IRIDEX
Annual Report 2009

Plain-text annual report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 FORM 10-K (cid:53) Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended January 2, 2010 or (cid:133) 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 0-27598 IRIDEX CORPORATION (Exact name of registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 77-0210467 (I.R.S. Employer Identification Number) 1212 Terra Bella Avenue, Mountain View CA 94043-1824 (Address of principal executive offices) (Zip Code) (650) 940-4700 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Common Name of Each Exchange on which Registered NASDAQ Global Market Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $0.01 per share Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933. Yes (cid:133) No (cid:53) Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”). Yes (cid:133) No (cid:53) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of 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 (cid:53) No (cid:133) 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 (cid:133) No (cid:133) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (cid:133) Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,”, and smaller reporting company in Rule 12b-2 of the Exchange Act. Large accelerated filer (cid:133) Accelerated filer (cid:133) Non-accelerated filer (cid:133) Smaller reporting company (cid:53) Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes (cid:133) No (cid:53) The aggregate market value of the voting common equity held by non-affiliates of the Registrant was approximately $8,684,467, as of July 2, 2009 the last business day of the Registrant’s most recently completed second fiscal quarter, based on the closing price reported for such date on the NASDAQ Global Market. The registrant did not have any non-voting common equity outstanding. For purposes of this disclosure, shares of common stock held by each executive officer and director and by each holder of 5% or more of the outstanding shares of common stock have been excluded from this calculation, because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of March 17, 2010, Registrant had 8,850,235 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Certain parts of the Proxy Statement for the Registrant’s 2010 Annual Meeting of Stockholders (the “Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K. Table of Contents Part I Item 1. Business Item 1A Risk Factors Item 1B Unresolved Staff Comments Item 2. Properties Item 3. Legal Proceedings Item 4. (Reserved) Part II Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters, and Issuer Purchases of Equity Securities Item 6. Selected Financial Data Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A(T). Controls and Procedures Item 9B. Other Information Part III Item 10. Directors, Executive Officers and Corporate Governance Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Item 13. Certain Relationships and Related Transactions, and Director Independence Item 14. Principal Accountant Fees and Services Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K Signatures Page No. 3 14 26 26 26 26 27 27 27 35 35 58 58 59 60 60 60 60 60 61 65 2 PART I This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, such as statements relating to levels of future sales and operating results; gross margins; managing cash flows; general economic conditions and levels of international sales, and our current and future liquidity and capital requirements; market acceptance of our products; expectations for and sources of future revenues; leveraging our core business and increasing recurring revenues; broadening our product lines through product innovation and new treatments; our marketing programs and trends in healthcare; our ability to take advantage of economies-of-scale in product development and manufacturing; efforts to decrease costs; estimates regarding the size of our markets; levels of future investment in research and development efforts; our ability to develop and introduce new products through strategic alliances, OEM relationships and acquisitions; the availability of components from third-party manufacturers; results of clinical studies and the status of our regulatory clearance; the impact of regulatory actions and determinations; and risks associated with bringing new products to market. In some cases, forward-looking statements can be identified by terminology, such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intends,” “potential,” “continue,” or the negative of such terms or other comparable terminology. These statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to differ materially from those expressed or implied by such forward-looking statements. The reader is strongly urged to read the information contained under the captions “Item 1A. Risk Factors - Factors That May Affect Future Results” in this Annual Report on Form 10-K for a more detailed description of these significant risks and uncertainties. The reader is cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this Form 10-K. We undertake no obligation to update such forward-looking statements to reflect events or circumstances occurring after the date of this report. Item 1. Business General IRIDEX Corporation is a leading worldwide provider of therapeutic based laser systems and delivery devices used to treat eye diseases in ophthalmology and skin conditions in dermatology (also referred to as aesthetics). Our products are sold in the United States predominantly through a direct sales force and internationally through approximately 100 independent distributors into 107 countries. Total revenues in 2009, 2008 and 2007 were $43.2 million, $48.5 million and $55.5 million, respectively. In 2009, we generated net income of $2.6 million, whereas we incurred net losses of $7.4 million and $22.3 million in 2008 and 2007, respectively. The net losses for 2008 and 2007 included impairment charges for the write down of Goodwill and Intangible assets of $5.4 million and $14.7 million, respectively. Our ophthalmology products consist of laser systems, delivery devices and laser probes and are used in the treatment of serious eye diseases, including the three leading causes of irreversible blindness: diabetic retinopathy, glaucoma and age-related macular degeneration (AMD). In addition, our ophthalmology products are often used in vitrectomy procedures (proliferative diabetic retinopathy, macular holes, retinal tears and detachments) which are generally performed in the operating room and require a consumable single use intraocular laser probe (EndoProbe) to deliver the light to the back of the eye. Therefore our ophthalmology business includes (i) a recurring revenue component, which consists of the sales of the consumable, single use EndoProbe devices, combined with the repair, servicing and extended service contract protection for our laser systems and (ii) a capital component, which consists of the laser systems combined with durable delivery devices. Our laser systems consist of the OcuLight product family which includes the OcuLight TX, the OcuLight Symphony (Laser Delivery System), OcuLight SL, OcuLight SLx, OcuLight GL, and OcuLight GLx laser photocoagulation systems, and the IQ 810 and IQ 577 laser systems. Our ophthalmology products contributed $31.0 million, $32.4 million and $32.3 million to our total revenues in 2009, 2008 and 2007, respectively. Our aesthetics products consist of laser systems and handpieces that focus on the treatment of pigmented and vascular lesions, skin rejuvenation, skin tightening, hair reduction, leg veins, and acne. The aesthetics products include the VariLite, DioLite XP, Gemini, Aura-i, Lyra-I, and Venus-i Laser Systems. Our aesthetics products are primarily used in a dermatologist’s or plastic surgeon’s office and contributed $12.2 million, $16.1 million and $23.2 million to our total revenues in 2009, 2008 and 2007, respectively. The IRIDEX ophthalmic and VariLite and DioLite XP laser systems consist of small, portable laser consoles and delivery devices. While dermatologists almost always use our laser systems in their offices or clinics, ophthalmologists and plastic surgeons typically use our laser systems in hospital operating rooms (OR) and ambulatory surgical centers (ASC), as well as their offices and clinics. In the OR and ASC, ophthalmologists use our laser systems with either an indirect laser ophthalmoscope or a consumable, single use EndoProbe. Since our first shipment in 1990, more than 10,000 medical laser systems manufactured by IRIDEX, for both ophthalmology and dermatology, have been sold worldwide. 3 IRIDEX Corporation was incorporated in California in February 1989 as IRIS Medical Instruments, Inc. In November 1995, we changed our name to IRIDEX Corporation and reincorporated in Delaware. Our executive offices are located at 1212 Terra Bella Avenue, Mountain View, California 94043-1824, and our telephone number is (650) 940-4700. We can also be reached at our website at www.IRIDEX.com, however, the information on, or that can be accessed through, our website is not part of this report. As used in this Annual Report on Form 10-K, the terms “Company,” “IRIDEX,” “we,” “us” and “our” refer to IRIDEX Corporation, a Delaware corporation, and when the context so requires, our wholly owned subsidiaries, IRIS Medical Instruments, Inc. and Light Solutions Corporation, both California corporations, and IRIDEX UK, and IRIDEX France S.A. The IRIDEX Strategy We are one of the worldwide leaders in developing, manufacturing, marketing, selling and servicing innovative medical laser systems and associated instrumentation. At the beginning of 2008 we set out a three stage plan: (a) to return to positive cash flows; (b) drive for profitability; and (c) position ourselves for growth. In 2008 we made significant strides in paying off our obligations and in 2009 we were cash flow positive. In 2009 we became profitable. In 2010 we will focus on growth. Key elements to our growth strategy are: 1. Leverage existing sales channels to drive more recurring revenues by adding additional consumable devices for our current ophthalmology market. 2. Introduce new complementary laser systems and durable delivery devices which either encourage replacement of the existing installed base, or expand the installed base by identifying new procedures or capabilities. We intend to continue our investment in research and development to improve the performance of our systems by developing innovative technologies which can address the customer needs. 3. These actions will consist of organic initiatives supplemented by acquisitions. See Item 1A. Risk Factors – Factors That May Affect Future Results – “Efforts to acquire additional companies or product lines may divert our managerial resources away from our business operations, and if we complete additional acquisitions, we may incur or assume additional liabilities or experience integration problems.” and “Our Future Success Depends on Our Ability to Develop and Successfully Introduce New Products and New Applications.” Ophthalmic Products We utilize a systems approach to product design. Each system includes a console, which generates the laser energy, and a number of interchangeable peripheral delivery devices for use in specific clinical applications. This approach allows our customers to purchase a basic console system and add additional delivery devices as their needs expand or as new applications develop. We believe that this systems approach is a distinguishing characteristic and also brings economies-of-scale to our product development and manufacturing efforts because individual applications do not require the design and manufacture of complete stand-alone products. Our primary equipment products range in price from $2,000 to $50,000, and consist of laser consoles and specialized durable delivery devices. Our line of consumable products has list prices of between $150 and $200 to end customers. Consoles Our laser consoles, which are identified below, incorporate the economic and technical benefits of solid state and semiconductor laser technology. Infrared Photocoagulator Consoles. The OcuLight and IQ 810 photocoagulator consoles used by ophthalmologists are available in two infrared (810nm) output power ranges: the OcuLight SL at 2 Watts and the IQ 810 and OcuLight SLx at 3 Watts. The OcuLight consoles weigh 14 pounds and have dimensions of 4”H x 12”W x 12”D. The IQ 810 console weighs 11 pounds and has dimensions of 7”H x 12”W x 12”D. Neither requires external air nor water cooling. We believe that the smaller overall sizes, lower weights and low input power requirements to operate represent distinct advantages over competing products. Visible (Green) Photocoagulator Consoles. Our OcuLight TX, OcuLight GL and OcuLight GLx solid state and semiconductor- based photocoagulator consoles used in ophthalmology deliver visible (532nm) laser light. The OcuLight TX was first shipped in late 2006 and offers an optional remote control and wireless power-adjust footswitch. The OcuLight TX/GL/GLx have dimensions of 6”H x 12”W x 12”D, draw a maximum of 300 Watts of wall power and requires no water cooling. In December 2002, we commenced 4 shipment of the Millennium Endolase module, which is sold exclusively to Bausch & Lomb for use in their Millennium Microsurgical System. It integrates 532nm photocoagulator capability into Bausch & Lomb’s array of microsurgical capabilities for the vitrectomy procedure. The Millennium Endolase module is compatible with the IRIDEX consumable EndoProbe handpieces and Laser Indirect Ophthalmoscope. Visible (Yellow) Photocoagulator Console. In 2009 we introduced the industry’s first solid state 577nm (yellow) photocoagulator – the IQ 577. This product utilizes state of the art user interface technology and delivers a 577 wavelength which is at the peak of oxyhemoglobin absorption which allows ophthalmologists to obtain optimal results with lower power (more tissue sparing) compared with green wavelengths. The IQ 577 console weighs 18 pounds, has dimensions of 7.5”H x 12”W x 14”D, draws a maximum of 250 Watts of wall power, requires no water cooling, and has a remote control and wireless footswitch. Multi-wavelength Laser System Configurations. When used in conjunction with specific IRIDEX laser consoles, our Symphony slit lamp adapters can deliver multiple laser wavelengths from a single slit lamp installation. It combines the clinical versatility and convenience of multiple wavelength delivery into one delivery device for retinal and glaucoma procedures. Currently, our compatible consoles are the OcuLight GLx and the OcuLight Tx green laser consoles and the OcuLight SLx and the IQ 810 infrared laser consoles. We intend to add the IQ 577 in 2010. Ophthalmic Delivery Devices Our versatile family of consoles and delivery devices has been designed to accommodate the addition of new capabilities with a minimal incremental investment. Users of our consoles can add capabilities by simply purchasing new interchangeable delivery devices and utilizing them with their existing console. We have developed both consumable and durable delivery devices and expect to continue to develop additional delivery devices. TruFocus Laser Indirect Ophthalmoscope (LIO). The indirect ophthalmoscope is designed to be worn on the physician’s head and to be used in procedures to treat peripheral retinal disorders, particularly in infants or adults requiring treatment in the supine position. This product can be used in both diagnosis and treatment procedures at the point-of-care. Slit Lamp Adapter (SLA). These adapters allow the physician to utilize a standard slit lamp in both diagnosis and treatment procedures. Doctors can install a slit lamp adapter in a few minutes and convert standard diagnostic slit lamps into a therapeutic photocoagulator delivery system. Slit lamp adapters are used in treatment procedures for both retinal diseases and glaucoma. These devices are available in a wide variety of spot diameters. Our standard slit lamp adapters have a single fiber and deliver laser light from a single laser console. Our Symphony slit lamp adapter has multiple fibers and can deliver laser light from two compatible laser consoles. Operating Microscope Adapter. These adapters allow the physician to utilize a standard operating microscope in both diagnosis and laser treatment procedures. These devices are similar to slit lamp adapters, except that they are oriented horizontally and therefore can be used to deliver retinal photocoagulation to a supine patient. EndoProbe. Our EndoProbe fiber optic delivery devices are used for endophotocoagulation, a retinal treatment procedure performed in the hospital operating room or surgery center during a vitrectomy procedure. These sterile consumable disposable probes are available in tapered, angled, stepped, aspirating, illuminating, and adjustable styles. G-Probe. The G-Probe is used in procedures to treat medically and surgically uncontrolled glaucoma, in many instances replacing cyclocryotherapy, or freezing of eye tissues. The G-Probe’s non-invasive procedure takes approximately ten minutes, is performed on an anesthetized eye in the doctor’s office, and results in less pain and fewer adverse side effects than cyclocryotherapy. The G-Probe is a sterile consumable product. DioPexy Probe. The DioPexy Probe is a hand-held instrument which is used in procedures to treat retinal tears, and breaks non- invasively through the sclera, as an alternative method of attaching the retina. Our DioPexy Probe results in increased precision, less pain and less inflammation than traditional cryotherapy. 5 Ophthalmology Treatments The following chart lists the procedures for treating ophthalmic diseases that can be addressed by utilizing our ophthalmic laser systems. These procedures typically are performed in an OR or an ASC and are non-elective and covered by insurance. Age-related Macular Degeneration Diabetic Retinopathy Macular Edema Proliferative Glaucoma Procedure Retinal Photocoagulation Grid Retinal Photocoagulation Focal Retinal Photocoagulation Pan-Retinal Photocoagulation Vitrectomy Procedure Console Delivery Devices Infrared & Visible Slit Lamp Adapter Infrared & Visible Slit Lamp Adapter & Operating Microscope Adapter, Visible Slit Lamp Adapter Infrared & Visible Slit Lamp Adapter, Operating Microscope Adapter, Laser Indirect Ophthalmoscope, EndoProbe* Primary Open-Angle Trabeculoplasty Infrared & Visible Slit Lamp Adapter Angle-closure Iridotomy Infrared & Visible Slit Lamp Adapter Uncontrolled Glaucoma Transscleral Infrared G-Probe* Retinal Tears and Detachments Cyclophotocoagulation Retinopexy Retinal Photocoagulation Vitrectomy Procedure Transscleral Retinal Photocoagulation Infrared & Visible Slit Lamp Adapter, Laser Indirect Ophthalmoscope, Operating Microscope Adapter, EndoProbe* Infrared DioPexy Probe Retinopathy of Prematurity Retinal Ocular Tumors Photocoagulation Retinal Photocoagulation Infrared Infrared Macular Holes ____________ * Consumable single use products Vitrectomy Procedure Visible Aesthetics Products Laser Indirect Ophthalmoscope Slit Lamp Adapter, Operating Microscope Adapter, Laser Indirect Ophthalmoscope EndoProbe* Although light-based products are used in a variety of aesthetics applications, our aesthetics business focuses primarily on pigmented and vascular lesions, skin rejuvenation, skin tightening, hair reduction, leg veins, and acne, treatments that make up three- quarters of all aesthetics laser procedures. Consoles Our aesthetics laser consoles, which are described below, incorporate high powered solid state and semi-conductor technology. Combination Infrared/Visible wavelength laser consoles: This includes the Gemini and VariLite. 6 The Gemini combines the best features of the Lyra and Aura systems, resulting in one of the most comprehensive and versatile multi-use systems available. It is FDA-cleared for use in 21 different aesthetics applications. It is one of the few dual wavelength lasers on the market, offering 532 nm KTP and 1064 nm Nd:YAG laser wavelengths. The KTP is a fast, high power laser used for skin rejuvenation and treatment of acne, pigmented lesions and other shallow vascular lesions. The Nd:YAG allows for deeper penetration and is used for hair reduction, wrinkle reduction, and the treatment of leg veins and other lesions. The VariLite is a unique product in the aesthetics business. It includes both 532 nm and 940 nm lasers, which are used for deeper and more recalcitrant vascular lesions that are not easily treated with 532 nm. The 940nm wavelength is also more effective on venous lakes than 532 nm lasers. Visible (Green) Consoles. The DioLite XP and Aura-i deliver (532 nm) laser light. These lasers deliver from three watts to 20 watts of power that is used for 14 FDA cleared applications ranging from vascular and pigmented lesions to acne. Infrared Consoles: This includes the Lyra-i and Venus-i Laser System. The Lyra-i uses a 1064 nm wavelength. This wavelength penetrates deeply into the skin to reach the hair bulb, leg veins, and the papillary dermis. It is used to treat 11 FDA cleared applications. The Venus-i Laser System is a portable, lightweight, high power Erbium:YAG laser system for skin resurfacing. It provides treatment for wrinkles and moderate sun damage, and can be used on both facial and non-facial skin. Its unique flat beam profile maintains consistent laser energy in the therapeutic range and avoids dangerous hot spots. It is roughly half the size and weight of most other Erbium systems currently available. Aesthetics Delivery Devices VersaStat-i and VersaStat 10 mm Handpieces. These handpieces are used on the Gemini, Aura-i and Lyra-i consoles. The VersaStat-i has an adjustable spot size that allows the physician to match the spot size to the treatment area. It is adjustable from 1 mm to 5 mm in 0.1 mm increments. The handpiece treats a wide range of conditions, including small telangictasias and large blue veins without the need to change handpieces. The VersaStat 10 mm Handpiece allows the physician the ability to treat larger areas, adding to speed and efficiency of treatments. Both handpieces offer contact cooling, which allows for increased patient comfort during treatments. Dermastat Handpieces. These handpieces are used with the Gemini and Aura-i. They are used as tracing instruments for the treatment of small cutaneous surface lesions, typically vascular, such as telangiectasia. DioLite Handpieces. These handpieces are handheld instruments used in the treatment of vascular and pigmented skin lesions. These devices are available in 200, 500, 700, and 1,000 micron spot diameters. VariLite Handpiece. The VariLite Handpiece is a handheld instrument used in the treatment of vascular, pigmented cutaneous skin lesions and small area hair reduction. Ergonomic handpieces can be used with both the 532 nm and 940 nm wavelengths and are available in 700, 1,000, 1,400, 2,000 and 2,800 micron spot diameter. ScanLite Scanner. The ScanLite XP is a computer pattern generator with integrated controls designed to enhance the capabilities of the DioLite XP and VariLite systems. They allow rapid and uniform treatment of larger-area vascular and pigmented skin lesions. Aesthetics Treatments The following chart lists the procedures for treating skin diseases that can be addressed by utilizing our dermatology laser systems. These procedures are normally performed in a physician’s office and are elective and private pay. 7 Procedure Console Selective Photothermolysis Visible Selective Photothermolysis Infrared Delivery Devices DioLite Handpiece Versastat-i Versastat 10 mm Dermastat ScanLite VariLite Handpiece Versastat-i Versastat 10 mm Skin Resurfacing Infrared Articulated Arm Condition Vascular Lesions Pigmented Lesions Cutaneous Lesions Acne Skin Rejuvenation Hair Reduction Leg Veins Hair Reduction Wrinkle Reduction Scars Acne Scar Reduction Research and Development We have close working relationships with researchers, clinicians and practicing physicians around the world who provide new ideas, test the feasibility of these new ideas and assist us in validating new products and new applications before they are introduced. Our research and development (R&D) activities are performed by a current team of 17 engineers, scientists and regulatory professionals with experience in various aspects of medical products, laser systems, delivery devices and clinical techniques with a focus to introduce innovative products which satisfy the unmet and emerging needs of our customers. The core competencies of the team include: mechanical engineering, electrical engineering, optics, lasers, fiber optics, software, firmware and delivery devices. The research and development process integrates all the necessary disciplines of the Company from product inception through customer acceptance. This process facilitates reliable new product innovations and a consistent pipeline of innovative products for our customers. Our research activities are managed internally by our research staff. We supplement our internal research staff by hiring consultants and/or partnering with physicians to gain specialized expertise and understanding. Research efforts are directed toward the development of new products and new applications for our existing products, as well as the identification of markets not currently addressed by our products. We believe that it is important to make a substantial contribution to improving clinical outcomes. For instance we have made substantial investments in researching and improving the treatment of serious eye diseases such as age-related macular degeneration, diabetic retinopathy and glaucoma. The objectives of developing new treatments and applications are to expand the potential patient population, to more effectively treat diseases, to treat patients earlier in the treatment regimen and to reduce the side effects of treatment. We spent $3.6 million on research and development in 2009, $4.0 million in 2008 and $5.8 million in 2007. We consider clinical projects to be a component of our research and development efforts and they may or may not result in additional commercial opportunities. See Item 1A. Risk Factors - Factors That May Affect Future Results – “While We Devote Significant Resources to Research and Development, Our Research and Development May Not Lead to New Products that Achieve Commercial Success” Customers and Customer Support Our products are currently sold to ophthalmologists - particularly those specializing in retina, glaucoma and pediatrics - dermatologists and plastic surgeons. Other customers include research and teaching hospitals, government installations, surgical centers and hospitals. No single customer or distributor accounted for 10% or more of total sales in fiscal years 2009, 2008 or 2007. We are continuing our efforts to broaden our customer base through the development of new products and new applications of our existing products for use by ophthalmologists and dermatologists. We currently estimate that there are approximately 18,000 ophthalmologists in the United States and 55,000 internationally who are potential customers. Additionally, we estimate that there are approximately 5,000 and 18,000 hospitals in the United States and internationally, respectively, as well as approximately 5,000 ambulatory surgical centers in the United States which potentially represent multiple unit sales. We believe there are approximately 9,000 dermatologists and approximately 8,000 plastic surgeons in the United States who are potential customers. Because independent ophthalmologists and dermatologists frequently practice at their own offices, as well as through affiliations with hospitals or other medical centers, each independent ophthalmologist, dermatologist, plastic surgeon, office, hospital and medical center is a potential customer for our products. 8 We seek to provide superior customer support and service and believe that our customer service and technical support distinguish our product offerings from those of our competitors. We provide depot service at our Mountain View facility for our ophthalmology and small aesthetics products and we provide field service for the large aesthetics products we acquired in the Laserscope acquisition. Our customer support representatives assist customers with orders, warranty returns and other administrative functions. Our technical support engineers provide customers with answers to technical and product-related questions. We maintain an “around-the-clock” telephone service line to service our customers. If a problem with a depot serviceable product cannot be diagnosed and resolved by telephone, a service loaner is shipped overnight to domestic customers under warranty or service contract, and by the most rapid delivery means available to our international customers, and the problem unit is returned to us. The small size and rugged design of our products allows for economical shipment and quick response to customers almost anywhere in the world. Sales and Marketing We sell and market our products in the United States predominantly through our direct sales force. Our direct sales force is separated into two separate divisions, one for ophthalmology and one for aesthetics. In total we had a direct sales force of 15 employees who were engaged in sales efforts within the United States as of January 2, 2010. Our sales and marketing organization is based at our corporate headquarters in Mountain View, California with area sales managers located throughout the United States. We sell and market our products internationally through approximately 100 independent distributors into over 107 countries. International sales represented 42.1%, 44.4% and 46.1% of our sales in 2009, 2008 and 2007, respectively. We believe that our international sales will continue to represent a significant portion of our revenues for the foreseeable future. As a result of the Laserscope acquisition we acquired two wholly owned subsidiaries, one located in the UK and the other in France. Our subsidiaries are responsible for selling, marketing and servicing our aesthetics products in their local geography. In June 2008, we transitioned the responsibility for the sales and service of our aesthetics products in the UK to an independent distributor. Our other international sales are made principally to customers in Europe, Asia, the Pacific Rim, the Middle East and Latin America. Our indirect international sales are administered through our corporate headquarters in Mountain View, California. Our distribution agreements with our international distributors are generally exclusive and typically can be terminated by either party without cause with 90 days notice. International sales may be adversely affected by the imposition of governmental controls, currency fluctuations, restrictions on export technology, political instability, trade restrictions, changes in tariffs and the economic condition in each country in which we sell our products. See Item 1A. Risk Factors - Factors That May Affect Future Results – “We Depend on International Sales for a Significant Portion of Our Operating Results.” To support our sales process we conduct marketing programs which include: clinical education, direct mail, trade shows, public relations, market research, and advertising in trade and academic journals and newsletters. We participate in over 100 trade shows worldwide on an annual basis. These meetings allow us to present our products to existing and prospective buyers. Through marketing, we collaborate with our customers to identify new products and applications which help meet their unmet needs , which in turn: provides us with new product concepts, enhances our ability to identify new applications for our products and validates new procedures using our products. Customers include key opinion leaders who are often the heads of the departments in which they work or professors at universities. We believe that these luminaries in the field of ophthalmology and dermatology are key to the successful introduction of new products and the subsequent acceptance of these new products by the general market. Acceptance of our products by these early adopters is key to our strategy in the validation and commercialization of our new products. Operations The manufacture of our infrared and visible light photocoagulators and the related delivery devices is a highly complex and precise process. Completed systems must pass quality control and reliability tests before shipment. Our manufacturing activities consist of specifying, sourcing, assembling and testing of components and certain subassemblies for assembly into our final product. As of January 2, 2010, we had a total of 51 employees engaged in manufacturing activities. The medical devices manufactured by us are subject to extensive regulation by numerous governmental authorities, including federal, state, and foreign governmental agencies. The principal regulator in the United States is the Food and Drug Administration (FDA). In April 1998, we received certification for ISO 9001/EN 46001, which is an international quality system standard that documents compliance to the European Medical Device Directive. In February 2004, we were certified to ISO 13485:2003, which replaced ISO 9001/EN46001 as the international standard for quality systems as applied to medical devices. In August 2008, we received FDA 510(k) clearance on our Family of IRIDEX IQ Laser Systems. This clearance covers the IRIDEX IQ 532, IQ 577, IQ 630-670, and IQ 810 Laser Systems and their associated delivery devices to deliver laser energy in either CW-Pulse, MicroPulse or LongPulse mode. These Laser Systems are intended for a wide range of specific applications in the medical specialties of ophthalmology, ear, nose and throat (ENT)/otolaryngology and dermatology. 9 We rely on third parties to manufacture substantially all of the components used in our products, although we assemble critical subassemblies and the final product at our facility in Mountain View, California. Some of these suppliers and manufacturers are sole source. We have some long-term or volume purchase agreements with our suppliers but currently purchase most components on a purchase order basis. These components may not be available in the quantities required, on reasonable terms, or at all. Financial or other difficulties faced by our suppliers or significant changes in demand for these components or materials could limit their availability. Any failures by such third parties to adequately perform may delay the submission of products for regulatory approval, impair our ability to deliver products on a timely basis or otherwise impair our competitive position. See Item 1A. Risk Factors - Factors That May Affect Future Results – “We Depend on Sole Source or Limited Source Suppliers.” International regulatory bodies often establish varying product standards, packaging requirements, labeling requirements, tariff regulations, duties and tax requirements. As a result of our sales in Europe, we are required to have all products “CE” marked, an international symbol affixed to all products demonstrating compliance to the European Medical Device Directive and all applicable standards. In July 1998, we received CE mark certification under Annex II guidelines, the most stringent path to CE certification. With Annex II CE mark certification, we have demonstrated our ability to both understand and comply with all applicable standards under the European Medical Device Directive. This allows us to CE mark any product upon our internal verification of compliance to all applicable European standards. Currently, all released products are CE marked. Continued certification is based on successful review of the process by our European Registrar during its annual audit. Any loss of certification would have a material adverse effect on our business, results of operations and financial condition. See Item 1A. Risk Factors - Factors That May Affect Future Results – “We Are Subject to Government Regulations Which May Cause Us to Delay or Withdraw the Introduction of New Products or New Applications for Our Products.” Competition Competition in the market for laser systems and delivery devices used for ophthalmic and aesthetics treatment procedures is intense and is expected to increase. This market is also characterized by rapid technological innovation and change. We compete by providing features and services that are valued by our customers such as: product performance, clinical outcomes, ease of use, durability, versatility, customer training services and rapid repair of equipment. Our principal competitors in ophthalmology are Alcon Inc., Carl Zeiss Meditec AG, Nidek Co. Ltd, Synergetics, Ellex Medical Lasers, Ltd. and Lumenis Ltd. Most of these companies currently offer a competitive, semiconductor-based laser system for ophthalmology. Also within ophthalmology, pharmaceutical alternative treatments for AMD such as Lucentis/Avastin (Genentech), and to a lesser extent Visudyne (Novartis) and Macugen (OSI Pharmaceuticals) compete rigorously with traditional laser procedures. In aesthetics our principal competitors are Cutera, Syneron, Palomar Technologies, Inc., Sciton, Lumenis Ltd. and Cynosure. Some ophthalmic and aesthetic competitors have substantially greater financial, engineering, product development, manufacturing, marketing and technical resources than we do. Some companies also have greater name recognition than us and long-standing customer relationships. In addition, other medical companies, academic and research institutions, or others, may develop new technologies or therapies, including medical devices, surgical procedures or pharmacological treatments and obtain regulatory approval for products utilizing such techniques that are more effective in treating the conditions targeted by us, or are less expensive than our current or future products. Our technologies and products could be rendered obsolete by such developments. Any such developments could have a material adverse effect on our business, financial condition and results of operations. See Item 1A. Risk Factors – Factors That May Affect Future Results – “We Face Strong Competition in Our Markets and Expect the Level of Competition to Grow in the Foreseeable Future.” Patents and Proprietary Rights Our success and ability to compete is dependent in part upon our proprietary information. We rely on a combination of patents, trade secrets, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect our intellectual property rights. We file patent applications to protect technology, inventions and improvements that are significant to the development of our business. We have been issued sixteen United States patents and five foreign patents on the technologies related to our products and processes, which have expiration dates ranging from 2010 to 2023. We have approximately six pending patent applications in the United States and five foreign pending patent applications that have been filed. Our patent applications may not be approved. Along with the acquisition of the AMS/Laserscope aesthetic products, we acquired a royalty-free license to eleven of the AMS/Laserscope patents. In addition, we acquired a license to a Palomar patent under which royalties are paid to Palomar based upon a percentage of sales of certain products acquired from AMS/Laserscope. 10 In addition to patents, we rely on trade secrets and proprietary know-how which we seek to protect, in part, through proprietary information agreements with employees, consultants and other parties. Our proprietary information agreements with our employees and consultants contain provisions requiring such individuals to assign to us, without additional consideration, any inventions conceived or reduced to practice by them while employed or retained by us, subject to customary exceptions - See Item 1A.Risk Factors – Factors That May Affect Future Results – “We Rely on Patents and Proprietary Rights to Protect our Intellectual Property and Business.” Government Regulation The medical devices to be marketed and manufactured by us are subject to extensive regulation by numerous governmental authorities, including federal, state, and foreign governmental agencies. Pursuant to the Federal Food, Drug, and Cosmetic Act, as amended, and the regulations promulgated thereunder (the “FDA Act”), the FDA serves as the principal federal agency within the United States with authority over medical devices and regulates the research, clinical testing, manufacture, labeling, distribution, sale, marketing and promotion of such devices. Noncompliance with applicable requirements can result in, among other things, warning letters, fines, injunctions, civil penalties, recall or seizures of products, total or partial suspension of production, failure of the government to grant pre-market clearance or approval for devices, withdrawal of marketing approvals, and criminal prosecution. The FDA also has the authority to request repair, replacement or refund of the cost of any medical device manufactured or distributed by us. In the United States, medical devices are classified into one of three classes (Class I, II or III). The class to which the device is assigned determines, among other things, the type of pre-marketing submission/application required for FDA clearance to market. If the device is classified as Class I or II, and if it is not exempt, a 510(k) pre-market notification will be required for marketing Under FDA regulations, Class I devices are subject to general controls (for example, labeling, pre-market notification and adherence to Quality System Regulations (“QSRs”) requirements). Class II devices receive marketing clearance through a 510(k) pre-market notification. For Class III devices, a pre-market approval (PMA) application will be required unless your device is a pre-amendments device (on the market prior to the passage of the medical device amendments in 1976, or substantially equivalent to such a device) and PMAs have not been called for. In that case, a 510(k) will be the route to market. A 510(k) clearance will be granted if the submitted information establishes that the proposed device is “substantially equivalent” to a legally marketed Class I or II medical device, or to a Class III medical device for which the FDA has not called for a PMA. The FDA may determine that a proposed device is not substantially equivalent to a legally marketed device, or that additional information or data are needed before a substantial equivalence determination can be made. A request for additional data may require that clinical studies of the device’s safety and efficacy be performed. Commercial distribution of a device for which a 510(k) notification is required can begin only after the FDA issues an order finding the device to be “substantially equivalent” to a previously cleared device. The FDA has recently been requiring a more rigorous demonstration of substantial equivalence than in the past. Even in cases where the FDA grants a 510(k) clearance, it can take the FDA from three to six months from the date of submission to grant a 510(k) clearance, but it may take longer. A “not substantially equivalent” determination, or a request for additional information, could delay the market introduction of new products that fall into this category and could have a materially adverse effect on our business, financial condition and results of operations. For any of our products that are cleared through the 510(k) process, such as our IQ 810 system, modifications or enhancements that could significantly affect the safety or efficacy of the device or that constitute a major change to the intended use of the device will require new 510(k) submissions. We have obtained 510(k) clearance for all of our marketed products. We have also modified aspects of our products since receiving regulatory clearance, but we believe that new 510(k) clearances are not required for these modifications. After a device receives 510(k) clearance or a PMA, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, will require a new clearance or approval. The FDA requires each manufacturer to make this determination initially, but the FDA can review any such decision and can disagree with a manufacturer’s determination. If the FDA disagrees with our determination not to seek a new 510(k) clearance or PMA, the FDA may retroactively require us to seek 510(k) clearance or pre-market approval. The FDA could also require us to cease marketing and distribution and/or recall the modified device until 510(k) clearance or PMA approval is obtained. Also, in these circumstances, we may be subject to significant regulating fines or penalties. Any products manufactured or distributed by us pursuant to FDA clearances or approvals are subject to pervasive and continuing regulation by the FDA, including record keeping requirements and reporting of adverse experiences with the use of the device. Device manufacturers are required to register their establishments and list their devices with the FDA and certain state agencies, and are 11 subject to periodic inspections by the FDA and certain state agencies. The FDA Act requires devices to be manufactured to comply with applicable QSR regulations which impose certain procedural and documentation requirements upon us with respect to design, development, manufacturing and quality assurance activities. We are subject to unannounced inspections by the FDA and the Food and Drug Branch of the California Department of Health Services, or CDHS, to determine our compliance with the QSR and other regulations, and these inspections may include the manufacturing facilities of our subcontractors. Labeling and promotion activities are subject to scrutiny by the FDA and in certain instances, by the Federal Trade Commission. The FDA actively enforces regulations prohibiting marketing of products for unapproved uses. We and our products are also subject to a variety of state laws and regulations in those states or localities where our products are or will be marketed. Any applicable state or local regulations may hinder our ability to market our products in those states or localities. Manufacturers are also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. We may be required to incur significant costs to comply with such laws and regulations now or in the future. Such laws or regulations may have a material adverse effect upon our ability to do business. Exports of our products are regulated by the FDA and are covered by the Export Amendment of 1996, which greatly expanded the export of approved and unapproved United States medical devices. However, some foreign countries require manufacturers to provide an FDA certificate for products for export (CPE) which requires the device manufacturer to certify to the FDA that the product has been granted pre-market clearance in the United States and that the manufacturing facilities appeared to be in compliance with QSR at the time of the last QSR inspection. The FDA will refuse to issue a CPE if significant outstanding QSR violations exist. We are also regulated under the Radiation Control for Health and Safety Act, which requires laser products to comply with performance standards, including design and operation requirements, and manufacturers to certify in product labeling and in reports to the FDA that their products comply with all such standards. The law also requires laser manufacturers to file new product and annual reports, maintain manufacturing, testing and sales records and report product defects. Various warning labels must be affixed and certain protective devices installed, depending on the class of the product. The introduction of our products in foreign markets will also subject us to foreign regulatory clearances which may impose substantial additional costs and burdens. International sales of medical devices are subject to the regulatory requirements of each country. The regulatory review process varies from country to country. Many countries also impose product standards, packaging requirements, labeling requirements and import restrictions on devices. In addition, each country has its own tariff regulations, duties and tax requirements. The approval by the FDA and foreign government authorities is unpredictable and uncertain. The necessary approvals or clearances may not be granted on a timely basis, if at all. Delays in receipt of, or a failure to receive, such approvals or clearances, or the loss of any previously received approvals or clearances, could have a material adverse effect on our business, financial condition and results of operations. Changes in existing requirements or adoption of new requirements or policies by the FDA or other foreign and domestic regulatory authorities could adversely affect our ability to comply with regulatory requirements. Failure to comply with regulatory requirements could have a material adverse effect on our business, financial condition and results of operations. We may be required to incur significant costs to comply with laws and regulations in the future. These laws or regulations may have a material adverse effect upon our business, financial condition or results of operations. Reimbursement The cost of a significant portion of medical care in the United States is funded by government programs, health maintenance organizations and private insurance plans. Our ophthalmology products are typically purchased by doctors, clinics, hospitals and other users, which bill various third-party payers, such as government programs and private insurance plans, for the health care services provided to their patients. Government imposed limits on reimbursement of hospitals and other health care providers have significantly impacted the spending budgets of doctors, clinics and hospitals to acquire new equipment, including our products. Under certain government insurance programs, a health care provider is reimbursed for a fixed sum for services rendered in treating a patient, regardless of the actual charge for such treatment. The Center for Medicare and Medicaid Services (CMS) reimburses hospitals on a prospectively-determined fixed amount for the costs associated with an in-patient hospitalization based on the patient’s discharge diagnosis. CMS reimburses physicians a prospectively-determined fixed amount based on the procedure performed, regardless of the actual costs incurred by the hospital or physician in furnishing the care and regardless of the specific devices used in that procedure. Reimbursement issues have affected sales of our ophthalmic products to a greater extent than sales of our aesthetics products because aesthetics procedures, in general, are not covered under most insurance programs and the cost of these procedures are paid for by the patient. 12 Private third-party reimbursement plans are also developing increasingly sophisticated methods of controlling health-care costs by imposing limitations on reimbursable procedures and the exploration of more cost-effective methods of delivering health care. In general, these government and private measures have caused health care providers, including our customers, to be more selective in the purchase of medical products. In addition, changes in government regulation or in private third-party payers’ policies may limit or eliminate reimbursement for procedures employing our products, which could have a material adverse effect on our business, results of operations and financial condition. See Item 1A Risk Factors – Factors That May Affect Future Results – “Our Operating Results May be Adversely Affected by Changes in Third Party Coverage and Reimbursement Policies and any Uncertainty Regarding Healthcare Reform Measures.” Doctors, clinics, hospitals and other users of our products may not obtain adequate reimbursement for use of our products from third-party payers. While we believe that the laser procedures using our products have generally been reimbursed, payers may deny coverage and reimbursement for our products if they determine that the device was not reasonable and necessary for the purpose used, was investigational or was not cost-effective. Backlog We generally do not maintain a high level of backlog. As a result, we do not believe that our backlog at any particular time is indicative of future sales levels. Employees At January 2, 2010 we had a total of 150 full-time employees (144 in the U.S. and 6 in France), including in the US: 81 in operations and service, 31 in sales and marketing, 17 in research and development and 15 in finance and administration. We also employ, from time to time, a number of temporary and part-time employees as well as consultants on a contract basis. At January 2, 2010, we employed 16 such persons. Our future success will depend in part on our ability to attract, train, retain and motivate highly qualified employees, who are in great demand. We may not be successful in attracting and retaining such personnel. Our employees are not represented by a collective bargaining organization, and we have never experienced a work stoppage or strike. We consider our employee relations to be good. Available Information Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available, free of charge, on our website at www.IRIDEX.com, as soon as reasonably practicable after such reports are electronically filed with the Securities and Exchange Commission, however, the information on, or that can be accessed through, our website is not part of this report. Additionally, these filings may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, NE, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330, by sending an electronic message to the SEC at publicinfo@sec.gov or by sending a fax to the SEC at 1- 202-777-1027. In addition, the SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically. 13 Item 1A. Risk Factors Factors That May Affect Future Results In addition to the other information contained in this Annual Report Form 10-K, we have identified the following risks and uncertainties that may have a material adverse effect on our business, common stock price, financial condition or results of operation. You should carefully consider the risks described below before making an investment decision. We Are Exposed to Risks Associated With Worldwide Economic Slowdowns and Related Uncertainties. We are subject to macro-economic fluctuations in the U.S. and worldwide economy. Concerns about consumer and investor confidence, volatile corporate profits and reduced capital spending, international conflicts, terrorist and military activity, civil unrest and pandemic illness could cause a slowdown in customer orders or cause customer order cancellations. In addition, political and social turmoil related to international conflicts and terrorist acts may put further pressure on economic conditions in the United States and abroad. During the past several quarters, macro-economic issues involving the broader financial markets, including the housing and credit system and general liquidity issues in the securities markets, have negatively impacted the economy and have and may in the future negatively affect our growth. In addition, weak economic conditions and declines in consumer spending and consumption may harm our operating results. Purchases of our products are often discretionary. In the current economic climate, customers or potential customers may delay, reduce or forego their purchases of our products and services, which has impacted and could in the future impact, our business in a number of ways, including lower prices for our products and services and reduced or delayed sales. There could be a number of follow-on effects from the current financial crisis on our business, including insolvency of key suppliers resulting in product delays, delays in customer payments of outstanding accounts receivable and/or customer insolvencies, counterparty failures negatively impacting our operations, and increased expense or inability to obtain future financing. If the negative macro-economic conditions persist, or if the economy enters a prolonged period of decelerating growth, our results of operations may be harmed. We Rely on Continued Market Acceptance of Our Existing Products and Any Decline in Sales of Our Existing Products Would Adversely Affect Our Business and Results of Operations. We currently market visible and infrared medical laser systems and delivery devices to the ophthalmology and aesthetics markets. We believe that continued and increased sales, if any, of these medical laser systems is dependent upon a number of factors including the following: • • • • • • acceptance of product performance, features, ease of use, scalability and durability; recommendations and opinions by ophthalmologists, dermatologists, plastic surgeons, other clinicians, and their associated opinion leaders; clinical study outcomes; price of our products and prices of competing products and technologies particularly in light of the current macro-economic environment, in which the availability of credit is limited and purchasers may delay capital investments or place additional emphasis on price when making their purchase decision; availability of competing products, technologies and alternative treatments; and level of reimbursement for treatments administered with our products. In addition, we derive a meaningful portion of our sales from recurring revenues including consumable EndoProbe devices and service. Our ability to increase recurring revenues from the sale of consumable EndoProbe devices will depend primarily upon the features of our current products and product innovation, the quality of our products, ease of use and prices of our products, including the relationship to prices of competing delivery devices. The level of our service revenues will depend on the quality of service we provide and the responsiveness and the willingness of our customers to request our services rather than purchase competing products 14 or services. Any significant decline in market acceptance of our products or our revenues derived from the sales of laser consoles, delivery devices, consumables or services may have a material adverse effect on our business, results of operations and financial condition. Our Operating Results May be Adversely Affected by Uncertainty Regarding Healthcare Reform Measures and Changes in Third Party Coverage and Reimbursement Policies. Changes in government legislation or regulation or in private third-party payers’ policies toward reimbursement for procedures employing our products may prohibit adequate reimbursement. There have been a number of legislative and regulatory proposals to change the healthcare system, reduce the costs of healthcare and change medical reimbursement policies. Doctors, clinics, hospitals and other users of our products may decline to purchase our products to the extent there is uncertainty regarding reimbursement of medical procedures using our products and any healthcare reform measures. Further proposed legislation, regulation and policy changes affecting third party reimbursement are likely. We are unable to predict what legislation or regulation, if any, relating to the health care industry or third-party coverage and reimbursement may be enacted in the future, or what effect such legislation or regulation may have on us. However, denial of coverage and reimbursement of our products would have a material adverse effect on our business, results of operations and financial condition. Our ophthalmology products are typically purchased by doctors, clinics, hospitals and other users, which bill various third-party payers, such as governmental programs and private insurance plans, for the health care services provided to their patients. Third-party payers are increasingly scrutinizing and challenging the coverage of new products and the level of reimbursement for covered products. Doctors, clinics, hospitals and other users of our products may not obtain adequate reimbursement for use of our products from third-party payers. While we believe that the laser procedures using our products have generally been reimbursed, payers may deny coverage and reimbursement for our products if they determine that the device was not reasonable and necessary for the purpose used, was investigational or was not cost-effective. We Depend on International Sales for a Significant Portion of Our Operating Results. We derive, and expect to continue to derive, a large portion of our revenues from international sales. For the fiscal year ended January 2, 2010, our international sales were $18.2 million or 42.1% of total sales. We anticipate that international sales will continue to account for a significant portion of our revenues, particularly ophthalmology, in the foreseeable future. None of our international revenues and costs has been denominated in foreign currencies, other than sales made by our French subsidiary. As a result, an increase in the value of the U.S. dollar relative to foreign currencies makes our products more expensive and thus less competitive in foreign markets. The factors stated above could have a material adverse effect on our business, financial condition or results of operations. Our international operations and sales are subject to a number of other risks and potential costs, including: • • impact of recessions in global economies and availability of credit; fluctuations in foreign currency exchange rates; • performance of our international channel of distributors; • longer accounts receivable collection periods; • differing local product preferences and product requirements; • cultural differences; • changes in foreign medical reimbursement and coverage policies and programs; • political and economic instability; • difficulty in staffing and managing foreign operations; • foreign certification requirements, including continued ability to use the “CE” mark in Europe, and other local regulatory requirements; 15 • reduced or limited protections of intellectual property rights in jurisdictions outside the United States; • potentially adverse tax consequences; and • multiple protectionist, adverse and changing foreign governmental laws and regulations. Any one or more of these factors stated above could have a material adverse effect on our business, financial condition or results of operations. As we expand our existing international operations we may encounter new risks. For example, as we focus on building our international sales and distribution networks in new geographic regions, we must continue to develop relationships with qualified local distributors and trading companies. If we are not successful in developing these relationships, we may not be able to grow sales in these geographic regions. These or other similar risks could adversely affect our revenues and profitability. We Face Strong Competition in Our Markets and Expect the Level of Competition to Grow in the Foreseeable Future. Competition in the market for devices used for ophthalmic and aesthetics treatment procedures is intense and is expected to increase. Our competitive position depends on a number of factors including product performance, characteristics and functionality, ease of use, scalability, durability and cost. Our principal competitors in ophthalmology are Alcon Inc., Carl Zeiss Meditec AG, Nidek Co. Ltd., Synergetics, Ellex Medical Lasers, Ltd. and Lumenis Ltd. Most of these companies currently offer a competitive, semiconductor-based laser system for ophthalmology. Also within ophthalmology, pharmaceutical alternative treatments for AMD such as Lucentis/Avastin (Genentech), and to a lesser extent Visudyne (Novartis) and Macugen (OSI Pharmaceuticals), compete rigorously with traditional laser procedures. In aesthetics, our principal competitors are Cutera, Syneron, Palomar Technologies, Inc., Sciton, Lumenis Ltd. and Cynosure. These competitors have more sales representatives supporting broader product lines. Some competitors have substantially greater financial, engineering, product development, manufacturing, marketing and technical resources than we do. In both markets, some companies also have greater name recognition than we do and long-standing customer relationships. In addition to other companies that manufacture photocoagulators, we compete with pharmaceuticals, other technologies and other surgical techniques. Some medical companies, academic and research institutions, or others, may develop new technologies or therapies that are more effective in treating conditions targeted by us or are less expensive than our current or future products. Any such developments could have a material adverse effect on our business, financial condition and results of operations. If We Cannot Increase Our Sales Volumes, Reduce Our Costs or Introduce Higher Margin Products to Offset Anticipated Reductions in the Average Unit Price of Our Products, Our Operating Results May Suffer. The average unit price of our products may decrease in the future in response to changes in product mix, competitive pricing pressures, new product introductions by our competitors or other factors. If we are unable to offset the anticipated decrease in our average selling prices by increasing our sales volumes or through new product introductions, our net revenues will decline. In addition, to maintain our gross margins we must continue to reduce the manufacturing cost of our products. If we cannot maintain our gross margins our business could be seriously harmed, particularly if the average selling price of our products decreases significantly without a corresponding increase in sales. If There is Not Sufficient Demand for the Aesthetics Procedures Performed with Our Products, Practitioner Demand for Our Products Could be Inhibited, Resulting in Unfavorable Operating Results and Reduced Growth Potential. The global aesthetics market has seen a continued contraction and we have seen reduced demand for our products because most procedures performed using our aesthetics products are elective procedures not reimbursable through government or private health insurance, with the costs borne by the patient. The decision to purchase our aesthetics products may therefore be influenced by a number of factors, including: • consumer confidence, which may be impacted by economic and political conditions; • the success of our sales and marketing efforts; 16 • evolving customer needs; • the introduction of new products and technologies; • evolving surgical practices; • evolving industry standards; • • the cost of procedures performed using our products; and the cost, safety and effectiveness of alternative treatments, including treatments which are not based upon laser or other light-based technologies and treatments which use pharmaceutical products. If, as a result of these factors, there is not sufficient demand for the procedures performed with our aesthetics products, practitioner demand for our aesthetics products could be reduced, resulting in unfavorable operating results and lower growth potential. Inability of Customers Obtaining Credit or Material Increases in Interest Rates May Harm Our Sales. Some of our products are sold to health care providers in general practice. Many of these health care providers purchase our products with funds they secure through various financing arrangements with third party financial institutions, including credit facilities and short-term loans. If availability of credit becomes more limited, or interest rates increase, these financing arrangements will be harder to obtain or more expensive to our customers, which may decrease demand for our products. Any reduction in the sales of our products would cause our business to suffer. Efforts to Acquire Additional Companies or Product Lines May Divert Our Managerial Resources Away from Our Business Operations, and If We Complete Additional Acquisitions, We May Incur or Assume Additional Liabilities or Experience Integration Problems. Since 1989, we have completed 4 acquisitions. Going forward, we may seek to acquire additional businesses or product lines for various reasons, including adding new products, adding new customers, increasing penetration with existing customers, adding new manufacturing capabilities or expanding into new geographic markets. Our ability to successfully grow through additional acquisitions depends upon our ability to identify, negotiate, complete and integrate suitable acquisitions and to obtain any necessary financings. These additional efforts could divert the attention of our management and key personnel from our business operations. If we complete additional acquisitions, we may also experience: • difficulties integrating any acquired products into our existing business; • delays in realizing the benefits of the acquired products; • diversion of our management’s time and attention from other business concerns; or • adverse customer reaction to the product acquisition. Additional acquisitions could materially impair our operating results by causing us to incur debt and acquisition expenses or requiring us to amortize acquired assets. Our Current and or Future Levels of Indebtness May Limit Our Ability to Operate Our Business, Finance Acquisitions and Pursue Business Strategies. As of January 2, 2010, our cash balance was $9.4 million, the amount outstanding under our bank line of credit was $3.5 million and we have repaid our bank debt during the first quarter of fiscal year 2010. If we are unable to maintain positive cash flows we may need to incur additional debt to sustain our operations. In addition it is our goal to seek growth through investments in internal programs and acquisitions both of which may result in us increasing our debt levels. Increased levels of debt and obligations may, among other things: 17 • make it more difficult for us to meet our payments and other obligations to other third parties; • increase our vulnerability to, and limit our flexibility in planning for, adverse economic and industry conditions; • increase our sensitivity to interest rate increases on our indebtedness with variable interest rates; • result in an event of default if we fail to comply with the financial and other restrictive covenants contained in our debt agreements, which event of default could result in all of our debt becoming immediately due and payable; • affect our credit rating; • limit our ability to obtain additional financing to fund future working capital, capital expenditures, additional acquisitions and other general corporate requirements; • create competitive disadvantages compared to other companies with less indebtedness; and • limit our ability to apply proceeds from an offering or asset sale to purposes other than the repayment of debt. Our ability to service any future indebtedness will depend on our future performance, which will be affected by prevailing economic conditions and financial, business, regulatory and other factors. Some of these factors are beyond our control. In addition credit markets remain very fragile. We cannot assure you that financing or refinancing will be available on a timely basis or on satisfactory terms, if at all. To the extent we incur additional indebtedness or other obligations in the future, the risks associated with our indebtedness described above, including our possible inability to service our debt, would increase. Our Future Success Depends on Our Ability to Develop and Successfully Introduce New Products and New Applications. Our future success is dependent upon, among other factors, our ability to develop, obtain regulatory approval or clearance of, manufacture and market new products. Successful commercialization of new products and new applications will require that we effectively transfer production processes from research and development to manufacturing and effectively coordinate with our suppliers. In addition, we must successfully sell and achieve market acceptance of new products and applications and enhanced versions of existing products. The extent of, and rate at which, market acceptance and penetration are achieved by future products is a function of many variables, which include, among other things, price, safety, efficacy, reliability, marketing and sales efforts, the development of new applications for these products, the availability of third-party reimbursement of procedures using our new products, the existence of competing products and general economic conditions affecting purchasing patterns. Our ability to market and sell new products may also be subject to government regulation, including approval or clearance by the United States Food and Drug Administration, or FDA, and foreign government agencies. Any failure in our ability to successfully develop and introduce new products or enhanced versions of existing products and achieve market acceptance of new products and new applications could have a material adverse effect on our operating results and would cause our net revenues to decline. While We Devote Significant Resources to Research and Development, Our Research and Development May Not Lead to New Products that Achieve Commercial Success. The Company’s ability to generate incremental revenue growth will depend, in part, on the successful outcome of research and development activities, including clinical trials that lead to the development of new products and new applications using our products. Our research and development process is expensive, prolonged, and entails considerable uncertainty. Because of the complexities and uncertainties associated with ophthalmic and aesthetics research and development, products we are currently developing may not complete the development process or obtain the regulatory approvals required to market such products successfully. The products currently in our development pipeline may not be approved by regulatory entities and may not be commercially successful, and our current and planned products could be surpassed by more effective or advanced products of current or future competitors. Therefore, even if we are able to successfully develop enhancements or new generations of our products, these enhancements or new generations of products may not produce revenue in excess of the costs of development and they may be quickly rendered obsolete by changing customer preferences or the introduction by our competitors of products embodying new technologies or features. 18 The Clinical Trial Process Required to Obtain Regulatory Approvals is Costly and Uncertain, and Could Result in Delays in New Product Introductions or Even an Inability to Release a Product. The clinical trials required to obtain regulatory approvals for our products are complex and expensive and their outcomes are uncertain. We incur substantial expense for, and devote significant time to, clinical trials but cannot be certain that the trials will ever result in the commercial sale of a product. We may suffer significant setbacks in clinical trials, even after earlier clinical trials showed promising results. Any of our products may produce undesirable side effects that could cause us or regulatory authorities to interrupt, delay or halt clinical trials of a product candidate. We, the FDA, or another regulatory authority may suspend or terminate clinical trials at any time if they or we believe the trial participants face unacceptable health risks. We Rely on Patents and Proprietary Rights to Protect our Intellectual Property and Business. Our success and ability to compete is dependent in part upon our proprietary information. We rely on a combination of patents, trade secrets, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect our intellectual property rights. We file patent applications to protect technology, inventions and improvements that are significant to the development of our business. We have been issued sixteen United States patents and five foreign patents on the technologies related to our products and processes. We have approximately six pending patent applications in the United States and five foreign pending patent applications that have been filed. Our patent applications may not be approved. Along with the acquisition of the AMS/Laserscope aesthetic products, we acquired a royalty-free license to eleven of the AMS/Laserscope patents. In addition, we acquired a license to a Palomar patent under which royalties are paid to Palomar based upon a percentage of sales of certain products acquired from AMS/Laserscope. Any patents granted now or in the future may offer only limited protection against potential infringement and development by our competitors of competing products. Moreover, our competitors, many of which have substantial resources and have made substantial investments in competing technologies, may seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make, use or sell our products either in the United States or in international markets. Patents have a limited lifetime and once a patent expires competition may increase. For example our “Connector Patent” used to connect our delivery devices (consumable & durable) to our laser consoles will expire in the second half of 2010. Delivery devices which do not utilize our Connector Patent technology are not recognized by our laser consoles. We derive, and expect to continue to derive, a large portion of our recurring revenue and profits from sales of our consumable EndoProbe devices. Expiration of this patent may increase competition from our competitors for our consumable EndoProbe device business and there can be no guarantees that we will maintain our market share of this business. In addition to patents, we rely on trade secrets and proprietary know-how which we seek to protect, in part, through proprietary information agreements with employees, consultants and other parties. Our proprietary information agreements with our employees and consultants contain industry standard provisions requiring such individuals to assign to us without additional consideration any inventions conceived or reduced to practice by them while employed or retained by us, subject to customary exceptions. Proprietary information agreements with employees, consultants and others may be breached, and we may not have adequate remedies for any breach. Also, our trade secrets may become known to or independently developed by competitors. The laser and medical device industry is characterized by frequent litigation regarding patent and other intellectual property rights. Companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. Numerous patents are held by others, including academic institutions and our competitors. Until recently patent applications were maintained in secrecy in the United States until the patents were issued. Patent applications filed in the United States after November 2000 generally will be published eighteen months after the filing date. However, since patent applications continue to be maintained in secrecy for at least some period of time, both within the United States and with regards to international patent applications, we cannot assure you that our technology does not infringe any patents or patent applications held by third parties. We have, from time to time, been notified of, or have otherwise been made aware of, claims that we may be infringing upon patents or other proprietary intellectual property owned by others. If it appears necessary or desirable, we may seek licenses under such patents or proprietary intellectual property. Although patent holders commonly offer such licenses, licenses under such patents or intellectual property may not be offered or the terms of any offered licenses may not be reasonable. Any claims, with or without merit, and regardless of whether we are successful on the merits, would be time-consuming, result in costly litigation and diversion of technical and management personnel, cause shipment delays or require us to develop non-infringing technology or to enter into royalty or licensing agreements. For example, during fiscal year 2007, the Company settled patent litigations with Synergetics, Inc., which was time-consuming, costly and a diversion of technical and management personnel. An adverse determination in a judicial or administrative proceeding and failure to obtain necessary licenses or develop alternate 19 technologies could prevent us from manufacturing and selling our products, which would have a material adverse effect on our business, results of operations and financial condition. We Rely on Our Direct Sales Force and Network of International Distributors to Sell Our Products and Any Failure to Maintain Our Direct Sales Force and Distributor Relationships Could Harm Our Business. Our ability to sell our products and generate revenues depends upon our direct sales force within the United States and relationships with independent distributors outside the United States. Currently our direct sales force consists of 14 employees and we maintain relationships with approximately 100 independent distributors internationally selling our products into 107 countries. We generally grant our distributors exclusive territories for the sale of our products in specified countries. The amount and timing of resources dedicated by our distributors to the sales of our products is not within our control. Our international sales are entirely dependent on the efforts of these third parties. If any distributor breaches terms of its distribution agreement or fails to generate sales of our products, we may be forced to replace the distributor and our ability to sell our products into that exclusive sales territory would be adversely affected. We do not have any long-term employment contracts with the members of our direct sales force. We may be unable to replace our direct sales force personnel with individuals of equivalent technical expertise and qualifications, which may limit our revenues and our ability to maintain market share. The loss of the services of these key personnel would harm our business. Similarly, our distributor agreements are generally terminable at will by either party and distributors may terminate their relationships with us, which would affect our international sales and results of operations. If We Lose Key Personnel or Fail to Integrate Replacement Personnel Successfully, Our Ability to Manage Our Business Could Be Impaired. Our future success depends upon the continued service of our key management, technical, sales, and other critical personnel. Our officers and other key personnel are employees-at-will, and we cannot assure you that we will be able to retain them. Key personnel have left our Company in the past, and there likely will be additional departures of key personnel from time to time in the future. The loss of any key employee could result in significant disruptions to our operations, including adversely affecting the timeliness of product releases, the successful implementation and completion of Company initiatives, and the results of our operations. Competition for these individuals is intense, and we may not be able to attract, assimilate or retain highly qualified personnel. Competition for qualified personnel in our industry and the San Francisco Bay Area, as well as other geographic markets in which we recruit, is intense and characterized by increasing salaries, which may increase our operating expenses or hinder our ability to recruit qualified candidates. In addition, the integration of replacement personnel could be time consuming, may cause additional disruptions to our operations, and may be unsuccessful. If We Fail to Accurately Forecast Demand For Our Product and Component Requirements For the Manufacture of Our Product, We Could Incur Additional Costs or Experience Manufacturing Delays and May Experience Lost Sales or Significant Inventory Carrying Costs. We use quarterly and annual forecasts based primarily on our anticipated product orders to plan our manufacturing efforts and determine our requirements for components and materials. It is very important that we accurately predict both the demand for our product and the lead times required to obtain the necessary components and materials. Lead times for components vary significantly and depend on numerous factors, including the specific supplier, the size of the order, contract terms and current market demand for such components. If we overestimate the demand for our product, we may have excess inventory, which would increase our costs. If we underestimate demand for our product and consequently, our component and materials requirements, we may have inadequate inventory, which could interrupt our manufacturing, delay delivery of our product to our customers and result in the loss of customer sales. Any of these occurrences would negatively impact our business and operating results. We Depend on Sole Source or Limited Source Suppliers. We rely on third parties to manufacture substantially all of the components used in our products, including optics, laser diodes and crystals. We have some long term or volume purchase agreements with our suppliers and currently purchase components on a purchase order basis. Some of our suppliers and manufacturers are sole or limited sources. In addition, some of these suppliers are relatively small private companies that may discontinue their operations at any time. For example, Synergetics Inc. currently is the sole source supplier of the Company’s line of adjustable laser probes under a non-exclusive agreement. There are risks associated with the use of independent manufacturers, including the following: 20 • • • • unavailability of, shortages or limitations on the ability to obtain supplies of components in the quantities that we require; delays in delivery or failure of suppliers to deliver critical components on the dates we require; failure of suppliers to manufacture components to our specifications, and potentially reduced quality; and inability to obtain components at acceptable prices. Our business and operating results may suffer from the lack of alternative sources of supply for critical sole and limited source components. The process of qualifying suppliers is complex, requires extensive testing with our products, and may be lengthy, particularly as new products are introduced. New suppliers would have to be educated in our production processes. In addition, the use of alternate components may require design alterations to our products and additional product testing under FDA and relevant foreign regulatory agency guidelines, which may delay sales and increase product costs. Any failures by our vendors to adequately supply limited and sole source components may impair our ability to offer our existing products, delay the submission of new products for regulatory approval and market introduction, materially harm our business and financial condition and cause our stock price to decline. Establishing our own capabilities to manufacture these components would be expensive and could significantly decrease our profit margins. Our business, results of operations and financial condition would be adversely affected if we are unable to continue to obtain components in the quantity and quality desired and at the prices we have budgeted. We Face Risks Associated with Our Collaborative and OEM Relationships. Our collaborators may not pursue further development and commercialization of products resulting from collaborations with us or may not devote sufficient resources to the marketing and sale of such products. We cannot provide assurance that these types of relationships will continue over a longer period. Our reliance on others for clinical development, manufacturing and distribution of our products may result in unforeseen problems. Further, our collaborative partners may develop or pursue alternative technologies either on their own or in collaboration with others. If a collaborator elects to terminate its agreement with us, our ability to develop, introduce, market and sell the product may be significantly impaired and we may be forced to discontinue altogether the product resulting from the collaboration. We may not be able to negotiate alternative collaboration agreements on acceptable terms, if at all. The failure of any current or future collaboration efforts could have a material adverse effect on our ability to introduce new products or applications and therefore could have a material adverse effect on our business, results of operations and financial condition. We Depend on Collaborative Relationships to Develop, Introduce and Market New Products, Product Enhancements and New Applications. We depend on both clinical and commercial collaborative relationships. We are party to a Manufacture and Supply Agreement with Synergetics, Inc. pursuant to which Synergetics manufactures the Company’s line of adjustable laser probes on a non-exclusive basis. We have entered into collaborative relationships with academic medical centers and physicians in connection with the research and innovation and clinical testing of our products. Commercially, we currently collaborate with Bausch & Lomb to design and manufacture a solid-state green wavelength (532nm) laser photocoagulator module for Bausch & Lomb, called the Millennium Endolase module. The Millennium Endolase module is designed to be a component of Bausch & Lomb’s ophthalmic surgical suite product offering and is not expected to be sold as a stand-alone product. Sales of the Millennium Endolase module are dependent upon the actual order rate from and shipment rate to Bausch & Lomb, which depends on the efforts of our partner and is beyond our control. We cannot assure you that our relationship with Bausch & Lomb will result in further sales of our Millennium Endolase module. The failure to obtain any additional future clinical or commercial collaborations and the resulting failure or success of such arrangements of any current or future clinical or commercial collaboration relationships could have a material adverse effect on our ability to introduce new products or applications and therefore could have a material adverse effect on our business, results of operations and financial condition. If We Fail to Maintain Our Relationships With Health Care Providers, Customers May Not Buy Our Products and Our Revenue and Profitability May Decline. We market our products to numerous health care providers, including physicians, hospitals, ambulatory surgical centers, government affiliated groups and group purchasing organizations. We have developed and strive to maintain close relationships with members of each of these groups who assist in product research and development and advise us on how to satisfy the full range of surgeon and patient needs. We rely on these groups to recommend our products to their patients and to other members of their organizations. The failure of our existing products and any new products we may introduce to retain the support of these various groups could have a material adverse effect on our business, financial condition and results of operations. 21 We Face Manufacturing Risks. The manufacture of our infrared and visible laser consoles and the related delivery devices is a highly complex and precise process. We assemble critical subassemblies and substantially all of our final products at our facility in Mountain View, California. We may experience manufacturing difficulties, quality control issues or assembly constraints, particularly with regard to new products that we may introduce. If our sales increase substantially, including increases in the sales of our aesthetics products, we may need to increase our production capacity and may not be able to do so in a timely, effective, or cost efficient manner. We may not be able to manufacture sufficient quantities of our products, which may require that we qualify other manufacturers for our products. Furthermore, we may experience delays, disruptions, capacity constraints or quality control problems in our manufacturing operations and as a result, product shipments to our customers could be delayed, which would negatively impact our net revenues. Our Operating Results May Fluctuate from Quarter to Quarter and Year to Year. Our sales and operating results may vary significantly from quarter to quarter and from year to year in the future. Our operating results are affected by a number of factors, many of which are beyond our control. Factors contributing to these fluctuations include the following: • • • • • • • • • • • • • general economic uncertainties and political concerns; the timing of the introduction and market acceptance of new products, product enhancements and new applications; changes in demand for our existing line of ophthalmology and aesthetics products; the cost and availability of components and subassemblies, including the willingness and ability of our sole or limited source suppliers to timely deliver components at the times and prices that we have planned; our ability to maintain sales volumes at a level sufficient to cover fixed manufacturing and operating costs; fluctuations in our product mix between ophthalmology and aesthetics products and foreign and domestic sales; our ability to address our liquidity issues should the need occur; the effect of regulatory approvals and changes in domestic and foreign regulatory requirements; introduction of new products, product enhancements and new applications by our competitors, entry of new competitors into our markets, pricing pressures and other competitive factors; our long and highly variable sales cycle; changes in the prices at which we can sell our products; changes in customers’ or potential customers’ budgets as a result of, among other things, reimbursement policies of government programs and private insurers for treatments that use our products; and increased product innovation costs. In addition to these factors, our quarterly results have been, and are expected to continue to be, affected by seasonal factors. Our European sales during the third quarter are generally lower. Our expense levels are based, in part, on expected future sales. If sales levels in a particular quarter do not meet expectations, we may be unable to adjust operating expenses quickly enough to compensate for the shortfall of sales, and our results of operations may be adversely affected. We encountered this adverse effect on our operating results during our recent history starting with the quarter ended March 31, 2007 through the quarter ended January 3, 2009. In addition, we have historically made a significant portion of each quarter’s product shipments near the end of the quarter. If that pattern continues, any delays in shipment of products could have a 22 material adverse effect on results of operations for such quarter. Due to these and other factors, we believe that quarter to quarter and year to year comparisons of our past operating results may not be meaningful. You should not rely on our results for any quarter or year as an indication of our future performance. Our operating results in future quarters and years may be below expectations, which would likely cause the price of our common stock to fall. Our Stock Price Has Been and May Continue to be Volatile and an Investment in Our Common Stock Could Suffer a Decline in Value. The trading price of our common stock has been subject to wide fluctuations in response to a variety of factors, some of which are beyond our control, including quarterly variations in our operating results, announcements by us or our competitors of new products or of significant clinical achievements, changes in market valuations of other similar companies in our industry and general market conditions. In addition, the trading price of our common stock has been significantly adversely affected by our recent operating performance and by liquidity issues. In the fiscal year ended January 2, 2010, the trading price of our common stock fluctuated from a low of $0.55 per share to a high of $3.40 per share. There can be no assurance our common stock trading price will not suffer declines. From time to time, we meet with investors and potential investors. Our common stock may experience an imbalance between supply and demand resulting from low trading volumes. These broad market fluctuations could have a significant impact on the market price of our common stock regardless of our performance. We Are Subject To Government Regulations Which May Cause Us to Delay or Withdraw the Introduction of New Products or New Applications for Our Products. The medical devices that we market and manufacture are subject to extensive regulation by the FDA and by foreign and state governments. Under the Federal Food, Drug and Cosmetic Act and the related regulations, the FDA regulates the design, development, clinical testing, manufacture, labeling, sale, distribution and promotion of medical devices. Before a new device can be introduced into the market, the product must undergo rigorous testing and an extensive regulatory review process implemented by the FDA under federal law. Unless otherwise exempt, a device manufacturer must obtain market clearance through either the 510(k) premarket notification process or the lengthier premarket approval application (PMA) process. Depending upon the type, complexity and novelty of the device and the nature of the disease or disorder to be treated, the FDA process can take several years, require extensive clinical testing and result in significant expenditures. Even if regulatory approval is obtained, later discovery of previously unknown safety issues may result in restrictions on the product, including withdrawal of the product from the market. Other countries also have extensive regulations regarding clinical trials and testing prior to new product introductions. Our failure to obtain government approvals or any delays in receipt of such approvals would have a material adverse effect on our business, results of operations and financial condition. The FDA imposes additional regulations on manufacturers of approved medical devices. We are required to comply with the applicable Quality System regulations and our manufacturing facilities are subject to ongoing periodic inspections by the FDA and corresponding state agencies, including unannounced inspections, and must be licensed as part of the product approval process before being utilized for commercial manufacturing. Noncompliance with the applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, withdrawal of marketing approvals, and criminal prosecution. The FDA also has the authority to request repair, replacement or refund of the cost of any device we manufacture or distribute. Any of these actions by the FDA would materially and adversely affect our ability to continue operating our business and the results of our operations. In addition, we are also subject to varying product standards, packaging requirements, labeling requirements, tariff regulations, duties and tax requirements. As a result of our sales in Europe, we are required to have all products “CE” marked, an international symbol affixed to all products demonstrating compliance with the European Medical Device Directive and all applicable standards. While currently all of our released products are CE marked, continued certification is based on the successful review of our quality system by our European Registrar during their annual audit. Any loss of certification would have a material adverse effect on our business, results of operations and financial condition. If We Fail to Comply With the FDA’s Quality System Regulation and Laser Performance Standards Our Manufacturing Operations Could Be Halted, and Our Business Would Suffer. We are currently required to demonstrate and maintain compliance with the FDA’s Quality System Regulation, or QSR. The QSR is a complex regulatory scheme that covers the methods and documentation of the design, testing, control, manufacturing, labeling, quality assurance, packaging, storage and shipping of our products. Because our products involve the use of lasers, our products also are covered by a performance standard for lasers set forth in FDA regulations. The laser performance standard imposes specific 23 record-keeping, reporting, product testing and product labeling requirements. These requirements include affixing warning labels to laser products, as well as incorporating certain safety features in the design of laser products. The FDA enforces the QSR and laser performance standards through periodic unannounced inspections. We have been, and anticipate in the future being, subject to such inspections. Our failure to take satisfactory corrective action in response to an adverse QSR inspection or our failure to comply with applicable laser performance standards could result in enforcement actions, including a public warning letter, a shutdown of our manufacturing operations, a recall of our products, civil or criminal penalties, or other sanctions, such as those described in the preceding risk factor above, which would cause our sales and business to suffer. If We Modify One of Our FDA Approved Devices, We May Need to Seek Reapproval, Which, if Not Granted, Would Prevent Us from Selling Our Modified Products or Cause Us to Redesign Our Products. Any modifications to an FDA-cleared device that would significantly affect its safety or effectiveness or that would constitute a major change in its intended use would require a new 510(k) clearance or possibly a premarket approval. We may not be able to obtain additional 510(k) clearance or premarket approvals for new products or for modifications to, or additional indications for, our existing products in a timely fashion, or at all. Delays in obtaining future clearance would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would harm our revenues and future profitability. We have made modifications to our devices in the past and may make additional modifications in the future that we believe do not or will not require additional clearance or approvals. If the FDA disagrees, and requires new clearances or approvals for the modifications, we may be required to recall and to stop marketing the modified devices, which could harm our operating results and require us to redesign our products. Because We Do Not Require Training for Users of Our Products, and Sell Our Products to Non-physicians, There Exists an Increased Potential for Misuse of Our Products, Which Could Harm Our Reputation and Our Business. Federal regulations restrict the sale of our products to or on the order of “licensed practitioners.” The definition of “licensed practitioners” varies from state to state. As a result, our products may be purchased or operated by physicians with varying levels of training, and in many states by non-physicians, including nurse practitioners and technicians. Outside the United States, many jurisdictions do not require specific qualifications or training for purchasers or operators of our products. We do not supervise the procedures performed with our products, nor do we require that direct medical supervision occur. We, and our distributors, generally offer but do not require purchasers or operators of our products to attend training sessions. In addition, we sometimes sell our systems to companies that rent our systems to third parties and that provide a technician to perform the procedure. The lack of training and the purchase and use of our products by non-physicians may result in product misuse and adverse treatment outcomes, which could harm our reputation and expose us to costly product liability litigation. Some of Our Laser Systems Are Complex in Design and May Contain Defects That Are Not Detected Until Deployed By Our Customers, Which Could Increase Our Costs and Reduce Our Revenues. Laser systems are inherently complex in design and require ongoing regular maintenance. The manufacture of our lasers, laser products and systems involves a highly complex and precise process. As a result of the technical complexity of our products, changes in our or our suppliers’ manufacturing processes or the inadvertent use of defective materials by us or our suppliers could result in a material adverse effect on our ability to achieve acceptable manufacturing yields and product reliability. To the extent that we do not achieve such yields or product reliability, our business, operating results, financial condition and customer relationships would be adversely affected. We provide warranties on certain of our product sales, and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires us to make estimates of failure rates and expected costs to repair or replace the products under warranty. We currently establish warranty reserves based on historical warranty costs. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of revenues may be required in future periods. Our customers may discover defects in our products after the products have been fully deployed and operated under peak stress conditions. In addition, some of our products are combined with products from other vendors, which may contain defects. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to identify and fix defects or other problems, we could experience, among other things: • loss of customers; • increased costs of product returns and warranty expenses; • damage to our brand reputation; 24 • failure to attract new customers or achieve market acceptance; • diversion of development and engineering resources; and • legal actions by our customers. The occurrence of any one or more of the foregoing factors could seriously harm our business, financial condition and results of operations. Our Products Could Be Subject to Recalls Even After Receiving FDA Approval or Clearance. A Recall Would Harm Our Reputation and Adversely Affect Our Operating Results. The FDA and similar governmental authorities in other countries in which we market and sell our products have the authority to require the recall of our products in the event of material deficiencies or defects in design or manufacture. A government mandated recall, or a voluntary recall by us, could occur as a result of component failures, manufacturing errors or design defects, including defects in labeling. A recall could divert management’s attention, cause us to incur significant expenses, harm our reputation with customers and negatively affect our future sales. If We Fail to Manage Growth Effectively, Our Business Could Be Disrupted Which Could Harm Our Operating Results. We have experienced and may in the future experience growth in our business, both organically and through the acquisition of businesses and products. We have made and expect to continue to make significant investments to enable our future growth through, among other things, new product innovation and clinical trials for new applications and products. We must also be prepared to expand our work force and to train, motivate and manage additional employees as the need for additional personnel arises. Our personnel, systems, procedures and controls may not be adequate to support our future operations. Any failure to effectively manage future growth could have a material adverse effect on our business, results of operations and financial condition. The Requirements of Complying with the Sarbanes-Oxley Act of 2002 Might Strain Our Resources, Which May Adversely Affect Our Business and Financial Condition. We are subject to a number of requirements, including the reporting requirements of the Securities Exchange Act of 1934, as amended, and the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting and that management perform an assessment of internal control over financial reporting. In order to maintain and improve the effectiveness of our disclosure controls and procedures and internal control over financial reporting, significant resources and management oversight will be required. As a result, our management’s attention might be diverted from other business concerns, which could have a material adverse effect on our business, financial condition, and operating results. In addition, we might need to hire additional accounting and financial staff with appropriate public company experience and technical accounting knowledge, and we might not be able to do so in a timely fashion. If Product Liability Claims are Successfully Asserted Against Us, We may Incur Substantial Liabilities That May Adversely Affect Our Business or Results of Operations. We may be subject to product liability claims from time to time. Our products are highly complex and some are used to treat extremely delicate eye tissue and skin conditions on and near a patient’s face. We believe we maintain adequate levels of product liability insurance but product liability insurance is expensive and we might not be able to obtain product liability insurance in the future on acceptable terms or in sufficient amounts to protect us, if at all. A successful claim brought against us in excess of our insurance coverage could have a material adverse effect on our business, results of operations and financial condition. If Our Facilities Were To Experience Catastrophic Loss, Our Operations Would Be Seriously Harmed. Our facilities could be subject to catastrophic loss such as fire, flood or earthquake. All of our research and development activities, manufacturing, our corporate headquarters and other critical business operations are located near major earthquake faults in Mountain View, California. Any such loss at any of our facilities could disrupt our operations, delay production, shipments and revenue and result in large expense to repair and replace our facilities. 25 Our Business is Subject to Environmental Regulations. Our facilities and operations are subject to federal, state and local environmental and occupational health and safety requirements of the United States and foreign countries, including those relating to discharges of substances to the air, water and land the handling, storage and disposal of hazardous materials and wastes and the cleanup of properties affected by pollutants. Failure to maintain compliance with these regulations could have a material adverse effect on our business or financial condition. In the future, federal, state or local governments in the United States or foreign countries could enact new or more stringent laws or issue new or more stringent regulations concerning environmental and worker health and safety matters that could affect our operations. Also, in the future, contamination may be found to exist at our current or former facilities or off-site locations where we have sent wastes. We could be held liable for such newly discovered contamination which could have a material adverse effect on our business or financial condition. In addition, changes in environmental and worker health and safety requirements could have a material adverse effect on our business or financial condition. Item 1. B Unresolved Staff Comments None. Item 2. Properties We lease 37,000 square feet of space in Mountain View, California. This facility is being substantially utilized for all of our manufacturing, research and development efforts and also serves as our corporate headquarters. This facility is utilized for both our ophthalmology medical device segment and our dermatology medical device segment. We also lease 1,722 square feet facility in Lisses, France that is used for sales, service and support. On December 14, 2009, we terminated our lease at Cwmbran, South Wales. Management believes that these facilities are adequate for our current needs and that suitable additional space or an alternative space would be available as needed in the future on commercially reasonable terms. Item 3. Legal Proceedings None Item 4. (Reserved) 26 PART II Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters, and Issuer Purchases of Equity Securities Market Information for Common Equity Our common stock is currently and has been quoted on the NASDAQ Global Market under the symbol “IRIX” and has been since our initial public offering on February 15, 1996. The following table sets forth for the periods indicated the high and low sales prices for our common stock, as reported on the NASDAQ Global Market. Fiscal 2009 Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2008 Fourth Quarter Third Quarter Second Quarter First Quarter High Low $ 3.40 $ 2.05 $ 2.42 $ 1.86 $ 2.55 $ 1.15 $ 1.34 $ 0.55 $ 3.58 $ 0.82 $ 4.29 $ 1.85 $ 2.68 $ 1.49 $ 4.15 $ 1.60 On March 17, 2010 the closing price on the NASDAQ Global Market for our common stock was $4.13 per share. As of March 17, 2010, there were approximately 63 holders of record (not in street name) of our common stock. Because many of our shares of common stock are held by brokers and other institutions on behalf of our stockholders, we are unable to estimate the total number of stockholders represented by these record holders. Dividend Policy We have never paid cash dividends on our common stock. We currently intend to retain any earnings for use in our business and do not anticipate paying cash dividends in the foreseeable future. In addition, the payment of cash dividends to our stockholders is currently prohibited by our credit facility. See Note 8 of Notes to Consolidated Financial Statements. Item 6. Selected Financial Data Not applicable. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview IRIDEX Corporation is a leading worldwide provider of therapeutic based laser systems and delivery devices used to treat eye diseases in ophthalmology and skin conditions in aesthetics. Our products are sold in the United States (US) predominantly through a direct sales force and internationally through approximately 100 independent distributors into 107 countries except for our aesthetics products which are sold, marketed and serviced directly in France. We manage and evaluate our business in two segments – ophthalmology and aesthetics. We further break down these segments by geography – Domestic (US) and International (the rest of the world). In addition, within ophthalmology, we review trends by laser system sales (consoles and durable delivery devices) and recurring sales (single use consumable laser probes (“consumables”), service and support). Our ophthalmology revenues arise primarily from the sale of our OcuLight and IQ laser systems, consumables and revenues from service and support activities. Our current family of OcuLight systems includes the OcuLight TX, the OcuLight Symphony (Laser Delivery System), OcuLight SL, OcuLight SLx, OcuLight GL and OcuLight GLx laser photocoagulation systems as well as the IQ 577 and IQ 810 laser system. We also produce the Millennium Endolase module which is sold exclusively to Bausch & Lomb and incorporated into their Millennium Microsurgical System. 27 Our aesthetics revenues arise primarily from the sales our aesthetics systems and service contracts. Our current family of systems includes the VariLite, DioLite, Gemini, Venus-i, Lyra-i and Aura-i Laser Systems. Sales to international distributors are made on open credit terms or letters of credit and are currently denominated in United States dollars and accordingly, are not subject to risks associated with currency fluctuations. Sales of aesthetics products to end customers from our French subsidiary are denominated in Euros. Cost of revenues consists primarily of the cost of purchasing components and sub-systems, assembling, packaging, shipping and testing components at our facility, direct labor and associated overhead, service and US field service costs and for 2007 and 2008, amortization of intangible assets. Research and development expenses consist primarily of personnel costs, materials to support new product development and research support provided to clinicians at medical institutions developing new applications which utilize our products and regulatory expenses. Research and development costs have been expensed as incurred. Sales and marketing expenses consist primarily of costs of personnel, sales commissions, travel expenses, advertising and promotional expenses. General and administrative expenses consist primarily of costs of personnel, legal, accounting and other public company costs, insurance and other expenses not allocated to other departments. Results of Operations – 2009, 2008 and 2007 Our fiscal year always ends on the Saturday closest to December 31. Fiscal 2009 ended on January 2, 2010, fiscal 2008 ended on January 3, 2009, and fiscal 2007 ended on December 29, 2007. Consequently, fiscal years 2009 and 2007 included 52 weeks of operations while fiscal year 2008 included 53 weeks of operations. The following table sets forth certain operating data as a percentage of revenue for the periods included. Revenues: Product revenues Service revenues Total revenues Cost of revenues Gross margin Operating expenses: Research and development Sales and marketing General and administrative Impairment of goodwill and intangible assets Total operating expense Income (loss) from operations Legal settlement Interest and other expense, net Other income, net Income (loss) before provision for income taxes Provision for income taxes Net income (loss) Percentage of Revenue Years Ended Jan 3, 2009 Jan 2, 2010 Dec 29, 2007 79.0% 21.0 100.0 53.1 46.9 8.4 21.4 11.3 0.0 41.1 5.8 1.8 (0.5) 1.3 7.1 1.1 6.0% 79.3% 20.7 100.0 59.4 40.6 8.2 22.7 14.1 11.1 56.1 (15.5) 1.6 (1.0) 0.6 (14.9) 0.3 (15.2)% 81.9% 18.1 100.0 56.3 43.7 10.4 32.6 17.6 26.5 87.1 (43.4) 4.5 (1.2) 3.3 (40.1) (0.0) (40.1)% 28 Comparison of 2009 and 2008 Revenues. Total revenues for 2009 were $43.2 million compared with $48.5 million in 2008, a decrease of $5.3 million or 11.0%. The decrease in total revenues is primarily due to the global economic environment that has resulted in reduced capital spending in the healthcare industry. The impact has been felt more acutely in our aesthetics business which is largely driven by discretionary spending. We did see an impact on our domestic ophthalmology business on the capital side at the beginning of the year as our customers became very cautious with capital spending although there were signs of a recovery towards the end of the year, and we believe that the number of domestic ophthalmology procedures that use our consumable probe fell during the year. Our international ophthalmology business saw growth as the international markets have been faster to recover from the recession and the weak dollar has provided assistance. Ophthalmology revenues in total decreased $1.4 million or 4.2%, from $32.4 million in 2008 to $31.0 million in 2009. Domestic ophthalmology systems decreased $0.8 million or 13.2%, from $6.0 million to $5.2 million. Ophthalmology recurring revenues consisting of consumables and service decreased $0.5 million or 2.9%, from $17.1 million to $16.6 million. International ophthalmology systems increased $0.4 million or 6.2%, from $7.4 million to $7.8 million. OEM revenues decreased $0.5 million or 27.1%, from $1.9 million to $1.4 million. Our OEM revenue is generated from a long standing relationship and demand for the end user products is decreasing. Aesthetics revenues in total decreased $3.9 million or 24.5%, from $16.1 million in 2008 to $12.2 million in 2009. Service revenues decreased $1.2 million or 16.9%, from $7.1 million to $5.9 million. Domestic aesthetics system revenues increased $0.3 million or 13.4%, from $2.2 million to $2.5 million. International aesthetics system revenues decreased $3.0 million or 44.7%, from $6.8 million to $3.8 million. Gross Profit. Gross profit increased $0.6 million from $19.7 million in 2008 to $20.3 million in 2009. The increase in gross profit is primarily attributable to an improvement in gross margins (from 40.6% to 46.9%) because we are no longer suffering the negative impacts to cost of revenues associated with the amortization of intangible assets, partially offset by a decrease in revenues. . Research and Development. Research and development (R&D) expenses decreased $0.4 million or 10.0%, from $4.0 million in 2008 to $3.6 million in 2009. The decrease is primarily attributable to a reduction in material costs consumed in engineering development projects , offset in part by an increase in salary and employee benefits associated with a headcount increase. Sales and Marketing. Sales and marketing expenses decreased $1.7 million or 15.7%, from $11.0 million in 2008 to $9.3 million in 2009. The decrease is primarily attributable to decreased headcount associated with headcount reductions, decreased amortization expenses for intangible assets, and reductions in advertising and promotion, business travel, and lower commission expenses resulting from lower sales. In addition, at the end of June 2008, we transferred our operating activities in the UK to a third party distributor, which contributed to the decrease in sales and marketing spending subsequent to the transfer. General and Administrative. General and administrative expenses decreased $1.9 million or 28.8%, from $6.8 million in 2008 to $4.9 million in 2009. The decrease is primarily attributable to decreases in audit, accounting, tax and legal fees, and temporary help and consulting. In addition, at the end of June 2008, we transferred our operating activities in the UK to a third party distributor, which contributed to the decrease in general and administrative spending subsequent to the transfer. Legal Settlement and Interest and Other Expense, net. Income from the settlement with Synergetics of legal claims related to patents infringement amounted to $0.8 million for both periods. The Company anticipates receiving an additional $2.4 million in other income from the settlement, to be paid to the Company 29 in three annual installments of $0.8 million on each April 16th until 2012. Interest and other expense, net consisting primarily of interest expense on bank debt, were $0.2 million and $0.5 million for 2009 and 2008, respectively. Income Taxes. We recorded a provision for income taxes of $496 thousand and an effective tax rate of 16% for the year ended January 2, 2010 compared to a provision for income taxes of $127 thousand for the year ended January 3, 2009. The increase in the provision for income taxes was primarily attributable to the increase in taxable income in the U.S. Comparison of 2008 and 2007 Revenues. Total revenues in 2008 were $48.5 million as compared with $55.5 million in 2007, a decrease of $7.0 million or 12.6%. The decrease was directly attributable to the decrease in aesthetics revenues. The decline was primarily due to the global economic environment which significantly affected demand for aesthetic products during fiscal 2008. Ophthalmology revenues in total remained constant. Ophthalmology recurring revenues consisting of consumables and service increased $1.3 million, or 8.4%, from $15.7 million in 2007 to $17.0 million in 2008. Domestic ophthalmology systems decreased $0.3 million, or 4.8%, from $6.3 to $6.0 million. International ophthalmology systems decreased $1.3 million, or 14.9%, from $8.7 million to $7.4 million. OEM revenues increased $0.3 million or 20.3% from $1.6 million to $1.9 million. Aesthetics revenues in total decreased $7.1 million or 30.4%, from $23.2 million in 2007 to $16.1 million in 2008. Service revenues increased $0.1 million or 2.6%, from $7.0 million to $7.1 million. International aesthetics system revenues decreased $3.4 million or 33.4%, from $10.2 million to $6.8 million, domestic aesthetics system revenues decreased $3.8 million or 63.6%, from $6.0 million to $2.2 million. Gross Profit. Gross profit decreased $4.6 million from $24.3 million in 2007 to $19.7 million in 2008. The decrease in gross profit was attributable to the overall reduction in revenues as mentioned above and a reduction in the gross margin obtained on revenues. Gross margin represented 40.6% in 2008 compared with 43.7% of revenues in 2007. Gross margins were negatively impacted by: amortization of intangible assets, 3.8%; expensing of previously capitalized manufacturing overhead costs associated with applying overhead burden to closing inventory, as a consequence of reducing inventory levels during 2008, 2.5%; and increases in inventory reserves, primarily relating to aesthetics inventory, 2.0%. The aggregate impact of these items reduced gross margins by 8.3%. Research and Development. Research and development (R&D) expenses decreased $1.8 million or 30.6%, from $5.8 million in 2007 to $4.0 million in 2008. The decrease was primarily attributable to decreases in salary, benefits, consulting and temporary help and related costs including stock compensation charges of $1.2 million and a reduction of material costs consumed in engineering development projects of $0.3 million as a result of reduced headcount, mostly management and our focus on cost control. Sales and Marketing. Sales and marketing expenses decreased $7.0 million or 39.2%, from $18.0 million in 2007 to $11.0 million in 2008. The decrease in spending, in general, was a result of the Company’s objective to return the Company to operating stability by carefully managing expenses. The decrease in spending was primarily attributable to decreases in salary, benefits, consulting and temporary help and related costs including stock compensation and travel expenses of $2.9 million as a result of a reduction in headcount. Commissions decreased $0.6 million as a result of reduced revenues and marketing expenses decreased $1.8 million. In addition, as a result of transferring the responsibility for sales and service in the UK to an independent distributor, sales and marketing expenses decreased $0.9 million. 30 General and Administrative. General and administrative expenses decreased $3.0 million or 30.4% from $9.8 million in 2007 to $6.8 million in 2008. The decrease in spending was primarily in legal fees, as a result of a settlement of litigation in 2007, which decreased $1.5 million and to decreases in consulting and temporary help and stock compensation of $1.2 million. In addition, as a result of transferring the responsibility for sales and service in the UK to an independent distributor, general and administrative expenses decreased $0.3 million. Impairment of Goodwill and Intangible Assets. In December 2008, in accordance with Impairment or Disposal of Long-Lived Assets Section of the Accounting Standards Codification (“ASC”) Subtopic 360-10, the Company performed its annual impairment test. Based on operating results for 2008 and the outlook for the aesthetics business for 2009 and beyond, management determined there was an impairment loss to goodwill of $3.2 million and goodwill was reduced from $3.2 million to $0. In addition the operating results for 2008 and the outlook for the aesthetics business for 2009 indicated that the carrying amount of the intangible assets may not be recoverable from future undiscounted cash flows. As a result, management tested the intangible assets to determine recoverability and consequently, in December 2008, a write down to the gross carrying value of intangible assets of $2.1 million was recorded reducing the gross carrying value from $8.6 million to $6.5 million. The net carrying value of all intangible assets as of January 3, 2009 was $1.5 million. A similar review was conducted at the end of fiscal 2007. The consequence was to write down goodwill by $6.9 million from $10.1 million to $3.2 million and write down the gross carrying value of the intangible assets by $7.8 million from $16.4 million to $8.6 million in fiscal 2007. Legal Settlement and Interest and Other Expense, net. Income from the settlement with Synergetics of legal claims related to patents infringement amounted to $0.8 million and $2.5 million for 2008 and 2007, respectively. Interest and other expense, net of $0.5 million was primarily interest expense on bank debt. Income Taxes. We recorded a provision for income taxes of $127 thousand and an effective tax rate of 2% for the year ended January 3, 2009 compared to a provision for income taxes of $13 thousand for the year ended December 29, 2007. The increase in the provision for income taxes was primarily attributable to the increase in taxable income in the U.S. Liquidity and Capital Resources Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing or to raise capital. As of January 2, 2010, we had cash and cash equivalents of $9.4 million and working capital of $13.2 million compared with cash and cash equivalents of $5.3 million and working capital of $9.2 million as of January 3, 2009. Net cash provided by operating activities in 2009 was $6.8 million compared with $0.1 million being used in operating activities in 2008. In 2009, the net cash provided by operating activities resulted primarily from the net income generated during 2009 and a reduction in inventories. During 2008 we made repayments to AMS of $6.3 million including interest as a result of the settlement agreement reached in August of 2007. Excluding these payments cash from operations was positive $6.2 million. As of January 3, 2009 all amounts owed to AMS have been repaid. The Company has an asset-based revolving line of credit facility with Wells Fargo Bank. The amount outstanding under the credit facility as of January 2, 2010 was $3.5 million. On March 25, 2010, the Company repaid in full all amounts outstanding under its loan agreement with Wells Fargo Bank and terminated the credit facility. Management is of the opinion that the Company’s current cash and cash equivalents together with our ability to generate cash flows from operations provide sufficient liquidity to operate for the next 12 months. 31 Contractual Payment Obligations Our contractual payment obligations that were fixed and determinable as of January 2, 2010 were as follows: Balance on revolving credit facility Operating leases payments Total contractual cash obligations Critical Accounting Policies 2010 Payments Due by Period ___ 2014 and Total thereafter 0 $ 3,520 $ 3,520 $ $ 3,661 $ 666 $ 690 $ 696 $ 710 $ 899 $ 7,181 $ 4,186 $ 690 $ 696 $ 710 $ 899 2011 2012 2013_ 0 $ 0 $ 0 $ Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, net sales and expenses, and the related disclosures. We base our estimates on historical experience, our knowledge of economic and market factors and various other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies are affected by significant estimates, assumptions, and judgments used in the preparation of our consolidated financial statements. Revenue Recognition. Our revenues arise from the sale of laser consoles, delivery devices, consumables and service and support activities. Revenue from product sales is recognized upon receipt of a purchase order and product shipment provided that no significant obligations remain and collection of the receivables is reasonably assured. Shipments are generally made with Free-On-Board (FOB) shipping point terms, whereby title passes upon shipment from our dock. Any shipments with FOB receiving point terms are recorded as revenue when the shipment arrives at the receiving point. Cost is recognized as product sales revenue is recognized. The Company’s sales may include post-sales obligations for training or other deliverables. For revenue arrangements such as these, we recognize revenue in accordance with the Revenue Recognition, Multiple-Element Arrangements Section of Subtopic ASC 605-25. When the Company has objective and reliable evidence of fair value of the undelivered elements, it defers revenue attributable to the post-sale obligations and recognizes such revenue when the obligation is fulfilled. Otherwise, the Company defers all revenue related to the transaction until all elements are delivered. Revenue relating to extended warranty contracts is recognized on a straight line basis over the period of the applicable warranty contract. We recognize repair service revenue upon completion of the work. Inventories. Inventories are stated at the lower of cost or market and include on-hand inventory physically held at the Company’s facility, sales demo inventory and service loaner inventory. Cost is determined on a standard cost basis which approximates actual cost on a first-in, first-out (FIFO) method. Lower of cost or market is evaluated by considering obsolescence, excessive levels of inventory, deterioration and other factors. Adjustments to reduce the cost of inventory to its net realizable value, if required, are made for estimated excess, obsolescence or impaired inventory and are charged to cost of revenues. Factors influencing these adjustments include changes in demand, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Revisions to these adjustments would be required if these factors differ from our estimates. Sales Returns Allowance and Allowance for Doubtful Accounts. The Company estimates future product returns related to current period product revenue. We analyze historical returns, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns allowance. Significant management judgment and estimates must be made and used in connection with establishing the sales returns allowance in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates. Our provision for sales returns is recorded net of the associated costs. The balance for the provision of sales returns, which is recorded to a deferred revenue account, was $207 thousand and $138 thousand as of January 2, 2010 and January 3, 2009, respectively. Similarly management must make estimates regarding the uncollectability of accounts receivable. We are exposed to credit risk in the event of non-payment by customers to the extent of amounts recorded on the balance sheet. As of January 2, 2010, we had accounts receivable totaling $7.4 million, net of an allowance for doubtful accounts of $0.8 million. As sales levels increase the level of accounts receivable would likely also increase. In addition, in the event that customers were to delay their payments to us, the levels 32 of accounts receivable would likely also increase. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is based on past payment history with the customer, analysis of the customer’s current financial condition, the aging of the accounts receivable balance, customer concentration and other known factors. Warranty. The Company accrues for estimated warranty costs upon shipment of products. Actual warranty costs incurred have not materially differed from those accrued. The Company’s warranty policy is applicable to products which are considered defective in their performance or fail to meet the product specifications. Warranty costs are reflected in the statement of operations as a cost of revenues. Income Taxes. We account for income taxes in accordance with ASC 740, “Income Taxes”, which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Under ASC 740, the liability method is used in accounting for income taxes. Deferred tax assets and liabilities are determined based on the differences between financial reporting and the tax basis of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized. We evaluate annually the realizability of our deferred tax assets by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization include our forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. In 2009 and 2008, we have recorded a full valuation allowance for our deferred tax assets based on our past losses and uncertainty regarding our ability to project future taxable income. In future periods if we are able to generate income we may reduce or eliminate the valuation allowance. Accounting for Uncertainty in Income Taxes. In December 2006, the Company adopted Financial Accounting Standards Interpretation, or FIN No. 48 (“ASC 740-10-25”), Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (as codified in ASC topic 740, Income Taxes (“ASC 740-10”)). ASC 740-10-25 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in a company’s income tax return, and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. ASC 740-10-25 utilizes a two-step approach for evaluating uncertain tax positions. Step one, recognition, requires a company to determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. Step two, measurement, is based on the largest amount of benefit, which is more likely than not to be realized on ultimate settlement. The cumulative effect of adopting ASC 740-10-25 on December 31, 2006 is recognized as a change in accounting principle, recorded as an adjustment to the opening balance of retained earnings on the adoption date. As a result of the implementation of ASC 740-10-25, the Company recognized no change in the liability for unrecognized tax benefits related to tax positions taken in prior periods. Upon adoption of ASC 740-10-25, the Company’s policy to include interest and penalties related to unrecognized tax benefits within the Company’s provision for (benefit from) income taxes did not change. Accounting for Stock-Based Compensation. We record compensation costs of share-based awards, options and purchases of our common stock pursuant to our employee stock purchase plan in accordance with ASC 718, "Stock Compensation" (formerly referred to as SFAS No. 123(R)). Stock-based compensation expense recognized in the years ended January 2, 2010, January 3, 2009, and December 29, 2007, included stock-based compensation expense for share-based awards granted subsequent to January 1, 2006, based on the fair value on the grant date estimated in accordance with the provisions of ASC 718. In conjunction with the adoption of ASC 718, we changed our method of attributing the value of stock-based compensation expense from the accelerated multiple-option method to the straight-line single option method. Stock-based compensation expense for all share-based awards granted prior to January 1, 2006 will continue to be recognized using the accelerated multiple-option approach, while stock-based compensation expense for all share-based awards granted subsequent to December 30, 2005 will be recognized using the straight-line single option method. ASC 718 requires that we recognize expense for awards ultimately expected to vest; therefore we are required to develop an estimate of the number of awards expected to cancel prior to vesting (forfeiture rate). The forfeiture rate is estimated based on historical pre-vest cancellation experience and is applied to all share-based awards. ASC 718 requires the forfeiture rate to be estimated at the time of grant and revised, if 33 necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to fiscal year 2006, we accounted for forfeitures as they actually occurred. Upon adoption of ASC 718, we selected the Black-Scholes option pricing model as the most appropriate method for determining the estimated fair value for stock options and ESPP Shares. The Black-Scholes model requires the use of highly subjective and complex assumptions which determine the fair value of share-based awards, including the option’s expected term and the price volatility of the underlying stock. For restricted stock or restricted stock units, stock-based compensation expense is calculated based on the fair market value of our stock on the date of grant. Recently Issued and Adopted Accounting Standards In February 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements. The amendments in the ASU remove the requirement for a Securities and Exchange Commission (SEC) filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements. In October 2009, the Financial FASB issued FASB Accounting Standards Update 2009-13. FASB Accounting Standards Update 2009-13 addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. Specifically, this guidance amends the criteria in the “Revenue Recognition – Multiple-Element Arrangements” subtopic of the Codification for separating consideration in multiple-deliverable arrangements. 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 estimates 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. FASB Accounting Standards Update 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with the option to provide retrospective presentation for prior years. Early adoption is permitted. The Company does not expect the adoption of FASB Standards Update 2009-13 will have a material impact on the Company’s Consolidated Financial Statements. In June 2009, the FASB issued Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — A Replacement of FASB Statement No. 162 (as codified in the FASB Accounting Standards CodificationTM (“ASC” or “Codification”) topic 105, Generally Accepted Accounting Principles (“ASC 105”)). This update to ASC 105 establishes the Codification as the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. This update to ASC 105 and the Codification are effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification supersedes all existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification has become non-authoritative. Following this update to ASC 105, the FASB will not issue new standards in the form of Statements, FASB Staff Positions (“FSP”), or Emerging Issues Task Force (“EITF”) Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to: (a) update the Codification; (b) provide background information about the guidance; and (c) provide the basis for conclusions on the change(s) in the Codification. The Company adopted the requirements of this standard for the quarter ended October 3, 2009. The adoption of this update to ASC 105 did not have a material impact on the Company’s Consolidated Financial Statements. In May 2009, the FASB issued SFAS No. 165, Subsequent Events (as codified in ASC topic 855, Subsequent Events (“ASC 855”)). This update to ASC 855 sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. The Company adopted the requirements of this standard as of July 4, 2009. The adoption of this update to ASC 855 did not have a material impact on the Company’s Consolidated Financial Statements. In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (as codified in ASC topic 825, Financial Instruments (“ASC 825”)). This update to ASC 825 requires companies to disclose in interim financial statements the fair value of financial instruments within the scope of ASC 825. However, companies are not required to provide in interim periods the disclosures about the concentration of credit risk of all financial instruments that are currently required in annual financial statements. The fair-value information disclosed in the footnotes must be presented together with the related 34 carrying amount, making it clear whether the fair value and carrying amount represent assets or liabilities and how the carrying amount relates to what is reported in the balance sheet. This update to ASC 825 also requires that companies disclose the method or methods and significant assumptions used to estimate the fair value of financial instruments and a discussion of changes, if any, in the method or methods and significant assumptions during the period. The Company adopted the requirements of this standard as of July 4, 2009. The adoption of this update to ASC 825 did not have a material impact on the Company’s Consolidated Financial Statements. Off-Balance Sheet Arrangements The Company has no off-balance sheet arrangements. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Market risk represents the risk of loss that may impact the financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We transact the majority of our business in US dollars and therefore changes in foreign currency rates will not have a significant impact on our income statement or cash flows. However, increases in the value of the US dollar against any local currencies could cause our products to become relatively more expensive to customers in a particular country or region, leading to reduced revenue or profitability in that country or region. As we continue to expand our international sales, our non-US dollar denominated revenue and our exposure to gains and losses on international currency transactions may increase. Our French subsidiary does transact business in its local geography in Euros. We currently do not engage in transactions to hedge against the risk of the currency fluctuation, but we may do so in the future. The Company currently requires debt to fund its operations and movements in the credit markets will impact the availability and the cost of this funding. Item 8. Financial Statements and Supplementary Data. Our consolidated balance sheets as of January 2, 2010 and January 3, 2009 and the consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for each of the three years ending in the period January 2, 2010, January 3, 2009, and December 29, 2007 together with the related notes and the report of our independent auditors, are on the following pages. Additional required financial information is described in Item 15. 35 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of IRIDEX Corporation We have audited the accompanying consolidated balance sheets of IRIDEX Corporation as of January 2, 2010 and January 3, 2009, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three year period ended January 2, 2010. Our audits also included the financial statement schedule listed in Item 15(a)(2). IRIDEX Corporation’s management is responsible for these consolidated financial statements and financial statement schedule. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of IRIDEX Corporation as of January 2, 2010 and January 3, 2009, and the results of its operations and its cash flows for each of the years in the three year period ended January 2, 2010 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, as of and for the years ended January 2, 2010, January 3, 2009 and December 29, 2007, when considered in relation to the consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Burr Pilger Mayer, Inc. San Francisco, California March 31, 2010 36 IRIDEX Corporation CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data) ASSETS Current assets: Cash and cash equivalents Accounts receivable, net of allowance for doubtful accounts of $754 in 2009 and $909 in 2008 Inventories, net Prepaids and other current assets Total current assets Property and equipment, net Other intangible assets, net Other long term assets Total assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable Bank line of credit Accrued compensation Accrued expenses Accrued warranty Deferred revenue Total current liabilities Long Term Liabilities: Deferred rent Total liabilities Commitments and contingencies (Note 9) Stockholders’ equity: Convertible preferred stock, $.01 par value: Authorized: 2,000,000 shares; Issued and outstanding: 500,000 shares in 2009 and 2008 Common stock, $.01 par value: Authorized: 30,000,000 shares; Issued and outstanding: 8,848,360 shares in 2009 and 8,824,301 shares in 2008 Additional paid-in capital Accumulated other comprehensive loss Treasury stock, at cost Accumulated deficit Total stockholders’ equity Total liabilities and stockholders’ equity The accompanying notes are an integral part of these consolidated financial statements. January 2, 2010 January 3, 2009 $ 9,378 $ 5,307 8,199 7,482 11,644 8,999 470 540 25,690 26,329 486 832 1,153 1,474 323 229 $ 28,291 $ 28,225 $ 1,872 $ 2,415 6,000 3,520 1,729 2,171 2,249 1,983 1,345 1,165 2,405 2,741 16,479 13,116 149 13,265 - 16,479 5 5 89 89 39,105 39,820 (212) (192) (430) (430) (24,246) (26,831) 15,026 11,746 $ 28,291 $ 28,225 37 IRIDEX Corporation CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) Revenues: Product revenues Service revenues Total revenues Cost of revenues Gross profit Operating expenses: Research and development Sales and marketing General and administrative Impairment of goodwill and intangible assets Total operating expenses Income (loss) from operations Other income and expenses: Legal settlement Interest and other expense, net Income (loss) before provision for income taxes Provision for income taxes Net income (loss) Net income (loss) per common share - basic Net income (loss) per common share - diluted Year Ended January 2, 2010 Year Ended January 3, 2009 Year Ended December 29, 2007 $ 34,121 9,091 43,212 22,939 20,273 $ 38,462 10,066 48,528 28,849 19,679 $ 45,502 10,030 55,532 31,248 24,284 3,609 9,273 4,873 - 17,755 4,009 10,998 6,844 5,364 27,215 5,779 18,098 9,832 14,690 48,399 2,518 (7,536) (24,115) 800 (237) 3,081 800 (507) (7,243) 2,500 (644) (22,259) 496 127 13 $ 2,585 $ (7,370) $ (22,272) $ 0.29 $ 0.26 $ (0.84) $ (0.84) $ (2.69) $ (2.69) Shares used in computing net income (loss) per common share - basic Shares used in computing net income (loss) per common share - diluted 8,840 9,940 8,824 8,824 8,293 8,293 IRIDEX Corporation CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (in thousands) Net income (loss) Foreign currency translation adjustments Comprehensive income (loss) Year Ended January 2, 2010 $ 2,585 (20) $ 2,565 Year Ended January 3, 2009 $ (7,370) (104) $ ($7,474) Year Ended December 29, 2007 $(22,272) (88) $(22,360) . The accompanying notes are an integral part of these consolidated financial statements. 38 IRIDEX Corporation CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Operating activities: Net income (loss) Adjustments to reconcile net loss to net cash used in operating activities: Loss on disposal of assets Depreciation and amortization Impairment of goodwill and intangible assets Stock compensation cost recognized Tax effect of stock compensation expense Provision for doubtful accounts Provision for inventory reserves Changes in operating assets and liabilities net of assets and liabilities acquired: Accounts receivable Inventories Prepaids and other current assets Other long term assets Accounts payable Accrued compensation Accrued expenses and deferred rent Accrued warranty Deferred revenue Net cash provided by (used in) operating activities Investing activities: Business acquisition cost Acquisition of property and equipment Purchases of intangible assets Net cash used in investing activities Cash flows from financing activities: Proceeds from issuance of common stock Proceeds from issuance of preferred stock and warrants, net of offering costs Proceeds of credit facility, net of issuing costs Proceeds from borrowings Repayment of borrowings Release (restriction) of funds under debt facility Net cash provided by (used in) financing activities Year Ended January 2, 2010 Year Ended January 3, 2009 Year Ended December 29, 2007 $ 2,585 $ (7,370) $ (22,272) — 899 — 360 350 126 (138) 136 3,221 5,364 322 88 208 1,442 591 2,783 70 (94) (543) 442 (117) (180) (336) 6,798 469 2,881 511 118 (472) (295) (5,560) (550) (609) (96) — 3,818 14,690 1,230 — 140 3,017 2,211 (6,676) 608 (194) 282 (640) 3,782 (742) 224 (522) — (232) — (232) (25,530) — (223) (776) — (171) (26,477) (223) 5 — — 42,308 (44,788) — (2,475) — — — 44,777 (48,656) 3,800 (79) 881 4,888 11,900 — (2,021) (3,800) 11,848 Effect of foreign exchange rate changes (20) (104) (91) Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Supplemental disclosure of cash flow information: Cash paid during the year for: Income taxes Interest paid Stock issued in acquisition 4,071 5,307 $ 9,378 $ (502) 5,809 5,307 (15,242) 21,051 5,809 $ $ 160 $ 242 — $ 20 $ $ 4 $ 691 $ 855 $ 2,014 $ — The accompanying notes are an integral part of these consolidated financial statements. 40 IRIDEX Corporation Notes to Consolidated Financial Statements 1. Business of the Company Description of Business. IRIDEX Corporation is a worldwide provider of therapeutic-based laser systems and delivery devices used to treat eye diseases in ophthalmology and skin conditions in dermatology (also referred to as aesthetics). Our products are sold in the United States predominately through a direct sales force and internationally through approximately 100 independent distributors into 107 countries. 2. Summary of Significant Accounting Policies Financial Statement Presentation. The consolidated financial statements include the accounts of IRIDEX Corporation and our wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Except as noted below, the Company has determined that the local currency of the country where the subsidiary is located is the functional currency for those foreign operations. Assets and liabilities were translated into their US dollar equivalent using the spot rate at the balance sheet date. Operating results were translated using average exchange rates for the period. Accordingly, translation adjustments for foreign subsidiaries are included as a component of accumulated other comprehensive loss. The Company’s UK subsidiary ceased operating activities in the third fiscal quarter of 2008. An independent distributor took over the responsibility for sales and service of our aesthetics products in the UK. Consequently at the start of the fourth quarter of 2008 in accordance with Financial Statements of an Equity Method Investee Impairment of Section of Subtopic ASC 830-15-5, management determined that the primary economic environment in which the entity was operating had changed to the US dollar and therefore the functional currency was changed to the US dollar. Effective at the start of the fourth quarter of 2008, non-monetary assets and liabilities were translated into their US dollar equivalent at the historical rate. Monetary assets and liabilities were translated at a spot rate at the balance sheet date, and the operating results were translated using average exchange rates for the period. Translation adjustments are included in “Interest and other (expense) income, net” in the period in which they occur. Our fiscal year always ends on the Saturday closest to December 31. Fiscal 2009 ended on January 2, 2010, fiscal 2008 ended on January 3, 2009, and fiscal 2007 ended on December 29, 2007. Consequently, fiscal 2009 and fiscal 2007 included 52 weeks of operations while fiscal year 2008 included 53 weeks. Use of Estimates. The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses and the related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent form other sources. Actual results may differ from these estimates. In addition, any change in these estimates or their related assumptions could have an adverse effect on our operating results. Cash and Cash Equivalents. We consider all highly liquid debt instruments with insignificant interest rate risk and an original maturity of three months or less when purchased to be cash equivalents. Cash equivalents consist primarily of cash deposits in money market funds that are available for withdrawal without restriction. Fair Value of Financial Instruments. ASC 820, “Fair Value Measurements and Disclosures” clarifies the definition of fair value of assets and liabilities, establishes a framework for measuring fair value of assets and liabilities and expands the disclosures on fair value measurements. The Fair Value Measurements and Disclosures topic was effective for fiscal years beginning after November 15, 2007 for financial assets. The FASB deferred the effective date until the fiscal years beginning after November 15, 2008 as it relates to the fair value measurement requirements for nonfinancial assets and liabilities that are initially measured at fair value, but not measured at fair value in subsequent periods. These non-financial assets include goodwill and other indefinite-lived intangible assets which are included within other assets. 41 The Company adopted the provisions of the Fair Value Measurements and Disclosures topic with respect to financial assets and liabilities effective December 30, 2007 and with respect to non-financial assets and liabilities effective January 4, 2009. The adoption of the provisions of the Fair Value Measurements and Disclosures topic did not have a material impact on the Company’s consolidated financial statements. The fair value framework requires the categorization of assets and liabilities into three levels based upon the assumptions used to price the assets or liabilities. Level 1 provides the most reliable measure of fair value, whereas Level 3, if applicable, generally would require significant management judgment. The three levels for categorizing assets and liabilities fair value measurements are as follows: • • • Level 1: Fair valuing the asset or liability using observable inputs, such as quoted prices in active markets for identical assets or liabilities; Level 2: Fair valuing the asset or liability using inputs other than quoted prices that are observable for the applicable asset or liability, either directly or indirectly, such as quoted prices for similar (as opposed to identical) assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active; and Level 3: Fair valuing the asset or liability using unobservable inputs that reflect the Company’s own assumptions regarding the applicable asset or liability. At January 2, 2010, the Company had $9.4 million in cash and cash equivalents. Of this amount, approximately $6.3 million were in money market funds whose fair market value was obtained from real-time quotes for transactions in active markets involving identical assets. At January 2, 2010, the Company had $3.5 million outstanding against its bank line of credit with Wells Fargo Bank. The book value of this bank line of credit approximates fair value due to its floating rate nature. The Company did not have any Level 3 assets or liabilities at January 2, 2010. Sales Returns Allowance and Allowance for Doubtful Accounts. The Company estimates future product returns related to current period product revenue. We analyze historical returns, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns allowance. Significant management judgment and estimates must be made and used in connection with establishing the sales returns allowance in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates. Our provision for sales returns is recorded net of the associated costs. The balance for the provision of sales returns, which is recorded to a deferred revenue account, was $207 thousand and $138 thousand as of January 2, 2010 and January 3, 2009, respectively. Similarly management must make estimates regarding the uncollectability of accounts receivable. We are exposed to credit risk in the event of non-payment by customers to the extent of amounts recorded on the balance sheet. As of January 2, 2010, we had accounts receivable totaling $7.4 million, net of an allowance for doubtful accounts of $0.8 million. As of January 3,2009, we had accounts receivable totaling $8.2 million, net of an allowance for doubtful accounts of $0.9 million. As sales levels change the level of accounts receivable would likely also change. In addition, in the event that customers were to delay their payments to us, the levels of accounts receivable would likely increase. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is based on past payment history with the customer, analysis of the customer’s current financial condition, the aging of the accounts receivable balance, customer concentration and other known factors. Inventories. Inventories are stated at the lower of cost or market and include on-hand inventory physically held at the Company’s facility, sales demo inventory and service loaner inventory. Cost is determined on a standard cost basis which approximates actual cost on a first-in, first-out (FIFO) method. Lower of cost or market is evaluated by considering obsolescence, excessive levels of inventory, deterioration and other factors. Adjustments to reduce the cost of inventory to its net realizable value, if required, are made for estimated excess, obsolescence or impaired inventory and are charged to cost of revenues. Factors influencing these adjustments include changes in demand, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Revisions to these adjustments would be required if these factors differ from our estimates. As part of our normal business, we generally utilize various finished goods inventory as either sales demos to facilitate the sale of our products to prospective customers, or as loaners that we allow our existing customers to use while we repair their products. The Company is amortizing these demos and loaners over four years. The amortization of the demos is charged to sales expense while the 42 amortization on the loaners is charged to cost of revenues. The gross value of demos and loaners was $1.7 million and $3.1 million and the accumulated amortization was $1.1 million and $2.1 million as of January 2, 2010 and January 3, 2009, respectively. Property and Equipment. Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided on a straight–line basis over the estimated useful lives of the assets, which is generally three years. Our net property and equipment was $0.5 million at the end of fiscal 2009 and $0.8 million at the end of fiscal 2008. We invested $0.2 million in property and equipment in 2009 compared to $0.2 million in 2008. Capital expenditures in fiscal 2009 have been primarily for software and computer equipment and in fiscal 2008, primarily for engineering, manufacturing and office equipment. Valuation of Goodwill and Intangible Assets. The purchase method of accounting for acquisitions requires estimates and assumptions to allocate the purchase price to the fair value of net tangible and intangible assets acquired. The amounts allocated to, and the useful lives estimated for, intangible assets, affect future amortization. There are a number of generally accepted valuation methods used to estimate fair value of intangible assets, and we use primarily a discounted cash flow method, which requires significant management judgment to forecast the future operating results and to estimate the discount factors used in the analysis. Purchased intangible assets were initially recorded in the first quarter of 2007 in conjunction with the acquisition of the aesthetics business of Laserscope. We review our intangible assets for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. An asset is considered impaired if its carrying amount exceeds the future non-discounted net cash flow the asset is expected to generate. If an asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. On an annual basis, the Company conducts an impairment analysis in accordance with Impairment or Disposal of Long-Lived Assets Section of ASC Subtopic 360-10. See Note 6 of Notes to Consolidated Financial Statements. Goodwill and intangible assets determined to have indefinite lives are not amortized, but are subject to an annual impairment test. To determine any goodwill impairment, a two-step process is performed on an annual basis, or more frequently if necessary, to determine 1) whether the fair value of the relevant reporting unit exceeds carrying value and 2) to measure the amount of an impairment loss, if any. Goodwill was initially recorded in the first quarter of 2007 in conjunction with the acquisition of the aesthetics business of Laserscope. On an annual basis, the Company conducts an impairment analysis in accordance with ASC 350, "Intangibles—Goodwill and Other". See Note 6 of Notes to Consolidated Financial Statements. Future changes in events or circumstances, such as an inability to achieve the cash flow forecasts determined above, may indicate that the recorded value of the intangible assets will not be recovered through future cash flows and the Company may be required to record an additional impairment charge and/or the intangible assets and or further modify the period of expected lives for the intangible assets. Revenue Recognition. Our revenues arise from the sale of laser consoles, delivery devices, consumables and service and support activities. Revenue from product sales is recognized upon receipt of a purchase order and product shipment provided that no significant obligations remain and collection of the receivables is reasonably assured. Shipments are generally made with Free-On-Board (FOB) shipping point terms, whereby title passes upon shipment from our dock. Any shipments with FOB receiving point terms are recorded as revenue when the shipment arrives at the receiving point. Cost is recognized as product sales revenue is recognized. The Company’s sales may include post-sales obligations for training or other deliverables. For revenue arrangements such as these, we recognize revenue in accordance with the Revenue Recognition, Multiple-Element Arrangements Section of Subtopic ASC 605-25. When the Company has objective and reliable evidence of fair value of the undelivered elements, it defers revenue attributable to the post-sale obligations and recognizes such revenue when the obligation is fulfilled. Otherwise, the Company defers all revenue related to the transaction until all elements are delivered. Revenue relating to service contracts is recognized on a straight line basis over the period of the applicable service contract. We recognize repair service revenue upon completion of the work. In international regions outside of France, we utilize distributors to market and sell our products. We recognize revenue upon shipment for sales to these independent, third party distributors as we have no continuing obligations subsequent to shipment. Generally our distributors are responsible for all marketing, sales, installation, training and warranty labor coverage for our products. Our standard terms and conditions do not provide price protection or stock retention rights to any of our distributors. 43 Deferred Revenue. Revenue related to service contracts is deferred and recognized on a straight line basis over the period of the applicable service period. Costs associated with these service arrangements are recognized as incurred. A reconciliation of the changes in the Company’s deferred revenue balances for the years ended January 2, 2010 and January 3, 2009 is provided as follows (in thousands): Balance, December 29, 2007 Additions to deferral Revenue recognized Balance, January 3, 2009 Additions to deferral Revenue recognized Balance, January 2, 2010 Warranty. $ 3,350 6,679 (7,288) $ 2,741 6,101 (6,437) $ 2,405 The Company accrues for estimated warranty costs upon shipment of products. Actual warranty costs incurred have not materially differed from those accrued. The Company’s warranty policy is applicable to products which are considered defective in their performance or fail to meet the product specifications. Warranty costs are reflected in the statement of operations as a cost of revenues. A reconciliation of the changes in the Company’s warranty liability for the years ended January 2, 2010 and January 3, 2009, is provided as follows (in thousands): Balance, December 29, 2007 Accruals for product warranties Cost of warranty claims Balance, January 3, 2009 Accruals for product warranties Cost of warranty claims Balance, January 2, 2010 Shipping and handling costs. $ 1,895 224 (774) $ 1,345 179 (359) $ 1,165 Our shipping and handling costs billed to customers are included in revenues and the associated expense is recorded in cost of revenues for all periods presented. Shipping and handling costs amounted to $0.3 million, $0.4 million and $0.3 million for the years ended January 2, 2010, January 3, 2009 and December 29, 2007, respectively. Research and Development. Research and development expenditures are charged to operations as incurred. Advertising. Advertising and promotion costs are expensed as they are incurred; such costs were approximately $350 thousand in 2009, $322 thousand in 2008, and $479 thousand in 2007 and are included in sales and marketing expenses in the accompanying consolidated statements of operations. Income Taxes. We account for income taxes in accordance with ASC 740, “Income Taxes”, which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Under ASC 740, the liability method is used in accounting for income taxes. Deferred tax assets and liabilities are determined based on the differences between financial reporting and the tax basis of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized. We evaluate annually the realizability of our deferred tax assets by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization include our forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. In 2009 and 2008, we have recorded a full valuation allowance for our deferred tax assets based on our past losses and uncertainty regarding our ability to project future taxable income. In future periods if we are able to generate income we may reduce or eliminate the valuation allowance. 44 Accounting for Uncertainty in Income Taxes. In December 2006, the Company adopted Financial Accounting Standards Interpretation, or FIN No. 48 (“ASC 740-10-25”), Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (as codified in ASC topic 740, Income Taxes (“ASC 740-10”)). ASC 740-10-25 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in a company’s income tax return, and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. ASC 740-10-25 utilizes a two-step approach for evaluating uncertain tax positions. Step one, recognition, requires a company to determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. Step two, measurement, is based on the largest amount of benefit, which is more likely than not to be realized on ultimate settlement. The cumulative effect of adopting ASC 740-10-25 on December 31, 2006 is recognized as a change in accounting principle, recorded as an adjustment to the opening balance of retained earnings on the adoption date. As a result of the implementation of ASC 740-10-25, the Company recognized no change in the liability for unrecognized tax benefits related to tax positions taken in prior periods. Upon adoption of ASC 740-10-25, the Company’s policy to include interest and penalties related to unrecognized tax benefits within the Company’s provision for (benefit from) income taxes did not change. Accounting for Stock-Based Compensation. We record compensation costs of share-based awards, options and purchases of our common stock pursuant to our employee stock option plan in accordance with ASC 718, "Stock Compensation". Stock-based compensation expense recognized in the years ended January 2, 2010, January 3, 2009, and December 29, 2007, included stock-based compensation expense for share-based awards granted subsequent to January 1, 2006, based on the fair value on the grant date estimated in accordance with the provisions of ASC 718. In conjunction with the adoption of ASC 718, we changed our method of attributing the value of stock-based compensation expense from the accelerated multiple-option method to the straight-line single option method. Stock-based compensation expense for all share-based awards granted prior to January 1, 2006 will continue to be recognized using the accelerated multiple-option approach, while stock-based compensation expense for all share-based awards granted subsequent to December 30, 2005 will be recognized using the straight-line single option method. ASC 718 requires that we recognize expense for awards ultimately expected to vest; therefore we are required to develop an estimate of the number of awards expected to cancel prior to vesting (forfeiture rate). The forfeiture rate is estimated based on historical pre-vest cancellation experience and is applied to all share-based awards. ASC 718 requires the forfeiture rate to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to fiscal year 2006, we accounted for forfeitures as they actually occurred. We determined that the Black-Scholes option pricing model is the most appropriate method for determining the estimated fair value for stock options and ESPP Shares. The Black-Scholes model requires the use of highly subjective and complex assumptions which determine the fair value of share-based awards, including the option’s expected term and the price volatility of the underlying stock. For restricted stock or restricted stock units, stock-based compensation expense is calculated based on the fair market value of our stock on the date of grant. Concentration of Credit Risk and Other Risks and Uncertainties. The Company’s cash and cash equivalents are deposited in demand and money market accounts of three financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally these deposits may be redeemed upon demand and therefore, bear minimal risk. The Company markets its products to distributors and end-users throughout the world. Sales to international distributors are generally made on open credit terms and letters of credit. Management performs ongoing credit evaluations of our customers and maintains an allowance for potential credit losses. Historically, the Company has not experienced any significant losses related to individual customers or a group of customers in any particular geographic area. For the years ended January 2, 2010, January 3, 2009, and December 29, 2007 no single customer accounted for greater than 10% of total sales. One customer accounted for 13.7% of our accounts receivables, net balance as of December 29, 2007. No single customer accounted for more than 10% of our accounts receivable, net balance, as of January 2, 2010 and January 3, 2009. The Company’s products require approvals from the Food and Drug Administration and international regulatory agencies prior to commercialized sales. The Company’s future products may not receive required approvals. If the Company were denied such approvals, or if such approvals were delayed, it would have a materially adverse impact on the Company’s business, results of operations and financial condition. 45 Reliance on Certain Suppliers. Certain components and services used by the Company to manufacture and develop its products are presently available from only one or a limited number of suppliers or vendors. The loss of any of these suppliers or vendors would potentially require a significant level of hardware and/or software development efforts to incorporate the products or services into the Company’s products. Net income (loss) per Share. Net income (loss) per share is computed in accordance with ASC topic 260, Earnings per Share. Basic net income (loss) per share is based upon the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is based upon the weighted average number of common shares outstanding and dilutive common stock equivalents outstanding during the period. Common stock equivalents consist of incremental common shares issuable upon the exercise of stock options and the conversion of Series A Preferred Stock into common stock and are calculated under the treasury stock method. Common stock equivalent shares from unexercised stock options and the conversion of Series A Preferred Stock are excluded from the computation for periods in which the Company incurs a loss as their effect is anti-dilutive or if the exercise price of such options is greater than the average market price of the stock for the period. See Note 14 of the Consolidated Financial Statements. Recently Issued and Adopted Accounting Standards. In February 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements. The amendments in the ASU remove the requirement for a Securities and Exchange Commission (SEC) filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements. In October 2009, the Financial FASB issued FASB Accounting Standards Update 2009-13. FASB Accounting Standards Update 2009-13 addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. Specifically, this guidance amends the criteria in the “Revenue Recognition – Multiple-Element Arrangements” subtopic of the Codification for separating consideration in multiple-deliverable arrangements. 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 estimates 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. FASB Accounting Standards Update 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with the option to provide retrospective presentation for prior years. Early adoption is permitted. The Company does not expect the adoption of FASB Standards Update 2009-13 will have a material impact on the Company’s Consolidated Financial Statements. In June 2009, the FASB issued Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — A Replacement of FASB Statement No. 162 (as codified in the FASB Accounting Standards CodificationTM (“ASC” or “Codification”) topic 105, Generally Accepted Accounting Principles (“ASC 105”)). This update to ASC 105 establishes the Codification as the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. This update to ASC 105 and the Codification are effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification supersedes all existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification has become non-authoritative. Following this update to ASC 105, the FASB will not issue new standards in the form of Statements, FASB Staff Positions (“FSP”), or Emerging Issues Task Force (“EITF”) Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to: (a) update the Codification; (b) provide background information about the guidance; and (c) provide the basis for conclusions on the change(s) in the Codification. The Company adopted the requirements of this standard for the quarter ended October 3, 2009. The adoption of this update to ASC 105 did not have a material impact on the Company’s Consolidated Financial Statements. In May 2009, the FASB issued SFAS No. 165, Subsequent Events (as codified in ASC topic 855, Subsequent Events (“ASC 855”)). This update to ASC 855 sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. The 46 Company adopted the requirements of this standard as of July 4, 2009. The adoption of this update to ASC 855 did not have a material impact on the Company’s Consolidated Financial Statements. In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (as codified in ASC topic 825, Financial Instruments (“ASC 825”)). This update to ASC 825 requires companies to disclose in interim financial statements the fair value of financial instruments within the scope of ASC 825. However, companies are not required to provide in interim periods the disclosures about the concentration of credit risk of all financial instruments that are currently required in annual financial statements. The fair-value information disclosed in the footnotes must be presented together with the related carrying amount, making it clear whether the fair value and carrying amount represent assets or liabilities and how the carrying amount relates to what is reported in the balance sheet. This update to ASC 825 also requires that companies disclose the method or methods and significant assumptions used to estimate the fair value of financial instruments and a discussion of changes, if any, in the method or methods and significant assumptions during the period. The Company adopted the requirements of this standard as of July 4, 2009. The adoption of this update to ASC 825 did not have a material impact on the Company’s Consolidated Financial Statements. 3. Inventories The components of the Company’s inventories are as follows (in thousands): Raw materials and work in process Finished goods Total inventories 4. Property and Equipment The components of the Company’s property and equipment are as follows (in thousands): Equipment Leasehold improvements Less: accumulated depreciation and amortization Property and equipment, net January 2, 2010 $ 5,069 3,930 $ 8,999 January 3, 2009 $ 7,753 3,891 $ 11,644 January 2, 2010 $ 6,610 2,236 (8,360) $ 486 January 3, 2009 $ 6,526 2,236 (7,930) 832 $ Depreciation expense related to property and equipment was $578 thousand, $876 thousand, and $926 thousand for the years ended January 2, 2010, January 3, 2009, and December 29, 2007. 5. Goodwill The carrying value of goodwill was $0.0 million at January 2, 2010 and January 3, 2009. Change in goodwill for the year ended January 3, 2009 is presented in the following table (in thousands): Balance, beginning of period Goodwill as a result of acquisition Impairment of goodwill Balance, end of period January 2, 2010 $ - - - $ - January 3, 2009 $ 3,239 - (3,239) $ - We tested for impairment of goodwill in the fourth quarter 2008. The fair value of the reporting unit was calculated using a combination of three methods: Income Approach – discounted cash flow method; Market Approach – guideline public company method; and Cost Approach. As a result of the contraction in the global aesthetics market, operating profits and cash flows for 2008 were lower than expected and the outlook was revised downwards. Consequently the Company determined that the carrying value of the reporting unit exceeded the fair value by $3.2 million; accordingly an impairment loss of that amount was recognized and is included within the statement of operations as impairment of goodwill and intangibles. 47 6. Intangible Assets The purchase method of accounting for acquisitions requires estimates and assumptions to allocate the purchase price to the fair value of net tangible and intangible assets acquired. The amounts allocated to, and the useful lives estimated for, intangible assets, affect future amortization. There are a number of generally accepted valuation methods used to estimate fair value of intangible assets, and we use primarily a discounted cash flow method, which requires significant management judgment to forecast the future operating results and to estimate the discount factors used in the analysis. An asset is considered impaired if its carrying amount exceeds the value of future net cash flow the asset is expected to generate. If an asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. Purchased intangible assets were initially recorded in the first quarter of 2007 in conjunction with the acquisition of the aesthetics business of Laserscope. Future changes in events or circumstances, such as an inability to achieve the cash flows determined above, may indicate that the recorded value of the intangible assets will not be recovered through future cash flows and the Company may be required to record an additional impairment charge for the intangible assets or further modify the period of expected lives for the intangible assets. The components of the Company’s purchased intangible assets as of January 2, 2010 are as follows (in thousands): Services - Contractual Customer Relationships Trade Name Other (non-Laserscope related) Useful Lives Annual Amortization Gross Carrying Value Accumulated Amortization Impairment Charge Gross Carrying Value after Impairment Net Carrying Value Useful Lives Remaining after Impairment 8 Years 1 Year 2 Years 163 102 57 322 $ 2,132 380 171 994 380 156 2,683 $ 1,530 $ - - - - 2,132 380 171 2,683 1,138 - 15 $ 1,153 $ 7 Years - 1 Year $ The components of the Company’s purchased intangible assets as of January 3, 2009 are as follows (in thousands): Gemini Handset - Core Technology Gemini - Current Technology Other Products - Current Technology Accessories - Current Technology Services - Contractual Customer Relationships Contractual Distribution Agreement Trade Name Other (non-Laserscope related) Useful Lives 4 Years 1 Year - - Annual Amortization $ 177 1,652 - - Gross Carrying Value Accumulated Amortization $ 993 $ 2,874 325 15 462 2,874 325 15 Impairment Charge 531 $ - - - Gross Carrying Value after Impairment $ 462 2,874 325 15 Net Carrying Value $ - - - - Useful Lives Remaining after Impairment - - - - 9 Years - 4 Years 2 Years 324 - 135 57 $ 2,345 $ 3,425 352 681 171 831 352 278 100 8,836 $ 5,237 1,293 - 301 - 2,125 $ 2,132 352 380 171 6,711 1,301 - 102 71 $ 1,474 $ 8 Years - 1 Years 2 Years In fiscal year 2008, as a result of the continued contraction in the global aesthetics market operating profits and cash flows for 2008 were lower than expected. Based on this trend, the cash flow forecasts anticipated to be generated by specific intangible assets were revised downwards in the fourth quarter of 2008. In addition, based on market trends for the aesthetics market, the Company determined that a reduction in the useful lives of certain specific assets were required. Consequently the Company determined that the carrying amount of these intangible assets as calculated on an asset by asset basis exceeded their fair value by $2.1 million; accordingly, an impairment loss of that amount was recognized and is included within the statement of operations as impairment of goodwill and intangibles. Aggregate amortization expense for the fiscal years ended January 2, 2010, January 3, 2009, and December 29, 2007 were $321 thousand, $2,345 thousand, and $3,047 thousand, respectively. Estimated future amortization expense for purchased intangible assets is as follows: (in thousands) 2010 2011 2012 2013 2014 Thereafter Total $ 177 163 163 163 163 324 $ 1,153 48 7. Accrued Expenses The components of the Company’s accrued expenses are as follows (in thousands): Income taxes payable Sales and use tax payable Distributor commission Other accrued expenses Total accrued expenses 8. Bank Borrowings January 2, 2010 $ 191 98 337 1,357 $ 1,983 January 3, 2009 $ 166 73 225 1,785 $ 2,249 In March 2008, the Company entered into (i) a Borrowing Agreement and (ii) an Export-Import Bank Loan and Security Agreement with Wells Fargo Bank (together referred to as the “Agreement”). The Agreement provides for an asset-based revolving line of credit of up to $8 million (the “New Revolving Loans”). Of the New Revolving Loans, up to $5 million of the principal amount (the “New Exim Sublimit”) will be guaranteed by Exim Bank. The Company’s obligations under the New Revolving Loans (including the New Exim Sublimit) are secured by a lien on substantially all of the Company’s assets. Interest on the New Revolving Loans (including the New Exim Sublimit) is currently set at the greater of 5% or prime as published in the Wall Street Journal, plus 2% on Floating Rate Advances per annum and 3.5% on LIBOR Advances, subject to adjustment under certain circumstances, including adjustments to the prime rate, late payment or the occurrence of an event of default. All outstanding amounts under the New Revolving Loans are payable in full on March 27, 2011. If at any time the amount outstanding under the New Revolving Loans exceeds the Borrowing Base as defined in the Agreement, the Company will be required to pay the difference between the outstanding amount and the Borrowing Base. The Company may prepay New Revolving Loans without penalty. These facilities contain certain financial and other covenants, including the requirement for the Company to maintain a certain level of net income (loss) and to be able to sufficiently cover its debt service needs. Other covenants include, but are not limited to, restricting the Company’s ability to incur indebtedness, incur liens, enter into mergers or consolidations, dispose of assets, make investments, pay dividends, enter into transactions with affiliates, or prepay certain indebtedness. In the event of noncompliance by the Company with the covenants under this Agreement, Wells Fargo Bank and Export-Import Bank, would be entitled to exercise their remedies, which include declaring all obligations immediately due and payable and disposing of the collateral if obligations are not paid. As of January 2, 2010, the Company was in compliance with the loan covenants in the Agreement and the total amount outstanding under the New Revolving Loans was $3.5 million. As of January 2, 2010, there was eligible collateral to support approximately an additional $2.4 million in borrowings. On March 25, 2010, the Company repaid in full all amounts outstanding under its loan agreement with Wells Fargo Bank and terminated the credit facility. 9. Commitments and Contingencies Lease Agreements. The Company leases its operating facilities under a noncancelable operating lease. On December 22, 2008, the lease was amended and renewed to lease for an additional six year period beginning March 1, 2009 until February 28, 2015. The Company also leases office space in Lisses, France. The lease is renewable annually and runs through 2018. The Company did lease office space in Cwmbran, South Wales, but this lease was terminated in December 2009. Rent expense totaled $624 thousand for the fiscal year ended January 2, 2010, $564 thousand for the fiscal year ended January 3, 2009, and $608 thousand for the fiscal year ended December 29, 2007. Future minimum lease payments under current operating leases at January 2, 2010 are summarized as follows (in thousands): Fiscal Year 2010 2011 2012 2013 2014 Beyond Total future minimum lease payments 49 Operating Lease Payments $ 666 690 696 710 770 129 $ 3,661 License Agreements. The Company is obligated to pay royalties equivalent to 5% and 7.5% of sales on certain products under certain license agreements. Royalty expense was approximately $102 thousand, $231 thousand, and $162 thousand for the years ended January 2, 2010, January 3, 2009, and December 29, 2007, respectively. Indemnification Arrangements. The Company enters into standard indemnification arrangements in our ordinary course of business. Pursuant to these arrangements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any trade secret, copyright, patent or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual anytime after the execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these agreements is not determinable. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. The Company has entered into indemnification agreements with its directors and officers that may require the Company to indemnify its directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct of a culpable nature; to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified; and to make good faith determination whether or not it is practicable for the Company to obtain directors and officers insurance. The Company currently has directors and officers liability insurance. In general, management believes that claims which are pending or known to be threatened, will not have a material adverse effect on the Company’s financial position or results of operations and are adequately covered by the Company’s liability insurance. However, it is possible that cash flows or results of operations could be materially affected in any particular period by the unfavorable resolution of one of more of these contingencies or because of the diversion of management’s attention and the incurrence of significant expenses. 10. Stockholders’ Equity Convertible Preferred Stock The Company is authorized to issue up to 2,000,000 shares of undesignated preferred stock from time to time in one or more series. During August 2007, the Company filed a Certificate of Designation authorizing the Company to issue up to 500,000 of the 2,000,000 shares of authorized undesignated preferred stock as shares of Series A Preferred Stock, par value $0.01 per share. In August 2007, the Company issued 500,000 shares of Series A Preferred Stock, convertible into 1 million shares of Common Stock, and warrants to purchase an aggregate of 600,000 shares of Common Stock at an exercise price of $0.01 per share. The warrants were to expire December 31, 2007 but were exercised prior to that date. The purchase price for a unit of 1 share of Series A Preferred Stock and a warrant to purchase 1.2 shares of Common Stock was $10.00, resulting in net proceeds to the Company of approximately $4.9 million. Of the total $4.9 million proceeds received, approximately $2.3 million has been allocated to the common stock warrants based on their estimated fair value at the time of issuance. In the event that the Common Stock of the Company trades on a trading market at or above a closing price equal to $5.00 per share (as adjusted for capital reorganizations, stock splits, reclassifications, etc.) for a period of 30 consecutive trading days, the shares of Series A Preferred Stock shall automatically convert to common stock. Holders of Series A preferred stock have preferential rights to noncumulative dividends when and if declared by the Board of Directors. In the event of liquidation, the holders have preferential rights to liquidation payments in the amount of the original purchase price plus declared and unpaid dividends, if any. At January 2, 2010, the aggregate liquidation preference was $5,000,000. In addition, holders of Series A preferred stock have certain registration rights including the requirement that the Company file a Form S-3 registration statement within 90 days of becoming eligible to file a Form S-3 registration statement and the right to request that the Company file a Form S-1 registration statement any time after February 29, 2008. 50 During 2009 the holders of the Series A preferred stock and the Company agreed to amend the Form S-3 registration rights. The agreement changed the clause requiring the Company to file a Form S-3 registration statement within 90 days of becoming eligible to a right to request the Company file a Form S-3 registration statement any time after June 30, 2009. In consideration for extending the period during which the Company is not required to file a registration statement, the Company issued the holders of Series A preferred stock warrants to purchase an aggregate of 20,000 shares Common Stock at an exercise price of $0.01 per share. The warrants were exercised prior to year end. Stock Option Plans 1998 Stock Plan. The 1998 Stock Plan (the 1998 Plan), as amended, provides for the granting to employees (including officers and employee directors) of incentive stock options and for the granting to employees (including officers and employee directors) and consultants of nonstatutory stock options, stock purchase rights (SPRs), restricted stock, restricted stock units, performance shares, performance units and stock appreciation rights. The exercise price of incentive stock options and stock appreciation rights granted under the 1998 Plan must be at least equal to the fair market value of the shares at the time of grant. With respect to any recipient who owns stock possessing more than 10% of the voting power of our outstanding capital stock, the exercise price of any option or SPR granted must be at least equal to 110% of the fair market value at the time of grant. Options granted under the 1998 Plan are exercisable at such times and under such conditions as determined by the Administrator; generally over a four year period. The maximum term of incentive stock options granted to any recipient must not exceed ten years; provided, however, that the maximum term of an incentive stock option granted to any recipient possessing more than 10% of the voting power of the Company’s outstanding capital stock must not exceed five years. In the case of SPRs, unless the Administrator determines otherwise, the Company has a repurchase option exercisable upon the voluntary or involuntary termination of the purchaser’s employment with the Company for any reason (including death or disability). Such repurchase option lapses at a rate determined by the Administrator. The purchase price for shares repurchased by the Company is the original price paid by the purchaser. In June of 2006, this plan was amended to shorten the contractual life of all option grants made after June 2006 to a seven year term. As of January 2, 2010 and January 3, 2009, no shares were subject to repurchase. The form of consideration for exercising an option or stock purchase right, including the method of payment, is determined by the Administrator. The 1998 Plan expired in February 2008. Stand-Alone Options. In July 2005, in connection with the employment of the Company’s then Chief Executive Officer, the Company’s Board of Directors granted a stand alone option, outside of the Company’s existing stock plans, to Barry Caldwell. The option entitled Mr. Caldwell to purchase up to 234,104 shares of the Company’s Common Stock at an exercise price of $6.07 per share. Mr. Caldwell left the services of the Company in October 2007 and as of January 2, 2010 there were no shares outstanding and exercisable under this option. In February 2007, in connection with the employment of the Company’s then Chief Financial Officer, the Company’s Board of Directors granted a stand alone option, outside of the Company’s existing stock plans, to Meryl Rains. The option entitled Ms. Rains to purchase up to 50,000 shares of the Company’s Common Stock at an exercise price of $9.42 per share. Ms. Rains left the services of the Company in December 2007 and as of January 2, 2010 there were no shares outstanding under this option. In February 2007, the Compensation Committee of the Company’s Board of Directors approved the grant of 235,000 non-qualified stock options, outside of the Company’s existing stock plans, to a total of 54 new employees, both domestic and international, hired in connection with the Company’s recently completed acquisition of the assets of the aesthetics business of Laserscope. The options were granted as of February 28, 2007 at an exercise price of $10.06 per share. As of January 2, 2010 there were 28,563 shares outstanding and exercisable under these options. 2008 Equity Incentive Plan On June 11, 2008, the shareholders approved the adoption of the 2008 Equity Incentive Plan, (the Incentive Plan). There are no material changes in the Incentive Plan from the 1998 Stock Plan. The maximum aggregate number of shares that may be awarded and sold under the Incentive Plan is 300,000 shares plus any shares subject to stock options or similar awards granted under the 1998 Stock Plan that expire or otherwise terminate without having been exercised in full and shares issued pursuant to awards granted under the 1998 Stock Plan that are forfeited to the Company on or after the date the 1998 Stock Plan expires. The terms and awards granted during the fiscal year 2008 under either plan were consistent with those described under the 1998 Stock Plan. 51 Exchange Program In August 2009, we completed a one-time stock exchange program to exchange certain employee stock options issued under the IRIDEX 1998 Stock Plan the IRIDEX 2008 Equity Incentive Plan or in connection with IRIDEX’s acquisition of the assets of the aesthetics business of Laserscope for stock options issued under our 2008 Equity Incentive Plan (the “Exchange Program”). The exchange offer was made to employees of the Company who, as of the date of the exchange offer commenced, were actively employed. Members of our board of directors and our executive officers who are subject to the provisions of Section 16 of the Exchange Act were not eligible to participate. The number of options held by eligible employees at the date of commencement was 663,018. Seventy two eligible employees surrendered 364,162 options in exchange for 197,116 new options. These new options were granted pursuant to the Exchange Program and have an exercise price of $2.35 per share, the closing price of IRIDEX common stock as reported by Nasdaq on August 27, 2009. The exchange of original options for new options was treated as a modification of the original options. As such, the Company will incur compensation cost for the incremental difference between the fair value of the new option and the fair value of the original options immediately before modification, reflecting the current facts and circumstances on the modification date, over the expected term of the new options in addition to the compensation cost being incurred for the original options, over the expected term of the original options. The Exchange resulted in a modification charge of approximately $38 thousand which is being recognized over the vesting periods of the new options which ranges from 6 months to 3 years. We recorded approximately $25 thousand of the modification charge in the twelve months ended January 2, 2010. The following table summarizes information regarding activity in our stock option plans during the fiscal year ended January 2, 2010: Information with respect to activity under these option plans are set forth below (in thousands except share and per share data): Outstanding Options Weighted Aggregate Number Average Price of Shares Exercise Price $ 6.00 $ 12,800 2,131,570 — — — 468,600 $ 8.16 3,824 (156,137) (785) $ 5.03 (584,496) (4,516) $ 7.73 — — — $ 6.09 11,323 1,859,537 — — — $ 2.34 1,605 686,712 — — — $ 6.18 — $ 4.81 (494,434) (3,052) — 9,876 — 2,051,815 — 280,416 (4,059) (744,664) 1,583,508 $ 2.29 643 (6) $ 1.43 (4,344) $ 5.79 — $ 3.91 — $ 6,169 Balances, December 30, 2006 Additional shares reserved Options granted Options exercised Options cancelled Options expired Balances, December 29, 2007 Additional shares reserved Options granted Options exercised Options cancelled Options expired Balances, January 3, 2009 Additional shares reserved Options granted Options exercised Options cancelled Options expired Balances, January 2, 2010 Shares Available for Grant 235,291 385,000 (468,600) — 584,496 (398,228) 337,959 568,863 (686,712) — 494,434 (448,581) 265,963 872,735 (280,416) — 744,664 (740,789) 862,157 52 The following table summarizes information with respect to stock options outstanding at January 2, 2010: Range of Exercise Prices $0.82- $0.86 $0.90 - $0.90 $0.99 - $2.34 $2.35 - $2.35 $2.38 - $2.52 $2.78 - $3.40 $3.41 - $4.10 $4.17 - $5.39 $5.56 - $6.84 $7.0 - $12.75 $0.82 - $12.75 Options Outstanding Weighted Number of Average Shares Outstanding Remaining at January 2, Contractual Life (Years) 2010 12,800 195,800 76,100 196,628 175,500 212,348 186,656 169,492 6.14 5.94 6.09 4.30 5.27 4.94 2.67 4.10 169,227 4.67 188,957 2.60 1,583,508 4.42 Weighted Average Exercise Price $ 0.82 $ 0.90 $ 2.21 $ 2.35 $ 2.48 $ 3.13 $ 3.72 $ 5.05 $ 5.95 $ 8.97 $ 3.91 Options Vested and Exercisable Number of Shares Exercisable at January 2, 2010 Weighted Average Weighted Average Remaining Exercise Contractual Life (Years) Price 81 $ 0.86 47,082 $ 0.90 24,496 $ 2.27 0 $ 0.00 88,618 $ 2.48 106,517 $ 3.15 163,100 $ 3.74 161,575 $ 5.07 5.92 5.94 5.99 0.00 5.16 4.67 2.31 4.07 167,350 $ 5.94 4.65 168,727 $ 9.01 2.55 927,546 $ 4.96 3.91 As of January 2, 2010, January 3, 2009, and December 29, 2007, options to purchase 1,583,508, 2,051,815, and 1,859,537 shares of common stock were outstanding at a weighted average exercise price of $3.91, $4.81, and $6.09, respectively. As of January 2, 2010, 1,440,254 shares were vested and expected to vest, at a weighted average exercise price of $4.03 per share and with a weighted average remaining contractual life of 4.33 years. The determination of fair value of all options granted by the Company is computed based on the Black-Scholes option-pricing model with the following weighted average assumptions: Employee Stock Option Plan 2009 2008 2007 2009 Employee Stock Purchase Plan 2008 2007 Average risk free interest rate Expected life (in years) Dividend yield Average volatility 1.76% 3.35 years — 104.0% 2.7% 4.8 years — 71.9% 4.4% 4.6 years — 59.0 – 65.0% — — — — — — — — 4.9% 0.12 — 36% Option-pricing models require the input of various subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The expected stock price volatility is based on analysis of the Company’s stock price history over a period commensurate with the expected term of the options, trading volume of the Company’s stock, look-back volatilities and Company specific events that affected volatility in a prior period. The Company has elected to use the simplified method for estimating the expected term. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. No dividend yield is included as the Company has not issued any dividends and does not anticipate issuing any dividends in the future. The following table shows stock-based compensation expense included in the Consolidated Statements of Operations for 2009, 2008 and 2007 (in thousands): Cost of revenues Research and development Sales and marketing General and administrative Year Ended January 2, 2010 $ 146 79 76 59 $ 360 Year Ended January 3, 2009 $ 152 85 65 20 $ 322 Year Ended December 29, 2007 $ 141 182 509 398 $ 1,230 53 Approximately $7 thousand, $7 thousand and $7 thousand of the stock based compensation expense recognized was capitalized into inventory as a component of overhead at January 2, 2010, January 3, 2009 and December 29, 2007, respectively. Information with respect to activity under these option plans are set forth below (in thousands except per share data): Outstanding at January 3, 2009 Options granted Options exercised Options forfeited/cancelled/expired Outstanding at January 2, 2010 Shares 2,051,815 280,416 (4,059) (744,664) 1,583,508 Weighted Average Exercise Price Aggregate Intrinsic Value $ 4.81 $ 2.29 $ 1.43 $ 5.79 $ 3.91 $ 787 The weighted average grant date fair value of option granted during 2009 as calculated using Black-Scholes was $0.58 per share. The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the Company’s closing stock price on the last trading day of fiscal 2009 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on January 2, 2010. This amount changes based on the fair market value of the Company’s stock. The total intrinsic value of options exercised during the years ended January 2, 2010 and January 3, 2009 were approximately $0.8 and $0 million, respectively. As a result of adopting the fair value recognition provisions in accordance with ASC 718, the impact to the consolidated financial statements for 2009, 2008, and 2007 from stock-based compensation is as follows (in thousands, except per share data): Stock-based compensation expense by award type: Employee stock options granted Employee stock purchase plan Total stock-based compensation Total effect on stock-based compensation at the Company’s marginal tax rate Effect on net income Effect on net income per share: Basic earnings per share Diluted earnings per share Year Ended January 2, 2010 Year Ended January 3, 2009 Year Ended December 29, 2007 $ 360 - 360 $ 322 - 322 $ 1,218 12 1,230 (144) (129) $ 193 $ 216 (467) $ 763 $ 0.02 $ 0.01 $ 0.09 $ 0.02 $ 0.01 $ 0.09 A summary of the status of the Company’s non-vested shares and changes during the period ended January 2, 2010 is presented below (in thousands, except per share amounts): Non-vested at January 3, 2009 Granted Vested Cancelled/forfeited Non-vested at January 2, 2010 Number of Shares 733,548 280,416 387,259 (744,664) 656,559 Weighted Average Grant Dated Fair Value $ 3.41 $ 0.58 $ 7.17 $ 6.04 $ 2.40 As of January 2, 2010, there were $1.6 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements under both of the plans. The cost is expected to be recognized over a weighted average period of three years. 11. Employee Benefit Plan The Company has a plan known as the IRIS Medical Instruments 401(k) trust to provide retirement benefits through the deferred salary deductions for substantially all US employees. Employees may contribute up to 15% of their annual compensation to the plan, limited to a maximum amount set by the Internal Revenue Service. The plan also provides for Company contributions at the discretion of the Board of Directors. On April 1, 2000 the Company commenced a Company match for the 401(k) in the amount of 50% of employee contributions up to an annual maximum of $2 thousand per year. Prior to the start of fiscal 2009, the Company suspended 54 the matching contributions. It is not known at this time when such matching contributions will be reinstated. The Company contributions totaled $0 in 2009, $214 thousand in 2008, and $260 thousand in 2007. 12. Income Taxes Pre-tax book income (loss) was comprised of the following: United States Foreign Total The provision for income taxes includes: Year Ended January 2, 2010 $ 3,487 (406) $ 3,081 Year Ended January 3, 2009 $ (7,049) (194) (7,243) $ Year Ended December 29, 2007 $ (20,772) (1,487) $ (22,259) Current: Federal State Foreign Deferred: Federal State Income tax provision Year Ended January 2, 2010___ Year Ended January 3, 2009 Year Ended December 29, 2007 $ 581 56 (141) 496 $ 87 40 — 127 $ 4 9 — 13 — — — $ 496 — — — 127 $ — — — 13 $ The Company’s effective tax rate differs from the statutory federal income tax rate as shown in the following schedule: Income tax provision at statutory rate State income taxes, net of federal benefit Nondeductible permanent differences Research and development credits Change in valuation allowance Foreign rate differential Effective tax rate Year Ended January 2, 2010 Year Ended January 3, 2009 34% 4% 6% (2%) (26%) 0% 16% 34% 5% (3%) 1% (40%) 1% (2%) Year Ended December 29, 2007 34% 4% (1%) 0% (35%) (2%) (0%) The tax effect of temporary differences and carry-forwards that give rise to significant portions of the net deferred tax assets are presented below (in thousands): Accruals and reserves Deferred revenue Fixed assets Intangibles Stock compensation Net operating loss R&D credits Other tax credits Other Net deferred tax asset Valuation allowance Net deferred tax assets January 2, 2010 $ 2,619 281 654 7,900 445 120 710 37 0 $ 12,766 (12,766) 0 $ January 3, 2009 $ 2,465 255 633 8,580 514 148 911 33 15 $ 13,554 (13,554) 0 $ 55 The Company has taxable income in 2009 and had a loss in 2008. The Company’s recent history of losses is negative evidence against the realizability of its deferred tax assets. Management feels that it is not more likely than not that the Company will be able to realize its deferred tax assets, and as such continues to record a full valuation allowance against deferred tax assets. During the year ended January 2, 2010, the Company utilized it’s entire federal net operating loss. As of January 2, 2010, the Company had federal and State net operating loss carry forwards of $0 and $3.4 million respectively. Of the total state NOL’s, $1.3 million relates to windfall stock option deductions which, when realized, will be credited to equity. The state losses will begin to expire in 2018. As of January 2, 2010, the Company had Federal and State research credit carry forwards of approximately $0.8 million and $1.2 million, respectively, available to offset future tax liabilities. The Federal credits will begin expiring in 2020 if not used. The state research credits do not expire. The Company also has $37 thousand of alternative minimum tax credits which do not expire and can be used to offset regular tax at a future date. The above net operating losses and R&D credits are subject to IRC sections 382 and 383. In the event of a change in ownership as defined by these code sections, the usage of the above mentioned NOL’s and credits may be limited. In December 2006, the Company adopted Financial Accounting Standards Interpretation, or FIN, No. 48 (“ASC 740-10-25”), “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (“ASC 740-10”). As a result of the implementation of FIN No. 48 (“ASC 740-10-25”), the Company recognized no change in the liability for unrecognized tax benefits related to tax positions taken in prior periods. Upon adoption of ASC 740-10-25, the Company’s policy to include interest and penalties related to unrecognized tax benefits within the Company’s provision for (benefit from) income taxes did not change. As of January 2, 2010, the Company had accrued $67 thousand for payment of interest and penalties related to unrecognized tax benefits. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands): Balance at the beginning of the year Additions based upon tax positions related to the current year Reductions resulting in lapse of statute of limitations Settlements Balance at the end of the year Year Ended January 2, 2010 Year Ended January 3, 2009 $ $ 585 52 - 637 $ $ 550 35 - 585 If the ending balance of $637 thousand of unrecognized tax benefits at January 2, 2010 were recognized, none of the recognition would affect the income tax rate. The Company does not anticipate any material change in its unrecognized tax benefits over the next twelve months. The unrecognized tax benefits may change during the next year for items that arise in the ordinary course of business. The Company files U.S. federal and state returns as well as foreign returns in France and the UK. The tax years 2001 to 2009 remain open in several jurisdictions, none of which have individual significance. 13. Major Customers and Business Segments The Company operates in two reportable segments: the ophthalmology segment and the aesthetics segment. In both segments, the Company develops, manufactures and markets medical devices. Our revenues arise from the sale of consoles, delivery devices, consumables and service and support activities. In the years ended January 2, 2010, January 3, 2009, and December 29, 2007, no customer individually accounted for more than 10% of our revenue. Revenue information shown by geographic region is as follows (in thousands): 56 United States Europe Rest of Americas Asia/Pacific Rim Year Ended January 2, 2010 $ 25,032 12,156 1,881 4,143 $ 43,212 Year Ended January 3, 2009 $ 26,959 14,809 2,584 4,176 $ 48,528 Year Ended December 29, 2007 $ 29,931 15,077 1,959 8,565 $ 55,532 Revenues are attributed to countries based on location of end customers. In the years ended January 2, 2010, January 3, 2009, and December 29, 2007, no individual country accounted for more than 10% of the Company’s sales, except for the United States, which accounted for 57.9%, 55.6%, and 53.9% of sales in 2009, 2008, and 2007 respectively. Information on reportable segments for the three years ended January 2, 2010, January 3, 2009, and December 29, 2007 is as follows (in thousands): Revenues Direct cost of revenues Direct gross profit Impairment of goodwill and intangible assets Total unallocated indirect costs Income from operations Revenues Direct cost of revenues Direct gross profit Impairment of goodwill and intangible assets Total unallocated indirect costs Loss from operations Revenues Direct cost of revenues Direct gross profit Impairment of goodwill and intangible assets Total unallocated indirect costs Loss from operations Year Ended January 2, 2010 Ophthalmology $ 31,032 8,663 $ 22,369 Aesthetics $ 12,180 4,070 $ 8,110 — Total $ 43,212 12,733 30,479 — (27,961) $ 2,518 Year Ended January 3, 2009 Ophthalmology $ 32,387 9,197 $ 23,190 Aesthetics $ 16,141 6,638 $ 9,503 5,364 Total $ 48,528 15,835 32,693 5,364 34,865 $ (7,536) Year Ended December 29, 2007 Ophthalmology $ 32,347 9,721 $ 22,626 Aesthetics $ 23,185 11,151 $12,034 14,690 Total $ 55,532 20,872 34,660 14,690 44,085 $ (24,115) Direct cost of revenues includes standard product cost (direct material, labor & fringe benefits) and any warranty and unit royalty costs. Indirect costs of manufacturing, service, research and development, selling and marketing, general and administrative costs are not allocated to the segments. The Company’s assets and liabilities are not evaluated on a segment basis. Accordingly, no disclosure on segment assets and liabilities is provided. 14. Computation of Basic Net Income (Loss) Per Common Share and Diluted Net Income (Loss) Per Common Share A reconciliation of the numerator and denominator of basic net loss per common share and diluted net loss per common share is provided as follows (in thousands, except per share amounts): Net income (loss) Denominator Weighted average common stock outstanding Effect of dilutive securities Weighted average common stock options Total weighted average stock and options outstanding Net income (loss) per common share Diluted net income (loss) per common share 57 Year Ended January 2, 2010 $ 2,585 Year Ended January 3, 2009 $ (7,370) Year Ended December 29, 2007 $ (22,272) 8,840 1,000 100 9,940 $ 0.29 $ 0.26 8,824 - - 8,824 $ (0.84) $ (0.84) 8,293 - - 8,293 (2.69) (2.69) $ $ In 2009, 2008, and 2007 there were 1,583,508, 2,051,815, and 1,859,537 outstanding options to purchase shares at a weighted average exercise price of $3.90, $4.81, and $6.09 and per share, respectively, that were not included in the computation of diluted net loss per common share because their effect was antidilutive. These options could dilute earnings per share in future periods. There are 500,000 shares of Preferred A stock which will automatically convert into 1,000,000 common shares in the event that the common stock of the Company trades at or above $5.00 per share for a period of 30 consecutive trading days. In 2009 the shares have been included in the computation of diluted net income per common share. In 2008 and 2007 the shares have not been included in the computation of diluted net loss because their effect is antidilutive. 15. Subsequent Events Credit Facility. On March 25, 2010, the Company repaid in full all amounts outstanding under its loan agreement with Wells Fargo Bank and terminated the credit facility. 16. Selected Quarterly Financial Data, (Unaudited) Year Ended January 2, 2010 Sales Gross profit Net income Basic net income per common share Diluted net income per common share Year Ended January 3, 2009 Sales Gross profit Net income (loss) Basic net income (loss) per common share Diluted net income (loss) per common share First Second Third Fourth (In thousands, except per share amounts) Quarter $ 10,736 $ 10,513 $ 5,048 $ 4,829 $ 224 $ 1,198 $ 0.03 $ 0.13 $ 0.02 $ 0.12 $ 10,400 $ 5,122 $ 646 $ 0.07 $ 0.07 $ 11,563 $ 5,274 $ 517 $ 0.06 $ 0.05 $ 11,474 $ 12,922 $ 4,805 $ 5,331 $ (892) $ 275 $ (0.10) $ 0.03 $ (0.10) $ 0.03 $ 11,987 $ 4,990 (249) $ (0.03) $ (0.03) $ $ 12,145 $ 4,553 $ (6,503) (0.74) $ (0.74) $ For the fiscal year ended January 2, 2010 the respective quarterly diluted net income per common share have been calculated using the total weighted average stock and options outstanding, which includes 1,000,000 shares of common stock equivalent attributable to the 500,000 shares of Preferred A stock outstanding for the year. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. Item 9A(T). Controls and Procedures Evaluation of Disclosure Controls and Procedures. We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Exchange Act, that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC 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 timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. 58 Management’s Report on Internal Control over Financial Reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Exchange Act. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of January 2, 2010 using the criteria for effective internal control over financial reporting as described in "Internal Control—Integrated Framework," issued by the Committee of Sponsoring Organization of the Treadway Commission. Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective at the reasonable assurance level. Changes in Internal Control over Financial Reporting. There were no changes in our internal control over financial reporting that occurred during the fourth quarter of fiscal year 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. This Annual Report on Form 10-K does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to temporary rules of the SEC that permit us to provide only management’s report in this Annual Report on Form 10-K. Item 9B. Other Information Not applicable. 59 PART III Certain information required by Part III has been omitted from this Form 10-K. This information is instead incorporated herein by reference to our definitive Proxy Statement for our 2010 Annual Meeting of Stockholders (the Proxy Statement), which we will file within 120 days after the end of our fiscal year pursuant to Regulation 14A in time for our Annual Meeting of Stockholders to be held June 16, 2010. Item 10. Directors and Executive Officers and Corporate Governance Information regarding our directors is incorporated herein by reference to “Proposal One - Election of Directors—Nominees” in our Proxy Statement. The information concerning our current executive officers is incorporated herein by reference to “Executive Officers” in our Proxy Statement. Information regarding delinquent filers is incorporated by reference to “Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy Statement. Information regarding our code of business conduct and ethics is incorporated herein by reference to “Proposal One — Election of Directors — Corporate Governance Matters — Code of Business Conduct and Ethics” in our Proxy Statement. Item 11. Executive Compensation The information required by this item is incorporated herein by reference to “Executive Compensation” in our Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is incorporated herein by reference to “Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is incorporated herein by reference to “Certain Relationships and Related Transactions” in our Proxy Statement. Item 14. Principal Accountant Fees and Services. The information required by this item is incorporated herein by reference to “Proposal Two — Ratification of Appointment of Independent Accountants” in our Proxy Statement. 60 Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K The following documents are filed in Part II of this Annual Report on Form 10-K: PART IV 1. Financial Statements Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets as of January 2, 2010 and January 3, 2009 Consolidated Statements of Operations for the years ended January 2, 2010, January 3, 2009, and December 29, 2007 Consolidated Statements of Stockholders’ Equity for the years ended January 2, 2010, January 3, 2009, and December 29, 2007 Consolidated Statements of Cash Flows for the years ended January 2, 2010, January 3, 2009, and December 29, 2007 Consolidated Statements of Comprehensive Income (Loss) for the years ended January 2, 2010, January 3, 2009, and December 29, 2007 Notes to Consolidated Financial Statements 2. Financial Statement Schedule The following financial statement schedule of IRIDEX Corporation for the years ended January 2, 2010, January 3, 2009, and December 29, 2007is filed as part of this Annual Report and should be read in conjunction with the Consolidated Financial Statements of IRIDEX Corporation Schedule II — Valuation and Qualifying Accounts Page in Form 10-K Report 36 37 38 39 40 38 41 64 Other schedules have been omitted because they are either not required, not applicable, or the required information is included in the consolidated financial statements or notes thereto. 3. Exhibits Exhibits 2.1(13) 3.1(1) 3.2(2) 4.1(3) 4.2(3) Exhibit Title Asset Purchase Agreement dated November 30, 2006 by and among American Medical Systems, Inc., a Delaware corporation, Laserscope, a California corporation and a wholly owned subsidiary of American Medical Systems, Inc., and IRIDEX Corporation. Exhibit Index Amended and Restated Certificate of Incorporation of Registrant. Amended and Restated Bylaws of Registrant. Certificate of Designation, Preferences and Rights of Series A Preferred Stock. Investor Rights Agreement, dated as of August 31, 2007, by and among the Company, BlueLine Capital Partners, LP; BlueLine Capital Partners III, LP and BlueLine Capital Partners II, LP. 10.1(1) Form of Indemnification Agreement with directors and officers. 10.2 (19) Lease Agreement dated December 6, 1996 by and between Zappettini Investment Co. and the Registrant, as amended pursuant to Amendment No. 1 dated September 15, 2003 and Amendment No. 2 dated December 22, 2008. 10.3(4)* 1995 Director Option Plan. 10.4(6)* 2005 Employee Stock Purchase Plan. 10.5(7)* 2009 Employee Incentive Program Summary. 10.6(8)* 2008 Equity Incentive Plan. 10.7 (19)* Change of Control Severance Agreement by and between the Company and James Mackaness, dated January 22, 2008. 10.8(5) 10.9(3) Settlement Agreement, dated April 6, 2007, by and among Synergetics, Inc., Synergetics USA, Inc. and IRIDEX Corporation. Securities Purchase Agreement, dated August 31, 2007, by and among BlueLine Capital Partners, LP, BlueLine Capital Partners III, LP, BlueLine Capital Partners II, LP and IRIDEX Corporation. 10.10(10) Credit and Security Agreement, dated March 27, 2008, by and between IRIDEX Corporation and Wells Fargo Bank, National Association, acting through its Wells Fargo Business Credit operating division. 61 10.12(10) Credit and Security Agreement (Ex-Im Subfacility), dated March 27, 2008, by and between IRIDEX Corporation and Wells Fargo Bank, National Association, acting through its Wells Fargo Business Credit operating division. 10.12(10) Borrower Agreement, dated March 27, 2008, by IRIDEX Corporation in favor of Export-Import Bank of the United States and Wells Fargo Bank, National Association, acting through its Wells Fargo Business Credit operating division. 10.13(11) First Amendment to Credit and Security Agreements and Waiver of Default, dated November 3, 2008, by and between IRIDEX Corporation and Wells Fargo Bank, National Association. 10.14(9) Letter Agreement, dated June 27, 2007, by and between American Medical Systems, Inc., a Delaware corporation, Laserscope, a California corporation and a wholly owned subsidiary of American Medical Systems, Inc., and IRIDEX Corporation, as amended. 10.15(9) Letter amendment, dated July 31, 2007, by and between Laserscope and IRIDEX Corporation. 10.16(9) Letter amendment, dated August 6, 2007, by and between Laserscope and IRIDEX Corporation. 10.17(9) 10.18(9) 10.19(9) Security Agreement made by the Company in favor of each of American Medical Systems, Inc. and Laserscope, dated August 14, 2007. Patent, Trademark and Copyright Security Agreement by and between the Company and Mid-Peninsula Bank, dated July 31, 2007. Subordination Agreement by and between the Company, Mid-Peninsula Bank, American Medical Systems, Inc. and Laserscope, dated August 14, 2007. 10.20(14) Amendment No. 1 to Investor Rights Agreement, dated as of March 31, 2009. 10.21(14) Common Stock Purchase Warrant, dated March 31, 2009, issued to BlueLine Capital Partners, LP. 10.22(14) Common Stock Purchase Warrant, dated March 31, 2009, issued to BlueLine Capital Partners II, LP. 10.23(14) Common Stock Purchase Warrant, dated March 31, 2009, issued to BlueLine Capital Partners II, LP. 10.24(15)* IRIDEX Corporation 2008 Equity Incentive Plan (as amended April 30, 2009). 10.25(15)* IRIDEX Corporation 1998 Stock Plan (as amended April 30, 2009). 10.26(16)* Form of 2008 Equity Incentive Plan Option Agreement 10.27(17)* Form of Stand-alone stock option agreement. 10.28 (18)* 2010 Employee Incentive Program Summary. 16.1(12) Letter from PricewaterhouseCoopers LLP to the Securities and Exchange Commission, dated as of August 19, 2007. 21.1(1) Subsidiaries of Registrant. 23.1 24.1 31.1 31.2 32.1 32.2 Consent of Burr Pilger Mayer Inc., Independent Registered Public Accounting Firm. Power of Attorney (See page 65). Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Indicates a management contract or compensatory plan or arrangement. (1) Incorporated by reference to the Exhibits filed with the Registration Statement on Form SB-2 (No. 333-00320-LA) which was declared effective on February 15, 1996. (2) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on November 21, 2007. (3) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on September 7, 2007. 62 (4) Incorporated by reference to Exhibit 10.3 filed with the Registrant’s Registration Statement on Form S-8 on August 3, 2004. (5) Incorporated by reference to Exhibit 10.1 filed with the Registrant’s Report on Form 10-Q for the quarter ended June 30, 2007. (6) Incorporated by reference to the appendix filed with the Registrant’s Proxy Statement for the Company’s 2004 Annual Meeting of Stockholders which was filed on April 30, 2004. (7) Incorporated by reference to Exhibit 99.1 filed with the Registrant’s Form 8-K on December 16, 2008. (8) Incorporated by reference to the appendix filed with the Registrant’s Proxy Statement for the Company’s 2008 Annual Meeting of Stockholders which was filed on April 24, 2008. (9) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 10-Q for the quarter ended September 29, 2007. (10) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on April 2, 2008. (11) Incorporated by reference to Exhibit 10.1 filed with the Registrant’s Report on Form 8-K on November 7, 2008. (12) Incorporated by reference to Exhibit 16.1 filed with the Registrant’s Report on Form 8-K on August 29, 2007. (13) Incorporated by reference to Exhibit 2.1 filed with the Registrant’s Report on Form 8-K on December 6, 2006. (14) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on April 6, 2009. (15) Incorporated by reference to the definitive proxy statement on Schedule 14A filed on May 4, 2009. (16) Incorporated by reference to Exhibit 99.1 filed with Registrant’s Registration Statement on Form S-8 on November 21, 2008. (17) Incorporated by reference to Exhibit 99.(d)(5) filed with the Registration Statement on Form SC TO-I July 30, 2009. (18) Incorporated by reference to Exhibit 99.1 filed with the Registrant’s Report on Form 8-K on December 15, 2009. (19) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 10-K for the year ended January 3, 2009. Trademark Acknowledgments IRIDEX, the IRIDEX logo, IRIS Medical, OcuLight, SmartKey, EndoProbe, Apex, Aura, Lyra, Gemini, Venus, Coolspot and Dermastat are our registered trademarks. G-Probe, DioPexy, DioVet, TruFocus, TrueCW, DioLite, IQ 810, IQ 577, MicroPulse, OtoProbe, ScanLite, Symphony, VariLite and EasyFit product names are our trademarks. All other trademarks or trade names appearing in this Annual Report on Form 10-K are the property of their respective owners. 63 IRIDEX CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (in thousands) Schedule I1 Description Balance for the year ended December 29, 2007: Allowance for doubtful accounts receivable Provision for inventory Balance for the year ended January 3, 2009: Allowance for doubtful accounts receivable Provision for inventory Balance for the year ended January 2, 2010: Allowance for doubtful accounts receivable Provision for inventory Balance at Beginning of The Period Additions Deductions Balance at End of The Period $ 439 $ 1,760 $ 470 $ 3,147 $ (209) $ (277) $ 700 $ 4,630 $ 700 $ 4,630 $ 410 $ 5,894 $ (201) $(4,073) $ 909 $ 6,451 $ 909 $ 6,451 $ 130 $1,288 $ (285) $(2,588) $ 754 $ 5,151 64 Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Mountain View, State of California, on the 31st day of March 2010. SIGNATURES IRIDEX CORPORATION By: /s/ Theodore A. Boutacoff Theodore A. Boutacoff President and Chief Executive Officer KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Theodore A. Boutacoff and James H. Mackaness, jointly and severally, their attorney-in-fact, each with full power of substitution, for him in any and all capacities, to sign on behalf of the undersigned any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and each of the undersigned does hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated. Signature /s/ Theodore A. Boutacoff (Theodore A. Boutacoff) /s/ James H. Mackaness (James H. Mackaness) /s/ Sanford Fitch (Sanford Fitch) /s/ Garrett A. Garrettson (Garrett A. Garrettson) /s/ James B. Hawkins (James B. Hawkins) /s/ William M. Moore (William M. Moore) /s/ Ruëdiger Naumann-Etienne (Ruëdiger Naumann-Etienne) Title President, and Chief Executive Officer (Principal Executive Officer) Date March 31, 2010 Chief Financial Officer (Principal Financial and Accounting Officer) March 31, 2010 Director March 31, 2010 Chairman of the Board March 31, 2010 March 31, 2010 March 31, 2010 March 31, 2010 Director Director Director 65 Exhibits 2.1(13) 3.1(1) 3.2(2) 4.1(3) 4.2(3) Exhibit Title Asset Purchase Agreement dated November 30, 2006 by and among American Medical Systems, Inc., a Delaware corporation, Laserscope, a California corporation and a wholly owned subsidiary of American Medical Systems, Inc., and IRIDEX Corporation. Exhibit Index Amended and Restated Certificate of Incorporation of Registrant. Amended and Restated Bylaws of Registrant. Certificate of Designation, Preferences and Rights of Series A Preferred Stock. Investor Rights Agreement, dated as of August 31, 2007, by and among the Company, BlueLine Capital Partners, LP; BlueLine Capital Partners III, LP and BlueLine Capital Partners II, LP. 10.1(1) Form of Indemnification Agreement with directors and officers. 10.2 (19) Lease Agreement dated December 6, 1996 by and between Zappettini Investment Co. and the Registrant, as amended pursuant to Amendment No. 1 dated September 15, 2003 and Amendment No. 2 dated December 22, 2008. 10.3(4)* 1995 Director Option Plan. 10.4(6)* 2005 Employee Stock Purchase Plan. 10.5(7)* 2009 Employee Incentive Program Summary. 10.6(8)* 2008 Equity Incentive Plan. 10.7 (19)* Change of Control Severance Agreement by and between the Company and James Mackaness, dated January 22, 2008. 10.8(5) 10.9(3) Settlement Agreement, dated April 6, 2007, by and among Synergetics, Inc., Synergetics USA, Inc. and IRIDEX Corporation. Securities Purchase Agreement, dated August 31, 2007, by and among BlueLine Capital Partners, LP, BlueLine Capital Partners III, LP, BlueLine Capital Partners II, LP and IRIDEX Corporation. 10.10(10) Credit and Security Agreement, dated March 27, 2008, by and between IRIDEX Corporation and Wells Fargo Bank, National Association, acting through its Wells Fargo Business Credit operating division. 10.11(10) Credit and Security Agreement (Ex-Im Subfacility), dated March 27, 2008, by and between IRIDEX Corporation and Wells Fargo Bank, National Association, acting through its Wells Fargo Business Credit operating division. 10.12(10) Borrower Agreement, dated March 27, 2008, by IRIDEX Corporation in favor of Export-Import Bank of the United States and Wells Fargo Bank, National Association, acting through its Wells Fargo Business Credit operating division. 10.13(11) First Amendment to Credit and Security Agreements and Waiver of Default, dated November 3, 2008, by and between IRIDEX Corporation and Wells Fargo Bank, National Association. 10.14(9) Letter Agreement, dated June 27, 2007, by and between American Medical Systems, Inc., a Delaware corporation, Laserscope, a California corporation and a wholly owned subsidiary of American Medical Systems, Inc., and IRIDEX Corporation, as amended. 10.15(9) Letter amendment, dated July 31, 2007, by and between Laserscope and IRIDEX Corporation. 10.16(9) Letter amendment, dated August 6, 2007, by and between Laserscope and IRIDEX Corporation. 10.17(9) 10.18(9) 10.19(9) Security Agreement made by the Company in favor of each of American Medical Systems, Inc. and Laserscope, dated August 14, 2007. Patent, Trademark and Copyright Security Agreement by and between the Company and Mid-Peninsula Bank, dated July 31, 2007. Subordination Agreement by and between the Company, Mid-Peninsula Bank, American Medical Systems, Inc. and Laserscope, dated August 14, 2007. 10.20(14) Amendment No. 1 to Investor Rights Agreement, dated as of March 31, 2009. 10.21(14) Common Stock Purchase Warrant, dated March 31, 2009, issued to BlueLine Capital Partners, LP. 10.22(14) Common Stock Purchase Warrant, dated March 31, 2009, issued to BlueLine Capital Partners II, LP. 66 10.23(14) Common Stock Purchase Warrant, dated March 31, 2009, issued to BlueLine Capital Partners II, LP. 10.24(15)* IRIDEX Corporation 2008 Equity Incentive Plan (as amended April 30, 2009). 10.25(15)* IRIDEX Corporation 1998 Stock Plan (as amended April 30, 2009). 10.26(16)* Form of 2008 Equity Incentive Plan Option Agreement 10.27(17)* Form of Stand-alone stock option agreement. 10.28 (18)* 2010 Employee Incentive Program Summary. 16.1(12) Letter from PricewaterhouseCoopers LLP to the Securities and Exchange Commission, dated as of August 19, 2007. 21.1(1) Subsidiaries of Registrant. 23.1 24.1 31.1 31.2 32.1 32.2 Consent of Burr Pilger Mayer, Inc., Independent Registered Public Accounting Firm. Power of Attorney (See page 65). Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Indicates a management contract or compensatory plan or arrangement. (1) Incorporated by reference to the Exhibits filed with the Registration Statement on Form SB-2 (No. 333-00320-LA) which was declared effective on February 15, 1996. (2) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on November 21, 2007. (3) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on September 7, 2007. (4) Incorporated by reference to Exhibit 10.3 filed with the Registrant’s Registration Statement on Form S-8 on August 3, 2004. (5) Incorporated by reference to Exhibit 10.1 filed with the Registrant’s Report on Form 10-Q for the quarter ended June 30, 2007. (6) Incorporated by reference to the appendix filed with the Registrant’s Proxy Statement for the Company’s 2004 Annual Meeting of Stockholders which was filed on April 30, 2004. (7) Incorporated by reference to Exhibit 99.1 filed with the Registrant’s Form 8-K on December 16, 2008. (8) Incorporated by reference to the appendix filed with the Registrant’s Proxy Statement for the Company’s 2008 Annual Meeting of Stockholders which was filed on April 24, 2008. (9) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 10-Q for the quarter ended September 29, 2007. (10) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on April 2, 2008. (11) Incorporated by reference to Exhibit 10.1 filed with the Registrant’s Report on Form 8-K on November 7, 2008. (12) Incorporated by reference to Exhibit 16.1 filed with the Registrant’s Report on Form 8-K on August 29, 2007. (13) Incorporated by reference to Exhibit 2.1 filed with the Registrant’s Report on Form 8-K on December 6, 2006. (14) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 8-K on April 6, 2009. (15) Incorporated by reference to the definitive proxy statement on Schedule 14A filed on May 4, 2009. 67 (16) Incorporated by reference to Exhibit 99.1 filed with Registrant’s Registration Statement on Form S-8 on November 21, 2008. (17) Incorporated by reference to Exhibit 99.(d)(5) filed with the Registration Statement on Form SC TO-I July 30, 2009. (18) Incorporated by reference to Exhibit 99.1 filed with the Registrant’s Report on Form 8-K on December 15, 2009. (19) Incorporated by reference to the Exhibits filed with the Registrant’s Report on Form 10-K for the year ended January 3, 2009. 68 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Exhibit 23.1 We hereby consent to the incorporation by reference in the Registration Statements on Forms S-8 (333-161630, 333-155598, 333- 147866, 333-135822, 333-127716, 333-117885, 333-107700, 333-97541, 333-67480, 333-45736, 333-86091, 333-57573, 333-32161) of IRIDEX Corporation of our report dated March 31, 2010 related to the financial statements and financial statement schedules as of January 2, 2010 and January 3, 2009 and for each of the three years in the period ended January 2, 2010 which appear in this Form 10- K. /s/ Burr Pilger Mayer, Inc. San Francisco, California March 31, 2010 69 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 13(a) or 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 EXHIBIT 31.1 I, Theodore A. Boutacoff, certify that: 1. I have reviewed this annual report on Form 10-K of IRIDEX Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any changes in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 31, 2010 By: /s/ THEODORE A. BOUTACOFF Name: Theodore A. Boutacoff Title: President and Chief Executive Officer (Principal Executive Officer) 70 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 13(a) or 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 EXHIBIT 31.2 I, James H. Mackaness, certify that: 1. I have reviewed this annual report on Form 10-K of IRIDEX Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 31, 2010 By: /s/ JAMES H. MACKANESS Name: James H. Mackaness Title: Chief Financial Officer (Principal Financial and Accounting Officer) 71 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 EXHIBIT 32.1 I, Theodore A. Boutacoff, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of IRIDEX Corporation on Form 10-K for the fiscal year ended January 2, 2010 (i) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and (ii) that information contained in such Annual Report on Form 10-K fairly presents, in all material respects, the financial condition and results of operations of IRIDEX Corporation. Date: March 31, 2010 By: /s/ THEODORE A. BOUTACOFF Name: Theodore A. Boutacoff Title: President and Chief Executive Officer (Principal Executive Officer) 72 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 EXHIBIT 32.2 I, James H. Mackaness, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of IRIDEX Corporation on Form 10-K for the fiscal year ended January 2, 2010 (i) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and (ii) that information contained in such Annual Report on Form 10-K fairly presents, in all material respects, the financial condition and results of operations of IRIDEX Corporation. Date: March 31, 2010 By: /s/ JAMES H. MACKANESS Name: James H. Mackaness Title: Chief Financial Officer (Principal Financial and Accounting Officer) 73 

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