| VITAL IMAGES INC Item 1A Risk Factors Discussion of our business and operations included in this annual report on Form 10-K should be read together with the risk factors set forth below |
| They describe various risks and uncertainties to which we are, or may become subject |
| These risks and uncertainties, together with other factors described elsewhere in this report, have the potential to affect our business, financial condition, results of operations, cash flows, strategies or prospects in a material and adverse manner |
| New risks may emerge at any time, and we cannot predict those risks or estimate the extent to which they may affect financial performance |
| Each of the risks described below could adversely impact the value of our securities |
| These statements, like all statements in this report, speak only as of the date of this report (unless another date is indicated), and we undertake no obligation to update or revise the statements in light of future developments |
| Market Acceptance Our success depends on our ability to continue to successfully market Vitrea and ViTALConnect software for clinical use, and on the ability and willingness of physicians to use enterprise-wide advanced visualization software medical imaging software in clinical analysis and therapy planning |
| The enterprise-wide advanced visualization software offered by Vitrea and ViTALConnect are alternatives to the conventional methods traditionally used for viewing medical images in the clinical setting |
| The acceptance of Vitrea and ViTALConnect by physicians and other clinicians will depend on our ability to educate those users as to the speed, ease-of-use and other benefits offered by the Vitrea and ViTALConnect systems, as well as our timely introduction of new features and functions |
| There can be no assurance that users will prefer advanced visualization and analysis software solutions over less expensive two-dimensional medical imaging software or that we will succeed in our efforts to further develop, commercialize, and achieve market acceptance for Vitrea and ViTALConnect or for any other product in the clinical setting |
| Further, all of our business in markets outside the United States is provided through third parties with whom we have marketing agreements |
| There can be no assurance that these third parties will wish to continue our relationships on an indefinite basis or under the same terms as the business is currently conducted |
| Further, although we plan to develop direct relationships with customers in markets outside the United States, there can be no assurance that we will be successful in doing so |
| The loss of or adverse changes in our relationships with our third party business partners, and our failure to establish direct relationships with customers outside the United States, would have a material adverse impact on our business, financial condition, and results of operations |
| Substantial Reliance on a Single Product Revenue related to Vitrea constituted 95prca of our total revenues for the year ended December 31, 2005, 96prca of our total revenues for the year ended December 31, 2004, and 98prca of our total revenues for the year ended December 31, 2003 |
| We anticipate that revenue from the sale of Vitrea will continue to account for a substantial portion of our revenue for the foreseeable future |
| As such, if Vitrea became disfavored by physicians, it would have a material adverse impact on our business, financial condition, and results of operations |
| Dependence on Major Customers One of our principal distribution channels is to sell our Vitrea medical imaging software in connection with medical imaging equipment sold by Toshiba |
| Sales to Toshiba accounted for 47prca of our total revenue for the year ended December 31, 2005, 50prca of our total revenue for the year ended December 31, 2004, and 42prca of our total revenue for the year ended December 31, 2003 |
| Toshiba’s account receivable represented 36prca of the Company’s accounts receivable at December 31, 2005 and 23prca at December 31, 2004 |
| A limited number of large customers may continue to account for a significant portion 14 ______________________________________________________________________ of our revenue during any given period for the foreseeable future |
| Except for our agreement with Toshiba, we have no long-term purchase commitments from any of our customers or business partners, and we generally make sales pursuant to individual transactions |
| Although our agreement with Toshiba has been extended by amendment three times, most recently through December 31, 2006, we can provide no assurance that our agreement with Toshiba will be extended beyond December 31, 2006 |
| A reduction, delay, or cancellation of orders from one or more of our significant customers, or our inability to collect accounts receivable from these customers, likely would have a material adverse effect on our financial condition and operating results |
| Impact of Purchase Commitments to Third Parties As part of our business, we may offer third party products as components within our products or as optional modules to our products |
| As a condition of entering into these agreements, or for other business reasons, the third parties may require us to commit to purchase a certain volume of their products, irrespective of the amount of their products that we sell to our customers |
| If we enter into such a volume commitment with a third party but do not sell a sufficient volume of its products, then we may be required to pay the third party directly for the deficit in sales |
| We incurred such an event during the fourth quarter of 2005, in which we did not sell a sufficient volume of our partner R2 Technology, Inc |
| ’s (“R2”) lung nodule computer-aided-diagnosis software product to meet our quarterly purchase commitment under our contract with R2, resulting in a loss of approximately dlra410cmam000 in the fourth quarter of 2005 |
| There can be no assurance that we will not have similar deficits in future quarters under commitments we may have made to R2 or other providers of third party products |
| Regarding R2, our commitment is for approximately dlra414cmam000 per quarter through the quarter ended March 31, 2006 |
| The contractual commitments continue through the quarter ended June 30, 2008, but they may be reduced during each quarter after the quarter ended March 31, 2006 to the lowest of: (i) the quarterly commitment in the preceding quarter; (ii) the quarterly commitment of the preceding quarter multiplied by the percent by which the R2 Lung CAD product revenue in the preceding quarter fell below that quarter’s quarterly commitment, up to a maximum decline of twenty-three percent (23prca); or (iii) two times the R2 Lung CAD product revenue generated by R2 during the preceding quarter through all other sales, marketing and distribution channels, excluding R2 Lung CAD product revenue generated through the agreement with us; provided, that if at any time during the remainder of the agreement the quarterly commitment is less than dlra414cmam000 and R2 Lung CAD Product revenue for a quarter exceeds dlra414cmam000, our quarterly commitment for the next quarter will again be dlra414cmam000, and the quarterly commitment for the following quarters may again be subject to the above adjustment |
| Additionally, at the end of every fourth quarter under the R2 agreement, if the aggregate revenue generated under the agreement in the previous four quarters exceeded dlra1cmam665cmam000, the remaining quarterly commitments shall be reduced by the amount of excess divided by the number of quarters remaining under the agreement |
| As of December 31, 2005, the remaining potential aggregate Applicable Minimums range from a minimum of approximately dlra414cmam000 to a maximum of approximately dlra4dtta1 million |
| Dependence on Market Growth The enterprise-wide advanced visualization industry in which we market our products is still developing due to the fairly recent availability of high-resolution CT, MR and combined CT-PET scanners, 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 |
| Historically, there has been a perception that enterprise-wide advanced visualization was too slow, unresolved or difficult for clinical use |
| This perception was due largely to the relatively slower processing speed of available workstations and the reality that true volumetric acquisition was not previously available |
| We believe that the recent advances in scanner acquisition resolution, the affordability of high-performance computers and the development of industry standards for the generation, transmission, and storage of imaging data will provide opportunities for substantial growth in the medical software industry |
| However, given the uncertainties associated with the developing stage of this market, there can be no assurance that it will continue to develop in the manner we anticipate |
| Accordingly, there can be no assurance that the enterprise-wide advanced visualization industry will provide growth opportunities for us and our software products or that our business strategies will be successful as the industry continues to evolve |
| Ultimately, if the enterprise-wide advanced visualization industry fails to develop as we expect, our business, results of operations and financial condition will be materially and adversely affected |
| Highly Competitive Industry We face intense competition in the enterprise-wide advanced visualization industry |
| We expect technology to continue to develop rapidly, and our success will depend to a large extent on our ability to maintain a competitive position with our products |
| Our competitors in the enterprise-wide advanced visualization industry include large, established manufacturers of CT and MR imaging equipment |
| Companies such as GE Healthcare, Siemens Medical Systems, Inc |
| and Philips Medical Systems typically offer their own enterprise-wide advanced visualization software and workstations as part of their integrated imaging and scanner systems |
| Our software works on the products offered by each of these companies |
| To win business 15 ______________________________________________________________________ against equipment manufacturers, we must convince customers to buy our software solutions separately from their purchase of imaging equipment instead of buying integrated systems from our competitors |
| In addition to having a competitive advantage in marketing enterprise-wide advanced visualization tools as an integrated part of their imaging products, our competitors have significantly greater capital and staffing resources for research and development that are critical to success in the dynamic enterprise-wide advanced visualization industry, more recognizable brand names, and more well-established marketing and distribution networks |
| Although price has been less significant than other factors, increasing competition may result in price reductions and reduced gross margins |
| Additionally, we face competition from other entities, such as PACS vendors and developers of competitive or ancillary software packages |
| We may not be able to compete effectively with such manufacturers or competing entities |
| Risk of Technological Obsolescence The enterprise-wide advanced visualization market is characterized by rapid innovation and technological change |
| We may be unable to compete effectively in the marketplace, and products developed by our competitors may render our products obsolete or non-competitive |
| Similarly, our competitors may succeed in developing or marketing products that are viewed as providing superior clinical performance or are less expensive than our current or future products |
| Sarbanes-Oxley Compliance Under Section 404 of the Sarbanes-Oxley Act of 2002, we are required to evaluate and determine the effectiveness of our internal controls over financial reporting |
| We have dedicated a significant amount of time and resources to ensure compliance with this legislation for the year ended December 31, 2005 and will continue to do so for future fiscal periods |
| We may encounter problems or delays in completing the review and evaluation, the implementation of improvements and the receipt of a positive attestation, or any attestation at all, from our independent registered public accounting firm |
| In addition, our assessment of our internal controls may identify deficiencies that need to be addressed in our internal controls over financial reporting or other matters that may raise concerns for investors and therefore adversely affect our stock price |
| Fluctuations in Operating Results We may experience significant fluctuations in future annual and quarterly operating results |
| If these fluctuations occur, they may result in volatility in the price of our common stock |
| Quarterly revenue and operating results may fluctuate as a result of a variety of factors that are outside of our control including, but not limited to, the timing of significant orders, the timing of product enhancements and new product introductions by us or our competitors, the pricing of our products, changes in customers’ budgets, and competitive conditions |
| Our quarterly license and services revenue may fluctuate and may be difficult to forecast for a variety of reasons, including the following: • a significant number of our existing and prospective clients’ decisions regarding whether to enter into license agreements with us are made within the last few weeks or days of each quarter; • the size of license transactions can vary significantly; • a decrease in license fee revenue may likely result in a decrease in services revenue in the same or subsequent quarters; • clients may unexpectedly postpone or cancel projects due to changes in their strategic priorities, project objectives, budget or personnel; • the uncertainty caused by potential business combinations in the software industry may cause clients and prospective clients to cancel, postpone or reduce capital spending projects on software; • client evaluations and purchasing processes vary significantly from company to company, and a client’s internal approval and expenditure authorization process can be difficult and time consuming to complete, even after selection of a vendor; • the number, timing and significance of software product enhancements and new software product announcements; • existing clients may decline to renew support for our products, and market pressures may limit our ability to increase support fees or require clients to upgrade from older versions of our products; • prospective clients may decline or defer the purchase of new products or releases if we do not have sufficient client references for those products; or • we may have to defer revenues under our revenue recognition policies |
| 16 ______________________________________________________________________ Government Regulation Our 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 record keeping procedures for medical devices, including 3D medical imaging 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 |
| Vitrea 2 and ViTALConnect and our add-on options have been cleared to be marketed for use with CT, MR and PET scanners |
| The FDA may not grant clearance with respect to our future products or enhancements, or future FDA review may involve delays that could adversely affect our ability to market such future products or enhancements |
| In addition, our future products or enhancements may be subject to a more lengthy and expensive pre-market approval process with the FDA Even if we obtain regulatory clearances and approvals to market a product from the FDA, these approvals may entail limitations on the indicated uses of the product |
| Product clearances and 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 our products and has the power to require the recall of such products |
| FDA regulations depend heavily on administrative interpretation, and future interpretations made by the FDA or other regulatory bodies may adversely affect us |
| The FDA may inspect our facilities and operations to determine whether we are in compliance with various regulations relating to specification, development, documentation, validation, testing, quality control and product labeling |
| If the FDA determines that we are in violation of such regulations, it could impose civil penalties, including fines, recall or seize products and, in extreme cases, impose criminal sanctions |
| We market our 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 |
| Our inability or failure to comply with the varying regulations, or the imposition of new regulations, could restrict our ability to sell our products internationally and could adversely affect our business |
| Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) The HIPAA regulations are causing our customers to request that we sign “business associate” agreements with them |
| A “business associate” is a person or entity that performs certain functions or activities that involve the use or disclosure of protected health information on behalf of, or that provides services to, a covered entity |
| By law, the HIPAA Privacy Rule applies only to covered entities – health plans, health care clearinghouses, and certain health care providers |
| However, most health care providers do not carry out all of their health care activities and functions by themselves |
| Instead, they often use the services of a variety of other persons or businesses |
| The Privacy Rule allows covered providers and health plans to disclose protected health information to these “business associates” if the providers or plans obtain satisfactory assurances that the business associate will use the information only for the purposes for which it was engaged by the covered entity, will safeguard the information from misuse, and will help the covered entity comply with some of the covered entity’s duties under the Privacy Rule |
| Covered entities may disclose protected health information to an entity in its role as a business associate only to help the covered entity carry out its health care functions – not for the business associate’s independent use or purposes, except as needed for the proper management and administration of the business associate |
| These agreements are necessary for us in the normal course of servicing and supporting our products |
| If we are not willing to or are unable to enter into a business associate agreement with current and potential customers, such customers may not purchase our products or services, which would have a material adverse effect on our business, financial condition, or results of operations |
| Uncertain Protection for Intellectual Property; Possible Claims of Others Although we have received patents and have filed patent applications with respect to certain aspects of our technology, we generally do not rely on patent protection with respect to our products and technologies |
| Instead, we rely 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 our products and technologies |
| Such measures may not provide meaningful protection of our trade secrets, know-how or other intellectual property in the event of any unauthorized use, misappropriation or disclosure |
| Others may independently develop similar technologies or duplicate our technologies |
| In addition, to the extent that we apply for any patents, such applications may not result in issued patents or, if issued, such patents may not be valid or of value |
| We do not believe that our products and technologies infringe any existing patents or intellectual property rights of third parties |
| However, our products and technologies may infringe existing patents or intellectual property rights of third parties |
| The costs of prosecuting or defending an intellectual property claim could be substantial and could adversely affect our business, even if we are ultimately successful in prosecuting or defending any such claims |
| If our products or technologies are found to infringe the rights of a third party, we could be required to pay significant damages or license fees or cease production, any of which could have a material adverse effect on our business |
| 17 ______________________________________________________________________ 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 |
| We currently maintain product liability insurance and coverage limits that we consider to be reasonable |
| However, our coverage limits may not be adequate to protect us from any liabilities we might incur in connection with claims in connection with our products |
| We may also need increased product liability coverage as we release additional products and updates |
| Such insurance is expensive and may not be available on acceptable terms, if at all |
| A successful product liability claim or series of such claims against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition, or results of operations |
| Need to Hire Additional Personnel Our ability to enhance and develop markets for our current products and to introduce new products to the marketplace also depends on our ability to attract and retain qualified scientific and management personnel |
| We compete for such personnel with other companies, academic institutions, and government entities and organizations, many of which have greater capital resources, name recognition, and research and development capabilities |
| There can be no assurance that we will be successful in recruiting or retaining such personnel |
| We may not be able to recruit and retain such personnel, which would have a material adverse effect on our business |
| Management of Growth Our ability to grow successfully requires an effective planning and management process |
| The expansion and growth of our business could place a significant strain on our management systems, infrastructure and other resources |
| To manage growth successfully, we must continue to improve and expand our systems and infrastructure in a timely and efficient manner |
| In addition, the success of any acquisition, such as our acquisition of HInnovation, Inc |
| in February 2004, will depend on our ability to successfully integrate the acquired business with our business |
| Our controls, systems, procedures and resources may not be adequate to support a changing and growing company |
| If management fails to respond effectively to changes and growth in business, including acquisitions, such failure could have a material adverse effect on our business, financial condition, or results of operations |
| Dependence on Third-Party Reimbursement Our products are purchased by hospitals, clinics, imaging centers 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 |
| There are currently Current Procedural Terminology (CPT) reimbursement codes for most of the diagnostic procedures that use our products |
| However, the amount of such reimbursement varies by location and is subject to change |
| 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 |
| Third party payers may not consider as cost effective the procedures in which our products are used |
| Reimbursement for such procedures may not be available or, if available, payers’ low reimbursement levels may adversely affect our ability to sell our 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 |
| A failure by hospitals and other users of our products to obtain reimbursement from third party payers, changes in third party payers’ policies toward reimbursement for procedures using our products or legislative action could have a material adverse effect on our business, financial condition, or results of operations |
| Uncertainty of Health Care Reform The levels of revenue and profitability of medical technology companies may be affected by the efforts of government and third party payers to contain or reduce the costs of health care through various means |
| In the United States, there have been, and we expect that there will continue to be, a number of federal, state, and private proposals to control health care costs |
| These proposals may contain measures intended to control public and private spending on health care as well as to provide universal public access to the health care system |
| If enacted, these proposals may result in a substantial restructuring of the health care delivery system |
| Significant changes in the nation’s health care system could have a substantial impact on the manner in which we conduct business and could have a material adverse effect on our business, financial condition and results of operations |
| 18 ______________________________________________________________________ Possible Issuances of Preferred Stock Our Articles of Incorporation authorize our Board of Directors, without any action by the holders of our common stock, to establish the rights and preferences of up to 5cmam000cmam000 shares of currently undesignated preferred stock |
| These shares of preferred stock could possess voting and conversion rights that could adversely affect the voting power of the holders of the common stock or dilute their ownership rights, and it may have the effect of delaying, deferring or preventing a change in control of Vital Images |
| No shares of preferred stock or other senior equity securities are currently designated, and currently we have no plan to designate or issue any such securities |
| Anti-Takeover Considerations We are subject to “anti-takeover” provisions of the Minnesota Business Corporation Act |
| In addition, we have adopted a Shareholder Rights Plan (the “Rights Agreement”) designed to protect against unsolicited attempts to acquire Vital Images |
| These measures may deter or discourage takeover attempts and other changes in control that are not approved by our Board of Directors, and they may have a depressive effect on any market for our common stock |
| As a result, our 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 our 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 our business |
| No Dividends We have not paid cash dividends on our common stock in the past, and we do not intend to do so in the foreseeable future |
| Any payment of dividends will be in the sole discretion of our Board of Directors |
| Limitations on Director Liability As permitted by Minnesota law, our Articles of Incorporation provide that members of our board of directors shall not be personally liable to us or our shareholders for monetary damages for breach of fiduciary duty as a director, with certain exceptions |
| These provisions may discourage shareholders from bringing suit against a director for breach of fiduciary duty and may reduce the likelihood of derivative litigation brought by shareholders on our behalf against a director |
| In addition, our Bylaws provide for mandatory indemnification of directors and officers to the fullest extent permitted by Minnesota law |