Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2008.

OR

For the transition period from                                          to

Commission File Number: 1-11388

PLC SYSTEMS INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code: (508) 541-8800

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x      No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)   Yes  o    No   x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Table of Contents

PLC SYSTEMS INC.

Index

Part I.         Financial Information

Item 1.        Financial Statements

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

LIABILITIES AND STOCKHOLDERS’ EQUITY

The accompanying notes are an integral part of the condensed consolidated financial statements.

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PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

The accompanying notes are an integral part of the condensed consolidated financial statements.

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PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

The accompanying notes are an integral part of the condensed consolidated financial statements.

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PLC SYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2008

1.             Business

                PLC Systems Inc. (“PLC” or the “Company”) is a medical device company specializing in innovative technologies for the cardiac and vascular markets.  The Company pioneered and manufactures the CO 2  Heart Laser System (the “Heart Laser System”) that cardiac surgeons use to perform carbon dioxide (CO 2 ) transmyocardial revascularization, or TMR, to alleviate symptoms of severe angina.  The Company also manufactures CO 2  surgical laser tubes and provides contract assembly services on general purpose CO 2  lasers, which it sells to a single customer on an original equipment manufacturer (“OEM”) basis.

                In addition, the Company has begun initial commercialization in the European Union (“EU”) of its newest product, RenalGuard ^TM . RenalGuard is designed to reduce the potentially toxic effects that contrast media can have on the kidneys when it is administered to patients during certain medical imaging procedures. It is believed that allowing contrast media to dwell in the kidneys can lead to contrast-induced nephropathy (“CIN”), a potentially deadly form of acute kidney injury. By inducing and maintaining a high urine flow rate before, during and after these medical imaging procedures, the Company believes the incidence rates of CIN in at-risk patients can be reduced. RenalGuard facilitates this increased urine clearance, enabling the body to more rapidly void the contrast media, thereby reducing its overall resident time and toxic effects in the kidney.

                The Company received full Food and Drug Administration (“FDA”) approval to conduct its first human clinical trial utilizing RenalGuard under an investigational device exemption (“IDE”). This pilot clinical trial was designed to evaluate the safety of RenalGuard and its ability to accurately measure and balance fluid inputs and outputs on patients undergoing a catheterization imaging procedure where contrast media would be administered.  In February 2008, the Company submitted an IDE supplement to the FDA seeking approval to move from its pilot study to a pivotal clinical trial to study the safety and effectiveness of RenalGuard in the prevention of CIN. In March 2008, the FDA granted the Company conditional approval to begin this pivotal study. The Company is also supporting a randomized controlled trial utilizing RenalGuard that is being conducted in Milan, Italy; it is designed to determine the effectiveness of RenalGuard in preventing CIN in at-risk patients. The Company announced in July 2008 that it will delay the start of the U.S. pivotal trial until such time as it can obtain data from the clinical trial in Italy that it hopes will enable it to raise sufficient additional capital necessary to complete the U.S. study.

                RenalGuard is currently approved for sale in the EU as a general fluid balancing device. The RenalGuard System consists of a proprietary, closed loop, software-controlled console and accompanying single-use sets that can be used by physicians and nurses to manage patient fluid levels. RenalGuard operates by first collecting and measuring patient urine outputs and then in real-time precisely matches these urine outputs with a prescribed replacement fluid by means of intravenous infusion. The RenalGuard System, with its matched fluid replacement capability, is intended to minimize the risk of over- or under-hydration during medical procedures where creating and maintaining high urine outputs is deemed beneficial to patients.

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                There are currently several medical procedures, such as cisplatin chemotherapy, where inducing high urine flow rates is deemed beneficial for patients and is a standard of care. In addition, high urine flow rates are frequently seen in post kidney transplant patients where the careful monitoring and replacement of fluid losses is necessary to avoid the risk of damage to the transplanted kidney. Accurate and timely matching of replacement fluids is important in these instances in order to best preserve and/or optimize kidney function. RenalGuard provides an automated method of measuring urine outputs and then matching these outputs with replacement fluid inputs, eliminating to a large degree what is otherwise an intensive and time consuming manual balancing task for physicians and nurses in these situations. The Company is establishing a distribution network in the EU with the intent to market RenalGuard into these already existing markets for general balancing applications utilizing the device.

                On March 20, 2007, the Company entered into a distribution agreement with Novadaq Corp. (“Novadaq”), a subsidiary of Novadaq Technologies Inc., pursuant to which the Company appointed Novadaq as its exclusive distributor in the United States for its TMR business.  The agreement amended and restated the exclusive distribution agreement between the Company and Edwards Lifesciences LLC (“Edwards”), which had been assigned by Edwards to Novadaq on the same date.  The agreement with Novadaq reflects substantially the same roles, responsibilities and financial terms as the previous agreement with Edwards.

2.             Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.  Operating results for the three and six months ended June 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.  These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

                The preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

3.             New Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”).  SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.  On February 6, 2008, the FASB announced it will issue a FASB Staff Position to allow a one-year deferral of adoption of SFAS No. 157 for non-financial assets and non-financial liabilities that are recognized at fair value on a nonrecurring basis. SFAS No. 157 provides a common fair value hierarchy for companies to follow in determining fair

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value measurements in the preparation of financial statements and expands disclosure requirements relating to how such fair value measurements are developed. SFAS No. 157 clarifies the principle that fair value should be based on the assumptions that the marketplace would use when pricing an asset or liability, rather than company specific data.  The Company is currently assessing the impact that SFAS No. 157 will have on its results of operations and financial position.

                In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities ” (“SFAS No. 159”). SFAS No. 159, which includes an amendment to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, permits entities the option to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007.  On January 1, 2008, the Company adopted SFAS 159, which did not have a material effect on its results of operations or financial condition.

4.             Inventories

                Inventories are stated at the lower of cost (computed on a first-in, first-out method) or market value and include allocations of labor and overhead.  As of June 30, 2008 and December 31, 2007, inventories consisted of the following (in thousands):

                At June 30, 2008 and December 31, 2007, inventories are stated net of a specific obsolescence allowance of $617,000 and $524,000, respectively.

5.             Stock-Based Compensation

                Stock Option Plans

                In May 2005, the Company’s shareholders approved the 2005 Stock Incentive Plan (the “2005 Plan”).  The 2005 Plan has replaced the 1997 Executive Stock Option Plan, 2000 Equity Incentive Plan, 2000 Non-Statutory Stock Option Plan and 2000 Non-Qualified Performance and Retention Equity Plan (collectively, the “Previous Plans”), under which no further awards can be granted.

                On June 18, 2008, the Board of Directors approved an amendment increasing the number of shares of common stock authorized for issuance under the 2005 Plan by an additional 2,000,000 shares.  The number of stock options that may be granted under the 2005 Plan is equal to 4,156,175 shares of common stock (subject to adjustment in the event of stock splits and other similar events), plus such number of shares as may become available under the Previous Plans after the date of the adoption of the 2005 Plan because any award previously granted under any such plan expires or is terminated, surrendered or cancelled without having been fully exercised

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or is forfeited in whole or in part or otherwise results in any common stock not being issued, provided that such number of additional shares may not exceed 2,535,492.  Incentive stock options are issuable only to employees of the Company, while non-qualified stock options may be issued to non-employee directors, consultants and others, as well as to employees. The options granted under the Previous Plans and the 2005 Plan become exercisable either immediately, or ratably over one to four years from the date of grant, and expire ten years from the date of grant.  Under the 2005 Plan, the per share exercise price of incentive stock options may not be less than the fair market value of the common stock on the date the option is granted.  The 2005 Plan provides that the Company may not grant non-qualified stock options at an exercise price less than 85% of the fair market value of the Company’s common stock.

                The Company grants stock options to its non-employee directors. Generally, new non-employee directors receive an initial grant of an option to purchase 30,000 shares of the Company’s common stock that vests in installments over three years.  Once the initial grant has fully vested, non-employee directors (other than the Chairman of the Board) receive an annual grant of an option to purchase 15,000 shares of the Company’s common stock that generally vests in four equal quarterly installments. The Chairman of the Board receives an annual grant of an option to purchase 30,000 shares of the Company’s common stock that generally vests in four equal quarterly installments. All such options have an exercise price equal to the fair market value of the Company’s common stock on the date of grant.

                Options granted during 2008 and 2007 vest ratably annually over a three year period for employees and ratably quarterly over a one year period for non-employee directors.

                The following is a summary of option activity under all plans (in thousands, except per option data):

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                The following table summarizes unvested option activity during the six months ended June 30, 2008:

                SFAS No. 123(R)

                The Company records share-based compensation pursuant to SFAS No. 123 (revised 2004), “Share-based Payment”.  The Company recorded compensation expense of $48,000 and $97,000 in the three and six months ended June 30, 2008, respectively, as compared to $37,000 and $70,000 in the three and six months ended June 30, 2007, respectively.  As of June 30, 2008, the Company had $343,000 of total unrecognized compensation cost related to its unvested options, which is expected to be recognized over a weighted average period of 1.9 years.

                The weighted average fair value of options issued during the three and six months ended June 30, 2008 was estimated using the Black-Scholes model.

                The expected life was calculated in 2008 and 2007 using the simplified method. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant for the expected term period.  Expected volatility is based exclusively on historical volatility data of the Company’s common stock.  The Company estimates an expected forfeiture rate based on its historical forfeiture activity.  Actual results, and future changes in estimates, may differ substantially from the Company’s current estimates.  The weighted average fair value of options granted during the three months ended June 30, 2008 was $0.25.

Stock Purchase Plan

The Company has a 2000 Employee Stock Purchase Plan (the “Purchase Plan”) for all eligible employees whereby shares of the Company’s common stock may be purchased at six-month intervals at 95% of the closing price of the Company’s common stock on the last business day of the relevant plan period.  Employees may purchase shares having a value not exceeding

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10% of their gross compensation during an offering period, subject to certain additional limitations.  Under the Purchase Plan, employees of the Company purchased 2,455 shares of common stock in the six months ended June 30, 2008 at an average price of $0.37 per share and 5,179 shares of common stock in the year ended December 31, 2007 at an average price of $0.47. At June 30, 2008, 313,618 shares were reserved for future issuance under the Purchase Plan.

6.             Revenue Recognition

The Company records revenue from the sale of TMR kits at the time of shipment to Novadaq.  TMR kit revenues include the amount invoiced to Novadaq for kits shipped pursuant to purchase orders received, as well as an amortized portion of deferred revenue related to a payment of $4,533,333 received in February 2004.  This payment was made in exchange for a reduction in the prospective purchase price the Company receives upon a sale of the kits.  The Company is amortizing this payment into its Consolidated Statements of Operations as revenue over a seven year period (culminating in 2010) under the units-of-revenue method as prescribed by Emerging Issues Task Force 88-18, “Sales of Future Revenue”.  The Company determined that a seven year timeframe was the most appropriate amortization period based on a valuation model it used to assess the economic fairness of the payment. Factors the Company considered in developing this valuation model included the estimated foregone revenues over a seven year period resulting from the reduction in the prospective purchase price payable to the Company, a discount rate deemed appropriate to this transaction and an estimate of the remaining economic useful life of the current TMR kit design, without any benefit being given to potential future product improvements the Company may make.  The Company reviews annually, and adjusts if necessary, the prospective revenue amortization rate for kits based on its best estimate of the total number of kits likely remaining to be shipped to hospital customers by Novadaq through 2010. The Company recorded amortization of $167,000 and $347,000 in the three and six months ended June 30, 2008, respectively, as compared to $181,000 and $371,000 in the three and six months ended June 30, 2007, respectively, which is included in revenues in the Consolidated Statements of Operations.

TMR lasers are billed to Novadaq in accordance with purchase orders that the Company receives.  Invoiced TMR lasers are recorded as other current assets and deferred revenue on the Company’s Consolidated Balance Sheet until such time as the laser is shipped to a hospital, at which time the Company records revenue and cost of revenue.

Under the terms of the Novadaq TMR distribution agreement, once Novadaq has recovered a prescribed amount of revenue from a hospital for the use or purchase of a TMR laser, any additional revenues earned by Novadaq are shared with the Company pursuant to a formula established in the distribution agreement. The Company only records its share of such additional revenue, if any, at the time the revenue is earned.

The Company records all other product revenue, including sales of TMR lasers and kits to international customers, sales of RenalGuard consoles and single-use sets and OEM sales of surgical tubes and general purpose CO ₂ lasers, at the time of shipment.

                Revenues from service and maintenance contracts are recognized ratably over the life of the contract.

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                Installation revenues related to a TMR laser transaction are recorded as a component of service fees when the laser is installed.

7.             Loss per Share

In the three and six months ended June 30, 2008 and 2007, basic and diluted loss per share have been computed using only the weighted average number of common shares outstanding during the period without giving effect to any potential future issuances of common stock related to stock option programs, since their inclusion would be antidilutive.

For the three months ended June 30, 2008 and 2007, 5,759,000 and 5,322,000 shares, respectively, and for the six months ended June 30, 2008 and 2007, 5,759,000 and 5,322,000 shares, respectively, attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the effect would have been antidilutive.  The following table sets forth the computation of basic and diluted loss per share:

8.             Comprehensive Loss

                Total comprehensive loss for the three and six months ended June 30, 2008 amounted to $673,000 and $1,431,000, respectively, as compared to $360,000 and $1,044,000 in the three and six months ended June 30, 2007, respectively.  Comprehensive loss is comprised of net loss plus the increase/decrease in currency translation adjustment.

9.             Warranty and Preventative Maintenance Costs

The Company warranties its products against manufacturing defects under normal use and service during the warranty period.  The Company obtains similar warranties from a majority of its suppliers, including those who supply critical Heart Laser System components.  In addition,

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under the terms of its TMR distribution agreement with Novadaq, the Company is able to bill Novadaq for actual warranty costs, including preventative maintenance services, up to a specified amount during the warranty period.

The Company evaluates the estimated future unrecoverable costs of warranty and preventative maintenance services for its installed base of lasers on a quarterly basis and adjusts its warranty reserve accordingly.  The Company considers all available evidence, including historical experience and information obtained from supplier audits.

Changes in the warranty accrual were as follows (in thousands):

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

This quarterly report (including certain information incorporated herein by reference) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Statements containing terms such as “believes”, “plans”, “expects”, “anticipates”, “intends”, “estimates” and similar expressions reflect uncertainty and are forward-looking statements. Forward-looking statements are based upon current plans and expectations and involve known and unknown important risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. Such important factors and uncertainties include, but are not limited to, those set forth below in Part II, Item 1A. Risk Factors, and elsewhere in this quarterly report.

Overview

We are a medical device company specializing in innovative technologies for the cardiac and vascular markets.  We pioneered and manufacture the Heart Laser System that cardiac surgeons use to perform TMR to alleviate symptoms of severe angina. We also manufacture CO 2  surgical laser tubes and provide contract assembly services on general purpose CO 2   lasers.

In addition, in 2007 we initiated our pilot clinical safety trial for RenalGuard. RenalGuard is designed to reduce the potentially toxic effects that contrast media can have on the kidneys when it is administered to patients undergoing image-guided procedures, such as those performed when placing drug-eluting stents. It is believed that allowing contrast media to dwell in the kidneys can lead to CIN. By inducing and maintaining a high urine flow rate before, during and after these image-guided procedures, it is believed the incidence rates of CIN in at-risk patients can be reduced. RenalGuard facilitates this increased urine clearance enabling the body to more rapidly void the contrast media, thereby reducing its overall resident time and toxic effects in the kidney.

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We enrolled a total of 23 patients in our initial pilot safety study. Based upon the positive safety data collected in the study and discussions we had with the FDA, we elected to stop enrolling new patients in the pilot study in November 2007.  We submitted an IDE supplement to the FDA in February 2008 seeking approval to move from our pilot study to a pivotal clinical trial to study the safety and effectiveness of RenalGuard in the prevention of CIN. In March 2008, the FDA granted us conditional approval to begin our pivotal study. We have received approval to study RenalGuard on 246 patients at up to 30 U.S. clinical sites. In July 2008 we announced that we would delay the start of this pivotal trial until such time as we can obtain data from the clinical trial being conducted in Milan, Italy that we hope will enable us to raise sufficient additional capital necessary to complete the U.S. study.

Our U.S. distributor for the Heart Laser System (Novadaq currently and Edwards prior to March 20, 2007) is our largest customer, accounting for 83% of our total revenues in both the three and six months ended June 30, 2008 and 85% in the year ended December 31, 2007, respectively.  We expect a high level of sales concentration to continue in the near future with Novadaq as our largest customer because it holds the exclusive U.S. distribution rights for our TMR products.

Approximately 89% of our revenues in both the three and six months ended June 30, 2008 and 87% in the year ended December 31, 2007, respectively, came from the sale and service of TMR lasers and related disposable kits. We believe that the number of opportunities for new TMR laser sales to hospital customers, and specifically sales of our HL2 laser, is likely to continue to decline in future quarters as a result of (1) a diminishing number of available hospitals that have not already implemented a TMR program that are still likely to do so in the future and (2) continuing financial pressures that hospitals face, in particular for the funding of new capital equipment purchases, in light of ongoing cutbacks in both Medicare and private insurance reimbursement rates for all medical procedures. In addition, we have seen a recent downward trend in the price at which new TMR lasers are being sold in the market as competition for the remaining available customers increases. As such, we expect to continue to see a decline in revenue generated from the sale of HL2 lasers in future quarters and TMR revenues in future quarters will be more dependent on the sale of TMR kits and service revenues.

Aggregate TMR kit shipments to U.S. hospitals decreased approximately 19% and 18% in the three and six months ended June 30, 2008 as compared to the three and six months ended June 30, 2007.  We believe it is likely that our TMR revenues in the second half of 2008 will be lower than the corresponding 2007 periods due to an expected decline in new TMR laser shipments .

Our management reviews a number of key performance indicators to assist in determining how to allocate resources and run our day to day operations. These indicators include (1) actual prior quarterly sales trends, (2) projected TMR laser and kit sales for the next four quarters, as provided by Novadaq in a rolling 12 month sales forecast, (3) projected future sales of RenalGuard consoles and single-use sets, (4) research and development progress as measured against internal project plan objectives, (5) budget to actual financial expenditure results, (6) inventory levels (both our own and Novadaq’s) and (7) short term and long term projected cash flows of the business.

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Critical Accounting Policies and Estimates

                Our financial statements are based on the application of significant accounting policies, many of which require us to make significant estimates and assumptions (see Note 2 to the Consolidated Financial Statements).  We believe that the following are some of the more material judgment areas in the application of our accounting policies that currently affect our financial condition and results of operations.

                Inventories

                Inventories are stated at the lower of cost (computed on a first-in, first-out method) or market value and include allocations of labor and overhead.  A specific obsolescence allowance is provided for slow moving, excess and obsolete inventory based on our best estimate of the net realizable value of inventory on hand taking into consideration factors such as (1) actual trailing 12 month sales, (2) expected future product line demand, based in part on sales forecast input received from Novadaq, and (3) service part stocking levels which, in management’s best judgment, are advisable to maintain in order to meet warranty, service contract and time and material spare part demands.  Historically, we have found our reserves to be adequate.

                Accounts Receivable

                Accounts receivable is stated at the amount we expect to collect from the outstanding balance.  We continuously monitor collections from customers, and we maintain a provision for estimated credit losses based upon historical experience and any specific customer collection issues that we have identified.  Historically, we have not experienced significant losses related to our accounts receivable. Collateral is not generally required. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

                Research and Development

                Research and development costs are expensed as incurred.

                Warranty and Preventative Maintenance Costs

We warranty our products against manufacturing defects under normal use and service during the warranty period.  We obtain similar warranties from a majority of our suppliers, including those who supply critical Heart Laser System components.  In addition, under the terms of our TMR distribution agreement with Novadaq, we are able to bill Novadaq for actual warranty costs, including preventative maintenance services, up to a specified amount during the warranty period.

We evaluate the estimated future unrecoverable costs of warranty and preventative maintenance services for our installed base of lasers on a quarterly basis and adjust our warranty reserve accordingly.  We consider all available evidence, including historical experience and information obtained from supplier audits.

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Revenue Recognition

We record revenue from the sale of TMR kits at the time of shipment to Novadaq.  TMR kit revenues include the amount invoiced to Novadaq for kits shipped pursuant to purchase orders received, as well as an amortized portion of deferred revenue related to a payment of $4,533,333 received in February 2004.  This payment was made in exchange for a reduction in the prospective purchase price we receive upon a sale of the kits.  We are amortizing this payment into our Consolidated Statements of Operations as revenue over a seven year period (culminating in 2010) under the units-of-revenue method as prescribed by Emerging Issues Task Force 88-18, “Sales of Future Revenue”.  We determined that a seven year timeframe was the most appropriate amortization period based on a valuation model we used to assess the economic fairness of the payment. Factors we considered in developing this valuation model included the estimated foregone revenues over a seven year period resulting from the reduction in the prospective purchase price payable to us, a discount rate deemed appropriate to this transaction and an estimate of the remaining economic useful life of the current TMR kit design, without any benefit being given to potential future product improvements we may make. We review annually, and adjust if necessary, the prospective revenue amortization rate for kits based on our best estimate of the total number of kits likely remaining to be shipped to hospital customers by Novadaq through 2010. We recorded amortization of $167,000 and $347,000 in the three and six months ended June 30, 2008, respectively, as compared to $181,000 and $371,000 in the three and six months ended June 30, 2007, respectively, which is included in revenues in our Consolidated Statements of Operations.

TMR lasers are billed to Novadaq in accordance with purchase orders that we receive.  Invoiced TMR lasers are recorded as other current assets and deferred revenue on our Consolidated Balance Sheet until such time as the laser is shipped to a hospital, at which time we record revenue and cost of revenue.

Under the terms of the TMR distribution agreement, once Novadaq has recovered a prescribed amount of revenue from a hospital for the use or purchase of a TMR laser, any additional revenues earned by Novadaq are shared with us pursuant to a formula established in the distribution agreement. We only record our share of such additional revenue, if any, at the time the revenue is earned.

We record all other product revenue, including sales of TMR lasers and kits to international customers, sales of RenalGuard consoles and single-use sets and OEM sales of surgical tubes and general purpose CO ₂ lasers, at the time of shipment.

                Revenues from service and maintenance contracts are recognized ratably over the life of the contract.

                Installation revenues related to a TMR laser transaction are recorded as a component of service fees when the laser is installed.

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Results of Operations

Results for the three and six months ended June 30, 2008 and 2007 and the related percent of revenues were as follows:

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Product Sales

Disposable TMR kit revenues, the largest component of product sales in the three months ended June 30, 2008, decreased by $34,000, or 5%, as compared to the three months ended June 30, 2007.  This decrease is primarily related to a lower volume of kit shipments to Novadaq in the three months ended June 30, 2008 as compared to the three months ended June 30, 2007.

In the six months ended June 30, 2008, disposable TMR kit revenues increased by $125,000, or 11%, as compared to the six months ended June 30, 2007. This increase is primarily related to a higher volume of kit shipments to Novadaq in the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. We expect that kit shipments to Novadaq during the remaining half of 2008 will be somewhat lower than the number of kits shipped in the first half of 2008 as Novadaq attempts to reduce its on-hand stocking level of kits in inventory by yearend.

TMR laser revenues decreased $413,000, or 67%, and $701,000, or 68%, respectively, in the three and six months ended June 30, 2008, as compared to the three and six months ended June 30, 2007.  These decreases are a result of (1) a decrease in the number of new TMR lasers sold and (2) a lower average selling price on the new TMR lasers sold.  We expect to see a continuation of the recent trend whereby TMR revenues in future quarters will be more dependent on the sale of TMR kits and service revenues than on sales of TMR lasers.

Other product sales decreased $41,000, or 22%, in the three months ended June 30, 2008 as compared to the three months ended June 30, 2007.  This overall decrease is a result of a decrease in manufacturing contract assembly product revenues, which resulted from a delay in incoming work product from our sole supplier of general purpose lasers. We expect normal incoming supply patterns to resume during the third and fourth quarters of 2008 and consequently we anticipate our revenues from other product sales will increase over the second half of 2008 as compared to the first half of 2008.

Other product sales decreased $240,000, or 47%, in the six months ended June 30, 2008 as compared to the six months ended June 30, 2007.  This overall decrease is a result of (1) a decrease in manufacturing contract assembly product revenues and (2) decreased revenues from Edwards related to the discontinued Optiwave 980 product line.  These decreases were offset in part by new international RenalGuard revenues.

Service Fee Revenues

Service fees decreased $134,000, or 33%, and $131,000, or 17%, in the three and six months ended June 30, 2008, respectively, as compared to the three and six months ended June 30, 2007. Domestic service fees related to billable service calls and spare part sales decreased $100,000 and $89,000, respectively in the three and six months ended June 30, 2008 as compared to the 2007 periods. International service fees decreased $34,000 and $42,000, respectively, in the three and six months ended June 30, 2008 as compared to the 2007 periods.

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Gross Profit

                Gross profit was $737,000, or 56% of total revenues, in the three months ended June 30, 2008 as compared with gross profit of $1,157,000, or 60% of total revenues, in the three months ended June 30, 2007.  The decrease in gross profit is due to (1) a decrease in both the number and the average selling prices of new TMR lasers sold, (2) lower revenues from service, (3) lower revenues from contract assembly services, (4) higher cost of sales related to both higher period manufacturing expenses and an increase in our inventory reserve and (5) lower disposable TMR kit revenue.  These decreases were partially offset by a reduction in our warranty accrual.

Gross profit was $1,500,000, or 61% of total revenues, in the six months ended June 30, 2008 as compared with gross profit of $1,856,000, or 54% of total revenues, in the six months ended June 30, 2007.  The decrease in gross profit is due to (1) a decrease in both the number and the average selling prices of new TMR lasers sold, (2) lower revenues from contract assembly services and (3) lower revenues from service.  These decreases were offset in part by higher disposable TMR kit revenues and new international RenalGuard revenues.

                Selling, General and Administrative Expenses

Selling, general and administrative expenditures decreased 23% and 14% in the three and six months ended June 30, 2008 as compared to the three and six months ended June 30, 2007.  In the three months ended June 30, 2008, there were decreases in (1) compensation related costs, (2) overall spending on sales and marketing activities related to RenalGuard, (3) bad debt expense, and (4) international expenses as compared to the three months ended June 30, 2007.  In the six months ended June 30, 2008, there were decreases in (1) compensation related costs, (2) overall spending on sales and marketing activities related to RenalGuard, and (3) corporate and legal expenditures incurred in connection with the transfer of the U.S. TMR distribution agreement and the origination of RenalGuard clinical trial contracts as compared to the six months ended June 30, 2007.

                Research and Development Expenses

Research and development expenditures increased 8% and 16% in the three and six months ended June 30, 2008 as compared to the three and six months ended June 30, 2007.  In the three months ended June 30, 2008, the increase was primarily related to a write-off of certain capitalized development equipment. In the six months ended June 30, 2008, the increase was due to increased RenalGuard related clinical costs and the write-off of certain capitalized development equipment offset in part by a decrease in TMR related clinical costs as compared to the six months ended June 30, 2007.

In July 2008, we announced that we would defer the commencement of the U.S. pivotal trial of RenalGuard. We expect therefore that our research and development expenditures for the second half of 2008 will remain at a similar level as the first half of 2008.

                Other Income

The largest component of other income consists of interest income earned on our cash and cash equivalents. Interest income decreased $87,000 and $153,000 in the three and six months ended June 30, 2008, respectively, due to lower average investable balances and lower

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interest rates on those investable balances in the three and six months ended June 30, 2008 periods as compared to the three and six months ended June 30, 2007.

                Net Loss

In the three and six months ended June 30, 2008 and 2007, we recorded a net loss of $671,000 and $1,433,000, respectively.  In the three and six months ended June 30, 2008, the increased loss was due to lower sales generating lower gross margin dollars, and lower interest income, offset in part by lower operating expenses as compared to the three and six months ended June 30, 2007.

Kit Shipments

                We generally view disposable kit shipments to end users as an important metric in evaluating our business, although we believe that specific short-term factors not indicative of long-term trends can sometimes affect shipments of disposable kits in any given quarter.

Disposable kit shipments to end users were as follows:

                Because a significant number of the total TMR procedures performed each year by cardiac surgeons are done in combination with open-heart bypass surgery, we believe any future growth in the number of TMR procedures will be partly dependent on the number of bypass surgeries performed in the future, which we believe have the potential to grow modestly over the next few years.

Liquidity and Capital Resources

Cash and cash equivalents totaled $5,506,000 as of June 30, 2008, a decrease of $2,554,000 from $8,060,000 as of December 31, 2007.  We have no debt obligations. We believe that our existing cash resources will meet our working capital requirements through at least the next 12 months.

Cash used for operating activities in the six months ended June 30, 2008 was $2,535,000 due to our net loss and unfavorable working capital changes, offset in part by non-cash depreciation and amortization, compensation related to stock options and a loss on retirement of equipment.  We received $1,000 from the issuance of common stock related to proceeds from our employee stock purchase plan. We used $27,000 for the purchase of equipment.  The effect of exchange rate changes provided an additional $7,000.

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In the near term we will be largely dependent on the future success of Novadaq’s sales and marketing efforts in the U.S. to continue to increase the installed base of HL2 lasers and to substantially increase TMR procedural volumes and revenues. Should the installed base of HL2 lasers or TMR procedural volume not increase sufficiently, our liquidity and capital resources will be negatively impacted.  Additionally, other unanticipated decreases in operating revenues or increases in expenses or changes or delays in third-party reimbursement to healthcare providers using our products would adversely impact our cash position and require further cost reductions or the need to obtain additional capital.  It is not certain that we, working with Novadaq and our international distributors, will be successful in achieving broad commercial acceptance of the Heart Laser Systems, or that we will be able to operate profitably in the future.

Some hospital customers prefer to acquire the Heart Laser Systems on a usage basis rather than as a capital equipment purchase.  We believe this is the result of current limitations at many hospitals regarding acquiring expensive capital equipment as well as competitive pressures in the marketplace.  A usage business model will result in a longer recovery period for Novadaq to recoup its investment in lasers it may purchase from us in the future.  This results in (1) a delay in our ability to receive additional shared revenue, if any, that we otherwise are entitled to receive under the terms of our new distribution agreement with Novadaq and (2) a potential delay in the purchase of new lasers by Novadaq if the installed base of lasers placed under usage contracts is under-performing and Novadaq chooses to re-deploy these lasers to other hospital sites in lieu of purchasing a new laser from us.

We believe we will incur losses at least through 2010.  We cannot be certain that we will be able to raise the additional capital necessary to complete the pivotal clinical trial in the U.S. that is necessary to obtain regulatory approval to market RenalGuard in the U.S., or that future sales, if any, of RenalGuard will justify the investments we plan to make.  There can be no assurance that the future capital we will need to implement our business plan will be available on terms and conditions acceptable to us, especially considering the current uncertainty in the global credit markets.  As a result of the current market conditions, we have deferred the commencement of the U.S. pivotal trial, and should additional financing not be available on terms and conditions acceptable to us, we will need to further curtail our RenalGuard program and take additional actions that will adversely impact our ability to continue to realize assets and satisfy liabilities in the normal course of business.  The consolidated financial statements set forth in this report do not include any adjustments to reflect the possible future effects of these uncertainties.

Off-Balance Sheet Arrangements

                None.

Item 3.        Quantitative and Qualitative Disclosures about Market Risk

                A portion of our operations consists of sales activities in foreign jurisdictions.  We manufacture our products exclusively in the U.S. and sell our products in the U.S. and abroad. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we distribute our products.  Our operating results are exposed to changes in exchange rates between the U.S. dollar and foreign currencies, especially the Euro. When the U.S. dollar strengthens against the Euro, the value of foreign sales decreases. When the U.S. dollar weakens, the functional currency amount of sales increases. No assurance can be given that foreign currency fluctuations in the future will not

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adversely affect our business, financial condition and results of operations, although at present we do not believe that our exposure is significant, as international sales represented 9% and 3% of our consolidated sales in the six months ended June 30, 2008 and the year ended December 31, 2007, respectively. We do not hedge any balance sheet exposures and intercompany balances against future movements in foreign exchange rates.

Our interest income and expense are sensitive to changes in the general level of U.S. and foreign interest rates. In this regard, changes in U.S. and foreign interest rates affect the interest earned on our cash and cash equivalents.  We do not believe that a 10% change to the applicable interest rates would have a material impact on our future results of operations or cash flows.

Item 4.        Controls and Procedures

Evaluation of Disclosure Controls and Procedures

                Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2008.  The term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.  Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.  Based on the evaluation of our disclosure controls and procedures as of June 30, 2008, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

                No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended June 30, 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II.  Other Information

Item 1A.       Risk Factors

                The risks and uncertainties described below are not the only risks we face.  Additional risks and uncertainties not presently known to us or currently deemed immaterial may also impair our business operations.  If any of the following risks actually occur, our financial condition and operating results could be materially adversely affected.

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We expect our common stock to be delisted from AMEX.

                Our stockholders’ equity was $3,617,000 as of June 30, 2008.  Under the AMEX listing requirements, because we have sustained losses from continuing operations and/or net losses in three of our four most recent fiscal years and our stockholders’ equity has fallen below $4,000,000 as of June 30, 2008 we expect that AMEX will notify us by a deficiency letter within ten business days after we file this quarterly report that we are not in compliance with the continued listing standards.  We do not anticipate being able to provide a plan to AMEX that will enable us to avoid our common stock from being delisted. When our common stock becomes delisted from AMEX and begins to trade on an over-the-counter basis, we could face a number of negative implications, including reduced liquidity in our common stock as a result of the loss of market efficiencies associated with AMEX and the loss of federal preemption of state securities laws, as well as the potential loss of confidence by investors, suppliers, customers and employees, fewer business development opportunities and greater difficulty in obtaining financing or credit.

We expect to incur significant operating losses in the near future.

                We expect to incur net losses in future quarters, at least through 2010.  We cannot provide any assurance that we will be successful with our business strategy, that we will be able to raise sufficient capital to complete our pivotal clinical trial of RenalGuard in the U.S. or that if such a clinical trial is completed that RenalGuard will receive FDA approval or commercial acceptance, or that we will ever return to profitability.

                Our company may be unable to raise needed capital.

                As of June 30, 2008, we had cash and cash equivalents totaling $5,506,000. Based upon our current operating plan, we anticipate that our existing capital resources should be sufficient to meet our working capital requirements for at least the next 12 months; however, we will need to raise additional capital for the future in order to implement our business plan.  As a result of current capital market conditions, we have deferred the commencement of the U.S. pivotal trial for RenalGuard, and should additional financing not be available on terms and conditions acceptable to us, we will need to further curtail our RenalGuard program and take additional actions that will adversely impact our ability to continue to realize assets and satisfy liabilities in the normal course of business.  To the extent that we raise additional capital by issuing equity or convertible securities, ownership dilution to our shareholders will result.  To the extent that we raise additional capital through the incurrence of debt, our activities may be restricted by the repayment obligations and other restrictive covenants related to the debt.

Our ability to commence our planned future U.S. pivotal clinical trial to study the safety and effectiveness of RenalGuard in preventing contrast-induced nephropathy is dependent on our ability to raise sufficient additional capital in the future to fund the completion of the study.

                Although we have received conditional FDA approval to commence our pivotal clinical trial in the U.S. to study the safety and effectiveness of RenalGuard in preventing contrast-induced nephropathy, we will need to raise additional capital in the future to fund the cost of completing the study. We can provide no assurance that we will be able to raise the necessary capital to complete this trial or that such capital will be available on terms and conditions acceptable to us, especially considering the current uncertainty in the global credit markets.

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Our company is currently dependent on one principal customer.

                Pursuant to the terms of our TMR distribution agreement with Novadaq, Novadaq is our exclusive distributor for our HL2 laser and TMR kits in the U.S.  As a result of this exclusive arrangement, our U.S. distributor (Novadaq currently and Edwards prior to March 20, 2007) accounted for 83% of total revenues in both the three and six months ended June 30, 2008, respectively, and 85% in the year ended December 31, 2007, and we expect Novadaq to account for the significant majority of our revenue in the near future.  As a result of this expected concentration of sales with Novadaq, we bear an increased financial risk of timely sales collection if, for any reason, Novadaq’s business condition should suffer.

We are dependent on Novadaq in the U.S. to attempt to increase our TMR revenues.

Novadaq’s sales organization is responsible for selling a number of different products, including our TMR products.  We are largely dependent on the future success of Novadaq’s sales and marketing efforts in the U.S. to increase the installed base of HL2 lasers and TMR procedural volumes and revenues.  If our relationship with Novadaq does not progress, or if Novadaq’s sales and marketing strategies fail to generate sales of our products in the future, our revenue will decrease significantly and our business, financial condition and results of operations will be seriously harmed.

                Our company is currently dependent upon one principal product line to generate revenues.

                We currently sell one principal product line, the Heart Laser Systems, which accounts for the majority of our total revenues.  Approximately 89% of our revenues in both the three and six months ended June 30, 2008, respectively, and 87% in the year ended December 31, 2007, were derived from the sales and service of our Heart Laser Systems.  This absence of a diversified product line means that we are directly and materially impacted by changes in the market for Heart Laser Systems. We believe that the number of opportunities for new TMR laser sales to hospital customers, and specifically sales of our HL2 laser, is likely to continue to decline in future quarters as a result of (1) a diminishing number of available hospitals that have not already implemented a TMR program that are still likely to in the future and (2) continuing financial pressures that hospitals face, in particular for the funding of new capital equipment purchases, in light of ongoing cutbacks in both Medicare and private insurance reimbursement rates for all medical procedures. In addition, we have seen a recent downward trend in the price for new TMR lasers in the market, as competition for the remaining available customers increases. These market factors and our dependency on revenues related to sales of the Heart Laser System pose a serious risk to our ongoing ability to generate sufficient cash to fund our operations, which may seriously harm our business, financial condition and results of operations in future quarters.

                Our company is dependent upon certain suppliers.

                Some of the components for our Heart Laser Systems, most notably the power supply and certain optics and fabricated parts for the HL2, are only available from one supplier, and we have no assurance that we will be able to source any of our sole-sourced components from additional suppliers.  We are dependent upon our sole suppliers to perform their obligations in a timely manner.  In the past, we have experienced delays in product delivery from our sole suppliers and, because we do not have an alternative supplier to produce these products for us, we have little

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leverage to enforce timely delivery. Any delay in product delivery or other interruption in supply from these suppliers could prevent us from meeting our commercial demands for our products, which could have a material adverse effect on our business, financial condition and results of operations.  Furthermore, we do not require significant quantities of any components because we produce a limited number of our products each year.  Our low-quantity needs may not generate substantial revenue for our suppliers.  Therefore, it may be difficult for us to continue our relationships with our current suppliers or establish relationships with additional suppliers on commercially reasonable terms, if at all, and such difficulties may seriously harm our business, financial condition and results of operations.

We are dependent upon our key personnel and may need to hire additional key personnel in the future.

Our ability to operate our business successfully depends in significant part upon the retention and motivation of certain key technical, regulatory, production and managerial personnel and consultants and our ongoing ability to hire and retain additional qualified personnel in these areas. Competition for such personnel is intense, particularly in the Greater Boston area. We cannot be certain that we will be able to attract such personnel and the loss of any of our current key employees or consultants could have a significant adverse impact on our business.

                In order to compete effectively, our current and future products need to gain commercial acceptance.

                Our current TMR products may never achieve widespread commercial acceptance.  To be successful, we and Novadaq need to:

·                   demonstrate to the medical community in general, and to heart surgeons and cardiologists in particular, that TMR procedures are effective, relatively safe and cost effective;

·                   support third-party efforts to document the medical processes by which TMR procedures relieve angina;

·                   train more heart surgeons to perform TMR procedures using the Heart Laser Systems; and

·                   maintain and expand third-party reimbursement for the TMR procedure.

                To date, only a limited number of heart surgeons have been trained in the use of TMR using the Heart Laser Systems.  We are dependent on Novadaq to expand related marketing and training efforts in the U.S. for the use of our products.

                The Heart Laser Systems have not yet received widespread commercial acceptance.  We believe that concerns over the lack of a consensus view about the reason or reasons why a TMR procedure relieves angina in patients who undergo the procedure has limited demand for and use of the Heart Laser Systems. Until there is consensus, if ever, on the medical processes by which TMR procedures relieve angina, we believe some hospitals will delay the implementation of a TMR program.

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                If we are unable to achieve widespread commercial acceptance of the Heart Laser Systems, our business, financial condition and results of operations will be materially and adversely affected.

Our newest product, RenalGuard, has only had limited testing in a clinical setting and we may need to modify it in the future to be commercially acceptable.

                We have only completed the first generation product design for RenalGuard and we have only been able to perform a limited amount of testing of this device in a clinical hospital setting as part of our recently completed initial pilot human clinical study. We may need to make substantial modifications to the design, features or functions of our device in order for it to eventually obtain FDA approval or otherwise to meet customer expectations in the EU where we are currently marketing it. These changes may not be able to be completed in a timely fashion, if at all. Should any such modifications prove to be significantly more costly or time consuming to engineer than we estimate, our ability to bring this product to market may be severely and negatively impacted.

                Our potential future success in marketing RenalGuard in the EU as a CIN prevention device and our ability to raise additional capital in the future will be largely dependent on the timely outcome of the current investigator-sponsored clinical trial of RenalGuard being conducted at the Centro Cardiologico Monzino (CCM) in Milan Italy.

                We currently are supporting an investigator-sponsored clinical trial at the CCM where RenalGuard is being compared in an equivalency study to that of an overnight hydration protocol in terms of its safety and effectiveness in preventing CIN in at-risk patients. We believe our ability to raise additional capital to fund our U.S. pivotal study of RenalGuard, as well as our ability to successfully market RenalGuard in the EU and gain widespread market adoption for our system as a CIN prevention device, is largely dependent on the CCM study results, specifically a favorable finding that RenalGuard is equivalent to overnight hydration in terms of safely preventing CIN in the at-risk patients studied.

                We can provide no assurance that the CCM study will be completed in a timely fashion, if at all, or that should it be completed that it will produce the desired result of showing that RenalGuard is equivalent to overnight hydration in the study population. If the study shows that RenalGuard is not at least equivalent to overnight hydration in terms of its safety or effectiveness in preventing CIN, then our ability to raise additional capital in the future to complete our U.S. pivotal trial, fund our operations and implement our business plan will be materially and adversely affected.

                Our planned U.S. pivotal clinical trial of RenalGuard will, if we can successfully raise the necessary capital to commence and complete it, take us a significant amount of time to complete, if we can complete it at all, and the results of this clinical trial may not show sufficient safety and efficacy for us to either obtain FDA approval or otherwise be able to successfully market and sell the product.

                Our business strategy to grow our revenues and profitability is largely dependent upon our success in the timely completion of our U.S. pivotal clinical trial of RenalGuard. We hope to be able to demonstrate through this clinical trial that RenalGuard is safe and effective in preventing CIN.

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                We can provide no assurance that when studied in humans, RenalGuard will be shown to be safe or effective in preventing CIN, or that the degree of any positive safety and efficacy results will be sufficient to either obtain FDA approval or otherwise successfully market our product. Furthermore, the completion of our planned clinical trial is dependent upon many factors, some of which are not entirely within our control, including, but not limited to, our ability to successfully recruit investigators, the availability of patients meeting the inclusion criteria of our clinical study, the competition for these particular study patients amongst other clinical trials being conducted by other companies at these same study sites, the ability of the sites participating in our study to successfully enroll patients in our trial, and proper data gathering on the part of the investigating sites.

                Should our U.S. pivotal clinical trial take longer than we expect to complete, our competitive position relative to existing preventative measures, or relative to new devices, drugs or therapies that may be developed, could be seriously harmed and our ability to successfully fund the completion of the trial and bring RenalGuard to market may be adversely affected.

                We will need to build a direct sales and marketing organization or otherwise enter into distribution arrangements in order to market RenalGuard in the U.S, if and when it is approved for sale, and in the EU, as we prepare for a sales launch in this market in 2009.

                We currently do not have a direct sales force. Instead, we market our TMR products through Novadaq in the U.S. and through independent distributors outside the U.S.  We do not plan to use Novadaq or our current international TMR distributors to market RenalGuard if and when it becomes commercially available. We will need to either build an internal direct sales and marketing organization or find new distribution partners to successfully market RenalGuard.

                If we choose to build a direct sales force, we may not be able to attract qualified individuals with the requisite training or experience to sell our product. In addition, we would need to devote substantial management time instituting policies, procedures and controls to oversee and effectively manage this new part of our organization, which could adversely impact our daily operations and would require us to invest significant financial resources, the cost of which could be prohibitive.

                If we instead choose to pursue an indirect distribution strategy, which is our current plan for the EU market, we may not be able to identify suitable distribution partners with sufficient industry experience, brand recognition, sales capacity and willingness or ability to maximize sales. Further, we may not be able to negotiate distribution agreements with terms and conditions that are acceptable to us, including ensuring that our product receives adequate sales force focus and attention.

                Rapid technological changes in our industry could make our products obsolete.

                Our industry is characterized by rapid technological change and intense competition.  New technologies and products and new industry standards will develop at a rapid pace, which could make our current and future planned products obsolete. The advent of new devices and procedures and advances in new drugs and genetic engineering are especially concerning competitive threats.  Our future success will depend upon our ability to develop and introduce product enhancements to address the needs of our customers.  Material delays in introducing product enhancements may cause customers to forego purchases of our products and purchase those of our competitors.

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                Many potential competitors have substantially greater financial resources and are in a better financial position to exploit marketing and research and development opportunities.

We must receive and maintain government clearances or approvals in order to market our products.

                Our products and our manufacturing activities are subject to extensive, rigorous and changing federal and state regulation in the U.S. and to similar regulatory requirements in other major international markets, including the EU and Japan.  These regulations and regulatory requirements are broad in scope and govern, among other things:

·                   product design and development;

·                   product testing;

·                   product labeling;

·                   product storage;

·                   premarket clearance and approval;

·                   advertising and promotion; and

·                   product sales and distribution.

                Furthermore, regulatory authorities subject a marketed product, its manufacturer and the manufacturing facilities to continual review and periodic inspections.  We are subject to ongoing FDA requirements, including required submissions of safety and other post-market information and reports, registration requirements, Quality Systems regulations and recordkeeping requirements. The FDA’s Quality Systems regulations include requirements relating to quality control and quality assurance, as well as the corresponding maintenance of records and documentation.  Depending on its activities, Novadaq may also be subject to certain requirements under the Federal Food, Drug, and Cosmetic Act and the regulations promulgated thereunder, and state laws and registration requirements covering the distribution of our products. Regulatory agencies may change existing requirements or adopt new requirements or policies that could affect our regulatory responsibilities or the regulatory responsibilities of a distributor like Novadaq.  We may be slow to adapt or may not be able to adapt to these changes or new requirements.

                Later discovery of previously unknown problems with our products, manufacturing processes or our failure to comply with applicable regulatory requirements may result in enforcement actions by the FDA and other international regulatory authorities, including, but not limited to:

·                   warning letters;

·                   patient or physician notification;

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·                   restrictions on our products or manufacturing processes;

·                   voluntary or mandatory recalls;

·                   product seizures;

·                   refusal to approve pending applications or supplements to approved applications that we submit;

·                   refusal to permit the import or export of our products;

·                   fines;

·                   injunctions;

·                   suspension or withdrawal of marketing approvals or clearances; and

·                   civil and criminal penalties.

                Should any of these enforcement actions occur, our business, financial condition and results of operations could be materially and adversely affected.

To date, we have received the following regulatory approvals for our products:

                Heart Laser Systems

                United States — We received FDA approval to market the HL1 Heart Laser System in August 1998 and the HL2 Heart Laser System in January 2001.  However, although we have received FDA approval, the FDA:

·                   has restricted the use of the Heart Laser Systems by not allowing us to market these products to treat patients whose condition is amenable to conventional treatments, such as heart bypass surgery, stenting and angioplasty; and

·                   could impose additional restrictions or reverse its ruling and prohibit use of the Heart Laser Systems at any time.

In addition, as a condition of our original FDA approval for our TMR products, we were required by the FDA to perform a postmarket surveillance study. The FDA requested that we submit a PMA Postapproval Study report summarizing this postmarket surveillance study. As part of this report, the FDA requested that we analyze and discuss the adverse event and mortality rates seen in the postmarket study and compare these results to the premarket study which was presented as part of our initial FDA PMA application. We filed this postapproval study report with the FDA on February 28, 2007.

Because of the significant safety information collected in the postapproval study, and as the FDA has indicated it plans to do in other product areas, we believe that the FDA plans to present the results at a future meeting of the FDA Circulatory System Devices Advisory Panel and thereafter determine what, if any, actions should be taken with respect to our current Heart Laser Systems PMA.

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                Europe — We received the CE Mark from the European Union for the HL1 and HL2 in March 1995 and February 2001, respectively.  However:

·                   the European Union could impose additional restrictions or reverse its ruling and prohibit use of the Heart Laser Systems at any time; and

·                   France has prohibited, and other European Union countries could prohibit or restrict, use of the Heart Laser Systems.

                Japan — Our HL1 Heart Laser System received marketing approval from the Japanese Ministry of Health, Labor and Welfare (“MHLW”) in May 2006. However, the MHLW could impose restrictions in the future or reverse its ruling and prohibit use of the Heart Laser Systems at any time.

                In addition, it is unclear what impact the introduction of the HL2 into the U.S. and other international markets will have on the ability of our Japanese distributor to market our older, first generation HL1 in Japan. Although our Japanese distributor has indicated to us that it plans to seek MHLW approval in the future to market our newer HL2, we can provide no assurance that the distributor will be successful in obtaining the necessary approvals or how long it may take to secure the required approvals.

                RenalGuard

                We presently have approval to market RenalGuard only in the EU. We must receive either FDA approval or clearance before we can market RenalGuard in the United States. Other countries may require their own approvals prior to our being able to market RenalGuard in those countries.

                The process of obtaining and maintaining regulatory approvals and clearances to market a medical device can be costly and time consuming, and we cannot predict when, if ever, such approvals or clearances will be granted. Pursuant to FDA regulations, unless an exemption is available, the FDA permits commercial distribution of a new medical device only after the device has received 510(k) clearance or is the subject of an approved PMA application. The FDA will clear marketing of a medical device through the 510(k) process only if it is demonstrated that the new product is substantially equivalent to other 510(k)-cleared products.

                At the present time we are not aware of any clear predicates with substantially the same proposed indications for use that would enable us to conclude that RenalGuard is likely to be cleared by the FDA as a 510(k) device. Therefore, we believe RenalGuard most likely will need to go through the PMA application process.

                Because the PMA application process is more costly, lengthy and uncertain than the 510(k) process and must be supported by extensive data, including data from preclinical studies and human clinical trials, we cannot predict when RenalGuard may eventually come to market in the U.S. Should we be unable to obtain FDA approval for RenalGuard, or should the approval process take longer than we anticipate, our future revenue growth prospects will be materially and adversely affected.

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                Changes in third party reimbursement for TMR procedures or our inability to obtain third party reimbursement for RenalGuard could materially affect future demand for our products.

                Demand for medical devices is often affected by whether third party reimbursement is available for the devices and related procedures.  Currently Medicare coverage is provided for TMR when it is performed as a sole therapy treatment.  In addition, when two or more medical procedures are performed in combination with each other, Medicare rules generally allow hospitals to bill for whichever of the two procedures carries the higher reimbursement amount. Therefore, in situations where sole therapy TMR reimbursement rates exceed that provided for bypass surgery alone, if hospitals perform a combination procedure where both bypass surgery and adjunctive TMR are performed on a patient, the hospital is able to bill for the higher TMR procedure reimbursement payment. In these instances, the doctor also can bill an additional amount for performing multiple procedures.

Certain private insurance companies and health maintenance organizations also currently provide reimbursement for TMR procedures performed with our products and physician reimbursement codes have been established for both surgical procedures.

                No assurance can be given, however, that these payers will continue to reimburse healthcare providers who perform TMR procedures using our products now or in the future.  Further, no assurance can be given that additional payers will reimburse healthcare providers who perform TMR procedures using our products or that reimbursement, if provided, will be timely or adequate.

                Should third party insurance reimbursement for TMR procedures be reduced or eliminated in the future, our business, financial condition and results of operations would be materially and adversely affected.

                Furthermore, we know of no existing Medicare coverage or other third party reimbursement that would be available to either hospitals or physicians that would help defray the additional cost that would result from the future purchase and/or use of our RenalGuard System. We also can provide no assurance that we will ever be able to obtain Medicare coverage or other third party reimbursement for the use of RenalGuard, which could materially and adversely affect the potential future demand for this product.

                In addition, the market for our all our products could be adversely affected by future legislation to reform the nation’s healthcare system or by changes in industry practices regarding reimbursement policies and procedures.

                Securing intellectual property rights for RenalGuard is critical to our future business plans, but may prove to be difficult or impossible for us to obtain.

                We have filed nine patent applications with the U.S. patent office related to RenalGuard and other intellectual property in the general field of preventing contrast-induced nephropathy and acute renal failure. Securing patent protection over our intellectual property ideas in this field is, we believe, critical to our plans to successfully differentiate and market RenalGuard and grow

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our future revenues. We can provide no assurance, however, that we will be successful in securing any patent protection for our intellectual property ideas in this field or that our efforts to obtain patent protection will not prove more difficult, and therefore more costly, than we are otherwise expecting. Furthermore, even if we are successful in securing patent protection for some or all of our intellectual property ideas in this field, we cannot predict when in the future any such potential patents may be issued, how strong such patent protection will prove to be, or whether these patents will be issued in a timely enough fashion to afford us any commercially meaningful advantage in marketing RenalGuard against other potentially competitive devices.

Asserting and defending intellectual property rights may impact our results of operations.

                In our industry, competitors often assert intellectual property infringement claims against one another.  The success of our business depends on our ability to successfully defend our intellectual property.  Future litigation may have a material impact on our financial condition even if we are successful in marketing our products. We may not be successful in defending or asserting our intellectual property rights.

                An adverse outcome in any litigation or interference proceeding could subject us to significant liabilities to third parties and require us to cease using the technology that is at issue or to license the technology from third parties.  In addition, a finding that any of our intellectual property is invalid could allow our competitors to more easily and cost-effectively compete with us.  Thus, an unfavorable outcome in any patent litigation or interference proceeding could have a material adverse effect on our business, financial condition or results of operations.

                The cost to us of any patent litigation or interference proceeding could be substantial.  Uncertainties resulting from the initiation and continuation of patent litigation or interference proceedings could have a material adverse effect on our ability to compete in the marketplace.  Patent litigation and interference proceedings may also absorb significant management time.