordingly, classified these warrants as liabilities. The estimated fair value of warrants classified as liabilities is adjusted for changes in estimated fair value at each reporting period, and the corresponding non-cash gain or loss is recorded in current period earnings.

We selected the Black-Scholes option pricing model to determine the fair value of warrants. The determination of the fair value using this model will be affected by assumptions regarding a number of complex and subjective variables. These variables include our expected stock volatility over the expected term of the warrant, risk-free interest rates, and the estimated fair value of the underlying preferred stock. The expected term used was equal to the remaining contractual term of the warrants. As we have been operating as a private company since inception, we were unable to use our actual stock price volatility data. Therefore, we estimated the volatility of the underlying stock based on historical stock prices of comparable medical device companies. Historical price volatilities of these companies were evaluated over a period of time equal to the expected term of the warrants. The risk-free interest rates were based on U.S. Treasury zero-coupon rates in effect at each reporting period with terms consistent with the expected term of the warrants.

The fair value of the underlying preferred stock at December 31, 2007 was determined by the board of directors based upon a valuation performed by management. These valuations were prepared utilizing the probability-weighted expected return method as prescribed by the AICPA Practice Aid Valuation of Privately-Held-Company Equity Securities Issued as Compensation. These valuations took into consideration the following scenarios: (i) completion of an initial public offering; (ii) sale or merger; and (iii) remaining private. The valuation amounts determined under each scenario were then probability-weighted based upon our management’s best estimates of the occurrence of each scenario. The resulting value was then allocated to our common and each series of preferred stock based upon the economic impact of the conversion rights and liquidation preferences of the preferred stock.

Income Taxes

We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under this method, we determine deferred tax assets and liabilities at the balance sheet date based upon the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. As of December 31, 2007, we had deferred tax assets amounting to $32.0 million of which $26.5 million was attributable to federal and state net operating loss carryforwards. Under SFAS 109, a valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence needs to be considered, including our past and future performance, the market environment in which we operate, the length of carryforward periods and annual carryforward limitations due to the ownership percentage change limitations provided by the Internal Revenue Code of 1986, as amended and similar state provisions.

 

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Accordingly, we have established a full valuation allowance against our deferred tax assets as of December 31, 2007 to reflect the uncertainty of realizing the deferred tax benefits, given our historical losses.

Our valuation allowance contains uncertainties because the calculation requires management to make assumptions and to apply judgment regarding a number of factors including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, and the length of carryforward periods and evaluation of potential tax planning strategies. If our performance or market conditions were to significantly deviate from our expectations or if the length of carryforward periods and/or the amount of annual loss carryforward available to us was limited, our income tax provision could be adversely affected.

We have not made any material change in the accounting methodology used to establish our valuation allowance during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions used to calculate our valuation allowance. However, if our estimates regarding the valuation allowance are inaccurate, we may be exposed to losses or gains that could be material. We expect to continue to maintain a full valuation allowance against our deferred tax assets until an appropriate level of profitability is sustained or we are able to develop tax strategies that would enable us to conclude that it is more likely than not that a portion of our deferred tax assets would be realizable.

Warranty Costs

We establish an accrual for estimated warranty expense associated with revenues as a component of cost of revenues at the time revenues are recognized from the sale of our products. We calculate our warranty reserves based upon historical experience of product failure rates and anticipated service delivery costs incurred in correcting a product failure. Our warranty reserves contain uncertainties because the calculation requires management to make assumptions and to apply judgment regarding a number of factors including an anticipated rate of claims based on historical data and service delivery costs. If we experience an increase in warranty claims due to new product introductions or potential changes in our third party manufacturers as compared with our anticipated rate of claims, or if the cost of servicing warranty claims is greater than the expectations on which the accrual has been based, our gross profit could be adversely affected.

We have not made any material change in the accounting methodology used to establish our estimated warranty reserves during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions used to calculate our warranty reserves. However, if our estimates regarding the warranty reserves are inaccurate, we may be exposed to losses that could be material. A 10% difference in the warranty reserves would result in an incremental $22,000 of expense in fiscal 2007. The liability for product warranties, included as a component of other accrued liabilities was $65,000 and $223,000 as of December 31, 2006 and 2007, respectively. We incurred warranty expense of $177,000, $159,000 and $971,000 for the years ended December 31, 2005, 2006 and 2007, respectively. The increase in warranty expense in the year ended December 31, 2007 over 2006 was due to the year-over-year increase in revenue as well as the costs associated with the phase out of our previous generation of bipolar single-use handheld devices in September 2007.

Valuation of Inventory

We value our inventory at the lower of cost or fair value through the establishment of inventory reserves. The inventory reserve is measured as the difference between the current cost of the inventory and estimated fair market value and is charged to the provision for inventory reserves, which is a component of our cost of revenues. At the point of recognition of an adjustment to reduce cost to estimated market value, a new, lower- cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in an increase in that newly established cost basis.

Our inventory reserve contains uncertainties because the calculation requires management to make assumptions and to apply judgment regarding a number of factors including inventory aging, forecasted customer

 

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demand for existing products and new product offerings, technological obsolescence and market conditions. If there were to be a sudden and significant decrease in demand for our products, a material difference between actual and forecasted demand for new products or if there were a higher incidence of inventory obsolescence because of rapidly changing technology, we could be required to increase our inventory allowance and our gross profit could be adversely affected.

We have not made any material change in the accounting methodology used to establish our inventory reserves during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions used to calculate our inventory reserves. However, if our estimates regarding the inventory reserves are inaccurate, we may be exposed to losses that could be material. A 10% difference in the inventory reserves would have resulted in an incremental $25,000 of expense in fiscal 2007. Our inventory balance, net of reserves, was $2.7 million and $4.1 million at December 31, 2006 and 2007, respectively. Our inventory reserve balance was $383,000 and $248,000 at December 31, 2006 and 2007, respectively. We recorded a net increase in the provision for inventory reserves of $128,000, $358,000 and $305,000 for the years ended December 31, 2005, 2006 and 2007, respectively.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Our allowance for doubtful accounts contains uncertainties because the calculation requires management to make assumptions and apply judgment regarding a number of factors including the aging of account balances, collection history, credit quality of the customer and current economic conditions that may affect a customer’s ability to pay.

We have not made any material change in the accounting methodology used to establish our allowance for doubtful accounts during the past three fiscal years. We generally maintain a diverse customer base that mitigates the risk of concentration with one customer. However, if the overall condition of the healthcare industry were to deteriorate, resulting in an impairment of our customers’ ability to make payments, significant additional allowances could be required. Additionally, if a major customer’s creditworthiness deteriorates, or if actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due to us could be overstated, and additional allowances could be required, which could have an adverse impact on our financial results.

We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions used to calculate our allowance for doubtful accounts. However, if our estimates regarding the allowance for doubtful accounts are inaccurate, we may be exposed to losses that could be material. A 10% difference in the allowance for doubtful accounts would have resulted in an incremental $9,000 of expense in fiscal 2007. Our accounts receivable balance, net of allowance for doubtful accounts, was $2.6 million and $3.8 million, as of December 31, 2006 and 2007, respectively. The allowance for doubtful accounts was $64,000 and $89,000 at December 31, 2006 and 2007, respectively. Our provision for doubtful accounts was $16,000, $26,000 and $29,000 for the years ended December 31, 2005, 2006, and 2007, respectively.

Related Party Transactions

We license our core technology from Medtronic, a current stockholder. Pursuant to our license agreement, we pay Medtronic a quarterly royalty fee on our product sales, which is described in additional detail under “Business—Intellectual Property—Medtronic License Agreement.” In addition, we finance this royalty obligation through the issuance of promissory notes and warrants to Medtronic. For the year ended December 31, 2007, we issued promissory notes to Medtronic related to our royalty obligations amounting to $646,000 and warrants to purchase approximately 40,888 shares of the company’s Series D Convertible Preferred Stock at an exercise price of $1.263 per share. Upon consummation of this offering, these warrants will be converted into warrants to purchase 44,875 shares of common stock at a pre-split exercise price of $1.263 per share. Starting in 2009, we will be obligated to pay royalties to Medtronic in cash.

 

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Recent Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 clarifies when tax benefits should be recorded in financial statements, requires certain disclosures of uncertain tax matters and indicates how any tax reserves should be classified in a balance sheet. We adopted the provisions of FIN 48 effective January 1, 2007. No cumulative adjustment to our accumulated deficit was required upon adoption.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement, or SFAS 157. This standard provides guidance on using fair value to measure assets and liabilities. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and is required to be adopted effective January 1, 2008. In February 2008 the FASB issued FASB Staff Position No. 157-2, Partial Deferral of the Effective Date of Statement 157, that will (1) partially defer the effective date of SFAS No. 157 for one year for certain non-financial assets and non-financial liabilities and (2) remove certain leasing transactions from the scope of SFAS No. 157. We are currently evaluating the effect that the adoption of SFAS 157 will have on our results of operations and financial position.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115, or SFAS 159. SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. Most of the provisions in Statement 159 are elective; however, the amendment to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale and trading securities. SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. We are currently evaluating the effect that the adoption of SFAS 159 will have on our results of operations and financial position.

In December 2007, FASB issued SFAS No. 141 (Revised 2007), Business Combinations, or SFAS 141(R). The objective of SFAS 141(R) is to improve the relevance, representational faithfulness and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) requires an acquirer to recognize the assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. It also requires the acquirer to recognize and measure the goodwill acquired in a business combination or a gain from a bargain purchase and how to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for financial statements issued for fiscal years beginning after December 15, 2008. The company is in the process of evaluating the impact, if any, that the adoption of SFAS 141 (R) will have on our results of operations and financial position.

In December 2007, FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51, or SFAS 160. The objective of SFAS 160 is to improve the relevance, comparability and transparency of the financial information that a reporting entity provides in its consolidated financial statements. SFAS 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 also changes the way the consolidated income statement is presented, establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation, requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated and expanded disclosures in the consolidated financial statements that clearly identify and distinguish between the interests of the parent’s owners and the interest of the noncontrolling owners of a subsidiary. SFAS 160 is effective for financial statements issued for the fiscal years beginning on or after December 15, 2008. The company is in the process of evaluating the impact, if any, that the adoption of SFAS 160 will have on our results of operations and financial position.

 

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BUSINESS

Overview

We are a medical technology company that develops and markets surgical products based on our proprietary Transcollation technology for the sealing of blood vessels and other collagen-based structures. We believe that our products improve surgical procedures and patient outcomes by enabling surgeons to substantially reduce blood loss during and after surgery. Our Transcollation technology has been used in over 165,000 surgical procedures to date. We focus on selling our products for use in orthopaedic hip and knee reconstructions and multi-level spinal fusions, which are significant markets with over 1.3 million procedures performed in the United States in 2007. Our Transcollation technology is also used in surgical oncology procedures and may be used in other surgical procedures, including trauma, single-level spinal fusions, minimally invasive spine and advanced laparoscopic procedures, which are markets we intend to pursue in the future.

Our principal Transcollation product, the Aquamantys System, was launched commercially in March 2006 and is comprised of single-use handheld devices and a radio frequency, or RF, energy generator system. This system delivers an optimized combination of RF energy and electrically conductive fluid, such as saline, to permanently seal blood vessels and other collagen-based structures in soft tissue and bone. Our Aquamantys System is designed to be easy to use and portable, allowing it to be used in different operating rooms throughout a hospital. Our Transcollation technology and Aquamantys System are based on our internally developed intellectual property, as well as intellectual property we license on a worldwide basis from Medtronic. Our marketed products have received FDA 510(k) clearance in the United States and equivalent regulatory clearance in targeted international markets.

We believe our Transcollation technology provides clinical and economic benefits to patients, physicians, hospitals and payors by addressing many of the limitations of alternative blood loss management methods currently on the market. Clinical studies comparing our products to alternative blood loss management methods have shown that our products significantly reduce blood loss, the need for blood transfusions and operating time. We believe that the clinical benefits of our Transcollation technology also result in cost savings to hospitals and payors.

Our goal is to establish our Transcollation products as the standard of care for controlling surgical-related blood loss. In the United States, we sell our products through a direct sales organization comprised of approximately 70 sales representatives and eight managers. We intend to significantly expand the size of our direct U.S. sales force in order to grow our customer base and further penetrate existing accounts. As of December 31, 2007, we had 437 active customer accounts in the United States, which represented a 44% increase over the comparable period in 2006. We define an active customer account as an account that has purchased products from us in the most recently ended fiscal quarter. Despite our significant growth in the number of customer accounts, our target market remains substantially underpenetrated. We believe our current accounts represent approximately 10% of hospitals in the United States performing our targeted procedures. Internationally, we sell our products through a combination of distributors and direct sales representatives, and we expect to selectively grow our international sales presence.

Our Strategy

Our strategy is to utilize our Transcollation technology to improve surgical procedures and patient outcomes. We intend to establish our Transcollation products as the standard of care for controlling surgical-related blood loss by demonstrating the clinical and economic benefits of Transcollation technology to clinicians, patients, hospitals and payors. To achieve this goal, we are pursuing the following business strategies:

 

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Expand Our Direct Sales Force to Open New Accounts.    We plan to significantly increase the size of our direct U.S. sales force to expand hospital account coverage. We estimate our current penetration rate in U.S.

 

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hospitals performing orthopaedic reconstructions and spinal surgeries to be 10%. As a result, we believe that we have a significant opportunity to sell into hospitals where our products are not yet being used.

 

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Further Penetrate Existing Accounts in the United States.    We believe there is a significant opportunity to increase our revenues with existing customers. We plan to leverage our relationships with existing customers to increase the number of surgeons using our products. In addition, through our demonstrated performance and supporting clinical and cost benefit data, we intend to expand the types of procedures for which our products are used by existing surgeon customers.

 

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Continue to Launch New Products Which Enhance the Value of the Aquamantys System.    We plan to launch several new products to further enhance the applicability and performance of our Aquamantys System. We believe these new products will provide greater utility to surgeons in performing certain surgical procedures, and we will continue to solicit feedback from surgeons in developing new products.

 

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Expand the Use of Our Technology Into New Market Opportunities.    We believe that our Transcollation technology represents a platform technology that can be used broadly in a number of new markets to seal blood vessels and other collagen-based structures. We intend to focus some of our research and development efforts in the near future on new market opportunities, including single-level spinal fusions, minimally invasive spine surgery, trauma surgery and advanced laparoscopic surgery.

 

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Continue to Expand and Protect Our Intellectual Property Position.    We believe we have a strong intellectual property portfolio, including technology and patents licensed from Medtronic. We own or license over 50 patents and over 25 patent applications in the United States and internationally. We intend to continue to expand and protect our intellectual property portfolio.

 

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Selectively Expand our International Sales Presence.    We plan to continue to expand our direct sales force and distributor network in selected countries outside the United States where we believe there is significant market opportunity for our products.

In addition, we plan to expand the use of our technology into surgical procedures where our technology may provide surgical benefits beyond reduced blood loss. We also intend to internally develop or acquire new surgical technologies we believe to be of value to our customers.

Market Opportunity

According to a study published by Medtech Insight, it is estimated that more than 32.7 million surgical procedures were performed in the United States in 2006. Bleeding and blood loss are common to all surgeries and represent a significant challenge to the healthcare system, particularly due to medical complications and costs associated with blood transfusions. Bleeding during certain procedures can often compromise surgeon visibility, which may impact patient outcomes and extend operative times. Blood loss during and after surgery may lead to sub-optimal clinical outcomes, extended hospital stays and increased costs.

Patients who receive blood transfusions are susceptible to bacterial and viral infections, transfusion reactions, immune system suppression and other medical complications. These risks vary from 1-in-1,000 for transfusion reactions to 1-in-30,000 for hepatitis and 1-in-1,500,000 for HIV. Human error associated with the handling of donated blood can also contribute to serious complications or death, with a recent study reporting that human error occurs in 1-in-25,000 blood transfusions. Blood shortages often occur due to high transfusion demand, a shrinking donor pool and the finite shelf life of blood, leading to cancellations or delay of elective surgeries.

Surgical procedures commonly associated with significant blood loss include orthopaedic, spine, oncological, gynecological, gastroenterology and other general surgeries. We currently focus primarily on orthopaedic hip and knee reconstructions and multi-level spinal fusions. These procedures represent large and growing market opportunities, driven by an active and aging population and improved surgical techniques. It was

 

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estimated by Medtech Insight that there were over 1.2 million hip and knee reconstructive procedures and 135,000 multi-level spinal fusions performed in the United States in 2007, which are projected to grow through 2012 at an annual rate of approximately 6% and 5%, respectively.

According to a study published in the Journal of Bone and Joint Surgery by Bierbaum et al., 15.7% of patients undergoing reconstructive hip and knee procedures received allogeneic blood transfusions. This rate ranges from 11% for patients receiving a primary knee replacement to 37% for patients undergoing a revision hip replacement. The study also demonstrated that receiving allogeneic blood transfusion results in a one day increase in hospital stay and a significant increase in the risk of infection. In addition, the study showed that patients who predonated blood may still require a blood transfusion from another donor, which is referred to as an allogeneic transfusion. According to a study published in SPINE by Nuttall et al. in 2000, approximately 36% of patients undergoing spinal fusions require allogeneic blood transfusions, with the transfusion risk increasing with the number of levels fused.

Physicians use a variety of methods separately or in combination to limit the amount of bleeding during surgery. The most common method used to manage blood loss is electrocautery. Electrocautery devices, often called “bovies,” utilize a generator to deliver RF energy to an electrode which can reach temperatures in excess of 300°C (572°F). We believe there are a number of drawbacks to electrocautery, including the length of time required to achieve hemostasis, charring of tissue, noxious smoke and the tearing and re-bleeding caused by electrodes sticking to tissues. In addition, we believe electrocautery is ineffective when used on large blood vessels or large areas of oozing tissue.

Other alternative blood loss management methods include autologous predonation of blood, topical sealants, gels, biologics, hypotensive anesthesia, hemodilution, reinfusion of lost blood, erythropoietin (EPO), hemostatic sponges, ultrasound and pharmaceutical agents designed to reduce operative blood loss. These alternative methods for managing surgical blood loss have significant drawbacks, including limited effectiveness, high transfusion rates, high cost, lack of suitability for certain patients, difficulty of use and increased risk of medical complications. We believe an unmet clinical need exists for technologies and products that enable surgeons to perform surgical procedures in a safer, easier, faster and more cost-effective manner.

Our Solution

We have developed our Aquamantys System and other products based on our proprietary Transcollation technology platform for sealing of blood vessels and other collagen-based structures. This technology enables physicians to better manage blood loss during and after surgery, which we believe provides clinical and economic benefits to patients, physicians, hospitals and payors. As of February 1, 2008, over 165,000 patients have been treated with our products to control blood loss in orthopaedic hip and knee reconstruction, multi-level spinal fusions, and surgical oncology procedures.

Our Transcollation technology targets collagen, a protein contained in tissue throughout the body, including blood vessel walls. When collagen is heated between 75°C and 100°C it shrinks, causing the blood vessel walls to contract, resulting in a permanent seal. See Figure 1 below.

Our single-use handheld Transcollation devices deliver RF energy in combination with saline to reduce surgical-related blood loss. The saline conducts RF energy from the electrodes of our devices to the treatment area and also acts as a cooling agent, keeping the surface of the tissue below 100°C which prevents it from charring. The saline also acts as a lubricant, allowing surgeons to move the handheld device in a simple painting motion on the surgical site. These attributes enable quick and consistent sealing of the targeted blood vessels to reduce surgical-related blood loss. As the tissue is treated, it changes color from pink to light tan which provides a visual cue that sealing is complete.

 

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Figure 1.

 

LOGO   LOGO   LOGO
Figure 1(a)   Figure 1(b)   Figure 1(c)

Figure 1 shows the effect of Transcollation technology on a blood vessel. Figure 1(a) shows a blood vessel prior to application of Transcollation technology. Figure 1(b) shows a blood vessel after the Transcollation process has been initiated with vessel wall thickening due to transformation of collagen. Figure 1(c) shows the permanently sealed blood vessel.

We believe that our Transcollation technology addresses many of the drawbacks associated with alternative blood loss management methods and that it provides the following benefits:

Benefits to Patients

 

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Reduced Need for Blood Transfusions.    Transcollation reduces the need for transfusions, which significantly reduces the risk of infections or other post-operative complications.

 

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Reduced Operating Time.    Transcollation reduces operating room time, which can lower the risk of anesthesia-related complications and surgical infection.

 

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Improved Post-Operative Outcomes.    Surgeons report that Transcollation improves post-operative outcomes, including reduced bruising, pain and swelling, which can result in improved range of motion, shorter hospital stays and faster recovery.

Benefits to Physicians

 

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Improved Visibility and Reduced Operating Time.    Transcollation improves surgeon visibility of the operative site by reducing excessive bleeding within the surgical field, which can allow the surgeon to complete surgeries more efficiently and effectively.

 

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Better Patient Outcomes.    Transcollation reduces blood loss, which surgeons report results in less bruising and swelling, allowing for earlier patient mobility and range of motion, which are correlated with improved patient outcomes.

 

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Reduced Need for Post-Operative Care.    Transcollation reduces the need for blood transfusions and surgical blood collection drains, which can result in a reduced need for post-operative care, fewer post-operative complications and less frequent physician follow up.

 

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Ease of Use.    Our Aquamantys RF generator has a simple user interface with pre-defined settings based on a proprietary algorithm that optimizes the relationship between the RF power level and saline flow rate.

 

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Benefits to Hospitals and Payors

 

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Reduced Incidence of Blood Transfusions.    Transcollation reduces the need for transfusions, which we believe generates cost savings for hospitals and payors. According to a January 2007 publication by the Joint Commission on the Accreditation of Healthcare Organizations (JCAHO), the cost of transfusing a unit of blood is estimated to be between $500 and $700. The total cost associated with a blood transfusion can significantly exceed $700 as a result of transfusion-related complications and the need for multiple units of blood.

 

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Reduced Operating Time.    Transcollation enables more efficient surgical procedures, which potentially allows hospitals to increase the turnover rate of operating rooms.

 

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Reduced Hospital Stay.    Transcollation reduces the amount of post-operative care and the risk of post-operative complications, both of which can lead to shorter hospital stays. Procedures requiring blood transfusions often require the patient to stay one or more additional days in the hospital. According to a study published by RTI Health Solutions in 2005, the average cost of one additional day in a hospital in the United States exceeds $1,100.

Our Products

Our products, based on our Transcollation technology, deliver an optimized combination of RF energy and saline to safely and effectively reduce surgical-related blood loss. The Aquamantys System, which was commercially launched in the first quarter of 2006, is the latest generation of our Transcollation products and is the primary system that our direct sales force currently markets in the United States. The Aquamantys System improves upon our earlier generation bipolar sealer (BPS) line, with superior performance characteristics including improved ease of use and more effective delivery of RF energy and saline.

The Aquamantys System

Our Aquamantys System is designed to be intuitive and easy to use for both surgeons and operating room staff. The Aquamantys System features our proprietary electrosurgical RF generator that optimizes the delivery of RF energy and saline flow through our proprietary single-use handheld bipolar sealers. See Figure 2 below. In our experience, operating room staff can typically be trained to use the Aquamantys System in one short training session. Our Aquamantys System is portable and can be easily wheeled from one operating room to another within a hospital. Our Aquamantys System is comprised of the following components:

 

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Our Aquamantys RF generator is an electrosurgical generator with a rotary peristaltic pump that is designed for use with our Aquamantys single-use handheld bipolar sealers. The generator provides the surgeon with a choice of flow rate settings via an easy to use touch screen panel on the front of the generator. We have embedded a proprietary algorithm into our generator that optimizes the relationship between RF power and saline flow rate upon activation of the single-use handheld device.

 

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Aquamantys Bipolar Sealers are single-use handheld devices that have been designed for use with our Aquamantys RF generator for sealing blood vessels and other collagen-based structures. A single button on the handheld device is used to activate the simultaneous flow of RF energy and saline, which is automatically controlled by our Aquamantys RF generator. Three versions of these handheld devices are currently available for clinical use. These devices differ in respect to the size and configuration of the electrode tips, allowing for procedure specific applications. Our newest single-use handheld device incorporates a malleable shaft and a LED which illuminates the treatment area, offering better visualization to users.

 

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Figure 2.

LOGO

Figure 2 shows our Aquamantys System, our Aquamantys RF generator, our Aquamantys bipolar sealer and a close-up of the electrodes on an Aquamantys bipolar sealer.

Our Monopolar Product Line

Our monopolar products, initially introduced in 2001, deliver RF energy and saline to a surgical site through the use of a single-use handheld device with a single electrode that is used in conjunction with a return electrode pad, also known as a grounding pad, attached to the patient’s body. These devices were optimized for use in surgical oncology procedures, and are used to seal blood vessels prior to cutting, to stop active bleeding during surgery and for blunt dissection of an organ to remove cancerous tissue. Multiple versions of our monopolar products are available for open and laparoscopic surgical procedures.

Our Clinical Results

Adoption of our Transcollation technology is supported by the positive clinical outcomes our customers and patients have experienced. These positive clinical outcomes include reductions in surgical-related blood loss, the need for blood transfusions and surgical procedure times as compared to alternative methods of controlling blood loss. Our clinical results are further supported by several controlled studies within our targeted markets which document significant improvements in clinical outcomes associated with our technology when compared to electrocautery and other alternative blood loss management methods. Some of these studies have demonstrated:

 

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A greater than 70% reduction in blood transfusions for patients receiving a primary hip replacement.

 

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A greater than 60% reduction in blood transfusions for patients receiving a primary knee replacement.

 

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A greater than 70% reduction in blood transfusions for liver resections.

 

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A greater than 33% reduction in operative time during multi-level spinal fusion surgery for pediatric scoliosis patients.

 

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A significant reduction in post-operative hemoglobin decline in patients undergoing total knee replacement.

A patient’s hemoglobin level is an objective measure of the oxygen carrying capacity of red blood cells in circulation that is often used to determine the need for blood transfusions. Hemoglobin levels decline significantly during surgical procedures as a result of blood loss, which may lead to anemia, fatigue, and the risk of cardiovascular complications. The clinical decision to transfuse a patient is often based on a patient’s hemoglobin level or the development of symptomatic anemia. The reduction in blood loss and transfusions associated with the use of our Transcollation technology is related primarily to its ability to preserve hemoglobin levels in patients undergoing surgical procedures.

We are targeting procedures which are associated with significant blood loss and high rate of transfusions. The ability of our Transcollation technology to significantly reduce bleeding allows for the maintenance of

 

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higher intraoperative and postoperative hemoglobin levels. This offers a clinical and competitive advantage compared to alternative blood loss management methods, which more frequently result in the need for a patient to receive a transfusion.

Sales and Marketing

Our sales and marketing efforts primarily focus on surgeons and hospital personnel responsible for product purchasing decisions related to our targeted surgical procedures.

In the United States, we sell our products through a direct sales force. As of December 31, 2007, our sales force in the United States consisted of approximately 70 sales representatives and eight managers. Each sales representative is responsible for opening new hospital accounts and cross-selling the use of our products across targeted surgical procedures within the hospital. The compensation package for our direct sales force and sales management in the United States is comprised of a base salary plus commission structured to drive revenue growth. The commission portion of each individual’s compensation package varies and consists of two rate tiers: a lower commission rate paid based on all revenue equal to the prior year revenue and a higher rate paid on incremental revenue over the prior year.

We intend to continue to increase the number of our direct sales representatives to further penetrate our target market. As of December 31, 2007, we had 437 active customer accounts in the United States or approximately 10% of all hospitals in the United States that perform our targeted procedures. The current focus of our sales force is on hospitals performing orthopaedic reconstructions and hospitals performing spine surgeries. Currently, no single hospital accounts for greater than 5% of our revenues.

Internationally, we sell our products through a combination of distributors and direct sales representatives. As of December 31, 2007, our international sales organization consisted of a network of nine international distributors and two direct sales representatives in the United Kingdom. We continue to strategically expand our international sales force through a combination of direct sales representatives and distributors.

Our current marketing efforts are designed to establish Transcollation products as the standard of care for blood loss management in a broad range of surgical procedures. Our primary marketing materials include published clinical data, internal marketing materials and medical conferences and trade shows. In the future, we intend to expand our marketing efforts beyond surgical blood loss management to include other applications being addressed through our research and development efforts.

Reimbursement

In the United States, we do not rely directly on reimbursement from third-party payors, such as Medicaid, Medicare and private insurers, for any of our products. Medicare reimburses hospitals at a pre-determined amount for inpatient procedures, regardless of the actual cost for such treatment, based primarily on the patient’s diagnosis and procedures performed on the patient during the hospital stay. As a result, hospitals do not receive reimbursement based on the costs of our product. Many other third-party payors, including commercial insurers and managed care companies, pay for inpatient hospital services using a payment system similar to Medicare’s or using a per diem payment system in which there is also no separate reimbursement for the costs of our product.

As of October 1, 2007, the Centers for Medicare and Medicaid Services, or CMS, implemented a revised version of the DRG system that uses 745 Medicare Severity DRGs, or MS-DRGs, instead of the approximately 540 DRGs Medicare previously used. The MS-DRGs are intended to account more accurately for the patient’s severity of illness when assigning each patient’s stay to a payment classification. Medicare pays a fixed amount to the hospital based on the MS-DRG into which the patient’s stay is assigned, regardless of the actual cost to the hospital of furnishing services to the patient. Accordingly, hospitals do not receive separate Medicare reimbursement under IPPS for the specific costs incurred in purchasing our products. Rather, reimbursement for

 

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these costs is deemed to be included within the MS-DRG-based payments made to hospitals for the services furnished to Medicare-eligible inpatients in which our products are utilized. Accordingly, a hospital must absorb the cost of our products as part of the payment it receives for the procedure in which our product is used. Many other private health insurance plans and Medicaid plans also use a DRG system or a per diem payment system in which the payment amount is fixed in advance and does not vary based on the services furnished to the particular patient, and other private health insurance plans pay hospitals a negotiated percentage of the hospital’s charges for each patient.

In international markets, reimbursement and health care payment systems vary significantly by country, and many countries have instituted price ceilings on specific product lines. There can be no assurance that reimbursements will be available for our products in these markets or, if available, that reimbursement policies of third parties will not adversely affect our ability to sell our products.

Research and Development

Our research and development efforts are focused primarily on developing enhancements to our current product lines and on developing complementary products and technologies for use in orthopaedic reconstruction, spinal surgeries and other new applications. Our research and development department has extensive experience in developing products that utilize our Transcollation technology to significantly reduce blood loss during surgical procedures. Our team continues to work closely with our physician advisory boards and customers to design products that are intended to improve patient care, simplify techniques and reduce overall costs.

As of February 1, 2008, we had 11 people engaged in research and development. We incurred research and development expense of approximately $3.0 million in 2007. We anticipate that research and development expense will increase as we expand the applications of our platform technology to further penetrate current markets and expand into new clinical areas.

Manufacturing

We outsource the manufacture of all our products. Our single-use handheld devices are made to our custom specifications by contract manufacturers located in the United States. The manufacturing process for our single-use handheld devices includes the assembly, testing, packaging, sterilization and inspection of components that have been manufactured to our specifications. Sterilization testing is processed at a certified third-party laboratory to verify the effectiveness of the sterilization process. Assembly operations at our contract manufacturers are supported by our quality assurance and manufacturing engineers.

We believe our current contract manufacturers have the capacity to meet our needs through 2010. We are in the process of bringing on line a second contract manufacturer for the manufacture of our Aquamantys single-use handheld devices. We believe this additional manufacturer, together with our current manufacturer, will be able to provide sufficient capacity to meet our needs for our Aquamantys single-use handheld devices through 2010. In addition to the contract manufacturers, we expect to have in-house pilot-line capability in our new facility which we expect to be constructed by the end of 2008. We believe this in-house pilot line capability will enhance our ability to quickly bring new products to market by allowing our engineers and quality staff to develop the manufacturing process prior to engaging the contract manufacturers.

Our Aquamantys RF generator is made in Germany by a contract manufacturer to our custom specifications. Our supply agreement with this vendor includes provisions for warranty and service. The agreement also states that in the event the current supplier cannot meet our production needs in the future, the current supplier will take all measures necessary to enable us to transfer the manufacturing to a new supplier.

The majority of our product components are purchased directly by our contract manufacturers, but some of the more expensive, complex or long-lead time components may be purchased by us and transferred to our contract manufacturers during the startup phase of a product’s life. Most of our components are single-sourced;

 

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however, we do not anticipate any difficulty identifying additional suppliers, if necessary. We own the molds and fixtures used to make components, and we believe that we can transfer such tooling to a new supplier without disrupting the production of finished single-use handheld devices.

We believe that our quality assurance systems are in compliance with the Quality System Regulation, or QSR mandated by the FDA. For sales of products outside the United States, we believe that our products and quality systems are in compliance with the current quality management standard, ISO 13485:2003 for medical devices.

Competition

The medical device industry is highly competitive, subject to rapid technological change and significantly affected by new product introductions and activities of other market participants. Our currently marketed products are, and any future products we commercialize will be, subject to intense competition. We believe the principal competitive factors in our markets include:

 

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safety and efficacy;

 

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ease of use;

 

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product recognition and reputation with practitioners and hospitals;

 

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speed to market;

 

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technical leadership and superiority; and

 

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cost of the product.

We are aware of several companies that make products or technologies involving the use of both RF and saline, as well as bipolar and monopolar devices. These companies include, but may not be limited to, Angiodynamics, Arthrocare, CONMED Medical, Covidien, Erbe, Gyrus, Integra LifeSciences, Johnson & Johnson, Medtronic, Resect Medical, Smith & Nephew, SurgRx and Synergetics. We are also aware of several companies that make products or technologies for blood loss management or dissection that do not involve the use of RF or saline. These products include, but may not be limited to, Covidien’s Ligasure System, Erbe’s Helix Hydro-Jet product, Haemonetics’ Cell Saver and OrthoPAT systems, Integra Life Sciences’ CUSA Ultrasonic Surgical Aspiration System, and Johnson & Johnson’s Harmonic products. Additionally, we face competition from several companies that provide alternative blood loss management methods such as surgical sealants, electrocautery, hemodilution, cell salvage, reinfusion of lost blood, erythropoietin (EPO), ultrasound and hemostatic sponges. These companies may have substantially greater sales and financial resources than we do. In addition, these companies may have more established distribution networks, entrenched relationships with physicians and hospitals, and greater experience in launching, marketing, distributing and selling products.

Our ability to compete successfully will depend on our ability to continue to develop products that reach the market in a timely manner and are safer, less invasive and less expensive than alternatives available for the same purpose. It will also depend on the ability of our customers to receive adequate reimbursement for the use of our products. Because of the size of the potential market, we anticipate that companies will dedicate significant resources to developing competing products.

 

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Intellectual Property

Medtronic License Agreement

In August of 1999, we entered into a license agreement with Medtronic pursuant to which we license certain intellectual property related to our products and technology. Our license agreement has been subsequently amended four times. This worldwide license is exclusive for a broad range of medical applications, is co-exclusive for certain other medical applications including spinal procedures and procedures relating to the brain, head and neck, and is non-exclusive for a standard RF generator. Among other provisions, our license with Medtronic enables us to sublicense in the areas in which we hold exclusive and non-exclusive rights, and does not grant back to Medtronic any rights to other intellectual property we have developed or acquired. As of February 1, 2008, there are five issued U.S. patents included in the license from Medtronic that relate to products or technology currently marketed by us. These patents relate to the simultaneous application of an electrically conductive fluid and RF energy for both our monopolar and bipolar products, and an RF generator that provides a flow of the electrically conductive fluid based on the RF power setting. In addition, there are another 44 issued U.S. patents included in the license from Medtronic. Our license agreement with Medtronic also provides that the licenses granted will continue until the date all patents licensed under the agreement have expired. The earliest of the licensed patents will begin to expire in 2013.

Our license agreement with Medtronic provides that we make certain royalty payments to Medtronic of 2.0% to 7.5% of net product sales based on our product sales mix and cumulative volume of sales to date, and also requires us to make minimum annual royalty payments of $300,000. Pursuant to amendments to our license agreement, we have made royalty payments to Medtronic in the years 2004, 2005, 2006 and 2007 and will continue to do so through 2008, in lieu of cash, in the form of promissory notes and warrants to purchase our Series D Convertible Preferred Stock, which will become warrants to purchase our common stock upon consummation of this offering. See “Description of Capital Stock—Warrants” and Note 10 to our audited consolidated financial statements, contained elsewhere in this prospectus, for additional detail.

Under the terms of the license agreement, Medtronic has a right of first refusal to prosecute claims that third parties have infringed the licensed intellectual property and will retain a majority of the proceeds from any such successful prosecution. If Medtronic does not prosecute such infringement, we may prosecute such claims, but must provide Medtronic with a portion of any proceeds we may recover from infringers. We have the option of offsetting the costs of such prosecution against our annual royalty payments in exchange for providing Medtronic a larger portion of any proceeds.

Intellectual Property Strategy

Our patent strategy is to seek patent protection for our products from the in-licensed Medtronic intellectual property, where plausible, as well as from our own internally created intellectual property for improvements beyond the Medtronic intellectual property. In this manner, our products may be protected by intellectual property from both sources, which includes numerous patents having varying priority dates. In addition to the patents licensed from Medtronic, as of February 1, 2008, we own six issued U.S. patents and 22 pending U.S. patent applications which cover products and technology developed by us. These patents will not begin to expire until 2020. Internationally, we have a number of patent applications pending in certain countries of the European Union and Japan.

Our trademark strategy is to seek trademark registration for our corporate trademarks, as well as certain trademarks related to our products and technology, in the United States and certain other major markets. We do not seek registration of all our marks in every country in which we do business, including the United States.

The SALIENT and TRANSCOLLATION word marks are pending for registration in the United States. Registration of the AQUAMANTYS word mark is pending in the United States and, through an international application, the European Union, China and Japan.

 

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We require our employees, consultants and advisors to execute confidentiality and inventions agreements in connection with their employment or services. We also require our inventors to execute assignments to the inventions for which we choose to seek patent protection.

Government Regulation

Governmental authorities in the United States, at the federal, state and local level, and other countries extensively regulate, among other things, the research, development, testing, manufacture, labeling, promotion, advertising, distribution, marketing and export and import of products such as those we sell and are developing. Failure to obtain approval to market our products under development and to meet the ongoing requirements of these regulatory authorities could prevent us from marketing and continuing to market our products.

United States

Our products are regulated as medical devices under the Federal Food, Drug and Cosmetic Act, or the FDCA, as implemented and enforced by the FDA. The FDA governs the following activities that we perform or that are performed on our behalf, to ensure that medical products we manufacture, promote and distribute domestically or export internationally are safe and effective for their intended uses:

 

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product design, preclinical and clinical development and manufacture;

 

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product premarket clearance and approval;

 

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product safety, testing, labeling and storage;

 

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record keeping procedures;

 

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product marketing, sales and distribution; and

 

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post-marketing surveillance, complaint handling, medical device reporting, reporting of deaths, serious injuries or device malfunctions and repair or recall of products.

FDA Premarket Clearance and Approval Requirements

Unless an exemption applies, each medical device we wish to commercially distribute in the U.S. will require either premarket notification, or 510(k), clearance or approval of a premarket approval application, or PMA, from the FDA. User fees, which increase each year and which are specific for the type of submission that is made, must be paid to the FDA at the time that the 510(k) or PMA is submitted. The information that must be submitted to the FDA in order to obtain clearance or approval to market a new medical device varies depending on how the medical device is classified by the FDA. Medical devices are classified into one of three classes on the basis of the controls deemed by the FDA to be necessary to reasonably ensure their safety and effectiveness. Class I devices, considered to have the lowest risk, are those for which safety and effectiveness can be assured by adherence to the FDA’s general regulatory controls for medical devices, or General Controls, including appropriate, truthful and non-misleading labeling, advertising and promotional materials, facility registration and product listing, reporting of adverse medical events and adherence to applicable portions of the FDA’s QSR, which are device-specific good manufacturing practices. Class II devices are subject to General Controls and any other special controls as deemed necessary by the FDA to ensure the safety and effectiveness of the device, or Special Controls, including special labeling requirements, mandatory performance standards and post-market surveillance. Manufacturers of most Class II and some Class I devices are required to submit to the FDA a premarket notification under Section 510(k) of the FDCA requesting permission to commercially distribute the device. Class III devices are those devices deemed by the FDA to pose the greatest risks, such as life-sustaining, life-supporting or implantable devices, or devices that have a new intended use, or use advanced technology that is not substantially equivalent to that of a legally marketed device. Class III devices require the FDA approval of a PMA before they can be marketed. All of our currently marketed products are Class II devices marketed pursuant to 510(k) clearances.

 

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510(k) Clearance Pathway

To obtain 510(k) clearance, we must submit a 510(k) pre-market notification demonstrating that the device in question is substantially equivalent to one or more legally marketed predicate devices that is either in Class I or Class II, or to a Class III device that was in commercial distribution before May 28, 1976 for which the FDA has not yet called for the submission of a PMA. In evaluating the 510(k), the FDA must determine that the device has the same intended use as the predicate device and either has the same technological characteristics as the predicate device or does not raise different questions of safety and effectiveness and is demonstrated to be as safe and effective as the legally marketed device. Most 510(k)s do not require clinical data for clearance. The FDA is required to issue a decision letter within 90 days if it has no additional questions or send a first action letter requesting additional information within 75 days. The FDA may not meet the applicable performance goal review time. In addition, requests for additional data, including clinical information, will increase the time necessary to review the notification. Unless the FDA informs the manufacturer that a 510(k) is not required or agrees that a new device is substantially equivalent to a predicate device, the new device will be classified in Class III, and the manufacturer must submit a PMA or, may, depending on the nature of the device, petition the FDA to make a risk-based determination of the new device and reclassify the new device as a Class I or II device. Modifications to 510(k)-cleared medical devices may or may not require the submission of another 510(k) or a PMA depending on whether the changes will significantly affect the safety or effectiveness of the device or will cause the device to be marketed for a new or different indication. We have made and plan to continue to make additional product enhancements to our marketed products that we believe do not require new 510(k) clearances. We cannot assure you that the FDA would agree with any of our decisions not to seek 510(k) clearance or PMA approval.

Clinical Trials

Clinical trials are generally required to support a PMA application and are sometimes required for 510(k) clearance. Such trials generally require an investigational device exemption application, or IDE, approved in advance by the FDA for a specified number of patients and study sites, unless the product is deemed a non-significant risk device eligible for more abbreviated IDE requirements. A significant risk device is one that presents a potential for serious risk to the health, safety, or welfare of a patient and either is implanted, used in supporting or sustaining human life, substantially important in diagnosing, curing, mitigating, or treating disease or otherwise preventing impairment of human health, or otherwise presents a potential for serious risk to a subject. Clinical trials are subject to extensive monitoring, recordkeeping and reporting requirements. Clinical trials must be conducted under the oversight of an institutional review board, or IRB, for the relevant clinical trial sites and must comply with FDA regulations, including but not limited to those relating to good clinical practices. To conduct a clinical trial, we also are required to obtain the patients informed consent in form and substance that complies with both FDA requirements and state and federal privacy and human subject protection regulations. We, the FDA or the IRB could suspend a clinical trial at any time for various reasons, including a belief that the risks to study subjects outweigh the anticipated benefits. Even if a trial is completed, the results of clinical testing may not adequately demonstrate the safety and efficacy of the device or may otherwise not be sufficient to obtain FDA clearance or approval to market the product in the U.S. Similarly, in Europe the clinical study must be approved by a local ethics committee and in some cases, including studies with high-risk devices, by the appropriate regulatory authority in the applicable country. To date, none of our submissions to the FDA have required the submission of clinical data. However, we are conducting some non-significant risk post-market studies. As a result, we do not believe that we are required to obtain FDA approval of an IDE. However, we did receive the approval of the participating IRBs and obtained informed consents from all study patients. If the FDA disagrees with our determination that the study is a non-significant risk study, the FDA could require us to stop the study and could take enforcement action against us.

 

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Pervasive and Continuing Regulation

After a device is placed on the market, numerous regulatory requirements apply. These include, among others:

 

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QSR, which requires manufacturers to follow design, testing, control, documentation and other quality assurance procedures during all aspects of the design and manufacturing process;

 

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labeling regulations, which govern product labels and labeling, prohibit the promotion of products for unapproved or off-label uses and impose other restrictions on labeling and promotional activities;

 

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medical device reporting, or MDR, regulations, which require that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur; and

 

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notices of corrections or removals, and recall regulations.

The MDR regulations require that we report to the FDA any incident in which our product may have caused or contributed to a death or serious injury, or in which our product malfunctioned and, if the malfunction were to recur, it would likely cause or contribute to a death or serious injury. As of February 1, 2008, we have submitted 18 MDR reports to the FDA. In December 2007, FDA requested additional information on three (3) MDR reports we submitted in 2006 and 2007 involving accidental burns to patients. We submitted a response to the FDA and have not received any further follow-up regarding these MDRs.

Advertising and promotion of medical devices are also regulated by the Federal Trade Commission and by state regulatory and enforcement authorities. Recently, some promotional activities for FDA-regulated products have been the subject of enforcement actions brought under health care reimbursement laws and consumer protection statutes. In addition, under the federal Lanham Act, competitors and others can initiate litigation relating to advertising claims.

We have registered with the FDA as a medical device specification developer. Compliance with regulatory requirements is assured through periodic, unannounced facility inspections by the FDA and these inspections may include the manufacturing facilities of our subcontractors. Failure to comply with applicable regulatory requirements can result in enforcement actions by the FDA, which may include any of the following sanctions:

 

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untitled letters, warning letters;

 

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fines, injunctions, consent decrees and civil penalties;

 

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recall or seizure of our products;

 

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customer notification, or orders for repair, replacement or refund;

 

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operating restrictions, partial suspension or total shutdown of production;

 

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refusing or delaying our request for 510(k) clearance or PMA approval of new products;

 

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withdrawing 510(k) clearance or PMA approvals that are already granted;

 

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refusal to grant export approval for our products; and

 

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criminal prosecution.

The FDA inspected our facility in 2002. In this inspection no significant incidents of noncompliance were found. We cannot assure you that we can maintain the same level of regulatory compliance in the future at our facility.

 

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Current Clearances

We have received 510(k) clearances to market our single-use handheld devices and our Aquamantys RF generator. Our single-use handheld devices and Aquamantys RF generator are Class II devices under FDA regulations, and are subject to 510(k) clearance prior to market. We do not presently have any 510(k) or pre-market approval submissions pending at the FDA.

Cleared 510(k)’s for Salient Surgical Technologies

 

Device

   510(k)#    Decision
Date

TissueLink Monopolar Floating Ball

   K002680    11/13/2000

TissueLink Bipolar Forceps

   K003005    12/08/2000

TissueLink Monopolar Floating Ball

   K010662    04/27/2001

TissueLink Bipolar Forceps

   K010661    05/03/2001

TissueLink Solid Cylinder Monopolar Device

   K014260    03/27/2002

TissueLink Bipolar Floating Ball

     

Amendment (ADP Adapter)

   K022532    06/30/2003

TissueLink Bipolar Floating Ball Device

   K020574    05/20/2002

TissueLink Bipolar Floating Ball Device

   K022532    02/12/2003

TissueLink Sealing Forceps, Model 1 21-202-1

   K030380    03/03/2003

TissueLink Bipolar Sealer 2.3

     

(Bipolar Floating Ball) Device

   K032132    08/20/2003

TissueLink Aquamantys Pump

     

Generator System

   K052859    10/25/2005

TissueLink Aquamantys SS 4.0 Bipolar Sealer

   K063639    02/22/2007

TissueLink Aquamantys Malleable Bipolar Sealer with Light

   K073495    01/09/2008

European Union

Our products are regulated in the European Union as medical devices per the Medical Device Directive. An authorized third party, or Notified Body, must approve our products for CE marking. Our existing single-use handheld devices were approved for CE marking, with the initial approvals occurring in 2001. All products, with the exception of the following single-use handheld devices, are currently CE marked: the BPS 2.3, the SS 4.0 Bipolar Sealer and the Malleable Bipolar Sealer with Light. We cannot assure you that we will be able to obtain the CE mark approval for new products in the future. The CE mark is contingent upon our continued compliance with the applicable regulations and the requirements for quality management systems specified in the ISO 13485:2003 standard.

The European Community has regulations similar to that of the FDA for the advertising and promotion of medical devices, clinical investigations, and adverse events. We believe that we are in compliance with such regulations at this time.

Rest of the World

Most major markets outside of the United States and the European Union have different levels of regulatory requirements for medical devices. Our monopolar single-use handheld devices are currently approved, cleared, licensed, or registered in Canada, South Africa, Japan, Australia, China, several South American countries and several Middle Eastern Countries. Our bipolar products are currently licensed in many of the same countries. Modifications to the approved products require a new regulatory submission in all major markets. The regulatory requirements and the review time vary significantly from country to country. We cannot assure you that we will be able to obtain or maintain the required regulatory approvals. Our devices can also be marketed in the several other countries that do not regulate medical devices. We cannot assure you of the timing or the successes of our efforts to obtain the approvals for the current and future products in international markets.

 

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Quality Systems

We maintain a state-of-the-art quality management system that focuses on the design, manufacture, packaging and distribution of our products and the continuous improvement of our systems. We achieved certification to the International Standards Organization, or ISO, quality management system standards ISO 9001/EN4600 in 2001. We successfully migrated our quality management system to ISO 13485:2003 in 2005. Our quality management system incorporates both advanced electronic and paper systems. We are continuing to move toward a completely electronic environment, with quality assurance processes and tools to continue to enable full audit trails. We believe our quality management systems are robust and scalable, and will continue to support our expected growth while ensuring that our products meet the highest standards of safety and quality.

The FDA has established regulations at part 11 of Title 21 of the Code of Federal Regulations applicable to records in electronic form that are created, modified, maintained, archived, retrieved, or transmitted under any records requirements set forth in FDA’s regulations, as well as any electronic records submitted to the FDA under the FDCA or the Public Health Service Act. We believe that we are currently in compliance with the FDA regulations concerning our electronic recordkeeping systems. If the FDA determines that we are not in compliance with its regulations, the FDA could require us to stop using our electronic recordkeeping systems and could take enforcement action against us.

Compliance with Fraud and Abuse Laws

We must comply with various federal and state laws, rules and regulations pertaining to health care fraud and abuse, including anti-kickback laws. Violations of these laws are punishable by criminal and civil sanctions, including, in some instances, exclusion from participation in federal and state health care programs, including Medicare, Medicaid, Veteran’s Administration health programs, workers’ compensation programs and TRICARE. We believe that our operations are in material compliance with such laws, rules and regulations. However, because of the far-reaching nature of such laws and government authorities’ wide discretion in enforcement of these laws, there can be no assurance that we will not be required to alter one or more of our practices to be deemed to be in compliance with these laws. In addition, there can be no assurance that the occurrence of one or more violations of these laws, rules or regulations will not result in a material adverse effect on our business, financial condition and results of operations.

Anti-Kickback Statute

The federal Anti-Kickback Statute prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the furnishing, arranging for or recommending a good or service for which payment may be made in whole or part under a federal health care program such as Medicare or Medicaid. The definition of remuneration has been broadly interpreted to include anything of value, including for such items as gifts, certain discounts, waiver of payments and providing anything at less than its fair market value.

Government officials have focused recent enforcement efforts on, among other things, the sales and marketing activities of health care companies, and recently have brought cases against individuals or entities with personnel who allegedly offered unlawful inducements to potential or existing customers in an attempt to procure their business. This enforcement trend is expected to continue. Settlements of these cases by health care companies have involved significant fines and penalties and in some instances criminal pleas. We are also aware of governmental investigations of device companies reportedly focusing on consulting and service agreements between these companies and surgeons. These enforcement developments are ongoing and we cannot predict the effects they will have on future prices for medical devices.

The Anti-Kickback Statute is broad and potentially prohibits many arrangements and practices that are lawful in businesses outside of the health care industry. The Office of Inspector General of Health and Human

 

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Services, or OIG, has issued a series of safe harbors that set forth certain requirements that, if fully met, will assure health care providers and other parties that they will not be prosecuted under the Anti-Kickback Statute. Although full compliance with these provisions ensures against prosecution under the Anti-Kickback Statute, failure of a transaction or arrangement to fit precisely within one or more safe harbors does not necessarily mean that it is illegal or that prosecution will be pursued. However, conduct and business arrangements that do not fully satisfy each applicable safe harbor may result in increased scrutiny by government enforcement authorities such as the OIG. The statutory penalties for violating the Anti-Kickback Statute include imprisonment for up to five years and fines of up to $25,000 per violation. In addition, through application of other laws, conduct that violates the Anti-Kickback Statute can also give rise to False Claims Act lawsuits, civil monetary penalties and possible exclusion from Medicare and Medicaid and other federal health care programs. In addition to the Federal Anti-Kickback Statute, many states have their own anti-kickback laws. Often, these laws closely follow the language of the federal law, although they do not always have the same scope, exceptions or safe harbors. In some states, these anti-kickback laws apply not only to payments made by a government health care program but also with respect to other payors, including commercial insurance companies.

False Claims Laws

The federal False Claims Act prohibits any person from knowingly presenting, or causing to be presented, a false claim or knowingly making, or causing to be made, a false statement to obtain payment from the federal government. Absent prompt self-reporting, when an entity is determined by a court or jury to have violated the False Claims Act, it must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,000 and $11,000 for each separate false claim.

By application of other laws, conduct that violates the False Claims Act can also give rise to exclusion from participation in Medicare, Medicaid and other government health programs. Actions filed under the False Claims Act can be brought by a relator or, more commonly, a whistleblower, who may share in any amounts paid by the accused entity to the government in damage awards or as settlements. In addition, certain states have enacted laws modeled after the federal False Claims Act. Qui tam actions have increased significantly in recent years, causing a greater number of health care companies to defend false claims actions, pay damages and penalties or be excluded from Medicare, Medicaid or other federal or state health care programs as a result of investigations arising out of such actions.

Compliance

As part of our continued efforts in the area of compliance, we have developed a compliance program that is designed to assist in the prevention and detection of violations. The medical device industry has established, and our compliance program is modeled in part on, a voluntary ethical code called the AdvaMed Code of Ethics on Interactions with Health Care Professionals, or the AdvaMed Code. The AdvaMed Code reflects the unique interactions between medical technology companies and health care professionals. Despite our efforts, we can make no assurance that our compliance programs will prevent and detect all potential compliance violations.

Environmental Matters

Our facilities and operations are subject to extensive federal, state, local and foreign environmental and occupational health and safety laws and regulations. These laws and regulations govern, among other things: air emissions, wastewater discharges, the generation, storage, handling, use and transportation of hazardous materials, the handling and disposal of hazardous wastes, the cleanup of contamination, and the health and safety of our employees. Under such laws and regulations, we are required to obtain permits from governmental authorities for some of our operations. If we violate or fail to comply with these laws, regulations or permits, we could be fined or otherwise sanctioned by regulators. We could also be held responsible for costs and damages arising from any contamination at our past or present facilities or at third-party waste disposal sites. We cannot completely eliminate the risk of contamination or injury resulting from hazardous materials, and we may incur material liability as a result of any contamination or injury.

 

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Privacy and Security

Regulations issued pursuant to Health Insurance Portability and Accountability Act of 1996, or HIPAA, require certain covered entities to comply with established standards regarding the privacy and security of protected health information and to use standardized code sets when conducting certain electronic transactions. The regulations also require business associates that provide services on behalf of the covered entity to agree to follow the same standards. We are neither a covered entity nor a business associate, and therefore technically we are not subject to the HIPAA regulations. Nonetheless, most of our customers are subject to these rules, so we must be familiar with and sensitive to the HIPAA requirements so as not to take actions that may lead to their customers violating the requirements. Additionally, whenever we sponsor a clinical trial, we must be cognizant of the HIPAA regulations and collect the necessary authorizations to enable the covered entity clinical investigator to disclose the resulting clinical data to us.

Employees

As of February 1, 2008, we had 144 employees worldwide, consisting of 11 in research and development, 102 in sales and marketing, 14 in operations and quality control, and 17 in general and administrative functions. From time to time, we also employ independent contractors to support our engineering, marketing, sales and support, clinical and administrative organizations. We have never experienced a work stoppage due to labor concerns, and we believe our relationships with our employees are good. None of our employees in the United States are represented by a labor union or subject to a collective bargaining agreement.

Facilities

We are headquartered in Dover, New Hampshire, where we lease approximately 21,000 square feet under a lease expiring October 31, 2010. We also lease 2,500 square feet of warehouse space in Rochester, New Hampshire for the storage of finished goods on a month-to-month basis. This warehouse also serves as the distribution point for all of our products.

On February 27, 2008, we executed a build-to-suit lease for premises in Portsmouth, New Hampshire. Construction is expected to begin at the end of March 2008, and we expect the building to contain approximately 55,000 square feet and to include office, warehouse, pilot-line capability and cleanroom space. We have no current plans to manufacture our products in-house. We expect to move our headquarters to the new facility after construction is completed, which we currently expect to be in the fourth quarter of 2008. The base term of the lease will be 10 years, with two optional extension periods of five years each. We are currently in negotiations with the landlord for the Dover facility to sublet or cancel the existing lease prior to its 2010 expiration. We believe that our current facility will be adequate for our needs until we move into the new space which will accommodate our growing needs as we expand our business. We also believe we will be able to obtain additional space, as needed, on commercially reasonable terms.

Legal Proceedings

From time to time we may be a party to various legal proceedings arising in the ordinary course of our business. We are not currently subject to any material legal proceedings.

 

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DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES

Our executive officers, key employees and directors and their respective ages and positions as of February 1, 2008 are as follows:

 

Name

   Age   

Position

Joseph Army

   44    President, Chief Executive Officer and Director

Richard Altieri

   48   

Vice President, Finance, Chief Financial Officer and Treasurer

David Brown

   50    Vice President, Sales & Marketing

Mark Roby, Ph.D.

   57    Vice President, Research & Development

Som Kovvuri

   44    Vice President, Regulatory Affairs & Quality Assurance

Tad Vaughn

   49    Vice President, Operations

Jay Schmelter(2)(3)

   42    Chairman of the Board

Gary Ellis(1)

   51    Director

Anthony Arnerich(2)

   58    Director

J. Neal Armstrong(1)(2)

   69    Director

Winston Wallin(3)

   81    Director

Richard Randall(1)(3)

   56    Director

 

(1) Member of the audit committee.
(2) Member of the compensation committee.
(3) Member of the nominating and corporate governance committee.

Joseph Army has been our President and Chief Executive Officer and a member of our board of directors since June 2007. Mr. Army joined the company in 1999 as Chief Financial Officer, Vice President, Finance and Treasurer. Mr. Army has also served as treasurer and assistant secretary to the board of directors since the company’s inception in 1999 and as interim Chief Operating Officer from March 2007 to June 2007. Prior to joining the company, Mr. Army was Vice President of Finance and Supply Chain Operations with Westaim Biomedical Corp., a startup company focused on infection control. Previously, Mr. Army worked at Coopers & Lybrand Consulting from 1991 to 1997, ultimately serving as director of its strategy consulting practice in the firm’s Philadelphia office. Mr. Army holds a Bachelor of Arts degree in History from the University of Rhode Island and a Masters of Business Administration from The Wharton School of the University of Pennsylvania.

Richard Altieri has been our Vice President, Finance, Chief Financial Officer and Treasurer since September 2007. Prior to joining the company, from 2004 to 2007, Mr. Altieri was Senior Vice President, Finance and Chief Financial Officer of Straumann USA, a global leader in the fields of implant dentistry and oral tissue regeneration. From 1992 to 2004, Mr. Altieri was the Vice President, Finance and Chief Financial Officer of Mitek Surgical Products, Inc., a manufacturer of proprietary surgical implants and devices used in sports medicine, which was acquired by Johnson & Johnson in 1995 and later became DePuy Mitek, a Johnson & Johnson company. Mr. Altieri is a Certified Public Accountant (MA, inactive status) and holds a Bachelor of Science degree in Business Administration/Accounting from Northeastern University and a Masters of Business Administration in finance from Babson College.

David Brown has been our Vice President, Sales & Marketing since January 2008. Prior to joining the company, Mr. Brown served as Vice President of Strategic Sales at the Orthopedic Reconstruction Division of Smith & Nephew from 2007 to 2008. Prior to that, Mr. Brown was employed for 17 years by Covidien’s U.S. Surgical division (formerly Tyco Healthcare Group LP), most recently as Vice President of Global Market Development from 2006 to 2007 and Vice President of Sales from 2001 to 2006. Mr. Brown holds a Bachelor of Science degree in Business Administration from Penn State University.

Mark Roby, Ph.D., has been our Vice President, Research & Development since January of 2008. Prior to joining the company, Dr. Roby was the Chief Operating Officer for Promethean Surgical Devices, a development stage surgical products company, from 2006 to 2007. From 1999 to 2006, Dr. Roby worked for Covidien’s U.S. Surgical division (formerly Tyco Healthcare Group LP). While at Covidien, Dr. Roby held a number of

 

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positions, including Vice President of Research and Development. Dr. Roby has 45 issued patents and 13 publications, and holds a Bachelor of Arts degree in Chemistry and a Ph.D. in Polymer Chemistry, both from the University of Connecticut, and a Masters of Business Administration degree from Nasson College.

Som Kovvuri has been our Vice President, Regulatory Affairs & Quality Assurance since September 2007. Mr. Kovvuri began working with the company as a Quality Assurance Consultant in 2005 and was hired as the Director of Quality Assurance in April 2007. Subsequently, he was promoted to Vice President, Regulatory Affairs & Quality Assurance in September 2007. Mr. Kovvuri worked as a consultant to the medical device industry in the areas of quality, regulatory and biomedical engineering from 2005 to 2007. Prior to that, he was Director, Quality Assurance, Regulatory Affairs, and Clinical Affairs for A-Med Systems from 1999 to 2004. Mr. Kovvuri holds a Bachelor of Engineering degree in Electronics and Communication Engineering from Osmania University (India), and a Master of Science degree in Biomedical Engineering from Case Western Reserve University.

Tad Vaughn has been our Vice President, Operations since 2006. Prior to joining the company, Mr. Vaughn served as a consultant for several medical device companies. From 1999 to 2005, Mr. Vaughn was Chief Operating Officer of ONUX Medical, Inc., a startup company for surgical laparoscopic devices. Mr. Vaughn has also served as Vice President of Manufacturing at Watkins Manufacturing Corporation. Mr. Vaughn holds a Bachelor of Science degree in Industrial and Operations Engineering from the University of Michigan.

Jay Schmelter is one of our co-founders and has served as chairman of our board of directors since March of 2007, and as a member of our board of directors since the company’s inception in August of 1999. Since 2000, Mr. Schmelter has served as a managing director and co-founder of RiverVest Venture Partners, a life science-focused venture capital fund. Prior to co-founding RiverVest, he served as a principal at Crescendo Ventures. Prior to his role at Crescendo, Mr. Schmelter served as a medical device research analyst at Piper Jaffray, Inc. and as a marketing manager at Medtronic, Inc. Mr. Schmelter holds a Bachelors of Arts degree in Accounting from Michigan State University and a Masters of Business Administration from the University of Chicago.

Gary Ellis has served as a member of our board of directors since 2006. In May 2005, he was named the Senior Vice President and Chief Financial Officer of Medtronic, Inc. Prior to that, he was promoted to Vice President, Corporate Controller and Treasurer of Medtronic in October 1999, and had served as Vice President of Finance for Medtronic Europe from 1992 to 1999. Mr. Ellis began his career at Medtronic in 1989 as Assistant Corporate Controller. Mr. Ellis is a member of the boards of directors of The Toro Company and Itamar Medical Ltd (based in Israel) and chairman of the American Heart Association. Mr. Ellis holds a Bachelor of Science degree in Accounting from the University of South Dakota.

Anthony Arnerich has served as a member of our board of directors since 2002. Mr. Arnerich has been the President and Founder of the firm Arnerich Massena & Associates, Inc. since 1991, with responsibilities in the areas of consulting, client service, internal operations and strategic planning. His client base includes a wide variety of private, public and not-for-profit organizations on the West Coast as well as high-net-worth individuals. His experience in the investment industry spans more than fifteen years, during which he served as an investment executive and helped found the Investment Management Consulting Group of Dain Bosworth. Mr. Arnerich is a director of Accumetrics Inc. and a sponsor and participant of the Arnerich Massena Portland Public Schools Classroom Assistance Program, which represents a significant commitment of funding and employee volunteer time to several neighborhood schools. Mr. Arnerich holds a Bachelor of Arts degree from the University of Santa Clara.

J. Neal Armstrong has served as a member of our board of directors since 2005. Mr. Armstrong served as Vice President, Chief Financial Officer, Secretary and Treasurer of Aspect Medical Systems, Inc., a developer and manufacturer of an anesthesia monitoring system, from 1996 until his retirement in 2005. From 1990 to 1996, Mr. Armstrong served as Vice President of Finance, Chief Financial Officer and as a director of Haemonetics, Inc., a manufacturer of blood processing systems. From 1985 to 1990, he was the Vice President of

 

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Finance and Administration, Treasurer and Chief Financial Officer at BTU International. Prior to 1985, he served for 14 years in senior operating and financial positions at Texas Instruments, Inc. Mr. Armstrong is a member of the boards of directors of Vapotherm, Inc., TransMedics and deCODE Genetics (based in Iceland). Mr. Armstrong holds a Bachelor of Arts degree in Accounting from the University of Texas.

Winston Wallin has served as a member of our board of directors since 2005. Since 1996, Mr. Wallin has served as Chairman Emeritus of Medtronic, Inc., where he previously served as Chairman from 1985 to 1996 and as Chief Executive Officer from 1985 to 1991. Prior to Medtronic, Mr. Wallin was President and Chief Operating Officer of Pillsbury. Mr. Wallin has served as an outside director for Cargill, Inc., First Bank Minneapolis, Bemis Companies, SuperValu and Soo Line Railroad, and as trustee for Abbot Northwestern Hospital, Carleton College, Minnesota Zoo, The Minneapolis Foundation, The Minneapolis Institute of the Arts, University of Minnesota Foundation and The Wallin Foundation, which provides college scholarships for high school students in Minnesota. Mr. Wallin holds a Bachelor of Business Administration degree from the University of Minnesota.

Richard Randall has served as a member of our board of directors since 2005. Since 2002, Mr. Randall has served as President and Chief Executive Officer of TranS1, Inc., a company dedicated to developing and marketing minimally-invasive therapies to treat lower back pain. Prior to joining TranS1, Mr. Randall served as Chief Executive Officer of Innovasive Devices, Inc. and Target Therapeutics, Inc. He is co-founder of Conceptus, Inc. and Cardima and currently serves on the board of AbbeyMoor Medical. Mr. Randall holds a Bachelor of Science degree in Biology and Science Education from the State University College of New York at Buffalo.

Composition of the Board of Directors

Our board of directors consists of seven members. The terms of service of each director will expire upon the election and qualification of successor directors at each annual meeting of our stockholders.

Our board of directors has reviewed the materiality of any relationship that each of our directors has with us, either directly or indirectly. Based on this review, the board has determined that, except for Mr. Army, all directors are independent directors as defined by The NASDAQ Global Market.

Under the terms of our amended and restated investors’ rights agreement, a voting agreement among us and the holders of our Series E Convertible Preferred Stock and our certificate of incorporation, the members of our board of directors are to be designated as follows: one member shall be designated by TLM Investors II, LLC; one member shall be designated by RiverVest Venture Fund I, L.P.; one member shall be designated by Medtronic, Inc.; one member shall be our Chief Executive Officer; and the remainder shall be designated according to our certificate of incorporation and by-laws. Upon consummation of this offering, these provisions will terminate, and there will be no further contractual obligations regarding the election of our directors. Our amended and restated certificate of incorporation provides that the authorized number of directors may be changed only by our board of directors and with the approval of our Series A, B, C, D and E Convertible Preferred Stock, voting as separate classes.

Upon the completion of this offering, our directors will be divided into three classes serving staggered three-year terms. At each annual meeting of our stockholders, directors will be elected to succeed the class of directors whose terms have expired. For our current directors, Class I directors’ terms will expire at our 2009 annual stockholders’ meeting, Class II directors’ terms will expire at our 2010 annual stockholders’ meeting and Class III directors’ terms will expire at our 2011 annual stockholders’ meeting. Messrs.                      and                      are our current Class I directors; Messrs.                      and                      are our current Class II directors; and Mr.                      is our current Class III director. Our classified board could have the effect of increasing the length of time necessary to change the composition of a majority of our board of directors. Generally, at least two annual meetings of stockholders will be necessary for stockholders to effect a change in the majority of the members of our board of directors.

 

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Committees of the Board of Directors

Our board of directors has an audit committee, a compensation committee and a nominating and corporate governance committee. Our board of directors has adopted charters for each of these committees.

Audit Committee

Our audit committee consists of Mr. Armstrong (chair), Mr. Ellis and Mr. Randall. The responsibilities of our audit committee include:

 

Ÿ  

meeting with our management periodically to consider the adequacy of our internal controls and the objectivity of our financial reporting;

 

Ÿ  

appointing our independent auditors, determining the compensation of our independent auditors and pre-approving the engagement of our independent auditors for audit and non-audit services;

 

Ÿ  

overseeing our independent auditors, including reviewing independence and quality control procedures and experience and qualifications of audit personnel that are providing us audit services;

 

Ÿ  

meeting with our independent registered public accounting firm and reviewing the scope and significant findings of the audits performed by them, and meeting with management and internal financial personnel regarding these matters;

 

Ÿ  

reviewing the adequacy and sufficiency of our financial and accounting controls, practices and procedures, the activities and recommendations of our auditors and our reporting policies and practices, and reporting recommendations to our full board of directors for approval; and

 

Ÿ  

establishing procedures for the receipt, retention and treatment of complaints regarding internal accounting controls or auditing matters and the confidential, anonymous submissions by employees of concerns regarding questionable accounting or auditing matters.

We believe each member of our audit committee satisfies the independence requirements for membership established by The NASDAQ Global Market and SEC. The board of directors has determined that                      is an audit committee financial expert and that he satisfies the independence requirements of the Securities Exchange Act of 1934. Our independent auditors and our financial personnel have regular private meetings with, and unrestricted access to, our audit committee.

Compensation Committee

Our compensation committee consists of Mr. Arnerich (chair), Mr. Armstrong and Mr. Schmelter. The functions of our compensation committee include:

 

Ÿ  

establishing overall employee compensation policies and recommending to our board of directors major compensation programs;

 

Ÿ  

reviewing and approving the compensation of our executive officers and directors, including salary and bonus awards;

 

Ÿ  

administering our various employee benefit, pension and equity incentive programs; and

 

Ÿ  

reviewing executive officer and director indemnification and insurance matters.

We believe each member of the compensation committee satisfies the independence requirements for membership established by The NASDAQ Global Market.

 

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Nominating and Corporate Governance Committee

Our nominating and corporate governance committee consists of Mr. Randall, Mr. Schmelter and Mr. Wallin. The functions of our governance and nominating committee include:

 

Ÿ  

identifying and recommending qualified candidates for election to our board of directors;

 

Ÿ  

evaluating and reviewing the performance of our existing directors;

 

Ÿ  

making recommendations to our board of directors regarding governance matters, including our certificate of incorporation, by-laws and charters of our committees; and

 

Ÿ  

developing and recommending to our board of directors governance and nominating guidelines and principles applicable to us.

We believe each member of the nominating and corporate governance committee satisfies the requirements for membership established by The NASDAQ Global Market.

Board of Directors Compensation

Our directors do not currently receive cash compensation for their services as members of our board of directors or committees of our board of directors. Our employee directors are eligible to participate in our Amended and Restated 1999 Equity Incentive Plan and all directors are eligible to participate in our 2003 Directors and Advisors Stock Option and Restricted Stock Plan.

In 2006, our board granted options to Mr. Armstrong, Mr. Randall and Mr. Wallin in connection with their joining our board. In 2007, our board granted additional options to Mr. Armstrong, Mr. Randall, Mr. Wallin, and to Mr. Army in his capacity as President and Chief Executive Officer. Each of these option grants is described in more detail in “Executive Compensation.” We reimburse our directors for reasonable out-of-pocket travel expenses incurred in connection with attending meetings of our board of directors.

Compensation Committee Interlocks and Insider Participation

The members of the compensation committee of our board of directors are currently Mr. Arnerich, Mr. Armstrong and Mr. Schmelter. During the last five years, no compensation committee members have served as officers or employees of the company. Mr. Arnerich is managing member of TLM Investors LLC and the chief executive officer of Arnerich Massena & Associates, Inc., the managing member of TLM Investors II, LLC, which are two of our principal stockholders. Mr. Schmelter is a managing director of RiverVest Venture Partners, which is one of our principal stockholders. None of our executive officers serves as a member of the board of directors or compensation committee of any entity that has one or more executive officers serving as a member of our board of directors or compensation committee.

Corporate Governance

We have adopted a code of business conduct and ethics that applies to all of our employees, officers and directors, including those officers responsible for financial reporting. The code of business conduct and ethics will be available on our Internet site at www.salientsurgical.com. We expect that any amendments to the code, or any waivers of its requirements, will be disclosed on our website.

Executive Officers

Each executive officer is elected by, and serves at the discretion of, our board of directors. Each of our executive officers and directors, other than non-employee directors, devotes his or her full time to our affairs.

 

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EXECUTIVE COMPENSATION

Named Executive Officers

For 2007, our named executive officers, or NEOs, were:

 

Ÿ  

Joseph Army, President and Chief Executive Officer;

 

Ÿ  

M. Jacqueline Eastwood, former President and Chief Executive Officer;

 

Ÿ  

Richard Altieri, Vice President, Finance, Chief Financial Officer and Treasurer;

 

Ÿ  

Nathan Harris, Vice President, U.S. Sales;

 

Ÿ  

Tad Vaughn, Vice President, Operations;

 

Ÿ  

Som Kovvuri, Vice President, Regulatory Affairs and Quality Assurance;

 

Ÿ  

Roberta Thompson, former Vice President, Regulatory & Clinical Affairs; and

 

Ÿ  

Michael McClurken, former Vice President, Research & Development.

In March 2007, Ms. Eastwood resigned. In September 2007, Ms. Thompson resigned. In October 2007, Mr. McClurken resigned. Effective January 28, 2008, Mr. Harris transitioned to his new role of Vice President, U.S. Sales, reporting to David Brown, Vice President, Sales & Marketing. In connection with his new role, Mr. Harris is no longer an executive officer.

Compensation Discussion and Analysis

Evolution of our Compensation Approach

Our compensation approach is necessarily tied to our stage of development. Historically, compensation decisions for our executive officers (other than the Chief Executive Officer) were approved by our board of directors upon the recommendation of our compensation committee, which in turn relied upon the recommendation of our Chief Executive Officer. The compensation recommendations of our Chief Executive Officer have been largely discretionary, based on our Chief Executive Officer’s subjective assessment of the particular executive officer and other data sources, including publicly available data relating to compensation of executive officers at other medical device companies. As we gain experience as a public company, we expect that the specific direction, emphasis and components of our executive compensation program will continue to evolve. For example, over time, we expect to continue to reduce our reliance upon subjective determinations made by our Chief Executive Officer in favor of a more empirically based approach that involves benchmarking the compensation paid to our executive officers against peer companies that we identify and the use of clearly defined, objective targets to determine incentive compensation awards.

Compensation Philosophy and Objectives

We are committed to prudent financial stewardship. Our compensation philosophy and practices reflect this commitment as we seek to align the interests and incentives of our executive officers with those of our investors through a pay-for-performance compensation program that serves to attract and retain outstanding people. Accordingly, the compensation of each executive officer is derived from the achievement of individual and company-wide performance objectives, which are determined each year and reviewed quarterly based on our operating plan.

Performance metrics generally focus on revenue growth, earnings growth and expense management. As a result, executive officers are motivated to achieve objectives that we believe result in value creation for our stockholders. We believe compensation plans that are tied to operating metrics that drive financial results are the optimum way of providing incentives to each executive officer. We believe these goals are linked to performance elements that are within each executive officer’s control and reward behaviors which drive long-term stockholder value.

 

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Determination of Executive Compensation Awards

Role of the Compensation Committee and CEO

Our compensation committee analyzes individual and corporate achievements and recommends to our board of directors appropriate compensation packages for our named executive officers. In making these determinations, our compensation committee solicits input from our Chief Executive Officer with respect to salary and option grant awards to our executive officers other than our Chief Executive Officer. While our Chief Executive Officer discusses his recommendations with respect to the compensation of other executive officers with the compensation committee, he does not participate in deliberation or determination of his own compensation. None of our other executive officers participate in the compensation committee’s discussions regarding executive compensation, and our Chief Executive Officer abstains from voting with respect to his compensation. The compensation of our executive officers is ultimately approved by our board of directors upon recommendation of the compensation committee. In 2007, the compensation committee accepted Mr. Army’s recommendations for executive officer compensation without change, and our board of directors approved the compensation committee’s recommendations for executive officer compensation without change. The compensation committee does not delegate any of its functions to others in determining executive compensation, although it has, from time to time, sought advice from consultants with respect to executive compensation matters.

We believe that in order to attract and retain sufficient executive talent, it is appropriate to compensate our executive officers at a level at least comparable to the compensation amounts provided to executives at comparable medical device companies, subject to the individual’s experience and expected contribution to us. Historically, our compensation committee relied on their experience with other medical device companies as well as publicly available data relating to compensation of executives at other medical device companies, such as Insulet Corporation, Senorx, Inc., Accuray Incorporated, Xtent, Inc. and Oculus Innovative Sciences, Inc., to establish compensation for our executive officers.

The group of companies that our compensation committee has used to compare our executive officers’ compensation has varied, based on our stage of development, from venture capital funded companies to publicly traded medical device companies in similar stages of development.

We believe the components of our current compensation program, which include cash salary, short-term cash incentive payments and long-term equity awards are generally consistent with the compensation components of other comparable medical device companies, although we generally do not benchmark the type of compensation awards with those of other companies.

The compensation committee has not established any formal policies or guidelines for allocating compensation between short-term and long-term incentive compensation, or between cash and non-cash compensation. In determining the amount and mix of compensation elements and whether each element provides the correct incentives and rewards for performance consistent with our short and long-term goals and objectives, our compensation committee relies on its judgment about each individual’s performance in a rapidly changing business environment rather than adopting a formulaic approach to compensatory decisions that are too narrowly responsive to short-term changes in business performance.

Components of our Executive Compensation Program

Our executive compensation program currently consists of the following components:

 

Ÿ  

base salary;

 

Ÿ  

annual cash and equity incentive opportunities; and

 

Ÿ  

benefits and other compensation.

 

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Our compensation philosophies with respect to each of these elements, including the basis for the compensation awarded to each of our executive officers, are discussed above. In addition, although each element of compensation described below is considered separately, each of the compensation committee and our board of directors takes into account the aggregate compensation package for each individual in its determination of each individual component of that package.

The following chart depicts the 2007 compensation mix (based on amounts from the Summary Compensation Table below)

2007 Compensation Mix

 

Name of Executive

   Salary     Annual Cash
Incentive
    Equity
Awards
    Other
Compensation
    Total  

Joseph Army

   57 %   27 %   16 %   0 %   100 %

M. Jacqueline Eastwood

   20 %   —   %   15 %   65 %   100 %

Richard Altieri

   70 %   18 %   12 %   —   %   100 %

Nathan Harris

   71 %   —   %   5 %   24 %   100 %

Tad Vaughn

   78 %   20 %   2 %   —   %   100 %

Som Kovvuri

   76 %   23 %   1 %   —       100 %

Roberta Thompson

   64 %   —   %   5 %   31 %   100 %

Michael McClurken

   88 %   —   %   11 %   1 %   100 %

Base Salary

The base salary of our executive officers is reviewed on an annual basis. With respect to the performance-based component, such determinations were based upon a subjective assessment of professional effectiveness and capabilities. In the case of our executive officers other than the Chief Executive Officer, this assessment was made by Mr. Army and was informed by his personal annual performance evaluation of the executive, since each of these executives report directly to him. In the case of our Chief Executive Officer, this assessment was made by our compensation committee. Historically, we have not applied specific formulas to set base salary or to determine salary increases, and we have not sought to formally benchmark base salary against similarly situated companies prior to 2007. Generally, our executive officer salaries are adjusted effective the first quarter of each year.

With respect to each executive officer other than Mr. Army, 2007 base salary was largely determined with the goal of paying the executive an amount that Mr. Army believed was necessary to be competitive with base salaries at a similarly situated company or professional services firm, based on his own business judgment and experience in such matters as well as on quantitative data and benchmarking, and to a lesser degree informed by his subjective assessment of the executive as described above. Beginning in 2007, with the promotion of Mr. Army to Chief Executive Officer and with the increased likelihood that we would undertake an initial public offering of our common stock, we felt it was more appropriate to compare our executive officers’ base salaries to executive officers at other publicly traded medical device companies in similar development stages, including Senorx, Accuray, Alphatech, Thermage and Volcano. It is important to note that this data is only one of many factors used by the compensation committee and that there is no rigid mathematical formula for deriving officer compensation from benchmark data. Accordingly, while mindful of competitive factors in determining base salary for our executive officers, our compensation philosophy places significant weight on those aspects of compensation tied to performance, such as annual cash incentives and long-term incentives in the form of stock options, as further described below. We promoted Mr. Army to interim Chief Operating Officer in March 2007, with a base salary of $225,000 per year on an annualized basis. Mr. Army was promoted to Chief Executive Officer in June 2007, at which time his base salary was increased to $290,000 per year on an annualized basis. His base salary was negotiated based on his prior experience, his prior levels of compensation and competitive market factors.

 

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The following table sets forth base salaries of our named executive officers for 2007 and 2008 and the percentage increase for each.

 

Executive

   2007
Salary(1)
   2008
Salary
   % Increase
(2007 – 2008)
 

Joseph Army(2)

   $ 290,000    $ 300,000    3.4 %

M. Jacqueline Eastwood(3)

   $ 263,798      n/a    n/a  

Richard Altieri

   $ 225,000    $ 233,000    3.6 %

Nathan Harris(4)

   $ 221,728      n/a    n/a  

Tad Vaughn(5)

   $ 164,500    $ 180,000    9.4 %

Som Kovvuri

   $ 160,000    $ 170,000    6.3 %

Roberta Thompson(3)

   $ 172,887      n/a    n/a  

Michael McClurken(3)

   $ 165,479      n/a    n/a  

 

(1) Represents base salary during 2007 on an annualized basis. For amounts actually paid during 2007, see “Summary Compensation Table” below.
(2) Mr. Army’s salary was $208,838 from January 1, 2007 through March 21, 2007, when it was increased to $225,000 with his promotion to Chief Operating Officer. Mr. Army’s salary was increased to $290,000 on June 16, 2007 when he was promoted to President and Chief Executive Officer.
(3) As noted above, Ms. Eastwood, Ms. Thompson and Mr. McClurken are no longer with the company.
(4) Effective January 2008, Mr. Harris transitioned to the role of Vice President, U.S. Sales, reporting to Mr. Brown, Vice President, Sales & Marketing and as such, is no longer an executive officer.
(5) Mr. Vaughn’s salary was $154,500 from January 1, 2007 through October 31, 2007. Mr. Vaughn’s salary was increased to $164,500 on November 1, 2007.

Annual Cash Incentive Opportunities

Our annual incentive plan is comprised of cash and equity-based awards. Cash incentive awards for our named executive officers are tied, in part, to our operating performance (i.e., achievement of revenue plan) and in part to each executive’s achievement of their personal objectives for the year. Each year the incentive plan is approved by our board of directors upon recommendation by the compensation committee.

Annual cash incentive opportunity is expressed as a percentage of salary and is determined initially by our overall performance against revenue plan. Half of each executive officer’s cash incentive is based on our performance, and half is based on the executive officers achievement of his or her personal objectives for the year.

For 2007, the plan required achievement of 80% of our revenue plan in order for our executive officers to receive any portion of their incentive opportunity. At 80% of revenue plan, executives were eligible to earn 50% of their target incentive opportunity, with a sliding scale up to 100% of revenue plan, where executives could earn 100% of their target incentive opportunity. In addition, our plan contained a stretch feature, whereby executives would be eligible for 120% of their incentive opportunity if our 2007 revenues reached 110% or more of plan. The 2008 plan is identical to the 2007 plan with the exception that we have to achieve 85% of revenue plan in order to trigger any incentive payments.

 

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The following table sets forth the target and stretch cash incentive for 2007 as a percentage of salary of our named executive officers.

 

Name of Executive

   2007 Target Cash
Incentive at 100% of
Revenue Plan

(as a % of salary)
    2007 Stretch Cash
Incentive at 110% of
Revenue Plan

(as a % of salary)
 

Joseph Army(1)

   40 %   48 %

M. Jacqueline Eastwood(2)

   40 %   48 %

Richard Altieri(1)

   20 %   24 %

Nathan Harris(3)

   n/a     n/a  

Tad Vaughn

   20 %   24 %

Som Kovvuri(1)

   20 %   24 %

Roberta Thompson(4)

   20 %   24 %

Michael McClurken(5)

   20 %   24 %

 

(1) Actual payments were pro-rated based on portions of the year in the position of Chief Executive Officer, Chief Financial Officer, and Vice President, Regulatory Affairs & Quality Assurance, as applicable.
(2) Amount actually paid was based on terms negotiated in Ms. Eastwood’s separation agreement.
(3) Mr. Harris does not participate in the cash incentive portion of the plan. He is paid salary and commission based solely on revenues generated.
(4) Amount actually paid was based on terms negotiated in Ms. Thompson’s separation agreement.
(5) No amount actually paid, as Mr. McClurken left the company during 2007.

Equity Awards

As noted above, our annual incentive plan is comprised of both cash and equity-based awards (i.e., stock options). The allocation between the cash and equity portion is approved each year by our board of directors at the recommendation of our compensation committee. Similar to the cash portion of the award, the opportunity for equity-based awards is tied to our company’s performance against revenue plan as well as each executive officer’s achievement of personal objectives.

For 2007, the plan required achievement of 80% of our revenue plan in order for our executive officers to receive any portion of their incentive opportunity. At 80% of revenue plan, executives were eligible to earn 50% of their incentive opportunity, with a sliding scale up to 100% of revenue plan, where executives could earn 100% of their incentive opportunity. In addition, our plan contained a stretch feature, whereby executives would be eligible for 120% of their incentive opportunity if the 2007 revenues were 110% or more of plan. The 2008 plan is identical to the 2007 plan with the exception that the company has to achieve 85% of revenue plan in order to trigger any incentive payments.

 

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The following table sets forth the target and stretch stock option incentive for 2007 of our named executive officers. The amounts awarded in 2007 are set forth in the Summary Compensation table below.

 

Name of Executive

   2007 Target Stock Option
Incentive at 100% of
Revenue Plan

(number of options)
   2007 Stretch Stock
Option Incentive at
110% of Revenue Plan

(number of options)

Joseph Army

   200,000    240,000

M. Jacqueline Eastwood(1)

   75,000    90,000

Richard Altieri(2)

   35,000    42,000

Nathan Harris

   20,000    24,000

Tad Vaughn

   20,000    24,000

Som Kovvuri(2)

   20,000    24,000

Roberta Thompson(3)

   37,500    45,000

Michael McClurken(4)

   37,500    45,000

 

(1) No options were issued as Ms. Eastwood resigned during 2007.
(2) Awards were pro-rated based on portions of the year in the position of Chief Financial Officer and Vice President, Regulatory Affairs & Quality Assurance, as applicable.
(3) No options were issued as Ms. Thompson left the company during 2007.
(4) No options were issued as Mr. McClurken left the company during 2007.

Benefits and Other Compensation

We provide the following benefits to our executive officers on the same basis as the benefits provided to all employees:

 

Ÿ  

health and dental insurance;

 

Ÿ  

short-term and long-term disability; and

 

Ÿ  

401(k) benefits.

Summary Compensation

The following table sets forth summary information concerning the compensation paid or earned for services rendered to us in all capacities during the fiscal year ended December 31, 2007 to our Chief Executive Officer and the former Chief Executive Officer, the Chief Financial Officer, each of the three most highly compensated persons serving as our executive officers as of December 31, 2007 who received total compensation in excess of $100,000 in 2006, and two additional individuals who would have qualified as one of the three most highly compensated person serving as our executive officers but for the fact that they were no longer with us as of December 31, 2007 (collectively, the Named Executive Officers or NEOs).

 

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Summary Compensation Table (1)

 

Name and Position

  Fiscal
Year
  Salary($)   Option
Award(s) (2) ($)
  Non-Equity
Incentive Plan
Compensation (3) ($)
  All Other
Compensation ($)
  Total ($)

Joseph Army, President & Chief Executive Officer

  2007   $ 259,982   $ 72,853   $ 124,340     n/a   $ 457,175

M. Jacqueline Eastwood, President & Chief Executive Officer (4)

  2007   $ 84,380   $ 63,105     n/a   $ 275,493   $ 422,978

Richard Altieri, Vice President, Finance, Chief Financial Officer & Treasurer

  2007   $ 73,413   $ 12,891   $ 18,000     n/a   $ 104,304

Nathan Harris, Vice President, Sales & Marketing (5)

  2007   $ 221,728   $ 14,490     n/a   $ 74,429   $ 310,647

Tad Vaughn, Vice President, Operations

  2007   $ 159,308   $ 4,625   $ 39,480     n/a   $ 203,413

Som Kovvuri, Vice President, Regulatory Affairs & Quality Assurance

  2007   $ 95,679   $ 1,020   $ 28,800     n/a   $ 125,499

Roberta Thompson, Vice President, Quality, Regulatory & Clinical (6)

  2007   $ 150,774   $ 12,388     n/a   $ 74,255   $ 237,417

Michael McClurken, Vice President, Research & Development (7)

  2007   $ 161,656   $ 20,028     n/a     1,796   $ 183,480

 

(1) Columns disclosing compensation under the headings “Bonus,” “Stock Awards” and “Non-Qualified Deferred Compensation Earnings” are not included because no compensation in these categories was awarded to, earned by or paid to our named executive officers in 2007.
(2) The amounts reported in this column reflect the compensation expense incurred in 2007 and computed in accordance with SFAS No. 123(R). The amounts reported reflect the compensation expense associated with options granted in 2006 and 2007, as well as an incremental charge associated with the re-pricing of previously granted stock options during 2007. Options granted under the 1999 Plan vest ratably over a period of one to four years from the date of grant. One quarter of the options vest on the one year anniversary of the grant date, with the remainder vesting ratably by month for the remainder of the four year term. For information about the vesting status of individual awards, see the Outstanding Equity Awards at Fiscal Year-End table below.
(3) All non-equity incentive plan compensation earnings shown above were earned in 2007 and paid in 2008.
(4) Amounts under the column “All Other Compensation” are comprised of severance payments of $186,857 and cash incentives of $88,636 in accordance with the terms of Ms. Eastwood’s separation agreement.
(5) Amounts under the column “All Other Compensation” are for sales commissions earned during 2007.
(6) Amounts under the column “All Other Compensation” are comprised of continuation payments in the form of consulting fees of $43,222 and cash incentives of $31,033 in accordance with the terms of Ms. Thompson’s separation agreement.
(7) Amounts under the column “All Other Compensation” represents imputed income for amounts paid for health benefits on behalf of Mr. McClurken’s domestic partner.

 

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Grants of Plan-Based Awards

The following table sets forth information concerning the stock option grants made to each of the NEOs during the fiscal year ended December 31, 2007, pursuant to the 1999 Plan and the 2003 Plan. We have never granted any stock appreciation rights.

Grants of Plan-Based Awards (1)

 

Name

  Grant Date   Estimated Future Payments
Under Equity Incentive Plan
Awards

(Number of Options)
  All Other Option
Awards; Number of
Securities

Underlying Options
(2)(3)
  Exercise or
Base Price of
Option

Awards ($)
  Grant Date Fair
Value of Option
Awards ($)(4)
    Threshold   Target   Maximum      
Joseph Army     100,000   200,000   240,000      
  02/01/07         21,173   $ 0.124   $ 4,158
  04/25/07         400,000   $ 0.124   $ 78,280
  08/17/07         1,850,000   $ 0.35   $ 430,865
M. Jacqueline Eastwood     n/a   n/a   n/a      
  02/01/07         42,345   $ 0.124   $ 8,317
Richard Altieri(5)     5,833   11,667   14,000      
  09/11/07         728,000   $ 0.35   $ 169,551
Nathan Harris     10,000   20,000   24,000      
  02/01/07         11,292   $ 0.124   $ 2,218
  04/24/07         250,000   $ 0.124   $ 48,925
Tad Vaughn     10,000   20,000   24,000      
  02/01/07         4,705   $ 0.124   $ 924
  04/24/07         50,000   $ 0.124   $ 9,785
  11/06/07         25,000   $ 0.58   $ 9,638
Som Kovvuri(6)     4,000   8,000   9,600      
  04/24/07         10,000   $ 0.124   $ 1,816
  09/11/07         40,000   $ 0.35   $ 9,316
Roberta Thompson     n/a   n/a   n/a      
  02/01/07         21,173   $ 0.124   $ 4,158
Michael McClurken     n/a   n/a   n/a      
  02/01/07         21,173   $ 0.124   $ 4,158
  04/24/07         150,000   $ 0.124   $ 29,355

 

(1) The column disclosing grants of plan-based awards under the heading “All other Stock Awards; Number of Shares” is not included in this table because no plan-based grants in these categories were granted to our named executive officers in 2007. The column disclosing estimated future payments under the heading “Estimated Future Payments Under Non-Equity Incentive Plan Awards” is not included in this table because 2007 awards were calculated and paid in February 2008 and are included in the Summary Compensation Table above.
(2) Options granted to our named executives on 2-1-07 represent awards earned in 2006 under the annual incentive plan. All other options granted during 2007 were earned in 2007.
(3) Options granted under the 1999 plan vest ratably over a period of one to four years from the date of grant. One quarter of the options vest on the one year anniversary of the grant date, with the remainder vesting ratably by month for the remainder of the four year term. For information about the vesting status of individual awards, see the Outstanding Equity Awards at Fiscal Year-End table below.
(4) The amounts reported in this column reflect the grant date fair value of those awards computed in accordance with SFAS No. 123(R).
(5) Amounts under the column “Estimated Future Payments Under Equity Incentive Plan Awards” are pro-rated based on the portion of the year that Mr. Altieri was employed by the Company.
(6) Amounts under the column “Estimated Future Payments Under Equity Incentive Plan Awards” are pro-rated to reflect that Mr. Kovvuri served a portion of the year as our Director of Quality Assurance before being promoted to Vice President, Regulatory Affairs and Quality Assurance.

 

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Option Exercises and Unexercised Option Holdings

The following table sets forth certain information regarding the number and value of exercisable options by each of the NEOs as of December 31, 2007 and the number and value of unexercised options held by each of the NEOs as of December 31, 2007.

Outstanding Equity Awards at Fiscal Year-End (1)(2)

 

Name of Executive

   Number of Securities
Underlying Unexercised
Options Exercisable
   Number of Securities
Underlying Unexercised
Options Unexercisable
   Option
Exercise
Price ($)
   Option
Expiration
Date (3)

Joseph Army

   -0-    753    $ 0.124    01/20/14
   -0-    13,452    $ 0.124    01/19/15
   -0-    48,155    $ 0.124    04/12/15
   -0-    2,911    $ 0.124    01/19/15
   -0-    19,532    $ 0.124    01/17/16
   -0-    21,173    $ 0.124    02/01/17
   -0-    400,000    $ 0.124    04/25/17
   -0-    1,850,000    $ 0.35    08/17/17

M. Jacqueline Eastwood

   -0-    -0-      n/a    n/a

Richard Altieri

   -0-    728,000    $ 0.35    09/11/17

Nathan Harris

   7,174    -0-    $ 0.124    07/15/13
   2,309    178    $ 0.124    01/20/14
   4,818    5,078    $ 0.124    01/19/15
   2,500    10,417    $ 0.124    04/17/16
   -0-    11,292    $ 0.124    02/01/17
   -0-    250,000    $ 0.124    04/24/17

Tad Vaughn

   17,708    32,292    $ 0.124    07/18/16
   -0-    4,705    $ 0.124    02/01/17
   -0-    50,000    $ 0.124    04/24/17
   -0-    25,000    $ 0.58    11/06/17

Som Kovvuri

   -0-    10,000    $ 0.124    04/24/17
   -0-    40,000    $ 0.35    09/11/17

Roberta Thompson

   -0-    -0-      n/a    n/a

Michael McClurken

   -0-    -0-      n/a    n/a

 

(1) Columns disclosing grants of plan-based awards under the headings “Number of Shares of Stock That Have Not Vested,” “Market Value of Shares That Have Not Vested,” “Equity Incentive Plan Awards: Number of Unearned Shares or Other Rights That Have Not Vested,” “Equity Incentive Plan Awards: Number of Securities Underlying Unexercised Unearned Options” and “Equity Incentive Plan Awards: Market or Payout Value of Unearned Shares or Other Rights That Have Not Vested” are not included in this table because no equity awards in these categories were granted to our named executive officers in 2007
(2) Options granted under the 1999 Plan vest ratably over a period of one to four years from the date of grant. One quarter of the options vest on the one year anniversary of the grant date, with the remainder vesting ratably by month for the remainder of the four year term.
(3) Options granted under the 1999 Plan are exercisable over a period of ten years from the date of grant. Accordingly, the grant date associated with each of the awards in the table above is equal to the date ten years prior to the expiration date indicated in this column.

 

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Option Exercises and Stock Vested

The following table provides information regarding options exercised and vested for the NEOs during the fiscal year ended December 31, 2007. We do not award stock. Therefore, no stock awards vested during 2007, and the columns under the headings “Number of Shares of Stock Acquired on Vesting” and “Value Realized on Vesting of Stock” were omitted from the table.

 

Name of Executive

   Number of Shares Acquired
on Exercise of Options
   Value Realized
on Exercise of
Options ($) (1)

Joseph Army

   726,772    $ 112,284

M. Jacqueline Eastwood

   2,490,659    $ 572,327

Richard Altieri

   —        —  

Nathan Harris

   193,863    $ 24,427

Tad Vaughn

   —        —  

Som Kovvuri

   —        —  

Roberta Thompson

   143,934    $ 18,136

Michael McClurken

   602,618    $ 144,638

 

(1) Represents the difference between the exercise price and the fair value of company common stock on the date of exercise.

Equity Benefit Plans

Amended and Restated 1999 Employee Incentive Plan

Our Amended and Restated 1999 Employee Incentive Plan, or the 1999 Plan, was adopted in 2000. The 1999 Plan permits us to make grants of incentive stock options, non-qualified stock options and restricted stock awards. We have reserved 15,047,452 shares of our common stock for the issuance of awards under the 1999 Plan. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. Generally, shares that are forfeited or canceled from awards under the 1999 Plan also will be available for future awards.

The 1999 Plan is administered by the compensation committee of our board of directors. Our compensation committee has full power and authority to select the participants to whom awards will be granted, to make any combination of awards to participants, to accelerate the exercisability or vesting of any award and to determine the specific terms and conditions of each award, subject to the provisions of the 1999 Plan. All directors, executive officers, and certain other key persons (including employees, consultants and advisors) are eligible to participate in the 1999 Plan.

The exercise price of stock options awarded under the 1999 Plan may not be less than the fair market value of our common stock on the date of the option grant and it is expected that the term of each option granted under the 1999 Plan will not exceed 10 years (or five years, in the case of an incentive stock option granted to a 10 percent shareholder) from the date of grant. Our compensation committee will determine at what time or times each option may be exercised (provided that in no event may it exceed 10 years from the date of grant) and, subject to the provisions of the 1999 Plan, the period of time, if any, after retirement, death, disability or other termination of employment during which options may be exercised.

Restricted stock may also be granted under our 1999 Plan. Restricted stock awards are shares of our common stock that vest in accordance with terms and conditions established by our compensation committee. Our compensation committee of our board of directors may impose whatever conditions to vesting it determines to be appropriate. Shares of restricted stock that do not vest are subject to our right of repurchase or forfeiture. Our compensation committee will determine the number of shares of restricted stock granted to any employee. Our 1999 Plan also gives our compensation committee discretion to grant stock awards free of any restrictions.

 

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Unless our compensation committee determines otherwise, our 1999 Plan does not generally allow for the transfer of awards and only the recipient of an award may exercise an award during his or her lifetime. In the event of certain consolidations, mergers or the transfer of substantially all of our assets, all outstanding awards under the 1999 Plan shall become exercisable immediately prior to consummation of such transaction unless our board of directors has arranged for the assumption of the awards or the grant of replacement awards by the acquiring corporation.

No awards may be granted under the 1999 Plan after March 2010. In addition, our board of directors may amend or discontinue the 1999 Plan at any time and our compensation committee may amend or cancel any outstanding award for the purpose of satisfying changes in law or for any other lawful purpose. No such amendment may adversely affect the rights under any outstanding award without the holder’s consent.

As of December 31, 2007, we had options to purchase 4,857,947 shares of our common stock outstanding under our 1999 Plan. No restricted stock was outstanding under the 1999 Plan as of December 31, 2007. Following this offering, our board of directors does not intend to grant any further awards under the 1999 Plan. We intend to adopt a new incentive plan in 2008, under which we expect to make all future awards.

2003 Directors and Advisors Stock Option and Restricted Stock Plan

Our 2003 Directors and Advisors Stock Option and Restricted Stock Plan, or the 2003 Plan, was adopted in July 2003. The 2003 Plan permits us to make grants of non-qualified stock options and restricted stock awards. We have reserved 924,539 shares of our common stock for the issuance of awards under the 2003 Plan. This number is subject to adjustment in the event of a stock split, stock dividend or other change in our capitalization. Generally, shares that are forfeited or canceled from awards under the 2003 Plan also will be available for future awards.

The 2003 Plan is administered by our compensation committee. Our compensation committee has full power and authority to select the participants to whom awards will be granted, to make any combination of awards to participants, to accelerate the exercisability or vesting of any award and to determine the specific terms and conditions of each award, subject to the provisions of the 2003 Plan. Directors, consultants and advisors selected by our board of directors are eligible to participate in the 2003 Plan.

The exercise price of stock options awarded under the 2003 Plan may not be less than the fair market value of the common stock on the date of the option grant and it is expected that the term of each option granted under the 2003 Plan will not exceed 10 years from the date of grant. Our compensation committee will determine at what time or times each option may be exercised (provided that in no event may it exceed 10 years from the date of grant) and, subject to the provisions of the 2003 Plan, the period of time, if any, after retirement, death, disability or other termination of employment during which options may be exercised.

Restricted stock may also be granted under our 2003 Plan. Restricted stock awards are shares of our common stock that vest in accordance with terms and conditions established by our compensation committee. Our compensation committee may impose whatever conditions to vesting it determines to be appropriate. Shares of restricted stock that do not vest are subject to our right of repurchase or forfeiture. Our compensation committee will determine the number of shares of restricted stock granted to any employee. Our 2003 Plan also gives our compensation committee discretion to grant stock awards free of any restrictions.

Unless our compensation committee provides otherwise, our 2003 Plan does not generally allow for the transfer of awards and only the recipient of an award may exercise an award during his or her lifetime. In the event of certain consolidations, mergers or the transfer of substantially all of our assets, all outstanding awards under the 2003 Plan shall become exercisable immediately prior to consummation of such transaction unless our board of directors has arranged for the assumption of the awards or the grant of replacement awards by the acquiring corporation.

 

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Our board of directors may amend or discontinue the 2003 Plan at any time and may amend or cancel any outstanding award for the purpose of satisfying changes in law or for any other lawful purpose. No such amendment may adversely affect the rights under any outstanding award without the holder’s consent.

As of December 31, 2007, we had options to purchase 537,288 shares of our common stock outstanding under our 2003 Plan. No restricted stock was outstanding under the 2003 Plan as of December 31, 2007. Following this offering, our board of directors does not intend to grant any further awards under the 2003 Plan. We intend to adopt a new incentive plan in 2008, under which we expect to make all future awards.

401(k) Plan

We maintain a retirement and deferred savings plan for our employees in the United States. This plan is intended to qualify as a tax-qualified plan under Section 401(a) of the Internal Revenue Code of 1986, as amended. The retirement and deferred savings plan provides that each participant may contribute a portion of his or her pre-tax compensation, subject to statutory limits. Under the plan, each employee is fully vested in his or her deferred salary contributions. Employee contributions are held and invested by the plan’s trustee. The retirement and deferred savings plan also permits us to make discretionary contributions, subject to established limits and a vesting schedule.

In 2006, we amended the plan to allow qualified employees to contribute a portion of their after-tax income into a Roth 401(k).

We have not made any discretionary contributions to the retirement and deferred savings plan on behalf of participating employees.

Pension Benefits

None of our NEOs participate in or have account balances in qualified or non-qualified defined benefit plans sponsored by us as of December 31, 2007, and as a result there is not a pension benefits table included in this registration statement.

Non-Qualified Deferred Compensation

None of our NEOs participate in or have account balances in non-qualified deferred compensation plans maintained by us as of December 31, 2007, and as a result there is not a non-qualified deferred compensation table included in this registration statement.

Employment and Change of Control Arrangements

Joseph Army.    We are party to an employment agreement with Joseph Army, dated as of January 22, 2008, for the position of President and Chief Executive Officer. The agreement provides for a base salary of $290,000 per year, subject to increase from time to time by our board of directors. Mr. Army is eligible to receive a cash bonus with a target of 40% of base salary. In addition, in each of fiscal 2007 and 2008, he is eligible to receive an equity bonus with a target of an option to purchase 200,000 shares of our common stock. Furthermore, with approval by our board of directors, the maximum amount of cash bonus may increase to 48% of his base salary and the maximum equity bonus may increase to qualify him for stock options to purchase up to 240,000 shares of our common stock, based on our overachievement of certain objectives. Mr. Army was also given a one-time grant of options to purchase 1,850,000 shares of our common stock. Mr. Army is entitled to participate in employee benefit plans on the same terms as our other executive officers.

 

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In the event of a change of control of the company, Mr. Army’s then unvested stock options which have not been otherwise accelerated by the board of directors pursuant to the 1999 Plan, will vest in four equal tranches over a 12 month period following the closing date, provided that Mr. Army remain employed on each vesting date. If we terminated Mr. Army’s employment other than for cause at any time, or if Mr. Army terminates his employment with us for good reason following a change of control, he will be entitled to receive the following severance benefits: (i) base salary for an additional 12 month period; (ii) a pro-rata bonus in the amount to which he would have been entitled had his employment not terminated; (iii) participation in employee benefit plans for an additional 12 month period; (iv) ability to exercise any vested stock options for an additional two and a half month period, or prior to the end of the calendar year in which his employment is terminated, whichever is later. Finally, if his employment is terminated other than for cause, or if Mr. Army terminates his employment for good reason during the 12 month period following a change of control, all of Mr. Army’s unvested options will vest immediately upon such termination.

Cause is defined to mean (i) failure to perform (other than by reason of disability) or negligence in the performance of duties and responsibilities for the company, if that failure or neglect remains uncured or continues after 30 days’ notice from the company; (ii) material breach of the employment agreement or any other agreement with the company; (iii) fraud, embezzlement or other dishonesty with respect to the company; (iv) a charge, indictment or conviction of or plea of nolo contendere to a felony or other crime involving moral turpitude; (v) willful misconduct (including violations of company policies, for example policies concerning insider trading, sexual harassment and the company’s code of conduct); (vi) material breach of fiduciary duty; or (vii) failure to cooperate, if requested by the board of directors, with any investigation or inquiry into Mr. Army’s or the company’s business practices, whether internal or external, including failure to be deposed or to provide testimony at any inquiry or trial.

Change of control is defined to mean any of the following events: (i) any consolidation or merger of the company with or into any other entity, or any other corporate reorganization, in which our outstanding shares immediately prior to such transaction (or the shares of the surviving corporation issued in respect of the shares of the company outstanding immediately prior to such transaction) do not, immediately after such transaction, represent more than 50% of the outstanding voting power of the surviving entity; (ii) any other transaction or series of related transactions engaged in by us or holders of our voting securities in which more than 50% of our voting power is transferred, except in connection with a public offering of our securities or other equity financing; or (iii) a sale or transfer of all or substantially all of the assets of the company.

Good reason is defined as any one or more of the following events occurring without Mr. Army’s consent following consummation of a change of control: (i) material breach of his employment agreement by the surviving company; (ii) a material diminution of any of Mr. Army’s significant duties, responsibilities or authority; provided that our failure to continue Mr. Army’s appointment or election as a director or officer of any affiliated entity, a change in reporting relationships resulting from the control of the company by another corporation, any diminution of the business of the company, or any sale or transfer of equity, property or other assets of the company or any affiliated entity does not constitute good reason; (iii) any reduction in or failure to pay Mr. Army’s base salary or any reduction in his target bonus; or (iv) relocation of Mr. Army’s primary worksite more than 35 miles from its then-current location.

 

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The table below reflects the payment that would have been received by Mr. Army if each of the events described in the column headings occurred on December 31, 2007.

 

     Change of
control
    Termination by the
company other than
for cause; not after a

change of control (1)
    Termination after a
change of control
by the company
(other than for
cause) or by

Mr. Army for good
reason (1)
 

Base Salary

     n/a     $ 290,000 (2)   $ 290,000 (2)

Cash Bonus

     n/a     $ 124,340 (3)   $ 124,340 (3)

Benefits

     n/a     $ 7,872 (2)   $ 7,872 (2)

Number of accelerated stock options

     (4 )     n/a       2,356,066 (5)

Value of accelerated options (6)

   $ 0     $ 0     $    

 

(1) “After a change of control” means within 12 months following a change of control.
(2) To be paid in installments over the 12 month period from December 31, 2007 until December 31, 2008, according to regular payroll practices.
(3) Reflects payment of bonus amount actually earned by and paid to Mr. Army for fiscal 2007.
(4) Stock options granted to Mr. Army that remain unvested immediately prior to a change of control, and the vesting of which has not been otherwise accelerated by the board of directors pursuant to the terms of the 1999 Plan, will be accelerated to vest in 4 equal tranches on the last day of each successive 3-month period during the 12 months immediately following the date of the change of control (provided that Mr. Army is employed by the company or the acquiror on such vesting dates).
(5) Reflects vesting of all unvested stock options owned by Mr. Army as of December 31, 2007.
(6) There was no public market for our common stock in 2007. We have estimated the market value of the unvested option shares based on an assumed public offering price of $             per share, which is the midpoint of the range set forth on the cover page of this prospectus.

Richard Altieri.    We are party to a letter agreement, dated as of August 31, 2007, with Richard Altieri for the position of Vice President Finance, Chief Financial Officer and Treasurer. The agreement provides for at-will employment at a base salary of $225,000 per year. Mr. Altieri received a non-qualified stock option to purchase 728,000 shares of our common stock under our incentive plan upon beginning his employment with us. In addition, he has the opportunity to earn a cash bonus of up to 20% of his base salary and an equity bonus of a stock option to purchase up to 35,000 shares of our common stock under our incentive plan, based on the achievement of a combination of company and personal milestones. Furthermore, with approval by our board of directors, the maximum amount of cash bonus may increase to 24% of his base salary and the maximum equity bonus may increase to qualify him for a stock option to purchase up to 42,000 shares of our common stock, based on our overachievement of certain objectives. Mr. Altieri’s stock options are subject to a four year vesting period, with 25% of his stock options vesting after one year, and monthly pro-rated vesting thereafter. The letter agreement does not contain any change of control provisions or contractual termination or severance benefits.

David Brown.    We are party to a letter agreement, dated as of January 14, 2008, with David Brown for the position of Vice President, Sales & Marketing. The agreement provides for at-will employment at a base salary of $225,000 per year. Mr. Brown has received a non-qualified stock option to purchase 550,000 shares of common stock under our incentive plan. In addition, he has the opportunity to earn a cash bonus of up to 20% of his base salary and an equity bonus of a stock option to purchase up to 35,000 shares of common stock under our incentive plan, based on the achievement of a combination of company and personal milestones. The maximum cash bonus amount may be increased to 35% of Mr. Brown’s base salary, based on overachievement of personal employment objectives. Furthermore, with approval by our board of directors, the maximum equity bonus may increase to qualify him for a stock option to purchase up to 42,000 shares of our common stock, based on our overachievement of certain objectives. Mr. Brown’s stock options are subject to a four year vesting period, with 25% of his stock options vesting after one year, and monthly pro-rated vesting thereafter. The letter agreement does not contain any change of control provisions or contractual termination or severance benefits.

Mark Roby, Ph.D.    We are party to a letter agreement, dated as of January 17, 2008, with Mark Roby for the position of Vice President, Research & Development. The agreement provides for at-will employment at a base salary of $220,000 per year. Dr. Roby has received a non-qualified stock option to purchase 575,000 shares

 

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of common stock under our incentive plan. In addition, he has the opportunity to earn a cash bonus of up to 20% of his base salary and an equity bonus of a stock option to purchase up to 35,000 shares of our common stock under our incentive plan, based on achievement of a combination of company and personal milestones. With approval by our board of directors, the maximum amount of the cash bonus may increase to qualify him for a stock option to purchase up to 24% of his base salary and the maximum amount of the equity bonus may increase to up to 42,000 shares of common stock, based on our overachievement of certain objectives. Dr. Roby’s stock options are subject to a four year vesting period, with 25% of his stock options vesting after one year, and monthly pro-rated vesting thereafter. The letter agreement does not contain any change of control provisions or contractual termination or severance benefits.

Som Kovvuri.    We are party to a letter agreement, dated as of January 3, 2007, with Som Kovvuri for the position of Director, Quality Assurance. The agreement provides for at-will employment at a base salary of $150,000 per year. Mr. Kovvuri received a non-qualified stock option to purchase 10,000 shares of our common stock under our incentive plan. In addition, he has the opportunity to earn a cash bonus of up to 12.5% of his base salary and an equity bonus of up to 4,000 stock options under our incentive plan, based on achievement of a combination of company and personal milestones. Mr. Kovvuri was promoted to the position of Vice President, Regulatory Affairs and Quality Assurance in September 2007, at which time our board of directors increased his base salary to $160,000 per year. Mr. Kovvuri received a non-qualified stock option to purchase 40,000 of common stock under our incentive plan upon his promotion. In addition, he has the opportunity to earn a cash bonus of up to 20% of his base salary and an equity bonus of a stock option to purchase up to 20,000 shares of our common stock under our incentive plan, based on achievement of a combination of company and personal milestones. Furthermore, with approval by our board of directors, the maximum amount of cash bonus may increase to 24% of his base salary and the maximum equity bonus may increase to qualify him for a stock option to purchase up to 24,000 shares of our common stock, based on company overachievement of certain objectives. Mr. Kovvuri’s stock options are subject to a four year vesting period, with 25% of his stock options vesting after one year, and monthly pro-rated vesting thereafter. The letter agreement does not contain any change of control provisions or contractual termination or severance benefits.

Tad Vaughn.    We are party to a letter agreement, dated as of July 11, 2006, with Tad Vaughn for the position of Vice President, Operations. The agreement provides for at-will employment at a base salary of $150,000 per year. Mr. Vaughn received a non-qualified stock option to purchase 50,000 shares of our common stock under our incentive plan upon beginning his employment with us. Effective January 1, 2007, Mr. Vaughn’s salary was increased to $154,500 per year. On November 1, 2007, Mr. Vaughn’s salary was increased to $164,500 per year. In addition, he has the opportunity to earn a cash bonus of up to 20% of his base salary and an equity bonus of a stock option to purchase up to 20,000 shares of common stock under the company incentive plan, based on achievement of a combination of company and personal milestones. Furthermore, with approval by the board of directors, the maximum amount of cash bonus may increase to 24% of his base salary and the maximum equity bonus may increase to qualify him for a stock option to purchase up to 24,000 shares of common stock, based on company overachievement. of certain objectives. Mr. Vaughn’s stock options are subject to a four year vesting period, with 25% of his stock options vesting after one year, and monthly pro-rated vesting thereafter. The letter agreement does not contain any change of control provisions or contractual termination or severance benefits.

Director Compensation

Non-employee Director Compensation Policy

Our directors do not currently receive cash compensation for their services as members of the board of directors or committees of the board of directors. Our employee directors are eligible to participate in the 1999 Plan and all directors are eligible to participate in the 2003 Plan. We reimburse each member of our board of directors who is not an employee for reasonable travel and other expenses in connection with attending meetings of the board of directors or committees thereof.

 

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The following table sets forth a summary of the compensation earned by certain of our directors in 2007. The columns under the headings “Fees Earned or Paid in Cash,” “Stock Awards,” “Non-Equity Incentive Plan Compensation,” “Change in Pension Value and Nonqualified Deferred Compensation Earnings” and “All Other Compensation” were omitted because no compensation in these categories were awarded to, earned by, or paid to our directors in 2007.

 

Name of Director

   Option
Awards
($)(1)
   Total
($)

Richard Randall (2)

   $ 12,744    $ 12,744

J. Neal Armstrong (2)

   $ 15,093    $ 15,093

Winston Wallin (2)

   $ 12,744    $ 12,744

Jay Schmelter

     —        —  

Gary Ellis

     —        —  

Anthony Arnerich

     —        —  

Robert Strauss (3)

   $ 15,564    $ 15,564

 

(1) Options granted under the 2003 plan vest one year from the date of grant.
(2) The amounts reported reflect the compensation expense associated with the vesting of options in 2007, as well as an incremental charge associated with the re-pricing of previously granted stock options during 2007.
(3) Mr. Strauss resigned from the board of directors in March 2003. Amounts reported in the table reflect the compensation expense incurred in 2007 for the incremental charges associated with the repricing of stock options previously awarded to Mr. Strauss in 2000 and 2003.

Limitation of Liability and Indemnification Agreements

The Delaware General Corporation Law authorizes corporations to eliminate, subject to certain conditions, the personal liability of directors to corporations and their stockholders for monetary damages for breach of their fiduciary duties. Our restated certificate of incorporation and restated by-laws limit the liability of our directors to the fullest extent permitted under Delaware law.

We have obtained directors’ and officers’ liability insurance to cover liabilities our directors and officers may incur in connection with their services to us, and plan to expand such coverage to include matters arising under the securities laws prior to the completion of this offering. Our restated certificate of incorporation and restated by-laws also provide that we will indemnify any of our directors and officers who, by reason of the fact that he or she is one of our officers or directors, is involved in a legal proceeding of any nature. We will repay certain expenses incurred by a director or officer in connection with any civil or criminal action or proceeding, specifically including actions by us or in our name (derivative suits). Such indemnifiable expenses include, to the maximum extent permitted by law, attorneys’ fees, judgments, civil or criminal fines, settlement amounts and other expenses customarily incurred in connection with legal proceedings. A director or officer will not receive indemnification if he or she is found not to have acted in good faith and in a manner he or she reasonably believed to be in, or not opposed to, our best interest.

We have entered into indemnification agreements with each of our directors. These agreements, among other things, require us to indemnify each director to the fullest extent permitted by Delaware law, including indemnification of expenses such as attorneys’ fees, judgments, fines and settlement amounts incurred by the director in any action or proceeding, including any action or proceeding by or in right of us, arising out of the person’s services as a director. We believe that these provisions and agreements are necessary to attract and retain qualified persons as directors.

Such limitation of liability and indemnification does not affect the availability of equitable remedies. In addition, we have been advised that in the opinion of the SEC, indemnification for liabilities arising under the Securities Act is against public policy as expressed in the Securities Act and is therefore unenforceable.

There is no pending litigation or proceeding involving any of our directors, officers, employees or agents in which indemnification will be required or permitted. We are not aware of any threatened litigation or proceeding that may result in a claim for such indemnification.

 

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CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Since January 1, 2005, we have engaged in the following transactions with our directors, executive officers, holders of more than five percent of our voting securities, or any member of the immediate family of the foregoing persons.

Transactions with our Principal Stockholders

Medtronic License Agreement

We are party to a license agreement with Medtronic under which we license intellectual property rights to our core technology. In connection with the license agreement, we have granted Medtronic promissory notes and warrants to purchase our common stock and our Series D Convertible Preferred Stock, which will become warrants to purchase our common stock upon consummation of this offering. Pursuant to the license agreement and our amended and restated certificate of incorporation, Medtronic is entitled to appoint a representative to our board of directors; however, this right will terminate automatically upon the completion of this offering. For more information regarding this agreement, see “Business—Intellectual Property—Medtronic License Agreement” and “Description of Capital Stock—Warrants.”

Investors’ Rights Agreement

We have entered into an amended and restated investors’ rights agreement with certain of our warrantholders and stockholders, including each of the holders of more than five percent of our voting securities and Wallin 2004 Partnership LLP. For more information regarding this agreement, see “Description of Capital Stock—Registration Rights” and “Description of Capital Stock—Right of First Offer and First Refusal, Take-Along Right and Co-Sale Right.”

Pursuant to registration rights provisions of our amended and restated investors’ rights agreement, the holders of 81,177,617 shares of our common stock (on an as-converted basis), including warrants to purchase up to 2,577,365 shares of common stock, are entitled to require us to register their shares or participate in a registration of shares by us under the Securities Act under certain circumstances. None of the holders have rights to register shares in connection with this offering. These holders include the following directors and holders of more than five percent of our voting securities:

 

Name

  

Relationship

   Number of
Registrable
Shares

Entities affiliated with Arnerich Massena & Associates, Inc. (1)

   5% Stockholder    30,217,571

Entities affiliated with QuestMark Advisers LLC (2)

   5% Stockholder    12,116,240

Entities affiliated with Medtronic, Inc. (3)

   5% Stockholder    6,576,974

Entities affiliated with RiverVest Venture Partners I, LLC (4)

   5% Stockholder    5,691,590

Entities affiliated with Vanguard VI Venture Partners, L.L.C. (5)

   5% Stockholder    4,426,978

Entities affiliated with Crescendo Ventures III, LLC (6)

   5% Stockholder    3,867,507

Wallin 2004 Partnership LLP (7)

                 Director    1,103,756

Total

      64,000,616

 

(1) Consists of 13,550,712 shares held by TLM Investors, LLC and 16,666,859 shares held by TLM Investors II, LLC. One of our directors, Mr. Arnerich, is the Managing Member of TLM Investors, LLC and Chief Executive Officer of Arnerich Massena & Associates, Inc., the Managing Member of TLM Investors II, LLC.
(2) Consists of 10,292,913 shares held by QuestMark Partners, L.P. and 1,823,327 shares held by QuestMark Partners Side Fund, L.P. QuestMark Advisers LLC is the General Partner of QuestMark Partners, L.P. and QuestMark Partners Side Fund, L.P.
(3) Consists of 1,243,578 shares held by Medtronic, Inc. and 5,333,396 shares held by its subsidiary, Medtronic International, Ltd. One of our directors, Mr. Ellis, is Senior Vice President and Chief Financial Officer of Medtronic, Inc. and Medtronic International, Ltd.
(4) Consists of 5,691,590 shares held by RiverVest Venture Fund I, L.P. One of our directors, Mr. Schmelter, is a Manager of RiverVest Venture Partners I, LLC, the General Partner of RiverVest Venture Fund I, L.P.

 

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(5) Consists of 3,460,098 shares held by Vanguard VI L.P., 143,103 shares held by Vanguard VI Affiliates Fund, L.P. and 823,777 shares held by Vanguard VI Annex Fund, L.P. Vanguard VI Venture Partners, L.L.C. is the General Partner of Vanguard VI L.P., Vanguard VI Affiliates Fund, L.P. and Vanguard VI Annex Fund, L.P.
(6) Consists of 3,688,285 shares held by Crescendo III, L.P., 91,766 shares held by Crescendo III Executive Fund, L.P. and 87,456 shares held by Crescendo III, GBR. Crescendo Ventures III, LLC is the General Partner of Crescendo III, L.P., Crescendo III Executive Fund, L.P. and Crescendo III, GBR.
(7) Wallin 2004 Partnership LLP is beneficially owned by four children of Mr. Wallin, one of our directors.

Voting Agreements

Pursuant to a voting agreement by and among us and the holders of our Series E Convertible Preferred Stock, including entities associated with RiverVest Venture Partners I, LLC, Arnerich Massena & Associates, Inc. and Wallin 2004 Partnership LLP, each of Anthony Arnerich and Jay Schmelter were elected to serve as members of our board of directors as representatives of our Series E Convertible Preferred Stock. Mr. Arnerich was designated by TLM Investors II, LLC and Mr. Schmelter was designated by RiverVest Venture Fund I, L.P. The voting agreement and all rights thereunder will automatically terminate upon completion of this offering.

Pursuant to a voting agreement by and among us and certain of our common stockholders and optionholders, including each of Messrs. Army, Vaughn, Armstrong, Randall and Wallin, each such common stockholder and optionholder agrees to vote their common stock issued upon conversion of options in favor of certain significant transactions if approved by our board of directors. The types of significant transactions covered by the voting agreement include sales, mergers, increases in authorized common stock, and private and public offerings of securities, as well as certain other similar transactions. The voting agreement and all rights thereunder will automatically terminate upon completion of this offering.

Financing Transactions

On February 12, 2007, we sold 27,346,379 shares of Series E Convertible Preferred Stock to venture capital investors, including holders of more than five percent of our voting securities, in a private placement at a price of $0.924 per share, resulting in net proceeds of approximately $20.0 million after conversion of approximately $5.3 million of outstanding principal and accrued interest on convertible promissory notes as described below.

 

Name

 

Relationship

  Shares of Series E
Convertible
Preferred Stock
Purchased
  Cash
Consideration
  Consideration from
Cancellation of
Indebtedness

Entities affiliated with Arnerich Massena & Associates, Inc. (1)

  5% Stockholder   18,547,739   $ 15,400,179   $ 1,737,933

Entities affiliated with QuestMark Advisers LLC (2)

  5% Stockholder   1,250,880     N/A   $ 1,155,813

Entities affiliated with Medtronic, Inc. (3)

  5% Stockholder   509,132     N/A   $ 470,438

Entities affiliated with RiverVest Venture Partners I, LLC (4)

  5% Stockholder   2,076,670   $ 1,500,000   $ 418,844

Entities affiliated with Crescendo Ventures III, LLC (5)

  5% Stockholder   475,721     N/A   $ 439,566

Wallin 2004 Partnership LLP (6)

  Director   1,082,251   $ 1,000,000     N/A

Total

    23,942,393   $ 17,900,179   $ 4,222,594

 

(1) Consists of 1,880,880 shares held by TLM Investors, LLC and 16,666,859 shares held by TLM Investors II, LLC. One of our directors, Mr. Arnerich, is the Managing Member of TLM Investors, LLC and Chief Executive Officer of Arnerich Massena & Associates, Inc., the Managing Member of TLM Investors II, LLC.
(2) Consists of 1,062,640 shares held by QuestMark Partners, L.P. and 188,240 shares held by QuestMark Partners Side Fund, L.P. QuestMark Advisers LLC is the General Partner of QuestMark Partners, L.P. and QuestMark Partners Side Fund, L.P.

 

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(3) Consists of 509,132 shares held by Medtronic International, Ltd. One of our directors, Mr. Ellis, is Senior Vice President and Chief Financial Officer of Medtronic International, Ltd.
(4) Consists of 2,076,670 shares held by RiverVest Venture Fund I, L.P. One of our directors, Mr. Schmelter, is a Manager of RiverVest Venture Partners I, LLC, the General Partner of RiverVest Venture Fund I, L.P.
(6) Consists of 457,406 shares held by Crescendo III, L.P., 13,606 shares held by Crescendo III Executive Fund, L.P. and 4,709 shares held by Crescendo III, GBR. Crescendo Ventures III, LLC is the General Partner of Crescendo III, L.P., Crescendo III Executive Fund, L.P. and Crescendo III, GBR
(5) Wallin 2004 Partnership LLP is beneficially owned by four children of Mr. Wallin, one of our directors.

On September 1, 2006, we entered into a secured subordinated convertible promissory note and warrant purchase agreement with venture capital investors, including holders of more than five percent of our voting securities, in a private placement, pursuant to which promissory notes with an aggregate principal amount of approximately $5,000,000 were issued, along with warrants to purchase 1,995,477 shares of Series E Convertible Preferred Stock.

 

Name

  

Relationship

   Principal Value of
Promissory Note
   Shares of Series E
Convertible Preferred
Stock Available upon
Exercise of Warrant
   Aggregate Cash
Consideration

Entities affiliated with Arnerich Massena & Associates, Inc. (1)

   5% Stockholder    $ 1,647,851    658,307    $ 1,649,500

Entities affiliated with QuestMark Advisers LLC (2)

   5% Stockholder    $ 1,095,904    437,808    $ 1,097,000

Entities affiliated with Medtronic, Inc. (3)

   5% Stockholder    $ 446,054    178,196    $ 446,500

Entities affiliated with RiverVest Venture Partners I, LLC (4)

   5% Stockholder    $ 397,134    158,652    $ 397,531

Entities affiliated with Crescendo Ventures III, LLC (5)

   5% Stockholder    $ 416,782    166,502    $ 417,199

Total

      $ 4,003,725    1,599,465    $ 4,007,730

 

(1) Consists of a promissory note in principal amount of $1,647,851 and warrants to purchase 658,307 shares held by TLM Investors, LLC. One of our directors, Mr. Arnerich, is the Managing Member of TLM Investors, LLC.
(2) Consists of a promissory note in principal amount of $930,986 and warrants to purchase 371,924 shares held by QuestMark Partners, L.P. and a promissory note in principal amount of $164,918 and warrants to purchase 65,884 shares held by QuestMark Partners Side Fund, L.P. QuestMark Advisers LLC is the General Partner of QuestMark Partners, L.P. and QuestMark Partners Side Fund, L.P.
(3) Consists of a promissory note in principal amount of $446,054 and warrants to purchase 178,196 shares held by Medtronic International, Ltd. One of our directors, Mr. Ellis, is Senior Vice President and Chief Financial Officer of Medtronic International, Ltd.
(4) Includes a promissory note in principal amount of $397,134 and warrants to purchase 158,652 shares by RiverVest Venture Fund I, L.P. One of our directors, Mr. Schmelter, is a Manager of RiverVest Venture Partners I, LLC, the General Partner of RiverVest Venture Fund I, L.P.
(5) Consists of a promissory note in principal amount of $400,736 and warrants to purchase 160,092 shares held by Crescendo III, L.P., a promissory note in principal amount of $11,920 and warrants to purchase 4,762 shares held by Crescendo III Executive Fund, L.P. and a promissory note in principal amount of $4,126 and warrants to purchase 1,648 shares held by Crescendo III, GBR. Crescendo Ventures III, LLC is the General Partner of Crescendo III, L.P., Crescendo III Executive Fund, L.P. and Crescendo III, GBR.

Transactions with Directors and Executive Officers

Board Compensation

Certain of our non-employee directors have received options to purchase shares of our common stock. For more information regarding these arrangements, see “Executive Compensation—Director Compensation.”

Employment Agreements

We have entered into offer letters or employment agreements with each of Messrs. Army, Altieri, Brown, Roby, Kovvuri and Vaughn. For more information regarding these arrangements, see “Executive Compensation—Employment and Change of Control Arrangements.”

 

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Indemnification Agreements

We have entered into indemnification agreements with each of our directors. These agreements, among other things, require us to indemnify each director to the fullest extent permitted by Delaware law, including indemnification of expenses such as attorneys’ fees, judgments, fines and settlement amounts incurred by the director in any action or proceeding, including any action or proceeding by or in right of us, arising out of the person’s services as a director.

Stock Option Grants

We have granted options to purchase shares of our common stock to our directors and executive officers. See “Executive Compensation—Director Compensation,” “Executive Compensation—Grants of Plan-Based Awards” and “Executive Compensation—Outstanding Equity Awards at Fiscal Year-End.”

Policies for Approval of Related Person Transactions

Our board of directors reviews and approves transactions with directors, executive officers, holders of more than five percent of our voting securities, or any member of the immediate family of the foregoing persons, or each, a related party. Prior to this offering, prior to our board of directors’ consideration of a transaction with a related party, the material facts as to the related party’s relationship or interest in the transaction are disclosed to our board of directors, and the transaction is not considered approved by our board of directors unless a majority of the directors who are not interested in the transaction approve the transaction. Following this offering, such transactions must be approved by our audit committee or another independent body of our board of directors. Further, when stockholders are entitled to vote on a transaction with a related party, the material facts of the related party’s relationship or interest in the transaction are disclosed to the stockholders, who must approve the transaction in good faith.

 

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PRINCIPAL STOCKHOLDERS

The following table sets forth certain information known to us regarding beneficial ownership of our common stock as of February 1, 2008, as adjusted to reflect the sale of shares of common stock offered by us in this offering, for:

 

Ÿ  

each person known by us to be the beneficial owner of more than 5% of our common stock;

 

Ÿ  

our named executive officers;

 

Ÿ  

each of our directors; and

 

Ÿ  

all executive officers and directors as a group.

Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and generally includes voting or investment power with respect to securities. Except as noted by footnote, and subject to community property laws where applicable, we believe based on the information provided to us that the persons and entities named in the table below have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them.

The table lists applicable percentage ownership based on shares of common stock outstanding as of February 1, 2008, and also lists applicable percentage ownership based on shares of common stock assumed to be outstanding after the closing of the offering. The table assumes all of our outstanding preferred stock has been converted into shares of our common stock and all outstanding warrants to purchase our preferred stock have been converted into warrants to purchase our common stock. Options and warrants to purchase shares of our common stock that are exercisable within 60 days of February 1, 2008, are deemed to be beneficially owned by the persons holding these options for the purpose of computing percentage ownership of that person, but are not treated as outstanding for the purpose of computing any other person’s ownership percentage.

 

    Shares Beneficially
Owned Prior to the
Offering
    Shares
Beneficially
Owned After

the Offering
  Percentage of
Shares Owned
Assuming Full
Exercise of an
Option Granted
to the
Underwriters

Name and Address of Beneficial Owner (1)

  Number   Percent     Number   Percent  

5% Stockholders

         

Entities affiliated with Arnerich Massena & Associates, Inc. (2)

2045 N.E. Martin Luther King Jr. Blvd.

Portland, Oregon 97212

  30,217,571   40.5 %      

Entities affiliated with QuestMark Advisers LLC (3)

One South Street, Suite 800

Baltimore, Maryland 21202

  12,116,240   16.1 %      

Entities affiliated with Medtronic, Inc. (4)

710 Medtronic Parkway, NE

Mail Stop LC390

Minneapolis, MN 55432

  6,576,974   8.8 %      

Entities affiliated with RiverVest Venture Partners I, LLC (5)

7733 Forsyth Boulevard, Suite 1650

Clayton, Missouri 63105

  5,691,590   7.6 %      

Entities affiliated with Vanguard VI Venture Partners, L.L.C. (6)

525 University Avenue, Suite 1200

Palo Alto, CA 94301

  4,426,978   5.9 %      

Entities affiliated with Crescendo Ventures III, LLC (7)

800 LaSalle Avenue, Suite 2250

Minneapolis, MN 55402

  3,867,507   5.2 %      

 

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     Shares Beneficially
Owned Prior to the
Offering
    Shares
Beneficially
Owned After

the Offering
   Percentage of
Shares Owned
Assuming Full
Exercise of an
Option Granted to
the Underwriters

Executive Officers and Directors

             

Joseph Army (8)

   751,110    1.0 %        

Richard Altieri

   0    *          

David Brown

   0    *          

Mark Roby, Ph.D.

   0    *          

Som Kovvuri

   0    *          

Tad Vaughn (9)

   22,206    *          

Jay Schmelter (5)

   5,691,590    7.6 %        

Gary Ellis (4)

   6,576,974    8.8 %        

Anthony Arnerich (2)

   30,217,571    40.5 %        

J. Neal Armstrong

   130,000    *          

Winston Wallin (10)

   100,000    *          

Richard Randall (11)

   100,000    *          

M. Jacqueline Eastwood

   2,490,659    3.3 %        

Michael McClurken, Ph.D.

   576,328    *          

Roberta Thompson

   143,934    *          

All executive officers and directors as a group (15 persons) (12)

   46,800,372    62.1 %        

 

* Indicates beneficial ownership of less than one percent.
(1) Unless otherwise indicated, the address for each beneficial owner is c/o Salient Surgical Technologies, Inc., Suite 400, One Washington Center, Dover, NH 03820.
(2) Consists of 13,550,712 shares held by TLM Investors, LLC and 16,666,859 shares held by TLM Investors II, LLC. Mr. Arnerich is the Managing Member of TLM Investors, LLC and Chief Executive Officer of Arnerich Massena & Associates, Inc., the Managing Member of TLM Investors II, LLC. As such, Mr. Arnerich may be deemed to share voting and investment power with respect to all shares held by such entity. Mr. Arnerich disclaims beneficial ownership of such shares except to the extent of his pecuniary interest, if any.
(3) Consists of 9,920,989 shares held by QuestMark Partners, L.P., 1,757,443 shares held by QuestMark Partners Side Fund, L.P., warrants to purchase 371,924 shares held by QuestMark Partners, L.P. and warrants to purchase 65,884 shares held by QuestMark Partners Side Fund, L.P. QuestMark Advisers LLC is the General Partner of QuestMark Partners, L.P. and QuestMark Partners Side Fund, L.P.
(4) Consists of 993,756 shares held by Medtronic, Inc., 5,155,200 shares held by its subsidiary, Medtronic International, Ltd., warrants to purchase 249,822 shares held by Medtronic, Inc. and warrants to purchase 178,196 shares held by its subsidiary, Medtronic International, Ltd. Mr. Ellis is Senior Vice President and Chief Financial Officer of Medtronic, Inc. and Medtronic International, Ltd. As such, Mr. Ellis may be deemed to share voting and investment power with respect to all shares held by such entity. Mr. Ellis disclaims beneficial ownership of such shares except to the extent of his pecuniary interest, if any.
(5) Consists of 5,691,590 shares held by RiverVest Venture Fund I, L.P. Mr. Schmelter is a Manager of RiverVest Venture Partners I, LLC, the General Partner of RiverVest Venture Fund I, L.P. As such, Mr. Schmelter may be deemed to share voting and investment power with respect to all shares held by such entity. Mr. Schmelter disclaims beneficial ownership of such shares except to the extent of his pecuniary interest, if any.
(6) Consists of 3,460,098 shares held by Vanguard VI L.P., 143,103 shares held by Vanguard VI Affiliates Fund, L.P. and 823,777 shares held by Vanguard VI Annex Fund, L.P. Vanguard VI Venture Partners, L.L.C. is the General Partner of Vanguard VI L.P., Vanguard VI Affiliates Fund, L.P. and Vanguard VI Annex Fund, L.P.
(7) Consists of 3,528,194 shares held by Crescendo III, L.P., 87,005 shares held by Crescendo III Executive Fund, L.P., 85,808 shares held by Crescendo III, GBR, warrants to purchase 160,091 shares held by Crescendo III, L.P., warrants to purchase 4,761 shares held by Crescendo III Executive Fund, L.P. and warrants to purchase 1,648 shares held by Crescendo III, GBR. Crescendo Ventures III, LLC is the General Partner of Crescendo III, L.P., Crescendo III Executive Fund, L.P. and Crescendo III, GBR
(8) Consists of 726,772 shares held by Joseph Army and Kimberly D. Army, as joint tenants with rights of survivorship and 24,338 shares of common stock issuable to Mr. Army upon exercise of stock options, which are currently exercisable or exercisable within 60 days of February 1, 2008.
(9) Consists of 22,206 shares of common stock issuable to Mr. Vaughn upon exercise of stock options, which are currently exercisable or exercisable within 60 days of February 1, 2008.
(10) Consists of 100,000 shares of common stock issuable to Mr. Wallin upon exercise of stock options, which are currently exercisable or exercisable within 60 days of February 1, 2008.
(11) Consists of 100,000 shares of common stock issuable to Mr. Randall upon exercise of stock options, which are currently exercisable or exercisable within 60 days of February 1, 2008.
(12) See footnotes 2, 4 through 5 and 8 through 11 above.

 

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DESCRIPTION OF CAPITAL STOCK

General

The following is a summary of the rights of our common stock and preferred stock and related provisions of our certificate of incorporation and by-laws as they will be in effect upon the closing of this offering, and does not purport to be complete. For more detailed information, please see our restated certificate of incorporation, by-laws and amended and restated investors’ rights agreement, filed as exhibits to the registration statement of which this prospectus forms a part. The summary below is also qualified by provisions of applicable law.

Our authorized capital stock currently consists of 180,000,000 shares of common stock, par value $0.01 per share, and 185,000,000 shares of preferred stock, $0.01 par value per share. Upon completion of this offering, our authorized capital stock will consist of              shares of common stock and              shares of preferred stock. These totals give effect to the amendment and restatement of our restated certificate of incorporation to delete references to the Series A, B, C, D and E convertible preferred stock.

As of February 1, 2008, we had outstanding 6,472,046 shares of common stock and 65,913,212 shares of preferred stock, held of record by 114 stockholders. All of the outstanding preferred stock will convert into 77,606,495 shares of common stock upon completion of this offering.

Upon completion of this offering, we expect to have approximately              shares of common stock outstanding.

Common Stock

Holders of common stock are entitled to one vote per share on matters on which our stockholders vote. There are no cumulative voting rights. Holders of common stock are entitled to receive dividends, if declared by our board of directors, out of funds that we may legally use to pay dividends. See the section of this prospectus entitled “Dividend Policy” for further information. If we liquidate or dissolve, holders of common stock are entitled to share ratably in our assets once our debts and any liquidation preference owed to any then-outstanding preferred stockholders are paid. Our certificate of incorporation does not provide the common stock with any redemption, conversion or preemptive rights. No shares of preferred stock will be outstanding immediately after the closing of this offering. All shares of common stock that are outstanding as of the date of this prospectus and, upon issuance and sale, all shares we are selling in this offering, will be fully-paid and nonassessable.

Preferred Stock

We are currently authorized to issue 185,000,000 shares of preferred stock. Upon completion of this offering, all issued and outstanding shares of preferred stock will convert into a total of 77,606,495 shares of common stock. Immediately after this conversion, the outstanding shares of preferred stock will be cancelled, and the total number of shares of preferred stock that we are authorized to issue will be reduced to              shares.

Upon completion of this offering, our board of directors may, without further action by our stockholders, from time to time, direct the issuance of shares of preferred stock in series and may, at the time of issuance, determine the rights, preferences and limitations of each series, including voting rights, dividend rights and redemption and liquidation preferences. Satisfaction of any dividend preferences of outstanding shares of preferred stock would reduce the amount of funds available for the payment of dividends on shares of our common stock. Holders of shares of preferred stock may be entitled to receive a preference payment in the event of any liquidation, dissolution or winding-up of our company before any payment is made to the holders of shares of our common stock. In some circumstances, the issuance of shares of preferred stock may render more difficult or tend to discourage a merger, tender offer or proxy contest, the assumption of control by a holder of a large block of our securities or the removal of incumbent management. Upon the affirmative vote of our board of directors, without stockholder approval, we may issue shares of preferred stock with voting and conversion rights which could adversely affect the holders of shares of our common stock.

 

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We have no current intention to issue any of our unissued, authorized shares of preferred stock. However, the issuance of any shares of preferred stock in the future could adversely affect the rights of the holders of our common stock.

Warrants

As of February 1, 2008, we have issued warrants to purchase an aggregate of 124,222 shares of our common stock, with an exercise price of $0.01 per share, expiring in August, 2009.

In addition, as of February 1, 2008, we have issued warrants to purchase an aggregate of 906,208 shares of our Series D Convertible Preferred Stock and an aggregate of 1,458,580 shares of our Series E Convertible Preferred Stock. Upon completion of this offering, the warrants to purchase Series D Convertible Preferred Stock will be exchanged for warrants to purchase an aggregate of 994,563 shares of our common stock, with an exercise price of $1.263 per share, expiring at various dates beginning in May 2014 through December 2017, and the warrants to purchase Series E Convertible Preferred Stock will be exchanged for warrants to purchase an aggregate of 1,458,580 shares of our common stock, with an exercise price of $0.21 per share, expiring at various dates beginning in September 2016 through February 2017.

Registration Rights

Under our amended and restated investors’ rights agreement, our preferred stockholders and warrantholders have the right to require us to register the common stock issuable upon conversion of their shares with the Securities and Exchange Commission so that those shares may be publicly resold, or to include their shares in any registration statement we file.

Demand Registration Rights

Pursuant to our amended and restated investors’ rights agreement, the holders of 33% or more of the common stock available for issuance upon conversion of our preferred stock and certain other common stock held, or available upon conversion of certain other securities, have the right to demand that we file a registration statement covering the resale of their common stock, subject to a maximum of two such demands in the aggregate for all holders and to other specified exceptions. If such offering is an underwritten offering, the underwriters of any such offering will have the right to limit the number of shares to be offered except that if the limit is imposed, then only shares held by holders who are parties to the investors’ rights agreement will be included in such offering and the number of shares to be included in such offering will be allocated pro rata among those same parties. In addition, while we are in registration, we generally will not be required to take any action to effect a demand registration.

If we qualify for the use of Form S-3 (or any similar registration form), we shall, on the request of a stockholder which is a party to the investors’ rights agreement, be obligated to prepare, file and cause to be effective such registration statement, subject to a maximum of two such demands in the aggregate for all holders in each calendar year and to other specified exceptions.

“Piggyback” Registration Rights

In general, if we register any securities for public sale (other than in this offering), stockholders with registration rights will have the right to include their shares in the registration statement. If such offering is an underwritten offering, the underwriters of such offering will have the right to limit the number of such shares to be included in the registration statement.

Expenses of Registration

Other than transfer taxes and underwriting fees, discounts and commissions and other limited exceptions, we will pay all reasonable expenses relating to piggyback and demand registrations.

 

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Indemnification

Our amended and restated investors’ rights agreement contains customary cross-indemnification provisions, pursuant to which we are obligated to indemnify our stockholders in the event of material misstatements or omissions in the registration statement attributable to us, and they are obligated to indemnify us for material misstatements or omissions attributable to them.

Expiration of Registration Rights

The registration rights described above will terminate upon the earlier of (i) the fifth anniversary of the effective date of this registration statement or (ii) the date on which there are no securities subject to the registration rights outstanding.

Right of First Offer and First Refusal, Take-Along Right and Co-Sale Right

Pursuant to our amended and restated investors’ rights agreement, we have granted to certain holders of our Series E Convertible Preferred Stock, subject to certain exceptions and adjustments, the following rights: a right of first offer to purchase up to a proportionate number of our securities proposed to be sold by us; a right of first refusal to purchase a proportionate number of our securities proposed to be sold by other holders; and co-sale rights, entitling all holders to participate proportionally in a proposed sale of our securities approved by management. Pursuant to our amended and restated investors’ rights agreement, we have also granted to the holders of our preferred stock, subject to certain exceptions and adjustments, the right of a majority of the holders, together with the holders of 66 2/3% of the Series E Convertible Preferred Stock, to force all holders to transfer all company securities held by them to a third party transferee. All of these rights will terminate upon completion of this offering.

Anti-Takeover Effects of Delaware Law, Our Certificate of Incorporation and Our Bylaws

In addition to the board of directors’ ability to issue shares of preferred stock, upon completion of this offering, our certificate of incorporation and by-laws will contain other provisions that are intended to enhance the likelihood of continuity and stability in the composition of the board of directors and which may have the effect of delaying, deferring or preventing a future takeover or change in control of our company unless such takeover or change in control is approved by our board of directors. These provisions include a classified board of directors, elimination of stockholder action by written consents, elimination of the ability of stockholders to call special meetings, advance notice procedures for stockholder proposals and supermajority vote requirements for amendments to our certificate of incorporation and by-laws.

Classified Board.    Our certificate of incorporation provides for our board to be divided into three classes, as nearly equal in number as possible, serving staggered terms. Approximately one-third of our board will be elected each year. See “Directors, Executive Officers and Key Employees—Composition of the Board of Directors.” Under the Delaware General Corporation Law, unless the certificate of incorporation otherwise provides, directors serving on a classified board can only be removed by the stockholders for cause. The provision for a classified board could prevent a party who acquires control of a majority of our outstanding common stock from obtaining control of the board until our second annual stockholders meeting following the date the acquirer obtains the controlling stock interest. The classified board provision could have the effect of discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of us and could increase the likelihood that incumbent directors will retain their positions.

Elimination of Stockholder Action Through Written Consent.    Our by-laws provide that stockholder action can be taken only at an annual or special meeting of stockholders and cannot be taken by written consent in lieu of a meeting.

 

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Elimination of the Ability to Call Special Meetings.    Our amended and restated certificate of incorporation and by-laws provide that, except as otherwise required by law, special meetings of our stockholders can only be called pursuant to a resolution adopted by a majority of our board of directors or by our chief executive officer or the chairman of our board of directors. Stockholders are not permitted to call a special meeting or to require our board to call a special meeting

Advanced Notice Procedures for Stockholder Proposals.    Our by-laws establish an advance notice procedure for stockholder proposals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our board. Stockholders at our annual meeting may only consider proposals or nominations specified in the notice of meeting or brought before the meeting by or at the direction of our board or by a stockholder who was a stockholder of record on the record date for the meeting, who is entitled to vote at the meeting and who has given to our secretary timely written notice, in proper form, of the stockholder’s intention to bring that business before the meeting. Although our by-laws do not give our board the power to approve or disapprove stockholder nominations of candidates or proposals regarding other business to be conducted at a special or annual meeting, our by-laws may have the effect of precluding the conduct of some business at a meeting if the proper procedures are not followed or may discourage or defer a potential acquirer from conducting a solicitation of proxies to elect its own slate of directors or otherwise attempting to obtain control of us.

Amendments to the Certificate of Incorporation or By-laws.    Our certificate of incorporation and by-laws provide that the affirmative vote of holders of at least 75% of the total votes eligible to be cast in the election of directors is required to amend, alter, change or repeal some of their provisions. This requirement of a super-majority vote to approve amendments to the certificate and by-laws could enable a minority of our stockholders to exercise veto power over any such amendments.

Provisions of Delaware law governing business combinations.    Following the consummation of this offering, we will be subject to the business combination provisions of Section 203 of the Delaware General Corporation Law. In general, such provisions prohibit a publicly held Delaware corporation from engaging in any business combination transactions with any interested stockholder for a period of three years after the date on which the person became an interested stockholder, unless:

 

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prior to such date, the board of directors approved either the business combination or the transaction which resulted in the interested stockholder obtaining such status;

 

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upon consummation of the transaction which resulted in the stockholder becoming an interested stockholder, the interested stockholder owned at least 85% of the voting stock of the corporation outstanding at the time the transaction commenced, excluding for purposes of determining the voting stock outstanding (but not the outstanding voting stock owned by the interested stockholder) those shares owned by (a) persons who are directors and also officers and (b) employee stock plans in which employee participants do not have the right to determine confidentially whether shares held subject to the plan will be tendered in a tender or exchange offer; or

 

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at or subsequent to such time the business combination is approved by the board of directors and authorized at an annual or special meeting of stockholders, and not by written consent, by the affirmative vote of at least 66 2/3 % of the outstanding voting stock which is not owned by the interested stockholder.

A business combination is defined to include mergers, asset sales and other transactions resulting in financial benefit to a stockholder. In general, an interested stockholder is a person who, together with affiliates and associates, owns 15% or more of a corporation’s voting stock or within three years did own 15% or more of a corporation’s voting stock. The statute could prohibit or delay mergers or other takeover or change in control attempts with respect to us and, accordingly, may discourage attempts to acquire us.

 

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Limitations on liability and indemnification of officers and directors.    Our certificate of incorporation limits the liability of our directors to the fullest extent permitted by the Delaware General Corporation Law and provides that we will indemnify them to the fullest extent permitted by such law. We have entered in indemnification agreements with some of our current directors prior to the completion of this offering and expect to enter into a similar agreement with any new directors. We expect to increase our directors’ and officers’ liability insurance coverage prior to the completion of this offering.

NASDAQ Global Market Listing

We have applied to have our common stock approved for quotation on The NASDAQ Global Market under the symbol “SLNT.”

Transfer Agent and Registrar

The transfer agent and registrar for our common stock is             .

 

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SHARES ELIGIBLE FOR FUTURE SALE

Prior to this offering, there has been no public market for our common stock. Future sales of our common stock in the public market, or the availability of such shares for sale in the public market, could adversely affect market prices prevailing from time to time. As described below, only a limited number of shares will be available for sale shortly after this offering due to contractual and legal restrictions on resale. Nevertheless, sales of our common stock in the public market after such restrictions lapse, or the perception that those sales may occur, could adversely affect the prevailing market price at such time and our ability to raise equity capital in the future.

Upon the closing of this offering, we will have outstanding an aggregate of approximately              shares of common stock, assuming no exercise of the underwriters’ overallotment option and no exercise of outstanding options or warrants after             . Of these shares, the              shares of common stock to be sold by us in this offering will be freely tradable without restriction or further registration under the Securities Act, unless the shares are held by any of our affiliates as such term is defined in Rule 144 of the Securities Act. All remaining shares of common stock held by existing stockholders will be “Restricted Securities” as that term is defined in Rule 144 under the Securities Act. Restricted Securities may be sold in the public market only if registered or it they qualify for exemption under Rules 144 or 701 under the Securities Act, which rules are summarized below, on another exemption.

As a result of the lock up agreements described below and the provisions of Rule 144 and Rule 701 under the Securities Act, the shares of our common stock (excluding the shares sold in this offering) that will be available for sale in the public market are as follows:

 

Date of Availability of Sale

   Approximate Number of
Shares

As of the date of this prospectus

  

90 days after the date of this prospectus

  

180 days after the date of this prospectus, although a portion of such shares will be subject to volume limitations pursuant to Rule 144

  

Lock-up Agreements

All of our directors, executive officers and certain holders of our capital stock have agreed that, during a period of not less than 180 days from the date of this prospectus, they will not, subject to certain exceptions, without the prior written consent of Bear, Stearns & Co. Inc. and Piper Jaffray & Co., dispose of or hedge any shares of our common stock or any securities convertible into or exercisable or exchangeable for shares of our common stock. If during the last 17 days of the 180-day lock-up period we issue an earnings release or material news or a material event relating to us occurs, or if prior to the expiration of the 180-day lock-up period we announce that we will release earnings results during the 16-day period beginning on the last day of the 180-day period, the restrictions described in the preceding paragraph will continue to apply until the expiration of the 18-day period beginning on the issuance of the earnings release or the occurrence of the material news or material event, unless such extension of the lock-up period is waived by Bear, Stearns & Co. Inc. and Piper Jaffray & Co.

After the expiration of the 180-day (or longer, if extended as provided in the previous paragraph) lock-up period, the shares subject to lock-up agreements may be sold in the public market, subject to compliance with Rules 144 or 701 under the Securities Act. Gifts to immediate family members and certain other transfers or dispositions can be made prior to the end of the lock-up period, provided that the recipient of the shares agrees in writing to be bound by the same restrictions on transfer of the shares. A sale of shares subject to lock-up agreements is also permitted prior to the end of the lock-up period in connection with a qualifying merger or reorganization of the company.

 

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Rule 144

In general, under Rule 144 of the Securities Act, unless subject to a contractual lock up restriction, beginning 90 days after the date of this prospectus, a person deemed to be our affiliate and who has beneficially owned shares of our common stock for at least six months will be entitled to sell within any three-month period a number of shares that does not exceed the greater of (i) either 1% of the then outstanding shares of our common stock, which will equal approximately              shares immediately after this offering, or (ii) the average weekly trading volume of our common stock on The NASDAQ Global Market during the four calendar weeks preceding the filing with the SEC of a notice on Form 144 with respect to such sale. Sales by a person deemed to be our affiliate are also subject to certain manner of sale provisions, notice requirements and the requirement that we have made current public information about ourselves available.

In general, under Rule 144 of the Securities Act, unless subject to a contractual lock-up restriction, beginning 90 days after the date of this prospectus, a person that is not deemed to be our affiliate and who has not had an affiliate relationship with us during the preceding three months will be entitled to sell an unrestricted amount of shares of our common stock (i) after satisfying a six-month holding period, subject to the requirement of the availability of public information about us, and (ii) after satisfying a twelve-month holding period, without further requirements.

Rule 701

Rule 701, as currently in effect, permits resales of shares in reliance upon Rule 144 but without compliance with some of the restrictions of Rule 144, including the holding period requirement. Most of our employees, officers, directors or consultants who purchased shares under a written compensatory plan or contract (such as our current stock option plans) may be entitled to rely on the resale provisions of Rule 701, but all holders of Rule 701 shares are required to wait until 90 days after the date of this prospectus before selling their shares.

Stock Plans

We intend to file one or more registration statements on Form S-8 under the Securities Act to register shares of our common stock issued or reserved for issuance under our stock option plans. The first such registration statement is expected to be filed soon after the date of this prospectus and will automatically become effective upon filing with the SEC. Accordingly, shares registered under such registration statement will be available for sale in the open market, unless such shares are subject to vesting restrictions with us or the lock-up restrictions described above.

 

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UNDERWRITING

We intend to offer the shares of our common stock through the underwriters. Subject to the terms and conditions in an underwriting agreement between us and Bear, Stearns & Co. Inc. and Piper Jaffray & Co., acting as representatives of the underwriters named below and joint book-running managers for this offering, we have agreed to sell to the underwriters, and the underwriters severally have agreed to purchase from us, the number of shares of common stock listed opposite their names below.

 

Underwriter

   Number of Shares

Bear, Stearns & Co. Inc.

  

Piper Jaffray & Co.

  

Wachovia Capital Markets, LLC

  

Total

  

The underwriters have agreed to purchase all of the shares sold under the underwriting agreement if any of these shares are purchased. If an underwriter defaults, the underwriting agreement provides that the purchase commitments of the non-defaulting underwriters may be increased or the underwriting agreement may be terminated.

We have agreed to indemnify the underwriters against certain liabilities, including liabilities under the Securities Act, or to contribute to payments the underwriters may be required to make in respect of those liabilities.

The underwriters are offering the shares, subject to prior sale, when, as and if issued to and accepted by them, subject to approval of legal matters by their counsel, including the validity of the shares, and other conditions contained in the underwriting agreement, such as the receipt by the underwriters of officer’s certificates and legal opinions. The underwriters reserve the right to withdraw, cancel or modify offers to the public and to reject orders in whole or in part.

Other Relationships

The underwriters may, from time to time, engage in transactions with and perform services for us in the ordinary course of their business.

Commissions and Discounts

The underwriters have advised us that they propose initially to offer the shares to the public at the public offering price on the cover page of this prospectus and to dealers at that price less a concession not in excess of $                 per share. The underwriters may allow, and the dealers may reallow, a discount not in excess of $                 per share to other dealers. After the public offering, the public offering price, concession and discount may be changed.

The following table shows the public offering price, underwriting discount and proceeds before expenses to us. The information assumes either no exercise or full exercise by the underwriters of their option to purchase additional shares.

 

     Per Share    No Exercise
of Option
   Full
Exercise of
Option

Public offering price

   $                $                $            

Underwriting discount

   $    $    $

Proceeds, before expenses, to us

   $    $    $

The expenses of the offering, excluding the underwriting discount and commissions and related fees, are estimated at $              million and are payable by us.

 

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Option to Purchase Additional Shares

We have granted the underwriters an option exercisable for 30 days from the date of this prospectus to purchase a total of up to              additional shares from us at the public offering price less the underwriting discount. To the extent the underwriters exercise this option in whole or in part, each will be obligated, subject to conditions contained in the underwriting agreement, to purchase a number of additional shares approximately proportionate to that underwriter’s initial commitment amount reflected in the above table.

If the underwriters sell more shares than could be covered by the option to purchase additional shares, a naked short position would be created that can only be closed out by buying shares in the open market. A naked short position is more likely to be created if the underwriters are concerned that there could be downward pressure on the price of the shares in the open market after pricing that could adversely affect investors who purchase in the offering.

No Sales of Similar Securities

Subject to certain exceptions, we, each of our executive officers and directors and all of the holders of our common stock, subject to limited exceptions, have agreed not to sell or transfer any shares of our common stock for 180 days after the date of this prospectus (which period could be extended by the underwriters for up to an additional 34 days under certain circumstances) without first obtaining the written consent of Bear, Stearns & Co. Inc. and Piper Jaffray & Co.

The 180-day period described in the preceding paragraph will be automatically extended if: (i) during the last 17 days of the 180-day period we issue an earnings release or announce material news or a material event; or (ii) prior to the expiration of the 180-day period, we announce that we will release earnings results during the 15-day period following the last day of the 180-day period, in either of which case the restrictions described in the preceding paragraph will continue to apply until the expiration of the 18-day period beginning on the issuance of the earnings release or the announcement of the material news or material event.

After the expiration of the 180-day (or longer, if extended as provided in the previous paragraph) lock-up period, the shares subject to lock-up agreements may be sold in the public market, subject to compliance with Rules 144 or 701 under the Securities Act. Gifts to immediate family members and certain other transfers or dispositions can be made prior to the end of the lock-up period, provided that the recipient of the shares agrees in writing to be bound by the same restrictions on transfer of the shares. A sale of shares subject to lock-up agreements is also permitted prior to the end of the lock-up period in connection with a qualifying merger or reorganization of the company.

Offering Price Determination

Before this offering, there has been no public market for our common stock. The initial public offering price will be determined by negotiation between the underwriters and us. The principal factors to be considered in determining the public offering price include: the information set forth in this prospectus and otherwise available to the underwriters; the history and the prospects for the industry in which we will compete; the ability of our management; the prospects for our future earnings; the present state of our development and our current financial condition; the general condition of the securities markets at the time of this offering; and the recent market prices of, and the demand for, publicly traded common stock of generally comparable companies.

Stabilization, Short Positions and Penalty Bids

The underwriters may engage in over-allotment, stabilizing transactions, syndicate covering transactions and penalty bids in accordance with Regulation M under the Securities Exchange Act of 1934, as amended.

 

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Over-allotment involves syndicate sales in excess of the offering size, which creates a syndicate short position.

 

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Stabilizing transactions permit bids to purchase the underlying security so long as the stabilizing bids do not exceed a specified maximum.

 

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Syndicate covering transactions involve purchases of the common stock in the open market after the distribution has been completed in order to cover syndicate short positions.

 

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Penalty bids permit the representatives to reclaim a selling concession from a syndicate member when the common stock originally sold by the syndicate member is purchased in a syndicate covering transaction to cover syndicate short positions.

Stabilizing transactions, syndicate covering transactions and penalty bids may cause the price of our common stock to be higher than it would otherwise be in the absence of these transactions. These transactions may be effected on The NASDAQ Global Market or otherwise and, if commenced, may be discontinued at any time.

NASDAQ Listing

We have applied to list our common stock on The NASDAQ Global Market under the symbol “SLNT.”

Discretionary Shares

In connection with this offering, the underwriters may allocate shares to accounts over which they exercise discretionary authority. The underwriters do not expect to allocate shares to discretionary accounts in excess of 5% of the total number of shares in this offering.

Sales in Other Jurisdictions

Each of the underwriters may arrange to sell shares in certain jurisdictions outside the United States through affiliates, either directly where they are permitted to do so or through affiliates.

Each of the underwriters has represented and agreed that:

 

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it has not made or will not make an offer of shares to the public in the United Kingdom within the meaning of section 102B of the Financial Services and Markets Act 2000 (as amended) (FSMA) except to legal entities which are authorized or regulated to operate in the financial markets or, if not so authorized or regulated, whose corporate purpose is solely to invest in securities or otherwise in circumstances which do not require the publication by us of a prospectus pursuant to the Prospectus Rules of the Financial Services Authority (FSA);

 

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it has only communicated or caused to be communicated and will only communicate or cause to be communicated an invitation or inducement to engage in investment activity (within the meaning of section 21 of FSMA) to persons who have professional experience in matters relating to investments falling within Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 or in circumstances in which section 21 of FSMA does not apply to us; and

 

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it has complied with and will comply with all applicable provisions of FSMA with respect to anything done by it in relation to the shares in, from or otherwise involving the United Kingdom.

The shares will not be offered, directly or indirectly, to the public in Switzerland and this prospectus does not constitute a public offering prospectus as that term is understood pursuant to article 652a or 1156 of the Swiss Federal Code of Obligations.

The shares (i) will not be offered or sold, directly or indirectly, to the public (appel public á l’ épargne) in the Republic of France and (ii) offers and sales of shares in the Republic of France (a) will only be made to qualified investors (investisseurs qualifiés) as defined in, and in accordance with, Articles L 411-1, L 411-2 and

 

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D 411-1 to D 411-3 of the French Code monétaire et financier or (b) will be made in any other circumstances which do not require the publication by the issuer of a prospectus pursuant to Article L 411-2 of the Code monétaire et financier and Article 211-2 of the Réglement Général of the Autorité des marchés financiers.

Investors are informed that this prospectus has not been admitted to the clearance procedures of the Autorité des marchés financiers, and that any subsequent direct or indirect circulation to the public of the shares so acquired may not occur without meeting the conditions provided for in Articles L 411-1, L 411-2, L 412-2 and L 621-8 to L 621-8-2 of the Code monétaire et financier.

In addition, the issuer represents and agrees that it has not distributed or caused to be distributed and will not distribute or cause to be distributed in the Republic of France, this prospectus or any other offering material relating to the shares other than to those investors (if any) to whom offers and sales of the shares in the Republic of France may be made as described above.

In relation to each Member State of the European Economic Area which has implemented the Prospectus Directive (each, a Relevant Member State), with effect from and including the date on which the Prospectus Directive is implemented in that Relevant Member State (the Relevant Implementation Date), it has not made and will not make an offer of shares to the public in that Relevant Member State prior to the publication of a prospectus in relation to the shares which has been approved by the competent authority in that Relevant Member State or, where appropriate, approved in another Relevant Member State and notified to the competent authority in that Relevant Member State, all in accordance with the Prospectus Directive, except that it may, with effect from and including the Relevant Implementation Date, make an offer of shares to the public in that Relevant Member State at any time:

 

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to legal entities which are authorized or regulated to operate in the financial markets or, if not so authorized or regulated, whose corporate purpose is solely to invest in securities;

 

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to any legal entity which has two or more of (1) an average of at least 250 employees during the last financial year; (2) a total balance sheet of more than €43,000,000; and (3) an annual net turnover of more than €50,000,000, as shown in its last annual or consolidated accounts; or

 

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in any other circumstances which do not require the publication by the issuer of a prospectus pursuant to Article 3 of the Prospectus Directive.

For the purposes of this provision, the expression an offer of shares to the public in relation to any shares in any Relevant Member State means the communication in any form and by any means of sufficient information on the terms of the offer and the shares to be offered so as to enable an investor to decide to purchase or subscribe the shares, as the same may be varied in that Member State by any measure implementing the Prospectus Directive in that Member State and the expression “Prospectus Directive” means Directive 2003/71/EC and includes any relevant implementing measure in each Relevant Member State.

 

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LEGAL MATTERS

Our counsel, Ropes & Gray LLP, Boston, Massachusetts, will pass upon the validity of the shares of common stock offered by this prospectus. The underwriters have been represented by Latham & Watkins LLP, New York, New York.

EXPERTS

The consolidated financial statements as of December 31, 2006 and 2007 and for each of the three years in the period ended December 31, 2007, included in this prospectus, have been so included in reliance on the report of PricewaterhouseCoopers LLP, an independent registered public accounting firm, given on the authority of said firm as experts in auditing and accounting.

WHERE YOU CAN FIND MORE INFORMATION

We have filed with the SEC a registration statement on Form S-1 (File Number 333- ) under the Securities Act with respect to the shares of common stock we are offering by this prospectus. This prospectus does not contain all of the information included in the registration statement. For further information pertaining to us and our common stock, you should refer to the registration statement and to its exhibits. Whenever we make reference in this prospectus to any of our contracts, agreements or other documents, the references are not necessarily complete, and you should refer to the exhibits attached to the registration statement for copies of the actual contract, agreement or other document.

Upon the closing of the offering, we will be subject to the informational requirements of the Securities Exchange Act of 1934 and will file annual, quarterly and current reports, proxy statements and other information with the SEC. You can read our SEC filings, including the registration statement, over the Internet at the SEC’s website at www.sec.gov. You may also read and copy any document we file with the SEC at its public reference facility at 100 F Street, N.E., Room 1580, Washington, D.C. 20549.

You may also obtain copies of the documents at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference facilities.

 

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I NDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

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Report of Independent Registered Public Accounting Firm

   F-2

Consolidated Balance Sheets as of December 31, 2006 and December 31, 2007

   F-3

Consolidated Statements of Operations for the years ended December 31, 2005, 2006 and 2007

   F-4

Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficit) for the years ended December 31, 2005, 2006 and 2007

   F-5