Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

 

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

For the fiscal year ended December 31, 2009

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)

3661 Valley Centre Drive, Suite 200   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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    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   þ
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, 2009 (which is the last business day of registrant’s most recently completed second fiscal quarter), as reported on the NASDAQ Global Market was approximately $311.4 million. Approximately 26.1 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, 2009 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, 2010, 49,700,997 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, 2009

TABLE OF CONTENTS

 

PART I

   2

Item 1.

 

Business

   2

Item 1A.

 

Risk Factors

   14

Item 1B.

 

Unresolved Staff Comments

   42

Item 2.

 

Properties

   42

Item 3.

 

Legal Proceedings

   43

Item 4.

 

Reserved

   43

PART II

   44

Item 5.

 

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

   44

Item 6.

 

Selected Financial Data

   46

Item 7.

 

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

   47

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

   66

Item 8.

 

Financial Statements and Supplementary Data

   68

Item 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   107

Item 9A.

 

Controls and Procedures

   107

Item 9B.

 

Other Information

   108

PART III

   109

Item 10.

 

Directors, Executive Officers and Corporate Governance

   109

Item 11.

 

Executive Compensation

   113

Item 12.

 

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

   141

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

   145

Item 14.

 

Principal Accounting Fees and Services

   146

PART IV

   148

Item 15.

 

Exhibits, Financial Statement Schedules

   148

SIGNATURES

   152

EXHIBIT INDEX

   153

EXHIBIT 10.23

  

EXHIBIT 10.26

  

EXHIBIT 10.27

  

EXHIBIT 10.29

  

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, or Annual Report, 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 our customers and 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 Annual Report. 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 Annual Report.

Volcano has registered and common law trademarks in the U.S. and elsewhere in the world including, but not limited to, Axsun®, ChromaFlo®, ComboMap®, ComboWire®, Eagle Eye®, PrimeWire®, Revolution®, s5™, s5i™ and SpinVision®. 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 consoles and single-use disposables that are used in the diagnosis and treatment of vascular disease. Our offerings include multi-modality consoles that provide intravascular ultrasound, or IVUS, and/or functional measurement, or FM, capabilities. We also offer IVUS and FM disposables for use on these consoles. We believe that these products enhance the diagnosis and treatment of vascular disease by improving the efficiency and efficacy of existing percutaneous interventional procedures, or PCI, in coronary and peripheral vessels. We market our products to physicians, nurses and technicians who perform and support these procedures in hospitals.

Our consoles have been designed to serve as a multi-modality platform for our digital and rotational IVUS catheters and can also include FM capabilities that support our fractional flow reserve, or FFR, pressure guide wires. We are developing additional offerings for integration into the platform, including IVUS-guided therapy catheters, Forward Looking IVUS, or FL.IVUS, catheters and ultra-high resolution Optical Coherence Tomography, or OCT, systems and catheters.

Our IVUS products consist of consoles, digital and rotational IVUS catheters and advanced imaging tools including virtual histology, or VH, IVUS tissue characterization and ChromaFlo stent apposition analysis. Our IVUS consoles are marketed as stand-alone or customized units that can be integrated into a variety of hospital-based interventional surgical suites called catheterization laboratories, or cath labs.

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 derive our revenues from two reporting segments: medical and telecommunications, or telecom. Our medical segment represents our core business, in which we derive revenues primarily from the sale of our multi-modality and FM consoles and our IVUS and FM single-procedure disposables. Our telecom segment derives

 

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revenues related to the sales of micro-optical spectrometers and optical channel monitors by Axsun Technologies, Inc., or Axsun, our wholly owned subsidiary, to telecommunication companies. We continue building direct sales capabilities in the United States, Western Europe, and Japan and have numerous distributor relationships in other geographies. During the year ended December 31, 2009, we generated worldwide revenues of $227.9 million, which is composed of $211.7 million from our medical segment and $16.2 million from our telecom segment, and incurred an operating loss of $30.8 million. Our total assets as of December 31, 2009 were $276.7 million. Our revenue, operating loss and total assets and other financial results for the last three fiscal years are described in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Consolidated Financial Statements” sections contained in this Annual Report. At December 31, 2009, we had a worldwide installed base of more than 5,000 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 77% of our medical segment revenues during the year ended December 31, 2009. In 2009, 48% of the Company’s revenues were generated in the United States, with the balance of sales occurring in international markets.

Our Strategy

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. In addition, we have a number of new offerings under development that will further leverage our multi-modality platform. Factors driving our strategy include:

 

   

Accelerating the trend toward 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 FM is instrumental in facilitating less invasive procedures.

 

   

Decreasing the number of interventional devices used per procedure and optimizing their usage. Our 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.

 

   

Improving ease of use of IVUS and FM 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.

 

   

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

 

   

Enhancing the outcomes of PCI 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.

 

   

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.

 

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Our goal is to establish our IVUS and FM products as the standard of care for PCI diagnostic and therapeutic procedures and expand the use of IVUS and FM for these 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. 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 and potentially other therapeutic devices, (2) FL.IVUS for applications including chronic total occlusions in the coronary and peripheral arteries, as well as other structural heart applications, (3) OCT light based imaging systems which we believe can be used in coronary, peripheral, and other vascular structures to image anatomy and other cellular activity, (4) micro-catheter 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 the VH IVUS technology that now forms the core of our ability to determine the composition of plaque from The Cleveland Clinic Foundation. We also acquired the intellectual property rights allowing us to develop our Revolution rotational catheter from Koninklijke Philips Electronics N.V., or Philips. 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. During 2008, we acquired Novelis, Inc., or Novelis, which is developing FL.IVUS technology; Impact Medical Technologies, LLC, which is developing innovative micro-catheter technologies; and Axsun which is a developer of optical and laser technologies. In May 2009, we agreed to distribute the Xtract thrombus aspiration catheter globally and in February 2010 we acquired the rights to the product line. We believe there will be additional opportunities to leverage these capabilities through select technology or company acquisitions as well as collaborations that enhance our capabilities or complement our markets.

Our Products

Our products include multi-modality and FM consoles, IVUS catheters, FM guide wires, thrombus aspiration devices, and various options that provide additional functionality. Our consoles are marketed as stand-alone units or units that can be integrated into cath labs. We offer consoles that combine IVUS and FFR technology, as well as systems that offer IVUS or FFR. Our s5i console is comprised of components that can be

 

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customized to each cath lab’s specifications and integrated into virtually any cath lab. The significantly expanded functionality of our offering enables the 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 the market adoption of our offering, and also expect our platform will support IVUS integrated with other interventional devices in the future.

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 devices to clinicians that are easy to use, require lower procedure times and provide a higher level of information. We have a family of consoles including our PC-based s5 and the IVUS In-Vision Gold, or IVG. The s5 family of consoles, which became our primary console product offering following its full commercial launch in July 2006, is smaller, lighter and less expensive to manufacture than our IVUS IVG console, and has enhanced functionality. The s5 family includes:

 

   

s5: This portable and mobile console is the lightest product on the market, and has a simple and easy user interface. The s5 weighs 95 pounds compared to greater than 300 pounds for our IVUS IVG console and Boston Scientific Corporation’s, or Boston Scientific, 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 acquiring 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 operate and interface solely with our family of IVUS consoles. We are the only company that offers both digital and rotational catheters. We believe this allows us to meet the needs of a greater number of physicians than our competitors. Each digital 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 uses, 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. We intend to develop additional functionality in the future. Currently, we offer:

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. 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 blood appears inside of the stent lumen. ChromaFlo can also help with the identification of luminal structures such as lumen border, bifurcations, dissections, and thrombus.

 

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VH IVUS. Conventional IVUS allows the visualization of atherosclerotic plaque. However, it is limited to a subjective, and therefore qualitative, review of vascular and plaque dimensions and composition. Our VH IVUS product allows, for the first time, easy to read and interpret IVUS images with color-coded identification of plaque composition. Additionally, a key element of the VH IVUS product is the capability to provide automatic identification 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 determine plaque vulnerability and therefore stratification of risk. We have developed fully functional devices for each of these technologies and used them in clinical studies. PROSPECT, a recent international multi-center study, demonstrated the ability to use VH IVUS to identify high-risk plaques that could potentially be treated to prevent future events, and low-risk plaques that may not need intervention. We are in the process of conducting several additional clinical studies to correlate plaque vulnerability to its clinical significance and risk and believe that these data will lead to further utilizization of VH IVUS to triage coronary lesions.

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 only from our guide wires. In addition, our FM products can be integrated with our s5 family of multi-modality consoles.

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.

Thrombus Aspiration

In May 2009, Volcano became the exclusive global distributor for the Xtract thrombus aspiration catheter. The unique features and multiple sizes of the Xtract catheter provide directional, fast, and powerful clot removal to help reestablish blood flow quickly during a heart attack. In February 2010, we purchased the rights to this product line. We believe that this addition to our product offerings is consistent with our strategy to provide therapeutic solutions aimed at PCI procedures whose outcomes are most challenging and disease states are most complex.

Product Expansion

We currently have a number of products under development that will leverage our existing platform technology and we believe will expand our presence in interventional medicine and related markets. Our product pipeline includes:

IVUS Guided Therapies

As more procedures become PCI-based, there is an opportunity to integrate the imaging capability of IVUS with coronary and peripheral therapeutic devices. We are developing IVUS guided therapy products that include IVUS guided stents and IVUS guided coronary and peripheral balloons. If commercialized, we believe these products will further expand and differentiate our product offering, drive IVUS utilization and enable us to participate in large endovascular market opportunities. 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 and structural heart disease applications.

 

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Forward Looking IVUS (FL.IVUS)

A principal area of focus for us is the development of our FL.IVUS 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 vasculature. Our strategy is to integrate these offerings into our s5 family of consoles and target markets such as chronic total inclusions and other coronary, peripheral and structural heart indications. We currently have two FL.IVUS products under development. The first provides forward looking ultrasonic guidance and will be used in conjunction with interventional guidewires to cross lesions. The second will incorporate this guidance capability with a therapeutic device that tunnels through lesions.

Optical Coherence Tomography (OCT)

In December 2007, we acquired OCT technology through our acquisition of CardioSpectra, which we expect to complement our existing product offerings and further enhance our position as an imaging technology leader in the field of interventional medicine. Since that time, the Volcano OCT system has generated positive results in several clinical studies in Europe and South America. We believe products based on this OCT technology 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 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. In December 2008, we acquired Axsun, a manufacturer of optical engines used in telecommunications, industrial spectroscopy and medical OCT imaging systems. In December 2009, Axsun announced the initial development and testing of a novel integrated light source for OCT imaging, the High Definition Swept Source, or HDSS. The HDSS is expected to enable high resolution at unprecedented speeds in medical imaging systems of 200 kHz—approximately 4 to 10 times faster than commercially available 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. We further expect the capabilities of our OCT technology will be highly valued by other device manufactures as they design and conduct clinical trials to assess the safety and effectiveness of new implantable devices.

Clinical Program

Our clinical studies are generally post-marketing studies using FDA-cleared and/or CE-marked products intended to provide data regarding diagnostic effectiveness and disease treatment outcomes, as well as the potential value of our products in providing therapy in markets and indications such as stent placement and optimization, vulnerable plaque detection and therapy guidance in the coronary and carotid arteries. The goal of our vulnerable plaque clinical program is to identify, risk assess, and guide PCI and pharmacologic (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 U.S. and in Europe. The objectives of the BLAST trial are to demonstrate that grayscale IVUS with VH offers more advanced diagnostic techniques to provide preinterventional knowledge of the amount, composition, and location of atherosclerotic plaque in both

 

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arterial branches, and 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 under expansion, and incomplete stent apposition. Enrollment commenced in November 2008. We have enrolled more than 100 patients in this trial as of the end of 2009.

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 an IVUS sub-study that will enroll 3,000 patients at sites in the U.S. 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 7,000 patients enrolled in the main study and over 1,500 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 100 patients enrolled at eight sites in the U.S. 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 2010.

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 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.

We have direct sales capability in the U.S., Western Europe and Japan. We intend to continue to increase our direct sales personnel. At December 31, 2009, we had a total of 230 direct sales and support professionals, including 144 in the U.S., 53 in Japan, 31 in Europe, and 2 in Asia. In addition, we have numerous distributor relationships in these and other geographies.

During 2009, we implemented programs to convert our sales strategy in Japan from a third-party distribution model to a direct distribution model and to increase our direct sales activity in Europe and the U.S. We have distribution relationships in Japan with Fukuda Denshi Co., Ltd., or Fukuda Denshi, and Johnson & Johnson K.K., Cordis Division, or Johnson & Johnson.

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

 

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At December 31, 2009, our global marketing team was comprised of 35 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.

Our relationships with physician thought leaders in interventional cardiology are an important component of our selling and marketing 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.

In the U.S., we sell our products directly to customers and through our third-party distribution and marketing agreements. Through August 2009, we sold our IVUS and FM products in Japan primarily through three direct distributors: Goodman Company Ltd., or Goodman, Fukuda Denshi and Johnson & Johnson. In August 2009, we terminated our distribution relationship with Goodman and implemented a direct sales program to replace that relationship. Fukuda Denshi continues to distribute our IVUS products to interventional cardiology accounts in Japan and Johnson & Johnson continues to distribute our IVUS disposable products for endovascular and peripheral applications in Japan. We currently support our Japanese customers through our Tokyo-based subsidiary, Volcano Japan Co., Ltd., or Volcano Japan. In Europe, we distribute our IVUS and FM products 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.

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:

 

    2009   Percent of
Total
Revenue
    2008   Percent of
Total
Revenue
    2007   Percent of
Total
Revenue
 

Revenues:

           

United States

  $ 110,502   48.5   $ 87,513   51.0   $ 66,411   50.9

Japan

    47,609   20.9     43,582   25.4     35,186   26.9

Europe, the Middle East and Africa

    52,339   23.0     33,197   19.4     23,995   18.4

Rest of world

    17,417   7.6     7,203   4.2     5,022   3.8
                                   
  $ 227,867   100.0   $ 171,495   100.0   $ 130,614   100.0
                                   

Approximately 59% of our long-lived assets, excluding financial assets, are located in the U.S., approximately 33% are located in Japan, and less than 10% are located in our remaining geographies.

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;

 

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apply our technology across products and markets;

 

   

successfully market our products;

 

   

develop proprietary products;

 

   

successfully conduct clinical studies that expand our markets;

 

   

obtain and maintain patent protection for our products;

 

   

obtain and maintain regulatory approvals;

 

   

achieve manufacturing efficiencies;

 

   

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, or Radi, 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.

Through our Axsun subsidiary, we compete on the basis of leading technology, high quality and the enhanced productivity that our products offer to customers in a variety of industries, including telecommunications, pharmaceutical manufacturing, high-speed industrial process control, chemical and petrochemical processing, medical diagnostics, and scientific discovery. Products developed by competitors based on lower performance tunable filter technology could compete on the basis of lower cost. In addition, customers may build similar functionality directly into their products. Our primary competitors in the telecommunications market include Optoplex Corporation, Aegis Lightwave, Inc. and BaySpec, Inc.

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.

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.

 

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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. For example, following our acquisition of Axsun in December 2008, we and Axsun were sued by LightLab Imaging, Inc., or LightLab. Additional information regarding our dispute with LightLab is provided in Note 4 “Commitments and Contingencies, Litigation” to our consolidated financial statements and 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, 2009, we had a broad portfolio of at least 458 owned or licensed U.S. and international patents and 258 pending applications for owned or licensed patents. Our patents expire at various dates through 2029. 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 and common law trademarks in the U.S. and elsewhere in the world including, but not limited to, Axsun®, ChromaFlo®, ComboMap®, ComboWire®, Eagle Eye®, PrimeWire®, Revolution®, s5™, s5i™ and SpinVision®. 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.

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, 2009, our research and development staff consisted of 120 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 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. 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 $37.4 million in 2009, $26.7 million in 2008, and $20.3 million in 2007. These totals include the research and development, clinical and regulatory affairs department expenses. In addition, we recognized in-process research and development expense of $14.0 million in 2009, $11.0 million related to additional development of our OCT project acquired from CardioSpectra and $3.0 million related to additional development of our FL.IVUS project acquired from Novelis; $12.7 million in 2008, related primarily to our acquisition of Novelis; and $26.2 million in 2007 related to our acquisition of CardioSpectra.

 

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Manufacturing

Our manufacturing facilities are located in Rancho Cordova, California, where we produce multi-modality consoles, FM consoles, IVUS catheters and FM guide wires, and Billerica, Massachusetts, where we produce our optical monitors, lasers, and optical engines used in OCT imaging systems as well as micro-optical spectrometers and optical channel monitors.

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 product testing to assure quality control. Our manufacturing strategy for our 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 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 for our IVUS and FM products 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. The control systems for our optical and laser products are certified under ISO 9001:2008. In February 2010, we started the process of recertification and we expect to remain in compliance with our certification.

Our IVUS and FM manufacturing 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 or requirements to recall or 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 medical device products are subject to extensive and rigorous regulation by the FDA, as well as other federal and state regulatory bodies in the U.S. and comparable authorities in other countries. We currently market our products in the U.S. under authorizations from the FDA, which are based on clearances of pre-market notification submissions, or 510(k); or approval of a premarket approval applications, or PMA. If we seek to market new products, or to market new indications for our existing products, we will be required to obtain 510(k) clearance or PMA approval.

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;

 

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product safety, testing, labeling and storage;

 

   

clinical trials;

 

   

record keeping;

 

   

product marketing, sales and distribution; and

 

   

post-marketing safety surveillance, complaint handling, investigating reports of adverse events and malfunctions, reporting of serious injuries, including deaths, repairs, and recall of products.

Failure to comply with applicable regulatory requirements can result in enforcement action by the FDA, which may be preceded by notices of deficiencies or noncompliance via inspectional observations on form FDA-483, or 483s, general correspondence known as “Untitled Letters,” and more formal letters called “Warning Letters.” If we do not adequately and appropriately address the cited deficiencies or noncompliance, including the repair, replacement or recall of affected products if necessary, within a reasonable period of time, the FDA may take any one or more the following actions, which could adversely affect our business:

 

   

order a mandatory recall;

 

   

physically seize the affected products;

 

   

seek a court-ordered injunction and consent decree that could include, but may not be limited to, operating restrictions, additional government oversight of our operations, specific corrective and preventative actions, and partial suspension or total shutdown of production;

 

   

suspend review or refuse to clear pending 510(k) submissions or approvals pending for new products, new intended uses, or modifications to existing products;

 

   

after notice and an opportunity for a hearing, withdraw 510(k) clearances or PMA approvals that have already been granted;

 

   

impose civil monetary penalties; and

 

   

initiate criminal prosecution.

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

Employees

At December 31, 2009, we had 969 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.

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.

 

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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.

 

Item 1A. Risk Factors

Risks Related to Our Business and Industry

We are dependent on the success of our consoles and catheters and cannot be certain that IVUS technology or our IVUS 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 a majority 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 but the penetration rate in the U.S. and Europe for the same type of procedure is relatively low. 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

 

   

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 competing products and services;

 

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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.

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, 2009, revenues to customers located in Europe, Middle East and Africa were $52.3 million and Japan were $47.6 million, representing approximately 23.0% and 20.9%, respectively, of our total revenues. As we expand internationally, particularly as a result of our direct sales efforts in Japan, 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 U.S. 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, U.S. export licenses and other required export or import licenses or approvals;

 

   

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.

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

 

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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. We have yet to generate sufficient revenues to sustain profitability. 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 period as an indication of our future operating performance. At December 31, 2009, we had an accumulated deficit of $133.3 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. Additionally, expenses will fluctuate as we make future investments in research and development, selling and marketing and general and administrative activities. This 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.

Competition from companies, particularly those 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 relative to alternative 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, sponsor or participate in clinical studies that expand our markets;

 

   

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. We also compete in Japan with respect to IVUS products with Terumo Corporation. Boston Scientific, St. Jude Medical, Inc., Terumo Corporation and other potential competitors who are substantially larger than us 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;

 

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greater experience in obtaining and maintaining 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 and other 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 may 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.

We also develop and manufacture optical monitors, lasers, and optical engines used in OCT imaging systems as well as micro-optical spectrometers and optical channel monitors with applications in telecommunications, pharmaceutical manufacturing, high-speed industrial process control, and chemical and petrochemical processing, medical diagnostics, and scientific discovery. Products developed by competitors based on tunable filter technology could compete on the basis of lower cost and other factors. In addition, customers may build similar functionality directly into their products, which in turn could decrease the demand for our OCT imaging systems and related products.

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 our products in the future, and we cannot guarantee that we will be able to compete successfully against them if they are commercialized.

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, FL.IVUS systems and catheters and image-guided therapy products. We have in the past, and may in the future, experience delays in various phases of product development and commercial launch, including during research and development, manufacturing, limited release testing, marketing and customer education efforts. In particular, developing and integrating products and technologies of acquired businesses is time consuming and in some cases resulted in longer developmental timelines than we initially anticipated. Any delays in our product launches may significantly impede our ability to successfully compete in the IVUS, FM, OCT, FL.IVUS and image-guided therapy markets and may reduce our revenues.

 

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

 

   

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

 

   

we do not achieve our objectives under our collaboration agreements;

 

   

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

 

   

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

 

   

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

 

   

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

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.

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:

 

   

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 or other medical problems;

 

   

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;

 

   

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

 

   

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;

 

   

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

 

   

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; 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, in December 2007, we acquired CardioSpectra, an OCT technology company, in May 2008, we acquired Novelis, a FL.IVUS technology company, and in December 2008, we acquired Axsun, a manufacturer of laser and optical engines used in medical OCT imaging systems and micro-optical spectrometers and optical channel monitors used in the telecommunications industry. We do not know if we will identify or complete any additional 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 inefficiencies 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 U.S. due to our acquisitions.

 

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We may also encounter risks, costs and expenses associated with any undisclosed or other unanticipated 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 negatively impact our operating results.

If our products and technologies are unable to adequately 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 products and 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. The PROSPECT study demonstrated the ability of IVUS and VH to stratify lesions according to risk. However, no randomized controlled trial has been performed to assess the benefit of treating or deferring treatment in these stratified lesions. 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.

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. Until October 2009, we did not engage in hedging activities with respect to our foreign currency exchange risk. In October 2009, we began using forward foreign exchange contracts to manage a portion of the foreign currency risk for foreign subsidiaries with monetary liabilities denominated in the yen and the euro. We do not engage in foreign currency hedging arrangements for our revenues or operating expenses, and, consequently, foreign currency fluctuations may adversely affect our revenues and earnings. Our hedges may not be effective and costs of the hedges may exceed their benefits. Fluctuations in the rate of exchange between the U.S. dollar and foreign currencies, primarily the euro and the yen, could require material amounts of cash to settle the hedge transactions. During 2009, 18.1% and 20.7% of our revenues were denominated in the euro and yen, respectively, 9.6% of our operating expenses were denominated in the euro and 11.4% of our operating expenses were denominated in the yen. Historically, revenues from our Japanese operations were primarily denominated in the U.S. dollar. Due to recent and anticipated increases in direct sales denominated in the Japanese yen as well as our transition to a direct sales effort in Japan, effective July 1, 2009, we changed the functional currency of Volcano Japan from the U.S. dollar to the Japanese yen. In 2009, the U.S. dollar weakened relative to the yen and strengthened relative to the euro. In periods of a strengthening U.S. dollar relative to the yen or euro, our results of operations could be negatively impacted.

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 U.S., Japan, Europe, Middle East and Africa, where we have generated most of our revenues, 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.

 

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In addition, 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 continue to decline as credit markets adjust to the national and global financial crisis. While our investment portfolio has experienced reduced yields, we have not yet experienced a deterioration of the credit quality of our holdings or other material adverse effects. If there is continued and expanded disruption in the credit markets, our investment portfolio could be adversely affected.

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.

If our transition to a direct sales force in Japan is not successful, then our business and results of operations may be materially and adversely affected.

A significant portion of our annual revenues has been derived from sales to Goodman, which was one of our key Japanese distributors. In 2007, 2008 and the first half of 2009, we generated revenues of $23.4 million, $24.7 million and $11.0 million, which accounted for approximately 18.0%, 14.4% and 4.8% of our revenues, respectively, from sales to Goodman.

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.

On July 8, 2009, the Company, Volcano Japan Co., Ltd., or Volcano Japan, and Goodman entered into a Distributor Termination Agreement, or the Termination Agreement, relating to the termination of certain agreements between Volcano and Volcano Japan, on the one hand, and Goodman, on the other hand, and the transition of the distribution of Volcano products in Japan from Goodman to Volcano Japan. Under the Termination Agreement, Goodman agreed to, among other things, (i) transfer title to all of Goodman’s inventory of IVUS and FM consoles and related disposable products to Volcano Japan, (ii) return to Volcano Japan the IVUS and FM consoles that Goodman leases from Volcano, (iii) transfer certain of its customer contracts, including contracts under which Goodman leases IVUS or FM consoles to customers, to Volcano Japan, and Volcano Japan agreed to assume the service obligations under such contracts, and (iv) not provide any service, support, product or technology that is competitive to the IVUS and FM products (excluding any Optical Coherence Tomography, or OCT, products) until December 31, 2009. Pursuant to the Termination Agreement, Volcano Japan made certain payments to Goodman in connection with such transfer and delivery to Volcano Japan of consoles in Goodman’s possession, and paid to Goodman commissions based on net receipts of Volcano Japan from the sale of products to sub-distributors and hospitals transferred as customers from Goodman to Volcano Japan during the period beginning July 1, 2009 and ending December 31, 2009.

As a result of the termination, we have incurred additional expenses sooner than initially planned. There is no assurance that we will be successful in completing our transition to a direct sales force in Japan and successfully place, sell and service our products in Japan. Our challenges and potential risks include, but are not limited to, (a) the successful retention and servicing of current Goodman customers in Japan, (b) strong market adoption of our technology in Japan, (c) the achievement of our growth and market development strategies in Japan, and (d) our ability to recruit, train and retain a direct sales force in Japan. Our efforts to successfully implement a direct sales strategy in Japan or the failure to achieve our sales objectives in Japan may adversely impact our revenues, results of operations and financial condition and negatively impact our ability to sustain and grow our business in Japan.

 

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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 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 supplier of FM wire pressure sensors ceased production of this key component on 4” wafers when they upgraded their production line to 6” wafers. In 2007, we secured an end-of-life purchase of the subject parts equivalent to an estimated four-year supply with the expectation that we would develop a new and improved pressure sensor on the 6” line to be available as a replacement in the FM pressure wire before the end of life inventory was depleted. However, as a result of a significant increase in FM wire sales, we have experienced increased usage and faster depletion of this sensor inventory. As a result, the FM pressure sensor supplier has agreed to produce additional inventory of the sensor using 4” wafers to address the potential shortfall in sensor supply while we complete the development of the new sensor. We believe this new supply of sensors using 4” wafers will provide us with adequate time to complete the development of the new sensor design. We expect that it will take approximately 12 months to complete design work and undertake the necessary testing and inspections before the new pressure sensors will be available as a replacement in the FM wire production.

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 12 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, in January 2007, 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 may not have sufficient inventory to meet our customers’ demands, which could negatively impact our revenues. In the event that EIT fails to supply the scanners, it would take us approximately six to 12 months to qualify a new supplier to manufacture these components.

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;

 

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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 with our suppliers for key components;

 

   

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 new manufacturing processes, making us vulnerable to production and supply problems that could negatively impact our revenues.

Through 2006, 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 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, during the first quarter of 2007, we implemented an automated system to replace the customized equipment, which is no longer produced or supported by a third party. While we believe that such 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 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.

During 2009, we also implemented lean manufacturing processes that attempt to optimize the timing of our inventory purchases and supply levels of our inventories. If we fail to plan for sufficient inventory, we may experience delays in the manufacturing of our products or fail to meet our customers’ demands, which could adversely affect our revenues and results of operations.

 

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If we do not manage our manufacturing capacity effectively, or if our facilities are damaged or destroyed, we may experience delays that could negatively 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 12 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. We have not made arrangements to obtain additional financing and our significant losses to date and the current national and global financial crisis may prevent us from obtaining additional funds on favorable terms, if at all.

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.

 

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

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, we may not realize the intended benefits or we may not be able to replace the arrangement on comparable terms.

If the third-party distributors that we rely on to market and sell our products are not successful, we may be unable to increase or maintain our level of revenues.

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 has been derived from sales to our Japanese distributors, primarily Goodman, Fukuda Denshi and Johnson and Johnson. In the year ended December 31, 2009, we generated revenues of $27.0 million, which accounted for approximately 11.8% of our revenues, from sales to our Japanese distributors. In July 2009, we formally terminated our distribution relationship with Goodman as part of our transition towards a direct sales model in Japan. We entered into an agreement with Fukuda Denshi in March 2006 that extended our commercial relationship through June 2012. In December 2006, we also entered into a memorandum of understanding relating to the distribution of our products by Johnson and Johnson. The memorandum of understanding continues on an annual basis unless either party indicates its intention to terminate, in writing, two months prior to expiration of the term.

A significant change in our relationship with our distributors or in the relationships among 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, 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 our net operating loss carryforwards. Should additional ownership changes occur in the future, our ability to utilize net operating loss carryforwards could be limited.

 

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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 or similar agreements with R. Scott Huennekens; our Chief Financial Officer, John T. Dahldorf; our Group President, Advanced Imaging Systems and Executive Vice President, Marketing and Business Development, Vince Burgess; our Executive Vice President, Global Sales, Jorge J. Quinoy; and Michel Lussier, President of Volcano Europe and Clinical and Scientific Affairs, but these agreements do not guarantee that they will remain employed by us in the future. For example, Mr. Burgess resigned from all positions with Volcano, effective March 5, 2010. 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 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.

Our product liability insurance covers our products and business operations, 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;

 

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injury to our reputation;

 

   

withdrawal of clinical study participants;

 

   

an inability to establish new strategic relationships;

 

   

increased product liability insurance rates; and

 

   

an inability to secure 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 or to make adequate, timely corrections, could lead to the imposition of injunctions, suspensions or loss of marketing clearances or approvals, product recalls, manufacturing cessation, termination of distribution, product seizures, civil penalties, or some combination of such actions. 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 clearance of a premarket notification submission, referred to as a “510(k),” or the approval of a premarket approval application, referred to as a “PMA.” The FDA will clear a 510(k) medical device if we demonstrate that the new or modified medical device is substantially equivalent to one or more 510(k)-cleared products. The PMA approval process is more costly and lengthy than the 510(k) clearance process and generally requires data from clinical trials to demonstrate that the product is safe and effective for its intended uses. We cannot guarantee the length of time the FDA will take to review a 510(k) or a PMA submission; nor can we guarantee that the FDA will clear or approve such submissions. If regulatory clearance or approvals are received, additional delays may occur related to manufacturing, distribution, or product labeling. In addition, we cannot assure you that any new or modified medical devices we develop will be eligible for the shorter 510(k) clearance process as opposed to the PMA process. To date, all of our products have qualified for marketing clearance through the 510(k) process. We have no experience in obtaining PMA approvals.

In the member states of the European Union there is a uniform system for the authorization of medical devices. The system of regulating medical devices under the Medical Devices Directive, or MDD, 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 MDD within their jurisdiction.

The means for achieving the requirements for a CE mark vary according to the nature of the device. Under the MDD, 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,

 

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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 European Union member states. If we fail to maintain compliance with the MDD, our products will no longer qualify for the CE mark and the relevant devices cannot be marketed in the European Union.

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 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 authorizations for these products. There is no assurance that U.S. or foreign regulatory bodies will accept the data from these clinical studies, or that the data would be adequate to support a marketing application, to show that the product meets applicable safety and efficacy standards, or that the applicable regulatory authority will ultimately grant market authorization for these products. Regulatory delays or failures to obtain marketing authorizations, including 510(k) clearances and PMA 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 or approvals are obtained.

Modifications to our products may require the submission of new 510(k) notifications, PMA applications, or other documents. If a modification is implemented to address a safety concern, we may also need to initiate a recall or cease distribution of the affected device. In addition, if the modified devices require the submission of a 510(k) or PMA and we distribute such modified devices without a new 510(k) clearance or PMA approval, we may be required to recall or cease distributing the devices. The FDA requires device manufacturers to initially make and document a determination of whether or not a modification requires a premarket submission and if it does, whether the submission should be a new PMA, PMA supplement, or 510(k). 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 clearance of a new 510(k) or approval of a new PMA submission 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 clearance of a new 510(k) or approval of a new PMA. If we begin manufacture and distribution of the modified devices and the FDA later disagrees with our determination and requires the submission of a new 510(k) or PMA for the modifications, we may also be required to recall the distributed modified devices and to stop distribution of the modified devices, which could have an adverse effect on our business. If the FDA does not clear or approve the modified devices, we may need to redesign the devices, which could also harm our business. When a device is marketed without a required clearance or approval, the FDA has the authority to bring an enforcement action, 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 the company’s corrective and preventive actions are inadequate to address the FDA’s concerns.

If a manufacturer determines that a modification to an FDA-cleared device could significantly affect its safety or effectiveness, or would constitute a major change in its intended use, then the manufacturer must seek and obtain clearance of a new 510(k) or, if applicable, an approval of a new PMA or PMA Supplement. Where we determine that modifications to our products require clearance of a new 510(k) or approval of a new PMA or PMA Supplement, we may not be able to obtain those additional clearances or approvals for the modifications or

 

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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.

The FDA is reviewing the 510(k) process and could change the criteria to obtain clearance which could affect our ability to obtain timely reviews and increase the resources needed to meet new criteria.

Over the past several years, concerns have been raised about whether the 510(k) program optimally achieves its intended goals. In light of these concerns, the FDA commissioned the Institute of Medicine, or IOM, to conduct an independent review of the program and, if necessary, to recommend administrative, regulatory, and/or statutory changes. Given that the IOM study is not expected to conclude until March 2011, the FDA has also convened an internal 510(k) Working Group to recommend possible actions that the FDA could take in the short term to strengthen the program, and to identify longer term options the FDA could consider to strengthen the 510(k) review process. To this end, the FDA held a public meeting entitled “Strengthening the Center for Devices and Radiological Health’s 510(k) Review Process” on February 18, 2010.

If the FDA makes changes to the 510(k) program, we may be required to prepare and submit more data and information than is currently required, which could require additional resources and more expense, require more time to prepare a submission, and result in a longer review period by the FDA. Such changes could adversely affect our business.

We are subject to federal, state, and foreign healthcare laws, and changes to such laws could adversely affect our business and results of operations.

In an effort to contain rising healthcare costs, the U.S. federal government and state governments are considering a number of comprehensive reform proposals that could significantly affect the payment for, and the availability of, healthcare services. Many of these proposals include fundamental changes to federal and state healthcare reimbursement programs. For instance, in 2009, the U.S. House of Representatives and the U.S. Senate adopted separate health reform proposals designed to expand access to affordable health insurance coverage and reduce federal spending on health care. In addition to establishing insurance purchasing “exchanges,” providing insurance subsidies, and expanding Medicaid eligibility, the House version would create a government-run health insurance option to compete with private plans. Both bills also would significantly reduce reimbursement for Medicare providers, which could result in reduced reimbursement for procedures using our products. The legislation also would impose a tax on manufacturers of medical devices and diagnostic products, to which we may be subject. It is uncertain whether Congress ultimately will enact a health reform bill, nor can we predict at this time the scope or impact of such legislation on the medical device industry in general, or on us in particular. If implemented, however, changes to the current U.S. healthcare laws, including a reduction in Medicare reimbursement rates, the establishment of a public health insurance option with potentially reduced reimbursement compared to private plans, the assessment of taxes on device manufacturers, and other policy changes, could materially and adversely impact our business and financial results. In the meantime, the ongoing uncertainty about federal healthcare reform efforts could have a negative impact on the purchasing decisions of our customers or on healthcare providers who perform procedures using our products. In addition, a number of foreign governments are also considering or have adopted proposals to reform their healthcare systems. Because a significant portion of our revenues from our operations is derived internationally, if significant reforms are made to the healthcare systems in other jurisdictions, our sales and results of operations may be materially and adversely impacted.

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

 

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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 some configurations of our s5 and s5i consoles. 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, was one of our Japanese distributors and had 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 raw materials used. Companies are not required by the revised law to withdraw 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 within a five-year timeframe, 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 filed new SHONIN applications for our IVUS catheters in 2009 and expect to file several new SHONIN applications for said products in 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 and regulations, the required content of the product approval application were greatly expanded. With the existing SHONINs, we relied on Fukuda Denshi’s and Goodman’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 the 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.

 

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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 must be in compliance 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 MDD—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 applicable regulations and standards, our operations could be disrupted and our manufacturing interrupted, and we may be subject to enforcement actions if our corrective and preventive actions are not adequate to ensure compliance.

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 any one or more of the following actions, including partial or total shut-down of our manufacturing operations unless and until adequate corrections are implemented, voluntary or FDA-ordered recall, FDA seizure of affected devices, court-ordered injunction or consent decree that could impose additional regulatory oversight and significant requirements and limitations on our manufacturing operations, significant fines, suspension or withdrawal of marketing clearances and approvals, 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.

We were inspected by the FDA in 2004, 2006, and 2009. The 2004 inspection resulted in two inspectional observations on Form FDA 483, which we promptly and adequately addressed. The 2006 inspection resulted in three inspectional observations on Form FDA 483, which we promptly and adequately addressed. The 2009 inspection resulted in one observation on Form FDA 483 which was annotated as corrected during the inspection. We 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 in approximately 2011; however, the FDA has the right to make unannounced inspections of our manufacturing facility at any time. We are not aware of, nor have we received notice of, any pending investigation or regulatory deficiency.

We were audited by the European Union Notified Body in December 2005, February 2007, June 2007, October 2007, and June 2008, June 2009 and July 2009. No major nonconformities were reported in the December 2005, February 2007, October 2007, June 2008, June 2009 and July 2009 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

 

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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 June 2009 audit resulted in one minor nonconformity and the July 2009 bi-annual microbiology audit resulted in no nonconformities. The full recertification audit is scheduled for April 2010. 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 in the future 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.

We were audited by Japan’s Pharmaceutical & Medical Device Administration, or PMDA, in December 2009. The purpose of this audit was to evaluate the Good Manufacturing Compliance (GMP) application section of currently pending SHONIN (approval) applications for phased array and rotational IVUS products. The PMDA issued two observations as a result of the audit. The formal communication of the observations was received in January 2010 and the response shall be submitted to the PMDA in February 2010.

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 or suspected. 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.

We are required to comply with medical device reporting, or MDR, requirements and must report certain malfunctions, deaths, and serious injuries associated with our products, which can result in voluntary corrective actions or agency enforcement actions.

Under the FDA MDR regulations, medical device manufacturers are required to submit information to the FDA when they receive a report or become aware 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.

Malfunction of our products could result in future voluntary corrective actions, such as recalls, including corrections, or customer notifications, or agency action, such as inspection or enforcement actions. Such malfunctions have been reported to us in the past. No injury to patients related to such malfunctions has been reported to us, but we can make no assurance that there will be no reports about past malfunctions or that any

 

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future malfunction 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 and preventive actions, we cannot guarantee that similar or different malfunctions will not occur in the future. If malfunctions do occur, we cannot guarantee that we will be able to correct the malfunctions adequately or prevent further malfunctions, in which case we may need to cease manufacture and distribution of the affected devices, initiate voluntary recalls, and redesign the devices; nor can we ensure that regulatory authorities will not take actions against us, such as ordering recalls, imposing fines, or seizing the affected devices. 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 a finding of failure to comply with such laws and regulations 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 criminal penalties, including large monetary penalties, damages, fines, imprisonment and exclusion from

 

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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, 2009, 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 U.S. Senate Committee on Finance and Senator Herb Kohl, Chairman, U.S. 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 have responded to 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 you 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 an 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. In addition, healthcare reform legislation proposed by the House and Senate would require medical device manufacturers, including us, to report and disclose a broad range of payments to physicians. Several states have adopted such reporting requirements, and additional states may adopt similar laws in the future. Voluntary industry guidelines also have been established regarding device manufacturer financial arrangements with health care professionals. There can be no assurances that such reporting and disclosure requirements will not impact our consulting arrangements or impose additional costs on our company.

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

 

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and the U.S. 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. Legislation, the Fraud Enforcement and Recovery Act of 2009, also was enacted in 2009 that further expands the scope of False Claims Act liability, facilitates whistleblower cases, and expands federal investigative tools in fraud cases. In addition, Congress is considering further expansion of federal fraud statutes as part of its health reform legislation, although it is uncertain at this time whether such legislation will be enacted and, if so, the specific provisions that would be adopted.

We also are subject to foreign fraud and abuse laws, which vary by country. For instance, 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 U.S., as well as in foreign countries, government-funded programs (such as Medicare and Medicaid) or private insurance programs, together commonly known as third-party payors, pay the cost of a significant portion of a patient’s medical expenses. 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 U.S. or outside, are developing increasingly sophisticated methods of controlling healthcare costs, through such mechanisms as limitations on covered items and services, prospective reimbursement, capitated payments, bundling of reimbursement for multiple services into a single payment, comparative effectiveness reviews, 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. Cost-containment programs adopted by third-party payers, including legislative and regulatory changes to coverage and reimbursement policies, could potentially limit the amount which healthcare providers are willing to pay for medical devices, which could adversely impact our business.

We believe that future coverage of and reimbursement for our products may be subject to increased restrictions both in the U.S. and in international markets. Third-party reimbursement and coverage for our products may not be available or adequate in either the U.S. or international markets. Future legislation, regulations, coverage or reimbursement policies adopted by third-party payors may adversely affect the growth of the IVUS and FM markets, reduce 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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We may be subject to health information privacy and security standards that include penalties for noncompliance.

The HIPAA statute and implementation regulations impose stringent requirements on covered entities to safeguard the privacy and security of individually-identifiable health information. Certain of our operations may be subject to these requirements, and we believe we are in compliance with the applicable standards. Penalties for noncompliance with these rules include both criminal and civil penalties. In addition, the Health Information Technology for Economic and Clinical Health Act, or HITECH Act, included in the American Recovery and Reinvestment Act of 2009, expanded federal health information privacy and security protections, including notification requirements for health data security breaches. Regulations to enforce the HITECH Act health information provisions were issued in October 2009. We cannot determine at this time the impact of the new policies on our operations.

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 U.S. environmental laws which we believe are, or may be, applicable include the 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 two linked environmental measures, 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 specified products placed on the market after July 1, 2006. Currently, the RoHS directive does not cover medical devices but it is possible that it may be amended to include such products and it is open to member states of the European Union to extend within their particular jurisdiction the list of products covered by the directive. In anticipation of a relevant directive

 

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amendment or an extension in individual member states, and under the company’s environmental policy, the company is working to ensure its compliance with the requirements of directive and that may involve incurring substantial costs to change our manufacturing processes, redesign or reformulate, and obtain substitute components for our products. 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 ensure RoHS compliance for certain products in the event of relevant changes in the law, we will not be able to offer our products within the European Union and if in breach we may be subject to civil or criminal liabilities.

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 recover and properly dispose of the equipment. The directive covers medical devices. We believe that our procedures in the European Union comply with the provisions of the WEEE directive. Compliance involves incurring ongoing expenses and those expenses could increase if compliance with the directive become more onerous. Penalties for failure to comply with the WEEE Directive differ across the European Union 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.

The European Union has also enacted the Registration, Evaluation, Authorisation & Restriction of Chemicals, or REACH, directive which requires registration with and notification to the European Chemicals Agency and the provision of information to customers if products placed on the market in the European Union exceed criteria related to the weight and release rate of certain chemicals. The products we produce and import into the European Union currently do not exceed these limits. Should the criteria change, we would incur additional costs in ensuring compliance.

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.

 

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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 U.S. 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 U.S. 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 U.S.

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 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 U.S. 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.

 

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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, FL.IVUS, 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.

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

 

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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’ earnings 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 U.S. 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;

 

   

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.

Additional 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, 2009, 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 or issuable in connection with past or any future acquisitions, would result in further dilution to investors. In particular, under the terms of the merger agreement with CardioSpectra, we have agreed to make additional payments of up to an aggregate of $38 million in the event certain milestones set forth in the merger agreement are achieved. The milestone payments would be payable, at the sole discretion of Volcano, in cash, shares of

 

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Volcano common stock, or a combination of both. The first milestone payments were made to the former CardioSpectra stockholders in January 2010 in the form of 609,360 shares of Volcano common stock and $531,000 of cash. Such shares are transferable in accordance with certain volume, notice and manner of sale restrictions under Rule 144 of the Securities Act of 1933. In addition, we have agreed to file, within 60 days after the first date on which Volcano issues any milestone shares, a registration statement with the Securities and Exchange Commission registering those shares for resale.

No prediction can be made regarding the number of shares of our common stock that may be issued or the effect that the 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, 2009, our directors, officers and principal stockholders each holding more than 5% of our common stock collectively controlled a majority of our outstanding common stock. To the extent our directors, officers and principal stockholders continue to hold a majority 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 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;

 

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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

The following table summarizes our principal facilities under lease as of December 31, 2009, the location and size of each such facility and their designed use.

 

Location

 

Purpose

  Square Feet
(Approximate)
  Term   Option(s) to
renew through

San Diego, California (1)

  Principal executive offices, marketing, administrative functions and research and development   31,686   July 2015   July 2018

Rancho Cordova, California

  Manufacturing operations and administrative functions   75,626   December 2014   December 2024

Rancho Cordova, California

  Research and development, marketing and regulatory operations   33,600   December 2014   December 2019

Rancho Cordova, California

  Production distribution operations   12,960   December 2014   December 2024

Rancho Cordova, California

  Shipping and receiving, quality inspection, systems refurbishment   13,705   December 2014   December 2024

Billerica, Massachusetts

  Axsun operations, research and development   64,784   October 2014   October 2019

Zaventem, Belgium

  Europe administrative functions, sales and product distribution   11,874   December 2011   n/a

Tokyo, Japan

  Japan sales operations and administrative functions   9,752   January 2012   n/a

 

(1) The square feet, term and renewal options reflect the terms of a lease agreement executed in January 2010. As of December 31, 2009, we had 22,000 square feet under lease through July 31, 2009.

 

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We also lease facilities in San Antonio, Texas; Forsyth County, Georgia; Andover, Massachusetts; and Cleveland, Ohio for various research and development activities; Alpharetta, Georgia and Woodmead, South Africa for sales administrative activities; and Tokyo, Japan for field service operations. Collectively, these facilities represent approximately 35,000 square feet of space. 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 are vacant and not utilized for our operations.

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

 

Item 3. Legal Proceedings

The information set forth under Note 4 “Commitments and Contingencies, Litigation” to our consolidated financial statements included in Part II, Item 8 of this Annual Report, is incorporated herein by reference.

 

Item 4. Reserved

 

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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

Year Ended December 31, 2009

     

First Quarter

   $ 12.51    $ 16.59

Second Quarter

     11.33      14.77

Third Quarter

     12.52      17.25

Fourth Quarter

     14.20      18.28

Year Ended December 31, 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

At March 1, 2010, the closing price of our Common Stock on the NASDAQ Global Market was $21.09 per share, and we had 90 stockholders of record.

 

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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, 2009 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.

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 2009.

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, 2009, 2008 and 2007, and the consolidated balance sheet data at December 31, 2009 and 2008 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, 2006 and 2005 and the consolidated balance sheet data at December 31, 2007, 2006 and 2005 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,  
     2009     2008     2007     2006     2005  

Consolidated Statement of Operations Data:

          

Revenues

   $ 227,867      $ 171,495      $ 130,614      $ 103,048      $ 91,900   

Cost of revenues

     91,489        64,293        51,559        41,715        47,843   
                                        

Gross profit

     136,378        107,202        79,055        61,333        44,057   

Operating expenses:

          

Selling, general and administrative

     111,598        84,369        62,631        47,614        35,365   

Research and development

     37,372        26,690        20,315        16,923        15,119   

In-process research and development (1)

     14,030        12,681        26,188        —          —     

Amortization of intangibles

     4,224        3,125        3,067        3,117        3,052   
                                        

Total operating expenses

     167,224        126,865        112,201        67,654        53,536   
                                        

Operating loss

     (30,846     (19,663     (33,146     (6,321     (9,479

Interest income

     756        4,828        5,841        958        458   

Interest expense

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

Exchange rate gain (loss)

     2,328        1,809        1,452        1,053        (859

Other, net

     —          54        —          18        —     
                                        

Loss before provision for income taxes

     (27,767     (13,085     (26,052     (8,305     (15,191
                                        

Provision for income taxes

     1,187        620        524        298        70   
                                        

Net loss

   $ (28,954   $ (13,705   $ (26,576   $ (8,603   $ (15,261
                                        

Net loss per share—basic and diluted

   $ (0.60   $ (0.29   $ (0.66   $ (0.41   $ (2.28
                                        

Shares used in calculating basic and diluted net loss per share

     48,400        47,376        40,024        21,113        6,693   
                                        

 

     At December 31,  
     2009    2008    2007    2006    2005  

Balance Sheet Data:

              

Cash and cash equivalents (1)

   $ 56,055    $ 100,949    $ 122,913    $ 77,738    $ 15,219   

Short-term available-for-sale investments

     66,028      48,941      66,205      17,787      —     

Working capital

     158,668      183,147      210,094      108,908      16,993   

Intangible assets, net (2)

     11,623      15,636      9,385      11,946      14,645   

Total assets

     276,734      275,479      266,574      154,725      68,468   

Short and long-term debt, including current maturities

     160      242      198      1,720      30,350   

Convertible preferred stock (3)

     —        —        —        —        63,060   

Total stockholders’ equity (deficit)

     214,815      229,732      232,937      129,182      (49,468

 

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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 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 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 products consist of multi-modality consoles which are marketed as stand-alone units or as 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 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 FL.IVUS, catheters, image-guided therapy catheters and ultra-high resolution Optical Coherence Tomography, or OCT, systems and catheters.

Our IVUS products include single-procedure disposable phased array and rotational IVUS imaging catheters and additional functionality options such as VH IVUS tissue characterization and ChromaFlo stent apposition analysis. Our FM offerings include FM consoles and single-procedure disposable 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 also develop and manufacture optical monitors, lasers, and optical engines used in OCT imaging systems as well as micro-optical spectrometers and optical channel monitors used in the telecommunications industry.

We have corporate infrastructure in the U.S., Europe and Japan; direct sales capabilities in the U.S.; and a combination of direct sales capabilities and distribution relationships in our primary international markets, including Japan, Europe, the Middle East, Canada, Asia Pacific and Latin America. Our corporate office is located in San Diego, California. Our worldwide manufacturing and research and development operations are located in Rancho Cordova, California. We also have additional research and development facilities in Cleveland, Ohio, Forsyth County, Georgia and San Diego, California. We have sales offices in Alpharetta, Georgia and Tokyo, Japan; sales and distribution offices in Zaventem, Belgium and Woodmead, South Africa; and third-party distribution facilities in Chiba, Japan and Tokyo, Japan. In addition, we have facilities in

 

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Billerica, Massachusetts for the manufacturing and operations of Axsun Technologies, Inc., or Axsun, our wholly owned subsidiary, and the research and development of OCT and FL.IVUS technology. In June 2009, we implemented a restructuring plan which we expect to complete by March 31, 2010 to close our facility in San Antonio, Texas and consolidate our OCT resources into our Billerica, Massachusetts facility.

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. At December 31, 2009, we had 969 employees worldwide, including 405 manufacturing employees, 265 sales and marketing employees and 120 research and development employees. 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. Beginning in the third quarter of 2009, we primarily sell our products directly to customers in Japan (see Recent Developments, Direct Sales Strategy in Japan below). We also have direct contractual relationships with Fukuda Denshi Co., Ltd., or Fukuda Denshi, and Johnson & Johnson K.K., Cordis Division, or Johnson & Johnson, through which our IVUS products are distributed in Japan. In certain 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.

At December 31, 2009, we had a worldwide installed base of over 5,000 consoles. We intend to grow and leverage this installed base to drive recurring sales of our single-procedure disposable catheters and guide wires. In the year ended December 31, 2009, the sale of our single-procedure disposable catheters and guide wires accounted for $162.5 million, or 76.8% of our medical segment revenues, a $37.1 million, or 29.6% increase from 2008, in which the sale of our single-procedure disposable catheters and guide wires accounted for $125.4 million, or 73.3% of our medical segment revenues.

We manufacture our multi-modality 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.

We completed an underwritten initial public offering on June 15, 2006 that resulted in net proceeds of $54.5 million; an underwritten follow-on offering on December 12, 2006 that resulted in net proceeds to the Company of $66.8 million; and an underwritten follow-on offering on October 23, 2007 that resulted in net proceeds to the company of $122.8 million.

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 significant. 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, Inc., or CardioSpectra. As a result, 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. OCT technology enables high resolution imaging of highly detailed structures in the vasculature, including vessel wall defects, intra-luminal thrombus and stent struts. Our long term goal is to integrate this OCT functionality into our s5 family of imaging products.

On May 15, 2008, we acquired Novelis, Inc., or Novelis, a company with proprietary ultrasonic visualization and therapy technology for minimally invasive diagnostic and therapeutic devices. Our acquisition

 

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of Novelis’ proprietary FL.IVUS technology platform is expected to help us 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 FL.IVUS and associated therapies in the interventional cardiology market. We expect to add these products and capability onto our s5 family of imaging products.

On December 24, 2008, we acquired Axsun Technologies, Inc., 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 sub-systems used in spectroscopy and other industrial applications. We believe Axsun’s proprietary OCT technology will provide us competitive advantages in the invasive imaging sector. Following the Axsun acquisition, we and Axsun were sued by LightLab Imaging, Inc., or LightLab, (see Note 4 “Commitments and Contingencies, Litigation” to our consolidated financial statements for more information regarding our dispute with LightLab).

Our revenues have increased from $130.6 million in 2007 to $171.5 million in 2008 and to $227.9 million in 2009. Our operating loss was $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. Our operating loss 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. Our operating loss increased to $30.8 million in 2009, which included an $11.0 million charge related to in-process research and development for a milestone of the CardioSpectra acquisition and a $3.0 million charge related to in-process research and development for a milestone of the Novelis acquisition. At December 31, 2009, our accumulated deficit was $133.3 million. Since our inception, we have not been profitable for a full fiscal year.

In the years ended December 31, 2009, 2008 and 2007, 38.9%, 19.4%, and 18.4%, respectively, of our revenues and 21.0%, 15.2%, and 11.5%, respectively, of our operating expenses were denominated in various non-U.S. dollar currencies, primarily the euro and the yen. We expect that a significant portion of our revenue and operating expenses will continue to be denominated in non-U.S. dollar currencies. As a result, we are subject to risks related to fluctuations in foreign currency exchange rates, which could affect our operating results in the future.

Economic conditions have continued to deteriorate significantly in many countries and regions, including without limitation the U.S., 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’ 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, 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.

Recent Developments

PROSPECT Study Results. In September 2009, results from the Providing Regional Observations to Study Predictors of Events in the Coronary Tree, or PROSPECT, trial, a natural history study sponsored by Abbott Vascular, a division of Abbott Laboratories, and co-funded by us, demonstrated that the measurements made using grayscale and VH IVUS had a statistically significant impact on study participants in determining the likelihood of a particular lesion type to cause a major adverse cardiac event, or MACE. Specifically, the highest risk PROSPECT plaque type, VH Thin Cap Fibroatheromas, or VH-TCFAs, with a minimum lumen area of less than or equal to 4mm2 and plaque burden greater than or equal to 70% were identified as having a 17.2% chance of causing a MACE within three years. We believe the results of the PROSPECT study demonstrate that VH IVUS has positive predictive value to identify high-risk plaques which supports more stenting in lesions not

 

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currently stented and negative predictive value to identify low-risk plaques which reduces stenting for those particular lesions. We believe this negative predictive value enables more targeted procedures and will contribute to the further adoption of our IVUS products.

FAME Study Results. In September 2009, published findings from the Fractional Flow Reserve versus Angiography for Multivessel Evaluation, or FAME, study demonstrated the potential of FFR in improving patient outcomes and reducing hospital costs. The FAME study’s results over a two year period demonstrated that patients in the study with multi-vessel coronary artery disease who were treated by FFR guidance had a 34% reduction in death and myocardial infarction compared to angiographic guidance alone. The FAME study also demonstrated that adhering to an FFR-guided regimen for multi-vessel disease can potentially provide cost benefits to the hospital and payers by reducing procedural costs and lowering average length of hospitalization. We believe these findings will continue to drive the growth and adoption of our disposable FFR wire products.

Direct Sales Strategy in Japan. Historically, we sold our products in Japan primarily through distributors. During the third quarter of 2009, we accelerated our direct sales strategy, our efforts to place and sell our products directly through an internal sales force, in Japan and we formally ended our distribution relationship with Goodman. On July 8, 2009, we entered into a Distributor Termination Agreement, or Termination Agreement, with Goodman that terminated certain agreements between us and Goodman effective August 31, 2009, and provided for the transition of the distribution of Volcano products in Japan to Volcano Japan Co. Ltd., or Volcano Japan. We believe that the termination of this relationship enables us to provide more focused service and support to the Japanese market, creates more favorable economics, including higher operating margins on the sale of Volcano products in Japan, and provides the ability for us to direct our own sales and marketing initiatives in Japan. Under the Termination Agreement, we paid Goodman 350 million Japanese yen and consumption tax (a total of approximately $3.9 million) during the third quarter of 2009 and Goodman transferred and delivered consoles owned by Goodman to us. In addition, we recorded approximately $3.7 million in expense related to commissions we agreed to pay Goodman as part of the transition plan. These commissions were paid on various dates through 2009 and the final payment was made during January 2010. As a result of the termination, we have incurred additional expenses sooner than initially planned. Our efforts to successfully implement a direct sales strategy in Japan or the failure to achieve our sales objectives in Japan may adversely impact our revenues, results of operations and financial condition. For additional information regarding the risks of our Goodman termination, see “Risk Factors—If our transition to a direct sales force in Japan is not successful, then our business and results of operations may be materially and adversely affected.” The aforementioned amounts related to the Termination Agreement have been converted to U.S. dollars from Japanese yen based on exchange rates in effect in August 2009, except for the commission expense which was converted using actual exchange rates in effect during the period.

Financial Operations Overview

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

Revenues. We derive our revenues from two reporting segments: medical and telecommunications, or telecom. Our medical segment represents our core business, in which we derive revenues primarily from the sale of our consoles and single-procedure disposables. Our telecom segment derives revenues related to the sales of Axsun’s micro-optical spectrometers and optical channel monitors to telecommunication companies. In the year ended December 31, 2009, we generated $227.9 million of revenues which is composed of $211.7 million from our medical segment and $16.2 million from our telecom segment. We experienced increases in revenues related to IVUS and FM single-procedure disposables from 2009 compared with 2008, while console sales remained relatively flat year over year. In the year ended December 31, 2009, 18.6% of our medical segment revenues were derived from the sale of our consoles, as compared with 23.4% in the year ended December 31, 2008. In the year ended December 31, 2009, IVUS single-procedure disposables accounted for 62.1% of our medical segment revenues, compared to 63.2% in 2008, while in the year ended December 31, 2009, 14.7% of our medical segment revenues were derived from the sale of our FM single-procedure disposables, as compared with 10.2% in the year ended December 31, 2008. Other revenues consist primarily of service and maintenance revenues,

 

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shipping and handling revenues, sales of distributed products, spare parts sales, and license fees. Goodman accounted for less than 10%, 14.4%, and 18.0% of our revenues for the years ended December 31, 2009, 2008 and 2007, respectively.

We expect to continue to experience variability in our quarterly revenues from console sales due in part to the timing of hospital capital equipment purchasing decisions. 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 future deliverables, such as unspecified hardware upgrades or training. In these cases, we would be required to defer associated revenues from these customers until we have met our future deliverables obligation.

Our medical segment sales in the U.S. are generated by our direct sales representatives and our products are shipped to hospitals throughout the U.S. from our facilities in Rancho Cordova, California and Billerica, Massachusetts. Our medical segment international sales are generated by our direct sales representatives or through independent distributors and are shipped throughout the world from our facilities in Rancho Cordova, California; Billerica, Massachusetts; Zaventem, Belgium; Chiba, Japan; Tokyo, Japan; and Woodmead, South Africa. Our telecom segment sales are generated by our direct sales representatives or through independent distributors and these products are shipped to telecommunications companies domestically and abroad from our facility in Billerica, Massachusetts.

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, depreciation and utilities. In addition, cost of revenues includes depreciation of company-owned consoles, royalty expenses for licensed technologies included in our products, service costs, provisions for warranty, distribution, freight and packaging costs and stock-based compensation expense. We expect our gross margin for IVUS and FM products to improve over time if we are successful in 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 generated by 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-based 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.

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-based 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, technologies and applications.

In-process Research and Development. In-process research and 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. Certain additional payments that may be required in connection with our acquisitions could result in future charges to IPR&D.

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 December 2009, we achieved a milestone specified in the CardioSpectra merger agreement related to the receipt of CE mark regulatory approval and $11.0 million became

 

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payable by us to the former stockholders of CardioSpectra. Although we have received CE mark approval for a preliminary version of our OCT product, this version is not intended to be commercialized. We believe there is significant incremental effort and costs that must be incurred to complete a product that is suitable for commercialization and there is significant risk that a commercializable product may not result from our efforts. As of December 31, 2009, we estimate that we will incur $7.2 million of additional costs in order to complete the OCT project for a total of approximately $15.4 million. The OCT project was originally expected to be commercialized by late 2008, however the OCT project was at an earlier stage of development than our initial assessment indicated. As of December 31, 2009, commercialization is not expected until early 2011. Accordingly, we have recorded $11.0 million to IPR&D expense related to the milestone for the year ended December 31, 2009. Additional milestone payments of up to $27.0 million may be paid in connection with successful and timely regulatory approvals and commercialization.

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 position, 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 FL.IVUS 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 FL.IVUS project as of the acquisition date, at an estimated cost of $3.9 million. In December 2009, we recorded $3.0 million of additional IPR&D expense related to the probable achievement of a regulatory approval for the FL.IVUS project. This represents a contractual milestone payment to be made to the former stockholders of Novelis. We expect to receive this regulatory approval in the first quarter of 2010. However, we believe there is significant incremental effort and costs that must be incurred to complete a product that is suitable for commercialization. As of December 31, 2009, we estimate that we will incur $4.5 million of additional costs in order to commercialize the first product using FL.IVUS for a total of $8.2 million. We originally expected the FL.IVUS project to receive regulatory approvals and be commercialized during 2009. As of December 31, 2009, the project was behind schedule by approximately one year.

If the FL.IVUS 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 our competitive position and experience a potential loss of revenues and associated market share and we may not be required to pay the milestone payment.

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 (in millions):

 

               Costs Incurred
Since Acquisition
   Estimated Cost to
Complete, as of
December 31, 2009
   Total Estimated
Costs to Complete
since Acquisition
Date
     As of Acquisition Date         

Project Name

   Fair
Value
   Estimated Cost to
Complete
        

OCT

   $ 26.3    $ 7.2    $ 8.2    $ 7.2    $ 15.4

FLIVUS

     12.2      3.9      3.7      4.5      8.2

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 lease obligations.

 

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Exchange Rate Gain. Exchange rate gain is comprised of foreign currency transaction and remeasurement gains and losses, net, and the effect of changes in value and net settlements of our foreign exchange forward contracts.

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, 2009 and 2008 to reflect these uncertainties. Our federal net operating loss carryforwards begin to expire in 2020 and our state net operating loss carryforwards begin to expire in 2012. Foreign net operating losses carry forward indefinitely. 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, 2009, 2008 and 2007 presented in both absolute dollars (in thousands) and as a percentage of revenues:

 

     Years Ended December 31,  
     2009     2008     2007  

Revenues

   $ 227,867      100.0   $ 171,495      100.0   $ 130,614      100.0

Cost of revenues

     91,489      40.2        64,293      37.5        51,559      39.5   
                                          

Gross profit

     136,378      59.8        107,202      62.5        79,055      60.5   

Operating expenses:

            

Selling, general and administrative

     111,598      48.9        84,369      49.2        62,631      48.0   

Research and development

     37,372      16.4        26,690      15.6        20,315      15.6   

In-process research and development

     14,030      6.1        12,681      7.4        26,188      20.0   

Amortization of intangibles

     4,224      1.9        3,125      1.8        3,067      2.3   
                                          

Total operating expenses

     167,224      73.3        126,865      74.0        112,201      85.9   
                                          

Operating loss

     (30,846   (13.5     (19,663   (11.5     (33,146   (25.4

Interest income

     756      0.3        4,828      2.8        5,841      4.5   

Interest expense

     (5   —          (113   (0.1     (199   (0.2

Exchange rate gain

     2,328      1.0        1,809      1.1        1,452      1.1   

Other, net

     —        —          54      0.1        —        —     
                                          

Loss before provision for income taxes

     (27,767   (12.2     (13,085   (7.6     (26,052   (19.9

Provision for income taxes

   $ 1,187      0.5      $ 620      0.4   $ 524      0.4
                                          

Net loss

   $ (28,954   (12.7 )%    $ (13,705   (8.0 )%    $ (26,576   (20.3 )% 
                                          

 

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The following table sets forth our revenues by segment and 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  
     2009    2008    2007    2008 to 2009     2007 to 2008  

Medical segment:

             

Consoles

   $ 39,438    $ 40,068    $ 28,911    (1.6 )%    38.6

Single-procedure disposables:

             

IVUS

     131,360      107,963      85,538    21.7      26.2   

FM

     31,125      17,388      12,260    79.0      41.8   

Other

     9,770      5,498      3,905    77.7      40.8   
                         

Sub-total medical segment

     211,693      170,917      130,614    23.9      30.9   

Telecom segment

     16,174      578      —      2,698.3      n/a   
                         
   $ 227,867    $ 171,495    $ 130,614    32.9   31.3
                         

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

 

     Years Ended December 31,    Percentage Change  
     2009    2008    2007    2008 to 2009     2007 to 2008  

Revenues (1):

             

United States

   $ 110,502    $ 87,513    $ 66,411    26.3   31.8

Japan

     47,609      43,582      35,186    9.2      23.9   

Europe, the Middle East and Africa

     52,339      33,197      23,995    57.7      38.3   

Rest of world

     17,417      7,203      5,022    141.8      43.4   
                         
   $ 227,867    $ 171,495    $ 130,614    32.9      31.3   
                         

 

(1) Revenues are attributed to geographies based on the location of the customer, except for shipments to original equipment manufacturers, which are attributed to the country of the origin of the equipment distributed.

Comparison of Years Ended December 31, 2009 and 2008

Revenues. Revenues increased $56.4 million, or 32.9%, to $227.9 million in the year ended December 31, 2009, as compared to revenues of $171.5 million in the year ended December 31, 2008. In the year ended December 31, 2009, revenues related to IVUS single-procedure disposables increased $23.4 million, or 21.7%, as compared to the year ended December 31, 2008, while revenues related to FM single-procedure disposables increased $13.7 million or 79.0% in the year ended December 31, 2009 as compared to the year ended December 31, 2008. Revenues related to console sales in the year ended December 31, 2009 were relatively flat as compared to the same period last year, as increases in console placements were partially offset by shifts in our customer mix. Overall, our revenue increases were driven by an increase in the number of PCIs performed, resulting in increased utilization of our single-procedure disposable products. Additionally, the increases in FM disposable revenues were primarily due to the broader availability of FFR technology as this functionality has been incorporated into our multi-modality console, in conjunction with an increased adoption of the technology based on recent clinical study data. Telecom segment revenues were $16.2 million in the year ended December 31, 2009. We had $578,000 of telecom segment revenues in the year ended December 31, 2008 as we acquired Axsun on December 24, 2008. Other revenues increased $4.3 million, or 77.7%, due primarily to higher service contract and rental revenues and the inclusion of Axsun medical segment revenues in the 2009 period, partially offset by lower sales of distributed products. Increases in revenues were realized across all our key geographic markets.

 

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Cost of Revenues. Cost of revenues increased $27.2 million, or 42.3%, to $91.5 million, or 40.2% of revenues in the year ended December 31, 2009, from $64.3 million, or 37.5% of revenues in the year ended December 31, 2008. Gross margin was 59.8% of revenues in the year ended December 31, 2009, down from 62.5% of revenues in the year ended December 31, 2008. The increase in the cost of revenues was primarily due to higher sales volume. The decrease in gross margin resulted primarily from the addition of lower margin products from Axsun, higher console depreciation and higher field service costs. These unfavorable gross margin impacts were partially offset by a decrease in the production costs of IVUS and FM disposable products due to ongoing cost reduction initiatives and higher manufacturing capacity utilization.

Selling, General and Administrative. Selling, general and administrative expenses increased $27.2 million, or 32.3%, to $111.6 million, or 48.9% of revenues in the year ended December 31, 2009, as compared to $84.4 million, or 49.2% of revenues in the year ended December 31, 2008. The increase in the year ended December 31, 2009 as compared with the year ended December 31, 2008 was primarily due to growth in our Japan operation to support our direct sales efforts there, increased headcount resulting from the expansion of our U.S. and Europe sales organizations, legal expenses related to the LightLab litigation, commission expenses related to the termination of our relationship with Goodman, increased infrastructure expenses to support company growth, inclusion of a full year of expenses from ongoing operations of Axsun and higher stock-based compensation expense. We acquired Axsun in December 24, 2008, therefore the year ended December 31, 2008 did not include significant expenses related to Axsun. These increases were partially offset by a decrease of $2.9 million in due diligence expenses that were incurred in the year ended December 31, 2008 related to an acquisition that was not consummated.

Research and Development. Research and development expenses increased $10.7 million, or 40.0%, to $37.4 million, or 16.4% of revenues in the year ended December 31, 2009, as compared to $26.7 million, or 15.6% of revenues in the year ended December 31, 2008. The increase in research and development expenses in the year ended December 31, 2009 was primarily due to the inclusion of a full year of expenses from ongoing operations of Novelis and Axsun, increased personnel related costs, increased spending on various product development projects and increased clinical trial and regulatory expenses. We acquired Axsun in December, 2008 therefore the year ended December 31, 2008 did not include significant expenses related to Axsun. We acquired Novelis was acquired in May 2008 therefore the year ended December 31, 2008 included approximately seven months of expenses relating to Novelis.

In-process Research and Development. IPR&D expenses were $14.0 million, or 6.1% of revenues in the year ended December 31, 2009. Of this amount, $11.0 million related to a milestone of our OCT project acquired from CardioSpectra and $3.0 million related to a milestone of our FL.IVUS project acquired from Novelis. IPR&D 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.

Amortization of Intangibles. Amortization expense increased to $4.2 million, or 1.9% of revenues in the year ended December 31, 2009, as compared to $3.1 million, or 1.8% of revenues in the year ended December 31, 2008. The increase in amortization expense is primarily related to the amortization of intangible assets acquired from Axsun.

Interest Income. Interest income decreased $4.1 million, or 84.3%, to $756,000 in the year ended December 31, 2009, as compared to $4.8 million in the year ended December 31, 2008. The decrease was primarily due to a decrease in the weighted-average interest rate on our investments and a decrease in our cash and cash equivalents and short-term available-for-sale investments.

Interest Expense. Interest expense decreased $108,000, or 95.6%, to $5,000 in the year ended December 31, 2009, as compared to $113,000 in the year ended December 31, 2008. The decrease was entirely due to a reduction in balances of our capital lease obligations. Interest expense during the years ended December 31, 2009 and 2008 primarily related to our capital lease obligations.

 

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Exchange Rate Gain. Exchange rate gain for the year ended December 31, 2009 increased $519,000, or 28.7%, to $2.3 million, as compared to $1.8 million for the year ended December 31, 2008. The increase was primarily a result of the fluctuation of the euro and the yen relative to the U.S. dollar and its related effect on the intercompany receivables between Volcano Corporation and Volcano Europe and Volcano Japan. Exchange rate gain was also favorably impacted by gains related to our foreign exchange forward contracts as a result of the hedging program we implemented during the fourth quarter of 2009.

Provision for Income Taxes. Provision for income taxes for the year ended December 31, 2009 was $1.2 million, compared to a provision for income taxes of $620,000 for the year ended December 31, 2008. The provision for income taxes consisted primarily of foreign income taxes and domestic state and local income taxes.

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, revenues related to sales of IVUS single-procedure disposables increased $22.4 million, or 26.2%, as compared to the year ended December 31, 2007. In the year ended December 31, 2008, revenues related to FM single-procedure disposables increased $5.1 million, or 41.8%, as compared to the year ended December 31, 2007. Console sales in the year ended December 31, 2008 increased by $11.2 million, or 38.6%, over revenues from console sales in the year ended December 31, 2007. Other revenues increased $1.6 million, or 40.8%, due primarily to higher shipping and handling revenues, increased IVUS console rentals, partially offset by decreases in sales of distributed products following the termination of the distribution agreement with ev3, Inc. 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.

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 in due diligence expenses that were incurred in the year ended December 31, 2008 relating 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 FL.IVUS products, increased stock-based compensation expense and increased clinical and regulatory costs in Japan.

 

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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 $620,000, compared to a provision for income taxes of $524,000 for the year ended December 31, 2007. The provision for income taxes consisted primarily of foreign income taxes and domestic state income taxes.

Liquidity and Capital Resources

Sources of Liquidity

Historically, our sources of cash have included:

 

   

Proceeds from the 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 that we own and place at our customer premises and other fixed assets;

 

   

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

 

   

cash used for acquisitions.

 

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Fluctuations in our working capital due to timing differences of our cash receipts and cash disbursements also impact our cash inflows and outflows.

We completed an underwritten initial public offering on June 15, 2006 that resulted in net proceeds of $54.5 million; an underwritten follow-on offering on December 12, 2006 that resulted in net proceeds of $66.8 million; and an underwritten follow-on offering on October 23, 2007 that resulted in net proceeds of $122.8 million.

At December 31, 2009, our cash and cash equivalents and short-term available-for-sale investments totaled $122.1 million. We invest our excess funds in short-term securities issued by corporations, banks, the U.S. government, municipalities, and financial holding companies and in money market funds comprised of U.S. Treasury and agency securities. We do not hold securities backed by mortgages.

At December 31, 2009, our accumulated deficit was $133.3 million. Since inception, we have generated significant operating losses and as a result we have not generated sufficient operating 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.

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,  
     2009     2008     2007  

Net cash (used in) provided by operating activities

   $ (1,651   $ 2,387      $ 4,236   

Net cash used in investing activities

     (44,383     (27,688     (81,615

Net cash provided by financing activities

     3,735        2,872        122,709   

Effect of exchange rate changes on cash and cash equivalents

     (2,595     465        (155
                        

Net (decrease) increase in cash and cash equivalents

   $ (44,894   $ (21,964   $ 45,175   
                        

Cash Flows from Operating Activities. Cash used in operating activities of $1.7 million for 2009 reflected our net loss of $29.0 million and non-cash investment amortization of $626,000. In addition, uses of cash include increases in accounts receivable and inventories of $8.9 million and $8.5 million, respectively, and a decrease of accounts payable of $1.1 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 decrease in accounts payable is primarily due to the timing of disbursements. These amounts were offset by benefits realized from non-cash expenses consisting of in-process research and development expense of $14.0 million related to milestones of the CardioSpectra and Novelis acquisitions, depreciation and amortization of $16.2 million and non-cash stock compensation expense of $10.9 million. In addition, sources of cash include an increase in accrued compensation of $1.4 million, primarily due to increased headcount and related accrued benefits, and an increase in accrued expenses and other current liabilities of $1.7 million primarily related to accrued commissions to Goodman and accrued legal costs for the LightLab litigation.

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 non-cash gain on foreign exchange of $1.8 million. In addition, uses of cash include increases in accounts receivable of $10.5 million, inventories of $5.0 million and prepaid

 

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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 and 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 non-cash gain on foreign exchange of $1.5 million. In addition, uses of cash include increases in accounts receivable $5.8 million, inventories 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 Flows from Investing Activities. Cash used in investing activities was $44.4 million in 2009, $27.7 million in 2008 and $81.6 million in 2007.

In 2009, $146.9 million was used to purchase short-term available-for-sale securities, $26.1 million was used for the purchases of long term assets, including capital expenditures for medical diagnostic equipment and manufacturing equipment. These purchases were partially offset by $129.1 million from the sale or maturity of short-term available-for-sale investments.

In 2008, $103.0 million was used to purchase short-term 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.

Cash Flows from Financing Activities. Cash provided by financing activities was $3.7 million in 2009, $2.9 million in 2008 and $122.7 million in 2007. Cash provided by financing activities in 2009 consisted primarily of proceeds from exercises of common stock options of $2.5 million and proceeds from the sale of common stock under our employee stock purchase plan of $2.1 million.

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 $122.7 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.

 

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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 U.S. and abroad, particularly in Japan where our strategy is to continue 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, 2009, 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 12 months. We intend to retain any future earnings to support operations and to finance the growth and development of our business, and we do not anticipate paying any dividends in the foreseeable future. At the present time, we have no material commitments for capital expenditures.

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—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.” 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, 2009, we have federal and state net operating loss carryforwards of approximately $68.0 million and $29.0 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.

 

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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, 2009, we have not incurred any costs to defend lawsuits or settle claims related to these indemnification arrangements.

In October 2007, we signed a clinical research support agreement with a third party in which the third party will conduct clinical studies concerning drug eluting stents. We have agreed to provide a total of $4.6 million to fund clinical study activities. At December 31, 2009, we have a remaining obligation of up to $3.9 million and we will be billed as services are performed under the agreement. In addition, we have entered into agreements with other third parties to sponsor clinical studies. Generally, we contract with one or more clinical research sites for a single study and no one agreement is material to our consolidated results of operations or financial condition. We are usually billed as services are performed based on enrollment and are required to make payments over periods ranging from less than one year up to three years. Our actual payments under these agreements will vary based on enrollment. At December 31, 2009, we estimate our contractual obligations related to these clinical studies are approximately $1.4 million over the next three years.

The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2009 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

Capital lease obligations (including interest)

   $ 209    $ 75    $ 134    $ —      $ —  

Operating lease obligations (1)

     19,404      5,148      8,261      5,995      —  

Non-cancelable purchase commitments (2)

     15,077      14,945      132      —        —  
                                  

Total (3)

   $ 34,690    $ 20,168    $ 8,527    $ 5,995    $ —  
                                  

 

(1) We lease office space and have entered into other lease commitments in the U.S. 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, 2009.

 

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

 

(3) The table above does not include milestone payments of up to an aggregate of $27.0 million which may be due to the former shareholders of CardioSpectra (see Note 2 “Acquisitions” to our consolidated financial statements) upon the achievement of certain milestones (and may, at our election, be payable in either cash or stock), and up to an estimated $1.4 million in payments for clinical studies which are billed as services are performed (see above).

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

 

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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, 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 Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, Topic 605-25, Multiple-Element Arrangements. 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 ASC Topic 605-50, Customer Payments and Incentives, to account for cash payments made under these agreements.

Fair Value

We record our short-term available-for-sale investments at fair value. At December 31, 2009, our cash and short-term available-for-sale investments totaled $122.1 million. FASB ASC Topic 820, Fair Value Measurements and Disclosures, or ASC 820, establishes three levels of inputs that may be used to measure fair value (see Note 3 “Financial Statement Details” to our consolidated financial statements included in this Annual Report). Each level of input represents varying degrees of subjectivity and difficulty involved in determining fair value. Valuations using Level 1 and 2 inputs are generally based on price quotations and other observable inputs in active markets and do not require significant management judgment or estimation. We utilize a third-party pricing service to assist us in obtaining fair value pricing for these investments. While pricing for these securities is based on proprietary models, the inputs used are based on observable market information, therefore we have classified our inputs as Level 1 and Level 2. We do not value any of our short-term available-for-sale investments using Level 3 inputs.

We also record our foreign exchange forward contracts at fair value. At December 31, 2009, the fair value of our foreign exchange forward contracts was recorded as assets totaling $190,000. We utilize a third-party broker to assist us in obtaining fair value pricing for these instruments. We classified these fair value inputs as Level 2.

 

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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 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 generally 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 FASB ASC Topic 350, Intangibles—Goodwill and Other, or ASC 350. 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.

ASC 350 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

 

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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.

Foreign Currency Translation

On July 1, 2009, we adopted the Japanese yen as the functional currency for Volcano Japan. Consistent with the considerations specified in FASB ASC Topic 830, Foreign Currency Matters, or ASC 830, the change was made to reflect recent developments with our Japan operations, including increases in direct sales denominated in the Japanese yen and growth in the local infrastructure that has enabled the day-to-day operations of Volcano Japan to become relatively self-contained and integrated into the Japanese economic environment. In accordance with ASC 830, assets and liabilities of Volcano Japan’s operations are translated into U.S. dollars at period-end exchange rates, revenues and expenses are translated into U.S. dollars at average exchange rates in effect during each reporting period, and adjustments resulting from the translation are reported on our consolidated balance sheet in accumulated other comprehensive loss. Due to the complexities and variability of foreign exchange rates between the U.S. dollar and Japanese yen, we are not able to estimate the financial effect this change will have on our future results of operations.

On October 1, 2009, approximately $23.4 million of intercompany receivable owed to Volcano Corporation from Volcano Japan was converted into a long-term investment, resulting in a decrease in the amount of yen-based receivables being marked-to-market. Our determination of the amount of long-term investment that would not be repaid for the foreseeable future is judgmental in nature and involved significant estimates and assumptions regarding future cash-flows. Actual results may vary.

Stock-based Compensation

We account for stock-based compensation under the provisions of FASB ASC Topic 718, Compensation—Stock Compensation, or ASC 718, which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors based on estimated fair values on the grant date. We adopted ASC 718 on January 1, 2006 using the modified prospective method. We estimate the fair value of stock-based awards on the date of grant using the Black-Scholes-Merton option pricing model, or Black-Scholes model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods using the straight-line method. We estimate forfeitures at the time of grant and revise our estimate in subsequent periods if actual forfeitures differ from those estimates. See Note 5 “Stockholders’ Equity” to our consolidated financial statements for a complete discussion of our equity compensation programs and the fair value assumptions used to determine our stock-based compensation expense.

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, risk-free interest rate, and expected option life. 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. For example, we granted stock options for 845,666 shares of our common stock during the year ended December 31, 2009. Using our assumptions, we calculated approximately $5.0 million of stock compensation expense related to these awards that will be amortized over four years. Given a ten percent change in our volatility assumption, the value of these awards would have differed by approximately $0.8 million. Given a one-hundred basis point change in our risk-free interest rate assumption, the value of these awards would have differed by approximately $0.2 million. Given a one year change in our expected option life assumption, the value of these awards would have

 

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differed by approximately $0.5 million. In addition, given a one-hundred basis point change in our weighted-average forfeiture rate assumption, our stock-compensation expense recorded in the year ended December 31, 2009 would have differed by approximately $50,000.

We apply the provisions of FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees, and use the Black-Scholes model to determine the fair value of each option grant to non-employees.

Income Taxes

We account for income taxes in accordance with FASB ASC Topic 740, 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 $42.3 million at December 31, 2009, 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 U.S. 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 U.S. 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 October 2009, the FASB issued Accounting Standards Update, or ASU, No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements, or ASU 2009-13, and ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements, or ASU 2009-14. ASU 2009-13 provides for two significant changes to the existing multiple-element revenue arrangements guidance. The first relates to the determination of when the individual deliverables included in a multiple-element arrangement may be treated as separate units of accounting. This change is significant as it will likely result in the requirement to separate more deliverables within an arrangement, ultimately leading to less revenue deferral. The second change modifies the manner in which the transaction consideration is allocated across the separately identified deliverables. ASU 2009-14 updates guidance on how entities account for revenue arrangements that contain both hardware and software elements. ASU 2009-13 and ASU 2009-14 are effective for us on January 1, 2011 and early adoption is permitted. We adopted ASU 2009-13 and ASU 2009-14 prospectively on January 1, 2010. Together, we expect these changes are likely to result in earlier recognition of revenue for our multiple-element arrangements than under previous guidance, however we do not expect these changes to have a material impact on our consolidated financial position or results of operations.

In April 2009, the FASB issued amendments to FASB ASC Topic 805, Business Combinations, or ASC 805, which requires that assets acquired and liabilities assumed in a business combination that arise from pre-acquisition contingencies be recognized at fair value, in accordance with ASC 820, if the fair value can be determined during the measurement period. If the fair-value of a pre-acquisition contingency cannot be determined during the measurement period, the contingency shall be recognized at the acquisition date in accordance with FASB ASC Topic 450, Contingencies. We will apply the guidance of ASC 805, as amended, to all of our future business combinations.

 

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Inflation

We do not believe that inflation has had a material impact on our historical results of operations; however, there can be no assurance that our business will not be materially 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, 2009 is related to the investment of our excess cash into highly liquid financial investments. At December 31, 2009, we held $122.1 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 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 $1.2 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. 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, 2009, 20.7% and 18.1% of our revenues were denominated in the yen and euro, respectively, and 11.4% and 9.6% of our operating expenses were denominated in the yen and euro, respectively. During the year ended December 31, 2009, revenues were unfavorably impacted by the valuation of the euro and favorably impacted by the valuation of the yen, as compared to the U.S. dollar. 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.

Exchange rate fluctuations resulting from the translation of the inter-company balances between Volcano Corporation, our U.S. entity, and Volcano Japan; and Volcano Corporation 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. On October 1, 2009, approximately $23.4 million of intercompany receivable owed to Volcano Corporation from Volcano Japan was converted into a long-term investment, resulting in a decrease in the amount of yen-based receivables being marked-to-market. 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. These conversions thereby reduce the impact of the exchange rate fluctuations in our consolidated statements of operations.

Through September 30, 2009, we did not engage in hedging activities with respect to our foreign currency exchange risk. Commencing October 2009, we began using foreign exchange forward contracts to manage a

 

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portion of the foreign currency risk for foreign subsidiaries with monetary assets and liabilities denominated in the yen and the euro. We only use derivative financial instruments to reduce the risk that our earnings and cash flows will be adversely affected by changes in exchange rates; we do not hold any derivative financial instruments for trading or speculative purposes. We primarily use foreign exchange forward contracts to hedge foreign currency exposures, and they generally have terms of one year or less. Realized and unrealized gains or losses on the value of financial contracts used to hedge the exchange rate exposure of these monetary assets and liabilities are also included in the determination of net income, as these transactions have not been designated for hedge accounting. These contracts effectively fix the exchange rate at which these specific monetary assets and liabilities will be settled so that gains or losses on the forward contracts offset the losses or gains from changes in the value of the underlying monetary assets and liabilities. These contracts contain net settlement features. If we experience unfavorable changes in foreign exchange rates, we may be required to use material amounts of cash to settle the transactions which may adversely affect the operating results that we report with respect to the corresponding period. During the year ended December 31, 2009, we recorded exchange rate gains of $715,000 related to our foreign exchange forward contracts.

We currently hold foreign exchange forward contracts with a single counterparty. The bank counterparty in these contracts exposes us to credit-related losses in the event of their nonperformance. However, to mitigate that risk, we only contract with counterparties who meet our minimum credit quality guidelines. In addition, our exposure in the event of a default by our counterparty is limited to the changes in value of our hedged balances. At December 31, 2009, we were in a net receivable position with our counterparty for $190,000.

 

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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

   69

Report of Independent Registered Public Accounting Firm

   70

Consolidated Balance Sheets at December 31, 2009 and 2008

   71

Consolidated Statements of Operations for the Years Ended December 31, 2009, 2008 and 2007

   72

Consolidated Statements of Stockholders’ Equity for the Years Ended December  31, 2009, 2008 and 2007

   73

Consolidated Statements of Cash Flows for the Years Ended December 31, 2009, 2008 and 2007

   74

Notes to Consolidated Financial Statements

   75

 

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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, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. 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, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.

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, 2009, 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 5, 2010 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Sacramento, California

March 5, 2010

 

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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, 2009, 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.

In our opinion, Volcano Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, 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, 2009 and 2008 and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2009, and our report dated March 5, 2010 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Sacramento, California

March 5, 2010

 

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VOLCANO CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

     December 31,  
     2009     2008  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 56,055      $ 100,949   

Short-term available-for-sale investments

     66,028        48,941   

Accounts receivable, net

     51,171        41,795   

Inventories

     37,710        28,936   

Prepaid expenses and other current assets

     5,892        5,869   
                

Total current assets

     216,856        226,490   

Restricted cash

     554        327   

Property and equipment, net

     44,734        30,007   

Intangible assets, net

     11,623        15,636   

Goodwill

     931        842   

Other non-current assets

     2,036        2,177   
                

Total assets

   $ 276,734      $ 275,479   
                

Liabilities and Stockholders’ Equity

    

Current liabilities:

    

Accounts payable

   $ 13,840      $ 14,867   

Accrued compensation

     14,142        12,690   

Accrued expenses and other current liabilities

     25,275        10,745   

Deferred revenues

     4,881        4,833   

Short-term debt

     —          151   

Current maturities of long-term debt

     50        57   
                

Total current liabilities

     58,188        43,343   

Long-term debt

     110        34   

Deferred revenues

     2,376        1,914   

Other

     1,245        456   
                

Total liabilities

     61,919        45,747   

Commitments and contingencies (Note 4)

    

Stockholders’ equity:

    

Preferred stock, par value of $0.001; 10,000 shares authorized; no shares issued and outstanding at December 31, 2009 and December 31, 2008

     —          —     

Common stock, par value of $0.001; 250,000 shares authorized at December 31, 2009 and December 31, 2008; 48,790 and 47,883 shares issued and outstanding at December 31, 2009 and December 31, 2008, respectively

     49        48   

Additional paid-in capital

     352,102        337,063   

Accumulated other comprehensive loss

     (4,079     (3,076

Accumulated deficit

     (133,257     (104,303
                

Total stockholders’ equity

     214,815        229,732   
                

Total liabilities and stockholders’ equity

   $ 276,734      $ 275,479   
                

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,  
     2009     2008     2007  

Revenues

   $ 227,867      $ 171,495      $ 130,614   

Cost of revenues

     91,489        64,293        51,559   
                        

Gross profit

     136,378        107,202        79,055   

Operating expenses:

      

Selling, general and administrative

     111,598        84,369        62,631   

Research and development

     37,372        26,690        20,315   

In-process research and development

     14,030        12,681        26,188   

Amortization of intangibles

     4,224        3,125        3,067   
                        

Total operating expenses

     167,224        126,865        112,201   
                        

Operating loss

     (30,846     (19,663     (33,146

Interest income

     756        4,828        5,841   

Interest expense

     (5     (113     (199

Exchange rate gain

     2,328        1,809        1,452   

Other, net

     —          54        —     
                        

Loss before provision for income taxes

     (27,767     (13,085     (26,052

Provision for income taxes

     1,187        620        524   
                        

Net loss

   $ (28,954   $ (13,705   $ (26,576
                        

Net loss per share—basic and diluted

   $ (0.60   $ (0.29   $ (0.66
                        

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

     48,400        47,376        40,024   
                        

 

See notes to consolidated financial statements.

 

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VOLCANO CORPORATION

CONSOLIDATED STATEMENTS STOCKHOLDERS’ EQUITY

(in thousands)

 

    Common Stock   Additional
Paid-In
Capital
  Accumulated
Deficit
    Accumulated
Other

Comprehensive
Loss
    Total
Stockholders’
Equity
 
    Shares   Amount        

Balance at December 31, 2006

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

Issuance of common stock under equity compensation 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

Changes in unrealized gain on available-for-sale investments

            56        56   
                 

Total comprehensive loss

              (27,532
                                       

Balance at December 31, 2007

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

Issuance of common stock under equity compensation plans

  822     1     2,770         2,771   

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

Changes in unrealized gain on available-for-sale investments

            12        12   
                 

Total comprehensive loss

              (15,523
                                       

Balance at December 31, 2008

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

Issuance of common stock under equity compensation plans, net of shares repurchased

  907     1     4,155         4,156   

Employee stock-based compensation cost

        10,613         10,613   

Non-employee stock-based compensation cost

        271         271   

Comprehensive loss

           

Net loss

          (28,954       (28,954

Foreign currency translation adjustments

            (931     (931

Changes in unrealized gain on available-for-sale investments

            (72     (72
           

Total comprehensive loss

              (29,957
                                       

Balance at December 31, 2009

  48,790   $ 49   $ 352,102   $ (133,257   $ (4,079   $ 214,815   
                                       

See notes to consolidated financial statements.

 

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VOLCANO CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Years Ended December 31,  
     2009     2008     2007  

Operating activities

      

Net loss

   $ (28,954   $ (13,705   $ (26,576

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

      

In-process research and development expense

     14,030        12,681        26,188   

Depreciation and amortization

     16,181        9,357        7,902   

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

     —          —          102   

Amortization (accretion) of investment premium (discount), net

     626        (652     (1,195

Non-cash stock compensation expense

     10,885        9,527        6,795   

Gain on foreign exchange

     (273     (1,809     (1,452

Loss on disposal of long-lived assets

     528        70        222   

Changes in operating assets and liabilities, net of acquisitions:

      

Accounts receivable

     (8,858     (10,487     (5,846

Inventories

     (8,498     (5,029     (7,659

Prepaid expenses and other assets

     251        (3,185     (1,942

Accounts payable

     (1,112     2,151        2,217   

Accrued compensation

     1,393        3,131        2,980   

Accrued expenses and other liabilities

     1,674        36        110   

Deferred revenues

     476        301        2,390   
                        

Net cash (used in) provided by operating activities

     (1,651     2,387        4,236   
                        

Investing activities

      

Purchase of short-term available-for-sale securities

     (146,932     (103,029     (105,823

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

     129,098        121,006        58,655   

Capital expenditures

     (26,146     (15,474     (9,101

Cash paid for acquisitions

     (613     (29,711     (25,158

Cash paid for other intangibles

     (315     (480     (233

Proceeds from net settlement of foreign currency contracts

     525        —          —     

Proceeds from sale of long-lived assets

     —          —          45   
                        

Net cash used in investing activities

     (44,383     (27,688     (81,615
                        

Financing activities

      

Proceeds from underwritten public stock offerings, net

     —          —          122,796   

Repayment of long-term debt

     (54     (126     (1,774

Repayment of short-term debt

     (151     —          —     

Proceeds from sale of common stock under employee stock purchase plan

     2,122        1,565        —     

Proceeds from exercise of common stock options

     2,450        1,202        1,687   

Repurchases of common stock

     (416     —          —     

Release of restricted cash

     70        231        —     

Increases of restricted cash

     (286     —          —     
                        

Net cash provided by financing activities

     3,735        2,872        122,709   

Effect of exchange rate changes on cash and cash equivalents

     (2,595     465        (155
                        

Net (decrease) increase in cash and cash equivalents

     (44,894     (21,964     45,175   

Cash and cash equivalents, beginning of year

     100,949        122,913        77,738   
                        

Cash and cash equivalents, end of year

   $ 56,055      $ 100,949      $ 122,913   
                        

Supplemental disclosures

      

Cash paid for interest

   $ 5      $ 113      $ 118   

Cash paid for income taxes

   $ 1,810      $ 643      $ 510   

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”, “Volcano” 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 products consist of consoles which have been designed to serve as a multi-modality platform for our phased array and rotational IVUS catheters, fractional flow reserve (“FFR”), pressure wires and Medtronic’s Pioneer reentry device. We are developing additional offerings for integration into the platform, including, forward-looking IVUS (“FL.IVUS”) catheters, image-guided therapy catheters and ultra-high resolution Optical Coherence Tomography (“OCT”) systems and catheters.

Our IVUS products include single-procedure disposable phased array and rotational IVUS imaging catheters and additional functionality options such as virtual histology (“VH”) IVUS tissue characterization and ChromaFlo stent apposition analysis. Our FM offerings include FM consoles and single-procedure disposable 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 also develop and manufacture optical monitors, lasers, and optical engines used in OCT imaging systems as well as micro-optical spectrometers and optical channel monitors used in the telecommunications industry.

Basis of Presentation and Principles of Consolidation

Our consolidated financial statements include our financial statements and the financial statements of our wholly-owned subsidiaries, Volcano Japan Co. Ltd. (“Volcano Japan”), Volcano Europe S.A./N.V. (“Volcano Europe”), Axsun Technologies, Inc. (“Axsun”), and Volcano Therapeutics South Africa (Pty) Ltd. (“Volcano South Africa”), 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.

Operating Segments

Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 280, Segment Reporting (“ASC 280”), establishes standards for the way public business enterprises report information about operating segments in annual consolidated financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. ASC 280 also establishes standards for related disclosures about products and services, geographic areas and major customers.

Historically, we considered ourselves to be a single reporting segment, specifically the manufacture, sale, discovery, development and commercialization of products for the diagnosis of atherosclerosis in the coronary arteries and peripheral vascular system (our “Medical Segment”). In connection with our acquisition of Axsun in December 2008, we operate an additional segment, specifically the discovery, development, manufacture and sale of micro-optical spectrometers and optical channel monitors to telecommunications companies (our “Telecom Segment”). The revenues and expenses related to this segment were not material to our overall operating results for the year ended December 31, 2008, therefore our reporting for the Telecom Segment commenced on January 1, 2009. See Note 7 “Segment and Geographic Information” for additional details regarding our segments.

 

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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, long-term investments in subsidiaries, 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.

On July 1, 2009, we adopted the Japanese yen as the functional currency for Volcano Japan. Consistent with the considerations specified in FASB ASC Topic 830, Foreign Currency Matters, the change was made to reflect recent developments with our Japan operations, including increases in direct sales denominated in the Japanese yen and growth in the local infrastructure that has enabled the day-to-day operations of Volcano Japan to become relatively self-contained and integrated into the Japanese economic environment. At December 31, 2009, assets and liabilities of Volcano Japan’s operations are translated into U.S. dollars at period-end exchange rates. Commencing July 1, 2009, revenues and expenses are translated into U.S. dollars at average exchange rates in effect during each reporting period and adjustments resulting from the translation are reported on our consolidated balance sheet in accumulated other comprehensive loss.

Prior to July 1, 2009, the U.S. dollar was the functional currency of Volcano Japan. At December 31, 2008, yen-based assets and liabilities of our Japanese operations are remeasured into U.S. dollars at period-end exchange rates. For the years ended December 31, 2008 and 2007 and the six months ended June 30, 2009, yen-based expenses are converted into U.S. dollars at average exchange rates in effect during each reporting period and 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.

Exchange rate fluctuations resulting from the translation of the inter-company balances between Volcano Corporation, our U.S. entity, and Volcano Japan; and Volcano Corporation 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. On October 1, 2009, approximately $23.4 million of intercompany receivable owed to Volcano Corporation from Volcano Japan was converted into a long-term investment, resulting in a decrease in the amount of yen-based receivables being marked-to-market. 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. These conversions thereby reduce the impact of the exchange rate fluctuations in our consolidated statements of operations.

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.

 

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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.

Financial Instruments

Our financial instruments include cash and cash equivalents, short-term available-for-sale investments, foreign exchange forward contracts, 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.

In October 2009, we began using foreign exchange forward contracts to manage a portion of the foreign currency risk for foreign subsidiaries with monetary assets and liabilities denominated in the yen and the euro. We only use derivative financial instruments to reduce the risk that our earnings and cash flows will be adversely affected by changes in exchange rates; we do not hold any derivative financial instruments for trading or speculative purposes. We primarily use forward exchange contracts to hedge foreign currency exposures, and they generally have terms of one year or less. Realized and unrealized gains or losses on the value of financial contracts used to hedge the exchange rate exposure of these monetary assets and liabilities are also included in the determination of net income, as these transactions have not been designated for hedge accounting. These contracts effectively fix the exchange rate at which these specific monetary assets and liabilities will be settled so that gains or losses on the forward contracts offset the losses or gains from changes in the value of the underlying monetary assets and liabilities. These contracts contain net settlement features. We offset fair value amounts recognized for receivables and payables arising from our foreign exchange forward contracts with our counterparty.

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 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.

Trade accounts receivable are recorded at the net invoice value and are not interest bearing. We consider receivables past due based on the contractual payment terms. 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.

Goodman Company, Ltd. (“Goodman”), a former distributor in Japan, accounted for less than 10%, 14% and 18% of our total revenues for the years ended December 31, 2009, 2008 and 2007, respectively, and 14% of our trade receivables at December 31, 2008. Goodman revenues are reported in our Medical Segment. No other single customer accounted for more than 10% of our revenues for any period presented and at December 31, 2009 and 2008, no other single customer accounted for more than 10% of our trade receivables.

 

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On July 8, 2009, we entered into a Distributor Termination Agreement (the “Termination Agreement”) with Goodman that terminated certain agreements between us and Goodman effective August 31, 2009 (the “Termination Date”) and provided for the transition of the distribution, formerly handled by Goodman, of Volcano products in Japan to Volcano Japan. Under the Termination Agreement, we paid Goodman 350 million Japanese yen and consumption tax (a total of approximately $3.9 million) and Goodman transferred and delivered any IVUS and FM consoles owned by Goodman. During the year ended December 31, 2009, approximately 287 million Japanese yen (approximately $3.1 million) was offset against receivables outstanding from Goodman and we paid the remaining amounts due to Goodman under the Termination Agreement in cash. Consoles acquired by us remain at the customer locations where they had been installed previously. IVUS consoles were recorded at their estimated fair value of approximately $3.9 million as property and equipment and depreciation will be recorded over their remaining useful lives of 2.5 years. The fair value of the IVUS consoles was initially measured using a discounted cash flow analysis using inputs developed by management. Such inputs are classified as Level 3 inputs under FASB ASC Topic 820, Fair Value Measurements and Disclosures (“ASC 820”). We also repurchased IVUS and FM disposables from Goodman totaling approximately $343,000 on August 31, 2009. These disposables were recorded as inventory. In addition, from July 1, 2009 to December 31, 2009, we agreed to pay Goodman commissions from the sale of products to sub-distributors or hospitals transferred as customers from Goodman. We guaranteed minimum total commissions of 310 million Japanese yen (approximately $3.3 million) payable at various dates through January 31, 2010. During the year ended December 31, 2009, we recorded commissions to Goodman under the Termination Agreement totaling 332 million Japanese yen (approximately $3.7 million) as selling, general, and administrative expense. The aforementioned amounts related to the Termination Agreement have been converted to U.S. dollars from Japanese yen based on exchange rates in effect in August 2009, except for the commission expense which was converted using actual exchange rates in effect during the period.

We currently hold foreign exchange forward contracts with a single counterparty. The bank counterparty in these contracts exposes us to credit-related losses in the event of their nonperformance and we do not require collateral for their performance. However, to mitigate that risk, we only contract with counterparties who meet our minimum credit quality guidelines. In addition, our exposure in the event of a default by our counterparty is limited to the changes in value of our hedged balances. At December 31, 2009, we were in a net receivable position with our counterparty for $190,000.

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).

Restricted Cash

At December 31, 2009 and 2008, we had restricted cash totaling $554,000 and $327,000, respectively. Restricted cash consists of approximately $200,000 at December 31, 2009 and 2008 in certificates of deposit restricted as to withdrawal and serves as a security deposit for a leased facility that expires in 2010; $288,000 at December 31, 2009 restricted as to withdrawal to provide collateral for our performance to customers in a foreign jurisdiction; and the remaining amounts at December 31, 2009 and 2008 serve as collateral to various operating leases. The certificates of deposit and cash in bank will remain restricted as to withdrawal until such time as new lease agreements are executed.

 

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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 including renewal periods that are reasonably assured 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.

Assets held under capital leases are recorded at the net present value of the minimum lease payments of the leased asset at the inception of the lease. Amortization expense is computed using the straight-line method over the shorter of the estimated useful lives of the assets or the period of the related lease and is included in our depreciation expense.

Goodwill and Intangible Assets

We account for goodwill and other intangible assets in accordance with FASB ASC Topic 350, Intangibles—Goodwill and Other, (“ASC 350”). 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.

At December 31, 2009 and 2008, our goodwill relates entirely to the acquisition of Axsun. We intend to integrate Axsun’s OCT technology in our future medical product offerings, therefore our goodwill is allocated entirely to our Medical Segment.

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.

ASC 350 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.

Impairment or Disposal of Long-Lived Assets

Impairment of long-lived assets is recognized when events or circumstances indicate that the carrying amount of the asset, or related groups of assets, may not be recoverable. Under FASB ASC Topic 360, Property, Plant, and Equipment, a long-lived asset is initially measured at the lower of its carrying amount or fair value. An impairment loss is recognized when estimated future cash flows, on an undiscounted basis, expected to result from the use of the asset, including its disposition, are less than the carrying value of the asset. The impairment loss is then calculated by comparing the carrying value of the asset with its fair value, which is usually estimated using discounted cash flows expected to be generated from the use of the assets.

 

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Product Warranty Costs

We typically offer a one-year warranty for parts and labor on our products commencing upon the transfer of title and risk of loss to the customer. We accrue the estimated cost of product warranties when we invoice our customers, based on historical results. The warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from these estimates, revisions to the estimated warranty liability would be required. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary.

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 transfer to the customer.

We occasionally enter into agreements requiring cash payments to partners who are also customers. We apply the provisions of FASB ASC Topic 605-50, Customer Payments and Incentives, to account for cash payments made under these agreements. During the years ended December 31, 2009, 2008 and 2007, we made payments to customers of approximately $382,000, $450,000 and $825,000, respectively. During the years ended December 31, 2009, 2008 and 2007, $459,000, $269,000 and $783,000, respectively, have been recorded as a reduction in revenues.

Installation and training are generally not required elements of our sales transactions as most of our products do not require installation and training. In instances where installation and training are required elements of the sales transaction, revenue is recognized upon completion.

Our revenue arrangements can include multiple elements or deliverables. These elements can consist of consoles, options for the console, single-procedure disposable products and service and maintenance agreements. The sale of these products and services are often contemplated in a single arrangement with delivery of the elements sometimes occurring in different periods. If an arrangement includes multiple elements, we determine (a) whether an arrangement involving multiple deliverables contains more than one unit of accounting and (b) determine how the arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. We use the residual method to allocate the arrangement consideration when we have not established objective and reliable evidence of the fair value of delivered items. The delivered items represent individual units of accounting because they have value to the customer on a stand-alone basis, objective and reliable evidence of fair value exists for the undelivered items, and arrangements do not contain a general right of return relative to the delivered items. Under the residual method, the amount of consideration allocated to the delivered items equals the total arrangement consideration less the aggregate fair value of the undelivered items.

Assuming all other criteria for revenue recognition have been met, we recognize revenue for delivered items when title and risk of loss transfer upon shipment to the customer and installation and training, if applicable, have been completed. Revenue for undelivered items, which include service and maintenance activities, is recognized ratably over the service period, which is generally one year.

All costs associated with the provision of service are recognized in cost of revenues as incurred. Amounts billed in excess of revenue recognized are included as deferred revenue in the consolidated balance sheets.

We sell our products through direct sales representatives in the U.S. and a combination of direct sales representatives and independent distributors in international markets. Sales to distributors are recorded when title and risk of loss transfer upon shipment (generally FOB shipping point). No direct sales customers or distributors

 

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have price protection and only one distributor has limited return rights in the event of termination of the agreement with that distributor. We periodically make evaluations regarding the estimated amount of returns that could be made under this right of return. Estimated returns, which are based on historical results, are recorded as allowances for sales returns and as a reduction in revenues.

Shipping and Handling Costs

Shipping and handling costs billed to customers are included in revenues. Shipping and handling costs we incur associated with shipping products to our customers are included in cost of revenues.

Research and Development

Company-sponsored research and development expenses include the costs of technical activities that are useful in developing new products, services, processes or techniques, as well as expenses for technical activities that may significantly improve existing products or processes and are expensed as incurred.

Clinical Studies

We accrue and expense costs for activities associated with clinical studies performed by third parties as incurred. All other costs relative to setting up clinical study sites are expensed as incurred to research and development expense. Clinical study site costs related to patient enrollment are accrued as patients are entered into the studies. Equipment that has alternative future use and is used at clinical study sites for participation in the studies are capitalized and expensed over the estimated life of the equipment.

Income Taxes

We use the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. To the extent a deferred tax asset cannot be recognized under the preceding criteria, allowances are established. At December 31, 2009 and 2008, within the U.S. and selected international jurisdictions, all deferred tax assets, without offsetting liabilities in the same jurisdiction, were fully offset by a valuation allowance.

FASB ASC Topic 740, Income Taxes (“ASC 740”), clarifies the accounting for uncertainty in income taxes recognized in the financial statements. ASC 740 provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits of the position. Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. ASC 740 also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted these provisions of ASC 740 on January 1, 2007, and the adoption did not have a material impact on our consolidated financial position or results of operations.

We accrue interest and penalties on underpayment of income taxes related to unrecognized tax benefits as a component of income tax expense in our consolidated statements of operations. The amounts recognized for interest and penalties during the years ended December 31, 2009, 2008 and 2007 were not significant.

Net Loss Per Share

Basic and diluted net loss per share is presented in accordance with FASB ASC Topic 260, Earnings per Share. Basic net loss per share is computed by dividing consolidated net loss by the weighted-average number of

 

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common shares outstanding during the period. Diluted net loss per share is computed by dividing consolidated net loss by the weighted-average number of common shares outstanding and dilutive common stock equivalent shares outstanding during the period. Our potentially dilutive shares include outstanding common stock options, restricted stock units and warrants. Such potentially dilutive shares are excluded when the effect would be to reduce a net loss per share. For the year ended December 31, 2009, 2008 and 2007, potentially dilutive shares totaling 3.9 million, 4.4 million and 4.6 million, respectively, have not been included in the computation of diluted net loss per share, as the result would be anti-dilutive.

The basic and diluted net loss per common share calculations are as follows:

 

     Years Ended December 31,  
     2009     2008     2007  

Net loss

   $ (28,954   $ (13,705   $ (26,576
                        

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

     48,400        47,376        40,024   
                        

Net loss per share—basic and diluted

   $ (0.60   $ (0.29   $ (0.66
                        

Stock-Based Compensation

We account for stock-based compensation under the provisions of FASB ASC Topic 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors based on estimated fair values on the grant date. We adopted ASC 718 on January 1, 2006 using the modified prospective method. We estimate the fair value of stock-based awards on the date of grant using the Black-Scholes-Merton option pricing model (“Black-Scholes model”). The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods using the straight-line method. We estimate forfeitures at the time of grant and revise our estimate in subsequent periods if actual forfeitures differ from those estimates. See Note 5 “Stockholders’ Equity” for a complete discussion of our equity compensation programs and the fair value assumptions used to determine our stock-based compensation expense.

We account for stock-based compensation awards and warrants granted to non-employees in accordance with FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees (“ASC 505-50”). Under ASC 505-50, we determine the fair value of the warrants or stock-based compensation awards granted as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. If the fair value of equity instruments issued is used, it is measured using the stock price and other measurement assumptions as of the earlier of either of (1) the date at which commitment for performance by the counterparty to earn the equity instruments is reached, or (2) the date at which the counterparty’s performance is complete.

Comprehensive Loss

Comprehensive loss represents the net loss for the period plus the results of certain changes to stockholders’ equity that are not reflected in the consolidated statements of operations. Our comprehensive loss consists of net losses, unrealized net gains and losses on short-term available-for-sale investments and foreign currency translation adjustments.

Recent Accounting Pronouncements

In October 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements (“ASU 2009-13”) and ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements (“ASU 2009-14”). ASU 2009-13 provides for two significant changes to the existing multiple-element revenue arrangements guidance.

 

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The first relates to the determination of when the individual deliverables included in a multiple-element arrangement may be treated as separate units of accounting. This change is significant as it will likely result in the requirement to separate more deliverables within an arrangement, ultimately leading to less revenue deferral. The second change modifies the manner in which the transaction consideration is allocated across the separately identified deliverables. ASU 2009-14 updates guidance on how entities account for revenue arrangements that contain both hardware and software elements. ASU 2009-13 and ASU 2009-14 are effective for us on January 1, 2011 and early adoption is permitted. We plan to adopt ASU 2009-13 and ASU 2009-14 prospectively on January 1, 2010. Together, we expect these changes are likely to result in earlier recognition of revenue for our multiple-element arrangements than under previous guidance, however we do not expect these changes to have a material impact on our consolidated financial position or results of operations.

In April 2009, the FASB issued amendments to FASB ASC Topic 805, Business Combinations (“ASC 805”) which requires that assets acquired and liabilities assumed in a business combination that arise from pre-acquisition contingencies be recognized at fair value, in accordance with ASC 820, if the fair value can be determined during the measurement period. If the fair-value of a pre-acquisition contingency cannot be determined during the measurement period, the contingency shall be recognized at the acquisition date in accordance with FASB ASC Topic 450, Contingencies. We will apply the guidance of ASC 805, as amended, to all of our future business combinations.

Reclassification

Certain reclassifications have been made to the prior year’s financial statement to conform to the current year presentation.

2. Acquisitions

CardioSpectra Acquisition

On December 18, 2007, we acquired all of the outstanding equity interests in CardioSpectra, Inc. (“CardioSpectra”), a privately-held corporation. The acquisition of CardioSpectra’s OCT technology is expected to complement our existing product offerings and further enhance our position as an imaging technology leader in the field of interventional medicine. The aggregate purchase price of $27.0 million consisted of $25.2 million in cash, transaction costs of $1.4 million and assumed liabilities of $0.4 million. The acquisition is accounted for as an asset purchase. We have included the operating results associated with the CardioSpectra acquisition in our consolidated financial statements from the date of acquisition.

Subject to the terms of the Merger Agreement, milestone payments of up to $38.0 million are payable as follows:

 

   

$11.0 million of the milestone payments to be paid upon approval by applicable U.S., Japanese or European regulators of a first generation OCT system on or before December 31, 2009;

 

   

$10.0 million of the milestone payments to be paid upon applicable U.S. regulatory approval of a productized version of the first generation OCT system on or before December 31, 2010;

 

   

$10.0 million of the milestone payments to be paid upon cumulative cash sales totaling $10.0 million from commercial sales of OCT products, so long as such cumulative cash sales are attained prior to the date that is three years after the date on which the applicable U.S. regulatory approval described in the second bullet point above was obtained (if such approval was obtained on or before December 31, 2010) or otherwise on or before December 31, 2013; and

 

   

$7.0 million of the milestone payments to be paid upon cumulative cash sales totaling $25.0 million from commercial sales of OCT products, so long as such cumulative cash sales are attained prior to the date that is four years after the date on which the applicable U.S. regulatory approval described in the second bullet point above was obtained (if such approval was obtained on or before December 31, 2010) or otherwise on or before December 31, 2014.

 

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The milestone payments are payable, at our sole discretion, in cash, shares of our common stock, or a combination of both and will be accounted for if and when the milestone payments become payable. We will use commercially reasonable efforts to cause the milestones to occur. However, if we reasonably determine that a technical failure or commercial failure has occurred with respect to all or a part of the OCT program, we may, at our sole discretion, terminate all or part of the OCT cardiovascular program.

In December 2009, the first milestone specified in the Merger Agreement was achieved and at December 31, 2009, the milestone payment totaling $10.5 million was recorded in accrued expenses and other current liabilities and $531,000 was recorded in accounts payable. In January 2010, we paid the milestone payment with the issuance of 609,360 shares our common stock and $531,000 of cash.

In connection with this acquisition, we recorded $11.0 million, $175,000, and $26.2 million of in-process research and development (“IPR&D”) expense in the years ended December 31, 2009, 2008 and 2007, respectively.

The purchase price allocation as of the acquisition date is summarized as follows (in thousands):

 

     December 18,
2007

Current assets:

  

Cash

   $ 24

Prepaid expenses and other current assets

     118
      

Total current assets

     142

Equipment

     132

Intangible assets (1)

     274

In-process research and development

     26,337
      

Total assets acquired

   $ 26,885
      

Current liabilities:

  

Accounts payable

   $ 316

Accrued compensation

     40

Accrued expenses and other current liabilities

     82
      

Total current liabilities

     438
      

Total liabilities acquired

     438
      

Net assets acquired

   $ 26,447
      

 

(1) Intangible assets acquired consisted entirely of assembled workforce, which is being amortized over 4 years.

At the closing of the merger, $2.5 million of the aggregate merger consideration was contributed to an escrow fund which was available for 12 months to indemnify us and related indemnitees for certain matters, including breaches of representations and warranties and covenants included in the merger agreement. In December 2008, we made a claim to the escrow in the amount of $118,000 for the reimbursement of excess indebtedness and the remaining escrow funds were released. We have the right to withhold and deduct amounts for any future indemnification claims from milestone payments otherwise payable by us. No amounts were withheld from the payment of the first milestone for indemnification claims.

Novelis Acquisition

On May 15, 2008, we acquired all of the outstanding equity interests in Novelis, Inc. (“Novelis”), a privately-held company, which developed proprietary ultrasonic visualization and therapy technology for minimally invasive diagnostic and therapeutic devices. The core product line of Novelis is based on FL.IVUS technology. The aggregate purchase price of $12.3 million was paid in cash and included transaction costs of

 

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$204,000. In addition, we may make an additional cash payment of $3.0 million based on the achievement of a specific regulatory milestone. The acquisition is accounted for as an asset purchase. We have included the operating results associated with the Novelis acquisition in our consolidated financial statements from the date of acquisition.

In December 2009, we determined that the achievement of the regulatory milestone was probable and recorded $3.0 million to IPR&D expense for the year ended December 31, 2009 which is recorded in accrued expenses and other current liabilities at December 31, 2009.

The purchase price allocation as of the acquisition date is summarized as follows (in thousands):

 

     May 15,
2008

Current Assets:

  

Equipment

   $ 100

In-process research and development (1)

     12,232
      

Total assets acquired

   $ 12,332
      

Total liabilities assumed

     —  
      

Net assets acquired

   $ 12,332
      

 

(1) The in-process research and development was charged to expense in our consolidated statement of operations in the year ended December 31, 2008.

Of the $12.3 million aggregate purchase price paid, $1.8 million was contributed to an escrow fund and was available for 12 months from the date of the acquisition to indemnify us and related indemnities for certain matters, including breaches of representations and warranties and covenants included in the merger agreement. The escrow fund was released in May 2009. In addition, we have the right to withhold and deduct up to $450,000 for any indemnification claims from the milestone payment otherwise payable by us.

Axsun Acquisition

On December 24, 2008, we acquired all of the outstanding equity interests in Axsun, a privately-held company that develops and manufactures optical monitors for telecommunications, lasers and optical engines used in OCT imaging systems and advanced photonic components and subsystems used in spectroscopy and other industrial applications. The aggregate purchase price of $23.8 million consisted of $22.3 million paid in cash, assumed liabilities of $6.5 million, and transaction costs of $725,000, net of cash received of $5.8 million. The acquisition is being accounted for under the purchase method of accounting. Under the purchase method of accounting, the purchase price is allocated to the net tangible and intangible assets based on their estimated fair values as of the acquisition date. We have included the operating results associated with the Axsun acquisition in our consolidated financial statements from the date of acquisition.

Of the $22.3 million cash consideration, $2.5 million was contributed to three escrow funds. One escrow fund of $120,000 was to indemnify us for damages arising from the exercise of appraisal rights by the former stockholders of Axsun. As there were no outstanding claims against the escrow, the $120,000 balance of the escrow account was released in May 2009. The remaining escrows of $2.4 million are available to indemnify us and related indemnitees for certain matters, including breaches of representations and warranties and covenants included in the merger agreement for 15 months following the closing.

 

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The purchase price allocation as of the acquisition date is summarized as follows (in thousands):

 

     December 24,
2008
 

Current assets:

  

Cash and cash equivalents

   $ 5,789   

Short-term available-for-sale investments

     50   

Accounts receivable

     3,764   

Inventories

     2,746   

Prepaid expenses and other current assets

     60   
        

Total current assets

     12,409   

Restricted cash

     200   

Property and equipment

     7,074   

Goodwill

     842   

Intangible assets

     8,895   

Other non-current assets

     50   
        

Total assets acquired

     29,470   

Current liabilities:

  

Accounts payable

     (1,738

Accrued compensation

     (516

Accrued expenses and other current liabilities

     (3,706

Short-term debt

     (151
        

Total current liabilities

     (6,111

Other long-term liabilities

     (351
        

Total liabilities acquired

     (6,462
        

Net assets acquired

   $ 23,008   
        

The intangible assets consist of developed technology in the amount of approximately $8.1 million and customer relationships in amount of $799,000. The developed technology represents the 40 GHz laser and related OCT technology that is technologically feasible and includes all fully functioning products at the date of the valuation. The amount assigned to the developed technology was assigned based on the estimated net discounted cash flows from the related product lines on the date of acquisition. The developed technology is being amortized on a straight-line basis over a weighted-average useful life of 8.9 years. The customer relationships are being amortized on a straight-line basis over a useful life of seven years. The weighted average amortization period of the identified intangible assets is approximately 8.7 years.

The purchase price in excess of the fair value of net tangible and intangible assets acquired resulted in $842,000 recorded to goodwill at December 31, 2008. Goodwill is allocated entirely to our medical segment. The goodwill is not deductible for income tax purposes and will be assessed annually for impairment. We recorded an additional $89,000 of transaction costs and other liabilities to goodwill, net of an adjustment to acquired inventories, during the year ended December 31, 2009.

We assumed a liability of $563,000 for costs to exit a facility lease and related costs. The lease expires in September 2010. Plans to exit the facility had been consummated prior to the acquisition date. As of December 31, 2009 and 2008, $354,000 and $560,000 related to these exit costs remained accrued in our consolidated balance sheets, respectively.

In-process Research and Development

In December 2007, we acquired the OCT project in connection with our acquisition of CardioSpectra, which was valued at $26.3 million. In-vitro testing and regulatory approval remained to be completed as of the

 

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acquisition date at an estimated cost of $7.2 million. In December 2009, we achieved a milestone specified in the CardioSpectra merger agreement related to the receipt of CE mark regulatory approval and $11.0 million became payable by us. Although we have received CE mark approval for a preliminary version of our OCT product, this version is not intended to be commercialized. We believe there is significant incremental effort and costs that must be incurred to complete a product that is suitable for commercialization and there is significant risk that a commercializable product may not result from our efforts. As of December 31, 2009, we estimate that we will incur $7.2 million of additional costs in order to complete the OCT project for a total cost of approximately $15.4 million. The OCT project was originally expected to be commercialized by late 2008, however the OCT project was at an earlier stage of development than our initial assessment indicated. As of December 31, 2009, commercialization is not expected until early 2011. Accordingly, we have recorded $11.0 million to IPR&D expense related to the milestone for the year ended December 31, 2009. Additional milestone payments of up to $27.0 million may be paid in connection with successful and timely regulatory approvals and commercialization.

In May 2008, we acquired the FL.IVUS 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 FL.IVUS project as of the acquisition date, at an estimated cost of $3.9 million. In December 2009, we recorded $3.0 million of additional IPR&D expense related to the probable achievement of a regulatory approval for the FL.IVUS project. Although we expect to receive this regulatory approval, we believe there is significant incremental effort and costs that must be incurred to complete a product that is suitable for commercialization. As of December 31, 2009, we estimate that we will incur $4.5 million of additional costs in order to commercialize the first product using FL.IVUS for a total of approximately $8.2 million. We originally expected the FL.IVUS project to receive regulatory approvals and be commercialized during 2009. As of December 31, 2009, the project was behind schedule by approximately one year.

In November 2008, we acquired an IPR&D project from Impact Medical Technologies, LLC, a minor acquisition, for a total purchase price of $300,000, which was recorded as IPR&D expense for the year ended December 31, 2008.

The following table summarizes our significant IPR&D projects (in millions):

 

                    Estimated Cost to
Complete,
as of
December 31, 2009
   Total Estimated
Costs to Complete
since Acquisition
Date
     As of Acquisition Date    Costs Incurred
Since Acquisition
     

Project Name

   Fair Value    Estimated Cost to
Complete
        

OCT

   $ 26.3    $ 7.2    $ 8.2    $ 7.2    $ 15.4

FLIVUS

     12.2      3.9      3.7      4.5      8.2

3. Financial Statement Details

Cash and Cash Equivalents and Short-term Available-for-Sale Investments

We invest our excess funds in short-term securities issued by the U.S. government, corporations, banks, municipalities, financial holding companies and in money market funds comprised of these same types of securities. Our cash and cash equivalents and short-term available-for-sale investments are placed with high credit quality financial institutions. Additionally, we diversify our investment portfolio in order to maintain safety and liquidity and we do not hold mortgage-backed securities. As of December 31, 2009, all of our investments will mature within one year. These investments are recorded at their estimated fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive loss.

 

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Short-term investments have been classified as available-for-sale investments. At December 31, 2009, available-for-sale investments are detailed as follows (in thousands):

 

     Amortized
Cost
   Gross Unrealized
Gains
   Gross Unrealized
Losses
   Estimated
Fair Value

Corporate debt securities

   $ 37,704    $ 9    $ 6    $ 37,707

U.S. Treasury and agency debt securities

     28,330      16      25      28,321
                           
   $ 66,034    $ 25    $ 31    $ 66,028
                           

Available-for-sale investments that are in an unrealized loss position at December 31, 2009 are detailed as follows (in thousands):

 

     Estimated
Fair Value
   Gross Unrealized
Losses

Corporate debt securities

   $ 10,004    $ 6

U.S. Treasury and agency debt securities

     14,191      25
             
   $ 24,195    $ 31
             

At December 31, 2009, five of our corporate debt securities and three of our U.S. Treasury and agency debt securities are temporarily in an unrealized loss position caused by interest rate increases. We fully expect to receive par value with full principal and interest when these securities mature. These investments have been in an unrealized loss position for less than 12 months. We do not intend to sell the investments and we will not be required to sell the investments before maturity. Because of the foregoing considerations, we do not consider these investments to be other-than-temporarily impaired at December 31, 2009.

At December 31, 2008, available-for-sale investments are detailed as follows (in thousands):

 

     Amortized
Cost
   Gross Unrealized
Gains
   Gross Unrealized
Losses
   Estimated
Fair Value

Corporate debt securities

   $ 43,877    $ 72    $ 8    $ 43,941

U.S. Treasury and agency debt securities

     4,998      2      —        5,000
                           
   $ 48,875    $ 74    $ 8    $ 48,941
                           

Derivative Financial Instruments

Our derivative financial instruments are composed entirely of foreign exchange forward contracts. We record derivative financial instruments as either assets or liabilities in our consolidated balance sheets and measure them at fair value. At December 31, 2009, the notional amount of our outstanding contracts was $24.2 million, which included the notional equivalent of $16.8 million in yen and $7.4 million in euro. At December 31, 2009, the outstanding derivatives had maturities of 90 days or less. The fair value of our foreign exchange forward contracts of $190,000 was included in prepaid expenses and other current assets in our consolidated balance sheet at December 31, 2009. For the year ended December 31, 2009, $715,000 of gains related to our derivative financial instruments are included in exchange rate gain in our consolidated statements of operations. Our use of derivative financial instruments commenced in October 2009, therefore no such gains or losses were recorded in any other period presented.

Fair Value Measurements

ASC 820 defines fair value as an exit price that would be received from the sale of an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction

 

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between market participants on the measurement date. ASC 820 establishes a three-level hierarchy for disclosure that is based on the extent and level of judgment used to estimate the fair value of assets and liabilities.

 

   

Level 1—Valuations based on quoted prices for identical assets or liabilities in active markets at the measurement date. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment. Our Level 1 assets consist of money market funds and U.S. Treasury and agency debt securities.

 

   

Level 2—Valuations based on quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data, such as alternative pricing sources with reasonable levels of price transparency. Our Level 2 assets consist of corporate debt securities including commercial paper, corporate bonds, certificates of deposit and foreign exchange forward contracts.

 

   

Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement. We have not measured the fair value of any of our assets on a recurring basis using Level 3 inputs.

We utilize a third-party pricing service to assist us in obtaining fair value pricing for our short-term available-for-sale investments. Pricing for these securities is based on proprietary models. Inputs are documented in accordance with the fair value disclosure hierarchy. During the year ended December 31, 2009, we performed a review of the pricing inputs to determine whether significant inputs have changed that would impact our classification within the fair value disclosure hierarchy. As a result of this review, we concluded that our pricing methodology for corporate debt securities including commercial paper, corporate bonds and certificates of deposit is more appropriately aligned with Level 2 of the fair value disclosure hierarchy as of December 31, 2008. Accordingly, we have reclassified all of our corporate debt securities from Level 1 to Level 2 as of December 31, 2008.

We utilize a third-party broker to assist us in obtaining fair value pricing for our foreign exchange forward contracts and have classified these financial instruments as Level 2.

During the years ended December 31, 2009 and 2008, no transfers were made into or out of the Level 3 categories. We will continue to review our fair value inputs on a quarterly basis.

The fair value of our financial assets subject to the disclosure requirements of ASC 820 was determined using the following levels of inputs at December 31, 2009 and 2008 (in thousands):

 

     Fair Value Measurements at December 31, 2009
         Total            Level 1            Level 2            Level 3    

Assets:

           

Cash

   $ 11,255    $ 11,255    $ —      $ —  

Money market funds

     44,800      44,800      —        —  

Corporate debt securities

     37,707      —        37,707      —  

U.S. Treasury and agency debt securities

     28,321      28,321      —        —  

Foreign exchange forward contracts

     190      —        190      —  
                           
   $ 122,273    $ 84,376    $ 37,897    $ —  
                           
     Fair Value Measurements at December 31, 2008
         Total            Level 1            Level 2            Level 3    

Assets:

           

Cash

   $ 14,243    $ 14,243    $ —      $ —  

Money market funds

     86,706      86,706      —        —  

Corporate debt securities

     43,941      —        43,941      —  

U.S. Treasury and agency debt securities

     5,000      5,000      —        —  
                           
   $ 149,890    $ 105,949    $ 43,941    $ —  
                           

 

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Accounts Receivable, Net

Accounts receivable, net consists of the following (in thousands):

 

     December 31,
     2009    2008

Trade accounts receivable

   $ 51,478    $ 42,149

Less: allowance for doubtful accounts

     307      354
             
   $ 51,171    $ 41,795
             

The change in the allowance for doubtful accounts for the years ended December 31, 2009, 2008 and 2007 is summarized in the following table (in thousands):

 

     Years Ended December 31,  
         2009             2008             2007      

Balance at beginning of year

   $ 354      $ 138      $ 201   

Additions charged to selling, general and administrative expense, net of recoveries

     (46     232        (79

Write-offs

     (10     —          —     

Foreign currency translation adjustments

     9        (16     16   
                        

Balance at end of year

   $ 307      $ 354      $ 138   
                        

Inventories

Inventories consist of the following (in thousands):

 

     December 31,
     2009    2008

Finished goods

   $ 10,985    $ 10,121

Work-in-process

     9,374      6,592

Raw materials

     17,351      12,223
             
   $ 37,710    $ 28,936
             

Property and Equipment

Property and equipment consists of the following (in thousands):

 

     December 31,  
     2009     2008  

Medical diagnostic equipment

   $ 43,234      $ 25,441   

Other equipment

     22,757        18,318   

Leasehold improvements

     6,352        4,460   

Purchased software

     2,970        1,763   

Construction-in-progress

     1,960        1,070   
                
     77,273        51,052   

Accumulated depreciation and amortization

     (32,539     (21,045
                
   $ 44,734      $ 30,007   
                

 

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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 $4.8 million, $1.7 million and $1.8 million is recorded in cost of revenues during the years ended December 31, 2009, 2008 and 2007, respectively. The net book value of this equipment was $23.2 million and $10.6 million at December 31, 2009 and December 31, 2008, 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 $1.8 million, $1.2 million and $793,000 during the years ended December 31, 2009, 2008 and 2007, respectively. The net book value of this equipment was $2.4 million and $3.5 million at December 31, 2009 and December 31, 2008, respectively. Medical diagnostic equipment is recorded at our cost to acquire or manufacture the equipment and is depreciated over its estimated useful life (generally three to five years).

Depreciation expense for the years ended December 31, 2009, 2008 and 2007 was $12.0 million, $6.0 million, and $4.8 million, respectively.

Intangible Assets

Intangible assets consist of developed technology, customer relationships, assembled workforce, 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.

During the year ended December 31, 2009, we recorded intangible asset additions of $315,000 related to internally developed patents and trademarks. In addition, we abandoned patents with a net book value of $100,000 in the same period.

During the year ended December 31, 2008, we recorded intangible asset additions of $481,000 related to internally developed patents and trademarks. In addition, we recorded $8.1 million of developed technology and $799,000 of customer relationships acquired in connection with our acquisition of Axsun. See Note 2 “Acquisitions” for more information.

Intangible assets subject to amortization, by major class, consist of the following (in thousands):

 

     December 31, 2009
     Cost    Accumulated
Amortization
   Net    Weighted-
Average Life
(in years)

Developed technology

   $ 20,565    $ 13,382    $ 7,183    7.3

Licenses

     7,034      4,747      2,287    10.0

Customer relationships

     2,473      1,788      685    6.7

Patents and trademarks

     2,231      900      1,331    6.9

Assembled workforce

     274      137      137    4.0
                       
   $ 32,577    $ 20,954    $ 11,623    7.6
                       
     December 31, 2008
     Cost    Accumulated
Amortization
   Net    Weighted-
Average Life
(in years)

Developed technology

   $ 20,565    $ 10,551    $ 10,014    7.3

Licenses

     7,034      4,094      2,940    10.0

Customer relationships

     2,473      1,415      1,058    6.7

Patents and trademarks

     2,082      663      1,419    7.5

Assembled workforce

     274      69      205    4.0
                       
   $ 32,428    $ 16,792    $ 15,636    7.6
                       

 

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We recorded amortization of intangible assets totaling $4.2 million, $3.1 million and $3.1 million for years ended December 31, 2009, 2008 and 2007, respectively.

The estimated future amortization expense of purchased intangible assets at December 31, 2009, is as follows (in thousands):

 

2010

   $ 2,071

2011

     2,071

2012

     2,003

2013

     1,671

2014

     1,067

Thereafter

     2,740