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This Report on Form 10-K contains certain forward-looking statements regarding future events. These statements include statements relating to our expectations as to the timing and success of our clinical trials and regulatory submissions, the mix of our sales and revenues derived from generators and handpieces, the rate of growth and success of our international sales and marketing efforts, our expectations regarding increased operating expenses and net losses as our business expands, the timing of new product introductions, and our ability to maintain current and planned operations through at least the next 12 months without raising additional funds. These forward-looking statements involve risks and uncertainties. The cautionary statements set forth throughout this Report and, specifically, those contained in “Additional Risk Factors,” commencing on page 13, identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. Such factors include, but are not limited to, failure to obtain regulatory approvals as anticipated, a slower rate of market acceptance of our products than expected, increased competition, continued adverse changes in general economic conditions in the United States and internationally, including adverse changes in the specific markets for our products, adverse changes in customer order patterns, pricing pressures, risks associated with foreign operations, failure to reduce costs or improve operating efficiencies, and our ability to attract, hire and retain key and qualified employees.

PART I

Item 1.   Business

Company Overview

Curon Medical, Inc was incorporated in Delaware in May 1997. We develop, manufacture and market innovative proprietary products for the treatment of gastrointestinal disorders. Our products consist of radiofrequency generators and single-use disposable devices.

Our first product, the Stretta® System, received United States Food and Drug Administration (“FDA”) clearance in April 2000 for the treatment of gastroesophageal reflux disease, or GERD, which affects approximately 14 million U.S. adults on a daily basis. In patients with GERD, acidic stomach contents reflux backward from the stomach into the esophagus, causing a wide range of symptoms and complications, including, most commonly, persistent heartburn and chest pain. Unlike medication, which temporarily suppresses GERD symptoms, our Stretta System applies radiofrequency energy to treat the causes of GERD. Our Stretta System consists of a disposable catheter with needle electrodes and our control module, which is a radiofrequency energy generator. Using the Stretta System, the physician delivers temperature-controlled radiofrequency energy to the muscle of the lower esophageal sphincter and upper portion of the stomach. The delivery of this energy creates thermal lesions that reabsorb over time causing tissue contraction. Clinical studies show a significant reduction in GERD symptom scores, esophageal acid exposure, and use of anti-secretory medications.

We commercially launched the Stretta System in May 2000. As of December 31, 2002, we have sold 194 control modules in the United States and approximately 3,500 patients have been treated with the Stretta Procedure.

Our second product, the Secca® System, is a radiofrequency energy-based system for treatment of fecal incontinence. Fecal incontinence is caused by damage to the anal sphincter from childbirth, surgery, neurological disease, injury or age, and affects up to 16 million adults in the United States. Using the Secca System, physicians deliver radiofrequency energy to the muscle of the anal canal. Clinical studies have shown a reduction in fecal incontinence symptoms and improvement in general quality of life. In March 2002, we received 510(k) clearance from the FDA to market the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback. We launched the Secca System commercially in June 2002.

We have a direct sales force to market and sell our products in the United States. We market the Stretta System, as an alternative to anti-reflux surgery, primarily to high volume general surgeons and gastroenterologists. In the United States, there are approximately 4,000 general surgeons and 9,000 gastroenterologists who actively perform endoscopy. We market the Secca System primarily to colon and rectal surgeons and to those general surgeons who perform colorectal surgery. There are approximately 1,000 colon and rectal surgeons and up to 2,000 general surgeons that perform colorectal surgery in the United States.

Our Stretta System has also received European, Australian and Canadian regulatory approval, and our Secca System has also received regulatory approval in Europe. We opened an office in Belgium in March 2001 to manage distribution of our products in Europe. In the quarter ended December 31, 2002, we entered into distribution agreements for the Stretta System in Switzerland, Austria, and the Netherlands, and to date have international distribution agreements for the Stretta System in 17 countries. The Secca System will also be sold through distributors in Europe. The first European Secca Procedures were performed in Germany, Denmark and Italy in March 2002. We do not expect to significantly expand our sales coverage beyond the United States and Europe before 2004.

We have recently experienced several changes in our senior management team. In July 2002, John Morgan resigned as the Company’s President and CEO. Board member Michael Berman became interim CEO and a search for a permanent CEO was commenced. In July 2002, our Vice President, Sales, James Goode, and our Vice President, Marketing, Carol Chludzinski, resigned from the Company. Larry Heaton joined the Company as President and CEO in January 2003, and also became a member of the Board of Directors. We are currently searching for a Vice President of Sales and Marketing.

Business Strategy

Our strategy is to establish our Stretta and Secca Systems as standard treatment options for patients with GERD and fecal incontinence, respectively. We believe that our products offer substantial improvements over the current treatment options in the care of patients with either disorders.

The typical Stretta patient has not achieved adequate symptom control on, or is intolerant of, escalated medical therapy, or does not wish to continue indefinite anti-secretory medication use. Until recently, the only option for these patients has been a surgical anti-reflux procedure. We believe that the Stretta System offers several significant benefits over anti-reflux surgery, including that it is most commonly an outpatient procedure rather than inpatient surgery, that it is typically performed under conscious sedation rather than general anesthesia, and that it has a lower incidence of side effects and complications. Patients also return to normal activities faster after the Stretta Procedure than after anti-reflux surgery. Due to these features, the Stretta Procedure is significantly less expensive than anti-reflux surgery, and thus insurance companies benefit through cost savings.

The Secca Procedure offers a treatment option for patients with fecal incontinence who have failed more conservative therapies such as diet modification and biofeedback. Currently, fecal incontinence patients have few treatment options. These options include fiber therapy, anti-diarrheal medications, biofeedback therapy, and major surgery, which may involve reconstruction of the sphincter muscle or implantation of a continence device. These therapies have only modest effectiveness, and we believe that there is a need for a minimally invasive treatment option that may be offered to patients as an alternative to major surgery. We believe that the Secca Procedure has several significant benefits over surgery, including that it is most commonly an outpatient procedure rather than inpatient surgery, that it is typically performed under conscious sedation rather than general anesthesia, and that it has a lower incidence of side effects and complications. Recovery after incontinence surgery may take several months, whereas recovery from a Secca Procedure is significantly shorter.

We have established a direct sales and distribution network in the United States to target the approximately 4,000 hospital endoscopy suites and approximately 4,000 ambulatory treatment centers. We are also developing a network of distributors in selected European countries. In the United States, we have ten salespeople, two regional sales managers, and three clinical applications specialists. In Europe and other selected countries, we have distributors covering 17 countries. We may hire additional salespeople or enter new distributor relationships to increase market penetration of our products.

We have acquired and may continue to acquire complementary technologies. We have a license agreement with Gyrus Group PLC (formerly Somnus Medical Technologies, Inc) for the use of technology related to Gyrus’ radiofrequency generator. We also have entered into license agreements with the University of Kansas Medical Institute and with Messrs. Shadduck and Baker relating to applying radiofrequency energy to tissue. We may enter into license agreements with other persons or companies covering technology relating to gastrointestinal tract diseases.

GERD: The problem and conventional treatment options

GERD is the frequent backward flow, or reflux, of stomach contents into the esophagus, the muscular tube that connects the mouth to the stomach. In the lower part of the esophagus, there is an area of thickened muscle known as the lower esophageal sphincter which, when functioning properly, acts as a one-way valve, allowing food to pass down from the esophagus into the stomach, but preventing reflux. In GERD patients, the lower esophageal sphincter does not function properly and allows chronic reflux to occur. Stomach acid, enzymes and bile irritate the esophagus and cause a wide range of symptoms and complications, most commonly persistent severe heartburn and chest pain. In some GERD sufferers, the pain is acute enough to require an emergency room visit. People with GERD often have difficulty sleeping due to increased reflux and heartburn when they lie down. Also, damage to the esophagus caused by reflux may result in more serious complications, such as erosion or ulceration of the esophagus, build-up of scar tissue that can narrow and obstruct the esophagus, and Barrett’s epithelium, a condition that increases the risk of esophageal cancer.

Prescription medication is the primary treatment option for patients with GERD. The most widely prescribed medications from the proton pump inhibitor drug class, such as Prilosec, have annual U.S. sales of approximately $6 billion. Although these medications temporarily ease heartburn symptoms by reducing stomach acid, they do not prevent reflux or treat the underlying causes of GERD. Side effects may include diarrhea, headaches, dizziness and nausea. Taken regularly, these medications are expensive, costing an estimated average of $2,300 per year, based solely on retail prices for medication requirements of the patients in our clinical trial. Many GERD patients do not want to be dependent on medications and have difficulty complying with prescribed lifestyle modifications that require ongoing fundamental changes in eating, drinking and sleeping behavior.

The most common corrective treatment for GERD is an anti-reflux surgical procedure. This inpatient surgical procedure costs approximately $11,250, involves a prolonged recovery period, and exposes the patient to a significant risk of serious side effects. Consequently, physicians may be reluctant to refer otherwise healthy patients for the surgery. An estimated 70,000 to 75,000 patients undergo anti-reflux surgery in the United States each year, and an estimated additional 200,000 are referred for this surgery who are either unsuitable for, or unwilling to undergo, the procedure.

The Stretta System: Treatment of GERD

Our proprietary Stretta System provides physicians with the tools to perform a minimally invasive, outpatient, and cost-effective procedure for the treatment of GERD. Unlike medication, the Stretta Procedure treats GERD, rather than simply managing the symptoms by inhibiting acid secretion into the stomach. Unlike anti-reflux surgery, the Stretta Procedure is most commonly an outpatient procedure with minimal side effects. The Stretta Procedure, which typically costs between $3,000 and $5,000, takes less than an hour, and utilizes techniques commonly used by general surgeons and gastroenterologists who perform endoscopy. Most treated patients have been able to return to normal activities within one day of treatment and reduce or eliminate medication use shortly thereafter. We believe that the Stretta Procedure’s effectiveness and relatively low cost, combined with the absence of significant discomfort and side effects, makes it a clinically and economically attractive GERD treatment for those patients with unsatisfactory symptom control on drugs, who are considering an anti-reflux surgical procedure.

The Stretta System consists of the Stretta Catheter, which is a disposable flexible catheter with needle electrodes, and the Curon Control Module, which is a radiofrequency energy generator. Using these devices, the physician delivers temperature-controlled radiofrequency energy to create thermal lesions in the muscle of the lower esophageal sphincter and upper stomach. These lesions reabsorb over several weeks and cause tissue contraction, which increases the ability of the lower esophageal sphincter to act as a barrier to reflux.

The Secca System: Treatment of Fecal Incontinence

The Secca System is designed to treat fecal incontinence, a condition that affects up to 16 million U.S. adults. Fecal incontinence is caused by damage to the anal sphincter from childbirth, surgery, neurological disease, injury or age. It is a life-altering condition that, unlike GERD, lacks minimally invasive corrective treatment alternatives. The most common treatment options control, but do not correct, the condition, and include the use of protective undergarments, diet modification and over-the-counter dietary supplements. Current corrective treatment options include major surgery and are rarely utilized.

The Secca System provides a minimally-invasive, outpatient, and cost-effective procedure for the treatment of fecal incontinence. The Secca Procedure utilizes the same technology and treatment concepts as the Stretta System. Using our Curon Control Module and our handheld disposable device called the Secca Handpiece, physicians deliver radiofrequency energy into the muscle of the anal sphincter to improve its barrier function. We completed a U.S. clinical trial of the Secca System in April 2001, and submitted the results to the FDA in December 2001. In March 2002, we received 510(k) clearance from the FDA to market the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback.

Product Description

We have developed a suite of products incorporating proprietary design features for use in the Stretta and Secca Procedures. These products consist of a disposable catheter and a disposable handpiece for delivery of controlled radiofrequency energy to tissue, and a radiofrequency generator, known as the Curon Control Module. Both our current products and products under development utilize proprietary software to interface with our Curon Control Module.

Both the Stretta Catheter and the Secca Handpiece are disposable products incorporating innovative designs that enable a physician to easily access the treatment site and accurately deliver radiofrequency energy into the tissue. Features include:

The Stretta System and the Secca System both incorporate our radiofrequency energy generator, the Curon Control Module. The Curon Control Module has four channels, each of which independently control the four needle electrodes on the Stretta Catheter and Secca Handpiece. The generator uses continuous data feedback to achieve precise tissue temperatures at the treatment site. The generator tracks surface tissue temperatures from each electrode, and if temperatures at either the treatment site or surface tissue exceed pre-set safe levels, the generator automatically stops delivering energy to that electrode. An integrated pump delivers water to surface tissue during the procedure. The Stretta System and the Secca System each utilize proprietary software installed onto the Curon Control Module. The software provides a distinct graphical user interface and the functions and parameters that are required for the particular procedure.

Our products are based on radiofrequency energy delivery, which has a long history of use in medical applications. Radiofrequency energy has been cleared by the FDA for many therapies involving tissue heating, tissue remodeling and nerve pathway interruption, including:

Clinical and Regulatory Status

In April 2000, we received 510(k) clearance from the FDA to market the Stretta System for the treatment of GERD. To evaluate the Stretta System, we conducted an open label multi-center U.S. clinical trial with leading investigators at 14 institutions, in which 131 patients were treated. We measured how well the procedure eliminated the need for heartburn medication, improved symptoms, improved quality of life, and reduced the amount of acid detected in the esophagus. Results from the initial 47 patients treated were submitted to the FDA. Six-month data was available for 44 of the 47 treated patients because three patients did not participate in the voluntary follow-up testing. The follow-up data indicated that the Stretta Procedure led to significant improvement in both objective and subjective measurements. Twelve-month data for 118 of the 131 patients was published in Gastrointestinal Endoscopy in 2002.

Patients in our trials experienced no persistent side effects or other significant complications during the treatment and follow-up period. Most patients resumed normal levels of activity on the day after treatment. A few patients reported difficulty swallowing, increased flatulence or mild abdominal discomfort for a period of days. These symptoms were significantly milder and shorter in duration than those typically experienced after anti-reflux surgery.

We have conducted an eight-center, double-blind, randomized sham-controlled trial of the Stretta System in the United States, treating 64 patients. A paper on this trial was presented at the Digestive Disease Week Conference in May 2002. This trial demonstrated significant improvements in GERD symptom scores and satisfaction that were not present in the sham (control) group. Further, there were significant improvements in acid exposure in the Stretta treated group at 12 months. We are using the data generated for future peer-reviewed publications and for presentations at national scientific meetings and expect that this data will influence physician adoption rates, facilitate reimbursement approvals and enhance marketing activity.

In November 1999, we conducted a pilot study at a leading medical institution in Mexico City. Ten patients with fecal incontinence were treated with the Secca System. Two years following the procedure, most patients showed significant improvements in fecal incontinence symptoms, incontinence-related quality of life and general quality of life, each as measured by validated questionnaires. We have received no reports of persistent complications or persistent side effects. The two-year data regarding these pilot patients was presented at the 2002 Meeting of the American Society of Colon and Rectal Surgeons, demonstrating durability of the effect of Secca Procedure on improving fecal incontinence symptoms.

Based on these encouraging preliminary results, we further evaluated the Secca System in a multi-center U.S. clinical study involving six sites and 50 patients. The data from this study was compiled and submitted to the FDA, and in March 2002 we received 510(k) clearance to market the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback. The results of this clinical trial were presented at the 2002 Meeting of the American Society of Colon and Rectal Surgeons. The study demonstrated that the Secca Procedure resulted in significant improvements in fecal incontinences scores, fecal incontinence related quality of life, and general quality of life.

Research and Development

Our research and development activities are conducted internally by a research and development staff and are focused on design changes intended to reduce manufacturing cost as well as evaluation of existing product alternatives. In addition to working on new products, our research and development organization is developing products and fixtures that are designed to reduce the time to manufacture, improve quality and reduce cost of products. Our research and development expenditures were $2.7 million in 2002, $2.8 million in 2001 and $4.2 million in 2000. Amortization of stock-based compensation included in these numbers was $66,000 in 2002, $205,000 in 2001 and $629,000 in 2000. Pilot manufacturing costs included in research and development were $235,000 in 2002 for the Secca System. Stretta pre-commercialization expense was $1.1 million in 2000, representing the cost of our entire manufacturing organization for the first five months of that year.

Manufacturing

We manufacture, assemble and test our products in-house. The manufacturing process consists primarily of assembling internally manufactured and externally purchased components and sub-assemblies in an environmentally controlled area. After assembly, each Stretta Catheter and Secca Handpiece are inspected and then sent out for sterilization by a sub-contractor. We manufacture the Curon Control Module primarily by in-house assembly and testing of components ordered from outside manufacturers.

In December 2000, we voluntarily withdrew certain of our catheters from the market because of manufacturing issues. In February 2003, we voluntarily recalled a limited number of our catheters, which contained nonconforming material. We took corrective action with regard to each of these occurrences and no patient injuries were sustained as a result of the use of the recalled items.

We purchase various materials and components from qualified suppliers that are subject to stringent quality specifications and inspections. We conduct quality audits of our key suppliers, several of which are experienced in the supply of components to manufacturers of medical devices. Most purchased components and services are available from more than one supplier. For the few components for which relatively few alternate supply sources exist, we have identified back-up suppliers. The qualification of these back-up suppliers may require regulatory approval, which may or may not be available on a timely basis or at all.

Currently, only one supply source exists for the peristaltic pump. This pump is manufactured by our supplier in accordance with our specifications. We have contracted with this supplier for ongoing supply, but we would need additional time to locate and qualify a new pump supplier should our current supplier fail to fulfill our needs. If a new pump is incorporated into the Control Module, then the Control Module may require regulatory clearance under the FDA’s 510(k) process, which could take several months or more. Also, a computer chip in the Control Module is no longer manufactured. This chip is currently available from multiple suppliers, but we cannot assure you that it will be available in the future. We have purchased an inventory of these chips sufficient to meet our projected manufacturing needs for at least the next 18 months and we are currently working on developing a revision to our current generator that will use newer chip technology. As with the pump, we cannot incorporate a new chip into the generator without regulatory clearance under the FDA’s 510(k) process, which could take several months or more.

Our manufacturing facility is subject to periodic inspection by regulatory authorities. Our quality assurance systems are subject to FDA regulations. These regulations require that we conduct our product design, testing, manufacturing, and control activities in conformance with these regulations and that we maintain our documentation of these activities in a prescribed manner. Our manufacturing facility is licensed by the California Department of Health Services, Food and Drug Branch. In addition, our facility has received ISO 9001/EN46001/ISO13485 certification and the European Union Certificate pursuant to the European Union Medical Device Directive 93/42/EEC, allowing us to CE mark our products after assembling appropriate documentation. ISO 9001/EN46001/ISO13485 certification standards for quality operations have been developed to ensure that companies know the standards of quality on a worldwide basis. Failure to maintain the CE mark will preclude us from selling our products in Europe. We cannot assure you that we will be successful in maintaining certification requirements in Europe or elsewhere.

Patents and Proprietary Technology

We have an aggressive program to obtain or license intellectual property in the United States, Europe and Asia for our medical advances. We are building a portfolio of apparatus and method patents covering aspects of our current and future technology.

As of December 31, 2002, we had 23 issued or allowed U.S. patents and 23 pending U.S. patent applications. We intend to continue to file for patents for our technologies to strengthen our position. We require our employees, consultants and advisors to execute confidentiality agreements in connection with their employment, consulting or advisory relationships with us. We also require employees, consultants and advisors who work on our products to agree to disclose and assign to us all inventions conceived during the work day, using our property or which relate to our business. Despite any measures taken to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary.

Certain aspects of our products incorporate technology subject to patents that we have licensed from others. As of December 31, 2002, we had licensed in 20 issued and allowed U.S. patents and 15 pending U.S. patent applications. We have a license with Gyrus Group PLC (formerly, Somnus Medical Technologies, Inc.) for their generator technology. The non-exclusive license gives us the right to manufacture, have manufactured, use, offer to sell, sell and import Gyrus’ radiofrequency generator technology for use in the treatment of GERD and other medical disorders of the digestive tract. The license expires on October 6, 2017. During the term of the license, we are obligated to pay a royalty to Gyrus for our sale of generators that incorporate the licensed technology. We have also licensed patented technology from the University of Kansas Medical Research Institute relating to applying radiofrequency energy to tissue. This is an exclusive, worldwide and royalty-bearing license allowing us to incorporate the patented technology in our products to treat medical disorders throughout the gastrointestinal tract. The license expires on September 17, 2013 and may be terminated earlier for breach. We have also licensed other patents that we believe may apply to our current business or that we may incorporate into future products. We intend to continue to license technologies to strengthen our competitive position.

The medical device industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. As the number of entrants into our market increases, the possibility of an infringement claim against us grows. While we attempt to ensure that our products do not infringe other parties’ patents and proprietary rights, our competitors may assert that our products and the methods they employ may be covered by U.S. patents held by them. In addition, our competitors may assert that future products we may market infringe their patents.

Competition

The medical device industry is subject to intense competition. To be successful, we must establish our products, and the procedures in which our products are used, as attractive alternatives to currently available treatments. We will also have to compete with a number of companies that have significantly greater resources than we do.

Our primary competitors in the GERD market are manufacturers and marketers of existing pharmaceutical and surgical treatments for GERD, and manufacturers focused on innovative outpatient treatments. We compete with manufacturers of medications, such as Zantac, Pepcid, Aciphex, Prilosec, Nexium, and others. These manufacturers and manufacturers of generic medication equivalents have significantly greater resources than we do. These companies may market products more aggressively, gain influence among opinion leaders, or lower their prices, all of which may affect the adoption of, and the market for, our products. We also compete with manufacturers of devices and equipment used in laparoscopic anti-reflux surgery. Increased publicity regarding these procedures or advantageous pricing may adversely affect the market for our products. Both medication treatment and anti-reflux surgery are established GERD therapies with well-defined reimbursement profiles.

We also compete with a number of companies that are working on GERD treatments that eliminate or reduce the need for medication but are less invasive than surgery. For example, C.R. Bard has developed an endoscopic suturing system that places a suture in the upper stomach during an outpatient procedure. The device used in this procedure received FDA marketing clearance in March 2000. We compete with several companies that are developing bulking agents to be injected into the muscle of the lower esophageal sphincter. For example, Enteric Medical, recently acquired by Boston Scientific, has developed a liquid polymer for injection into the lower esophageal sphincter. This product was recently reviewed by an FDA Gastroenterology and Urology Devices Panel, which recommended that FDA approve commercial use of the device. We expect the product to receive final approval from FDA in 2003. Endonetics, recently acquired by Medtronic, is also developing an injectable bulking agent. Another company, NDO, delivers a stapled fold in the upper portion of the stomach in an attempt to mimic the action of anti-reflux surgery. There may also be other companies developing innovative therapies for minimally invasive treatment of GERD.

In the fecal incontinence market, we consider our primary competitors to be American Medical Systems, who received FDA clearance in December 2001 to market their Artificial Bowel Sphincter (ABS) for the treatment of severe fecal incontinence, and Medtronic, which is developing an implantable nerve stimulation device for treatment of incontinence. There are also a small number of companies pursuing injectable therapies for fecal incontinence.

Government Regulation

Our products are medical devices subject to extensive regulation by the FDA and other regulatory bodies. FDA regulations govern, among other things, the following activities that we will perform:

In April 2000, we received 510(k) premarket clearance from the FDA for the Stretta System for the treatment of GERD, and in March 2002 we received 510(k) premarket clearance from the FDA for the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback.

Each medical device that we wish to commercially distribute in the United States will likely require either prior 510(k) clearance or prior PMA approval from the U.S. Food and Drug Administration under the Federal Food, Drug, and Cosmetic Act. Devices deemed to pose relatively minimal risk are placed in either Class I or II, which requires the manufacturer to submit a premarket notification requesting permission for commercial distribution; this is known as 510(k) clearance. Some low risk devices are exempted from this requirement. Devices deemed by the FDA to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously 510(k) cleared device or a preamendment Class III device for which PMA applications have not been called, are placed in Class III, requiring PMA approval.

510(k) Clearance Pathway::     To obtain 510(k) clearance for one of our products, we must submit a premarket notification demonstrating that the proposed device is substantially equivalent in intended use and in safety and effectiveness to a previously 510(k) cleared device or a device that was in commercial distribution before May 28, 1976, for which the FDA has not yet called for submission of PMA applications. The FDA's 510(k) clearance pathway usually takes from four to 12 months, but it can last longer.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or could require a PMA approval. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any such decision. If the FDA disagrees with a manufacturer’s decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to seek 510(k) clearance or PMA approval. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or PMA approval is obtained.

PMA Approval Pathway :    If the FDA denies 510(k) clearance for one of our products, the product must follow the PMA approval pathway, which requires proof of the safety and effectiveness of the device to the FDA’s satisfaction. A PMA application must provide extensive preclinical and clinical trial data and also information about the device and its components regarding, among other things, device design, manufacturing and labeling. After approval of a PMA, a new PMA or PMA supplement is required in the event of a modification to the device, its labeling or its manufacturing process. The PMA approval pathway is much more costly, lengthy and uncertain than 510(k) clearance. It generally takes from one to three years or even longer.

Clinical Trials :    A clinical trial is almost always required to support a PMA application and is sometimes required for a 510(k) premarket notification. Such trials generally require submission of an application for an Investigational Device Exemption, or IDE. The IDE application must be supported by appropriate data, such as animal and laboratory testing results, showing that it is safe to test the device in humans and that the testing protocol is scientifically sound. The FDA must approve the IDE in advance for a specified number of patients unless the product is deemed a non-significant risk device eligible for more abbreviated IDE requirements. Clinical trials may begin once the IDE application is approved by the FDA and the appropriate institutional review boards at the clinical trial sites. In June 2000, we received IDE approval allowing us to commence a multicenter clinical trial of the Secca System. We began the trial in July 2000. In April 2001, we completed this trial and the results were submitted to the FDA in December 2001.

In April 2000, we received 510(k) premarket clearance from the FDA for the Stretta System for the treatment of GERD, and in March 2002 we received 510(k) premarket clearance from the FDA for the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback. We cannot assure you that the FDA will not deem one or more of our future products to be a class III device subject to the more burdensome PMA approval process.

After a device is placed on the market, numerous regulatory requirements apply. These include: the quality system regulation, or QSR, which requires manufacturers to follow elaborate design, testing, control, documentation and other quality assurance procedures during the manufacturing process; labeling regulations; the FDA’s general prohibition against promoting products for unapproved or off-label uses; and the Medical Device Reporting regulation, which requires that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur. Class II devices also can have special controls such as performance standards, postmarket surveillance, patient registries, and FDA guidelines that do not apply to Class I devices. Unanticipated changes in existing regulatory requirements or adoption of new requirements could hurt our business, financial condition and results of operations.

We are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. If the FDA finds that we have failed to comply, the Agency can institute a wide variety of enforcement actions against us, ranging from a public Warning Letter to more severe sanctions such as:

The FDA also has the authority to require repair, replacement or refund of the cost of any medical device manufactured or distributed by us. Our failure to comply with applicable requirements could lead to an enforcement action that may have an adverse effect on our financial condition and results of operations.

We have been an FDA registered medical device facility since January 1999 and we obtained our manufacturing license from the California Department of Health Services, or CDHS, in September 1999. We are subject to inspection by both the FDA and CDHS for compliance with the quality systems regulations and other applicable regulations.

We also must comply with numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and hazardous substance disposal. We may be required to incur significant costs to comply with such laws and regulations in the future and such laws and regulations may hurt our business, financial condition and results of operations. We are subject to quarterly audits performed by Underwriters Laboratories to ensure that our Control Module production continues to comply with the original requirements. Failure to comply could result in production delays, and potential product recall.

Our products are also regulated as medical devices outside the United States by government agencies and are subject to registration requirements in many of the foreign countries in which we plan to sell our products. Our Stretta and Secca Systems carry a CE Mark, which is required for European product sales. The Stretta System carries a Therapeutic Goods Administration license, which is required for product sales in Australia, and a license issued by Health Canada, which allows commercialization in Canada. Our facility has been audited and certified to be ISO9001/EN46001/ISO13485 compliant, which allows us to sell our products in Europe. Our facility is subject to inspection by TUV/Essen. We plan to seek approval to sell the Stretta and Secca Systems in additional foreign countries. The time and cost required to obtain clearance required by foreign countries may be longer or shorter than that required for FDA clearance, and requirements for licensing a product in a foreign country may differ significantly from FDA requirements.

Third Party Reimbursement

In the United States, health care providers generally rely on third-party payers, principally private health insurance plans, Medicare and Medicaid, to reimburse all or part of the cost of procedures in which medical devices are used. Medicare reimburses hospital outpatient clinics on a prospectively determined fixed amount for the costs associated with an outpatient procedure. Individual outpatient procedures are assigned Ambulatory Payment Classification (APC) codes. Effective October 1, 2001, the Center for Medicare and Medicaid Services, CMS (formerly HCFA), designated a code for the Stretta System. Further, CMS has also provided guidance on the use of existing physician CPT codes for Stretta. However, as this coding direction does not constitute a coverage decision, and we cannot assure you that the Stretta Procedure will be reimbursed or that the amounts reimbursed under this code will be adequate.

The current cost reduction orientation of the third-party payer community makes it exceedingly difficult for new medical devices and surgical procedures to obtain reimbursement. Often, it is necessary to convince these payers that the new devices or procedures will establish an overall cost savings compared to currently reimbursed devices and procedures. We believe that the Stretta System may offer an opportunity for payers to reduce the cost of treating GERD patients by possibly eliminating or reducing the costs of medication or anti-reflux surgery. While we believe that the Stretta System possesses economic advantages that will be attractive to payers, we cannot assure you that they will make reimbursement decisions based upon these advantages.

Reimbursement by third-party payers is often positively influenced by the existence of peer-reviewed publications of long-term safety and efficacy data. We have collected data on six-month results after treatment with the Stretta System, and this information was published in a peer-reviewed journal in 2001. We have collected and published data on twelve-month results, and this information was published in a peer-reviewed journal in 2002. Follow-up data in the form of a Stretta Registry, supporting the durability of the procedure for up to 33 months, was published in a peer-reviewed journal in December 2002. While we cannot assure you that our products will be reimbursed without publications of longer-term data, we are actively encouraging ongoing research studies to evaluate and publish the long-term safety and efficacy of the Stretta System. In addition, many third-party payers require that randomized studies be conducted to determine the effect of the procedure versus placebo or another standard of care. We have completed a double-blind, randomized, sham-controlled, multi-center study to generate this data, and these results were presented in May 2002 at the Digestive Disease Week Conference. We cannot assure you that results of this study will be published in a timely manner or at all, or that such publication will benefit our marketing and reimbursement efforts.

To facilitate reimbursement for the Stretta and Secca Systems, we have established a dedicated reimbursement department. The department trains physicians and physician office staff in obtaining pre-determination (agreement upon medical necessity) from insurance carriers prior to treating patients with the Stretta or Secca Procedure. In addition to assisting physicians with case-by-case pre-determination for coverage, we are actively involved in pursuit of local coverage decisions. The first two carriers to implement positive coverage policies for the Stretta Procedure are Medicare of Georgia and Wellmark Blue Cross and Blue Shield of Iowa.

We believe that achieving reimbursement for the Stretta Procedure is one of the major impediments to growth in sales. We believe that we are making progress toward wider reimbursement of the procedure. However, while we are actively pursuing reimbursement through case-by-case approvals and by pursuing coverage decisions by local carriers, we cannot guarantee the speed or the scale to which payers will approve reimbursement of the Stretta Procedure. While the Secca Procedure has been on the market a shorter amount of time, we anticipate similar challenges in achieving reimbursement for this product.

Reimbursement systems in international markets vary significantly by country and, within some countries, by region. Reimbursement approvals must be obtained on a country-by-country basis or a region-by-region basis. In addition, reimbursement systems in international markets may include both private and government sponsored insurance. We have so far obtained limited international reimbursement approvals. We cannot assure you that we will obtain any further approvals in a timely manner, if at all. If we fail to receive international reimbursement approvals at all, or in acceptable amounts, market acceptance of our products would be adversely affected.

Employees

As of December 31, 2002, we had 69 employees, with 29 employees in operations, seven employees in research and development, 22 employees in sales and marketing, seven employees in general and administrative, two employees in reimbursement and two employees in clinical and regulatory affairs. We believe that our future success will depend in part on our continued ability to attract, hire and retain qualified personnel. None of our employees is represented by a labor union, and we believe our employee relations are good.

Available Information

We are subject to the reporting requirements under the Securities Exchange Act of 1934. Consequently, we are required to file reports and information with the Securities and Exchange Commission (SEC), including reports on the following forms: annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These reports and other information concerning the company may be accessed through the SEC’s website at http://www.sec.gov.

You may also find on our website (http://www.curonmedical.com) electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. Such filings are placed on our website as soon as reasonably possible after they are filed with the SEC.

Additional Risk Factors

We may never achieve or maintain significant revenues or profitability.

We have only a limited operating history upon which you can evaluate our business. We have incurred losses every year since we began operations. In particular, we incurred net losses of $15.4 million in 2002, $15.4 million in 2001, and $15.8 million in 2000. As of December 31, 2002, we had an accumulated deficit of approximately $63.7 million. We have generated limited revenues from the sale of our products, and it is possible that we will never generate significant revenues from product sales in the future. Even if we do achieve significant revenues from our product sales, we expect to incur significant net losses over the next several years and these losses may increase. It is possible that we will never achieve profitable operations.

If health care providers are not adequately reimbursed for the procedures, which use our products, or for the products themselves, we may never achieve significant revenues.

Although the Center for Medicare and Medicaid Services (CMS) granted a new specific APC Code, designating higher facility reimbursement levels for the Stretta Procedure for Medicare purposes on October 1, 2001, there is no assurance that local Medicare or private payers will pay for this procedure. Physicians, hospitals and other health care providers are unlikely to purchase our products if they are not adequately reimbursed for the Stretta Procedure or the products. To date, only a limited number of private third-party payers have agreed to reimburse for the cost of the Stretta Procedure or products. Until a sufficient amount of positive peer-reviewed clinical data has been published, insurance companies and other payers may refuse to provide reimbursement for the cost of the Stretta Procedure or may reimburse at levels that are not acceptable to providers. Some payers may refuse adequate reimbursement even upon publication of peer-reviewed data. If users of our products cannot obtain sufficient reimbursement from health care payers for the Stretta Procedure or the Stretta System disposables, then it is unlikely that our products will ever achieve significant market acceptance. The Secca Procedure has not yet received any coding decision and there is little data yet regarding the willingness of third party health care payers to reimburse the costs of the procedure. We cannot assure you that the procedure will ever be reimbursed. Failure to achieve reimbursement will have a serious negative effect on our revenues.

Reimbursement from third-party health care payers is uncertain due to factors beyond our control and changes in third-party health care payers’ policies could adversely affect our sales growth.

Even if third-party payers provide adequate reimbursement for the Stretta Procedure, adverse changes in third-party payers’ policies toward reimbursement could preclude market acceptance for our products and have a material adverse effect on our sales and revenue growth. We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payers.

For example, some health care payers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. We cannot assure you that in a prospective payment system, which is used in many managed care systems, the cost of our products will be incorporated into the overall payment for the procedure or that there will be adequate reimbursement for our products separate from reimbursement for the procedure.

Internationally, market acceptance of our products will be dependent upon the availability of adequate reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. Although we are seeking international reimbursement approvals, we cannot assure you that any such approvals will be obtained in a timely manner or at all. If foreign third-party payers do not adequately reimburse providers for the Stretta Procedure and the products used with it, then our sales and revenue growth may be limited.

If we fail to take adequate action to remedy problems that have adversely affected our operations our future performance may be harmed.

In the past, we became aware of some issues that negatively impacted our earnings. For example, we learned that it is time consuming to obtain purchase commitments for our products because of the number of individuals at hospitals who need to approve the purchase. As a result, we changed our sales and marketing models to more effectively address this issue. We also became aware of misinformation in the marketplace regarding past adverse events associated with our procedure. In response, we dedicated resources to educating physicians regarding the use of our products to combat this misinformation. Our efforts to rectify these situations may not be sufficient to materially improve our earnings. In addition, the cost of our efforts in addressing these matters diverts resources that could be allocated towards other efforts at increasing revenues. In the future, we may experience similar problems and if we are unable to take appropriate action, our results of operations and our financial performance will be harmed.

The Stretta System is our primary marketed product. If physicians do not adopt our Stretta System, we will not achieve future sales growth.

We commercially introduced our Stretta System, which consists of a radiofrequency generator and a disposable handheld device, in May 2000. We are highly dependent on Stretta System sales because we anticipate that the Stretta System will account for substantially all our revenue through at least 2003. To achieve increasing sales, our product must continue to gain recognition and adoption by physicians who treat gastrointestinal disorders. The Stretta System represents a significant departure from conventional GERD treatment methods. We believe that, generally, physicians will not adopt our Stretta System unless they determine, based on published peer-reviewed journal articles, long-term clinical data and their professional experience, that the Stretta System provides an effective and attractive alternative to conventional means of treatment for GERD. Currently, there are 11 peer-reviewed journal articles and we are awaiting publication of the Stretta randomized trial. Physicians are traditionally slow to adopt new products and treatment practices, partly because of perceived liability risks and uncertainty of third-party reimbursement. For example, we believe that physician adoption rates have been negatively impacted by adverse events and a voluntary market withdrawal, all of which occurred early in the launch of the Stretta System. Future adverse events or recalls would also impact future acceptance rates. If we cannot achieve increasing physician adoption rates of our Stretta System, we may never achieve significant revenues or profitability.

If the effectiveness and safety of our products are not supported by long-term data, our sales could decline and we could be subject to liability.

If we do not produce clinical data supported by the independent efforts of clinicians, our products may never be accepted. We received clearance from the FDA for the use of the Stretta System to treat GERD based upon the study of 47 patients. Safety and efficacy data presented to the FDA for the Stretta System was based on six-month follow-up studies on 44 of these patients. Although the twelve-month follow-up data supports the six-month data, we may find that data from longer-term patient follow-up studies is inconsistent with those indicated by our relatively short-term data. However, if longer-term patient studies or clinical experience indicate that treatment with the Stretta System does not provide patients with sustained benefits or that treatment with our product is less effective or less safe than our current data suggests, our sales could decline and we could be subject to significant liability. Further, we may find that our data is not substantiated in studies involving more patients, in which case we may never achieve significant revenues or profitability.

We received clearance from the FDA for the use of the Secca System to treat fecal incontinence, for patients who have failed more conservative treatments such as diet modification or biofeedback. This clearance was based upon the study of 50 patients. Safety and efficacy data presented to the FDA for the Secca System was based on six-month follow-up studies on these patients. We may find that data from longer-term patient follow-up studies is inconsistent with those indicated by our relatively short-term data. However, if longer-term patient studies or clinical experience indicate that treatment with the Secca System does not provide patients with sustained benefits or that treatment with our product is less effective or less safe than our current data suggests, our sales could decline and we could be subject to significant liability. Further, we may find that our data is not substantiated in studies involving more patients, in which case we may never achieve significant revenues or profitability. If patient studies or clinical experience do not meet our expectations regarding the benefits of the Secca System, our expected revenues from this product may never materialize.

Any failure in our physician education efforts could significantly reduce product sales.

It is important to the success of our sales efforts to educate physicians in the techniques of using our products. We rely on physicians to spend their time and money to attend pre-sale educational sessions. Positive results using the Stretta and Secca Systems are highly dependent upon proper physician technique. If physicians use either system improperly, they may have unsatisfactory patient outcomes or cause patient injury, which may give rise to negative publicity or lawsuits against us, any of which could have a material adverse effect on our sales and profitability.

Because we have only recently shifted our marketing strategy to reposition the Stretta product as an alternative to anti-reflux surgery, targeting surgeons in addition to gastroenterologists, we cannot predict the effect this shift will have on our future sales.

Because we are a young company, we are determining how best to market our Stretta System. We initially focused our marketing efforts toward gastroenterologists, but have recently shifted toward selling to general surgeons. There can be no assurance that this will result in increased sales.

We face competition from more established GERD treatments and from competitors with greater resources, which will make it difficult for us to achieve significant market penetration.

Companies that have well-established products, reputations and resources dominate the market for the treatment of GERD. When our primary marketing strategy was directed at gastroenterologists, we competed directly with large pharmaceutical manufacturers of anti-secretory drugs. Because we have shifted our marketing focus to general surgeons, our primary competitors are now large medical device manufacturers such as Ethicon Endosurgical and United States Surgical, manufacturers of instrumentation for anti-reflux surgery, and C.R. Bard, which manufactures an endoscopic sewing device for GERD. Other large, established companies have experimental products that may, in the future, provide competition for the Stretta Procedure. These include Boston Scientific and Medtronic, who have experimental injectable products being studied for the treatment of GERD. Other, yet undisclosed, competitive devices may be developed.

These larger companies enjoy several competitive advantages over us, which may include:

We do not feel that we compete directly with large pharmaceutical companies, such as AstraZeneca, Takeda Abbott Pharmaceutical, Wyeth Laboratories and Eisai, because candidate patients for Stretta have, by definition, failed, or only partially responded to, drug therapy. However, these companies have an established relationship with the gastroenterology community and over $6 billion in annual U.S. revenues from the proton pump inhibitor drug class. We could be adversely affected if one or more pharmaceutical companies elects to market aggressively against our product, or if a new, more effective, pharmaceutical product is developed. For example, AstraZeneca has developed a new proton pump inhibitor, Nexium, for the treatment of GERD, which doctors may prescribe in lieu of recommending the Stretta Procedure. Further, less expensive, generic drugs will be introduced to treat GERD as AstraZeneca’s patent for Prilosec, the leading prescription medication for the treatment of GERD, expired in 2001. If we cannot compete effectively in this highly competitive market, we may not be able to achieve our expected revenue growth.

We have limited sales and marketing experience, and failure to build and manage our sales force or to market and distribute our products effectively will hurt our revenues and profits.

We have limited sales and marketing experience. As December 31, 2002, we relied on ten direct sales employees to sell our Stretta System in the United States. We must manage this sales team over the next 24 months to achieve our market share and revenue growth goals. Since we have only recently launched the Secca System, our sales force has little experience marketing the product, and we cannot predict how successful they will be in selling the product. There are significant risks involved in building and managing our sales force and marketing our products, including our:

Our failure to adequately address these risks will harm our ability to sell our products.

Internationally, we rely on third-party distributors to sell our products, and we cannot assure you that these distributors will commit the necessary resources to effectively market and sell our products.

Internationally, we rely on a network of distributors to sell our products. We depend on these distributors in such markets and we will need to attract additional distributors to grow our business and expand the territories into which we sell our products. Distributors may not commit the necessary resources to market and sell our products to the level of our expectations. If current or future distributors do not perform adequately, we may not realize expected international revenue growth.

We have limited experience manufacturing our products in commercial quantities, which could adversely impact the rate at which we grow.

Because we have only limited experience in manufacturing our products in commercial quantities, we may encounter unforeseen situations that would result in delays or shortfalls. For example, in December 2000, we voluntarily withdrew certain of our catheters from the market because of manufacturing issues. In February 2003, we voluntarily recalled a limited number of our catheters, which contained non-conforming material. This material formed part of the catheter shaft and showed a tendency to degrade over time. The problem was identified, corrected, and the outside vendor was changed. If the material were to fail during use, there would be a remote possibility of superficial injury to the patient’s esophageal or pharyngeal lining. No injuries have been reported and all unused catheters in the affected lots have been recovered.

We may encounter difficulties and delays in manufacturing our products for the following additional reasons:

Although we believe that our current manufacturing facility will be adequate to support our commercial manufacturing activities for the foreseeable future, we may be required to expand our manufacturing facilities to begin large-scale manufacturing. We cannot provide any assurance that we will be able to establish high volume manufacturing or, if established, that we will be able to manufacture our products in high volumes with commercially acceptable yields. If we are unable to provide customers with high-quality products in a timely manner, we may not be able to achieve market acceptance for our Stretta or Secca Systems. Our inability to successfully manufacture or commercialize our devices could have a material adverse effect on our product sales.

If we lose our relationship with any individual suppliers of product components, we will face regulatory requirements with regard to replacement suppliers that could delay the manufacture of our products.

Third-party suppliers provide materials and components used in our products. If these suppliers become unwilling or unable to supply us with our requirements, replacement or alternative sources might not be readily obtainable due to regulatory requirements applicable to our manufacturing operations. Obtaining components from a new supplier may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product sales. This process may take a substantial period of time, and we cannot assure you that we would be able to obtain the necessary regulatory clearance or approval. This could create supply disruptions that would reduce our product sales and revenue.

If our suppliers or we fail to comply with the FDA quality system regulation, manufacturing operations could be delayed and our business could be harmed.

Our manufacturing processes are required to comply with the quality system regulation, or QSR, which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging and shipping of our products. The FDA enforces the QSR through inspections. In May 2001, we received the report on our first QSR inspection, which was completed in March 2001. There were no significant findings. If we fail any future QSR inspections, our operations could be disrupted and our manufacturing delayed. Failure to take corrective action in response to a QSR inspection could force a shut-down of our manufacturing operations and a recall of our products, which would have a material adverse effect on our product sales, revenues, and expected revenues and profitability. Furthermore, we cannot assure you that our key component suppliers are, or will continue to be, in compliance with applicable regulatory requirements, will not encounter any manufacturing difficulties, or will be able to maintain compliance with regulatory requirements. Any such event could have a material adverse effect on our available inventory and product sales.

Our failure to obtain or maintain necessary FDA clearances or approvals could hurt our ability to commercially distribute and market our products in the United States.

Our products are considered medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an exemption applies, each medical device that we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. Either process can be lengthy and expensive. The FDA’s 510(k) clearance process usually takes from four to twelve months, but may take longer. The premarket application (“PMA”) approval process is much more costly, lengthy and uncertain. It generally takes from one to three years or even longer. Delays in obtaining regulatory clearance or approval will adversely affect our revenues and profitability.

Although we have obtained 510(k) clearance for both the Stretta System, for use in treating GERD, and the Secca System, for treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback, our clearance can be revoked if postmarketing data demonstrates safety issues or lack of effectiveness. Moreover, we will need to obtain 510(k) clearance or PMA approval to market any other new products. We cannot assure you that the FDA will not impose the more burdensome PMA approval process upon this technology in the future. More generally, we cannot assure you that the FDA will ever grant 510(k) clearance or premarket approval for any product we propose to market. If the FDA withdraws or refuses to grant approvals, we will be unable to market such products in the United States.

If we market our products for uses that the FDA has not approved, we could be subject to FDA enforcement action.

Our Stretta and Secca Systems are cleared by the FDA; the Stretta System for the treatment of GERD and the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback. FDA regulations prohibit us from promoting or advertising either system, or any future cleared or approved devices, for uses not within the scope of our clearances or approvals, and prohibit us from making unsupported safety and effectiveness claims. These determinations can be subjective, and the FDA may disagree with our promotional claims. If the FDA requires us to revise our promotional claims or takes enforcement action against us based upon our labeling and promotional materials, our sales could be delayed, our profitability could be harmed and we could be required to pay significant fines or penalties.

Modifications to our marketed devices may require new 510(k) clearances or PMA approvals or require us to cease marketing or recall the modified devices until such clearances are obtained.

Any modification to an FDA 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new FDA 510(k) clearance or, possibly, PMA approval. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can review any such decision. We have modified aspects of our Stretta System, but we believe that new 510(k) clearances are not required. We may modify future products after they have received clearance or approval, and, in appropriate circumstances, we may determine that new clearance or approval is unnecessary. We cannot assure you that the FDA would agree with any of our decisions not to seek new clearance or approval. If the FDA requires us to seek 510(k) clearance or PMA approval for any modification to a previously cleared product, we also may be required to cease marketing or recall the modified device until we obtain such clearance or approval. Also, in such circumstances, we may be subject to significant regulatory fines or penalties.

Complying with FDA and other regulations is an expensive and time-consuming process, and any failure to comply could result in substantial penalties.

Our products are medical devices that are subject to extensive regulation. FDA regulations are wide-ranging and govern, among other things:

Noncompliance with applicable regulatory requirements can result in enforcement action, which may include recalling products, ceasing product marketing, paying significant fines, and penalties, and similar FDA actions which could limit product sales, delay product shipment, and adversely affect our profitability.

We face risks related to our international operations, including the need to obtain necessary foreign regulatory approvals.

In the quarter ended December 31, 2002, we entered into distribution agreements in Switzerland, Austria, and the Netherlands, and to date have international distribution agreements in 17 countries. We are training these distributors and only began selling our products in international markets in April 2001. To successfully market our products internationally, we must address many issues with which we have little or no experience. We have obtained regulatory clearance to market the Stretta System in the European Union, Australia and Canada and to market the Secca System in the European Union, but we have not obtained any other international regulatory approvals for other markets or products. We cannot assure you that we will be able to obtain or maintain such approvals. Furthermore, although contracts already signed with European distributors specify payment in U.S. dollars, future international sales may be made in currencies other than the U.S. dollar. As a result, currency fluctuations may impact the demand for our products in countries where the U.S. dollar has increased compared to the local currency. Engaging in international business involves the following additional risks:

In addition, contracts may be difficult to enforce and receivables difficult to collect through a foreign country’s legal system, and the protection of intellectual property in foreign countries may be more difficult to enforce. Once we begin selling our products internationally, any of these factors could cause our international sales to decline, which would impact our expected sales and growth rates.

Product liability suits against us may result in expensive and time-consuming litigation, payment of substantial damages and an increase in our insurance rates.

The development, manufacture and sale of medical products involves a significant risk of product liability claims. The use of any of our products may expose us to liability claims, which could divert management’s attention from our core business, be expensive to defend, and result in substantial damage awards against us. For example, we are currently a party to four product liability lawsuits where there are allegations that our products are defectively designed and that we were negligent in manufacturing our products. We maintain product liability insurance at coverage levels which we believe to be commercially acceptable; however there can be no assurance that product liability or other claims will not exceed such insurance coverage limits or that such insurance will continue to be available on the same or substantially similar terms, or at all. We re-evaluate annually whether we need to obtain additional product liability insurance. Even if we obtain additional product liability insurance there can be no assurance that it would not have a material adverse effect on our business, financial condition, and results of operations. Any product liability claims brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing any coverage in the future. Even in the absence of a claim, our insurance rates may rise in the future to a point where we decide not to carry any insurance.

We have limited protection for our intellectual property. If our intellectual property does not sufficiently protect our products, third parties will be able to compete against us more directly and more effectively.

As of December 31, 2002, we had 43 issued or allowed U.S. patents and 38 pending U.S. patent applications; this includes 20 issued U.S. patents and 15 pending U.S. patent applications licensed in from third-parties. We rely on patent, copyright, trade secret and trademark laws to protect our products, including our Stretta Catheter, our Secca Handpiece and our Curon Control Module, from being duplicated by competitors. However, these laws afford only limited protection. Our patent applications and the notices of allowance we have received may not issue as patents or, if issued, may not issue in a form that will be advantageous to us. Patents we have obtained and may obtain in the future may be challenged, invalidated or legally circumvented by third parties. We may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by consultants, vendors, former employees or current employees, despite the existence of nondisclosure and confidentiality agreements and other contractual restrictions. Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. If our intellectual property rights do not adequately protect our commercial products, our competitors could develop new products or enhance existing products to compete more directly and effectively with us and harm our product sales and market position.

Because, in the United States, patent applications are secret unless and until issued as patents, or corresponding applications are published in other countries, and because publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain that we were the first to file patent applications for such inventions. Litigation or regulatory proceedings, which could result in substantial cost and uncertainty, may also be necessary to enforce patent or other intellectual property rights or to determine the scope and validity of other parties’ proprietary rights. There can be no assurance that we will have the financial resources to defend our patents from infringement or claims of invalidity.

Because of our reliance on unique technology to develop and manufacture innovative products, we depend on our ability to operate without infringing or misappropriating the proprietary rights of others.

There is a substantial amount of litigation over patent and other intellectual property rights in the medical device industry. Because we rely on unique technology to develop and manufacture innovative products, we are especially sensitive to the risk of infringing intellectual property rights. While we attempt to ensure that our products do not infringe other parties’ patents and proprietary rights, our competitors may assert that our products and the methods they employ may be covered by patents held by them or invented by them before they were invented by us. Although we may seek to obtain a license or other agreement under a third party’s intellectual property rights to bring an end to certain claims or actions asserted against us, we may not be able to obtain such an agreement on reasonable terms or at all. If we were not successful in obtaining a license or redesigning our products, our product sales and profitability could suffer, and we could be subject to litigation and potentially substantial damage awards.

Also, one or more of our products may now be infringing inadvertently on existing patents. As the number of competitors in our markets grows, the possibility of a patent infringement claim against us increases. Whether a product infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Infringement and other intellectual property claims, with or without merit, can be expensive and time-consuming to litigate and divert management’s attention from our core business. If we lose in this kind of litigation, a court could require us to pay substantial damages or grant royalties, and prohibit us from using technologies essential to our products. This kind of litigation is expensive to all parties and consumes large amounts of management’s time and attention. In addition, because patent applications can take many years to issue, there may be applications now pending of which we are unaware and which may later result in issued patents that our products may infringe.

If we lose our rights to intellectual property that we have licensed we may be forced to develop new technology and we may not be able to develop that technology or may experience delays in manufacturing as a result.

Our license with Gyrus Group PLC, a public company incorporated and existing under the laws of England and Wales, allows us to manufacture and sell our products using their radiofrequency generator technology. In addition, the University of Kansas license allows us to apply radiofrequency energy to tissue. To the extent these license interests become jeopardized through termination or material breach of the license agreements, our operations may be harmed. We may have to develop new technology or license other technology. We cannot provide any assurance that we will be able to develop such technology or that other technology will be available for license. Even if such technology is available, we may experience delays in our manufacturing as we transition to a different technology.

If we are unable to attract and retain qualified personnel, we will be unable to expand our business.

We believe our future success will depend upon our ability to successfully manage our employees, which includes attracting and retaining engineers and other highly skilled personnel. Our employees are at-will employees and are not subject to employment contracts. The loss of services of one or more key employees could materially adversely affect our growth. In addition, our stock price is depressed and the results of our operations have been less successful than anticipated. This history of performance may make it difficult to attract and retain qualified personnel. Failure to attract and retain personnel, particularly management and technical personnel, would materially harm our ability to grow our business rapidly and effectively. Because of recent changes in our management structure, we do not have a Vice President of Sales and Marketing. As long as this position remains unfilled, existing employees whose job descriptions would not ordinarily include certain sales and marketing activities will be required to perform those functions. Placing such additional responsibilities on existing staff members may strain resources, distract employees, or disrupt our operations, all of which would have an adverse effect on our business.

Due to our failure in meeting the NASDAQ continued listing standards, we are now listed on the lesser-known NASDAQ SmallCap Market. This may adversely affect our ability to raise capital.

During the quarter ended September 30, 2002, our stock began trading under $1.00. The continued listing standards for inclusion of our stock on the NASDAQ National Market, required that our stock not close below $1.00 for 30 consecutive trading days. As we could not meet this standard, we chose to move our listing to the NASDAQ SmallCap Market, and on March 10, 2003, NASDAQ advised us that we were again in compliance with minimum bid requirements. The move to the NASDAQ SmallCap Market could adversely affect the liquidity and price of our stock. As a result, there may be less demand for our stock and we may be unable to raise sufficient capital to fund our operations.

Our directors, executive officers and principal stockholders have significant voting power and may take actions that may not be in the best interests of our other stockholders.

Our officers, directors and principal stockholders holding more than 5% of our common stock together control over 50% of our outstanding common stock. As a result, these stockholders, if they act together, will be able to control the management and affairs of our company and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control and might adversely affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders.

Our stockholder rights plan, certificate of incorporation, bylaws and Delaware law contain provisions that could discourage a takeover.

In November 2001, we adopted a stockholder rights plan. The purpose of the plan is to assure fair value in the event of a future unsolicited business combination or similar transaction involving Curon. If an individual or entity accumulates 15% of our stock, or 20% in the case of certain existing stockholders, the rights become exercisable for additional shares of our common stock or, if followed by a merger or other business combination where Curon does not survive, additional shares of the acquirer’s common stock. The intent of these rights is to force a potential acquirer to negotiate with the Board to increase the consideration paid for our stock. The existence of this plan, however, may deter a potential acquirer, which could negatively impact shareholder value.

In addition, our basic corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. Any of the above provisions might discourage, delay or prevent a change in the control of our company or a change in our management. The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.

Item 2.   Properties

We are headquartered in Sunnyvale, California, where we lease one building with approximately 20,000 square feet of office, research and development, and manufacturing space under leases expiring September 30, 2003. We are currently in the process of identifying a new headquarters to move into before September 30, 2003.

Item 3.   Legal Proceedings

In June 2001, a civil action was filed against us in the United States District Court, Western District of Kentucky, Louisville Division, in which the plaintiff alleges that he sustained a nerve injury and damage to his gastrointestinal tract during a Stretta Procedure caused by the defective design and manufacture of our product. Plaintiff’s allegations against us include strict liability for a product that was in a defective and unreasonably dangerous condition, negligence in the design and manufacturing of the product, breach of implied warranty of merchantability, and loss of consortium. Plaintiff was a subject in a randomized clinical trial and had been provided with an approved Informed Consent form and counseling by the physician. Prior to treatment, Plaintiff provided consent to proceed. Plaintiff is seeking a trial by jury and unspecified damages. The trial date is currently set in September 2003. We believe Plaintiff’s claim is without merit.

In September 2001, a civil action was filed against a number of defendants, including Curon, in the Superior Court of the State of California in and for the City and County of Santa Clara, alleging that the plaintiff sustained injury when undergoing a procedure utilizing the Stretta System, caused by defects in design and manufacture. Plaintiff also alleges negligence in the design, manufacture, advertising and sale of the Stretta System and that its warnings, instructions and directions for use were inadequate. Additional defendants include the treating physicians and the associated medical institutions, who, it is alleged, were medically negligent in treatment of Plaintiff. Plaintiff is seeking unspecified damages. On January 24, 2003 we filed a Motion for Summary Judgment, which will be heard on April 22, 2003.

In June 2002, a civil action was filed against a number of defendants, including Curon, in the Court of Common Pleas, Philadelphia County, in the State of Pennsylvania, alleging that the plaintiff sustained injury during a Secca Procedure caused by the device being defective and/or in an unreasonably dangerous condition. Plaintiff was a subject in a clinical trial and had been provided with an approved Informed Consent form and counseling by the physician. Prior to treatment, Plaintiff provided consent to proceed. Additional defendants include the treating physician, the associated medical institution who, it is alleged, were medically negligent in treatment of Plaintiff, and the members of the Institutional Review Board who approved the protocol for the clinical trial. Plaintiff has demanded a trial by jury and unspecified damages. The case has since been moved to the United States District Court for the Eastern District of Pennsylvania. We believe Plaintiff’s claim against us is without merit.

In February 2003, a civil action was filed against us in the District Court of Dallas County, in the State of Texas, alleging that the plaintiff sustained serious injuries during a Stretta Procedure performed in February 2001, caused by the device being in a defective condition. We have no further information on this claim, and believe it to be without merit.

Item 4.   Submission of Matters to a Vote of Security Holders

Not applicable.

PART II

Item 5.  Market for Registrant’s Common Equity and Related Stockholder Matters

Our Common Stock trades under the symbol CURN. As of December 9, 2002, our Common Stock is currently quoted on the NASDAQ SmallCap Market. Until that date, our Common Stock had been quoted on the NASDAQ National Market since our initial public offering on September 22, 2000. The following table shows the high and low sales prices for the Company’s Common Stock for the periods indicated, as reported on the NASDAQ SmallCap or National Markets.

As of March 11, 2003, the last reported sales price of our Common Stock on the NASDAQ SmallCap Market was $1.17 per share, and the number of beneficial common stockholders was approximately 1,500. We currently intend to retain any earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future.

On September 26, 2000, we completed the sale of 5,000,000 shares of our common stock at a per share price of $11.00 in a firm commitment underwritten public offering. The offering was effected pursuant to a Registration Statement on Form S-1 (Registration No. 333-378666), which the United States Securities and Exchange Commission declared effective on September 21, 2000. On October 24, 2000, we completed the sale of an additional 475,000 shares of our common stock at a per share price of $11.00 pursuant to the exercise of the over-allotment option by the underwriters. All shares sold were shares of our common stock, $0.001 par value per share. UBS Warburg LLC, CIBC World Markets, and SG Cowen were the managing underwriters of the IPO. Aggregate gross proceeds to us from the IPO (prior to deduction of underwriting discounts and commissions and expenses of the offering) were $60.2 million. There were no selling stockholders in the IPO.

We paid underwriting discounts and commissions of approximately $4.2 million and other expenses of approximately $1.2 million in connection with the IPO. The total expenses paid by us in the IPO were approximately $5.5 million and the net proceeds to us in the IPO were approximately $54.8 million.

Of the approximately $54.8 million in net offering proceeds, through December 31, 2002, we have used approximately $12.0 million for the repayment of debt and accrued interest, $7.0 million for research and development, $8.8 million for the manufacture of products, $4.0 million for clinical expense and reimbursement efforts, $14.0 million for sales and marketing initiatives to support the commercialization of the Stretta System and $9.0 million for general corporate purposes. We have now used the entire balance of our net IPO proceeds. From time to time, we have discussed potential strategic acquisitions and investments with third parties. To date, we do not have any agreements or commitments to complete any such transactions.

The Board of Directors approved a stock repurchase program in July 2002 pursuant to which up to 1,000,000 shares of our outstanding common stock may be repurchased from time to time. The duration of the repurchase program is open-ended. Under the program, we may purchase shares of common stock through open market transactions at prices deemed appropriate by management. The timing and amount of repurchase transactions under this program will depend on market conditions and corporate and regulatory considerations. The purchases will be funded from available working capital. As of December 31, 2002, we have repurchased approximately 325,300 shares pursuant to this repurchase program.

Item 6.   Selected Financial Data

The following tables reflect selected summary financial data for each of the last five fiscal years. This data should be read in conjunction with the financial statements and notes thereto, and with Item 7, Management’s Discussion and Analysis of Results of Operations and Financial Condition in this Annual Report on Form 10-K. The information provided below is in thousands, except for per share data.

Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the attached financial statements and notes thereto for the fiscal years ended December 31, 2002, 2001, and 2000.

Overview

We were incorporated in May 1997. Business activities before January 1998 were negligible. Prior to December 31, 2000 we were in the development stage and until that time, we had devoted substantially all of our efforts to raising capital and developing, marketing and selling our products.

In 1998, our primary activity was developing the Curon Control Module and Stretta Catheter for the treatment of gastroesophageal reflux disease, or GERD. In October 1999, we received CE Mark approval of the Stretta System, indicating that the Stretta System meets Euro standards allowing us to market it within the European Union. We received 510(k) clearance from the FDA in April 2000 and commercially launched in the United States in May 2000.

In April 1999, we began developing our second set of products, the Secca System, for the treatment of fecal incontinence. In November 1999, we conducted a 10-patient human clinical pilot study outside the United States and, in July 2000, we began a U.S. multi-center clinical trial of the Secca System under an Investigational Device Exemption. In September 2001, we received CE Mark approval of the Secca System, indicating that the Secca System meets European medical device standards, allowing us to market it within the European Union. Our multi-center clinical trial was completed, and the results were used to support a 510(k) submission to the FDA in December 2001. We received 510(k) clearance from the FDA in March 2002 to market the system for the treatment of fecal incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback. We made our first sales of the Secca System in June 2002.

We are focusing our sales efforts in the United States through a direct sales force. In international markets, we rely primarily on third-party distributors. In November 2000, we incorporated a subsidiary company in Belgium and hired a European manager to support European distributors’ sales, marketing and clinical efforts. As of December 31, 2002, this subsidiary had three employees. In the quarter ended December 31, 2002, we entered into distribution agreements in Switzerland, Austria, and the Netherlands, giving us a total of 17 international distributors, who have all received shipments of product. Our gross margins on sales through international third-party distributors will be lower than our gross margins on U.S. sales as a result of distributor discounts.

To date, we have generated limited revenues. Our revenues are, and will be, derived from the sale of radiofrequency generators and our disposable devices, such as the Stretta Catheter and Secca Handpiece. We expect that disposable sales will continue to form the basis of a recurring revenue stream. However, domestic disposable sales continue to grow more slowly than expected primarily due to difficulties encountered by our physician customers in easily obtaining reimbursement for the Stretta Procedure on a case-by-case basis. Some of our customers also find the 45 minutes necessary to perform a Stretta Procedure to be a limiting issue, as their endoscopy unit schedule is typically dominated by short diagnostic procedures. Although disposable sales from outside the United States are increasing, they are not yet sufficient to offset the current domestic situation. Our strategies of pursuing national reimbursement coverage, focusing on entrenching the therapy to promote repeat catheter sales and incorporating technical improvements to our systems to reduce treatment times are designed to address these issues and we expect that our revenue from disposables will increase on implementation.

Through December 31, 2002, we recorded limited product sales while incurring cumulative net losses of $63.7 million. In addition to increasing expenditures related to continuing selling activities of the Stretta and Secca Systems, we anticipate that our expenses will increase as we continue to develop new products, conduct clinical trials, commercialize our products and acquire additional technologies as opportunities arise. As a result, we expect our operating expenses and cumulative net losses to increase.

We have recently experienced several changes in our senior management team. In July 2002, John Morgan resigned as the Company’s President and CEO. Board member Michael Berman became interim CEO and a search for a permanent CEO was commenced. In July, 2002, our Vice President Sales, James Goode, and our Vice President, Marketing, Carol Chludzinski, resigned from the Company. Larry Heaton joined the Company as President and CEO in January 2003, and also became a member of the Board of Directors.

Critical Accounting Polices and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.

We believe the following critical accounting policies, among others, affect its more significant judgments and estimates in the preparation of its consolidated financial statements:

RESULTS OF OPERATIONS

Revenues were $3.4 million, $3.3 million, and $1.2 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. Sales have increased successively over all three years, although increases in 2002 were lower than anticipated, primarily due to the sales and marketing efforts involved in repositioning the Stretta System as an alternative to anti-reflux surgery, which required us to refocus our sales force to target surgeons as opposed to gastroenterologists. Stretta System products accounted for 97% of total 2002 revenues as compared to Secca System products, which accounted for 3% of 2002 revenues. There were no Secca System sales in prior years so revenue was entirely derived through sales of the Stretta System. The Stretta Control Module and Catheter accounted for 51% and 46%, respectively, of the Stretta product line sales for the year ended December 31, 2002, compared to 50% and 45%, respectively, for the same period in 2001, and 65% and 32%, respectively, in 2000. International sales accounted for $423,000 for the year ended December 31, 2002, compared to $134,000 for the same period in 2001, and none in 2000. Commercial shipments of the Stretta System began in the United States in June 2000.

Our costs of goods sold represent the cost of producing generators and disposable devices. We also license a technology used in the generators that we sell. We are required to pay licensing fees based on the sales price of the units. We believe that there are alternative technologies that could be utilized should we choose to do so. Cost of goods sold was $4.5 million, $5.0 million and $2.1 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. As sales volume increases, we expect gross profit to become positive and increase accordingly. Our sales have not yet reached a level that would absorb our manufacturing capacity to the extent that we would experience positive gross profit. In addition to various cost reduction strategies, the decrease in 2002 as compared to 2001 was due to $235,000 of manufacturing capacity related to Secca pilot manufacturing that was charged to research and development prior to the product commercialization in June 2002. In 2000, $1.1 million of manufacturing expense for the first five months of that year was charged to research and development related to pilot manufacturing of the Stretta System, which was commercialized in June 2000.

Research and development expenses consist primarily of personnel costs, professional services, patent application and maintenance costs, materials, supplies and equipment. Research and development expenses were $2.7 million, $2.8 million, and $4.2 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. Spending levels in 2002 and 2001 are relatively comparable. The decrease in expenses in 2001 compared to 2000 was due to the completion of Stretta pilot manufacturing activities in the second quarter of 2000, when commercialization occurred. Amortization of stock-based compensation accounted for $66,000, $205,000, and $629,000 in the twelve months ended December 31, 2002, 2001, and 2000, respectively. During the quarter ended September 30, 2002, we reduced the number of research and development personnel from ten to seven. Costs associated with terminating these individuals were $83,000.

Clinical and regulatory expenses consist primarily of expenses associated with the costs of clinical trials, clinical support personnel, the collection and analysis of the results of these trials, and the costs of submission of the results to the FDA. Clinical and regulatory expenses were $1.4 million, $1.7 million, and $1.8 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. Spending decreased in 2002 as compared to 2001 due to the costs involved in the U.S. Secca trial and the Stretta randomized control trial, which were both ongoing in 2001, and were completed in that year. Spending on the Secca randomized control trial, begun in May 2002, has been limited to date. Spending levels in 2001 and 2000 are relatively comparable. Clinical trial costs include payments to hospitals, and the related travel expense for Curon employees. Amortization of stock-based compensation accounted for $51,000, $121,000, and $174,000 in the twelve months ended December 31, 2002, 2001, and 2000, respectively. During the quarter ended September 30, 2002, we reduced the number of clinical personnel from four to three. Costs associated with terminating these individuals were $13,000.

Sales and marketing expenses consist of personnel related costs, advertising, public relations and attendance at selected medical conferences. Sales and marketing expenses were $7.1 million, $7.0 million, and $3.5 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. Spending increases in each year are primarily due to increases in expenditures for activities to promote reimbursement for our products. In addition, headcount increases for field sales personnel occurred between 2001 and 2000, related to the commercialization of Stretta in June 2000. Amortization of stock-based compensation accounted for $47,000, $250,000, and $418,000 in the twelve months ended December 31, 2002, 2001, and 2000, respectively. During the quarter ended September 30, 2002, we reduced the number of sales and marketing personnel from 28 to 26. Costs associated with terminating these individuals were $147,000.

General and administrative expenses consist primarily of the cost of corporate operations and personnel, legal, accounting and other general operating expenses of our company. General and administrative expenses were $4.0 million, $4.4 million, and $4.2 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. After eliminating the stock-based compensation and termination costs noted below, spending in 2002 is comparable to 2001. Spending increased in 2001 as compared to 2000 due to higher costs related to being a publicly held company, including legal, accounting, insurance and investor relations; 2001 was our first full year as a public company. Amortization of stock-based compensation accounted for $186,000, $670,000, and $1.3 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. During the quarter ended September 30, 2002, we reduced the number of general and administrative personnel from nine to seven. Costs associated with terminating these individuals were $555,000.

Interest income was $751,000, $2.2 million, and $1.3 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. Interest income has decreased in 2002 as compared to 2001, due to a declining balance of marketable securities. Average cash and investment balances in 2001 were $45.1 million, compared to the 2002 average of $30.8 million. Earnings have also been affected by declining interest rates through 2001 and 2002. The increase in interest income in 2001 as compared to 2000 was due to earnings on a greater marketable securities balance obtained as a result of our initial public offering in September 2000.

Interest expense was $8,000, $4,000, and $4.1 million in the twelve months ended December 31, 2002, 2001, and 2000, respectively. In 2002 and 2001, minimal notes payable related to insurance policies generated interest expense. Interest expense in 2000 was primarily related to the warrants and beneficial conversion feature on the convertible debt, and as such was not a cash expenditure; this debt was extinguished in the third quarter of 2000.

As a result of our net losses, we did not incur any income tax obligations in each of the twelve-month periods ended December 31, 2002, 2001 and 2000.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, we have funded our operations and capital investments from gross proceeds from our initial public offering completed in September 2000 totaling $55.0 million, from the partial exercise of the underwriter’s over-allotment provision totaling $5.2 million, from the private sale of equity securities totaling $22.0 million, from the issuance of convertible notes totaling $11.8 million and from bank equipment line financing totaling $780,000. At December 31, 2002, we had $24.8 million in working capital and our primary source of liquidity was $23.0 million in cash and cash equivalents and marketable securities. In addition, we had $528,000 invested in long-term securities at that date. We intend to finance our operations primarily through our cash and cash equivalents, marketable securities, future financing and future revenues. We believe we have enough cash to fund operations for at least 18 to 24 months, and that alternative financing is available, if needed, however, there can be no assurance that such efforts will succeed or that sufficient funds will be made available.

Cash used in operating activities was $14.4 million in the twelve months ended December 31, 2002, compared to $14.3 million for the same period in 2001. Losses in each year were $15.4 million. In 2002, inventory balances declined, providing $115,000 of cash, compared to 2001, when $544,000 of cash was used to increase inventory balances. This decreasing investment in inventories was due to implementation of system and process improvements in materials management. Cash from interest income has decreased by $1.5 million. Cash from selling activities has increased to $3.4 million in 2002 as compared to $2.9 million in 2001.

Cash provided by investing activities was $15.6 million in the twelve months ended December 31, 2002, compared to $4.7 million for the same period in 2001. This reflects the fact that we used our investments to fund operations of the company during 2002, while in 2001, the higher balance of cash and cash equivalents at December 31, 2000 offset the need to reduce investment balances in 2001.

Cash used by financing activities was $76,000 for the twelve months ended December 31, 2002. This use was primarily due to payments on the notes payable used to finance insurance policies. During 2002, sales of stock through employee stock plans were offset by purchases of treasury stock. Cash provided by financing activities was $439,000 in the twelve months ended December 31, 2001, primarily related to sales of stock through employee stock plans, and the note payable used to finance the Directors and Officers insurance policy. The Company has no significant outstanding long-term obligations except operating lease commitments.

The Company leases office space under noncancelable operating leases expiring in September 2003. Future minimum payments due under operating leases are $409,000 for 2003.

Recent Accounting Pronouncements

In June 2002, The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), Accounting for Costs Associated with Exit or Disposal Activities, which supersedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This new standard requires companies to recognize costs associated with exit or disposal activities when the costs are incurred rather than at the date of a commitment to an exit disposal plan. Costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operations, plant closing, or other exit or disposal activity. This standard is effective for exit or disposal activities that are initiated after December 31, 2002. We will adopt SFAS No. 146 as of January 1, 2003 and we do not believe that the adoption will have a significant impact on the financial position or results of operations.

In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 45 (“FIN45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We believe that the adoption of this standard will have no material impact on our financial statements.

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Management believes that the adoption of this standard will have no material impact on its financial statements.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. The adoption of this standard did not have a material impact on our financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We do not have any ownership in any variable interest entities as of December 31, 2003. We will apply the consolidation requirement of FIN 46 in future periods if we should own any interest in any variable interest entity.

Item 7A.   Quantitative and Qualitative Disclosure About Market Risk

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. That means that a change in prevailing interest rates may cause the fair value of the principal amount of an investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing rate rises, the fair value of the principal amount of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. The average duration of all of our investments has generally been less than eighteen months. Due to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments.

Our exposure to market risk for changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our available funds for investment. We do not plan to use derivative financial instruments in our investment portfolio. We plan to ensure the safety and preservation of our invested principal funds by limiting default risks, market risk and reinvestment risk. We plan to mitigate default risk by investing in high-credit quality securities.

All of our revenue is realized in U.S. dollars. Therefore, we do not believe that we currently have any significant direct foreign currency exchange rate risk.