UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

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

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

Commission file number: 0-24663

 

ASPECT MEDICAL SYSTEMS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		04-2985553
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

One Upland Road, Norwood, Massachusetts		02062
(Address of Principal Executive Offices)		(Zip Code)

(617) 559-7000
(Registrant’s Telephone Number, Including Area Code)

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 þ     No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o     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. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o (Do not check if smaller reporting company)		Smaller reporting company o

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

The Registrant had 17,447,499 shares of Common Stock, $0.01 par value per share, outstanding as of November 1, 2009.

 

 

ASPECT MEDICAL SYSTEMS, INC.

TABLE OF CONTENTS

		Page
PART I FINANCIAL INFORMATION		1
Item 1. Financial Statements		1
Condensed Consolidated Balance Sheets (unaudited) as of October 3, 2009 and December 31, 2008		1
Condensed Consolidated Statements of Operations (unaudited) for the Three and Nine months Ended October 3, 2009 and September 27, 2008		2
Condensed Consolidated Statements of Cash Flows (unaudited) for the Nine Months Ended October 3, 2009 and September 27, 2008		3
Notes to Condensed Consolidated Financial Statements		4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 3. Quantitative and Qualitative Disclosures About Market Risk		30
Item 4. Controls and Procedures		30
PART II OTHER INFORMATION		31
Item 1. Legal Proceedings		31
Item 1A. Risk Factors		33
Item 6. Exhibits		54
SIGNATURES
Ex-10.5 Amendment 1 to BISx Development, Purchase and License Agreement, dated August 26, 2009
Ex-10.6 Amendment 2 to OEM Deleplement and Purchase Agreement, dated July 24, 2003
Ex-31.1 Section 302 Certification of Chief Executive Officer
Ex-31.2 Section 302 Certification of Chief Financial Officer
Ex-32.1 Section 906 Certification of Chief Executive Officer
Ex-32.2 Section 906 Certification of Chief Financial Officer

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

ASPECT MEDICAL SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data and per share amounts)
(unaudited)

		October 3,				December 31,
		2009				2008
ASSETS
Current assets:
Cash and cash equivalents		$	26,816			$	12,066
Short-term investments			51,783				65,985
Accounts receivable, net of allowance of $214 at October 3, 2009 and $121 at December 31, 2008			14,298				13,193
Current portion of investment in sales-type leases			851				1,057
Inventory			8,911				7,796
Deferred tax assets			4,729				4,729
Other current assets			2,213				2,905
Total current assets			109,601				107,731
Property and equipment, net			7,530				8,319
Intangible assets, net			663				—
Restricted cash			1,103				839
Long-term investments			3,047				4,561
Long-term investment in sales-type leases			993				1,454
Deferred financing fees			1,424				1,852
Long-term deferred tax assets			10,733				12,090
Other long-term assets			1,709				128
Total assets		$	136,803			$	136,974
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	2,468			$	2,155
Accrued liabilities			13,151				13,288
Current portion of obligation under capital lease			73				71
Deferred revenue			502				236
Total current liabilities			16,194				15,750
Long-term portion of obligation under capital lease			36				100
Long-term portion of deferred revenue			69				94
Long-term debt			57,950				65,000
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $.01 par value; 5,000,000 shares authorized, no shares issued or outstanding			—				—
Common stock, $.01 par value; 60,000,000 shares authorized, 17,447,499 and 17,352,438 shares issued and outstanding at October 3, 2009 and December 31, 2008, respectively			176				176
Treasury stock, at cost; 276,493 shares			(5,008	)			(5,008	)
Additional paid-in capital			191,812				187,374
Accumulated other comprehensive loss			(12	)			(105	)
Accumulated deficit			(124,414	)			(126,407	)
Total stockholders’ equity			62,554				56,030
Total liabilities and stockholders’ equity		$	136,803			$	136,974

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

ASPECT MEDICAL SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
Revenue		$	26,235			$	24,758			$	76,428			$	74,371
Costs of revenue (1)			6,761				6,104				18,884				18,943
Gross profit			19,474				18,654				57,544				55,428
Operating expenses: (1)
Research and development			4,080				4,183				11,753				12,056
Sales and marketing			10,318				12,687				31,322				34,561
General and administrative			5,376				3,920				14,197				12,034
Total operating expenses			19,774				20,790				57,272				58,651
(Loss) income from operations			(300	)			(2,136	)			272				(3,223	)
Other income (expense):
Interest income			217				867				997				3,248
Interest expense			(443	)			(849	)			(1,355	)			(2,725	)
Gain on valuation of warrants			1,043				—				1,043				—
Realized gain on sale of investments			—				—				30				—
Other-than-temporary impairment of investments			—				(840	)			—				(840	)
Gain on repurchase of debt			—				5,881				3,049				9,821
Income before income taxes			517				2,923				4,036				6,281
Provision for income taxes			685				1,883				2,043				3,577
Net (loss) income		$	(168	)		$	1,040			$	1,993			$	2,704
Net (loss) income per share:
Basic		$	(0.01	)		$	0.06			$	0.11			$	0.16
Diluted		$	(0.01	)		$	0.06			$	0.11			$	0.16
Weighted average shares used in computing net (loss) income per share:
Basic			17,442				17,317				17,411				17,228
Diluted			17,442				23,254				17,412				17,373

(1) Stock-based compensation included in costs and expenses:
Costs of revenue		$	99			$	127			$	317			$	370
Research and development			318				489				1,124				1,445
Sales and marketing			335				627				1,267				1,972
General and administrative			508				647				1,586				1,975

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

ASPECT MEDICAL SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

		Nine Months Ended
		October 3,				September 27,
		2009				2008
Cash flows from operating activities:
Net income		$	1,993			$	2,704
Adjustments to reconcile net income to net cash provided by operating activities —
Depreciation and amortization			2,344				2,251
Gain on repurchase of debt			(3,049	)			(9,821	)
Gain on sale of investment			(30	)			—
Loss on other-than-temporary impairment of investments			—				840
Non-cash gain on valuation of warrants			(1,043	)
Provision for doubtful accounts			94				(102	)
Stock-based compensation expense			4,233				5,688
Tax benefit for stock option exercises			70				90
Deferred taxes			1,357				3,122
Changes in assets and liabilities —
Increase in accounts receivable			(1,199	)			(606	)
Increase in inventory			(1,115	)			(416	)
Decrease (increase) in other current assets			692				(554	)
Decrease in investment in sales-type leases			667				1,219
Decrease in other long-term assets			51				—
Increase (decrease) in accounts payable			313				(16	)
(Decrease) increase in accrued liabilities			(137	)			2,414
Increase in deferred revenue			241				78
Net cash provided by operating activities			5,482				6,891
Cash flows from investing activities:
(Increase) decrease in restricted cash			(264	)			155
Acquisitions of property and equipment			(1,308	)			(1,336	)
Acquisition of U.S. distribution rights for LiDCO products			(1,266	)			—
Purchases of investments			(48,919	)			(66,072	)
Proceeds from sales and maturities of investments			64,595				90,275
Net cash provided by investing activities			12,838				23,022
Cash flows from financing activities:
Proceeds from issuance of common stock			134				846
Repayment of long-term debt			(3,805	)			(14,413	)
Repayment of capital lease			(62	)			(59	)
Net cash used for financing activities			(3,733	)			(13,626	)
Effect of exchange rate changes on cash			163				(50	)
Net increase in cash and cash equivalents			14,750				16,237
Cash and cash equivalents, beginning of period			12,066				19,828
Cash and cash equivalents, end of period		$	26,816			$	36,065

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

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

(1) Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements of Aspect Medical Systems, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Quarterly Report on Form 10-Q and Regulation S-X promulgated pursuant to the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all normal, recurring adjustments considered necessary for a fair presentation have been included. The unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with the audited consolidated financial statements and accompanying notes thereto for the year ended December 31, 2008 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”). Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim period.

     The Company follows a system of fiscal quarters as opposed to calendar quarters. Therefore, the first three quarters of each fiscal year end on the Saturday of the thirteenth week of each quarter and the last quarter of the fiscal year always ends on December 31.

(2) Summary of Significant Accounting Policies

     A summary of the significant accounting policies used by the Company in the preparation of its financial statements follows:

Principles of Consolidation

     The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated.

Foreign Currency

     The functional currency of each of the Company’s international subsidiaries is the local currency of such international subsidiary. Gains and losses resulting from translation adjustments have been included as part of accumulated other comprehensive (loss) income and have not been material. Transaction gains and losses and remeasurement of foreign currency denominated assets and liabilities are included in net (loss) income and are not material.

Cash, Cash Equivalents and Investments

     The Company invests its excess cash in money market accounts, certificates of deposit, high-grade commercial paper, high grade corporate bonds and debt obligations of various government agencies. The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.

     The Company accounts for its investments in marketable securities in accordance with the Investments — Debt and Equity Securities Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification. The Company has classified all of its investments in marketable securities as available-for-sale at October 3, 2009 and December 31, 2008. The investments are reported at fair value, with any unrealized gains or losses excluded from earnings and reported as a separate component of stockholders’ equity as accumulated other comprehensive (loss) income in the accompanying condensed consolidated balance sheets. Investments that have contractual maturity dates of more than twelve months from the balance sheet date are included in long-term investments in the accompanying condensed consolidated balance sheets.

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

Revenue Recognition

     The Company primarily sells its BIS monitors through a combination of a direct sales force and distributors. The Company sells its BIS Modules to original equipment manufacturers who incorporate them into their equipment and then sell to the end user. BIS Sensors are sold through a combination of a direct sales force, distributors and original equipment manufacturers. The Company also sells the LiDCOrapid monitoring system and related products through its direct sales force as part of the distribution and technology licensing agreement with LiDCO Limited (the “LiDCO Distribution Agreement”) as discussed in footnote 6. Direct product sales are structured as sales, sales-type lease arrangements or sales under the Company’s Equipment Placement (“EP”) program. Sales, sales-type lease agreements and sales under the EP program are subject to the Company’s standard terms and conditions of sale and do not include any customer acceptance criteria, installation or other post shipment obligations (other than warranty) or any rights of return. The Company’s BIS monitor is a standard product and does not require installation as it can be operated with the instructions included in the operator’s manual.

     Revenue is recognized when persuasive evidence of an arrangement exists, product delivery has occurred or services have been rendered, the price is fixed or determinable and collectibility is reasonably assured. For product sales, revenue is not recognized until title and risk of loss have transferred to the customer. The Company’s revenue arrangements with multiple elements are divided into separate units of accounting if specified criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units.

     Under the Company’s sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. The minimum lease payment, consisting of the additional charge per BIS Sensor, less the unearned interest income, which is computed at the interest rate implicit in the lease agreement, is recorded as the net investment in sales-type leases. The Company recognizes equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period.

     In addition, the Company reviews and assesses the net realizability of its investment in sales-type leases at each reporting period. This review includes determining, on a customer specific basis, if a customer is significantly underperforming relative to the customer’s cumulative level of committed BIS Sensor purchases as required by the sales-type lease agreement. If a customer is underperforming, the Company records an allowance for lease payments as a charge to revenue to reflect the lower estimate of the net realizable investment in sales-type lease balance.

     As of October 3, 2009, the Company does not consider any sales-type lease agreement, against which an allowance for lease payments has been established, an impaired asset.

     Under the Company’s EP program, the customer is granted the right to use the BIS monitors for a mutually agreed upon period of time. During this period, the customer purchases BIS Sensors at a price that may include a premium above the list price of the BIS Sensors to cover the rental of the equipment, but without any minimum purchase commitments. At the end of the agreed upon period, the customer has the option of purchasing the BIS monitors, continuing to use them under the EP program or returning them to the Company. Under the EP program, no equipment revenue is recognized as the equipment remains the Company’s property and title does not pass to the customer and the criteria for sales-type leases are not met. The BIS monitors under the EP program are depreciated over two years and the depreciation is charged to costs of revenue. BIS Sensor revenue under the EP program is recognized either at shipment or delivery of the BIS Sensors in accordance with the agreed upon contract terms.

     The Company’s obligations under warranty are limited to repair or replacement of any product that the Company reasonably determines to be covered by the warranty. The Company records an estimate for its total warranty obligation based on historical experience and an expectation of future conditions.

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

Research and Development Costs

     The Company charges research and development costs to operations as incurred. Research and development costs include costs associated with new product business development, product improvements and extensions, clinical studies and project consulting expenses.

Allowance for Doubtful Accounts

     The Company makes estimates and judgments in determining its allowance for doubtful accounts based on the Company’s historical collections experience, historical write-offs of its receivables, current trends, credit policies and a percentage of the Company’s accounts receivable by aging category. The Company also reviews the credit quality of its customer base as well as changes in its credit policies. The Company continually monitors collections and payments from its customers and adjusts the allowance for doubtful accounts as needed.

Inventory

     The Company values inventory at the lower of cost or estimated market value, and determines cost on a first-in, first-out basis. The Company regularly reviews inventory quantities on hand and records a provision for excess or obsolete inventory primarily based on production history and on its estimated forecast of product demand. The medical device industry in which the Company markets its products is characterized by rapid product development and technological advances that could result in obsolescence of inventory. Additionally, the Company’s estimates of future product demand may prove to be inaccurate, in which case it would need to change its estimate of the provision required for excess and obsolete inventory. If revisions are deemed necessary, the Company would recognize the adjustments in the form of a charge to its costs of revenue at the time of the determination.

Warranty

     Equipment that the Company sells is generally covered by a warranty period of twelve months for direct business and up to twenty four months for distributor or OEM business. The Company accrues a warranty reserve for estimated costs to provide warranty services. The Company’s estimate of costs to service its warranty obligations is based on historical experience and an expectation of future conditions. Warranty expense, included in costs of revenue in the condensed consolidated statements of operations, for the three and nine months ended October 3, 2009 and September 27, 2008, and accrued warranty cost, included in accrued liabilities in the condensed consolidated balance sheet at October 3, 2009, were as follows:

		Three Months Ended								Nine Months Ended
		October 3, 2009				September 27, 2008				October 3, 2009				September 27, 2008
Beginning balance		$	266			$	254			$	270			$	250
Warranty expense			23				12				52				42
Deductions and other			(16	)			(11	)			(49	)			(37	)
Ending balance		$	273			$	255			$	273			$	255

Shipping and Handling Costs

     Shipping and handling costs are included in costs of revenue in the condensed consolidated statements of income.

Advertising Costs

     Advertising costs are expensed as incurred. These costs are included in sales and marketing expense in the condensed consolidated statements of operations.

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

Property and Equipment

     Property and equipment is recorded at cost and depreciated using the straight-line method over the estimated useful lives of the related property and equipment. The costs of improvements to the Company’s leased building are capitalized as leasehold improvements and amortized using the straight-line method over the shorter of the life of the lease or the useful life of the asset. Repair and maintenance expenditures are charged to expense as incurred. The Company does not develop software for internal use and the costs of software acquired for internal use are either capitalized or expensed based on the nature of the costs and the software’s stage of development.

Income Taxes

     Deferred tax assets and liabilities are recognized for the expected future tax consequences, utilizing currently enacted tax rates of temporary differences between the carrying amounts and the tax basis of assets and liabilities. Deferred tax assets are recognized, net of any valuation allowance, for the estimated future tax effects of deductible temporary differences and tax operating loss and credit carryforwards. See footnote 7 for additional disclosure relating to income taxes.

Concentration of Credit Risk

     Financial instruments that potentially expose the Company to concentrations of credit risk primarily consist of cash, cash equivalents, investments, accounts receivable and investment in sales-type lease receivables. The Company does not require collateral or other security to support financial instruments subject to credit risk. To minimize the financial statement risk with respect to accounts receivable and investment in sales-type lease receivables, the Company maintains reserves for potential credit losses and historically such losses, in the aggregate, have not exceeded the reserves established by management. The Company maintains cash and investments with various financial institutions. The Company performs periodic evaluations of the relative credit quality of investments and the Company’s policy is designed to limit exposure to any one institution or type of investment. The primary objective of the Company’s investment strategy is the safety of the principal invested. The Company does not maintain foreign exchange contracts or other off-balance sheet financial investments.

Single or Limited Source Suppliers

     The Company currently obtains certain key components of its products from single or limited sources. The Company purchases components pursuant to purchase orders, and in select cases, long-term supply agreements and generally does not maintain large volumes of inventory. The Company has experienced shortages and delays in obtaining certain components of its products in the past. The Company may experience similar shortages and delays in the future. The disruption or termination of the supply of components or a significant increase in the costs of these components from these sources could have a material adverse effect on the Company’s business, financial position, results of operations and cash flows.

Net (Loss) Income Per Share

     Basic net (loss) income per share for the three and nine months ended October 3, 2009 and September 27, 2008 were computed by dividing net (loss) income by the weighted average number of common shares outstanding during those periods and diluted net (loss) income per share was computed using the weighted average number of common shares outstanding and other dilutive securities, including stock options, unvested restricted stock and convertible debt during those periods.

     For the three and nine months ended October 3, 2009, approximately 3,017,000 and 4,444,000 respectively, of potentially dilutive instruments, consisting of common stock options and unvested restricted stock, have been excluded from the computation of diluted weighted average shares outstanding as their effect would be antidilutive. For the three and nine months ended September 27, 2008, approximately 4,602,000 and 10,757,000, respectively, of potentially dilutive instruments, consisting of common stock options, unvested restricted stock and convertible debt, have been excluded from the computation of diluted weighted average shares outstanding as their effect would be antidilutive.

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

     Basic and diluted net (loss) income per share amounts for the three and nine months ended October 3, 2009 and September 27, 2008 were determined as follows:

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
Basic:
Net (loss) income		$	(168	)		$	1,040			$	1,993			$	2,704
Weighted average shares outstanding			17,442				17,317				17,411				17,228
Basic net (loss) income per share		$	(0.01	)		$	0.06			$	0.11			$	0.16
Diluted:
Net (loss) income		$	(168	)		$	1,040			$	1,993			$	2,704
Interest expense on convertible debt, net			—				306				—				—
Net (loss) income as adjusted		$	(168	)		$	1,346			$	1,993			$	2,704
Weighted average shares outstanding			17,442				17,317				17,411				17,228
Effect of dilutive stock options and restricted stock			—				36				1				145
Conversion of convertible notes			—				5,901				—				—
Weighted average shares assuming dilution			17,442				23,254				17,412				17,373
Diluted net (loss) income per share		$	(0.01	)		$	0.06			$	0.11			$	0.16

Comprehensive Income

     Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Other than the Company’s net (loss) income, the only other element of comprehensive (loss) income impacting the Company is the unrealized gains (losses) on its investments for all periods presented and cumulative currency translation adjustments.

Stock-Based Compensation

     The Company has three stock incentive plans, one non-employee director stock option plan and an employee stock purchase plan. Stock options and restricted common stock generally vest over three to four years and provide, in certain instances, for the acceleration of vesting in connection with a change of control of the Company. Options under the stock incentive plans expire ten years from the date of grant. The Company’s stock incentive plans provide for the grant, at the discretion of the Board of Directors, of options for the purchase of up to 12,110,000 shares of common stock to employees, directors, consultants and advisors.

     The Company accounts for share-based payments to employees under the fair value recognition and measurement provisions of the Stock Compensation subtopic of the FASB Accounting Standards Codification. Compensation expense recognized during the three and nine months ended October 3, 2009 and September 27, 2008 included: (a) compensation expense for all share-based awards granted prior to, but not yet vested as of, December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”) and (b) compensation expense for all share-based awards granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R.

     On July 10, 2009, the Company’s stock option exchange offer (the “Exchange Offer”), which had been initiated in June 2009, expired. In the Exchange Offer, the Company offered eligible employees who held certain stock options, the right to exchange some or all of such outstanding eligible options for new stock options to be granted under the Company’s 2001

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

Plan. Under the terms of the Exchange Offer, “eligible options” were those granted under the Company’s 1998 Stock Incentive Plan, as amended, or its 2001 Stock Incentive Plan, as amended (the “2001 Plan”), to purchase shares of the Company’s common stock, with a per share exercise price (a) equal to or greater than $15.00 and (b) greater than the closing price of the Company’s common stock on the Nasdaq Global Market on the expiration date of the Exchange Offer. Eligible optionholders tendered, and the Company accepted for cancellation, eligible options at exercise prices of $15.00 or greater to purchase an aggregate of 1,051,357 shares of the Company’s common stock from 161 participants, representing 82.5% of the total shares underlying options eligible for exchange in the Exchange Offer. The Company has granted new options to purchase an aggregate of 312,587 shares of the Company’s common stock in exchange for the cancellation of the tendered eligible options. The exercise price per share of each new option granted in the Exchange Offer is $5.99, which is the closing price of the Company’s common stock as reported by the Nasdaq Global Market on July 10, 2009, the expiration of the Exchange Offer. The Exchange Offer represents a fair value exchange and, therefore, no incremental stock-based compensation expense was recorded.

     The Company uses the Black-Scholes option pricing methodology to calculate the grant-date fair value of an award. During the three and nine months ended October 3, 2009 and September 27, 2008, the Company calculated the grant-date fair value using the following assumptions:

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
Options granted			322				157				1,013				455
Weighted average exercise price		$	5.99			$	5.20			$	4.99			$	9.18
Weighted average grant date fair value		$	3.09			$	2.93			$	2.82			$	4.49
Assumptions:
Risk-free interest rate			2.13	%			3.64	%			2.46	%			3.22	%
Expected term		4.33 years				5.76 years				5.54 years				5.76 years
Expected volatility			64	%			58	%			62	%			51	%

     Risk-free interest rate: the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model.

     Expected term: the expected term of an employee option is the period of time for which the option is expected to be outstanding. The Company uses a Monte Carlo simulation model to estimate the assumed expected term in connection with determining the grant date valuation as it believes that this information is currently the best estimate of the expected term of a new option.

     Expected volatility: in estimating its expected volatility, the Company considers both trends in historical volatility and the implied volatility of its publicly traded stock. The Company has used a combination of its implied volatility and historical volatility to estimate expected volatility for the three and nine months ended October 3, 2009. The Company believes that in addition to the relevance of historical volatility, consideration of implied volatility is relevant since it represents the expected volatility that marketplace participants would likely use in determining an exchange price for an option, and is therefore an appropriate assumption to use in the calculation of grant date fair value.

     Expected dividend yield: this assumption is not applicable to the Company’s calculation as the Company has not declared, nor does it expect to declare in the foreseeable future, any dividends.

     Expense:

     The Company uses the straight-line attribution method to recognize expense for all option and restricted stock grants. The amount of stock-based compensation expense recognized during a period is based on the value of the portion of the awards that is ultimately expected to vest. Stock-based compensation expense is recorded on a straight-line basis over the requisite service period, which is generally the vesting period. The Company estimates forfeitures at the time of grant and revises the estimate, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. For the three and nine months ended October 3, 2009, the Company applied a forfeiture rate of approximately 7.1%. The Company’s results for the three and nine months ended October 3, 2009 include stock-based compensation expense of approximately $1,260,000 and $4,294,000, respectively, and approximately $1,890,000 and $5,762,000 in the three and nine months ended September 27, 2008, respectively. For the three and nine months ended October 3, 2009, approximately $19,000 and $61,000, respectively, of the stock-based compensation expense relates to tax on deferred compensation which is included in the condensed consolidated statement of operations within the applicable operating expense where the Company reports the option holders’ and restricted stock holders’ compensation cost. For the three and nine months ended September 27, 2008, approximately $23,000 and $74,000, respectively, of the stock-based compensation expense relates to tax on deferred compensation.

     As of October 3, 2009, total compensation cost related to unvested stock options and unvested restricted stock awards was $4,228,000 and $3,792,000, respectively, which is expected to be recognized in the statement of operations over a weighted-average period of approximately 28 months and 21 months, respectively.

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles requires management 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.

Fair Value of Financial Instruments

     The estimated fair market values of the Company’s financial instruments, which include investments, accounts receivable, investment in sales-type leases, long-term debt and accounts payable, approximate their carrying values. The fair value of warrants issued by LiDCO Group Plc to the Company is estimated using the Black-Scholes Option Pricing Model.

Recent Accounting Guidance

     In January 2009, the FASB issued updated accounting guidance on the impairment guidance to achieve a more consistent determination of whether an other-than-temporary impairment has occurred. This guidance is effective for interim and annual reporting periods ending after December 15, 2008. The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or cash flow.

     In April 2009, the FASB issued updated accounting guidance intended to provide additional guidance and enhance disclosures regarding fair value measurements and impairments of securities. The updated accounting guidance relates to determining fair values when no active market exists or where the price inputs used represent distressed sales, increase the frequency of fair value disclosures for financial instruments not currently reported on the balance sheet of companies at fair value from once a year to a quarterly basis and provides additional guidance to create greater clarity and consistency in accounting for and presenting impairment losses on securities. This guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or cash flow.

     In May 2009, the FASB issued updated accounting guidance to establish general standards of accounting for disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance is effective for financial statements issued for fiscal year and interim periods ending after June 15, 2009. The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or cash flow.

     In August 2009, the FASB issued Accounting Standards Update 2009-05, Fair Value Measurements and Disclosures (the "Update"). The objective of this Update is to provide clarification that in circumstances where a quoted price in an active market for the identical liability is not available, fair value is required to be measured using a valuation technique that uses the quoted price of the identical liability when traded as an asset or for similar liabilities or similar liabilities when traded as assets or another valuation technique with consistent principles. The Update did not have a material impact on the Company’s results of operations, financial position or cash flow.

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

(3) Comprehensive (Loss) Income

     The Company’s total comprehensive income is as follows:

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
Net (loss) income		$	(168	)		$	1,040			$	1,993			$	2,704
Other comprehensive (loss) income:
Foreign currency translation adjustments			71				(50	)			163				(50	)
Unrealized loss on investments			(23	)			(760	)			(70	)			(984	)
Comprehensive (loss) income		$	(120	)		$	230			$	2,086			$	1,670

(4) Investment in Sales-Type Leases

     The components of the Company’s net investment in sales-type leases are as follows:

		October 3,				December 31,
		2008				2009
Total minimum lease payments receivable		$	2,679			$	3,457
Less:
Unearned interest income			339				459
Allowance for lease payments			496				487
Net investment in sales-type leases			1,844				2,511
Less — current portion			851				1,057
		$	993			$	1,454

(5) Inventory

     Inventory consists of the following:

		October 3,				December 31,
		2009				2008
Raw materials		$	4,682			$	4,552
Work-in-progress			49				25
Finished goods			4,180				3,219
		$	8,911			$	7,796

(6) Intangible Assets

     On July 28, 2009, the Company signed the LiDCO Distribution Agreement. Under the terms of the Agreement, the Company will have exclusive rights to market, sell and distribute the LiDCOrapid monitoring system as well as non-exclusive rights to market, sell and distribute the LiDCOplus system in the United States. In addition, the LiDCO Distribution Agreement includes an exclusive license to integrate LiDCO and BIS^® technologies into a combined product for sale in the United States, referred to below as the “LiDCOrapid and Aspect BIS Combined Product”. The Agreement has an initial term of 10 years and will automatically renew for successive 3 year renewal terms thereafter unless and until either party gives the other party notice of its desire not to so renew at least twelve months prior to the expiration of the initial term or prior to the end of the then-current renewal term. In consideration for these rights, the Company paid an upfront license fee of approximately $1,150,000. Additionally, the Company agreed to pay a royalty to LiDCO for each combined product placed based on a formula set forth in the LiDCO Distribution Agreement. Concurrently, LiDCO Group Plc granted to the Company a warrant to purchase 8% of the outstanding shares of LiDCO Group Plc as of July 28, 2009 at an exercise price equal to a 20% premium over the average trading price of LiDCO Group plc shares

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

reported by the London Stock Exchange for the ten days prior to and the ten days after the issuance date of the warrant. For the first six months of the LiDCO Distribution Agreement, the Company’s exclusive rights under the Agreement in certain U.S. territories are subject to the exclusive rights granted by LiDCO to a third party. The warrants would become exercisable in installments over the next three years based upon the Company’s achievement of specified purchase minimums. The warrants are included in other long-term assets on the condensed consolidated balance sheets. See footnote 8 for additional disclosure. The LiDCO Distribution Agreement was accounted for as an asset acquisition in accordance with the Business Combinations Topic of the FASB Accounting Standards Codification.

     The Company acquired the following intangible assets:

		Acquisition
		Amount
Exclusive Product Distribution Rights — LiDCOrapid and Aspect BIS Combined Product		$	562,000
Customer Relationships			116,000
		$	678,000

     The costs of the intangible assets are based on fair values at the date of acquisition and are being amortized on a straight-line basis over their estimated useful lives, which range from 3.7 to 6.3 years. The Company recorded approximately $14,000 of amortization expense in the three and nine month period ended October 3, 2009. The Company expects to record approximately $88,000 of amortization expense in 2010 through 2012 and $67,000 in 2013.

(7) Income Taxes

     The Company is subject to income taxes in numerous jurisdictions and at various rates worldwide and the use of estimates is required in determining the provision for income taxes. For the three and nine months ended October 3, 2009, the Company recorded a tax provision of $685,000 and $2,043,000 on income before taxes of $517,000 and $4,036,000, respectively. Included in the income tax provision for the three months ended October 3, 2009 is approximately $570,000 resulting from the cumulative correction of immaterial errors from prior periods related to international tax matters which were not previously considered in the income tax provision. The Company does not believe that these previously unrecorded amounts were material to the results of operations or the financial position of the Company for any interim period in 2007, 2008 or year to date 2009. The provision for income taxes was the result of applying an effective income tax rate of 132% and 51% to income before tax for the three and nine months ended October 3, 2009, respectively. For the three and nine months ended October 3, 2009, the difference between the effective tax rate and the U.S. federal statutory income tax rate of 34% was due mainly to the impact of state income taxes, the disallowance for tax purposes of certain stock-based compensation deductions, a taxable gain on the repurchase of the Company’s convertible debt, the correction of a prior period immaterial error of $570,000, associated with Internal Revenue Code Section 956 income inclusion and the tax treatment for the gain on warrant valuations. For the three and nine months ended September 27, 2008, the Company recorded a tax provision of $1,883,000 and $3,577,000, on income before taxes of $2,923,000 and $6,281,000, resulting in an effective income tax rate of 64% and 57%, respectively.

     In the first quarter of 2008, the Company recorded a valuation allowance of approximately $257,000 for a portion of its federal research and development credits since these credits are expected to expire unused based on current projections. In addition, in the third quarter of 2008, the Company recorded a valuation allowance on a capital loss related to its commercial paper investments since it did not anticipate that it would be able to benefit from this loss in the near future. In the third quarter of 2009, the Company recorded a valuation allowance of approximately $251,000 for a portion of the Company’s foreign tax credits generated in 2007 and 2008 since it does not expect that it will be able to utilize the credits before expiration. The Company also released a valuation allowance of approximately $97,000, which was related to federal research and development credits that expired unutilized. As of October 3, 2009, the Company’s total cumulative valuation allowance was approximately $961,000.

     As of January 1, 2009, the Company had gross unrecognized tax benefits of $805,000 (net of the federal benefit on state issues), which represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in any future periods. The Company classifies interest and penalties related to unrecognized tax benefits as

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

income tax expense. There were no significant changes to any of these amounts during the third quarter of 2009. The Company does not reasonably estimate that the unrecognized tax benefit will change significantly within the next twelve months.

     The Company and one of its subsidiaries files income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. The Company is generally no longer subject to income tax examinations by U.S. federal, state and local or non-U.S. income tax examinations by tax authorities for years before 1993.

(8) Fair Value Measurements

     Available-for-sale investments at October 3, 2009 and December 31, 2008 consist of the following:

		Amortized				Unrealized				Unrealized
		Cost				Gains				Losses				Fair Value
October 3, 2009 —
U.S. Government debt securities		$	48,642			$	60			$	(4	)		$	48,698
Corporate obligations			5,803				37				—				5,840
Certificates of deposit			1,396				—				—				1,396
		$	55,841			$	97			$	(4	)		$	55,934
December 31, 2008 —
U.S. Government debt securities		$	50,952			$	323			$	—			$	51,275
Corporate obligations			13,200				—				(207	)			12,993
Commercial paper			5,953				46				—				5,999
Certificates of deposit			279				—				—				279
		$	70,384			$	369			$	(207	)		$	70,546

     All available-for-sale investments have contractual maturities of one to two years.

     The Company evaluates its investments with unrealized losses for other-than-temporary impairment. When assessing investments for other-than-temporary declines in value, the Company considers such factors as, among other things, how significant the decline in value is as a percentage of the original cost, how long the market value of the investment has been less than its original cost, the Company’s ability and intent to hold the investment until a recovery of fair value and whether it is more likely than not that the Company will be required to sell the investment before recovery of the investment’s amortized cost basis and market conditions in general.

     For the nine months ended October 3, 2009, the Company disposed of certain investments, resulting in gross realized gains of approximately $30,000. The cost of securities sold is determined based on the specific identification method for purposes of recording realized gains and losses.

     The aggregate fair value of investments with unrealized losses was approximately $6,024,000 at October 3, 2009. At October 3, 2009, three investments were in an unrealized loss position. All such investments have been in an unrealized loss position for less than a year and these losses are considered temporary. The Company has the ability and intent to hold these investments until a recovery of fair value.

     The Fair Value and Disclosures Topic of the FASB Accounting Standards Codification defines and establishes a framework for measuring fair value and expands disclosure about fair value measurements. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as follows: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities; Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3 inputs are unobservable inputs that reflect the Company’s own assumptions about the assumptions market participants would use in pricing the asset or liability.

     Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company has classified its financial assets and liabilities that are required to be measured at fair value as of October 3, 2009 as follows:

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

		Fair Value Measurements at October 3, 2009
		Balance at
		October 3, 2009				Level 1				Level 2				Level 3
Money market funds		$	18,683			$	18,683			$	—			$	—
Available for sale securities		$	54,537			$	—			$	54,537			$	—
Warrants		$	1,632			$	—			$	—			$	1,632

     In connection with the LiDCO Distribution Agreement (footnote 6), LiDCO Group Plc issued warrants to the Company to purchase shares of its common stock in an amount equal to 8% of the outstanding shares of LiDCO Group Plc as of July 28, 2009 at an exercise price equal to a 20% premium over the average trading price of LiDCO Group plc shares reported by the London Stock Exchange for the ten days prior to and the ten days after the issuance date of the warrant. The fair value of these warrants is estimated using the Black-Scholes Option Pricing Model. The following table summarizes the beginning and ending balance for the warrants:

		Warrants
Balance at July 28, 2009		$	589
Total gains included in other income			1,043
Balance at October 3, 2009		$	1,632

(9) Segment Information and Enterprise Reporting

     The Company operates in one reportable segment as it markets and sells anesthesia and hemodynamic monitoring systems. The Company does not disaggregate financial information by product or geographically, other than sales by region and sales by product, for management purposes. Substantially all of the Company’s assets are located within the United States. All of the Company’s BIS products are manufactured in the United States.

     Revenue by geographic region and as a percentage of total revenue by geographic region is as follows:

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
Geographic Area by Region
Domestic		$	18,418			$	17,337			$	52,506			$	51,747
International		$	7,817			$	7,421			$	23,922			$	22,624
Total		$	26,235			$	24,758			$	76,428			$	74,371

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
Geographic Area by Region
Domestic			70	%			70	%			69	%			70	%
International			30				30				31				30
Total			100	%			100	%			100	%			100	%

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

     The Company did not have sales in any individual country, other than the United States, or to any individual customer, that accounted for more than 10% of the Company’s total revenue or accounts receivable for the three and nine months ended October 3, 2009 and September 27, 2008.

(10) Commitments and Contingencies

     Leases

     In February 2006, the Company entered into a lease agreement pursuant to which the Company agreed to lease approximately 136,500 square feet of research and development, sales and marketing, production and general and administrative space in Norwood, Massachusetts. The lease expires in December 2016, and the Company has been granted the option to extend the term for three additional five-year periods. In connection with this lease, the Company provided an original security deposit in the amount of $911,000 to the lessor in accordance with the terms of the lease agreement. This security deposit was subsequently reduced to $759,000 in 2008. This lease is classified as an operating lease. The lease contains a rent escalation clause that requires additional rental amounts in the later years of the term. Rent expense is being recognized on a straight-line basis over the minimum lease term.

     Legal Proceedings

     The Company is aware of three putative class action lawsuits related to the Offer and the Merger discussed in footnote 14 below, as follows:

     (i) On October 6, 2009, a putative class action complaint, Albert Donnay v. Nassib Chamoun, et al., Civil Action No. 09-4249-BLS, was filed in the Massachusetts Superior Court for Suffolk County, Business Litigation Session. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, certain of its directors, United States Surgical Corporation, and Transformer Delaware Corp. as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value and failing to engage in a fair sale process. The complaint also alleges that Aspect, United States Surgical Corporation and Transformer Delaware Corp. aided and abetted the alleged breaches of fiduciary duties by certain of Aspect’s directors. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger. On October 8, 2009, Aspect and the individual defendants filed an answer in which they have denied the allegations, and they also served a motion to dismiss and/or for judgment on the pleadings. On October 16, 2009, Aspect and the individual defendants filed a motion to stay the action. On October 19, 2009, the plaintiff filed a motion to amend the complaint to add claims asserting that Aspect and the individual defendants failed to disclose in SEC filings material information regarding the Merger.

     (ii) On October 13, 2009, a second putative class action complaint, Roland A. Cherwek v. Aspect Medical Systems, Inc., et al. was filed in Delaware Chancery Court. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, its directors, United States Surgical Corporation, Transformer Delaware Corp., and Covidien plc as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value, failing to engage in a fair sale process, and failing to disclose in SEC filings material information regarding the Merger. The complaint also alleges that Aspect, United States Surgical Corporation, Transformer Delaware Corp., and Covidien plc aided and abetted the alleged breaches of fiduciary duties by Aspect’s directors. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger and damages in an unspecified amount. On October 26, 2009, plaintiff (on behalf of himself and the members of the putative class) and all defendants entered into a memorandum of understanding reflecting an agreement in principle to settle the matter. The agreement in principle is subject to the parties reaching agreement on the terms of a mutually acceptable definitive settlement agreement. Thereafter, the settlement agreement will be subject to approval by the court and also conditioned upon consummation of the Merger.

     (iii) On October 14, 2009, a third putative class action complaint, Milton Pfeiffer v. Nassib Chamoun, et al., Case No. 09-4377-BLS, was filed in the Massachusetts Superior Court for Suffolk County, Business Litigation Session. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, certain of its directors, United States Surgical Corporation, and Transformer Delaware Corp. as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value, failing to engage in a fair sale process, and failing to disclose in SEC filings material information regarding the Merger. The complaint also alleges that Aspect, United States Surgical Corporation and Transformer Delaware Corp. aided and abetted the alleged breaches of fiduciary duties by the Aspect directors named in the action. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger and damages in an unspecified amount. On October 16, 2009, Aspect and the individual defendants filed a motion to stay the action.

     On October 10, 2007, a purported holder of the Company’s common stock (the plaintiff), filed suit in the U.S. District Court for the Western District of Washington against Morgan Stanley and Deutsche Bank AG, the lead underwriters of the Company’s 2000 initial public offering, alleging violations of Section 16(b) of the Securities Exchange Act of 1934 (the “Exchange Act”). The complaint alleges that the combined number of shares of the Company’s common stock beneficially owned by the lead underwriters and certain of the Company’s unnamed officers, directors, and principal stockholders exceeded ten percent of the Company’s outstanding common stock from the date of its initial public offering on January 28, 2000, through at least January 27, 2001. The complaint further alleges that those entities and individuals were subject to the reporting requirements of Section 16(a) of the Exchange Act and the short-swing trading prohibition of Section 16(b) of the Exchange Act, and failed to comply with those provisions. The complaint seeks to recover from the lead underwriters any “short-swing profits” obtained by them in violation of Section 16(b) of the Exchange Act. The Company was named as a nominal defendant in the action, but has no liability for the asserted claims. None of its directors or officers serving in such capacities at the time of its initial public offering (many of whom still serve as officers or directors of the Company) was named as defendants in this action. On February 25, 2008, the plaintiff filed an amended complaint asserting substantially similar claims as those set forth in the initial complaint. On July 25, 2008, the Company joined with 29 other issuers to file the Issuer Defendants’ Joint Motion to Dismiss. The plaintiff filed her opposition on September 8, 2008, and the Company and the other Issuer Defendants filed their Reply in Support of their Joint Motion to Dismiss on October 23, 2008. Oral argument on the Joint Motion to Dismiss was held on January 16, 2009.

     On March 12, 2009, the Court granted the Issuer Defendants’ Joint Motion to Dismiss, dismissing the complaint without prejudice on the grounds that the plaintiff had failed to make an adequate demand on the Company prior to filing her complaint. In its order, the Court stated it would not permit the plaintiff to amend her demand letters while pursuing her claims in the litigation. Because the Court dismissed the case on the grounds that it lacked subject matter jurisdiction, it did not specifically reach the issue of whether the plaintiff’s claims were barred by the applicable statute of limitations. However, the Court also granted the Underwriters’ Joint Motion to Dismiss with respect to cases involving non-moving issuers, holding that the cases were barred by the applicable statute of limitations because the issuers’ shareholders had notice of the potential claims more than five years prior to filing suit.

     The plaintiff filed a Notice of Appeal on April 10, 2009, and the underwriters subsequently filed a Notice of Cross-Appeal, arguing that the dismissal of the claims involving the moving issuers should have been with prejudice because the claims were untimely under the applicable statute of limitations. The plaintiff’s opening brief in the appeal was filed on August 26, 2009; the Company and the underwriters’ responses and the underwriters’ brief in support of their cross-appeal was filed on October 2, 2009; the plaintiff’s reply brief and opposition to the cross-appeal was filed on November 2, 2009; and the underwriters’ reply brief in support of their cross-appeals is due on November 17, 2009. The Company currently believes that the outcome of this litigation will not have a material adverse impact on its consolidated financial position and results of operations.

(11) Loan Agreements

     The Company is entitled to borrow up to $2,000,000 under a revolving line of credit, which expires in May 2010. The line of credit may be extended on an annual basis at the discretion of the commercial bank. Interest on any borrowings under the revolving line of credit is, at the election of the Company, either the prime rate or at the London Inter-Bank Offer Rate, or LIBOR, plus 2.25%. Up to $1,500,000 of the $2,000,000 revolving line of credit is available for standby letters of credit. At October 3, 2009, the Company had outstanding standby letters of credit with the commercial bank of approximately $1,081,000. At October 3, 2009, there was no outstanding balance under this revolving line of credit.

     The revolving line of credit agreement contains restrictive covenants that require the Company to maintain liquidity and net worth ratios and is secured by certain investments of the Company, which are shown as restricted cash in the accompanying condensed consolidated balance sheets. The Company is required to maintain restricted cash in an amount equal to 102% of

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

the outstanding amounts under the revolving line of credit agreement. At October 3, 2009, the Company had $1,103,000 classified as restricted cash on the condensed consolidated balance sheet relating to standby letters of credit issued in connection with the Company’s leased building in Massachusetts, leased computers and an international service provider. At October 3, 2009, the Company was in compliance with all covenants contained in the revolving line of credit agreement.

     In March 2009, a bank guarantee of approximately $155,000 was given by an international bank to the State of the Netherlands on the Company’s behalf related to tax services for a subsidiary.

(12) Convertible Debt

     During the first quarter of 2009, the Company repurchased an aggregate of $7,050,000 of its 2.5% convertible notes for total consideration of $3,805,000, plus accrued interest of approximately $28,000 through the dates of repurchase. As a result of these transactions, the Company recorded a gain on debt repurchase of $3,049,000 in the first quarter of 2009, which is net of the write-off of the ratable portion of unamortized deferred financing fees.

(13) Stock Repurchase Program

     On August 3, 2006, the Company’s Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company’s common stock through the open market or in privately negotiated transactions. The repurchase program may be suspended or discontinued at any time. There were no repurchases under this plan in 2008 or during the nine months ended October 3, 2009. As of October 3, 2009, the Company has repurchased a total of 276,493 shares of common stock under this repurchase program for $5,008,000. Repurchased shares are held in treasury pending use for general corporate purposes, including issuances under various employee stock plans. As of October 3, 2009, the Company is authorized to repurchase an additional 1,723,507 shares of common stock in the future, provided however that any such repurchase would require the consent of the Parent and the Purchaser under the Merger Agreement as defined in footnote 14 below.

(14) Merger Agreement

     On September 27, 2009, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with United States Surgical Corporation, a Delaware corporation (“Parent”), and Transformer Delaware Corp., a Delaware corporation and a wholly-owned subsidiary of Parent (“Purchaser”). Parent and Purchaser are wholly-owned subsidiaries of Covidien plc. Pursuant to the Merger Agreement, on October 8, 2009, the Purchaser commenced a tender offer (the “Offer”) to acquire all of the outstanding shares of common stock of the Company at a purchase price of $12.00 per share (the “Offer Price”) net to the holder in cash, without interest thereon, subject to any required withholding of taxes, upon the terms and subject to the conditions set forth in the Offer to Purchase, dated October 8, 2009, and the related Letter of Transmittal, each as amended or supplemented from time to time.

     The initial offering period for the Offer expired at 12:00 midnight, New York City time, at the end of Thursday, November 5, 2009. According to the depositary for the Offer, as of the expiration of the initial offering period, 16,195,245 shares of the Company’s common stock had been tendered, representing approximately 90% of the Company’s outstanding shares of common stock (not including 297,066 shares of common stock tendered under guaranteed delivery procedures). Purchaser has accepted for payment all shares of the Company’s common stock that were validly tendered and not withdrawn during the initial offering period, in accordance with the terms of the Offer. The Company has been advised that shares validly tendered in satisfaction of guaranteed delivery procedures will also be accepted for payment and promptly paid for. Pursuant to the Merger Agreement, promptly upon acceptance for payment of, and payment for, the tendered shares of the Company’s common stock in the Offer, Purchaser has the right to designate a number of individuals to the Company’s board of directors.

     Purchaser intends to complete its acquisition of the Company as promptly as practicable by means of a merger under Delaware law (“Merger”). As a result of its purchase of shares in the Offer and its exercise of its option to purchase newly acquired shares from the Company, Purchaser has sufficient voting power to approve the Merger without the affirmative vote of any other stockholder of the Company. As a result of such merger, the Company will become an indirect wholly-owned subsidiary of Covidien and each share of the Company’s outstanding common stock will be cancelled and (except for shares held by the Company, Purchaser or Parent, or by holders who properly exercise their

ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)

appraisal rights under Delaware law) will be converted into the right to receive the same consideration, without interest, received by holders who tendered shares in the tender offer. Following the effective time of the Merger, the Company’s common stock will cease to be traded on Nasdaq.

     The Merger Agreement provides that all options to purchase common stock that are outstanding immediately prior to the effective time of the Merger (“Effective Time”), whether vested or unvested, will become fully vested and be cancelled immediately prior to the Merger in exchange for a cash payment to be made by Purchaser as soon as practicable following the Effective Time (but in no event later than 10 business days thereafter) equal to the excess of the Offer Price over the exercise price of the option, multiplied by the number of shares of common stock underlying the option. Options with exercise prices greater than or equal to the Offer Price will be cancelled without any payment being made in respect thereof. Each share of Company restricted stock outstanding immediately prior to the Effective Time shall become fully vested and free of any vesting or other restrictions immediately prior to the Effective Time. As a result, all restricted stock will be treated in a manner consistent with the other shares of common stock and will be converted into the right to receive $12.00 in cash in connection with the Merger.

(15) Subsequent Event

     The Company has evaluated subsequent events for potential recognition and/or disclosure through November 6, 2009, the date the consolidated financial statements were issued.

     On October 26, 2009, the Company entered into a memorandum of understanding with respect to the class action complaint, Roland A. Cherwek v. Aspect Medical Systems, Inc., et al. Please refer to footnote 10 for additional information.

     The initial offering period for the Offer expired at 12:00 midnight, New York City time, at the end of Thursday, November 5, 2009. According to the depositary for the Offer, as of the expiration of the initial offering period, 16,195,245 shares of the Company’s common stock had been tendered, representing approximately 90% of the Company’s outstanding shares of common stock (not including 297,066 shares of common stock tendered under guaranteed delivery procedures). Purchaser has accepted for payment all shares of the Company’s common stock that were validly tendered and not withdrawn during the initial offering period in accordance with the terms of the Offer. Please refer to footnote 14 for additional information about the Offer and the Merger.

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

Agreement and Plan of Merger

     On September 27, 2009, we entered into an Agreement and Plan of Merger, or Merger Agreement, with United States Surgical Corporation, a Delaware corporation, which we refer to herein as Parent, and Transformer Delaware Corp., a Delaware corporation and a wholly-owned subsidiary of Parent, which we refer to herein as Purchaser. Parent and Purchaser are wholly-owned subsidiaries of Covidien plc. Pursuant to the Merger Agreement, Purchaser has completed a cash tender offer for all of our outstanding common stock at a purchase price of $12.00 per share. The tender offer expired at 12:00 midnight at the end of November 5, 2009, after which Purchaser accepted and paid for all shares validly tendered and not withdrawn at the time, representing approximately 90% of our outstanding common stock (not including 297,066 shares of common stock tendered under guaranteed delivery procedures). Pursuant to the terms of the Merger Agreement, Purchaser exercised its option to purchase newly issued shares from us at the tender offer price. Following the purchase, Purchaser owned sufficient shares to effect a short-form merger with and into Aspect, which will then become an indirect wholly owned subsidiary of Covidien (the “Merger”). We expect that Purchaser will complete the Merger as soon as practicable . For a further discussion of the Offer and the Merger, refer to footnote 14 of the notes to our condensed consolidated financial statements included in this quarterly report on Form 10-Q.

Overview

     We develop, manufacture and market an anesthesia monitoring system that we call the BIS^® system. The BIS system is based on our patented core technology, the Bispectral Index, which we refer to as the BIS index. The BIS system provides information that allows clinicians to assess and manage a patient’s level of consciousness in the operating room, intensive care and procedural sedation settings and is intended to assist the clinician in better determining the amount of anesthesia or sedation needed by each patient. Our proprietary BIS system includes: our BIS monitor; BIS Module Kit, which includes components of BIS monitoring technology that are integrated into equipment sold by original equipment manufacturers, or BISx system, which allows original equipment manufacturers to incorporate the BIS index into their monitoring products; and our group of sensor products, which we collectively refer to as BIS Sensors. On July 28, 2009, we entered into a distribution and technology licensing agreement with LiDCO Limited, which we refer to as the LiDCO Distribution Agreement. Under the terms of the agreement, we obtained exclusive rights to market, sell and distribute the LiDCOrapid monitoring system as well as non-exclusive rights to market, sell and distribute the LiDCOplus system in the United States. In addition, the agreement includes an exclusive license to integrate LiDCO and BIS^® technologies into a combined product for sale in the United States.

     We derive our revenue primarily from sales of BIS Sensors and from our original equipment manufacturer products (including BIS Module Kits and the BISx system) and related accessories, and BIS monitors, which we collectively refer to as Equipment. In addition, our domestic revenue also includes sales of LiDCO Smart Cards as part of the LiDCO Distribution Agreement. We refer to revenue from sales of the LiDCOrapid monitoring systems and related products as “LiDCO revenue”. To assist management in assessing and managing our business, we segregate our revenue by sales by region and sales by products, as shown in the following table:

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
		(dollars in thousands)
Domestic revenue		$	18,418			$	17,337			$	52,506			$	51,747
Percent of total revenue			70	%			70	%			69	%			70	%
International revenue		$	7,817			$	7,421			$	23,922			$	22,624
Percent of total revenue			30	%			30	%			31	%			30	%
Total revenue		$	26,235			$	24,758			$	76,428			$	74,371
BIS Sensor revenue		$	21,814			$	20,788			$	64,927			$	62,819
Percent of total revenue			83	%			84	%			85	%			84	%
Equipment revenue		$	4,345			$	3,970			$	11,425			$	11,552
Percent of total revenue			17	%			16	%			15	%			16	%
LiDCO revenue		$	76				—			$	76				—
Percent of total revenue			—				—				—				—
Total revenue		$	26,235			$	24,758			$	76,428			$	74,371

     At October 3, 2009, we had cash, cash equivalents, restricted cash and investments of approximately $82.7 million and working capital of approximately $93.4 million.

     We follow a system of fiscal quarters as opposed to calendar quarters. Under this system, the first three quarters of each fiscal year end on the Saturday of the thirteenth week of each quarter and the last quarter of the fiscal year always ends on December 31.

     We believe our ability to grow our revenue is directly related to whether our customers continue to purchase and use our BIS Sensors after they purchase our Equipment. As we seek to continue to achieve this growth, we have expanded our sales forces and have implemented new sales and marketing programs. We expect that as we seek to grow our business, revenue from the sale of BIS Sensors will contribute an increasing percentage of product revenue. Additionally, we believe that, over time, revenue from the sale of BIS Module Kits and our BISx system will increase as a percentage of total Equipment revenue as healthcare organizations purchase our technology as part of an integrated solution offered by our original equipment manufacturers. We also expect revenue from our LiDCO Distribution Agreement to contribute to product revenue as we continue to incorporate LiDCO’s advanced hemodynamic monitoring system into our product portfolio.

     In order to sustain profitability, we believe that we need to continue to maintain our gross profit and control the growth of our operating expenses. To maintain our gross profit, we believe we must continue to focus on maintaining our average unit sales prices of our BIS Sensors, increasing revenue from the sale of BIS Sensors as a percentage of total revenue, as BIS Sensors have a higher gross profit than Equipment, and continuing to reduce the costs of manufacturing our products.

     For those healthcare organizations desiring to acquire our BIS monitors directly from us, we offer two primary options. Our customers have the option either to purchase BIS monitors outright or to acquire BIS monitors pursuant to a sales-type lease agreement whereby the customer contractually commits to purchase a minimum number of BIS Sensors per BIS monitor per year. Under our sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. We also grant these customers an option to purchase the BIS monitors at the end of the term of the agreement, which is typically three to five years. We recognize Equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period.

     We also offer customers the opportunity to use the BIS monitors under our Equipment Placement program, which we refer to as the EP program. Under the EP program, the customer is granted the right to use the BIS monitors for a mutually agreed upon period of time. During this period, the customer purchases BIS Sensors at a price that may include a premium above the list price of the BIS Sensors to cover the rental of the equipment, but without any binding minimum purchase commitments. At the end of the agreed upon period, the customer has the option of purchasing the BIS monitors, continuing to use them under the EP program or returning them to us.

     We have subsidiaries in The Netherlands, United Kingdom, Germany and France to facilitate the sale of our products into the international market. We are continuing to develop our international sales and distribution program through a combination of distributors and marketing partners, including companies with which we have entered into original equipment manufacturer relationships.

     We are party to a distribution agreement with Nihon Kohden Corporation to distribute BIS monitors in Japan. Nihon Kohden has received approval from the Japanese Ministry of Health, Labor and Welfare for marketing in Japan our A-1050 EEG Monitor with BIS, our A-2000 BIS Monitor, our BIS module (our product that integrates BIS monitoring technology into equipment sold by original equipment manufacturers), our BIS XP system and, most recently in December 2007, our BISx and the BIS VISTA monitor. In January 2002, the Japanese Ministry of Health, Labor and Welfare granted reimbursement approval for use of our BIS monitors. With this approval, healthcare providers in Japan are eligible to receive partial reimbursement of 1,000 Yen each time BIS monitoring is used. Sales to Nihon Kohden represented approximately 16% and 15% of international revenue in the three and nine months ended October 3, 2009, respectively, and approximately 15% of international revenue in both the three and nine months ended September 27, 2008.

     We account for share-based payments to employees under the Stock Compensation subtopic of the Accounting Standards Codification of the Financial Accounting Standards Board, or FASB. For the three and nine months ended October 3, 2009, we recognized approximately $1.3 million and $4.3 million, respectively, of stock-based compensation expense in our condensed consolidated statements of income and in the three and nine months ended September 27, 2008, we recognized approximately $1.9 million and $5.8 million, respectively, of stock-based compensation expense. See Note 2 of the Notes to our Condensed Consolidated Financial Statements contained in Item 1 of this Quarterly Report on Form 10-Q for further information regarding stock-based compensation.

     Various factors may adversely affect our quarterly operating results at least through the fourth quarter of 2009. For example, a third party study that was published in March 2008 in the New England Journal of Medicine compared BIS monitoring with a protocol based on end-tidal gas anesthetic in a patient population considered to be at high risk of awareness and concluded that, based upon a similar occurrence of awareness in both groups, no benefit of BIS monitoring was demonstrated. While the study results were consistent with earlier studies that showed a low incidence of awareness using BIS, we believe the conclusions drawn by the authors are not supported by their data and that there were several flaws in the design and execution of the trial. However, we believe that the publication of this study has had, and may continue to have an adverse effect on the rate at which existing or potential new customers purchase and use our products. We have also expanded our sales force and expect that the resulting increase in operating expenses would not be offset, at least initially, by an increase in revenue. Additionally, we face risks beyond our control presented by the continued challenges of the U.S. and worldwide economies, the healthcare industry, hospital purchases and our business. On September 27, 2009, we entered into the Merger Agreement, and sales of our products may be adversely affected as a result of our agreement to be acquired by an affiliate of Covidien pursuant to the terms of the Merger Agreement.

Critical Accounting Policies and Estimates

     Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Note 2 of the Notes to Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q includes a summary of our significant accounting policies and methods used in the preparation of our financial statements. In preparing these financial statements, we have made estimates and judgments in determining certain amounts included in the financial statements. The application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. We do not believe there is a significant likelihood that materially different amounts would be reported under different conditions or using different assumptions. We believe that our critical accounting policies and estimates are as follows:

Revenue Recognition

     We sell our BIS monitors primarily through a combination of a direct sales force and distributors. We sell our BIS modules to original equipment manufacturers who incorporate them into their equipment and sell to the end user. BIS Sensors are sold through a combination of a direct sales force, distributors and original equipment manufacturers. Direct product sales are structured as sales, sales-type lease arrangements or sales under our EP program. Revenue is recognized when persuasive evidence of an arrangement exists, product delivery has occurred or services have been rendered, the price is fixed or determinable and collectibility is reasonably assured. For product sales, revenue is not recognized until title and risk of loss have transferred to the customer.

     Under our sales-type leases, customers purchase BIS Sensors and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term of the agreement. The minimum lease payment, consisting of the additional charge per BIS Sensor, less the unearned interest income, which is computed at the interest rate implicit in the lease, is recorded as the net investment in sales-type leases. We recognize Equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period it is acquired. We review and assess the net realizability of our investment in sales-type leases at each reporting period. This review includes determining, on a customer specific basis, if a customer is significantly underperforming relative to the customer’s cumulative level of committed BIS Sensor purchases as required by the sales-type lease agreement. If a customer is underperforming, we record an allowance for lease payments as a charge to revenue to reflect the lower estimate of the net realizable investment in sales-type lease balance. Changes in the extent of underperformance in the agreements could increase or decrease the amount of revenue recorded in future periods.

     We recognize revenue either at shipment or delivery in accordance with the agreed upon contract terms with distributors and original equipment manufacturers. Contracts executed for sales to distributors and original equipment manufacturers include a clause that indicates that customer acceptance is limited to confirmation that our products function in accordance with our applicable product specifications in effect at the time of delivery. Formal acceptance by the distributor or original equipment manufacturer is not necessary to recognize revenue provided that we objectively demonstrate that the criteria specified in the acceptance provisions are satisfied. Each product is tested prior to shipment to ensure that it meets the applicable product specifications in effect at the time of delivery. Additionally, we have historically had a minimal number of defective products shipped to distributors and original equipment manufacturers, and any defective products are subject to repair or replacement under warranty as distributors and original equipment manufacturers do not have a right of return.

     We exercise judgment in determining the specific time periods in which we can recognize revenue in connection with sales of our products. To the extent that actual facts and circumstances differ from our initial judgments, our revenue recognition could change accordingly and any such change could affect our reported results.

   Stock-Based Compensation

     The Stock Compensation Topic of the FASB Accounting Standards Codification requires that stock-based compensation expense associated with equity instruments be recognized in the consolidated statement of income. Determining the amount of stock-based compensation to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock options. We calculate the grant-date fair values using the Black-Scholes valuation methodology. The use of valuation models requires us to make estimates of the following assumptions:

Risk-free interest rate: the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model.

Expected term: the expected term of an employee option is the period of time for which the option is expected to be outstanding. We use a Monte Carlo simulation model to estimate the assumed expected term for the grant date valuation as we believe that this information is currently the best estimate of the expected term of a new option.

Expected volatility: in estimating expected volatility, we consider both trends in historical volatility and the implied volatility of our publicly traded stock. We used a combination of our implied volatility and historical volatility to estimate expected volatility for the three and nine months ended October 3, 2009. We believe that in addition to the relevance of historical volatility, consideration of implied volatility is appropriate since it represents the expected volatility that marketplace participants would likely use in determining an exchange price for an option, and is therefore an appropriate assumption to use in the calculation of grant date fair value.

     Additionally, we are required to make assumptions regarding the forfeiture rate, which we estimate at the time of grant and revise, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We used a forfeiture rate of approximately 7.1% in our calculation at October 3, 2009. We re-evaluate this forfeiture rate on a quarterly basis and adjust the rate as necessary.

     These assumptions involve significant judgment and estimates. Future stock-based compensation expense could vary significantly from the amount recorded in the current period due to changes in assumptions and due to the extent of stock option activity and restricted stock issued in future periods.

     As of October 3, 2009, the total unrecognized compensation cost related to unvested stock options and unvested restricted stock awards was $4,228,000 and $3,792,000 respectively, which will be amortized over the weighted average remaining requisite service of 28 months and 21months, respectively.

   Allowance for Doubtful Accounts

     We determine our allowance for doubtful accounts by making estimates and judgments based on our historical collections experience, current trends, historical write-offs of our receivables, credit policy and a percentage of our accounts receivable by aging category. We also review the credit quality of our customer base as well as changes in our credit policies. We continuously monitor collections and payments from our customers. While credit losses have historically been within our expectations and the provisions established, our credit loss rates in the future may not be consistent with our historical experience. To the extent that we experience a deterioration in our historical collections experience or increased credit losses, bad debt expense would likely increase in future periods.

   Inventories

     We value inventory at the lower of cost or estimated market value, and determine cost on a first-in, first-out basis. We regularly review inventory quantities on hand and record a provision for excess or obsolete inventory primarily based on production history and on our estimated forecast of product demand. The medical device industry in which we market our products is characterized by rapid product development and technological advances that could result in obsolescence of inventory. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we would need to change our estimate of the provision required for excess or obsolete inventory. If revisions are deemed necessary, we would recognize the adjustments in the form of a charge to costs of revenue at the time of the determination. Therefore, although we continually update our forecasts of future product demand, any significant unanticipated declines in demand or technological developments, such as the introduction of new products by our competitors, could have a significant negative impact on the value of our inventory, results of operations and cash flows in future periods.

   Warranty

     Equipment that we sell is generally covered by a warranty period of twelve months for direct business and up to twenty four months for distributor or OEM business. We accrue a warranty reserve for estimated costs to provide warranty services. Our estimate of costs to service its warranty obligations is based on historical experience and an expectation of future conditions. While our warranty costs have historically been within our expectations and the provisions established, to the extent we experience an increased number of warranty claims or increased costs associated with servicing those claims, our warranty expenses will increase, and we may experience decreased gross profit and cash flow.

Income Taxes

     Our provision for income taxes is composed of a current and a deferred portion. The current income tax provision is calculated as the estimated taxes payable or refundable on tax returns for the current year. The deferred income tax provision is calculated for the estimated future tax effects attributable to temporary differences and carryforwards using expected tax rates in effect in the years during which the differences are expected to reverse.

     Effective January 1, 2007, we adopted the FASB guidance related to accounting for uncertainty in income taxes. The updated guidance clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold of more-likely-than-not to be sustained upon examination. Upon adoption of this update, our policy to include interest and penalties related to gross unrecognized tax benefits within our provision for income taxes did not change. We did not accrue interest expense related to these unrecognized tax benefits due to our historical carryforward loss position, the uncertain benefits have not yet reduced taxes payable and, accordingly, no interest expense has been accrued.

Results of Operations

     The following tables present, for the periods indicated, financial information expressed as a percentage of revenue and a summary of our total revenue. This information has been derived from our condensed consolidated statements of income included elsewhere in this Quarterly Report on Form 10-Q. You should not draw any conclusions about our future results from the results of operations for any period.

		Three Months Ended								Nine Months Ended
		October 3,				September 27,				October 3,				September 27,
		2009				2008				2009				2008
Revenue			100	%			100	%			100	%			100	%
Costs of revenue			26				25				25				25
Gross margin			74				75				75				75
Operating expenses:
Research and development			16				17				15				16
Sales and marketing			39				51				41				46
General and administrative			20				16				19				16
Total operating expenses			75				84				75				78
(Loss) income from operations			(1	)			(9	)			0				(3	)
Interest income, net			(1	)			—				0				—
Gain on valuation of warrants			4				—				1				—
Impairment loss on investments			—				(3	)			—				(1	)
Gain on repurchase of debt			—				24				4				13
Income before income taxes			2				12				5				9
Provision for incomes taxes			3				8				3				5
Net income			(1	)%			4	%			2	%			4	%

Three and Nine Months Ended October 3, 2009 Compared with the Three and Nine Months Ended September 27, 2008

		Three Months Ended												Nine Months Ended
										Percentage												Percentage
		October 3,				September 27,				Increase				October 3,				September 27,				Increase
		2009				2008				(Decrease)				2009				2008				(Decrease)
		(in thousands, except												(in thousands, except unit
		unit amounts)												amounts)
Revenue — Worldwide
BIS Sensor		$	21,814			$	20,788				5	%		$	64,927			$	62,819				3	%
BIS monitor			2,446				1,847				32	%			6,307				5,888				7	%
Original equipment manufacturer products			775				1,227				(37	)%			2,483				3,194				(22	)%
Other equipment and accessories			1,124				896				25	%			2,635				2,470				7	%
Total Equipment			4,345				3,970				9	%			11,425				11,552				(1	)%
LiDCO revenue			76				—				—				76				—				—
Total revenue		$	26,235			$	24,758				6	%		$	76,428			$	74,371				3	%
Unit Analysis — Worldwide
BIS Sensors			1,564000				1,514,000				3	%			4,770,000				4,575,000				4	%
BIS monitors			869				599				45	%			2,344				1,986				18	%
Original equipment manufacturer BIS products			1,415				1,510				(6	)%			3,972				4,294				(7	)%
Installed base			62,327				53,630				16	%			62,327				53,630				16	%

     Revenue. Revenue from the sale of BIS Sensors increased approximately 5% in the three months ended October 3, 2009 compared with the three months ended September 27, 2008. During this period, we experienced an increase of approximately 3% in the number of BIS Sensors sold as a result of growth in the installed base of BIS monitors. The number of domestic sensors sold was approximately 945,000 during the third quarter of 2008 and increased to approximately 984,000 during the third quarter of 2009, an increase of approximately 4%, while the number of international sensors sold increased approximately 2%, from approximately 569,000 during the third quarter of 2008 to approximately 580,000 during the third quarter of 2009. Our installed base of BIS monitors and original equipment manufacturer products increased 16% to approximately 62,327 units at October 3, 2009 compared with approximately 53,630 units at September 27, 2008.

     In the nine months ended October 3, 2009, revenue from the sale of BIS Sensors increased approximately 3% compared with the nine months ended September 27, 2008. We believe the increase in revenue from the sale of BIS Sensors and the number of BIS Sensors sold during this period was attributable to growth in the installed base of BIS monitors primarily as a result of the introduction of the Bilateral Vista monitors at the end of 2008. The increase in revenue from the sale of BIS Sensors was primarily attributable to an increase in the number of BIS Sensors sold, from approximately 4.6 million BIS Sensors sold during the nine months ended September 27, 2008 to approximately 4.8 million sold during the nine months ended October 3, 2009. BIS Sensor sales domestically remained relatively stable with approximately 2.9 million BIS Sensors sold in the nine months ended September 27, 2008 and in the nine months ended October 3, 2009. The number of BIS Sensors sold internationally increased approximately 12%, from approximately 1.7 million BIS Sensors sold during the nine months ended September 27, 2008 to approximately 1.9 million sold during the nine months ended October 3, 2009.

     During the three months ended October 3, 2009 compared with the three months ended September 27, 2008, total Equipment revenue increased by approximately 9%. The increase in Equipment revenue during this period was a result of an increase of approximately 32% in BIS monitor revenue, an increase of approximately 25% in other equipment revenue, offset by a decrease of

approximately 37% in original equipment manufacturer product revenue. The increase in monitor revenue was a result of an increase of approximately 45% in the number of monitors sold combined with a decrease in the average selling price of approximately 9% due primarily to our Bilateral Vista monitor promotion, which we implemented in the first quarter of 2009 and which involves trade-ins of A-2000 BIS monitors at a discounted price for Bilateral Vista monitors, implemented during the first quarter of 2009. The decrease in original equipment manufacturer product revenue was a result of a decrease of approximately 6% in the number of products sold to our original equipment manufacturers and a decrease of approximately 33% in average selling prices.

     In the nine months ended October 3, 2009, total Equipment revenue decreased approximately 1% compared with the nine months ended September 27, 2008. The decrease in Equipment revenue during the 2009 period was primarily driven by a decrease in original equipment manufacturer product revenue of approximately 22%, offset by an increase in BIS monitor revenue of approximately 7% and an increase in other equipment revenue of approximately 7%. The decrease in original equipment manufacturer product revenue was a result of a decrease of approximately 7% in the number of products sold to our original equipment manufacturers combined with a decrease of approximately 16% in average selling prices. The increase in monitor revenue was a result of an increase of approximately 18% in the number of monitors sold combined with a decrease in the average selling price of approximately 9% due primarily to our Bilateral Vista monitor promotion which involves trade-ins of A-2000 BIS monitors at a discounted price for Bilateral Vista monitors, implemented during the first quarter of 2009.

     Our gross margin was approximately 74.2% and 75.3% of revenue in the three and nine months ended October 3, 2009, respectively, compared with a gross margin of approximately 75.3% and 74.5% of revenue in the three and nine months ended September 27, 2008, respectively. The decrease in the gross margin in the three months ended October 3, 2009 compared with the same period in the prior year is primarily the result of a decrease in the average monitor selling price due primarily to our Bilateral Vista monitor promotion. The increase in gross margin in the nine months ended October 3, 2009 compared with the same period in the prior year is primarily the result of favorable manufacturing variances related to material pricing and cost reductions we implemented in the fourth quarter of 2008 and the first quarter of 2009.

Expense Overview

		Three Months Ended												Nine Months Ended
										Percentage												Percentage
		October 3,				September 27,				Increase				October 3,				September 27,				Increase
		2009				2008				(Decrease)				2009				2008				(Decrease)
		(in thousands)												(in thousands)
Expenses
Research and development		$	4,080			$	4,183				(2	)%		$	11,753			$	12,056				(3	)%
Sales and marketing			10,318				12,687				(19	)			31,322				34,561				(9	)
General and administrative			5,376				3,920				37				14,197				12,034				18

     Research and Development. The decrease in research and development expenses in the three months ended October 3, 2009 compared with the three months ended September 27, 2008 was primarily attributable to a decrease of approximately $158,000 in consulting expenses, mainly driven by cost reduction efforts.

     For the nine months ended October 3, 2009 compared with the nine months ended September 27, 2008, the decrease in research and development expenses was due primarily to a decrease of approximately $129,000 in consulting expenses, a decrease of approximately $86,000 in materials expenses and a decrease of approximately $79,000 in recruiting expenses. We expect research and development expenses in the fourth quarter of 2009 to decrease compared to the level of research and development expenses in the third quarter of 2009 due mainly to decreased product development expenses.

     Sales and Marketing. The decrease in sales and marketing expenses in the three months ended October 3, 2009 compared with the three months ended September 27, 2008 was primarily attributable to a decrease of approximately $494,000 in compensation and benefits, a decrease of approximately $392,000 in travel and entertainment expenses and a decrease of approximately $1,483,000 in other operating expenses driven by cost reduction efforts. The decrease in other operating expenses was primarily attributable to a decrease of approximately $428,000 in recruiting and training expenses related to the sales force expansion which we initiated during the second quarter of 2008, a decrease of approximately $237,000 in market research expenses, a decrease of approximately $221,000 related to foreign exchange fluctuations, a decrease of approximately $167,000 in temporary help expenses and a decrease of approximately $130,000 in meeting expenses. In addition, approximately $188,000 of commission expense paid to our original equipment manufacturers are included in the three months ended September 27, 2008. For the three

months ended October 3, 2009, approximately $262,000 of commissions expense has been recorded as a reduction to sensor revenue as a result of a change in contract terms. The decrease in compensation and benefits is principally the result of the completion of the sales force retention program in the first quarter of 2009 which we implemented in April 2008.

     For the nine months ended October 3, 2009 compared with the nine months ended September 27, 2008, the decrease in sales and marketing expenses was driven by a decrease of approximately $613,000 in compensation and benefits, a decrease of approximately $467,000 in travel and entertainment expenses and a decrease of approximately $2,159,000 in other operating expenses. The decrease in compensation and benefits is primarily driven by the completion of the sales force expansion program which we initiated during the second quarter of 2008 and a decrease in stock-based compensation expense. The decrease in other operating expenses is principally the result of a decrease of approximately $514,000 in recruiting and training expenses related to the sales force expansion which we initiated during the second quarter of 2008, a decrease of approximately $298,000 in market research expenses, a decrease of approximately $298,000 in meeting expenses, a decrease of approximately $286,000 in temporary employment expenses and a decrease of approximately $212,000 related to foreign exchange fluctuations. In addition, approximately $572,000 of commission expense paid to our original equipment manufacturers are included in the nine months ended September 27, 2008. For the nine months ended October 3, 2009, approximately $701,000 of commissions expense has been recorded as a reduction to sensor revenue as a result of a change in contract terms. We expect the level of sales and marketing expenses in the fourth quarter of 2009 to decrease compared to the level of sales and marketing expenses in the third quarter of 2009 due mainly to continued cost reduction efforts.

     General and Administrative. The increase in general and administrative expenses in the three months ended October 3, 2009 compared with the three months ended September 27, 2008 was primarily attributable to an increase of approximately $309,000 in compensation and benefits to general and administrative personnel and an increase of approximately $990,000 in professional services fees, including legal services and accounting and tax related services related primarily to Covidien’s proposed acquisition of our business.

     For the nine months ended October 3, 2009 compared with the nine months ended September 27, 2008, the increase in general and administrative expenses was driven by an increase of approximately $183,000 in compensation and benefits to general and administrative personnel and an increase of approximately $1,817,000 in professional services fees, including legal services and accounting and tax related services relating to Covidien’s proposed acquisition of our business. We expect the level of general and administrative expenses in the fourth quarter of 2009 to decrease compared with the level of general and administrative expenses in the third quarter of 2009 mainly due to decreased professional services expenses.

     Interest Income. Interest income decreased to approximately $217,000 in the three months ended October 3, 2009 from approximately $867,000 in the three months ended September 27, 2008, a decrease of approximately 75%. For the nine months ended October 3, 2009 compared with the nine months ended September 27, 2008, interest income decreased approximately 69% from approximately $3.2 million to approximately $997,000. The decrease in interest income in the three and nine months ended October 3, 2009 compared with the three and nine months ended September 27, 2008 was primarily attributable to a lower cash and investment balance resulting from repurchases of a portion of our convertible debt in 2008 and the first quarter of 2009 combined with a decrease in interest and other investment return rates. We expect interest income in the fourth quarter of 2009 to be comparable to the level of interest income in the third quarter of 2009.

     Interest Expense. Interest expense decreased to approximately $443,000 in the three months ended October 3, 2009 compared with $849,000 in the three months ended September 27, 2008. For the nine months ended October 3, 2009 compared with the nine months ended September 27, 2008, interest expense decreased from approximately $2.7 million to approximately $1.4 million. The decrease in interest expense in the three and nine months ended October 3, 2009 was primarily due to repurchases of portions of our convertible debt during 2008 and the first quarter of 2009. We expect interest expense in the fourth quarter of 2009 to be comparable to the level of interest expense in the third quarter of 2009.

     Other Income. Other income was approximately $1.0 million and $4.1 million in the three months and nine months ended October 3, 2009, respectively, compared with approximately $5.0 million and $9.0 million in the three and nine months ended September 27, 2008, respectively. The other income in the three months ended October 3, 2009 includes a fair value adjustment on the warrants we acquired in connection with the LiDCO Distribution Agreement. For the nine months ended October 3, 2009, other income also included aggregate gains of approximately $3.0 million resulting from repurchase of portions of our convertible debt. Other income in the nine months ended September 27, 2008 is primarily due to aggregate gains of approximately $9.8 million resulting from a repurchase of portions of our convertible debt in September 2008, offset by an other-than-temporary impairment loss on investment of approximately $840,000 during the third quarter of 2008. We expect other income in the fourth quarter of 2009 to be below the level of other income in the third quarter of 2009.

     Income Taxes. We are subject to income tax in numerous jurisdictions and at various rates worldwide and the use of estimates is required in determining the provision for income taxes. For the three and nine months ended October 3, 2009, we recorded a tax provision of $685,000 and $2.0 million on income before taxes of $517,000 and $4.0 million, respectively. Included in the income tax provision for the three months ended October 3, 2009 is approximately $570,000 resulting from the cumulative correction of immaterial errors from prior periods related to international tax matters which were not previously considered in the income tax provision. We do not believe that this previously unrecorded amount was material to our results of operations or the financial position any interim period in 2007, 2008 or year to date 2009. The provision for income taxes was the result of applying an effective income tax rate of 132% and 51% to income before tax for the three and nine months ended October 3, 2009, respectively. For the three and nine months ended October 3, 2009, the difference between the effective tax rate and the U.S. federal statutory income tax rate of 34% was due mainly to the impact of state income taxes, the disallowance for tax purposes of certain stock-based compensation deductions, a taxable gain on the repurchase of our convertible debt, the correction of a prior period error of $570,000 related to Internal Revenue Code Section 956 income inclusion and the tax treatment for the gain on warrant valuations. For the three and nine months ended September 27, 2008, we recorded a tax provision of $1,883,000 and $3,577,000 on income before taxes of $2,923,000 and $6,281,000, resulting in an effective income tax rate of 64% and 57%, respectively.

     In the first quarter of 2008, we recorded a valuation allowance of approximately $257,000 for a portion of our federal research and development credits since these credits are expected to expire unused based on current projections. In addition, in the third quarter of 2008, we recorded a valuation allowance on a capital loss related to our commercial paper investments since we do not anticipate that we will be able to benefit from this loss in the near future. In the third quarter of 2009, we recorded a valuation allowance of approximately $251,000 for a portion of our foreign tax credits generated in 2007 and 2008 since we do not expect that we will be able to utilize the credits before expiration. We also released a valuation allowance of approximately $97,000, which was related to federal research and development credits that expired unutilized. As of October 3, 2009, our total cumulative valuation allowance was approximately $961,000.

     As of January 1, 2009, we had gross unrecognized tax benefits of $805,000 (net of the federal benefit on state issues) which represent the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in any future periods. We classify interest and penalties related to unrecognized tax benefits as income tax expense. There were no significant changes to any of these amounts during the third quarter of 2009. We do not reasonably estimate that the unrecognized tax benefit will change significantly within the next twelve months.

Liquidity and Capital Resources

     In May 2001, we entered into an agreement with Bank of America for a $5.0 million revolving line of credit which we amended in June 2009 to reduce the available line of credit to $2.0 million. The June 2009 amendment also extended the expiration date of the loan agreement to May 2010. The revolving line of credit contains restrictive covenants that require us to maintain liquidity and net worth ratios and is secured by certain investments, which are shown as restricted cash on our consolidated balance sheets. In connection with this revolving line of credit agreement, we are required to maintain restricted cash in an amount equal to 102% of the outstanding amounts under the revolving line of credit. At October 3, 2009, we were in compliance with all covenants contained in the revolving line of credit agreement. Interest on any borrowings under the revolving line of credit is, at our election, either the prime rate or the London Inter-Bank Offer Rate, or LIBOR, plus 2.25%. Up to $1.5 million of the $2.0 million revolving line of credit is available for standby letters of credit. At October 3, 2009, the interest rate on the line of credit was 3.25%, there was no amount outstanding under this line of credit and we had standby letters of credit outstanding relating to our leased facility, leased computers and an international service provider in the amount of approximately $1.1 million which is shown on our consolidated balance sheet as restricted cash.

     In March 2009, a bank guarantee of approximately $155,000 was given by an international bank to the State of the Netherlands on our behalf related to tax services for a subsidiary.

     In June 2007, we completed a private placement of $125.0 million aggregate principal amount of 2.5% convertible notes due 2014. Net proceeds received from the issuance of the notes were $121.0 million, which is net of the initial purchasers’ discount of $4.0 million. As of October 3, 2009, we have used approximately $85.0 million of these proceeds to repurchase 5.5 million shares of our common stock, of which 4.5 million shares were repurchased from Boston Scientific Corporation and 1.0 million shares were repurchased in connection with our 2.5% convertible senior note offering that we completed in June 2007.

     On August 3, 2006, our Board of Directors authorized the repurchase of up to 2,000,000 shares of our common stock from time to time on the open market or in privately negotiated transactions. As of October 3, 2009, we had repurchased 276,493 shares of

our common stock for approximately $5.0 million under this plan, and we are authorized to repurchase an additional 1,723,507 shares of common stock in the future, provided that any such repurchase would require the consent of the Purchaser and Parent under the Merger Agreement.

     We expect to meet our near-term liquidity needs through the use of cash and short-term investments on hand at October 3, 2009 and cash generated from operations. We believe that the financial resources available to us, including our current working capital, our long-term investments and available revolving line of credit will be sufficient to finance our planned operations and capital expenditures for at least the next twelve months. However, our future liquidity and capital requirements will depend upon numerous factors, including the resources required to further develop our marketing and sales organization domestically and internationally, to finance our research and development programs, to implement new marketing programs, to finance our sales-type lease program, to meet market demand for our products and to repay our convertible notes.

     We expect to fund the growth of our business over the long term through cash flow from operations and, if the acquisition of our business by the Purchaser pursuant to the Merger Agreement is not consummated, through issuances of capital stock, promissory notes or other securities. Any sale of additional equity or debt securities may result in dilution to our stockholders, and we cannot be certain that additional public or private financing will be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to delay, reduce the scope of, or eliminate one or more aspects of our business development activities, which could harm the growth of our business.

     Currently, our 2.5% convertible senior notes due 2014 are convertible, under certain circumstance, solely into shares of our common stock. However, under the terms of the Indenture and such notes, we have the option to settle potential conversions of these notes with cash and, if applicable, shares of our common stock, commonly referred to as “net share settlement”, if we first obtain stockholder approval of this net share settlement feature, and we irrevocably elect to use such settlement method. If we obtain stockholder approval of the net share settlement feature in connection with the potential conversion of such notes and we irrevocably elect to use such settlement method, then upon conversion of such notes we would (1) pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the notes being converted and the daily conversion value (the product of the conversion rate and the current trading price) of the notes being converted and (2) issue shares of our common stock only to the extent that the daily conversion value of the notes exceeded one-fortieth of the principal amount of the notes being converted for each trading day of the relevant 40 trading day observation period. In order to fund the cash payments due upon conversion, we may be required to use a significant portion or all of our existing cash or raise the cash for such payments through the sale of shares of our common stock or additional debt securities or through one or more other financing transactions. We may not have sufficient cash on hand or be able to acquire the necessary funds via financing on terms favorable to us or our stockholders, or at all, which would result in an event of default under the notes. Moreover, the use of a substantial portion of our existing cash may adversely affect our liquidity and cash available to fund the growth of our business.

     Working capital at October 3, 2009 was approximately $93.4 million compared with approximately $92.0 million at December 31, 2008.

     Cash provided by operations. We received approximately $5.5 million of cash from operations in the nine months ended October 3, 2009 compared with cash received from operations of approximately $6.9 million in the nine months ended September 27, 2008. The cash received in the nine months ended October 3, 2009 was primarily attributable to our net income of approximately $2.0 million, non-cash stock-based compensation expense of approximately $4.2 million and depreciation and amortization of approximately $2.3 million. These amounts were offset by a non-cash gain of approximately $3.0 million resulting from the repurchase of an aggregate of approximately $7.1 million of our 2.5% convertible notes during the period. The cash received in the nine months ended September 27, 2008 was primarily attributable to our net income of approximately $2.7 million, non-cash stock-based compensation expense of approximately $5.7 million, deferred taxes of approximately $3.1 million, an increase in accrued liabilities of approximately $2.4 million and depreciation and amortization of approximately $2.3 million. These amounts were offset by non-cash gains of approximately $9.8 million resulting from the repurchase of an aggregate of $25.0 million of our 2.5% convertible notes during the period.

     Cash provided by investing activities. Approximately $12.8 million of cash was provided by investing activities in the nine months ended October 3, 2009 compared with cash provided of approximately $23.0 million in the nine months ended September 27, 2008. The cash provided in the nine months ended October 3, 2009 was primarily the result of net proceeds from sales of investments of approximately $15.7 million, offset by approximately $1.3 million in capital expenditures and approximately $1.3 million of cash paid to LiDCO Limited in connection with our distribution and licensing agreement. The cash provided in the nine months ended September 27, 2008 was primarily the result of net proceeds from sales and maturities of investments of approximately $24.2 million, offset by approximately $1.3 million in capital expenditures. We anticipate the level of capital

expenditures in the fourth quarter of 2009 will increase compared with the level of capital expenditures in the third quarter of 2009 mainly due to purchases related to our manufacturing equipment.

     Cash used for financing activities. We used approximately $3.7 million of cash from financing activities in the nine months ended October 3, 2009 compared with the use of approximately $13.6 million of cash in the nine months ended September 27, 2008. The cash used for financing activities was primarily the result of our repurchase of an aggregate of approximately $7.1 million of our 2.5% convertible notes during the period for approximately $3.8 million. The cash used in the nine months ended September 27, 2008 was primarily the result of the repurchase of an aggregate of $25.0 million of our 2.5% convertible notes during the period for approximately $14.4 million.

Off-Balance Sheet Arrangements

     We do not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Effects of Inflation

     We believe that inflation and changing prices over the past three fiscal years have not had a significant impact on our net sales and revenues or on our income from continuing operations.

Recent Accounting Pronouncements

     In January 2009, the FASB issued updated accounting guidance on the impairment guidance to achieve a more consistent determination of whether an other-than-temporary impairment has occurred. This guidance is effective for interim and annual reporting periods ending after December 15, 2008. The adoption of this guidance did not have a material impact on our results of operations, financial position or cash flow.

     In April 2009, the FASB issued updated accounting guidance intended to provide additional guidance and enhance disclosures regarding fair value measurements and impairments of securities. The updated accounting guidance relates to determining fair values when no active market exists or where the price inputs used represent distressed sales, increase the frequency of fair value disclosures for financial instruments not currently reported on the balance sheet of companies at fair value from once a year to a quarterly basis and provides additional guidance to create greater clarity and consistency in accounting for and presenting impairment losses on securities. This guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have a material impact on our results of operations, financial position or cash flow.

     In May 2009, the FASB issued updated accounting guidance to establish general standards of accounting for disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance is effective for financial statements issued for fiscal year and interim periods ending after June 15, 2009. The adoption of this guidance did not have a material impact on our results of operations, financial position or cash flow.

     In August 2009, the FASB issued Accounting Standards Update 2009-05, Fair Value Measurements and Disclosures. The objective of this Update is to provide clarification that in circumstances where a quoted price in an active market for the identical liability is not available, fair value is required to be measured using a valuation technique that uses the quoted price of the identical liability when traded as an asset or for similar liabilities or similar liabilities when traded as assets or another valuation technique with consistent principles. The Update did not have a material impact on our results of operations, financial position or cash flow.

Forward-Looking Statements

     This Quarterly Report on Form 10-Q contains, in addition to historical information, forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, including information relating to our ability to maintain profitability, information with respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors, original equipment manufacturer products and BIS Sensors, our dependence on the BIS system, regulatory approvals for our products, our ability to remain competitive and achieve future growth, information with respect to other plans and strategies for our business, factors that may influence our revenue for the fiscal quarter ending December 31, 2009 and thereafter and our proposed merger with Covidien plc. These forward-looking statements involve risks and uncertainties and are not guarantees of future performance. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and variations of

these words and similar expressions are intended to identify forward-looking statements. Our actual results could differ significantly from the results discussed in these forward-looking statements. The important factors discussed under Part II – Item 1A. “Risk Factors” below represent some of the current challenges to us that create risk and uncertainty. In addition, subsequent events and developments may cause our expectations to change. While we may elect to update these forward-looking statements we specifically disclaim any obligation to do so, even if our expectations change.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

   Interest Rate Exposure

     Our investment portfolio consists primarily of money market accounts, certificates of deposit, high-grade commercial paper, high grade corporate bonds and debt obligations of various governmental agencies. We manage our investment portfolio in accordance with our investment policy. The primary objectives of our investment policy are to preserve principal, maintain a high degree of liquidity to meet operating needs, and obtain competitive returns subject to prevailing market conditions. Investments are made with an average maturity of twelve months or less and a maximum maturity of 24 months. These investments are subject to risk of default, changes in credit rating and changes in market value. These investments are also subject to interest rate risk and will decrease in value if market interest rates increase. Due to the conservative nature of our investments and relatively short effective maturities of the debt instruments, we believe interest rate risk is mitigated. Our investment policy specifies the credit quality standards for our investments and limits the amount of exposure from any single issue, issuer or type of investment.

     Our investment in sales-type leases and line of credit agreement are also subject to market risk. The interest rates implicit in our sales-type leases are fixed and not subject to interest rate risk. In addition, the interest rate on the 2.5% convertible senior notes due 2014 is fixed and not subject to interest rate risk. The interest rate on our line of credit agreement is variable and subject to interest rate risk. The interest rate risk experienced to date related to the line of credit has been mitigated primarily by the fact that the line of credit is typically not utilized.

   Foreign Currency Exposure

     Most of our revenue, expenses and capital spending are transacted in U.S. dollars. The expenses and capital spending of our international subsidiaries are transacted in the respective country’s local currency and subject to foreign currency exchange rate risk. Our foreign currency transactions are translated into U.S. dollars at prevailing currency rates. Gains or losses resulting from foreign currency transactions are included in current period income as incurred and translation adjustments have been included as part of accumulated other comprehensive income. Currently, transactions that are denominated in foreign currencies have not been material.

Item 4. Controls and Procedures.

     (a) 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 October 3, 2009. 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 an issuer that are designed to ensure that information required to be disclosed by the issuer 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 SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, 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 October 3, 2009, 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.

     (b) Changes in Internal Controls.

     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 October 3, 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

     We are aware of three putative class action lawsuits related to the Offer and the Merger, as follows:

     (i) On October 6, 2009, a putative class action complaint, Albert Donnay v. Nassib Chamoun, et al., Civil Action No. 09-4249-BLS, was filed in the Massachusetts Superior Court for Suffolk County, Business Litigation Session. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, certain of its directors, United States Surgical Corporation, and Transformer Delaware Corp. as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value and failing to engage in a fair sale process. The complaint also alleges that Aspect, United States Surgical Corporation and Transformer Delaware Corp. aided and abetted the alleged breaches of fiduciary duties by certain of Aspect’s directors. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger. On October 8, 2009, Aspect and the individual defendants filed an answer in which they have denied the allegations, and they also served a motion to dismiss and/or for judgment on the pleadings. On October 16, 2009, Aspect and the individual defendants filed a motion to stay the action. On October 19, 2009, the plaintiff filed a motion to amend the complaint to add claims asserting that Aspect and the individual defendants failed to disclose in SEC filings material information regarding the Merger.

     (ii) On October 13, 2009, a second putative class action complaint, Roland A. Cherwek v. Aspect Medical Systems, Inc., et al. was filed in Delaware Chancery Court. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, its directors, United States Surgical Corporation, Transformer Delaware Corp., and Covidien plc as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value, failing to engage in a fair sale process, and failing to disclose in SEC filings material information regarding the Merger. The complaint also alleges that Aspect, United States Surgical Corporation, Transformer Delaware Corp., and Covidien plc aided and abetted the alleged breaches of fiduciary duties by Aspect’s directors. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger and damages in an unspecified amount. On October 26, 2009, plaintiff (on behalf of himself and the members of the putative class) and all defendants entered into a memorandum of understanding reflecting an agreement in principle to settle the matter. The agreement in principle is subject to the parties reaching agreement on the terms of a mutually acceptable definitive settlement agreement. Thereafter, the settlement agreement will be subject to approval by the court and also conditioned upon consummation of the Merger.

     (iii) On October 14, 2009, a third putative class action complaint, Milton Pfeiffer v. Nassib Chamoun, et al., Case No. 09-4377-BLS, was filed in the Massachusetts Superior Court for Suffolk County, Business Litigation Session. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, certain of its directors, United States Surgical Corporation, and Transformer Delaware Corp. as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value, failing to engage in a fair sale process, and failing to disclose in SEC filings material information regarding the Merger. The complaint also alleges that Aspect, United States Surgical Corporation and Transformer Delaware Corp. aided and abetted the alleged breaches of fiduciary duties by the Aspect directors named in the action. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger and damages in an unspecified amount. On October 16, 2009, Aspect and the individual defendants filed a motion to stay the action.

     On October 10, 2007, a purported holder of our common stock (the plaintiff), filed suit in the U.S. District Court for the Western District of Washington against Morgan Stanley and Deutsche Bank AG, the lead underwriters of our 2000 initial public offering, alleging violations of Section 16(b) of the Securities Exchange Act of 1934 (the “Exchange Act”). The complaint alleges that the combined number of shares of our common stock beneficially owned by the lead underwriters and certain of our unnamed officers, directors and principal stockholders exceeded ten percent of our outstanding common stock from the date of our initial public offering on January 28, 2000, through at least January 27, 2001. The complaint further alleges that those entities and individuals were subject to the reporting requirements of Section 16(a) of the Exchange Act and the short-swing trading prohibition of Section 16(b) of the Exchange Act, and failed to comply with those provisions. The complaint seeks to recover from the lead underwriters any “short-swing profits” obtained by them in violation of Section 16(b) of the Exchange Act. We

were named as a nominal defendant in the action, but have no liability for the asserted claims. None of our directors or officers serving in such capacities at the time of our initial public offering (many of whom still serve as officers or directors) was named as defendants in this action. On February 25, 2008, the plaintiff filed an amended complaint asserting substantially similar claims as those set forth in the initial complaint. On July 25, 2008, we joined with 29 other issuers to file the Issuer Defendants’ Joint Motion to Dismiss. The plaintiff filed her opposition on September 8, 2008, and we and the other Issuer Defendants filed our Reply in Support of their Joint Motion to Dismiss on October 23, 2008. Oral argument on the Joint Motion to Dismiss was held on January 16, 2009.

     On March 12, 2009, the Court granted the Issuer Defendants’ Joint Motion to Dismiss, dismissing the complaint without prejudice on the grounds that the plaintiff had failed to make an adequate demand on us prior to filing her complaint. In its order, the Court stated it would not permit the plaintiff to amend her demand letters while pursuing her claims in the litigation. Because the Court dismissed the case on the grounds that it lacked subject matter jurisdiction, it did not specifically reach the issue of whether the plaintiff’s claims were barred by the applicable statute of limitations. However, the Court also granted the Underwriters’ Joint Motion to Dismiss with respect to cases involving non-moving issuers, holding that the cases were barred by the applicable statute of limitations because the issuers’ shareholders had notice of the potential claims more than five years prior to filing suit.

     The plaintiff filed a Notice of Appeal on April 10, 2009, and the underwriters subsequently filed a Notice of Cross-Appeal, arguing that the dismissal of the claims involving the moving issuers should have been with prejudice because the claims were untimely under the applicable statute of limitations. The plaintiff’s opening brief in the appeal was filed on August 26, 2009; our response and the underwriters’ response and the underwriters’ brief in support of their cross-appeal was filed on October 2, 2009; the plaintiff’s reply brief and opposition to the cross-appeal was filed on November 2, 2009; and the underwriters’ reply brief in support of their cross-appeals is due on November 17, 2009. We currently believe that the outcome of this litigation will not have a material adverse impact on our consolidated financial position and results of operations.

Item 1A. Risk Factors

     You should carefully consider the following risk factors, in addition to other information included in this Quarterly Report on Form 10-Q, in evaluating our business. Failure to adequately overcome or address any of the following challenges could have a material adverse effect on our results of operations, business or financial condition. The following risk factors supersede the risk factors previously disclosed in Item 1A. of our 2008 Annual Report on Form 10-K.

If our acquisition by affiliates of Covidien plc is not completed as expected, our stock price, business and results of operations may suffer.

     On September 27, 2009, we entered into the Merger Agreement with Parent and Purchaser, which we have previously filed with the SEC. Pursuant to the Merger Agreement, Purchaser commenced a tender offer for all of our outstanding common stock at a purchase price of $12.00 per share, net to the holder in cash, subject to any required withholding of taxes. The initial offering period for the Offer expired at 12:00 midnight, New York City time, at the end of Thursday, November 5, 2009, after which Purchaser accepted and paid for all shares validly tendered and not withdrawn at the time, representing approximately 90% of our outstanding common stock (excluding shares tendered under guaranteed delivery procedures). Pursuant to the terms of the Merger Agreement, Purchaser exercised its option to purchase newly issued shares from us at the tender offer price. Following the purchase, Purchaser owned sufficient shares to effect a short-form merger with and into Aspect, which will then become an indirect wholly owned subsidiary of Covidien (the “Merger”). We expect that Purchaser will complete the Merger as soon as practicable.

     Although the Offer was successfully completed, it is possible that the required conditions to the short-form merger procedures provided by Delaware law or the merger generally under the Merger Agreement may not be satisfied. The merger might be delayed if the Purchaser cannot use the short-form merger procedure and is required to obtain stockholder approval, or it could be prevented if a court or other governmental authority were to block the merger or make it illegal. If the merger is delayed or otherwise not consummated within the contemplated time periods or at all, we could suffer a number of consequences that may adversely affect our business, results of operations and stock price, including:

	•		activities related to the Offer or the merger and related uncertainties may lead to a loss of revenue and market position that we may not be able to regain if the proposed transaction does not occur;
	•		the market price of our common stock could decline following an announcement that the proposed transaction had been abandoned or delayed;
	•		if the merger is delayed or otherwise not consummated within the contemplated time periods or at all, because the Purchaser would own a substantial majority of our common stock, there may not be an active trading market for our remaining shares of common stock and we may not be able to sustain our Nasdaq listing;
	•		we would remain liable for our costs related to the proposed transaction, including substantial legal, accounting and investment banking expenses; and
	•		we may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures.

Lawsuits have been filed against us and the members of our Board of Directors arising out of our acquisition by affiliates of Covidien plc, which may delay or prevent the proposed transaction.

     Three putative class action lawsuits related to the Offer and the Merger have been filed against us and the members of our board of directors.

     On October 6, 2009, a putative class action complaint, Albert Donnay v. Nassib Chamoun, et al., Civil Action No. 09-4249-BLS, was filed in the Massachusetts Superior Court for Suffolk County, Business Litigation Session. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, certain of its directors, United States Surgical Corporation, and Transformer Delaware Corp. as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value and failing to engage in a fair sale process. The complaint also alleges that Aspect, United States Surgical Corporation and Transformer Delaware Corp. aided and abetted the alleged breaches of fiduciary duties by certain of Aspect’s directors. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger. On October 8, 2009, Aspect and the individual defendants filed an answer in which they have denied the

allegations, and they also served a motion to dismiss and/or for judgment on the pleadings. On October 16, 2009, Aspect and the individual defendants filed a motion to stay the action. On October 19, 2009, the plaintiff filed a motion to amend the complaint to add claims asserting that Aspect and the individual defendants failed to disclose in SEC filings material information regarding the Merger.

     On October 13, 2009, a second putative class action complaint, Roland A. Cherwek v. Aspect Medical Systems, Inc., et al. was filed in Delaware Chancery Court. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, its directors, United States Surgical Corporation, Transformer Delaware Corp., and Covidien plc as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value, failing to engage in a fair sale process, and failing to disclose in SEC filings material information regarding the Merger. The complaint also alleges that Aspect, United States Surgical Corporation, Transformer Delaware Corp., and Covidien plc aided and abetted the alleged breaches of fiduciary duties by Aspect’s directors. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger and damages in an unspecified amount. On October 26, 2009, plaintiff (on behalf of himself and the members of the putative class) and all defendants entered into a memorandum of understanding reflecting an agreement in principle to settle the matter. The agreement in principle is subject to the parties reaching agreement on the terms of a mutually acceptable definitive settlement agreement. Thereafter, the settlement agreement will be subject to approval by the court and also conditioned upon consummation of the Merger.

     On October 14, 2009, a third putative class action complaint, Milton Pfeiffer v. Nassib Chamoun, et al., Case No. 09-4377-BLS, was filed in the Massachusetts Superior Court for Suffolk County, Business Litigation Session. This action purports to be brought on behalf of all public stockholders of Aspect, and names Aspect, certain of its directors, United States Surgical Corporation, and Transformer Delaware Corp. as defendants. The complaint alleges, among other things, that the consideration to be paid to Aspect stockholders in the proposed acquisition is unfair and undervalues Aspect. In addition, the complaint alleges that the Aspect directors named in the action violated their fiduciary duties by, among other things, failing to maximize stockholder value, failing to engage in a fair sale process, and failing to disclose in SEC filings material information regarding the Merger. The complaint also alleges that Aspect, United States Surgical Corporation and Transformer Delaware Corp. aided and abetted the alleged breaches of fiduciary duties by the Aspect directors named in the action. The complaint seeks, among other relief, an injunction preventing completion of the Merger or, if the Merger is consummated, rescission of the Merger and damages in an unspecified amount. On October 16, 2009, Aspect and the individual defendants filed a motion to stay the action.

     We intend to vigorously defend against these claims; however, the outcome of all litigation is uncertain and we may not be successful in defending against these claims. Regardless of the outcome of this lawsuit, it could delay or prevent our acquisition by Covidien, divert the attention of our management and employees from our day-to-day business and otherwise adversely affect us financially.

We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our BIS system and purchase our BIS Sensors in sufficient quantities.

     Although we were profitable for the years ended December 31, 2008 and 2007, we will not continue to be profitable or increase our level of profitability if hospitals and anesthesia providers do not buy and use our BIS system in sufficient quantities. Our customers may determine that the cost of the BIS system exceeds cost savings in drugs, personnel and post-anesthesia care recovery that may result from use of the BIS system. Also, if third party reimbursement is based on charges or costs, patient monitoring with the BIS system may have the effect of reducing reimbursement because the charges or costs for surgical procedures may decline as a result of monitoring with the BIS system. In addition, hospitals and anesthesia providers may not accept the BIS system as an accurate or superior means of assessing a patient’s level of consciousness during surgery or in the intensive care unit. If extensive or frequent malfunctions occur, healthcare providers may also conclude that the BIS system is unreliable. If hospitals and anesthesia providers do not accept the BIS system as cost-effective, accurate and reliable, they will not buy and use the BIS system in sufficient quantities to enable us to continue to be profitable.

     Moreover, additional clinical research we or third parties undertake may fail to support the benefit of our products, including failing to support evidence of a link between the use of BIS monitoring and a reduction in the incidence of awareness. For example, a third-party study published in March 2008 in the New England Journal of Medicine compared BIS monitoring with a protocol based on end-tidal gas anesthetic in a patient population considered to be at high risk of awareness and concluded that, based upon a similar occurrence of awareness in both groups, no benefit of BIS monitoring was demonstrated. We believe that the rate of growth of our sensor revenue has been and may, in future periods continue to be, adversely affected as a result of this publication. If the patient safety benefits of BIS monitoring are not persuasive enough to lead to a wider adoption of our BIS technology, our business, financial condition and results of operations could be adversely affected.

     The success of our business depends in a large part on continued use of the BIS system by our customers and, accordingly, sales by us of BIS Sensors. Sales of BIS Sensors have increased over time as a percentage of our revenue as compared to sales of Equipment as we built our installed base of monitors and modules, and we expect they will continue to increase. If use of our BIS system, and accordingly, sales of our BIS Sensors, do not increase, our ability to grow our revenue and maintain profitability could be adversely affected.

We depend on our BIS system for substantially all of our revenue, and if the BIS system does not gain widespread market acceptance, then our revenue will not grow.

     To date, we have not achieved widespread market acceptance of the BIS system for use in the operating room or in the intensive care unit from healthcare providers or professional anesthesia organizations. Because we depend on our BIS system for substantially all of our revenue, and we have no other significant products, if we fail to achieve widespread market acceptance for the BIS system, we will not be able to sustain or grow our product revenue.

Various factors may adversely affect our quarterly operating results through the fourth fiscal quarter of 2009.

     Various factors may adversely affect our quarterly operating results through the fourth fiscal quarter of 2009. Among these factors are the following:

	•		a third party study published in March 2008 in the New England Journal of Medicine compared BIS monitoring with a protocol based on end-tidal gas anesthetic in a patient population considered to be at high risk of awareness and concluded that, based upon a similar occurrence of awareness in both groups, no benefit of BIS monitoring was demonstrated. We believe that the publication of this study has had, and may continue to have an adverse effect on the rate at which existing or potential new customers purchase and use our products, which could adversely affect our operating results;
	•		we have expanded our sales force and expect that the resulting increase in operating expenses would not be offset at least initially by an increase in revenue; as a result our operating results in such periods could be adversely affected;
	•		we have repurchased a portion of our 2.5% convertible senior notes due 2014, referred to as our notes, and we may make additional repurchases in the future. If any such repurchases are made at a discount to the face value of the note, we expect to record a gain on such transaction, which could affect our operating results in the quarter in which any such repurchase is made;
	•		we face risks beyond our control with respect to the continued challenges of the U.S. and worldwide economies, including without limitation the effects of domestic inflation, declines in the value of our investments, the global rise in energy costs and reductions in hospital spending; and
	•		we have entered into a Merger Agreement with Parent and Purchaser and activities and uncertainties related to this transaction may lead to a loss of revenue and market position that we may not be able to regain.

     If these or any other adverse factors cause a decline in our operating results, or if the market perceives that any such adverse factors could cause a decline in our operating results, in the fourth quarter of 2009 or beyond, then the trading price of our common stock may decline and your investment may lose value.

Fluctuations in our quarterly operating results could cause our stock price to decrease.

     Our operating results have fluctuated significantly from quarter to quarter in the past and are likely to vary in the future. These fluctuations are due to several factors relating to the sale of our products, including:

	•		the timing and volume of customer orders for our BIS system;
	•		market acceptance of our BIS VISTA monitor;
	•		use of and demand for our BIS Sensors;

	•		the timing and amount of sales from new products and technologies we may introduce, such as products we may sell under the LiDCO Distribution Agreement;
	•		customer cancellations;
	•		introduction of competitive products;
	•		regulatory approvals;
	•		changes in management;
	•		turnover in our direct sales force;
	•		expansion of our direct sales force which has increased our operating expenses, and this increase will not be offset, at least initially, by an increase in revenue;
	•		effectiveness of new marketing and sales programs;
	•		communications published by industry organizations or other professional entities in the anesthesia community that are unfavorable to our business, including publication of the results of clinical studies;
	•		trading in our convertible debt instruments;
	•		repurchases of shares of our common stock or our notes;
	•		the amount of our outstanding indebtedness and interest payments under debt obligations;
	•		reductions in orders by our distributors and original equipment manufacturers; and
	•		the timing and amount of our expenses.

     Because of these factors, it is likely that in some future quarter or quarters our operating results could fall below the expectations of securities analysts or investors. If our quarterly operating results are below expectations in the future, the market price of our common stock would likely decrease. In addition, because we do not have a substantial backlog of customer orders for our BIS system or our BIS Sensors, revenue in any quarter depends on orders received in that quarter. Our quarterly results may also be adversely affected because some customers may have inadequate financial resources to purchase our products or may fail to pay for our products after receiving them. In particular, hospitals continue to experience financial constraints, consolidations and reorganizations as a result of cost containment measures and declining third-party reimbursement for services, which may result in decreased product orders or an increase in bad debt allowances in any quarter.

The current crisis in global credit and financial markets could materially and adversely affect our business and results of operations and our investment portfolio may become impaired further by a continuation of the global economic crisis.

     As widely reported, global credit and financial markets have been experiencing extreme disruptions in recent months, including severely diminished liquidity and credit availability, declines in consumer confidence, declines in economic growth, increases in unemployment rates and uncertainty about economic stability. There can be no assurance that there will not be further deterioration in credit and financial markets and confidence in economic conditions. The current tightening of credit in financial markets may lead hospitals to postpone spending, which may cause our customers to cancel, decrease or delay their existing and future orders with us. The volatility in the credit markets has severely diminished liquidity and capital availability. We are unable to predict the likely duration and severity of the current disruptions in the credit and financial markets and adverse global economic conditions, and if the current uncertain economic conditions continue or further deteriorate, our business and results of operations could be materially and adversely affected.

     Our investment portfolio consists primarily of money market accounts, certificates of deposit, high-grade commercial paper, high grade corporate bonds and debt obligations of various governmental agencies. Although the primary objectives of our investment policy are to preserve principal, maintain a high degree of liquidity to meet operating needs, and obtain competitive returns subject to prevailing market conditions, these investments are subject to risk of default, changes in credit rating and changes in market value. The current adverse financial market conditions have negatively affected investments in many industries,

including those in which we invest. The current global economic crisis may continue to have a negative impact on the market values of the investments in our investment portfolio.

If the estimates we make, and the assumptions on which we rely, in preparing our financial statements prove inaccurate, our actual results may vary from those reflected in our financial statements.

     Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses, the amounts of charges accrued by us and related disclosure of contingent assets and liabilities. This includes estimates and judgments regarding revenue recognition, warranty reserves, inventory valuations, valuation allowances for deferred tax assets, allowances for doubtful accounts and share-based compensation expense. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances at the time such estimates and judgments were made. There can be no assurance, however, that our estimates and judgments, or the assumptions underlying them, will be correct.

Compliance with changing regulation of corporate governance and public disclosure as well as potential new accounting pronouncements are likely to impact our future financial position or results of operations.

     Changing laws, regulations and standards relating to corporate governance and public disclosure, new regulations of the Securities and Exchange Commission, or SEC, and Nasdaq Global Market rules are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. In addition, future changes in financial accounting standards may cause adverse, unexpected revenue fluctuations and affect our financial position or results of operations. New accounting pronouncements and varying interpretations of pronouncements have occurred with frequency in the past and may occur again in the future and as a result we may be required to make changes in our accounting policies.

     Our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and management time related to compliance activities. We expect these efforts to require the continued commitment of significant resources. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may be harmed and we might be subject to sanctions or investigation by regulatory authorities, such as the SEC. Any such action could adversely affect our financial results and the market price of our common stock.

Failure to maintain effective internal controls in accordance with section 404 of the Sarbanes-Oxley act could have a material adverse effect on our business and stock price.

     Section 404 of the Sarbanes-Oxley Act of 2002 requires management’s annual review and evaluation of our internal controls, and attestations of the effectiveness of our internal controls by our independent auditors. Our failure to maintain the effectiveness of our internal controls in accordance with the requirements of Section 404 of the Sarbanes-Oxley Act, as such standards are modified, supplemented or amended from time to time, could have an adverse effect on our business, operating results and stock price.

We may need additional financing for our future capital needs and may not be able to raise additional funds on terms acceptable to us, or at all.

     We believe that the financial resources available to us, including our current working capital and available revolving line of credit, will be sufficient to finance our planned operations and capital expenditures through at least the next 12 months. If we are unable to increase our revenue and continue to maintain positive cash flow, we will need to raise additional funds. We may also need additional financing if:

	•		the research and development costs of our products or technology currently under development increase beyond current estimates;
	•		we decide to expand faster than currently planned;
	•		we develop new or enhanced services or products ahead of schedule;
	•		we decide to undertake new sales and/or marketing initiatives;
	•		we are required to defend or enforce our intellectual property rights, or respond to other legal challenges with respect to our products, including product liability claims;
	•		sales of our products do not meet our expectations domestically or internationally, including sales of our BIS Sensors;
	•		we are required or elect to pay the principal under our notes in cash at or prior to maturity or we determine to repurchase any portion of our notes;
	•		we experience unexpected losses in our cash investments or are otherwise unable to liquidate these investments due to unfavorable conditions in the capital markets;
	•		we need to respond to competitive pressures; or
	•		we decide to acquire complementary products, businesses or technologies.

     The current economic crisis has severely diminished the availability of capital. While we have no immediate need to access the equity or credit markets, the current economic crisis may limit our ability to access these markets to obtain financing in the future. The cost and terms of such future financing is unclear and we can provide no assurance that we will be able to raise additional funds on terms acceptable to us, if at all. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future operations which would significantly limit our ability to implement our business plan and could result in a default under our 2.5% convertible senior notes due 2014. In addition, we may have to issue equity securities that may have rights, preferences and privileges senior to our common stock or issue debt securities that may contain limitations or restrictions on our ability to engage in certain transactions in the future.

Cases of awareness with recall during monitoring with the BIS system could limit market acceptance of the BIS system and could expose us to product liability claims.

     Clinicians have reported to us cases of possible awareness with recall during surgical procedures monitored with the BIS system. In most of the cases that were reported to us, when BIS index values were recorded at the time of awareness, high BIS index values were noted, indicating that the BIS index correctly identified the increased risk of awareness with recall in these patients. However, in a small number of these reported cases, awareness with recall may not have been detected by monitoring

with the BIS system. We have not systematically solicited reports of awareness with recall. It is possible that additional cases of awareness with recall during surgical procedures monitored with the BIS system have not been reported to us. Anesthesia providers and hospitals may elect not to purchase and use the BIS system if there is adverse publicity resulting from the report of cases of awareness with recall that were not detected during procedures monitored with the BIS system. If anesthesia providers and hospitals do not purchase and use the BIS system, then we may not sustain or grow our product revenue. Although our multi-center, multinational clinical studies have demonstrated that the use of BIS monitoring to help guide anesthetic administration may be associated with the reduction of the incidence of awareness with recall in adults using general anesthesia and sedation, we may be subject to product liability claims for cases of awareness with recall during surgical procedures monitored with the BIS system. Any of these claims could require us to spend significant time and money in litigation or to pay significant damages.

We may not be able to compete with new products or alternative techniques developed by others, which could impair our ability to remain competitive and achieve future growth.

     The medical device industry in which we market our products is characterized by rapid product development and technological advances. Our competitors have received clearance by the FDA, for, and have introduced commercially, anesthesia monitoring products. If we do not compete effectively with these monitoring products, our revenue could be adversely affected. Our current and planned products are at risk of obsolescence from:

	•		other new monitoring products, based on new or improved technologies;
	•		new products or technologies used on patients or in the operating room during surgery in lieu of monitoring devices;
	•		electrical or mechanical interference from new or existing products or technologies;
	•		alternative techniques for evaluating the effects of anesthesia;
	•		significant changes in the methods of delivering anesthesia; and
	•		the development of new anesthetic agents.

     We may not be able to improve our products or develop new products or technologies quickly enough to maintain a competitive position in our markets and to grow our business.

If we do not maintain our relationships with the anesthesia community and if anesthesiologists and other healthcare providers do not recommend and endorse our products, our sales may decline or we may be unable to increase our sales and profits.

     Physicians typically influence the medical device purchasing decisions of the hospitals and other healthcare institutions in which they practice. Consequently, our relationships with anesthesiologists are critical to our growth. We believe that these relationships are based on the quality of our products, our long-standing commitment to the consciousness monitoring market, our marketing efforts and our presence at medical society and trade association meetings. Any actual or perceived diminution in our reputation or the quality of our products, or our failure or inability to maintain our commitment to the consciousness monitoring market and our other marketing and product promotion efforts could damage our current relationships, or prevent us from forming new relationships, with anesthesiologists and other anesthesia professionals and cause our growth to be limited or decline and our business to be harmed.

     In order for us to sell our products, anesthesia professionals must recommend and endorse them. We may not obtain the necessary recommendations or endorsements from this community. Acceptance of our products depends on educating the medical community as to the distinctive characteristics, perceived benefits, safety, clinical efficacy and cost-effectiveness of our products compared to traditional methods of consciousness monitoring and the products of our competitors, and on training healthcare professionals in the proper application of our products. For example, we believe that the publication in March 2008 of a study in the New England Journal of Medicine that concluded that no benefit of BIS monitoring was demonstrated when compared to an alternative protocol for consciousness monitoring has adversely affected, and could continue to adversely affect, market perceptions of the benefits of our BIS monitoring products and, accordingly, the degree to which anesthesia professionals and other healthcare providers endorse those products. If we are not successful in obtaining and maintaining the recommendations or endorsements of anesthesiologists and other healthcare professionals for our products, our sales may decline or we may be unable to increase our sales and profits.

Negative publicity or unfavorable media coverage could damage our reputation and harm our operations.

     Certain companies that manufacture medical devices have received significant negative publicity in the past when their products did not perform as the medical community or patients expected. This publicity, and the perception such products may not have functioned properly, may result in increased litigation, including large jury awards, legislative activity, increased regulation and governmental review of company and industry practices. If we were to receive such negative publicity or unfavorable media attention, whether warranted or unwarranted, our reputation would suffer, our ability to market our products would be adversely affected, we may be required to change our products and become subject to increased regulatory burdens and we may be required to pay large judgments or fines. Any combination of these factors could further increase our cost of doing business and adversely affect our financial position, results of operations and cash flows.

     A third party study published in March 2008 in the New England Journal of Medicine compared BIS monitoring with a protocol based on end-tidal gas anesthetic in a patient population considered to be at high risk of awareness and concluded that, based upon a similar occurrence of awareness in both groups, no benefit of BIS monitoring was demonstrated. We believe that the publication of this study has had, and may continue to have an adverse effect on the rate at which existing or potential new customers purchase and use our products.

If we do not successfully develop or acquire and introduce enhanced or new products we could lose revenue opportunities and customers.

     Our success in developing or acquiring and commercializing new products and enhancements of current products is affected by our ability to:

	•		identify and respond, in a timely manner, to new market trends or opportunities;
	•		assess customer needs;
	•		successfully develop or acquire competitive products;
	•		complete regulatory clearance in a timely manner;
	•		successfully develop cost effective manufacturing processes;
	•		introduce such products to our customers in a timely manner; and
	•		achieve market acceptance of the BIS system.

     If we are unable to continue to develop or acquire and market new products and technologies, we may experience a decrease in demand for our products, and a loss of market share and our business would suffer. We depend on our BIS system for substantially all our revenue, and we have no other significant products. As the market for our BIS system matures, we need to develop or acquire and introduce new products for anesthesia monitoring or other applications. Additionally, we have been researching the use of BIS monitoring to diagnose, track and manage neurological diseases, including Alzheimer’s disease and depression. We face at least the following two risks with respect to our planned development of new products and our entrance into potential new markets:

	•		we may not successfully adapt the BIS system to function properly for procedural sedation, when used with anesthetics we have not tested or with patient populations we have not studied, such as infants; and
	•		our technology is complex, and we may not be able to develop it further for applications outside anesthesia monitoring, such as the diagnosis and tracking of neurological diseases.

     We are focused on the market for brain monitoring products. The projected demand for our products could materially differ from actual demand if our assumptions regarding this market and its trends and acceptance of our products by the medical community prove to be incorrect or do not materialize or if other products or technologies gain more widespread acceptance, which in each case would adversely affect our business prospects and profitability.

     If we do not successfully adapt the BIS system for new products and applications both within and outside the field of anesthesia monitoring, or if such products and applications are developed but not successfully commercialized, then we could lose revenue opportunities and customers. We recently entered into an exclusive U.S. distribution and technology licensing agreement

with LiDCO Limited pursuant to which we obtained exclusive rights to distribute LiDCO’s LiDCOrapid monitoring system in the United States, non-exclusive rights to distribute the LiDCOplus system and an exclusive license to integrate LiDCO and BIS^® technologies into a combined product for sale in the United States. We may not be able to successfully distribute LiDCO’s products, integrate those products into a combined product, or realize any revenue from the arrangement.

If our clinical trials are delayed or unsuccessful, our business could be adversely affected.

     Clinical trials require sufficient patient enrollment, which is a function of many factors, including the size of the patient population, the nature of the protocol and the eligibility criteria for the clinical trial. Delays in patient enrollment can result in increased costs and longer development times.

     We cannot predict whether we will encounter problems with respect to any of our completed, ongoing or planned clinical trials that will cause us or regulatory authorities to delay or suspend our clinical trials or delay the analysis of data from our completed or ongoing clinical trials. Moreover, the final results of our clinical trials may not support or confirm any preliminary or interim results and we may not successfully reach the endpoints in these trials. Even if we successfully complete our clinical trials, the FDA or other regulatory agencies may not accept the results.

     Any of the following could delay the completion of our ongoing and planned clinical trials, or result in a failure of these trials to support our business:

	•		delays or the inability to obtain required approvals from institutional review boards or other governing entities at clinical sites selected for participation in our clinical trials;
	•		delays in enrolling patients and volunteers into clinical trials;
	•		lower than anticipated retention rates of patients and volunteers in clinical trials; or
	•		failure of our clinical trials to demonstrate the efficacy or clinical utility of our potential products.

     If we determine that the costs associated with attaining regulatory approval of a product exceed the potential financial benefits or if the projected development timeline is inconsistent with our determination of when we need to get the product to market, we may choose to stop a clinical trial and/or development of a product.

If we do not develop and implement a successful sales and marketing strategy, we will not expand our business.

     In the past, we have experienced high turnover in our direct sales force. It is possible that high turnover may occur in the future. If new sales representatives do not acquire the technological skills to sell our products in a timely and successful manner or we experience high turnover in our direct sales force, we may not be able to sustain and grow our product revenue. In addition, in order to increase our sales, we need to continue to strengthen our relationships with our international distributors and continue to add international distributors. Also, we need to continue to strengthen our relationships with our original equipment manufacturers and other sales channels and increase sales through these channels. On an ongoing basis, we need to develop and introduce new sales and marketing programs and clinical education programs to promote the use of the BIS system by our customers. If we do not implement new sales and marketing and education programs in a timely and successful manner, we may not be able to achieve the level of market awareness and sales required to expand our business. Among other things, we need to:

	•		provide or assure that distributors and original equipment manufacturers provide the technical and educational support customers need to use the BIS system successfully;
	•		promote frequent use of the BIS system so that sales of our disposable BIS Sensors increase;
	•		establish and implement successful sales and marketing and education programs that encourage our customers to purchase our products or the products that are made by original equipment manufacturers incorporating our technology;
	•		manage geographically dispersed operations; and
	•		modify our products and marketing and sales programs for foreign markets.

We encourage our direct sales force, distributors and original equipment manufacturers to maximize the amount of our products they sell and they may engage in aggressive sales practices that may harm our reputation.

     We sell our products through a combination of a direct sales force, third party distributors and original equipment manufacturers. As a means to incentivize the sales force, distributors and original equipment manufacturers, the compensation we pay increases with the amount of our products they sell. For example, the compensation paid to the members of our direct sales force consists, in part, of commissions and, the greater the amount of sales, the higher the commission we pay. The participants in our sales channels may engage in sales practices that are aggressive or considered to be inappropriate by existing or potential customers. In addition, we do not exercise control over, and may not be able to provide sufficient oversight of, the sales practices and techniques used by third party distributors and original equipment manufacturers. Negative public opinion resulting from these sales practices can adversely affect our ability to keep and attract customers and could expose us to litigation.

Our third-party distribution and original equipment manufacturer relationships could negatively affect our profitability, cause sales of our products to decline and be difficult to terminate if we are dissatisfied.

     Sales through distributors could be less profitable than direct sales. Sales of our products through multiple channels could also confuse customers and cause the sale of our products to decline. We do not control our original equipment manufacturers and distribution partners. Our partners could sell competing products, may not incorporate our technology into their products in a timely manner and may devote insufficient sales efforts to our products. In addition, our partners are generally not required to purchase minimum quantities. As a result, even if we are dissatisfied with the performance of our partners, we may be unable to terminate our agreements with these partners or enter into alternative arrangements.

We may not be able to generate enough additional revenue from our international expansion to offset the costs associated with establishing and maintaining foreign operations.

     A component of our growth strategy is to expand our presence in international markets. We conduct international business primarily in Europe and Japan, and we are attempting to increase the number of countries in which we do business. It is costly to establish international facilities and operations and to promote the BIS system in international markets. We have encountered barriers to the sale of our BIS system outside the United States, including less acceptance by anesthesia providers for use of disposable products, such as BIS Sensors, delays in regulatory approvals outside of the United States, particularly in Japan, and difficulties selling through indirect sales channels. In addition, we have little experience in marketing and distributing products in international markets. Revenue from international activities may not offset the expense of establishing and maintaining these international operations.

We may not be able to meet the unique operational, legal and financial challenges that we will encounter in our international operations, which may limit the growth of our business.

     We are increasingly subject to a number of challenges which specifically relate to our international business activities. These challenges include:

	•		failure of local laws to provide adequate protection against infringement of our intellectual property;
	•		protectionist laws and business practices that favor local competitors, which could slow or prohibit our growth in international markets;
	•		difficulties in terminating or modifying distributor arrangements because of restrictions in markets outside the United States;
	•		less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors;
	•		delays in regulatory approval of our products;
	•		currency conversion issues arising from sales denominated in currencies other than the United States dollar;
	•		foreign currency exchange rate fluctuations;

	•		longer sales cycles to sell products like the BIS system to hospitals and outpatient surgical centers, which could slow our revenue growth from international sales; and
	•		longer accounts receivable payment cycles and difficulties in collecting accounts receivable.

     If we are unable to meet and overcome these challenges, our international operations may not be successful, which would limit the growth of our business and could adversely impact our results of operations.

We may experience customer dissatisfaction and our reputation could suffer if we fail to manufacture enough products to meet our customers’ demands.

     We rely on third-party manufacturers to assemble and manufacture the components of our BIS monitors, original equipment manufacturer products and a portion of our BIS Sensors. We manufacture substantially all BIS Sensors in our own manufacturing facility. We have only one manufacturing facility. If we fail to produce enough products at our own manufacturing facility or at a third-party manufacturing facility for any reason, including damage or destruction of the facility, or experience a termination or modification of any manufacturing arrangement with a third party, we may be unable to deliver products to our customers on a timely basis. Even if we are able to identify alternative facilities to manufacture our products, if necessary, we may experience disruption in the supply of our products until such facilities are available. Although we believe we possess adequate insurance for damage to our property and the disruption of our business from casualties, such insurance may not be sufficient to cover all of our potential losses and may not be available to us on acceptable terms or at all. Additionally, failure to deliver products on a timely basis could lead to customer dissatisfaction and damage our reputation.

Our reliance on sole-source suppliers could adversely affect our ability to meet our customers’ demands for our products in a timely manner or within budget.

     Some of the components that are necessary for the assembly of our BIS system, including some of the components used in our BIS Sensors, are currently provided to us by sole-source suppliers or a limited group of suppliers. We purchase components through purchase orders, and in select cases, long-term supply agreements, and generally do not maintain large volumes of inventory. We have experienced shortages and delays in obtaining some of the components of our BIS systems in the past, and we may experience similar shortages or delays in the future. The disruption or termination of the supply of components could cause a significant increase in the costs of these components, which could affect our profitability. A disruption or termination in the supply of components could also result in our inability to meet demand for our products, which could lead to customer dissatisfaction and damage our reputation. If a supplier is no longer willing or able to manufacture components that we purchase and integrate into the BIS system, we may attempt to design replacement components ourselves that would be compatible with our existing technology. In doing so, we would incur additional research and development expenses, and there can be no assurance that we would be successful in designing or manufacturing any replacement components. Furthermore, if we are required to change the manufacturer of a key component of the BIS system, we may be required to verify that the new manufacturer maintains facilities and procedures that comply with quality standards and with all applicable regulations and guidelines. The delays associated with the verification of a new manufacturer could delay our ability to manufacture BIS system products in a timely manner or within budget.

We may be required to bring litigation to enforce our intellectual property rights, which may result in substantial expense and may divert our attention from the implementation of our business strategy.

     We believe that the success of our business depends, in part, on obtaining patent protection for our products, defending our patents once obtained and preserving our trade secrets. We rely on a combination of contractual provisions, confidentiality procedures and patent, trademark and trade secret laws to protect the proprietary aspects of our technology. These legal measures afford only limited protection, and competitors may gain access to our intellectual property and proprietary information. Any patents we have obtained or will obtain in the future might also be invalidated or circumvented by third parties. Our pending patent applications may not issue as patents or, if issued, may not provide commercially meaningful protection, as competitors may be able to design around our patents or produce alternative, non-infringing designs. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of our proprietary rights. Any litigation could result in substantial expense and diversion of our attention from the business and may not be adequate to protect our intellectual property rights.

We may be sued by third parties which claim that our products infringe on their intellectual property rights, particularly because there is substantial uncertainty about the validity and breadth of medical device patents.

     We may be subject to litigation by third parties based on claims that our products infringe the intellectual property rights of others. This risk is exacerbated by the fact that the validity and breadth of claims covered in medical technology patents involve complex legal and factual questions for which important legal principles are unresolved. Any litigation or claims against us, whether or not valid, could result in substantial costs, could place a significant strain on our financial resources and could harm our reputation. In addition, intellectual property litigation or claims could force us to do one or more of the following:

	•		cease selling, incorporating or using any of our products that incorporate the challenged intellectual property, which would adversely affect our revenue;
	•		obtain a license from the holder of the infringed intellectual property right, which license may not be available on reasonable terms, if at all; and
	•		redesign our products, which may be costly, time-consuming and may not be successful.

We could be exposed to significant product liability claims which could divert management attention and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at satisfactory rates or in adequate amounts and our reputation.

     The manufacture and sale of our products expose us to product liability claims and product recalls, including those which may arise from misuse or malfunction of, or design flaws in, our products or use of our products with components or systems not manufactured or sold by us. There may be increased risk of misuse of our products if persons not skilled in consciousness monitoring attempt to use our BIS monitoring products. Product liability claims or product recalls, regardless of their ultimate outcome, could require us to spend significant time and money in litigation or to pay significant damages. We currently maintain product liability insurance; however, it may not cover the costs of any product liability claims made against us. Furthermore, we may not be able to obtain insurance in the future at satisfactory rates or in adequate amounts. In addition, publicity pertaining to the misuse or malfunction of, or design flaws in, our products could impair our ability to successfully market and sell our products and could lead to product recalls.

Several class action lawsuits have been filed against the underwriters of our initial public offering which may result in negative publicity and potential litigation against us that would be costly to defend and the outcome of which is uncertain and may harm our business.

     The underwriters of our initial public offering are named as defendants in several class action complaints which have been filed allegedly on behalf of certain persons who purchased shares of our common stock between January 28, 2000 and December 6, 2000. These complaints allege violations of the Securities Act and the Securities Exchange Act of 1934, as amended, or the Securities Exchange Act. Primarily they allege that there was undisclosed compensation received by our underwriters in connection with our initial public offering. While we and our officers and directors have not been named as defendants in these suits, based on comparable lawsuits filed against other companies, there can be no assurance that we and our officers and directors will not be named in similar complaints in the future. In addition, the underwriters may assert that we are liable for some or all of any liability that they are found to have to the plaintiffs, pursuant to the indemnification provisions of the underwriting agreement we entered into as part of the initial public offering, or otherwise.

     We can provide no assurance as to the outcome of these complaints or any potential suit against us or our officers and directors. Any conclusion of these matters in a manner adverse to us could have a material adverse affect on our financial position and results of operations. In addition, the costs to us of defending any litigation or other proceeding, even if resolved in our favor, could be substantial. Such litigation could also substantially divert the attention of our management and our resources in general. Even if we are not named as defendants in these lawsuits, we may also be required to incur significant costs and our management may be distracted by being required to provide information, documents or testimony in connection with the actions against our underwriters. Uncertainties resulting from the initiation and continuation of any litigation or other proceedings and the negative publicity associated with this litigation could harm our ability to compete in the marketplace.

We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could result in unanticipated expenses and fluctuations in operating results.

     Depending on factors such as the timing of our introduction of new products which utilize our BIS technology, as well as warranty claims and product returns, we may need to reserve amounts in excess of those currently reserved for product obsolescence, excess inventory, warranty claims and product returns. These reserves may not be adequate to cover all costs associated with these items. If these reserves are inadequate, we would be required to incur unanticipated expenses which could result in unexpected fluctuations in quarterly operating results.

We may not be able to compete effectively, which could result in price reductions and decreased demand for our products.

     We are facing increased competition in the domestic level of consciousness monitoring market as a result of a number of competitors’ monitoring systems which have been cleared for marketing by the FDA. These products are marketed by well-established medical products companies with significant resources. We may not be able to compete effectively with these and other potential competitors. We may also face substantial competition from companies which may develop sensor products that compete with our proprietary BIS Sensors for use with our BIS monitors or with third-party monitoring systems or anesthesia delivery systems that incorporate the BIS index. We also expect to face competition from companies currently marketing conventional electroencephalogram, or EEG, monitors using standard and novel signal-processing techniques. Other companies may develop anesthesia-monitoring systems that perform better than the BIS system and/or sell for less. In addition, one or more of our competitors may develop products that are substantially equivalent to our FDA-approved products, in which case they may be able to use our products as predicate devices to more quickly obtain FDA approval of their competing products. Medical device companies developing these and other competitive products may have greater financial, technical, marketing and other resources than we do. Competition in the sale of anesthesia-monitoring systems could result in price reductions, fewer orders, reduced gross margins and loss of market share. If we are not successful in developing new products or technologies, or if we experience delays in development or release of such products, we may not be able to compete successfully.

Our ability to market and sell our products and generate revenue depends upon receipt of domestic and foreign regulatory approval of our products and manufacturing operations.

     Our products are classified as medical devices and are subject to extensive regulation in the United Sates by the FDA and other federal, state, and local authorities. These regulations relate to the manufacturing, labeling, sale, promotion, distribution, importing, exporting and shipping of our products. Before we can market new products or a new use of, or claim for, an existing product in the United States, we must obtain clearance or approval from the FDA. If the FDA concludes that any of our products do not meet the requirements to obtain clearance of a premarket notification under Section 510(k) of the Food, Drug and Cosmetic Act, then we would be required to file a premarket approval application. For example, there can be no guarantee that the FDA will accept the results from our depression clinical trial as supportive of a 510(k) notification without requiring additional studies and/or a premarket approval application. Both of these processes can be lengthy, expensive, may require extensive data from preclinical studies and clinical trials and may require significant user fees. The premarket approval process typically is more burdensome, expensive, time-consuming and uncertain than the premarket notification process. We may not obtain clearance of a 510(k) notification or approval of a premarket approval application with respect to any of our products on a timely basis, if at all. If we fail to obtain timely clearance or approval for our products, we will not be able to market and sell our products, which will limit our ability to generate revenue. We may also be required to obtain clearance of a 510(k) notification from the FDA before we can market certain previously marketed products which we modify after they have been cleared. We have made certain enhancements to our currently marketed products which we have determined do not necessitate the filing of a new 510(k) notification. However, if the FDA does not agree with our determinations, it will require us to file a new 510(k) notification for the modification, and we may be prohibited from marketing the modified devices until we obtain FDA clearance, or be required to recall devices that may be on the market, or be subject to other sanctions.

     Medical devices may be marketed only for the indications for which they are approved or cleared. The FDA may fail to approve or clear indications that are necessary or desirable for successful commercialization of our products. The FDA also may refuse our request for 510(k) clearance or premarket approval of new products, new intended uses, or modification to products once they are approved or cleared. Our approvals or clearance can be revoked if safety or effectiveness problems develop.

     Our promotional materials and training methods must comply with the FDA and other applicable laws and regulations. If the FDA determines that our promotional materials or training constitute promotion of an unapproved use, it could request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil monetary penalties, or criminal prosecution. It also is possible that other

federal, state, or foreign enforcement authorities might take action if they consider our promotional or training materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement. In that event, our reputation could be damaged, adoption of the products could be impaired, and we might not be able to promote the products for certain uses for which we had expected to promote them.

     The FDA also requires us to adhere to current Good Manufacturing Practices regulations, also known as the Quality System Regulation, or QSR, in the case of medical devices, which include production controls, design controls, testing, quality control, documentation procedures, verification and validation of the design and of the production process, purchasing controls for materials and components, implementation of corrective and preventive actions, and servicing, among other requirements. The FDA may at any time inspect our facilities to determine whether adequate compliance with QSR requirements has been achieved. Compliance with the QSR regulations for medical devices is difficult and costly. In addition, we may not continue to be compliant as a result of future changes in, or interpretations of, regulations by the FDA or other regulatory agencies. If we do not achieve continued compliance, the FDA may issue a warning letter, withdraw marketing clearance, require product recall, seize products, seek an injunction or consent decree, or seek criminal prosecution, among other possible remedies. When any change or modification is made to a device or its intended use, the manufacturer may be required to reassess compliance with the QSR regulations, which may cause interruptions or delays in the marketing and sale of our products.

     Sales of our products outside the United States are subject to foreign regulatory requirements that vary from country to country. The time required to obtain approvals from foreign countries may be longer than that required for FDA approval, and requirements for foreign licensing may differ from FDA requirements.

     The federal, state and foreign laws and regulations regarding the manufacture and sale of our products are subject to future changes, as are administrative interpretations of regulatory agencies. If we fail to comply with applicable federal, state or foreign laws or regulations, we could be subject to enforcement actions, including product seizures, recalls, withdrawal of clearances or approvals and civil and criminal penalties.

All of our manufacturing activities are performed at a single site and any disaster at this site could disrupt our ability to manufacture our products for a substantial length of time, which could cause our revenues to decrease.

     We assemble all of our BIS hardware and produce all of our BIS Sensors in one facility in Norwood, Massachusetts. Despite precautions we take, events such as fire, flood, power loss or other disasters at this facility could significantly impair our ability to manufacture our products and operate our business. Our facility and certain manufacturing equipment located in that facility would be difficult to replace and could require substantial replacement lead-time. Catastrophic events may also destroy any inventory of product or components located in our facility. While we carry insurance for natural disasters and business interruption, the occurrence of such an event could result in losses that exceed the amount of this insurance coverage, which would impair our financial results.

Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply with ongoing regulatory requirements our products could be subject to restrictions or withdrawal from the market.

     We are subject to the Medical Device Reporting, or MDR, regulations that require us to report to the FDA if our products may have caused or contributed to patient death or serious injury, or if our device malfunctions and a recurrence of the malfunction would likely result in a death or serious injury. We must also file reports of device corrections and removals and adhere to the FDA’s rules on labeling and promotion. Our failure to comply with these or other applicable regulatory requirements could result in enforcement action by the FDA, which may include any of the following:

	•		untitled letters, warning letters, fines, injunctions and civil penalties;
	•		administrative detention, which is the detention by the FDA of medical devices believed to be adulterated or misbranded;
	•		customer notification, or orders for repair, replacement or refund;
	•		voluntary or mandatory recall or seizure of our products;
	•		operating restrictions, partial suspension or total shutdown of production;
	•		refusal to review pre-market notification or pre-market approval submissions;

	•		rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval; and
	•		criminal prosecution.

     Any of the foregoing actions by the FDA could have a material adverse effect on our business and results of operations.

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

     Our operations may be directly or indirectly affected by various state and federal healthcare fraud and abuse laws, including the federal Anti-Kickback Statute, which prohibits any person from knowingly and willfully offering, paying, soliciting or receiving remuneration, directly or indirectly, to induce or reward either the referral of an individual, or the furnishing or arranging for an item or service, for which payment may be made under federal healthcare programs, such as the Medicare and Medicaid programs. If our past or present operations are found to be in violation of these laws, we or our officers may be subject to civil or criminal penalties, including large monetary penalties, damages, fines, imprisonment and exclusion from Medicare and Medicaid program participation. If enforcement action were to occur, our business and financial condition would be harmed.

If we do not retain our senior management and other key employees, we may not be able to successfully implement our business strategy.

     Our president and chief executive officer, Nassib Chamoun, joined us at our inception in 1987. Our Founder Chairman, J. Breckenridge Eagle, began serving as a director in 1988. Many other members of our management and key employees have extensive experience with us and other companies in the medical device industry. Our success is substantially dependent on the ability, experience and performance of these members of our senior management and other key employees. Because of their ability and experience, if we lose one or more of the members of our senior management or other key employees, our ability to successfully implement our business strategy could be seriously harmed. We compensate our executive officers in part with equity incentives, including stock options. A significant portion of the stock options held by our senior management and employees have exercise prices below the fair market value of our common stock.

If we do not attract and retain skilled personnel, or if we do not maintain good relationships with our employees, we will not be able to expand our business.

     Our products are based on complex signal-processing technology. Accordingly, we require skilled personnel to develop, manufacture, sell and support our products. Our future success will depend largely on our ability to continue to hire, train, retain and motivate additional skilled personnel, particularly sales representatives who are responsible for customer education and training and post-installation customer support. In order to hire and train skilled personnel, we believe that we will need to provide compensation arrangements, including incentive-based programs, that are competitive with programs offered by comparable medical device companies. Various factors may prevent us from implementing or maintaining such programs, including business and general market conditions and fluctuations in our stock price. If we are not able to attract and retain skilled personnel, we will not be able to manage and expand our business.

     In addition, we may be subject to claims that we engage in discriminatory or other unlawful practices with respect to our hiring, termination, promotion and compensation processes for our employees. Such claims, with or without merit, could be time consuming, distracting and expensive to defend, could divert attention of our management from other tasks important to the success of our business and could adversely affect our reputation as an employer.

If we make any acquisitions, we will incur a variety of costs and may never successfully integrate the acquired business into ours.

     We may attempt to acquire businesses, technologies, services or products that we believe are a strategic complement to our business whether by purchase, exclusive license, assignment or comparable arrangements. For example, we recently entered into the LiDCO Distribution Agreement, pursuant to which we obtained exclusive rights to distribute LiDCO’s LiDCOrapid monitoring system in the United States, non-exclusive rights to distribute the LiDCOplus system and an exclusive license to integrate LiDCO and BIS^® technologies into a combined product for sale in the United States. For the first six months of the distribution agreement, our exclusive rights under the agreement in certain U.S. territories are subject to the exclusive rights granted by LiDCO to a third party. We may encounter operating difficulties and expenditures relating to integrating an acquired business, technology, service or product, such as the product license and distribution rights we gained under our agreement with LiDCO. These acquisitions may also absorb significant management attention that would otherwise be available for ongoing

development of our business. Moreover, we may never realize the anticipated benefits of any acquisition. For example, we may not be able to successfully distribute LiDCO’s products, integrate those products into a combined product, or realize any revenue from the arrangement. We may also make dilutive issuances of equity securities, incur debt or experience a decrease in the cash available for our operations, or incur contingent liabilities in connection with any future acquisitions, all of which could have a material adverse affect on our business, financial condition and results of operations.

Our employees may engage in misconduct or other improper activities, including insider trading.

     We are exposed to the risk that employee fraud or other misconduct could occur. Misconduct by employees could include failures to comply with FDA regulations, to provide accurate information to the FDA, to comply with manufacturing standards we have established, to comply with federal and state healthcare fraud and abuse laws and regulations, to accurately report financial information or data or to disclose unauthorized activities to us. Employee misconduct could also involve improper sales tactics or use of customer information or information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. We have adopted a written code of business conduct and ethics, but it is not always possible to identify and deter employee misconduct, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses.

     In addition, during the course of our operations, our directors, executives and employees may have access to material, non-public information regarding our business, our results of operations or potential transactions we are considering. Despite our adoption of an Insider Trading Policy, we may not be able to prevent a director or employee from trading in our common stock on the basis of, or while in possession of, material, non-public information. If a director or employee was to be investigated, or an action was to be brought against a director or employee, for insider trading, it could have a negative impact on our reputation and our stock price. Such a claim, with or without merit, could also result in substantial expenditures of time and money, and divert attention of our management team from other tasks important to the success of our business.

Failure of users of the BIS system, or users of future products we may develop, to obtain adequate reimbursement from third-party payors could limit market acceptance of the BIS system and other products, which could prevent us from sustaining profitability.

     Anesthesia providers are generally not reimbursed separately for patient monitoring activities utilizing the BIS system. For hospitals and outpatient surgical centers, when reimbursement is based on charges or costs, patient monitoring with the BIS system may reduce reimbursements for surgical procedures, because charges or costs may decline as a result of monitoring with the BIS system. Failure by hospitals and other users of the BIS system to obtain adequate reimbursement from third-party payors, or any reduction in the reimbursement by third-party payors to hospitals and other users as a result of using the BIS system, could limit market acceptance of the BIS system, which could prevent us from sustaining profitability.

     In addition, market acceptance of future products serving the depression and Alzheimer’s disease markets could depend upon adequate reimbursement from third-party payors. The ability and willingness of third-party payors to authorize coverage and sufficient reimbursement to compensate and encourage physicians to use such products is uncertain.

The market price of our stock is highly volatile, and this volatility could cause your investment in our stock to suffer a decline in value and cause us to incur significant costs from class action litigation.

     The market price of our stock is highly volatile. For example, from January 1, 2009 through November 1, 2009, the price of our common stock has ranged from a high of $12.14 to a low of $2.86. As a result of this volatility, your investment in our stock could rapidly lose its value. Our stock price could fluctuate for many reasons, including without limitation:

	•		variations in our quarterly operating results or those of companies that are perceived to be similar to us;
	•		third-party sales of large blocks of our common stock;
	•		rumors relating to us or our competitors;
	•		changes to our research and development plans and/or announcements regarding new technologies by us or our competitors;
	•		adverse results in clinical trials of our BIS monitoring system products and products under development;

	•		negative publicity or unfavorable media coverage;
	•		lawsuits involving us;
	•		sales by us of equity or debt to fund our operations;
	•		the loss of any of our key scientific or management personnel;
	•		information relating to the proposed acquisition of all of our outstanding shares of common stock pursuant to the Merger Agreement;
	•		FDA or international regulatory actions or lawsuits concerning the safety of our products; and
	•		market conditions, both in the medical device sector and generally.