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EX-32.1 - EXHIBIT 32.1_SECTION 906 CERTIFICATION - CYTORI THERAPEUTICS, INC.exhibit321_section906cert.htm
EX-31.2 - EXHIBIT 31.2_SECTION 302_CFO CERTIFICATION - CYTORI THERAPEUTICS, INC.exhibit312_cfocertification.htm
EX-31.1 - EXHIBIT 31.1_SECTION 302_CEO CERTIFICATION - CYTORI THERAPEUTICS, INC.exhibit311_ceocertification.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 


FORM 10-Q

(Mark One)
ý
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
     
For the quarterly period ended June 30, 2010
     
OR
     
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
For the transition period from                     to
 
Commission file number 0-32501

 
CYTORI THERAPEUTICS, INC.
(Exact name of Registrant as Specified in Its Charter)

DELAWARE
 
33-0827593
(State or Other Jurisdiction
of Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
     
3020 CALLAN ROAD, SAN DIEGO, CALIFORNIA
 
92121
(Address of principal executive offices)
 
(Zip Code)
     
Registrant’s telephone number, including area code: (858) 458-0900


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 (“the Exchange Act”) 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   ý  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 definition 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 ý
Non-Accelerated Filer o
Smaller reporting company o
   
(Do not check if a smaller reporting company)
 

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

As of July 31, 2010, there were 45,905,944 shares of the registrant’s common stock outstanding.


 
 

 


CYTORI THERAPEUTICS, INC.

INDEX
 
Page

 
     
   
       
   
       
   
       
   
       
   
       
 
       
 
       
 
       
 
       
 
 
 
 
 
 
 




 
 

 


                                 
PART I.  FINANCIAL INFORMATION
                               
Item 1.  Financial Statements
                               

CYTORI THERAPEUTICS, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS
(UNAUDITED)
 
   
As of June 30, 2010
   
As of December 31, 2009
 
Assets
           
Current assets:
           
Cash and cash equivalents
  $ 38,100,000     $ 12,854,000  
Accounts receivable, net of allowance for doubtful accounts of $566,000 and $751,000 in 2010 and 2009, respectively
    2,573,000       1,631,000  
Inventories, net
    2,555,000       2,589,000  
Other current assets
    581,000       1,024,000  
                 
Total current assets
    43,809,000       18,098,000  
                 
Property and equipment, net
    1,220,000       1,314,000  
Investment in joint venture
    555,000       280,000  
Other assets
    456,000       500,000  
Intangibles, net
    524,000       635,000  
Goodwill
    3,922,000       3,922,000  
                 
Total assets
  $ 50,486,000     $ 24,749,000  
                 
Liabilities and Stockholders’ Equity (Deficit)
               
Current liabilities:
               
Accounts payable and accrued expenses
  $ 5,251,000     $ 5,478,000  
Current portion of long-term obligations
    1,978,000       2,705,000  
                 
Total current liabilities
    7,229,000       8,183,000  
                 
Deferred revenues, related party
    5,512,000       7,634,000  
Deferred revenues
    2,435,000       2,388,000  
Warrant liability
    2,644,000       6,272,000  
Option liability
    1,340,000       1,140,000  
Long-term obligations, less current portion
    17,226,000       2,790,000  
                 
Total liabilities
    36,386,000       28,407,000  
                 
Commitments and contingencies
               
Stockholders’ equity (deficit):
               
Preferred stock, $0.001 par value; 5,000,000 shares authorized; -0- shares issued and outstanding in 2010 and 2009
           
Common stock, $0.001 par value; 95,000,000 shares authorized; 45,900,581 and 40,039,259 shares issued and 45,900,581 and 40,039,259 shares outstanding in 2010 and 2009, respectively
    46,000       40,000  
Additional paid-in capital
    204,385,000       178,806,000  
Accumulated deficit
    (190,331,000 )     (182,504,000 )
                 
Total stockholders’ equity (deficit)
    14,100,000       (3,658,000 )
                 
Total liabilities and stockholders’ equity (deficit)
  $ 50,486,000     $ 24,749,000  

 
 
SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
 
 
 
3

 
 
CYTORI THERAPEUTICS, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)
 

 

 
   
For the Three Months
Ended June 30,
   
For the Six Months
Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Product revenues:
                       
    Related party
  $     $ 9,000     $ 9,000     $ 573,000  
    Third party
    2,091,000       1,268,000       4,347,000       2,616,000  
      2,091,000       1,277,000       4,356,000       3,189,000  
                                 
Cost of product revenues
    883,000       776,000       1,813,000       1,863,000  
                                 
Gross profit
    1,208,000       501,000       2,543,000       1,326,000  
                                 
Development revenues:
                               
Development, related party
          7,250,000       2,122,000       7,250,000  
Research grant and other
    7,000       14,000       28,000       22,000  
      7,000       7,264,000       2,150,000       7,272,000  
Operating expenses:
                               
Research and development
    2,301,000       2,919,000       4,546,000       6,388,000  
Sales and marketing
    2,425,000       1,463,000       4,424,000       2,748,000  
General and administrative
    3,052,000       2,309,000       6,271,000       4,803,000  
Change in fair value of warrant liability
    (1,461,000 )     2,133,000       (3,628,000 )     1,112,000  
Change in fair value of option liability
    (60,000 )     (630,000 )     200,000       (420,000 )
                                 
Total operating expenses
    6,257,000       8,194,000       11,813,000       14,631,000  
                                 
Operating loss
    (5,042,000 )     (429,000 )     (7,120,000 )     (6,033,000 )
                                 
Other income (expense):
                               
Interest income
    2,000       4,000       3,000       18,000  
Interest expense
    (254,000 )     (374,000 )     (530,000 )     (774,000 )
Other expense, net
    (49,000 )     (16,000 )     (125,000 )     (108,000 )
Equity loss from investment in joint venture
    (34,000 )     (11,000 )     (55,000 )     (27,000 )
                                 
Total other expense
    (335,000 )     (397,000 )     (707,000 )     (891,000 )
                                 
Net loss
  $ (5,377,000 )   $ (826,000 )   $ (7,827,000 )   $ (6,924,000 )
                                 
Basic and diluted net loss per common share
  $ (0.12 )   $ (0.02 )   $ (0.18 )   $ (0.21 )
                                 
Basic and diluted weighted average common shares
    45,295,965       35,077,783       43,772,219       33,732,954  
                                 

 

 
SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 
4

 

CYTORI THERAPEUTICS, INC.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)


   
For the Six Months Ended June 30,
 
   
2010
   
2009
 
Cash flows from operating activities:
           
Net loss
  $ (7,827,000 )   $ (6,924,000 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    553,000       876,000  
Amortization of deferred financing costs and debt discount
    199,000       386,000  
Warranty provision
          (23,000 )
Provision for doubtful accounts
    567,000       300,000  
Change in fair value of warrants
    (3,628,000 )     1,112,000  
Change in fair value of option liabilities
    200,000       (420,000 )
Share-based compensation expense
    1,468,000       1,276,000  
Equity loss from investment in joint venture
    55,000       27,000  
Increases (decreases) in cash caused by changes in operating assets and liabilities:
               
Accounts receivable
    (1,509,000 )     (496,000 )
Inventories
    34,000       282,000  
Other current assets
    289,000       78,000  
Other assets
          51,000  
Accounts payable and accrued expenses
    (227,000 )     (1,153,000 )
Deferred revenues, related party
    (2,122,000 )     (7,250,000 )
Deferred revenues
    47,000       (7,000 )
Long-term deferred rent
          (168,000 )
                 
Net cash used in operating activities
    (11,901,000 )     (12,053,000 )
                 
Cash flows from investing activities:
               
Purchases of property and equipment
    (348,000 )     (18,000 )
Investment in joint venture
    (330,000 )      
                 
Net cash used in investing activities
    (678,000 )     (18,000 )
                 
Cash flows from financing activities:
               
Principal payments on long-term obligations
    (5,454,000 )     (803,000 )
Proceeds from long term obligations
    20,000,000        
Debt issuance costs and loan fees                                                                                                
    (559,000 )      
Proceeds from exercise of employee stock options and warrants
    7,042,000       21,000  
Proceeds from sale of common stock and warrants
    17,314,000       11,189,000  
Costs from sale of common stock and warrants
    (518,000 )     (960,000 )
Proceeds from sale of treasury stock
          3,933,000  
                 
Net cash provided by financing activities
    37,825,000       13,380,000  
                 
Net increase in cash and cash equivalents
    25,246,000       1,309,000  
                 
Cash and cash equivalents at beginning of period
    12,854,000       12,611,000  
                 
Cash and cash equivalents at end of period
  $ 38,100,000     $ 13,920,000  
                 
Supplemental disclosure of cash flows information:
               
Cash paid during period for:
               
Interest
  $ 287,000     $ 399,000  
Final payment fee on long-term debt
    205,000        
                 
Supplemental schedule of non-cash investing and financing activities:
               
Fair value of warrants allocated to additional paid in capital
  $ 279,000     $  
                 


SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 
5

 


CYTORI THERAPEUTICS, INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
June 30, 2010
(UNAUDITED)


1.
Basis of Presentation

Our accompanying unaudited consolidated condensed financial statements as of June 30, 2010 and for the three and six months ended June 30, 2010 and 2009 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements.  Our consolidated condensed balance sheet at December 31, 2009 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations of Cytori Therapeutics, Inc., and our subsidiaries (the Company) have been included.  Operating results for the three and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.  These financial statements should be read in conjunction with the consolidated financial statements and notes therein included in our annual report on Form 10-K for the year ended December 31, 2009.

2.
Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions affecting 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 revenue and expenses during the reporting period.  Our most significant estimates and critical accounting policies involve recognizing revenue, evaluating goodwill for impairment, valuing our put option arrangement with Olympus Corporation (Put option) (see notes 14 and 15), valuing warrants, determining the assumptions used in measuring share-based compensation expense, valuing our deferred tax assets, assessing how to report our investment in Olympus-Cytori, Inc., valuing allowances for doubtful accounts and inventories.

Actual results could differ from these estimates.  Current economic conditions, including illiquid credit markets and volatile equity markets, contribute to the inherent uncertainty of such estimates.  Management’s estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the periods they are determined to be necessary.

3.
Liquidity
 
We incurred net losses of $5,377,000 and $7,827,000 for the three and six months ended June 30, 2010 and $826,000 and $6,924,000 for the three and six months ended June 30, 2009, respectively.  We have an accumulated deficit of $190,331,000 as of June 30, 2010.  Additionally, we have used net cash of $11,901,000 and $12,053,000 to fund our operating activities for the six months ended June 30, 2010 and 2009, respectively.  To date these operating losses have been funded primarily from outside sources of invested or borrowed capital.

During 2010, we expanded our commercialization activities while simultaneously pursuing available financing sources to support operations and growth.  We have had, and continue to have, an ongoing need to raise additional cash from outside sources to fund our operations.  If we cannot do so, we would be required to reduce our research, development, and administrative operations, including reductions of our employee base, in order to offset lack of available funding.   We continue to evaluate available financing opportunities as part of our normal course of business. 

In June 2010, we entered into an Amended and Restated Loan and Security Agreement with General Electric Capital Corporation (GECC), Silicon Valley Bank (SVB) and Oxford Finance Corporation (together, the Lenders), pursuant to which the Lenders agreed to make a term loan to the Company in an aggregate principal amount of up to $20.0 million (Term Loan).  The Term Loan amends and restates the term loan agreement entered into with GECC and SVB on October 14, 2008 (Original Term Loan), of which an aggregate balance of approximately $4.1 million along with prorated final payment fee of $205,000 remained outstanding and was refinanced under the Term Loan.  The net proceeds of the Term Loan, after payment of lender fees and expenses and the refinancing of the Original Term Loan, were approximately $15.3 million. 
 

 
 
6

 
 
In June 2010, we completed a common stock purchase agreement with Seaside 88, LP (“Seaside”) relating to the offering and sale of a total of up to 7,150,000 shares of our common stock. The agreement required us to issue and Seaside to buy 275,000 shares of our common stock every two weeks, subject to the satisfaction of customary closing conditions.  Between June 2009 and June 2010, we raised approximately $30,172,000 in gross proceeds from the sale of 7,150,000 shares of our common stock related to Seaside closings.

With consideration of these endeavors as well as existing funds, cash generated by operations, and other accessible sources of financing, we believe our cash position is adequate to satisfy our working capital, capital expenditures, debt service, and other financial commitments into 2012, subject to minimum cash and cash liquidity requirements of the Amended and Restated Loan and Security Agreement, which requires that we maintain at least six months of cash on hand to avoid an event of default.  Management actively monitors cash expenditures we incur as our business progresses in an effort to match projected expenditures to available cash flow.

4.
Recent Accounting Pronouncements
 
In June 2009, the Financial Accounting Standards Board (FASB) issued an update to the consolidation topic of the FASB Accounting Standards Codification (the ASC or the Codification).  This update requires an enterprise to qualitatively assess the determination of the primary beneficiary (or “consolidator”) of a variable interest entity, or VIE, based on whether the entity (1) has the power to direct matters that most significantly impact the activities of the VIE, and (2) has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Also, it changes the consideration of kick-out rights in determining if an entity is a VIE and requires an ongoing reconsideration of the primary beneficiary. It also amends the events that trigger a reassessment of whether an entity is a VIE. This update is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  The adoption of this standard did not have a material impact on our consolidated condensed financial statements.
 
In October 2009, the FASB issued an update to the revenue recognition topic of the Codification.  The update addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence; (b) third-party evidence; or (c) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. In addition, this guidance significantly expands required disclosures related to a vendor’s multiple-deliverable revenue arrangements. The update 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and early adoption is permitted.  We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements.
 
In March 2010, the Task Force reached a consensus on EITF 08-9, “Milestone Method of Revenue Recognition” that the milestone method is a valid application of the proportional performance model for revenue recognition if the milestones are substantive and there is substantive uncertainty about whether the milestones will be achieved.  The Task Force agreed that whether milestone is substantive is a judgment that should be made at the inception of the arrangement.  Provided that the EITF’s consensus is ratified by the FASB, an Accounting Standard Update will be issued to update the Codification to reflect the new guidance.  If ratified, the new guidance will be effective for interim and annual periods beginning on or after June 15, 2010.  We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements.

5.
Short-Term Investments

We invest excess cash in money market funds, highly liquid debt instruments of financial institutions and corporations with strong credit ratings, and in United States government obligations. We have established guidelines relative to diversification and maturities to maintain safety and liquidity. These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates.   After considering current market conditions, and in order to minimize our risk, management has elected to invest all excess funds in money market funds and other highly liquid investments that are appropriately classified as cash equivalents as of June 30, 2010 and December 31, 2009.

6.
Warrant Liability
 
Effective January 1, 2009, we changed our method of accounting for certain common stock purchase warrants with exercise price reset features due to the adoption of a new accounting standard.   These warrants were issued in connection with our August 2008 private placement of 2,825,517 unregistered shares of common stock and 1,412,758 common stock warrants. The warrants had an original exercise price of $8.50 and expire in August 2013.  Under the new standard, these warrants previously recognized in stockholders’ equity (deficit) are now accounted for as fair value liabilities, with changes in fair value included in net earnings (loss).
 

 
 
7

 
 
The cumulative effect of the adoption is to present these warrants as liabilities on the date of the adoption as if they had been accounted for as liabilities since the warrants were issued.  As a result on January 1, 2009, we recognized a $1.7 million long-term warrant liability, a $2.9 million decrease in accumulated deficit and a corresponding decrease in additional paid-in capital of $4.6 million. During 2009, the fair value of the warrant liability increased to $6.3 million and as a result we recognized $4.6 million loss from the change in the fair value of warrants in 2009.  The fair value of these warrants decreased to $2.6 million as of June 30, 2010, which resulted in a $1.5 million and $3.6 million gain from the change in fair value of warrants for the three and six months ended June 30, 2010, respectively.

Since these warrants do not qualify for hedge accounting, all future changes in the fair value of the warrants will be recognized currently in earnings until such time as the warrants are exercised or expire. These warrants are not traded in an active securities market, and as such, we estimated the fair value of these warrants using the Black-Scholes option pricing model using the following assumptions:

   
As of
June 30, 2010
   
As of
December 31, 2009
 
Expected term
 
3.12 years
   
3.61 years
 
Common stock market price
  $ 3.48     $ 6.10  
Risk-free interest rate
    1.00 %     1.70 %
Expected volatility
    80.70 %     76.16 %
Resulting fair value (per warrant)
  $ 1.37     $ 3.28  

Expected volatility is based primarily on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the expected term of the warrants. We believe this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. We currently have no reason to believe future volatility over the expected remaining life of these warrants is likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is the interest rate for treasury constant maturity instruments published by the Federal Reserve Board that is closest to the expected term of the warrant.
 
7.
Long-term Obligation
 
On June 11, 2010, we entered into an Amended and Restated Loan and Security Agreement with General Electric Capital Corporation (GECC), Silicon Valley Bank (SVB) and Oxford Finance Corporation (together, the “Lenders”), pursuant to which the Lenders agreed to make a term loan in an aggregate principal amount of up to $20.0 million (Term Loan), subject to the terms and conditions set forth in the Term Loan.  On June 14, 2010, the Lenders funded a Term Loan in the principal amount of $20.0 million.  The Term Loan accrues interest at a fixed rate of 9.87% per annum.  We are  required to make monthly payments of interest-only, through March 1, 2011, and are required to repay the principal amount of the Term Loan over a period of twenty-seven (27) consecutive equal monthly installments of principal plus accrued interest, commencing on April 1, 2011.   At maturity of the Term Loan, we will also make a final payment equal to 5% ($1,000,000) of the Term Loan.  We may incur additional fees if we elect to prepay the Term Loan.  In connection with the Term Loan, on June 11, 2010, we issued to the Lenders warrants to purchase up to an aggregate of 101,266 shares of our common stock at an exercise price of $3.95 per share.  These warrants are immediately exercisable and will expire on June 11, 2017.  

The Term Loan amended and restated the Original Term Loan, of which an aggregate balance of approximately $4.1 million remained outstanding along with a prorated final payment fee of $205,000. The net proceeds of the Term Loan, after payment of lender fees and expenses and the refinancing of the Original Term Loan, were approximately $15.3 million. 

We accounted for this amendment to the Original Term Loan as debt modification since the terms of the amended Term Loan and the Original Term Loan were not substantially different and as present value of cash flows of the modified instrument was within 10% of the original debt instrument.  Accordingly, the fees associated with the amended Term Loan of $354,000 and the existing unamortized debt discount from the Original Term Loan of $242,000 will be amortized as an adjustment of interest expense over the remaining term of the Term Loan using the effective interest method.

We allocated the aggregate proceeds of the Term Loan between the warrants and the debt obligations based on their relative fair values.  The fair value of the warrant issued to the Lenders is calculated utilizing the Black-Scholes option-pricing model. We are amortizing the relative fair value of the warrants as a discount of $279,000 over the term of the loan using the effective interest method, with an effective interest rate of 14.78%. If the maturity of the debt was accelerated due to an event of default, then the amortization would be accelerated. We were in compliance with our financial and non-financial covenants as of June 30, 2010.  


 
8

 
 
 
8.
Revenue Recognition
 
Product Sales

We recognize revenue from product sales when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable and (iv) collection of the resulting accounts receivable is reasonably assured.

For all sales, we use a binding purchase order or a signed agreement as evidence of an arrangement.  Revenue for these product sales is recognized upon delivery to the customer, as all risks and rewards of ownership have been substantively transferred to the customer at that point.  For Celution® 800/CRS System sales to customers who arrange for and manage the shipping process, we recognize revenue upon shipment from our facilities.  Shipping and handling costs that are billed to our customers are classified as revenue.  The customer’s obligation to pay and the payment terms are set at the time of delivery and are not dependent on the subsequent use or resale of our product.

For those sales that include multiple deliverables, we allocate revenue based on the relative fair values of the individual components.  When more than one element such as product maintenance or technical support services are included in an arrangement, we allocate revenue between the elements based on each element’s relative fair value, provided that each element meets the criteria for treatment as a separate unit of accounting.  An item is considered a separate unit of accounting if it has value to the customer on a standalone basis and there is objective and reliable evidence of the fair value of the undelivered items.  Fair value is generally determined based upon the price charged when the element is sold separately.  In the absence of fair value for a delivered element, we allocate revenue first to the fair value of the undelivered elements and allocate the residual revenue to the delivered elements.  Fair values for undelivered elements are determined based on vendor-specific objective evidence as well as market participant quotes for similar services.  Deferred service revenue is recognized ratably over the period the services are provided.  In the absence of fair value for an undelivered element, the arrangement is accounted for as a single unit of accounting, resulting in a deferral of revenue recognition for delivered elements until all undelivered elements have been fulfilled.
 
Concentration of Significant Customers
 
For the six months ended June 30, 2010, our sales were concentrated in two direct customers, which in aggregate comprised 32% of our revenue recognized for the six months ended June 30, 2010.  Our Asia-Pacific and North America region sales accounted for 87% of our revenue recognized for the six months ended June 30, 2010.  Additionally, one distributor and two direct customers accounted for 37% of total outstanding accounts receivable as of June 30, 2010.
 
For the six months ended June 30, 2009, our sales were concentrated in three distributors and one direct customer, which in aggregate comprised 61% of our revenue recognized for the six months ended June 30, 2009.  Our Asia-Pacific region sales accounted for 49% of our revenue recognized for the six months ended June 30, 2009.  Additionally, one distributor and one end customer accounted for 50% of total outstanding accounts receivable as of June 30, 2009.

Research and Development

We earn revenue for performing tasks under research and development agreements with both commercial enterprises, such as Olympus and Senko, and governmental agencies like the National Institutes of Health (“NIH”).  Revenue earned under development agreements is classified as either research grant or development revenues depending on the nature of the arrangement.  Revenues derived from reimbursement of direct out-of-pocket expenses for research costs associated with grants are recorded as research grant and other within development revenues.  Research grant revenue is recorded at the gross amount of the reimbursement.  The costs associated with these reimbursements are reflected as a component of research and development expense in our consolidated statements of operations.  Additionally, research and development arrangements we have with commercial enterprises such as Olympus and Senko are considered a key component of our central and ongoing operations.  Accordingly, when recognized, the inflows from such arrangements are presented as revenues in our consolidated statements of operations.

We received funds from Olympus and Olympus-Cytori, Inc. during 2005 and 2006.   We recorded upfront fees totaling $28,311,000 as deferred revenues, related party.  In exchange for these proceeds, we agreed to (a) provide Olympus-Cytori, Inc. an exclusive and perpetual license to our Celution® System device technology and certain related intellectual property, and (b) provide future development contributions related to commercializing the Celution® System platform.  The license and development services are not separable and as a result the recognition of this deferred amount requires achievement of service related milestones, under a proportional performance methodology.  If and as such revenues are recognized, deferred revenue will be decreased.  Proportional performance methodology was elected due to the nature of our development obligations and efforts in support of the Joint Venture (“JV”), including product development activities and regulatory efforts to support the commercialization of the JV products. The application of this methodology uses the achievement of R&D milestones as outputs
 
 
9

 
 
of value to the JV.  We received up-front, non-refundable payments in connection with these development obligations, which we have broken down into specific R&D milestones that are definable and substantive in nature, and which will result in value to the JV when achieved.  As our research and development efforts progress, we periodically evaluate,  and modify if necessary, the milestone points in our proportional performance model to ensure that revenue recognition accurately reflects our best estimate of substantive value deliverable to the JV.  Revenue will be recognized as the above mentioned R&D milestones are completed.  Of the amounts received and deferred, we recognized development revenues of $0 and $2,122,000 for the three and six months ended June 30, 2010, respectively.  During 2009, we recognized revenues of $7,250,000 for the three and six months ended June 30, 2009.    All related development costs are expensed as incurred and are included in research and development expense on the statement of operations.

Under a Distribution Agreement with Senko, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  We have also earned or will be entitled to earn additional payments under the Distribution Agreement based on achieving the defined research and development milestones. There was no development revenue recognized during the three and six months ended June 30, 2010 and 2009.

9.
Inventories

 
Inventories are carried at the lower of cost or market, determined on the first-in, first-out (FIFO) method.

 
Inventories consisted of the following:

   
June 30,
   
December 31,
 
   
2010
   
2009
 
             
Raw materials
  $ 1,592,000     $ 1,763,000  
Work in process
    569,000       387,000  
Finished goods
    394,000       439,000  
    $ 2,555,000     $ 2,589,000  

10.
Long-Lived Assets
 
We assess certain long-lived assets, such as property and equipment and intangible assets other than goodwill, for potential impairment when there is a change in circumstances that indicates carrying values of assets may not be recoverable.  Such long-lived assets are deemed to be impaired when the undiscounted cash flows expected to be generated by the asset (or asset group) are less than the asset’s carrying amount.  Any required impairment loss would be measured as the amount by which the asset’s carrying value exceeds its fair value, and would be recorded as a reduction in the carrying value of the related asset and a charge to operating expense.  During the three and six months ended June 30, 2010 and 2009, we had no impairment losses associated with our long-lived assets.

11.
Share-Based Compensation

During the first quarter of 2010, we issued to our directors, executive officers and certain non-executive employees options to purchase an aggregate of up to1,155,000 shares of our common stock, with four-year vesting for our officers and employees and two-year vesting for our directors. The grant date fair value of the awards granted to our officers and employees was $4.07 and to our directors was $4.16 per share. The resulting share-based compensation expense of $4,713,000, net of estimated forfeitures, will be recognized as expense over the respective vesting periods.

During the first quarter of 2009, we made a company-wide option grant to our non-executive employees to purchase an aggregate of up to 249,250 shares of our common stock, subject to a four-year vesting schedule. The grant date fair value of the awards was $2.00 per share.  Following the reduction of our workforce at the end of the same quarter, 182,100 of these options remained outstanding.  The resulting share-based compensation expense of $364,200, net of estimated forfeitures, will be recognized as expense over the employees’ respective vesting periods.

During the first quarter of 2009, we issued to our officers and directors options to purchase an aggregate of up to 585,000 shares of our common stock, with four-year vesting for our officers and two-year vesting for our directors. The grant date fair value of the awards granted to our officers and directors was $2.70 per share. The resulting share-based compensation expense of $1,579,500, net of estimated forfeitures, will be recognized as expense over the respective vesting periods.

During the second quarter of 2009, we made a company-wide option grant to our non-executive employees to purchase an aggregate of up to 155,580 shares of our common stock, subject to a four-year vesting schedule. The grant date fair value of the awards was $1.18 per share.  The resulting share-based compensation expense of $183,000, net of estimated forfeitures, will be recognized as expense over the employees’ respective vesting periods.
 
 
10

 
 

 
12.
Loss per Share

Basic per share data is computed by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted per share data is computed by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding during the period increased to include, if dilutive, the number of additional common shares that would have been outstanding as calculated using the treasury stock method. Potential common shares were related entirely to outstanding but unexercised options and warrants for all periods presented.

We have excluded all potentially dilutive securities from the calculation of diluted loss per share attributable to common stockholders for the three and six months ended June 30, 2010 and 2009, as their inclusion would be antidilutive.  Potentially dilutive common shares excluded from the calculations of diluted loss per share were 18,821,894 for the three and six month periods ended June 30, 2010 and 20,186,975 for the three and six month periods ended June 30, 2009, respectively.

13.
Commitments and Contingencies

We have entered into agreements, which have provisions for cancellation, with various clinical research organizations for pre-clinical and clinical development studies. Under the terms of these agreements, the vendors provide a variety of services including, but not limited to, conducting pre-clinical development research, recruiting and enrolling patients, monitoring studies, and data analysis. Payments under these agreements typically include fees for services and reimbursement of expenses. The timing of payments due under these agreements is estimated based on current schedules of pre-clinical and clinical studies in progress.  As of June 30, 2010, we have pre-clinical research study obligations of $148,000 (which are expected to be fully completed within a year) and clinical research study obligations of $3,200,000 ($2,300,000 of which are expected to be completed within a year).

We are subject to various claims and contingencies related to legal proceedings.  Due to their nature, such legal proceedings involve inherent uncertainties including, but not limited to, court rulings, negotiations between affected parties, and governmental actions.  Management assesses the probability of loss for such contingencies and accrues a liability and/or discloses the relevant circumstances, as appropriate.  Management believes that any liability to us or other remedy that may arise as a result of currently pending legal proceedings will not have a material adverse effect on our financial condition, liquidity, or results of operations as a whole.

During 2008, we entered into a supply agreement with minimum purchase requirements clause.  As of June 30, 2010, we have remaining minimum purchase obligations of $1,700,000 ($1,488,000 of which are to be expected to be completed within a year).

Refer to note 14 for a discussion of our commitments and contingencies related to our transactions with Olympus, including (a) our obligation to the Joint Venture in future periods and (b) certain put and call rights embedded in the arrangements with Olympus.

14.
Transactions with Olympus Corporation

Initial Investment by Olympus Corporation in Cytori

In 2005, we entered into a common stock purchase agreement with Olympus in which we received $11,000,000 in cash proceeds.  We received an additional $11,000,000 from Olympus in August 2006 for the issuance of approximately 1,900,000 shares of our common stock at $5.75 per share.  We received an additional $6,000,000 from Olympus in August 2008 for the issuance of 1,000,000 unregistered shares of our common stock at $6.00 per share and 500,000 common stock warrants (with an original exercise price of $8.50 per share) under a private placement offering.

As of June 30, 2010, Olympus holds approximately 8.74% of our issued and outstanding shares.  Additionally, Olympus has a right, which it has not yet exercised, to designate a director to serve on our Board of Directors.

Formation of the Olympus-Cytori Joint Venture

In 2005, we entered into a joint venture and other related agreements (the “Joint Venture Agreements”) with Olympus.  The Joint Venture is owned equally by Olympus and us.  We have determined that the Joint Venture is a variable interest entity or VIE, but that Cytori is not the VIE’s primary beneficiary.  Accordingly, we have accounted for our interests in the Joint Venture using the equity method of accounting, since we can exert significant influence over the Joint Venture’s operations.  At June 30, 2010, the carrying value of our investment in the Joint Venture is $555,000.  We are under no obligation to provide additional funding to the Joint Venture, but may choose to do so.  During the three and six months ended June 30, 2010, we contributed $330,000 to the Joint Venture.  We made no cash contributions to the Joint Venture during the three and six months ended June 30, 2009.

 
 
11

 
 
Put/Calls and Guarantees

The Shareholders’ Agreement between Cytori and Olympus provides that in certain specified circumstances of our insolvency or if we experience a change in control, Olympus will have the rights to (i) repurchase our interests in the Joint Venture at the fair value of such interests or (ii) sell its own interests in the Joint Venture to Cytori (the “Put”) at the higher of (a) $22,000,000 or (b) the Put’s fair value.

At June 30, 2010 and December 31, 2009, the estimated fair value of the Put was $1,340,000 and $1,140,000, respectively.  Fluctuations in the Put value are recorded in the consolidated condensed statements of operations as a component of change in fair value of option liabilities. The estimated fair value of the Put has been recorded as a long-term liability in the caption option liability in our consolidated condensed balance sheets.

The valuations of the Put were completed using an option pricing theory based simulation analysis (i.e., a Monte Carlo simulation).  The valuations are based on assumptions as of the valuation date with regard to the market value of Cytori and the estimated fair value of the Joint Venture, the expected correlation between the values of Cytori and the Joint Venture, the expected volatility of Cytori and the Joint Venture, the bankruptcy recovery rate for Cytori, the bankruptcy threshold for Cytori, the probability of a change of control event for Cytori, and the risk free interest rate.

The following assumptions were employed in estimating the value of the Put:

   
June 30, 2010
   
December 31, 2009
 
             
Expected volatility of Cytori                                                    
    74.00 %     72.00 %
Expected volatility of the Joint Venture
    74.00 %     72.00 %
Bankruptcy recovery rate for Cytori
    28.00 %     19.00 %
Bankruptcy threshold for Cytori                                                    
  $ 6,921,000     $ 11,308,000  
Probability of a change of control event for Cytori
    2.65 %     2.95 %
Expected correlation between fair values of Cytori and the Joint Venture in the future
    99.00 %     99.00 %
Risk free interest rate                                                    
    2.97 %     3.85 %

The Put has no expiration date.  Accordingly, we will continue to recognize a liability for the Put and mark it to market each quarter until it is exercised or until the arrangements with Olympus are amended.


15.
Fair Value Measurements
 
Fair value measurements are market-based measurements, not entity-specific measurements.  Therefore, fair value measurements are determined based on the assumptions that market participants would use in pricing the asset or liability.  We follow a three-level hierarchy to prioritize the inputs used in the valuation techniques to derive fair values.  The basis for fair value measurements for each level within the hierarchy is described below:
 
 
· Level 1: Quoted prices in active markets for identical assets or liabilities.
 
 
· Level 2: Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets.
 
 
· Level 3: Valuations derived from valuation techniques in which one or more significant inputs are unobservable in active markets.
 
 
The following table provides a summary of the recognized assets and liabilities that we measure at fair value on a recurring basis:
 
   
Balance as of
   
Basis of Fair Value Measurements
 
   
June 30, 2010
   
Level 1
   
Level 2
   
Level 3
 
Assets:
                       
Cash equivalents
  $ 34,305,000     $ 34,305,000     $     $  
                                 
Liabilities:
                               
Put option liability
  $ (1,340,000 )   $     $     $ (1,340,000 )
Warrant liability
  $ (2,644,000 )   $     $ (2,644,000 )   $  
                                 
 

 

 
12

 

 

 
   
Balance as of
   
Basis of Fair Value Measurements
 
   
December 31, 2009
   
Level 1
   
Level 2
   
Level 3
 
Assets:
                       
Cash equivalents
  $ 10,780,000     $ 10,780,000     $     $  
                                 
Liabilities:
                               
Put option liability
  $ (1,140,000 )   $     $     $ (1,140,000 )
Warrant liability
  $ (6,272,000 )   $     $ (6,272,000 )   $  
                                 
 
We use quoted market prices to determine the fair value of our cash equivalents, which consist of money market funds and therefore these are classified in Level 1 of the fair value hierarchy.
 
We value our put liability (see note 14) using an option pricing theory based simulation analysis (i.e., a Monte Carlo simulation). Assumptions are made with regard to the market value of Cytori and the estimated fair value of the Joint Venture, the expected correlation between the values of Cytori and the Joint Venture, the expected volatility of Cytori and the Joint Venture, the bankruptcy recovery rate for Cytori, the bankruptcy threshold for Cytori, the probability of a change of control event for Cytori, and the risk free interest rate.  Because some of the inputs to our valuation model are either not observable quoted prices or are not derived principally from or corroborated by observable market data by correlation or other means, the put option liability is classified as Level 3 in the fair value hierarchy.
 
The following table summarizes the change in our Level 3 put option liability value:
 
   
Six months ended
   
Three months ended
 
Put option liability
 
June 30, 2010
   
June 30, 2010
 
             
Beginning balance
  $ (1,140,000 )   $ (1,400,000 )
Decrease (increase)  in fair value recognized in operating expenses
    (200,000 )     60,000  
Ending balance
  $ (1,340,000 )   $ (1,340,000 )

Common stock purchase warrants issued in connection with our August 2008 private equity placement do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the Black-Scholes option pricing model in which all significant inputs are observable in active markets, such as common stock market price, volatility, and risk free rate, therefore the warrant liability is classified as Level 2 in the fair value hierarchy.  See note 6 for further discussion of fair value for these warrants.

No other assets or liabilities are measured at fair value on a recurring basis, or have been measured at fair value on a non-recurring basis subsequent to initial recognition, on the accompanying consolidated condensed balance sheet as of June 30, 2010.

16.
Fair Value

 
Financial Instruments

We disclose fair value information about all financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate fair value. The disclosures of estimated fair value of financial instruments at June 30, 2010 and December 31, 2009, were determined using available market information and appropriate valuation methods. Considerable judgment is necessary to interpret market data and develop estimated fair value. The use of different market assumptions or estimation methods may have a material effect on the estimated fair value amounts.

The carrying amounts for cash and cash equivalents, accounts receivable, inventories, other current assets, accounts payable, accrued expenses and other liabilities approximate fair value due to the short-term nature of these instruments.

We utilize quoted market prices to estimate the fair value of our fixed rate debt, when available.  If quoted market prices are not available, we calculate the fair value of our fixed rate debt based on a currently available market rate assuming the loans are outstanding through maturity and considering the collateral. In determining the current market rate for fixed rate debt, a market spread is added to the quoted yields on federal government treasury securities with similar terms to the debt. 


 
13

 

At June 30, 2010 and December 31, 2009, the aggregate fair value and the carrying value of the Company’s fixed rate debt were as follows:

   
June 30, 2010
   
December 31, 2009
 
                         
   
Fair Value
   
Carrying Value
   
Fair Value
   
Carrying Value
 
                         
Fixed rate debt
  $ 19,248,000     $ 19,172,000     $ 5,508,000     $ 5,460,000  

Carrying value includes $1,828,000 and $366,000 of debt discount as of June 30, 2010 and December 31, 2009, respectively.   

Nonfinancial Assets and Liabilities

We apply fair value techniques on a non-recurring basis associated with: (1) valuing potential impairment losses related to goodwill which are accounted for pursuant to the authoritative guidance for intangibles—goodwill and other; and (2) valuing potential impairment losses related to long-lived assets which are accounted for pursuant to the authoritative guidance for property, plant and equipment.

All of our goodwill is associated with our regenerative cell technology reporting unit, and we determine the fair value of this reporting unit based on a combination of inputs including the market capitalization of the company, as well as Level 3 inputs such as discounted cash flows which are not observable from the market, directly or indirectly. We conduct our goodwill impairment analysis annually as of November 30 each year, or upon the occurrence of certain triggering events. No such triggering events occurred during the three and six months ended June 30, 2010. Historically, the fair value of our primary business reporting unit has significantly exceeded its carrying value.

We test for the impairment of our long-lived assets when triggering events occur and such impairment, if any, is measured at fair value. The inputs for fair value of our long lived assets would be based on Level 3 inputs as data used for such fair value calculations would be based on discounted cash flows using market place participant assumptions. No triggering events occurred during the three and six months ended June 30, 2010.

17.
Stockholders’ Deficit
 
Common Stock

On March 10, 2009, we raised approximately $10,000,000 in gross proceeds from sale to institutional investors of a total of 4,771,174 shares of our common stock and warrants to purchase up to a total of 6,679,644 additional shares of our common stock at a purchase price of $2.10 per unit, with each unit consisting of one (1) share and one and four-tenths (1.4) warrants.  The warrants will not be exercisable until six months after the date of issuance and will expire five years after the date the warrants are first exercisable. The warrants will have an exercise price of $2.59 per share, which was the consolidated closing bid price of the Company's common stock on March 9, 2009, as reported by NASDAQ. The shares and the warrants are immediately separable and will be issued separately.  We have accounted for the warrants as a component of stockholders’ equity (deficit).  The warrants must be settled through a cash exercise whereby the warrant holder exchanges cash for shares of Cytori common stock, unless the exercise occurs when the related registration statement is not effective, in which case the warrant holder can only exercise through the cashless exercise feature of the warrant agreement. 

On May 14, 2009, we raised approximately $4,242,000 in net proceeds from a private placement of 1,864,783 shares of our common stock and warrants to purchase up to a total of 3,263,380 additional shares of our common stock at a purchase price of $2.28 per unit, with each unit consisting of one (1) share and one and three-fourths (1.75) warrants.  The warrants are exercisable immediately and will expire five years after the date of issuance. The warrants will have an exercise price of $2.62 per share. We have accounted for the warrants as a component of stockholders’ equity (deficit).  

Additionally, on June 19, 2009, we entered into a common stock purchase agreement with Seaside 88, LP relating to the offering and sale of a total of up to 7,150,000 shares of our common stock. The agreement required us to issue and Seaside to buy 275,000 shares of our common stock once every two weeks, subject to the satisfaction of customary closing conditions.  Between June 2009 and June 2010, we raised approximately $30,172,000 in aggregate gross proceeds from this transaction from the sale of 7,150,000 shares of our common stock, of which $5,938,000 and $17,314,000 in gross proceeds from the sale of 1,375,000 and 3,300,000 shares during the three and six months ended June 30, 2010, respectively, in our scheduled closings with Seaside 88, LP.  We have accounted for each of the completed closings as a component of stockholders’ equity (deficit).


 
14

 

Warrant Adjustments

Our March 2009 offering of 4,771,174 shares of our common stock and warrants to purchase up to a total of 6,679,644 additional shares of our common stock with an exercise price of $2.59 per share, our May 2009 equity offering of 1,864,783 shares of our common stock and warrants to purchase up to a total of 3,263,380 additional shares of our common stock with an exercise price of $2.62 per share, and our closings with Seaside 88, LP through June 30, 2010  triggered an adjustment to the exercise price and number of shares issuable under the warrants issued to investors in our August 2008 private placement financing.  As a result, as of June 30, 2010, the common stock warrants issued on August 11, 2008, are currently exercisable for 1,933,727 shares of our common stock at an exercise price of $6.21 per share.

Other Related Party Transactions

On February 8, 2008, we agreed to sell 2,000,000 shares of unregistered common stock to Green Hospital Supply, Inc., a related party, for $12,000,000 cash, or $6.00 per share in a private stock placement.  On February 29, 2008, we closed the first half of the private placement with Green Hospital Supply, Inc. and received $6,000,000.  We closed the second half of the private placement on April 30, 2008 and received the second payment of $6,000,000. As of June 30, 2010, Green Hospital Supply, Inc., our distribution partner in Japan and a related party, holds approximately 6.54% of our issued and outstanding shares of common stock.

Treasury Stock

As part of our equity offering on March 10, 2009, we sold our remaining 1,872,834 shares of common stock from our treasury for $3,933,000 cash, or $2.10 per share.  The cost basis of the treasury stock sold was at a weighted average purchase price, or $3.63 per share, resulting in a loss of $1.53 per share, or $2,861,000 in aggregate, and was accounted for as a charge to additional paid-in capital.

18.
Subsequent Events
 
We lease 60,118 square feet at 3020 and 3030 Callan Road, San Diego, California pursuant to a lease agreement entered into on April 2, 2010.  The lease agreement bears monthly rent at a rate of $1.75 per square foot, with annual increase of $0.05 per square foot.  The lease term is 64 months, commencing on July 1, 2010 and expiring on October 31, 2015.  The lease agreement required us to execute a letter of credit for $350,000 naming landlord as a beneficiary.  The letter of credit was issued in July 2010 and required us to maintain $350,000 as restricted cash.


 
 
15

 

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

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) includes the following sections:

·  
Overview that discusses our operating results and some of the trends that affect our business.
·  
Results of Operations that includes a more detailed discussion of our revenue and expenses.
·  
Liquidity and Capital Resources which discusses key aspects of our statements of cash flows, changes in our financial position and our financial commitments.
·  
Significant changes since our most recent Annual Report on Form 10-K in the Critical Accounting Policies and Significant Estimates that we believe are important to understanding the assumptions and judgments underlying our financial statements.

You should read this MD&A in conjunction with the financial statements and related notes in Item 1 and our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains certain statements that may be deemed “forward-looking statements” within the meaning of United States of America securities laws.  All statements, other than statements of historical fact, that address activities, events or developments that we intend, expect, project, believe or anticipate and similar expressions or future conditional verbs such a will, should, would, could or may occur in the future are forward-looking statements. Such statements are based upon certain assumptions and assessments made by our management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate.

These statements include, without limitation, statements about  our anticipated expenditures, including those related to clinical research studies, and general and administrative expenses;  the potential size of the market for our products,  future  development and/or expansion of our products and therapies in our markets,  ability to generate  product revenues or effectively manage our gross profit margins; our ability to obtain regulatory clearance; expectations as to our future performance; the “Liquidity and Capital Resources” section of this report, including our need for additional financing and the availability thereof; and the potential enhancement of our cash position through development, marketing, and licensing arrangements.   Our actual results will likely differ, perhaps materially, from those anticipated in these forward-looking statements as a result of various factors, including: our need and ability to raise additional cash, our joint ventures, risks associated with  laws or regulatory requirements applicable to us, market conditions, product performance, unforeseen litigation, and competition within the regenerative medicine field,  to name a few. The forward-looking statements included in this report are subject to a number of additional material risks and uncertainties, including but not limited to the risks described our filings with the Securities and Exchange Commission and under the “Risk Factors” section in Part II below. 

We encourage you to read our Risk Factors descriptions carefully.  We caution you not to place undue reliance on the forward-looking statements contained in this report.  These statements, like all statements in this report, speak only as of the date of this report (unless an earlier date is indicated) and we undertake no obligation to update or revise the statements except as required by law.  Such forward-looking statements are not guarantees of future performance and actual results will likely differ, perhaps materially, from those suggested by such forward-looking statements.

Overview

Cytori Therapeutics, Inc. (Cytori) develops, manufactures, and commercializes innovative medical devices, which allow physicians to practice regenerative medicine worldwide.  Cytori’s core device provides access to patients’ own stem and regenerative cells which reside naturally within their adipose (fat) tissue. These stem and regenerative cells help to improve blood flow in damaged or diseased  tissues and therefore can potentially be used to treat multiple conditions resulting from a lack of blood supply. Cytori has two main product lines: the Celution® family, which includes the first and only broadly available device that provides clinical grade adipose derived autologous stem and regenerative cells at the point of care and the StemSource® family for use in laboratory research and stem cell banking.

Our commercialization model is based on the sale of the Celution® System and the generation of recurring revenue thereafter from the sale of single-use consumables used in every patient procedure, as well as sales of related instrumentation and ancillary products. Cytori’s near term strategy is to focus first on development and sales in the cosmetic and reconstructive surgery (CRS) market and the cell banking market, which we believe can be successfully penetrated more quickly than our other target markets.  We are also developing our Celution® System for cardiovascular applications which we believe will require a greater investment in time and money to bring to market. In addition to our current clinical trials for breast reconstruction and cardiovascular disease, our customers at academic hospitals are simultaneously identifying and developing new applications for our technology, including stress urinary incontinence, wound healing, burns, liver disease, renal failure, pelvic health conditions and gastrointestinal disorders. The more therapeutic applications that are developed for the Celution® System and its cellular output, the more opportunities we will have to offer the Celution® System and related consumable sets to hospitals, clinics, and physicians.
 

 
 
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In Europe, our commercial activities are focused on market specific development and marketing the Celution® System family of products for use in cosmetic and augmentation procedures, as well as soft tissue reconstructive procedures. In 2009, we broadened our commercialization efforts, with an increased emphasis on direct sales. These efforts included bringing on additional sales, technical and customer support personnel to our EU –based sales team, launching an educational campaign directed at patients, and developing additional products for use in the CRS market.  Our education campaign is designed to raise awareness and educate patients about cosmetic and reconstructive applications for fat grafts that have been enriched with adipose-derived stem and regenerative cells. In 2010 our goal is to help our customers to build their own Celution® based practices and raise awareness among their patient base for cell-enriched procedures through various means, including educational campaigns.

Subsequent to the end of the quarter in July 2010, Cytori received expanded CE Mark indications for the Celution® System. The new indications include key medical applications such as breast reconstruction, repair of soft tissue defects, as well as the facilitation of healing certain types of wounds, such as those resulting from Crohn’s disease. In addition, we received the CE Mark for the PureGraft™ 250/PURE System for autologous fat transfers in July 2010. PureGraft™ will be commercialized in Europe as both a standalone product and as a complement to Cytori’s Celution® 800/CRS System in Europe. Having both PureGraft™ and Celution® now approved in Europe allows Cytori to offer a broader portfolio of products to plastic and cosmetic surgeons and expand our market opportunity. In addition, the PureGraft System offers a lower cost entry point for customers to whom we could potentially up-sell a Celution® System.

To further support broad adoption and reimbursement for Celution® based cosmetic and reconstructive procedures in Europe, Cytori has invested in RESTORE 2, a 70-patient post-marketing breast reconstruction study. Enrollment in RESTORE 2, which was initiated in 2008, was completed in November 2009. The goal of the study was to expand cosmetic and reconstructive surgery claims and seek reimbursement for the use of the Celution® System in post-partial mastectomy defect reconstruction. Positive interim six month results were reported in December 2010 and further supported by additional six and twelve month interim results reported in June 2010. Final results from this study are expected to be reported in the first half of 2011.

In the United States, we are currently focused on establishing an autologous fat grafting business, starting with the sale of the PureGraft™ 250/PURE System and the Celbrush™. In the second quarter of 2010, we expanded our U.S. sales team to focus on building our physician customer base. The PureGraft™ 250/PURE System is designed to facilitate and streamline the fat graft preparation process, washing and filtering the tissue to remove contaminants. In January 2010, we received 510(k) clearance from the FDA for our PureGraft™ 250/PURE System which gives us the freedom to market the PureGraft™ product line in the United States. PureGraft™ was formally launched at the meeting of the American Society of Aesthetic Plastic Surgery in April 2010. The Celbrush™ is a precision micro-droplet delivery tool that is designed to complement our other cosmetic and reconstructive products.

To complement U.S. sales of our autologous fat grafting products, Cytori has launched a new e-commerce product site for our U.S. customers to order the PureGraft™ and Celbrush™ product lines online. The site, www.puregraft.com, is designed to simplify the order process, facilitate customer support and provide detailed product information to our customers.

We are continuing to seek regulatory and marketing approval of the Celution® System family of products in the United States. In July 2009, we learned that the Celution® System will be regulated in the United States by the FDA as a medical device. Subsequently, we filed a 510(k) marketing application for use in aesthetic body contouring and/or filling of soft tissue voids with the FDA in November 2009. Our application was reviewed by the FDA's Center for Biologics Evaluation and Research under the law applicable to medical devices. In February 2010, we were informed by the FDA that we will be required to seek approval for the Celution® System for use in aesthetic body contouring and filling of soft tissue defect voids through the pre-market approval application (“PMA”) process.  We are now working to determine the necessary size and scope of clinical studies to obtain this approval of Celution®.

We are simultaneously developing the cardiovascular application for the Celution® System. Cardiovascular disease, which represents a longer term investment for Cytori, is currently the most advanced application in our pipeline. We have sponsored two European safety and feasibility clinical trials, one for acute heart attack (the APOLLO study) and the other for chronic ischemia (the PRECISE study). Enrollment in both studies was completed in 2009. Six month data showing positive outcomes from both studies was presented at the 7th International Symposium on Stem Cell Therapy & Cardiovascular Innovations on May 7, 2010.   Currently, Cytori is working closely with our Notified Body in Europe to finalize the acceptance criteria for the design and protocol of a pivotal study for heart attack, which we expect to initiate in late 2010 or early 2011. This will be a European approval study that is expected to range in size from 259 to 360 patients.
 
 
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Our StemSource® cell banking business will contribute to product sales in 2010, but we expect sales to further ramp once a greater number of therapeutic applications are available. We believe that an increasing number of cell bank orders will be from cosmetic and reconstructive surgery clinics in regions outside the U.S. where physicians are already using stem and regenerative cells, as such clinics are ideally suited to integrate cell banking into their business practice. The StemSource®900/MB, is marketed as a standalone piece of laboratory research equipment and serves as the foundation of the StemSource® Cell Bank, both of which are offered worldwide to hospitals, tissue banks and other research centers so they can develop new uses for ADRC’s, and in turn offer patients the opportunity to cryopreserve their own adipose-derived stem and regenerative cells. The StemSource® Cell Bank is being offered directly by Cytori, and through our commercialization partners including: Green Hospital Supply in Japan, Korea, Taiwan and Thailand, and GE Healthcare in the United States and select European countries. We expect that growth in the cell bank business in 2010 within Asia Pacific will be driven in part by hospitals where a device is already installed as part of an investigator-initiated study, and where physicians are already familiar with the use of the system and its benefits. Once installed, commercialization activities are performed predominantly by our customers.

Coinciding with our increased investment in commercial activities, we significantly reduced preclinical research and development expenses in 2009. Because we have passed the feasibility stage and are now manufacturing commercial products, we have less reliance going forward on basic and preclinical development activities. Preclinical research will continue at a base level required to fulfill demands for potential partnerships, expanding intellectual property, and supporting commercial activities. Our strategy for the future, in this current financial environment with a new product that has multiple potential applications, is to focus the majority of our financial resources on activities that will promote immediate sales of the Celution®, StemSource®, and PureGraft™  products, through investment in sales and marketing activities, as well as on the planning and initiation of a cardiac pivotal study. We can effectively manage our investment in these initiatives with our current cash position, but to broaden investment in our pipeline activities will require additional funds.

Olympus Partnership

On November 4, 2005, we entered into a strategic development and manufacturing joint venture agreement and other related agreements, which we refer to as the JV Agreements, with Olympus Corporation.  As part of the terms of the JV Agreements, we formed a joint venture, Olympus-Cytori, Inc., which we refer to as the Joint Venture, to develop and manufacture future generation devices based on our Celution® System platform.

Under the Joint Venture Agreements:

·  
Olympus paid $30,000,000 for its 50% interest in the Joint Venture.  Moreover, Olympus simultaneously entered into a License/Joint Development Agreement with the Joint Venture and us to develop a second generation commercial system and manufacturing capabilities.

·  
We licensed our device technology, including the Celution® System platform and certain related intellectual property, to the Joint Venture for use in future generation devices.  These devices will process and purify adult stem and regenerative cells residing in adipose (fat) tissue for various therapeutic clinical applications.  In exchange for this license, we received a 50% interest in the Joint Venture, as well as an initial $11,000,000 payment from the Joint Venture; the source of this payment was the $30,000,000 contributed to the Joint Venture by Olympus.  Moreover, upon receipt of a CE mark for the first generation Celution® System platform in January 2006, we received an additional $11,000,000 development milestone payment from the Joint Venture.

Put/Calls and Guarantees

The Shareholders’ Agreement between Cytori and Olympus provides that in certain specified circumstances of insolvency or if we experience a change in control, Olympus will have the rights to (i) repurchase our interests in the Joint Venture at the fair value of such interests or (ii) sell its own interests in the Joint Venture to Cytori (the “Put”) at the higher of (a) $22,000,000 or (b) the Put’s fair value.

As of June 30, 2010, the estimated fair value of the Put was $1,340,000.  Fluctuations in the estimated Put value are recorded in the statements of operations as a component of change in fair value of option liabilities. The estimated fair value of the Put has been recorded as a long-term liability on the consolidated condensed balance sheets in the caption option liability.

The Put has no expiration date.  Accordingly, we will continue to recognize a liability for the Put and mark it to market each quarter until it is exercised or until the arrangements with Olympus are amended.

Olympus-Cytori Joint Venture

The Joint Venture currently has exclusive access to our technology for the development, manufacture, and supply of the devices (second generation and beyond) for all therapeutic applications.  Once a later generation Celution® System is developed and approved by regulatory agencies, the Joint Venture would sell such systems exclusively to us at a formula-based transfer price; we have retained marketing rights to the second generation devices for all therapeutic applications of adipose stem and regenerative cells.
 

 
 
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We have worked closely with Olympus’ team of scientists and engineers to design the future generations Celution® System so that it will contain certain product enhancements and can be manufactured in a streamlined manner.

In August 2007, we entered into a License and Royalty Agreement with the Joint Venture which allowed us to commercially launch the Celution® System platform earlier than we could have otherwise done so under the terms of the Joint Venture Agreements.  The Royalty Agreement provides for the sale of the Cytori-developed Celution® System platform, including the Celution® 800/CRS and StemSource® 900/MB, until such  time as the Joint Venture’s products are commercially available for the same market served by the Cytori platform, subject to a reasonable royalty payable to the Joint Venture for all such sales.

We account for our investment in the Joint Venture under the equity method of accounting.

Other Related Party Transactions

In a separate agreement entered into on February 23, 2006, we granted Olympus an exclusive right to negotiate a commercialization collaboration for the use of adipose regenerative cells for a specific therapeutic area outside of cardiovascular disease.  In exchange for this right, we received a $1,500,000 payment from Olympus, which was non-refundable but could be applied toward a definitive commercial collaboration in the future.  As part of this agreement, Olympus would conduct market research and pilot clinical studies in collaboration with us for the therapeutic area up to December 31, 2008 when this exclusive right expired.  The $1,500,000 payment was received in the second quarter of 2006 and recorded as deferred revenues, related party.  Accordingly, on December 31, 2008, we recognized $1,500,000 as other development revenue and reduced our deferred revenues, related party balance for the same amount.

On February 8, 2008, we agreed to sell 2,000,000 shares of unregistered common stock to Green Hospital Supply, Inc. for $12,000,000 cash, or $6.00 per share, in a private stock placement.  On February 29, 2008, we closed the first half of the private placement with Green Hospital Supply, Inc. and received $6,000,000.  We closed the second half of the private placement on April 30, 2008 and received the second payment of $6,000,000.

In August 2008, we received an additional $6,000,000 from Olympus in a private placement of 1,000,000 unregistered shares of our common stock and a warrant to purchase an additional 500,000 shares of our common stock at an original exercise price of $8.50 per share.  The purchase price was $6.00 per unit (with each unit consisting of one share and 50% warrant coverage).  The warrant is exercisable anytime after February 11, 2009 and will expire on August 11, 2013.

Thin Film Japan Distribution Agreement

In 2004, we sold the majority of our Thin Film business to MAST Biosurgery AG.  We retained all rights to Thin Film business in Japan (subject to a purchase option of MAST, which expired in May 2007), and we received back from MAST a license of all rights to Thin Film technologies in the spinal field, exclusive at least until 2012, and the field of regenerative medicine, non-exclusive on a perpetual basis.

In the third quarter of 2004, we entered into a Distribution Agreement with Senko Medical Trading Company.  Under this agreement, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  Specifically, the license covers Thin Film products with the following indications: anti-adhesion; soft tissue support; and minimization of the attachment of soft tissues.  The Distribution Agreement with Senko commences upon “commercialization.”  Commercialization will occur when one or more Thin Film product registrations are completed with the Japanese Ministry of Health, Labour and Welfare, or MHLW.  Following commercialization, the Distribution Agreement has a duration of five years and is renewable for an additional five years after reaching mutually agreed minimum purchase guarantees.

We received a $1,500,000 upfront license fee from Senko.  We have recorded the $1,500,000 received as a component of deferred revenues in the accompanying consolidated condensed balance sheet.  Half of the license fee is refundable if the parties agree commercialization is not achievable and a proportional amount is refundable if we terminate the arrangement, other than for material breach by Senko, before three years post-commercialization.

Under the Distribution Agreement, we will also be entitled to earn additional payments from Senko based on achieving defined milestones.  On September 28, 2004, we notified Senko of completion of the initial regulatory application to the MHLW for the Thin Film product.  As a result, we became entitled to a nonrefundable payment of $1,250,000, which we received in October 2004 and had recorded as a component of deferred revenues.  We did not recognize any development revenues with respect to Senko during the three and six months ended June 30, 2010.


 
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Results of Operations

Our overall net losses for the three and six months ended June 30, 2010 were $5,377,000 and $7,827,000 as compared to the net losses for the three and six months ended June 30, 2009 of $826,000 and $6,924,000, respectively.  The increase in the losses for the three and six months ended June 30, 2010 is primarily due to the recognition of non-cash development revenue of $2,122,000 during first quarter of 2010 as compared to recognition of non-cash development revenue of 7,250,000 of during second quarter of 2009.

Product revenues

Product revenues consisted of revenues primarily from our Celution® System products and StemSource® Cell Banks.

The following table summarizes the components for the three and six months ended June 30, 2010 and 2009:

   
For the three months ended June 30,
   
For the six months ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
    Related party
  $     $ 9,000     $ 9,000     $ 573,000  
    Third party
    2,091,000       1,268,000       4,347,000       2,616,000  
Total product revenues
  $ 2,091,000     $ 1,277,000     $ 4,356,000     $ 3,189,000  
% attributable to Green Hospital Supply, Inc.
          0.7 %     0.2 %     18.0 %
% attributable to Olympus
                       


Beginning in March of 2008, we began sales and shipments of our Celution® 800/CRS System to the European and Asia-Pacific reconstructive surgery markets.  Assuming all other applicable revenue recognition criteria have been met, revenue for these product sales is recognized upon delivery to the customer, as all risks and rewards of ownership have been substantively transferred to the customer at that point.  For product sales to customers who arrange for and manage all aspects of the shipping process, we recognize revenue upon shipment from our facilities.  For product sales that include a combination of equipment, services, or other multiple deliverables that will be provided in the future, we defer an estimate of the fair value of those future deliverables from product revenue until such deliverables have been provided or earned.  Shipping and handling costs that are billed to our customers are classified as revenue.

The future:  We expect to continue to generate regenerative cell technology product revenues from Celution® 800/CRS and consumable sales in Europe and we expect to generate product revenues from StemSource® Cell Bank sales in Japan through direct sales and through our distribution partner Green Hospital Supply, as well as from StemSource® banking and research products in the U.S. and elsewhere through direct sales and through our distribution partner GE Healthcare. Additionally, we expect to have Thin Film product revenues when commercialization of the Thin Film products in Japan occurs and we begin Thin Film shipments to Senko, pending regulatory approval.

Cost of product revenues

Cost of product revenues relate primarily to Celution® System products and StemSource® Cell Banks and includes material, manufacturing labor, and overhead costs.  The following table summarizes the components of our cost of revenues for the three and six months ended June 30, 2010 and 2009:

   
For the three months ended June 30,
   
For the six months ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
Cost of product revenues
  $ 869,000     $ 765,000     $ 1,784,000     $ 1,835,000  
Share-based compensation
    14,000       11,000       29,000       28,000  
Total cost of product revenues
  $ 883,000     $ 776,000     $ 1,813,000     $ 1,863,000  
Total cost of product revenues as % of product revenues
    42.2 %     60.8 %     41.6 %     58.4 %

 
·
Cost of product revenues as a percentage of product revenues was 42.2% and 41.6% for the three and six months ended June 30, 2010 and 60.8% and 58.4% for the three and six months ended June 30, 2009, respectively.  Fluctuation in this percentage is to be expected due to the product mix as well as mix of distributor and direct sales comprising the revenue for the period.
 
 
 
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The future.  We expect to continue to see variation in our gross profit margin as the product mix comprising revenues fluctuates.  Additionally, we expect to incur costs related to our MacroPore products if and when commercialization is achieved for our Japan Thin Film product line.

Development revenues

The following table summarizes the components of our development revenues for the three and six months ended June 30, 2010 and 2009:


   
For the three months ended June 30,
   
For the six months ended June 30,
 
                         
   
2010
   
2009
   
2010
   
2009
 
                         
Development (Olympus)
  $     $ 7,250,000     $ 2,122,000     $ 7,250,000  
Research grant (NIH)
          13,000             20,000  
Service plan and other
    7,000       1,000       28,000       2,000  
Total
  $ 7,000     $ 7,264,000     $ 2,150,000     $ 7,272,000  

We recognize deferred revenues, related party, as development revenue when certain performance obligations are met (i.e., using a proportional performance approach).  In the first quarter of 2010, we recognized $2,122,000 of revenue associated with our arrangements with Olympus as a result of achieving one product development milestone as well as a clinical milestone related to the completion of a primary monitoring end point in one of our cardiac trials.  In the second quarter of 2009, we recognized $7,250,000 of revenue associated with our arrangements with Olympus as a result of achieving two clinical milestones during the quarter relating to the achievement of the primary goals of safety and feasibility as well as the completion of the enrollment process for both of our clinical cardiac trials.

The future.  We expect to recognize additional development revenues from our regenerative cell technology segment during the remainder of 2010, as the anticipated completion for the next phase of our Joint Venture and other Olympus product development performance obligations is in 2010.  If we are successful in completing these activities, we may recognize approximately $700,000 in revenues during the remainder of 2010.  The exact timing of when amounts will be reported in revenue will depend on internal factors (for instance, our ability to complete certain contributions and obligations that we have agreed to perform) as well as external considerations, including obtaining certain regulatory clearances and/or approvals related to the Celution® System.  The cash for these contributions and obligations was received when the agreement was signed and no further related cash payments will be made to us.

We will continue to recognize revenue from the Thin Film development work we are performing on behalf of Senko, based on the relative fair value of the milestones completed as compared to the total efforts expected to be necessary to obtain regulatory clearance from the MHLW.  We are still awaiting regulatory clearance from the MHLW in order for initial commercialization to occur.  Accordingly, we expect to recognize approximately $1,129,000 (consisting of $879,000 in deferred revenues plus a non-refundable payment of $250,000 to be received upon commercialization) in revenues associated with this milestone arrangement if and when regulatory approval is achieved.  Moreover, we expect to recognize $500,000 per year associated with deferred Senko license fees over a three-year period following commercialization, if achieved, as the refund rights associated with the license payment expire.

Research and development expenses

Research and development expenses include costs associated with the design, development, testing and enhancement of our products, regulatory fees, the purchase of laboratory supplies, pre-clinical studies and clinical studies.  The following table summarizes the components of our research and development expenses for the three and six months ended June 30, 2010 and 2009:



   
For the three months ended June 30,
   
For the six months ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
General research and development
  $ 1,760,000     $ 2,448,000     $ 3,459,000     $ 5,013,000  
Development milestone (Joint Venture)
    436,000       337,000       864,000       1,127,000  
Share-based compensation
    105,000       134,000       223,000       248,000  
Total research and development expenses
  $ 2,301,000     $ 2,919,000     $ 4,546,000     $ 6,388,000  
 
 
 
 
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·  
Research and development expenses relate to the development of a technology platform that involves using adipose tissue as a source of autologous regenerative cells for therapeutic applications.  These expenses, in conjunction with our continued development efforts related to our Celution® System, result primarily from the broad expansion of our research and development efforts enabled by the funding we received from Olympus in 2005 and 2006 and from other investors during the last few years.  Labor-related expenses, not including share-based compensation, increased by $122,000 and decreased by $435,000 for the three and six months ended June 30, 2010, respectively, as compared to the same periods in 2009.  The decrease in labor related expenses for the six months ended June 30, 2010 primarily due the decrease in the headcount as a result of reduction in staffing levels implemented at the end first quarter of 2009 as an element of our cost cutting efforts.  Clinical and preclinical study expense decreased by $276,000 and $382,000 for the three and six months ended June 30, 2010 as compared to the same periods in 2009.

·  
Expenditures related to the Joint Venture with Olympus, which are included in the variation analysis above, include costs that are necessary to support the commercialization of future generation devices based on our Celution® System.  These development activities, which began in November 2005, include performing pre-clinical and clinical studies, seeking regulatory approval, and performing product development related to therapeutic applications for adipose regenerative cells for multiple large markets.  For the three and six months ended June 30, 2010, costs associated with the development of the device were $436,000 and $864,000, respectively.  For the three and six months ended June 30, 2009, costs associated with the development of the device were $337,000 and $1,127,000, respectively.  The decrease in the costs related to the Joint Venture with Olympus is primarily due to the completion of product development milestone activities. The three months ended June 30, 2010 and 2009 expenses were composed of $295,000 and $145,000 in labor and related benefits, $122,000 and $150,000 in consulting and other professional services, $0 and $15,000 in supplies and $19,000 and $27,000, respectively, in other miscellaneous expense.  The six months ended June 30, 2010 and 2009 expenses were composed of $560,000 and $411,000 in labor and related benefits, $277,000 and $474,000 in consulting and other professional services, $1,000 and $186,000 in supplies and $26,000 and $56,000, respectively, in other miscellaneous expense.

The future:  We expect research and development expenditures to remain stable for the remainder of 2010.

Sales and marketing expenses

Sales and marketing expenses include costs of marketing personnel, tradeshows, physician training, and promotional activities and materials.  The following table summarizes the components of our sales and marketing expenses for the three and six months ended June 30, 2010 and 2009:


   
For the three months ended June 30,
   
For the six months ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
                         
International sales and marketing
  $ 2,237,000     $ 1,342,000     $ 4,046,000     $ 2,515,000  
Share-based compensation
    188,000       121,000       378,000       233,000  
Total sales and marketing expenses
  $ 2,425,000     $ 1,463,000     $ 4,424,000     $ 2,748,000  

 

· 
The increase in international sales and marketing expense for the three and six months ended June 30, 2010 as compared to the same periods in 2009 was mainly attributed to the increase in salary and related benefits expense of $453,000 and $752,000, respectively, not including share-based compensation, an increase in travel related expenses of $156,000 and $286,000 and promotional effort expenses of $63,000 and $88,000, respectively, which are due to our emphasis in seeking strategic alliances and/or co-development partners for our regenerative cell technology as well as sales and marketing efforts related to our commercialization activities.

The future.  We expect sales and marketing expenditures related to the regenerative cell technology to increase as we continue to expand our base of distribution partners, strategic alliances and co-development partners, as well as our direct marketing sales force for our Celution® System and StemSource® Cell Bank.


 
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General and administrative expenses

General and administrative expenses include costs for administrative personnel, legal and other professional expenses, and general corporate expenses.  The following table summarizes the general and administrative expenses for the three and six months ended June 30, 2010 and 2009:

   
For the three months ended June 30,
   
For the six months ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
General and administrative
  $ 2,657,000     $ 1,942,000     $ 5,433,000     $ 4,036,000  
Share-based compensation
    395,000       367,000       838,000       767,000  
Total general and administrative expenses
  $ 3,052,000     $ 2,309,000     $ 6,271,000     $ 4,803,000  

·  
An increase in general and administrative expenses occurred during the three and six months ended June 30, 2010 as compared to the same periods in 2009.  This resulted primarily from an increase in salary and related benefits expense of $272,000 and $362,000, respectively, not including share-based compensation, an increase in professional services expenses of $165,000 and $229,000, travel related expenses of $101,000 and $184,000, and increase in bad debt expense of $43,000 and $268,000 for the three and six months ended June 30, 2010, respectively, as compared to the same periods in 2009.

The future.  We expect general and administrative expenses to stay at the same level or to be reduced in the remainder of 2010 as we are seeking ways to minimize these expenses where possible.

Share-based compensation expenses

Stock-based compensation expenses include charges related to options issued to employees, directors and non-employees.  Prior to January 1, 2006, the stock-based compensation expenditures connected to options granted to employees and directors (in their capacity as board members) was the difference between the exercise price of the stock based awards and the market value of our underlying common stock on the date of the grant.  Unearned employee stock-based compensation is amortized over the remaining vesting periods of the options, which generally vest over a four-year period from the date of grant.  Beginning January 1, 2006, we measure stock-based compensation expense based on the grant-date fair value of any awards granted to our employees.  Such expense is recognized over the period of time that employees provide service to us and earn all rights to the awards.

The following table summarizes the components of our share-based compensation expenses for the three and six months ended June 30, 2010 and 2009:

   
For the three months ended June 30,
   
For the six months ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
                         
Cost of product revenues
  $ 14,000     $ 11,000     $ 29,000     $ 28,000  
Research and development-related
    105,000       134,000       223,000       248,000  
Sales and marketing-related
    188,000       121,000       378,000       233,000  
General and administrative-related
    395,000       367,000       838,000       767,000  
Total share-based compensation
  $ 702,000     $ 633,000     $ 1,468,000     $ 1,276,000  


Most of the share-based compensation expenses in the three and six month ended June 30, 2010 and 2009 related to the vesting of stock option awards to employees.

During the first quarter of 2010, we issued to our directors, executive officers and certain non-executive employees options to purchase an aggregate of up to 1,155,000 shares of our common stock, with four-year vesting for our officers and employees and two-year vesting for our directors. The grant date fair value of the awards granted to our officers and employees was $4.07 and to our directors was $4.16 per share. The resulting share-based compensation expense of $4,713,000, net of estimated forfeitures, will be recognized as expense over the respective vesting periods.

During the first quarter of 2009, we made a company-wide option grant to our non-executive employees to purchase an aggregate of up to 249,250 shares of our common stock, subject to a four-year vesting schedule. The grant date fair value of the awards was $2.00 per share.  Following the reduction of our workforce at the end of this quarter, 182,100 of these options remained outstanding.  The resulting share-based compensation expense of $364,200, net of estimated forfeitures, will be recognized as expense over the employees’ respective vesting periods.
 
 
 
23

 

 
During the first quarter of 2009, we issued to our officers and directors options to purchase an aggregate of up to 585,000 shares of our common stock, with four-year vesting for our officers and two-year vesting for our directors. The grant date fair value of the awards granted to our officers and directors was $2.70 per share. The resulting share-based compensation expense of $1,579,500, net of estimated forfeitures, will be recognized as expense over the respective vesting periods.

During the second quarter of 2009, we made a company-wide option grant to our non-executive employees to purchase an aggregate of up to 155,580 shares of our common stock, subject to a four-year vesting schedule. The grant date fair value of the awards was $1.18 per share.  The resulting share-based compensation expense of $183,000, net of estimated forfeitures, will be recognized as expense over the employees’ respective vesting periods.

The future.  We expect to continue to grant options (which will result in an expense) to our employees, directors, and, as appropriate, to non-employee service providers.  In addition, previously-granted options will continue to vest in accordance with their original terms.  As of June 30, 2010, the total compensation cost related to non-vested stock options not yet recognized for all our plans is approximately $6,619,000. These costs are expected to be recognized over a weighted average period of 1.97 years.

Change in fair value of warrant liability

The following is a table summarizing the change in fair value of our warrant liability for the three and six months ended June 30, 2010 and 2009:
 

   
For the three months
ended June 30,
   
For the six months
ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
                         
Change in fair value of warrant liability
  $ (1,461,000 )   $ 2,133,000     $ (3,628,000 )   $ 1,112,000  
                                 
 
In August 2008, we issued common stock purchase warrants in connection with our private placement of 2,825,517 unregistered shares of common stock and 1,412,758 common stock warrants. The common stock purchase warrants were not issued with the intent of effectively hedging any future cash flow, fair value of any asset, liability or any net investment in a foreign operation. The warrants do not qualify for hedge accounting, and as such, all future changes in the fair value of these warrants will be recognized currently in earnings until such time as the warrants are exercised or expire. These common stock purchase warrants do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the Black-Scholes option pricing model using the following assumptions:


   
As of
June 30, 2010
   
As of
December 31, 2009
 
Expected term
 
3.12 years
   
3.61 years
 
Common stock market price
  $ 3.48     $ 6.10  
Risk-free interest rate
    1.00 %     1.70 %
Expected volatility
    80.70 %     76.16 %
Resulting fair value (per warrant)
  $ 1.37     $ 3.28  


Expected volatility is based primarily on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the expected term of the warrants. We believe this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. We currently have no reason to believe future volatility over the expected remaining life of these warrants is likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is the interest rate for treasury constant maturity instruments published by the Federal Reserve Board that is closest to the expected term of the warrant.

The future.  Future changes in the fair value of the warrant liability will be recognized currently in earnings until such time as the warrants are exercised or expire.


 
24

 

Change in fair value of option liability

The following is a table summarizing the change in fair value of our put option liability for the three and six months ended June 30, 2010 and 2009:
 

   
For the three months ended June 30,
   
For the six months ended June 30,
 
                   
   
2010
   
2009
   
2010
   
2009
 
                         
                         
Change in fair value of put option liability
  $ (60,000 )   $ (630,000 )   $ 200,000     $ (420,000 )
                                 
 
·  
In reference to the Joint Venture, the Shareholders’ Agreement between Cytori and Olympus provides that in certain specified circumstances of insolvency or if we experience a change in control, Olympus will have the right to (i) repurchase our interests in the Joint Venture at the fair value of such interests or (ii) sell its own interests in the Joint Venture to us at the higher of (a) $22,000,000 or (b) the Put’s fair value.  The Put has been classified as a liability.

The valuations of the Put were completed using an option pricing theory-based simulation analysis (i.e., a Monte Carlo simulation).  The valuations are based on assumptions as of the valuation date with regard to the market value of Cytori and the estimated fair value of the Joint Venture, the expected correlation between the values of Cytori and the Joint Venture, the expected volatility of Cytori and the Joint Venture, the bankruptcy recovery rate for Cytori, the bankruptcy threshold for Cytori, the probability of a change of control event for Cytori, and the risk-free interest rate.

The following assumptions were employed in estimating the value of the Put:


   
June 30, 2010
   
December 31, 2009
 
             
Expected volatility of Cytori                                                    
    74.00 %     72.00 %
Expected volatility of the Joint Venture
    74.00 %     72.00 %
Bankruptcy recovery rate for Cytori
    28.00 %     19.00 %
Bankruptcy threshold for Cytori                                                    
  $ 6,921,000     $ 11,308,000  
Probability of a change of control event for Cytori
    2.65 %     2.95 %
Expected correlation between fair values of Cytori and the Joint Venture in the future
    99.00 %     99.00 %
Risk free interest rate                                                    
    2.97 %     3.85 %

The future.  The Put has no expiration date.  Accordingly, we will continue to recognize a liability for the Put until it is exercised or until the arrangements with Olympus are amended.

Financing items

The following table summarizes interest income, interest expense, and other income and expense for the three and six months ended June 30, 2010 and 2009:

   
For the three months ended June 30,
   
For the six months ended
June 30,
 
                         
   
2010
   
2009
   
2010
   
2009
 
                         
Interest income
  $ 2,000     $ 4,000     $ 3,000     $ 18,000  
Interest expense
    (254,000 )     (374,000 )     (530,000 )     (774,000 )
Other income (expense)
    (49,000 )     (16,000 )     (125,000 )     (108,000 )
Total
  $ (301,000 )   $ (386,000 )   $ (652,000 )   $ (864,000 )


·  
Interest income decreased for the three and six months ended June 30, 2010 as compared to the same periods in 2009 due to a decrease in interest rates.

·  
Interest expense decreased for the three and six months ended June 30, 2010 as compared to the same period in 2009 due to cash interest and non-cash amortization of debt issuance costs and debt discount for the term loan we entered into in October 2008.  During second quarter of 2010, we entered into an Amended and Restated Loan and Security Agreement, pursuant to which the lenders funded a term loan in the amount of $20.0 million on June 14, 2010, and which refinanced the remaining balance of the term loan from 2008.
 
 
 
25

 
 

 
·  
The changes in other income (expense) in the three and six months ended June 30, 2010 as compared to the same periods in 2009 resulted primarily from changes in foreign currency exchange rates.

The future.   Interest income earned in the remainder of 2010 will be dependent on our levels of funds available for investment as well as general economic conditions.  Subject to our future financing activities, we expect interest expense to increase during the remainder of 2010 as a result of the funding of term loan in the principal amount of $20.0 million on June 14, 2010.

 
Equity loss from investment in Joint Venture

The following table summarizes our equity loss from investment in joint venture for the three and six months ended June 30, 2010 and 2009:


   
For the three months ended June 30,
   
For the six months ended June 30,
 
                         
   
2010
   
2009
   
2010
   
2009
 
Equity loss in investment
  $ (34,000 )   $ (11,000 )   $ (55,000 )   $ (27,000 )

The activity relates entirely to our 50% equity interest in the Joint Venture, which we account for using the equity method of accounting.

The future.  We do not expect to recognize significant losses from the activities of the Joint Venture in the foreseeable future.  Over the next one to two years, the Joint Venture is expected to incur labor costs related to the development of our second generation commercial system as well as general and administrative expenses, offset by royalty and other revenue expected to be generated by our current Celution® 800/CRS and future generation devices.  Though we have no obligation to do so, we plan to contribute funding to the Joint Venture to cover any costs should the Joint Venture deplete its cash balance.

Liquidity and Capital Resources

Short-term and long-term liquidity

The following is a summary of our key liquidity measures at June 30, 2010 and December 31, 2009:

   
June 30,
   
December 31,
 
   
2010
   
2009
 
Cash and cash equivalents
  $ 38,100,000     $ 12,854,000  
                 
Current assets
  $ 43,809,000     $ 18,098,000  
Current liabilities                                           
    7,229,000       8,183,000  
Working capital                                           
  $ 36,580,000     $ 9,915,000  

We incurred net losses of $5,377,000 and $7,827,000 for the three and six months ended June 30, 2010 and $826,000 and $6,924,000 for the three and six months ended June 30, 2009, respectively.  We have an accumulated deficit of $190,331,000 as of June 30, 2010.  Additionally, we have used net cash of $11,901,000 and $12,053,000 to fund our operating activities for the six months ended June 30, 2010 and 2009, respectively.  To date these operating losses have been funded primarily from outside sources of invested capital and borrowed capital.

During 2010, we expanded our commercialization activities while simultaneously pursuing available financing sources to support operations and growth.  We have had, and continue to have, an ongoing need to raise additional cash from outside sources to fund our operations.  If we cannot do so, we would be required to reduce our research, development, and administrative operations, including reductions of our employee base, in order to offset lack of available funding.   We continue to evaluate available financing opportunities as part of our normal course of business. 

In June 2010, we entered into an Amended and Restated Loan and Security Agreement with General Electric Capital Corporation, Silicon Valley Bank and Oxford Finance Corporation (together, the Lenders), pursuant to which the Lenders agreed to make a term loan to Cytori in an aggregate principal amount of up to $20.0 million (Term Loan).  The Term Loan amends and restates the term loan agreement entered into with GECC and SVB on October 14, 2008 (Original Term Loan), of which an aggregate balance of approximately $4.1 million along with prorated final payment fee of $205,000 remained outstanding and was refinanced under the Term Loan.  The net proceeds of the Term Loan, after payment of lender fees and expenses and the refinancing of the Original Term Loan, were approximately $15.3 million. 
 
 
 
26

 

 
In June 2010, we completed a common stock purchase agreement with Seaside 88, LP (“Seaside”) relating to the offering and sale of a total of up to 7,150,000 shares of our common stock. The agreement required us to issue and Seaside to buy 275,000 shares of our common stock every two weeks, subject to the satisfaction of customary closing conditions.  Between June 2009 and June 2010, we raised approximately $30,172,000 in gross proceeds from the sale of 7,150,000 shares of our common stock related to Seaside closings.

With consideration of these endeavors as well as existing funds, cash generated by operations, and other accessible sources of financing, we believe our cash position is adequate to satisfy our working capital, capital expenditures, debt service, and other financial commitments into 2012, subject to minimum cash and cash liquidity requirements of the Amended and Restated Loan and Security Agreement, which requires that we maintain at least six months of cash on hand to avoid an event of default.  Management actively monitors cash expenditures we incur as our business progresses in an effort to match projected expenditures to available cash flow.

In order to continue the operations of our regenerative cell business at or near current levels, we will need to either substantially increase revenues or continue to raise additional capital in the near term.

From inception to June 30, 2010, we have financed our operations primarily by:

·  
Issuing stock in pre-IPO transactions, a 2000 initial public offering in Germany, and stock option exercises,

·  
Generating revenues,

·  
Selling the bioresorbable implant CMF product line in September 2002,

·  
Selling the bioresorbable implant Thin Film product line (except for the territory of Japan), in May 2004,

·  
Licensing distribution rights to Thin Film in Japan, in exchange for an upfront license fee in July 2004 and an initial development milestone payment in October 2004,

·  
Obtaining a modest amount of capital equipment long-term financing,

·  
Selling 1,100,000 shares of common stock to Olympus under an agreement which closed in May 2005,

·  
Receiving upfront and milestone fees from our Joint Venture with Olympus, which was entered into in November 2005,

·  
Receiving funds in exchange for granting Olympus an exclusive right to negotiate in February 2006,

·  
Receiving $16,219,000 in net proceeds from a common stock sale under the shelf registration statement in August 2006,

·  
Receiving $19,901,000 in net proceeds from the sale of common stock plus common stock warrants under the shelf registration statement in February 2007,

·  
Receiving $6,000,000 in net proceeds from a private placement to Green Hospital Supply, Inc. in April 2007,

·  
Receiving gross proceeds of $3,175,000 from the sale of our bioresorbable spine and orthopedic surgical implant product line to Kensey Nash in May 2007,

·  
Receiving $12,000,000 in net proceeds from a private placement to Green Hospital Supply, Inc. during first half 2008,

·  
Receiving $17,000,000 in gross proceeds in August 2008 from a private placement of 2,825,517 unregistered shares of common stock and 1,412,758 common stock warrants (with an original exercise price of $8.50 per share) to a syndicate of investors including Olympus Corporation, who acquired 1,000,000 unregistered shares and 500,000 common stock warrants in exchange for $6,000,000 of the total proceeds raised,

·  
Obtaining a term loan of $7,500,000 from General Electric Capital Corporation (GECC) and Silicon Valley Bank (SVB) in October 2008,

·  
Receiving approximately $10,000,000 in gross proceeds from sale to institutional investors of a total of 4,771,174 shares of our common stock and warrants to purchase up to a total of 6,679,644 additional shares of our common with an exercise price of $2.59 per share in March 2009,
 
 
 
27

 

 
·  
Receiving approximately $4,242,000 in net proceeds from a private placement of 1,864,783 unregistered shares of common stock and 3,263,380 common stock warrants (with an exercise price of $2.62 per share) to a syndicate of investors in May 2009,

·  
In June 2010, we completed a common stock purchase agreement with Seaside 88, LP relating to the offering and sale of a total of up to 7,150,000 shares of our common stock. The agreement required us to issue and Seaside to buy 275,000 shares of our common stock once every two weeks.  Between June 2009 and June 2010, we raised an aggregate of approximately $30,172,000 in gross proceeds from the sale of 7,150,000 shares of our common stock, and

·  
In June 2010, we entered into an Amended and Restated Loan and Security Agreement with the GECC, SVB, and Oxford Finance Corporation (Lenders), pursuant to which the Lenders funded a term loan in the amount of $20,000,000 on June 14, 2010, which refinanced the remaining balance of the term loan entered into with GECC and SVB on October 14, 2008.

We do not expect significant capital expenditures during the remainder of 2010.

Any excess funds are expected to be invested as cash equivalents in money market accounts.

Our cash requirements for the remainder of 2010 and beyond will depend on numerous factors, including successful revisions of our operating plan and business strategies as described above.  Under our previous operating plan, we would have expected to incur research and development expenses at high levels in our regenerative cell platform for an extended period of time.  Under the new plan, we will seek to reduce these expenditures as much as possible.

The following summarizes our contractual obligations and other commitments at June 30, 2010, and the effect such obligations could have on our liquidity and cash flow in future periods:

   
Payments due by period
 
Contractual Obligations
 
Total
   
Less than 1
year
   
1 – 3 years
   
3 – 5 years
   
More than
5 years
 
                               
Long-term obligations
  $ 21,033,000     $ 2,222,000     $ 18,811,000     $     $  
Interest commitment on long-term obligations
    3,797,000       1,912,000       1,885,000              
Operating lease obligations
    7,307,000       1,209,000       2,857,000       2,772,000       469,000  
Minimum purchase requirements
    1,700,000       1,488,000       212,000              
Pre-clinical research study obligations
    148,000       148,000                    
Clinical research study obligations
    3,200,000       2,300,000       900,000              
Total
  $ 37,185,000     $ 9,279,000     $ 24,665,000     $ 2,772,000     $ 469,000  

Cash (used in) provided by operating, investing, and financing activities for the six months ended June 30, 2010 and 2009 is summarized as follows:
 
   
For the six months ended June 30,
 
   
2010
   
2009
 
             
Net cash used in operating activities
  $ (11,901,000 )   $ (12,053,000 )
Net cash used in investing activities
    (678,000 )     (18,000 )
Net cash provided by financing activities
    37,825,000       13,380,000  

Operating activities

Operational activities, inclusive of research and development, sales and marketing, and general and administrative efforts, offset in part by product sales, generated an operating loss of $7,120,000 for the six months ended June 30, 2010.  The operating cash impact of this loss was $11,901,000, after adjusting for the recognition of non-cash development revenue of $2,122,000, the consideration of non-cash share-based compensation, other adjustments for material non-cash activities, such as depreciation and amortization, change in fair value of option liabilities and warrants, changes in working capital due to timing of product shipments (accounts receivable) and payment of liabilities.

Research and development efforts and other operational activities, offset in part by product sales, generated an operating loss of $6,033,000 for the six months ended June 30, 2009.  The operating cash impact of this loss was $12,053,000, after adjusting for the recognition of non-cash development revenue of $7,250,000, the consideration of non-cash share-based compensation, other adjustments for material non-cash activities, such as depreciation and amortization, change in fair value of option liabilities and warrants, changes in working capital due to timing of product shipments (accounts receivable) and payment of liabilities.
 

 
 
28

 

Investing activities

Net cash used in investing activities for the six months ended June 30, 2010 resulted from cash outflow for investment in joint venture and purchases of property and equipment.

Net cash used in investing activities for the six months ended June 30, 2009 resulted from purchases of property and equipment.

Financing Activities

The net cash provided by financing activities for the six months ended June 30, 2010 related primarily to a sale of 3,300,000 shares for approximately $17,314,000  in gross proceeds in connection with common stock purchase agreement with Seaside entered into on June 19, 2009 and proceeds from exercise of warrants and employee stock options of $7,042,000.  Additionally, in June 2010, we obtained a term loan in the amount of $20,000,000, less fees and expenses, which was used in part to refinance the remaining balance of the term loan entered into with GECC and SVB on October 14, 2008.

The net cash provided by financing activities for the six months ended June 30, 2009 related primarily to a March 2009 equity offering of approximately $10,000,000 in gross proceeds to institutional investors for a total of 4,771,174 shares of our common stock and warrants to purchase up to a total of 6,679,644 additional shares of our common stock and a May 2009 private placement of approximately $4,242,000 in net proceeds to a syndicate of investors for a total of 1,864,783 unregistered shares of common stock and 3,263,380 common stock warrants.

Critical Accounting Policies and Significant Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of our assets, liabilities, revenues, and expenses, and that affects our recognition and disclosure of contingent assets and liabilities.

While our estimates are based on assumptions we consider reasonable at the time they were made, our actual results may differ from our estimates, perhaps significantly.  If results differ materially from our estimates, we will make adjustments to our financial statements prospectively if needed.
 
 
We believe it is important for you to understand our most critical accounting policies as these are policies that require us to make our most significant judgments and, as a result, could have the greatest impact on our future financial results.  Below are the key updates to our accounting policies for the three and six months ended June 30, 2010.  These accounting policies should be read in conjunction with the accounting policies included in our annual report on Form 10-K for the year ended December 31, 2009.

Warrant Liability 

Effective January 1, 2009, we changed our method of accounting for certain common stock purchase warrants with exercise price reset features due to the adoption of a new accounting standard.   These warrants were issued in connection with our August 2008 private placement of 2,825,517 unregistered shares of common stock and 1,412,758 common stock warrants. The warrants had an original exercise price of $8.50 and expire in August 2013.  Under the new standard, these warrants previously recognized in stockholders’ equity (deficit) are now accounted for as fair value liabilities, with changes in fair value included in net earnings (loss).

The cumulative effect of the adoption is to present these warrants as liabilities on the date of the adoption as if they had been accounted for as liabilities since the warrants were issued.  As a result on January 1, 2009, we recognized a $1.7 million long-term warrant liability, a $2.9 million decrease in accumulated deficit and a corresponding decrease in additional paid-in capital of $4.6 million. During 2009, the fair value of the warrant liability increased to $6.3 million and as a result we recognized $4.6 million loss from the change in the fair value of warrants in 2009.  The fair value of these warrants decreased to $2.6 million as of June 30, 2010, which resulted in a $1.5 million and $3.6 million gain from the change in fair value of warrants for the three and six months ended June 30, 2010, respectively.


 
29

 

Since these warrants do not qualify for hedge accounting, all future changes in the fair value of the warrants will be recognized currently in earnings until such time as the warrants are exercised or expire. These warrants are not traded in an active securities market, and as such, we estimated the fair value of these warrants using the Black-Scholes option pricing model using the following assumptions:

   
As of
June 30, 2010
   
As of
December 31, 2009
 
Expected term
 
3.12 years
   
3.61 years
 
Common stock market price
  $ 3.48     $ 6.10  
Risk-free interest rate
    1.00 %     1.70 %
Expected volatility
    80.70 %     76.16 %
Resulting fair value (per warrant)
  $ 1.37     $ 3.28  

Expected volatility is based primarily on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the expected term of the warrants. We believe this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. We currently have no reason to believe future volatility over the expected remaining life of these warrants is likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is the interest rate for treasury constant maturity instruments published by the Federal Reserve Board that is closest to the expected term of the warrant.

 
Revenue Recognition

Product Sales

We recognize revenue from product sales when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable and (iv) collection of the resulting accounts receivable is reasonably assured.

For all sales, we use a binding purchase order or a signed agreement as evidence of an arrangement.  Revenue for these product sales is recognized upon delivery to the customer, as all risks and rewards of ownership have been substantively transferred to the customer at that point.  For Celution® 800/CRS System sales to customers who arrange for and manage the shipping process, we recognize revenue upon shipment from our facilities.  Shipping and handling costs that are billed to our customers are classified as revenue.  The customer’s obligation to pay and the payment terms are set at the time of delivery and are not dependent on the subsequent use or resale of our product.

For those sales that include multiple deliverables, we allocate revenue based on the relative fair values of the individual components.  When more than one element such as product maintenance or technical support services are included in an arrangement, we allocate revenue between the elements based on each element’s relative fair value, provided that each element meets the criteria for treatment as a separate unit of accounting.  An item is considered a separate unit of accounting if it has value to the customer on a standalone basis and there is objective and reliable evidence of the fair value of the undelivered items.  Fair value is generally determined based upon the price charged when the element is sold separately.  In the absence of fair value for a delivered element, we allocate revenue first to the fair value of the undelivered elements and allocate the residual revenue to the delivered elements.  Fair values for undelivered elements are determined based on vendor-specific objective evidence as well as market participant quotes for similar services.  Deferred service revenue is recognized ratably over the period the services are provided.  In the absence of fair value for an undelivered element, the arrangement is accounted for as a single unit of accounting, resulting in a deferral of revenue recognition for delivered elements until all undelivered elements have been fulfilled.
 
Concentration of Significant Customers
 
For the six months ended June 30, 2010, our sales were concentrated in two direct customers, which in aggregate comprised 32% of our revenue recognized for the six months ended June 30, 2010.  Our Asia-Pacific and North America region sales accounted for 87% of our revenue recognized for the six months ended June 30, 2010.  Additionally, one distributor and two direct customers accounted for 37% of total outstanding accounts receivable as of June 30, 2010.
 
For the six months ended June 30, 2009, our sales were concentrated in three distributors and one direct customer, which in aggregate comprised 61% of our revenue recognized for the six months ended June 30, 2009.  Our Asia-Pacific region sales accounted for 49% of our revenue recognized for the six months ended June 30, 2009.  Additionally, one distributor and one end customer accounted for 50% of total outstanding accounts receivable as of June 30, 2009.


 
30

 

Research and Development

We earn revenue for performing tasks under research and development agreements with both commercial enterprises, such as Olympus and Senko, and governmental agencies like the National Institutes of Health (“NIH”).  Revenue earned under development agreements is classified as either research grant or development revenues depending on the nature of the arrangement.  Revenues derived from reimbursement of direct out-of-pocket expenses for research costs associated with grants are recorded as development revenues.  We record grant revenue for the gross amount of the reimbursement.  The costs associated with these reimbursements are reflected as a component of research and development expense in our consolidated statements of operations.  Additionally, research and development arrangements we have with commercial enterprises such as Olympus and Senko are considered a key component of our central and ongoing operations.  Accordingly, when recognized, the inflows from such arrangements are presented as revenues in our consolidated statements of operations.

We received funds from Olympus and Olympus-Cytori, Inc. during 2005 and 2006.   We recorded upfront fees totaling $28,311,000 as deferred revenues, related party.  In exchange for these proceeds, we agreed to (a) provide Olympus-Cytori, Inc. an exclusive and perpetual license to our Celution® System device technology and certain related intellectual property, and (b) provide future development contributions related to commercializing the Celution® System platform.  The license and development services are not separable and as a result the recognition of this deferred amount requires achievement of service related milestones, under a proportional performance methodology.  If and as such revenues are recognized, deferred revenue will be decreased.  Proportional performance methodology was elected due to the nature of our development obligations and efforts in support of the Joint Venture (“JV”), including product development activities and regulatory efforts to support the commercialization of the JV products. The application of this methodology uses the achievement of R&D milestones as outputs of value to the JV.  We received up-front, non-refundable payments in connection with these development obligations, which we have broken down into specific R&D milestones that are definable and substantive in nature, and which will result in value to the JV when achieved.  As our research and development efforts progress, we periodically evaluate,  and modify if necessary, the milestone points in our proportional performance model to ensure that revenue recognition accurately reflects our best estimate of substantive value deliverable to the JV.  Revenue will be recognized as the above mentioned R&D milestones are completed.  Of the amounts received and deferred, we recognized development revenues of $0 and $2,122,000 for the three and six months ended June 30, 2010, respectively.  During 2009, we recognized $7,250,000 in development revenues for the three and six months ended June 30, 2009.  All related development costs are expensed as incurred and are included in research and development expense on the statement of operations.

Under a Distribution Agreement with Senko, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  We have also earned or will be entitled to earn additional payments under the Distribution Agreement based on achieving the defined research and development milestones. There was no development revenue recognized during the three and six months ended June 30, 2010 and 2009.

Goodwill Impairment Testing

In late 2002, we purchased StemSource, Inc. and recognized over $4,600,000 in goodwill associated with the acquisition, of which $3,922,000 remains on our balance sheet as of June 30, 2010.  We test this goodwill at least annually for impairment as well as when an event occurs or circumstances change such that it is reasonably possible that impairment may exist.  The application of the goodwill impairment test involves a substantial amount of judgment.  The judgments employed may have an effect on whether a goodwill impairment loss is recognized.

In 2009, we completed our goodwill impairment testing using a combination of an income-based approach incorporating discounted projections of estimated future cash flows as well as a market-based approach.  We concluded that the fair value of our main reporting unit exceeded its carrying value, and that none of our reported goodwill was impaired.  Additionally, no triggering events occurred during the three and six months ended June 30, 2010.

Variable Interest Entity (Olympus-Cytori Joint Venture)

A variable interest entity, or VIE, must be consolidated by its primary beneficiary.  Evaluating whether an entity is a VIE and determining its primary beneficiary involves significant judgment.

We concluded that the Olympus-Cytori Joint Venture was a VIE based on the following factors:

·  
An entity is a VIE if it has insufficient equity to finance its activities.  We recognized that the initial cash contributed to the Joint Venture formed by Olympus and Cytori ($30,000,000) would be completely utilized by the first quarter of 2006.  Moreover, it was highly unlikely that the Joint Venture would be able to obtain the necessary financing from third party lenders without additional subordinated financial support – such as personal guarantees by one or both of the Joint Venture stockholders.  Accordingly, the Joint Venture will require additional financial support from Olympus and Cytori to finance its ongoing operations, indicating that the Joint Venture is a VIE.  In fact, we contributed $330,000, $300,000 and $150,000 in the second quarter of 2010, fourth quarter of 2007 and first quarter of 2006, respectively, to fund the Joint Venture’s ongoing operations.
 
 
 
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·  
Moreover, Olympus has a contingent put option that would, in specified circumstances, require Cytori to purchase Olympus’s interests in the Joint Venture for a fixed amount of $22,000,000.  Accordingly, Olympus is protected in some circumstances from absorbing all expected losses in the Joint Venture, and as such, Olympus may not be an “at-risk” equity holder, although Olympus clearly has decision rights over the operations of the Joint Venture.

Because the Joint Venture is undercapitalized, and because one of the Joint Venture’s decision makers may be protected from losses, we have determined that the Joint Venture is a VIE.

Significant judgment was involved in determining the primary beneficiary of the Joint Venture.   We believe that Olympus and Cytori are “de facto agents” and, together, will absorb more than 50% of the Joint Venture’s expected losses and residual returns.  Ultimately, we concluded that Olympus, and not Cytori, was the party most closely related with the joint venture and, hence, its primary beneficiary.  Our conclusion also considered the following factors:

·  
The business operations of the Joint Venture will be most closely aligned to those of Olympus (i.e., the manufacturer of devices).

·  
Olympus controls the Board of Directors as well as the day-to-day operations of the Joint Venture, and therefore has the primary power to direct activities that could significantly impact economic performance.

Had we consolidated the Joint Venture, though, there would be no effect on our net loss or shareholders’ equity at December 31, 2009 or for the year then ended.  However, certain balance sheet and income statement captions would have been presented in a different manner.  For instance, we would not have presented a single line item entitled investment in joint venture in our balance sheet but, instead, would have performed a line by line consolidation of each of the Joint Venture’s accounts into our financial statements.  We reassess our conclusions regarding consolidation of the Joint Venture quarterly.

Income Taxes

Income taxes are accounted for under the asset and liability method.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (loss) in the years in which those temporary differences are expected to be recovered or settled.  Due to our history of loss, a full valuation allowance is recognized against our deferred tax assets.

Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (FASB) issued an update to the consolidation topic of the FASB Accounting Standards Codification (the ASC or the Codification).  This update requires an enterprise to qualitatively assess the determination of the primary beneficiary (or “consolidator”) of a variable interest entity, or VIE, based on whether the entity (1) has the power to direct matters that most significantly impact the activities of the VIE, and (2) has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Also, it changes the consideration of kick-out rights in determining if an entity is a VIE and requires an ongoing reconsideration of the primary beneficiary. It also amends the events that trigger a reassessment of whether an entity is a VIE. This update is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  The adoption of this standard did not have a material impact on our consolidated condensed financial statements.
 
In October 2009, the FASB issued an update to the revenue recognition topic of the Codification.  The update addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence; (b) third-party evidence; or (c) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. In addition, this guidance significantly expands required disclosures related to a vendor’s multiple-deliverable revenue arrangements. The update 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and early adoption is permitted.  We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements.

 
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In March 2010, the Task Force reached a consensus on EITF 08-9, “Milestone Method of Revenue Recognition” that the milestone method is a valid application of the proportional performance model for revenue recognition if the milestones are substantive and there is substantive uncertainty about whether the milestones will be achieved.  The Task Force agreed that whether milestone is substantive is a judgment that should be made at the inception of the arrangement.  Provided that the EITF’s consensus is ratified by the FASB, an Accounting Standard Update will be issued to update the Codification to reflect the new guidance.  If ratified, the new guidance will be effective for interim and annual periods beginning on or after June 15, 2010.  We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are exposed to market risk related to fluctuations in foreign currency exchange rates.

Interest Rate Exposure

We are not subject to market risk due to fluctuations in interest rates on our long-term obligations as they bear a fixed rate of interest.  Our exposure relates primarily to short-term investments, including funds classified as cash equivalents.  As of June 30, 2010, all excess funds were invested in money market funds and other highly liquid investments, therefore our interest rate exposure is not considered to be material.

Foreign Currency Exchange Rate Exposure

Our exposure to market risk due to fluctuations in foreign currency exchange rates relates primarily to our activities in Europe and Japan.  Transaction gains or losses resulting from cash balances and revenues have not been significant in the past and we are not engaged in any hedging activity in the Euro, the Yen or other currencies.  Based on our cash balances and revenues derived from markets other than the United States for the year ended December 31, 2009, a hypothetical 10% adverse change in the Euro or Yen against the U.S. dollar would not result in a material foreign currency exchange loss.  Consequently, we do not expect that reductions in the value of such sales denominated in foreign currencies resulting from even a sudden or significant fluctuation in foreign exchange rates would have a direct material impact on our financial position, results of operations or cash flows.

Notwithstanding the foregoing, the indirect effect of fluctuations in interest rates and foreign currency exchange rates could have a material adverse effect on our business, financial condition and results of operations.  For example, foreign currency exchange rate fluctuations may affect international demand for our products.  In addition, interest rate fluctuations may affect our customers’ buying patterns.  Furthermore, interest rate and currency exchange rate fluctuations may broadly influence the United States and foreign economies resulting in a material adverse effect on our business, financial condition and results of operations.

Under our Japanese Thin Film agreement with Senko, we would receive payments in the nature of royalties based on Senko’s net sales.  Such sales and resulting royalties would be Yen denominated.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or furnished pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure.  In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report of Form 10-Q.  Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and were operating at a reasonable assurance level as of June 30, 2010.
 
 
 
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Changes in Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting during the quarter ended June 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, we have been involved in routine litigation incidental to the conduct of our business. As of June 30, 2010, we were not a party to any material legal proceeding.

Item 1A. Risk Factors

In analyzing our company, you should consider carefully the following risk factors together with all of the other information included in this quarterly report on Form 10-Q.  Factors that could adversely affect our business, operating results, and financial condition, as well as adversely affect the value of an investment in our common stock,  include those discussed below, as well as those discussed above in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this quarterly report on Form 10-Q.

We are subject to the following significant risks, among others:

We need to raise more cash in the future

We have almost always had negative cash flows from operations.  Our business will continue to result in a substantial requirement for research and development expenses for several years, during which we may not be able to bring in sufficient cash and/or revenues to offset these expenses.  We will be required to raise capital from one or more sources in the future to continue funding our operations to profitability.  We do not currently believe that our cash balance and the revenues from our operations will be sufficient to fund the development and marketing efforts required to reach profitability without raising additional capital from accessible sources of financing in the future.  In addition, our Amended and Restated Loan and Security Agreement with General Electric Capital Corporation, Silicon Valley Bank and Oxford Finance Corporation requires us to maintain certain minimum cash requirements, and if our cash reserves fall below those minimum requirements, then we could be in default under our loan agreement and subject to potential adverse remedies by the lenders.  Any of these events would have a substantial and material adverse effect on our business, financial condition, results of operations, the value of our common stock and warrants and our ability to raise capital.  There is no guarantee that adequate funds will be available when needed from additional debt or equity financing, arrangements with development and commercialization partners, increased results of operations, or from other sources, or on terms attractive to us.  Inability to obtain sufficient additional funds in the future would, at a minimum, require us to delay, scale back, or eliminate some or all of our research or product development, manufacturing operations, clinical or regulatory activities, which could have a substantial negative effect on our results of operations and financial condition.
 
Continued turmoil in the economy could harm our business
 
Negative trends in the general economy, including trends resulting from an actual or perceived recession, tightening credit markets, increased cost of commodities, including oil, actual or threatened military action by the United States and threats of terrorist attacks in the United States and abroad, could cause a reduction of investment in and available funding for companies in certain industries, including ours.  Our ability to raise capital has been and may also be adversely affected by further downturn in current credit conditions, financial markets and the global economy.
 
We have never been profitable on an operational basis and expect significant operating losses for the next few years

We have incurred net operating losses in each year since we started business.  As our focus on the Celution® System platform and development of therapeutic applications for its cellular output has increased, losses have resulted primarily from expenses associated with research and development activities and general and administrative expenses.  While we are implementing cost reduction measures where possible, we nonetheless expect to continue operating in a loss position on a consolidated basis and that recurring operating expenses will be at high levels for the next several years, in order to perform clinical trials, additional pre-clinical research, product development, and marketing.  As a result of our historic losses, we have historically been, and continue to be, reliant on raising outside capital to fund our operations as discussed in the prior risk factor.


 
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Our business strategy is high-risk

We are focusing our resources and efforts primarily on development of the Celution® System family of products and the therapeutic applications of its cellular output, which requires extensive cash needs for research, development, and commercialization activities.  This is a high-risk strategy because there is no assurance that our products will ever become commercially viable (commercial risk), that we will prevent other companies from depriving us of market share and profit margins by selling products based on our inventions and developments (legal risk), that we will successfully manage a company in a new area of business (regenerative medicine) and on a different scale than we have operated in the past (operational risk), that we will be able to achieve the desired therapeutic results using stem and regenerative cells (scientific risk), or that our cash resources will be adequate to develop our products until we become profitable, if ever (financial risk).  We are using our cash in one of the riskiest industries in the economy (strategic risk).  This may make our stock an unsuitable investment for many investors.

We must keep our joint venture with Olympus operating smoothly

Our business depends in part on keeping our Joint Venture collaboration with Olympus operating smoothly and efficiently.  We have given Olympus-Cytori, Inc. an exclusive license to manufacture future generation Celution® System devices.  If Olympus-Cytori, Inc. does not successfully develop and manufacture these devices, we may not be able to commercialize these devices successfully into the market.  In addition, future disruption or breakup of our relationship would be extremely costly to our reputation, in addition to causing many serious practical problems.

We and Olympus must overcome contractual and cultural barriers.  Although our relationship is formally measured by a set of complex contracts, many aspects of the relationship will be non-contractual and must be worked out between the parties and the responsible individuals.  The Joint Venture is intended to have a long life, and it is difficult to maintain cooperative relationships over a long period of time in the face of various kinds of change.  Cultural differences, including language barrier to some degree, may affect the efficiency of the relationship.

Olympus-Cytori, Inc. is 50% owned by us and 50% owned by Olympus.  By contract, each side must consent before any of a wide variety of important business actions can occur.  This situation possesses a risk of potentially time-consuming and difficult negotiations which could at some point delay the Joint Venture from pursuing its business strategies.

Olympus is entitled to designate the Joint Venture's chief executive officer and a majority of its board of directors, which means that day-to-day decisions which are not subject to a contractual veto will essentially be controlled by Olympus.  In addition, Olympus-Cytori, Inc. may require more money than its current capitalization in order to complete development and production of future generation devices.  If we are unable to help provide future financing for Olympus-Cytori, Inc., our relative equity interest in Olympus-Cytori, Inc. may decrease.

Furthermore, under a License/Joint Development Agreement among Olympus-Cytori, Inc., Olympus, and us, Olympus will have a primary role in the development of Olympus-Cytori, Inc.’s next generation devices.  Although Olympus has extensive experience in developing medical devices, this arrangement will result in a reduction of our control over the development and manufacturing of the next generation devices.

We have a limited operating history; operating results and stock price can be volatile like many life science companies

Our prospects must be evaluated in light of the risks and difficulties frequently encountered by emerging companies and particularly by such companies in rapidly evolving and technologically advanced biotech and medical device fields.  Due to limited operating history and the transition from the MacroPore biomaterials to the regenerative medicine business, comparisons of our year-to-year operating results are not necessarily meaningful and the results for any periods should not necessarily be relied upon as an indication of future performance.  All 2007 product revenues came from our spine and orthopedics implant product line, which we sold in May 2007.

From time to time, we have tried to update our investors’ expectations as to our operating results by periodically announcing financial guidance.  However, we have in the past been forced to revise or withdraw such guidance due to lack of visibility and predictability of product demand.

We are vulnerable to competition and technological change, and also to physicians’ inertia

We compete with many domestic and foreign companies in developing our technology and products, including biotechnology, medical device, and pharmaceutical companies.  Many current and potential competitors have substantially greater financial, technological, research and development, marketing, and personnel resources.  There is no assurance that our competitors will not succeed in developing alternative products that are more effective, easier to use, or more economical than those which we have developed or are in the process of developing, or that would render our products obsolete and non-competitive.  In general, we may not be able to prevent others from developing and marketing competitive products similar to ours or which perform similar functions.
 
 
 
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Competitors may have greater experience in developing therapies or devices, conducting clinical trials, obtaining regulatory clearances or approvals, manufacturing and commercialization.  It is possible that competitors may obtain patent protection, approval, or clearance from the FDA or achieve commercialization earlier than we can, any of which could have a substantial negative effect on our business.  Finally, Olympus and our other partners might pursue parallel development of other technologies or products, which may result in a partner developing additional products competitive with ours.

We compete against cell-based therapies derived from alternate sources, such as bone marrow, umbilical cord blood and potentially embryos.  Doctors historically are slow to adopt new technologies like ours, whatever the merits, when older technologies continue to be supported by established providers.  Overcoming such inertia often requires very significant marketing expenditures or definitive product performance and/or pricing superiority.

We expect physicians’ inertia and skepticism to also be a significant barrier as we attempt to gain market penetration with our future products. We believe we will need to finance lengthy time-consuming clinical studies (so as to provide convincing evidence of the medical benefit) in order to overcome this inertia and skepticism particularly in reconstructive surgery, cell preservation, the cardiovascular area and many other indications.

Most potential applications of our technology are pre-commercialization, which subjects us to development and marketing risks

We are in a relatively early stage of the path to commercialization with many of our products.  We believe that our long-term viability and growth will depend in large part on our ability to develop commercial quality cell processing devices and useful procedure-specific consumables, and to establish the safety and efficacy of our therapies through clinical trials and studies.  With our Celution® System platform, we are pursuing new approaches for reconstructive surgery, preservation of stem and regenerative cells for potential future use, therapies for cardiovascular disease, gastrointestinal disorders and spine and orthopedic conditions.  There is no assurance that our development programs will be successfully completed or that required regulatory clearances or approvals will be obtained on a timely basis, if at all.

There is no proven path for commercializing the Celution® System platform in a way to earn a durable profit commensurate with the medical benefit.  Although we began to commercialize our reconstructive surgery products in Europe and certain Asian markets, and our cell banking products in Japan, Europe, and certain Asian markets in 2008, additional market opportunities for our products and/or services are likely to be another two to four years away.

Successful development and market acceptance of our products is subject to developmental risks, including failure of inventive imagination, ineffectiveness, lack of safety, unreliability, failure to receive necessary regulatory clearances or approvals, high commercial cost, preclusion or obsolescence resulting from third parties’ proprietary rights or superior or equivalent products, competition from copycat products, and general economic conditions affecting purchasing patterns.  There is no assurance that we or our partners will successfully develop and commercialize our products, or that our competitors will not develop competing technologies that are less expensive or superior.  Failure to successfully develop and market our products would have a substantial negative effect on our results of operations and financial condition.

The timing and amount of Thin Film revenues from Senko are uncertain

The sole remaining product line in our MacroPore Biosurgery segment is our Japan Thin Film business.  Our right to receive royalties from Senko, and to recognize certain deferred revenues, depends on the timing of MHLW approval for commercialization of the product in Japan.  We have no control over this timing and our previous expectations have not been met.  Also, even after commercialization, we will be dependent on Senko, our exclusive distributor, to drive product sales in Japan.

We have limited manufacturing experience

We have limited experience in manufacturing the Celution® System platform or its consumables at a commercial level.  With respect to our Joint Venture, although Olympus is a highly capable and experienced manufacturer of medical devices, there can be no guarantee that the Olympus-Cytori Joint Venture will be able to successfully develop and manufacture the next generation Celution® System in a manner that is cost-effective or commercially viable, or that development and manufacturing capabilities might not take much longer than currently anticipated to be ready for the market.

Although we have begun introduction of the Celution® 800 and the StemSource® 900-based Cell Bank in 2008, we cannot assure that we will be able to manufacture sufficient numbers of such products to meet the demand, or that we will be able to overcome unforeseen manufacturing difficulties for these sophisticated medical devices, as we await the availability of the Joint Venture next generation Celution® System.
 
 
 
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In the event that the Olympus-Cytori Joint Venture is not successful, Cytori may not have the resources or ability to self-manufacture sufficient numbers of devices and consumables to meet market demand, and this failure may substantially extend the time it would take for us to bring a more advanced commercial device to market. This makes us significantly dependant on the continued dedication and skill of Olympus for the successful development of the next generation Celution® System.

We may not be able to protect our proprietary rights

Our success depends in part on whether we can maintain our existing patents, obtain additional patents, maintain trade secret protection, and operate without infringing on the proprietary rights of third parties.

There can be no assurance that any of our pending patent applications will be approved or that we will develop additional proprietary products that are patentable. There is also no assurance that any patents issued to us will not become the subject of a re-examination, will provide us with competitive advantages, will not be challenged by any third parties, or that the patents of others will not prevent the commercialization of products incorporating our technology.  Furthermore, there can be no guarantee that others will not independently develop similar products, duplicate any of our products, or design around our patents.

Our commercial success will also depend, in part, on our ability to avoid infringing on patents issued to others.  If we were judicially determined to be infringing on any third-party patent, we could be required to pay damages, alter our products or processes, obtain licenses, or cease certain activities.  If we are required in the future to obtain any licenses from third parties for some of our products, there can be no guarantee that we would be able to do so on commercially favorable terms, if at all.  U.S. patent applications are not immediately made public, so we might be surprised by the grant to someone else of a patent on a technology we are actively using.  As noted above and in the case of the University of Pittsburgh lawsuit, even patents issued to us or our licensors might be judicially determined to belong in full or in part to third parties.

Litigation, which would result in substantial costs to us and diversion of effort on our part, may be necessary to enforce or confirm the ownership of any patents issued or licensed to us, or to determine the scope and validity of third-party proprietary rights.  If our competitors claim technology also claimed by us and prepare and file patent applications in the United States of America, we may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office or a foreign patent office to determine priority of invention, which could result in substantial costs to and diversion of effort, even if the eventual outcome is favorable to us.  Any such litigation or interference proceeding, regardless of outcome, could be expensive and time-consuming.

Successful challenges to our patents through oppositions, reexamination proceedings or interference proceedings could result in a loss of patent rights in the relevant jurisdiction. If we are unsuccessful in actions we bring against the patents of other parties and it is determined that we infringe the patents of third-parties, we may be subject to litigation, or otherwise prevented from commercializing potential products in the relevant jurisdiction, or may be required to obtain licenses to those patents or develop or obtain alternative technologies, any of which could harm our business. Furthermore, if such challenges to our patent rights are not resolved in our favor, we could be delayed or prevented from entering into new collaborations or from commercializing certain products, which could adversely affect our business and results of operations.

Competitors or third parties may infringe our patents. We may be required to file patent infringement claims, which can be expensive and time-consuming. In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or that the third party’s technology does not in fact infringe upon our patents. An adverse determination of any litigation or defense proceedings could put one or more of our patents at risk of being invalidated or interpreted narrowly and could put our related pending patent applications at risk of not issuing. Litigation may fail and, even if successful, may result in substantial costs and be a distraction to our management. We may not be able to prevent misappropriation of our proprietary rights, particularly in countries outside the U.S. where patent rights may be more difficult to enforce.  Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential or sensitive information could be compromised by disclosure in the event of litigation. In addition, during the course of litigation there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial adverse effect on the price of our common stock.

In addition to patents, which alone may not be able to protect the fundamentals of our regenerative cell business, we also rely on unpatented trade secrets and proprietary technological expertise.  Some of our intended future cell-related therapeutic products may fit into this category.  We rely, in part, on confidentiality agreements with our partners, employees, advisors, vendors, and consultants to protect our trade secrets and proprietary technological expertise. There can be no guarantee that these agreements will not be breached, or that we will have adequate remedies for any breach, or that our unpatented trade secrets and proprietary technological expertise will not otherwise become known or be independently discovered by competitors.

Our amended regenerative cell technology license agreement with the Regents of the University of California (“UC”) which includes issued U.S. patent number 7,470,537,  contains certain developmental milestones, which if not achieved could result in the loss of exclusivity or loss of the license rights. The loss of such rights could impact our ability to develop certain regenerative cell technology products.  Also, our power as licensee to successfully use these rights to exclude competitors from the market is untested.
 
 
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Failure to obtain or maintain patent protection, or protect trade secrets, for any reason (or third-party claims against our patents, trade secrets, or proprietary rights, or our involvement in disputes over our patents, trade secrets, or proprietary rights, including involvement in litigation), could have a substantial negative effect on our results of operations and financial condition.

We may not be able to protect our intellectual property in countries outside the United States

Intellectual property law outside the United States is uncertain and in many countries is currently undergoing review and revisions.  The laws of some countries do not protect our patent and other intellectual property rights to the same extent as United States laws.  This is particularly relevant to us as most of our current commercial product sales and clinical trials are outside of the United States.  Third parties may attempt to oppose the issuance of patents to us in foreign countries by initiating opposition proceedings. Opposition proceedings against any of our patent filings in a foreign country could have an adverse effect on our corresponding patents that are issued or pending in the U.S. It may be necessary or useful for us to participate in proceedings to determine the validity of our patents or our competitors’ patents that have been issued in countries other than the U.S. This could result in substantial costs, divert our efforts and attention from other aspects of our business, and could have a material adverse effect on our results of operations and financial condition. We currently have pending patent applications in Europe, Australia, Japan, Canada, China, Korea, and Singapore, among others.

We and Olympus-Cytori, Inc. are subject to FDA regulation

As newly developed medical devices, the Celution® System family of products must receive regulatory clearances or approvals from the FDA and, in many instances, from non-U.S. and state governments prior to their sale.  The Celution® System family of products is subject to stringent government regulation in the United States by the FDA under the Federal Food, Drug and Cosmetic Act.  The FDA regulates the design/development process, clinical testing, manufacture, safety, labeling, sale, distribution, and promotion of medical devices and drugs.  Included among these regulations are pre-market clearance and pre-market approval requirements, design control requirements, and the Quality System Regulations/Good Manufacturing Practices.  Other statutory and regulatory requirements govern, among other things, establishment registration and inspection, medical device listing, prohibitions against misbranding and adulteration, labeling and post-market reporting.

The regulatory process can be lengthy, expensive, and uncertain.  Before any new medical device may be introduced to the United States of America market, the manufacturer generally must obtain FDA clearance or approval through either the 510(k) pre-market notification process or the lengthier pre-market approval application, or PMA, process.  It generally takes from three to 12 months from submission to obtain 510(k) pre-market clearance, although it may take longer.  Approval of a PMA could take four or more years from the time the process is initiated.  The 510(k) and PMA processes can be expensive, uncertain, and lengthy, and there is no guarantee of ultimate clearance or approval.  We expect that some of our future products under development as well as Olympus-Cytori’s will be subject to the lengthier PMA process.  Securing FDA clearances and approvals may require the submission of extensive clinical data and supporting information to the FDA, and there can be no guarantee of ultimate clearance or approval.  Failure to comply with applicable requirements can result in application integrity proceedings, fines, recalls or seizures of products, injunctions, civil penalties, total or partial suspensions of production, withdrawals of existing product approvals or clearances, refusals to approve or clear new applications or notifications, and criminal prosecution.

Medical devices are also subject to post-market reporting requirements for deaths or serious injuries when the device may have caused or contributed to the death or serious injury, and for certain device malfunctions that would be likely to cause or contribute to a death or serious injury if the malfunction were to recur.  If safety or effectiveness problems occur after the product reaches the market, the FDA may take steps to prevent or limit further marketing of the product.  Additionally, the FDA actively enforces regulations prohibiting marketing and promotion of devices for indications or uses that have not been cleared or approved by the FDA.

There can be no guarantee that we will be able to obtain the necessary 510(k) clearances or PMA approvals to market and manufacture our other products in the United States of America for their intended use on a timely basis, if at all.  Delays in receipt of or failure to receive such clearances or approvals, the loss of previously received clearances or approvals, or failure to comply with existing or future regulatory requirements could have a substantial negative effect on our results of operations and financial condition.

To sell in international markets, we will be subject to regulation in foreign countries

In cooperation with our distribution partners, we intend to market our current and future products both domestically and in many foreign markets. A number of risks are inherent in international transactions.  In order for us to market our products in Europe, Canada, Japan and certain other non-U.S. jurisdictions, we need to obtain and maintain required regulatory approvals or clearances and must comply with extensive regulations regarding safety, manufacturing processes and quality.  For example, we still have not obtained regulatory approval for our Thin Film products in Japan.  These regulations, including the requirements for approvals or clearances to market, may differ from the FDA regulatory scheme.  International sales also may be limited or disrupted by political instability, price controls, trade restrictions and changes in tariffs.  Additionally, fluctuations in currency exchange rates may adversely affect demand for our products by increasing the price of our products in the currency of the countries in which the products are sold.
 
 
 
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There can be no assurance that we will obtain regulatory approvals or clearances in all of the countries where we intend to market our products, or that we will not incur significant costs in obtaining or maintaining foreign regulatory approvals or clearances, or that we will be able to successfully commercialize current or future products in various foreign markets.  Delays in receipt of approvals or clearances to market our products in foreign countries, failure to receive such approvals or clearances or the future loss of previously received approvals or clearances could have a substantial negative effect on our results of operations and financial condition.

Changing, New and/or Emerging Government Regulations

Government regulations can change without notice. Given the fact that Cytori operates in various international markets, our access to such markets could change with little to no warning due to a change in government regulations that suddenly up-regulate our product(s) and create greater regulatory burden for our cell therapy and cell banking technology products.

Due to the fact that there are new and emerging cell therapy and cell banking regulations that have recently been drafted and/or implemented in various countries around the world, the application and subsequent implementation of these new and emerging regulations have little to no precedence. Therefore, the level of complexity and stringency is not known and may vary from country to country, creating greater uncertainty for the international regulatory process.

Health Insurance Reimbursement Risks

New and emerging cell therapy and cell banking technologies, such as those provided by the Celution®