Exhibit 99.3

 

PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Consolidated Financial Statements

December 31, 2010 and 2009

(With Independent Auditors’ Report Thereon)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Table of Contents

 

		Page
Independent Auditors’ Report			1
Consolidated Financial Statements:
Balance Sheets			2
Statements of Operations			3
Statements of Stockholders’ Deficit and Comprehensive Loss			4
Statements of Cash Flows			5
Notes to Consolidated Financial Statements			6

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		KPMG LLP 4200 Wells Fargo Center 90 South Seventh Street Minneapolis, MN 55402

Independent Auditors’ Report

The Board of Directors

Pioneer Surgical Technology, Inc.:

We have audited the accompanying consolidated balance sheets of Pioneer Surgical Technology, Inc. and subsidiaries (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ deficit and comprehensive loss, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pioneer Surgical Technology, Inc. and subsidiaries as of December 31, 2010 and 2009, and the consolidated results of their operations, and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

 

May 16, 2011

 

		KPMG LLP is a Delaware limited liability partnership, the U.S. member firm of KPMG International Cooperative (“KPMG International”), a Swiss entity.

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2010 and 2009

(In thousands, except share data)

 

		2010				2009
Assets
Current assets:
Cash and cash equivalents		$	3,373				15,789
Short-term investments			2,282				2,250
Accounts receivable, net			9,747				12,354
Inventory			20,680				19,322
Prepaid expenses			709				363
Refundable taxes			134				703
Total current assets			36,925				50,781
Property, plant, and equipment, net			18,485				19,889
Intangible assets, net			1,140				—
Long-term investments			4,000				—
Other long-term assets			233				94
Total assets		$	60,783				70,764
Liabilities and Stockholders’ Deficit
Current liabilities:
Line of credit		$	—				6,264
Current maturities of long-term debt			2,290				2,327
Accounts payable			5,412				4,272
Accrued expenses and other current liabilities			5,868				7,387
Total current liabilities			13,570				20,250
Long-term liabilities:
Series B embedded derivative			13,986				15,280
Long-term debt, net of current maturities			6,597				8,816
Other liabilities			869				777
Total liabilities			35,022				45,123
Series A Preferred Stock subject to redemption, no par value. Authorized, issued, and outstanding 7,519,706 shares (liquidation preference of $48,197 and $43,033 at December 31, 2010 and 2009, respectively)			49,726				41,842
Series B Preferred Stock subject to redemption, no par value. Authorized, 5,434,783 shares; issued and outstanding 4,619,565 shares (liquidation preference of $29,830 and $27,545 at December 31, 2010 and 2009, respectively)			7,128				3,674
Common stock subject to redemption, no par value. Issued and outstanding 588,560 and 5,481,032 shares at December 31, 2010 and 2009, respectively			398				7,536
Commitments and contingencies (notes 6, 9, 15, and 17)
Stockholders’ deficit:
Common stock, no par value. Authorized, 57,867,124 shares; issued and outstanding (excluding shares subject to redemption), 32,120,110 and 27,303,278, at December 31, 2010 and 2009, respectively			4,395				7,625
Notes receivable from sale of common stock			(931	)			(1,035	)
Accumulated deficit			(35,024	)			(34,001	)
Accumulated other comprehensive loss			69				—
Total stockholders’ deficit			(31,491	)			(27,411	)
Total liabilities and stockholders’ deficit		$	60,783				70,764

See accompanying notes to consolidated financial statements.

 

2

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Consolidated Statements of Operations

Years ended December 31, 2010 and 2009

(In thousands)

 

		2010				2009
Net sales		$	68,948				71,226
Cost of sales			17,127				19,687
Gross profit			51,821				51,539
Operating expenses:
General and administrative			15,480				14,988
Selling and marketing			25,389				24,279
Research and development			11,771				13,121
Total operating expenses			52,640				52,388
Operating loss			(819	)			(849	)
Other income (expense):
Interest income			146				239
Interest expense			(716	)			(474	)
Gain (loss) on embedded Series B derivative			1,294				(1,237	)
Other (loss) income, net			(891	)			25
Total other expense			(167	)			(1,447	)
Loss before income tax			(986	)			(2,296	)
Income tax expense (benefit)			37				(316	)
Net loss		$	(1,023	)			(1,980	)

See accompanying notes to consolidated financial statements.

 

3

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Deficit and Comprehensive Loss

Years ended December 31, 2010 and 2009

(In thousands, except share data)

 

		Common stock equity classified								Notes receivable from sale of				Accumulated				Accumulated other comprehensive				Total stockholders’
		Shares				Amount				common stock				deficit				income (loss)				deficit
Balance at December 31, 2008			27,352,775			$	14,628				(1,306	)			(32,021	)			(13	)			(18,712	)
Comprehensive loss:
Net loss			—				—				—				(1,980	)			—				(1,980	)
Foreign currency translation adjustment			—				—				—				—				13				13
Total comprehensive loss			—				—				—				(1,980	)			13				(1,967	)
Issuance – common stock			98,625				166				(71	)			—				—				95
Redemption – common stock			(210,122	)			(400	)			342				—				—				(58	)
Share-based compensation			—				680				—				—				—				680
Accretion – preferred stock to redemption value			—				(6,930	)			—				—				—				(6,930	)
Accretion – preferred stock issuance costs			—				(328	)			—				—				—				(328	)
Accretion – common stock subject to redemption			—				(301	)			—				—				—				(301	)
Changes in shareholder redemption rights			62,000				110				—				—				—				110
Balance at December 31, 2009			27,303,278				7,625				(1,035	)			(34,001	)			—				(27,411	)
Comprehensive loss:
Net loss			—				—				—				(1,023	)			—				(1,023	)
Foreign currency translation adjustment			—				—				—				—				69				69
Total comprehensive loss			—				—				—				(1,023	)			69				(954	)
Issuance – common stock			38,914				118				(64	)			—				—				54
Redemption – common stock			(114,554	)			(215	)			168				—				—				(47	)
Share-based compensation			—				1,067				—				—				—				1,067
Accretion – preferred stock to redemption value			—				(10,828	)			—				—				—				(10,828	)
Accretion – preferred stock issuance costs			—				(510	)			—				—				—				(510	)
Accretion – common stock subject to redemption			—				90				—				—				—				90
Changes in shareholder redemption rights			4,892,472				7,048				—				—				—				7,048
Balance at December 31, 2010			32,120,110			$	4,395				(931	)			(35,024	)			69				(31,491	)

See accompanying notes to consolidated financial statements.

 

4

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Years ended December 31, 2010 and 2009

(In thousands, except share data)

 

		2010				2009
Cash flows from operating activities:
Net loss		$	(1,023	)			(1,980	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			5,233				5,704
Loss on disposal of property and equipment			972				590
Impairment of property, plant, and equipment			43				—
Impairment of intellectual property			—				57
Bad debt expense			139				860
Provision for excess and obsolete inventory			621				733
Change in derivative			(1,294	)			1,237
Change in interest rate swap liabilities			34				(432	)
Amortization of debt issuance costs			9				11
Share-based compensation expense			1,067				641
Deferred income tax assets			—				(167	)
Changes in operating assets and liabilities:
Accounts receivable			2,338				(1,073	)
Inventory			(2,176	)			(1,754	)
Prepaid expenses and other assets			(495	)			(213	)
Refundable taxes			594				166
Accounts payable			1,552				(808	)
Accrued and other liabilities			(1,462	)			1,623
Net cash provided by operating activities			6,152				5,195
Cash flows from investing activities:
Purchase of short-term investments			(32	)			(2,250	)
Purchase of long-term investments			(4,000	)			—
Purchase of property, plant, and equipment			(4,819	)			(2,867	)
Proceeds from disposition of property and equipment			61				12
Purchase of intangible assets			(1,170	)			—
Net cash used in investing activities			(9,960	)			(5,105	)
Cash flows from financing activities:
Change in line of credit			(6,264	)			(115	)
Payments on long-term debt			(2,333	)			(2,088	)
Proceeds from the exercise of common stock options			54				104
Redemption of common stock			(47	)			(58	)
Proceeds from issuance of preferred stock including embedded derivative			—				2,000
Net cash used in financing activities			(8,590	)			(157	)
Effect of exchange rate changes on cash			(18	)			6
Net decrease in cash and cash equivalents			(12,416	)			(61	)
Cash and cash equivalents – beginning of year			15,789				15,850
Cash and cash equivalents – end of year		$	3,373				15,789
Supplemental cash flow information – cash paid (refunded) for:
Interest		$	732				902
Income taxes, net			(332	)			(134	)

Supplemental disclosures of noncash investing and financing activities:
The Company increased the carrying amount of preferred stock by an aggregate of $11,338 and $7,258 in 2010 and 2009, respectively.
The Company (decreased) increased the carrying amount of common stock subject to redemption by an aggregate of $(7,138) and $200 in 2010 and 2009, respectively.
The Company increased common stock by $64 and $71 related to options exercised with a shareholder note along with accrued interest in 2010 and 2009, respectively.
The Company repurchased 87,088 and 192,157 shares of common stock in lieu of repayment of a shareholder note and accrued interest of $168 and $342 in 2010 and 2009, respectively.

See accompanying notes to consolidated financial statements.

 

5

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(1)	Description of Business and Significant Accounting Policies

 

(a)

Description of Business

Pioneer Surgical Technology, Inc. and subsidiaries (the Company) are engaged in the business of developing, manufacturing, and distributing spinal and orthopedic surgical implants and instruments. Having a worldwide customer base and sales force, the Company operates an administrative, research, and manufacturing facility in Marquette, Michigan; two complimentary research facilities in the United States of America (U.S.); a marketing and engineering office in Austin, Texas; and a sales and distribution office in The Netherlands.

 

(b)

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Pioneer Surgical Technology, Inc. and its wholly owned subsidiaries—Pioneer Surgical Orthobiologics, Inc., Angstrom Acquisition Corp. II, and Pioneer Surgical Technology, BV. Intercompany transactions and balances have been eliminated.

 

(c)

Revision of 2009 Consolidated Financial Statements

The Company made an immaterial correction to the fair value measurement of the Series B embedded derivative at December 31, 2009. This resulted in a decrease in the carrying amount of the Series B embedded derivative and accumulated deficit at December 31, 2009, and a decrease in the loss on the embedded derivative and the net loss for the year ended December 31, 2009. This revision resulted in the Series B embedded derivative, included in long-term liabilities in 2009, to change from $17,240, as previously presented, to $15,280.

 

(d)

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts and disclosures in the consolidated financial statements and accompanying notes. The following amounts, among others, presented in the financial statements are subject to management estimates: allowance for uncollectible receivables, inventory provisions, self-funded insurance liabilities, deferred income tax asset valuation allowances, and share-based compensation expense. Actual results could differ from those estimates.

 

(e)

Concentration of Credit Risk

The Company is potentially subject to credit risk in connection with its accounts receivable and draws provided to distributors. The Company has a credit policy and performs ongoing credit evaluations of its customers. The Company does not generally require collateral or other security and maintains an allowance for potential credit losses. As of December 31, 2010, one customer represented 10% of the outstanding accounts receivable balance. As of December 31, 2009, a different customer represented 34% of the outstanding accounts receivable balance.

 

		6		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(f)

Sources of Supply

Certain of the Company’s raw materials and purchased components are supplied by single sources due to technology, price, quality, or other considerations. Some of these single-sourced components are manufactured to the Company’s design and specifications. Most of these items, however, may be sourced from other suppliers, often after a qualification process. Sourcing from alternative suppliers, in some cases, may require additional product design to accommodate variations from the original components. In the event the Company’s supply of critical raw materials or components were interrupted due to the time required to qualify materials or components, or modify product designs, the Company’s ability to manufacture the related product in the desired quantities and in a timely manner could be adversely affected. The Company mitigates these risks by working closely with key suppliers to coordinate product plans and the transition to replacement components for critical parts.

 

(g)

Cash and Cash Equivalents

The Company considers highly liquid investments with original maturities of 90 days or less to be cash equivalents. Cash equivalents are stated at market value, which approximates cost. The Company’s cash equivalents are primarily invested in money market funds.

 

(h)

Short-Term Investments

Short-term investments are investments with an original maturity greater than 90 days and less than a year. The Company carries the investment at market value, which approximates cost. The Company’s short-term investments are primarily invested in certificates of deposit.

 

(i)

Long-Term Investments

Long-term investments are investments with an original maturity greater than a year. The Company carries the investments at cost. The Company’s long-term investments are primarily invested in certificates of deposit.

 

(j)

Accounts Receivable

The Company grants credit to customers in the normal course of business, but generally does not require collateral or any other security to support its receivables. Accounts receivable are stated at net invoice amounts. The Company maintains an allowance for uncollectible amounts. This allowance is an estimate and is regularly evaluated by the Company for adequacy by considering factors such as past experience, credit quality of the customer base, age of the receivable balances (both individually and in the aggregate), and current economic conditions that may affect a customer’s ability to pay. Uncollectible accounts are written off against the allowance when it is deemed that a customer account is uncollectible. Allowances for uncollectible amounts attributed to bad debts are recorded in general and administrative expenses in the accompanying consolidated

 

		7		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

statements of operations. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. A rollforward of the allowance for uncollectible amounts is as follows:

 

		2010				2009
Beginning balance		$	1,148				476
Provision			139				860
Write-offs			(815	)			(188	)
Ending balance		$	472				1,148

 

(k)

Inventory

Inventory, including consigned finished goods, is stated at the lower of cost or market, with cost determined on the first-in, first-out method. The Company’s evaluation of inventories for obsolescence and excess quantities includes analyses of inventory levels including consigned finished goods, historical loss trends, expected product lives, product at risk of expiration, sales levels by product, and projections of future sales demand. Current products and related inventories may require additional provisions based upon changes in market demand or introduction of competing technologies. Increases in the provision for excess and obsolete inventory result in a corresponding expense to cost of sales in the accompanying consolidated statements of operations. The Company reduces excess and obsolete provisions for products no longer requiring reserves at the time product is sold or otherwise disposed of. Consigned finished goods are included in inventory until revenue is recognized as described in note 1(t).

 

(l)

Property, Plant, and Equipment

Property, plant, equipment, and software are recorded at cost and depreciated utilizing the straight-line method over the estimated useful lives of the respective assets. The cost for purchased software includes the cost of development and implementation. Leasehold improvements are amortized over the shorter of the useful life of the assets or term of the lease. Repairs and maintenance are expensed as incurred.

 

(m)

Surgical Instruments

Surgical instruments are handheld devices used by surgeons during implant procedures. The Company retains title to the surgical instruments, which are recorded within property, plant, and equipment at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on an estimated useful life of three years. Depreciation for instruments is included in selling and marketing expenses in the accompanying consolidated statements of operations.

 

(n)

Intangible Assets

Intangible assets include license agreements and patent rights. Intangible assets are amortized over the estimated useful life on a straight-line basis. At the time of acquisition, the asset life is estimated based upon the term of the license agreement, patent life, or market exclusivity of the asset and an assessment of future sales and profitability of the asset.

 

		8		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(o)

Impairment of Long-Lived Assets

Long-lived assets, which include property, plant, and equipment, and purchased intangible assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset be tested for impairment, the Company first compares undiscounted cash flows expected to be generated by an asset group to the carrying amount of the assets. If the carrying amounts of the long-lived assets were not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying amount of individual assets exceeds their fair value. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values, or third-party independent appraisals as considered necessary.

 

(p)

Derivative Instruments

The Company has entered into interest rate swaps in connection with certain debt financing to enhance the predictability of the related expense and cash flows, and has elected to forgo the documentation required to obtain hedge accounting. All of the Company’s derivative instruments are recorded on the consolidated balance sheet as either an asset or a liability and measured at fair value. The changes in the derivatives’ fair values are recognized as interest expense or interest income in the accompanying consolidated statements of operations.

In connection with the Company’s Series B Preferred Stock issuance, the Company was required to bifurcate an embedded derivative and account for it as a bundled derivative instrument as described in note 13(d).

 

(q)

Stock and Stock Options Subject to Conditional Redemption Rights

The Company’s Series A and Series B Preferred Stock and certain common shares are subject to conditional redemption rights that are outside of the control of the Company. The Company has elected to account for conditionally redeemable equity instruments within mezzanine equity. For common shares subject to conditional redemption rights that are probable of being met, the Company records the carrying amount of the shares at their redemption price at each year-end. Changes in the carrying amounts of preferred and common shares recorded in mezzanine equity are treated in the same manner as dividends on nonredeemable stock.

Certain employee stock options accounted for using the intrinsic value method are subject to conditional redemption rights. The Company records these options at their grant-date redemption value less any exercise proceeds not yet paid. For those options that are both currently not redeemable and where it is not probable that they will become redeemable, no subsequent adjustment is made to their carrying amount until it is probable that the security will become redeemable. Options subject to unconditional redemption rights and vesting rights are recorded in mezzanine equity pro rata based upon the vesting terms.

 

		9		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(r)

Foreign Currency Translation

The euro is the functional currency of Pioneer Surgical Technology, BV, the Company’s wholly owned European subsidiary. Assets and liabilities of Pioneer Surgical Technology, BV are translated into U.S. dollars at the rate of exchange in effect at the close of the year. Income and expenses are translated at an average rate of exchange for the year. The aggregate effect of translating the consolidated financial statements is included in accumulated other comprehensive income (loss) in the accompanying consolidated statements of stockholders’ deficit and comprehensive loss. Foreign currency transaction gains and losses are included in other (loss) income, net in the accompanying consolidated statements of operations. The aggregate transaction (loss) gain was $(771) and $125 in 2010 and 2009, respectively.

 

(s)

Other Comprehensive Loss

Foreign currency translation adjustments, net of tax, are reported as a direct adjustment to equity in the consolidated balance sheet. This item, along with net loss, are considered components of comprehensive loss. The currency translation adjustment is not adjusted for income taxes. Comprehensive loss was $954 and $1,967 in 2010 and 2009, respectively.

 

(t)

Revenue Recognition and Cost of Sales

The Company sells a significant portion of its products directly to original equipment manufacturers and through third-party distributors to healthcare facilities. In limited circumstances, the Company will sell directly to healthcare facilities. Revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists; shipment or delivery has occurred, based on the sales terms; the sales price is fixed or determinable; and collectibility is reasonably assured. Sales directly to other companies are recognized when title and risk of ownership have been transferred, which are typically upon shipment to the customer.

A significant amount of inventory is held on consignment within the third-party distributor network by either distributor field representatives or hospitals with the Company retaining risk of inventory ownership. Distributors are representatives of the Company and are aware of consignment inventory sales because a distributor is generally present at the time the product is implanted in a patient. Consignment inventory sales are recognized when the Company receives notification via a delivered order form that a product has been used or implanted. The Company is responsible for establishing pricing and retains accounts receivable collection risk. Distributor commissions are determined through distributor agreements and such commissions are recognized as a selling cost.

During the year ended December 31, 2010, the Company adopted new accounting guidance related to revenue recognition for research and development projects contingent on the achievement of certain milestones. Revenue is recognized in the period the milestone is achieved if the revenue was related to the Company’s performance to achieve the milestone, relates solely to past performance, and is reasonable relative to all of the deliverables and payment terms within the arrangement. The amount of revenue recognized based on the achievement of milestones during the year ended December 31, 2010 was not material to the Company’s financial statements.

 

		10		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Revenue recognition and payment terms are consistent for both domestic and international sales. All sales are recorded net of any trade or volume discounts. There are no prompt payment discounts offered. Products sold to hospitals are either implanted or one-time use medical devices and are not subject to return. Products sold through resellers are subject to return, and as such, an allowance is maintained for returns.

The Company has significant revenues and receivable balances with individual customers. In 2010, sales to two customers represented 21% and 11% each, of the Company’s total net sales and 3% and 10% each, of accounts receivable. One of these customers represented 29% of the Company’s net sales and 34% of accounts receivable in 2009. For both customers, the majority of revenue is recognized at the time of shipment from the Company. The remaining revenue relates to consigned inventory where sales are recognized monthly based on a contractual percentage of sales and inventory balances confirmed by the distributors for both customers. Collection terms for these customers are net 30 days.

Sales taxes collected from customers and remitted to governmental authorities are accounted for on a net basis and, therefore, are excluded from net sales in the accompanying consolidated statements of operations. Shipping and handling costs billed to customers for the delivery of finished goods are not significant and recorded in net sales in the accompanying consolidated statements of operations and these costs are recorded within cost of sales in the accompanying consolidated statements of operations as they are incurred. Cost of sales in the accompanying consolidated statements of operations—consisting primarily of raw materials, components, direct labor, and manufacturing overhead—is recognized in the same period in which the related revenue is recognized.

Net sales were made to customers in the following geographic regions:

 

		2010				2009
North America		$	60,548				65,222
Europe, Middle East, and Africa			6,703				5,558
Asia			1,697				446
Total		$	68,948				71,226

 

(u)

Income Taxes

The Company accounts for income taxes under the asset and liability method, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company records a valuation allowance to reduce deferred tax assets when it is more likely than not the deferred tax asset will not be realized.

 

		11		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(v)

Share-Based Compensation

The Company measures and recognizes the cost of employee services received in exchange for equity instruments classified within equity based on the grant-date fair value of those awards. Compensation cost for equity-classified awards is recognized ratably using the straight-line attribution method over the expected vesting period, which is considered to be the requisite service period, based on awards ultimately expected to vest and is reduced for estimated forfeitures of unvested awards. The cost of employee services received in exchange for equity instruments classified as liabilities is initially measured and recognized based on the grant-date fair value of those awards. Employee liability classified awards reported under the consolidated balance sheet caption, other liabilities in the accompanying consolidated balance sheets, are remeasured at each reporting date at fair value on a pro rata basis consistent with the vesting schedule for such awards. The increase or decrease in the fair value is recorded as compensation expense.

For purposes of calculating share-based compensation, the Company estimates the fair value of stock options using a Black-Scholes option pricing model. The Black-Scholes option pricing model incorporates various assumptions, including volatility, expected life, interest rates, and dividends.

The Company records expense for all stock options granted to nonemployees who are not directors in an amount equal to the estimated fair value at the earlier of the performance commitment date or the date at which performance is complete, determined using the Black-Scholes option pricing model. The expense is recognized ratably over the vesting period.

 

(w)

Advertising Costs

Advertising costs are expensed as incurred. The Company markets its products primarily through a direct sales force, distributor networks, and original equipment manufacturers. Advertising expense for 2010 and 2009 was $308 and $65, respectively.

 

(x)

Research and Development

Research and development expenditures are charged to expense as incurred and include the costs to design, develop, test, deploy, and enhance products. Research and development expense in the accompanying consolidated statements of operations also includes the cost of acquired in-process research and development, clinical trials, and obtaining regulatory approval for products.

 

(y)

In-Process Research and Development (IPR&D)

Payments for the acquisition of products that are under development or are not approved by the Food and Drug Administration (FDA) for marketing—and have not reached technical feasibility or have no foreseeable alternative future uses—are expensed as research and development or acquired IPR&D.

 

		12		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

IPR&D acquired in a business combination is capitalized at fair value as an indefinite lived intangible asset until completion of the IPR&D project or abandonment. Upon completion of the project, acquired IPR&D assets are amortized over the estimated useful life. If the IPR&D project was abandoned, the related assets would be impaired and written down to the remaining fair value. IPR&D acquired in an asset purchase is expensed immediately. For the year ended December 31, 2010, no IPR&D was capitalized.

 

(z)

Recently Issued Accounting Statements

In April 2010, the Financial Accounting Standards Board (FASB) issued guidance on the criteria for determining whether the milestone method of revenue recognition is appropriate for recognizing revenue. A company can recognize consideration that is contingent upon achievement of a milestone in its entirety as revenue in the period in which the milestone is achieved if certain criteria were met. The consideration earned by achieving the milestone should 1) be proportionate with either the company’s performance to achieve the milestone or the enhancement of the value of the item delivered as a result of a specific outcome resulting from the company’s performance to achieve the milestone, 2) relate solely to past performance, and 3) be reasonable relative to all deliverables and payment terms in the arrangement. The updated guidance is effective for milestones achieved in fiscal years beginning after June 15, 2010, with early adoption permitted. The Company elected to early adopt the accounting guidance, and therefore, the guidance is in effect for 2010. The Company’s adoption did not have a material effect on financial statements for the period ended December 31, 2010.

In January 2010, the FASB updated the disclosure requirements for fair value measurements. The updated guidance requires companies to disclose separately the investments that transfer in and out of Levels 1 and 2 and the reasons for the transfers and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. The updated guidance was effective for the Company for 2010, except for the disclosures about purchases, sales, issuances, and settlements in the Level 3 reconciliation, which are effective for the Company beginning in 2011. The 2010 adoption did not result in a material impact to the Company’s financial statements.

In October 2009, the FASB updated the revenue recognition accounting guidance related to the accounting for revenue arrangements that involve more than one deliverable or unit of accounting. The updated guidance allows companies to allocate arrangement consideration in multiple deliverable arrangements in a manner that better reflects the economics of the transaction by revising certain thresholds for separation, and providing criteria for allocation of revenue among deliverables. The updated guidance is effective for the Company beginning in 2011. The Company is still analyzing the impact of the adoption on the financial statements.

 

(aa)

Recently Issued Tax Legislation

In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act of 2010 (Acts). The Company’s

 

		13		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

current financial position and results of operations are not impacted by these Acts. However, for the years ending after December 31, 2012, the Company’s results of operations are expected to be adversely impacted as the Acts impose a 2.3% excise tax on U.S. sales of Class I, II, and III medical devices. Further, the Obama Administration announced several international tax legislative proposals to reform the U.S. tax rules, including provisions that may limit the deferral of U.S. income tax on the Company’s unremitted foreign earnings, substantially reduce the Company’s ability to claim foreign tax credits, and defer various tax deductions until foreign earnings are repatriated to the U.S. If any such proposals were enacted into law, they could have a material adverse impact on the Company’s financial position and results of operations.

 

(2)

Inventory

Inventory consisted of the following at December 31:

 

		2010				2009
Raw materials		$	2,302				1,971
Work in process			5,544				5,592
Finished goods			5,551				6,002
Consigned inventory			7,283				5,757
		$	20,680				19,322

 

(3)	Property, Plant, and Equipment

Property, plant, and equipment are summarized as follows at December 31:

 

		2010				2009				Depreciable life (years)
Land		$	284				301
Land improvements			354				354			20
Buildings			9,383				9,375			40
Machinery and equipment			16,040				16,290			3 – 10
Furniture and fixtures			1,748				1,363			3 – 5
Computer equipment and software			3,466				2,699			3 – 5
Surgical instrumentation			8,834				8,806			3
Construction in progress			204				154
			40,313				39,342
Accumulated depreciation			(21,828	)			(19,453	)
		$	18,485				19,889

 

		14		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

The depreciation and amortization expense for property, plant, and equipment under a capital lease was $215 and $197 in 2010 and 2009, respectively. Accumulated depreciation related to property, plant, and equipment under capital lease totaled $1,007 and $802 as of December 31, 2010 and 2009, respectively. Depreciation expense for surgical instrumentation was $2,791 and $3,184 in 2010 and 2009, respectively.

Disposal of fixed assets during 2010 and 2009 resulted in a loss of $972 and $590, respectively. The losses were recorded as operating expenses.

As of December 31, 2010 and 2009, the Company had net property, plant, and equipment of $385 and $250, respectively, located in foreign jurisdictions.

 

(4)	Intangible Assets

The following table provides the gross and net amounts of intangible assets as of December 31:

 

		2010
		License agreement				Patent rights				Total
Original cost		$	1,170				850				2,020
Accumulated amortization/write-offs			(30	)			(850	)			(880	)
Total intangible assets		$	1,140				—				1,140

 

		2009
		License agreement				Patent rights				Total
Original cost		$	—				850				850
Accumulated amortization/write-offs			—				(850	)			(850	)
Total intangible assets		$	—				—				—

During 2010, the Company acquired a licensing agreement along with an immaterial amount of inventory and instrumentation. The license agreement is being amortized over a ten-year period.

During 2009, the Company evaluated certain patent rights and related intellectual property and determined that the commercialization of the technology was impracticable. As a result the Company recorded an impairment charge to research and development expenses in the accompanying consolidated statements of operations of $57, thus reducing the net carrying amount to zero.

 

		15		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Amortization expense was $30 and $17 for the years ended December 31, 2010 and 2009, respectively.

Expected future amortization expense for intangible assets is as follows:

 

2011		$	117
2012			117
2013			117
2014			117
2015			117
Thereafter			555
Total		$	1,140

 

(5)	Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consisted of the following at December 31:

 

		2010				2009
Accrued payroll		$	2,829				2,985
Commissions payable			1,344				1,212
Accrued vacation			773				970
Accrued royalties			91				1,174
Accrued discounts			253				253
Value Added Tax payable			13				430
Other current liabilities			565				363
Total accrued expenses and other current liabilities		$	5,868				7,387

 

(6)	Line-of-Credit Facility

The Company’s reload credit agreement has a capacity of $12,000 with available credit of $10,712 at December 31, 2010, and carries an interest rate of 0.25% below the bank’s prime rate (effective rate of 2.51% at December 31, 2010). This agreement expires September 29, 2012, and is collateralized by substantially all the Company’s assets. The Company had a similar agreement at December 31, 2009. Balances outstanding were $0 and $6,264 as of December 31, 2010 and 2009, respectively.

Under the terms of the current agreement the Company must maintain certain financial ratios, including a debt service coverage ratio and net funded debt to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), and limit its capital expenditures as well as other enumerated restrictions which, if not met, can result in an event of default. A default that remains uncured or is not waived by the bank may result in immediate repayment of the debt. At December 31, 2010, the Company was in compliance with all provisions of the loan agreement.

 

		16		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(7)	Long-Term Debt

Long-term debt at December 31 consisted of the following:

 

		2010				2009
Term loan dated October 19, 2007, with interest rate of 1.25% above 30-day LIBOR, collateralized by specific equipment, due in monthly installments of $47 plus interest through October 2012, effective rate of 1.51% at December 31, 2010		$	5,035				5,601
Equipment notes payable in monthly installments of $20 to $38, expiring in June 2011 to January 2015, with interest at 5.90% to 7.00%, collateralized by specific equipment			1,784				2,616
Michigan Strategic Fund Bond Debt – limited obligation revenue bonds secured by a letter of credit collateralized by specific assets of the Company. Yearly principal payment of $600 through September 2012 with a variable interest rate of 1.50% over the Municipal Swap Index, effective rate of 0.40% at December 31, 2010			1,400				2,000
Economic Development Corporation (EDC) Bond Debt – tax-exempt industrial revenue bonds secured by a letter of credit collateralized by specific assets of the Company and the personal guarantee of a stockholder. Annual principal payments of $200 to $225 through June 2012 with a variable interest rate set weekly at approximately 10 to 30 basis points above the Bond Market Association Index, effective rate of 0.55% at December 31, 2010			400				400
Leases and loans payable in monthly installments of $3 to $10 expiring in December 2010 through May 2012, with interest at 2.19% to 7.00%, collateralized by specific equipment			268				526
Total			8,887				11,143
Less current maturities			2,290				2,327
Long-term maturities		$	6,597				8,816

 

		17		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Future contractual maturities of long-term debt outstanding, including capital leases, as of December 31, 2010 were as follows:

 

2011		$	2,290
2012			1,984
2013			1,005
2014			810
2015			594
Thereafter			2,204
Total		$	8,887

Based on the borrowing rates currently available to the Company for loans with similar terms and average maturities, the fair value of long-term debt (exclusive of leases), including current maturities, at December 31, 2010 was $8,599 compared to the carrying amount of $8,619.

Equipment with gross costs of $1,359 and $1,286 as of December 31, 2010 and 2009, respectively, were financed by four capital leases. For financial statement purposes, the present values of the net minimum lease payments have been capitalized and are being amortized over the useful lives of the assets to which they relate, and are included in property, plant, and equipment in the accompanying consolidated balance sheets. The present values of net minimum lease payments are included in long-term debt in the accompanying consolidated balance sheets.

 

(8)	Interest Rate Swaps

The Company has entered into two interest rate swap agreements with notional amounts at December 31, 2010 of $700 and $4,900 maturing on August 31, 2012 and 2019, respectively. The $700 swap converts the variable rate of 1.50% over the Municipal Swap Index to a fixed rate of 3.69%. The $4,900 swap converts a variable rate of 1.25% over LIBOR to a fixed rate of 5.90%. The Company entered into these swaps to manage variable interest rate cash flows associated with long-term variable rate debt obligations. The notional amounts decline over the period of the agreements as the associated debt is repaid. The Company has made an election not to document the hedge accounting relationship and ongoing effectiveness and ineffectiveness testing that are required for the Company to apply hedge accounting. Accordingly, changes in fair value of the arrangements are recognized within interest expense in the accompanying consolidated statements of operations. The fair value of the Company’s obligation on the interest rate swaps was $803 and $769 at December 31, 2010 and 2009, respectively. These balances have been included in other long-term liabilities in the accompanying consolidated balance sheets.

 

(9)

Leases

The Company has noncancelable operating leases for office space that expire over the next five years.

Minimum rent payments under operating leases are recognized on a straight-line basis over the terms of the leases including any periods of free rent. Rental expense for operating leases (except those with lease terms of a month or less that were not renewed) during 2010 and 2009 was $521 and $255, respectively.

 

		18		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Future minimum lease payments under capital leases and noncancelable operating leases (with initial or remaining lease terms in excess of one year) as of December 31, 2010 were as follows:

 

		Capital leases				Operating leases
2011		$	155				659
2012			59				371
2013			18				351
2014			16				144
2015			10				149
Thereafter			—				—
Total minimum lease payments			258			$	1,674
Less amounts representing interest			(9	)
Present value of net minimum lease payments		$	249

 

(10)	Fair Value Measurements

The authoritative guidance for fair value measurements defines fair value as an exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. The authoritative guidance establishes a valuation hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability and developed based on independent market data sources. Unobservable inputs are inputs that reflect the Company’s assumptions about the factors market participants would use in valuing the asset or liability and developed based upon the best information available. This hierarchy prioritizes the inputs into three broad levels as follows:

 

(a)

Level 1: Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.

 

(b)

Level 2: Inputs are quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly.

 

(c)

Level 3: Inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value.

Assets and Liabilities that are Measured at Fair Value on a Recurring Basis

The fair value authoritative guidance applies to certain financial assets and liabilities that are measured at fair value on a recurring basis. For the Company, financial liabilities include interest rate swaps and the bundled derivative associated with the Series B Preferred Stock. The Company had previously and will continue to record these items at fair value on a recurring basis; however, the definition of fair value is now applied using the authoritative guidance mentioned above.

 

		19		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

The following table provides the assets and liabilities carried at fair value measured on a recurring basis as of December 31:

 

		Fair value				Quoted prices in active markets (Level 1)				Significant other observable inputs (Level 2)				Significant unobservable inputs (Level 3)
2010
Liabilities:
Interest rate swaps		$	803				—				803				—
Bundled derivative			13,986				—				—				13,986
Total		$	14,789				—				803				13,986
2009
Liabilities:
Interest rate swaps		$	769				—				769				—
Bundled derivative			15,280				—				—				15,280
Total		$	16,049				—				769				15,280

The valuation techniques used to determine market value were as follows:

 

(a)

Interest rate swaps were valued using models that use readily observable market data as their basis.

 

(b)

To determine the value of the bundled derivative, a valuation of the Company was performed, employing both discounted cash flow and market comparability techniques. Those values were then allocated to the various equity components. The value assigned to the Series B was further allocated to the stock component based on the fair market value of the equity component plus accrued dividends, with the remainder deemed to be the bundled derivative value.

 

		20		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

There were no transfers between Level 1 and Level 2 during the years ended December 31, 2010 and 2009.

The following table presents the Company’s activity for the liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

 

		2010				2009
Beginning balance		$	15,280				12,579
Total realized and unrealized (gains) losses:
Included in earnings (1)			(1,294	)			1,237
Included in other comprehensive income			—				—
Purchases, issuances, and settlements (net)			—				1,464
Transfers in/out of Level 3 (net)			—				—
Ending balance		$	13,986				15,280
(Gain) loss recorded in earnings for Level 3 assets still held at December 31		$	(1,294	)			1,237

 

(1)	Amounts are included in Gain (loss) on embedded Series B derivative in the accompanying consolidated statements of operations.

 

(11)	Income Taxes

For the years ended December 31, the provision for income taxes consisted of the following:

 

		2010				2009
Current federal and state benefit		$	37				(316	)
Deferred federal and state expense			—				—
Total income tax expense (benefit)		$	37				(316	)

 

		21		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

A reconciliation of the total income tax expense (benefit) to income taxes computed by applying the statutory U.S. federal rate to loss before taxes is as follows:

 

		2010				2009
Income tax benefit, computed at 34% of pretax loss		$	(336	)			(1,447	)
State income taxes, net of federal benefit			(10	)			(1	)
Series B mark-to-market adjustment			(440	)			1,087
Encelle royalties			—				336
Share-based compensation			58				153
Other permanent items			73				203
Impact of amended returns and NOL carryback claims			—				1,059
General business tax credits			(247	)			(232	)
Reserve for uncertain tax positions			—				(167	)
Change in valuation allowance			914				(1,311	)
Other adjustments			25				4
Total income tax expense (benefit)		$	37				(316	)

 

		22		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Net deferred tax assets and liabilities consisted of the following components:

 

		2010				2009
Deferred tax assets:
Allowance for doubtful accounts		$	174				424
Inventory			1,673				1,462
Property, plant, and equipment			—				331
Intangibles			518				575
Share-based compensation			1,582				1,290
Contributions subject to income limitation			151				113
Vacation and deferred compensation			204				512
Interest rate swap derivative			287				284
Accrued discount			163				94
Net operating loss carryforwards			3,441				3,505
Research and development credit carryforward			1,294				1,048
State credit carryforward			23				23
Unrealized currency loss			219				—
Instruments			290				—
Alternative Minimum Tax credit carryforward			114				—
Other			131				—
Gross deferred tax assets			10,264				9,661
Deferred tax liabilities:
Property, plant, and equipment			(806	)			—
Other			(30	)			(29	)
Gross deferred tax liabilities			(836	)			(29	)
Net deferred tax assets before valuation allowance			9,428				9,632
Less valuation allowance			(9,428	)			(9,632	)
Net deferred tax assets		$	—				—

In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences are deductible. Based on the level of historical taxable income and projections of future taxable income over the periods in which the deferred tax assets are deductible, management currently does not believe that it is more likely than not that the Company will realize the benefits of these deductible differences. Accordingly, the Company recorded a valuation allowance against net deferred tax assets for the years ended December 31, 2010 and 2009.

As of December 31, 2010, the Company has generated federal net operating loss and tax credit carryforwards of approximately $6,818 and $1,294, respectively, which are available to offset future

 

		23		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

federal taxable income, if any, through 2028. Additionally, as of December 31, 2010, the Company has acquired net operating loss carryforwards of approximately $2,948 subject to the limitations of Internal Revenue Code statute 382, which may be applied to offset future federal taxable income and expire from 2021 through 2027.

As of December 31, 2010, the Company’s pool of excess tax benefits related to share-based compensation previously recorded in common stock totals $433. Shortfalls in expected tax benefits from shared-based compensation are recognized first as an offset to this pool of excess tax benefits rather than as income tax expense, until the pool of previously recognized excess tax benefits is exhausted.

The Company had no gross unrecognized tax benefits as of December 31, 2010 and 2009. Following is a reconciliation of the beginning and ending amount of unrecognized tax benefit for December 31:

 

		2010				2009
Beginning balance		$	—				(167	)
Increase related to current year tax positions			—				—
Decrease related to prior year tax positions			—				167
Lapse of statute			—				—
Ending balance		$	—				—

The Company recognizes interest and penalties related to income tax matters in other (loss) income, net in the accompanying consolidated statements of operations. Amounts recognized for interest and penalties were not material for the years ended December 31, 2010 and 2009.

The Company files a U.S. federal tax return, and returns in The Netherlands and various state jurisdictions. Uncertain tax positions are related to tax years that remain subject to examination. As of December 31, 2010, U.S. federal tax returns for calendar years 2003 through 2010 and state tax returns for calendar years 2005 through 2010 remain subject to examination by tax authorities. The statute of limitations for the Company’s foreign subsidiary extends for five years.

 

		24		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(12)	Redeemable Stock

The following table presents stock subject to redemption:

 

		Series A preferred stock subject to redemption								Series B preferred stock subject to redemption								Common stock subject to  redemption
		Shares				Amount				Shares				Amount				Shares				Amount
Balance at December 31, 2008			7,519,706			$	36,270				4,076,087			$	1,453				5,534,184			$	7,336
Issuance – preferred stock, net of issuance costs			—				—				543,478				535				—				—
Issuance – common voting			—				—				—				—				8,848				9
Accretion – preferred stock to redemption value			—				5,312				—				1,618				—				—
Accretion – preferred stock issuance costs			—				260				—				68				—				—
Accretion – common stock subject to redemption			—				—				—				—				—				301
Change in shareholder redemption rights			—				—				—				—				(62,000	)			(110	)
Balance at December 31, 2009			7,519,706				41,842				4,619,565				3,674				5,481,032				7,536
Accretion – preferred stock to redemption value			—				7,622				—				3,206				—				—
Accretion – preferred stock issuance costs			—				262				—				248				—				—
Accretion – common stock subject to redemption			—				—				—				—				—				(90	)
Change in shareholder redemption rights			—				—				—				—				(4,892,472	)			(7,048	)
Balance at December 31, 2010			7,519,706			$	49,726				4,619,565			$	7,128				588,560			$	398

For further discussion of redeemable stock, see notes 13 and 14.

 

(13)	Series A and B Redeemable Convertible Preferred Stock

In December 2008, the Company amended its Articles of Incorporation, authorizing 12,954,489 shares of preferred stock, with no par value. Prior to 2007, the Company sold 7,519,706 shares of Series A Preferred Stock (Series A) for gross proceeds of $30,500, including issuance costs of $1,734. In 2008, the Company sold 4,076,087 shares of Series B Preferred Stock (Series B) for gross proceeds of $15,000. In 2009, an additional 543,478 shares of Series B shares were sold for gross proceeds of $2,000. Issuance costs for Series B were $1,078. The following is a summary of the terms of the preferred stock:

 

(a)

Ranking

The Series A and Series B rank senior to the Company’s common stock with respect to payment of dividends upon the Company’s liquidation, dissolution, or winding down. While any shares of preferred stock are outstanding, the Company cannot authorize or issue any class or series of stock that ranks senior to or in parity with the preferred stock as to dividends or upon liquidation, dissolution, or winding down without the consent of the holders of 70% of the outstanding shares of preferred stock.

 

(b)

Registration Rights

Upon the second anniversary of the Shareholders Agreement dated December 16, 2008, the preferred stockholders can participate in a request for registration of the Company’s common shares with the Securities Exchange Commission.

 

		25		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(c)

Dividends

Preferred stockholders are entitled to receive dividends when, as, and if, declared by the board of directors. The preferred stock does not bear a stated dividend rate. No dividends were declared or paid for the years ended December 31, 2010 and 2009.

 

(d)

Redemption

At any time after the earlier to occur of (i) the closing of an underwritten initial public offering of shares of common stock where net proceeds are less than $60,000 and the per share price is less than $9.00 (a nonqualified public offering) or (ii) December 15, 2012; holders of preferred stock may redeem such shares at their sole discretion at a redemption price equal to the greater of (a) the original issue price for such shares for Series A, and 150% of the original issue price for Series B or (b) the fair market value of such shares at the time of redemption as determined by an appraisal. Because the redemption is not mandatory, the preferred stock is not required to be classified as a liability, but rather is classified in the mezzanine section of the consolidated balance sheets. The aggregate fair market value of the preferred stock and bundled derivative was $110,980 and $104,201 at December 31, 2010 and 2009, respectively.

Series A

The fair market value of the Series A was $69,810 and $63,919 at December 31, 2010 and 2009, respectively. The excess of the fair market value of Series A over the original issuance price of $30,500 is being accreted to the redemption value using the effective-interest method. Changes in the estimated redemption value of Series A are prospectively reflected in the accretion calculation.

Issuance costs associated with Series A are reflected as a reduction in the carrying amount of Series A and are amortized using the effective-interest method. Unamortized Series A issuance costs were $522 and $784 at December 31, 2010 and 2009, respectively. For the years ended December 31, 2010 and 2009, the Company recognized Series A accretion of $7,884 and $5,572, respectively, in the consolidated statements of stockholders’ deficit for accretion to redemption value and amortization of issuance costs.

Series B

The Series B was initially recorded at its issuance price, net of issuance costs of $1,078 and less the amount allocated to the embedded derivative. The Series B conversion feature and the conditional redemption rights upon a liquidation event or a nonqualified public offering are an embedded bundled derivative to be accounted for separately from the Series B preferred stock. The aggregate fair market value of the Series B preferred stock and the embedded bundled derivative was $41,170 and $40,282 at December 31, 2010 and 2009, respectively.

Upon the December 2008 issuance, the embedded bundled derivative had a fair value of $12,579. The issuance of Series B in April 2009 included an embedded bundled derivative fair value of $1,464. Changes to the recorded fair value of the bundled derivative are reflected in the consolidated

 

		26		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

statement of operations as gain (loss) on embedded Series B derivative in the accompanying consolidated statements of operations. The (decrease) increase in the fair value for 2010 and 2009 was $(1,294) and $1,237, respectively.

Issuance costs associated with Series B are reflected as a reduction in the carrying amount of Series B and are amortized using the effective-interest method. Allocation of a portion of the Series B proceeds to the embedded derivative are being accreted to the Series B redemption value using the effective-interest method. Accretion recorded in 2010 and 2009 for Series B was $3,454 and $1,686, respectively.

The redemption value of the Series B is calculated as a 12% cumulative dividend and 150% of the original issuance price. The redemption value of Series B will be $35,125 upon the first redemption date of December 15, 2012. All other attributes of fair value related to the Series B are accounted for in the bundled derivative. Therefore, the fair value of Series B upon its first redemption date will be the sum of the value of the Series B redeemable preferred stock and the fair value of the embedded derivative.

 

(e)

Liquidation Preference

In the event of any liquidation of the Company, the holders of preferred stock are entitled to receive—in preference to the holders of any other class of stock—an amount equal to the purchase price paid for such preferred stock plus 12% compounded per annum and any accrued or declared but unpaid dividends (the Preference Amount). In addition, the holders of the Series B receive a premium of 50% of the original purchase price. A liquidation includes the dissolution or winding down of the Company, the sale of the Company, or the merger or consolidation of the Company. As of December 31, 2010, the Series A and B stock liquidation preference was $78,028.

The holders of preferred stock also have participation rights on an as-if converted pro rata basis with common shareholders in the Company’s net assets in the event of any liquidation after satisfaction of all liabilities and full payment of the Preference Amount. In no event will the aggregate amount paid to the holders of Series A exceed the greater of the purchase price for such shares multiplied by 300% or the amount to which the holders of Series A would have been entitled had all such shares been converted to shares of common stock immediately prior to such liquidation. The Series B shareholders are entitled to receive no more than 375% of the purchase price for such shares, or the amount to which the holders of Series B would have been entitled had all such shares been converted to shares of common stock immediately prior to such liquidation.

 

(f)

Voting Rights

The Company is prohibited from taking the following actions without approval by 70% of the holders of preferred stock, entitled to vote as a separate class: liquidation, dissolution, and wind-up; amendments to the Company’s Articles of Incorporation or Bylaws; authorization or issuance of additional equity securities; declare or pay dividends or distributions; make provisions to purchase, redeem, or retire equity securities; enter into agreements with related or affiliated parties; incur indebtedness in excess of $5,000 in the aggregate; acquire or enter into any agreement to acquire the

 

		27		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

assets or capital stock of any entity having a value of more than $5,000; and increase or decrease the number of directors constituting the board to other than seven members. In regards to all other Company actions requiring shareholder approval, each share of preferred stock issued and outstanding is entitled to the number of votes equal to the number of shares of common stock into which it is convertible.

 

(g)

Conversion Rights

The preferred stock will be converted into shares of common stock at any time at the option of a holder or automatically in the event of a qualified public offering (as defined below). The number of shares of common stock into which preferred stock will be converted will be determined by dividing the purchase price of the preferred stock being converted by the then applicable conversion price. As of December 31, 2010, conversion of the preferred stock would result in the issuance of 14,172,407 common shares. The preferred stock conversion is subject to adjustment for stock splits, combinations, and like occurrences. Further, the preferred stock conversion is subject to antidilution adjustments for any subsequent equity offerings or equity-related financing at a purchase price less than the conversion price then in effect for the preferred stock. The antidilution rights through June 15, 2010 required adjustment of the conversion price to the per share amount of any triggering financings. After June 15, 2010, the determination of the new conversion price upon a triggering financing is based on a weighted average formula.

All outstanding shares of preferred stock will be converted automatically into shares of common stock, at the then applicable conversion rate, in the event of the closing of an underwritten initial public offering of shares of common stock of the Company (adjusted as required to reflect changes in the conversion price for preferred stock, stock splits, dividends, combinations, and other similar events), resulting in net aggregate proceeds to the Company of at least $60,000 and a per share price of at least $9.00 (a qualified public offering).

If the Company completes an underwritten initial public offering of shares of common stock at a per share price of less than three times the preferred stock conversion price then in effect, the conversion price will automatically be reduced to one-third of the price per share of common stock.

 

(14)	Common Stock

 

(a)

Authorized Shares

The Company has entered into various agreements with common shareholders and option holders that contain defined redemption rights for the holders and mandatory or optional repurchase obligations/rights for the Company.

 

		28		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Shares Classified as Mezzanine Equity or Liability

Below are descriptions of the general terms (including the accounting treatment) of each of the buy and sell agreements under which shares are classified as mezzanine equity or liability.

1992 and 1994 Buy and Sell Agreements

These agreements grant the Company an option to acquire the shareholder’s shares at a mutually agreed-upon price at any time or at fair value if (a) the shares become subject to the claims of a creditor, or (b) the stock becomes held by the shareholder’s spouse. If the shareholder receives a bona fide offer to acquire the shareholder’s shares from a third party, the Company has the option to acquire the shares at the lower of the third-party offer or fair value. Upon the shareholder’s death or in the event of felonious conviction, the Company is required to repurchase the common shares at fair value. As the Company’s mandatory redemption in the event of death or felonious conviction is outside of the control of the Company, common shares subject to these arrangements are classified as mezzanine equity.

1995 Buy and Sell Agreement

The 1995 buy and sell agreement has the same redemption rights as the 1992 and 1994 buy and sell agreements in addition to mandatory redemption at either a defined contract price or fair value upon voluntarily leaving for a competitor or for termination of employment for other reasons. Employee stock options subject to the 1995 buy and sell agreement are required to be accounted for as variable awards. As the Company is subject to various mandatory redemption obligations, which are outside of the control of the Company, common shares and common shares underlying stock options subject to this arrangement are classified as either mezzanine equity or liabilities.

1997 Buy and Sell Agreements

In general, the 1997 buy and sell agreements grant the Company an option to acquire the shareholder’s common shares at fair value upon (a) a mutually agreed-upon price at any time, (b) if the shares are subject to the claims of a creditor, or (c) if the stock becomes held by the shareholder’s spouse. If the shareholder receives a bona fide offer to acquire the shareholder’s shares from a third party, the Company has the option to acquire the shares at the lower of the third-party offer or 10.9 times earnings before interest and taxes (EBIT), as defined in the agreement. Upon the shareholder’s death, the Company is required to repurchase the shareholder’s shares at 10.9 times EBIT. In the event of a felonious conviction, the Company is required to repurchase the common shares at book value. Upon the shareholder’s termination to join a competitor, the Company is required to repurchase the common shares at either book value or a defined contract value. If terminated for any other reason, the Company shall acquire the shares at book value. Shares underlying stock options subject to the 1997 buy and sell agreements are required to be accounted for as variable awards as the redemption provisions upon termination are not based on fair value formulas. As the Company is subject to various mandatory redemption obligations, which are outside of the control of the Company, common shares and common shares underlying stock options subject to these arrangements are classified as either mezzanine equity or liabilities.

 

		29		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Termination of the 1992, 1994, 1995, and 1997 Buy and Sell Agreements

During 2010, a majority of shareholders subject to the terms of these various buy and sell agreements entered into the 2010 buy and sell agreement (see description below) and the shares were reclassified from mezzanine equity to common stock.

The tables below present the common shares and common shares underlying stock options, including those exercised with notes that are subject to these agreements as of December 31:

 

		2010				2009
Common shares (1)			588,560				5,391,118
Common share options			—				89,914
Mezzanine equity			588,560				5,481,032
Liabilities			—				84,666
Total mezzanine equity and liabilities			588,560				5,565,698
(1)       Recorded at the greatest redemption value under applicable agreement		$	398				7,443

The table below presents the common shares under each buy and sell agreement as of December 31:

 

		2010				2009
1992 and 1994			255,000				3,846,247
1995			—				160,996
1997			333,560				1,383,875
			588,560				5,391,118

 

		30		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

The table below presents the common shares underlying stock options, including those exercised with notes, under each buy and sell agreement as of December 31:

 

		2010				2009
1992 and 1994			—				—
1995			—				102,180
1997			—				72,400
			—				174,580

Shares Classified within Stockholders’ Deficit

2002, 2003, and 2010 Buy and Sell Agreements

These agreements grant the Company the option to acquire the shareholder’s shares upon a mutually agreed-upon price at any time, upon a bona fide offer to acquire the shareholder’s shares from a third party, or upon the felonious conviction of the shareholder.

2006 and 2008 Buy and Sell Agreements

In conjunction with the sale of the Series A, the Company entered into an agreement with certain holders of the Company’s common stock (the Shareholder Agreement). Management shareholders subject to this agreement are prohibited from selling or otherwise transferring their shares until after a qualifying public offering. Prior to a qualifying public offering, if nonmanagement common shareholders receive an offer to sell their shares, the Company and then the investors, as a group, have a right of first refusal to acquire the shares at the offering price. All common shareholders subject to the Shareholder Agreement have defined registration rights. The preferred stock investors have rights to purchase a pro rata number of new securities issued by the Company. In conjunction with the sale of the Series B, the Company entered into an agreement with most of the same shareholders subject to the Shareholder Agreement and on very similar terms.

The table below presents the common shares, including those exercised with notes, under each buy and sell agreement as of December 31:

 

		2010				2009
2002 and 2003			4,413,994				4,345,788
2006 and 2008			19,743,324				19,818,980
2010			4,884,888				—
			29,042,206				24,164,768

 

		31		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

The table below presents the common shares underlying stock options under each buy and sell agreement as of December 31:

 

		2010				2009
2002 and 2003			1,424,761				1,618,946
2006 and 2008			1,306,389				2,224,432
2010			42,820				—
			2,773,970				3,843,378

A significant shareholder and former member of senior management holds 2,250,000 shares of restricted common stock that are subject to forfeiture if certain products do not receive FDA approval. The restricted shares cannot be sold or transferred to any third party. These restrictions lapse at such time as Company shares are sold in an initial public offering or upon FDA approval of the products. Compensation expense associated with these restricted shares is subject to variable accounting adjustments through the vesting dates, reflecting changes in the value of the Company’s common stock. Unrecognized compensation expense of $2,436 at December 31, 2010 is being amortized over the estimated remaining vesting periods of two and six years.

A shareholder who provides consulting services and is a member of the Company’s board of directors holds 1,200,000 shares of common stock, which are subject to forfeiture. Unrecognized compensation expense of $297 at December 31, 2010 is being amortized over three years based on the contractual end date. Compensation expense is subject to variable accounting adjustments through the vesting date, reflecting changes in the value of the Company’s common stock.

A member of senior management holds 25,000 shares of restricted stock units that vest upon the individual remaining employed with the Company for four continuous years. Unrecognized compensation expense of $26 at December 31, 2010 is being amortized over the remaining vesting period of one and a half years.

 

(b)

Stock Options

The Company has stock options outstanding under the 1997 Plan, the 2007 Plan, and the Long-Term Incentive Plan (LTIP). The 1997 Plan was succeeded by the 2007 Plan on January 1, 2007, and the 2007 Plan was superseded by the LTIP on January 1, 2009. The LTIP allows for the granting of stock options to the Company’s employees, directors, and consultants for up to 4,686,201 shares of common stock, of which 3,090,894 shares were available for future grants as of December 31, 2010. Option awards are generally granted with an exercise price at least equal to the market price of the Company’s stock at the date of grant. For persons owning greater than 10% of the Company’s outstanding common stock, the exercise price of compensatory options must be at least 110% of fair market value at the grant date. The plan allows the compensation committee substantial flexibility in determining the terms of awards, interpreting the plan, and modifying awards. Awards vest based on a variety of service periods and performance conditions and have contractual terms of up to 10 years.

 

		32		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Estimates of option fair values are based on a Black-Scholes option valuation model that uses the weighted average assumptions noted in the following table. Since the Company does not have sufficient historical volatility data of its common stock, the expected volatility is based on the volatility of similar public companies. In choosing similar companies, the Company considers factors such as industry, stage of life cycle, size, and financial leverage, and engages the assistance of an independent valuation firm to assist with the analysis. The expected term of all nonemployee options granted is the contractual option term. The expected term for employee option grants is based on historical experience. The risk-free interest rate is based on the U.S. Treasury yield curve in effect for the expected term of the option at the time of the grant or other measurement date. The Company has never declared or paid any cash dividends and does not presently plan to pay cash dividends in the foreseeable future. The Company uses historical termination behavior to support an estimated annual forfeiture rate of 5%.

The following weighted average assumptions were used to estimate the fair value of stock option grants:

 

		2010				2009
Volatility			40.0	%			50.0	%
Stock dividend yield			—				—
Expected option term in years			3.1				4.5
Risk-free interest rate			1.1	%			1.4	%

Total share-based compensation expense included in net loss was $1,067 for 2010, and $641 for 2009, including $22 related to cash payments upon redemption. There was no compensation cost capitalized as part of inventory and property, plant, and equipment in 2010 or 2009. Share-based compensation has been recorded as an increase or decrease to common stock and common stock subject to redemption in the accompanying consolidated balance sheets.

 

		33		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

A summary of option activity under the plans for the years ended December 31, 2010 and 2009 is presented below:

 

										Weighted average
Options		Shares available for grant				Shares under options				Exercise price per share				Remaining contractual term (years)				Aggregate intrinsic value
Balance December 31, 2008			1,597,717				4,892,466			$	2.83				3.0			$	744
Authorized and available for new LTIP grants			4,261,985				—
Granted			(333,945	)			333,945				1.78
Expired			(1,597,717	)			—
Exercised			—				(107,473	)			0.96
Cancelled			311,662				(500,722	)			4.19
Balance December 31, 2009			4,239,702				4,618,216				2.64				2.3				598
Granted			(1,550,200	)			1,550,200				2.26
Exercised			—				(38,914	)			1.42
Cancelled			401,392				(736,464	)			2.65
Balance December 31, 2010			3,090,894				5,393,038			$	2.54				2.0			$	263
At December 31, 2010:
Vested or expected to vest							4,832,000			$	2.45				1.9			$	263
Exercisable							3,856,197				2.54				1.5				263

The weighted average grant-date fair value of options granted during 2010 and 2009 was $0.38 and $0.74 per share, respectively. The total intrinsic value of options exercised during the years ended December 31, 2010 and 2009 was $15 and $96, respectively.

The intrinsic values above represent the aggregate value of the pretax intrinsic value of legally outstanding option shares, based on an estimated common stock fair value of $1.56 per share at December 31, 2010.

 

		34		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

The following table summarizes unvested options for the years ended December 31, 2010 and 2009:

 

		Shares				Weighted average grant- date fair value
Unvested at December 31, 2008			2,231,610			$	1.12
Granted			333,945				0.74
Vested			(905,288	)			1.11
Forfeited			(403,692	)			0.92
Unvested at December 31, 2009			1,256,575				1.12
Granted			1,550,200				0.38
Vested			(860,292	)			0.88
Forfeited			(409,642	)			0.64
Unvested at December 31, 2010			1,536,841			$	0.45

As of December 31, 2010, there was $311 of unrecognized compensation expense related to 896,000 unvested employee common stock option awards. The remaining expense is expected to be recognized over a period of three years. As of December 31, 2010, there was $14 of unrecognized compensation expense related to 80,000 unvested nonemployee options. The remaining expense is expected to be recognized over a period of one to three years, and is subject to variable accounting adjustments until vested.

The following table summarizes shares underlying stock options granted in the years ended December 31:

 

		2010				2009
Shares granted to employees:
Time vesting(1)			1,319,000				134,745
Milestone vesting			—				199,200
Total granted to employees			1,319,000				333,945
Shares granted to nonemployees:
Time vesting(1)			10,000				—
Milestone vesting			221,200				—
Total granted to nonemployees			231,200				—
			1,550,200				333,945

 

(1)	Shares vest immediately or over a one- to five-year period

 

		35		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

As of December 31, 2010, options granted include 561,000 shares that are not expected to vest.

Cash received from options exercised under all share-based payment arrangements for the years ended December 31, 2010 and 2009 was $54 and $104, respectively. Upon option exercise new shares of common stock are issued.

 

(c)

Shareholder Notes Receivable

Prior to May 5, 2009, pursuant to the Company’s 1997 Stock Option Plan, the Company’s compensation committee had granted the authority to accept notes payable to the Company from employees exercising options. Interest rates were at least equal to the applicable federal rate and the term could not exceed nine years. On May 5, 2009, the Company’s compensation committee withdrew that authority and notes no longer would be issued for stock option exercises. Existing notes continue to be subject to the terms of the agreements under which they were issued. As a result of this modification, options that had not been previously exercised were subject to a final value measurement.

The Company had notes receivable as of December 31, 2010 and 2009, with a carrying amount of $931 and $1,035, respectively. The notes receivable are carried on the consolidated balance sheets as a contra equity account at face value plus accrued interest. Principal was added to the Company’s common stock account upon receipt of the note. Interest is accrued semiannually resulting in an adjustment to common stock. Notes have a nine-year term, allow for prepayment, and are issued at fixed interest rates ranging from 4.70% to 8.25%. The Company retains the stock certificates as collateral and has legal right to additional recourse; however, security rights are not perfected and the notes are accounted for as if nonrecourse. During 2010, the Company redeemed 87,088 collateral shares, representing a carrying value of $168 principal and interest; in 2009, 192,157 shares were redeemed for $342 of principal and interest. No compensation expense was recognized as the shares were redeemed in lieu of repayment of the shareholder notes. As of December 31, 2010 and 2009, 882,158 and 1,097,370 shares, respectively, exercised with Company notes are included in these consolidated financial statements as outstanding shares of common stock, but are deemed still outstanding as options for the purpose of computing share-based compensation costs.

 

(15)	Other Commitments and Contingencies

 

(a)

Royalty Arrangements

The Company has patent-related license agreements requiring royalty payments of between 1% and 5% of net sales of related products. Royalty expenses relating to the agreements totaled $210 and $154 in 2010 and 2009, respectively. As further described below, the Company entered into royalty arrangements in connection with the Encelle, Inc. (Encelle) and Angstrom Medica, Inc. (Angstrom) acquisitions.

 

		36		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

Angstrom Medica, Inc.

As part of the acquisition of Angstrom in 2007, the Company is required to pay future royalty payments of 1.5% and 3.0% of net sales for products using the acquired technology through October 2021. In 2010, royalty expenses related to this agreement were $49. There was no royalty expense in 2009. Additional contingent common stock considerations still outstanding are:

 

•

205,000 shares of common stock upon the Company submitting to the FDA an application for regulatory approval of Angstrom technology-based cement for indication in humans.

 

•

615,000 shares of common stock upon receipt of FDA approval of the previously described application.

Encelle, Inc.

Under the terms of the 2007 acquisition agreement, there was no upfront consideration, but rather two contingent payments based on future commercial sales of spine and orthopedic-related products using the Encelle technology. The first commercial sales commenced in January 2009 thus obligating the Company to pay the sum of 50% of net sales for the next 12 months. An additional payment is based on 50% of net sales for the 12 months starting in January 2011. During 2010 and 2009, sales of products developed under this agreement resulted in royalties to the former owners of Encelle of $33 and $988, respectively, all of which were paid in 2010.

Additionally, Encelle’s former owners were also entitled to the net proceeds of sales of nonspine applications, which represented $0 and $122 in 2010 and 2009, respectively.

 

(b)

Purchase Commitments

The Company is committed to purchase materials for production over the next year at prevailing market prices. At December 31, 2010, purchase order commitments to acquire materials used in production totaled $4,485.

 

(c)

Employee and Officer Termination Benefits

Employment agreements signed by nine employees and officers require the Company to make severance payments of an amount equal to or greater than current salary over a period of 6 to 12 months if the employees or officers were terminated.

 

(d)

Litigation

Through the normal course of business the Company has various legal claims and contingent matters outstanding. The Company believes that any ultimate liabilities arising from these actions will not have a material impact on the Company’s financial condition or results of operations.

 

		37		(Continued)

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PIONEER SURGICAL TECHNOLOGY, INC.

AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2010 and 2009

(In thousands, except share data)

 

(16)	Retirement Plan

The Company maintains an Employee Retirement Income Security Act safe harbor qualified retirement plan for substantially all employees established pursuant to Internal Revenue Code Section 401(k). Contributions are based on a partial match of employees’ contributions. The Company match is based on the amount of salary the employee elects to defer. For the first 3% of an employee’s salary that is deferred, the Company will match 100%. For the next 2% of an employee’s salary that is deferred, the Company will match 50%. The Company does not match deferral amounts in excess of 5% of an employee’s salary. The employer match was $620 and $597 for the years ended December 31, 2010 and 2009, respectively.

 

(17)	Related-Party Transactions

During 2010 and 2009, the Company redeemed 26,966 shares for $1.78 per share and 14,329 shares for $3.35 per share of common stock, respectively, from a relative of the Company’s largest individual stockholder.

A member of the board of directors has signed a consulting agreement that includes a 1% royalty payment on certain sales of products yet to be approved by the FDA. The same board member was a partial owner of Angstrom. He received 45,143 shares of Company common stock in connection with this transaction and will receive a pro rata amount, based on his former share ownership, of any future consideration paid to the Angstrom shareholders, of which none was paid in 2010 or 2009.

The Company has entered into a license agreement with its largest stockholder that requires royalty payments of 1% of net sales of the related product yet to be approved by the FDA.

 

(18)	Subsequent Events

Subsequent events have been evaluated up to and including May 16, 2011, which is the date these financial statements were issued.

 

		38