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CARDICA, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS

December 31, 2006

(unaudited)

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Cardica, Inc. (“Cardica”, the “Company”, “we”, “our” or “us”) was incorporated in the state of Delaware on October 15, 1997, as Vascular Innovations, Inc. On November 26, 2001, the Company changed its name to Cardica, Inc. The Company designs, manufactures and markets proprietary automated anastomotic systems used in surgical procedures. The Company’s first product, the PAS-Port system, received the CE Mark for sales in Europe in March 2003, and regulatory approval for sales in Japan in January 2004. The Company’s second product, the C-Port system, received the CE Mark for sales in Europe in April 2004 and 510(k) clearance in the United States in November 2005. The C-Port xA system, a next generation C-Port system, received the CE Mark for sales in Europe in July 2006 and 510(k) clearance in the United States in November 2006.

Basis of Presentation

The accompanying unaudited condensed financial statements of Cardica have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. The unaudited interim financial statements have been prepared on the same basis as the annual financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments necessary for the fair statement of results for the periods presented, have been included. The results of operations of any interim period are not necessarily indicative of the results of operations for the full year or any other interim period.

The accompanying condensed financial statements should be read in conjunction with the audited financial statements and notes thereto for the fiscal year ended June 30, 2006 filed on Form 10-K with the Securities and Exchange Commission (the “SEC”) on September 14, 2006.

Reverse Stock Split

On December 12, 2005 the Board of Directors approved, and on January 6, 2006 the stockholders approved, a one-for-three reverse split of the Company’s issued or outstanding shares of common stock and preferred stock, and on January 9, 2006 the Company filed an amended and restated certificate of incorporation effecting the reverse split. All issued or outstanding common stock, preferred stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect this reverse stock split.

New Accounting Standard

In September 2006, the SEC staff published Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, (“SAB 108”). SAB 108 addresses quantifying the financial statement effects of misstatements and considering the effects of prior year uncorrected errors’ effect on the statements of operations as well as the balance sheets. SAB 108 does not change the requirements under SAB 99 regarding qualitative considerations in assessing the materiality of misstatements. The Company will adopt SAB 108 in the fourth quarter of fiscal 2007. The Company does not expect that the adoption of SAB 108 will have a material impact on its financial statements.

In September 2006, the Financial Accounting Standards Board (the “FASB”) issued Statement of

Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”), which provides guidance for using fair value to measure assets and liabilities. The pronouncement clarifies (1) the extent to which companies measure assets and liabilities at fair value; (2) the information used to measure fair value; and (3) the effect that fair value measurements have on earnings. SFAS 157 will apply whenever another standard requires (or permits) assets or liabilities to be measured at fair value. SFAS 157 is effective for the Company as of July 1, 2008. The Company is currently evaluating the impact this statement will have on its financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes,” an interpretation of SFAS No. 109, “Accounting for Income Taxes.” The interpretation contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109. The provisions are effective for the Company as of July 1, 2007. The Company is currently evaluating the impact this statement will have on its financial statements.

Use of Estimates

To prepare financial statements in conformity with U.S. generally accepted accounting principles, management must make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates based upon future events.

All estimates are evaluated on an on-going basis. In particular, the Company regularly evaluates estimates related to recoverability of accounts receivable, inventory and accrued liabilities for its operations. The Company bases its estimates on historical experience and on various other specific assumptions that management believes to be reasonable under the circumstances. Those estimates and assumptions form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.

Available-for-Sale Securities

The Company has classified its investments in marketable securities as available-for-sale. Such investments are reported at market value, and unrealized gains and losses, if any, are excluded from earnings and are reported in other comprehensive income (loss) as a separate component of stockholders’ equity until realized. The cost of securities sold is based on the specific-identification method. Interest on securities classified as available-for-sale is included in interest income. The net realized gains on sales of available-for-sale securities were not material in any of the periods presented.

Unrealized gains or losses on available-for-sale securities at December 31, 2006 and June 30, 2006 are classified as accumulated other comprehensive loss on the accompanying balance sheet.

Available-for-sale securities at December 31, 2006 consisted primarily of corporate debt securities and debt instruments of the U.S. Government and its agencies. We restrict our exposure to any single corporate issuer by imposing concentration limits. The underlying contractual maturities of the debt securities are greater than one year. Although maturities may extend beyond one year, it is management’s intent that these securities will be used for current operations, and, therefore, such investments are classified as short-term.

Inventories

Inventories are recorded at the lower of cost (which approximates actual cost on a first-in, first-out basis) or market. The Company periodically assesses the recoverability of all inventories, including raw materials, work-in-process and finished goods, to determine whether adjustments for impairment are required. Inventory that is obsolete or in excess of forecasted usage is written down to its estimated realizable net value based on assumptions about future demand and market conditions.

Revenue Recognition

Revenue is recognized upon shipment of product, provided title to the product has been transferred at the point of shipment. If title to the product transfers at the point of receipt by the customer, revenue is recognized upon customer receipt of the shipment. Product revenue is recognized upon receipt of payments when collectibility is not probable. The Company does not require collateral from its customers. Amounts received in advance of meeting the revenue recognition criteria are recorded as deferred revenue. Customers have the right to return products that are defective. There are no other return rights. Revenue generated from development contracts is recognized upon acceptance of milestones by the customer. The Company includes shipping and handling costs in cost of product revenue.

NOTE 2 — STOCK-BASED COMPENSATION

On November 4, 2005, upon filing of the initial Registration Statement on Form S-1, the Company adopted SFAS 123R (“SFAS 123R”), Share-Based Payments, which revises SFAS 123, Accounting for Stock-Based Compensation. SFAS 123R establishes accounting for stock-based awards exchanged for employee services. Under SFAS 123R, stock-based compensation cost is measured on the grant date, based on the fair value of the award, and is recognized as an expense over the employee requisite service period. Upon adoption of SFAS 123R, the Company elected to recognize compensation expense using the graded method. Prior to the adoption of SFAS 123R in the second quarter of fiscal year 2006, the Company accounted for stock-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“Opinion 25”) and Financial Accounting Standard Board Interpretation (FIN) No. 44, Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB No. 25. The Company adopted SFAS 123R applying the “prospective method” under which it would continue to account for nonvested equity awards outstanding at the date of adoption of SFAS 123R in the same manner as they had been accounted for prior to adoption, that is, it would continue to apply Opinion 25 in future periods to equity awards outstanding at the date it adopted SFAS 123R.

SFAS 123R applies to new awards and to awards modified, repurchased, or cancelled after the required effective date. The Company uses the Black-Scholes model to value its new stock option grants under SFAS 123R, and used the following assumptions for awards granted during the periods listed below:


	Three months ended						Six months ended
	December 31,						December 31,
	2006			2005			2006
Risk-free interest rate		4.61	%		4.14	%		4.75	%
Dividend yield		—			—			—
Weighted-average expected life	6 years			6 years			6 years
Volatility		70	%		70	%		70	%

Since the Company is a newly public entity with no historical data on volatility of its stock, the expected volatility used in fiscal 2007 is based on volatility of similar entities (referred to as “guideline” companies). In evaluating similarity, the Company considered factors such as industry, stage of life cycle, size, and financial leverage.

The expected term of options granted is determined using the “shortcut” method allowed by SAB 107. Under this approach, the expected term would be presumed to be the mid-point between the vesting date and the end of the contractual term. The shortcut approach is not permitted for options granted, modified or settled after December 31, 2007. The risk-free rate for periods within the contractual life of the option is based on a risk-free zero-coupon spot interest rate at the time of grant. The Company has never declared or paid any cash dividends and does not presently plan to pay cash dividends in the foreseeable future. SFAS 123R also requires the Company to estimate forfeitures in calculating the expense related to stock-based compensation. The Company recorded fair-value stock-based compensation expenses of $206,000, or $0.02 per share and $25,000, or $0.02 per share in the three months ended December 31, 2006 and 2005, respectively, and $260,000, or $0.03 per share and $25,000, or $0.02 per share in the six months ended December 31, 2006 and 2005, respectively. In addition, SFAS 123R requires the Company to reflect the benefits of tax deductions in excess of recognized compensation cost to be reported as both a financing cash inflow and an operating cash outflow upon adoption. The Company has recognized no such tax benefits to date.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. All statements other than statements of historical facts are “forward-looking statements” for purposes of these provisions, including any projections of earnings, revenue or other financial items, any statement of the plans and objectives of management for future operations, any statements concerning proposed new products or licensing or collaborative arrangements, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “potential,” or “continue” or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained herein are reasonable, there can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, including but not limited to the risk factors set forth below, and for the reasons described elsewhere in this report. All forward-looking statements and reasons why results may differ included in this report are made as of the date hereof, and we assume no obligation to update these forward-looking statements or reasons why actual results might differ.

Overview

We design and manufacture proprietary automated anastomotic systems used by surgeons to perform coronary bypass surgery. In coronary artery bypass grafting, or CABG, procedures, veins or arteries are used to construct alternative conduits to restore blood flow beyond closed or narrowed portions of coronary arteries, “bypassing” the occluded portion of the coronary artery that is impairing blood flow to the heart muscle. Our products provide cardiovascular surgeons with easy-to-use automated systems to perform consistent, rapid and reliable connections, or anastomoses, of the vessels, which surgeons generally view as the most critical aspect of the bypass procedure. We currently sell our C-Port^{^®} Distal Anastomosis System, or C-Port system, and C-Port^{^®} xA Distal Anastomosis System, or C-Port xA system, in Europe and the United States. We currently sell our PAS-Port^{^®} Proximal Anastomosis System, or the PAS-Port system, in Europe and Japan, and we initiated a clinical trial of this system in the U.S. and Europe in June 2006. Our strategy is to further enhance and leverage our technology to develop next-iteration automated anastomotic systems that facilitate the performance of minimally invasive endoscopic coronary bypass surgery, as well as automated systems to be used in other surgical applications.

In December 2005, we entered into a license, development and commercialization agreement with Cook Incorporated, or Cook, relating to development of our X-Port™ Vascular Access Closure Device, or X-Port, a product candidate of ours that we are currently studying in preclinical animal model studies. Under the agreement, we will develop the X-Port with Cook, and Cook will have exclusive commercialization rights to market the product for medical procedures anywhere in the body. We received and recognized in development revenue an aggregate of $500,000 for the six month period ended December 31, 2006 and $1.0 million during fiscal year ended June 30, 2006 from Cook after completion to Cook’s satisfaction of certain milestones under a development plan. Cook will pay us up to a total of an additional $500,000 in future milestone payments assuming achievement of the remaining development milestone under the development agreement. We may also receive royalty income based on Cook’s annual worldwide sales of the X-Port, if any.

We manufacture the C-Port and PAS-Port systems with parts and components supplied by vendors, which we then assemble, test and package. For the six month period ended December 31, 2006, we generated net revenue of $1.4 million and incurred a net loss of $6.1 million. As of December 31, 2006, our accumulated deficit was $66.5 million. Since our inception, we have not been profitable. We expect to continue to incur net losses for the foreseeable future.

Critical Accounting Policies and Significant Judgments and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses, and disclosures of contingent assets and liabilities at the date of the financial statements. On a periodic basis, we evaluate our estimates, including those related to accounts receivable, inventories and stock-based compensation. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ materially from those estimates under different assumptions or conditions.

We believe the following critical accounting policies to be the most critical to an understanding of our financial statements because they affect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue Recognition. We recognize revenue in accordance with SEC Staff Accounting Bulletin, or SAB No. 104, “Revenue Recognition.” SAB No. 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) title has transferred; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured. We generally use contracts and customer purchase orders to determine the existence of an arrangement. We use shipping documents and third-party proof of delivery to verify that title has transferred. We assess whether the fee is fixed or determinable based upon the terms of the agreement associated with the transaction. To determine whether collection is probable, we assess a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not reasonably assured, we would defer the recognition of revenue until collection becomes reasonably assured, which is generally upon receipt of payment.

Revenue generated from development contracts is recognized upon acceptance of non-refundable milestone payments by the customer in accordance with contractual terms, and when the earnings process is complete.

Inventory. We state our inventories at the lower of cost or market, computed on a standard cost basis (which approximates actual cost on a first-in, first-out basis) and market being determined as the lower of replacement cost or net realizable value. Standard costs are monitored on a quarterly basis and updated as necessary to reflect changes in raw material costs and labor and overhead rates. Inventory write-downs are established when conditions indicate that the selling price could be less than cost due to physical deterioration, usage, obsolescence, reductions in estimated future demand and reductions in selling prices. Inventory write-downs are measured as the difference between the cost of inventory and estimated market value. Inventory write-downs are charged to cost of revenue and establish a lower cost basis for the inventory. We balance the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology and customer demand levels. Unfavorable changes in market conditions may result in a need for additional inventory write-downs that could adversely impact our financial results.

Clinical Trial Accounting. Clinical trial costs are a component of research and development expenses and include fees paid to participating hospitals and other service providers that conduct clinical trial activities with patients on our behalf and clinical trial insurance. The various costs of the trial are contractually based on the nature of the services, and we accrue the costs as the services are provided. Accrued costs are based on estimates of the work completed under the service agreements, patient enrollment and past experience with similar contracts. Our estimate of the work completed and associated costs to be accrued include our assessment of information received from our third-party service providers and the overall status of our clinical trial activities. If we have incomplete or inaccurate information, we may underestimate costs associated with various trials at a given point in time. Although our experience in estimating these costs is limited, the differences between accrued expenses based on our estimates and actual expenses have not been material to date.

Stock-Based Compensation. Upon filing our initial Registration Statement on Form S-1 in November 2005, we adopted Statement of Financial Accounting Standards, or SFAS 123R, Share-Based Payments, which revises SFAS 123, “Accounting for Stock-Based Compensation.” SFAS 123R establishes accounting for stock-based awards exchanged for employee services. Under SFAS 123R, stock-based compensation cost is measured on the grant date, based on the fair value of the award, and is recognized as an expense over the employee requisite service period. SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option pricing module. We value share-based awards using the Black-Scholes option pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our statements of operations. Determining the appropriate fair value model and calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility, forfeiture rates and expected life. Total compensation expense related to unvested awards not yet recognized is approximately $796,000 at December 31, 2006 and is expected to be recognized over the next 47 months.

Prior to the adoption of SFAS 123R in the quarter ended December 31, 2005, we accounted for stock-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion, or APB No. 25, Accounting for Stock Issued to Employees and Financial Accounting Standard Board, or FASB Interpretation, or FIN No. 44, Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB No. 25. Upon adoption of SFAS 123R we apply the “prospective method” under which we continue to account for nonvested equity awards outstanding at the date of adoption of SFAS 123R in the same manner as we had accounted for prior to adoption, that is, we would continue to apply APB 25 in future periods to equity awards outstanding at the date we adopted SFAS 123R. Total unamortized deferred stock-based compensation at December 31, 2006 is approximately $799,000. We expect to record aggregate amortization of stock-based compensation expenses of $171,000 for the remainder of fiscal year 2007, $325,000 in fiscal year 2008, $281,000 in fiscal year 2009 and $22,000 in fiscal year 2010.

Results of Operations

Comparison of the three months ended December 31, 2006 and 2005

Net Revenue. Total net revenue increased by $729,000, or 366%, to $928,000 for the three months ended December 31, 2006 compared to $199,000 for the same period in 2005. Product revenue increased by $217,000, or 109%, to $416,000 for the three months ended December 31, 2006 compared to $199,000 for the same period in 2005. The increase in product revenue for the three months ended December 31, 2006 reflected C-Port and C-Port xA system sales in the United States and higher sales of the PAS-Port system in Japan. Product revenue for the three month period ended December 31, 2005 did not include any C-Port or C-Port xA system sales in the United States as the C-Port system was not cleared by the FDA until November 2005 and the C-Port xA system was not cleared by the FDA until November 2006.

On January 12, 2007, we initiated a voluntary recall of 55 units of our C-Port xA systems shipped to our customers due to a supplier manufacturing defect in a single component. Only a portion of the C-Port xA systems in specific manufacturing lots are affected. The voluntary recall was not based on any customer complaint and we believe did not involve any risk to the patient. This recall had a negative impact on our product revenues for the three month period ended December 31, 2006 and will have a negative impact for the three month period ending March 31, 2007.

Development revenue of $500,000 for the three month period ended December 31, 2006 was comprised of the payment from Cook for the achievement of the third milestone in the development of the X-Port Vascular Access Closure Device under our development agreement with Cook. The achievement of the milestone was based upon the completion to Cook’s satisfaction of certain deliverables under the development agreement. No development revenue was recognized for the three month period ended December 31, 2005.

Cost of Product Revenue. Cost of product revenue consists primarily of material, labor and overhead costs. Cost of product revenue increased $674,000, or 321%, to $884,000 for the three months ended December 31, 2006 compared to $210,000 for the same period in 2005. The increase in costs in the three months ended December 31, 2006 was primarily attributable to write-offs of excess C-Port inventories of

$205,000, write-offs of C-Port xA inventories of $93,000 as a result of the product recall announced and increased scrap expenses on production of the C-Port systems.

Selling, General and Administrative Expense. Selling, general and administrative expenses consist primarily of stock-based compensation charges, administrative and sales and marketing personnel, intellectual property and marketing expenses. Selling, general and administrative expenses increased $1.3 million or 139%, to $2.2 million for the three months ended December 31, 2006 compared to $923,000 for the same period in 2005. The increase in expenses in the three month period ended December 31, 2006 was attributable to higher personnel related and travel expenses as a result of building a field sales force in the United States to sell C-Port and C-Port xA systems, higher legal expenses associated with the on-going patent interference proceeding and higher public company expenses.

Interest Income. Interest income increased $235,000, or 373%, to $298,000 for the three months ended December 31, 2006 compared to $63,000 for the same period in 2005. The increase in interest income for the three months ended December 31, 2006 was primarily due to higher cash and short-term investment balances available for investing as a result of our initial public offering in February 2006 and higher overall market interest rates during the period.

Interest Expense. Interest expense decreased $132,000, or 50%, to $132,000 for the three months ended December 31, 2006 compared to $264,000 for the same period in 2005 The decrease in interest expense for the three months ended December 31, 2006 was due to lower average long-term debt balances during the period as a result of the elimination of the related party debt of $10.3 million during the period.

Gain on early retirement of notes payable to related party. Gain on early retirement of notes payable to related party of $1.2 million for the three month period ended December 31, 2006 primarily resulted from the lower market value of the 1,432,550 shares of common stock issued to Guidant at a conversion price of $5.00 per share in connection with the conversion of outstanding notes in the aggregate principal amount of $7.2 million offset in part by $250,000 of expense paid. The closing market price of the common stock on the delivery date was $4.00 per share.

Comparison of the six months ended December 31, 2006 and 2005

Net Revenue. Total net revenue increased by $1.0 million, or 281%, to $1.4 million for the six months ended December 31, 2006 compared to $367,000 for the same period in 2005. Product revenue increased by $514,000, or 143%, to $874,000 for the six months ended December 31, 2006 compared to $360,000 for the same period in 2005. The increase in product revenue for the six months ended December 31, 2006 reflected C-Port and C-Port xA system sales in the United States and higher sales of the PAS-Port system in Japan. Product revenue for the six month period ended December 31, 2005 did not include any C-Port or C-Port xA system sales in the United States as the C-Port system was not cleared by the FDA until November 2005 and the C-Port xA system was not cleared by the FDA until November 2006.

Development revenue of $500,000 for the six month period ended December 31, 2006 was comprised of the payment from Cook for the achievement of the third milestone in the development of the X-Port Vascular Access Closure Device under our development agreement with Cook. The achievement of the milestone was based upon the completion to Cook’s satisfaction of certain deliverables under the development agreement. No development revenue was recognized for the six month period ended December 31, 2005.

Cost of Product Revenue. Cost of product revenue consists primarily of material, labor and overhead costs. Cost of product revenue increased $726,000, or 87%, to $1.6 million for the six months ended December 31, 2006 compared to $837,000 for the same period in 2005. The increase in costs in the six months ended December 31, 2006 was primarily attributable to increased unit sales of our products during the period, write-offs of excess C-Port inventories of $205,000, write-offs of C-Port xA inventories as a result of the product recall announced, higher scrap expenses on production of the C-Port and C-Port xA systems and lower of cost or market reserve for Pas-Port systems of $112,000, offset in part by lower scrap and obsolete expenses for the Pas-Port systems of $181,000. The costs for the six months ended December 31, 2005 included inventory write-offs of $211,000 for obsolete PAS-Port systems.

Research and Development Expense. Research and development expenses consist primarily of personnel costs within our product development, regulatory and clinical groups and the costs of clinical trials. Research and development expenses increased by $407,000, or 15%, to $3.1 million for the six months ended December 31, 2006 compared to $2.7 million for the same period in 2005. The increase in costs for the six month period ended December 31, 2006 was attributable to increases in quality control and regulatory personnel related expenses and higher clinical trial expenses for PAS-Port system, C-Port xA program costs, offset in part by lower facility related expenses and lower non-cash stock compensation charges for the period. We anticipate that research and development expenses will increase in absolute terms in future periods as we continue the clinical study for the PAS-Port system, continue to enhance our existing product lines and begin to develop new applications of our technology.

Selling, General and Administrative Expense. Selling, general and administrative expenses consist primarily of stock-based compensation charges, administrative and sales and marketing personnel, intellectual property and marketing expenses. Selling, general and administrative expenses increased $2.1 million, or 99%, to $4.3 million for the six months ended December 31, 2006 compared to $2.1 million for the same period in 2005. The increase in expenses in the six month period ended December 31, 2006 was attributable to higher personnel related and travel expenses as a result of building a field sales force in the United States to sell the C-Port system, higher legal expenses associated with the on-going patent interference proceeding and higher public company expenses, offset in part by a decrease of $372,000 in non-cash stock-based compensation expense.

During the six months ended December 31, 2005, we recorded $583,000 in non-cash stock-based compensation expense related to previously outstanding loans to three directors, each of whom is or was also an officer, to purchase shares of our common stock with promissory notes. These loans were repaid with common stock in October 2005. We recognized no non-cash stock based compensation expense related to these loans during the six months ended December 31, 2006 or three months ended December 31, 2005. We expect selling, general and administrative expenses to increase as we expand our sales and marketing efforts and the requirements of being a public company.

Interest Income. Interest income increased $552,000, or 409%, to $687,000 for the six months ended December 31, 2006 compared to $135,000 for the same period in 2005. The increase in interest income for the six months ended December 31, 2006 was primarily due to higher cash and short-term investment balances available for investing as a result of the initial public offering in February 2006 and higher overall market interest rates during the period.

Interest Expense. Interest expense decreased $132.000, or 25%, to $396,000 for the six months ended December 31, 2006 compared to $528,000 for the same period in 2005. The decrease in interest expense for the six months ended December 31, 2006 was due to lower average loan balances as a result of the elimination of the related party debt of $10.3 million during the period.

Gain on early retirement of notes payable to related party. Gain on early retirement of notes payable to related party of $1.2 million for the six month period ended December 31, 2006 primarily resulted from the lower market value of the 1,432,550 shares of common stock issued to Guidant at a conversion price of $5.00 per share in connection with the conversion of outstanding notes in the aggregate principal amount of $7.2 million offset in part by $250,000 of expense paid. The closing market price of the common stock on the delivery date was $4.00 per share.

Liquidity and Capital Resources

As of December 31, 2006, our accumulated deficit was $66.5 million. We currently invest our cash and cash equivalents in large money market funds and our short-term investments primarily in debt instruments of the U.S. government, its agencies and high-quality corporate issuers. We have financed our operations primarily through private sales of convertible preferred stock resulting in aggregate net proceeds of $38.9 million, long-term notes payable of $13.3 million and net proceeds of $32.6 million from our initial public offering.

As of December 31, 2006, except for operating leases, we did not have any off-balance sheet liabilities. We had cash, cash equivalents and short-term investments of $19.4 million as of December 31, 2006.

The following table discloses aggregate information, as of December 31, 2006, about our contractual obligations and the periods in which payments are due (in thousands):


			Less than 1				More than
Contractual Obligations	Total		Year		1-3 Years		3 Years
Operating lease – real estate	$	749	$	469	$	280	$	—
Subordinated notes payable, including interest		3,245		150		3,095		—

Total	$	3,994	$	619	$	3,375	$	—

The long-term commitments under operating leases shown above consist of payments related to our real estate leases for our headquarters in Redwood City, California expiring in 2008.

The subordinated notes payable were issued in connection with our Japan Distribution Agreement with Century Medical, Inc. The subordinated notes are due in June 2008 and bear interest at 5% per annum that is payable quarterly. The holder of the subordinated notes has a continuing security interest in all of our personal property and assets, including intellectual property.

Summary liquidity and cash flow data is as follows (in thousands):


	Six months ended
	December 31,
	2006			2005
Net cash used in operating activities	$	(9,560	)	$	(3,958	)
Net cash provided by investing activities		16,020			2,004
Net cash provided by (used in) financing activities		(2,909	)		8

During the three months ended December 31, 2006, we entered into a note conversion agreement with Guidant pursuant to which Guidant converted a portion of our outstanding indebtedness to Guidant into shares of our common stock. We had previously issued to Guidant 8.75% Notes (the “Notes”), dated August 19, 2003 and February 25, 2004 in the principal amounts of $5.0 million and $5.3 million, respectively, which would have matured in August 2008 along with the accrued interest payable. Pursuant to a note conversion agreement, $7.2 million of the outstanding principal amount under the Notes was converted into an aggregate of 1,432,550 shares of our common stock at a conversion price of $5.00 per share. The remaining principal balance of $3.1 million along with accrued interest of approximately $2.7 million was paid in cash to Guidant in full satisfaction of all amounts owing under the Notes, and the Notes have been cancelled.

Net cash used in operating activities for the six month periods ended December 31, 2006 and 2005 was $9.6 million and $4.0 million, respectively. The use of cash for the six months ended December 31, 2006 was attributable to our net loss and a $1.4 million gain on early retirement of notes payable to Guidant, a related party, adjusted for non-cash stock-based compensation charges and depreciation, a payment made to Guidant, a related party, of interest payable of $2.3 million, a decrease in accounts payable and other accrued liabilities, an increase in inventories, offset in part by a decrease in prepaid expenses due to the amortization of insurances to operating expense and a decrease in other current liabilities due to lower accrued legal expenses. The use of cash for the six-months ended December 31, 2005 was attributable to our net loss adjusted for non-cash stock-based compensation charges, an increase in prepaid and other

assets primarily resulting from deferred offering costs adjusted for non-cash compensation charges and depreciation expenses.

Net cash provided by investing activities for the six month periods ended December 31, 2006 and 2005 was $16.0 million and $2.0 million, respectively. Net cash provided by investing activities represent purchases, sales and maturities of investments and purchases of property and equipment. The increase in net cash provided by investing activities for the six months ended December 31, 2006 was related to the maturities of investments used to fund our operating losses. Purchases of property and equipment were $230,000 and $249,000 in the six month periods ended December 31, 2006 and 2005, respectively.

Net cash used by financing activities for the six months ended December 31, 2006 was $2.9 million compared to net cash provided by financing activities of $8,000 for the same period in 2005. Net cash used by financing activities for the six months ended December 31, 2006 consisted primarily of $3.1 million paid in cash to Guidant ,a related party, to retire a portion of notes payable and $250,000 paid for advisement services in conjunction with the retirement of the notes payable.

Our future capital requirements depend upon numerous factors. These factors include but are not limited to the following:

	•		market acceptance and adoption of our products;

	•		our revenue growth;

	•		costs associated with our sales and marketing initiatives and manufacturing activities;

	•		costs of obtaining and maintaining FDA and other regulatory clearances and approvals for our products;

	•		securing, maintaining and enforcing intellectual property rights;

	•		costs of developing marketing and distribution capabilities;

	•		the extent of our ongoing research and development programs;

	•		the progress of clinical trials; and

	•		the effects of competing technological and market developments.

We believe that our current cash, cash equivalents and short-term investments, along with cash that we expect to generate from operations, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least 15 months from December 31, 2006. If these sources of cash are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities, obtain a credit facility or enter into development or license agreements with third parties. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of debt securities, these securities could have rights senior to those associated with our common stock and could contain covenants that would restrict our operations. Any licensing or strategic agreements we enter into may require us to relinquish valuable rights. Additional financing may not be available at all, or in amounts or upon terms acceptable to us. If we are unable to obtain this additional financing, we may be required to reduce the scope of our planned product development and marketing efforts.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We invest our excess cash in money market funds, auction rate preferred securities and debt instruments of the U.S. Government and its agencies, and, by policy, restrict our exposure to any single corporate issuer by imposing concentration limits. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk-sensitive instruments, positions or transactions to any material extent. Accordingly, we believe that, while the instruments we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments. Due to the short-term nature of these investments, a 1% change in market interest rates would not have a significant impact on the total value of our portfolio as of December 31, 2006.

Although substantially all of our sales and purchases are denominated in U.S. dollars, future fluctuations in the value of the U.S. dollar may affect the price competitiveness of our products outside the United States. We do not believe, however, that we currently have significant direct foreign currency exchange rate risk and have not hedged exposures denominated in foreign currencies.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Effectiveness of Disclosure Controls and Procedures

Based on their evaluation as of December 31, 2006, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a–15(e) and 15d–15(e) of the Securities Exchange Act of 1934 as amended) were effective to ensure that the information required to be disclosed by us in the reports that we file with the Securities and Exchange Commission was recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting.

There were no changes in our internal control over financial reporting during the quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Limitations on the Effectiveness of Controls

Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives. Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

An interference is a proceeding within the U.S. Patent and Trademark Office to determine priority of invention of the subject matter of patent claims. The declaration of interference is made by the Patent Appeals Board only after claims in a patent application are deemed allowable but for the interfering subject matter (in this case our issued patent) and a determination that interfering subject matter exists. The declaration of interference initiates an adversarial proceeding in the U. S. Patent and Trademark Office before the Patent Appeals Board. The proceeding will involve issues including but not limited to whether an interference proceeding is appropriate, whether the involved claims of the parties are patentable and which party was first to invent the interfering subject matter.

We will vigorously defend our patents against such claim of interference, although there can be no assurance that we will succeed in doing so. We continue to believe that if IVIT’s patent claims are allowed in their present form, our products would not infringe such claims. There can be no assurance that IVIT’s patent claims, if allowed, will be in their present form, or that our products would not be found to infringe such claims or any other claims that are issued.

ITEM 1A. RISK FACTORS

Our business is subject to the risks set forth below.

We have marked with an asterisk (*) those risks described below that reflect substantive changes from the risks described under “Item 1A. Risk Factors” included in our Annual Report on Form 10-K filed with the SEC on September 14, 2006.

Risks Related to Our Business

We are dependent upon the success of our current products, and we have U.S. regulatory clearance for our C-Port and C-Port xA systems only. We cannot be certain that any of our other products will receive regulatory clearance or approval or that any of our products, including the C-Port or C-Port xA systems, will be commercialized in the United States. If we are unable to commercialize our products in the United States, or experience significant delays in doing so, our ability to generate revenue will be significantly delayed or halted, and our business will be harmed. *

We have expended significant time, money and effort in the development of our current products, the C-Port and C-Port xA systems, and the PAS-Port system. While we have received regulatory approval for the commercial sale of our C-Port and C-Port xA systems in the United States and in the European Union and of our PAS-Port system in the European Union and Japan, we do not have clearance or approval in the United States for the PAS-Port system, later iterations of the C-Port or C-Port xA systems or any other product. While we believe most of our revenue in the near future will be derived from the sales and distribution of the C-Port and C-Port xA systems, we anticipate that our ability to increase our revenue in the longer term will depend on the regulatory clearance or approval and commercialization of the PAS-Port system and later iterations of the C-Port or C-Port xA systems in the United States.

If we are not successful in commercializing our C-Port or C-Port xA systems or obtaining U.S. Food and Drug Administration, or FDA, clearance or approval of either our later iterations of the C-Port or C-Port xA systems or the current iteration of the PAS-Port system, or if FDA clearance or approval of any of our products is significantly delayed, we may never generate substantial revenue, our business, financial

condition and results of operations would be materially and adversely affected, and we may be forced to cease operations. We commenced sales of our C-Port system in the United States in January 2006 and C-Port xA system in November 2006, but sales may not meet our expectations. Although we have other products under development, we may never obtain regulatory clearance or approval of those devices. We may be required to spend significant amounts of capital or time to respond to requests for additional information by the FDA or foreign regulatory bodies or may otherwise be required to spend significant amounts of time and money to obtain FDA clearance or approval and foreign regulatory approval. Imposition of any of these requirements could substantially delay or preclude us from marketing our products in the United States or foreign countries.

A prior automated cardiac proximal anastomosis system was introduced by another manufacturer but was withdrawn from the market, and, as a result, we may experience difficulty in commercializing our C-Port, C-Port xA and PAS-Port systems. *

A prior automated proximal anastomosis device was introduced by another manufacturer in the United States in 2002. The FDA received reports of apparently device-related adverse events, and in 2004, the device was voluntarily withdrawn from the market by the manufacturer. Because of the FDA’s experience with this prior device, the FDA has identified new criteria for the clinical data required to obtain clearance for a proximal anastomosis device like the PAS-Port. We may not be able to show that the PAS-Port satisfies these criteria, and we may therefore be unable to obtain FDA clearance or approval to market the device in the United States, which would substantially harm our business and prospects. Moreover, physicians who have experience with or knowledge of prior anastomosis devices may be predisposed against using our C-Port, C-Port xA or PAS-Port products, which could limit our ability to commercialize them if they are approved by the FDA. If we fail to achieve market adoption, our business, financial condition and results of operations would be materially harmed.

Lack of third-party coverage and reimbursement for our products could delay or limit their adoption.

We may experience limited sales growth resulting from limitations on reimbursements made to purchasers of our products by third-party payors, and we cannot assure you that our sales will not be impeded and our business harmed if third-party payors fail to provide reimbursement that hospitals view as adequate.

In the United States, our products will be purchased primarily by medical institutions, which then bill various third-party payors, such as the Centers for Medicare & Medicaid Services, or CMS, which administer the Medicare program, and other government programs and private insurance plans, for the health care services provided to their patients. The process involved in applying for coverage and incremental reimbursement from CMS is lengthy and expensive. Even if our products receive FDA and other regulatory clearance or approval, they may not be granted coverage and reimbursement in the foreseeable future, if at all. Moreover, many private payors look to CMS in setting their reimbursement policies and amounts. If CMS or other agencies limit coverage or decrease or limit reimbursement payments for doctors and hospitals, this may affect coverage and reimbursement determinations by many private payors.

We cannot assure you that CMS will provide coverage and reimbursement for our products. If a medical device does not receive incremental reimbursement from CMS, then a medical institution would have to absorb the cost of our products as part of the cost of the procedure in which the products are used. Acute care hospitals are now generally reimbursed by CMS for inpatient operating costs under a Medicare hospital inpatient prospective payment system. Under the Medicare hospital inpatient prospective payment system, acute care hospitals receive a fixed payment amount for each covered hospitalized patient based upon the Diagnosis-Related Group, or DRG, to which the inpatient stay is assigned, regardless of the actual cost of the services provided. At this time, we do not know the extent to which medical institutions would consider insurers’ payment levels adequate to cover the cost of our products. Failure by hospitals and physicians to receive an amount that they consider to be adequate reimbursement for procedures in which our products are used could deter them from purchasing our products and limit our revenue growth. In addition, pre-determined DRG payments may decline over time, which could deter medical institutions

from purchasing our products. If medical institutions are unable to justify the costs of our products, they may refuse to purchase them, which would significantly harm our business.

We have limited data regarding the safety and efficacy of the PAS-Port, C-Port and C-Port xA and have only recently begun training physicians in the United States to use the C-Port and C-Port xA systems. Any data that is generated in the future may not be positive or consistent with our existing data, which would affect market acceptance and the rate at which our devices are adopted. *

The C-Port, C-Port xA and PAS-Port systems are innovative products, and our success depends upon their acceptance by the medical community as safe and effective. An important factor upon which the efficacy of the C-Port, C-Port xA and PAS-Port will be measured is long-term data regarding the duration of patency, or openness, of the artery or the graft vessel. Equally important will be physicians’ perceptions of the safety of our products. Our technology is relatively new in cardiac bypass surgery, and the results of short-term clinical experience of the C-Port, C-Port xA and PAS-Port systems do not necessarily predict long-term clinical benefit. We believe that physicians will compare long-term patency for the C-Port, C-Port xA and PAS-Port devices against alternative procedures, such as hand-sewn anastomoses. If the long-term rates of patency do not meet physicians’ expectations, or if physicians find our devices unsafe, the C-Port, C-Port xA and PAS-Port systems may not become widely adopted and physicians may recommend alternative treatments for their patients. In addition, we have recently begun training physicians in the United States to use our C-Port and C-Port xA systems. Any adverse experiences of physicians using the C-Port or C-Port xA systems, or adverse outcomes to patients, may deter physicians from using our products and negatively impact product adoption.

Our C-Port, C-Port xA and PAS-Port systems were designed for use with venous grafts. Additionally, while our indications for use of the C-Port system cleared by the FDA refer broadly to grafts, we have studied the use of the C-Port system only with venous grafts and not with arterial grafts. Using the C-Port system with arterial grafts may not yield patency rates or material adverse cardiac event rates comparable to those found in our clinical trials using venous grafts, which could negatively affect market acceptance of our C-Port system. In addition, the clips and staples deployed by our products are made of 316L medical-grade stainless steel, to which some patients are allergic. These allergies may result in adverse reactions that negatively affect the patency of the anastomoses or the healing of the implants and may therefore adversely affect outcomes, particularly when compared to anastomoses performed with other materials, such as sutures. Additionally, in the event a surgeon, during the course of surgery, determines that it is necessary to convert to a hand-sewn anastomosis and to remove an anastomosis created by one of our products, the removal of the implants may result in more damage to the target vessel (such as the aorta or coronary artery) than would typically be encountered during removal of a hand-sewn anastomosis. Moreover, the removal may damage the target vessel to an extent that could further complicate construction of a replacement hand-sewn or automated anastomosis, which could be detrimental to patient outcome. These or other issues, if experienced, could limit physician adoption of our products.

Even if the data collected from future clinical studies or clinical experience indicates positive results, each physician’s actual experience with our device outside the clinical study setting may vary. Clinical studies conducted with the C-Port, C-Port xA and PAS-Port systems have involved procedures performed by physicians who are technically proficient, high-volume users of the C-Port, C-Port xA and PAS-Port systems. Consequently, both short- and long-term results reported in these studies may be significantly more favorable than typical results of practicing physicians, which could negatively impact rates of adoption of the C-Port, C-Port xA and PAS-Port systems.

Our current and planned clinical trials may not begin on time, or at all, and may not be completed on schedule, or at all.*

The commencement or completion of any of our clinical trials may be delayed or halted for numerous reasons, including, but not limited to, the following:

	•		the FDA or other regulatory authorities suspend or place on hold a clinical trial, or do not approve a clinical trial protocol or a clinical trial;

	•		the data and safety monitoring committee of a clinical trial recommends that a trial be placed on hold

			or suspended;

	•		patients do not enroll in clinical trials at the rate we expect;

	•		patients are not followed-up at the rate we expect;

	•		clinical trial sites decide not to participate or cease participation in a clinical trial;

	•		patients experience adverse side effects or events related to our products;

	•		patients die or suffer adverse medical effects during a clinical trial for a variety of reasons, which may not be related to our product candidates, including the advanced stage of their disease and medical problems,;

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

	•		regulatory inspections of our clinical trials or manufacturing facilities may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials if investigators find us not to be in compliance with regulatory requirements;

	•		third-party suppliers fail to provide us with critical components that conform to design and performance specifications;

	•		the failure of our manufacturing process to produce finished products that conform to design and performance specifications;

	•		changes in governmental regulations or administrative actions;

	•		the interim results of the clinical trial are inconclusive or negative;

	•		pre-clinical or clinical data is interpreted by third parties in different ways; or

	•		our trial design, although approved, is inadequate to demonstrate safety and/or efficacy.

Clinical trials sometimes experience delays related to outcomes experienced during the course of the trials. For example, in our PAS-Port pivotal trial, we recently had an administrative hold of the trial related to an adverse event, which lasted approximately 72 hours while the adverse event was investigated. The data safety monitoring board subsequently concluded that there was no clear evidence that our device had caused the adverse event and enrollment continued. While this event was resolved in a timely manner and did not result in any material delay in the trial, future similar or other types of events could lead to more significant delays or other effects on the trial.

Clinical trials may require the enrollment of large numbers of patients, and suitable patients may be difficult to identify and recruit. Patient enrollment in clinical trials and completion of patient follow-up in clinical trials depend on many factors, including the size of the patient population, the nature of the trial protocol, the proximity of patients to clinical sites and the eligibility criteria for the study and patient compliance. For example, patients may be discouraged from enrolling in our clinical trials if the trial protocol requires them to undergo extensive post-treatment procedures to assess the safety and effectiveness of our product candidates, or they may be persuaded to participate in contemporaneous trials of competitive products. Delays in patient enrollment or failure of patients to continue to participate in a study may cause an increase in costs and delays or result in the failure of the trial.

Our clinical trial costs will increase if we have material delays in our clinical trials or if we need to perform more or larger clinical trials than planned. Adverse events during a clinical trial could cause us to repeat a trial, terminate a trial or cancel the entire program.

If the third parties on whom we rely to conduct our clinical trials do not perform as contractually required or expected, we may not be able to obtain regulatory approval for or commercialize our product candidates.

We do not have the ability to independently conduct clinical trials for our product candidates, and we must rely on third parties, such as contract research organizations, medical institutions, clinical investigators and contract laboratories, to conduct our clinical trials. In addition, we rely on third parties to assist with our pre-clinical development of product candidates. Furthermore, our third-party clinical trial investigators may be delayed in conducting our clinical trials for reasons outside of their control, such as changes in regulations, delays in enrollment, and the like. If these third parties do not successfully carry out their contractual duties or regulatory obligations or meet expected deadlines, if these third parties need to be replaced or if the quality or accuracy of the data they obtain is compromised due to the failure to adhere to our clinical protocols or regulatory requirements or for other reasons, our clinical trials may be extended, delayed, suspended or terminated, and we may not be able to obtain regulatory approval for or successfully commercialize our product candidates on a timely basis, if at all.

Even though our C-Port and C-Port xA products have received U.S. regulatory clearance, our PAS-Port system, as well as our future products, may still face future development and regulatory difficulties. *

Even though the current iteration of the C-Port and C-Port xA systems have received U.S. regulatory clearance, the FDA may still impose significant restrictions on the indicated uses or marketing of this product or ongoing requirements for potentially costly post-clearance studies. Any of our other products, including the PAS-Port system and future iterations of the C-Port and C-Port xA systems, may also face these types of restrictions or requirements. In addition, regulatory agencies subject a product, its manufacturer and the manufacturer’s facilities to continual review, regulation and periodic inspections. If a regulatory agency discovers previously unknown problems with a product, including adverse events of unanticipated severity or frequency, or problems with the facility where the product is manufactured, a regulatory agency may impose restrictions on that product, our collaborators or us, including requiring withdrawal of the product from the market. Our products will also be subject to ongoing FDA requirements for the labeling, packaging, storage, advertising, promotion, record-keeping and submission of safety and other post-market information on the product. If our products fail to comply with applicable regulatory requirements, a regulatory agency may impose any of the following sanctions:

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

	•		customer notifications, repair, replacement, refunds, recall or seizure of our products;

	•		operating restrictions, partial suspension or total shutdown of production;

	•		delay in processing marketing applications for new products or modifications to existing products;

	•		withdrawing approvals that have already been granted; and

	•		criminal prosecution.

To market any products internationally, we must establish and comply with numerous and varying regulatory requirements of other countries regarding safety and efficacy. Approval procedures vary among countries and can involve additional product testing and additional administrative review periods. The time required to obtain approval in other countries might differ from that required to obtain FDA clearance or approval. The regulatory approval process in other countries may include all of the risks detailed above regarding FDA clearance or approval in the United States. Regulatory approval in one country does not ensure regulatory approval in another, but a failure or delay in obtaining regulatory approval in one country may negatively impact the regulatory process in others. Failure to obtain regulatory approval in other countries or any delay or setback in obtaining such approval could have the same adverse effects detailed above regarding FDA clearance or approval in the United States, including the risk that our products may not be approved for use under all of the circumstances requested, which could limit the uses of our products and adversely impact potential product sales, and that such clearance or approval may require costly, post-

marketing follow-up studies. If we fail to comply with applicable foreign regulatory requirements, we may be subject to fines, suspension or withdrawal of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution.

If we do not achieve our projected development goals in the time frames we announce and expect, the commercialization of our product candidates may be delayed and, as a result, our stock price may decline.

From time to time, we may estimate and publicly announce the timing anticipated for the accomplishment of various clinical, regulatory and other product development goals, which we sometimes refer to as milestones. These milestones may include an Investigational Device Exemption application to commence our enrollment of patients in our clinical trials, the release of data from our clinical trials, receipt of clearances or approvals from regulatory authorities or other clinical and regulatory events. These estimates are based on a variety of assumptions. The actual timing of these milestones can vary dramatically compared to our estimates, in some cases for reasons beyond our control. If we do not meet these milestones as publicly announced, the commercialization of our products may be delayed and, as a result, our stock price may decline.

Our products may never gain any significant degree of market acceptance, and a lack of market acceptance would have a material adverse effect on our business. *

We cannot assure you that our products will gain any significant degree of market acceptance among physicians or patients, even if necessary regulatory and reimbursement approvals are obtained. We believe that recommendations by physicians will be essential for market acceptance of our products; however, we cannot assure you that any recommendations will be obtained. Physicians will not recommend the products unless they conclude, based on clinical data and other factors, that the products represent a safe and acceptable alternative to other available options. In particular, physicians may elect not to recommend using our products in surgical procedures until such time, if ever, as we successfully demonstrate with long-term data that our products result in patency rates comparable to or better than those achieved with hand-sewn anastomoses, and we resolve any technical limitations that may arise.

We believe graft patency will be a significant factor for physician recommendation of our products. Although we have not experienced low patency rates in our clinical trials, graft patency determined during the clinical trials conducted by us or other investigators may not be representative of the graft patency actually encountered during commercial use of our products. The surgical skill sets of investigators in our clinical trials may not be representative of the skills of future product users, which could negatively affect graft patency. In addition there may have been a selection bias in the patients, grafts and target vessels used during the clinical trials that positively affected graft patency. The patients included in the clinical trials may not be representative of the general patient population in the United States, which may have resulted in improved graft patency in patients enrolled in the clinical trials. Finally, patient compliance in terms of use of prescribed anticlotting medicines may have been higher in clinical trials than may occur during commercial use, thereby negatively affecting graft patency during commercial use.

Market acceptance of our products is also dependant on our ability to demonstrate consistent quality and safety of our products. Our recent recall of certain C-Port xA devices may impact physicians’ perception of our products.

Widespread use of our products will require the training of numerous physicians, and the time required to complete training could result in a delay or dampening of market acceptance. Even if the safety and efficacy of our products is established, physicians may elect not to use our products for a number of reasons beyond our control, including inadequate or no reimbursement from health care payors, physicians’ reluctance to perform anastomoses with an automated device, the introduction of competing devices by our competitors and pricing for our products. Failure of our products to achieve any significant market acceptance would have a material adverse effect on our business, financial condition and results of operations.

Because one customer accounts for a substantial portion of our product revenue, the loss of this significant customer could cause a substantial decline in our revenue. *

We derive a substantial portion of our revenue from sales to Century Medical, Inc., or Century, our distributor in Japan. The loss of Century as a customer would cause a decrease in revenue and, consequently, an increase in net loss. For the six month period ended December 31, 2006, sales to Century accounted for approximately 61% of our total product revenue. We expect that Century will continue to account for a substantial portion of our revenue in the near term. As a result, if we lose Century as a customer, our revenue and net loss would be adversely affected. In addition, customers that have accounted for significant revenue in the past may not generate revenue in any future period. The failure to obtain new significant customers or additional orders from existing customers will materially affect our operating results.

If our competitors have products that are approved in advance of ours, marketed more effectively or demonstrated to be more effective than ours, our commercial opportunity will be reduced or eliminated and our business will be harmed.

The market for anastomotic solutions and cardiac bypass products is competitive. Competitors include a variety of public and private companies that currently offer or are developing cardiac surgery products generally and automated anastomotic systems specifically that would compete directly with ours.

We believe that the primary competitive factors in the market for medical devices used in the treatment of coronary artery disease include:

	•		improved patient outcomes;

	•		access to and acceptance by leading physicians;

	•		product quality and reliability;

	•		ease of use;

	•		device cost-effectiveness;

	•		training and support;

	•		novelty;

	•		physician relationships; and

	•		sales and marketing capabilities.

We may be unable to compete successfully on the basis of any one or more of these factors, which could have a material adverse affect on our business, financial condition and results of operations.

A number of different technologies exist or are under development for performing anastomoses, including sutures, mechanical anastomotic devices, suture-based anastomotic devices and shunting devices. Currently, substantially all anastomoses are performed with sutures and, for the foreseeable future we believe that sutures will continue to be the principal alternative to our anastomotic products. Sutures are far less expensive than our automated anastomotic products, and other anastomotic devices may be less expensive than our own. Surgeons, who have been using sutures for their entire careers, may be reluctant to consider alternative technologies, despite potential advantages. Any resistance to change among practitioners could delay or hinder market acceptance of our products, which would have a material adverse effect on our business.

Cardiovascular diseases may also be treated by other methods that do not require anastomoses, including, interventional techniques such as balloon angioplasty with or without the use of stents,

pharmaceuticals, atherectomy catheters and lasers. Several of these alternative treatments are widely accepted in the medical community and have a long history of use. In addition, technological advances with other therapies for cardiovascular disease, such as drugs, or future innovations in cardiac surgery techniques could make other methods of treating this disease more effective or lower cost than bypass procedures. For example, the number of bypass procedures in the United States and other major markets has declined in recent years and is expected to decline in the years ahead because competing treatments are, in many cases, far less invasive and provide acceptable clinical outcomes. Many companies working on treatments that do not require anastomoses may have significantly greater financial, manufacturing, marketing, distribution, and technical resources and experience than we have. Many of our competitors have significantly greater financial resources and expertise in research and development, manufacturing, pre-clinical testing, clinical trials, obtaining regulatory clearance or approval and marketing approved products than we do. Smaller or early-stage companies may also prove to be significant competitors, particularly through collaborative arrangements with large and established companies. Our competitors may succeed in developing technologies and therapies that are more effective, better tolerated or less costly than any that we are developing or that would render our product candidates obsolete and noncompetitive. Our competitors may succeed in obtaining clearance or approval from the FDA and foreign regulatory authorities for their products sooner than we do for ours. We will also face competition from these third parties in recruiting and retaining qualified scientific and management personnel, establishing clinical trial sites and patient enrollment for clinical trials and in acquiring and in-licensing technologies and products complementary to our programs or advantageous to our business.

We have limited manufacturing experience and may encounter difficulties in increasing production to provide an adequate supply to customers.

To date, our manufacturing activities have consisted primarily of producing limited quantities of our products for use in clinical studies and for sales in Japan and Europe. We do not have experience in manufacturing our products in the commercial quantities that might be required to market our products in the United States. Production in commercial quantities will require us to expand our manufacturing capabilities and to hire and train additional personnel. We may encounter difficulties in increasing our manufacturing capacity and in manufacturing commercial quantities, including:

	•		maintaining product yields;

	•		maintaining quality control and assurance;

	•		providing component and service availability;

	•		maintaining adequate control policies and procedures; and

	•		hiring and retaining qualified personnel.

Difficulties encountered in increasing our manufacturing could have a material adverse effect on our business, financial condition and results of operations.

The manufacture of our products is a complex and costly operation involving a number of separate processes and components. In addition, the current unit costs for our products, based on limited manufacturing volumes, are very high, and it will be necessary to achieve economies of scale to become profitable. Certain of our manufacturing processes are labor intensive, and achieving significant cost reductions will depend in part upon reducing the time required to complete these processes. We cannot assure you that we will be able to achieve cost reductions in the manufacture of our products and, without these cost reductions, our business may never achieve profitability.

We have considered, and will continue to consider as appropriate, manufacturing in-house certain components currently provided by third parties, as well as implementing new production processes. Manufacturing yields or costs may be adversely affected by the transition to in-house production or to new production processes, when and if these efforts are undertaken, which would materially and adversely affect our business, financial condition and results of operations.

Our manufacturing facilities, and those of our suppliers, must comply with applicable regulatory requirements. Failure to obtain regulatory approval of our manufacturing facilities would harm our business and our results of operations. *

Our manufacturing facilities and processes are subject to periodic inspections and audits by various U.S. federal, U.S. state and foreign regulatory agencies. For example, our facilities have been inspected by State of California regulatory authorities pursuant to granting a California Device Manufacturing License, but not, to date, by the FDA. Additionally, to market products in Europe, we are required to maintain ISO 13485:2003 certification and are subject to periodic surveillance audits. We are currently ISO 13485:2003 certified; however, our failure to maintain necessary regulatory approvals for our manufacturing facilities could prevent us from manufacturing and selling our products.

Additionally, our manufacturing processes and, in some cases, those of our suppliers are required to comply with FDA’s Quality System Regulation, or QSR, which covers the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our products, including the PAS-Port, C-Port and C-Port xA. We are also subject to similar state requirements and licenses. In addition, we must engage in extensive record keeping and reporting and must make available our manufacturing facilities and records for periodic inspections by governmental agencies, including FDA, state authorities and comparable agencies in other countries. If we fail a QSR inspection, our operations could be disrupted and our manufacturing interrupted. Failure to take adequate corrective action in response to an adverse QSR inspection could result in, among other things, a shut-down of our manufacturing operations, significant fines, suspension of product distribution or other operating restrictions, seizures or recalls of our device and criminal prosecutions, any of which would cause our business to suffer. Furthermore, our key component suppliers may not currently be or may not continue to be in compliance with applicable regulatory requirements, which may result in manufacturing delays for our products and cause our revenue to decline.

We may also be required to recall our products due to manufacturing supply defects. For example, we recently initiated a voluntary recall of 55 units of our C-Port xA device from specific manufacturing lots. Internal testing had revealed a supplier manufacturing defect in a single component of the device in the most recently received incoming lots of this component. Only a portion of the C-Port xA devices in specific manufacturing lots were affected. A portion of the devices manufactured in the affected lot was utilized in patients prior to the recall. While we believe that the altered product does not present a hazard to patients, we may incur liabilities to patients in connection with these devices. This recall had a negative impact on our revenues for the quarter ended December 31, 2006 and will have a negative effect on our revenues for the quarter ending March 31, 2007. If we issue additional recalls of our products in the future, our revenues and business could be further harmed.

If we are unable to establish sales and marketing capabilities or enter into and maintain arrangements with third parties to market and sell our products, our business may be harmed.

We are in the beginning stages of building a sales and marketing organization, and we have limited experience as a company in the sales, marketing and distribution of our products. Century is responsible for marketing and commercialization of the PAS-Port system in Japan. To promote our current and future products in the United States and Europe, we must develop our sales, marketing and distribution capabilities or make arrangements with third parties to perform these services. Competition for qualified sales personnel is intense. Developing a sales force is expensive and time consuming and could delay any product launch. We may be unable to establish and manage an effective sales force in a timely or cost-effective manner, if at all, and any sales force we do establish may not be capable of generating sufficient demand for our products. To the extent that we enter into arrangements with third parties to perform sales and marketing services, our product revenue may be lower than if we directly marketed and sold our products. We expect to rely on third-party distributors for substantially all of our international sales. If we are unable to establish adequate sales and marketing capabilities, independently or with others, we may not be able to generate significant revenue and may not become profitable.

We will need to increase the size of our organization, and we may experience difficulties in managing this growth.

As of December 31, 2006, we had 64 employees. We will need to continue to expand our managerial, operational, financial and other resources to manage and fund our operations and clinical trials, continue our research and development activities and commercialize our products. It is possible that our management and scientific personnel, systems and facilities currently in place may not be adequate to support this future growth. Our need to effectively manage our operations, growth and programs requires that we continue to improve our operational, financial and management controls, reporting systems and procedures and to attract and retain sufficient numbers of talented employees. We may be unable to successfully implement these tasks on a larger scale and, accordingly, may not achieve our research, development and commercialization goals.

We are dependent upon a number of key suppliers, including single source suppliers, the loss of which would materially harm our business.

We use or rely upon sole source suppliers for certain components and services used in manufacturing our products, and we utilize materials and components supplied by third parties with which we do not have any long-term contracts. In recent years, many suppliers have ceased supplying raw materials for use in implantable medical devices. We cannot assure you that materials required by us will not be restricted or that we will be able to obtain sufficient quantities of such materials or services in the future. Moreover, the continued use by us of materials manufactured by third parties could subject us to liability exposure. Because we do not have long-term contracts, none of our suppliers is required to provide us with any guaranteed minimum production levels.

We cannot quickly replace suppliers or establish additional new suppliers for some of these components, particularly due to both the complex nature of the manufacturing process used by our suppliers and the time and effort that may be required to obtain FDA clearance or approval or other regulatory approval to use materials from alternative suppliers. Any significant supply interruption or capacity constraints affecting our facilities or those of our suppliers would have a material adverse effect on our ability to manufacture our products and, therefore, a material adverse effect on our business, financial condition and results of operations.

We may in the future be a party to patent litigation and administrative proceedings that could be costly and could interfere with our ability to sell our products.

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the industry have used intellectual property litigation to gain a competitive advantage. We may become a party to patent infringement claims and litigation or interference proceedings declared by the U.S. Patent and Trademark Office to determine the priority of inventions. The defense and prosecution of these matters are both costly and time consuming. Additionally, we may need to commence proceedings against others to enforce our patents, to protect our trade secrets or know-how or to determine the enforceability, scope and validity of the proprietary rights of others. These proceedings would result in substantial expense to us and significant diversion of effort by our technical and management personnel.

We are aware of patents issued to third parties that contain subject matter related to our technology. We cannot assure you that these or other third parties will not assert that our products and systems infringe the claims in their patents or seek to expand their patent claims to cover aspects of our products and systems. An adverse determination in litigation or interference proceedings to which we may become a party could subject us to significant liabilities or require us to seek licenses. In addition, if we are found to willfully infringe third-party patents, we could be required to pay treble damages in addition to other penalties. Although patent and intellectual property disputes in the medical device area have often been settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include ongoing royalties. We may be unable to obtain necessary licenses on satisfactory terms, if at all. If we do not obtain necessary licenses, we may be required to redesign our products to avoid infringement, and it may not be possible to do so effectively. Adverse determinations in a judicial or

administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling the C-Port, C-Port xA or PAS-Port systems or any other product we may develop, which would have a significant adverse impact on our business.

On March 16, 2006, we received notice that the Board of Patent Appeals and Interferences of the U.S. Patent and Trademark Office, or the Patent Appeals Board, declared an interference between our U.S. Patent No 6,391,038 (which relates to our C-Port system) and a pending U.S. Patent Application 10/243,543, which patent application has been assigned to Integrated Vascular Interventional Technologies, LLC, or IVIT. An interference is a proceeding within the U.S. Patent and Trademark Office to determine priority of invention of the subject matter of patent claims. The declaration of interference is made by the Patent Appeals Board only after claims in a patent application are deemed allowable but for the interfering subject matter (in this case our issued patent) and a determination that interfering subject matter exists. The declaration of interference initiates an adversarial proceeding in the U. S. Patent and Trademark Office before the Patent Appeals Board. The proceeding will involve issues including but not limited to whether an interference proceeding is appropriate, whether the involved claims of the parties are patentable and which party was first to invent the interfering subject matter. We will vigorously defend our patents against such claim of interference, although there can be no assurance that we will succeed in doing so. There can be no assurance that IVIT’s patent claims, if allowed, will be in their present form, or that our products would not be found to infringe such claims or any other claims that are issued.

Intellectual property rights may not provide adequate protection, which may permit third parties to compete against us more effectively.

We rely upon patents, trade secret laws and confidentiality agreements to protect our technology and products. Our pending patent applications may not issue as patents or, if issued, may not issue in a form that will be advantageous to us. Any patents we have obtained or will obtain in the future might be invalidated or circumvented by third parties. If any challenges are successful, competitors might be able to market products and use manufacturing processes that are substantially similar to ours. We may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by consultants, vendors or former or current employees, despite the existence generally of confidentiality agreements and other contractual restrictions. Monitoring unauthorized use and disclosure of our intellectual property is difficult, and we do not know whether the steps we have taken to protect our intellectual property will be adequate. In addition, the laws of many foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. To the extent that our intellectual property protection is inadequate, we are exposed to a greater risk of direct competition. In addition, competitors could purchase any of our products and attempt to replicate some or all of the competitive advantages we derive from our development efforts or design around our protected technology. If our intellectual property is not adequately protected against competitors’ products and methods, our competitive position could be adversely affected, as could our business.

We also rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. We require our employees, consultants and advisors to execute appropriate confidentiality and assignment-of-inventions agreements with us. These agreements typically provide that all materials and confidential information developed or made known to the individual during the course of the individual’s relationship with us be kept confidential and not disclosed to third parties except in specific circumstances and that all inventions arising out of the individual’s relationship with us shall be our exclusive property. These agreements may be breached, and in some instances, we may not have an appropriate remedy available for breach of the agreements. Furthermore, our competitors may independently develop substantially equivalent proprietary information and techniques, reverse engineer our information and techniques, or otherwise gain access to our proprietary technology.

Our products face the risk of technological obsolescence, which, if realized, could have a material adverse effect on our business.

The medical device industry is characterized by rapid and significant technological change. There can be no assurance that third parties will not succeed in developing or marketing technologies and products that are more effective than ours or that would render our technology and products obsolete or

noncompetitive. Additionally, new, less invasive surgical procedures and medications could be developed that replace or reduce the importance of current procedures that use our products. Accordingly, our success will depend in part upon our ability to respond quickly to medical and technological changes through the development and introduction of new products. The relative speed with which we can develop products, complete clinical testing and regulatory clearance or approval processes, train physicians in the use of our products, gain reimbursement acceptance, and supply commercial quantities of the products to the market are expected to be important competitive factors. Product development involves a high degree of risk, and we cannot assure you that our new product development efforts will result in any commercially successful products. We have experienced delays in completing the development and commercialization of our planned products, and there can be no assurance that these delays will not continue or recur in the future. Any delays could result in a loss of market acceptance and market share.

We may not be successful in our efforts to expand our product portfolio, and our failure to do so could cause our business and prospects to suffer. *

We intend to use our knowledge and expertise in anastomotic technologies to discover, develop and commercialize new applications in endoscopic surgery, general vascular surgery or other markets. However, the process of researching and developing anastomotic devices is expensive, time-consuming and unpredictable. Our efforts to create products for these new markets are at a very early stage, and we may never be successful in developing viable products for these markets. Even if our development efforts are successful and we obtain the necessary regulatory and reimbursement approvals, we cannot assure you that these or our other products will gain any significant degree of market acceptance among physicians, patients or health care payors. Accordingly, we anticipate that, for the foreseeable future, we will be substantially dependent upon the successful development and commercialization of anastomotic systems and instruments for cardiac surgery, mainly the PAS-Port, C-Port and C-Port xA systems. Failure by us to successfully develop and commercialize these systems for any reason, including failure to overcome regulatory hurdles or inability to gain any significant degree of market acceptance, would have a material adverse effect on our business, financial condition and results of operations.

We may be subject, directly or indirectly, to federal and state healthcare fraud and abuse laws and regulations and, if we are unable to fully comply with such laws, could face substantial penalties.

Our operations may be directly or indirectly affected by various broad state and federal healthcare fraud and abuse laws, including the federal healthcare program Anti-Kickback Statute, which prohibit any person from knowingly and willfully offering, paying, soliciting or receiving remuneration, directly or indirectly, to induce or reward either the referral of an individual, or the furnishing or arranging for an item or service, for which payment may be made under federal healthcare programs, such as the Medicare and Medicaid programs. Foreign sales of our products are also subject to similar fraud and abuse laws, including application of the U.S. Foreign Corrupt Practices Act. If our operations, including any consulting arrangements we may enter into with physicians who use our products, are found to be in violation of these laws, we or our officers may be subject to civil or criminal penalties, including large monetary penalties, damages, fines, imprisonment and exclusion from Medicare and Medicaid program participation. If enforcement action were to occur, our business and financial condition would be harmed.

We could be exposed to significant product liability claims, which could be time consuming and costly to defend, divert management attention, and adversely impact our ability to obtain and maintain insurance coverage. The expense and potential unavailability of insurance coverage for our company or our customers could adversely affect our ability to sell our products, which would adversely affect our business. *

The testing, manufacture, marketing, and sale of our products involve an inherent risk that product liability claims will be asserted against us. Additionally, we are currently training physicians in the United States on the use of our C-Port and C-Port xA systems. During training, patients may be harmed, which could also lead to product liability claims. Product liability claims or other claims related to our products, or their off-label use, regardless of their merits or outcomes, could harm our reputation in the industry, reduce our product sales, lead to significant legal fees, and result in the diversion of

management’s attention from managing our business. As of February 5, 2007, we were not aware of any existing product liability claims.

Although we maintain product liability insurance in the amount of $5,000,000, we may not have sufficient insurance coverage to fully cover the costs of any claim or any ultimate damages we might be required to pay. We may not be able to obtain insurance in amounts or scope sufficient to provide us with adequate coverage against all potential liabilities. Any product liability claims brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing continuing coverage. Product liability claims in excess of our insurance coverage would be paid out of cash reserves, harming our financial condition and adversely affecting our financial condition and operating results.

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

We sell our systems internationally and are subject to various risks relating to these international activities, which could adversely affect our revenue.

To date, the majority of our revenue has been attributable to sales in international markets. By doing business in international markets, we are exposed to risks separate and distinct from those we face in our domestic operations. Our international business may be adversely affected by changing economic conditions in foreign countries. Because most of our sales are currently denominated in U.S. dollars, if the value of the U.S. dollar increases relative to foreign currencies, our products could become more costly to the international customer and, therefore, less competitive in international markets, which could affect our results of operations. Engaging in international business inherently involves a number of other difficulties and risks, including:

	•		export restrictions and controls relating to technology;

	•		the availability and level of reimbursement within prevailing foreign healthcare payment systems;

	•		pricing pressure that we may experience internationally;

	•		required compliance with existing and changing foreign regulatory requirements and laws;

	•		laws and business practices favoring local companies;

	•		longer payment cycles;

	•		difficulties in enforcing agreements and collecting receivables through certain foreign legal systems;

	•		political and economic instability;

	•		potentially adverse tax consequences, tariffs and other trade barriers;

	•		international terrorism and anti-American sentiment;

	•		difficulties and costs of staffing and managing foreign operations; and

	•		difficulties in enforcing intellectual property rights.

Our exposure to each of these risks may increase our costs, impair our ability to market and sell our products and require significant management attention. We cannot assure you that one or more of these factors will not harm our business.

We are dependent upon key personnel, the loss of any of which could have a material adverse affect on our business.

Our business and future operating results depend significantly on the continued contributions of our key technical personnel and senior management, including those of our co-founder, CEO and President, Bernard Hausen, M.D., Ph.D. These services and individuals would be difficult or impossible to replace and none of these individuals is subject to a post-employment non-competition agreement. While we are subject to certain severance obligations to Dr. Hausen, either he or we may terminate his employment at any time and for any lawful reason or for no reason. Our business and future operating results also depend significantly on our ability to attract and retain qualified management, manufacturing, technical, marketing, sales and support personnel for our operations. Competition for such personnel is intense, and there can be no assurance that we will be successful in attracting or retaining such personnel. Additionally, although we have key-person life insurance in the amount of $3.0 million on the life of Dr. Hausen, we cannot assure you that this amount would fully compensate us for the loss of Dr. Hausen’s services. The loss of key employees, the failure of any key employee to perform or our inability to attract and retain skilled employees, as needed, could materially adversely affect our business, financial condition and results of operations.

Our operations are currently conducted at a single location that may be at risk from earthquakes, terror attacks or other disasters.

We currently conduct all of our manufacturing, development and management activities at a single location in Redwood City, California, near known earthquake fault zones. We have taken precautions to safeguard our facilities, including insurance, health and safety protocols, and off-site storage of computer data. However, any future natural disaster, such as an earthquake, or a terrorist attack, could cause substantial delays in our operations, damage or destroy our equipment or inventory and cause us to incur additional expenses. A disaster could seriously harm our business and results of operations. Our insurance does not cover earthquakes and floods and may not be adequate to cover our losses in any particular case.

If we use hazardous materials in a manner that causes injury, we may be liable for damages.

Our research and development and manufacturing activities involve the use of hazardous materials. Although we believe that our safety procedures for handling and disposing of these materials comply with federal, state and local laws and regulations, we cannot entirely eliminate the risk of accidental injury or contamination from the use, storage, handling or disposal of these materials. If one of our employees were accidentally injured from the use, storage, handling or disposal of these materials, the medical costs related to his or her treatment should be covered by our workers’ compensation insurance policy. However, we do not carry specific hazardous waste insurance coverage, and our property and casualty and general liability insurance policies specifically exclude coverage for damages and fines arising from hazardous waste exposure or contamination. Accordingly, in the event of contamination or injury, we could be held liable for damages or penalized with fines in an amount exceeding our resources, and our clinical trials or regulatory clearances or approvals could be suspended or terminated.

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

If our products receive FDA clearance or approval, our promotional materials and training methods regarding physicians will need to comply with FDA and other applicable laws and regulations. If the FDA determines that our promotional materials or training constitutes promotion of an unapproved use, it could request that we modify our training or promotional materials or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalties. It is also possible that other federal, state or foreign enforcement authorities might take action if they consider our promotional or training materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement. In that event, our reputation could be damaged and adoption of the products would be impaired.

Risks Related to Our Finances and Capital Requirements

We have a history of net losses, which we expect to continue for the foreseeable future, and we are unable to predict the extent of future losses or when we will become profitable, if at all.

We have incurred net losses since our inception in October 1997. As of December 31, 2006, our accumulated deficit was approximately $66.5 million. We expect to incur substantial additional losses until we can achieve significant commercial sales of our products, which depend upon a number of factors, including the successful commercial launch of our C-Port and C-Port xA systems in the United States and receipt of regulatory clearance or approval and market adoption of our additional products in the United States. We commenced commercial sales of the C-Port system in Europe in 2004 and in the United States in 2006, the C-Port xA system in Europe in July 2006 and in the United States in November 2006, and the PAS-Port system in Japan in 2004. Our short commercialization experience makes it difficult for us to predict future performance. Our failure to accurately predict financial performance may lead to volatility in our stock price.

Our cost of product revenue was 179% and 233% of our net product revenue for the six month periods ending December 31, 2006 and 2005, respectively. We expect to continue to have high costs of product revenue for the foreseeable future. In addition, we expect that our operating expenses will increase as we commence our commercialization efforts and devote resources to our sales and marketing, as well as conduct other research and development activities. If, over the long term, we are unable to reduce our cost of producing goods and expenses relative to our net revenue, we may not achieve profitability even if we are able to generate significant revenue from sales of the C-Port, C-Port xA and PAS-Port systems. Our failure to achieve and sustain profitability would negatively impact the market price of our common stock.

We currently lack a significant source of product revenue and we may not become or remain profitable.

Our ability to become and remain profitable depends upon our ability to generate product revenue. Our ability to generate significant continuing revenue depends upon a number of factors, including:

	•		achievement of U.S. regulatory clearance or approval for our additional products;

	•		successful completion of ongoing clinical trials for our products; and

	•		successful sales, manufacturing, marketing and distribution of our products.

We do not anticipate that we will generate significant product revenue for the foreseeable future. If we are unable to generate significant product revenue, we will not become or remain profitable, and we may be unable to continue our operations.

We will need substantial additional funding and may be unable to raise capital when needed, which would force us to delay, reduce or eliminate our research and development programs or commercialization efforts.

Our development efforts have consumed substantial capital to date. We believe that our existing cash, cash equivalents and short-term investments, along with cash that we expect to generate from operations, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures through at least 15 months from December 31, 2006. Because we do not anticipate that we will generate significant product revenue for the foreseeable future, if at all, we will need to raise substantial additional capital to finance our operations in the future. Our future liquidity and capital requirements will depend upon, and could increase significantly as a result of, numerous factors, including:

	•		market acceptance and adoption of our products;

	•		our revenue growth;

	•		costs associated with our sales and marketing initiatives and manufacturing activities;

	•		costs of obtaining and maintaining FDA and other regulatory clearances and approvals for our products;

	•		securing, maintaining and enforcing intellectual property rights;

	•		the costs of developing marketing and distribution capabilities;

	•		the extent of our ongoing research and development programs;

	•		the progress of clinical trials; and

	•		effects of competing technological and market developments.

Until we can generate significant continuing revenue, if ever, we expect to satisfy our future cash needs through public or private equity offerings, debt financings or corporate collaboration and licensing arrangements, as well as through interest income earned on cash balances. We cannot be certain that additional funding will be available on acceptable terms, or at all. Any corporate collaboration and licensing arrangements may require us to relinquish valuable rights. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate our commercialization efforts or one or more of our research and development programs.

If we do not generate sufficient cash flow through increased revenue or raising additional capital, then we may not be able to meet our substantial debt obligation that becomes due in 2008.

As of December 31, 2006, we had an aggregate principal amount of approximately $3.0 million in long-term note payable to Century that matures in June 2008. This substantial indebtedness has and will continue to impact us by:

	•		making it more difficult to obtain additional financing; and

	•		constraining our ability to react quickly in an unfavorable economic climate.

Currently we are not generating positive cash flow. Adverse occurrences related to our product commercialization, development and regulatory efforts would adversely impact our ability to meet our obligations to repay the principal amount on our note when due in June 2008. If we are unable to satisfy our debt service requirements, we may not be able to continue our operations. We may not generate sufficient cash from operations to repay our note or satisfy any additional debt obligations when they become due and may have to raise additional financing from the sale of equity or debt securities, enter into commercial transactions or otherwise restructure our debt obligations. There can be no assurance that any such financing or restructuring will be available to us on commercially acceptable terms, if at all. If we are unable to restructure our obligations, we may be forced to seek protection under applicable bankruptcy laws. Any restructuring or bankruptcy could materially impair the value of our common stock.

Existing creditor has rights to our assets that are senior to our stockholders.

An existing arrangement with our current lender, Century, as well as future arrangements with other creditors, allow or may allow this creditor to liquidate our assets, which may include our intellectual property rights, if we are in default or breach of our debt obligation for a continued period of time. The proceeds of any sale or liquidation of our assets under these circumstances would be applied first to any of our debt obligations and would have priority over any of our capital stock, including any liquidation preference of the preferred stock. After satisfaction of our debt obligations, we may have little or no proceeds left under these circumstances to distribute to the holders of our capital stock.

Our quarterly operating results and stock price may fluctuate significantly.


	December 31,			June 30,
	2006			2006
	(unaudited)			(Note 1)
Assets
Current assets
Cash and cash equivalents	$	7,653		$	4,102
Short-term investments		11,766			27,978
Accounts receivable		188			164
Inventories		562			432
Prepaid expenses and other current assets		394			571

Total current assets		20,563			33,247

Property and equipment, net		1,261			1,401
Restricted cash		510			510

Total assets	$	22,334		$	35,158


Liabilities and stockholders’ equity

Current liabilities
Accounts payable	$	415		$	629
Accrued compensation		281			236
Other accrued liabilities		349			565
Current portion of leasehold improvement obligation		122			122
Deferred rent		102			93

Total current liabilities		1,269			1,645

Deferred rent		66			120
Notes payable to related party		—			10,250
Interest payable to related party		—			2,333
Subordinated note		3,000			3,000
Leasehold improvement obligation		72			133

Commitments and contingencies

Stockholders’ equity
Preferred stock		—			—
Common stock		11			10
Additional paid-in capital		85,857			79,843
Treasury stock at cost		(596	)		(596	)
Deferred stock compensation		(799	)		(1,029	)
Receivable from stock option exercises		—			(79	)
Accumulated other comprehensive loss		(9	)		(47	)
Accumulated deficit		(66,537	)		(60,425	)

Total stockholders’ equity		17,927			17,677

Total liabilities and stockholders’ equity	$	22,334		$	35,158


	Three months ended						Six months ended
	December 31,						December 31,
	2006			2005			2006			2005
Net revenue
Product revenue, net	$	416		$	199		$	874		$	360
Development revenue		500			—			500			—
Product and royalty revenue from related party		12			—			25			7

Total net revenue		928			199			1,399			367

Operating costs and expenses
Cost of product revenue		884			210			1,563			837
Research and development		1,661			1,576			3,149			2,742
Selling, general and administrative		2,203			923			4,273			2,146

Total operating costs and expenses		4,748			2,709			8,985			5,725


Loss from operations		(3,820	)		(2,510	)		(7,586	)		(5,358	)

Interest income		298			63			687			135
Interest expense (includes related party interest expense of $94 and $226 for the three months ended December 31, 2006 and 2005, respectively, and $320 and $452 for the six months ended December 31, 2006 and 2005, respectively)		(132	)		(264	)		(396	)		(528	)
Other expense		—			(1	)		—			(5	)
Gain on early retirement of notes payable to related party		1,183			—			1,183			—

Net loss	$	(2,471	)	$	(2,712	)	$	(6,112	)	$	(5,756	)


Basic and diluted net loss per share	$	(0.23	)	$	(1.70	)	$	(0.60	)	$	(3.81	)

Shares used in computing basic and diluted net loss per share		10,642			1,595			10,210			1,511


	Six months ended
	December 31,
	2006			2005
Operating activities
Net loss	$	(6,112	)	$	(5,756	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		370			385
Loss on disposal of property and equipment		—			3
Gain on early retirement of notes payable to related party		(1,433	)		—
Stock-based compensation expenses		444			931
Changes in assets and liabilities:
Accounts receivable		(24	)		(82	)
Accounts receivable from related party		—			5
Prepaid expenses and other current assets		177			(1,033	)
Inventories		(130	)		200
Interest receivable from shareholders		—			(3	)
Accounts payable and other accrued liabilities		(458	)		981
Accrued compensation		45			43
Deferred rent		(45	)		(24	)
Leasehold improvement obligation		(61	)		(60	)
Interest payable to related party		(2,333	)		452

Net cash used in operating activities		(9,560	)		(3,958	)

Investing activities
Purchases of property and equipment		(230	)		(249	)
Proceeds from sale of equipment		—			3
Purchases of short-term investments		(4,994	)		(2,600	)
Proceeds from sales and maturities of short-term investments		21,244			4,850

Net cash provided by investing activities		16,020			2,004

Financing activities
Payment of notes payable to related		(3,087	)		—
Proceeds from issuance of common stock pursuant to the exercise of stock options for cash		99			14
Proceeds from payment of receivable from stock option exercises		79			—
Repurchase of common stock		—			(6	)

Net cash provided by (used in) financing activities		(2,909	)		8


Net increase (decrease) in cash and cash equivalents		3,551			(1,946	)
Cash and cash equivalents at beginning of period		4,102			1,951

Cash and cash equivalents at end of period	$	7,653		$	5


Supplemental disclosure of cash flow information
Cash paid for interest (related party of $2,652 for the six months ended December 31, 2006 and none in 2005)	$	2,727		$	75

Issuance of common stock to related party for early retirement of notes payable	$	5,730		$	—


				Outstanding Options
							Weighted-
	Shares						Average
	Available for			Number of			Exercise Price
	Grant			shares			Per Share
Balance at June 30, 2006		242,847			1,017,739		$	4.32
Shares reserved		250,000			—			—
Options granted		(73,033	)		73,033			5.58
Options exercised		—			(49,117	)		2.01
Options forfeited		90,952			(90,952	)		8.44

Balance at December 31, 2006 (unaudited)		510,766			950,703		$	4.15


			Weighted-
			Average
			Remaining		Number
	Number		Contractual		Vested and
Exercise Price	Outstanding		Life		Exercisable
$0.30 - $2.25		222,473		5.25		211,119
$2.85		422,911		8.05		217,709
$4.38 - $8.00		252,258		9.09		24,339
$9.00		13,333		8.78		3,888
$9.75		39,728		8.96		10,206

Total outstanding		950,703		7.72		467,261

Options vested and expected to vest		835,351		7.51


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


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


Delaware (State or other jurisdiction of incorporation or organization)		94-3287832 (I.R.S. Employer Identification No.)


Item		Page
PART I.
FINANCIAL INFORMATION

1.	Condensed Financial Statements (unaudited)

	a. Condensed Balance Sheets at December 31, 2006 and June 30, 2006		3
	b. Condensed Statements of Operations for the three and six months ended December 31, 2006 and 2005		4
	c. Condensed Statements of Cash Flows for the six months ended December 31, 2006 and 2005		5
	d. Notes to Condensed Financial Statements		6

2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		13

3.	Quantitative and Qualitative Disclosures About Market Risk		20

4.	Controls and Procedures		20

PART II.
OTHER INFORMATION

1.	Legal Proceedings		21

1A.	Risk Factors		21

2.	Unregistered Sales of Equity Securities and Use of Proceeds		38

3.	Defaults Upon Senior Securities		38

4.	Submission of Matters to a Vote of Security Holders		38

5.	Other Information		39

6.	Exhibits		40

	SIGNATURES		41
EXHIBIT 10.17
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1


Fiscal year ending June 30,

2007 (remaining)	$	171
2008		325
2009		281
2010		22

	$	799


	December 31, 2006
			Gross		Gross
	Amortized		Unrealized		Unrealized
	Cost		Gains		Losses			Fair Value
Available-for-sale securities:
Corporate bonds	$	4,999	$	—	$	(4	)	$	4,995
Commercial paper		1,973		—		—			1,973
Federal agency bonds		4,803		—		(5	)		4,798

Total	$	11,775	$	—	$	(9	)	$	11,766


	June 30, 2006
			Gross		Gross
	Amortized		Unrealized		Unrealized
	Cost		Gains		Losses			Fair Value
Available-for-sale securities:
Corporate bonds	$	3,838	$	—	$	(11	)	$	3,827
Auction rate preferred		9,000		—		—			9,000
Commercial paper		8,413		—		(9	)		8,404
Federal agency bonds		6,774		—		(27	)		6,747

Total	$	28,025	$	—	$	(47	)	$	27,978

	•		the rate of physician adoption of our products;

	•		the results of clinical trials related to our products;

	•		the introduction by us or our competitors, and market acceptance of, new products;

	•		the results of regulatory and reimbursement actions;

	•		the timing of orders by distributors or customers;

	•		the expenditures incurred in the research and development of new products; and

	•		competitive pricing.


	Votes
Nominee	For		Withheld
Bernard Hausen		7,730,126		34,753
J. Michael Egan		7,730,126		34,753
Kevin Larkin		7,750,777		14,102
Richard Powers		7,750,777		14,102
Jeffrey Purvin.		7,750,777		14,102
Robert Robbins		7,750,777		14,102
John Simon		7,750,777		14,102
Stephen Yencho		7,720,133		44,746
William Younger		7,750,777		14,102


Votes For	Votes against		Abstain
5,255,493		242,248		126,902


Exhibit
No.		Description.
3.1		Amended and Restated Certificate of Incorporation of Cardica, Inc. (filed as Exhibit 3.2 to Registration Statement on Form S-1 (File No. 333-129497), as amended, and incorporated herein by reference).

3.2		Amended and Restated Bylaws of Cardica, Inc. (filed as Exhibit 3.4 to Registration Statement on Form S-1 (File No. 333-129497), as amended, and incorporated herein by reference).

4.1		Warrant dated March 17, 2000 exercisable for 12,270 shares of common stock. †

4.2		Warrant dated July 5, 2001 exercisable for 10,417 shares of common stock. †

4.3		Warrant dated July 5, 2001 exercisable for 41,665 shares of common stock. †

4.4		Warrant dated June 13, 2002 exercisable for 32,146 shares of common stock. †

4.5		Warrant dated October 31, 2002 exercisable for 60,017 shares of common stock. †

10.2		Cardica, Inc. 2005 Equity Incentive Plan, as amended. (1)(2)

10.14		Note Conversion Agreement, dated November 7, 2006, by and between Cardica, Inc. and Guidant Investment Corporation. (2)

10.15		Registration Rights Agreement, dated November 7, 2006, by and between Cardica, Inc. and Guidant Investment Corporation. (2)

10.16		Consent to Grant of Registration Rights and Amendment to Amended and Restated Investor Rights Agreement, dated November 7, 2006, by and between Cardica, Inc. and the investors set forth there. (2)

10.17		Cardica, Inc. Non-Employee Director Compensation. (1)

31.1		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

31.2		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

32.1*		Certification required by Rule 13a-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).


†		Filed as the like-numbered exhibits to the Company’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on November 4, 2005, as amended.

*		The certification attached as Exhibit 32.1 accompanying this Quarterly Report on Form 10-Q is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Cardica, Inc., under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Quarterly Report on Form 10-Q and irrespective of any general incorporation language contained in any such filing.

(1)		Compensation plan or arrangement in which executive officer or director participates.

(2)		Filed as the like-numbered exhibits to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on November 8, 2006 and incorporated herein by reference.


		Cardica, Inc.

Date: February 5, 2007		/s/ Bernard A. Hausen
		Bernard A. Hausen, M.D., Ph.D
		President, Chief Executive Officer, Chief Medical
		Officer and Director
		(Principal Executive Officer)

Date: February 5, 2007		/s/ Robert Y. Newell
		Robert Y. Newell
		Vice President, Finance & Operations and Chief
		Financial Officer
		(Principal Financial and Accounting Officer)