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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

For the transition period from _____________________ to _____________________

Commission File Number: 001-33966

MAKO Surgical Corp.

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x   No  o

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

Large Accelerated Filer  o       Accelerated Filer  x       Non-accelerated Filer  o       Smaller reporting company  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o   No  x

Number of shares outstanding of each of the issuer’s classes of common stock as of October 28, 2010:

MAKO Surgical Corp.

INDEX TO FORM 10-Q

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PART I

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.

MAKO SURGICAL CORP.

Condensed Balance Sheets

(in thousands, except share and per share data)

(Unaudited)

See accompanying notes.

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MAKO SURGICAL CORP.

Condensed Statements of Operations

(in thousands, except per share data)

(Unaudited)

See accompanying notes.

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MAKO SURGICAL CORP.

Condensed Statements of Cash Flows

(in thousands, except share data)

(Unaudited)

See accompanying notes.

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MAKO SURGICAL CORP.

Notes to Condensed Financial Statements

September 30, 2010

(Unaudited)

1.  Description of the Business

MAKO Surgical Corp. (the “Company” or “MAKO”) is an emerging medical device company that markets its advanced robotic arm solution and orthopedic implants for orthopedic procedures called MAKOplasty^®. The Company was incorporated in the State of Delaware on November 12, 2004 and is headquartered in Fort Lauderdale, Florida. In February 2008, the Company’s common stock began trading on The NASDAQ Global Market under the ticker symbol “MAKO.”

2.  Summary of Significant Accounting Policies

Basis of Presentation

In the opinion of management, the accompanying unaudited condensed financial statements (“condensed financial statements”) of the Company have been prepared on a basis consistent with the Company’s December 31, 2009 audited financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary to fairly state the information set forth herein. These condensed financial statements have been prepared in accordance with the regulations of the Securities and Exchange Commission and, therefore, omit certain information and footnote disclosure necessary to present the statements in accordance with accounting principles generally accepted in the United States of America. These quarterly condensed financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2009 (the “Form 10-K”). The results of operations for the three and nine months ended September 30, 2010 may not be indicative of the results to be expected for the entire year or any future periods.

Liquidity and Operations

In executing its current business plan, the Company believes its existing cash, cash equivalents and investment balances and interest income earned on these balances will be sufficient to meet its anticipated cash requirements for at least the next twelve months. To the extent the Company’s available cash, cash equivalents and investment balances are insufficient to satisfy its operating requirements, the Company will need to seek additional sources of funds, including selling additional equity, debt or other securities or entering into a credit facility, or modifying its current business plan. The sale of additional equity and convertible debt securities may result in dilution to the Company’s current stockholders. If the Company raises additional funds through the issuance of debt securities, these securities may have rights senior to those of its common stock and could contain covenants that could restrict the Company’s operations and issuance of dividends. The Company may also require additional capital beyond its currently forecasted amounts. Any required additional capital, whether forecasted or not, may not be available on reasonable terms, or at all. If the Company is unable to obtain additional financing, the Company may be required to reduce the scope of, delay or eliminate some or all of its planned research, development and commercialization activities, which could materially harm its business and results of operations.

Concentrations of Credit Risk and Other Risks and Uncertainties

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash and cash equivalents, investments, and accounts receivable. The Company’s cash and cash equivalents are held in demand and money market accounts at four large financial institutions. The Company’s investments are held in a variety of interest bearing instruments, including notes and bonds from U.S. government agencies, certificates of deposit and investment grade rated U.S. corporate debt at three large financial institutions. Such deposits are generally in excess of insured limits. The Company has not experienced any historical losses on its deposits of cash and cash equivalents.

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The Company may perform credit evaluations of its customers’ financial condition and, generally, requires no collateral from its customers. The Company will provide an allowance for doubtful accounts when collections become doubtful but has not experienced any credit losses to date.

The Company is subject to risks common to emerging companies in the medical device industry including, but not limited to: new technological innovations, dependence on key personnel, dependence on key suppliers, changes in general economic conditions and interest rates, protection of proprietary technology, compliance with changing government regulations and taxes, uncertainty of widespread market acceptance of products, access to credit for capital purchases by our customers, product liability and the need to obtain additional financing. The Company’s products include components subject to rapid technological change. Certain components used in manufacturing have relatively few alternative sources of supply and establishing additional or replacement suppliers for such components cannot be accomplished quickly. The inability of any of these suppliers to fulfill the Company’s supply requirements may negatively impact future operating results. While the Company has ongoing programs to minimize the adverse effect of such uncertainty and considers technological change in estimating the net realizable value of its inventory, uncertainty continues to exist.

The Company’s current versions of its RIO^® Robotic Arm Interactive Orthopedic (“RIO”) system, which is the second generation of its Tactile Guidance System™ (“TGS™”), its RESTORIS^® unicompartmental and RESTORIS MCK multicompartmental knee implant systems and its TGS have been cleared by the U.S. Food and Drug Administration (“FDA”). Certain products currently under development by the Company will require clearance or approval by the FDA or other international regulatory agencies prior to commercial sale. There can be no assurance that the Company’s products will receive the necessary clearances or approvals. If the Company were to be denied such clearance or approval or such clearance or approval were delayed, it could have a material adverse impact on the Company.

Revenue Recognition

Revenue is generated: (1) from unit sales of the Company’s RIO system, including associated instrumentation, installation services and training; (2) from sales of implants and disposable products; and (3) by providing extended warranty services. The Company recognizes revenue in accordance with Accounting Standards Codification (“ASC”) 605-10-S99,  Revenue Recognition, when persuasive evidence of an arrangement exists, the fee is fixed or determinable, collection of the fee is probable and delivery has occurred. For all sales, the Company uses either a signed agreement or a binding purchase order as evidence of an arrangement.

The Company’s multiple-element arrangements are generally comprised of the following elements that qualify as separate units of accounting: (1) RIO system sales; (2) sales of implants and disposable products; and (3) extended warranty services on the RIO system hardware. The Company’s revenue recognition policies generally result in revenue recognition at the following points:

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A portion of the Company’s end-user customers acquire the RIO system through a leasing arrangement with one of a number of qualified third-party leasing companies. In these instances, the Company typically sells the RIO system to the third-party leasing company, and the end-user customer enters into an independent leasing arrangement with the third-party leasing company. The Company recognizes RIO system revenue for a RIO system sale to a third-party leasing company on the same basis as a RIO system sale directly to an end-user customer. The Company sells implants and disposable products utilized in MAKOplasty procedures directly to end-user customers under a separate agreement.

The Company’s sales contracts generally do not provide the customer with a right of return. If such a right is provided, all related revenues would be deferred until such right expires or is waived. In a limited number of RIO system sales, the Company’s agreement with a customer provides for a customer acceptance period, which typically does not exceed three months, following which the customer may either accept or return the RIO system.  No system revenue is recognized for these RIO system sales until the customer has unconditionally accepted the RIO system.

Effective January 1, 2010, the Company early adopted the Financial Accounting Standards Board (“FASB”) Accounting Standard Update No. 2009-13, Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force (“ASU 2009-13”) and Update No. 2009-14,  Certain Revenue Arrangements That Include Software Elements, a consensus of the FASB Emerging Issues Task Force (“ASU 2009-14”) on a prospective basis for applicable transactions originating or materially modified after December 31, 2009. In accordance with ASU 2009-13 (as codified under ASC 605-25, Multiple-Element Arrangements) and ASU 2009-14, the Company allocates arrangement consideration to the RIO systems and associated instrumentation, its implants and disposables and its extended warranty services based upon the relative selling-price method. Under this method, revenue is allocated at the time of sale to all deliverables based on their relative selling price using a specific hierarchy. The hierarchy is as follows: vendor-specific objective evidence (“VSOE”) of fair value of the respective elements, third-party evidence of selling price (“TPS”), or best estimate of selling price.

The Company has established VSOE of fair value for its RIO system and TPS for its implants and disposables and its extended warranty services.

The Company’s RIO system includes software that is essential to the functionality of the product. Since the RIO system’s software and non-software components function together to deliver the RIO system’s essential functionality, they are considered one deliverable that is excluded from the software revenue recognition guidance under ASU 2009-13 and ASU 2009-14.

Prior to the adoption of ASU 2009-13 and ASU 2009-14, the Company accounted for the sale of the RIO systems and associated instrumentation pursuant to ASC 985-605, Software – Revenue Recognition, which required the Company to allocate arrangement consideration to the RIO systems and associated instrumentation based upon VSOE of fair value of the respective elements. Had the new accounting guidance been applied to revenue at the beginning of 2009, the resultant revenue and net loss for the year ended December 31, 2009 would have been substantially the same.

Subsequent to December 31, 2008, the Company no longer manufactures TGS units, to which associated TGS sales arrangements required it to provide upgrades and enhancements, through and including the delivery of the RIO system. The Company commercially released the RIO system in the first quarter of 2009. Sales arrangements for RIO systems do not require the Company to provide upgrades and enhancements. As a result, revenues related to RIO system sales are generally recognized upon installation of the system and training of at least one surgeon.

For sales of TGS units through December 31, 2008, VSOE of fair value was not established for upgrades and enhancements (through and including delivery of the RIO system), which the TGS sales arrangements required the Company to provide. Accordingly, prior to delivery of the RIO system, sales of TGS units were recorded as deferred revenue and the direct cost of revenue associated with the sale of TGS units was recorded as deferred cost of revenue. Revenue for all previously deferred TGS sales was recognized in the Company’s statement of operations during the nine months ended September 30, 2009, upon delivery of the RIO system. As of September 30, 2010, the deferred revenue balance consists primarily of deferred service revenue as discussed below.

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Costs associated with establishing an accrual for the RIO system standard one-year warranty liability and royalties covered by licensing arrangements related to the sale of RIO systems are expensed upon installation and are included in cost of revenue - systems, in the statements of operations.

Deferred Revenue

Deferred revenue consists of deferred service revenue and deferred system revenue. Deferred service revenue results from the advance payment for services to be delivered over a period of time, usually in one-year increments. Service revenue is recognized ratably over the service period. Deferred system revenue arises from timing differences between the installation of RIO systems and satisfaction of all revenue recognition criteria consistent with the Company’s revenue recognition policy. Deferred revenue expected to be realized within one year is classified as a current liability. The deferred revenue balance as of September 30, 2010 consists primarily of deferred service revenue for extended warranty services on the RIO system hardware.

Foreign Currency Transactions

Gains or losses from foreign currency transactions are included in interest and other income. To date, realized gains and losses recognized from foreign currency transactions were not significant.

Intangible Assets

The Company’s intangible assets are comprised of patents, patent applications and licenses to intellectual property rights. These intangible assets are carried at cost, net of accumulated amortization. Amortization is recorded using the straight-line method over their respective useful lives, which range from 5 to 13 years based on the respective anticipated lives of the underlying patents and patent applications.

Inventory

Inventory is stated at the lower of cost or market value on a first-in, first-out basis. Inventory costs include direct materials, direct labor and manufacturing overhead. The Company reviews its inventory periodically to determine net realizable value and considers product upgrades in its periodic review of realizability. The Company writes down inventory, if required, based on forecasted demand and technological obsolescence. These factors are impacted by market and economic conditions, technology changes and new product introductions and require estimates that may include uncertain elements.

Beginning with the fourth quarter of 2008, manufacturing overhead costs have been capitalized and included in inventory. As of September 30, 2010 and December 31, 2009, capitalized manufacturing overhead included in inventory was approximately $1.9 million and $1.1 million, respectively. Previously, such overhead costs were fully expensed as selling, general and administrative expense as capitalizable amounts were not significant.

Property and Equipment

Property and equipment are stated at cost, net of accumulated depreciation. Depreciation of property and equipment is computed using the straight-line method over their estimated useful lives of two to seven years. Leasehold improvements are amortized on a straight-line basis over the lesser of their useful life or the term of the lease and are included in depreciation expense in the accompanying statements of operations. Upon retirement or sale, the cost and related accumulated depreciation are removed from the balance sheet and the resulting gain or loss is reflected in operations. Maintenance and repairs are charged to operations as incurred.

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The Company loans instrumentation to its customers, who use the instrumentation to perform MAKOplasty procedures in conjunction with using the RIO system. These loaned instrument sets are comprised of tools and equipment that facilitate the implantation of the Company’s knee implants (“Implant Instruments”). Implant Instruments loaned to customers are not part of the tangible product sold and title of Implant Instruments remains with the Company. Accordingly, Implant Instruments are classified as a long-lived asset and included as a component of property and equipment. Undeployed Implant Instruments are carried at cost, net of allowances for excess and obsolete instruments. Implant Instruments in the field are carried at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on an estimated useful life of five years. The Company reviews instruments for impairment whenever events or changes in circumstances indicate that the carrying value of an instrument may not be recoverable. To better reflect the economics of the implant instruments and enhance comparability with other companies in our industry, depreciation expense on Implant Instruments has been reclassified from cost of revenue – procedures to selling, general and administrative expense beginning in the first quarter of 2010. Depreciation expense for Implant Instruments was approximately $304,000 and $170,000 for the nine months ended September 30, 2010 and 2009, respectively.

Prior to 2010, Implant Instruments were included as components of a RIO system sale and undeployed Implant Instruments were classified as inventory. Beginning in the first quarter of 2010, Implant Instruments are no longer included as components of a RIO system sale. To better reflect the economics of the Implant Instruments and be consistent with industry practice, undeployed Implant Instruments have been reclassified from inventory to property and equipment. As of September 30, 2010 and December 31, 2009, approximately $1.5 million and $1.8 million, respectively, of undeployed Implant Instruments have been included as property and equipment.

The Company also enters into RIO system consignment arrangements for clinical evaluation and clinical research purposes with terms ranging from one to three years. Under the terms of such arrangements, the Company installs a RIO system at the customer site and retains title to the RIO system, while the customer has use of the RIO system and purchases the Company’s implants and disposables products. Depreciation expense on consigned RIO systems and instruments is classified in selling, general and administrative expense and is computed using the straight-line method based on the estimated useful life of three years. As of September 30, 2010, the Company had 2 consigned RIO systems.

Service and demonstration RIO systems and instruments consist of RIO systems, associated instrumentation, service tools and equipment, and MAKOplasty procedure models used for sales demonstrations, surgeon training, and temporary RIO system placements at customer sites under warranty and extended warranty agreements. Service and demonstration RIO systems and instruments are classified as a long-lived asset and included as a component of property and equipment. Depreciation expense on service and demonstration RIO systems and instruments is classified in selling, general and administrative expense and is computed using the straight-line method based on an estimated useful life of three years.

Net Loss Per Share

The Company calculated net loss per share in accordance with ASC 260, Earnings per Share. Basic earnings per share (“EPS”) is calculated by dividing the net income or loss by the weighted average number of common shares outstanding for the period, without consideration for common stock equivalents. Diluted EPS is computed by dividing the net income or loss by the weighted average number of common shares outstanding for the period and the weighted average number of dilutive common stock equivalents outstanding for the period determined using the treasury stock method. The following table sets forth potential shares of common stock that are not included in the calculation of diluted net loss per share because to do so would be anti-dilutive as of the end of each period presented:

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Reclassifications

Certain reclassifications have been made to the prior periods’ statement of cash flows and to the prior periods’ statement of operations to conform to the current period’s presentation. In addition, the Company reclassified its Implant Instruments from inventory to property and equipment and reclassified depreciation expense on its Implant Instruments from cost of revenue – procedures to selling, general and administrative expense as described in greater detail in “Property and Equipment” above.

3.  Investments

The Company’s investments are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses included in other comprehensive income within stockholders’ equity. Realized gains and losses, interest and dividends and declines in value determined to be other-than-temporary on available-for-sale securities are included in interest and other income. During the nine months ended September 30, 2010 and 2009, realized gains and losses recognized on the sale of investments were not significant. The cost of securities sold is based on the specific identification method.

The amortized cost and fair value of short and long-term investments, with gross unrealized gains and losses, were as follows:

As of September 30, 2010

As of December 31, 2009

As of September 30, 2010, all investments had maturity dates of less than one year.

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The fair values of the Company’s investments based on the level of inputs are summarized below:

No investments measured at fair value on a recurring basis used Level 3 or significant unobservable inputs for the three months and nine months ended September 30, 2010. There have been no transfers between Level 1 and Level 2 measurements during the three months and nine months ended September 30, 2010.

Fair Value of Financial Instruments

Carrying amounts of certain of the Company’s financial instruments, including cash and cash equivalents, investments, accounts receivable and other accrued liabilities approximate fair value due to their short maturities or market rates of interest.

4.  Inventory

Inventory consisted of the following:

In the first quarter of 2010, the Company wrote-off approximately $1.9 million, or $(0.06) per basic and diluted share, of excess RESTORIS unicompartmental knee implant system (“RESTORIS Classic”) implants and related instrumentation with excess implants of approximately $1.0 million charged to cost of revenue – procedures, cancellation charges of $130,000 charged to cost of revenue – service and other and excess instrumentation of approximately $808,000 charged to selling, general and administrative expenses. These charges were necessitated by the rapid adoption of the RESTORIS MCK multicompartmental knee implant system and the corresponding decline in the usage of RESTORIS Classic. RESTORIS Classic was introduced in the third quarter of 2008 and was modeled after existing well-known unicompartmental designs. In connection with the launch of the RIO system, in the second quarter of 2009, the Company launched its next generation RESTORIS MCK multicompartmental knee implant system (“RESTORIS MCK”). RESTORIS MCK was designed as a premium addition to the RESTORIS product family with the goal of delivering a more natural feeling knee by preserving bone and providing anatomical features such as high flexion. 

The Company reviews its inventory periodically to determine net realizable value and considers product upgrades in its periodic review of realizability. Depending on demand for the Company’s products and technical obsolescence, additional future write-offs of the Company’s inventory may occur.

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5.  Commitments and Contingencies

Purchase Commitments

At September 30, 2010, the Company was committed to make future purchases for inventory related items and instrumentation under various purchase arrangements with fixed purchase provisions aggregating approximately $3.6 million.

Contingencies

The Company is a party to legal contingencies or claims arising in the normal course of business, none of which the Company believes is material to its financial position, results of operations or cash flows.

Warranty

Upon installation of a RIO system, the Company establishes an accrual for the estimated costs associated with providing a standard one-year warranty for defects in materials and workmanship. Estimates for warranty cost are made based primarily on historical warranty claim experience. The Company periodically evaluates and adjusts the warranty reserve to the extent actual warranty expense differs from the original estimates. The following table reflects the change in the warranty accrual during the nine months ended September 30, 2010 and 2009, respectively (in thousands):

Development Agreement

In June 2009, the Company entered into a Research and Development License and Supply Agreement (the “R&D Agreement”) associated with a potential future product for RIO-enabled hip MAKOplasty procedures. The R&D Agreement required an up-front payment of $450,000, and requires future milestone payments based on development progress. The aggregate milestone payments the Company is obligated to pay under the R&D Agreement are $1.6 million assuming the achievement of all development milestones. Through September 30, 2010, the Company paid the $450,000 up-front payment and $550,000 of milestone payments which became due upon the achievement of the related milestones. The aggregate up-front payment and milestone payments of $2.0 million the Company is required to pay under the R&D Agreement were recognized as research and development expense on a straight-line basis from June 2009 through August 2010, the period in which development services were performed under the R&D Agreement. As of September 30, 2010, the Company had an accrued liability of $1.0 million which will become payable upon the achievement of the final milestones under the R&D Agreement, which the Company believes is probable.

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6.  Related Party Transactions

In February 2010, the Company completed the acquisition of substantially all of the intellectual property portfolio of Z-Kat, Inc. (“Z-Kat”).  The terms of the Asset Purchase Agreement between the Company and Z-Kat (the “Asset Purchase Agreement”) terminated the Company’s prior licenses with Z-Kat, including Z-Kat’s nonexclusive sublicense to the Company’s intellectual property portfolio, and transferred to the Company ownership rights to certain intellectual property assets for core technologies in computer assisted surgery (“CAS”), haptics and robotics, including U.S. and foreign patents and patent applications, proprietary software and documentation, trade secrets and trademarks owned by Z-Kat, and certain contractual and other rights to patents, patent applications and other intellectual property licensed to Z-Kat under licenses. In connection with the acquisition, the Company also entered into a new license agreement with Z-Kat (the “License Agreement”) pursuant to which the Company obtained an exclusive worldwide, fully transferable, perpetual, royalty-free and fully paid-up sublicense to certain intellectual property for technologies in CAS licensed by Z-Kat.  This new License Agreement expands the Company’s rights in this intellectual property from the field of orthopedics to the medical field generally.  Certain of the Company’s rights under the Asset Purchase Agreement and License Agreement remain subject to any prior license granted by Z-Kat, including a license to Biomet Manufacturing Corp. In consideration for consummation of the transactions contemplated by the Asset Purchase Agreement and License Agreement, the Company issued 230,458 shares of its unregistered common stock to Z-Kat in a private placement, which was treated as a related party transaction because certain directors and executive officers of the Company had a material interest in Z-Kat by virtue of their ownership of Z-Kat stock. The Company and Z-Kat are not entities under common control. The Asset Purchase Agreement and License Agreement were approved by the independent members of the board of directors and audit committee of the Company. The value of the intellectual property acquired under the Asset Purchase Agreement of $3.1 million was based on the closing price per share of $13.25 of the Company’s common stock on February 25, 2010, the date the transaction was closed, and was recorded as an intangible asset and is being amortized over its estimated useful life of eight years.

In August 2009, the Company entered into a Research and Development Agreement (the “Sensor Agreement”) with a third-party sensor company associated with the potential future development of intellectual property and technology related to sensing devices in orthopedics. The Sensor Agreement required an initial payment of $50,000 and required future payments in the event that the Company decided to enter into a licensing and supply agreement with the third-party sensor company following the end of the research and development period. In August 2010, the Company exercised its option to enter into a non-exclusive license and supply agreement for an upfront payment of $250,000 (the “Non-Exclusive License Payment”). The Non-Exclusive License Payment was recorded as an intangible asset and will be amortized over its estimated useful life of ten years. In October 2010, the Company exercised its option to enter into an exclusive license and supply agreement which required an upfront payment of $500,000 and a future payment of $250,000 to be made by January 7, 2011 (the “Exclusive License Payments”). The Exclusive License Payments will be recorded as an intangible asset and amortized over its estimated useful life of approximately four years. The Sensor Agreement was treated as a related party transaction because certain directors of the Company had a material interest in the third-party sensor company by virtue of their ownership of the third-party sensor company’s outstanding stock. The Company and the third-party sensor company are not entities under common control. The members of the audit committee of our board of directors having no financial interest in the Sensor Agreement approved the terms of the Sensor Agreement.

7.  Stockholders’ Equity

Common Stock

As of September 30, 2010 and December 31, 2009, the Company was authorized to issue 135,000,000 shares of $0.001 par value common stock. Common stockholders are entitled to dividends as and if declared by the Board of Directors, subject to the rights of holders of all classes of stock outstanding having priority rights as to dividends. There have been no dividends declared to date on the common stock. The holder of each share of common stock is entitled to one vote.

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Comprehensive Loss

Comprehensive loss is defined as the change in equity from transactions and other events and circumstances other than those resulting from investments by owners and distributions to owners. For the three months ended September 30, 2010 and 2009, the Company recorded comprehensive losses of approximately $8,945,000 and $9,438,000, respectively. For the nine months ended September 30, 2010 and 2009, the Company recorded comprehensive losses of approximately $28,852,000 and $24,735,000, respectively. The difference between comprehensive loss and net loss for the three months and nine months ending September 30, 2010 and 2009 is due to changes in unrealized gains and losses on the Company’s available-for-sale securities.

Stock Option Plans and Stock-Based Compensation

The Company recognizes compensation expense for its stock-based awards in accordance with ASC 718, Compensation-Stock Compensation. ASC 718 requires the recognition of compensation expense, using a fair value based method, for costs related to all stock-based payments including stock options. ASC 718 requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model.

On February 4, 2010, the Company issued 100,000 shares of restricted stock to its CEO at a fair value of $1.2 million, or $11.95 per share, on the date of issuance. The restricted stock will vest over a four-year period. On April 13, 2010, the Company issued 75,000 shares of restricted stock to its CEO at a fair value of approximately $476,000 on the date of issuance. The April 13, 2010 grant is subject to performance conditions based on the achievement of certain performance metrics. Upon satisfaction of the performance conditions, 50% of the shares will vest on March 13, 2013 and 50% of the shares will vest on March 13, 2014. For the nine months ended September 30, 2010, 28,307 shares of common stock were surrendered by the CEO to the Company to cover payroll taxes associated with the taxable income from the vesting of restricted stock previously granted to the Company’s CEO. As of September 30, 2010, 879,723 shares of restricted stock granted to the Company’s CEO were issued and outstanding.

During the three months ended September 30, 2010 and 2009, stock-based compensation expense was approximately $1.7 million and $1.1 million, respectively. Included within stock-based compensation expense for the three months ended September 30, 2010 were $­1.3 million related to stock option grants, $345,000 related to the partial vesting of shares of restricted stock granted to the Company’s CEO at various dates from 2006 through 2010, and $64,000 related to employee stock purchases under the MAKO Surgical Corp. 2008 Employee Stock Purchase Plan (the “2008 Employee Stock Purchase Plan”). During the nine months ended September 30, 2010 and 2009, stock-based compensation expense was approximately $4.6 million and $2.9 million, respectively. Included within stock-based compensation expense for the nine months ended September 30, 2010 were $3.4 million related to stock option grants, $1.0 million related to the partial vesting of shares of restricted stock granted to the Company’s CEO at various dates from 2006 through 2010, and $188,000 related to employee stock purchases under the 2008 Employee Stock Purchase Plan.

The Company’s 2004 Stock Incentive Plan (the “2004 Plan”), its MAKO Surgical Corp. 2008 Omnibus Incentive Plan (the “2008 Plan,” and together with the 2004 Plan, the “Plans”), and its 2008 Employee Stock Purchase Plan are described in the notes to financial statements in the Form 10-K. Generally, the Company’s outstanding stock options vest over four years. Stock options granted to certain non-employee directors prior to 2010 generally vest over three years; however, stock options granted to non-employee directors after January 1, 2010 generally vest over one year. Continued vesting typically terminates when the employment or consulting relationship ends. Vesting generally begins on the date of grant.

The 2008 Plan contains an evergreen provision whereby the authorized shares available under the 2008 Plan increase on January 1st of each year in an amount equal to the least of (1) four percent (4%) of the total number of shares of the Company’s common stock outstanding on December 31st of the preceding year, (2) 2.5 million shares and (3) a number of shares determined by the Company’s Board of Directors that is lesser than (1) and (2). The number of additional shares authorized under the 2008 Plan on January 1, 2009 and 2010 were approximately 998,000 and 1,330,000, respectively.

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Under the terms of the Plans, the maximum term of options intended to be incentive stock options granted to persons who own at least 10% of the voting power of all outstanding stock on the date of grant is 5 years. The maximum term of all other options is 10 years. Options issued under the 2008 Plan that are forfeited or expire will again be made available for issuing grants under the 2008 Plan. Options issued under the 2004 Plan that are forfeited or expire will not be made available for issuing grants under the 2008 Plan. All future equity awards will be made under the Company’s 2008 Plan.

Activity under the Plans is summarized as follows:

The Company records stock-based compensation expense on a straight-line basis over the vesting period. As of September 30, 2010, there was total unrecognized compensation cost of approximately $14.4 million, net of estimated forfeitures, related to non-vested stock-based payments (including stock option grants, restricted stock grants and compensation expense relating to shares issued under the 2008 Employee Stock Purchase Plan) granted to the Company’s employees and non-employee directors. The unrecognized compensation cost will be adjusted for future changes in estimated forfeitures, and is expected to be recognized over a remaining weighted average period of 2.6 years as of September 30, 2010.

The estimated grant date fair values of the employee stock options were calculated using the Black-Scholes-Merton valuation model, based on the following assumptions:

Warrants

In December 2004, the Company issued at the purchase price of $0.03 per share warrants to purchase 462,716 shares of common stock. The warrants were immediately exercisable at an exercise price of $3.00 per share, with the exercise period expiring in December 2014. As of September 30, 2010, 429,862 warrants were outstanding and exercisable.

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In October 2008, the Company entered into a Securities Purchase Agreement for an equity financing with gross proceeds of approximately $40.2 million. In connection with the financing, the Company issued warrants to the participating investors to purchase 1,290,323 shares of common stock at a purchase price of $0.125 per warrant and an exercise price of $7.44 per share. The warrants became exercisable on April 29, 2009 and have a seven-year term. As of September 30, 2010, all the warrants were outstanding and exercisable. In addition, in consideration for the right (the “Call Right”) to require certain participants in the financing to purchase an additional $20 million of common stock and warrants to purchase common stock, the Company issued warrants to purchase 322,581 shares of common stock at a purchase price of $0.125 per warrant and an exercise price of $6.20 per share to participating investors. These warrants became exercisable on December 31, 2009 and have a seven-year term. As of September 30, 2010, all the warrants were outstanding and exercisable. The Company did not exercise its Call Right, which expired on December 31, 2009.

8.  Income Taxes

The Company accounts for income taxes under ASC 740, Income Taxes. Deferred income taxes are determined based upon differences between financial reporting and income tax bases of assets and liabilities and are measured using the enacted income tax rates and laws that will be in effect when the differences are expected to reverse. The Company recognizes any interest and penalties related to unrecognized tax benefits as a component of income tax expense.

Due to uncertainty surrounding realization of the deferred income tax assets in future periods, the Company has recorded a 100% valuation allowance against its net deferred tax assets. If it is determined in the future that it is more likely than not that the deferred income tax assets are realizable, the valuation allowance will be reduced.

9.  Subsequent Event

In October 2010, the Company entered into a Strategic Alliance Agreement (the “Agreement”) with Pipeline Biomedical Holdings, LLC. (“Pipeline”) to develop advanced implant technologies for use with the Company’s RIO system. Upon execution of the Agreement on October 1, 2010, the Company issued and delivered to Pipeline 203,417 unregistered shares of its common stock as consideration for the rights granted to MAKO under the Agreement. The Company has no further obligation to fund Pipeline’s research of implant technologies under the Agreement. The Agreement contains provisions under which Pipeline will supply the Company implants developed under the Agreement.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

In this report, “MAKO Surgical,” “MAKO,” the “Company,” “we,” “us” and “our” refer to MAKO Surgical Corp.

The following discussion and analysis of our financial condition and results of operations should be read together with our financial statements and related notes appearing elsewhere in this report. This report contains forward-looking statements regarding, among other things, statements related to expectations, goals, plans, objectives and future events. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 21E of the Securities Exchange Act of 1934 and the Private Securities Reform Act of 1995. In some cases, you can identify forward-looking statements by the following words: “may,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing” or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words.  Examples of such statements include, but are not limited to, statements about the nature, timing and number of planned new product introductions; market acceptance of the MAKOplasty® solution; the future availability from third-party suppliers, including single source suppliers, of implants for and components of our RIO® Robotic Arm Interactive Orthopedic system, or RIO system; the anticipated adequacy of our capital resources to meet the needs of our business; our ability to sustain, and our goals for, sales and earnings growth including projections regarding systems installations; and our success in achieving timely approval or clearance of products with domestic and foreign regulatory entities. These statements are based on the current estimates and assumptions of our management as of the date of this report and are subject to risks, uncertainties, changes in circumstances, assumptions and other factors that may cause actual results to differ materially from those indicated by forward-looking statements, many of which are beyond our ability to control or predict. Such factors, among others, may have a material adverse effect on our business, financial condition and results of operations and may include the potentially significant impact of a continued economic downturn or delayed economic recovery on the ability of our customers to secure adequate funding, including access to credit, for the purchase of our products or cause our customers to delay a purchasing decision, changes in competitive conditions and prices in our markets, unanticipated issues relating to intended product launches, decreases in sales of our principal product lines, increases in expenditures related to increased or changing governmental regulation or taxation of our business, unanticipated issues in securing regulatory clearance or approvals for new products or upgrades or changes to our current products, the impact of the recently enacted United States healthcare reform legislation on hospital spending, reimbursement, and the taxing of medical device companies, loss of key management and other personnel or inability to attract such management and other personnel and unanticipated intellectual property expenditures required to develop, market, and defend our products. These and other risks are described in greater detail under Item 1A, Risk Factors, contained in our Annual Report on Form 10-K for the year ended December 31, 2009 and under Item 1A, Risk Factors, contained in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2010. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We do not undertake any obligation to release any revisions to these forward-looking statements publicly to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.

We have received or applied for trademark registration of and/or claim trademark rights for the following marks: “MAKOplasty®,” “RIO®,” “RESTORIS®,” “Tactile Guidance System” and “TGS,” as well as in the MAKO Surgical Corp. “MAKO” logo, whether standing alone or in connection with the words “MAKO Surgical Corp.” 

Overview

We are an emerging medical device company that markets our advanced robotic arm solution and orthopedic implants for orthopedic procedures. We offer knee MAKOplasty, an innovative, restorative surgical solution that enables orthopedic surgeons to consistently, reproducibly and precisely treat patient specific, early to mid-stage osteoarthritic knee disease. In February 2008, our common stock began trading on The NASDAQ Global Market under the ticker symbol “MAKO” in connection with the closing of our initial public offering.

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We have incurred net losses in each year since our inception and, as of September 30, 2010, we had an accumulated deficit of $143.1 million. We expect to continue to incur significant operating losses as we increase our sales and marketing activities and otherwise continue to invest capital in the development and expansion of our products and our business generally. We expect that our general and administrative expenses will increase to support the sales and marketing efforts associated with the growing commercialization of MAKOplasty and to support our continued growth in operations. We also expect our research and development expenses to increase as we continue to expand our research and development activities, including the support of existing products and the research of potential future products.

Recent key milestones in the development of our business include the following:

•  During the nine month period ended September 30, 2010, a total of 2,339 knee MAKOplasty procedures were performed, including nineteen procedures performed at a clinical research site in Glasgow, Scotland as discussed below, representing a 125% increase over the same period in 2009.

•  In February 2010, we received 510(k) marketing clearance from the FDA for an application that assists a surgeon in performing all components of a total hip arthroplasty using the RIO system. We believe this represents achievement of a necessary milestone towards what we anticipate will be our continuing development and future commercialization of a RIO-enabled hip application.

•  In April 2010, we secured the necessary European Union CE markings for our RIO system and our RESTORIS MCK multicompartmental knee implant system, which is a legal requirement for medical devices intended for sale in Europe.

•  During the second quarter of 2010, we launched a clinical research study in partnership with Glasgow Royal Infirmary, Strathclyde University and National Health Services in Glasgow, Scotland. In connection with the clinical research study, we placed a RIO system at the Glasgow Royal Infirmary. The system is being utilized in a three-year randomized prospective clinical trial with the objective of demonstrating the clinical, functional and ultimately, economic benefits of knee MAKOplasty.  Glasgow Royal Infirmary reported that 6 procedures were performed at its site during the third quarter of 2010.

•  In October 2010, the first RIO-enabled hip MAKOplasty was completed as part of our surgeon preference evaluation process, designed to solicit user feedback in advance of MAKO’s full commercial release of a hip MAKOplasty application, currently expected in the second half of 2011.

We believe that the keys to growing our business are expanding the acceptance and application of knee MAKOplasty to unicompartmental and multicompartmental knee resurfacing procedures and introducing other potential future applications, including a RIO-enabled hip MAKOplasty application. To successfully commercialize our products and grow our business, we must gain market acceptance for MAKOplasty procedures.

Factors Which May Influence Future Results of Operations

The following is a description of factors that may influence our future results of operations, including significant trends and challenges that we believe are important to an understanding of our business and results of operations.

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Revenue

Revenue is generated: (1) from unit sales of our RIO system, including associated instrumentation, installation services and training; (2) from sales of implants and disposable products; and (3) by providing extended warranty services. We recognize revenue in accordance with Accounting Standards Codification, or ASC, 605-10-S99,  Revenue Recognition, when persuasive evidence of an arrangement exists, the fee is fixed or determinable, collection of the fee is probable and delivery has occurred. For all sales, we use either a signed agreement or a binding purchase order as evidence of an arrangement.

Our multiple-element arrangements are generally comprised of the following elements that qualify as separate units of accounting: (1) RIO system sales; (2) sales of implants and disposable products; and (3) extended warranty services on the RIO system hardware. Our revenue recognition policies generally result in revenue recognition at the following points:

A portion of our end-user customers acquire the RIO system through a leasing arrangement with one of a number of qualified third-party leasing companies. In these instances, we typically sell the RIO system to the third-party leasing company, and the end-user customer enters into an independent leasing arrangement with the third-party leasing company. We recognize RIO system revenue for a RIO system sale to a third-party leasing company on the same basis as a RIO system sale directly to an end-user customer. We sell implants and disposable products utilized in MAKOplasty procedures directly to end-user customers under a separate agreement.

Our sales contracts generally do not provide the customer with a right of return. If such a right is provided, all related revenues would be deferred until such right expires or is waived. In a limited number of RIO system sales, our agreement with a customer provides for a customer acceptance period, which typically does not exceed three months, following which the customer may either accept or return the RIO system.  No system revenue is recognized for these RIO system sales until the customer has unconditionally accepted the RIO system.

Effective January 1, 2010, we early adopted the Financial Accounting Standards Board, or FASB, Accounting Standard Update No. 2009-13, Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force, or ASU 2009-13, and Update No. 2009-14,  Certain Revenue Arrangements That Include Software Elements, a consensus of the FASB Emerging Issues Task Force, or ASU 2009-14, on a prospective basis for applicable transactions originating or materially modified after December 31, 2009. In accordance with ASU 2009-13 (as codified under ASC 605-25, Multiple-Element Arrangements) and ASU 2009-14, we allocate arrangement consideration to the RIO systems and associated instrumentation, our implants and disposables and our extended warranty services based upon the relative selling-price method. Under this method, revenue is allocated at the time of sale to all deliverables based on their relative selling price using a specific hierarchy. The hierarchy is as follows: vendor-specific objective evidence, or VSOE, of fair value of the respective elements, third-party evidence of selling price, or TPS, or best estimate of selling price.

We have established VSOE of fair value for our RIO system and TPS for our implants and disposables and our extended warranty services.

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Our RIO system includes software that is essential to the functionality of the product. Since the RIO system’s software and non-software components function together to deliver the RIO system’s essential functionality, they are considered one deliverable that is excluded from the software revenue recognition guidance under ASU 2009-13 and ASU 2009-14.

Prior to the adoption of ASU 2009-13 and ASU 2009-14, we accounted for the sale of the RIO systems and associated instrumentation pursuant to ASC 985-605, Software – Revenue Recognition, which required us to allocate arrangement consideration to the RIO systems and associated instrumentation based upon VSOE of fair value of the respective elements. Had the new accounting guidance been applied to revenue at the beginning of 2009, the resultant revenue and net loss for the year ended December 31, 2009 would have been substantially the same.

Subsequent to December 31, 2008, we no longer manufacture TGS units, to which associated TGS sales arrangements required us to provide upgrades and enhancements, through and including the delivery of the RIO system. We commercially released the RIO system in the first quarter of 2009. Sales arrangements for RIO systems do not require us to provide upgrades and enhancements. As a result, revenues related to RIO system sales are generally recognized upon installation of the system and training of at least one surgeon.

For sales of TGS units through December 31, 2008, VSOE of fair value was not established for upgrades and enhancements (through and including delivery of the RIO system), which the TGS sales arrangements required us to provide. Accordingly, prior to delivery of the RIO system, sales of TGS units were recorded as deferred revenue and the direct cost of revenue associated with the sale of TGS units was recorded as deferred cost of revenue. Revenue for all previously deferred TGS sales was recognized in our statement of operations during the nine months ended September 30, 2009, upon delivery of the RIO system. As of September 30, 2010, the deferred revenue balance of $572,000 consists primarily of deferred service revenue for extended warranty services on the RIO system hardware.

Future revenue from sales of our products is difficult to predict and we expect that it will only modestly reduce our continuing and increasing losses resulting from selling, general and administrative expenses, research and development expenses and other activities for at least the next two or three years. Our future revenue may also be adversely affected by the current general economic downturn and the resulting tightening of the credit markets, which may cause purchasing decisions to be delayed or cause our customers to experience difficulties in securing adequate funding to buy our products.

The generation of recurring revenue through sales of our knee implants, disposable products and extended warranty service contracts is an important part of the MAKOplasty business model. We anticipate that recurring revenue will constitute an increasing percentage of our total revenue as we leverage each new installation of our RIO system to generate recurring sales of implants and disposable products and as we expand our implant product offering.

Cost of Revenue

Cost of revenue primarily consists of the direct costs associated with the manufacture of RIO systems, implants and disposable products for which revenue has been recognized in accordance with our revenue recognition policy. Costs associated with providing services are expensed as incurred. Cost of revenue also includes the allocation of manufacturing overhead costs, the cost associated with establishing at the time of installation an accrual for the RIO system standard one-year warranty liability, royalties related to the sale of products covered by licensing arrangements and write-offs of obsolete, impaired or excess inventory.

In the first quarter of 2010, we wrote-off approximately $1.9 million, or $(0.06) per basic and diluted share, of excess RESTORIS unicompartmental knee implant system, or RESTORIS Classic, implants and related instrumentation with excess implants of approximately $1.0 million charged to cost of revenue – procedures, cancellation charges of $130,000 charged to cost of revenue – service and other and excess instrumentation of approximately $808,000 charged to selling, general and administrative expenses. These charges were necessitated by the rapid adoption of the RESTORIS MCK multicompartmental knee implant system and the corresponding decline in the usage of RESTORIS Classic. RESTORIS Classic was introduced in the third quarter of 2008 and was modeled after existing well-known unicompartmental designs. In connection with the launch of the RIO system, in the second quarter of 2009, we launched our next generation RESTORIS MCK multicompartmental knee implant system, or RESTORIS MCK. RESTORIS MCK was designed as a premium addition to the RESTORIS product family with the goal of delivering a more natural feeling knee by preserving bone and providing anatomical features such as high flexion. 

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Selling, General and Administrative Expenses

Our selling, general and administrative expenses consist primarily of compensation, including stock-based compensation and benefits, for sales, marketing, clinical research, operations, regulatory, quality, executive, finance, legal and administrative personnel. Other significant expenses include costs associated with sales and marketing activities, marketing and advertising materials, insurance, professional fees for legal and accounting services, consulting fees, travel expenses, facility and related operating costs, and recruiting expenses. Our selling, general and administrative expenses are expected to continue to increase due to the planned increase in the number of employees necessary to support the sales and marketing efforts associated with the growing commercialization of MAKOplasty and an increased number of employees necessary to support our continued growth in operations. In addition, we expect to incur additional costs associated with securing and protecting our intellectual property rights as necessary to support our future product offerings.

We loan instrumentation to our customers, which are used to perform MAKOplasty procedures in conjunction with using the RIO system. These loaned instrument sets, or implant instruments, are comprised of tools and equipment that facilitate the implantation of our knee implants. Implant instruments loaned to customers are not part of the tangible product sold and title of loaned instrument remains with the Company. To better reflect the economics of the implant instruments and enhance comparability with other companies in our industry, depreciation expense on implant instruments has been reclassified from cost of revenue – procedures to selling, general and administrative expense beginning in the first quarter of 2010. Depreciation expense for implant instruments was approximately $304,000 and $170,000 for the nine months ended September 30, 2010 and 2009, respectively.

Research and Development Expenses

Costs related to research, design and development of products are charged to research and development expense as incurred. These costs include direct salary and benefit costs for research and development employees including stock-based compensation, cost for materials used in research and development activities and costs for outside services. We expect our research and development expense to increase as we continue to expand our research and development activities, including the support of existing products and the research and development of potential future products, including our RIO-enabled hip application.

Critical Accounting Policies

Effective January 1, 2010, we early adopted the ASU 2009-13, and ASU 2009-14 on a prospective basis for applicable transactions originating or materially modified after December 31, 2009 as described in greater detail in “Factors Which May Influence Future Results of Operations” above.

Other than as described above, there have been no significant changes in our critical accounting policies during the nine months ended September 30, 2010 as compared to the critical accounting policies described in our Form 10-K for the year ended December 31, 2009.

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Results of Operations

Comparison of the Three Months Ended September 30, 2010 to the Three Months Ended September 30, 2009

Revenue.  Revenue was $12.0 million for the three months ended September 30, 2010, compared to $6.7 million for the three months ended September 30, 2009. The increase in revenue of $5.3 million, or 79%, was primarily due to a $2.1 million, or 105%, increase in procedure revenue and a $2.9 million, or 64%, increase in RIO system revenue. The $2.1 million increase in procedure revenue was attributable to an increase in knee MAKOplasty procedures performed during the three months ended September 30, 2010 as compared with the three months ended September 30, 2009. There were 815 knee MAKOplasty procedures performed during the three months ended September 30, 2010 compared to 418 knee MAKOplasty procedures performed during the three months ended September 30, 2009. The increase in knee MAKOplasty procedures performed was driven by the continued adoption of knee MAKOplasty, both in terms of utilization per commercial site and total commercial installed base. Total revenue was also positively impacted by $7.6 million of revenue from nine unit sales of our RIO system during the three months ended September 30, 2010, including eight domestic commercial sales and one international demonstration system, as compared to the recognition of $4.6 million of revenue from six unit sales of our RIO system during the three months ended September 30, 2009. We expect our revenue to continue to increase as unit sales of our RIO system increase in future periods and the number of knee MAKOplasty procedures performed increases in future periods.

Cost of Revenue.  Cost of revenue was $4.6 million for the three months ended September 30, 2010, compared to $3.9 million for the three months ended September 30, 2009. The increase in cost of revenue of $663,000, or 17%, was primarily due to an increase in knee MAKOplasty procedures performed and to the recognition of the cost of revenue from nine unit sales of our RIO system during the three months ended September 30, 2010 as compared to the recognition of the cost of revenue from six unit sales of our RIO system during the three months ended September 30, 2009. We expect our cost of revenue to continue to increase as unit sales of our RIO system increase in future periods and the number of knee MAKOplasty procedures performed increases in future periods. 

Selling, General and Administrative.  Selling, general and administrative expense was $11.6 million for the three months ended September 30, 2010, compared to $7.9 million for the three months ended September 30, 2009. The increase of $3.7 million, or 47%, was primarily due to an increase in sales, marketing and operations costs associated with the production and commercialization of our products and an increase in general and administrative costs to support our continued growth. Selling, general and administrative expense for the three months ended September 30, 2010 also included $1.4 million of stock-based compensation expense compared to $883,000 for the three months ended September 30, 2009. The increase in stock-based compensation expense was primarily due to additional option grants and restricted stock grants made in 2010. We expect our selling, general and administrative expenses to continue to increase substantially due to our planned increase in the number of employees necessary to support the sales and marketing efforts associated with the growing commercialization of our products and an increased number of employees necessary to support our continued growth in operations.

Research and Development.  Research and development expense was $4.0 million for the three months ended September 30, 2010, compared to $3.8 million for the three months ended September 30, 2009. The increase of $260,000, or 7%, was primarily due to an increase in research and development activities associated with on-going development of our RIO system, our MAKO implant systems and potential future products, including our RIO-enabled hip application. We expect our research and development expense to increase as we continue to expand our research and development activities, including the support of existing products and the research of potential future products.

Depreciation and Amortization.  Depreciation and amortization expense was $795,000 for the three months ended September 30, 2010, compared to $595,000 for the three months ended September 30, 2009. The increase of $200,000, or 34%, was primarily due to an increase in depreciation of property and equipment as a result of purchases made during 2010 and 2009. 

Interest and Other Income.  Interest and other income was $84,000 for the three months ended September 30, 2010, compared to $59,000 for the three months ended September 30, 2009. The increase of $25,000, or 42%, was primarily due to higher yields realized on our cash, cash equivalents and investments for the three months ended September 30, 2010 compared with the same period of 2009.

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Income Taxes.  No federal income taxes were recognized for the three months ended September 30, 2010 and 2009, due to net operating losses in each period. State and local income taxes were $16,000 for the three months ended September 30, 2010, compared to $51,000 for the three months ended September 30, 2009. Income taxes recognized to date have not been significant due to net operating losses we have incurred in each period since our inception in November 2004. In addition, no current or deferred income taxes were recorded for the three months ended September 30, 2010 and 2009, as all income tax benefits were fully offset by a valuation allowance against our net deferred income tax assets.

Comparison of the Nine Months Ended September 30, 2010 to the Nine Months Ended September 30, 2009

Revenue.  Revenue was $29.5 million for the nine months ended September 30, 2010, compared to $25.4 million for the nine months ended September 30, 2009. The increase in revenue of $4.2 million, or 16%, was primarily due to a $7.1 million, or 148%, increase in procedure revenue and a $7.7 million, or 86%, increase in RIO system revenue. The $7.1 million increase in procedure revenue was attributable to an increase in knee MAKOplasty procedures performed during the nine months ended September 30, 2010 as compared with the nine months ended September 30, 2009. There were 2,339 knee MAKOplasty procedures performed during the nine months ended September 30, 2010 compared to 1,041 knee MAKOplasty procedures performed during the nine months ended September 30, 2009. Total revenue was also positively impacted by $16.6 million of revenue from twenty unit sales of our RIO system during the nine months ended September 30, 2010, including eighteen domestic commercial sales and two international demonstration systems, as compared to the recognition of approximately $8.9 million of revenue from twelve unit sales of our TGS during the nine months ended September 30, 2009. This was partially offset by the recognition of $11.3 million of revenue from seventeen previously deferred unit sales of our TGS during the nine months ended September 30, 2009. In accordance with our revenue recognition policy, recognition of revenue on unit sales of our TGS was deferred until delivery of the RIO system, which we commercially released in the first quarter of 2009.

Cost of Revenue.  Cost of revenue was $12.2 million for the nine months ended September 30, 2010, compared to $17.1 million for the nine months ended September 30, 2009. The decrease in cost of revenue of $4.9 million, or 29%, was primarily due to the recognition of the direct cost of revenue from seventeen previously deferred unit sales of our TGS during the nine months ended September 30, 2009, including the cost of providing the RIO system upgrades, as described in the “Factors Which May Influence Future Results of Operations” section above. This was partially offset by an increase in knee MAKOplasty procedures performed and to the recognition of the cost of revenue from twenty unit sales of our RIO system during the nine months ended September 30, 2010 as compared to the recognition of the cost of revenue from twelve unit sales of our RIO system during the nine months ended September 30, 2009. Cost of revenue for the nine months ended September 30, 2010 was also impacted by a write-off of approximately $1.0 million of excess RESTORIS Classic implants as discussed in “Factors Which May Influence Future Results of Operations” above.   

Selling, General and Administrative.  Selling, general and administrative expense was $33.2 million for the nine months ended September 30, 2010, compared to $22.2 million for the nine months ended September 30, 2009. The increase of $11.0 million, or 49%, was primarily due to an increase in sales, marketing and operations costs associated with the production and commercialization of our products and an increase in general and administrative costs to support our continued growth. Selling, general and administrative expense for the nine months ended September 30, 2010 was also impacted by a write-off of approximately $808,000 of excess RESTORIS classic instrumentation as discussed in “Factors Which May Influence Future Results of Operations” above. Selling, general and administrative expense for the nine months ended September 30, 2010 also included $3.9 million of stock-based compensation expense compared to $2.4 million for the nine months ended September 30, 2009. The increase in stock-based compensation expense was primarily due to additional option grants and restricted stock grants made in 2009 and 2010.

Research and Development.  Research and development expense was $11.0 million for the nine months ended September 30, 2010, compared to $9.4 million for the nine months ended September 30, 2009. The increase of $1.6 million, or 18%, was primarily due to an increase in research and development activities associated with on-going development of our RIO system, our MAKO implant systems and potential future products, including our RIO-enabled hip application. We expect our research and development expense to increase as we continue to expand our research and development activities, including the support of existing products and the research of potential future products.

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Depreciation and Amortization.  Depreciation and amortization expense was $2.2 million for the nine months ended September 30, 2010, compared to $1.7 million for the nine months ended September 30, 2009. The increase of $504,000, or 30%, was primarily due to an increase in depreciation of property and equipment as a result of purchases made during 2010 and 2009. 

Interest and Other Income.  Interest and other income was $256,000 for the nine months ended September 30, 2010, compared to $348,000 for the nine months ended September 30, 2009. The decrease of $92,000, or 26%, was primarily due to lower yields realized on our cash, cash equivalents and investments for the nine months ended September 30, 2010 compared with the same period of 2009.

Income Taxes.  No federal income taxes were recognized for the nine months ended September 30, 2010 and 2009, due to net operating losses in each period. State and local income taxes were $63,000 for the nine months ended September 30, 2010, compared to $56,000 for the nine months ended September 30, 2009. Income taxes recognized to date have not been significant due to net operating losses we have incurred in each period since our inception in November 2004. In addition, no current or deferred income taxes were recorded for the nine months ended September 30, 2010 and 2009, as all income tax benefits were fully offset by a valuation allowance against our net deferred income tax assets.

Liquidity and Capital Resources

We have incurred net losses and negative cash flow from operating activities for each period since our inception in November 2004. As of September 30, 2010, we had an accumulated deficit of $143.1 million and have financed our operations principally through the sale of our equity securities.

In August 2009, we completed a public offering of our common stock, issuing 8,050,000 shares at an offering price to the public of $7.25 per share, resulting in net proceeds of approximately $54.3 million, after underwriting discounts and commissions and expenses.

As of September 30, 2010, we had approximately $41.1 million in cash, cash equivalents and investments. Our cash and investment balances are held in a variety of interest bearing instruments, including notes and bonds from U.S. government agencies, certificates of deposit and investment grade rated U.S. corporate debt.

Net Cash Used in Operating Activities

Net cash used in operating activities primarily reflects the net loss for those periods, which was reduced in part by depreciation and amortization, stock-based compensation, inventory write-downs and property and equipment write-downs. For the nine months ended September 30, 2010, inventory write-downs of $1.3 million and property and equipment write-downs of $986,000 were incurred primarily due to the write-off of excess RESTORIS Classic implants and instrumentation as discussed in “Factors Which May Influence Future Results of Operations” above. Net cash used in operating activities was also affected by changes in operating assets and liabilities. Included in changes in operating assets and liabilities for the nine months ended September 30, 2010 are approximately $5.9 million of increases to inventory necessitated by increased sales of implants and disposable products and our RIO-enabled hip application, $4.1 million of increases to accounts receivable due to increased sales in 2010, which was partially offset by $2.8 million of increases to other accrued liabilities. Included in changes in operating assets and liabilities for the nine months ended September 30, 2009 are approximately $11.3 million and $3.6 million of decreases to the deferred revenue balance and deferred cost of revenue balance, respectively, due to the recognition of seventeen previously deferred unit sales of our TGS, and $5.3 million of increases in inventory necessitated by the commercial release of the RIO system, the commercial release of the RESTORIS MCK implant system and increased sales of implants and disposable products.

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Net Cash Provided by (Used in) Investing Activities

Net cash provided by investing activities for the nine months ended September 30, 2010 was primarily attributable to proceeds of $37.6 million from sales and maturities of investments, which was partially offset by the purchase of investments of $8.5 million and purchases of $2.2 million of property and equipment. Net cash used in investing activities for the nine months ended September 30, 2009 was primarily attributable to the purchase of investments of $17.4 million, which was partially offset by proceeds of $3.3 million from sales and maturities of investments and purchases of $3.7 million of property and equipment which primarily consisted of implant instruments used to perform knee MAKOplasty procedures necessitated by the commercial release of the RESTORIS MCK implant system and an increase in knee MAKOplasty procedures performed.

Net Cash Provided by Financing Activities

Net cash provided by financing activities for the nine months ended September 30, 2010 was primarily attributable to proceeds received under our employee stock purchase plan and to proceeds received on the exercise of stock options and warrants. Net cash provided by financing activities for the nine months ended September 30, 2009 was primarily attributable to net proceeds received in connection with our equity financing in August 2009.

Operating Capital and Capital Expenditure Requirements

To date, we have not achieved profitability. We anticipate that we will continue to incur substantial net losses for at least the next two or three years as we expand our sales and marketing capabilities in the orthopedic products market, continue to commercialize our RIO system and RESTORIS MCK multicompartmental knee implant system, continue research and development of existing and future products, including our RIO-enabled hip application, and continue development of the corporate infrastructure required to sell and market our products and support operations. We also expect to experience increased cash requirements for inventory and property and equipment in conjunction with the continued commercialization of our RESTORIS MCK multicompartmental knee implant system and our RIO system.

In executing our current business plan, we believe our existing cash, cash equivalents and investment balances, and interest income we earn on these balances will be sufficient to meet our anticipated cash requirements for at least the next twelve months. To the extent our available cash, cash equivalents and investment balances are insufficient to satisfy our operating requirements, we will need to seek additional sources of funds, including selling additional equity, debt or other securities or entering into a credit facility, or modify our current business plan. The sale of additional equity and convertible debt securities may result in dilution to our current stockholders. If we raise additional funds through the issuance of debt securities, these securities may have rights senior to those of our common stock and could contain covenants that could restrict our operations and issuance of dividends. We may also require additional capital beyond our currently forecasted amounts. Any required additional capital, whether forecasted or not, may not be available on reasonable terms, or at all. If we are unable to obtain additional financing, we may be required to reduce the scope of, delay or eliminate some or all of our planned research, development and commercialization activities, which could materially harm our business and results of operations.

Because of the numerous risks and uncertainties associated with the development of medical devices and the current economic situation, we are unable to estimate the exact amounts of capital outlays and operating expenditures necessary to complete the development of our products and successfully deliver commercial products to the market. Our future capital requirements will depend on many factors, including but not limited to the following:

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Contractual Obligations

In September 2010, we entered into a ten year operating lease for our headquarters in Fort Lauderdale, Florida, and terminated our previous lease. Under the new lease, we are obligated to make lease payments of approximately $90,000 in the fourth quarter of 2010, $300,000 in 2011, $700,000 in 2012 – 2013, $1.2 million in 2014 – 2015, and $3.7 million thereafter.

At September 30, 2010, we were committed to make future purchases for inventory related items and instrumentation under various purchase arrangements with fixed purchase provisions aggregating approximately $3.6 million.

Other than as described above and scheduled payments through September 30, 2010, there have been no significant changes in our contractual obligations during the nine months ended September 30, 2010 as compared to the contractual obligations described in our Form 10-K for the year ended December 31, 2009.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Our exposure to market risk is confined to our cash, cash equivalents, investments and exchange rate risk on international sales. The goals of our cash investment policy are the security of the principal invested and fulfillment of liquidity needs, with the need to maximize value being an important consideration. To achieve our goals, we maintain a portfolio of cash equivalents and investments in a variety of securities including notes and bonds from U.S. government agencies, certificates of deposit and investment grade rated U.S. corporate debt. The securities in our investment portfolio are not leveraged and are classified as available-for-sale. We currently do not hedge interest rate exposure or exchange rate risk. We do not believe that a variation in market rates of interest would significantly impact the value of our investment portfolio. We do not believe that a variation in the value of the U.S. dollar relative to foreign currencies would significantly impact our results of operations.

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ITEM 4. CONTROLS AND PROCEDURES.

Disclosure Controls and Procedures.

In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934, or the Exchange Act, our management evaluated, with the participation of our chief executive officer and chief financial officer, or the Certifying Officers, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of September 30, 2010. Based upon their evaluation of these disclosure controls and procedures, our Certifying Officers concluded that the disclosure controls and procedures were effective as of September 30, 2010 to provide reasonable assurance that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commission rules and forms, and to provide reasonable assurance that information required to be disclosed by us in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure.

We believe that a controls system, no matter how well designed and operated, is based in part upon certain assumptions about the likelihood of future events, and therefore can only provide reasonable, not absolute, assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

Changes in Internal Control over Financial Reporting.

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

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PART II

OTHER INFORMATION

ITEM 1A. RISK FACTORS.

There have been no material changes in our risk factors from those disclosed in our Form 10-K for the year ended December 31, 2009 and our Form 10-Q for the quarter ended March 31, 2010, except for the risk factor listed below:

If our current and future MAKOplasty solutions do not gain market acceptance, we will not be able to generate the revenue necessary to develop a sustainable, profitable business.

Achieving patient, surgeon and hospital acceptance of MAKOplasty as the preferred method of treating early to mid-stage osteoarthritis of the knee and osteoarthritis of the hip is crucial to our success. We believe MAKOplasty represents a fundamentally new way of performing arthroplasty, employing computer assisted robotic arm technology and a patient specific visualization system in an effort to optimize the clinical outcome. The orthopedic market has been traditionally slow to adopt new products and treatment practices. We believe that if surgeons and hospitals do not broadly adopt the concept of computer assisted robotics enabled technology and do not perceive such technology and related products as valuable and having significant advantages over conventional arthroplasty procedures, patients will be less likely to accept or be offered MAKOplasty and we will fail to meet our business objectives. Surgeons’ and hospitals’ perceptions of such technology having significant advantages are likely to be based on a determination that, among other factors, our products are safe, reliable, cost-effective and represent acceptable methods of treatment. Even if we can prove the clinical value of MAKOplasty through clinical use, surgeons may elect not to use our current and future MAKOplasty solutions for any number of other reasons. For example, surgeons may continue to recommend total knee replacement surgery or standard instrumented hip replacement surgery simply because such surgeries are already widely accepted. In addition, surgeons may be slow to adopt our current and future MAKOplasty solutions because of the perceived liability risks arising from the use of new products. Surgeons may not accept our current and future MAKOplasty solutions if we fail to maintain an acceptable level of product reliability. Hospitals may not accept MAKOplasty because the RIO system is a piece of capital equipment, representing a significant portion of a hospital’s budget. The RIO system may not be cost-efficient if hospitals are not able to perform a significant volume of MAKOplasty procedures. If our current and future MAKOplasty solutions fail to achieve market acceptance for any of these or other reasons, we will not be able to generate the revenue necessary to develop a sustainable, profitable business.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

(a)           Sales of Unregistered Securities

On July 6, 2010, we entered into an agreement for the provision of certain consulting services to us in consideration for cash compensation and a non-qualified stock option to purchase 15,000 shares of our common stock. This stock option has an exercise price of $12.10, which was the closing price per share of our common stock on July 6, 2010, the grant date, and vests and becomes exercisable ratably quarterly over one year starting on the grant date. This option was issued in a transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.  No commissions or other remuneration were paid in connection with this issuance.

(c)           Issuer Purchases of Equity Securities

The following table summarizes the surrenders of the Company’s common stock during the three month period ended September 30, 2010:

ITEM 6. EXHIBITS.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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EXHIBIT INDEX