3. Variable Interest Entity (VIE)

The Company follows authoritative guidance for the consolidation of its VIE, which requires an enterprise to determine whether its variable interest gives it a controlling financial interest in a VIE. Determination about whether an enterprise should consolidate a VIE is required to be evaluated continuously as changes to existing relationships or future transactions may result in consolidating or deconsolidating the VIE.

Cercacor Laboratories, Inc.

Cercacor Laboratories, Inc., or Cercacor, is an independent entity spun off from the Company to its stockholders in 1998. Joe Kiani and Jack Lasersohn, members of the Company’s board of directors, or the Board, are also members of the board of directors of Cercacor. Joe Kiani, the Company’s Chairman and Chief Executive Officer, is also the Chairman and Chief Executive Officer of Cercacor. The Company is a party to a Cross-Licensing Agreement with Cercacor, which was most recently amended and restated effective January 1, 2007, that governs each party’s rights to certain intellectual property held by the two companies.

Under the Cross-Licensing Agreement, the Company granted Cercacor an exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET owned by the Company, including all improvements on this technology, for the monitoring of non-vital signs measurements and to develop and sell devices incorporating Masimo SET for monitoring non-vital signs measurements in any product market in which a product is intended to be used by a patient or pharmacist rather than a professional medical caregiver. The Company refers to this market as the Cercacor Market. The Company also granted Cercacor a non-exclusive, perpetual and worldwide license, with sublicense rights to use all Masimo SET for the measurement of vital signs in the Cercacor Market.

The Company exclusively licenses from Cercacor the right to make and distribute products in the professional medical caregiver markets, which the Company refers to as the Masimo Market, that utilize rainbow^® technology for the measurement

of carbon monoxide, methemoglobin, fractional arterial oxygen saturation, and total hemoglobin, which includes hematocrit. To date, the Company has developed and commercially released devices that measure carbon monoxide, methemoglobin and total hemoglobin using licensed rainbow^® technology. The Company also has the option to obtain the exclusive license to make and distribute products that utilize rainbow^® technology for the monitoring of other non-vital signs measurements, including blood glucose, in product markets where the product is intended to be used by a professional medical caregiver.

From May 1998 through May 2009, Cercacor contracted the services of the Company’s employees for the development of rainbow^® technology. The Company paid Cercacor for the option to market and develop products based on Cercacor technology in defined markets. Through December 2005, the Company paid Cercacor $7.5 million in option fees. Nearly all these option fees were used by Cercacor to repay the Company for the services that the Company had provided to Cercacor. In addition, through September 2009, the Company exercised its options to three licenses, for $2.5 million each, for the right to market products based on the new carbon monoxide, methemoglobin and total hemoglobin parameter technologies developed by Cercacor. Effective as of January 1, 2007, the Company entered into a Services Agreement with Cercacor to govern the general and administrative services the Company provides to Cercacor.

The Company’s license to rainbow^® technology for these parameters in these markets is exclusive on the condition that the Company continues to pay Cercacor royalties on its products incorporating rainbow^® technology, subject to certain minimum aggregate royalty thresholds, and that the Company use commercially reasonable efforts to develop or market products incorporating the licensed rainbow^® technology. The royalty is up to 10% of the rainbow^® royalty base, which includes handhelds, tabletop and multi-parameter devices. Handheld products incorporating rainbow^® technology will carry a 10% royalty rate. For other products, only the proportional amount attributable to that portion of the Company’s products used to monitor non-vital signs measurements, sensors and accessories, rather than for monitoring vital signs measurements, will be included in the 10% rainbow^® royalty base. Effective January 2009, for multi-parameter devices, the rainbow^® royalty base will include the percentage of the revenue based on the number of rainbow^® enabled measurements. For hospital contracts where the Company places equipment and enters into a sensor contract, the Company pays a royalty to Cercacor on the total sensor contract revenues based on the ratio of rainbow^® enabled devices to total devices.

The Company is also subject to certain specific annual minimum aggregate royalty payments. The aggregate royalty payments were $1.3 million and $3.8 million for the three and nine months ended September 29, 2012, respectively, and $1.3 million and $3.8 million for the three and nine months ended October 1, 2011, respectively. In addition, in connection with a change in control, as defined in the Cross-Licensing Agreement, the minimum aggregate annual royalties for all licensed rainbow^® measurements payable to Cercacor will increase to $15.0 million per year for 2012 and thereafter and up to $2.0 million per year for other rainbow^® measurements.

In February 2009, in order to accelerate the product development of an improved total hemoglobin spot-check measurement device, Pronto-7, the Company’s Board of Directors agreed to fund additional Cercacor engineering expenses. Specifically, these expenses included third party engineering materials and supplies expense as well as 50% of Cercacor’s total engineering and engineering related payroll expenses, from April 2009 through June 2010, the original anticipated completion date of this product development effort. Since July 2010, Cercacor has continued to assist the Company with product development efforts and charged the Company accordingly. Beginning in 2012, due to a revised estimate of the support required by the Company to complete the various Pronto-7 related projects, the Company’s Board of Directors approved an increase in the percentage of Cercacor’s total engineering and engineering related payroll expenses funded by the Company from 50% to 60%. During the nine months ended September 29, 2012, and until both parties agree to end these services, Cercacor assisted and will continue to assist the Company with continuing productization efforts of the new handheld noninvasive multi-parameter spot-check hemoglobin testing device. During the three and nine months ended September 29, 2012, the expenses for these additional services, material and supplies totaled $1.0 million and $2.6 million, respectively. During the three and nine months ended October 1, 2011, the expenses for these additional services, material and supplies totaled $0.5 million and $1.9 million, respectively.

The condensed consolidated balance sheets include a noncontrolling interest in Cercacor of $2.7 million and $2.8 million as of September 29, 2012 and December 31, 2011, respectively, which represents the value of common stock, additional paid in capital and retained earnings of Cercacor, which are not available to the Company. In addition, the condensed consolidated balance sheets include, net of intercompany eliminations, total assets of $8.6 million and $6.0 million as of September 29, 2012 and December 31, 2011, respectively, related to Cercacor. Cercacor’s total assets as of September 29, 2012 included $4.1 million for intangible assets, $2.2 million for property and equipment and $1.4 million related to deferred tax assets. Its total assets as of December 31, 2011 included $2.5 million for intangible assets, $1.4 million related to deferred tax assets and $1.2 million for property and equipment. The condensed consolidated balance sheets include total liabilities, net of intercompany eliminations, of $2.2 million and $1.2 million as of September 29, 2012 and December 31, 2011, respectively, related to Cercacor.

Pursuant to authoritative accounting guidance, Cercacor is consolidated within the Company’s financial statements for all periods presented. The Company was required to consolidate Cercacor since the Company was deemed to be the primary beneficiary of Cercacor’s activities. This determination was based on the Company’s significant influence over the operations and decision making of Cercacor. Accordingly, all intercompany royalties, option and license fees and other charges between the Company and Cercacor as well as all intercompany payables and receivables have been eliminated in the consolidation. Also, all direct engineering expenses that have been incurred by the Company and charged to Cercacor have not been eliminated and are included as research and development expense in the Company’s condensed consolidated statements of comprehensive income. Upon consolidation, $2.0 million and $2.9 million of receivables due from the Company as of September 29, 2012 and December 31, 2011, respectively, were eliminated. Also upon consolidation, $5.0 million and $5.3 million of deferred revenue related to technology licensed to the Company as of September 29, 2012 and December 31, 2011, respectively, were eliminated. Assets of Cercacor can only be used to settle obligations of Cercacor and creditors of Cercacor have no recourse to the general credit of the Company.

For the foreseeable future, the Company anticipates that it will continue to consolidate Cercacor pursuant to the current authoritative accounting guidance; however, in the event that Cercacor is no longer considered a VIE or in the event that the Company is no longer the primary beneficiary of Cercacor, the Company may discontinue consolidating the entity.

The changes in noncontrolling interest for Cercacor are as follows (in thousands):


	Nine Months Ended September 29, 2012
Noncontrolling interest, beginning of period	$	2,838
Increase in additional paid-in capital of noncontrolling interest		60
Net loss attributable to noncontrolling interest		(168	)
Other comprehensive income attributable to noncontrolling interest		—

Noncontrolling interest, end of period	$	2,730