Item 1. Legal Proceedings
On May 15, 2007, GE Healthcare, a competitor of ours, filed a lawsuit against us in the federal district court in the Western District of Wisconsin. The lawsuit alleges that our
MicroMaxx and/or TITAN products willfully infringe GE's U.S. patents Nos. 4,932,415, 5,584,294, 6,120,447, 6,210,327 and 6,418,225 relating to ultrasound technology. GE is seeking unspecified monetary damages and an injunction. On July 5, 2007, we filed a
counterclaim against GE and certain of its affiliates. In parallel, we filed our answer to the complaint denying all of GE's claims and alleging that the asserted patents are either invalid, not infringed, or both. In our counterclaim complaint, we assert that GE and
its affiliated companies have infringed certain of our U.S. patents through their sales of ultrasound products, including GE's compact ultrasound systems. Subsequent to these initial filings, GE added another patent to its claims (6,102,859) and SonoSite added
patents to its counterclaims against GE so that SonoSite is now alleging infringement of four patents by GE's products (6,569,101, 6,962,566, 6,364,839 and 6,471,651). Our complaint also seeks unspecified monetary damages and a court injunction against future
infringement by GE and its affiliates.
Item 1A. Risk Factors
If we are unable to effectively develop new and innovative products and product features that achieve market acceptance, our products will become technologically obsolete in the ultrasound market and our
business will fail.
Because substantially all of our revenue comes from the sales of our existing HCU systems and related products, in order to remain competitive, our future financial success will
depend in large part upon our ability to successfully invent, deliver and market new and innovative products and product features. In October 2007, we released several new products, including the M-Turbo system and the S Series imaging tools which are customized for
different clinical applications. The development of new, technologically advanced products and product features is a complex and uncertain process requiring great innovation and the ability to anticipate technological and market trends and needs. We may be unable to
achieve or maintain market acceptance of any new products we develop, and we may be required to expend more costs than anticipated to successfully introduce these products. Without successful product innovation and market introduction of new offerings and
improvements, our products will become technologically obsolete and we will be unable to compete effectively in the ultrasound market. Even with successful innovation and development, we cannot assure you that revenues from the sales of our HCU systems will continue
to remain at or above current levels or that we will continue to be financially profitable.
Because technology innovation is complex, it can require long development and testing periods. If the launch of new products or product improvements are delayed for any reason, our
business may be adversely affected. Factors which could cause delays in our product development or release schedules or cancellation of our product development projects include:
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research and development challenges;
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defects or errors in newly developed products or software for those products;
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third-party intellectual property rights that preclude us from pursuing a new product design; and
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the availability, cost and performance of supplies and components needed for new products.
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We may experience delays in our innovation cycle, and in the scheduled introduction of future new products. Any such delays could adversely affect our ability to compete effectively
in the ultrasound market and could adversely affect our operating results.
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We may be unable to expand the market for our products to new applications and new users, which will limit our ability to grow our business.
We seek to sell our products to current users of ultrasound, as well as to physicians and other healthcare providers who do not currently use ultrasound. Our market focus, and we
believe our greatest growth opportunities, will come from new point-of-care clinical applications and new users of ultrasound. Any new users of ultrasound will not only require training and education to properly administer ultrasound examinations but also must
develop an appreciation of the treatment value of our products so that our products will become successfully integrated into their day-to-day practices. Although we have spent, and will continue to spend, considerable marketing resources educating potential customers
about the value of HCU products in new applications, our efforts may be unsuccessful. If these potential customers are unable or unwilling to be trained due to cost, time constraints, unavailability of courses or other reasons, or if they consider our products
nonessential to their medical practices, our ability to expand the market for our products and to increase our revenues could be limited.
Our efforts to integrate the business and technology of any future acquisition may result in significant costs or create significant disruptions that outweigh the benefits of any such
acquisition.
We intend to explore the possible acquisition of one or more medical device companies or medical device products in an effort to expand our product portfolio, expand our sales
channels, create international operating leverage, improve marketing and other efficiencies and leverage manufacturing and supply chain economics. In furtherance of this strategy, in July 2007, we raised $208.5 million in net proceeds from a convertible debt offering
and we may raise additional funds to position ourselves to pursue any desirable acquisition candidates that we may identify. If we are unable to identify suitable acquisition candidates or to successfully consummate acquisitions and integrate, into our business, the
operations, technology, products, customers, suppliers and personnel of any such acquired business or technology, our ability to grow our business may be limited. Also in July 2007, we acquired LumenVu, Inc. a private development stage company that has developed, in
conjunction with a leading academic research institution, a patented technology to improve the accuracy of catheter placement. We expect to introduce products based on this technology in late 2008.
Any acquisition we do complete may be costly and difficult and we may experience:
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difficulty in integrating operations, including combining teams and processes in various functional areas;
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delays in realizing the benefits of the acquired company or technology;
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limited market acceptance of acquired products or technology;
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diversion of our management's time and attention from other business concerns;
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lack of or limited direct experience in new markets we may enter;
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difficulties in obtaining regulatory approvals or reimbursement codes for acquired technologies;
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increased risk of product liability actions from acquired products or technologies;
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additional costs, including fees and expenses of professionals involved in completing the integration process; and
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unexpected costs associated with existing liabilities of any acquired business.
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In addition, an acquisition could materially impair our operating results by causing us to incur debt or requiring us to incur one-time charges or amortize acquisition expenses and
related assets. If we fail in our attempts to integrate any acquired business or technology, or if the costs and burdens of such acquisition or integration outweigh the benefits of such acquisition, our financial resources or financial results could be
impaired.
If we are unable to compete effectively, we will fail to generate sufficient revenue to maintain our business.
Competition in the cart-based and portable ultrasound systems market is very significant. Our main competitors in this industry are GE Healthcare, Siemens, and Philips. These
companies are very large global organizations that have the following competitive advantages over us:
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significantly greater financial and infrastructure resources;
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larger research and development staffs;
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greater experience in product manufacturing, marketing and distribution;
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greater brand name recognition; and
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long-standing relationships with many of our existing and potential customers.
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These manufacturers of cart-based and portable ultrasound systems could use their greater resources to further increase the level of competition in the market through various means,
including:
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price and payment terms that we are unable to match;
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marketing strategies that bundle the sale of portable systems with other medical products that we do not sell;
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technological innovation;
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market penetration and hospital systems integration that we cannot match;
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employee compensation that we cannot match; and
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complimentary services such as warranty protection, maintenance and product training that is outside of the scope of our product offerings.
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Existing product supply relationships between these competitors and our potential customers could adversely impact the level or rate of adoption of our products due to brand loyalty
or preferred customer discounts. Competing portable or traditional cart-based ultrasound devices may be more accepted or cost-effective than our products. Competition from these companies for employees with experience in the primary point-of-care market could result
in higher turnover of our employees. If we are unable to respond to competitive pressures within the cart-based and HCU markets, we could experience delayed or reduced market acceptance of our products, higher expenses and lower revenue.
We expect the market for high-performance HCU products, and the competition in the HCU market, to continue to increase as new and existing competitors enter the portable ultrasound
market or modify their existing products to more closely approximate the combined portability, quality, performance and cost of our products. If we are unable to compete effectively with current or new entrants to the high-performance HCU market, we will be unable to
generate sufficient revenue to maintain our business.
If our relationships with our distributors and channel partners are unsuccessful, our ability to sell our products will be limited.
We currently depend on distributors to help promote market acceptance and demand for our products in countries in which we do not have a direct sales force. We also depend on a
channel partner to provide expanded sales capacity in the United States for the physician office market. Distributors and channel partners that are in the business of selling other medical products may not devote a sufficient level of resources and support required
to generate awareness of our products and grow or maintain product sales. In addition, because our relationship with our U.S. channel partner is relatively new, we cannot predict the degree to which this partner will succeed in expanding our penetration into the
physician office market. If our distributors and channel partners are unwilling or unable to market and sell our products, or if they do not perform to our expectations, we could experience delayed or reduced market acceptance and sales of our products.
In addition, disagreements with our distributors and channel partner or non-performance by these third parties could lead to costly and time-consuming litigation or
arbitration and disrupt distribution channels for a period of time and require us to re-establish a distribution channel.
Existing or potential intellectual property claims and litigation either initiated by or against us may divert our resources and subject us to significant liability for damages, substantial litigation expense
and the loss of our proprietary rights.
In order to protect or enforce our patent rights, we may initiate patent litigation. For example, we filed a patent infringement suit against Zonare Medical Systems, Inc. alleging
that Zonare infringed one of our key patents through sales of its z.one ultrasound system. On March 14, 2007, Zonare filed an answer to our claim which included a counterclaim against us alleging that our products infringe its patent related to its portable docking
station.
Others may initiate patent litigation against us. On May 15, 2007, GE Healthcare, a competitor of ours, filed a lawsuit against us in the federal district court in the Western
District of Wisconsin. The lawsuit alleges that our MicroMaxx and/or TITAN products willfully infringe GE's U.S. patents Nos. 4,932,415, 5,584,294, 6,120,447, 6,210,327 and 6,418,225 relating to ultrasound technology. GE is seeking unspecified monetary damages and an
injunction. On July 5, 2007, we filed a counterclaim against GE and certain of its affiliates. In parallel, we filed our answer to the complaint denying all of GE's claims and alleging that the asserted patents are either invalid, not infringed, or both. In our
counterclaim complaint, we assert that GE and its affiliated companies have infringed certain of our U.S. patents through their sales of ultrasound products, including GE's compact ultrasound systems. Subsequent to these initial filings, GE added another patent to
its claims in (6,102,859) and SonoSite added patents to its counterclaims against GE so that SonoSite is now alleging infringement of four patents by GE's products (6,569,101, 6,962,566, 6,364,839 and 6,471,651). Our complaint also seeks unspecified monetary damages
and a court injunction against future infringement by GE and its affiliates.
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If we fail to successfully defend GE's or Zonare's claim, we may be required to pay monetary damages (including treble damages) and, unless we are able to redesign our products to
avoid infringing the asserted patents or to license proprietary rights from them, we may be prevented from continuing to market and sell our MicroMaxx and/or TITAN products, sales of which represent a substantial portion of our total revenues. If this outcome were to
occur, we may be unable to redesign our products in a timely and cost effective manner, and licensing proprietary rights from GE or Zonare may not be possible on commercially reasonable terms, if at all. Even if we are successful in defending these actions and in
proving infringement by GE or Zonare, we are likely to incur substantial costs that could adversely affect our financial condition and the actions will be distracting to management.
We may become subject to interference proceedings conducted in patent and trademark offices to determine the priority of inventions. There are numerous issued and pending patents in
the ultrasound field. The validity and breadth of medical technology patents may involve complex legal and factual questions for which important legal principles may remain unresolved.
We may be liable for infringing the intellectual property of others as there could be existing patents of which we are unaware, or pending applications of which we are unaware which
may later result in issued patents, that one or more of our products may infringe. Litigation may be necessary to:
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assert or defend against claims of infringement;
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enforce our issued and licensed patents;
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protect our trade secrets or know-how; or
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determine the enforceability, scope and validity of the proprietary rights of others.
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We may also become involved in the defense and prosecution, if necessary, of intellectual property suits, patent interferences, opposition proceedings and other administrative
proceedings. For example, we successfully defended a patent infringement suit, Neutrino Development Corporation vs. SonoSite, in the U.S. District Court for the Southern District of Texas for more than five years, from 2001 through the end of 2006. Although we were
successful, this litigation forced us to incur substantial costs and, at certain points in the litigation, distracted our management personnel from the pursuit of our business strategy.
Involvement in intellectual property claims and litigation, including those described above, could have significant adverse consequences, including:
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diversion of management, scientific and financial resources;
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exposure to significant adverse judgments and financial liabilities;
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forcing us to incur substantial litigation costs;
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causing product shipment delays and lost sales;
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requiring us to enter into royalty or licensing agreements with third parties on terms that may not be acceptable to us; or
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forcing us to modify or discontinue selling our products, or to develop new products.
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If we are unable to protect our patents and proprietary rights, we may be unable to compete effectively and we may lose sources of revenue.
Much of our value arises out of our proprietary technology and intellectual property for the design, manufacture and use of point-of-care ultrasound imaging systems. We rely on
patent, copyright, trade secret and trademark laws to protect our proprietary technology and limit the ability of others to compete with us using the same or similar technology. Third parties may infringe or misappropriate our intellectual property, which could harm
our business.
We currently hold 44 U.S and foreign patents relating to our technology. A number of other patents are pending in the United States and in foreign jurisdictions. Although we enter
into confidentiality agreements with our employees, consultants and strategic partners, and generally control access to and distribution of our proprietary information, the steps we have taken to protect our intellectual property may not prevent misappropriation. In
addition, we do not know whether we will be able to defend our proprietary rights since the validity, enforceability and scope of protection of proprietary rights is still evolving.
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Our efforts may not adequately protect our rights to the extent necessary to sustain any competitive advantage we may have. Despite our efforts to protect our intellectual property,
we may experience:
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unauthorized use of our technology by competitors;
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independent development of the same or similar technology by a competitor, coupled with a lack of enforceable patents on our part;
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failure of our pending patent applications to result in issued patents;
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successful interference actions to our patents, successful patent infringement lawsuits or successful oppositions to our patents and patent applications;
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unauthorized disclosure or use of our proprietary information by former employees or affiliates; and
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failure by our commercial partners to comply with their obligations to share technology or use our technology in a limited manner.
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Policing unauthorized use of our intellectual property is difficult, costly and time-intensive. We may fail to prevent misappropriation of our technology, particularly in countries
where the laws may not protect our proprietary rights to the same extent as do the laws of the United States. If we cannot prevent other companies from using our proprietary technology or if our patents are found invalid or otherwise unenforceable, we may be unable
to compete effectively against other manufacturers of ultrasound systems, which could decrease our market share.
Changes in the healthcare industry could result in a reduction in the size of the market for our products or may require us to decrease the selling price for our products, either of which could have a negative
impact on our financial performance.
Trends toward managed care, healthcare cost containment, and other changes in government and private sector initiatives in the United States and other countries in which we do
business are placing increased emphasis on lowering the cost of medical therapies, which could adversely affect the sale or the prices of our products. For example:
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major third-party payers of hospital and non-hospital based healthcare services, including Medicare, Medicaid and private healthcare insurers, are considering revising their payment methodologies which may
result in stricter standards for reimbursement of imaging charges and/or lower or more bundled payment;
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numerous legislative proposals have been considered that would result in major reforms in the U.S. and foreign healthcare systems that could harm our business;
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there has been a consolidation among healthcare facilities and purchasers of medical devices in the United States and foreign countries who prefer to limit the number of suppliers from whom they purchase medical
products, and these entities may decide to stop purchasing our products or demand discounts on our prices;
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there is economic pressure to contain healthcare costs in worldwide markets; and
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there are proposed and existing laws and regulations in domestic and international markets regulating pricing and profitability of companies in the healthcare industry.
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These trends could lead to pressure to reduce prices for our products and could cause a decrease in the size of the market that could adversely affect our revenue and profitability,
which could harm our business.
If healthcare reimbursement policies place limits on which providers may receive payment for imaging services or substantially reduce reimbursement amounts or coverage for specific procedures, market
acceptance of our products may be reduced.
Continued demand for our products depends in part on the extent to which our customers receive reimbursement for the use of our products from third-party payers such as Medicare,
Medicaid and private health insurers (and equivalent third-party payers in foreign countries). Presently, reimbursement policies for physician-performed diagnostic imaging services are fairly unrestricted in the United States. The continuing efforts of governmental
authorities, private health insurers and other third-party payers to contain or reduce the costs of healthcare could, however, result in more restricted payment policies for diagnostic imaging. As an example, a Medicare payment policy arising from the Deficit
Reduction Act of 2005, effective January 1, 2007, caps payments to physician offices and freestanding imaging centers for the technical component of most imaging services. Although reimbursement amounts for most ultrasound procedures were not lowered by this payment
policy, vascular ultrasound examinations and ultrasound guidance of needle procedures, such as biopsies, aspirations and injections are now being paid at a lower rate than they were previously. In markets in which the use of ultrasound continues to be an emerging
standard of care, the enactment of this provision may dampen market demand for ultrasound equipment.
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Some private insurers have implemented imaging privileging programs as a means of controlling utilization of imaging services. For example, Highmark Blue Cross Blue Shield, a private
insurer operating in Pennsylvania, requires that providers meet specific criteria in order to receive payment for imaging services provided to its subscribers. These criteria, in some instances, exclude some providers by virtue of their clinical specialty. Other
criteria require providers to obtain specific credentials from third-party accreditation organizations. In addition, future congressional legislation related to the Medicare program may include the requirement that non-physician sonographers obtain a credential from
third-party credentialing organizations in order to provide ultrasound service under the program. Such legislation may also include the requirement that non-hospital providers of imaging services be accredited through a third-party accreditation organization. These
programs, which increase the regulation of providers, could restrict the potential new users for our products and, in turn, limit our ability to grow our business.
Finally, both governmental and private third-party payers are calling for increasing levels of evidence of beneficial clinical outcomes and cost effectiveness in addition to proof of
clinical efficacy as a prerequisite to granting coverage for new technologies and devices and new applications of existing technologies. Thus, to the extent that services performed with current or future products that we may bring to market are not described by
existing Current Procedural Terminology codes or are not covered under existing coverage policies, there is a risk that reimbursement for these applications may not be attained at all or within a reasonable timeframe. For example, carotid intima media thickness
measurement, which is an application of ultrasound performed by our SonoCalc IMT software, is not currently reimbursed by Medicare and is not a part of third-party payers' standard benefits packages.
We may be unable to predict our sales and plan manufacturing requirements with accuracy, which may adversely affect our operating results.
Our customers typically order products on a purchase order basis. In some circumstances, customer orders may be cancelled, changed or delayed on short notice. Lack of significant
order backlog makes it difficult for us to forecast future sales with certainty and could result in over or under production, which could lead to higher expense, lower than anticipated revenue, and reduced gross margin. Varying quarterly demands from our customers,
particularly as we introduce new products, also make it difficult to accurately forecast component and product requirements, exposing us to the following risks:
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If we overestimate our requirements, we may be obligated to purchase more components or third-party products than we need; and
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If we underestimate our requirements or experience shortages of product components from time to time, we could experience an interruption in revenue, because our third-party manufacturers and suppliers may have
an inadequate product or product component inventory to satisfy our requirements.
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The final assembly and testing of our products is done at our Bothell, Washington factory where we integrate different components manufactured by various suppliers. If we encounter
supplier, regulatory, engineering or technical difficulties in manufacturing on account of events at our factory or our suppliers' factories, we may incur delays in delivery of these products to customers and that could adversely affect our revenues.
If our suppliers, including our single-source suppliers, fail to supply us with the components that we need to manufacture our products on a timely basis, we could experience production delays, cost increases
and lost sales.
We depend on suppliers, including some single-source suppliers, to provide highly specialized parts, such as custom-designed integrated circuits, cable assemblies and transducer
components. We also depend on single-source suppliers to provide other components, such as image displays, batteries, capacitors and cables. We do not maintain significant inventories of certain components, and may experience an interruption of supply if a supplier
is unable or unwilling to meet our time, quantity and quality requirements. There are relatively few alternative sources of supply for some of these components. An increase in demand for some parts by other companies could also interrupt our supply of components. We
have in the past experienced supply problems in timeliness and quality, but to date these problems have not resulted in lost sales or lower demand. Nevertheless, if we experience an interruption of supply or are required to switch suppliers, the manufacture and
delivery of our products could be interrupted, our manufacturing costs could substantially increase and we could lose substantial amounts of product sales.
In addition, our circuit boards are produced in Thailand by one of the world's largest electronic manufacturing services suppliers. These circuit boards are highly customized and
securing a different source of supply for this critical component of our product would be particularly difficult. If we experience delays in the receipt or deterioration in product yields of these critical components, we may experience delays in manufacturing or an
increase in costs resulting in lost sales or a deterioration in gross margin.
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If we are unable to overcome the risks inherent in international business activities, the growth of our business will be limited and our profitability will decline.
We have ten wholly owned subsidiaries located in the United Kingdom, France, Germany, Italy, India, Spain, Japan, Canada, Australia and China. The percentage of our total revenue originating outside the United
States equaled 48% and 46% for the years ended December 31, 2006 and 2005, respectively, and 49% for the nine months ended September 30, 2007. Successful maintenance of these international operations requires us to:
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maintain an efficient and self-reliant local infrastructure;
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continue to attract, hire, train, manage and retain qualified local sales and administrative personnel;
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comply with diverse and potentially burdensome local regulatory requirements and export laws, including license requirements, trade restrictions and tariff increases; and
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maintain complex information, financial, distribution and control systems.
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Our presence in international markets has required, and will continue to require, substantial financial and managerial resources. The costs of maintaining our presence in
international markets are unpredictable, difficult to control and may exceed budgeted amounts. In addition, we may be subject to the following conditions in countries where we conduct our operations:
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adverse regional political or economic conditions;
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currency exchange rate fluctuations;
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difficulty in enforcing any judgment against non-U.S. distributors or other third parties upon which our business is heavily dependent; and
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reduced protection for our intellectual property rights.
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Despite our expenditures and efforts internationally to mitigate the challenges above, we may not continue to generate a proportional substantial increase in international revenue,
and such a deficiency would impair our operating results.
Currency exchange rate fluctuations in various currencies in which we do business and longer receivables collection periods outside of the United States could adversely affect our business.
Total sales denominated in a currency other than USD were $14.0 million, or 28% of our total consolidated revenues for the three months ended September 30, 2007, and $42.9 million,
or 31% of our total consolidated revenues for the nine months ended September 30, 2007. As a result, our results of operations could be adversely affected by certain movements in exchange rates. Although we take steps to hedge a substantial portion of our foreign
currency exposures, there is no assurance that our hedging strategy will be successful or that the hedging markets will have sufficient liquidity or depth for us to implement our strategy in a cost effective manner.
Additionally, as of September 30, 2007, 62% of our outstanding accounts receivable balance was from international customers, of which 53%, or $15.7 million, was denominated in a
currency other than USD. Although we regularly review our receivable positions in foreign countries for any indication that collection may be at risk, our revenue from international sales may be adversely affected by longer receivables collection periods and greater
difficulty in receivables collection.
If we, or our suppliers, fail to comply with U.S. and foreign governmental regulations applicable to our products and manufacturing practices, we could experience product introduction delays, production
delays, cost increases and lost sales and our future revenues may be adversely affected.
Our products, our manufacturing and marketing activities, and the manufacturing activities of our third-party medical device manufacturers are subject to extensive regulation by a
number of governmental agencies, including the Food and Drug Administration, or FDA, and comparable international agencies. Our third-party manufacturers and we are or may be required to:
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obtain prior clearance or approval from these agencies before we can market and sell our products;
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undergo rigorous inspections by domestic and international agencies; and
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satisfy content requirements for all of our sales and promotional materials.
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The processes for obtaining regulatory approval can be lengthy and expensive, and the results are unpredictable. If we are unable to obtain clearances or approvals needed to market
existing or new products, or obtain such clearances or approvals in a timely manner, our revenues and profitability could be adversely affected. Moreover, clearances and approvals, if granted, may limit the uses for which a product may be marketed, which could reduce
or eliminate the commercial benefit of manufacturing any such product.
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To ensure that manufacturers adhere to good manufacturing practices, medical device manufacturers are routinely subject to periodic inspections by the FDA and may be inspected by
foreign regulatory agencies from countries in which we do business. In addition, the Business Standards Institution performs periodic assessments of our manufacturing processes and quality system. Compliance with the regulations of various agencies, including the
Environmental Protection Agency and the Occupational Safety and Health Administration, may require us to incur substantial costs and may delay or prevent the introduction of new or improved products. Although to date these actions by regulatory bodies have not
required us to incur substantial costs or delay product shipments, we expect to experience further inspections and incur additional costs as a result of governmental regulation.
Failure to comply with applicable regulatory requirements can result in enforcement action, including product recall, the issuance of fines, injunctions, civil and criminal
penalties, detaining or banning our products, and operating restrictions. Our third-party medical device manufacturers may also be subject to the same sanctions if they fail to comply with the laws and regulations and, as a result, may fail to supply us with
components required to manufacture our products.
A failure to manage our growth could impair our ability to achieve our business objectives.
We have experienced rapid and substantial growth in recent years. Our revenue increased to $171.1 million in 2006 from $147.5 million in 2005 and $115.8 million in 2004. Our growth
could strain our existing management, operational and financial resources and, if we are unable to manage this growth successfully, our business and financial performance will be adversely affected. In order to manage our growth effectively, we will need to expand
our manufacturing and quality assurance staff, our sales staff and our international support staff and improve the productivity and efficiency of our existing operational, financial and management resources and information systems. We may be unable to hire and retain
the personnel necessary to operate and expand our business. We also may be unable to increase the productivity and efficiency of our existing resources.
Product liability and other claims and product field actions initiated against us could increase our costs, delay or reduce our sales and damage our reputation, adversely affecting our financial
condition.
Our business exposes us to the risk of product liability, malpractice or warranty claims inherent in the sale and support of medical device products, including those based on claims
that the use or failure of one of our products resulted in a misdiagnosis or harm to a patient. Such claims may cause financial loss, damage our reputation by raising questions about our products' safety and efficacy, and could interfere with our efforts to market
our products. Although to date we have not been involved in any medical malpractice or product liability litigation, we may incur significant liability if such litigation were to occur. We may also face adverse publicity resulting from product field actions or
regulatory proceedings brought against us. Although we currently maintain liability insurance in amounts we believe are commercially reasonable, any product liability we incur may exceed our insurance coverage. Liability insurance is expensive and may cease to be
available on acceptable terms, if at all. A product liability or other claim or product field action not covered by our insurance or exceeding our coverage could significantly impair our financial condition. In addition, a product field action or a liability claim
against us could significantly harm our reputation and make it more difficult to obtain the funding and commercial relationships necessary to maintain our business.
Our reliance on a single manufacturing facility may expose us to enhanced risk from natural disasters or other unforeseen catastrophic events.
Our manufacturing facilities are located in two buildings in Bothell, Washington, in close proximity to each other. Despite precautions taken by us, a natural disaster such as an
earthquake or other unanticipated catastrophic events at this location could significantly impair our ability to manufacture our products and operate our business. Our facilities and certain manufacturing equipment would be difficult to replace and could require
substantial replacement lead-time. Such catastrophic events may also destroy any inventory of product or components. While we carry insurance for natural disasters and business interruption for our Bothell facilities, the occurrence of such an event could result in
losses that exceed the amount of our insurance coverage, which would impair our financial results.
We may incur greater than expected warranty expense.
We expect our warranty liability and expense to continue to increase significantly due to the five-year warranty offered with the MicroMaxx system. Additionally, we will offer a
five-year warranty with the M-Turbo and S Series systems. Should actual failure rates and repair or replacement costs differ from our estimates, additional warranty expense may be incurred and our results may be materially affected.
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The loss of key employees or management personnel could impair our ability to achieve our business objectives and negatively affect our financial results.
Our success depends heavily on our ability to retain the services of certain key employees or certain technical expertise. Competition among medical device companies for qualified
employees is intense. We may fail to retain these key employees, and we may fail to attract qualified replacements if they do leave. We do not maintain key-person insurance on any of our employees. We do not have employment agreements with any of our employees except
for employees in certain countries outside the United States and change in control agreements with certain members of senior management. The loss of any of our key employees could significantly delay or prevent the achievement of our product development or business
objectives.
In addition, our future success will depend, to a significant extent, on the ability of our management to operate effectively, both individually and as a group. We must successfully
manage transition and replacement issues that may result from the departure or retirement of members of our senior management. Transitions of management personnel may cause disruption to our operations or customer relationships, or a decline in our financial
results.
Our results of operations are subject to significant quarterly variation.
Our quarterly operating results may vary significantly due to a combination of factors, many of which are beyond our control. These factors include:
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the timing of new product introductions by us or our competitors;
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the timing of regulatory approvals;
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the timing of orders from major customers and distributors, including bulk orders from governmental entities and demo orders from new distributors;
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seasonal buying patterns of our customers;
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development and promotional expenses relating to new product introductions;
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the revenue mix by product and geography;
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changes in pricing policies by us or our competitors;
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foreign exchange rates;
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writeoffs resulting from obsolete inventory;
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fluctuations in our consolidated tax rates;
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our ability to meet demand for our products;
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the market acceptance of our products;
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legal costs and the results of litigation;
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changes in distribution channels; and
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the ability of our sales force to effectively market and sell our products.
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Accordingly, our quarterly sales and operating results may vary significantly in the future, and period-to-period comparisons of our results of operations may not be meaningful and
should not be relied upon as indicators of future performance.
Seasonality and concentration of revenues at the end of the quarter could cause our revenues to fall below the expectations of securities analysts and investors, resulting in a decrease in our stock
price.
As a result of customer buying patterns and the efforts of our sales force to meet or exceed quarterly and year-end quotas, historically we have earned a substantial portion of each
year's revenues during the last quarter and a substantial portion of each quarter's revenues during its last month. If expected revenues at the end of any quarter are delayed, our revenues for that quarter could fall below the expectations of securities analysts and
investors, resulting in a decrease in our stock price.
We may be unable to sustain or increase our profitability.
Prior to 2004, we had incurred losses in each year since our inception in 1999. As of December 31, 2006, we had an accumulated deficit of $51.8 million. We achieved
profitability in 2004 and were profitable for each of 2005 and 2006, but we may be unable to sustain or increase future profitability on a quarterly or annual basis. We may incur losses if we cannot increase or sustain our revenue. We expect that our operating
expenses will increase in the foreseeable future as we expand our product development activities, our sales and marketing infrastructure and our administrative support and our product offerings and as we pursue the acquisition of additional companies or technologies
to further our growth. Our expansion and acquisition efforts, to be successful, may require more funding than we currently anticipate.
Accordingly, we will need to generate significant additional revenue in the future in order to be able to sustain or increase profitability. If we cannot generate sufficient revenue
to sustain or increase our profitability, then our business will be adversely affected.
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Conversion of the notes will dilute the ownership interest of shareholders at the time of conversion.
Upon conversion of some or all of the senior notes the ownership interests of shareholders will be diluted. Any sales in the public market of the common stock issuable upon such
conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the senior notes may encourage short selling by market participants because the conversion of the notes could be used to satisfy short positions, or
anticipated conversion of the notes into shares of our common stock could depress the price of our common stock.
In addition, if a fundamental change occurs, under certain circumstances we will adjust the conversion rate by a number of shares of our common stock for notes converted in
connection with such fundamental change. The adjustment to the conversion rate will be determined based on the date on which the fundamental change becomes effective and the price paid per share of our common stock in such transaction, as described under the terms of
the notes.
As more fully defined in the indenture applicable to the notes, a fundamental change will be deemed to have occurred upon the consummation of certain significant corporate
transactions, including for example, the acquisition by one party or group of more than 50% of the voting power of our common equity, the consummation of certain recapitalizations, consolidations or mergers, the sale of all or substantially all of our assets,
shareholder approval of our liquidation or dissolution, the failure of our common stock to be listed on any U.S. national securities exchange or a change in the composition of our board of directors as a result of which our incumbent directors, or directors appointed
by our incumbent directors, do not constitute a majority of our board.
Sales of a significant number of shares of our common stock in the public markets, or the perception of such sales, could depress the market price of our common stock.
Sales of a substantial number of shares of our common stock or other equity-related securities in the public markets could depress the market price of our common stock, and impair
our ability to raise capital through the sale of additional equity securities. We cannot predict the effect that future sales of our common stock or other equity-related securities would have on the market price of our common stock. The price of our common stock
could be affected by possible sales of our common stock by investors who view the notes as a more attractive means of equity participation in our company and by hedging or arbitrage trading activity, which we expect to occur involving our common stock. This hedging
or arbitrage could, in turn, affect the market price of our common stock.
The convertible note hedge and warrant transactions may affect the value of our common stock.
The convertible note hedge and warrant transactions may affect the value of our common stock. In connection with the pricing of the notes, we entered into a convertible note hedge
transaction with an option counterparty. We also entered into a warrant transaction with this option counterparty. The convertible note hedge transaction covers approximately 42% of any converted notes, and is expected to reduce potential dilution to our common stock
upon any such conversion. However, the warrant transaction could separately have a dilutive effect on our earnings per share to the extent that the market value per share of our common stock exceeds the applicable strike price of the warrants.
In connection with establishing its initial hedge of these transactions, the option counterparty or its affiliates:
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entered into various derivative transactions with respect to our common stock concurrently with or shortly after the pricing of the notes; and
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may enter into or unwind various derivative transactions with respect to our common stock and/or purchase or sell our common stock in secondary market transactions following the pricing of the notes (and would
likely do so during any observation period related to the conversion of the notes).
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These activities could have the effect of increasing or preventing a decline in the price of our common stock concurrently with or shortly after the pricing of the notes and during
any observation period related to a conversion of the notes.
In addition, the option counterparty or its affiliates will likely modify its hedge position from time to time prior to conversion or maturity of the notes by purchasing and selling
our common stock, other of our securities or other instruments it may wish to use in connection with such hedging. In particular, such hedging activity would likely occur during any observation period for a conversion of notes, which may have a negative effect on the
value of the consideration received in relation to the conversion of those notes.
We intend to exercise options we hold under the convertible note hedge transaction whenever notes are converted. In order to unwind its hedge position with respect to those exercised
options, the option counterparty or its affiliates would expect to sell shares of our common stock in secondary market transactions or unwind various derivative transactions with respect to our common stock during the observation period for the converted notes.
We have also agreed to indemnify the option counterparties for losses incurred in connection with a potential unwinding of its hedge positions under certain circumstances.
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The potential effect, if any, of any of these transactions and activities on the market price of our common stock will depend in part on market conditions and cannot be ascertained
as of the date of this quarterly report. Any of these activities could adversely affect the price of our common stock and, as a result, the value of the consideration and the number of shares of our common stock, if any, that the noteholders would receive upon the
conversion of the notes.
If we, or our independent registered public accounting firm, determine that we have additional material weaknesses in our internal control over financial reporting, current and potential shareholders could
lose confidence in our financial reporting, which could harm our business and the trading price of our stock.
Under Section 404 of the Sarbanes-Oxley Act of 2002, we are required to evaluate and determine the effectiveness of our internal control over financial reporting. As a part of
the annual audit of our internal control over financial reporting and our consolidated financial statements for the year ended December 31, 2006, we determined that we did not have the appropriate level of expertise to properly prepare and review our accounting for
income taxes and we identified a material weakness regarding the level of resources and expertise for preparation and review of our tax provision. Because of this material weakness, our management concluded that, as of December 31, 2006, we did not maintain effective
internal control over financial reporting based on those criteria. As a result, KPMG LLP issued an adverse opinion with respect to our internal control over financial reporting for the year ended December 31, 2006. We have taken steps to remediate this material
weakness, but we will be unable to reach final conclusions regarding the success of our remediation efforts until after our fiscal year end.
We have dedicated a significant amount of time and resources in an effort to ensure future compliance with this legislation since our Annual Report on Form 10-K for the year ended
December 31, 2006 and will continue to do so for future fiscal periods. We may encounter problems or delays in completing the review and evaluation, the implementation of improvements and the receipt of a positive attestation, or any attestation at all, by our
independent auditors. Additionally, management's assessment of our internal control over financial reporting may identify additional deficiencies that need to be addressed in our internal control over financial reporting or other matters that may raise concerns for
investors.
We may be unable to utilize our deferred tax assets, which could adversely affect our future operating results.
We may be subject to higher tax in future periods. In the fourth quarter of 2004 and based on Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes,"
("SFAS 109"), we began to recognize deferred tax assets relating to our U.S. operations on our balance sheet as a non-recurring income tax benefit. In addition, in the fourth quarter of 2006, we began to recognize deferred tax assets relating to our international
operations on our balance sheet as a non-recurring income tax benefit. The deferred tax assets primarily represent the income tax benefit of the net operating loss we have incurred from our operations since inception.
Our consolidated income tax rate may fluctuate as U.S. and international operations become more or less profitable. We will continue to evaluate our ability to utilize our tax credit
carry-forwards in future periods and, in compliance with SFAS 109, record any resulting adjustments that may be required to deferred income tax expense.
If we fail to comply with our obligations in our license with ATL, we could lose license rights that are important to our business.
We license certain technology from ATL that is incorporated into our single technology platform, and we use this ATL technology in all of our HCU systems. A substantial majority of
our revenue is attributable to products incorporating this ATL technology.
ATL may terminate our license in the event of an uncured material default by us in our obligations under the license agreement. The termination or other loss of our license to use
ATL technology would significantly impair our ability to manufacture, market and sell our products. If this license is terminated, we may be unable to generate sufficient revenue to maintain our business.
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If we incur a tax liability in connection with our spin-off from ATL, we would be required to pay a potentially significant expense, which would diminish our financial resources.
Our spin-off was treated by ATL as a tax-free spin-off under Section 355 of the Internal Revenue Code of 1986, or the Code. If ATL were to recognize taxable gain from the
spin-off, the Internal Revenue Service, or IRS, could impose that liability on any member of the ATL consolidated group as constituted prior to the spin-off, including us. Generally, the IRS may assert that our spin-off from ATL is a taxable transaction until the
expiration of the statute of limitations applicable to ATL with respect to the spin-off transaction. The expiration of the statute of limitations with respect to the spin-off transaction depends upon the actions and tax filings of ATL and the special rules applicable
to spin-offs in general, which special rules could result in the extension of the general statute of limitations for an indefinite period of time. In the event of a tax liability, ATL has agreed to cover 85% of any such liability, unless the tax is imposed due to our
actions solely or by ATL solely, in which case, we have agreed with ATL that the party who is solely at fault shall bear all of the tax liability. We are unaware of any actions that would result in a tax liability to us under the indemnity agreement regarding the
spin-off transaction. We are aware that ATL was acquired in a transaction subsequent to the spin-off transaction, which could potentially result in the spin-off being treated as a taxable transaction, but which resulting tax liability in our view would be the sole
responsibility of ATL pursuant to our agreement with ATL. ATL may refuse, however, to indemnify us for a tax liability arising out of the spin-off transaction or may argue that it did not cause the tax liability to be imposed. In such event, we may incur a
significant expense for all or a portion of the taxes related to the spin-off.
Our articles of incorporation, bylaws, rights plan and Washington law contain provisions that could discourage a change in control.
Certain provisions of our restated articles of incorporation and bylaws, our shareholder rights plan and Washington law would make it more difficult for a third party to acquire us,
even if doing so would be beneficial for our shareholders. This could limit the price that certain investors might be willing to pay in the future for shares of our common stock. For example, certain provisions of our articles of incorporation or bylaws:
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allow our board to issue preferred stock without any vote or further action by the shareholders;
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limit the right of shareholders to act by written consent without a meeting;
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eliminate cumulative voting in the election of directors by holders of our common stock; and
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specify a minimum threshold for shareholders to call a special meeting.
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We have adopted a shareholder rights plan, which is triggered upon commencement or announcement of a hostile tender offer or when any one person or group acquires 20% or more of our
common stock. Once triggered, the rights plan would result in the issuance of preferred stock to the holders of our common stock other than the acquirer.
We are also subject to certain provisions of Washington law that could delay or make more difficult a merger, tender offer or proxy contest involving us. In particular, Chapter
23B.19 of the Washington Business Corporation Act prohibits corporations incorporated in Washington from engaging in certain business combinations with any interested shareholder for a period of five years unless specific conditions are met.
These provisions of our restated articles of incorporation, bylaws and rights plan and Washington law could have the effect of delaying, deferring or preventing a change in control
of us, including, without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock. The provisions could also limit the price that investors might be willing to pay in the future for shares of our
common stock.