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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___ to ___
Commission File Number 0-22229
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VITAL IMAGES, INC.
(Exact name of Registrant as specified in its charter)
MINNESOTA 42-1321776
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3100 WEST LAKE STREET, SUITE 100 55416
MINNEAPOLIS, MINNESOTA (Zip Code)
(Address of principal
executive offices)
(612) 915-8000
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
Preferred Stock Purchase Rights
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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___
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K 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 the
Form 10-K. ____
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of February 28, 1999 was $17,174,993.
The number of shares outstanding of the issuer's classes of common stock as of
February 28, 1999: Common stock, $.01 Par Value - 4,887,372.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of registrant's definitive Proxy Statement in connection with the
Annual Meeting of Shareholders to be held May 12, 1999 ("1999 Proxy Statement")
are incorporated by reference into Part III.
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VITAL IMAGES, INC.
FORM 10-K
TABLE OF CONTENTS
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Page
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PART I
Item 1. Business...................................................................................... 3
Item 2. Properties.................................................................................... 19
Item 3. Legal Proceedings............................................................................. 20
Item 4. Submission of Matters to a Vote of Security Holders........................................... 20
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters......................... 20
Item 6. Selected Financial Data....................................................................... 21
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations......... 22
Item 8. Financial Statements and Supplementary Data................................................... 28
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure........................................................... 28
PART III
Item 10. Directors and Executive Officers of the Registrant............................................ 28
Item 11. Executive Compensation........................................................................ 28
Item 12. Security Ownership of Certain Beneficial Owners and Management................................ 28
Item 13. Certain Relationships and Related Transactions................................................ 28
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............................... 29
Signatures.................................................................................... 30
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FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains certain forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995. For
this purpose, any statements contained in this Form 10-K that are not statements
of historical fact may be deemed to be forward-looking statements. Without
limiting the foregoing, words such as "may," "will," "expect," "believe,"
"anticipate," "estimate," or "continue" or the negative or other variations
thereof or comparable terminology are intended to identify forward-looking
statements. These statements by their nature involve substantial risks and
uncertainties, and actual results may differ materially depending on a variety
of factors, including those set forth in the section below entitled "Important
Factors."
Item 1. BUSINESS
Vital Images, Inc. ("Vital Images" or the "Company") was incorporated in Iowa in
September 1988. In March 1997, the Company re-incorporated under the laws of the
state of Minnesota. The Company's principal executive offices are located at
3100 West Lake Street, Suite 100, Minneapolis, Minnesota 55416 (telephone (612)
915-8000, facsimile (612) 915-8010, e-mail - [email protected]). From May
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24, 1994 through May 11, 1997, the Company was a wholly-owned subsidiary of
Bio-Vascular, Inc. ("Bio-Vascular").
Business Description
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Vital Images is engaged in the business of developing, marketing and supporting
medical visualization and analysis software for use in clinical diagnosis,
surgical planning and medical research. Medical visualization and analysis
software involves the application of computer graphics and image processing
technologies to data supplied by standard medical imaging equipment, such as
computed tomography ("CT") scanners, magnetic resonance ("MR") imaging devices
and ultrasound scanning equipment. By applying these technologies to medical
imaging data, Vital Images' products allow clinicians to create both two- and
three-dimensional views of human anatomy and to navigate around, or "fly
through," these images to support their clinical diagnosis, surgical planning
and medical research.
Vital Images develops computer-based visualization and analysis software and, in
particular, three-dimensional visualization and analysis software based on
"volume rendering" of imaging data. The Company's technology, which utilizes
high-speed volume visualization and analysis, as well as network communications
based on DICOM and Internet protocols, cost-effectively brings 3D visualization
and analysis into the routine, day-to-day practice of medicine.
Vital Images' current products include its Vitrea(R), VoxelView(R) and Advanced
3DI(TM) medical visualization and analysis software. Vitrea, an advanced version
of Vital Images' technology for medical visualization and analysis applications,
is directed primarily at the clinical market for radiological and surgical
applications. Vital Images offers Vitrea both as a software package and as part
of an integrated software and hardware system to radiologists, surgeons and
other care providers. Vitrea and the integrated Vitrea system are both designed
for ready integration into hospital radiology networks. VoxelView, Vital Images'
first medical visualization product, is directed primarily at the medical
research market. Advanced 3DI is Vital Images' medical visualization and
analysis product for the ultrasound market. The Company markets its products to
healthcare providers and to manufacturers of diagnostic imaging systems through
a direct sales force in the United States and independent distributors in
international markets.
In 1994, Vital Images was acquired by Bio-Vascular in a tax-free merger
accounted for as a "pooling of interests." The acquisition by Bio-Vascular
provided financial and management resources to Vital Images and enabled Vital
Images to leverage these resources and focus its efforts on medical applications
for its technologies. By the fall of 1994, Vital Images discontinued its efforts
in the microscopy market and, in July 1995, granted an exclusive source code
license for its VoxelGeo(R) product for gas and oil exploration to Paradigm
Geophysical Corporation ("Paradigm"). In exchange for this license, Vital Images
received a one-
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time license fee of $1,500,000 and future royalty payments that began in 1997.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations."
Spin-off from Bio-Vascular
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On October 28, 1996, the Board of Directors of Bio-Vascular, the former parent
company of Vital Images, Inc., approved a plan to spin off and establish Vital
Images as an independent, publicly-owned company. On May 12, 1997 (the
"Distribution Date"), Bio-Vascular distributed all of the shares of Vital Images
to the shareholders of Bio-Vascular (the "Distribution"), and on that date Vital
Images began operating as an independent public company. All Bio-Vascular
shareholders of record as of May 5, 1997 received one share of Vital Images
common stock for each two shares of Bio-Vascular stock held on that date, and
cash in lieu of fractional shares. As a result of Bio-Vascular's spin-off of
Vital Images, Vital Images' financial statements and notes thereto report the
business of Vital Images as an independent company. Vital Images is currently
traded on the OTC Bulletin Board under the symbol VTAL.
In anticipation of the Distribution, Bio-Vascular assigned to Vital Images,
$10,000,000 in cash, cash equivalents and marketable securities, effective
November 1, 1996. Subsequently, Bio-Vascular's Board of Directors agreed to make
such additional contributions as were necessary to bring cash, cash equivalents
and marketable securities to a combined total of $10,000,000 effective as of the
Distribution Date. On the Distribution Date, Bio-Vascular contributed to Vital
Images an additional $1,845,000 in cash equivalents in order to increase Vital
Images' cash, cash equivalents and marketable securities balance to $10,000,000.
Additionally, Bio-Vascular made capital contributions to Vital Images of
approximately $3,200,000 representing net advances of cash over the period
beginning May 24, 1994, the date on which Vital Images was acquired by
Bio-Vascular, and ending May 11, 1997, the last date on which Vital Images was a
part of Bio-Vascular.
On July 17, 1997, the Board of Directors of the Company adopted a resolution
changing the Company's fiscal year end from October 31 to December 31, effective
with the calendar year beginning January 1, 1997. The 1998 and 1997 fiscal years
ended on December 31, whereas the 1996 fiscal year ended on October 31.
Accordingly, a two-month transition period from November 1, 1996 through
December 31, 1996 preceded the start of the 1997 fiscal year.
Technology
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The core technologies underlying the Company's products are based on a
visualization technique known as "volume rendering." Volume rendering is an
advanced technique for displaying two- or three-dimensional views on a computer
monitor that has significant advantages over the alternative technique, known as
"surface rendering," in that it permits the direct display of imaging data
without mathematical modeling and allows interactive control of the level of
"transparency" of the data. By comparison, surface rendering requires the
creation of artificial surfaces based on imaging data, and the usefulness of the
resulting visual image is largely dependent on where these surfaces are "set" by
the clinical technician. Volume rendering is not dependent on the creation of
artificial surfaces and allows visualization of varying components that might
otherwise be eliminated from a surface rendered image due to surface
approximation.
Traditionally, volume rendering was largely overlooked by visualization
companies because the computer power necessary to perform volume rendering is,
in general, significantly more intensive than the requirements for surface
rendering. The Company's experience with volume rendering has its basis in the
efforts of Vincent J. Argiro, Ph.D., the founder of the Company, who developed
three-dimensional visualization software using volume rendering as an aid in his
research in developmental neuroscience. While other researchers focused on
optimizing their work within the constraints of surface rendering, Dr. Argiro
focused on accelerating the performance of volume rendering on standard computer
platforms. As a result of his work, he developed expertise in accelerated volume
rendering, which forms the core of the Company's volume rendering technology.
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As the performance of standard computer platforms continues to increase while
the relative cost of such performance continues to decrease, the Company
believes that volume rendering is becoming a more accessible imaging solution
for routine clinical applications.
Strategy
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The Company's overall strategy is to develop and market leading edge medical
visualization and analysis software and systems to end users, and to seek
opportunities to integrate its technologies into medical imaging equipment
developed and marketed by other medical device manufacturers. The Company
leverages its core competencies in volume rendering, computer graphics, network
technologies and medical applications and, in addition, is pursuing
collaborative partnerships with leading medical institutions to further develop
its product offerings.
The Company has concentrated its efforts, and will continue to do so during the
short-term, on the development and sale of advanced radiology visualization and
analysis systems, consisting of third party workstations and the Company's
proprietary visualization and analysis software. These workstations provide
accelerated two- and three-dimensional visualization and analysis capabilities
for clinical diagnosis, screening and surgical planning. As this strategy is
advanced, the Company expects to continue to add clinical value to these
integrated systems, including additional "pre-set" parameters for visualization
of certain anatomical structures known as "protocols", in order to establish a
leading edge position in the clinical application of its products. The Company
also plans to migrate its technology to increasingly cost-effective computers
and operating environments, leveraging personal computer and Internet
technologies. As these technologies evolve, the demand for integrated radiology
workstations is expected to increase, extending to primary care physicians,
surgeons and other care providers. In addition, the Company plans to offer
elements of its software technologies or complete customized software solutions
to manufacturers of diagnostic and medical imaging devices for integration into
their systems. Although the Company expects to focus its marketing efforts
primarily on its Vitrea software, VoxelView software and any successor product
will continue to be offered to the medical marketplace.
Industry Background
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Medical practices in the areas of diagnostic imaging, surgery and cancer
treatment have changed dramatically over the past 20 years, due in part to the
introduction of a variety of new imaging, visualization, analysis, computer,
networking, catheter and navigation technologies. The result has been the rapid
adoption and increased use of CT, MR and ultrasound devices and the
incorporation of new physician-care practices based on the imaging information
provided by these devices.
Each of these modalities captures data that provides a two- or three-dimensional
image of the inside of the human body. These images have traditionally been
viewed as a series of two-dimensional, cross-sectional slices on x-ray-type
film. As computer and networking technologies improved, companies began offering
systems that provided for the electronic storage and transmission of these
images and allowed clinicians to view these images on a computer screen. The
first of these systems visualized the slice data on a computer monitor and then,
more recently, began to permit viewing and manipulation of the data as a single,
three-dimensional image. As a result, the medical visualization industry today
involves the visualization, manipulation, analysis and communication of medical
images in two and three dimensions.
While the market for medical imaging devices in the United States and other
industrialized countries is generally mature, the medical visualization industry
and the markets for medical visualization and analysis products have
historically lagged the imaging market due to the lack of industry standards for
the generation, transmission and storage of medical imaging data and due to
computer costs and performance considerations. Over the past several years, a
number of technical and cost barriers to the growth of the medical visualization
industry and the picture archive and communication systems ("PACS") industry
have begun to erode. In
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particular, the medical industry has embraced an image transmission and
archiving standard called DICOM3.0, promulgated by the American College of
Radiology (ACR) and the National Electronic Manufacturer's Association (NEMA).
This standard permits imaging, visualization, networking and archiving equipment
and systems from different vendors to work cooperatively within a single
network. In addition, the cost-to-performance ratio of computer products used in
visualization and PACS has improved dramatically, bringing the prices for
medical visualization and analysis capabilities and PACS within the grasp of
many healthcare providers. The Company believes that the increasing acceptance
of industry standards such as DICOM3.0 and the improvements in the cost-to-
performance ratio for clinical workstations will support continued market growth
in the medical visualization and PACS industries.
The Company also expects that a number of other trends and innovations in
medical imaging and visualization will support growth in the medical
visualization industry, such as:
. higher levels of resolution, or image quality, being provided by
medical imaging devices, allowing higher quality visualization and
analysis results;
. increasing numbers of images or "slices" being provided by medical
imaging devices, making the viewing of printed images on x-ray film,
rather than in a visualization system, logistically impractical and
expensive; and
. increasing clinical acceptance of electronic visualization and
analysis as teaching institutions rely more heavily on computer
technology and as DICOM-compliant PACS networks and imaging systems
become standard in radiology departments.
The Company believes that the increased use of medical visualization and
analysis technologies and of PACS will improve medical practices and clinical
and economic outcomes in the fields of diagnostic radiology, surgery and
oncology. More specifically, the Company believes that:
. increased use of medical visualization and analysis technology has the
potential to improve radiologists' ability to determine anatomical
positions and pathologies and enhance their ability to communicate
their findings to fellow clinicians and patients;
. advanced visualization and analysis may enhance surgeons' abilities to
plan and perform surgery by providing them with improved, three-
dimensional visual information regarding the position of structures in
the surgical field;
. visualization and analysis may enhance oncologists' ability to isolate
and plan radiation therapy treatment and follow up on its
effectiveness by providing realistic, three-dimensional views of the
treatment area; and
. the integration of these clinical disciplines through electronic
visualization, networking and the Internet has the potential to
provide the opportunity for greater cross-discipline coordination due
to increased speed, access to three-dimensional visual information,
and the resulting ability to perform consultative, interactive
planning and examination on computer workstations.
Markets
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The Company participates in the developing medical visualization market, which
has several segments, each at its respective stage of maturity and with its own
level of market penetration. The medical visualization market interrelates with
a number of other markets such as the diagnostic imaging equipment market, the
PACS market and the hospital and clinical information systems markets.
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Medical visualization and analysis software and systems have applications in
diagnostic screening and radiology, remote diagnosis and consultation (e.g.,
telemedicine), surgical assessment, planning, navigation and follow-up, cancer
assessment and radiation and chemotherapy treatment planning and medical
education. The customers for these applications include radiology, surgery and
oncology departments of hospitals and research centers, diagnostic imaging and
screening centers, outpatient surgery centers, clinics and physician groups.
As discussed above, the overall market for medical visualization and analysis
software and systems is developing, as the related technology and products that
define this market are relatively new and undergoing rapid change. Medical
visualization and analysis software and system solutions for diagnostic
radiology have existed for the past five years. However, most have been
expensive (over $100,000), slow, difficult to use and of limited clinical
application. The use of medical visualization and analysis software and systems
to assist in surgical planning and navigation has only begun to emerge into
clinical practice in the last five years, and primarily in applications such as
biopsy guidance in neuroradiology. While medical visualization and analysis
software and systems have been used in these applications and to support cancer
treatment planning in the past, the Company believes that perspective,
three-dimensional volume rendering represents an untapped resource to
practitioners for diagnostic screening and radiology, surgical planning and
navigation and cancer treatment.
Products and Product Development
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The Company's primary products include its initial medical visualization
software product, VoxelView, as well as Vitrea, its advanced medical
visualization and analysis software product for clinical applications, which was
commercially released in October 1997.
In December 1995, the Company assessed its business strategy and determined that
to optimize its dedicated participation in the medical field it needed to create
a new product for direct clinical application. The objective for this new
product effort was to produce an easy-to-use, clinical software tool to allow
radiologists and other clinicians to use two- and three-dimensional
visualization in their routine clinical processes. Unlike its VoxelView
software, the Company set out to design this new software product for users with
clinical knowledge, rather than computer graphics expertise. Specifications for
this new product, called Vitrea, were developed in early 1996, with software
coding beginning in late spring of that year. The Company submitted 510(k)
documentation in September 1996 for Vitrea and was granted marketing clearance
by the FDA in December 1996 for use as a clinical diagnostic and surgical
planning device when used with CT and MR medical imaging data.
Vitrea software capitalizes on the Company's experience in medical visualization
and provides clinicians with an easy-to-use tool with which to diagnose and plan
surgery, and represents the Company's most important step to date as a provider
of a range of clinical tools for broad distribution to the medical visualization
market. Vitrea's primary features are its high-speed rendering capability and
the ability to provide two- and three-dimensional viewing for routine diagnosis
and surgical planning, without requiring the user to be trained in computer
graphics techniques. The Company believes that both of these features now make
it possible to use three-dimensional medical visualization in daily clinical
routines. A Vitrea user can view the image data in two or three dimensions using
visualization settings based on specific clinical applications stored within the
system, as dedicated visualization protocols, and then interactively navigate
around, or "fly through," the image, allowing the user to view
clinically-relevant anatomies and pathologies. Vitrea software also allows the
user to capture views by taking "snapshots," which can be downloaded into
customized reports for electronic transmission and archiving.
Vitrea software conforms to the latest medical imaging and computer industry
standards, such as OpenGL(TM) computer graphics format and DICOM3.0.
The Company offers Vitrea both as a software package and as a part of an
integrated software and hardware system, consisting of Vitrea software installed
on a Silicon Graphics O2(R) workstation. Pursuant to an
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arrangement under a reseller agreement between the Company and Silicon Graphics,
the Company purchases O2 workstations at a nominal discount, installs its Vitrea
software, and markets the package as an integrated medical visualization and
analysis solution, thereby implementing the Company's strategy to develop,
market, sell and support an integrated visualization and analysis workstation.
In addition to its immediate clinical applications, Vitrea software also
incorporates a number of additional technological advances, making it adaptable
to routine clinical use in surgical navigation and cancer treatment and for
integration into diagnostic imaging equipment manufactured by other companies.
In particular, Vitrea software was written using advanced programming
techniques, a modular, object-oriented design, C++ programming language, and a
shared messaging structure. These characteristics make it practical to modify
Vitrea software to suit the clinical needs of surgical navigation and oncology,
as well as allowing diagnostic equipment manufacturers to integrate Vitrea
software or its components into imaging system consoles and off-line review
stations, thereby providing the Company with the opportunity to leverage the
Vitrea software development investment into new commercial areas.
The Company's VoxelView software received marketing clearance from the United
States Food and Drug Administration (the "FDA") in November 1995 for use as a
clinical diagnostic and surgical planning device when used with CT and MR
medical imaging data. VoxelView software is marketed primarily to medical
researchers, although it is also used by radiologists and surgeons as a clinical
diagnostic and planning tool. VoxelView software's primary capability is the
ability to provide volume rendered, three-dimensional views of human anatomy
using three-dimensional image data sets from imaging devices such as CT and MR
scanners. VoxelView software is a highly flexible tool, allowing the clinician
or researcher to interactively control many visualization parameters, including
brightness, contrast, color, transparency, shading, lighting, texture,
reflectivity and orientation. However, the need to control these visualization
parameters limits the usefulness of VoxelView software in the routine clinical
setting, where an end user may be a skilled medical technician lacking expertise
in computer graphics techniques.
In addition to its system and software products, the Company also offers
maintenance and support services to its customers, as well as certain other
services such as installation and training. Maintenance services for VoxelView
software have typically been offered to licensees on an annual basis, and
provide for software updates, error correction, telephone support and other
general maintenance services in exchange for an annual maintenance fee. In
connection with the licensing of Vitrea software, the Company also markets
similar annual maintenance services for both Vitrea software and the integrated
Vitrea system, pursuant to which the Company provides updates, error correction,
telephone support and general maintenance services. Outside of these maintenance
services, the Company is required by FDA regulation to provide certain levels of
support to end users as a result of the use of its products as medical devices.
Maintenance services currently marketed by the Company do not include
installation, training, testing and other services, whether on- or off-site, as
such services are charged separately by the Company.
In August 1996, the Company entered into a product development agreement with
ATL Ultrasound, Inc. ("ATL"), one of the leading ultrasound system vendors.
Pursuant to this agreement, each party agreed to collaborate exclusively with
the other for a period of five years in connection with the development of
three-dimensional visualization products for medical diagnostic ultrasound
imaging applications, provided that the Company may collaborate with other
parties in connection with products to be used in multi-modality environments
(i.e., environments that offer multiple imaging technologies and not just
ultrasound imaging). ATL reimburses the Company for certain product development
costs and has responsibility for obtaining regulatory approvals. Intellectual
property developed jointly by the parties pursuant to this agreement is jointly
owned by both parties, each with the right to use or license such intellectual
property. The first product developed under this agreement, Advanced 3DI
software, was released in the fourth quarter of 1998.
License fees accounted for 61%, 62% and 57% of total revenue in each of the
fiscal years ended December 31, 1998 and 1997, and October 31, 1996,
respectively. Maintenance and services comprised 12%, 24% and 39% of total
revenue for the years ended December 31, 1998 and 1997 and the year ended
October 31, 1996,
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respectively, while hardware accounted for 27%, 14% and 4% of
total revenue for the years ended December 31, 1998 and 1997 and the year ended
October 31, 1996, respectively.
The Company expensed $1,815,000, $2,255,000 and $1,459,000 incurred in its
research and development efforts in each of the fiscal years ended December 31,
1998 and 1997, and October 31, 1996, respectively.
Competition
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The medical visualization market is developing and growing rapidly. It is
intensely competitive, subject to rapid change and significantly affected by new
product introductions and other market activities of industry participants. The
Company's primary competitors are the various diagnostic imaging system
suppliers, which are typically large, multinational companies, having far
greater financial and technical resources than the Company, and which also have
well established sales and distribution networks for their products. These
companies, including GE Medical Systems, Siemens Medical Systems, Inc., Picker
International, Inc. and Philips Medical Systems, are engaged in the business of
developing and marketing medical imaging systems, such as CT and MR equipment,
and either offer, or will likely seek to offer, visualization capabilities
integrated into their products in addition to the visualization capabilities
typically provided as a part of the operator's console on the imaging equipment
itself. This visualization capability may be internally developed by these
companies, or may be licensed from independent vendors.
The Company also faces competition from (i) other visualization systems and
software suppliers; (ii) PACS vendors; (iii) hospital, radiology and clinical
system suppliers; and (iv) internal development projects sponsored by hospital
radiology departments.
Other visualization systems and software suppliers compete on the basis of
volume rendering or other visualization technologies, such as surface rendering.
PACS companies sometimes provide visualization capability in addition to their
image archiving and networking products. Vendors of hospital, clinical and
radiology information systems have also diversified into the PACS and medical
visualization product lines, either through internal development or business
development. These companies, which may be large or small, attempt to offer an
integrated system covering a full range of administrative, clinical and
radiology information management capabilities to healthcare providers. Finally,
many research and university healthcare institutions attempt to develop their
own visualization systems. Some departments have in the past, and may in the
future, attempt to secure FDA clearance for such systems, and to license such
systems or technology for general commercial sale.
The Company's competitive position is based on its ability to (i) provide
differentiated medical visualization and analysis products that operate in
multi-vendor network and image source environments; (ii) provide clinical
quality, three-dimensional images, volume rendered at high speed, and
interactive navigation on a low cost standard computer; (iii) integrate clinical
knowledge from its collaborative clinical partners into its products; (iv) offer
a "DICOM client" product which can operate on any DICOM network, independent of
the imaging system and network provider; (v) serve both original equipment
manufacturers ("OEM") and end-user customers through the development of a
modular end-user product that can easily be segmented for OEM customers; and
(vi) leverage its visualization technology across multiple clinical disciplines,
including radiology, surgical planning and medical research.
The Company believes that product quality, performance, functionality and
features, quality of support and service, company reputation and price are also
important competitive factors. While price has been less significant than other
factors, increasing competition as the medical visualization markets continues
to develop may result in price reductions and reduced gross margins. In
particular, should one or more of the diagnostic imaging system suppliers choose
to provide or distribute more competitive visualization products than the ones
offered by the Company, the Company's business, financial condition and results
of operations could be materially adversely affected. All of these competitors
have substantially greater financial, marketing and technical resources than the
Company.
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Marketing, Distribution and Customer Support
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The Company markets its products both as a software package and as part of an
integrated software and hardware system to radiologists, surgeons, primary care
physicians and medical researchers. The Company markets its products directly to
end-user customers, such as hospitals and clinics, as well as to select
diagnostic imaging companies, digital imaging equipment manufacturers and PACS
companies for resale on either a Vital Images' branded or private label basis.
In addition, the Company markets its products directly to OEMs on either a
standard or customized basis. In connection with its OEM opportunities, the
Company will either provide complete systems for resale by such OEMs or will
provide elements of its technology for incorporation into the products and
systems of such OEMs. The Company has already established an OEM relationship
with ATL, pursuant to a sales and marketing agreement entered into in August
1996. Pursuant to this agreement, ATL has been granted exclusive world-wide
rights to market products jointly developed by the parties for use in the
medical diagnostic ultrasound market in return for royalty payments on such
sales. ATL's exclusivity will continue from year to year for each product upon
the attainment of agreed-upon market objectives.
The Company markets its products both domestically and internationally. In the
United States, the Company markets its products through its direct sales force
as well as through OEMs and resellers. Internationally, the Company markets its
products through OEMs and resellers. See Note 8 to the Financial Statements -
"Major Customers and Geographic Data" for information regarding the Company's
export sales. As of February 28, 1999, the Company had five direct salespeople
in the U.S., one international reseller salesperson, one OEM customer and five
international resellers.
Toshiba America Medical Systems and Paradigm Geophysical Corporation accounted
for 23% and 14%, respectively, of revenue for the year ended December 31, 1998.
A reduction, delay, or cancellation of orders from Toshiba America Medical
Systems could have a material adverse effect on the Company's operating results.
See Note 8 to the Financial Statements - "Major Customers and Geographic Data"
for information regarding the Company's significant customers.
Intellectual Property
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Although the Company has filed patent applications with respect to certain
aspects of its technology, it generally does not rely on patent protection with
respect to its products and technologies. Instead, the Company relies primarily
on a combination of trade secret and copyright law, employee and third-party
nondisclosure agreements and other protective measures to protect intellectual
property rights pertaining to its products and technologies. Because of the
rapid pace of technological change in the medical visualization industry, the
Company believes that patent, trade secret and copyright protection are less
significant to its competitive position than factors such as the knowledge,
ability and experience of its personnel; new product developments and
enhancements; and ongoing, reliable product maintenance and support.
Pursuant to a licensing agreement dated June 30, 1992 between the Company and
Maharishi International University ("MIU"), MIU granted a perpetual, worldwide,
exclusive source code license to certain volume rendering software developed by
Dr. Argiro at MIU and used in the Company's VoxelView product. Royalty
obligations of the Company pursuant to this agreement expired in May of 1996.
Vitrea includes certain DICOM libraries that are owned by Duke University
("Duke"). These libraries, which allow the Company's products to interface with
DICOM networks, are the subject of a licensing agreement that was entered into
between the Company and Duke in August 1997. Under the terms of the agreement,
the Company has the non-exclusive right to use, market, distribute and sell the
Duke DICOM libraries with its products. In exchange for the license, which has a
perpetual term but may be terminated by Duke for cause, the Company paid Duke
$75,000.
10
<PAGE>
Manufacturing and Service
- -------------------------
The Company's manufacturing efforts are limited to the production, quality
assurance and distribution of its VoxelView and Vitrea software, which is
distributed on CD-ROM. The software is sent to the customer site and loaded into
the computer on site. VoxelView software is loaded into the computer by the
customer with telephone assistance from the Company, as needed. The software for
Vitrea is loaded into the computer by Company personnel, as part of the
Company's installation services, which are priced and billed incrementally to
the software license billing. In addition to the loading of software into the
computer, the Company's installation services also include integrating Vitrea
workstations into customers' computer networks, configuring network requirements
and validating operations on site.
The Company relies primarily on its own software development as its core value
added. Given the nature of software, there is no raw material as such. The
Company sources its DICOM libraries from Duke, see "Intellectual Property"
above, and the operating system for integrated computer workstations from other
parties. In addition, the Company sources systems components, computers and
computer peripherals from suppliers such as Silicon Graphics and Access
Graphics, Inc. See "Important Factors--Dependence on Single Platform."
Governmental Regulation
- -----------------------
As medical devices, the Company's medical visualization and analysis products
are subject to extensive and rigorous regulation by numerous governmental
authorities, principally the FDA and corresponding foreign agencies. In the
United States, the FDA administers the Federal Food, Drug and Cosmetic Act and
its amendments. These regulations classify medical devices as either Class I, II
or III devices, which are subject to general controls, special controls or
pre-market approval requirements, respectively. Most Class I and II devices, as
well as some Class III devices, can be cleared for marketing pursuant to a
510(k) pre-market notification. The process of obtaining a 510(k) clearance
typically can take several months to a year or longer.
Some Class III devices require more stringent clinical investigation and
pre-market clearance requirements. In such cases, the FDA will require that the
manufacturer submit a pre-market approval ("PMA") application that must be
reviewed and approved by the FDA prior to sale and marketing of the device in
the United States. The process of obtaining a PMA can be expensive, uncertain
and lengthy, frequently requiring anywhere from one to several years from the
date of FDA submission, if approval is obtained at all. Moreover, a PMA, if
granted, may include significant limitations on the indicated uses for which a
product may be marketed.
Both of the Company's current products, VoxelView and Vitrea, are classified as
Class II medical devices and have received marketing clearance from the FDA as
the result of 510(k) submissions. In the early 1990's, the review time by the
FDA to clear medical devices for commercial release lengthened and the number of
clearances, both of 510(k) submissions and PMA's, decreased. In response to
public and congressional concern, the FDA Modernization Act of 1997 was adopted
with the intent of bringing better definition to the clearance process. Although
it is expected that the 1997 Act will result in improved cycle times for product
clearance, there can be no assurance that the FDA review process will not
involve delays or that certain clearances will be granted on a timely basis.
The Company is also increasingly becoming subject to regulation in those foreign
countries in which it sells its products. Many of the regulations applicable to
the Company's products in such countries are similar to those of the FDA. The
Company's ability to successfully market and sell its products internationally
depends in large part on its ability to comply with such foreign regulatory
requirements. Vitrea software has been CE marked, indicating conformance with
applicable sections of the Medical Device Directive 93/42/EEC, which allows the
product to be marketed in the member countries of the European Communities.
11
<PAGE>
The Company is also subject to periodic inspections by the FDA, whose primary
purpose is to audit the Company's compliance with quality system regulations
established by the FDA and other applicable government standards. Regulatory
action may be initiated in response to audit deficiencies or to product
performance problems. The Company believes that its manufacturing and quality
control procedures are in essential compliance with the requirements of the FDA
regulations.
The financial arrangements through which the Company markets, sells and
distributes its products may be subject to certain federal and state laws and
regulations in the United States with respect to the provision of services or
products to patients who are Medicare or Medicaid beneficiaries. Violations of
these laws and regulations may result in civil and criminal penalties, including
substantial fines and imprisonment. In a number of states, the scope of these
laws and regulations have been extended to include the provision of services or
products to all patients, regardless of the source of payment, although there is
variation from state to state as to the exact provisions of such laws or
regulations. In other states, and, on a national level, several health care
reform initiatives have been proposed which would have a similar impact. The
Company believes that its operations and its marketing, sales and distribution
practices currently comply in all respects with all current fraud and abuse and
physician anti-referral laws and regulations, to the extent they are applicable.
Third Party Reimbursement and Cost Containment
- ----------------------------------------------
The Company's products are purchased primarily by hospitals, clinics and other
users that bill various third party payers for the services provided to the
patients. These payers, which include Medicare, Medicaid, private insurance
companies and managed care organizations, reimburse part or all of the costs and
fees associated with the procedures utilizing the Company's products. Medicare
and Medicaid reimbursement for hospitals is based on a fixed amount for
admitting a patient with a specific diagnosis. Because of this fixed
reimbursement method, hospitals have incentives to use less costly methods in
treating Medicare and Medicaid patients, and will frequently make capital
expenditures to take advantage of less costly treatment technologies.
Frequently, reimbursement is reduced to reflect the availability of a new
procedure or technique and, as a result, hospitals are generally willing to
implement new cost-saving technologies before these downward adjustments take
effect. Likewise, because the rate of reimbursement for certain physicians who
perform certain procedures has been, and may in the future, be reduced in the
event of changes in the resource-based relative value scale method of payment
calculation, physicians may seek greater cost efficiency in treatment to
minimize any negative impact of reduced reimbursement. Any amendments to
existing reimbursement rules and regulations which restrict or terminate the
reimbursement eligibility (or the extent or amount of coverage) of medical
procedures using the Company's products or the eligibility (or the extent or
amount of coverage) of the Company's products could have a material adverse
impact on business.
In response to the focus of national attention on rising health care costs, a
number of changes to reduce costs have been proposed or have begun to emerge.
There have been, and may continue to be proposals by legislators and regulators
and third party payers to reduce these costs. There has also been a significant
increase in the number of Americans enrolling in some form of managed care plan
and, in addition, many hospitals participate in or have agreements with HMOs. It
has become a typical practice for hospitals to affiliate themselves with as many
managed care plans as possible. Higher managed care penetration typically drives
down the prices of healthcare procedures, which in turn places pressure on
medical supply prices. This causes hospitals to implement tighter vendor
selection and certification processes, by reducing the number of vendors used,
purchasing more products from fewer vendors and trading discounts on price for
guaranteed higher volumes to vendors. Hospitals have also sought to control and
reduce costs over the last decade by joining group purchasing organizations or
purchasing alliances. The Company cannot predict what continuing or future
impact these practices, the existing or proposed legislation, or such third
party payer measures may have on its future business.
12
<PAGE>
Employees
- ---------
As of February 28, 1999, the Company had 50 employees, with 17 involved in
research and development, 12 in sales and marketing, 9 in technical support
functions and 12 in administrative functions.
EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below are the names of the executive officers of the Company as of
March 22, 1999, their ages, the year first elected as an executive officer of
the Company and employment for the past five years.
<TABLE>
<CAPTION>
NAME AGE TITLE
- -------------------------------------------------------------------------------
<S> <C> <C>
Douglas M. Pihl 60 Chairman of the Board, President,
Chief Executive Officer and Director
Vincent J. Argiro, Ph.D. 43 Executive Vice President, Chief
Technology Officer and Director
Steven P. Canakes 43 Vice President - U.S. Sales
David M. Frazee 38 Vice President - Engineering
Gregory S. Furness 45 Senior Vice President - Finance, Chief
Financial Officer, Treasurer
and Secretary
Jay D. Miller 39 Senior Vice President and General
Manager
Robert C. Samec 46 Vice President - Regulatory Affairs and
Quality Assurance
</TABLE>
Douglas M. Pihl. Mr. Pihl has been a director of the Company since May 1997, its
Chairman of the Board since December 1997, and its Chief Executive Officer since
February 1998. Since August 1996, Mr. Pihl has been a private investor. From May
1992 to August 1996, Mr. Pihl was the President and Chief Executive Officer of
NetStar, Inc. Mr. Pihl has over 30 years of experience in the computer industry
with extensive responsibility in design, product planning and management. From
February 1989 to December 1990 he was Senior Vice President, Development for
Apertus Technologies, Inc. (formerly Lee Data Corporation). From December 1987
until February 1989, Mr. Pihl was an independent consultant. Mr. Pihl was Senior
Vice President-Development of Lee Data Corporation ("Lee Data") from April 1979
until December 1987. Mr. Pihl was a founder in 1979 of Lee Data, which then
developed, manufactured and marketed computer peripheral products.
Vincent J. Argiro, Ph.D. Dr. Argiro was appointed Executive Vice President and
Chief Technology Officer of Vital Images in October 1995. From May 1994 until
May 1997, Dr. Argiro also served as a Vice President of Bio-Vascular, the former
parent company of Vital Images. Dr. Argiro served as a director of Bio-Vascular
from May 1994 until March 1996. Following the acquisition of the Company by Bio-
Vascular in May 1994, Dr. Argiro served as President of the Company until
October 1995. Dr. Argiro, the founder of the Company, served as Chairman of the
Board of the Company from 1988 until May 1994. From 1988 to 1990 and from
September 1991 to June 1992, Dr. Argiro also served as President of the Company.
Prior to June 1992, Dr. Argiro served as an Associate Professor of Physiology at
Maharishi University of Management in Fairfield, Iowa, where he conducted
research in neuroscience and cell biology.
13
<PAGE>
Steven P. Canakes. Mr. Canakes was named Vice President - U.S. Sales in August
1998. Prior to that he was the Company's Director of U.S. Sales from March 1998.
From July 1996 to March 1998, Mr. Canakes was Vice President of Business
Development for MedManagement, LLC in Plymouth, Minnesota. From February 1994 to
July 1996, Mr. Canakes served as Vice President of Sales for Medintell Systems
and Value Health Corporation, a Medintell Systems Division. Prior to February
1994, Mr. Canakes was a CT Product Sales Manager for Picker International, Inc.
David M. Frazee. Mr. Frazee was named Vice President - Engineering in March
1999. From July 1998 to March 1999, Mr. Frazee served as a Manager in the
Solution Strategies Practice of Whittman-Hart, Inc. From April 1997 to July
1998, Mr. Frazee was Director of Program Management and Internet Products at
LodgeNet Entertainment, Inc. Prior to April 1997, Mr. Frazee held several
systems and software development and management positions at GE Medical Systems,
Inc., most recently as Manager of the Global Software Applications Operation.
Gregory S. Furness. Mr. Furness was named Senior Vice President - Finance in
August 1998 and has served as Chief Financial Officer, Treasurer and Secretary
of Vital Images since February 1997. From December 1987 to December 1996 Mr.
Furness served as Executive Vice President and Chief Financial Officer of CAMAX
Manufacturing Technologies, Inc., a computer-aided manufacturing software
developer, which was acquired by Structural Dynamics Research Corporation in
June 1996. Prior to December 1987, Mr. Furness was employed as Vice President,
Finance and Chief Financial Officer of Mizar, Inc., and as an audit manager at
Deloitte and Touche LLP. Mr. Furness is a Certified Public Accountant.
Jay D. Miller. Mr. Miller was named Senior Vice President and General Manager in
August 1998 and served as Vice President Marketing and Sales of Vital Images
from February 1998 to August 1998. Mr. Miller served as the Company's Vice
President - Marketing and Business Development from February 1997 to February
1998. From 1989 until his employment by the Company, Mr. Miller was employed by
GE Medical Systems, Inc. in positions of increasing responsibility in the
marketing area, including serving as product manager and global product line
strategy for MR imaging products and marketing manager for the cardiology market
segment. Prior to 1989, Mr. Miller was employed by Siemens Medical Systems in
technical marketing.
Robert C. Samec. Mr. Samec was named Vice President - Regulatory Affairs and
Quality Assurance in October 1998. Mr. Samec served as Vice President,
Regulatory/Quality of ContiMed, Inc., a urologic device developer from October
1997 to October 1998. Prior to October 1997, Mr. Samec spent 15 years with
Aequitron Medical, Inc., a developer of portable respiratory devices, where he
was Vice President, Regulatory Affairs/Quality Assurance.
ITEM 1A - IMPORTANT FACTORS
The following factors are important and should be considered carefully in
connection with any evaluation of the Company's business, financial condition,
results of operations and prospects. Additionally, the following factors could
cause the Company's actual results to materially differ from those reflected in
any forward-looking statements of the Company.
Historical Operating Losses
- ---------------------------
The Company had operating losses of $3,467,000, $5,211,000 and $2,545,000 for
the years ended December 31, 1998 and 1997 and October 31, 1996, respectively,
and, with the exception of the fiscal year ended October 31, 1995, has incurred
operating losses each year since 1990. As of December 31, 1998, the Company's
accumulated deficit was $14,011,000. While the Company is optimistic that it can
achieve its first quarterly profit in the fourth quarter of 1999, there can be
no assurance that the Company will be profitable at any time in the future. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
14
<PAGE>
Dependence on Market Growth
- ---------------------------
The medical visualization industry in which the Company markets its products is
still developing. The developing stage of the industry is attributable to the
fairly recent availability of high performance computers at reduced prices, the
recent adoption of industry standards for the generation, transmission and
storage of medical imaging data, and changing medical practices. Although the
Company believes that the recent advances in the affordability of high
performance computers and in the development of industry standards for imaging
data will provide opportunities for growth in the medical visualization
industry, given the uncertainties associated with the developing stage of the
industry, there can be no assurance that the industry will continue to develop
in the manner anticipated by the Company. Accordingly, there can be no assurance
that the medical visualization industry will provide growth opportunities for
the Company and its volume rendering software products or that the Company's
business strategies and focus on volume rendering technology will be successful
as the medical visualization industry continues to evolve.
The success of the Company's products will depend on its ability to successfully
market its products, the ability and willingness of physicians to use two- and
three-dimensional imaging software in clinical diagnosis, surgical planning,
patient screening, and other diagnosis and treatment protocols, and the ability
of the Company to differentiate its volume rendering software from competing
products employing surface rendering or other technologies. There can be no
assurance that the Company will be able to succeed in its efforts to further
develop, commercialize, and achieve market acceptance for its Vitrea software,
or for any other product. See "Business--Description," "--Technology,"
"--Industry Background," "--Markets" and "--Competition."
Need for Additional Capital
- ---------------------------
In anticipation of the Distribution, Bio-Vascular agreed to assign to Vital
Images $10,000,000 in cash, cash equivalents and marketable securities effective
November 1, 1996. Subsequent to November 1, 1996, Bio-Vascular's Board of
Directors determined to make such additional capital contributions as necessary
to increase Vital Images' cash, cash equivalents, and marketable securities to
$10,000,000, effective as of the Distribution Date. Accordingly, on the
Distribution Date, Bio-Vascular transferred an additional $1,845,000 in cash
equivalents to Vital Images in order to increase Vital Images' cash, cash
equivalents and marketable securities to an aggregate of $10,000,000.
If Vital Images' operations progress as anticipated, of which there can be no
assurance, the Company believes that the capital contributions made by
Bio-Vascular, together with cash flows from operations and borrowings available
under the credit agreement entered into in March 1999, should be sufficient to
satisfy its cash requirements for at least the next twelve months. The timing of
Vital Images' future capital requirements, however, will depend on a number of
factors, including the ability of Vital Images to successfully market its
products; the ability and willingness of physicians to use two- and
three-dimensional imaging software in clinical diagnosis, surgical planning,
patient screening and other diagnosis and treatment protocols; the impact of
competition in the medical visualization business; the ability of Vital Images
to differentiate its volume rendering software from competing products employing
surface rendering or other technologies; the ability of the Company to build an
effective sales and distribution channel; and the ability to enhance existing
products and develop new products on a timely basis. To the extent that Vital
Images' operations do not progress as anticipated, additional capital may be
required sooner. There can be no assurance that any required additional capital
will be available on acceptable terms, or at all, and the failure to obtain any
such required capital would have a material adverse effect on Vital Images'
business. The issuance of additional equity capital may result in dilution of
current shareholder voting and ownership interests. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations."
15
<PAGE>
Highly Competitive Industry; Risk of Technological Obsolescence
- ---------------------------------------------------------------
The Company faces intense competition in the medical visualization industry.
While the industry is in a developing stage, its development to date has been
characterized by rapid innovation and technological change. The Company expects
technology to continue to develop rapidly, and the Company's success will depend
to a large extent on its ability to maintain a competitive position with its
volume rendering technology. There can be no assurance that the Company will be
able to compete effectively in the marketplace or that products developed by its
competitors will not render its products obsolete or non-competitive. Similarly,
there can be no assurance that the Company's competitors will not succeed in
developing or marketing products that are viewed as providing superior clinical
performance or are less expensive relative to the Company's products currently
marketed or to be developed. Companies competing with the Company in the medical
visualization industry include large, established manufacturers of medical
imaging equipment. In addition to having significantly greater capital and
staffing resources for research and development that are critical to success in
the rapidly changing medical visualization industry, such companies also have
well-established marketing and distribution networks and may have a competitive
advantage in marketing visualization and analysis tools as an integrated part of
their imaging products. Additionally, the Company faces competition from other
entities, such as PACS vendors, hospital, radiology and clinical systems
suppliers and internal development projects sponsored by hospital radiology
departments. There can be no assurance that the Company will be able to compete
effectively with such manufacturers or competing entities. See
"Business--Technology," "--Industry Background" and "--Competition."
Dependence on Single Platform
- -----------------------------
Substantially all the Company's product offerings are designed to run on
workstations manufactured and sold by Silicon Graphics. To the extent that
Silicon Graphics workstations become unavailable to the Company or that end-
users of the Company's products utilize platforms manufactured by other
companies, the Company may encounter difficulty in marketing its products. In
any such event, the Company may be required to engage in substantial research
and development and sales and marketing efforts, at potentially significant
expense, to reconfigure and remarket its products to run at optimal performance
levels on workstations other than those manufactured by Silicon Graphics. There
can be no assurance that end-users of the Company's products will not determine
to use platforms other than those currently compatible with the Company's
products, and any such use could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Business--Products
and Product Development."
Dependence on Major Customers
- -----------------------------
For the year ended December 31, 1998, sales by the Company to Toshiba America
Medical Systems ("Toshiba") and Paradigm Geophysical Corporation accounted for
approximately 23% and 14%, respectively, of the Company's net revenue. Further,
management believes a limited number of large customers may continue to account
for a significant portion of the Company's revenues during any given period for
the foreseeable future. The Company currently has no long-term purchase
agreements with any of its customers and sales are generally made pursuant to
purchase orders. A reduction, delay, or cancellation of orders from one or more
of its significant customers could have a material adverse effect on the
Company's operating results.
Fluctuations in Quarterly Results
- ---------------------------------
The Company may experience significant fluctuations in future annual and
quarterly operating results. If these fluctuations occur, they may result in
volatility in the price of the Company's Common Stock. Quarterly revenues and
operating results may fluctuate as a result of a variety of factors including
the timing of significant orders, the timing of product enhancements and new
product introductions by the Company, its competitors and its customers, the
pricing of the Company's products, changes in customers' budgets, and
16
<PAGE>
competitive conditions. Although the Company's revenues have increased in recent
quarterly periods, there can be no assurance that the Company's revenues will
increase in future quarters.
The Company's largest customer, Toshiba--see "Business--Dependence on Major
Customers"--has recently begun marketing and selling a new high speed CT
scanner, the Aquillion(TM). Toshiba has only begun delivering the Aquillion to
its customers and has many scanner purchases on back order. Since some of these
orders will not be delivered until later in 1999, this may have the effect of
delaying shipments of Vitrea software and hardware purchased in conjunction with
a Toshiba scanner. Accordingly, some of the revenue the Company expects to
realize in the first half of 1999 may be delayed until the second half of 1999.
The Company estimates that a delay in revenue, if it occurs may result in
fluctuations in the Company's quarterly results, but will not have a material
adverse effect on the Company's long-term financial position or results of
operations.
Uncertain Protection for Intellectual Property; Possible Claims of Others
- -------------------------------------------------------------------------
Although the Company has filed patent applications with respect to certain
aspects of its technology, it generally does not rely on patent protection with
respect to its products and technologies. Instead, the Company relies primarily
on a combination of trade secret and copyright law, employee and third-party
nondisclosure agreements and other protective measures to protect intellectual
property rights pertaining to its products and technologies. There can be no
assurance, however, that these measures will provide meaningful protection of
the Company's trade secrets, know-how or other intellectual property in the
event of any unauthorized use, misappropriation or disclosure or that others
will not independently develop similar technologies or duplicate any technology
developed by the Company. In addition, to the extent that any patents are
applied for, there can be no assurance that such applications will result in
issued patents or, if issued, that such patents will be held to be valid or will
otherwise be of value. While the Company does not believe that its products and
technologies infringe any existing patents or intellectual property rights of
third parties, there can be no assurance that such infringement does not exist.
The costs of defending an intellectual property claim could be substantial and
could adversely affect the Company, even if it were ultimately successful in
defending any such claims. If the Company's products or technologies were found
to infringe the rights of a third party, the Company could be required to pay
significant damages or license fees or cease production, which could have a
material adverse effect on the Company's business. See "Business--Intellectual
Property."
Product Liability Risk; Limited Insurance Coverage
- --------------------------------------------------
The manufacture and sale of products used in the practice of medicine entail
significant risk of product liability claims. While the Company currently
maintains product liability insurance in the amount of $6,000,000 per occurrence
and $7,000,000 in total and also maintains errors and omissions coverage in the
amount of $6,000,000 per occurrence and in total, there can be no assurance that
its coverage limits will be adequate to protect the Company from any liabilities
it might incur in connection with the sale of its products, or that the Company
will be able to maintain this level of coverage in the future. In addition, in
order to compete in the medical visualization industry, the Company will have to
maintain a steady pace of new product rollouts and updates or enhancements of
existing products. Accordingly, the Company may require increased product
liability coverage as additional products and updates come to the marketplace.
Such insurance is expensive and in the future may not be available on acceptable
terms, if at all. A successful product liability claim or series of such claims
against the Company in excess of the Company's insurance coverage could have a
material adverse effect on its business.
Dependence on Key Employee; Need to Hire Additional Personnel
- -------------------------------------------------------------
The Company will depend upon the active participation of Dr. Argiro, its founder
and Executive Vice President and Chief Technology Officer. Loss of the services
of Dr. Argiro could have a material adverse effect on the Company's future
business. Dr. Argiro does not have an employment agreement with the
17
<PAGE>
Company. The Company has key-man life insurance coverage for Dr. Argiro in the
amount of $500,000. Furthermore, the Company's success as a company will depend
on its ability to enhance and develop markets for its current products as well
as to introduce new products to the marketplace. This success will depend
largely on its ability to attract and retain other qualified scientific and
management personnel. The Company competes for such personnel with other
companies, academic institutions, government entities and organizations, many of
which have substantially greater capital resources and research and development
capabilities than the Company. There can be no assurance that the Company will
be successful in recruiting or retaining such personnel, and the inability of
the Company to recruit and retain such personnel would have a material adverse
effect on the Company's business.
Government Regulation
- ---------------------
The Company's products are subject to regulation by the FDA and by comparable
agencies in foreign countries. In the United States, the FDA regulates the
development, introduction, manufacturing, labeling and recordkeeping procedures
for medical devices, including medical visualization and analysis software and
systems. The process of obtaining marketing clearance from the FDA for new
products and new applications for existing products can be time-consuming and
expensive. All of the products currently marketed by the Company have received
marketing clearance from the FDA pursuant to 510(k) pre-market notifications.
There can be no assurance, however, that clearance will be granted with respect
to future products or enhancements or that FDA review will not involve delays
that would adversely affect the Company's ability to market such future products
or enhancements. In addition, there can be no assurance that future products or
enhancements will not be subject to the more lengthy and expensive pre-market
approval process with the FDA.
Even if regulatory approvals to market a product are obtained from the FDA,
these approvals may entail limitations on the indicated uses of the product.
Product approvals by the FDA can also be withdrawn due to failure to comply with
regulatory standards or the occurrence of unforeseen problems following initial
approval. The FDA could also limit or prevent the distribution of the Company's
products and has the power to require the recall of such products. FDA
regulations depend heavily on administrative interpretation, and there can be no
assurance that future interpretations made by the FDA or other regulatory bodies
will not adversely affect the Company. The FDA may inspect the Company and its
facilities from time to time to determine whether the Company is in compliance
with various regulations relating to specification, development, documentation,
validation, testing, quality control and product labeling. A determination that
the Company is in violation of such regulations could lead to imposition of
civil penalties, including fines, product recalls or product seizures and, in
extreme cases, criminal sanctions.
The Company markets its products both domestically and internationally.
International regulatory bodies have established varying regulations governing
product standards, packaging requirements, labeling requirements, import
restrictions, tariff regulations, duties and tax requirements. The inability or
failure of the Company to comply with the varying regulations or the imposition
of new regulations could restrict its ability to sell its products
internationally and could thereby adversely affect the Company's business. See
"Business--Governmental Regulation."
Limitations on Third-Party Reimbursement
- ----------------------------------------
The Company's products are purchased by hospitals, clinics and other users,
which bill various third party payers, such as government health programs,
private health insurance plans, managed care organizations and other similar
programs, for the health care goods and services provided to their patients.
Payers may deny reimbursement if they determine that a product used in a
procedure was not used in accordance with established payer protocol regarding
cost-effective treatment methods or was used for an unapproved indication. Third
party payers are increasingly challenging the prices charged for medical
services and, in some instances, have put pressure on service providers to lower
their prices or reduce their services. The Company is unable to predict what
changes will be made in the reimbursement methods used by third party healthcare
payers. There can be no assurance that procedures in which the Company's
products are used will
18
<PAGE>
be considered cost effective by third party payers, that reimbursement for such
procedures will be available or, if available, that payers' reimbursement levels
will not adversely affect the Company's ability to sell its products on a
profitable basis. In addition, there have been and may continue to be proposals
by legislators, regulators and third party payers to curb further these costs in
the future. Failure by hospitals and other users of the Company's products to
obtain reimbursement from third party payers, changes in third party payers'
policies towards reimbursement for procedures using the Company's products or
legislative action could have a material adverse effect on the Company's
business. See "Business--Third Party Reimbursement and Cost Containment."
Certain Anti-Takeover Considerations
- ------------------------------------
The Company's Articles authorize the Board of Directors, without any action by
shareholders, to establish the rights and preferences of up to 5,000,000 shares
of undesignated preferred stock. The Company is also subject to certain
"anti-takeover" provisions of the Minnesota Business Corporation Act. In
addition, the Company has adopted a Shareholder Rights Plan (the "Rights
Agreement") designed to protect the Company and its shareholders from
unsolicited attempts or inequitable offers to acquire the Company. These
measures may, in certain circumstances, deter or discourage takeover attempts
and other changes in control of the Company not approved by its Board of
Directors. As a result, the Company's shareholders may lose opportunities to
dispose of their shares at the higher prices typically available in takeover
attempts or that may be available under a merger proposal. In addition, these
measures may have the effect of permitting the Company's current directors to
retain their positions and place them in a better position to resist changes
that shareholders may wish to make if they are dissatisfied with the conduct of
the Company's business.
Effects of Trading in the Over-the-Counter Market
- -------------------------------------------------
The Company's common stock is traded in the over-the-counter market on the OTC
Electronic Bulletin Board. Consequently, the liquidity of the Company's common
stock may be impaired, not only in the number of shares that may be bought and
sold, but also through delays in the timing of transactions, and coverage by
security analysts and the news media may also be reduced. As a result, prices
for shares of the Company's Common Stock may be lower than might otherwise
prevail if the Company's Common Stock were traded on a national securities
exchange.
Item 2. PROPERTIES
The Company's principal offices, sales, marketing and operations, as well as
some product development activities, are located in Minneapolis, Minnesota,
where the Company currently occupies approximately 14,000 square feet under a
lease that expires January 31, 2002. Under this lease, the Company has the
option to expand its facilities, and under certain conditions, the lease may be
terminated early by the Company on January 31, 2000. The Company is required to
post a security deposit of up to $150,000 if, during the term of the lease, the
aggregate balance of cash and marketable securities owned by the Company falls
below $3,000,000 or its equity falls below $1,000,000.
In addition, a portion of the Company's product development, quality engineering
and customer support operations are conducted in facilities with approximately
9,000 square feet located in Fairfield, Iowa under a lease that expires on June
1, 2000. In December 1998, the Company made a decision to consolidate its
operations at its headquarters in Minneapolis, Minnesota and close its facility
in Fairfield, Iowa.
The Company considers its current facilities adequate for its current needs and
believes that suitable additional space will be available as needed.
19
<PAGE>
Item 3. LEGAL PROCEEDINGS
The Company is not engaged in any legal proceedings at this time.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There was no matter submitted to the vote of security holders during the fourth
quarter of 1998.
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
The Company's Common Stock has traded on the OTC Bulletin Board under the symbol
"VTAL" since May 14, 1997. The following table sets forth, for each of the
periods indicated, the high and low closing bid quotations for the Company's
Common Stock as reported by the OTC Bulletin Board. Such prices reflect
inter-dealer prices, do not include adjustments for retail mark-ups, mark-downs
or commissions and may not necessarily represent actual transactions.
<TABLE>
<CAPTION>
High Low
---- ---
<S> <C> <C>
1998
----
Fourth Quarter $2.1250 $1.0625
Third Quarter $3.2188 $1.1250
Second Quarter $3.2500 $1.7500
First Quarter $2.3125 $1.0000
1997
----
Fourth Quarter $1.6875 $1.1875
Third Quarter $2.1250 $1.6250
Second Quarter $2.5000 $1.5000
(commencing May 14, 1997)
</TABLE>
The Company has never paid or declared any cash dividends on its Common Stock
and does not intend to pay dividends on its Common Stock in the near future. To
date, the Company has incurred losses and presently expects to retain its future
anticipated earnings to finance development and expansion of its business. As of
February 28, 1999, there were approximately 5,500 beneficial owners and
approximately 1,200 registered holders of record of the Company's Common Stock.
20
<PAGE>
Item 6. SELECTED FINANCIAL DATA
The following selected financial data for each of the fiscal years in the
five-year period ended December 31, 1998 is derived from the audited financial
statements of the Company and the notes thereto. The information set forth below
should be read in conjunction with the Company's financial statements, including
the notes thereto, and "Management's Discussion and Analysis of Financial
Condition and Results of Operations," which are included elsewhere in this
Annual Report on Form 10-K.
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FOR THE YEARS ENDED OR AS OF FOR THE TWO MONTHS
DECEMBER 31 ENDED OR AS OF FOR THE YEARS ENDED OR AS OF OCTOBER 31
---------------------------- DECEMBER 31, ---------------------------------------
STATEMENTS OF OPERATIONS: 1998 1997 (1) 1996 (1) 1996 (1) 1995(1) 1994(1)
---- -------- -------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C>
Revenue $ 4,527 $ 1,218 $ 65 $ 882 $2,894 (2) $ 1,680
Gross margin 3,302 915 53 720 2,488 (2) 1,170
Operating expenses:
Selling, general and
administrative 4,954 3,871 328 1,805 879 1,098
Research and development 1,815 2,255 333 1,460 1,357 1,255
Acquisition costs - - - - - 71
------- ------- -------- ------- ------ -------
Operating income (loss) (3,467) (5,211) (608) (2,545) 252 (2) (1,254)
Net income (loss) $(3,209) $(4,774) $ (521) $(2,546) $ 253 $(1,261)
======= ======= ======= ======= ====== =======
Net income (loss)
per share - basic (3) $ (0.66) $ (1.00) $ (.11) $ (.54) $ .07
======= ======= ======== ======= ======
Weighted average common shares
outstanding - basic (3) 4,841 4,772 4,745 4,716 3,786
======= ======= ======== ======= ======
Net income (loss)
per share - diluted (3) $ (0.66) $ (1.00) $ (.11) $ (.54) $ .06
======= ======= ======== ======= ======
Weighted average common shares
outstanding - diluted (3) 4,841 4,772 4,745 4,716 4,031
======= ======= ======== ======= ======
BALANCE SHEETS:
Working capital (deficiency) $ 3,360 $ 6,415 $ 6,214 $ (258) $ (144) $ 4
Total assets 5,938 8,296 10,493 943 739 855
Short and long-term debt - - - - - -
Total equity 4,134 7,253 9,720 174 321 343
</TABLE>
(1) Reflects Vital Images' results as a wholly-owned subsidiary of Bio-Vascular
from May 1994 through May 1997. Vital Images was merged with Bio-Vascular
in May 1994 in a transaction accounted for as a pooling-of-interests and
subsequently spun-off as an independent, publicly-owned company in May
1997. Results of operations during the period from May 1994 through May
1997 include allocations of certain general corporate expenses of Bio-
Vascular.
(2) Includes $1,500 of one-time license fee revenue, which contributed $1,322
to gross margin and operating income.
(3) For periods after the Distribution, basic and diluted net loss per share is
computed using the weighted average common shares outstanding during the
period. Common share equivalents are not included in the net loss per share
calculations since they are anti-dilutive.
For periods prior to the Distribution, the weighted average common shares
outstanding used in the net income (loss) per share calculation is one-half
of the weighted average of Bio-Vascular common shares outstanding based on
the distribution of one share of the Company's common stock for each two
shares of Bio-Vascular's common stock pursuant to the Distribution. To the
extent the common share equivalents are dilutive, the weighted average
common shares include one-half of Bio-Vascular's weighted average common
share equivalents.
21
<PAGE>
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Vital Images, Inc. (the "Company" or "Vital Images") develops and markets
visualization and analysis software for clinical diagnosis, surgical planning
and medical research. The Company's technology, which utilizes high-speed
visualization and analysis, as well as network communications based on DICOM and
Internet protocols, cost-effectively brings 3D visualization and analysis into
the routine, day-to-day practice of medicine. The Company, which operates in a
single business segment, markets its products to healthcare providers and to
manufacturers of diagnostic imaging systems through a direct sales force in the
United States and independent distributors in international markets.
On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.
("Bio-Vascular"), the former parent company of Vital Images, approved a plan to
spin off and establish Vital Images as an independent, publicly-owned company.
On May 12, 1997 (the "Distribution Date"), Bio-Vascular distributed all of the
shares of Vital Images to the shareholders of Bio-Vascular (the "Distribution"),
and on that date Vital Images began operating as an independent public company.
All Bio-Vascular shareholders of record as of May 5, 1997 received one share of
Vital Images common stock for each two shares of Bio-Vascular stock held on that
date, and cash in lieu of fractional shares. As a result of Bio-Vascular's
spin-off of Vital Images, Vital Images' financial statements and notes thereto
report the business of Vital Images as an independent company. Vital Images is
currently traded on the OTC Bulletin Board under the symbol VTAL.
In anticipation of the Distribution, Bio-Vascular assigned to Vital Images,
$10,000,000 in cash, cash equivalents and marketable securities, effective
November 1, 1996. Subsequently, Bio-Vascular's Board of Directors agreed to make
such additional contributions as were necessary to bring cash, cash equivalents
and marketable securities to a combined total of $10,000,000 effective as of the
Distribution Date. On the Distribution Date, Bio-Vascular contributed to Vital
Images an additional $1,845,000 in cash equivalents in order to increase Vital
Images' cash, cash equivalents and marketable securities balance to $10,000,000.
Additionally, Bio-Vascular made capital contributions to Vital Images of
approximately $3,200,000 representing net advances of cash over the period
beginning May 24, 1994, the date on which Vital Images was acquired by
Bio-Vascular, and ending May 11, 1997, the last date on which Vital Images was a
part of Bio-Vascular.
On July 17, 1997, the Board of Directors of the Company adopted a resolution
changing the Company's fiscal year end from October 31 to December 31, effective
with the calendar year beginning January 1, 1997. The 1998 and 1997 fiscal years
ended on December 31, whereas the 1996 fiscal year ended on October 31.
Accordingly, a two-month transition period from November 1, 1996 through
December 31, 1996 preceded the start of the 1997 fiscal year.
References to 1998, 1997 and 1996 discussed below refer to the years ended
December 31, 1998 and 1997 and October 31, 1996, respectively.
REVENUE
Total revenue increased 272% to $4,527,000 in 1998 compared with $1,218,000 in
1997. Total revenue in 1997 increased 38% from total revenue of $882,000 in
1996. These increases were primarily the result of volume increases in shipments
of Vitrea(R), the Company's flagship medical visualization and analysis software
released in October 1997. Software and hardware revenue from Vitrea shipments
totaled $3,234,000 in 1998, compared with $404,000 in 1997, and none in 1996. In
addition, there was an increase in maintenance and service revenue related to
Vitrea sales and an increase in royalties received from the Company's license
22
<PAGE>
agreement with Paradigm Geophysical Corporation ("Paradigm"). Revenue received
under the license agreement with Paradigm was $618,000, $313,000 and none in
1998, 1997 and 1996, respectively. These increases more than offset a decline in
both license fee revenue and maintenance revenue from VoxelView(R) software, the
Company's product for the research market. Management expects to achieve
significant revenue growth in 1999 over 1998. However, actual results could vary
materially from the foregoing forward-looking statement as a result of lower
than expected demand for the Vitrea product or the timing of future releases of
Vitrea software.
GROSS MARGIN
The gross margin percentage decreased to 73% in 1998 from 75% in 1997 and 82% in
1996, primarily as a result of Vitrea system sales increasing as a proportion of
the Company's product mix. The Vitrea system, consisting of Vitrea software and
third-party hardware and peripherals, is designed to offer end users an
integrated visualization and analysis system. The Company receives only a
nominal discount in purchasing the third-party hardware and peripheral
components of the Vitrea system, and the Company's gross margin on the resale of
these system components approximates its discount. The Company anticipates that
as hardware revenue related to the sale of Vitrea software continues as a
significant proportion of the Company's total revenue, the overall gross margin
percentage will approximate the results of 1998. This forward-looking statement
will be influenced primarily by vendor discounts on the third-party hardware and
peripheral components of the Vitrea system, the selling price of the Vitrea
system and on the Company's product mix.
SALES AND MARKETING
Sales and marketing expenses were $2,955,000, $2,167,000 and $846,000 for 1998,
1997 and 1996, respectively. The increase from 1997 to 1998 was primarily due to
increased compensation costs as a result of increased sales commissions and
additional personnel, including the addition of a Vice President of U.S. Sales,
and increased travel expenses related to selling and promoting the Vitrea
product. The increase from 1996 to 1997 was primarily due to increased
compensation costs, including the addition of a Vice President of Marketing and
Business Development, as well as promotional, consulting and travel expenses
related to the marketing and promotion of the Vitrea product. The Company
expects sales and marketing costs to increase in future periods primarily as a
result of the cost of additional sales and customer support personnel.
RESEARCH AND DEVELOPMENT
Research and development expenses were down 20% to $1,815,000 in 1998 from
$2,255,000 in 1997. The decrease was primarily due to reimbursement of $285,000
of engineering costs pursuant to the development contract with ATL Ultrasound,
Inc. ("ATL"), fewer software engineers and a decrease in travel expenses.
Research and development expenses were $1,459,000 in 1996. The increase in 1997
from the 1996 level was primarily due to increased compensation costs resulting
from increased staffing for the development of the Vitrea product. In addition,
travel, depreciation and other expenses related to staffing also increased in
1997 as compared to 1996 due to increased development efforts for Vitrea
software. The Company anticipates that research and development expenses will
increase in future periods as additional releases of Vitrea software are
developed and the reimbursement of engineering costs by ATL decreases.
GENERAL AND ADMINISTRATIVE
General and administrative expenses were $1,999,000, $1,703,000 and $960,000 in
1998, 1997, and 1996, respectively. The increase from 1997 to 1998 was due
primarily to a charge of $180,000 in connection with the resignation of the
Company's former Chief Executive Officer and expenses of $100,000 related to the
planned closing of the Company's Iowa facility. In December 1998 the Company
made a decision to consolidate its operations at its headquarters in
Minneapolis, Minnesota and close its facility in Fairfield, Iowa. In addition,
compensation expense increased as a result of increased staffing, including the
addition of a Vice President of Regulatory Affairs and Quality Assurance, and
compensation costs for employees hired in 1997 that were
23
<PAGE>
present for all of 1998. Incremental costs associated with being an independent
public company, including professional fees and shareholder reporting, also
contributed to the increase. These increases were partially offset by a decrease
of $441,000 related to stock-based compensation costs in 1997. The increase from
1996 to 1997 was due to increases in the Company's administrative
infrastructure, and the incremental costs associated with becoming an
independent public company. During 1997, the Company leased new corporate
offices resulting in increased rent expense, increased its purchases of property
and equipment resulting in increased depreciation, and incurred costs for legal
and investor relations expenses as a result of becoming an independent public
company. In addition, compensation costs increased as a result of increased
staffing, including the addition of a Chief Financial Officer and an increase
related to deferred stock-based compensation costs. The Company believes that
general and administrative costs will increase in future periods primarily due
to increased compensation expense for employees hired in 1998 that will be
present for all of 1999 and additional new hires in 1999, as well as additional
costs related to the closing of the Company's Iowa facility.
RESULTS OF OPERATIONS
The increasing revenues from Vitrea shipments net of the increased expenses
attributable to the development of the Company's management team and
infrastructure and the development and promotion of the Vitrea product, resulted
in an operating loss of $3,467,000 for 1998 compared with an operating loss of
$5,211,000 for 1997 and an operating loss of $2,545,000 for 1996.
INTEREST INCOME
There was $264,000 of interest income for 1998, compared with $443,000 in 1997
and $1,000 in 1996. The decrease in interest income from 1997 to 1998 was due to
a lower balance of cash, cash equivalents and marketable securities as a result
of the use of cash to fund the Company's operations. The increase from 1996 to
1997 was primarily the result of interest income on the $10,000,000 in cash,
cash equivalents and marketable securities assigned by Bio-Vascular to the
Company, effective November 1, 1996, as well as the $1,845,000 contributed on
the Distribution Date, less cash used for operations subsequent to those dates.
INCOME TAXES
As a wholly-owned subsidiary of Bio-Vascular through May 11, 1997, the Company
did not file separate federal income tax returns, but rather was included in the
federal income tax returns filed by Bio-Vascular. For purposes of the Company's
financial statements prior to the Distribution, the Company's allocated income
tax provisions were based on the "separate return" method. The income tax
provisions for all years presented consist solely of certain state minimum fees.
A valuation allowance has been established to completely reserve for the
deferred tax assets of the Company.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1998, the Company had $3,737,000 in cash, cash equivalents
and marketable securities. The Company's working capital was $3,360,000 and the
Company had no material borrowings. In March 1999, the Company entered into a
collateralized line of credit agreement with a bank for $950,000. Borrowings
under the agreement are limited to the lower of $950,000 or the Company's
borrowing base, which consists of a specified percentage of certain accounts
receivable. The Company is also required to maintain a cash and cash equivalents
balance of at least $1,000,000. As of March 19, 1999, the Company's available
borrowings under the agreement were $561,000.
Cash flows used in operations decreased to $2,342,000 for 1998 from $4,075,000
in 1997. For 1996, $1,905,000 was used in operations. Cash flows were used
primarily to fund operating losses in each of the years 1998, 1997 and 1996,
which were partially offset by non-cash expenses for depreciation and
amortization in 1998, 1997 and 1996 and stock-based compensation in 1997 and
1996. Increases in current
24
<PAGE>
liabilities increased cash flows in each of the years 1998 and 1997 and were
offset in 1998 and 1997 by increases in accounts receivable. Changes in deferred
revenue resulted in increased cash in 1998 and 1996 and in decreased cash in
1997.
The increases in current liabilities in 1998 and 1997 were due primarily to
increases in accounts payable and accrued payroll and other liabilities. The
increases in accounts receivable and accounts payable were due primarily to
volume increases in Vitrea sales and costs related thereto, respectively, and
the increase in accrued payroll and other liabilities was due primarily to
increases in bonuses, commissions and accrued vacation pay related to increases
in employee headcount. In 1996, the increase in current liabilities was due to
an increase in deferred revenue related to the development agreement with ATL.
Net investing activities provided $3,555,000 of cash in 1998 primarily due to
the conversion of marketable securities into cash. In 1997, the Company used
$3,776,000 in investing activities primarily due to the investment of cash in
marketable securities. The Company used $380,000 in investing activities in
1996. The Company added property and equipment of $423,000, $796,000 and
$371,000 in 1998, 1997 and 1996, respectively, primarily for computer equipment
to accommodate the increases in employee headcount in 1998, 1997 and 1996 and
telecommunications equipment to accommodate the Company's move into new
facilities in 1997.
Cash provided by financing activities totaled $91,000, $1,818,000 and $2,285,000
in 1998, 1997 and 1996, respectively. Net cash investments made by Bio-Vascular
of $1,798,000 and $2,285,000 accounted for nearly all of the cash from financing
activities in 1997 and 1996, respectively. During 1998 and 1997, net cash of
$91,000 and $20,000, respectively, was provided by proceeds from the Company's
employee stock option plans.
The Company has never paid or declared any cash dividend and does not intend to
pay dividends in the near future. The Company has no current commitments for
material capital expenditures. See Note 5 to the financial statements, "Lease
Commitments," for additional commitments and contingencies. The Company expects
to use cash in the near term as it continues to develop the infrastructure to
support its business and develop the market for its products.
If the Company's operations progress as anticipated, of which there can be no
assurance, management believes that its cash, cash equivalents and marketable
securities and borrowings available under the credit agreement entered into in
March 1999 should be sufficient to satisfy its cash requirements for at least
the next twelve months. The timing of the Company's future capital requirements,
however, will depend on a number of factors, including the ability and
willingness of physicians to use three-dimensional visualization and analysis
software in clinical diagnosis, surgical planning, patient screening and other
diagnosis and treatment protocols; the ability of the Company to successfully
market its products; the ability of the Company to differentiate its volume
rendering software from competing products employing surface rendering or other
technologies; the ability of the Company to build an effective sales and
distribution channel; the impact of competition in the medical visualization
business; and the ability of the Company to enhance existing products and
develop new products on a timely basis. To the extent that the Company's
operations do not progress as anticipated, additional capital may be required
sooner. There can be no assurance that any required additional capital will be
available on acceptable terms or at all, and the failure to obtain any such
capital would have a material adverse effect on the Company's business.
YEAR 2000 READINESS
Many computer programs and embedded computer chips are unable to distinguish
between the year 1900 and the year 2000. Therefore, some computer hardware and
software will need to be modified prior to the year 2000 in order to remain
functional. This is commonly known as the Year 2000 ("Y2K") issue.
25
<PAGE>
The Company has a formal program in place with an assigned Year 2000 project
team to ensure that its critical areas will operate normally at the turn of the
century. The goal of the Year 2000 team is to ensure that the Company's
equipment, systems and processes and those of its significant business partners
are sufficiently Year 2000 compliant such that no date/time issue will have any
material adverse impact on the products or services that the Company provides
its customers or the timely and accurate processing of transactions.
The project team has identified its Y2K risks in the following four categories:
Company products, financial software, embedded chip technology and non-financial
software, and noncompliance by suppliers and customers.
Company Products. The Company is in the process of assessing the Y2K readiness
of its software products and has made the commitment that any product releases
in 1999 and later will be Y2K compliant. Management expects this assessment to
be completed by June 30, 1999. The Company has posted a table detailing the Y2K
readiness status of its products on its website at www.vitalimages.com. The
-------------------
table will be updated periodically as the Company completes the testing and/or
review procedures on each of its products. Management believes that a lack of
Y2K readiness in any of its products, except for Vitrea and Advanced 3DI, would
not have a material impact on the Company's results of operations or financial
condition. The Company expects to have certified Y2K compliant versions of both
Vitrea and Advanced 3DI prior to December 31, 1999.
Financial Software. During 1997, the Company purchased and installed a new
accounting software package. The Company has obtained a statement from the
vendor indicating that the software is Y2K compliant. The Company also plans to
test the Y2K readiness of this software by June 30, 1999.
Embedded Chip Technology and Non-financial Software. The Company has assessed
its Y2K readiness with regard to critical and non-critical embedded chip
technology and non-financial software. The Company's assessment of its Y2K
readiness did not reveal any critical embedded chip technology or non-financial
software that was not Y2K compliant. The Company's assessment did reveal that
certain non-critical assets containing embedded chip technology and certain
non-financial software were not Y2K compliant. The Company expects to replace or
upgrade these non-compliant assets and non-financial software products by June
30, 1999.
Noncompliance by Suppliers and Customers. The Company has identified its
critical suppliers and service providers. The Company intends to contact such
suppliers and service providers by June 30, 1999 to determine the state of their
Y2K readiness. To the extent that responses to the Y2K issue are unsatisfactory,
the Company will consider changing suppliers or service providers, but there can
be no assurance that the Company will be successful in finding such alternative
suppliers or service providers. The Company does not have any formal information
concerning the Y2K compliance status of its customers. If customers experience
significant Y2K problems, they may choose to delay or cancel orders for the
Company's products. In the event that any of the Company's significant suppliers
or customers do not achieve Y2K compliance in a timely manner, and the Company
is unable to replace them with alternate suppliers or customers, the Company's
operations could be materially adversely affected.
The costs incurred by the Company to date in addressing its Year 2000 readiness
issues have not been material. The Company currently estimates that the total
additional costs for addressing its internal Year 2000 readiness will not be
material. These costs are being expensed as they are incurred. The Company plans
to devote the necessary resources to resolve all significant Year 2000 issues in
a timely manner.
Throughout 1999, the Company will determine areas where contingency planning is
needed. The planning efforts include, but are not limited to, identification and
mitigation of potential serious business interruptions and establishing crisis
response processes to address unexpected problems.
26
<PAGE>
The Company's statements regarding its Year 2000 readiness are forward-looking
statements and are, therefore, subject to change as a result of known and
unknown factors. Both the Company's cost estimates and completion time frames
could be influenced by the Company's ability to successfully identify all Year
2000 issues, the nature and amount of remediation required, the availability and
cost of trained personnel in this area and the Year 2000 success that key third
parties and customers attain. While these and other unforeseen factors could
have a material adverse impact on the Company's financial position, results of
operations or liquidity in future periods due to possible business disruptions
caused by a lack of third party Year 2000 readiness, management believes that it
has implemented an effective Year 2000 compliance program that will minimize the
possible negative consequences to the company.
The Year 2000 readiness disclosure statement set forth above is a "Year 2000
Readiness Disclosure" under the federal Year 2000 Information and Readiness
Disclosure Act.
FOREIGN CURRENCY TRANSACTIONS
Substantially all of the Company's foreign transactions are negotiated, invoiced
and paid in U.S. dollars.
INFLATION
Management believes inflation has not had a material effect on the Company's
operations or on its financial condition.
NEW ACCOUNTING STANDARDS
During 1998, the Company adopted Statement of Financial Accounting Standards No.
("SFAS") 130, Reporting Comprehensive Income, which establishes standards for
reporting and display of comprehensive income and its components (revenue,
expenses, gains and losses) in a full set of general-purpose financial
statements. The effect of adopting SFAS 130 is included in the Statement of
Shareholders' Equity.
The Company also adopted SFAS 131, Disclosure about Segments of an Enterprise
and Related Information during 1998. SFAS 131 requires disclosure of segment
data in a manner consistent with that used by an enterprise for internal
management reporting and decision-making. SFAS 131 establishes requirements to
report selected segment information quarterly and to report entity-wide
disclosures about products and services, major customers and the material
countries in which the entity holds assets and reports revenue. The Company is
in one business segment, the visualization software business. Therefore the
adoption of SFAS 131 did not impact the Company's financial reporting practices.
Effective January 1, 1998 the Company adopted Statement of Position 97-2,
Software Revenue Recognition (SOP 97-2), which provides guidance on applying
generally accepted accounting principles in recognizing revenue on software
transactions and supersedes SOP 91-1, Software Revenue Recognition. SOP 97-2 did
not materially impact the Company's revenue recognition practices, financial
position or results of operations for the year ended December 31, 1998 and would
not have materially impacted the revenue recognition practices, financial
position or results of operations for the year ended December 31, 1997, the two
months ended December 31, 1996 or the year ended October 31, 1996.
MARKET RISK
The Company is exposed to market risk related to changes in the fair value of
its financial instruments due to changes in interest rates. As of December 31,
1998, the Company's financial instruments had remaining maturities of two months
or less. As a result, a 1% change in interest rates would not have a material
impact on the fair value of the Company's financial instruments as of December
31, 1998.
27
<PAGE>
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's financial statements, supplemental schedule and Report
of Independent Accountants thereon, all of which are included in this
Annual Report on Form 10-K, are listed in Item 14 (a) (1) of this Form
10-K.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
(a) Directors of the Registrant.
The information under the caption "Election of Directors" in the
Company's 1999 Proxy Statement is incorporated herein by reference.
(b) Executive officers of the Registrant.
Information concerning Executive Officers of the Company is included
in this Report on page 13 under Item 1, "Executive Officers of the
Registrant."
(c) Compliance with 16(a) of the Securities Exchange Act of 1934.
The information under the caption "Compliance with Section 16 (a)" in
the Company's 1999 Proxy Statement is incorporated herein by
reference.
Item 11. EXECUTIVE COMPENSATION
The information under the caption "Executive Compensation" and
"Compensation of Directors" in the Company's 1999 Proxy Statement is
incorporated herein by reference.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information under the caption "Security Ownership of Certain
Beneficial Owners and Management" in the Company's 1999 Proxy
Statement is incorporated herein by reference.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information under the caption "Certain Relationships and Related
Transactions" in the Company's 1999 Proxy Statement is incorporated
herein by reference.
28
<PAGE>
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) The following financial statements and supplemental schedule
of Vital Images, Inc. and Report of Independent Accountants thereon
are included herein:
<TABLE>
<CAPTION>
Page
----
<S> <C>
Report of Independent Accountants.................................................................. 31
Balance Sheets as of December 31, 1998 and 1997.................................................... 32
Statements of Operations for the years ended December 31, 1998 and 1997, the two
months ended December 31, 1996 and the year ended October 31, 1996........................... 33
Statements of Shareholders' Equity for the years ended December 31, 1998 and 1997, the two
months ended December 31, 1996 and the year ended October 31, 1996........................... 34
Statements of Cash Flows for the years ended December 31, 1998 and 1997, the two
months ended December 31, 1996 and the year ended October 31, 1996........................... 35
Notes to Financial Statements...................................................................... 36
Schedule II. Valuation and Qualifying Accounts..................................................... 49
</TABLE>
(a) (2) Included in Item 14 (a) (1) above
All other schedules to the financial statements required by Article
7 of Regulation S-X are not required under the related instructions
or are inapplicable and therefore have been omitted.
(a) (3) LISTING OF EXHIBITS
The Exhibits required to be a part of this Report are listed in the
Index to Exhibits which follows the Financial Statement Schedule on
page 50.
(b) REPORTS ON FORM 8-K
No reports on Form 8-K were filed during the quarter ended December
31, 1998.
(c) EXHIBITS
Included in Item 14 (a) (3) above.
29
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, in Minneapolis, Minnesota,
on the 30th day of March 1999.
VITAL IMAGES, INC.
By: /s/ Gregory S. Furness
--------------------------------
Gregory S. Furness
Chief Financial Officer and
Senior Vice President-Finance
(Chief Accounting Officer)
Pursuant to the requirement of the Securities Exchange Act of 1934, this Report
has been signed by the following persons in the capacities and on the dates
indicated.
<TABLE>
<CAPTION>
Signature Title Date
- --------- ----- ----
<S> <C> <C>
/s/Douglas M. Pihl Chairman of the Board, President, March 30, 1999
- ----------------------- Chief Executive Officer and Director
Douglas M. Pihl (Principal Executive Officer)
/s/Gregory S. Furness Chief Financial Officer, Senior March 30, 1999
- ----------------------- Vice President-Finance, Treasurer
Gregory S. Furness and Secretary
(Chief Accounting Officer)
/s/Vincent J. Argiro Executive Vice President, Chief March 30, 1999
- ----------------------- Technology Officer and Director
Vincent J. Argiro
/s/James B. Hickey, Jr. Director March 30, 1999
- -----------------------
James B. Hickey, Jr.
/s/Richard W. Perkins Director March 30, 1999
- -----------------------
Richard W. Perkins
/s/Edward E. Strickland Director March 30, 1999
- -----------------------
Edward E. Strickland
/s/Michael W. Vannier Director March 30, 1999
- -----------------------
Michael W. Vannier
/s/Sven A. Wehrwein Director March 30, 1999
- -----------------------
Sven A. Wehrwein
</TABLE>
30
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of
Vital Images, Inc.:
In our opinion, the financial statements listed in the index appearing under
Item 14(a)(1) present fairly, in all material respects, the financial position
of Vital Images, Inc. (the Company) as of December 31, 1998 and 1997 and the
results of its operations and its cash flows for the years ended December 31,
1998 and 1997, the two months ended December 31, 1996 and the year ended October
31, 1996, in conformity with generally accepted accounting principles. In
addition, in our opinion, the financial statement schedule listed in the index
appearing under Item 14(a)(1) presents fairly, in all material respects, the
information set forth therein when read in conjunction with the related
financial statements. These financial statements and financial statement
schedule are the responsibility of the Company's management; our responsibility
is to express an opinion on these financial statements and financial statement
schedule based on our audits. We conducted our audits of these statements in
accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for the opinion expressed
above.
/s/PricewaterhouseCoopers LLP
-----------------------------
Minneapolis, Minnesota
February 10, 1999, except
as to Note 10, for which
the date is March 19, 1999
31
<PAGE>
VITAL IMAGES, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
-----------------------------------------
1998 1997
---- ----
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 1,751,615 $ 448,377
Marketable securities 1,985,556 5,963,464
Accounts receivable, net of allowance for doubtful accounts
of $78,000 and $40,000 as of December 31, 1998 and 1997, respectively 1,149,109 581,130
Prepaid expenses and other current assets 135,117 264,826
------------ ------------
Total current assets 5,021,397 7,257,797
Property and equipment, net 916,238 997,947
Other assets - 40,267
------------ ------------
TOTAL ASSETS $ 5,937,635 $ 8,296,011
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 505,260 $ 203,579
Accrued payroll 587,261 322,572
Deferred revenue 380,851 212,556
Other current liabilities 188,381 104,003
------------ ------------
Total current liabilities 1,661,753 842,710
Deferred revenue 141,615 200,107
------------ ------------
Total liabilities 1,803,368 1,042,817
Commitments
Shareholders' equity:
Preferred stock: $0.01 par value; 5,000,000 shares authorized; none issued
or outstanding as of December 31, 1998 and 1997 - -
Common stock: $0.01 par value; 20,000,000 shares authorized; 4,870,497 and
4,806,561 shares issued and outstanding as of December 31, 1998 and 1997,
respectively 48,705 48,066
Additional paid-in capital 18,096,707 18,006,824
Accumulated deficit (14,011,145) (10,801,696)
------------ ------------
Total shareholders' equity 4,134,267 7,253,194
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 5,937,635 $ 8,296,011
============ ============
</TABLE>
(The accompanying notes are an integral part of the financial statements.)
32
<PAGE>
VITAL IMAGES, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE YEARS
ENDED FOR THE TWO FOR THE YEAR
DECEMBER 31, MONTHS ENDED ENDED
----------------------------------- DECEMBER 31, OCTOBER 31,
1998 1997 1996 1996
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenue:
License fees $ 2,734,783 $ 751,810 $ 14,176 $ 506,267
Maintenance and services 511,564 290,769 50,790 343,534
Hardware 1,281,004 175,592 - 32,325
------------- ------------ ------------ ------------
Total revenue 4,527,351 1,218,171 64,966 882,126
Cost of revenue:
License fees 147,387 143,135 11,894 122,714
Maintenance and services 120,989 3,309 - 13,669
Hardware 956,767 157,032 - 25,903
------------- ------------ ------------ ------------
Total cost of revenue 1,225,143 303,476 11,894 162,286
Gross margin 3,302,208 914,695 53,072 719,840
Operating expenses:
Sales and marketing 2,955,317 2,167,400 179,066 845,561
Research and development 1,814,602 2,255,030 333,011 1,459,490
General and administrative 1,999,141 1,703,024 148,743 959,961
------------- ------------ ------------ ------------
Total operating expenses 6,769,060 6,125,454 660,820 3,265,012
Operating loss (3,466,852) (5,210,759) (607,748) (2,545,172)
Interest income 263,668 443,439 87,045 923
------------- ------------ ------------ ------------
Loss before income taxes (3,203,184) (4,767,320) (520,703) (2,544,249)
Income taxes 6,265 6,500 - 1,500
------------- ------------ ------------ ------------
Net loss $ (3,209,449) $ (4,773,820) $ (520,703) $ (2,545,749)
============= ============ ============ ============
Net loss per share - basic and diluted $ (0.66) $ (1.00) $ (0.11) $ (0.54)
============= ============ ============ ============
Weighted average common shares
outstanding - basic and diluted 4,840,814 4,771,739 4,744,547 4,716,401
============= ============ ============ ============
</TABLE>
(The accompanying notes are an integral part of the financial statements.)
33
<PAGE>
VITAL IMAGES, INC.
STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
Net
Common Stock Additional Investment
------------------ Paid-In Deferred by Bio- Accumulated
Shares Amount Capital Compensation Vascular Deficit
------ ------ ------- ------------ -------- -------
<S> <C> <C> <C> <C> <C> <C>
Balances as of October 31, 1995 1,000 $ 10 $ 2,428,047 $ - $ 854,011 $(2,961,424)
Issuance of option for common stock
at below market price - - 575,000 (575,000) - -
Amortization of deferred compensation - - - 115,000 - -
Net amount received from Bio-Vascular - - - - 2,284,509 -
Comprehensive income (loss):
Net loss - - - - - (2,545,749)
Total comprehensive income (loss)
----------- -------- ----------- ---------- ---------- -----------
Balances as of October 31, 1996 1,000 10 3,003,047 (460,000) 3,138,520 (5,507,173)
Contribution of capital from
Bio-Vascular - - 10,000,000 - - -
Amortization of deferred compensation - - - 19,166 - -
Net amount received from
Bio-Vascular - - - - 60,190 -
Comprehensive income (loss):
Net loss - - - - - (520,703)
Change in unrealized loss
on marketable securities - - - - - -
Total comprehensive income (loss)
----------- -------- ----------- ---------- ---------- -----------
Balances as of December 31, 1996 1,000 10 13,003,047 (440,834) 3,198,710 (6,027,876)
Cancellation of common stock owned
by Bio-Vascular (1,000) (10) - - 10 -
Contribution of capital from Bio-Vascular - - 1,797,814 - - -
Issuance of common stock in connection
with spin-off from Bio-Vascular 4,772,422 47,724 3,150,996 - (3,198,720) -
Amortization of deferred compensation - - - 440,834 - -
Cancellation of restricted stock (2,565) (25) 25 - - -
Issuance of common stock under
Employee Stock Purchase Plan 15,776 158 20,490 - - -
Issuance of common stock awards 20,928 209 34,452 - - -
Comprehensive income (loss):
Net loss - - - - - (4,773,820)
Change in unrealized loss on
marketable securities - - - - - -
Total comprehensive income (loss)
----------- -------- ----------- ---------- --------- ------------
Balances as of December 31, 1997 4,806,561 48,066 18,006,824 - - (10,801,696)
Cancellation of restricted stock (2,383) (24) 24 - - -
Issuance of common stock upon exercise
of stock options 41,925 419 57,391 - - -
Issuance of common stock under
Employee Stock Purchase Plan 24,394 244 32,468 - - -
Comprehensive income (loss):
Net loss - - - - - (3,209,449)
Total comprehensive income (loss)
----------- -------- ----------- ---------- --------- ------------
Balances as of December 31, 1998 4,870,497 $ 48,705 $18,096,707 $ - $ - $(14,011,145)
=========== ======== =========== ========== ========= ============
<CAPTION>
Accumulated
Other Total
Comprehensive Shareholders'
Income (Loss) Equity
------------- ------
<S> <C> <C>
Balances as of October 31, 1995 $ - $ 320,644
Issuance of option for common stock
at below market price - -
Amortization of deferred compensation - 115,000
Net amount received from Bio-Vascular - 2,284,509
Comprehensive income (loss):
Net loss -
Total comprehensive income (loss) (2,545,749)
--------- -----------
Balances as of October 31, 1996 - 174,404
Contribution of capital from
Bio-Vascular - 10,000,000
Amortization of deferred compensation - 19,166
Net amount received from Bio-Vascular - 60,190
Comprehensive income (loss):
Net loss -
Change in unrealized loss
on marketable securities (13,125)
Total comprehensive income (loss) (533,828)
--------- -----------
Balances as of December 31, 1996 (13,125) 9,719,932
Cancellation of common stock owned
by Bio-Vascular - -
Contribution of capital from Bio-Vascular - 1,797,814
Issuance of common stock in connection
with spin-off from Bio-Vascular - -
Amortization of deferred compensation - 440,834
Cancellation of restricted stock - -
Issuance of common stock under
Employee Stock Purchase Plan - 20,648
Issuance of common stock awards - 34,661
Comprehensive income (loss):
Net loss -
Change in unrealized loss on marketable securities 13,125
Total comprehensive income (loss) (4,760,695)
--------- -----------
Balances as of December 31, 1997 - 7,253,194
Cancellation of restricted stock - -
Issuance of common stock upon exercise
of stock options - 57,810
Issuance of common stock under
Employee Stock Purchase Plan - 32,712
Comprehensive income (loss):
Net loss -
Total comprehensive income (loss) (3,209,449)
--------- -----------
Balances as of December 31, 1998 $ - $ 4,134,267
========= ===========
</TABLE>
(The accompanying notes are an integral part of the financial statements.)
<PAGE>
VITAL IMAGES, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS
ENDED FOR THE TWO FOR THE YEAR
DECEMBER 31, MONTHS ENDED ENDED
---------------------------------- DECEMBER 31, OCTOBER 31,
1998 1997 1996 1996
---- ---- ---- ----
<S> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (3,209,449) $(4,773,820) $ (520,703) $ (2,545,749)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 504,949 511,085 33,613 183,396
Stock-based compensation - 475,495 19,166 115,000
Provision for uncollectible accounts
receivable 52,313 12,452 700 36,592
Other 40,267 - - 1,073
Changes in operating assets and
liabilities:
Accounts receivable (620,292) (504,218) 100,743 6,633
Prepaid expenses and other current
assets 129,709 (65,511) 15,676 (51,255)
Accounts payable 301,681 116,049 27,997 (7,327)
Deferred revenue 109,803 (84,197) (15,264) 378,613
Accrued payroll and other liabilities 349,067 237,816 (8,091) (21,629)
--------------- ----------- ------------ ------------
Net cash used in operating
activities (2,341,952) (4,074,849) (346,163) (1,904,653)
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment (423,240) (795,828) (95,466) (371,217)
Increase in other assets - (17,011) (14,617) (8,639)
Investments in marketable securities (9,522,092) (9,826,875) - -
Maturities of marketable securities 13,500,000 6,863,411 - -
------------ ----------- ------------ ------------
Net cash provided by (used in)
investing activities 3,554,668 (3,776,303) (110,083) (379,856)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net investment by Bio-Vascular - 1,797,814 6,937,313 2,284,509
Purchases of common stock under
stock option plans 90,522 20,648 - -
------------ ----------- ------------ ------------
Net cash provided by financing
activities 90,522 1,818,462 6,937,313 2,284,509
NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS 1,303,238 (6,032,690) 6,481,067 -
CASH AND CASH EQUIVALENTS,
BEGINNING OF PERIOD 448,377 6,481,067 - -
------------ ----------- ------------ ------------
CASH AND CASH EQUIVALENTS, END OF
PERIOD $ 1,751,615 $ 448,377 $ 6,481,067 $ -
============ ============ ============ ============
</TABLE>
(The accompanying notes are an integral part of the financial statements.)
35
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
(1) BUSINESS DESCRIPTION, BACKGROUND AND BASIS OF PRESENTATION
Business Description
Vital Images, Inc. (the "Company" or "Vital Images") develops and markets
visualization and analysis software for clinical diagnosis, surgical planning
and medical research. The Company's technology, which utilizes high-speed
visualization and analysis, as well as network communications based on DICOM and
Internet protocols, cost-effectively brings 3D visualization and analysis into
the routine, day-to-day practice of medicine. The Company, which operates in a
single business segment, markets its products to healthcare providers and to
manufacturers of diagnostic imaging systems through a direct sales force in the
United States and independent distributors in international markets.
Background
On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.
("Bio-Vascular"), the former parent company of Vital Images, approved a plan to
spin off and establish Vital Images as an independent, publicly-owned company.
On May 12, 1997 (the "Distribution Date"), Bio-Vascular distributed all of the
shares of Vital Images to the shareholders of Bio-Vascular (the "Distribution"),
and on that date Vital Images began operating as an independent public company.
All Bio-Vascular shareholders of record as of May 5, 1997 received one share of
Vital Images common stock for each two shares of Bio-Vascular stock held on that
date, and cash in lieu of fractional shares.
In anticipation of the Distribution, Bio-Vascular assigned to Vital Images,
$10,000,000 in cash, cash equivalents and marketable securities, effective
November 1, 1996. Subsequently, Bio-Vascular's Board of Directors agreed to make
such additional contributions as were necessary to bring cash, cash equivalents
and marketable securities to a combined total of $10,000,000 effective as of the
Distribution Date. On the Distribution Date, Bio-Vascular contributed to Vital
Images an additional $1,845,000 in cash equivalents in order to increase Vital
Images' cash, cash equivalents and marketable securities balance to $10,000,000.
Additionally, Bio-Vascular made capital contributions to Vital Images of
approximately $3,200,000 representing net advances of cash over the period
beginning May 24, 1994, the date on which Vital Images was acquired by
Bio-Vascular, and ending May 11, 1997, the last date on which Vital Images was a
part of Bio-Vascular.
Basis of Presentation
The financial statements for periods subsequent to May 11, 1997 reflect the
assets, liabilities, shareholders' equity, revenues and expenses of the Company
on a stand-alone basis. The financial statements for periods prior to May 12,
1997 reflect the assets, liabilities, equity, revenues and expenses of the
Company as it was operated as a wholly-owned subsidiary of Bio-Vascular. Prior
to May 12, 1997, the Statements of Operations include an allocation of certain
general corporate expenses of Bio-Vascular for administration, accounting,
finance, human resources and regulatory functions. These allocations were based
on estimates of personnel time and effort spent on the Company. Management
believes these allocations were made on a reasonable basis. Corporate overhead
allocations were $77,000 for the year ended December 31, 1997, $38,000 for the
two-month period ended December 31, 1996, and $226,000 for the year ended
October 31, 1996.
36
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
The Company's financing requirements through the Distribution Date were
represented primarily by cash transactions with Bio-Vascular and are reflected
in the "Net Investment by Bio-Vascular" equity account. Activity in the Net
Investment by Bio-Vascular equity account relates to net cash received from
Bio-Vascular through intercompany advances to fund the Company's operating
deficits. These amounts received from Bio-Vascular were considered to be capital
contributions, as the Company did not have the ability to substantially repay
these advances. The financial information included herein for periods prior to
the Distribution may not necessarily be indicative of the financial position,
results of operations or cash flows of the Company, if it had been a separate,
independent company during the periods prior to the Distribution.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Fiscal Year
On July 17, 1997, the Board of Directors of the Company adopted a resolution
changing the Company's fiscal year end from October 31 to December 31, effective
with the calendar year beginning January 1, 1997. The 1998 and 1997 fiscal years
ended on December 31, whereas the 1996 fiscal year ended on October 31.
Accordingly, a two-month transition period from November 1, 1996 through
December 31, 1996 preceded the start of the 1997 fiscal year.
Use of Estimates
The preparation of the Company's financial statements in conformity with
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 as of the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those estimates. Principal
areas requiring the use of estimates include the allocation of general corporate
expenses between the Company and Bio-Vascular for periods prior to the
Distribution, the determination of the treatment of software development costs
and the allowance for uncollectible accounts receivable.
Financial Instruments
The Company considers all highly liquid investments acquired with an original
maturity of three months or less to be cash equivalents. Investments having
original maturities in excess of three months are classified as marketable
securities. Investments are classified as short-term or long-term on the balance
sheet based on their maturity date. As of December 31, 1998 and 1997, all of the
Company's marketable securities are classified as available-for-sale and all
mature in one year or less. Available-for-sale investments are recorded at
market value, which is based on quoted market prices, with unrealized holding
gains and losses included as a separate component of shareholders' equity. The
Company uses a specific identification cost method to determine the gross
realized gains and losses on the sale of its securities.
Concentration of Credit Risk
Cash is held primarily by one financial institution. Cash equivalents and
marketable securities are invested in a limited number of corporate bonds. The
Company's customer base is generally concentrated with a small base of
customers. The Company reviews the creditworthiness of its customers prior to
product shipment and generally does not require collateral.
37
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Property and Equipment
Property and equipment are stated at cost. Depreciation is computed using the
straight-line method over the related asset's estimated useful life, generally
three to seven years. Leasehold improvements are amortized over the shorter of
their estimated useful lives or the remaining terms of the related leases. The
asset cost and related accumulated depreciation or amortization are adjusted for
asset retirement or disposal with the resulting gain or loss, if any, credited
or charged to other income.
Revenue Recognition
Revenue is derived from the licensing of computer software, sales of system
hardware and from service revenue consisting of maintenance, installation,
training and consulting services. License and hardware revenue is recognized
upon shipment, provided there are no remaining post-delivery obligations and
collection is deemed probable. If post-delivery obligations exist or if a
product is subject to customer acceptance, revenues are deferred until no
obligations remain or until acceptance has occurred. Software maintenance
revenue is recognized ratably over the maintenance period and other service
revenue is recognized as the services are performed.
Research and Development Costs
Costs related to research, design and development of products are charged to
research and development expense as incurred. Software development costs are
capitalized beginning when a product's technological feasibility has been
established and ending when a product is available for general release to
customers. The Company uses the working model approach to determine
technological feasibility. Generally, the Company's products are released soon
after technological feasibility has been established. As a result, the Company
has not capitalized any software development costs, since such costs have not
been significant.
Income Taxes
The Company accounts for income taxes using the asset and liability method.
Deferred income tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. Valuation allowances are established when
necessary to reduce deferred tax assets to the amounts expected to be realized.
As a wholly-owned subsidiary of Bio-Vascular through May 11, 1997, the Company
did not file separate federal income tax returns, but rather was included in the
federal income tax returns filed by Bio-Vascular. The Company's allocated income
tax provisions for the period from January 1, 1997 through May 11, 1997, the two
months ended December 31, 1996 and the year ended October 31, 1996 are based on
the "separate return" method and consist solely of certain state minimum fees.
38
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Net Loss Per Share
For periods after the Distribution, net loss per share is computed using the
weighted average common shares outstanding during the period. Common share
equivalents are not included in the net loss per share calculations since they
are anti-dilutive. Warrants and options to purchase common stock could
potentially dilute basic earnings per share in future periods, if the Company
generates net income.
For periods prior to the Distribution, the weighted average common shares
outstanding used in the net loss per share calculation is one-half of the
weighted average of Bio-Vascular common shares outstanding based on the
distribution of one share of the Company's common stock for each two shares of
Bio-Vascular's common stock pursuant to the Distribution. Common share
equivalents are not included in the net loss per share calculations, since they
are anti-dilutive.
Stock-Based Compensation
Statement of Financial Accounting Standards No. ("SFAS") 123 Accounting for
Stock-Based Compensation, encourages but does not require companies to record
compensation cost for stock-based compensation awards at fair value. The Company
has chosen to continue to account for stock options using the intrinsic value
method prescribed by APB Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations. Accordingly, compensation cost for stock
options granted is measured as the excess, if any, of the value of the Company's
stock as of the date of the grant over option exercise price. Such compensation
cost is amortized on a straight-line basis over the underlying vesting term of
the option.
Recent Accounting Pronouncements
During 1998, the Company adopted SFAS 130, Reporting Comprehensive Income, which
establishes standards for reporting and display of comprehensive income and its
components (revenue, expenses, gains and losses) in a full set of general-
purpose financial statements. The effect of adopting SFAS 130 is included in the
Statement of Shareholders' Equity.
The Company also adopted SFAS 131, Disclosure about Segments of an Enterprise
and Related Information during 1998. SFAS 131 requires disclosure of segment
data in a manner consistent with that used by an enterprise for internal
management reporting and decision-making. SFAS 131 establishes requirements to
report selected segment information quarterly and to report entity-wide
disclosures about products and services, major customers and the material
countries in which the entity holds assets and reports revenue. The Company is
in one business segment, the visualization software business. Therefore, the
adoption of SFAS 131 did not impact the Company's financial reporting practices.
Effective January 1, 1998 the Company adopted Statement of Position 97-2,
Software Revenue Recognition (SOP 97-2), which provides guidance on applying
generally accepted accounting principles in recognizing revenue on software
transactions and supersedes SOP 91-1, Software Revenue Recognition. SOP 97-2 did
not materially impact the Company's revenue recognition practices, financial
position or results of operations for the year ended December 31, 1998 and would
not have materially impacted the revenue recognition practices, financial
position or results of operations for the year ended December 31, 1997, the two
months ended December 31, 1996 or the year ended October 31, 1996.
39
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
(3) SUPPLEMENTAL FINANCIAL STATEMENT INFORMATION
Cash and Cash Equivalents and Marketable Securities
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------
1998 1997
------------ --------
<S> <C> <C>
Cash and cash equivalents:
Cash $ 201,217 $ 23,693
Corporate debt securities 999,167 -
Money market funds 551,231 424,684
----------- -----------
Cash and cash equivalents $ 1,751,615 $ 448,377
=========== ===========
Marketable securities:
Corporate debt securities $ 1,985,556 $ 2,963,464
Debt securities issued by U.S. government agency - 3,000,000
---------- -----------
Marketable securities $ 1,985,556 $ 5,963,464
=========== ===========
</TABLE>
Cost approximates market for all classifications of financial instruments.
Realized gains and losses were not material for the years ended December 31,
1998 and 1997, the two months ended December 31, 1996 and the year ended October
31, 1996. A net unrealized holding loss of $13,125 has been included in
shareholders' equity as of December 31, 1996.
Property and Equipment
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------
1998 1997
-------- --------
<S> <C> <C>
Furniture and fixtures $ 203,229 $ 177,647
Equipment 1,708,556 1,922,852
Computer software 242,117 227,338
Leasehold improvements 23,048 23,048
----------- -----------
Total property and equipment 2,176,950 2,350,885
Less accumulated depreciation and amortization (1,260,712) (1,352,938)
----------- ------------
Property and equipment, net $ 916,238 $ 997,947
=========== ===========
</TABLE>
Non-Cash Financing Transactions
Effective November 1, 1996, Bio-Vascular assigned approximately $3,000,000 of
marketable securities to Vital Images, along with the related accrued interest.
40
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
(4) DEFERRED REVENUE
Deferred revenue consists of deferred maintenance revenue and also includes
amounts received from ATL Ultrasound, Inc. ("ATL") in August 1996 to enter into
an exclusive development agreement with the Company. The agreement with ATL is a
five-year agreement to co-develop the Company's 3D volume rendering technology
for use in ATL's ultrasound imaging systems. The contract fee revenue of
$300,000 received in 1996 from ATL is being amortized on a straight-line basis
over the five-year term of the agreement.
(5) LEASE COMMITMENTS
The Company leases office facilities under a non-cancelable operating lease in
Minneapolis, Minnesota expiring January 31, 2002. Under the terms of the lease
the Company is also required to contribute to the cost of certain building
improvements and operating costs. In addition, the Company leases office
facilities in Fairfield, Iowa under a non-cancelable operating lease, which
expires on June 1, 2000. Total rent expense, including charges for monthly
operating costs, was $368,000 and $234,000 for the years ended December 31, 1998
and 1997, respectively, $12,000 for the two months ended December 31, 1996 and
$74,000 for the year ended October 31, 1996.
Scheduled minimum lease payments are approximately as follows:
<TABLE>
<S> <C>
1999 $ 225,000
2000 185,000
2001 157,000
2002 13,000
-------------
Total $ 580,000
=============
</TABLE>
The lease on the Minneapolis facility also requires the Company to post a
security deposit of up to $150,000 if, during the term of the lease, the
Company's aggregate balance of cash and marketable securities falls below
$3,000,000 or the Company's equity falls below $1,000,000.
(6) SHAREHOLDERS' EQUITY
Change in Authorized Shares
Prior to the Distribution, Bio-Vascular, the Company's sole shareholder,
approved an increase in the number of authorized shares of capital stock from
1,000 shares to 25,000,000 shares and the reservation of 5,000,000 of such
shares as undesignated preferred stock, having such rights, preferences and
designations as determined by the Board of Directors. As a result, the Company's
authorized capital stock as of December 31, 1998 consists of 20,000,000 shares
of common stock and 5,000,000 shares of preferred stock.
41
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Rights Plan
In April 1997 the Company declared a dividend distribution of one Preferred
Stock Purchase Right for each outstanding share of the Company's common stock
(the "Rights"). With certain exceptions, the Rights become exercisable only in
the event that (i) an acquiring party accumulates 15% or more of the Company's
common stock, (ii) a party announces an offer to acquire 15% or more of the
Company's common stock, or (iii) the acquisition of a substantial amount of the
Company's common stock by a person whom the Board of Directors has determined is
an Adverse Person as defined in the underlying Rights Agreement. Each Right
entitles the holder to purchase one-thousandth of a share of the Company's
Series A Junior Preferred Stock at a price of $20.00 (the "Exercise Price"). If
a person or group becomes the beneficial owner of 15% or more of the Company's
common stock or the Board of Directors determines that a person is an Adverse
Person, each holder of a Right shall thereafter have the right to receive
preferred stock having a fair market value equal to two times the Exercise
Price. Upon the occurrence of certain mergers, combinations or acquisitions of
the Company's assets, each holder of a Right shall thereafter have the right to
receive that number of shares of common stock of the acquiring company which
equals the Exercise Price of the Right divided by one-half of the current market
price of such common stock as of the date of the occurrence of the event. The
Company is generally entitled to redeem the Right at $.001 per Right at any time
until ten days following the acquisition of 15% or more of the Company's common
stock or ten days after the point at which the Company's Board of Directors
determines that a person is an Adverse Person, as defined by the Rights
Agreement. The Rights expire on April 30, 2007, if not previously redeemed or
exercised.
Restricted Stock
Under certain compensation agreements, an arrangement which provides for awards
of restricted common stock to key management was adopted by Bio-Vascular in
1992. Pursuant to the agreement governing the Company's spin-off from
Bio-Vascular (the "Distribution Agreement"), Vital Images assumed its
proportionate share of obligations represented by such restricted shares such
that 25,375 restricted shares were issued by the Company on the Distribution
Date in connection with the spin-off from Bio-Vascular. As of December 31, 1998,
4,848 shares of restricted stock, generally vesting over a period of one to two
years, remain unearned by certain key Bio-Vascular employees.
42
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Stock Option Plans
In connection with the Distribution, Bio-Vascular, as the sole shareholder of
the Company, approved and adopted several option plans and stand-alone option
grants, which covered employees of both Vital Images and Bio-Vascular. The
adopted plans include the Incentive Stock Option Adjustment Plan, the 1990
Management Incentive Stock Option Plan, the 1992 Director Stock Option
Adjustment Plan, the 1992 Stock Option Plan, and the 1995 Stock Incentive
Adjustment Plan (collectively, the "Mirror Plans"). Each of these plans is
intended to mirror the provisions of a corresponding Bio-Vascular plan that was
in effect at the time of the Distribution. As each Bio-Vascular option plan
generally provided for the termination of options following termination of
employment, each of the Mirror Plans, as well as each of the stand-alone option
grants (the "Mirror Grants"), were approved and adopted to provide that the
Distribution would not cause a termination of any Vital Images employee for the
purposes of such plans or option grant, and that Bio-Vascular options held by
Vital Images employees following the Distribution would remain exercisable
following the Distribution, so long as such employees remain employed by Vital
Images or any subsidiary. Similar provisions were also adopted with respect to
Vital Images options held by Bio-Vascular employees. On the Distribution Date,
608,534 options were issued in connection with the Mirror Plans and the Mirror
Grants (collectively, the "Mirror Options"). These options have vesting periods
ranging from less than one year up to four years and terms ranging from less
than one year up to ten years. No additional grants may be made pursuant to any
of the Mirror Plans.
In May 1997, Bio-Vascular, as the sole shareholder of the Company, approved and
adopted the Vital Images, Inc. 1997 Stock Option and Incentive Plan (the "Stock
Option Plan"), which became effective on the Distribution Date. Under the terms
of the plan, the Board of Directors may grant options and other stock-based
awards to key employees to purchase shares of the Company's common stock at an
option exercise price equal to or greater than 85% of the fair market value on
the date of grant. The options are exercisable at such times, in installments or
otherwise, as the Board of Directors may determine. Generally, these options are
incentive stock options with a term of eight years and are exercisable to 28% of
the total grant one year after the date of grant and 2% per month thereafter. In
May of 1998 the shareholders of the Company approved an increase of 250,000
common shares, bringing the total number of shares of common stock that may be
issued or awarded under the Stock Option Plan to 925,000. As of December 31,
1998, there are 203,857 shares available for grant under the Stock Option Plan.
Also in May 1997, Bio-Vascular, as the sole shareholder of the Company, approved
and adopted the Vital Images, Inc. 1997 Director Stock Option Plan (the
"Director Plan") (together with the Stock Option Plan, the "1997 Plans"), which
became effective on the Distribution Date. The Director Plan provides
non-employee directors with automatic grants of stock options, and allows the
Board of Directors to make additional discretionary option grants to any or all
directors. Options that are granted under the Director Plan are generally
granted with an option price equal to the fair market value on the date of
grant, with a term of eight years, are non-qualified options and become
exercisable in three equal annual installments beginning on the first occurring
December 31 after the date of grant. In May of 1998 the shareholders of the
Company approved an increase of 30,000 common shares, bringing the total number
of shares of common stock that may be issued or awarded under the Director Plan
to 105,000. As of December 31, 1998, there are 15,000 shares available for grant
under the Director Plan.
Subsequent to December 31, 1998, the Board of Directors approved an increase of
500,000 common shares for the Stock Option Plan and an increase of 105,000
common shares for the Director Plan. These increases are subject to approval by
the shareholders of the Company.
43
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Certain non-plan options were granted to an officer of the Company in 1998. The
Company has reserved and granted 300,000 shares of common stock for issuance in
connection with non-plan options. These non-plan options have a term of eight
years, vest over a two year period and were granted at exercise prices at least
equal to fair market value of the Company's common stock on the date of grant.
The following table summarizes stock option activity for 1998 and 1997:
<TABLE>
<CAPTION>
Weighted-Average
Exercise
Shares Under Price Per
Option Share
----------------- ---------------
<S> <C> <C>
Total outstanding as of December 31, 1996 - -
Mirror Options granted 608,534 $ 2.85
Options granted 482,268 2.34
Options exercised - -
Options canceled (143,784) 2.40
--------- ------
Total outstanding as of December 31, 1997 947,018 2.66
Options granted 731,000 2.06
Options exercised (41,925) 1.38
Options canceled (195,775) 2.30
--------- ------
Total outstanding as of December 31, 1998 1,440,318 $ 2.44
========= ======
Options exercisable as of:
December 31, 1997 437,583 $ 2.86
December 31, 1998 654,850 $ 2.59
</TABLE>
Various price ranges and weighted average information for options outstanding as
of December 31, 1998 are as follows:
<TABLE>
<CAPTION>
OUTSTANDING OPTIONS EXERCISABLE OPTIONS
---------------------------------------------------- ------------------------------------
NUMBER WEIGHTED WEIGHTED NUMBER WEIGHTED
RANGE OF OUTSTANDING AVERAGE AVERAGE EXERCISABLE AVERAGE
EXERCISE PRICES AS OF DEC 31, REMAINING EXERCISE PRICE AS OF DEC 31, EXERCISE PRICE
1998 CONTRACTUAL LIFE 1998
- ----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$0.96 - $1.37 328,050 6.47 years $1.16 163,300 $1.19
$1.63 - $2.31 375,865 6.83 years $2.12 59,045 $2.02
$2.38 336,928 6.38 years $2.38 191,594 $2.38
$2.39 - $4.64 379,947 6.07 years $3.75 222,389 $3.70
$4.89 - $6.27 19,528 4.32 years $5.73 18,522 $5.75
--------- -------
1,440,318 654,850
========= =======
</TABLE>
44
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Employee Stock Purchase Plan
The 1997 Employee Stock Purchase Plan (the "ESPP") was approved and adopted by
Bio-Vascular, as the sole shareholder of the Company, in May 1997. The ESPP,
which became effective on July 1, 1997, enables eligible employees to purchase
the Company's common stock at 85% of the fair market value of the stock on the
date an offering commences or on the date an offering terminates, whichever is
lower. The ESPP covers an aggregate of up to 250,000 shares of common stock that
can be issued and sold to participating employees of the Company through a
series of three-month offerings, beginning July 1, 1997. The ESPP covers
substantially all employees, subject to certain limitations. Each employee may
elect to have up to 10% of his or her base pay withheld and applied toward the
purchase of shares in each such offering. Purchases under the ESPP for 1998 were
24,394 shares generating proceeds to the Company of $32,712 at an average
purchase price of $1.34 and for 1997 there were 15,776 shares purchased,
generating proceeds to the Company of $20,648 at an average purchase price of
$1.31. As of December 31, 1998, there are 209,830 shares of common stock
reserved for purchases under the ESPP.
Stock-Based Compensation
If compensation cost for the Mirror Options, the ESPP, the Stock Option Plan,
the Director Plan and the non-plan options been determined based on the fair
value on the grant dates for awards in 1998 and 1997 consistent with the
provisions of SFAS No. 123, the Company's net loss and net loss per share for
1998 and 1997 would have been increased to the pro forma amounts indicated
below:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
------------------------------------------
1998 1997
------------------- -------------------
<S> <C> <C>
Net loss As reported $ (3,209,449) $ (4,773,820)
Pro forma $ (3,647,000) $ (5,009,000)
Net loss per share - As reported $ (0.66) $ (1.00)
basic and diluted Pro forma $ (0.75) $ (1.05)
The weighted average fair values of options granted were:
Options under the 1997 Plans $ 1.28 $ 1.44
Options under ESPP $ 0.24 $ 0.26
Non-plan options $ 0.60 $ -
Mirror Options $ - $ 1.21
</TABLE>
The weighted average fair value for the Mirror Options, the 1997 Plans and the
non-plan options was based on the fair value on the date of grant. The fair
value of options under the ESPP was based on the 15 percent purchase discount.
The fair value for the Mirror Options, the 1997 Plans and the non-plan options
was calculated using the Black-Sholes option pricing model with the following
weighted average assumptions:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------
1998 1997
----------------- -----------------
<S> <C> <C>
Expected option life 5.2 years 4.4 years
Expected volatility factor 88.7 % 60.1 %
Expected dividend yield 0 % 0 %
Risk-free interest rate 5.53 % 6.42 %
</TABLE>
The pro forma effects on the net losses for 1998 and 1997 are not necessarily
representative of the pro forma effect that may occur on the net income (losses)
of future periods.
45
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Warrants
In connection with a 1995 stock offering and issuance of Bio-Vascular common
stock, Bio-Vascular issued to the underwriter warrants to purchase 90,000 shares
of Bio-Vascular common stock, at an exercise price of $16.375 per share. Under
the Distribution Agreement the Company is required to assume its respective
obligations represented by such underwriter warrants and to issue 45,000 shares
of its common stock upon the exercise thereof, based upon the spin-off
distribution ratio of one share of the Company's common stock for each two
shares of Bio-Vascular common stock. In exchange, the Distribution Agreement
provides that the Company will receive a proportionate share of the exercise
price set by the agreement. Accordingly, upon exercise of the warrants, the
Company will receive proceeds of approximately $3.35 per share and Bio-Vascular
will receive proceeds of approximately $13.03 per share. The warrants are
exercisable until September 1999. None of the warrants have been exercised as of
December 31, 1998.
(7) INCOME TAXES
The income tax provision, if any, for each of the periods presented represents
state minimum taxes. As of December 31, 1998, the Company has net operating loss
carryforwards of approximately $10,773,000 for federal income tax reporting
purposes and unused research and development credits of approximately $437,000,
which expire in varying amounts from 2004 to 2013. For financial reporting
purposes, a valuation allowance has been established to completely reserve for
the deferred tax assets related to those carryforwards.
As a result of Bio-Vascular's acquisition of the Company in May 1994, the
Company experienced an ownership change as defined by the Internal Revenue Code
(the "Code"). Under the Code, the amount of pre-acquisition net operating loss
carryforwards and research and development credits that can be used to offset
future taxable income and income taxes will be limited. As of the date of the
Company's acquisition by Bio-Vascular, the Company had approximately $1,600,000
of net operating loss carryforwards and approximately $137,000 of research and
experimentation credits, both of which will be subject to limitation under the
Code.
The significant components of the Company's tax-effected net deferred tax
assets, based on an assumed effective tax rate of 40%, are:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------
1998 1997
-------- --------
<S> <C> <C>
Net operating loss carryforwards $ 4,309,000 $ 3,067,000
Research and development tax credit carryforwards 437,000 346,000
Deferred compensation 230,000 230,000
Deferred revenue 63,000 87,000
Other, net 96,000 52,000
----------- ----------
Net deferred tax assets before valuation allowance 5,135,000 3,782,000
Less valuation allowance (5,135,000) (3,782,000)
----------- ----------
Net deferred tax assets $ - 0 - $ - 0 -
=========== ===========
</TABLE>
46
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
(8) MAJOR CUSTOMERS AND GEOGRAPHIC DATA
<TABLE>
<CAPTION>
SIGNIFICANT PERCENTAGE OF
CUSTOMER REVENUE TOTAL REVENUE
----------- ------- -------------
<S> <C> <C> <C>
Year ended December 31, 1998 Toshiba America $1,020,000 23%
Medical Systems
Paradigm $ 618,000 14%
Geophysical
Corporation
Year ended December 31, 1997 Paradigm $ 313,000 26%
Geophysical
Corporation
Two months ended December 31, 1996 ATL Ultrasound, Inc. $ 10,000 15%
Stanford University $ 8,000 12%
Year ended October 31, 1996 Mitsubishi $ 99,000 11%
Chemical
</TABLE>
In August 1995, the Company entered into a source code license agreement with
Paradigm Geophysical Corporation ("Paradigm") granting Paradigm a worldwide,
exclusive license for use in oil and gas exploration applications. Under the
agreement, Paradigm became both the exclusive developer and marketer of
VoxelGeo(R). The Company receives royalty payments based upon cash collections
from sales of VoxelGeo software by Paradigm. These royalty payments will cease
on January 1, 2001 or when the aggregate amount of royalties received equals
$2,000,000, whichever occurs earlier. During 1998, the Company received royalty
payments of $618,000. Through December 31, 1998, total royalty payments received
by the Company under this license agreement are $931,000.
The Company's accounts receivable is generally concentrated with a small base of
customers. As of December 31, 1998, two customers, each accounting for more than
10% of accounts receivable, accounted for 22% of accounts receivable, while as
of December 31, 1997, six customers, each accounting for more than 10% of
accounts receivable, accounted for 73% of accounts receivable.
Export revenue amounted to 7% and 18% of total revenue for the years ended
December 31, 1998 and 1997, respectively, 27% for the two months ended December
31, 1996, and 13% for the year ended October 31, 1996. Substantially all of the
Company's export sales are negotiated, invoiced and paid in U.S. dollars.
47
<PAGE>
VITAL IMAGES, INC.
NOTES TO FINANCIAL STATEMENTS
Export sales by geographic area are summarized as follows:
<TABLE>
<CAPTION>
FOR THE YEARS
ENDED FOR THE TWO FOR THE YEAR
DECEMBER 31, MONTHS ENDED ENDED
------------------------------------------ DECEMBER 31, OCTOBER 31,
1998 1997 1996 1996
------------------- ------------------- ------------------ -----------------
<S> <C> <C> <C> <C>
Europe $ 222,000 $ 146,000 $ 4,000 $ 111,000
Asia and Pacific Region $ 77,000 $ 45,000 $ 14,000 $ 144,000
Canada, Mexico and others $ 8,000 $ 26,000 $ - $ 6,000
</TABLE>
(9) EMPLOYEE BENEFIT PLAN
During 1997, the Company adopted the Vital Images, Inc. Salary Savings Plan (the
"Plan"), which is intended to qualify under Section 401(k) of the Internal
Revenue Code, as amended. The Plan covers substantially all employees. Each
employee may elect to contribute to the Plan through payroll deductions up to
25% of his or her salary, subject to certain limitations. At the discretion of
the Board of Directors, the Company may make matching contributions equal to a
percentage of the salary reduction contributions or other discretionary amounts.
There were no contributions to the Plan by the Company in 1998 or 1997.
(10) SUBSEQUENT EVENT
On March 19, 1999, the Company entered into a credit agreement with a bank for a
short-term line of credit for borrowings up to $950,000. Borrowings under the
line of credit agreement bear interest at one-half percent over the prime rate
as printed in the Wall Street Journal (7.75% as of December 31, 1998).
-------------------
Borrowings under the agreement are limited to the lower of $950,000 or the
Company's borrowing base, which consists of a specified percentage of certain
accounts receivable. Borrowings under the agreement are collateralized by
substantially all of the Company's assets. The line of credit agreement is
renewable on an annual basis and contains certain restrictive covenants which,
among other things, require the Company to maintain a net worth of at least
$2,000,000 and cash and cash equivalents of at least $1,000,000.
48
<PAGE>
VITAL IMAGES, INC.
VALUATION AND QUALIFYING ACCOUNTS
SCHEDULE II
<TABLE>
<CAPTION>
BALANCE AS OF CHARGES TO BALANCE
BEGINNING COST AND AS OF END
DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS OF PERIOD
- -------------------------------------------------- ---------------- -------------- ---------------- --------------
<S> <C> <C> <C> <C>
Allowance for doubtful accounts:
Year ended December 31, 1998 $40,000 $52,313 $14,313 $78,000
======= ======= ======= =======
Year ended December 31, 1997 $49,500 $12,452 $21,952 $40,000
======= ======= ======= =======
Two months ended December 31, 1996 $48,800 $ 700 $ - $49,500
======= ======= ======= =======
Year ended October 31, 1996 $20,000 $36,592 $ 7,792 $48,800
======= ======= ======= =======
</TABLE>
49
<PAGE>
VITAL IMAGES, INC.
FORM 10-K
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Item No. Description
- -------- -----------
<S> <C>
3.1 Articles of Incorporation of the Company (incorporated by
reference to Exhibit 3.1 to the Company's registration statement
on Form 10 (File No. 0-22229)).
3.2 By-laws of the Company (incorporated by reference to Exhibit 3.2
to the Company's registration statement on Form 10 (File No. 0-
22229)).
4.1 Form of common stock Certificate of the Company (incorporated by
reference to Exhibit 4.3 to the Company's registration statement
on Form 10 (File No. 0-22229)).
4.2 Rights Agreement, dated effective as of May 1, 1997 between the
Company and American Stock Transfer and Trust Company, which
includes as Exhibit B the form of Rights Certificate
(incorporated by reference to Exhibit 4.4 to the Company's
registration statement on Form 10 (File No. 0-22229)).
4.3 Certificate of Designation, Preferences and Rights of Series A
Junior Preferred Stock of the Company (incorporated by reference
to Exhibit 4.5 to the Company's registration statement on Form
10 (File No. 0-22229)).
10.1 Form of Distribution Agreement, effective as of May 2, 1997
between Bio-Vascular, Inc. and the Company (incorporated by
reference to Exhibit 10.1 to the Company's registration statement
on Form 10 (File No. 0-22229)).
10.2 Form of Employee Benefits Agreement, effective as of May 2, 1997,
between Bio-Vascular, Inc. and the Company (incorporated by
reference to Exhibit 10.2 to the Company's registration statement
on Form 10 (File No. 0-22229)).
</TABLE>
50
<PAGE>
<TABLE>
<S> <C>
10.3 Form of Tax Sharing Agreement, effective as of May 2, 1997,
between Bio-Vascular, Inc. and the Company (incorporated by
reference to Exhibit 10.3 to the Company's registration statement
on Form 10 (File No. 0-22229)).
10.4 Form of Transition Services Agreement, effective as of May 2,
1997 between Bio-Vascular, Inc. and the Company (incorporated by
reference to Exhibit 10.4 to the Company's registration statement
on Form 10 (File No. 0-22229)).
10.5 Incentive Stock Option Adjustment Plan (incorporated by reference
to Exhibit 10.5 to the Company's registration statement on Form
10 (File No. 0-22229)).
10.6 1990 Stock Option Plan (incorporated by reference to Exhibit 10.6
to the Company's registration statement on Form 10 (File No. 0-
22229)).
10.7 1992 Stock Option Plan (incorporated by reference to Exhibit 10.7
to the Company's registration statement on Form 10 (File No. 0-
22229)).
10.8 1992 Director Stock Option Adjustment Plan (incorporated by
reference to Exhibit 10.8 to the Company's registration statement
on Form 10 (File No. 0-22229)).
10.9 1995 Stock Incentive Adjustment Plan (incorporated by reference
to Exhibit 10.9 to the Company's registration statement on Form
10 (File No. 0-22229)).
10.10 Employee Stock Purchase Plan (incorporated by reference to
Exhibit 10.10 to the Company's registration statement on Form 10
(File No. 0-22229)).
10.11 1997 Stock Option and Incentive Plan (incorporated by reference
to Exhibit 10.11 to the Company's registration statement on Form
10 (File No. 0-22229)).
10.12 1997 Director Stock Option Plan (incorporated by reference to
Exhibit 10.12 to the Company's registration statement on Form 10
(File No. 0-22229)).
10.13 Stock Option Adjustment Agreement between the Company and Andrew
M. Weiss (incorporated by reference to Exhibit 10.13 to the
Company's registration statement on Form 10 (File No. 0-22229)).
</TABLE>
51
<PAGE>
<TABLE>
<S> <C>
10.14 License Agreement dated August 25, 1995 between the Company and
Paradigm Geophysical Corporation (formerly CogniSeis Development,
Inc.) (incorporated by reference to Exhibit 10.14 to the
Company's registration statement on Form 10 (File No. 0-22229)).
10.15 Lease agreement dated May 14, 1993, as amended April 15, 1997,
between Vital Images, Inc. and Douglas Green IRA Trust
(incorporated by reference to Exhibit 10.15 to the Company's
registration statement on Form 10 (File No. 0-22229)).
10.16 Lease Agreement dated January 31, 1997 between ACKY - 3100 Lake
Limited Partnership and the Company (incorporated by reference to
Exhibit 10.16 to the Company's registration statement on Form 10
(File No. 0-22229)).
10.17 Form of Change in Control Agreement between the Company and
Andrew M. Weiss, Vincent J. Argiro, Ph.D., David A. Davis,
Gregory S. Furness and Jay D. Miller (incorporated by reference
to Exhibit 10.17 to the Company's registration statement on Form
10 (File No. 0-22229)).
10.18 Joint Development Agreement dated August 14, 1996 between the
Company and ATL Ultrasound, Inc.* (incorporated by reference to
Exhibit 10.18 to the Company's registration statement on Form 10
(File No. 0-22229)).
10.19 Sales and Marketing Agreement dated August 14, 1996 between the
Company and ATL Ultrasound, Inc.* (incorporated by reference to
Exhibit 10.19 to the Company's registration statement on Form 10
(File No. 0-22229)).
10.20 Software License Agreement dated August 1, 1997 between the
Company and Duke University (incorporated by reference to Exhibit
10.20 to the Company's Annual Report on Form 10-K for the year
ended December 31, 1997 (File No. 0-22229)).
10.21 Severance Agreement dated February 13, 1998 between the Company
and Mr. Weiss (incorporated by reference to Exhibit 10.21 to the
Company's Annual Report on Form 10-K for the year ended December
31, 1997 (File No. 0-22229)).
10.22 Employment Agreement dated February 1, 1998 between the Company
and Douglas M. Pihl (incorporated by reference to Exhibit 10.22
to the Company's Annual Report on Form 10-K for the year ended
December 31, 1997 (File No. 0-22229)).
</TABLE>
52
<PAGE>
<TABLE>
<S> <C>
10.23 Non-qualified Stock Option Agreement dated February 24, 1998
between the Company and Douglas M. Pihl (incorporated by
reference to Exhibit 10.23 to the Company's Annual Report on Form
10-K for the year ended December 31, 1997 (File No. 0-22229)).
23.1 Consent of PricewaterhouseCoopers LLP (filed herewith
electronically).
27.1 Financial Data Schedule (filed herewith electronically).
</TABLE>
* Portions of such exhibit are subject to a request for confidential
treatment filed with the Commission by the Registrant.
53
<PAGE>
Exhibit 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the Registration Statements of
Vital Images, Inc. on Form S-8 (File Nos. 333-26797, 333-39189, 333-39213,
333-30771, 333-69761, and 333-69765) of our report dated February 10, 1999,
except as to Note 10, for which the date is March 19, 1999, on our audits of the
financial statements and financial statement schedule of Vital Images, Inc. as
of December 31, 1998 and 1997, and for the years ended December 31, 1998 and
1997, the two months ended December 31, 1996, and the year ended October 31,
1996, which report is included in this 1998 Annual Report on Form 10-K.
/s/ PricewaterhouseCoopers LLP
--------------------------------
Minneapolis, Minnesota
March 26, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS AND RELATED NOTES FOR THE YEAR ENDED DECEMBER 31, 1998 AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 1,751,615
<SECURITIES> 1,985,556
<RECEIVABLES> 1,227,109
<ALLOWANCES> 78,000
<INVENTORY> 46,080
<CURRENT-ASSETS> 5,021,397
<PP&E> 2,176,950
<DEPRECIATION> 1,260,712
<TOTAL-ASSETS> 5,937,635
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0
0
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</TABLE>
