UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10‑Q

(Mark One)

For the quarterly period ended June 30, 2017

For the transition period from           to           

Commission File No. 001-37417

INVUITY, INC.

(Exact name of the registrant as specified in its charter)

444 De Haro Street, San Francisco, California 94107

(Address of principal executive offices, Zip Code)

(415) 655-2100

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒   No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S‑T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒   No ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

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

The number of shares of the registrant’s Common Stock outstanding as of July 24, 2017 was 17,050,067.

TABLE OF CONTENTS

PART I—Financial Information

ITEM 1. Financial Statements.

INVUITY, INC.

Condensed Balance Sheets

(In thousands, except share and per share amounts)

(Unaudited)

See accompanying notes to unaudited condensed financial statements.

INVUITY, INC.

Condensed Statements of Operations and Comprehensive Loss

(In thousands, except share and per share amounts)

(Unaudited)

See accompanying notes to unaudited condensed financial statements.

INVUITY, INC.

Condensed Statements of Cash Flows

(In thousands)

(Unaudited)

See accompanying notes to unaudited condensed financial statements.

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

1.           Organization and Description of Business

Invuity, Inc. (the “Company”) was incorporated in California on November 29, 2004 and reincorporated in Delaware in May 2015. The Company is a commercial-stage medical technology company that utilizes its proprietary Intelligent Photonics technology to develop single-use and reusable illuminated surgical devices, which provide surgeons with illumination and direct visualization of surgical cavities during minimal access procedures. The Company’s manufacturing, development and management facilities are located in San Francisco, California.

Liquidity

The Company has incurred net losses from operations since inception, including $23.6 million in the six months ended June 30, 2017, and has an accumulated deficit of $169.8 million as of June 30, 2017.  The Company has $26.3 million in cash and cash equivalents and short-term investments, and $23.5 million in debt outstanding at June 30, 2017.  The Company expects to incur additional losses and negative cash flows for the foreseeable future. Management believes that its cash,cash equivalents and short-term investments at June 30, 2017, and additional funding available under the revolving credit facility with MidCap Financial Trust, and their affiliates (“MidCap”), will provide sufficient funds to enable the Company to meet its operating plan through at least the next twelve months.  In addition, on July 1, 2016, the Company filed a prospectus supplement for an at-the-market offering (“ATM”) program of up to $25.0 million.  However, if the Company’s anticipated operating results are not achieved in future periods, additional debt or equity financing may need to be raised, or planned expenditures may need to be reduced.

Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and in accordance with the instructions to Form 10‑Q and Rule 10‑01 of Regulation S‑X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The unaudited interim condensed financial statements have been prepared on the same basis as the annual financial statements. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair statement of the financial position, results of operations and cash flows for the periods presented. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10‑K for the year ended December 31, 2016 and filed with the U.S. Securities and Exchange Commission (the “SEC”). The accompanying year-end balance sheet was derived from the audited financial statements included in the Company’s Annual Report on Form 10‑K for the year ended December 31, 2016. The results for the three months and six months ended June 30, 2017 are not necessarily indicative of the results expected for the full fiscal year or any other periods.

2.           Summary of Significant Accounting Policies

Use of Estimates

The Company’s financial statements have been prepared in conformity with U.S. GAAP. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, fair value of assets and liabilities, inventory, income taxes and stock-based compensation. Actual results could differ from those estimates and assumptions.

Cash Equivalents

Cash equivalents consist of short-term, highly liquid investments with original maturities of three months or less from the date of purchase. Cash equivalents consist primarily of amounts invested in money market funds.

Restricted Cash

Restricted cash represents a certificate of deposit held at a financial institution as collateral for a letter of credit related to the Company’s facility lease in San Francisco, California.

Fair Value of Financial Instruments

The carrying amounts of the Company’s financial instruments, including cash equivalents, short-term investments, accounts receivable and accounts payable, approximate fair value due to their relatively short maturities. As of June 30, 2017 and December 31, 2016, based on Level 2 inputs and the borrowing rates available to the Company for loans with similar terms and consideration of the Company’s credit risk, the carrying value of the Company’s long-term debt approximates its fair value.

Customer Concentration

Significant customers are those which represent 10% or more of the Company’s total revenue for each period presented in the condensed statements of operations and comprehensive loss or 10% or more of the Company’s net accounts receivable balance at each respective balance sheet date. As of and for the year ended December 31, 2016 and as of and for the three and six months ended June 30, 2017 and 2016, the Company had no customers that represented 10% or more of its revenue or accounts receivable balances.

Revenue Recognition

The Company’s revenue is generated from the sale of its products to hospitals and medical centers through direct sales representatives and independent sales agents. The Company recognizes revenue when all of the following criteria are met:

persuasive evidence of an arrangement exists;

the sales price is fixed or determinable;

collection of the relevant receivable is reasonably assured at the time of sale; and

delivery has occurred.

The Company recognizes revenue when title to the goods and risk of loss transfers to the customer, which is upon shipment of the product under the Company’s standard terms and conditions. Shipping and handling costs billed to the customer are recorded in revenue.

Segment Reporting

The Company manages its operations as a single operating segment for the purposes of assessing performance and making operating decisions. All of the Company’s assets are maintained in the United States. The Company derives the majority of its revenue from sales to customers in the United States, based upon the billing address of the customer.

Net loss per Common Share

Basic net loss per common share is calculated by dividing the net loss by the weighted-average number of shares of common stock outstanding during the period, without consideration of potentially dilutive securities. Diluted net loss per common share is the same as basic net loss per common share since the effect of potentially dilutive securities are anti-dilutive. Shares subject to repurchase are excluded from the weighted-average shares.

Recent Accounting Pronouncements

The Company is in the process of evaluating the impact of the new revenue guidance on its financial statements.

As a result of adopting ASU No. 2016‑09, the Company has made an accounting policy election to account for forfeitures as they occur. This change has been applied on a modified retrospective basis, with no material impacts on the Company’s financial statements. The adoption of ASU No. 2016‑09 also requires excess tax benefits and tax deficiencies be recorded in the income statement as opposed to additional paid‑in capital when the awards vest or are settled, and has been applied on a prospective basis with no impact on the financial statements as of and for the three and six months ended June 30, 2017. As a result of the adoption, the Company's increased its total NOLs by $1.0 million on January 1, 2017 related to deferred tax assets that arose directly from tax deductions related to equity compensation greater than compensation recognized for financial reporting purposes. This amount is fully offset by the valuation allowance.

The adoption of ASU No. 2016‑09 related to the accounting for minimum statutory withholding tax requirements and cash paid by an employer when directly withholding shares for tax-withholding purposes had no impact on the Company's current consolidated financial statements or on any prior period financial statements presented.

3.            Fair Value Measurements

The Company discloses and recognizes the fair value of its assets and liabilities using a hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The hierarchy gives the highest priority to valuations based upon unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to valuations based upon

unobservable inputs that are significant to the valuation (Level 3 measurements). The guidance establishes three levels of the fair value hierarchy as follows:

Level 1—Inputs are unadjusted quoted prices in active markets for identical assets or liabilities at the measurement date.

Level 2—Inputs (other than quoted market prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

Level 3—Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The Company’s financial instruments consist of Level 1 and 2 assets. Level 1 assets consist primarily of highly liquid money market funds that are included in cash, cash equivalents, and restricted cash. Commercial paper and corporate debt securities are classified in Level 2 of the fair value hierarchy because these valuation inputs are observable or market-corroborated.

The following table sets forth the fair value of the Company’s financial assets and liabilities measured at fair value on a recurring basis based on the three-tier fair value hierarchy (in thousands):

As of June 30, 2017 and December 31, 2016, the carrying value of the Company’s short term investments approximates their fair value.

4.            Balance sheet components

Inventory

Inventory consisted of the following (in thousands):

Prepaid Expenses and Other Assets

Prepaid expenses and other assets consisted for the following (in thousands):

Property and Equipment, Net

Property and equipment, net, consisted of the following (in thousands):

Depreciation and amortization expense was $0.5 million for each of the three months ended June 30, 2017 and 2016, and $1.0 million for each of the six months ended June 30, 2017 and 2016.

Accrued and Other Current Liabilities

Accrued and other current liabilities consisted of the following (in thousands):

5.           Debt

On March 10, 2017, the Company entered into a credit and security agreement with MidCap, as agent, for up to $30.0 million in term loans. Under the terms of the agreement, the Company borrowed the first term loan of $20.0 million (“Tranche 1”) at closing and will be eligible for an additional term loan of $10.0 million (“Tranche 2”) which can be drawn down prior to December 31, 2018, subject to the Company meeting a certain revenue target prior to that date, which the Company has not met, and does not expect to meet in the next twelve months. The term loans accrue interest at a floating rate equal to 6.50% per annum, plus the greater of (i) 1.5% or (ii) one month Libor. Interest shall accrue on the date of the commencement of funding and is payable in arrears on the first day of each month. Principal is payable in 36 equal monthly installments beginning April 1, 2019 until paid in full on March 1, 2022. The Company used $17.2 million of the $20.0 million Tranche 1 term loan to pay off in full the outstanding $15.0 million loan with Health Care Royalty Partners including a $1.8 million prepayment fee and $0.4 million in interest.

The Company also entered into a separate credit and security agreement with MidCap that provides for a revolving credit facility of up to $10.0 million based on the eligible accounts receivable and inventory balances. The Company may increase the total commitments under the revolving credit facility by up to an additional $10.0 million, subject to the company meeting a certain revenue target prior to that date. Loans under the revolving credit facility

accrue interest at a floating rate equal to 3.25% per annum, plus the greater of (i) 1.5% or (ii) one month LIBOR. Interest is payable in arrears on the first day of each month subsequent to the draw down date. The facility terminates in full on March 1, 2022 unless terminated earlier. As of June 30, 2017, the Company had drawn down $3.5 million under the revolving credit facility. This revolving credit facility replaced the Company’s $7.5 million accounts receivable credit facility that existed with Silicon Valley Bank (“SVB”), which the Company terminated in March 2017 and paid a termination fee of $150,000.

The term loan facility and the revolving credit facility are secured by substantially all of the Company’s assets, including intellectual property. In addition, under the terms of the agreement, the Company is required to meet certain covenants which if the Company is unable to meet, or if the Company does not make its payments, the Company may be found in default and all obligations may be accelerated and become immediately due and payable upon the sole election of the lenders. The Company must also comply with a financial covenant relating to certain quarterly minimum Net Revenue (as defined in the credit agreements) requirements on a trailing twelve month basis. As of June 30, 2017, the Company was in compliance with all required covenants.

In connection with the term loan facility, the Company agreed to issue to each lender warrants to purchase shares of the Company’s common stock upon the drawdown of each tranche in an aggregate amount equal to 2.0% of the amount drawn, divided by the exercise price per share for that tranche. In connection with the Tranche 1 term loan, the Company issued warrants to purchase an aggregate of 50,618 shares of the Company’s common stock, at an exercise price equal to $7.90 per share. If the Company borrows the Tranche 2 term loan, it must issue additional warrants to the Tranche 2 lenders in accordance with the formula used to calculate the number of shares subject to the Tranche 1 warrants.  These warrants, which were recorded within stockholders’ equity, were fair valued at $279,000 upon issuance using a Black-Scholes valuation model. The assumptions used in the Black-Scholes model consisted of a 10 year contractual term, interest free rate of 2.58%, dividend yield of 0.0% and volatility of 60.0%.  The fair value was recorded as a discount to the initial $20.0 million term loan and will be amortized as interest expense over the term of the agreement, which is approximately five years.

6.           Stock Option Plans

In April 2015, the Company’s board of directors and stockholders approved the 2015 Equity Incentive plan (the “2015 Plan”), effective June 11, 2015, covering incentive stock options, nonstatutory stock options and restricted stock awards that may be granted to employees, directors and consultants.

During the three months ended June 30, 2017 and 2016, the Company granted 125,525 and 72,200 options, respectively, to employees, with a weighted average grant date fair value of $7.32 per share and $7.02 per share respectively. During the six months ended June 30, 2017 and 2016, the Company granted 734,705 and 735,550 options, respectively, to employees, with a weighted average grant date fair value of $6.65 per share and $7.37 per share, respectively. The options granted in 2017 included 268,000 options granted to certain executive officers with a market-based condition. The 268,000 options were valued at an aggregate value of $0.7 million using the Monte Carlo Simulation model, which will be amortized over three years from the date of grant.

The aggregate intrinsic value of options exercised was $0.3 million for both of the three and six months ended June 30, 2017, and $0.2 million and $0.3 million for the three and six months ended June 30, 2016, respectively. The weighted-average remaining contractual life of options outstanding was 7.6 and 7.5 years at June 30, 2017 and December 31, 2016, respectively. For vested and expected to vest options, the weighted-average remaining contractual life as of June 30, 2017 and December 31, 2016, was 7.6 and 7.5 years, respectively.

For the three months ended June 30, 2017, the Company granted approximately 72,000 restricted stock units (“RSUs”) to non-employee board members (“Outside Directors”) with a grant date fair value, in the aggregate, of $0.5 million.  Under the Company’s Restricted Stock Unit Deferral Program for Outside Directors, Outside Directors may elect to defer the receipt of shares upon vesting of RSUs granted under the 2015 Plan.  A deferral election will apply to the entirety of the particular RSU award and no partial elections may be made.  A deferral election is irrevocable once made. In the event an Outside Director makes a deferral election, the shares of common stock underlying the deferred RSUs will not be distributed to such Outside Director until the earlier of his or her separation of service as a board member or upon a “Change in Control” (as defined in the 2015 Plan) of the Company.  Three out of four of the Company’s Outside Directors elected to defer receipt of the RSUs granted to them on the date of the Company’s 2017 Annual Meeting (the “2017 Annual Meeting”) under the 2015 Plan.

For the six months ended June 30, 2017, the total RSUs granted were 153,000 with a fair value of $1.0 million, including the RSUs granted to Outside Directors described above and 71,500 RSUs granted to executive officers with a fair value of $0.5 million. The RSUs granted to executive officers have a four-year term and vest 25% annually. The RSUs granted to Outside Directors on the date of the 2017 Annual Meeting will vest 100% on the earlier of the 2018 Annual Meeting of Stockholders or the one year anniversary of the 2017 Annual Meeting, with the exception of any RSUs that an Outside Director elected to defer, which RSUs generally will vest 100% on the first anniversary of the date that the Outside Director elected to defer such RSUs.

During the three months ended June 30, 2016, the Company granted 64,000 RSUs to board members with a grant date fair value of $0.3 million. For the six months ended June 30, 2016, the Company granted a total of 207,000 RSUs with a grant date fair value of $1.4 million. The RSU awards granted to executive officers have a five year term and vest 20% annually while the RSU awards granted to board members vested 100% on June 19, 2016.

Stock‑Based Compensation

The fair value of stock options granted to employees is amortized on a straight-line basis over the requisite service period of the award. Stock‑based compensation related to stock options granted to non-employees is recognized as the stock options are earned. The Company recognized total employee-related stock compensation expenses of $0.7 million and $1.3 million for the three and six months ended June 30, 2017, respectively, and $0.7 million and $1.1 million for the three months and six months ended June 30, 2016, respectively. In addition, the Company recognized non-employee stock compensation expenses of $44,000 and $111,000 for the three and six months ended June 30, 2017, respectively, and $19,000 and $42,000 for the three and six months ended June 30, 2016, respectively.

The following table summarizes stock‑based compensation expense related to stock options and restricted stock units included in the condensed statements of operations and comprehensive loss (in thousands):

As of June 30, 2017, unrecognized compensation expense related to unvested options was $5.7 million, which the Company expects to recognize on a straight‑line basis over a weighted‑average period of 3.1 years. Unrecognized compensation expense related to unvested RSUs was $ 1.4 million, which the Company expects to recognize on a straight‑line basis over a weighted‑average period of 2.9 years.

7.           Net Loss per Common Share

As the Company generated net losses for all the periods presented, all potentially dilutive common securities are determined to be anti-dilutive. The following table sets forth the computation of the basic and diluted net loss per share(in thousands, except share and per share data):

The following outstanding shares of potentially dilutive securities have been excluded from diluted net loss per share because their inclusion would be anti‑dilutive:

8.           Commitments and Contingencies

On February 27, 2017, a purported stockholder class action titled Paciga v. Invuity, Inc., et al., Case No. 3:17‑cv‑01005, was filed in the United States District Court for the Northern District of California against the Company, its Chief Executive Officer, and its Chief Financial Officer. The complaint alleges that the defendants made false or misleading statements to investors regarding the Company’s business prospects. The complaint purports to assert claims for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and the Securities Exchange Commission Rule 10b-5 on behalf of a purported class consisting of all purchasers of the Company’s common stock between July 19, 2016 and November 3, 2016, and seeks unspecified compensatory damages, attorney fees and costs, and other relief. On May 30, 2017, the Court appointed Mike Paciga as lead plaintif.  The led plantiff has until July 31, 2017 to either file an amended complaint or designate the current complaint as the operative complaint.  The Company intends to defend the litigation vigorously. Based on information currently available, the Company has determined that the amount of any possible loss or range of possible loss is not reasonably estimable.

The Company is, and from time to time may become, involved in legal proceedings arising from the ordinary course of its business. Management is currently not aware of any matters that will have a material adverse effect on the financial position, results of operations or cash flows of the Company.

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed financial statements and the related notes included in Item 1 of Part I of this Quarterly Report on Form 10‑Q, and together with our audited financial statements and the related notes included in our Annual

Report on Form 10‑K for the period ended December 31, 2016. Historic results are not necessarily indicative of future results. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors including those discussed in the section titled “Risk Factors” included elsewhere in this Quarterly Report on Form 10‑Q.

We also use our investor relations website as a channel of distribution for important company information. Important information, including press releases, analyst presentations and financial information regarding us, as well as corporate governance information, is routinely posted and accessible on our investor relations website. Information on or that can be accessed through our websites is not part of this Quarterly Report on Form 10‑Q.

Overview

We are a commercial-stage medical technology company pioneering the use of advanced photonics to provide surgeons with improved direct visualization of surgical cavities during minimal access surgical procedures. We integrate our Intelligent Photonics® technology platform into our single-use and reusable advanced surgical devices to address some of the critical intracavity illumination and visualization challenges facing surgeons today. We utilize our proprietary advance photonics technology to develop optical waveguides that direct and shape thermally cool, brilliant light into broad, uniform and volumetric illumination of the surgical target. We believe that improving a surgeon’s ability to see critical anatomical structures can lead to better clinical and aesthetic outcomes, improved patient safety and reduced surgical time and healthcare costs. We are also using our advanced photonics technology to develop new devices and modalities to broaden the application and adoption of minimal access procedures and enable new advanced surgical techniques. Notably, in September 2016, we received U.S. Food and Drug Administration, or FDA, 510(k) clearance of,  PhotonBladeTM ,   a dynamic precision illuminator with enhanced energy delivery. The PhotonBladeTM is a first-of-its-kind device, delivering directed, thermally-cool illumination at the precise point of surgical treatment in conjunction with a novel energy platform allowing for precise tissue cutting and coagulation with minimal tissue damage. As such, PhotonBladeTM represents a new category of Intelligent Photonics® and strategically expands our current product portfolio. We initiated a limited launch of the PhotonBladeTM device in the first quarter of 2017, announced and implemented a voluntary recall of the device in the second quarter of 2017 due to physician feedback on unintended energy discharge, and plan to re-introduce the product more broadly in the third quarter of 2017.

Photonics is the science and technological applications of light. We have applied advanced principles of photonics to develop our Intelligent Photonics® technology platform, which enables the transmission, management and manipulation of light in surgical procedures. Our initial application of this technology is integrated into our family of proprietary optical waveguides. Our waveguides are sophisticated devices that rely on the principles of optics to shape and direct light. They are coupled to a modified fiber optic cable and are designed to work with the standard xenon or light-emitting diode, or LED, light sources typically found and utilized in the operating room. Our optical waveguides are incorporated into surgical devices, including our customized line of illuminated surgical retractors, handheld illuminated aspiration devices, drop-in intracavity illuminators and, most recently, PhotonBladeTM. Our handheld illuminated aspiration devices, drop-in intracavity illuminator, and PhotonBladeTM are single-use products. Our retractors are reusable, but utilize a single-use optical waveguide with each procedure.

We currently sell our devices in the United States, primarily through a direct sales force. We had 65 direct sales representatives as of June 30, 2017, and over time we expect to continue to expand our direct sales force and marketing organization to further penetrate and expand the market by demonstrating the benefits of our advanced photonics technology platform to surgeons. Although our sales and marketing efforts are directed at surgeons because they are the primary users of our technology, the hospitals where surgical procedures are performed are our customers, as they typically are responsible for making the decisions to purchase our devices. Our currently marketed devices are commonly treated as general supplies utilized in surgery. As a result, the hospital or surgical center receives a single reimbursement from the third-party payor that is intended to cover the overall cost of treatment, including the cost of devices used during the procedure, as well as the overhead cost associated with the facility where the procedure is performed. There is no separate reimbursement for our devices.

In addition to marketing and selling our existing products, we are engaged in ongoing research and development. Our research and development efforts are focused on developing new devices and modalities to broaden the application and adoption of open minimal access procedures and enable new advanced surgical techniques. Our manufacturing involves the combined utilization of our internal manufacturing resources and expertise, approved

suppliers and contract manufacturers. We outsource the manufacture of components, subassemblies and certain finished devices that are produced to our specifications and shipped to our facilities in San Francisco, California for final assembly or inspection, and certification. Finished products are stored at and distributed from our facility. We believe our facility is sufficient to support our operations and that suitable facilities would be available to us should our operations require it.

Components of Our Results of Operations

Revenue

All of our revenue is primarily derived from sales of our devices in the United States but we recently started selling into Asia. We earn revenue from the sale of our devices primarily through our direct sales force as complemented by our independent sales agents.

Recent revenue growth has been driven by the growth of our sales and marketing infrastructure and increased surgeon awareness of the benefits of our advanced photonics technology platform over traditional surgical lighting options in the operating room. We are pursuing a number of strategies that we believe will enable us to continue to grow. Our products have broad applicability to open, smaller incision surgeries which we estimate to be approximately 40% of all surgical procedures in the United States. We are targeting our sales and marketing efforts to surgeons for the following women’s health clinical applications: breast cancer and breast reconstruction surgery, gynecology and thyroid surgery. Additional applications include procedures for electrophysiology, spine, orthopedic, cardiothoracic and general surgery. Although we have made progress towards our goals there are still many areas for growth. To achieve these goals, we are focused on the following initiatives to continue to drive revenue growth:

We have experienced seasonality during the year. Revenue tends to be the lowest in the first quarter as the result of the resetting of annual patient healthcare insurance plan deductibles and by hospitals and military facilities working off their inventories of products purchased in the fourth quarter. The third quarter is similarly negatively impacted by lower procedure rates typically associated with vacation plans of both patients and surgeons. Revenue in the fourth quarter tends to be the highest as demand may be impacted by the desire of patients to spend their remaining balances in their flexible spending accounts or because they have met their annual deductibles under their health insurance plans. In addition, in the fourth quarter, our results can be impacted by the budgeting and buying patterns of hospitals and military facilities.

Cost of Goods Sold and Gross Margin

Cost of goods sold consists primarily of material costs, manufacturing overhead, direct labor and third-party services, such as sterilization. Manufacturing overhead represents a significant portion of cost of goods sold and includes the cost of quality assurance, material procurement, inventory control, facilities, equipment and operations supervision and management. We expect overhead costs as a percentage of revenue to decrease as our production volume increases and our production process becomes more efficient. Cost of goods sold also includes depreciation expense for production equipment and certain direct costs such as shipping cost.

We calculate gross margin as gross profit divided by revenue. Our gross margin has been and will continue to be affected by a variety of factors, primarily production volumes, manufacturing costs and product yields, adjustments to inventory reserves and the implementation of cost-reduction strategies. Gross margin on our current product portfolio, may increase over the long term as our production volume increases and we are able to spread the fixed portion of our manufacturing overhead costs over a larger number of units produced, thereby reducing our per unit manufacturing costs; however this positive trend may be offset by new product introductions, notably the PhotonBladeTM, as new

products are produced at low volumes which may result in lower margins as component costs are usually higher at lower volumes. Therefore, our gross margin will likely fluctuate from quarter to quarter in the near term.

Research and Development Expenses

Our research and development, or R&D, expenses consist primarily of product research, engineering, product development, quality assurance and depreciation. These expenses include personnel costs, including stock-based compensation expense, consulting services, laboratory materials and supplies, and an allocation of related facilities costs. We expect our R&D costs to increase in absolute dollars as we hire additional personnel to develop new devices and device enhancements. We expense R&D costs as they are incurred.

Selling, General and Administrative Expenses

Our selling, general and administrative, or SG&A, expenses consist primarily of personnel costs including salaries, sales commissions, bonuses and stock compensation for sales, executives, and administrative personnel. Other significant SG&A expenses include independent sales agent commissions, conferences, trade shows, promotional activities including trunk stock expenses associated with the sales team demonstrating our products, and professional fees for legal and accounting services, consulting fees, insurance costs and travel expenses.

We expect SG&A expenses to continue to increase in absolute dollars as we expect to hire incremental direct sales representatives and expand our commercial infrastructure to both drive and support our planned revenue growth. We also expect to incur additional SG&A expenses as a result of supporting a dynamically growing company, including investments in human resources and other administrative functions.

Interest Expense

Interest expense consists of cash and non-cash components. The cash component of interest expense is attributable to our borrowings under our loan agreements. The non-cash component consists of interest expense recognized from the amortization of debt discounts derived from the issuance of warrants and debt issuance costs capitalized on our balance sheets.

Interest and Other Income (Expense), Net

Interest and other income (expense), net consists primarily of interest income earned on our cash, cash equivalents and marketable securities, and the fair value re-measurement related to our outstanding common stock warrants, which have been accounted for as a discount to our MidCap debt and will be marked-to-market at each future reporting period.

Loss on Extinguishment of Debt

Loss on extinguishment of debt consists primarily of prepayment penalties in association with the early payment of our loan with HealthCare Royalty Partners, or HCRP, in addition to the write-off of original debt issuance costs and debt discount associated with this loan agreement.

Results of Operations

Comparison of the Three and Six Months Ended June 30, 2017 and 2016

Revenue, cost of goods sold, gross profit and gross margin were as follows for the periods presented

Revenue increased $1.6 million, or 19%, to $9.8 million during the three months ended June 30, 2017, compared to $8.2 million for the same period in 2016. Revenue for the six months ended June 30, 2017 increased $4.2 million, or 28%, to $18.8 million compared to $14.6 million for the same period in 2016. The growth in revenue for both comparable periods was attributable to an increase in the number of hospitals ordering our devices, which increased to approximately 825 in the three months ended June 30, 2017 compared to 610 for the same period in 2016. We continue to see increased adoption of our devices in breast cancer and breast reconstruction surgery driven by our Hidden Scar marketing programs, advances within certain gynecological procedures and early interest in certain electrophysiology procedures. The number of our direct sales representatives was 65 as of June 30, 2017, compared to 69 as of June 30, 2016.

Cost of goods sold increased $0.9 million, or 44%, to $3.0 million during the three months ended June 30, 2017, compared to $2.1 million for the same period in 2016. Cost of goods sold for the six months ended June 30, 2017 increased $0.9 million, or 22%, to $5.1 million compared to $4.2 million for the same period in 2016. The increase in cost of goods sold was primarily due to the increase in the number of devices sold as we expanded our sales and marketing efforts and increased our device sales. The increase in cost was further affected by a $0.2 million write-off of PhotonBladeTM inventory to cost of goods sold.

Gross margin for the three months ended June 30, 2017 was 69.1% compared to 74.6% for the same period in 2016. The gross margin was negatively impacted by 3.5% due to the voluntary recall of the PhotonBladeTM, 2% from write off of inventory and 1.5% due to additional manufacturing inefficiencies relating to the action.

Gross margin for the six months ended June 30, 2017 was 72.8% compared to 71.3% for the same period in 2016. The year over year increase in gross margin is a direct result of the economies of scale as we manufacture larger quantities of our mature product and therefore allocate a smaller portion of our overhead expenses to these products such as the Eikon LT retractors and our single use waveguides. These production gains were partially offset by the PhotonBladeTM launch which has yet to benefit from volume production, in addition to the non-recurring expenses associated with the voluntary recall of the PhotonBladeTM as noted above.

Operating Expenses

Research and development expenses:  

Expenses remained consistent quarter over quarter and increased by just under $0.1 million, or 3%, to $2.4 million during the quarter ended June 30, 2017, compared to $2.3 million during the quarter ended June 30, 2016. Research and development expenses decreased $0.1 million, or 2%, to $4.8 million during the six months ended June 30, 2017, compared to $4.9 million during the comparable period ended June 30, 2016. This decrease in expenses was primarily attributable to a decrease in expenses associated with the PhotonBladeTM which was released for commercial sale in the first quarter of 2017.

Selling, general and administrative expenses:  

Expenses increased by approximately $0.8 million, or 6%, to $14.2 million during the quarter ended June 30, 2017, compared to $13.4 million during the quarter ended June 30, 2016. The increase in expenses was primarily attributable to a $1.3 million increase in professional service fees, including litigation fees, and in increased consulting fees. These increases were offset by a decrease in sales and marketing of $0.3 million, and a decrease of $0.2 million in personnel related expenses. Selling, general and administrative expenses increased $2.3 million, or 9%, to $29.1 million during the six months ended June 30, 2017, compared to $26.8 million during the comparable period ended June 30, 2016. The year over year increase in expenses was primarily attributable to a $2.9 million increase in professional service fees and in consulting fees plus $0.3 million in personnel related expenses. These increases were offset by a decrease in sales and marketing of $0.7 million, and a decrease of $0.2 million in travel and entertainment expenses.

Interest expense, interest, and other income (expense):

Non-operating items, including interest expense, interest, and other expense, were as follows for the periods presented: