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Volcano 10-K 2009
Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

 

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

For the fiscal year ended December 31, 2008

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 000-52045

 

 

LOGO

Volcano Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Delaware   33-0928885

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification Number)

 

11455 El Camino Real, Suite 460   92130
San Diego, California   (Zip Code)
(Address of Principal Executive Offices)  

Registrant’s telephone number, including area code:

(800) 228-4728

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, $0.001 per share par value   The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

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

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

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

 

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

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

The aggregate market value of the voting common equity held by non-affiliates of the registrant, based upon the closing price of a share of the registrant’s common stock on June 30, 2008 (which is the last business day of registrant’s most recently completed second fiscal quarter), as reported on the NASDAQ Global Market was approximately $290.1 million. Approximately 23.5 million shares of common stock held by each executive officer and director and by each person who owns 5% or more of the outstanding common stock at June 30, 2008 have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

At March 1, 2009, 48,204,237 shares of Common Stock, par value $0.001, of the registrant were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None

 

 

 


Table of Contents

VOLCANO CORPORATION

ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2008

TABLE OF CONTENTS

 

PART I

   2

Item 1.

 

Business

   2

Item 1A.

 

Risk Factors

   15

Item 1B.

 

Unresolved Staff Comments

   40

Item 2.

 

Properties

   40

Item 3.

 

Legal Proceedings

   41

Item 4.

 

Submission of Matters to a Vote of Security Holders

   41

PART II

   42

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   42

Item 6.

 

Selected Financial Data

   44

Item 7.

 

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

   45

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

   64

Item 8.

 

Financial Statements and Supplementary Data

   66

Item 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   103

Item 9A.

 

Controls and Procedures

   103

Item 9B.

 

Other Information

   104

PART III

   105

Item 10.

 

Directors, Executive Officers and Corporate Governance

   105

Item 11.

 

Executive Compensation

   109

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   135

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

   139

Item 14.

 

Principal Accounting Fees and Services

   140

PART IV

   142

Item 15.

 

Exhibits, Financial Statement Schedules

   142

SIGNATURES

   146

EXHIBIT INDEX

   147

EXHIBIT   2.5

  

EXHIBIT 10.23

  

EXHIBIT 12.1

  

EXHIBIT 21.1

  

EXHIBIT 23.1

  

EXHIBIT 31.1

  

EXHIBIT 31.2

  

EXHIBIT 32.1

  

EXHIBIT 32.2

  

 

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This annual report on Form 10-K contains forward-looking statements regarding future events and our future results that are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. In some cases, you can identify these “forward-looking statements” by words like “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of those words and other comparable words. These statements include, but are not limited to, those concerning the following; our intentions, beliefs and expectations regarding our future financial performance, anticipated growth and trends in our business; the timing and success of our clinical trials and regulatory submissions; our belief that our cash and cash equivalents and short-term available for sale investments will be sufficient to satisfy our anticipated cash requirements; our operating results; our expectations regarding our revenues and customers: our distributors and statements regarding market penetration and expansion efforts. Forward-looking statements are subject to risks and uncertainties that could cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties, see the “Risk Factors” section of this Form 10-K. Any forward-looking statement speaks only as of the date on which it is made, and except as required by law, we undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-K.

We currently have registered trademarks including, but not limited to, Volcano®, Eagle Eye®, Visions®, Revolution®, ComboWire®, SmartMap®, ComboMap®, SmartWire®, Brightwire®, FloWire®, WaveWire®, VH®, Trak Back®, FloMap®, ChromaFlo® and Avanar® and are in the process of registering certain other of our trademarks with the United States Patent and Trademark Office including, but not limited to, vfusion powered by VolcanoTM, vfusionTM, AimTM, Safe and SoundTM , Primewire™, SpinVisionTM and pcFM™. We have other common law trademarks as well. Other brand names or trademarks appearing in this Annual Report are the property of their respective holders.

PART I

 

Item 1. Business

Overview

We design, develop, manufacture and commercialize a broad suite of intravascular ultrasound, or IVUS, and functional measurement, or FM, products. We believe that these products enhance the diagnosis and treatment of vascular heart disease by improving the efficiency and efficacy of existing percutaneous interventional, or PCI, therapy procedures in the coronary or peripheral arteries. We market our products to physicians and technicians who perform PCI procedures in hospitals and to other personnel who make purchasing decisions on behalf of hospitals.

Our IVUS products consist of ultrasound consoles, single-procedure disposable phased array and rotational IVUS imaging catheters and additional functionality options such as virtual histology, or VH, IVUS tissue characterization and ChromaFlo stent apposition analysis. Our IVUS consoles are marketed as stand-alone units or customized units that can be integrated into a variety of hospital-based interventional surgical suites called catheterization laboratories, or cath labs. We have developed customized cath lab versions of these consoles and are developing additional functionality options as part of our cath lab integration initiative. Our IVUS consoles have been designed to serve as a multi-modality platform for our phased array and rotational IVUS catheters, fractional flow reserve, or FFR, pressure wires and Medtronic’s Pioneer reentry device. We are developing additional offerings for integration into the platform, including Forward-Looking IVUS, or FLIVUS, catheters, image-guided therapy catheters and ultra-high resolution Optical Coherence Tomography, or OCT, systems and catheters.

Our FM offerings include consoles and single-use pressure and flow guide wires used to measure the pressure and flow characteristics of blood around plaque enabling physicians to gauge the plaque’s physiological impact on blood flow and pressure.

 

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We have or are building direct sales capabilities in the United States, Western Europe, and Japan and have approximately 50 distributor relationships in 40 other countries. During the year ended December 31, 2008, we generated worldwide revenues of $171.5 million and incurred an operating loss of $19.7 million. At December 31, 2008, we had a worldwide installed base of over 3,200 IVUS consoles and over 800 FM consoles. We intend to grow and leverage this installed base of consoles to drive recurring sales of our single-procedure disposable catheters and guide wires, which accounted for approximately 73% of our revenues during the year ended December 31, 2008. In 2008, 51% of the Company’s revenues were generated in the United States, with the balance of sales occurring in international markets.

Our Strategy

We have a number of new offerings under development and our strategy is to offer a multi-modality platform that seeks to deliver all of the benefits associated with conventional IVUS and FM devices, while providing enhanced functionality and proprietary features that address the limitations associated with conventional forms of these technologies. Factors driving our strategy include:

 

   

Accelerating the trend towards less invasive procedures. Our IVUS products offer continuous, real-time three-dimensional imaging, plaque visualization, color-coded identification of plaque composition, and automatic drawing of lumen and vessel borders allowing for automatic vessel sizing. Our FM products offer physicians a simple pressure and flow based method to determine whether stenting or additional PCI is required. We believe our combination of IVUS enhancements and functional assessment is instrumental in facilitating less invasive procedures.

 

   

Improving ease of use of IVUS technologies to drive market adoption. We have designed our console offerings to be “always there, always on, and easy to use.” Our consoles are easily integrated into an existing or newly constructed cath lab facility. In addition, our IVUS offerings provide intravascular visualization during stenting procedures and also help physicians to conduct increasingly complex percutaneous procedures.

 

   

Improving the diagnosis of cardiovascular disease. We believe our VH IVUS products will significantly improve the diagnosis of cardiovascular disease by addressing the limitations of diagnostic angiography, and will allow clinicians to identify patients and lesions at risk for future adverse coronary vascular system events.

 

   

Improving the outcomes of percutaneous interventional procedures. We believe our products, enabled with novel technological enhancements, provide clinically significant information that improves the outcomes of current and increasingly complex PCI procedures.

 

   

Decreasing the number of interventional devices used per procedure and optimizing their usage. FM products offer the opportunity to physiologically assess lesion severity and determine whether stents are needed. Additionally, our IVUS products provide intra-vascular imaging. As a result, our IVUS and FM products have the potential to reduce the number of devices deployed by identifying the correct lesion appropriate for stenting and ensuring that it is placed and expanded correctly thereby enhancing patient outcomes and lowering treatment costs.

 

   

Enabling new procedures to treat CAD, PAD and structural heart disease. Current treatment of a number of vascular and structural heart diseases, including coronary, peripheral and carotid artery disease and atrial fibrillation, is limited by conventional catheter-based techniques and angiography. Because our technologies address many of these current limitations, we believe our products provide the potential to enable these diseases to be diagnosed and, optimally, treated percutaneously.

Our goal is to establish our IVUS and FM products as the standard of care for percutaneous interventional diagnostic and therapeutic procedures. The key elements of our strategy for achieving this goal are to:

 

   

Increase market share in existing IVUS and FM markets. We continue to introduce product enhancements to meet physicians’ needs for improved visualization, characterization, and ease of use.

 

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We believe these enhancements make our products easier to use than competing products while providing substantially more and better information to improve procedural outcomes, thereby driving greater usage of our IVUS and FM products within the existing PCI market. We have implemented several strategies to increase penetration. First, we have addressed limitations of conventional IVUS such as difficulty in use, lack of automation and grayscale imaging by developing technologies and introducing features such as automatic real-time drawing of lumen and vessel borders, color-coded identification of plaque composition, and automatic vessel sizing. Second, we developed PC-based IVUS and FM consoles that can be integrated easily into cath labs, thereby making it easier for physicians to adopt and use our products. Third, we have increased the size of our direct sales force and initiated direct distribution strategies in key geographies. We have also entered into distribution and marketing agreements with leading cath lab equipment and stent manufacturers. We intend to grow and leverage our installed base of IVUS and FM consoles to drive recurring sales of our single-procedure disposable catheters and guide wires.

 

   

Expand into new markets and develop clinical applications for and utilization of our technology in new markets. We plan to leverage our current technology and develop new technology to expand into new markets and increase clinical applications through clinical studies, conducted by us or in collaboration with other companies. This includes programs for (1) IVUS guided therapy products that combine IVUS with balloons, (2) OCT light based imaging systems which we believe can be used for coronary, peripheral, and other vascular structures to image anatomy and other cellular activity, (3) FLIVUS for applications including chronic total occlusions in the coronary and peripheral arteries as well as other structural heart applications, (4) microcatheter technologies for use in coronary, peripheral and other vascular applications, and (5) unique optical and micro-electro-mechanical systems technologies in telecommunications, industrial spectroscopy or medical OCT applications.

 

   

Enhance product capabilities and introduce new products through collaborations or acquisitions. We have a successful track record of acquiring and licensing technologies and collaborating with third parties to create synergistic product offerings. For instance, we licensed from The Cleveland Clinic Foundation the VH IVUS technology that now forms the core of our ability to determine the composition of plaque and acquired from Philips the intellectual property rights allowing us to develop our Revolution rotational catheter. In December 2007, we acquired CardioSpectra, Inc., or CardioSpectra, whose core product line, based on innovative OCT technology, is expected to complement our existing product offerings. In addition, during 2008 we acquired Novelis, Inc., or Novelis, which is developing FLIVUS technology; Impact Medical Technologies, LLC, which is developing innovative catheter technologies; and Axsun Technologies, Inc., or Axsun, which is a developer of optical and laser technologies. We believe there will be additional opportunities to leverage these capabilities through technology or company acquisitions as well as collaborations.

Our Products

Our products include IVUS and FM consoles, IVUS catheters, FM guide wires and additional functionality options. Our consoles are marketed as stand-alone units or units that can be integrated into cath labs. We market the integrated cath lab version of these consoles and additional functionality options as part of our cath lab integration initiative. Our s5i console is comprised of components that can be customized to each cath lab’s specifications and integrated into virtually any cath lab. With the commercialization of our s5i IVUS consoles and upon the commercialization of other new products and technologies, we expect our offering will include cath lab-integrated IVUS and FM capabilities, real-time VH IVUS functionality with color-coded identification of plaque composition and automatic real-time drawing of lumen and vessel borders. Our offering would also support IVUS integrated with other interventional devices. The significantly expanded functionality of our offering would allow for networking of patient information, control of IVUS and FM information at both the operating table and in the cath lab control room, as well as the capability for images to be displayed on standard cath lab monitors. We expect to continue to develop new products and technologies to expand our offering.

 

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Our IVUS Products

Consoles. We design, develop, manufacture and commercialize consoles that are proprietary, high-speed electronic systems that process the signals received from our IVUS catheters. These consoles generate high-resolution images that can be displayed on a monitor and can be permanently stored on the system or another medium. Our IVUS market strategy includes offering clinicians devices that are easier to use, require lower procedure times and provide a higher level of information. We have a family of consoles including our IVUS In-Vision Gold, or IVG, and the new PC-based s5. The s5 family of consoles, which became our primary console following its full commercial launch in July 2006, is smaller, lighter and less expensive to manufacture, and has enhanced functionality. The s5 family includes:

 

   

s5: This portable and mobile console is the lightest product on the market, and we believe it has the simplest and easiest user interface. The s5 weighs 95 pounds compared to greater than 300 pounds for our IVUS IVG console and Boston Scientific’s Galaxy product.

 

   

s5i: This console is made up of components that can be customized to each cath lab’s specifications and integrated into virtually any cath lab while retaining the full functionality of the s5. When the s5i is integrated into the cath lab, it works seamlessly with the workflow of the cath lab in terms of manipulating and archiving patient images and data.

 

   

s5 and s5i with FFR: These consoles are identical to the s5 and s5i, except that they also include the functionality to measure pressure and FFR.

Catheters. Our single-procedure disposable catheters only operate and interface with our family of IVUS consoles. We are the only company that offers both phased array and rotational catheters. We believe this allows us to meet the needs of a greater number of physicians than our competitors. Each phased array IVUS catheter contains a cylindrical transducer array with 64 elements capable of separately sending and receiving signals. Our 45 MHz Revolution rotational catheter is the highest frequency catheter on the market and we believe it offers better resolution in the area close to the end of the catheter, or near-field, than competitive rotational catheters. The Revolution develops images by rotating a single transducer element inside the tip of the catheter using a flexible torque cable. Our IVUS catheters vary in their principal use, frequencies, shaft sizes, shaft lengths, guide wire compatibility and distal tip lengths. These differences allow for the use of different catheters in various portions of the vascular system.

Additional Functionality. Our IVUS products incorporate key features that add valuable clinical functionality addressing a number of the historical limitations of conventional IVUS and we intend to incorporate additional functionality in the future. Our IVUS products incorporate ChromaFlo and VH IVUS which contains in-vivo color-coded identification of plaque composition and automatic drawing of lumen and vessel borders.

ChromaFlo. Angiography alone does not always identify malapposed stents because the contrast injection that makes the lumen visible on x-ray can flow inside the stent, and in between the stent and vessel wall. When this occurs, the stent struts are too small to compete with the dark lumen of the x-ray, leaving the two dimensional image inconclusive or misleading. ChromaFlo stent apposition analysis uses sequential IVUS frames to differentiate circulating blood from stationary or anchored tissue, and when enabled, highlights moving blood in orange. ChromaFlo can be particularly important when assessing stent placement as the detailed cross-sectional image clearly identifies moving blood inside and outside of the stent lumen, prompting physicians in many cases to expand the stent until all of the orange colored blood appears inside of the stent lumen.

VH IVUS. Conventional IVUS allows the visualization of atherosclerotic plaque. However, in standard IVUS grayscale images, calcified regions of plaque and dense fibrous components generally reflect ultrasound energy well and thus appear bright and homogeneous. Conversely, regions of low echo reflectance are usually labeled as soft or mixed plaque. However, the visual interpretation is limited and does not allow qualitative and quantitative real-time assessment of plaque composition. This can make reading IVUS images difficult, drawing lumen and vessel borders cumbersome and identifying vulnerable plaque not possible. Our VH IVUS product

 

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allows, for the first time, easy to read and interpret IVUS images with color-coded identification of plaque types. Additionally, a key element of the VH IVUS product is the capability to provide automatic drawing of lumen and vessel borders. This feature enables automated vessel sizing, which makes it easier and faster to use our IVUS products. Finally, our VH IVUS functionality offers the potential to identify vulnerable plaque alone or in conjunction with other techniques.

Our FM Products

Our FM products consist of pressure and flow consoles and single-procedure disposable pressure and flow guide wires. We believe we are the only company that offers a full line of pressure and flow guide wires as well as a guide wire that can measure both pressure and flow. Our consoles are mobile, proprietary and high speed electronic systems with different functionalities and sizes designed and manufactured to process the signals received from only our guide wires. During 2008, we introduced the PrimeWire, our enhanced pressure guide wire that measures FFR. In addition, we introduced FFR capability in our s5 consoles in the United States and Europe in mid-2008. We believe that the recent release and publication of favorable trial data relating to the measurement of FFR in addition to angiography will lead to further adoption of FM technology by clinicians.

Product Expansion

Forward-Looking IVUS

A principal area of focus for us is the development of FLIVUS offerings, utilizing advanced imaging technology we obtained through our acquisition of Novelis. This proprietary technology has potential applications for a number of minimally invasive diagnostic and therapeutic applications in the coronary and peripheral arteries. Our strategy is to integrate these offerings into our s5 hub and target markets such as chronic total inclusions and other coronary, peripheral and structural heart indications. We currently have two FLIVUS products under development. The first is a therapy guidance device used with other therapeutic devices, while the second includes a therapeutic solution.

Optical Coherence Tomography (OCT)

In December 2007, we acquired OCT technology through our acquisition of CardioSpectra, which is expected to complement our existing product offerings and further enhance our position as an imaging technology leader in the field of interventional medicine. We believe this OCT technology and products will be an important addition to Volcano, as we expect that it will allow us to expand our reach into clinical situations where extremely high resolution imaging is paramount. Our long term goal is to integrate this OCT functionality directly into our s5i integrated imaging suite of products. Our OCT system allows fast, easy imaging of highly detailed structures in the vasculature, including vessel wall defects, intra-luminal thrombus and stent struts. The ability to visualize stent expansion and apposition is excellent when using OCT. Our OCT resolution is able to visualize even very thin layers of cells covering drug eluting stent struts at follow-up. We expect this capability will be highly valued by other device manufacturers as they design and conduct clinical trials to assess the safety and effectiveness of new implantable devices. In December 2008, we acquired Axsun, a manufacturer of lasers and optical engines used in telecommunications, industrial spectroscopy and medical OCT imaging systems. We believe the Axsun acquisition will bolster our ability to pursue a number of medical OCT applications outside intravascular coronary and peripheral imaging.

IVUS Guided Therapies

As more procedures move to PCI approaches, there is an opportunity to integrate the imaging capability of IVUS with coronary and peripheral therapeutic devices. Many such devices have been developed and tested including IVUS guided chronic total occlusion re-entry devices, balloons, stents, and cell or drug delivery systems for angiogenesis, or the proliferation of blood vessels, and myogenesis, or the proliferation of heart tissue. We are developing IVUS guided therapy products that, if commercialized, will further expand and

 

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differentiate our product offering, drive IVUS utilization and enable us to participate in large endovascular market opportunities, including the market for coronary and peripheral balloons. We believe there may be additional IVUS guided therapy market opportunities, such as bare metal stents. IVUS can also be integrated with and guide leads for implantable cardiac rhythm management devices, percutaneous valves, abdominal aortic aneurysm grafts, plaque ablation or excision devices, inferior vena cava filters, and thrombectomy devices. Additionally, there are opportunities to extend the utility of the pressure and flow guide wires into different electrophysiology applications and structural heart disease assessments.

Our Vulnerable Plaque Products and Technology

We have accumulated a portfolio of patent protected technologies and products for the identification of vulnerable plaque including IVUS, VH IVUS tissue characterization, IVUS palpography, and elastography. IVUS palpography and elastography involve measuring the strain of the lumen and the plaque respectively with ultrasound signals gained during different cardiac cycles. We have developed fully functional working devices for each of these technologies and have used them in clinical studies. At this time, our focus is on our IVUS base of technologies to identify and risk stratify vulnerable plaque with other patient related information that is readily available. With our IVUS and FM technologies we have been able to clinically demonstrate that we can identify many of the characteristics and locations of vulnerable plaque. We are in the process of conducting numerous clinical studies to correlate vulnerable plaque to its clinical significance and risk.

Clinical Program

We have pursued a clinical development strategy of using United States Food and Drug Administration, or FDA, -cleared IVUS products to be at the forefront in demonstrating utility in markets into which we are attempting to increase penetration or which we intend to develop as new markets. These markets include stent placement and optimization, vulnerable plaque detection and therapy guidance in the coronary and carotid arteries. Our clinical studies are generally post-marketing studies conducted to provide data regarding diagnostic effectiveness and disease treatment outcomes. These studies often collect acute, procedural, safety and long-term efficacy data. They include randomized prospective studies, registries and single-center studies. The goal of our vulnerable plaque clinical program is to identify, risk assess, and guide PCI and pharmacologic, or relating to the study of drugs, their sources, their nature and their properties, treatments of vulnerable plaque in the coronary and carotid arteries.

Our significant ongoing clinical studies include:

Bifurcation Lesion Analysis and Stenting (BLAST)

BLAST is a global multi-center, prospective, two-arm (blinded to IVUS grayscale and VH-IVUS information vs. non-blinded), randomized study for bifurcation lesion stenting using only drug-eluting stents, or DES. There will be approximately 220 patients enrolled at sites in the United States and in Europe. The objectives of the BLAST trial are to demonstrate that grayscale IVUS with VH are more advanced diagnostic techniques to provide preinterventional knowledge of the amount, composition, and location of atherosclerotic plaque in both arterial branches, and to demonstrate that IVUS with VH guidance leads to better post procedural outcomes when compared to angiography guidance only. The study will be measuring procedural outcomes such as lesion coverage, distal embolization, residual edge stenosis, edge dissections, acute vessel closure, plaque shift, stent underexpansion, and incomplete stent apposition. Enrollment commenced in November 2008.

Assessment of Dual Anti-Platelet Therapy with Drug-Eluting Stents (ADAPT-DES)

ADAPT-DES is a prospective, multi-center, registry of at least 11,000 (and up to 15,000) consecutive patients with coronary artery disease undergoing stent-assisted PCI using DES without major procedural complications. The objectives of this trial are to determine the frequency and timing of DES thrombosis. There is

 

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an IVUS sub-study that will enroll 3,000 patients at sites in the United States and Europe. The purpose of the sub-study is to determine whether one or more IVUS parameters are independent predictors of stent thrombosis. Enrollment commenced in 2008 and currently there are nearly 4,000 patients enrolled in the main study and over 800 patients enrolled in the sub-study.

Volcano OCT Image Lesion Analysis using Intravascular Optical Coherence Tomography (VOILA)

The VOILA study is a randomized, un-blinded, multi-center OCT imaging study in patients scheduled for either coronary diagnostic catheterization or intervention. There will be approximately 115 patients enrolled at five sites in the United States. The primary objective is to evaluate the safety and efficacy of the OCT system in the observation of coronary arteries. Enrollment is expected to commence in the second quarter of 2009.

Clinical Studies Using IVUS and VH Products

We are or have been involved with GlaxoSmithKline plc, Novartis AG, Lipid Sciences, Inc., Tanabe Seiyaku Co., Ltd. and Kowa Company, Ltd. in clinical studies using IVUS and our VH IVUS product. This may enable us to participate in a growing number of drug studies.

Sales, Marketing and Distribution

We have direct sales capability in the United States, Western Europe and Japan. We intend to continue to increase our direct sales personnel. At December 31, 2008, we had a total of 150 direct sales and support professionals, including 110 in the United States, 20 direct sales and support professionals in Europe, and 20 direct sales and support professionals in Japan. In addition, we have approximately 50 distributor relationships in 40 other countries.

During 2008, we initiated programs to convert our sales strategy in Japan to a direct distribution model and to increase our direct sales activity in Europe. We have Japanese distribution relationships with Goodman Company Ltd., or Goodman, Fukuda Denshi Co., Ltd., or Fukuda Denshi, and Johnson & Johnson K.K., Medical Company Cordis Division, or Johnson & Johnson.

We have agreements with other leading healthcare companies, including General Electric Company, or GE, Koninklijke Philips Electronics N.V., or Philips, Medtronic, Inc. and certain of its affiliates, or Medtronic, Johnson & Johnson Cordis, or Johnson and Johnson, and Abbott Laboratories. We plan to enter into additional agreements to market integrated systems. These agreements allow us to coordinate our marketing efforts with our strategic partners while still dealing directly with the customer.

We sell consoles and disposables through our own direct sales force and distributors. In addition, we sell our consoles through our supply and distribution agreements with third parties. Our strategy is to leverage our installed base of consoles to drive recurring sales of our proprietary disposables. We provide training and clinical support to users of our products to increase their familiarity with product features and benefits, and thereby increase usage.

Our relationships with physician thought leaders in interventional cardiology are an important component of our selling efforts. These relationships are typically built around research collaborations that enable us to better understand and articulate the most useful features and benefits of our products, and to develop new solutions to challenges in PCI medicine.

At December 31, 2008, our global marketing team was comprised of 29 individuals, covering product management, corporate communications and programs, clinical support, and education and training. We devote significant resources to training and educating physicians in the use and benefits of our products. We also promote our products through medical society meetings attended by interventionalists.

 

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United States

In the United States, we sell our products directly to customers and through our third-party distribution and marketing agreements. At December 31, 2008, we had 110 direct sales professionals focused on selling both our IVUS and FM products. Our United States sales organization includes 37 account sales representatives, 63 clinical consultants and ten sales administration personnel. Account sales representatives are responsible for selling our products while the clinical consultants work with customers on training and supporting product use. We currently have eight regions each of which is headed by a regional manager. There are two Vice Presidents of U.S. Sales and an Executive Vice President of Global Sales.

Japan

We have sold our IVUS and FM products in Japan primarily through three direct distributors: Goodman, Fukuda Denshi and Johnson & Johnson. In addition, Fukuda Denshi has sub-distribution agreements with other parties. While these multi-level relationships allow us to access specific customers and markets, they create complex distribution arrangements and increase our reliance on our Japanese distributors. During 2008, we began to implement a strategy to sell our products in Japan directly through an internal sales force and expect to continue the implementation of such strategy in 2009.

We currently support our Japanese distributors through our Tokyo-based subsidiary, Volcano Japan Co., Ltd., or Volcano Japan. At December 31, 2008, Volcano Japan had a General Manager, a Vice President of Sales, five division sales managers, two marketing professionals, 14 sales representatives and two support staff. As a result of the transfer of the marketing authorization and other regulatory approvals, or SHONINs, to us we have retained a third party to assist with the additional responsibilities related to importation and warehousing. Our distribution agreements in Japan are generally organized according to specific clinical markets including:

Interventional Cardiology. Goodman distributes our IVUS products for use in interventional cardiology to over 400 Japanese accounts under no contractual distribution agreement. In addition, Fukuda Denshi distributes our IVUS products to approximately 200 additional interventional cardiology accounts in Japan.

Functional Measurement. Goodman also distributes our FM products in Japan on a non-exclusive basis under no contractual distribution agreement.

Endovascular/ Peripheral Applications. Johnson & Johnson distributes our IVUS disposable products in Japan for use in endovascular and peripheral applications. Our current contractual arrangements allow us to engage other third parties to distribute our IVUS products in Japan for this market.

Europe

We distribute our IVUS and FM products in Europe through our subsidiary, Volcano Europe, S.A./N.V., or Volcano Europe. We sell our products directly to customers in certain European markets and utilize distributors in other European markets, including Spain, Portugal and parts of Italy. At December 31, 2008, our distribution efforts in Europe were led by our President Volcano Europe, a Director of European Sales, 16 account representatives and three clinical specialists.

 

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Financial Information About Geographic Areas

The following table sets forth our revenues by geography expressed as dollar amounts (in thousands) and as a percentage of revenue by geography to total revenue:

 

     2008    Percent of
Total
Revenue
    2007    Percent of
Total
Revenue
    2006    Percent of
Total
Revenue
 

Revenues:

               

United States

   $ 87,513    51.0 %   $ 66,411    50.9 %   $ 51,013    49.5 %

Japan

     43,582    25.4       35,186    26.9       30,082    29.2  

Europe, the Middle East and Africa

     33,197    19.4       23,995    18.4       17,765    17.2  

Rest of world

     7,203    4.2       5,022    3.8       4,188    4.1  
                           
   $ 171,495    100.0 %   $ 130,614    100.0 %   $ 103,048    100.0 %
                           

Our international operations expose us and our representatives, agents, and distributors to risks inherent in operating in foreign jurisdictions, including the risks described in “Risk Factors—The risks inherent in our international operations may adversely impact our revenues, results of operations and financial condition.”

Competition

We compete primarily on the basis of our ability to assist in the diagnosis and treatment of vascular diseases safely and effectively, with ease and predictability of product use, adequate third-party reimbursement, brand name recognition and cost. We believe that we compete favorably with respect to these factors, although there can be no assurance that we will be able to continue to do so in the future or that new products that perform better than those we offer will not be introduced. We believe that our continued success depends on our ability to:

 

   

innovate and maintain scientifically advanced technology;

 

   

apply our technology across products and markets;

 

   

develop proprietary products;

 

   

successfully conduct clinical studies that expand our markets;

 

   

obtain and maintain patent protection for our products;

 

   

obtain and maintain regulatory approvals;

 

   

manufacture cost-effectively;

 

   

successfully market our products;

 

   

attract and retain skilled personnel; and

 

   

successfully add complementary offerings and technology through acquisitions, licensing agreements and strategic partnerships.

Our primary IVUS competitor globally is Boston Scientific, but we also compete with Terumo Corporation in Japan. In the FM market, our primary competitor is Radi Medical Systems AB, which was acquired by St. Jude Medical, Inc. in 2008. Because of the size of the vascular market opportunities, competitors and potential competitors have dedicated and will continue to dedicate significant resources to aggressively promote their products. New product developments that could compete with us more effectively are likely because the vascular disease market is characterized by extensive research efforts and technological progress. Competitors may develop technologies and products that are safer, more effective, easier to use or less expensive than ours.

We have encountered and expect to continue to encounter potential physician customers who, due to existing relationships with our competitors, are committed to or prefer the products offered by these competitors. We expect that competitive pressures may result in price reductions and reduced margins over time for our products. Our products may be rendered obsolete or uneconomical by technological advances developed by one or more of our competitors.

 

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Additional information regarding the risks associated with our competitive position and environment is described in “Risk Factors—Risks Related to Our Business and Industry.”

Intellectual Property

We believe that in order to maintain a competitive advantage in the marketplace, we must develop and maintain the proprietary aspects of our technologies. We rely on a combination of patent, trademark, trade secret, copyright and other intellectual property rights and measures to aggressively protect our intellectual property.

We require our employees and consultants to execute confidentiality agreements in connection with their employment or consulting relationships with us. We also require our employees and consultants who work on our products to agree to disclose and assign to us all inventions conceived during the term of their employment, while using our property or which relate to our business. Despite measures taken to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, our competitors may independently develop similar technologies.

The medical device industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. As the number of entrants into our market increases, the risk of an infringement claim against us grows. While we attempt to ensure that our products and methods do not infringe other parties’ patents and proprietary rights, our competitors may assert that our products, and the methods we employ, are covered by patents held by them. In addition, our competitors may assert that future products and methods we may employ infringe their patents. If third parties claim that we infringe upon their intellectual property rights, we may incur liabilities and costs and may have to redesign or discontinue selling the affected product. Risks related to our intellectual property rights are listed in “Risk Factors—Risks Related to Our Intellectual Property and Potential Litigation.”

Patents and Trademarks

We continue to expand and protect our intellectual property position. At December 31, 2008, we had a broad portfolio of at least 312 owned or licensed United States and international patents and 225 pending applications for owned or licensed patents. Our patents expire at various dates through 2028. We intend to continue to expand our intellectual property position to protect the design and use of our products, principally in the areas of IVUS, OCT imaging, guided therapies and FM for the diagnosis and guidance of treatment of vascular and structural heart disease.

Additionally, we utilize trademarks, trade names or logos in conjunction with the sale of our products. We currently have registered trademarks including, but not limited to, Volcano®, Eagle Eye®, Visions®, Revolution®, ComboWire®, SmartMap®, ComboMap®, SmartWire®, Brightwire®, FloWire®, WaveWire®, VH®, Trak Back®, FloMap®, ChromaFlo® and Avanar® and are in the process of registering certain other of our trademarks with the United States Patent and Trademark Office including, but not limited to, vfusion powered by VolcanoTM, vfusionTM, AimTM, Safe and SoundTM, Primewire™, SpinVisionTM and pcFM™. We continue to invest in internal research and development of concepts within our current markets and within other potential future markets. This enables us to continue to build our patent portfolio in areas of company interest.

Third-party Licenses

We have expanded our product portfolio by both the in-licensing and out-licensing of technology and intellectual property.

The Cleveland Clinic License. In April 2002, we entered into a license agreement with The Cleveland Clinic Foundation. The incorporation of our VH IVUS functionality into our IVUS product offerings depends on access to patents owned by The Cleveland Clinic Foundation and made available to us pursuant to an exclusive,

 

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irrevocable, in-bound license granted to us by The Cleveland Clinic Foundation pursuant to the license agreement. These worldwide license rights are within the field of diagnosis and treatment of atherosclerosis and related vascular diseases using intravascular methods and include the right to sublicense. In relation to the sale of our products which incorporate any of the licensed patents, we will be responsible for paying certain royalties to The Cleveland Clinic Foundation.

Asset Transfer Agreement with Philips. In 2003, we entered into an asset transfer agreement with Philips whereby Philips transferred to us rights to certain intellectual property that is related to IVUS and is owned by Boston Scientific. Boston Scientific was required to make these patents and related intellectual property available to third parties based on action by the Federal Trade Commission and the United States District Court. In addition to certain upfront and annual payments, we must pay Philips royalties based on the volume of products sold by us that incorporate technology acquired pursuant to the asset transfer agreement. This intellectual property in conjunction with the intellectual property that we acquired from Jomed, Inc. in 2003 and the intellectual property we have developed form the foundation of our IVUS products.

License with Medtronic. Concurrent with our acquisition of the IVUS and FM product lines from Jomed, Inc. in July 2003, we granted to Medtronic a fully paid, royalty free, worldwide, exclusive license to certain of our patents for a specific field. The field allows the inclusion of our IVUS imaging components into Medtronic’s Pioneer product.

Research and Development

Our research efforts are directed towards the development of new products and technologies that expand our existing platform of capabilities and applications in support of PCI. At December 31, 2008, our research and development staff consisted of 129 full-time engineers and technicians. The majority of this staff is located in Rancho Cordova, California. We also have research and development staff in Cleveland, Ohio; San Antonio, Texas; Forsyth County, Georgia; San Diego, California; and Andover and Billerica, Massachusetts. Our research and development staff is focused on the development of new IVUS systems and catheters, FM consoles and guide wires, image-guided therapy systems, OCT and additional clinical applications that support our core business objectives.

Our product development process incorporates teams organized around each of our core technologies, with each team having representatives from research and development, marketing, regulatory, quality, clinical affairs and manufacturing. Consultants are utilized when additional specialized expertise is required. Our team sets development priorities based on communicated customer needs. The feedback received from beta testing is incorporated into successive design iterations until a new product is ready for release.

Our research and development expenses were $26.7 million in 2008, $20.3 million in 2007 and $16.9 million in 2006. These totals include the research and development, clinical and regulatory affairs department expenses. In addition, we recognized in-process research and development expense of $12.7 million, related primarily to our acquisition of Novelis in May 2008, and $26.3 million related to our acquisition of CardioSpectra in December 2007.

Manufacturing

Our manufacturing facility is located in Rancho Cordova, California, where we produce IVUS consoles, FM consoles, IVUS catheters and FM guide wires. Our console manufacturing strategy is to use third-party manufacturing partners to produce circuit boards and mechanical sub-assemblies. We perform incoming inspection, final assembly and test of products to assure quality control. Our manufacturing strategy for the single-procedure disposable products is to use third-party manufacturing partners for certain proprietary components. We perform incoming inspection on these components, assemble them into finished devices and test the final product to assure quality control. A portion of the assembly is performed at a third party contractor’s

 

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facility using automated assembly processes and equipment. We are dependent on the third party for its day-to-day control and protection of the system. We conduct the remaining process operations including final testing on the scanner at our Rancho Cordova facility. We continuously improve our manufacturing processes to reduce costs and improve margins. We believe that by moving to PC-based consoles and improving our manufacturing processes through increased automation and design enhancements, we will be able to continue to reduce the cost to manufacture our consoles and single-procedure disposable products.

We manufacture our products in a controlled environment and have implemented quality control systems as part of our manufacturing processes. The control systems materially comply with the FDA Quality System Regulations, or QSR. We believe we are in material compliance with the FDA QSR for medical devices, with ISO 13485 quality standards, and with applicable medical device directives promulgated by the European Union and the policy on the Canadian Medical Devices Conformity Assessment System, which facilitates entry of our products into the European Union and Canada. The FDA and European Union Notified Body have both inspected our manufacturing facilities during the last 20 months.

Our current facility has been inspected by the FDA, the California Department of Health Services Food and Drug Branch, and the European Union Notified Body. Observations for improvements were noted as well as findings of deficiencies. We believe we have adequately addressed the inspectional observations and we are in material compliance with applicable regulatory directives. We expect to be inspected by the FDA and state and international authorities again in the future. If the FDA or state or international authorities find significant shortcomings, we could be subject to fines, recalls or requirements to halt manufacturing and shipments of affected products. Any of these enforcement actions could have a material effect on our business, by disrupting our ability to manufacture and sell product, impacting our profitability or harming our reputation or that of our products. See “Risk Factors—Risks Related to Government Regulation.”

Government Regulation

Our products are medical devices subject to extensive and rigorous regulation by the FDA, as well as other Federal and state regulatory bodies in the United States and comparable authorities in other countries. We currently market our products in the United States under pre-market notification, or 510(k), clearance. If we seek to market new products, or to market new indications for our existing products, we will be required to file for and obtain 510(k) clearance or pre-market approval, or PMA.

The FDA regulations govern the following activities that we perform, or that are performed on our behalf, to ensure that medical products distributed domestically or exported internationally are safe and effective for their intended uses:

 

   

product design, development and manufacture;

 

   

product safety, testing, labeling and storage;

 

   

pre-marketing clearance or approval;

 

   

record keeping procedures;

 

   

product marketing, sales and distribution; and

 

   

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

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

 

   

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

 

   

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

 

   

operating restrictions, partial suspension or total shutdown of production;

 

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refusing our requests for 510(k) clearance or PMA approval of new products, new intended uses or modifications to existing products;

 

   

withdrawing 510(k) clearance or PMA approvals that have already been granted; and

 

   

criminal prosecution.

See “Risk factors—Risks related to Government Regulation.”

Employees

At December 31, 2008, we had 883 employees. None of our employees is represented by a labor union, and we believe our employee relations are good.

Seasonality

Our business is generally seasonal in nature, and historically demand for our products has been the highest in the fourth quarter. Our working capital requirements vary from period to period depending on manufacturing volumes, the timing of deliveries and the payment cycles of our customers.

Inventory and Working Capital

Our manufacturing operations require a wide variety of raw materials. We purchase integrated circuits and other key components for use in our products. For certain components, which are currently single sourced, there are relatively few sources of supply. Although we believe that other suppliers could provide similar components on comparable terms, establishment of additional or replacement suppliers cannot be accomplished quickly. In addition, while we generally attempt to keep our inventory at minimal levels, we purchase incremental inventory as circumstances warrant to protect our supply chain.

At December 31, 2008, our working capital was $182.1 million and we believe our current cash and cash equivalents and our short-term available-for-sale investments will be sufficient to fund working capital requirements, capital expenditures, and operations for at least the next twelve 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. At the present time, we have no material commitments for capital expenditures.

Corporate Information

We were incorporated in the state of Delaware in January 2000 and until 2003 were a development stage company substantially devoted to the research and development of tools designed to diagnose vulnerable plaque. In July 2003, we acquired substantially all of the assets related to the IVUS and FM product lines from Jomed, Inc. and commenced the manufacturing, sale and distribution of IVUS and FM products. Our principal executive offices are located in San Diego, California.

Available Information

Our corporate website is www.volcanocorp.com and our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on our website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding the company, at www.sec.gov. These reports and other information concerning the company may also be accessed at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The contents of these websites are not incorporated into this filing. Further, our references to the URLs for these websites are intended to be inactive textual references only.

 

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Item 1A. Risk Factors

Risks Related to Our Business and Industry

We are dependent on the success of our IVUS consoles and catheters and cannot be certain that our products will achieve the broad acceptance necessary to develop a sustainable, profitable business.

Our revenues are primarily derived from sales of our IVUS products, which include our consoles and our single-procedure disposable catheters. We expect that sales of our IVUS products will continue to account for more than 75% of our revenues for the foreseeable future. IVUS technology is widely used for determining the placement of stents in patients with coronary disease in Japan, where we believe, based on internal estimates, the procedure penetration rate was over 63% in 2008. By contrast, the penetration rate in the United States for the same type of procedure was approximately 14% in 2008. It is difficult to predict the penetration and future growth rate or size of the market for IVUS technology. The expansion of the IVUS market depends on a number of factors, such as:

 

   

physicians accepting the benefits of the use of IVUS in conjunction with angiography;

 

   

physician experience with IVUS products;

 

   

the availability of, and physicians’ willingness to participate in, training required to gain proficiency in the use of IVUS products;

 

   

the additional procedure time required for use of IVUS;

 

   

the perceived risks generally associated with the use of new products and procedures;

 

   

the availability of alternative treatments or procedures that are perceived to be or are more effective, safer, easier to use or less costly than IVUS technology;

 

   

the availability of adequate reimbursement; and

 

   

the marketing efforts and publicity regarding IVUS technology.

Even if IVUS technology gains wide market acceptance, our IVUS products may not adequately address market requirements and may not continue to gain market acceptance among physicians, healthcare payors and the medical community due to factors such as:

 

   

the lack of perceived benefits of information on plaque composition available to the physician through use of our IVUS products, including the ability to identify calcified and other forms of plaque;

 

   

the actual and perceived ease of use of our IVUS products;

 

   

the quality of the images rendered by our IVUS products;

 

   

the cost, performance, benefits and reliability of our IVUS products relative to the products and services offered by our competitors;

 

   

the lack of perceived benefit of integration of our IVUS products into the cath lab; and

 

   

the extent and timing of technological advances.

If IVUS technology generally, or our IVUS products specifically, do not gain wide market acceptance, we may not be able to achieve our anticipated growth, revenues or profitability and our results of operations would suffer.

We have a limited operating history, have incurred significant operating losses since inception and cannot assure you that we will achieve profitability.

We were formed in January 2000 and until 2003 were a development stage company substantially devoted to the research and development of tools designed to diagnose vulnerable plaque. In July 2003, we acquired substantially all of the assets related to the IVUS and FM product lines from Jomed, Inc. and commenced the

 

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manufacturing, sale and distribution of IVUS and FM products. In December 2007, we acquired CardioSpectra, Inc., or CardioSpectra, an OCT technology company, in May 2008, we acquired Novelis, Inc., or Novelis, a Forward-Looking IVUS technology company, and in December 2008, we acquired Axsun, a manufacturer of laser and optical engines used in medical OCT imaging systems and advanced photonic components and subsystems used in other industrial applications. We have yet to demonstrate that we have sufficient revenues to become a sustainable, profitable business. Even if we do increase revenues, we expect our operating expenses will increase as we expand our business to meet anticipated growing demand for our products and as we devote resources to our sales, marketing and research and development activities. If we are unable to reduce our cost of revenues and our operating expenses, we may not achieve profitability. Although we achieved profitability during the quarters ended December 31, 2008 and September 30, 2008, you should not rely on our operating results for any prior quarterly or annual periods as an indication of our future operating performance. At December 31, 2008, we had an accumulated deficit of $104.3 million. We expect to experience quarterly fluctuations in our revenues due to the timing of capital purchases by our customers and to a lesser degree the seasonality of disposable consumption by our customers and in our expenses as we make future investments in research and development, selling and marketing and general and administrative activities that will cause us to experience variability in our reported earnings and losses in future periods. Failure to achieve and sustain profitability would negatively impact the market price of our common stock.

General national and worldwide economic conditions may materially and adversely affect our financial performance and results of operations.

Our operations and performance depend significantly on national and worldwide economic conditions and the resulting impact on purchasing decisions and the level of spending on our products by customers in the geographic markets in which our IVUS and FM products are sold or distributed. These economic conditions have recently deteriorated significantly in many countries and regions, including without limitation the United States, and may remain depressed for the foreseeable future. If our customers do not obtain or do not have access to the necessary capital to operate their businesses, or are otherwise adversely affected by the deterioration in national and worldwide economic conditions, this could result in reductions in the sales of our products, longer sales cycles and slower adoption of new technologies by our customers, which would materially and adversely affect our business. In addition, our customers’, distributors’ and suppliers’ liquidity, capital resources and credit may be adversely affected by the current financial and credit crisis, which could adversely affect our ability to collect on our outstanding invoices and lengthen our collection cycles, distribute our products or limit our timely access to important sources of raw materials necessary for the manufacture of our consoles and catheters. There can be no assurances that government responses to the disruptions in the financial or credit markets will improve the national and worldwide economic conditions in the near term or that the national and worldwide economic conditions will not worsen.

Competition from companies that have longer operating histories and greater resources than us may harm our business.

The medical device industry, including the market for IVUS and FM products, is highly competitive, subject to rapid technological change and significantly affected by new product introductions and market activities of other participants. As a result, even if the size of the IVUS and FM market increases, we can make no assurance that our revenues will increase. In addition, as the markets for medical devices, including IVUS and FM products, develop, additional competitors could enter the market. To compete effectively, we will need to continue to demonstrate that our products are attractive alternatives to other devices and treatments. We believe that our continued success depends on our ability to:

 

   

innovate and maintain scientifically advanced technology;

 

   

apply our technology across products and markets;

 

   

develop proprietary products;

 

   

successfully conduct or sponsor clinical studies that expand our markets;

 

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obtain and maintain patent protection for our products;

 

   

obtain and maintain regulatory clearance or approvals;

 

   

manufacture cost-effectively;

 

   

successfully market our products; and

 

   

attract and retain skilled personnel.

With respect to our IVUS products, our biggest competitor is Boston Scientific. Our FM products compete with the products of St. Jude Medical, Inc. through its December 2008 acquisition of Radi Medical Systems AB, or Radi. Historically, as Radi was a privately-held company without any public reporting obligations, the actual size of the FM market was difficult to ascertain. We also compete in Japan with Terumo Corporation. Boston Scientific, St. Jude Medical, Inc., Terumo Corporation and other potential competitors who are substantially larger than us and may enjoy competitive advantages, including:

 

   

more established distribution networks;

 

   

entrenched relationships with physicians;

 

   

products and procedures that are less expensive;

 

   

broader ranges of products and services that may be sold in bundled arrangements;

 

   

greater experience in launching, marketing, distributing and selling products;

 

   

greater experience in obtaining and maintaining the FDA and other regulatory clearances and approvals;

 

   

established relationships with healthcare providers and payors; and

 

   

greater financial and other resources for product development, sales and marketing, acquisitions of products and companies, and intellectual property protection.

For these reasons, we may not be able to compete successfully against our current or potential future competitors, and sales of our IVUS and FM products may decline.

Failure to innovate will adversely impact our competitive position and may adversely impact our product revenues.

Our future success will depend upon our ability to innovate new products and introduce enhancements to our existing products in order to address the changing needs of the marketplace. Frequently, product development programs require assessments to be made of future clinical need and commercial feasibility, which are difficult to predict. Customers may forego purchases of our products and purchase our competitors’ products as a result of delays in introduction of our new products and enhancements, failure to choose correctly among technical alternatives or failure to offer innovative products or enhancements at competitive prices and in a timely manner. In addition, announcements of new products may result in a delay in or cancellation of purchasing decisions in anticipation of such new products. We may not have adequate resources to effectively compete in the marketplace. Any delays in product releases may negatively affect our business.

We also compete with new and existing alternative technologies that are being used to penetrate the worldwide vascular imaging market without using IVUS technology. These products, procedures or solutions could prove to be more effective, faster, safer or less costly than our IVUS products. Technologies such as angiography, angioscopy, multi-slice computed tomography, intravascular magnetic resonance imaging, or MRI, electron beam computed tomography, and MRI with contrast agents are being used to image the vascular system. The introduction of new products, procedures or clinical solutions by competitors may result in price reductions, reduced margins, loss of market share and may render our products obsolete. We cannot guarantee that these alternative technologies will not be commercialized and become viable alternatives to IVUS in the future, and we cannot guarantee that we will be able to compete successfully against them if they are commercialized.

 

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Delays in planned product introductions may adversely affect our business and negatively impact future revenues.

We are currently developing new products and product enhancements with respect to our IVUS and FM products. We are also developing OCT systems and catheters, FLIVUS systems and catheters and image-guided therapy products. We may experience delays in any phase of product development and commercial launch, including during research and development, manufacturing, limited release testing, marketing and customer education efforts. Any delays in our product launches may significantly impede our ability to successfully compete in the IVUS, FM, OCT, FLIVUS and image-guided therapy markets and may reduce our revenues.

We and our present and future collaborators may fail to develop or effectively commercialize products covered by our present and future collaborations if:

 

   

we do not achieve our objectives under our collaboration agreements;

 

   

we or our collaborators are unable to obtain patent protection for the products or proprietary technologies we develop in our collaborations;

 

   

we are unable to manage multiple simultaneous product discovery and development collaborations;

 

   

our collaborators become competitors of ours or enter into agreements with our competitors;

 

   

we or our collaborators encounter regulatory hurdles that prevent commercialization of our products; and

 

   

we develop products and processes or enter into additional collaborations that conflict with the business objectives of our other collaborators.

In addition, conflicts may arise with our collaborators, such as conflicts concerning the interpretation of clinical data, the achievement of milestones, the interpretation of financial provisions or the ownership of intellectual property developed during the collaboration. If any conflicts arise with our existing or future collaborators, they may act in their self-interest, which may be adverse to our best interest.

If we or our collaborators are unable to develop or commercialize products, or if conflicts arise with our collaborators, we will be delayed or prevented from developing and commercializing products which will harm our business and financial results.

We are dependent on our collaborations, and events involving these collaborations or any future collaborations could delay or prevent us from developing or commercializing products.

The success of our current business strategy and our near- and long-term viability will depend on our ability to execute successfully on existing strategic collaborations and to establish new strategic collaborations. Collaborations allow us to leverage our resources and technologies and to access markets that are compatible with our own core areas of expertise. To penetrate our target markets, we may need to enter into additional collaborative agreements to assist in the development and commercialization of future products. Establishing strategic collaborations is difficult and time-consuming. Potential collaborators may reject collaborations based upon their assessment of our financial, regulatory or intellectual property position or our internal capabilities. Our discussions with potential collaborators may not lead to the establishment of new collaborations on favorable terms or at all.

We have collaborations with Medtronic, The Cleveland Clinic Foundation, GE, and Philips. In each collaboration, we combine our technology or core capabilities with that of the third party to either permit greater penetration into markets, as in the case of Medtronic, GE and Philips, or enhance the functionality of our current and planned products, as in the case of The Cleveland Clinic Foundation.

 

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We have limited control over the amount and timing of resources that our current collaborators or any future collaborators devote to our collaborations or potential products. These collaborators may breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, our collaborators may not develop or commercialize products that arise out of our collaborative arrangements or devote sufficient resources to the development, manufacture, marketing or sale of these products. Moreover, in the event of termination of a collaboration agreement, termination negotiations may result in less favorable terms.

If the PROSPECT study is delayed or stopped, our ongoing and future business may be negatively affected because of the potential inability to obtain useful clinical data or increased costs and delays in completing the study.

We sponsor PROSPECT, a natural history study of plaque, with Abbott Vascular, a division of Abbott Laboratories. Pursuant to the terms of our collaboration agreement with Abbott Vascular, either party may terminate the agreement without cause upon 60 days notice. Abbott Vascular, or if sponsorship of the study is transferred by Abbott Vascular, a new collaborator, may elect to delay or stop the PROSPECT study prematurely, causing a disruption in gathering clinical data related to vulnerable plaque or limiting the number of patients enrolled. If we choose to continue the study without a collaborator, we would have additional financial burdens. If we are unable to access the clinical data generated prior to termination, we may have to restart the study which would increase our financial burden and delay the timing of obtaining useful clinical data from the study. In the event that PROSPECT does not result in usable data and we are unable to prove a causal connection between vulnerable plaque and coronary events, the market for our vulnerable plaque products may not materialize. If we have to assume more of the financial burden of this clinical study, we would divert valuable financial and clinical resources from other areas of our business.

If the clinical studies that we sponsor or co-sponsor are unsuccessful, or clinical data from studies conducted by other industry participants are negative, we may not be able to develop or increase penetration in identified markets and our business prospects may suffer.

We sponsor or co-sponsor several clinical studies to demonstrate the benefits of our products in current markets where we are trying to increase use of our products and in new markets. Implementing a study is time consuming and expensive, and the outcome is uncertain. The completion of any of these studies may be delayed or halted for numerous reasons, including, but not limited to, the following:

 

   

the FDA institutional review boards or other regulatory authorities do not approve a clinical study protocol or place a clinical study on hold;

 

   

patients do not enroll in a clinical study or do not follow-up at the expected rate;

 

   

patients experience adverse side effects, including adverse side effects to our or a co-sponsor’s drug candidate or device;

 

   

patients die during a clinical study for a variety of reasons that may or may not be related to our products, including the advanced stage of their disease and medical problems;

 

   

third-party clinical investigators do not perform the clinical studies on the anticipated schedule or consistent with the clinical study protocol and good clinical practices, or other third-party organizations do not perform data collection and analysis in a timely or accurate manner;

 

   

our co-sponsors do not perform their obligations in relation to the clinical study or terminate the study;

 

   

regulatory inspections of manufacturing facilities, which may, among other things, require us or a co-sponsor to undertake corrective action or suspend the clinical studies;

 

   

changes in governmental regulations or administrative actions; and

 

   

the interim results of the clinical study are inconclusive or negative, and the study design, although approved and completed, is inadequate to demonstrate safety and efficacy.

 

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Some of the studies that we co-sponsor are designed to study the efficacy of a third-party’s drug candidate or device. Such studies are designed and controlled by the third-party and the results of such studies will largely depend upon the success of the third-party’s drug candidate or device. These studies may be terminated before completion for reasons beyond our control such as adverse events associated with a third-party drug candidate or device. A failure in such a study may have an adverse impact on our business by either the attribution of the study’s failure to our technology or our inability to leverage publicity for proper functionality of our products as part of a failed study.

Clinical studies may require the enrollment of large numbers of patients, and suitable patients may be difficult to identify and recruit. For example, the ADAPT-DES study has a projected enrollment of 11,000 patients, PROSPECT has enrolled 700 patients, BLAST is expected to enroll 220 patients and VOILA has a projected enrollment of 115 patients. Patient enrollment in clinical studies and completion of patient follow-up depend on many factors, including the size of the patient population, the study protocol, the proximity of patients to clinical sites, eligibility criteria for the study and patient compliance. For example, patients may be discouraged from enrolling in our clinical studies if the applicable protocol requires them to undergo extensive post-treatment procedures or if they are persuaded to participate in different contemporaneous studies conducted by other parties. Delays in patient enrollment or failure of patients to continue to participate in a study may result in an increase in costs, delays or the failure of the study. Such events may have a negative impact on our business by making it difficult to penetrate or expand certain identified markets. Further, if we are forced to contribute greater financial and clinical resources to a study, valuable resources will be diverted from other areas of our business.

Negative results from clinical studies conducted by other industry participants could harm our results. For example, recently the number of PCI procedures declined due to concerns attributed to late stent thrombosis and the long-term efficacy of drug-eluting stents. If the number of PCI procedures declines, the need for IVUS procedures could also decline and our business prospects may suffer.

If we choose to acquire new businesses, products or technologies, we may experience difficulty in the identification or integration of any such acquisition, and our business may suffer.

Our success depends on our ability to continually enhance and broaden our product offerings in response to changing customer demands, competitive pressures and technologies. Accordingly, we have pursued, and may in the future pursue, the acquisition of complementary businesses, products or technologies instead of developing them ourselves. For example, we acquired CardioSpectra in December 2007, Novelis in May 2008, and Axsun in December 2008. We do not know if we will be able to identify or complete any acquisitions, or whether we will be able to successfully integrate any acquired business, product or technology or retain key employees. Integrating any business, product or technology we acquire could be expensive and time consuming, disrupt our ongoing business and distract our management. If we are unable to integrate any acquired businesses, products or technologies effectively, our business will suffer. We have entered, and may in the future enter, markets through our acquisitions that we are not familiar with and have no experience managing. For example, Axsun historically sold devices in the industrial and telecommunications sectors for the optical monitoring market and we will continue to serve these markets. If we fail to integrate these operations into our business, our resources may be diverted from our core business and this could have a material adverse effect on our business, financial condition and results of operations.

Our business has become more decentralized geographically through our acquisitions and this may expose us to operating inefficiences across these diverse locations, including difficulties and unanticipated expenses related to the integration of departments, information technology systems, and accounting records and maintaining uniform standards, such as internal accounting controls, procedures and policies. In addition, we have, and in the future may increase, our exposure to risks related to business operations outside the United States due to our acquisitions.

 

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We may also encounter risks, costs and expenses associated with any undisclosed or potential liabilities or use more cash and other financial resources on integration and implementation activities than we expect. In addition, any amortization or other charges resulting from acquisitions could harm our operating results.

In connection with the Axsun acquisition, we and Axsun were sued by LightLab Imaging, Inc., or LightLab, for alleged breach of a development and supply agreement between Axsun and LightLab pursuant to which Axsun supplies tunable lasers to LightLab for use in LightLab’s OCT products. LightLab, a wholly owned subsidiary of Goodman, our distributor of IVUS and FM products in Japan, develops and sells OCT products for cardiovascular imaging and other medical uses. LightLab obtained a preliminary injunction against us and Axsun, that among other things, prohibits us from using Axsun tunable lasers in our OCT products. A hearing to reconsider the motion for preliminary injunction was held on March 6, 2009 and we are currently awaiting the judge’s ruling. While we believe the complaint is without merit and we opposed the preliminary injunction motion and intend to defend ourselves vigorously, the preliminary injunction has delayed our ability to fully utilize the employees and technology available through Axsun. Consequently, there is a risk that we will be delayed in realizing or may never realize all of the benefits from the Axsun acquisition that we anticipated when we acquired Axsun.

If we are unable to identify the plaque that is most likely to rupture and cause a coronary event we may not be able to develop a market for our vulnerable plaque products or expand the market for existing products.

We are utilizing substantial resources toward developing technologies to aid in the identification, diagnosis and treatment of the plaque that is most likely to rupture and cause a coronary event, or vulnerable plaque. To date, a connection between ruptured plaque and coronary events has been shown in post-mortem studies, hypothetical models and certain statistical analyses. However, no technology has been proven in clinical trials to identify, prior to the occurrence of a coronary event, the plaque that is most likely to rupture and cause such an event. If we are unable to develop products or technologies that can identify vulnerable plaque, a market for products to identify vulnerable plaque may not materialize and our business may suffer.

Our manufacturing operations are dependent upon third party suppliers, which makes us vulnerable to supply problems, price fluctuations and manufacturing delays.

We rely on ON Semiconductor Corporation, or OSC, for the supply of application specific integrated circuits, or ASICs, and for the supply of wafers used in the manufacture of our IVUS consoles and our catheters. These ASICs and wafers are critical to these products, and there are relatively few alternative sources of supply. OSC is shutting down their 5” wafer fabrication plant, or fab, and as a result we are moving our device to their 8” wafer fab. We have purchased additional 5” wafers to support production while we transition to the 8” wafer design. In addition, we do not carry a significant inventory of the ASICs. If we had to change suppliers, we expect that it would take at least a year, and possibly 18 months or longer, to identify an appropriate replacement supplier, complete design work and undertake the necessary inspections before the ASICs or wafers would be available. We rely on International Micro Industries, Inc., or IMI, to undertake additional processing of certain of the ASICs that are produced by OSC for use in the manufacture of our catheters. We do not carry a significant inventory of the circuits that are finished by IMI. We expect that in the event it is necessary to replace IMI, it would take at least three months, and possibly six months or longer, to identify an appropriate replacement supplier that is able to undertake the additional processing of the ASICs. We are not parties to supply agreements with either OSC or IMI but instead use purchase orders as needed.

Our former supplier of FM wire pressure sensors ceased production of this key component on 4” wafers. In 2007, we secured an end-of-life purchase of the subject parts equivalent to an estimated four-year supply. We believe this will provide us with adequate time to initiate and qualify a replacement supplier or new design to replace the product. We expect that it will take approximately 24 months to identify an appropriate replacement supplier, complete design work and undertake the necessary inspections before the new pressure sensors will be available.

 

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We also rely upon Endicott Interconnect Technologies, or EIT, for the assembly operation of the scanner used on the IVUS catheters. We do not carry a significant inventory of the scanner assemblies that are finished by EIT. We expect that in the event it is necessary to replace EIT for the assembly operation, it would take at least twelve months to identify and qualify an appropriate replacement supplier that is able to undertake the additional assembly operation. A Manufacturing Services Agreement is in place with EIT for the assembly of the scanner devices.

In addition, we implemented a new automated system to replace certain customized equipment, which is no longer produced or supported by a third party for the manufacture of the scanners located on our phased array catheters. The new automated system is located at EIT’s facility and we are dependent on EIT for the day-to-day control and protection of the system. If the new automated system does not perform as expected, if we are not provided with the product as requested, or if we are not provided access to the system, we may encounter delays in the manufacture of our catheters and many not have sufficient inventory to meet our customers’ demands, which could negatively impact our revenues.

Our reliance on these sole source suppliers subjects us to a number of risks that could impact our ability to manufacture our products and harm our business, including:

 

   

inability to obtain adequate supply in a timely manner or on commercially reasonable terms;

 

   

interruption or delayed delivery of supply resulting from difficulty in accessing financial or credit markets or otherwise secure cash and capital resources;

 

   

interruption of supply resulting from modifications to, or discontinuation of, a supplier’s operations;

 

   

delays in product shipments resulting from uncorrected defects, reliability issues or a supplier’s variation in a component;

 

   

uncorrected quality and reliability defects that impact performance, efficacy and safety of products from replacement suppliers;

 

   

price fluctuations due to a lack of long-term supply arrangements for key components with our suppliers;

 

   

difficulty identifying and qualifying alternative suppliers for components in a timely manner;

 

   

production delays related to the evaluation and testing of products from alternative suppliers and corresponding regulatory qualifications; and

 

   

delays in delivery by our suppliers due to changes in demand from us or their other customers.

Any significant delay or interruption in the supply of components or materials, or our inability to obtain substitute components or materials from alternate sources at acceptable prices and in a timely manner, could impair our ability to meet the demand of our customers and harm our business. Identifying and qualifying additional or replacement suppliers for any of the components or materials used in our products may not be accomplished quickly or at all and could involve significant additional costs. Any supply interruption from our suppliers or failure to obtain additional suppliers for any of the components or materials used to manufacture our products would limit our ability to manufacture our products and could therefore have a material adverse effect on our business, financial condition and results of operations.

We manufacture our IVUS catheters and have implemented a new manufacturing process, making us vulnerable to production and supply problems that could negatively impact our revenues.

Until recently, we had used customized equipment which is no longer produced or supported by a third party for the manufacture of the scanners located on our phased array catheters. This equipment was supported by the company that designed and manufactured it until 2002. That company ceased operations in 2002, because changes in manufacturing technology made the design and manufacture of similar equipment more mainstream and automated and made customized manufacturing equipment, such as ours, much less economical to build and

 

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support. If the equipment malfunctioned and we were unable to locate spare parts or hire qualified personnel to repair the equipment, we could have encountered delays in the manufacture of our catheters and may not have had sufficient inventory to meet our customers’ demands, which would have negatively impacted our revenues.

In response to this situation, we implemented a new automated system to replace the customized equipment, which is no longer produced or supported by a third party. While we believe the new automated system, located at a third party vendor, has demonstrated the ability to meet our anticipated volumes, the system will continue to be located at the vendor’s facility, which requires us to be dependent on them for the day-to-day control and protection of the system. If the new automated system does not perform as expected, if the vendor does not provide us with product as requested, or if the vendor does not allow us to have access to the system, we may encounter delays in the manufacture of our catheters and may not have sufficient inventory to meet our customers’ demands, which could negatively impact our revenues.

If we do not manage our manufacturing capacity effectively, or if our facilities are damaged or destroyed, we may experience delays that could negative impact our revenues.

It is likely that we will need to expand our manufacturing capacity in the first half of 2010. We expect that any expansion would be achieved through modified space utilization in our current leased facilities, improved efficiencies, automation and acquisition of additional tooling and equipment. If we experience a demand in our products that exceeds our manufacturing capacity, we may not have sufficient inventory to meet our customers’ demands, which would negatively impact our revenues.

Our facilities may be affected by natural or man-made disasters. If one of our facilities were affected by a disaster, we would be forced to rely on third party manufacturers or shift production to another manufacturing facility. In such an event, we would face significant delays in manufacturing which would prevent us from being able to sell our products. In addition, our insurance may not be sufficient to cover all of the potential losses and may not continue to be available to us on acceptable terms, or at all.

We may require significant additional capital to pursue our growth strategy, and our failure to raise capital when needed could prevent us from executing our growth strategy.

We believe that our existing cash and cash equivalents and short-term available-for-sale investments will be sufficient to meet our anticipated cash needs for at least the next twelve months. However, we may need to obtain additional financing to pursue our business strategy, to respond to new competitive pressures or to act on opportunities to acquire or invest in complementary businesses, products or technologies. The timing and amount of our working capital and capital expenditure requirements may vary significantly depending on numerous factors, including:

 

   

market acceptance of our products;

 

   

the revenues generated by our products;

 

   

the need to adapt to changing technologies and technical requirements, and the costs related thereto;

 

   

the costs associated with expanding our manufacturing, marketing, sales and distribution efforts; and

 

   

the existence and timing of opportunities for expansion, including acquisitions and strategic transactions.

If our capital resources are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities or to obtain debt financing. The sale of additional equity or debt securities, or the use of our stock in an acquisition or strategic transaction, would result in additional dilution to our stockholders. Additional debt would result in increased expenses and could result in covenants that would restrict our operations. Our significant losses to date and the current national and global financial crisis may prevent us from

 

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obtaining additional funds on favorable terms, if at all. We have not made arrangements to obtain additional financing, and there is no assurance that financing, if required, will be available in amounts or on terms acceptable to us, if at all.

The risks inherent in our international operations may adversely impact our revenues, results of operations and financial condition.

We derive, and anticipate we will continue to derive, a significant portion of our revenues from operations in Japan and Europe. In the year ended December 31, 2008, revenues to customers located in Japan and Europe were $43.6 million and $33.2 million, representing 25.4% and 19.4%, respectively, of our total revenues. As we expand internationally, we will need to hire, train and retain qualified personnel for our direct sales efforts, retain distributors and train their personnel in countries where language, cultural or regulatory impediments may exist. We cannot ensure that distributors, physicians, regulators or other government agencies will accept our products, services and business practices. In addition, we purchase some components on the international market. The sale and shipment of our products and services across international borders, as well as the purchase of components from international sources, subject us to extensive United States and foreign governmental trade regulations. Compliance with such regulations is costly. Any failure to comply with applicable legal and regulatory obligations could impact us in a variety of ways that include, but are not limited to, significant criminal, civil and administrative penalties, including imprisonment of individuals, fines and penalties, denial of export privileges, seizure of shipments and restrictions on certain business activities. Failure to comply with applicable legal and regulatory obligations could result in the disruption of our shipping and sales activities. Our international sales operations expose us and our representatives, agents and distributors to risks inherent in operating in foreign jurisdictions, including:

 

   

our ability to obtain, and the costs associated with obtaining, United States export licenses and other required export or import licenses or approvals;

 

   

operating under government-run healthcare systems and changes in third-party reimbursement policies;

 

   

changes in duties and tariffs, taxes, trade restrictions, license obligations and other non-tariff barriers to trade;

 

   

burdens of complying with a wide variety of foreign laws and regulations related to healthcare products;

 

   

costs of localizing product and service offerings for foreign markets;

 

   

business practices favoring local companies;

 

   

longer payment cycles and difficulties collecting receivables through foreign legal systems;

 

   

difficulties in enforcing or defending agreements and intellectual property rights; and

 

   

changes in foreign political or economic conditions.

We cannot ensure that one or more of these factors will not harm our business. Any material decrease in our international revenues or inability to expand our international operations would adversely impact our revenues, results of operations and financial condition.

Fluctuations in foreign currency exchange rates could result in declines in our reported revenues and earnings.

Our reported revenues and earnings are subject to fluctuations in currency exchange rates. We do not engage in foreign currency hedging arrangements, and, consequently, foreign currency fluctuations may adversely affect our revenues and earnings. Should we choose to engage in hedging activities in the future we cannot be assured our hedges will be effective or that the costs of the hedges will not exceed their benefits. Fluctuations in the rate of exchange between the U.S. dollar and foreign currencies, primarily the Euro and the Yen, could adversely affect our financial results. During the year ended December 31, 2008, 19.4% of our revenues were denominated in the Euro, 10.7% of our operating expenses were denominated in the Euro and 4.5% of our operating expenses

 

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were denominated in Yen. Revenues from our Japanese operations are denominated in the U.S. Dollar. In addition, revenues were positively impacted by the valuation of foreign currencies, primarily the Euro, versus the U.S. dollar, particularly during the first three quarters of fiscal 2008. During the fourth quarter of 2008, the U.S. dollar strenghthened versus the Euro. In periods of a strengthening U.S. dollar, our results of operations including the amount of revenue that we report in future periods could be negatively impacted.

Future interest income and the value of our investments may be impacted by further declines in interest rates and the broader effect of the recent disruption of credit markets.

We are conservative in our investment policies and our policies allow us to invest our excess cash primarily in corporate notes, money market funds and United States municipal debt securities. As of December 31, 2008, we have invested our excess cash in money market funds and corporate debt securities issued by banks and corporations. The interest paid on these types of investments and the value of certain securities may decline in the future as credit markets adjust to the national and global financial crisis. While our investment portfolio has not yet been adversely impacted, if there is continued and expanded disruption in the credit markets, our investment portfolio could be adversely affected in the future.

To market and sell our products, we depend on third-party distributors, and they may not be successful.

A portion of our revenue is generated by our third-party distributors. If these distributors cease or limit operations or experience a disruption of their business operations, or are not successful in selling our products, we may be unable to increase or maintain our level of revenues. Over the long term, we intend to grow our business internationally, and to do so we will need to attract additional distributors to expand the territories in which we do not directly sell our products. Our distributors may not commit the necessary resources to market and sell our products. If current or future distributors do not continue to distribute our products or do not perform adequately or if we are unable to locate distributors in particular geographic areas, we may not realize revenue growth internationally.

A significant portion of our annual revenues is derived from sales to our Japanese distributors, primarily Fukuda, Goodman, and Johnson & Johnson. In the year ended December 31, 2008, we generated revenues of $41.7 million, which accounted for approximately 24.3% of our revenues, from sales to our Japanese distributors. In the year ended December 31, 2008, Goodman accounted for 14.4% of our revenues.

On May 19, 2008, we and Goodman mutually terminated the Exclusive Distribution Agreement, dated September 27, 2004, pursuant to which Goodman distributed our rotational IVUS products in Japan on an exclusive basis. Additionally, on May 19, 2008, the oral agreement between us and Goodman, relating to the exclusive distribution of our FM products in Japan, originally distributed by Goodman under the International Distributor Agreement, dated September 17, 1994, by and among the Company, Goodman and Kaneko Enterprise, Inc., as amended, and any other oral agreements between the Company and Goodman relating to the distribution of our products in Japan, was terminated. We did not pay and we are not obligated to pay a fee in connection with this termination. On June 30, 2008, Goodman transferred to us all SHONINs for all rotational IVUS and FM products held by Goodman or its affiliates. Although Goodman currently continues to distribute our rotational IVUS and FM products in Japan on a non-exclusive, purchase order basis, there is no assurance that they will continue to do so in the future. Upon termination of our agreements with Goodman, we monitor the credit risk associated with Goodman as well as other general economic conditions and, accordingly, we have made and continue to make adjustments to the credit terms that are extended to Goodman.

In connection with the Axsun acquisition, we and Axsun were sued by LightLab, for alleged breach of a development and supply agreement between Axsun and LightLab pursuant to which Axsun supplies tunable lasers to LightLab for use in LightLab’s OCT products. LightLab, a wholly owned subsidiary of Goodman, develops and sells OCT products for cardiovascular imaging and other medical uses.

We entered into an agreement with Fukuda Denshi in March 2006 that extended our commercial relationship through June 2012. This agreement became effective upon the transfer of the related regulatory

 

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approvals held by Fukuda Denshi, which took place on June 1, 2006. We also entered into a distribution agreement with Johnson and Johnson in December 2006.

A significant change in our relationship with our distributors, such as the recent changes in our relationship with Goodman, or in the relationships between our distributors may have a negative impact on our ability to sustain and grow our business in Japan.

We also use distributors in certain other international markets. Other than Japan, no one market in which we use distributors represents a significant portion of our revenues but, in the aggregate, problems with these distribution arrangements could negatively affect our international sales strategy, negatively impact our revenues and the market price of our stock.

If we become profitable and there is an ownership change, we cannot assure you that our net operating losses will be available to reduce our tax liability.

Our ability to use our net operating losses to reduce future income tax obligations may be limited or reduced. Generally, a change of more than 50 percentage points in the ownership of our shares, by value, over the three-year period ending on the date the shares were acquired constitutes an ownership change and may limit our ability to use net operating loss carryforwards. Should an ownership change occur in the future, our ability to utilize net operating loss carryforwards could be limited.

If we fail to properly manage our anticipated growth, our business could suffer.

Rapid growth of our business is likely to place a significant strain on our managerial, operational and financial resources and systems. To execute our anticipated growth successfully, we must attract and retain qualified personnel and manage and train them effectively. In addition, we anticipate hiring additional personnel to assist in the commercialization of our current products and in the development of future products. We will be dependent on our personnel and third parties to effectively market and sell our products to an increasing number of customers. We will also depend on our personnel to develop and manufacture new products and product enhancements. Further, our anticipated growth will place additional strain on our suppliers resulting in increased need for us to carefully monitor for quality assurance. Any failure by us to manage our growth effectively could have an adverse effect on our ability to achieve our development and commercialization goals.

If we are unable to recruit, hire and retain skilled and experienced personnel, our ability to effectively manage and expand our business will be harmed.

Our success largely depends on the skills, experience and efforts of our officers and other key employees who may terminate their employment at any time. The loss of any of our senior management team, in particular our President and Chief Executive Officer, R. Scott Huennekens, could harm our business. We have entered into employment contracts with R. Scott Huennekens, our Chief Financial Officer, John T. Dahldorf, and our Executive Vice President, Global Sales, Jorge J. Quinoy, but these agreements do not guarantee that they will remain employed by us in the future. The announcement of the loss of one of our key employees could negatively affect our stock price. Our ability to retain our skilled workforce and our success in attracting and hiring new skilled employees will be a critical factor in determining whether we will be successful in the future. We face challenges in hiring, training, managing and retaining employees in certain areas including clinical, technical, sales and marketing. This could delay new product development and commercialization, and hinder our marketing and sales efforts, which would adversely impact our competitiveness and financial results.

The expense and potential unavailability of insurance coverage for our company, customers or products may have an adverse effect on our financial position and results of operations.

While we currently have insurance for our business, property, directors and officers, and products, insurance is increasingly costly and the scope of coverage is narrower, and we may be required to assume more risk in the future. If we are subject to claims or suffer a loss or damage in excess of our insurance coverage, we will be

 

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required to cover the amounts in excess of our insurance limits. If we are subject to claims or suffer a loss or damage that is outside of our insurance coverage, we may incur significant costs associated with loss or damage that could have an adverse effect on our financial position and results of operations. Furthermore, any claims made on our insurance policies may impact our ability to obtain or maintain insurance coverage at reasonable costs or at all. We do not have the financial resources to self-insure, and it is unlikely that we will have these financial resources in the foreseeable future.

We have product liability insurance that covers our products and business operation, but we may need to increase and expand this coverage commensurate with our expanding business. Any product liability claims brought against us, with or without merit, could result in:

 

   

substantial costs of related litigation or regulatory action;

 

   

substantial monetary penalties or awards;

 

   

decreased demand for our products;

 

   

reduced revenue or market penetration;

 

   

injury to our reputation;

 

   

withdrawal of clinical study participants;

 

   

an inability to establish new strategic relationships;

 

   

increased product liability insurance rates; and

 

   

prevention of securing continuing coverage.

Some of our customers and prospective customers may have difficulty in procuring or maintaining liability insurance to cover their operation and use of our products. Medical malpractice carriers are withdrawing coverage in certain regions or substantially increasing premiums. If this trend continues or worsens, our customers may discontinue using our products and potential customers may opt against purchasing our products due to the cost or inability to procure insurance coverage.

Risks Related to Government Regulation

If we fail to obtain, or experience significant delays in obtaining, regulatory clearances or approvals for our products or product enhancements, our ability to commercially distribute and market our products could suffer.

Our products are subject to rigorous regulation by the FDA and numerous other Federal, state and foreign governmental authorities. Our failure to comply with such regulations could lead to the imposition of injunctions, suspensions or loss of regulatory clearances or approvals, product recalls, termination of distribution, product seizures or civil penalties. In the most egregious cases, criminal sanctions or closure of our manufacturing facilities are possible. The process of obtaining regulatory authorizations to market a medical device, particularly from the FDA, can be costly and time consuming, and there can be no assurance that such authorizations will be granted on a timely basis, if at all. In particular, the FDA permits commercial distribution of a new medical device only after the device has received 510(k) clearance or is the subject of an approved pre-market approval, or PMA, 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 one or more 510(k)-cleared products. The PMA approval process is more costly, lengthy and uncertain than the 510(k) clearance process. Introduction to the market of products we develop that require regulatory clearance or approval may be delayed if clearance or approval is not received within the timeframe expected. If regulatory clearance or approvals are received, additional delays may occur related to manufacturing, distribution, or product labeling. In addition, because we cannot assure you that any new products or any product enhancements we develop will be subject to the shorter

 

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510(k) clearance process as opposed to the PMA process, in which case new products or enhancements may take significantly longer to bring to market, if at all. To date, all of our products have been cleared through the 510(k) process. We have no experience in obtaining PMA approvals.

In the member states of the European Union there is a consolidated system for the authorization of medical devices. The system of regulating medical devices operates by way of a certification for each medical device. Each certificated device is marked with a CE mark which shows that the device has a Certificat de Conformité. There are national bodies, known as Competent Authorities, in each member state that oversee the implementation of the European Union Medical Device Directive within their jurisdiction.

The means for achieving the requirements for a CE mark vary according to the nature of the device. Under the requirements of European Union member states, our products are required to be assessed by a Notified Body. If a Notified Body of one member state has issued a Certificat de Conformité, the device can be sold throughout the European Union without further conformance tests being required in other member states. Our products, including their design and manufacture, have been certified by the British Standards Institute, or BSI, in the United Kingdom as being compliant with the requirements of European Union law. Consequently, we are entitled to affix a CE mark to our products and their packaging and this gives us the right to sell them in Europe.

Foreign governmental authorities that regulate the manufacture and sale of medical devices have become increasingly stringent, and to the extent we continue to market and sell our products in foreign countries, we will be subject to rigorous regulation in the future. In such circumstances, we would rely significantly on our distributors to comply with the varying regulations, and any failures on their part could result in restrictions on the sale of our products in foreign countries.

We have conducted, but are not currently conducting, clinical studies with some of our products under an investigational device exemption. Clinical studies must be conducted in compliance with regulations of the FDA and those of regulatory agencies in other countries in which we conduct clinical studies. The data collected from these clinical studies are intended to be used to support a submission to obtain marketing clearance for these products. There is no assurance that United States or foreign regulatory bodies will accept the data from these clinical studies or that they will ultimately allow market clearance or approval for these products, or that the data would be adequate to support a PMA for these products if such a submission were to be required. Regulatory delays or failures to obtain clearances and approvals could disrupt our business, harm our reputation and adversely affect our sales.

Modifications to our products may require new regulatory clearances or approvals or may require us to recall or cease marketing our products until clearances are obtained.

Modifications to our products may require new 510(k) notifications, PMA applications, or other regulatory agency approval applications. If there is a safety concern, it may require us to recall or cease marketing the devices and cause us to modify the devices. In addition, if the modified devices have been distributed without a new 510(k) clearance or PMA approval, we may be required to recall or cease marketing the devices. The FDA requires device manufacturers to initially make and document a determination of whether or not a modification requires a new approval, supplement or clearance, or does not require any marketing submission. A marketing submission is not required for a modification that a manufacturer determines does not significantly affect safety or efficacy and does not represent a major change in its intended use. However, the FDA can review a manufacturer’s decision and may disagree. The FDA may also on its own initiative determine that a new 510(k) notification or PMA application is required. We have made modifications to our products in the past and may make additional modifications in the future that we believe do not or will not require a new 510(k) notification or PMA application. If the FDA disagrees and requires a new 510(k) notification or PMA application for the modifications, we may be required to recall and to stop marketing our products as modified if we have already begun marketing them, which could require us to redesign our products and harm our operating results. The FDA has the authority to bring an enforcement action when a device is marketed without required clearance or

 

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approval, including injunction, seizure and, in egregious circumstances, criminal prosecution. The FDA considers such additional actions generally when there is a serious risk to public health or safety and recall of the product from the market does not adequately mitigate the risk.

If a manufacturer determines that a modification to an FDA-cleared device could significantly affect its safety or efficacy, or would constitute a major change in its intended use, then the manufacturer must file a new 510(k) notification or, if applicable, a PMA application. Where we determine that modifications to our products require a new 510(k) notification or PMA application, we may not be able to obtain those additional clearances or approvals for the modifications or additional indications in a timely manner, or at all. For those products sold in the European Union, we must notify BSI, our European Union Notified Body, if significant changes are made to the products or if there are substantial changes to our quality assurance systems affecting those products. Delays in obtaining required future clearances or approvals would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would harm our future growth.

If we fail to adequately manage our regulatory responsibilities following the Japanese regulatory approvals, our ability to sell our IVUS products in Japan would be impaired.

We currently market our IVUS products in Japan under two types of regulatory approval known as a SHONIN and a NINSHO. SHONINs for medical devices are issued by Japan’s Ministry of Health, Labour and Welfare, or MHLW, to a Marketing Authorization Holder, or MAH, who thereafter holds the SHONINs for, or possesses regulatory approval permitting the import of such devices into Japan. NINSHOs for medical devices are issued by MHLW-approved third-party agencies such as BSI-Japan. Under the third-party program, only certain devices are authorized to be reviewed and approved in this manner. Our IVUS imaging consoles fall within this category. We have elected to participate in this program and have received approval for the s5i. The SHONINs for our IVUS products were previously held by Fukuda Denshi, the MAH for our IVUS products, who acted as our importer. Fukuda Denshi is one of our Japanese distributors and has been responsible for our regulatory compliance in Japan. Until June 1, 2006, we did not have the authority to import or sell our IVUS products directly in Japan, and we were dependent on Fukuda Denshi to do so. The SHONINs for our rotational IVUS and FM products were previously held by Goodman, the MAH for our rotational IVUS and FM products, who acted as our importer, is one of our Japanese distributors and has been responsible for our regulatory compliance in Japan. Until June 30, 2008, we did not have the authority to import or sell our rotational IVUS and FM products directly in Japan, and we were dependent on Goodman to do so.

Fukuda Denshi transferred the SHONINs for our phased-array IVUS products to us on June 1, 2006. Goodman transferred the SHONINs for our rotational IVUS and FM products to us on June 30, 2008. Due to the transfer of the SHONINs, responsibility for Japanese regulatory filings and future compliance resides with us. There is a risk that the transfer of the SHONINs and regulatory responsibility will lead to disruption or lack of coordination in our ongoing compliance activities in Japan. As the holder of the SHONINs, we have the authority to import and sell those phased-array and rotational IVUS and FM products for which we have the SHONINs as well as those products for which we have obtained a NINSHO, but are subject to greater scrutiny. As such, we have to dedicate greater internal resources to direct regulatory compliance in Japan. We cannot guarantee that we will be able to adequately meet the increased regulatory responsibilities. Non-compliance with Japanese regulations may result in action to prohibit further importation and sale of our products in Japan, a significant market for our products. If we are unable to sell our phased-array and rotational IVUS and FM products in Japan, we will lose a significant part of our annual revenues, and our business will be substantially impacted.

Changes in the Japanese regulatory requirements for medical devices could impact our ability to market our products in Japan and subject us to fines, penalties or other sanctions.

In April 2005, Japan changed the law regarding medical device approvals to require that SHONINs include additional information beyond what had been required in the past, including information about manufacturing processes, shipping and other raw materials used. Companies are not required by the revised law to withdraw

 

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their existing SHONINs, and the revised law states that SHONINs approved under the prior law will still be considered valid. However, importers marketing products in Japan must update their SHONINs on a five-year cycle, and the updates are expected to include the additional information required by the revised law.

These new regulations increase the regulatory and quality assurance requirements for both our manufacturing facilities and our efforts in obtaining and maintaining regulatory approvals in Japan. While parts of the new regulations are still being defined, we expect that the new regulations may result in higher costs and delays in securing approval to market our products in Japan.

We expect to file new SHONIN applications for our IVUS catheters sometime between 2009 and 2010, although we are not required under the Japanese regulatory laws to do so until 2010. We may decide to file such new SHONIN applications at a time that is deemed advantageous. This new filing will comply with the new law which encompasses design, manufacturing, shipping and quality processes. In connection with the new law, the Japanese government has prepared new guidance documents, including one document that addresses raw materials that along with the new law, greatly expand the required content of the product approval application from the prior law. With the existing SHONINs, we relied on Fukuda Denshi’s regulatory expertise that the product approval applications appropriately reflected our devices and therefore were in compliance with the law at the time as well as its assessment regarding continuing compliance with the law over the years. We are now the MAH for our phased-array and rotational IVUS and FM products and have full responsibility for their continued legal compliance in Japan.

We cannot guarantee that the Japanese regulatory authorities will not take a different view of compliance with the existing SHONINs and conclude that because the new laws require inclusion of new information, we must cease marketing or even recall our phased-array and rotational IVUS and FM catheters until we have updated, and received approval of, our SHONIN to include the additional information required by the new law. Alternatively, the Japanese regulatory authorities could disagree with our distributor’s past conclusions and determine that we should have disclosed this information in the earlier SHONINs that were filed under prior law, and they could require us to cease marketing, recall the product or impose other regulatory penalties. In the event that the Japanese regulatory authorities come to such a conclusion and take corrective action, our business will suffer from lost revenue, lost reputation and lost market share.

If we or our suppliers fail to comply with the FDA’s Quality System Regulation or ISO Quality Management Systems, manufacturing of our products could be negatively impacted and sales of our products could suffer.

Our manufacturing practices are required to comply with the FDA’s 21 CFR Part 820 Quality System Regulation, or QSR, which governs the facilities, methods, controls, procedures, and records of the design, manufacture, packaging, labeling, storage, shipping, installation, and servicing of our products intended for human use. We are also subject to similar state and foreign requirements and licenses, including the Medical Device Directive—93/42/EEC and the ISO 13485 Quality Management Systems, or QMS, standard applicable to medical devices. In addition, we must engage in regulatory reporting in the case of potential patient safety risks and must make available our manufacturing facilities, procedures, and records for periodic inspections and audits by governmental agencies, including the FDA, state authorities and comparable foreign agencies. If we fail to comply with the QSR, QMS, or other regulations and standards, our operations could be disrupted and our manufacturing interrupted.

Failure to take adequate corrective action in response to inspectional observations or any notice of deficiencies from a regulatory inspection or audit could result in, among other things, a shut-down of our manufacturing operations, significant fines, suspension of marketing clearances and approvals, seizures or recalls of our devices, operating restrictions and criminal prosecutions, any of which would cause our business to suffer. Furthermore, our key component suppliers may not currently be or may not continue to be in compliance with applicable regulatory requirements, which may result in manufacturing delays for our products and cause our revenue to decline.

 

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We were inspected by the FDA in 2004 and in 2006. The 2004 inspection resulted in two inspectional observations on Form FDA 483. The 2006 inspection resulted in three inspectional observations on Form FDA 483. We have responded to these observations and believe that we have adequately completed all necessary evaluation of, and implementation of adjustments to, the affected processes. The FDA has acknowledged our responses to the audits and has indicated that the corrective actions should adequately address the inspectional observations. We are due for another FDA inspection. We are not aware of, nor have we received notice of, any pending investigation. The FDA has the right to make unannounced inspections of our manufacturing facility.

We were audited by the European Union Notified Body in December 2005, February 2007, June 2007, October 2007, and June 2008. No major nonconformities were reported in the December 2005, February 2007, October 2007, and June 2008 audits. As a result of the audit in June 2007, one major nonconformity was identified. A corrective action plan was submitted to, and accepted by, the European Union Notified Body. As a result, continued ISO 13485:2003 certification was granted. The certification was subject to biannual assessments until April 2008 to reassess the corrective actions. After the June 2008 audit, which resulted in no major nonconformities and nine minor nonconformities, the European Union Notified Body agreed to switch from biannual to annual audits. The European Union Notified Body has the right to make unannounced audits of our manufacturing facility. We believe that we have taken sufficient corrective actions to address the observations and non-conformities noted by the FDA and the European Union Notified Body, but there can be no assurance that our actions will satisfy the FDA, the European Union Notified Body, or other regulatory agencies. These regulatory agencies may impose additional inspections or audits at any time which may conclude that our quality system is noncompliant with applicable regulations and standards. Such findings could potentially disrupt our business, harm our reputation and adversely affect our sales.

Our products may in the future be subject to product recalls or voluntary market withdrawals that could harm our reputation, business and financial results.

The FDA and similar foreign governmental authorities have the authority to require the recall of commercialized products in the event of material deficiencies or defects in design or manufacture that could affect patient safety. In the case of the FDA, the authority to require a recall must be based on an FDA finding that there is a reasonable probability that the device would cause serious adverse health consequences or death. In addition, foreign governmental bodies have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacture. Manufacturers may, under their own initiative, recall a product if any material deficiency in a device is found. A government-mandated recall or voluntary recall by us or one of our distributors could occur as a result of component failures, manufacturing errors, design or labeling defects or other issues. Recalls, which include corrections as well as removals, of any of our products would divert managerial and financial resources and could have an adverse effect on our financial condition, harm our reputation with customers, reduce our ability to achieve expected revenues, and negatively affect our stock price.

If our products, or malfunction of our products, cause or contribute to death or serious injury, we will be subject to medical device reporting regulations, which can result in voluntary corrective actions or agency enforcement actions.

Under the FDA medical device reporting regulations, medical device manufacturers are required to report to the FDA information that a device has or may have caused or contributed to a death or serious injury or has or may have a malfunction that would likely cause or contribute to death or serious injury if the malfunction were to recur. All manufacturers placing medical devices on the market in the European Union are legally bound to report any serious or potentially serious incidents involving devices they produce or sell to the Competent Authority in whose jurisdiction the incident occurred. Were this to happen to us, the relevant Competent Authority would file an initial report, and there would then be a further inspection or assessment if there are particular issues. This would be carried out either by the Competent Authority or it could require that the BSI, as the Notified Body, carry out the inspection or assessment.

 

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Malfunction of our products could result in future voluntary corrective actions, such as recalls or customer notifications, or agency action, such as inspection or enforcement action. Such malfunctions have been reported to us in the past. No injury to patients resulted from any of these incidents, but we can make no assurance that any future incident would not result in harm to patients. Upon learning of the malfunctions, we have taken all actions required by law and notified the appropriate regulatory authorities, including the FDA. While we investigated each of the incidents and believe we have taken the necessary corrective actions, we cannot guarantee that malfunctions will not occur in the future. If they do occur, we may elect to take voluntary corrective action, and we may be subject to involuntary corrective action such as notification, fines, seizures or recalls. If someone is harmed by a malfunction or by product mishandling, we may be subject to product liability claims. Any corrective action, whether voluntary or involuntary, as well as defending ourselves in a lawsuit, will require the dedication of our time and capital, distract management from operating our business, and may harm our reputation and financial results.

Failure to obtain regulatory approval in additional foreign jurisdictions will prevent us from expanding the commercialization of our products abroad.

We intend to market our products in a number of international markets. Although certain of our IVUS products have been approved for commercialization in Japan and in the European Union, in order to market our products in other foreign jurisdictions, we have had to, and will need to in the future, obtain separate regulatory approvals. The approval procedure varies among jurisdictions and can involve substantial additional testing. Approval or clearance of a device by the FDA does not ensure approval by regulatory authorities in other jurisdictions, and approval by one foreign regulatory authority does not ensure marketing authorization by regulatory authorities in other foreign jurisdictions or by the FDA. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval in addition to other risks. In addition, the time required to obtain foreign approval may differ from that required to obtain FDA approval, and we may not obtain foreign regulatory approvals on a timely basis, if at all. We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any foreign market other than in the European Union and Japan.

We may be subject to Federal, state and foreign healthcare fraud and abuse laws and regulations and other regulatory reforms, and a finding of failure to comply with such laws, regulations and reforms could have a material adverse effect on our business.

Our operations may be directly or indirectly affected by various broad Federal, state or foreign healthcare fraud and abuse laws. These include the Federal anti-kickback statute, which prohibits any person from knowingly and willfully offering, paying, soliciting or receiving remuneration, directly or indirectly, in return for or to induce the referring, ordering, leasing, purchasing or arranging for or recommending the ordering, purchasing or leasing of an item or service, for which payment may be made under Federal healthcare programs, such as the Medicare and Medicaid programs. The Federal anti-kickback statute, a felony statute, is very broad in scope, and many of its provisions have not been uniformly or definitively interpreted by existing case law or regulations. In addition, many states have adopted laws similar to the Federal anti-kickback statute, and some of these laws are broader than that statute in that their prohibitions are not limited to items or services paid for by a Federal healthcare program but, instead, apply regardless of the source of payment. Some states also have enacted laws that restrict our marketing activities with physicians, and require us to report consulting and other payments to physicians. Finally, many foreign jurisdictions have anti-bribery provisions and other restrictions on interactions with physicians and other healthcare providers. These vary by country.

Our financial relationships with healthcare providers and others who provide products or services to Federal healthcare program beneficiaries or are in a position directly or indirectly to recommend or arrange for use of our products are potentially governed by the Federal anti-kickback statute and similar state laws, as well as laws in foreign jurisdictions. If our past or present operations, including our consulting arrangements with physicians who use our products, are found to be in violation of these laws, we or our officers may be subject to civil or

 

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criminal penalties, including large monetary penalties, damages, fines, imprisonment and exclusion from Medicare and Medicaid program participation. In connection with their services, some physicians serve as consultants and have in the past been awarded options to purchase our common stock. As of December 31, 2008, 90,906 shares of common stock have been purchased in connection with the exercise of these options and options to purchase 27,272 shares of common stock remain outstanding, vested and exercisable. Additionally, some physicians are paid consulting fees or reimbursed for expenses. In October 2008, we received a letter from Senator Charles E. Grassley, ranking member of the United States Senate Committee on Finance and Senator Herb Kohl, Chairman, United States Senate Special Committee on Aging, requesting information regarding payments made to the Cardiovascular Research Foundation, Columbia University and certain affiliated physicians. Additionally, the letter requests information regarding the COURAGE trial. We are cooperating with the request. While we believe that the pending inquiry is not likely to have a material adverse effect on our business or financial condition, similar investigations by other state agencies or governmental agencies are possible and we cannot assure that the costs of defending or resolving those investigations or proceedings would not have a material adverse effect on our financial condition, results of operations and cash flows. If enforcement action were to occur, our business and financial condition would be harmed.

In addition, Federal and state authorities and private whistleblower plaintiffs recently have brought actions against manufacturers alleging that the manufacturers’ activities constituted aiding and abetting healthcare providers in the submission of false claims, alleging that the manufacturers themselves made false or misleading statements to the Federal government, or alleging that the manufacturers improperly promoted their products for “off-label” uses not approved by the FDA. Such investigations or litigation could be time-consuming and costly to us and could divert management’s attention from operating our business, which could have a material adverse effect on our business. In addition, if our activities were found to violate Federal or state false claims provisions, it could have a material adverse effect on our business and results of operations.

We do not believe that we are now subject to state or Federal physician self-referral laws, but changes in Federal or state legislation or regulatory interpretations could occur. Federal physician self-referral legislation (commonly known as the “Stark Law”) prohibits, subject to certain exceptions, physician referrals of Medicare and Medicaid patients to an entity providing certain “designated health services” if the physician or an immediate family member has any financial relationship with the entity. The Stark Law also prohibits the entity receiving the referral from billing any good or service furnished pursuant to an unlawful referral, and any person collecting any amounts in connection with an unlawful referral is obligated to refund such amounts. A person who engages in a scheme to circumvent the Stark Law’s referral prohibition may be fined up to $100,000 for each such arrangement or scheme. The penalties for violating the Stark Law also include civil monetary penalties of up to $15,000 per referral and possible exclusion from Federal healthcare programs such as Medicare and Medicaid. Various states have corollary laws to the Stark Law, including laws that require physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Both the scope of and exceptions to such laws vary from state to state. Finally, pending Federal legislation introduced by Senators Grassley and Kohl, if passed, would require us to report and disclose a broad range of payments to physicians.

We could also be subject to investigation and enforcement activity under Title II of the Health Insurance Portability and Accountability Act of 1996, or HIPAA, which created two new Federal crimes. A healthcare fraud statute prohibits knowingly and willfully executing a scheme to defraud any healthcare benefit program, including private payors. A false statements statute prohibits knowingly and willfully falsifying, concealing, or covering up a material fact or making any materially false, fictitious, or fraudulent statement or representation in connection with the delivery of or payment for healthcare benefits, items or services. A violation of these statutes is a felony and could result in fines, imprisonment or exclusion from government-sponsored programs. Additionally, HIPAA granted expanded enforcement authority to the Department of Health and Human Services and the United States Department of Justice and provided enhanced resources to support investigative and enforcement activities by governmental entities regarding fraud and abuse violations relating to healthcare delivery and payment.

 

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In the United States, there have been a number of legislative and regulatory proposals to change the healthcare system in ways that could impact our ability to sell our products profitably. Federal and state lawmakers regularly propose and, at times, enact new legislation establishing significant changes in the healthcare system, particularly following changes in presidential administrations and senior government officials. We cannot predict whether new Federal legislation will be enacted in the future or the full impact that any such new legislation will have on our business. The potential for adoption of healthcare reform proposals on a state-by-state basis could require us to develop state-specific marketing and sales approaches. In addition, we may experience pricing pressures in connection with the sale of our products due to additional legislative proposals or healthcare reform initiatives. Our results of operations and our business could be adversely affected by future healthcare reforms. In the European Union, legislation on inducements offered to physicians and other healthcare workers or hospitals differ from country to country. Breach of the laws relating to such inducements may expose us to the imposition of criminal sanctions. It may also harm our reputation, which could in turn affect sales.

If our customers are unable to obtain coverage of or sufficient reimbursement for procedures performed with our products, it is unlikely that our products will be widely used.

Successful sales of our products will depend on the availability of adequate coverage and reimbursement from third-party payors. Healthcare providers that purchase medical devices for treatment of their patients generally rely on third-party payors to reimburse all or part of the costs and fees associated with the procedures performed with these devices. Both public and private insurance coverage and reimbursement plans are central to new product acceptance. Customers are unlikely to use our products if they do not receive reimbursement adequate to cover the cost of our products and related procedures.

To the extent we sell our products internationally, market acceptance may depend, in part, upon the availability of coverage and reimbursement within prevailing healthcare payment systems. Coverage, reimbursement, and healthcare payment systems in international markets vary significantly by country, and by region in some countries, and include both government-sponsored healthcare and private insurance. We may not obtain international reimbursement approvals in a timely manner, if at all. Our failure to receive international coverage or reimbursement approvals would negatively impact market acceptance of our products in the international markets in which those approvals are sought.

To date, our products have generally been covered as part of procedures for which reimbursement has been available. However, in the United States, as well as in foreign countries, government-funded or private insurance programs, commonly known as third-party payors, pay the cost of a significant portion of a patient’s medical expenses. No uniform policy of coverage or reimbursement for medical technology exists among all these payors. Therefore, coverage of and reimbursement for medical technology can differ significantly from payor to payor.

All third-party coverage and reimbursement programs, whether government funded or insured commercially, whether inside the United States or outside, are developing increasingly sophisticated methods of controlling healthcare costs through limitations on covered items and services, prospective reimbursement and capitation programs, group purchasing, redesign of benefits, second opinions required prior to major surgery, careful review of bills, encouragement of healthier lifestyles and exploration of more cost-effective methods of delivering healthcare. These types of programs and legislative changes to coverage and reimbursement policies could potentially limit the amount which healthcare providers may be willing to pay for medical devices.

We believe that future coverage and reimbursement may be subject to increased restrictions both in the United States and in international markets. Third-party reimbursement and coverage for our products may not be available or adequate in either the United States or international markets. Future legislation, regulation, coverage or reimbursement policies of third-party payors may adversely affect the growth of the IVUS and FM markets, the demand for our existing products or our products currently under development, and limit our ability to sell our products on a profitable basis.

 

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Compliance with environmental laws and regulations could be expensive, and failure to comply with these laws and regulations could subject us to significant liability.

We use hazardous materials in our research and development and manufacturing processes. We are subject to Federal, state and local regulations governing use, storage, handling and disposal of these materials and associated waste products. We are currently licensed to handle such materials, but there can be no assurance that we will be able to retain these licenses in the future or obtain licenses under new regulations if and when they are required by governing authorities. Although we believe our procedures for use, storage, handling and disposing of these materials comply with legally prescribed standards, we cannot completely eliminate the risk of contamination or injury resulting from hazardous materials, and we may incur liability as a result of any such contamination or injury. In the event of an accident, we could be held liable for damages or penalized with fines, and the liability could exceed our resources and any applicable insurance. We have also incurred and may continue to incur expenses related to compliance with environmental laws. Such future expenses or liability could have a significant negative impact on our business, financial condition and results of operations. Further, we cannot assure that the cost of compliance with these laws and regulations will not materially increase in the future. We may also incur expenses related to ensuring that our operations comply with environmental laws related to our operations, and those of prior owners or operators of our properties, at current or former manufacturing sites where operations have previously resulted in spills, discharges or other releases of hazardous substances into the environment. The United States environmental laws which we believe are, or may be, applicable include Resource Conservation and Recovery Act, or RCRA, as amended by the Hazardous and Solid Waste Amendments of 1984 and the Comprehensive Environmental Response, Compensation, and Liability Act, or CERCLA. These laws regulate the management and disposal of wastes, provide for the investigation and remediation of contaminated land and groundwater resources and establish a pollution prevention program. In addition, various states have implemented environmental protection laws which are the counterparts of CERCLA and/or RCRA in the jurisdiction where the Company had or maintains facilities (e.g., California). These laws may give rise to liability (including strict liability, or liability without fault, and cleanup responsibility) to governmental entities or private parties under these Federal, state or local environmental laws, as well as under common law. For example, we could be held strictly liable under CERCLA for contamination of property that we currently or formerly owned or operated without regard to fault or whether our actions were in compliance with law at the time. Our liability could also increase if other responsible parties, including prior owners or operators of our facilities, fail to complete their clean-up obligations or satisfy indemnification obligations to us.

The European Union has enacted the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment, or RoHS, and the Waste Electrical and Electronic Equipment, or WEEE, directives. The RoHS directive prohibits the use of certain levels of six substances, including lead, mercury, cadmium and hexavalent chromium, in covered products placed on the market after July 1, 2006. The WEEE directive obligates parties that place electrical and electronic equipment onto the market in the European Union to clearly mark the equipment, register with and report to European Union regulators regarding distribution of the equipment, and provide a mechanism to recall and properly dispose of the equipment. Each European Union member country has enacted, or is expected to soon enact, legislation clarifying what is and what is not covered by the WEEE and RoHS directives in that country. However, there is still some uncertainty in certain European Union countries as to which party involved in the manufacture, distribution and sale of electronic equipment will be ultimately held responsible. If our subsidiary, Axsun, is deemed to be a manufacturer of covered products, we may be required to register as a producer in certain European Union countries, and incur financial responsibility with respect to products sold within the European Union, including products of other manufacturers that have been replaced by our products. We may also incur substantial costs to change our manufacturing processes, redesign or reformulate, and obtain substitute components for, our products that are deemed covered products under the RoHS directive. We may also incur significant inventory write-downs if certain components held in inventory become unusable because they are not RoHS-compliant. If we fail to timely provide RoHS-compliant products, we will not be able to offer our products within European Union, and we may be subject to civil or criminal liabilities. Penalties for failure to comply with the WEEE Directive differ across European countries and come under two headings: failure to register and non-compliance. Those failing to register generally are subject to a fine and non-compliant products are either blocked or taken off the market.

 

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The use, misuse or off-label use of our products may result in injuries that could lead to product liability suits, which could be costly to our business.

Our currently marketed products have been cleared by the FDA for particular indications for the qualitative and quantitative evaluation of the coronary and peripheral vasculature. Our products are also CE marked, licensed in Canada, have approvals in Japan, as well as regulatory approvals in many other countries around the world for specific indications for use. There may be increased risk of injury if physicians attempt to use our products in procedures outside of those indications cleared for use, known as off-label use. Our sales force is trained according to company policy not to promote our products for off-label uses, and in our instructions for use in all markets we specify that our products are not intended for use outside of those indications cleared for use. However, we cannot prevent a physician from using our products for off-label applications. Our catheters and guide wires are intended to be single-procedure products. In spite of clear labeling and instructions against reuse, we are aware that certain physicians have elected to reuse our products. Reuse of our catheters and guide wires may increase the risk of product liability claims. Reuse may also subject the party reusing the product to regulatory authority inspection and enforcement action. Physicians may also misuse our product if they are not adequately trained, potentially leading to injury and an increased risk of product liability. If our products are defectively designed, manufactured or labeled, contain defective components or are misused, we may become subject to costly litigation by our customers or their patients. Product liability claims could divert management’s attention from our core business, be expensive to defend and result in sizable damage awards against us.

Risks Related to Our Intellectual Property and Potential Litigation

Our ability to protect our intellectual property and proprietary technology through patents and other means is uncertain.

Our success depends significantly on our ability to protect our intellectual property and proprietary technologies. Our policy is to obtain and protect our intellectual property rights. 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 proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. Our pending United States and foreign patent applications may not issue as patents or may not issue in a form that will be advantageous to us. Among other reasons, for example, the United States Supreme Court and other courts have issued and continue to issue opinions that may affect the scope of or whether we will be able to obtain patent protection. Any patents we have obtained or will obtain may be challenged by re-examination, opposition or other administrative proceeding, or in litigation. Such challenges could result in a determination that the patent is invalid. In addition, competitors may be able to design alternative methods or devices that avoid infringement of our patents. To the extent our intellectual property protection offers inadequate protection, or is found to be invalid, we are exposed to a greater risk of direct competition. If our intellectual property does not provide adequate protection against our competitors’ products, our competitive position could be adversely affected, as could our business. Both the patent application process and the process of managing patent disputes can be time consuming and expensive. Furthermore, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

In addition to pursuing patents on our technology, we have taken steps to protect our intellectual property and proprietary technology by entering into confidentiality agreements and intellectual property assignment agreements with our employees, consultants, corporate partners and, when needed, our 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, and we may not be able to prevent such unauthorized disclosure. Monitoring unauthorized disclosure is difficult, and we do not know whether the steps we have taken to prevent such disclosure are, or will be, adequate.

In the event a competitor infringes upon our patent or other intellectual property rights, litigation to enforce our intellectual property rights or to defend our patents against challenge, even if successful, could be expensive

 

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and time consuming and could require significant time and attention from our management. We may not have sufficient resources to enforce our intellectual property rights or to defend our patents against challenges from others.

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

The medical device industry is characterized by extensive litigation and administrative proceedings over patent and other intellectual property rights. Whether or not a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our competitors may assert that they own U.S. or foreign patents containing claims that cover our products, their components or the methods we employ in the manufacture or use of our products. In addition, we may become a party to an interference proceeding declared by the United States Patent and Trademark Office to determine the priority of invention. Because patent applications can take many years to issue and in many instances at least 18 months to publish, there may be applications now pending of which we are unaware, which may later result in issued patents that contain claims that cover our products. There could also be existing patents, of which we are unaware, that contain claims that cover one or more components of our products. As the number of participants in our industry increases, the possibility of patent infringement claims against us also increases.

Any interference proceeding, litigation or other assertion of claims against us may cause us to incur substantial costs, could place a significant strain on our financial resources, divert the attention of our management from our core business and harm our reputation. If the relevant patents were upheld as valid and enforceable and we were found to be infringing, we could be required to pay substantial damages and/or royalties and could be prevented from selling our products unless we could obtain a license or were able to redesign our products to avoid infringement. Any such license may not be available on reasonable terms, if at all. If we fail to obtain any required licenses or make any necessary changes to our products or technologies, we may be unable to make, use, sell or otherwise commercialize one or more of our products in the affected country. In addition, if we are found to infringe willfully, we could be required to pay treble damages and attorney fees, among other penalties.

We expect to enter new product fields, such as IVUS guided therapies, FLIVUS, and OCT imaging, in the future. Entering such additional fields may subject us to claims of infringement. Defending any infringement claims would be expensive and time consuming.

We are aware of certain third-party U.S. patents in these fields. We do not have licenses to these patents nor do we believe that such licenses are required to develop, commercialize or sell our products in these areas. However, the owners of these patents may initiate a lawsuit alleging infringement of one or more of these or other patents. If they do, we may be required to incur substantial costs related to patent litigation, which could place a significant strain on our financial resources and divert the attention of management from our business and harm our reputation. Adverse determinations in such litigation could cause us to redesign or prevent us from manufacturing or selling our products in these areas, which would have an adverse effect on our business by limiting our ability to generate revenues through the sale of these products.

From time to time in the ordinary course of business, we receive letters from third parties advising us of third-party patents that may relate to our business. The letters do not explicitly seek any particular action or relief from us. Although these letters do not threaten legal action, these letters may be deemed to put us on notice that continued operation of our business might infringe intellectual property rights of third parties. We do not believe we are infringing any such third-party rights, and we are unaware of any litigation or other proceedings having been commenced against us asserting such infringement. We cannot assure you that such litigation or other proceedings may not be commenced against us in the future.

 

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Our rights to a worldwide license of certain IVUS patents owned or licensed by Boston Scientific may be challenged.

The marketing and sale of our current rotational IVUS catheters and pullback products depend on a license for IVUS-related patents owned or licensed by Boston Scientific. Boston Scientific was required to transfer the related intellectual property rights pursuant to a 1995 order of the Federal Trade Commission. We obtained rights to the license in 2003 through our former wholly-owned subsidiary, Pacific Rim Medical Ventures, which merged into us on December 30, 2004. In the event Boston Scientific disputes our rights to the license or seeks to terminate the license, we may be required to expend significant time and resources defending our rights. An adverse determination could cause us to redesign or prevent us from manufacturing or selling our rotational IVUS catheters and pullback products, which would have an adverse effect on our business. Additionally, in the event that the chain of title from the 1995 transfer of rights from Boston Scientific through the 2003 transfer to us is successfully challenged, we may have fewer rights to the technology than our business requires which will negatively impact our ability to continue our development of rotational IVUS catheters and pullback products or subject us to disputes with Boston Scientific or others with respect to the incorporation of this intellectual property into our products.

Our VH IVUS business depends on a license from The Cleveland Clinic Foundation, the loss of which would severely impact our business.

The marketing and sale of our VH IVUS functionality for IVUS depends on an exclusive license to patents owned by The Cleveland Clinic Foundation, the license to which we obtained in April 2002. We are aware that maintenance of the license depends upon certain provisions being met by us including payment of royalties, commercialization of the licensed technology and obtaining regulatory clearances or approvals. If The Cleveland Clinic Foundation were to claim that we committed a material breach or default of these provisions and we were not able to cure such breach or default, The Cleveland Clinic Foundation would have a right to terminate the agreement. The loss of the rights granted under the agreement could require us to redesign our VH IVUS functionality or prevent us from manufacturing or selling our IVUS products containing VH IVUS in countries covered by these patents. In addition, our exclusive license shall become non-exclusive if we fail to obtain regulatory clearances or approvals to commercialize the licensed technology within a proscribed time period. The cost of redesigning or an inability to sell our VH IVUS products would have a negative impact on our ability to grow our business and may cause a drop in our stock price.

Risks Related to Our Common Stock

We expect that the price of our common stock will fluctuate substantially.

The market price of our common stock could be subject to significant fluctuation. Factors that could cause volatility in the market price of our common stock include the following:

 

   

changes in earnings estimates, investors’ perceptions, recommendations by securities analysts or our failure to achieve analysts’ earning estimates;

 

   

quarterly variations in our or our competitors’ results of operations;

 

   

changes in governmental regulations or in the status of our regulatory clearance or approvals;

 

   

changes in availability of third-party reimbursement in the United States or other countries;

 

   

the announcement of new products or product enhancements by us or our competitors;

 

   

the announcement of an acquisition or other business combination or strategic transaction;

 

   

announcements related to patents issued to us or our competitors;

 

   

the announcement of pending or threatened litigation;

 

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sales of large blocks of our common stock, including sales by our executive officers and directors; and

 

   

general market and economic conditions and other factors unrelated to our operating performance or the operating performance of our competitors.

These factors may materially and adversely affect the market price of our common stock.

Future equity issuances or a sale of a substantial number of shares of our common stock may cause the price of our common stock to decline.

As of December 31, 2008, the holders of a significant number of shares of our common stock may require us, subject to certain conditions, to file a registration statement covering those shares. If any of these stockholders cause a large number of securities to be sold in the public market, the sales could reduce our stock price. In addition, sales of these shares could make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem reasonable or appropriate. Because we may need to raise additional capital in the future to continue to expand our business and develop new products, among other things, we may conduct additional equity offerings. These future equity issuances, together with any additional shares issued in connection with acquisitions, will result in further dilution to investors. As of December 31, 2008, options to purchase 5,957,995 shares of our common stock were outstanding under our equity compensation plans. On February 27, 2009, 88,303 restricted stock units vested and converted to shares of our common stock. No prediction can be made regarding the effect that future sales of shares of our common stock will have on the market price of our shares.

Our directors, officers and principal stockholders have significant voting power and may take actions that may not be in the best interests of our other stockholders.

As of December 31, 2008, our directors, officers and principal stockholders each holding more than 5% of our common stock collectively controlled 64% of our outstanding common stock. To the extent our directors, officers and principal stockholders continue to hold a significant percentage of our outstanding common stock, these stockholders, if they act together, would be able to exert significant influence over the management and affairs of our company and most matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control, might adversely affect the market price of our common stock and may not be in the best interests of our other stockholders.

Anti-takeover provisions in our amended and restated certificate of incorporation and bylaws and Delaware law could discourage a takeover.

Our amended and restated certificate of incorporation and bylaws and Delaware law contain provisions that might enable our management to resist a takeover. These provisions include:

 

   

a classified board of directors;

 

   

advance notice requirements to stockholders for matters to be brought at stockholder meetings;

 

   

a supermajority stockholder vote requirement for amending certain provisions of our amended and restated certificate of incorporation and bylaws; and

 

   

the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer.

We are also subject to the provisions of Section 203 of the Delaware General Corporation Law that, in general, prohibit any business combination or merger with a beneficial owner of 15% or more of our common stock unless the holder’s acquisition of our stock was approved in advance by our board of directors. These provisions might discourage, delay or prevent a change in control of our company or a change in our

 

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management. The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.

We have adopted a stockholder rights plan that may discourage, delay or prevent a change of control and make any future unsolicited acquisition attempt more difficult. Under the rights plan:

 

   

the rights will become exercisable only upon the occurrence of certain events specified in the plan, including the acquisition of 20% of our outstanding common stock by a person or group, with limited exceptions;

 

   

each right will entitle the holder, other than an acquiring person, to acquire shares of our common stock at a discount to the then prevailing market price;

 

   

our board of directors may redeem outstanding rights at any time prior to a person becoming an acquiring person at a minimal price per right; and

 

   

prior to a person becoming an acquiring person, the terms of the rights may be amended by our board of directors without the approval of the holders of the rights.

We have not paid dividends in the past and do not expect to pay dividends in the future.

We have never declared or paid cash dividends on our capital stock. We currently intend to retain all future earnings for the operation and expansion of our business and, therefore, do not anticipate declaring or paying cash dividends in the foreseeable future. The payment of dividends will be at the discretion of our board of directors and will depend on our results of operations, capital requirements, financial condition, prospects, contractual arrangements, any limitations on payments of dividends present in our current and future debt agreements, and other factors our board of directors may deem relevant. If we do not pay dividends, a return on your investment will only occur if our stock price appreciates.

 

Item 1B. Unresolved Staff Comments

None

 

Item 2. Properties

Our corporate headquarters is located in San Diego, California. We lease 8,369 square feet at this location and the lease expires in June 2009. We also conduct a portion of our research and development activities at this facility. Our manufacturing operations and a portion of our administrative functions are located in a 75,626 square foot facility in Rancho Cordova, California. We have leased this facility through December 2014 with options to renew through December 2024. In early 2006, we moved our research and development, marketing and regulatory operations to an approximately 33,600 square foot facility also located in Rancho Cordova, California. We have leased this facility through December 2014 with options to renew through December 2024. Our product distribution operations are also located in Rancho Cordova, California. We have leased this 12,960 square foot facility through October 2009 with an option to renew through October 2014. We also lease a 13,705 square foot facility in Rancho Cordova, California through December 2014 with options to renew through December 2024. We conduct our shipping and receiving, quality inspection, and systems refurbishment activities at this facility. We also lease 4,565 square feet of general office space in Alpharetta, Georgia, from which we conduct U.S. sales administration operations. This lease expires in June 2014 with an option to renew through June 2019. We also lease 6,409 square feet of office and warehouse space in Forsyth County, Georgia through May 2019 with options to renew through May 2020, from which we conduct research and development for our catheter products. We also lease 10,361 square feet of office space in San Antonio, Texas for the research and development of our OCT technology. This lease expires in August 2013. We also lease 5,049 square feet of office space in Andover, Massachusetts through May 2011 for the research and development of our FLIVUS technology. We also lease 64,784 square feet of office space in Billerica, Massachusetts through October 2009

 

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with an option to renew through November 2014, for the primary operations of Axsun, our wholly owned subsidiary. We also currently lease 4,694 square feet of general office space in Cleveland, Ohio through March 2010 with options to renew through March 2012. This space is occupied by research and development personnel.

In April of 2004 we opened our Japanese sales office concurrently with the creation of our subsidiary, Volcano Japan. We lease 3,660 square feet of office space located in Minato-ku, Tokyo, Japan. This lease expires in March 2009. In October 2008, we executed a lease for approximately 9,752 square feet of office space located in Minato-ku, Tokyo, Japan from February 2009 through January 2012. We intend to relocate our Japanese sales office to this new facility. In July 2008, we leased a field service office of approximately 3,100 square feet in Tokyo, Japan through June 2010.

We conduct our European administrative, sales and product distribution operations through our European subsidiary, Volcano Europe, from approximately 11,874 square feet of leased offices located in Zaventem, Belgium. This lease is expires in 2013.

We believe that our current and planned facilities are adequate to meet our needs for the foreseeable future.

In connection with the acquisition of Axsun, we lease facilities in Livermore, California for a total of 14,288 square feet through September 2010 that is vacant and not utilized for our operations.

 

Item 3. Legal Proceedings

On January 7, 2009, LightLab Imaging Inc., or LightLab, filed a complaint against Volcano and its wholly-owned subsidiary, Axsun, in the Superior Court of Massachusetts, Suffolk County, seeking injunctive relief and unspecified damages. LightLab’s complaint alleges that Volcano interfered with LightLab’s development and supply agreement with Axsun and its advantageous business relationship with Axsun, engaged in unfair competition, engaged in unfair or deceptive acts or practices and engaged in misappropriation and wrongful use of LightLab’s confidential information and trade secrets. LightLab’s complaint alleges that Axsun breached its development and supply agreement with LightLab, breached the implied covenant of good faith and fair dealing, misappropriated and wrongfully used and disclosed LightLab’s confidential information and trade secrets, engaged in unfair competition, and engaged in unfair or deceptive acts or practices. The allegations in the complaint are based primarily on Volcano’s acquisition of Axsun and Volcano’s access to the specifications to the lasers manufactured by Axsun for LightLab. LightLab, a wholly owned subsidiary of Goodman, our distributor of IVUS and FM products in Japan, develops and sells OCT products for cardiovascular imaging and other medical uses. Along with its complaint, on January 7, 2009, LightLab also filed a motion for a temporary restraining order, which Axsun and Volcano opposed. After a hearing held on January 8, 2009, the Superior Court issued a preliminary injunction against Axsun and Volcano, that among other things, prohibits Volcano from using Axsun tunable lasers in Volcano’s OCT products under development. The court indicated that the motion for a preliminary injunction would be reconsidered after the parties had time to complete discovery and fully brief the court on the issues. A hearing was held on March 6, 2009 to reconsider the preliminary injunction and we are currently awaiting the judge’s ruling. Volcano and Axsun have not yet answered the complaint.

We may be subject to various other claims and legal actions arising in the ordinary course of business from time to time.

 

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fiscal fourth quarter ended December 31, 2008.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

We completed our initial public offering on June 15, 2006. Our Common Stock is traded on the NASDAQ Global Market under the symbol “VOLC”. The following table sets forth the high and low sales price of our common stock for the periods indicated.

 

     Price Range
     Low    High

Fiscal 2008:

     

First Quarter

   $ 10.55    $ 14.69

Second Quarter

     11.41      14.92

Third Quarter

     11.94      19.50

Fourth Quarter

     11.60      18.04

Fiscal Year

     10.55      19.50

Fiscal 2007:

     

First Quarter

   $ 16.18    $ 21.87

Second Quarter

     17.59      23.10

Third Quarter

     14.40      20.97

Fourth Quarter

     12.04      19.09

Fiscal Year

     12.04      23.10

At February 27, 2009, the closing price of our Common Stock on the NASDAQ Global Market was $14.96 per share, and we had 58 stockholders of record.

Performance Graph

The following Performance Graph and related information shall not be deemed “soliciting material” or “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such filing.

The graph below compares total stockholder return on our common stock from June 15, 2006 (the first day our stock was traded on the NASDAQ Global Market) through December 31, 2008 with the cumulative total return of (a) the NASDAQ Composite Index and (b) the NASDAQ Medical Equipment Index assuming a $100 investment made in each on June 15, 2006. Each of the three measures of cumulative total return assumes reinvestment of dividends, if any. The stock performance shown on the graph below is based on historical data and is not indicative of, or intended to forecast, possible future performance of our common stock.

 

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COMPARISON OF 30 MONTH CUMULATIVE TOTAL RETURN *

Among Volcano Corporation, The NASDAQ Composite Index

And The NASDAQ Medical Equipment Index

LOGO

Equity Compensation Plan Information

Information regarding our equity compensation plans is included in Part III, Item 12 of this Annual Report on Form 10-K.

Recent Sales of Unregistered Securities

None

Recent Purchase of our Registered Equity Securities

We did not purchase any shares of our common stock during the fourth quarter of 2008.

Dividends

We have never declared or paid any cash dividends on our capital stock. We currently intend to retain any future earnings to fund the development and expansion of our business, and therefore we do not anticipate paying cash dividends on our common stock in the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors. None of our outstanding capital stock is entitled to any dividends.

 

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Item 6. Selected Financial Data

The selected financial data set forth below are derived from our consolidated financial statements. The consolidated statement of operations data for the years ended December 31, 2008, 2007 and 2006, and the consolidated balance sheet data at December 31, 2008 and 2007 are derived from our audited consolidated financial statements included elsewhere in this report. The consolidated statement of operations data for the years ended December 31, 2005 and 2004 and the consolidated balance sheet data at December 31, 2006, 2005 and 2004 are derived from our audited consolidated financial statements which are not included herein.

The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this report (in thousands, except per share data):

 

     Years Ended December 31,  
     2008     2007     2006     2005     2004  

Consolidated Statement of Operations Data:

          

Revenues

   $ 171,495     $ 130,614     $ 103,048     $ 91,900     $ 61,098  

Cost of revenues

     64,293       51,559       41,715       47,843       29,860  
                                        

Gross profit

     107,202       79,055       61,333       44,057       31,238  

Operating expenses:

          

Selling, general and administrative

     84,369       62,631       47,614       35,365       30,374  

Research and development

     26,690       20,315       16,923       15,119       9,800  

In-process research and development (1)

     12,681       26,188       —         —         —    

Amortization of intangibles

     3,125       3,067       3,117       3,052       2,929  
                                        

Total operating expenses

     126,865       112,201       67,654       53,536       43,103  
                                        

Operating loss

     (19,663 )     (33,146 )     (6,321 )     (9,479 )     (11,865 )

Interest income

     4,828       5,841       958       458       153  

Interest expense

     (113 )     (199 )     (4,013 )     (5,311 )     (4,784 )

Exchange rate gain (loss)

     1,809       1,452       1,053       (859 )     342  

Other, net

     54       —         18       —         —    
                                        

Loss before provision for income taxes

     (13,085 )     (26,052 )     (8,305 )     (15,191 )     (16,154 )
                                        

Provision for income taxes

     620       524       298       70       37  
                                        

Net loss

   $ (13,705 )   $ (26,576 )   $ (8,603 )   $ (15,261 )   $ (16,191 )
                                        

Net loss per share—basic and diluted

   $ (0.29 )   $ (0.66 )   $ (0.41 )   $ (2.28 )   $ (2.57 )
                                        

Shares used in calculating basic and diluted net loss per share

     47,376       40,024       21,113       6,693       6,291  
                                        

 

     At December 31,  
     2008    2007    2006    2005     2004  

Balance Sheet Data:

             

Cash and cash equivalents (1)

   $ 100,949    $ 122,913    $ 77,738    $ 15,219     $ 11,438  

Short-term available-for-sale investments

     48,941      66,205      17,787      —         —    

Working capital

     182,108      210,094      108,908      16,993       12,042  

Intangible assets, net (2)

     15,636      9,385      11,946      14,645       17,279  

Total assets

     275,479      266,574      154,725      68,468       59,141  

Short and long-term debt, including current maturities

     242      198      1,720      30,350       34,534  

Convertible preferred stock (3)

     —        —        —        63,060       47,696  

Total stockholders’ equity (deficit)

     229,732      232,937      129,182      (49,468 )     (36,976 )

 

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These historical results are not necessarily indicative of results expected for any future period.

 

  (1) In December 2007, we paid $25.2 million for the acquisition of CardioSpectra. In May 2008, we paid $12.3 million for the acquisition of Novelis. In December 2008, we paid $21.5 million for the acquisition of Axsun.

 

  (2) Includes the effects of the Axsun acquisition in December 2008.

 

  (3) Includes the issuance of Series B preferred stock in March 2004 in the amount of $250,000, the issuance of Series B preferred stock warrants in 2004 related to debt agreements in the amount of $224,000, the issuance of Series C preferred stock in February 2005 in the amount of $15.4 million and the conversion of all outstanding shares of preferred stock into 18,123,040 shares of our common stock in June 2006.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with “Selected Financial Data” and our consolidated financial statements and notes thereto included elsewhere in this annual report.

Overview

We design, develop, manufacture and commercialize a broad suite of IVUS and FM products. We believe that these products enhance the diagnosis and treatment of vascular heart disease by improving the efficiency and efficacy of existing PCI therapy procedures in the coronary or peripheral arteries. We market our products to physicians and technicians who perform PCI procedures in hospitals and to other personnel who make purchasing decisions on behalf of hospitals.

Our IVUS products consist of ultrasound consoles, single-procedure disposable phased array and rotational IVUS imaging catheters and additional functionality options such as virtual histology, or VH, IVUS tissue characterization and ChromaFlo stent apposition analysis. Our IVUS consoles are marketed as stand-alone units or customized units that can be integrated into a variety of hospital-based interventional surgical suites called catheterization laboratories, or cath labs. We have developed customized cath lab versions of these consoles and are developing additional functionality options as part of our cath lab integration initiative. Our IVUS consoles have been designed to serve as a multi-modality platform for our phased array and rotational IVUS catheters, FFR pressure wires and Medtronic’s Pioneer reentry device. We are developing additional offerings for integration into the platform, including, FLIVUS catheters, image-guided therapy catheters and ultra-high resolution OCT systems and catheters.

Our FM offerings include consoles and single-use pressure and flow guide wires used to measure the pressure and flow characteristics of blood around plaque enabling physicians to gauge the plaque’s physiological impact on blood flow and pressure.

We have focused on building our domestic and international sales and marketing infrastructure to market our products to physicians and technicians who perform PCI procedures in hospitals and to other personnel who make purchasing decisions on behalf of hospitals. We expanded our worldwide sales organization from 60 employees in July 2003 to 180 employees at December 31, 2008, which included 150 direct sales representatives in the United States, Western Europe and Asia. We sell our products directly to customers in certain European markets and utilize distributors in other European markets, including Spain, Portugal and parts of Italy. At December 31, 2008, our distribution efforts in Europe were led by a General Manager, a Director of European Sales, 16 account representatives and three clinical specialists. Three companies distribute our IVUS and FM products in Japan. We have direct contractual relationships with Goodman, Fukuda Denshi and Johnson & Johnson through which our IVUS and FM products are distributed in Japan. In addition, Fukuda Denshi has sub-distribution agreements with other parties. While these multi-level relationships allow us to access specific customers and markets, they create complex distribution arrangements and increase our reliance on our Japanese distributors. As of December 31, 2008, we support our Japanese

 

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distributors through Volcano Japan which is led by a General Manager, two marketing, three distribution, and 16 sales and support staff. In emerging markets, including the major markets of Asia Pacific, Latin America, Europe, Australia, Africa and the Middle East, we have distributor relationships through which we sell our products. Our distributors are involved in product launch planning, education and training, physician support and clinical trial management.

Fukuda Denshi accounted for 14.2% of our revenues in 2006 and accounted for less than 10% of our revenues in 2007 and 2008. In the first quarter of 2005, Goodman, formerly Boston Scientific’s distributor of its IVUS products in Japan, began to distribute our IVUS products in Japan through a sub-distribution agreement with Fukuda Denshi. Additionally, Fukuda Denshi transferred the Japanese regulatory approvals, or SHONINs, for our phased array IVUS products to us on June 1, 2006. Due to the transfer, we are now able to sell directly to distributors in Japan as opposed to being required to sell our phased array IVUS products only to Fukuda Denshi. As a result, for a portion of 2006, we sold directly to Goodman and Fukuda Denshi and the percentage of our revenues attributable to Fukuda Denshi declined, while the percentage of revenues attributed to Goodman increased, accounting for 14.4%, 18.0%, and 15.0% of our revenues for the years ended December 31, 2008, 2007 and 2006, respectively.

On May 19, 2008, we and Goodman, mutually terminated the Exclusive Distribution Agreement, dated September 27, 2004, pursuant to which Goodman distributed our IVUS products in Japan. Also on May 19, 2008, the oral agreement between us and Goodman, related to the exclusive distribution of our FM products in Japan, was terminated. We did not pay and we are not obligated to pay a termination fee in connection with this termination. On June 30, 2008, Goodman transferred to us all marketing authorization and other regulatory approvals, or SHONINs, for all specified products held by Goodman or its affiliates. Although Goodman currently continues to distribute our rotational IVUS and FM products in Japan on a non-exclusive, purchase order basis, there is no assurance that they will continue to do so in the future. Upon termination of our agreements with Goodman, we monitor the credit risk associated with Goodman as well as other general economic conditions and, accordingly, we have made and continue to make adjustments to the credit terms that are extended to Goodman.

We are also collaborating with GE for the development and distribution worldwide, except Japan, of our s5i GE Innova system, which is our IVUS imaging system console that is installed directly into a cath lab on a permanent basis and is able to be integrated with GE’s Innova system.

At December 31, 2008, we had a worldwide installed base of over 3,200 IVUS consoles and over 800 FM consoles. We intend to grow and leverage this installed base to drive recurring sales of our single-procedure disposable catheters and guide wires. In 2008, the sale of our single-procedure disposable catheters and guide wires accounted for $125.4 million, or 73.1% of our revenues, a $27.6 million, or 28.2% increase from 2007, in which the sale of our single-procedure disposable catheters and guide wires accounted for $97.8 million, or 74.9% of our revenues.

We manufacture our IVUS and FM consoles, IVUS catheters and FM guide wires at our facility in Rancho Cordova, California. We use third-party manufacturing partners to produce circuit boards and mechanical sub-assemblies used in the manufacture of our consoles. We also use third-party manufacturing partners for certain proprietary components used in the manufacture of our single-procedure disposable products. We perform incoming inspection on these circuit boards, mechanical sub-assemblies and components, assemble them into finished products, and test the final product to assure quality control. Our former supplier of FM wire pressure sensors ceased production of this key component on 4” wafers. We secured an end-of-life purchase in 2007 of the subject parts equivalent to an estimated four-year supply. We believe this will provide us with adequate time to initiate and qualify a replacement supplier or a new design to replace the product. We expect that it will take approximately 24 months to identify an appropriate replacement supplier, complete design work and undertake the necessary inspections before the new pressure sensors will be available.

 

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From our inception in January 2000 until July 2003, we were engaged principally in the research and development of tools designed to diagnose vulnerable plaque. In July 2003, we purchased substantially all of the assets and assumed certain liabilities associated with the IVUS and FM product lines of Jomed, Inc. We also acquired certain IVUS patents and technology from Philips in July 2003. These purchases were significant in executing our strategy to leverage our IVUS technology and build our business. Our revenues have increased from $103.0 million in 2006 to $130.6 million in 2007 to $171.5 million in 2008. Our operating loss increased from $6.3 million in 2006 to $33.1 million in 2007, which included a $26.2 million charge related to in-process research and development acquired as part of the acquisition of CardioSpectra, then decreased to $19.7 million in 2008, which included a $12.2 million charge related to in-process research and development acquired as part of the Novelis acquisition. At December 31, 2008, our accumulated deficit was $104.3 million. Since our inception, we have not been profitable for a full fiscal year, and we expect to continue to incur net losses for the foreseeable future.

We completed an underwritten initial public offering on June 15, 2006 in which we sold 7,820,000 shares of our common stock to the public at an offering price of $8.00 per share. The initial public offering resulted in net proceeds of $54.5 million, after deducting offering expenses and underwriting discounts and commissions.

On December 12, 2006, we completed an underwritten follow-on offering in which 3,500,000 shares of our common stock were sold by the Company and 4,000,000 shares were sold by certain selling stockholders, including officers of the company. In addition, we sold 795,000 shares under an over-allotment option exercised by the underwriters. The follow-on offering, including the exercise of the over-allotment option, resulted in net proceeds to the Company of $66.8 million, after deducting offering expenses and underwriting discounts and commissions.

On October 23, 2007, we completed an underwritten follow-on offering in which 8,050,000 shares of our common stock were sold by the Company, including 1,050,000 shares under an over-allotment option exercised by the underwriters. The follow-on offering, including the exercise of the over-allotment option, resulted in net proceeds to the company of $122.8 million, after deducting offering expenses and underwriting discounts and commissions.

During the second half of 2007 and the first quarter of 2008, we pursued an acquisition with an interventional therapy company. Given the other entity’s complex legal structure, global revenue base and lack of U.S. GAAP financial statements, the due diligence and deal-related costs were unusually high. We were not able to reach a final definitive agreement and, during the year ended December 31, 2008, we expensed approximately $2.9 million in third-party costs incurred during the due diligence process.

On December 18, 2007, we acquired CardioSpectra, a company founded in 2005 and based in San Antonio, Texas. CardioSpectra’s core product line is based on technology licensed from the University of Texas and Dr. Thomas Milner, a co-founder of CardioSpectra. Through CardioSpectra, we are developing innovative OCT technology, which is expected to complement our existing product offerings and further enhance our position as an imaging technology leader in the field of interventional medicine.

On May 15, 2008, we acquired Novelis, a company with proprietary ultrasonic visualization and therapy technology for minimally invasive diagnostic and therapeutic devices. Novelis’ proprietary FLIVUS technology platform is expected to build upon our existing suite of products and further enhance our position as an imaging technology leader in the field of interventional medicine by enabling FLIVUS and associated therapies in the interventional cardiology market. We expect to add the Novelis products and capability onto our s5i multi-modality integrated platform/hub.

On December 24, 2008, we acquired Axsun, a company that develops and manufactures optical monitors for telecommunications, lasers and optical engines used in medical OCT imaging systems and advanced photonic components and subsystems used in spectroscopy and other industrial applications. We believe Axsun’s

 

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proprietary OCT technology will provide us competitive advantages in the invasive imaging sector. In connection with the Axsun acquisition, we and Axsun were sued by LightLab. LightLab is a wholly owned subsidiary of Goodman, our distributor of IVUS and FM products in Japan, and LightLab develops and sells OCT products for cardiovascular imaging and other medical uses. We believe the complaint is without merit and we intend to opposed the preliminary injunction motion and intend to defend ourselves vigorously.

Financial Operations Overview

The following is a description of the primary components of our revenue and expenses.

Revenues. We derive our revenues primarily from the sale of our IVUS and FM consoles and single-procedure disposables. In 2008, 85.6% of our revenues were derived from the sale of our IVUS consoles and IVUS single-procedure disposables, as compared with 86.0% in 2007 and 85.8% in 2006. In 2008, 73.1% of our revenues were derived from the sale of our IVUS and FM single-procedure disposables, as compared with 74.9% in 2007 and 74.1% in 2006. Other revenues consist primarily of spare parts sales, service and maintenance revenues, shipping and handling revenues and license fees from Medtronic, a related party. Fukuda Denshi accounted for 14.2% of our revenues in 2006. Goodman accounted for 14.4%, 18.0%, and 15.0% of our revenues for the years ended December 31, 2008, 2007 and 2006, respectively.

Our sales in the United States are generated by our direct sales representatives and our products are shipped and billed to hospitals throughout the United States from our facility in Rancho Cordova, California. Our international sales are generated by our direct sales representatives or through independent distributors and are shipped and billed throughout the world from our facilities in Rancho Cordova, California, Zaventem, Belgium and Chiba, Japan.

We experienced a significant increase in our IVUS consoles, IVUS single-procedure disposables and FM single-procedure disposables revenues from 2008 compared with 2007, offset slightly by a decline in our FM consoles business which represents a shift towards our integrated IVUS console product offerings that incorporate the features of our FM consoles.

We expect to experience variability in our quarterly revenues from IVUS and FM consoles due to the timing of hospital capital equipment purchasing decisions, a condition which is inherent in our industry. Further, we expect variability of our revenues based on the timing of our new product introductions which may cause our customers to delay their purchasing decisions until the new products are commercially available. Alternatively, we may include in our arrangements with customers an obligation to deliver new products which are not yet commercially available. In these cases, we would be required to defer associated revenues from these customers until we have met our delivery obligations.

Cost of Revenues. Cost of revenues consists primarily of material costs for the products that we sell and other costs associated with our manufacturing process such as personnel costs, rent and depreciation. In addition, cost of revenues includes royalty expenses for licensed technologies included in our products, service costs, provisions for warranty, distribution, freight and packaging costs and stock compensation expense. We expect our gross margin for IVUS and FM products to improve if we are able to complete our ongoing efforts to streamline and improve our manufacturing processes and increase production volumes. We expect our overall gross margins to decrease due to the acquisition of Axsun and the lower gross margin on their product lines.

Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries and other related costs for personnel serving the sales, marketing, executive, finance, information technology and human resource functions. Other costs include travel and entertainment expenses, facility costs, trade show, training and other promotional expenses, professional fees for legal and accounting services and stock compensation expense. We expect that our selling, general and administrative expenses will increase as we continue to expand our sales force and marketing efforts and invest in the necessary infrastructure to support our continued growth.

 

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Research and Development. Research and development expenses consist primarily of salaries and related expenses for personnel, consultants, prototype materials, clinical studies, depreciation, regulatory filing fees, certain legal costs related to our intellectual property and stock compensation expense. We expense research and development costs as incurred. We expect our research and development expenses to increase as we continue to develop our products and technologies.

In-process Research and Development. In-process research development, or IPR&D, consists of our projects acquired in connection with acquisitions that had not reached technological feasibility and had no alternative future uses as of each acquisition date.

In December 2007, we acquired the OCT project in connection with our acquisition of CardioSpectra, which was valued at $26.3 million. In-vivo testing and regulatory approval remained to be completed as of the acquisition date at an estimated cost of $7.2 million. In addition, milestone payments of up to $38 million may be paid in connection with successful and timely regulatory approvals and commercialization. The OCT project was expected to be commercialized by late 2008. Our initial assessment of the stage of completion of the OCT project at the acquisition date was underestimated. As of December 31, 2008, the OCT project in-vivo testing had begun and commercialization was behind schedule by approximately two years. In addition, we expect additional costs to complete the OCT project of approximately $12 million. We believe the current schedule is attainable and consistent with deadlines associated with milestone payments. However, if the OCT project is not completed in a timely manner, such as if we experience delays associated with significant design changes that result from unsuccessful human trials or discoveries during human trials, we may jeopardize a potential competitive advantage, experience difficulties in obtaining our forecasted revenues and associated market share and we may not be required to pay some or all of the milestone payments.

In May 2008, we acquired the FLIVUS project in connection with our acquisition of Novelis, which was valued at $12.2 million. In-vivo testing and regulatory approval protocols remained to be completed for the FLIVUS project as of the acquisition date, at an estimated cost of $3.9 million. We expected the FLIVUS project to receive regulatory approvals and be commercialized during 2009. As of December 31, 2008, the project was on schedule. However, if the FLIVUS project is not completed in a timely manner, such as if we experience delays associated with significant design changes that result from unsuccessful human trials or discoveries during human trials, we may jeopardize a potential competitive advantage and experience a potential loss of revenues and associated market share.

In November 2008, we acquired an IPR&D project in connection with our acquisition of Impact Medical Technologies, LLC, a minor acquisition, valued at approximately $300,000.

The following table summarizes our significant IPR&D projects:

 

Project Name

   Fair Value    Estimated Cost to Complete,
as of acquisition date

OCT

   $ 26.3 million    $ 7.2 million

FLIVUS

     12.2 million      3.9 million

Amortization of Intangibles. Intangible assets, which consist of our developed technology, licenses, customer relationships, patents and trademarks, are amortized using the straight-line method over their estimated useful lives ranging from three to ten years.

Interest Income. Interest income is comprised of interest income earned from our cash and cash equivalents and our short-term available-for-sale investments.

Interest Expense. Interest expense is comprised primarily of interest expense on capital leases for the years ended December 31, 2008 and 2007. Interest expense is comprised primarily of interest expense on short-term debt and term loans for the year ended December 31, 2006.

 

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Exchange Rate Gain. Exchange rate gain is comprised of foreign currency transaction and remeasurement gains and losses, net.

Provision for Income Taxes. Provision for income taxes is comprised of state, local and foreign income taxes.

We have evaluated our ability to fully utilize the net deferred tax assets on an individual jurisdiction basis. For those jurisdictions in which we believe there is sufficient uncertainty surrounding the realization of deferred tax assets through future taxable income, we have provided a full valuation allowance and no current benefit has been recognized for the net operating loss and other deferred tax assets. Accordingly, deferred tax asset valuation allowances have been established at December 31, 2008, 2007 and 2006 to reflect these uncertainties. The federal net operating loss carryforwards begin to expire in 2020, the state net operating loss carryforwards begin to expire in 2012 and the foreign net operating loss carryforwards begin to expire in 2009, unless these net operating losses are previously utilized. We also have federal research and experimentation tax credits, which begin to expire in 2022, and state research and experimentation tax credits, which carry forward indefinitely.

Results of Operations

The following table sets forth items derived from our consolidated statements of operations for the years ended December 31, 2008, 2007 and 2006 presented in both absolute dollars (in thousands) and as a percentage of revenues:

 

     Years Ended December 31,  
     2008     2007     2006  

Revenues

   $ 171,495     100.0 %   $ 130,614     100.0 %   $ 103,048     100.0 %

Cost of revenues

     64,293     37.5       51,559     39.5       41,715     40.5  
                                          

Gross profit

     107,202     62.5       79,055     60.5       61,333     59.5  

Operating expenses:

            

Selling, general and administrative

     84,369     49.2       62,631     48.0       47,614     46.2  

Research and development

     26,690     15.6       20,315     15.6       16,923     16.4  

In-process research and development

     12,681     7.4       26,188     20.0       —       —    

Amortization of intangibles

     3,125     1.8       3,067     2.3       3,117     3.0  
                                          

Total operating expenses

     126,865     74.0       112,201     85.9       67,654     65.6  
                                          

Operating loss

     (19,663 )   (11.5 )     (33,146 )   (25.4 )     (6,321 )   (6.1 )

Interest income

     4,828     2.8       5,841     4.5       958     0.9  

Interest expense

     (113 )   (0.1 )     (199 )   (0.2 )     (4,013 )   (3.9 )

Exchange rate gain

     1,809     1.1       1,452     1.1       1,053     1.0  

Other, net

     54     0.1       —       —         18     0.0  
                                          

Loss before provision for income taxes

     (13,085 )   (7.6 )     (26,052 )   (19.9 )     (8,305 )   (8.1 )

Provision for income taxes

     620     0.4       524     0.4       298     0.3  
                                          

Net loss

   $ (13,705 )   (8.0 )%   $ (26,576 )   (20.3 )%   $ (8,603 )   (8.3 )%
                                          

 

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The following table sets forth our revenues by geography expressed as dollar amounts (in thousands) and the changes in revenues between the specified periods expressed as percentages:

 

     Years Ended December 31,    Percentage Change  
     2008    2007    2006    2007 to 2008     2006 to 2007  

Revenues (1):

             

United States

   $ 87,513    $ 66,411    $ 51,013    31.8 %   30.2 %

Japan

     43,582      35,186      30,082    23.9 %   17.0 %

Europe, the Middle East and Africa

     33,197      23,995      17,765    38.4 %   35.1 %

Rest of world

     7,203      5,022      4,188    43.4 %   19.9 %
                         
   $ 171,495    $ 130,614    $ 103,048    31.3 %   26.8 %
                         

 

(1) Revenues are attributed to geographies based on location of the customer, except for original equipment manufacturer revenues which are attributed to the geography of the legal entity invoicing.

The following table sets forth our revenues by product expressed as dollar amounts (in thousands) and the changes in revenues between the specified periods expressed as percentages:

 

     Years Ended December 31,    Percentage Change  
     2008    2007    2006    2007 to 2008     2006 to 2007  

IVUS:

             

Consoles

   $ 38,788    $ 26,847    $ 22,128    44.5 %   21.3 %

Single-procedure disposables

     107,963      85,538      66,268    26.2 %   29.1 %

FM:

             

Consoles

     1,280      2,064      1,954    (38.0 )%   5.7 %

Single-procedure disposables

     17,388      12,260      10,072    41.8 %   21.7 %

Other

     6,076      3,905      2,626    55.6 %   48.7 %
                         
   $ 171,495    $ 130,614    $ 103,048    31.3 %   26.8 %
                         

Comparison of Years Ended December 31, 2008 and 2007

Revenues. Revenues increased $40.9 million, or 31.3%, to $171.5 million in the year ended December 31, 2008, as compared to revenues of $130.6 million in the year ended December 31, 2007. In the year ended December 31, 2008, IVUS revenues increased $34.4 million, or 30.6%, as compared to the year ended December 31, 2007, which is comprised of an increase of $22.4 million, or 26.2%, from sales of our single-procedure disposable IVUS products and an increase of $11.9 million, or 44.5% in sales of our IVUS consoles. In the year ended December 31, 2008, FM revenues increased $4.3 million, or 30.3%, as compared to the year ended December 31, 2007, which is comprised of an increase of $5.1 million, or 41.8%, in sales of our single-procedure disposable FM products, which was partially offset by a decrease of $784,000, or 38.0%, in sales of our FM consoles. Other revenues increased $2.2 million, or 55.6%, due primarily to higher shipping and handlings revenues, increased IVUS console rentals, and the inclusion of Axsun revenues for the one week in December following the acquisition, partially offset by decreases in sales of distributed products following the termination of the distribution agreement with ev3. The increases in shipping and handling revenues were related to higher sales volumes. The increases in IVUS and FM revenues were primarily due to growth in the overall IVUS and FM markets and the launch of new products. In addition, revenues in the year ended December 31, 2008 were favorably impacted by $1.8 million in foreign currency translation, when compared to the year ended December 31, 2007. Increases in revenues were realized across all our key geographic markets.

 

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Cost of Revenues. Cost of revenues increased $12.7 million, or 24.7%, to $64.3 million, or 37.5% of revenues in the year ended December 31, 2008, from $51.6 million, or 39.5% of revenues in the year ended December 31, 2007. Gross margin was 62.5% of revenues in the year ended December 31, 2008, up from 60.5% of revenues in the year ended December 31, 2007. The increase in the cost of revenues was primarily due to higher sales volume. The increase in gross margin resulted primarily from an increase in the average selling prices of IVUS and FM disposables and a decrease in production costs of disposables products due to ongoing cost reduction initiatives and higher manufacturing capacity utilization, partially offset by higher distribution, service and depreciation costs.

Selling, General and Administrative. Selling, general and administrative expenses increased $21.7 million, or 34.7%, to $84.4 million, or 49.2% of revenues in the year ended December 31, 2008, as compared to $62.6 million, or 48.0% of revenues in the year ended December 31, 2007. The increase in the year ended December 31, 2008 as compared with the year ended December 31, 2007 was primarily due to increased headcount resulting from the expansion of our sales force, higher marketing expenses (largely the result of an increase in promotional activities and customer training expense), increased infrastructure expenses, $2.9 million of expenses related to an acquisition that was not consummated and higher stock-based compensation expense.

Research and Development. Research and development expenses increased $6.4 million, or 31.4%, to $26.7 million, or 15.6% of revenues in the year ended December 31, 2008, as compared to $20.3 million, or 15.6% of revenues in the year ended December 31, 2007. The increase in research and development expenses in the year ended December 31, 2008 was primarily due to higher costs associated with development of our OCT and FLIVUS products, increased stock-based compensation expense and increased clinical and regulatory costs in Japan.

In-process Research and Development. In-process research and development expenses were $12.7 million, or 7.4% of revenues in the year ended December 31, 2008. Of this amount, $12.2 million related to the acquisition of Novelis. In-process research and development expenses of $26.2 million in the year ended December 31, 2007 related to the acquisition of CardioSpectra.

Amortization of Intangibles. Amortization expense was relatively unchanged at $3.1 million, or 1.8% of revenues in 2008, as compared to $3.1 million, or 2.3% of revenues in 2007.

Interest Income. Interest income decreased $1.0 million, or 17.3%, to $4.8 million in the year ended December 31, 2008, as compared to $5.8 million in the year ended December 31, 2007. The decrease was primarily due to a decrease in our cash and cash equivalents and short-term available-for-sale investments, primarily related to the acquisitions of Novelis and Axsun, and a decrease in the weighted-average interest rate on our investments.

Interest Expense. Interest expense decreased $86,000, or 43.2%, to $113,000 in the year ended December 31, 2008, as compared to $199,000 in the year ended December 31, 2007. The decrease was entirely due to a reduction in debt balances. Interest expense during the year ended December 31, 2008 primarily related to our capital leases.

Exchange Rate Gain. Exchange rate gain for the year ended December 31, 2008 increased $357,000, or 24.6%, to $1.8 million, as compared to $1.5 million for the year ended December 31, 2007. The increase related primarily to the impact of the change in the U.S. Dollar to Euro exchange rate on the intercompany receivable between Volcano Corporation and Volcano Europe.

Provision for Income Taxes. Provision for income taxes for the year ended December 31, 2008 was $0.6 million, compared to a provision for income taxes of $0.5 million for the year ended December 31, 2007. The provision for income taxes consisted primarily of foreign income taxes and domestic state income taxes.

 

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Comparison of Years Ended December 31, 2007 and 2006

Revenues. Revenues increased $27.6 million, or 26.8%, to $130.6 million in 2007, as compared to revenues of $103.0 million in 2006. In 2007, a large part of our growth in revenues was derived from our IVUS disposable products with a $19.3 million increase in revenues attributable to higher sales volume of our single-procedure disposable IVUS products. We attribute the increase in IVUS disposable revenue to increased market penetration of IVUS in interventional procedures and gains in our market share world-wide. Additionally, for the year ended December 31, 2007, IVUS console revenue increased $4.7 million, or 21.3%, as compared with the same period in 2006. The increase in IVUS console revenue resulted primarily from an increase in the number of consoles sold. Increases in revenues were realized across all geographies.

Cost of Revenues. Cost of revenues increased $9.8 million, or 23.6%, to $51.6 million, or 39.5% of revenues in 2007, from $41.7 million, or 40.5% of revenues in 2006. Gross margin was 60.5% of revenues in 2007 as compared to 59.5% of revenues in 2006. The increase in gross margin percentage is largely due to an increase in the average selling price and a decrease in production cost of certain IVUS catheters, as well as an increase in the average selling prices for certain FM disposables. These factors were partially offset by average selling price reductions of s5i IVUS consoles, higher warranty expense and higher shipping expense.

Selling, General and Administrative. Selling, general and administrative expenses increased $15.0 million, or 31.5%, to $62.6 million, or 48.0% of revenues in 2007, as compared to $47.6 million, or 46.2% of revenues in 2006. The increase in 2007 as compared with 2006 is a result of higher payroll related costs due to increased headcount, higher stock compensation expense, higher marketing expenses, primarily related to attendance at trade shows, and new product launches, and an increase in corporate expenditures, including costs associated with our reporting obligations as a public company, including compliance with Sarbanes-Oxley.

Research and Development. Research and development expenses increased $3.4 million, or 20.0%, to $20.3 million, or 15.6% of revenues in 2007, as compared to $16.9 million, or 16.4% of revenues in 2006. The increase in research and development expenses in 2007 was due to higher payroll related costs associated with increased headcount, higher material costs related to increased consumption, higher clinical trial expenses, higher regulatory expenses primarily related to product introductions in Japan and higher stock compensation expense.

In-process Research and Development. In-process research and development was $26.2 million in 2007 and relates to our acquisition of CardioSpectra.

Amortization of Intangibles. Amortization expense was relatively unchanged at $3.1 million, or 2.3% of revenues in 2007, as compared to $3.1 million, or 3.0% of revenues in 2006.

Interest Income. Interest income was $5.8 million in 2007 as compared to $958,000 in 2006. Higher interest income, earned on our cash and cash equivalents and short-term available-for-sale investments, related to proceeds of our underwritten public offerings.

Interest Expense. Interest expense decreased $3.8 million, or 95.0%, to $199,000, or 0.2% of revenues in 2007, as compared to $4.0 million, or 3.9% of revenues in 2006. The decrease in interest expense in 2007 as compared to 2006 was attributable to lower average debt balances. Our average debt balances decreased primarily due to the repayment of $29.2 million of our senior subordinated debt and the repayment of $750,000 of our short-term debt in 2006.

Exchange Rate Gain. Exchange rate gain was $1.5 million on foreign exchange transactions in 2007 as compared to $1.1 million in 2006. The increase related primarily to the impact of the change in the U.S. Dollar to Euro exchange rate on the intercompany receivable between Volcano Corporation and Volcano Europe.

 

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Liquidity and Capital Resources

Sources of Liquidity

Historically, our sources of cash have included:

 

   

issuance of equity securities, including underwritten public offerings of our common stock, cash generated from the exercise of stock options and participation in our employee stock purchase plan;

 

   

cash generated from operations, primarily from the collection of accounts receivable resulting from product sales; and

 

   

interest income.

Our historical cash outflows have primarily been associated with:

 

   

cash used for operating activities such as the purchase and growth of inventory, expansion of our sales and marketing and research and development infrastructure and other working capital needs;

 

   

expenditures related to increasing our manufacturing capacity and improving our manufacturing efficiency;

 

   

capital expenditures related to the acquisition of equipment and other fixed assets;

 

   

cash used to repay our debt obligations and related interest expense; and

 

   

cash used for acquisitions.

Other factors that impact our cash inflow and outflow include:

 

   

significant increases in our product revenue, resulting in gross margins of 62.5%, 60.5%, and 59.5% in the years ended December 31, 2008, 2007, and 2006, respectively; and

 

   

fluctuations in our working capital due to timing differences of our cash receipts and cash disbursements.

At December 31, 2008, our cash and cash equivalents and short-term available-for-sale investments totaled $149.9 million. We invest our excess funds in short-term securities issued by corporations, banks, the United States government, municipalities, financial holding companies and in money market funds comprised of United States Treasury securities. We do not hold auction rate securities or securities backed by mortgages.

On October 23, 2007, we completed a follow-on underwritten public offering in which we sold 8,050,000 shares of our common stock, including 1,050,000 shares under an over-allotment option exercised by the underwriters. The follow-on offering, including the exercise of the over-allotment option, resulted in net proceeds to the Company of $122.8 million, after deducting offering expenses and underwriting discounts and commissions.

At December 31, 2008, our accumulated deficit was $104.3 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. Accordingly, prior to our initial public offering, we financed our operations and acquisitions primarily through the issuances of $62.5 million of preferred stock, $20.0 million of senior subordinated notes and $7.0 million of term loans. These issuances of equity and debt were supplemented with borrowings from a revolving credit facility and equipment financing arrangements. The issuances of our senior subordinated notes, term loans and revolving credit facility included warrants to purchase our Series B preferred stock, which automatically converted into warrants to purchase common stock upon the completion of our initial public offering, or our common stock. In May 2007 our revolving credit facility expired as scheduled.

 

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In connection with our acquisition of Axsun in December 2008, we assumed debt in the amount of $151,000. The debt was subsequently repaid in January 2009.

Cash Flows

 

     Years Ended December 31,  
     2008     2007     2006  

Net cash provided by (used in) operating activities

   $ 2,387     $ 4,236     $ (3,374 )

Net cash used in investing activities

     (27,688 )     (81,615 )     (23,166 )

Net cash provided by financing activities

     2,872       122,709       89,106  

Effect of exchange rate changes on cash and cash equivalents

     465       (155 )     (47 )
                        

Net (decrease) increase in cash and cash equivalents

   $ (21,964 )   $ 45,175     $ 62,519  
                        

Cash Flows from Operating Activities. Cash provided by operating activities of $2.4 million for 2008 reflected our net loss of $13.7 million, non-cash investment accretion of $652,000 and a gain on foreign exchange of $1.8 million. In addition, uses of cash include increases in accounts receivable of $10.5 million, inventory of $5.0 million and prepaid expenses and other current assets of $3.2 million. The increase in accounts receivable is due to the increased sales volume and timing of cash receipts, the increase in inventory is due to anticipated increased sales volume, the increase in prepaid expenses and other current assets is primarily due to payments made for future expenses. These amounts were offset by benefits realized from non-cash expenses consisting of in-process research and development expense of $12.7 million related primarily to the acquisition of Novelis, depreciation and amortization of $9.4 million and non-cash stock compensation expense of $9.5 million. In addition, sources of cash include accounts payable increases of $2.2 million related to the increase in inventory and timing of payments, accrued compensation increases of $3.1 million, primarily due to increased headcount and salary deferrals for the employee stock purchase plan, and deferred revenue increases of $301,000.

Cash provided by operating activities of $4.2 million for 2007 reflected our net loss of $26.6 million, non-cash investment accretion of $1.2 million and a gain on foreign exchange of $1.5 million. In addition, uses of cash include increases in accounts receivable $5.8 million, inventory of $7.7 million and prepaid expenses and other current assets of $1.9 million. The increase in accounts receivable is due to the increased sales volume and timing of cash receipts, the increase in inventory is due to anticipated increased sales volume and the increase in prepaid expenses and other current assets is primarily due to payments made for future expenses. These amounts were offset by non-cash expenses consisting of in-process research and development expense of $26.2 million related to the acquisition of CardioSpectra, depreciation and amortization of $7.9 million and non-cash stock compensation expense of $6.8 million. In addition, sources of cash include accounts payable increases of $2.2 million related to the increase in inventory and timing of payments, accrued compensation increases of $3.0 million, primarily due to increased headcount and salary deferrals for the employee stock purchase plan, and deferred revenue increases of $2.4 million.

Cash used in operating activities of $3.4 million for 2006 reflected our net loss of $8.6 million and a non-cash gain on foreign exchange of $1.1 million, offset by adjustments for non-cash expenses consisting primarily of depreciation and amortization of $8.5 million, interest capitalized as debt principal of $2.0 million, stock compensation expense of $3.2 million and the amortization and early pay-off of debt discount and deferred financing fees of $1.8 million. In addition, uses of cash include increases in accounts receivable of $5.1 million, inventory of $3.0 million, and a decrease in accounts payable of $2.7 million. These uses of cash are due to the timing of cash receipts and payments, as well as the increase in sales and manufacturing activity. These uses of cash were partially offset by a $1.5 million increase in accrued compensation expense resulting from an increase in accrued commissions, as a result of higher sales, and increased relocation costs.

Cash Flows from Investing Activities. Cash used in investing activities was $27.7 million in 2008, $81.6 million in 2007, and $23.2 million in 2006. In 2008, $103.0 million was used to purchase short-term

 

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available-for-sale securities, $15.5 million was used for the purchases of long term assets, including capital expenditures for medical diagnostic equipment and manufacturing equipment, and $29.7 million was used for acquisitions. These purchases were partially offset by $121.0 million from the sale or maturity of short-term available-for-sale investments.

In 2007, $105.8 million was used to purchase short-term available-for-sale securities, $25.2 million was used to purchase CardioSpectra and $9.1 million was used for purchases of long term assets including capital expenditures for medical diagnostic equipment and manufacturing equipment. These purchases were partially offset by $58.7 million from the sale or maturity of short-term available-for-sale investments.

In 2006, $17.9 million was used to purchase short-term available-for-sale investments and $5.0 million was primarily related to purchases of long term assets, including capital expenditures for medical diagnostic equipment and manufacturing equipment.

Cash Flows from Financing Activities. Cash provided by financing activities was $2.9 million in 2008, $122.7 million in 2007, and $89.1 million in 2006. Cash provided by financing activities in 2008 consisted primarily of proceeds from exercises of common stock options of $1.2 million and proceeds from the sale of common stock under our employee stock purchase plan of $1.6 million. Cash provided by financing activities in 2007 consisted primarily of $122.8 million in proceeds from our underwritten follow-on public offering and proceeds from exercises of common stock options of $1.7 million, partially offset by repayment of long-term debt of $1.8 million. Cash provided by financing activities in 2006 consisted primarily of the $121.3 million in net proceeds from our initial public offering and follow-on offering, partially offset by repayment of debt of $32.4 million.

Future Liquidity Needs

Our primary short-term needs for capital, which are subject to change, include expenditures related to:

 

   

medical diagnostic equipment that we own and place at our customers’ premises;

 

   

our facilities expansion needs, including costs of leasing additional facilities and associated tenant improvements;

 

   

the acquisition of equipment and other fixed assets for use in our current and future manufacturing and research and development facilities;

 

   

upgrades to our information technology infrastructure to enhance our capabilities and improve overall productivity;

 

   

support of our commercialization efforts related to our current and future products, including expansion of our direct sales force and field support resources in the United States and abroad, particularly in Japan where our strategy is to pursue a direct sales model;

 

   

the continued advancement of research and development activities;

 

   

improvements in our manufacturing capacity and efficiency; and

 

   

acquisitions of technologies that enhance our capabilities or compliment our markets.

Our capital expenditures are largely discretionary and within our control. We expect that our product revenue and the resulting operating income, as well as the status of each of our new product development programs, will significantly impact our cash management decisions.

At December 31, 2008, we believe our current cash and cash equivalents and our short-term available-for-sale investments will be sufficient to fund working capital requirements, capital expenditures, and operations for at least the next twelve 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. At the present time, we have no material commitments for capital expenditures.

 

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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, our sales and marketing programs, the continuing acceptance of our products in the marketplace, competing technologies and changes in the market and regulatory environment.

Our ability to fund our longer-term cash needs is subject to various risks, many of which are beyond our control—See “Risk Factors.” Should we require additional funding, such as 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, if at all.

At December 31, 2008, we have federal and state net operating loss carryforwards of approximately $71.5 million and $21.5 million, respectively, available to reduce future taxable income if we become profitable. Pursuant to Internal Revenue Code Section 382, use of net operating loss carryforwards related to acquisitions of approximately $29.0 million is limited. 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, future limitations on our ability to use net operating loss carryforwards and other minimum state taxes may increase our overall tax obligations.

Off-Balance Sheet Arrangements and Other Contractual Obligations

In conjunction with the sale of our products in the ordinary course of business, we provide standard indemnification to business partners and customers for losses suffered or incurred for patent, copyright or any other intellectual property infringement claims by any third parties with respect to our products. The term of these indemnification arrangements is generally perpetual. The maximum potential amount of future payments we could be required to make under these agreements is unlimited. At December 31, 2008, we have not incurred any costs to defend lawsuits or settle claims related to these indemnification arrangements.

The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2008 for each of the periods indicated (in thousands):

 

     Payment Due By Period

Contractual Obligations and Commercial Commitments

   Total    Less
Than

1 Year
   1-2
Years
   3-5
Years
   More
than

5 Years

Debt

   $ 151    $ 151    $ —      $ —      $ —  

Capital lease obligations (including interest)

     96      61      35      —        —  

Operating lease obligations (1)

     17,463      3,525      7,181      4,570      2,187

Minimum payments under license agreements (2)

     579      504      50      25      —  

Non-cancelable purchase commitments (3)

     13,928      13,928      —        —        —  
                                  

Total (4)

   $ 32,217    $ 18,169    $ 7,266    $ 4,595    $ 2,187
                                  

 

(1) We lease office space and have entered into other lease commitments in the United States as well as locations in Europe and Asia. Operating lease obligations include future minimum lease payments under all our non-cancelable operating leases at December 31, 2008.

 

(2) Our license agreements include provisions that require us to make milestone or royalty payments to the licensor based on the amount of future sales of covered products. Certain of these agreements require that the royalties we pay in a given year total at least a minimum amount as set forth in the agreements. The royalty obligations we may incur in excess of these minimum amounts are not included in the table above because we cannot, at this time, determine the timing or amount of these obligations.

 

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(3) Consists of non-cancelable commitments primarily for the purchase of production materials.

 

(4) The table above does not include potential milestone payments up to an aggregate of $38.0 million due to the former shareholders of CardioSpectra, $3.0 million potentially due to the former shareholders of Novelis (see “Acquisitions” note to our consolidated financial statements), and up to $4.1 million in payments for a clinical research support agreement which is billed as services are performed.

Critical Accounting Policies

Our financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP. 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’s most difficult, 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

In accordance with Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, we recognize revenues when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable and collectibility is reasonably assured. Revenue from the sale of our products is generally recognized when title and risk of loss transfers to the customer upon shipment, the terms of which are generally free on board shipping point. We use contracts and customer purchase orders to determine the existence of an arrangement. We use shipping documents and third-party proof of delivery to verify that title has transferred. We assess whether the fee is fixed or determinable based upon the terms of the agreement associated with the transaction. To determine whether collection is probable, we assess a number of factors, including past transaction history with the customer and the creditworthiness of the customer.

We frequently enter into sales arrangements with customers that contain multiple elements or deliverables, and for these 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 our products and services are 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, the determination of whether any undelivered elements are essential to the functionality of the delivered elements 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. The elements of a typical revenue arrangement can include a console, options for the console, single-procedure disposable products and a service and maintenance agreement.

We occasionally enter into agreements requiring cash payments to partners who are also customers. We apply the provisions of EITF 01-09, Accounting for Consideration Given by a Vendor to a Customer, to account for cash payments made under these agreements.

Inventory Valuation

We state our inventories at the lower of cost or market value, determined on a first-in, first-out basis. We provide inventory allowances when conditions indicate that the selling price could be less than cost due to obsolescence and reductions in estimated future demand. We balance the need to maintain strategic inventory

 

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levels with the risk of obsolescence due to changing technology and customer demand levels. Unfavorable changes in market conditions may result in a need for additional inventory reserves that could adversely impact our gross margins. Conversely, favorable changes in demand could result in higher gross margins when we sell products.

Valuation of Long-lived Assets

Our long-lived assets consist of property and equipment and intangible assets. Equipment is carried at cost and is depreciated over the estimated useful lives of the assets, which are generally three to five years, and leasehold improvements are amortized over the lesser of the lease term or the estimated useful lives of the improvements, which is between three and ten years. The straight-line method is used for depreciation and amortization. Intangible assets primarily consist of developed technology, customer relationships, licenses, and patents and trademarks, which are amortized using the straight-line method over periods ranging from three to ten years, representing the estimated useful lives of the assets. We capitalize external legal costs and filing fees associated with obtaining patents on our new discoveries and amortize these costs using the straight-line method over the shorter of the legal life of the patent or its economic life, generally ten years. Acquired intellectual property is recorded at cost and is amortized over its estimated useful life. We believe the useful lives we assigned to these assets are reasonable.

Goodwill and Intangible Assets

We account for goodwill and other intangible assets in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, or SFAS 142. The purchase method of accounting for acquisitions requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired. We use the discounted cash flow method to estimate the value of intangible assets acquired. The estimates used to value and amortize intangible assets are consistent with the plans and estimates that we use to manage our business and are based on available historical information and industry estimates and averages.

Intangible assets, consisting of acquired technology, licenses, patents and trademarks, and customer relationships, are amortized using the straight-line method over their estimated useful lives ranging from three to ten years.

SFAS 142 requires that goodwill and certain intangible assets be assessed for impairment on an annual basis, or more frequently if indicators of impairment exist, using fair value measurement techniques. The goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill to measure the amount of the impairment loss, if any. The implied fair value of goodwill is determined in the same manner as in a business combination. Determining the fair value of the implied goodwill is judgmental in nature and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of any such charge. Acquisitions which cause us to recognize goodwill and other intangible assets require us to make determinations that involve estimates and judgments about the value and recoverability of those assets.

We consider no less frequently than quarterly whether indicators of impairment of long-lived assets are present. These indicators may include, but are not limited to, significant decreases in the market value of an asset and significant changes in the extent or manner in which an asset is used. If these or other indicators are present, we determine whether the estimated future undiscounted cash flows attributable to the assets in question are less than their carrying value. If less than their carrying value, we recognize an impairment loss based on the excess of the carrying amount of the assets over their respective fair values. Fair value is determined by discounted future cash flows, appraisals or other methods. The evaluation of asset impairments related to long-lived assets require us to make assumptions about future cash flows over the life of the asset being evaluated which requires significant judgment. Actual results may differ from assumed or estimated amounts.

 

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Stock-based Compensation

Effective January 1, 2006, we began accounting for stock-based awards under the provisions of Statement of Financial Accounting Standards, or SFAS, 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 modified prospective method which requires the application of the accounting standard as of January 1, 2006. Our consolidated financial statements at and for the year ended December 31, 2006 reflect the impact of SFAS 123(R).

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-Merton option pricing model, or Black-Scholes model, to determine the fair value of each option grant to non-employees. See the “Stockholders’ Equity” note to our consolidated financial statements.

Stock Option Activity. The following table shows information concerning all options granted during the period January 1, 2006 through December 31, 2008:

 

     Number of Options
Granted
   Option Exercise
Price
   Fair Value of
Common Stock
on

Grant Date
   Intrinsic Value
Per

Share
Grant Date            

2006 Grants

           

February

   145,406    $ 10.56    $ 10.56    $ —  

May

   91,339      10.56      10.56      —  

July

   66,500      8.50      8.50      —  

November

   61,000      18.10      18.10      —  
             

Total 2006 grants

   364,245         
             

2007 Grants

           

January

   1,071,456    $ 19.15    $ 19.15    $ —  

April

   83,000      18.36      18.36      —  

June

   76,000      21.07      21.07      —  

July

   481,833      20.22      20.22      —  

October

   131,000      17.27      17.27      —  

December

   124,666      13.52      13.52      —  
             

Total 2007 grants

   1,967,955         
             

2008 Grants

           

January

   120,500    $ 12.02    $ 12.02    $ —  

February

   331,938      12.96      12.96      —  

April

   261,750      12.63      12.63      —  

May

   73,000      13.52      13.52      —  

June

   56,000      13.16      13.16      —  

July

   268,500      12.25      12.25      —  

October

   93,000      17.11      17.11      —  

November

   8,500      16.80      16.80      —  

December

   243,500      14.52      14.52      —  
             

Total 2008 grants

   1,456,688         
             

 

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Under SFAS 123(R), we have used the Black-Scholes model to estimate fair value of our stock-based awards which requires various judgmental assumptions including estimating stock price volatility, expected option 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 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.

Restricted Stock Unit Activity. Restricted stock unit, or RSU, activity for the year ended December 31, 2008 is as follows:

 

     Shares  

Non-vested shares subject to RSUs at December 31, 2007

   —    

Granted

   374,656  

Vested

   —    

Forfeitures or expirations

   (11,845 )
      

Non-vested shares subject to RSUs at December 31, 2008

   362,811  
      

These time-vested RSUs entitle the holder to shares of common stock as the units vest in equal annual installments over a four-year period. The weighted-average grant-date fair value of the RSUs granted during the year ended December 31, 2008 was $12.95.

Employee Stock Purchase Plan Activity. On June 7, 2007, our stockholders approved the adoption of our 2007 Employee Stock Purchase Plan, or the Purchase Plan. The Purchase Plan provides eligible employees the opportunity to purchase shares of Volcano Corporation common stock at the lower of up to 85% of the fair market value on the first or last day of the applicable offering period, by having withheld from their salary an amount up to 15% of their compensation, without paying brokerage fees or commissions on purchases. Our Purchase Plan is deemed to be compensatory, and therefore, Purchase Plan expense under SFAS 123(R) has been included in our consolidated statements of operations for the years ended December 31, 2008 and 2007. Volcano Corporation pays for the program’s administrative expenses. No employee may purchase more than $25,000 worth of common stock (calculated at the time the purchase right is granted) in any calendar year, nor may purchase more than 750 shares in any six-month purchase period. The Purchase Plan is administered by the Compensation Committee of the Board of Directors and the first offering period began on September 1, 2007.

The Purchase Plan provides for the purchase of up to an aggregate of 500,000 shares of common stock of the Company. Commencing January 1, 2008, common stock reserved for under the Purchase Plan automatically increases by the lower of 1  1/2% of our outstanding common stock or 600,000 shares on the first day of January of each year. As a result, on January 1, 2008, the number of shares of common stock reserved for issuance under the Purchase Plan increased by 600,000 shares to 1,100,000 shares.

During the year ended December 31, 2008, 151,013 shares were purchased at an average per share price of $10.36. No shares were purchased during the year ended December 31, 2007. The fair value of those purchase rights granted during the year ended December 31, 2008 and 2007, as defined by SFAS 123(R), was $3.64 and $4.70, respectively.

At December 31, 2008, 948,987 shares of common stock reserved for issuance under the Purchase Plan.

 

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Fair Value Assumptions. Under SFAS 123(R), the fair value of each option is estimated on the date of grant using the Black-Scholes model utilizing the following weighted-average assumptions:

 

     Years Ended
December 31,
 
     2008     2007     2006  

Risk-free interest rate

   2.88 %   4.67 %   4.76 %

Expected life (years)

   5.02     4.52     4.56  

Estimated volatility factor

   49.3 %   51.7 %   57.4 %

Expected dividends

   None     None     None  

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

For options granted January 1, 2006 through December 31, 2007, we adopted a temporary “shortcut approach” 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. For options granted after January 1, 2008, we estimated the expected term using our historical share option exercise experience.

Estimated volatility was calculated using the historical volatility of the common stock of comparable medical device companies using weekly price observations over a period generally commensurate with the expected term of our options. We did not exclude any period due to discrete historical events. We use the historical volatility of similar companies due to the limited trading history of our common stock. Since the completion of our initial public offering, we have also included the weekly price observations of our common stock, weighted for the number of price observations, in our estimate of volatility. We also evaluate, at least annually, whether circumstances have changed such that the identified entities are no longer similar to us, and remove or replace the peer company in our analysis. We will continue to assess the appropriateness of our methodology for future periods.

We use a zero value of the expected dividend value factor since we have not declared any dividends in the past and we do not anticipate declaring any dividends in the foreseeable future.

The first offering period under the Purchase Plan commenced in September 2007. Under SFAS 123(R), the fair value of each purchase option under the Purchase Plan is estimated at the beginning of this purchase period using the Black-Scholes model utilizing the following weighted- average assumptions:

 

     Years Ended
December 31,
     2008     2007     2006

Risk-free interest rate

   2.53 %   4.20 %   n/a

Expected life (years)

   0.5     0.5     n/a

Estimated volatility factor

   49.2 %   49.0 %   n/a

Expected dividends

   None     None     n/a

The computation of the expected volatility assumption used in the Black-Scholes model for purchase rights is based on the trading history of our common stock. The expected life assumption is based on the six-month term of each offering period. The risk-free interest rate is based on the United States Treasury constant maturity securities with the same or substantially equivalent remaining term in effect at the time of grant. We use a zero value of the expected dividend value factor for purchase rights since we have not declared any dividends in the past and we do not anticipate declaring any dividends in the foreseeable future.

 

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Under SFAS 123(R), we estimate forfeitures and only recognize expense for those shares expected to vest. Our estimated forfeiture rates in the years ended December 31, 2008, 2007, and 2006 are based on our historical forfeiture experience.

At December 31, 2008, we had approximately $18.2 million of unrecognized compensation cost remaining to be amortized over a weighted-average term of 2.7 years.

Income Taxes

We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Our deferred tax assets are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are expected to be recovered or settled.

The realization of our deferred tax assets, which had a gross carrying value of $37.6 million at December 31, 2008, is dependent upon our ability to generate sufficient future taxable income. We have evaluated our deferred tax assets on an individual jurisdiction basis. Within the United States and selected international jurisdictions, we have established a full valuation allowance against our deferred tax assets to reflect the uncertainty of realizing the deferred tax benefits. 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 utilization of tax attributes in the past, and the length of carryforward periods and evaluation of potential tax planning strategies. We expect to continue to maintain a full valuation allowance in the United States and selected international jurisdictions 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 in the respective jurisdictions.

Recent Accounting Pronouncements

In December 2007, the Emerging Issues Task Force (EITF) issued Issue No. 07-1, Accounting for Collaborative Arrangements (EITF 07-1). EITF 07-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, and shall be applied retrospectively to all prior periods presented for all collaborative arrangements existing as of the effective date. EITF 07-1 requires that transactions with third parties (i.e., revenue generated and costs incurred by the partners) should be reported in the appropriate line item in each company’s financial statement pursuant to the guidance in EITF Issue No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. EITF 07-1 also includes enhanced disclosure requirements regarding the nature and purpose of the arrangement, the rights and obligations under the arrangement, the accounting policy, the amount and the income statement classification of collaboration transactions between the parties. We are currently evaluating the impact that EITF 07-1 will have on our consolidated financial position and results of operations.

In December 2007, the Financial Accounting Standards Board, or FASB, issued SFAS No. 141 (Revised 2007), Business Combinations, or SFAS 141(R), which provides revised guidance on the acquisition of businesses. This standard changes the current guidance to require that all acquired assets, liabilities, minority interests and certain contingencies be measured at fair value, and certain other acquisition-related costs be expensed rather than capitalized. SFAS 141(R) also includes a substantial number of new disclosure requirements. SFAS 141(R) will apply to acquisitions that are effective after December 31, 2008. Application of the standard to acquisitions that are effective prior to that date is not permitted. SFAS 141(R) will have an impact on our consolidated financial statements if we are involved in a business combination on or after January 1, 2009.

In December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements-an Amendment of ARB No. 51, or SFAS 160. SFAS 160 establishes accounting and reporting standards for non-controlling interests in consolidated financial statements. SFAS 160 is effective for fiscal years

 

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and interim periods within those fiscal years, beginning on or after December 15, 2008 and early adoption is prohibited. We currently have no non-controlling interests that would require application of the pronouncement at the date of required implementation.

In February 2008, the FASB issued FASB Staff Position No. 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157, Fair Value Measurements, or SFAS 157, for nonfinancial assets and nonfinancial liabilities to fiscal periods beginning after November 15, 2008. As a result, we have delayed the application of SFAS 157 to our nonfinancial assets and nonfinancial liabilities, which include assets and liabilities acquired in connection with a business combination and intangible assets. We are currently evaluating the impact that SFAS 157 will have for nonfinancial assets and liabilities on our consolidated financial position and results of operations.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133, or SFAS 161. SFAS 161 requires enhanced disclosure related to derivatives and hedging activities and thereby seeks to improve the transparency of financial reporting. SFAS 161 is effective for fiscal years, and interim periods within those fiscal years, beginning after November 15, 2008 and early application is encouraged. We currently have no derivatives or hedging activities that would require application of the pronouncement at the date of required implementation.

In April 2008, the FASB issued a final FASB Staff Position on SFAS 142-3, Determination of the Useful Life of Intangible Assets, or FSP SFAS 142-3, which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets. FSP SFAS 142-3 will be effective for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. We are currently evaluating the impact that FSP SFAS 142-3 will have on our consolidated financial position and results of operations.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles, or SFAS 162. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of non-governmental entities that are presented in conformity with generally accepted accounting principles. SFAS 162 will become effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. We are currently evaluating the impact that SFAS 162 will have on our consolidated financial position and results of operations.

Inflation

We believe that inflation has not had a material impact on our historical results of operations; however, there can be no assurance that our business will not be affected by inflation in the future.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of changes in the value of market risk sensitive instruments caused by fluctuations in interest rates, foreign exchange rates and commodity prices. Changes in these factors could cause fluctuations in our results of operations and cash flows. In the ordinary course of business, we are exposed to interest rate and foreign exchange risk. Fluctuations in interest rates and the rate of exchange between the U.S. dollar and foreign currencies, primarily the Euro and Yen, could adversely affect our financial results.

Interest Rate Risk

Our exposure to interest rate risk at December 31, 2008 is related to the investment of our excess cash into highly liquid financial investments. At December 31, 2008, we held $149.9 million in cash and cash equivalents and short-term available-for-sale investments consisting of highly liquid financial investments with original maturities of one year or less. Based upon our balance of cash and cash equivalents and short-term

 

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available-for-sale investments, a decrease in interest rates of 100 basis points would cause a corresponding decrease in our annual interest income of approximately $1.5 million for these investments. Due to the nature of our highly liquid cash equivalents and short-term available-for-sale investments, a change in interest rates would not materially change the fair market value of our cash equivalents and short-term available-for-sale investments.

The primary objectives of our investment policy are to preserve principal, maintain proper liquidity to meet operating needs and maximize yields. Our investment policy specifies credit quality standards for our investments. Due to the short-term nature of our investments, we have assessed that there is no material exposure to interest rate risk arising from them.

Foreign Currency Exchange Risk

We are exposed to foreign currency risk related to our European and Japanese operations. We do not engage in hedging activities with respect to our foreign exchange risk. Fluctuations in the rate of exchange between the U.S. dollar and foreign currencies, primarily the Euro and the Yen, could adversely affect our financial results. Due to the wide range of scenarios involved with our foreign currency exchange risk, it is impracticable for us to quantify the effects that future fluctuations in the rate of exchange between the U.S. dollar and the Euro or the U.S. dollar and the Yen may have on our results of operations. During the year ended December 31, 2008, 19.4% of our revenues were denominated in the Euro, 10.7% of our operating expenses were denominated in the Euro and 4.5% of our operating expenses were denominated in Yen. Revenues from our Japanese operations are denominated in the U.S. Dollar. In addition, revenues were positively impacted by the valuation of foreign currencies, primarily the Euro, versus the U.S. dollar, particularly during the first three quarters of fiscal 2008. During the fourth quarter of 2008, the U.S. dollar strengthened versus the Euro. In periods of a strengthening U.S. dollar, our results of operations including the amount of revenue that we report in future periods could be negatively impacted. In April 2008, $22.6 million of intercompany receivable owed to Volcano Corporation from Volcano Europe was converted into equity, resulting in a decrease in the amount of Euro-based receivables being marked-to-market, thereby reducing the impact of the exchange rate fluctuation during the year.

 

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Item 8. Financial Statements and Supplementary Data

VOLCANO CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   67

Report of Independent Registered Public Accounting Firm

   68

Consolidated Balance Sheets at December 31, 2008 and 2007

   69

Consolidated Statements of Operations for the Years Ended December 31, 2008, 2007 and 2006

   70

Consolidated Statements of Convertible Preferred Stock and Stockholders’ Equity (Deficit) for the Years Ended December 31, 2008, 2007 and 2006

   71

Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006

   73

Notes to Consolidated Financial Statements

   74

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of Volcano Corporation

We have audited the accompanying consolidated balance sheets of Volcano Corporation as of December 31, 2008 and 2007, and the related consolidated statements of operations, convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Volcano Corporation at December 31, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 1 to the consolidated financial statements, in 2007 the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Volcano Corporation’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2009 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Sacramento, California

March 9, 2009

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of Volcano Corporation

We have audited Volcano Corporation’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Volcano Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

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

As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Axsun Technologies, Inc., which is included in the 2008 consolidated financial statements of Volcano Corporation and constituted $26,147,000 and $43,000 of total and net assets, respectively, as of December 31, 2008 and $578,000 and $38,000 of revenues and net income, respectively, for the year then ended. Our audit of internal control over financial reporting of Volcano Corporation also did not include an evaluation of the internal control over financial reporting of Axsun Technologies, Inc.

In our opinion, Volcano Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Volcano Corporation as of December 31, 2008 and 2007, and the related consolidated statements of operations, convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2008, and our report dated March 9, 2009 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Sacramento, California

March 9, 2009

 

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VOLCANO CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

     December 31,  
     2008     2007  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 100,949     $ 122,913  

Short-term available-for-sale investments

     48,941       66,205  

Accounts receivable, net

     41,795       27,976  

Inventories

     28,936       21,243  

Prepaid expenses and other current assets

     5,869       3,997  
                

Total current assets

     226,490       242,334  

Restricted cash

     327       365  

Property and equipment, net

     30,007       13,692  

Intangible assets, net

     15,636       9,385  

Goodwill

     842       —    

Other non-current assets

     2,177       798  
                

Total assets

   $ 275,479     $ 266,574  
                

Liabilities and Stockholders’ Equity

    

Current liabilities:

    

Accounts payable

   $ 14,867     $ 11,077  

Accrued compensation

     12,690       9,083  

Accrued expenses and other current liabilities

     10,745       6,600  

Deferred revenues

     5,872       5,360  

Short-term debt

     151       —    

Current maturities of long-term debt

     57       120  
                

Total current liabilities

     44,382       32,240  

Long-term debt

     34       78  

Deferred license fee from a related party

     875       1,125  

Other

     456       194  
                

Total liabilities

     45,747       33,637  

Commitments and contingencies (Note 6)

    

Stockholders’ equity:

    

Preferred stock, par value of $0.001; 10,000 shares authorized; no shares issued and outstanding at December 31, 2008 and 2007

     —         —    

Common stock, par value of $0.001; 250,000 shares authorized at December 31, 2008 and 2007; 47,883 and 46,957 shares issued and outstanding at December 31, 2008 and 2007, respectively

     48       47  

Additional paid-in capital

     337,063       324,746  

Accumulated other comprehensive loss

     (3,076 )     (1,258 )

Accumulated deficit

     (104,303 )     (90,598 )
                

Total stockholders’ equity

     229,732       232,937  
                

Total liabilities and stockholders’ equity

   $ 275,479     $ 266,574  
                

See notes to consolidated financial statements.

 

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VOLCANO CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 

     Years Ended December 31,  
     2008     2007     2006  

Revenues

   $ 171,495     $ 130,614     $ 103,048  

Cost of revenues

     64,293       51,559       41,715  
                        

Gross profit

     107,202       79,055       61,333  

Operating expenses:

      

Selling, general and administrative

     84,369       62,631       47,614  

Research and development

     26,690       20,315       16,923  

In-process research and development

     12,681       26,188       —    

Amortization of intangibles

     3,125       3,067       3,117  
                        

Total operating expenses

     126,865       112,201       67,654  
                        

Operating loss

     (19,663 )     (33,146 )     (6,321 )

Interest income

     4,828       5,841       958  

Interest expense

     (113 )     (199 )     (4,013 )

Exchange rate gain

     1,809       1,452       1,053  

Other, net

     54       —         18  
                        

Loss before provision for income taxes

     (13,085 )     (26,052 )     (8,305 )

Provision for income taxes

     620       524       298  
                        

Net loss

   $ (13,705 )   $ (26,576 )   $ (8,603 )
                        

Net loss per share—basic and diluted

   $ (0.29 )   $ (0.66 )   $ (0.41 )
                        

Shares used in calculating net loss per share—basic and diluted

     47,376       40,024       21,113  
                        

See notes to consolidated financial statements.

 

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VOLCANO CORPORATION

CONSOLIDATED STATEMENTS OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)

(in thousands)

 

    Designated
Series A
Convertible
Preferred
Stock
    Designated
Series B
Convertible
Preferred

Stock
    Designated
Series C
Convertible
Preferred

Stock
         Common Stock   Additional
Paid-In
Capital
    Deferred
Stock
Compensation
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income (loss)
    Total
Stockholders’
Equity
(Deficit)
 
    Shares     Amount     Shares     Amount     Shares     Amount          Shares   Amount          

Balance at December 31, 2005

  2,304       2,304     14,949       45,392     2,662       15,364         3,883     4     8,443       (2,888 )     (55,419 )     392       (49,468 )

Reversal of deferred stock compensation upon adoption of SFAS 123-R

                        (2,888 )     2,888           —    

Issuance of common stock under stock option plans

                  466     —       194             194  

Employee stock-based compensation cost

                        2,913             2,913  

Non-employee stock-based compensation cost

                        434             434  

Common stock issued in connection with public offerings

                  12,115     12     121,334             121,346  

Conversion of convertible preferred stock into common stock upon initial public offering

  (2,304 )     (2,304 )   (14,949 )     (45,392 )   (2,662 )     (15,364 )       18,123     19     63,041             63,060  

Exercise of warrants

                  3,133     3     (3 )        

Comprehensive loss

                             

Net loss

                            (8,603 )       (8,603 )

Foreign currency translation adjustments

                              (693 )     (693 )

Unrealized net loss on investments

                              (1 )     (1 )
                                   

Total comprehensive loss

                                (9,297 )
                                                                                               

Balance at December 31, 2006

  —       $ —       —       $ —       —       $ —           37,720   $ 38     193,468     $ —       $ (64,022 )   $ (302 )   $ 129,182  

Issuance of common stock under stock option plans

                  1,152     1     1,695             1,696  

Employee stock-based compensation cost

                        6,454             6,454  

Non-employee stock-based compensation cost

                        341             341  

Common stock issued in connection with public offerings

                  8,050     8     122,788             122,796  

Exercise of warrants

                  35     —               —    

Comprehensive loss

                             

Net loss

                            (26,576 )       (26,576 )

Foreign currency translation adjustments

                              (1,012 )     (1,012 )

Unrealized net gain on investments

                              56       56  
                                   

Total comprehensive loss

                                (27,532 )
                                                                                               

Balance at December 31, 2007

  —       $ —       —       $ —       —       $ —           46,957   $ 47   $ 324,746     $ —       $ (90,598 )   $ (1,258 )   $ 232,937  

 

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VOLCANO CORPORATION

CONSOLIDATED STATEMENTS OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)—(Continued)

(in thousands)

 

    Designated
Series A
Convertible
Preferred
Stock
  Designated
Series B
Convertible
Preferred
Stock
  Designated
Series C
Convertible
Preferred
Stock
       Common Stock   Additional
Paid-In
Capital
  Deferred
Stock
Compensation
  Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income (loss)
    Total
Stockholders’
Equity
(Deficit)
 
    Shares   Amount   Shares   Amount   Shares   Amount        Shares   Amount          

Issuance of common stock under stock option plans

                  671     1     1,205           1,206  

Issuance of common stock under employee stock purchase plan

                  151     —       1,565           1,565  

Employee stock-based compensation cost

                        9,317           9,317  

Non-employee stock-based compensation cost

                        230           230  

Exercise of warrants

                  104               —    

Comprehensive loss

                                —    

Net loss

                            (13,705 )       (13,705 )

Foreign currency translation adjustments

                              (1,830 )     (1,830 )

Unrealized net gain on investments

                              12       12  
                                   

Total comprehensive loss

                                (15,523 )
                                                                               

Balance at December 31, 2008

  —     $ —     —     $ —     —     $ —         47,883   $ 48   $ 337,063   $ —     $ (104,303 )   $ (3,076 )   $ 229,732  
                                                                               

See notes to consolidated financial statements.

 

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VOLCANO CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Years Ended December 31,  
     2008     2007     2006  

Operating activities

      

Net loss

   $ (13,705 )   $ (26,576 )   $ (8,603 )

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

      

In-process research and development expense

     12,681       26,188       —    

Depreciation and amortization

     9,357       7,902       8,480  

Amortization and write-off of debt discount and deferred financing fees

     —         102       1,781  

Accretion of investment discount, net

     (652 )     (1,195 )     —    

Interest capitalized as debt principal

     —         —         1,973  

Non-cash stock compensation expense

     9,527       6,795       3,195  

Gain on foreign exchange

     (1,809 )     (1,452 )     (1,052 )

Loss on disposal of long-lived assets

     70       222       —    

Changes in operating assets and liabilities, net of acquisitions:

      

Accounts receivable

     (10,487 )     (5,846 )     (5,078 )

Inventories

     (5,029 )     (7,659 )     (2,992 )

Prepaid expenses and other assets

     (3,185 )     (1,942 )     (399 )

Accounts payable

     2,151       2,217       (2,682 )

Accrued compensation

     3,131       2,980       1,505  

Accrued expenses and other liabilities

     36       110       283  

Deferred revenues

     301       2,390       465  

Deferred license fee from a related party

     —         —         (250 )
                        

Net cash provided by (used in) operating activities

     2,387       4,236       (3,374 )
                        

Investing activities

      

Purchase of short-term available-for-sale securities

     (103,029 )     (105,823 )     (17,853 )

Sale or maturity of short-term available-for-sale securities

     121,006       58,655       —    

Capital expenditures

     (15,474 )     (9,101 )     (4,990 )

Cash paid for acquisitions, net of cash acquired

     (29,711 )     (25,158 )     —    

Cash paid for other intangibles

     (480 )     (233 )     (373 )

Proceeds from sale of long-lived assets

     —         45       50  
                        

Net cash used in investing activities

     (27,688 )     (81,615 )     (23,166 )
                        

Financing activities

      

Proceeds from underwritten public stock offerings, net

     —         122,796       121,346  

Repayment of long-term debt

     (126 )     (1,774 )     (32,384 )

Proceeds from issuance of short-term debt

     —         —         750  

Repayment of short-term debt

     —         —         (750 )

Proceeds from sale of common stock under employee stock purchase plan

     1,565       —         —    

Proceeds from exercise of common stock options

     1,202       1,687       178  

Release of (increase in) restricted cash

     231       —         (34 )
                        

Net cash provided by financing activities

     2,872       122,709       89,106  

Effect of exchange rate changes on cash and cash equivalents

     465       (155 )     (47 )
                        

Net (decrease) increase in cash and cash equivalents

     (21,964 )     45,175       62,519  

Cash and cash equivalents, beginning of year

     122,913       77,738       15,219  
                        

Cash and cash equivalents, end of year

   $ 100,949     $ 122,913     $ 77,738  
                        

Supplemental disclosures

      

Interest capitalized as debt principal

   $ —       $ —       $ 1,973  

Cash paid for interest

   $ 113     $ 118     $ 259  

Cash paid for income taxes

   $ 643     $ 510     $ 71  

Non-cash investing and financing activities

      

Preferred stock converted into common stock upon initial public offering

   $ —       $ —       $ 63,060  

See notes to consolidated financial statements.

 

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VOLCANO CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Summary of Significant Accounting Policies

Our Company

Volcano Corporation (“we”, “us”, “our” or the “Company”), formerly Volcano Therapeutics, Inc., was incorporated under the laws of the State of Delaware on January 12, 2000. We design, develop, manufacture and commercialize a broad suite of intravascular ultrasound (“IVUS”) and functional measurement (“FM”) products that we believe enhance the diagnosis and treatment of vascular and structural heart disease. Our IVUS products consist of consoles, single-procedure disposable catheters and advanced functionality options and our FM products consist of pressure and flow consoles and single-procedure disposable pressure and flow guide wires. We are also developing ultra-high resolution Optical Coherence Tomography (“OCT”) systems and catheters, Forward-Looking IVUS (“FLIVUS”) systems and catheters and image-guided therapy products.

Basis of Presentation and Principles of Consolidation

Our consolidated financial statements include the financial statements of the Company and the financial statements of its wholly-owned subsidiaries, Volcano Japan Co. Ltd. (“Volcano Japan”), Volcano Europe S.A./N.V., formerly Volcano Therapeutics Europe (“Volcano Europe”), Axsun Technologies, Inc. (“Axsun”), and Volcano Therapeutics South Africa (Pty) Ltd., a wholly-owned subsidiary of Volcano Europe. The operating results associated with acquired entities have been included in our consolidated financial statements since the date of acquisition. All significant intercompany balances and transactions have been eliminated in consolidation.

Reverse Stock Split

On May 22, 2006, our Board of Directors and stockholders approved a 1-for-1.1 reverse split of our common stock and, on May 24, 2006, we filed a Certificate of Amendment to our Restated Certificate of Incorporation effecting the reverse split. All common share and per share amounts retroactively reflect the reverse stock split. Except as otherwise noted, references to preferred stock do not reflect the reverse stock split, as the conversion price for each series of preferred stock and the number of shares of common stock into which each share of preferred stock is convertible were adjusted, in accordance with the terms and conditions of such series of preferred stock, upon the filing of the Certificate of Amendment to reflect the reverse stock split.

Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Estimates are used for, but not limited to, the allowance for doubtful accounts, inventory reserves, depreciation and amortization, intangible assets, sales returns, business combinations, warranty costs, certain accruals, long-lived asset impairment calculations and contingencies. Actual results could differ materially from the estimates and assumptions we use in the preparation of our consolidated financial statements.

Foreign Currency Translation

The Euro is the functional currency of Volcano Europe, as it is the primary currency within the economic environment in which it operates. Assets and liabilities of Volcano Europe’s operations are translated into U.S. dollars at period-end exchange rates, and revenues and expenses are translated into U.S. dollars at average exchange rates in effect during each reporting period. Adjustments resulting from the translation are reported in other comprehensive loss.

 

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Exchange rate fluctuations resulting from the translation of the inter-company balances between Volcano Corporation U.S. and Volcano Europe and other non-U.S. dollar denominated liabilities into U.S. dollars are recorded as foreign currency transaction gains or losses and are included in exchange rate gain in the consolidated statement of operations. In April 2008, $22.6 million of intercompany receivable owed to Volcano Corporation from Volcano Europe was converted into equity, resulting in a decrease in the amount of Euro-based receivables being marked-to-market, thereby reducing the impact of the exchange rate fluctuation during the year.

The U.S. dollar is the functional currency of Volcano Japan, as it is the primary currency within the economic environment in which it operates. Yen-based assets and liabilities of our Japanese operations are remeasured into U.S. dollars at period-end exchange rates, and Yen-based expenses are converted into U.S. dollars at average exchange rates in effect during each reporting period. Adjustments resulting from the translation are recorded as foreign currency transaction gains or losses and are included in exchange rate gain in the consolidated statement of operations. We will continue to assess the appropriateness of the functional currency of Volcano Japan.

Financial Instruments

Our financial instruments include cash and cash equivalents, short-term available-for-sale investments, accounts receivable, accounts payable, certain other accrued liabilities and debt. The carrying amounts of cash and cash equivalents, short-term available-for-sale investments, accounts receivable, accounts payable, other accrued liabilities and debt approximate their fair values due to the short-term nature of those instruments.

Cash and Cash Equivalents

All highly liquid investments with a maturity of three months or less on the date of purchase are considered to be cash equivalents.

Short-term Available-for-Sale Investments

Our short-term available-for-sale investments consist of highly liquid financial investments with original maturities of greater than three months, but less than one year. All short-term investments are classified as available for sale and are recorded at market value using the specific identification method. Unrealized gains and losses are reflected in other comprehensive loss.

Restricted Cash

At December 31, 2008 and 2007, we had restricted cash totaling $327,000 and $365,000, respectively. Restricted cash consists of $200,000 at December 31, 2008 in certificates of deposit restricted as to withdrawal and serves as a security deposit for a leased facility that expires in 2010; $127,000 and $134,000 at December 31, 2008 and 2007, respectively, restricted as to withdrawal and serves as a security deposit for another leased facility pursuant to a lease that expires in 2013; and $231,000 at December 31, 2007 is in the form of collateral to a letter of credit issued to one of our principal landlords as a security deposit on a lease that expires in 2009. The letter of credit expired in October 2008 and was not renewed. The certificates of deposit and cash in bank will remain restricted as to withdrawal until such time as new lease agreements are executed.

Concentration of Credit Risk

Financial instruments which subject us to potential credit risk consist of our cash and cash equivalents, short-term available-for-sale investments, accounts receivable and short-term debt. We have established guidelines to limit our exposure to credit risk by placing investments with high credit quality financial institutions, diversifying our investment portfolio and placing investments with maturities that maintain safety

 

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and liquidity. We place our cash and cash equivalents with high credit quality financial institutions. Deposits with these financial institutions may exceed the amount of insurance provided; however, these deposits typically are redeemable upon demand and, therefore, we believe the financial risks associated with these financial instruments are minimal.

We perform ongoing credit evaluations of our customers, and generally we do not require collateral on our accounts receivable. We estimate the need for allowances for potential credit losses based on historical collection activity and the facts and circumstances relevant to specific customers and we record a provision for uncollectible accounts when collection is uncertain. To date, we have not experienced significant credit related losses.

Fukuda Denshi Co., Ltd. (“Fukuda Denshi”), a distributor in Japan, accounted for 14% of our revenues for the year ended December 31, 2006 and 14% of our trade receivables at December 31, 2006. Goodman Company, Ltd., a distributor in Japan, accounted for 14%, 18% and 15% of our revenues for the years ended December 31, 2008, 2007 and 2006, respectively, and 14% and 21% of our trade receivables at December 31, 2008 and 2007, respectively. No other single customer accounted for more than 10% of our revenues for any period presented and at December 31, 2008 and 2007, no other single customer accounted for more than 10% of our trade receivables.

In May 2008, we and Goodman mutually terminated our exclusive distribution agreements related to the distribution of our IVUS and FM products in Japan. We did not pay and we are not obligated to pay a fee in connection with this termination. Upon termination of our agreements with Goodman, we monitor the credit risk associated with Goodman as well as other general economic conditions and, accordingly, we have made and continue to make adjustments to the credit terms that are extended to Goodman.

We purchase integrated circuits and other key components for use in our products. For certain components, which are currently single sourced, there are relatively few sources of supply. Although we believe that other suppliers could provide similar components on comparable terms, establishment of additional or replacement suppliers cannot be accomplished quickly. Any significant supply interruption could have a material adverse effect on our business, financial condition and results of operations.

Inventories

Inventories are valued at the lower of cost (first-in, first-out basis) or market value (net realizable value or replacement cost).

Property and Equipment

Property and equipment is stated at cost, net of accumulated depreciation and amortization. Equipment and capitalized software are depreciated over the estimated useful lives of the assets (generally three to five years). Leasehold improvements are amortized over the lesser of the lease term or the estimated useful lives of the improvements, which is between three and ten years. The straight-line method is used for depreciation and amortization. Significant improvements which substantially extend the useful lives of assets are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.

Property and equipment includes certain medical diagnostic equipment that is located at customer premises. We retain the ownership of the equipment and have the right to remove the equipment if it is not being utilized according to expectations. Depreciation expense relating to this equipment of $1.7 million, $1.8 million and $1.8 million is recorded in cost of revenues during the years ended December 31, 2008, 2007 and 2006, respectively. The net book value of this equipment was $10.6 million and $4.8 million at December 31, 2008 and December 31, 2007, respectively. Also included in medical diagnostic equipment is property and equipment used for demonstration and evaluation purposes. Depreciation expense for equipment used for demonstration and evaluation purposes, recorded in selling, general and administrative expenses, totaled $1.2 million, $793,000, and