UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10‑Q

(Mark One)

For the quarterly period ended March 31, 2018

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 May 1, 2018 was 24,041,337.

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.

The year-end condensed balance sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

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)

In this Quarterly Report on Form 10-Q, references to “Invuity,” “we,” “us,” “our” and the “Company” refer to

Invuity, Inc., unless expressly indicated or the context otherwise requires

1.           Organization and Description of Business

Invuity, Inc. 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 and Going Concern

The Company has incurred net losses from operations since inception, including $11.2 million in the three months ended March 31, 2018, and has an accumulated deficit of $197.3 million as of March 31, 2018. In March 2018, the Company issued and sold a total of 6,800,000 shares of its common stock at $3.50 per share, resulting in total net proceeds of approximately $21.7 million. The Company has $32.6 million in cash and cash equivalents and short-term investments, and $33.6 million in debt outstanding at March 31, 2018.

The Company is required to comply with a financial covenant relating to certain quarterly minimum Net Revenue (as defined in the debt agreements) requirements on a trailing twelve-month basis. See Note 5 for further details. As of March 31, 2018, the Company was not in compliance with this covenant. As disclosed in Note 10, the Company entered into an Amendment No. 2 to the Credit and Security Agreement with MidCap Financial Trust to revise the financial covenant. After the execution of the amendment, the Company was in compliance with the revised covenant. The Company expects to incur additional losses and negative cash flows for the foreseeable future as the Company continues to invest in its sales and marketing efforts and research and development activities to continue to grow its business.

If the Company is not able to perform according to the Company’s plan, the Company’s available capital resources may be consumed more rapidly than currently expected, and therefore may be required to raise additional funds. However, the Company may not be able to secure such financing in a timely manner or on favorable terms, if at all. Without additional funds, the Company may be forced to delay, scale back or eliminate some of its sales and marketing efforts, research and development activities, or other operations and potentially delay product development in an effort to provide sufficient funds to continue its operations.

The Company believes that its cash, cash equivalents and short-term investments as of March 31, 2018, and expected sales from its products together with additional funding available under the Company’s revolving credit facility will provide sufficient funds to enable the Company to meet its projected operating requirements for the next twelve months from the issuance of these financial statements. However, the uncertainty around the achievement of the Company’s plans to mitigate the risk of going concern, including future compliance with the financial covenant described above, raises substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

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, 2017 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, 2017. The results for the three months ended March 31, 2018 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 March 31, 2018 and December 31, 2017, 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, 2017 and as of and for the three months ended March 31, 2018 and 2017, the Company had no customers that represented 10% or more of its revenue or accounts receivable balances.

Changes in Significant Accounting Policies

Except for the accounting policies for revenue recognition and deferred commissions that were updated as a result of adopting Topic 606, there have been no changes to our significant accounting policies described in the Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March 5, 2018, that have had a material impact on the Company’s condensed financial statements and related notes. 

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 accounts for a contract with a customer when there's approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance, collectability of consideration is probable and the risks and rewards of ownership are transferred.

In certain circumstances, the Company enters into arrangements in which multiple performance obligations are provided to customers. Under multiple performance obligations arrangements, the Company accounts for individual products and services separately if they are distinct, that is, if a product or service is separately identifiable from other items in the bundled package and if a customer can benefit from it on its own or with other resources that are readily available to customer. The consideration (including any discounts) is allocated between separate products and services in a bundle based on their individual stand-alone selling price (“SSP”). The SSP is determined based on observable prices at which the Company separately sells the products and services.  

The Company does not offer rights of return or price protection and does not provide credits or incentives, which may be required to be accounted for as variable consideration when estimating the amount of revenue to be recognized. With the exception of PhotonVue®, whereby customers can purchase service contracts for future periods of time, the Company has no post-delivery obligations other than the standard warranty for the Company’s products.

Single use devices

Single use device revenues include the Company’s single use products, such as the PhotonGuide® (which is used in conjunction with our reusable retractors), Photonsaber® F, the Photonsaber® Y, and the PhotonBlade®. Revenues from the sale of single use devices are recognized when the Company transfers the risks and rewards of ownership to the customer. The Company’s products do not require installation being readily available for use upon transfer of physical possession.

Reusable retractors

Reusable retractor revenues include the Company’s reusable products, such as the Eikon® LT, the Breisky, and the Breiten®. Revenues from the sale of reusable retractors are recognized when the Company transfers the risks and rewards of ownership to the customer. The Company’s products do not require installation being readily available for use upon transfer of physical possession.

Sales to 3rd party medical device manufacturers

At times, the Company sells uniquely modified products to 3rd party medical device manufacturers. The products are modified based on the specifications provided by 3rd party medical device manufacturers, who then incorporate these parts into products sold to their customers. Revenues from the sale to 3rd party medical device manufacturers are recognized when the Company transfers the risks and rewards of ownership to the 3rd party manufacturers. The Company’s products do not require installation being readily available for use upon transfer of physical possession.

Other

Other revenues include revenues from sales of accessories and extended service agreements. Revenues for sales of accessories, such as cables and trays, are recognized when the accessories are delivered to the customer and control is transferred. Revenues from extended service agreements are accounted for ratably over the term of the service agreement.

Segment Reporting

The Company manages its operations as a single operating segment for the purposes of assessing performance and making operating decisions.  The majority of the Company’s assets are maintained in the United States. The

Company derives its revenue primarily from sales to customers in the United States, based upon the billing address of the customer. In June 2017, the Company started selling into Asia with sales through March 31, 2018 being immaterial.

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.

Contract Balances

The timing of revenue recognition, billings and cash collections results in accounts receivables and deferred revenues on the Condensed Balance Sheet. Service contracts are usually billed upon initial purchase with the PhotonVue® system, resulting in a contract liability. These contract liabilities are reported as deferred revenues on the Condensed Balance Sheet at the end of each reporting period.

Recent Accounting Pronouncements

The adoption of ASC 606, using the modified retrospective approach in the first quarter of 2018 did not have a material impact on the Company’s financial statements.

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 March 31, 2018 and December 31, 2017, 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 Current Assets

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

Property and Equipment, Net

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

Depreciation and amortization expense was $0.4 million for the three months ended March 31, 2018, and $0.5 million for the three months ended March 31, 2017.

Accrued and Other Current Liabilities

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

5.           Debt

MidCap credit and security agreement:

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. The Tranche 1 term loan accrues 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, subject to extension to October 1, 2019, if the Company achieves a certain revenue target, 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 (“HCRP”). The Company also terminated its accounts receivable credit facility with Silicon Valley Bank which was never drawn down. The transaction was accounted for as a debt extinguishment and a loss of $2.3 million was accounted for as loss on extinguishment of debt in the income statement. The loss amount includes a $1.8 million prepayment fee paid to HCRP, a $150,000 fee paid to Silicon Valley Bank for termination of the accounts receivable facility and a $0.3 million non-cash expense related to unamortized issuance costs.

On September 26, 2017, the Company amended the credit and security agreement with MidCap and borrowed the second term loan of $10.0 million (“Tranche 2”). The Tranche 2 term loan accrues 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, subject to extension to October 1, 2019, if the Company achieves a certain revenue target, until paid in full on March 1, 2022.

The Company also entered into a separate credit and security agreement with MidCap on March 10, 2017 that provides for a revolving credit facility of up to $10.0 million based on the eligible accounts receivable and inventory balances, as amended on September 26, 2017. 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 certain conditions. 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 March 31, 2018, the Company had drawn down $4.4 million under the revolving credit facility.

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 requirements on a trailing twelve month basis, which were amended on April 30, 2018. The minimum Net Revenue requirements on a trailing twelve month basis for the remainder of 2018 is $41,428,108 for the period ending June 30, 2018, $43,427,626 for the period ending September 30, 2018, and $46,000,000 for the period ending December 31, 2018. Additionally, the credit and security agreement with MidCap, includes customary events of default, including failure to pay amounts due, breaches of covenants and warranties, and material adverse effect events. If an event of default occurs, MidCap may require immediate repayment of all amounts due. As of March 31, 2018, the Company was not in compliance with this covenant. As disclosed in Note 10, the Company entered into an Amendment No. 2 to the Credit and Security Agreement with MidCap Financial Trust to revise the financial covenant. After the execution of the amendment, the Company was in compliance with the revised covenant.

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. 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. In connection with the Tranche 2 term loan, the Company issued warrants to purchase an aggregate of 47,790 shares of the Company’s common stock, at an exercise price equal to $8.37 per share. These warrants, which were recorded within stockholders’ equity, were fair valued at $278,000 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 2.24%, dividend yield of 0.0% and volatility of 60.0%.  The fair value was recorded as a discount to the initial $10.0 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 March 31, 2018 and 2017, the Company granted 316,500 and 597,180 options, respectively, to employees and consultants, with a weighted average grant date fair value of $4.12 per share and $6.50 per share, respectively. The options granted as of March 31, 2018 included 30,000 options granted to consultants, which included 20,000 options with a performance-based condition.

The aggregate intrinsic value of options exercised was $15,600 and $29,000 for the three months ended March 31, 2018 and 2017, respectively. As of March 31, 2018 and December 31, 2017, the weighted-average remaining contractual life of options outstanding was 6.3 and 7.0 years, respectively, and for options vested and expected to vest, was 6.3 and 7.0 years, respectively.

For the three months ended March 31, 2018, the Company granted restricted stock units (“RSUs”) to the Company’s new interim President and Chief Executive Officer as part of the Employment Agreement, dated March 6, 2018, by and between the Company and Scott Flora, as filed as Exhibit 10.2 to our Current Report on Form 8-K on March 6, 2018. The restricted stock units had a grant date value of $150,000, which will vest in full on March 1, 2019 subject to continued services provided through such date.

For the three months ended March 31, 2018, the Company granted 177,985 RSUs with a fair value of $0.7 million to executive officers. For the three months ended March 31, 2017, the Company granted 71,500 RSUs with a fair value of $0.5 million to executive officers. With the exception of the RSUs granted as part of the new interim President and Chief Executive Officer’s employment agreement, these RSUs have a four-year term and vest 25% annually.

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 $1.0 million and $0.7 million for the three months ended March 31, 2018 and March 31, 2017, respectively. Of the $1.0 million of employee-related stock compensation expenses, $0.3 million was related to the accelerated vesting of unvested shares as outlined in the separation agreement between the Company and its former President, Chief Executive Officer and member of the board of directors.

In addition, the Company recognized non-employee stock-based compensation expense of $18,500 and $67,000 for the three months ended March 31, 2018 and March 31, 2017, 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 March 31, 2018, unrecognized compensation expense related to unvested options was $4.9 million, which the Company expects to recognize on a straight‑line basis over a weighted‑average period of 2.9 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 2.5 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 (the “Exchange Act”), 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 plaintiff. The lead plaintiff filed an amended complaint on July 31, 2017. Defendants filed a motion to dismiss on September 14, 2017, and the lead plaintiff filed his opposition to the motion on October 30, 2017. Defendants filed a reply brief on December 4, 2017. 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.

In December 2016, Medtronic, which competes with us across multiple product lines, filed a civil complaint in the State Court of Minnesota against us, alleging tortious interference with contract, and two of our former sales employees, alleging breach of contract, misappropriation of trade secrets and breach of duty of loyalty. The complaint seeks unspecified monetary damages. In April 2018, we entered into an agreement with Medtronic, pursuant to which we agreed to pay $1.0 million to Medtronic, and Medtronic agreed to dismiss this complaint.

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.

9.           Disaggregation of Revenues

The Company disaggregates its revenues by product categories, as the Company believes this best depicts how the nature, amount, timing, and uncertainty of revenues and cash flows are affected by economic factors. See details in the tables below.

10.         Subsequent Events

Debt Covenants:

As of March 31, 2018, the Company was not in compliance with the financial covenant relating to the Term Loan Agreement and the Revolving Loan Agreement with MidCap Financial Trust. On April 30, 2018, the Company

entered into an Amendment No. 2 to Credit and Security Agreement (Term Loan) (the “Term Loan Amendment”) to its Credit and Security Agreement (Term Loan), dated as of March 10, 2017 (as amended, the “Term Loan Credit Agreement”), with MidCap Financial Trust, as agent, the lenders party thereto and the Company. In connection with the Term Loan Amendment, the Company also entered into an Amendment No. 2 to Credit and Security Agreement (Revolving Loan) (the “Revolving Loan Amendment”) to its Credit and Security Agreement (Revolving Loan), dated as of March 10, 2017 (as amended, the “Revolving Loan Credit Agreement”), with MidCap Financial Trust, as agent, the lenders party thereto and the Company. The financial covenant relating to certain quarterly minimum net revenue requirements on a trailing twelve month basis was revised, and the exit fee was increased from 6.25% to 6.5% of the total amount of all term loans.

The foregoing description does not purport to be complete and is qualified in its entirety by reference to the Term Loan Amendment and the Revolving Loan Amendment, copies of which are attached hereto as Exhibits 10.3 and 10.4, respectively, and incorporated herein by reference

Restructuring:

On May 1, 2018, the Company implemented a corporate restructuring program to streamline the company and increase productivity in the Company’s commercial operations and product development process. As a result of this restructuring program, the Company expects to incur expenses of approximately $1.0 million in severance and benefit charges.

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, 2017. 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 leading medical technology company focused on developing and marketing advanced surgical devices to improve the ability of physicians to perform minimal access surgery through smaller and hidden incisions. Our patented Intelligent Photonics® technology delivers enhanced visualization which facilitates surgical precision, efficiency and safety. In addition, we utilize comprehensive strategic marketing programs to create stronger institutional partnerships. Clinical applications include women's health, encompassing breast cancer and breast reconstruction surgery, gynecology and thyroid surgery. Additional applications include procedures for electrophysiology, spine, orthopedic, cardiothoracic, and general surgery. 

We channel our development through two broad categories of innovation. First, 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 this proprietary technology to develop optical waveguides, called PhotonGuides®, which 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.

Our second broad category of innovation for minimally invasive and minimal access surgical procedures is in the development and commercialization of a novel advanced energy platform. In September 2016, we received U.S. Food and Drug Administration, or FDA, 510(k) clearance of PhotonBlade®, a dynamic precision illuminator with enhanced energy delivery. PhotonBlade® is a first-of-its-kind device, delivering directed, thermally cool illumination at the precise point of surgical treatment in conjunction with a novel advanced energy platform allowing for precise tissue cutting and coagulation with minimal tissue damage. As such, PhotonBlade® represents a new category of Intelligent Photonics® ® and strategically expands our current product portfolio. After a preliminary market launch in March 2017, we fully launched the PhotonBlade® in September 2017.

Finally, in the third quarter of 2017, through a distribution arrangement with our manufacturing partner, Fluoptics Imaging Inc., we began a limited market launch of a fluorescence imaging system, called PhotonVue®, which is used for the visual assessment of blood flow in adults as an adjunctive method for the evaluation of tissue perfusion.

We sold our devices to approximately 880 hospitals in the first quarter of 2018, as compared to approximately 770 hospitals in the first quarter of 2017. Based on the number of single-use units we have shipped as of March 31, 2018, we estimate that our devices have been used in approximately 398,000 surgical procedures cumulative from inception.

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 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. In January, 2018, we secured additional space for storage and distribution, and believe these facilities are sufficient to support our operations and that suitable facilities would be available to us should our operations require it.

On May 1, 2018, we implemented a corporate restructuring program to streamline our company and increase productivity in our commercial operations and product development process. As a result of this restructuring program, we expect to incur expenses of approximately $1.0 million in severance and benefit charges.

Components of Our Results of Operations

Revenue

Substantially of our revenue is derived from sales of our devices in the United States. In June 2017, we started selling into Asia with sales through March 31, 2018 not being considered material. We earn revenue from the sale of our devices primarily through our direct sales force as complemented by our independent sales agents.

We consider revenue derived from our single-use products to be the most important part of our business. Therefore, our focus is on procedure adoption. 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. However, we expect overhead costs as a percentage of revenue to decrease over time as our production volume increases and our production process becomes more efficient. In addition, new product launches typically have higher costs due to less efficient manufacturing process costs and higher material costs due lower production volumes. 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 has been offset by new product introductions, notably the PhotonBlade® and PhotonVue®, 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 salaries, healthcare benefits, bonuses, stock-based compensation expense, consulting services, laboratory materials and supplies, and an allocation of related facilities costs. In the near term, we expect our R&D costs to be fairly constant in absolute dollars as we look to increase our operating efficiencies and then over the longer term to increase in absolute dollars as we hire additional personnel to develop new devices and device enhancements.

Selling, General and Administrative Expenses

Our selling, general and administrative, or SG&A, expenses consist primarily of personnel costs including salaries, healthcare benefits, 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.

In the near term, we expect SG&A expenses to be fairly constant in absolute dollars as we look to increase our operating efficiencies and then over the longer term, to increase in absolute dollars as we expect to 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 Income and Other Expense, Net

Interest income and other expense, net consists primarily of interest income earned on our cash, cash equivalents and marketable securities offset by tax expenses, 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 associated with the early payment of our loan with 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 months Ended March 31, 2018 and 2017

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

Revenue increased $0.5 million, or 5%, to $9.5 million during the three months ended March 31, 2018, compared to $9.0 million for the same period in 2017. The growth in revenue was primarily attributable to an increase in the number of hospitals ordering our devices, which increased to approximately 880 in the three months ended March 31, 2018 compared to 770 for the same period in 2017 and by increased procedure use of our single use devices driven by growing adoption of our PhotonBlade® in breast and electrophysiology procedures. Our reusable retractor revenues declined primarily due to the decline in the rate of new account openings, and the introduction of PhotonBlade®, a single use device that does not require a reusable retractor.

Cost of goods sold increased $0.8 million, or 39%, to $2.9 million during the three months ended March 31, 2018, compared to $2.1 million for the same period in 2017. The increase in cost of goods sold was primarily due to the increase in the number of devices sold.

Gross margin for the three months ended March 31, 2018 was 69.3% compared to 76.7% for the same period in 2017.  The decline in gross margins in the first quarter of 2018 was due predominately to lower margin contributions associated with our new products PhotonBlade® and PhotonVue® that have yet to benefit from volume production.

Operating Expenses

Research and development expenses:  

Expenses decreased by $0.5 million, or 22.5%, to $1.9 million for the three months ended March 31, 2018, compared to $2.4 million during the three months ended March 31, 2017. These decreases are the result of the cadence of new product releases and were primarily attributable to a decrease in personnel and consulting related expenses of $0.5 million.

Selling, general and administrative expenses:  

Expenses increased by approximately $0.3 million, or 1.7%, to $15.1 million during the three months ended March 31, 2018, compared to $14.9 million during the three months ended March 31, 2017. The total expenses included litigation and severance costs of $3.0 million during the three months ended March 31, 2018, compared to $1.4 million during the three months ended March 31, 2017.

The increase in expenses was primarily attributable to a $0.2 million increase in Consultants and Contractors fees, a $0.4 million increase in professional service fees, including litigation fees, and a $0.2 million increase in IT and travel expenses, offset by a $0.4 million in payroll related expenses and a $0.1 million decrease in sales and marketing expenses.

Interest expense, interest income, and other expense, net:

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

Interest expense increased $0.3 million during the three months ended March 31, 2018, compared to the comparable period in 2017. This was primarily due to higher interest expense on a higher average debt balance.

For the three months ended March 31, 2017, the expense of $2.3 million related to the extinguishment of our loan with HCRP. This expense included a $1.8 million prepayment fee, approximately $0.4 million in expenses relating to the immediate recognition of debt discounts that were being amortized over the term of the original loan, and a $150,000 fee for ending our access to our Silicon Valley Bank, or SVB, credit facility.

Critical accounting policies and estimates

Management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material.

Except for the accounting policies for revenue recognition and deferred commissions that were updated as a result of adopting Topic 606, there have been no changes to our significant accounting policies described in the Annual Report on Form 10-K filed with the SEC on March 5, 2018, that have had a material impact on the Company’s condensed financial statements and related notes. 

Liquidity and Capital Resources

Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing or to raise capital. The accompanying financial statements have been prepared on a basis which assumes we will continue as a going concern and which contemplates the realization of assets and satisfaction of liabilities and commitments in the normal course of business. We have incurred net losses from operations since inception, including $11.2 million in the three months ended March 31, 2018, and have an accumulated deficit of $197.3 million as of March 31, 2018. In March 2018, we issued and sold a total of 6,800,000 shares of our common stock at $3.50 per share, resulting in total net proceeds of approximately $21.7 million. We have $32.6 million in cash and cash equivalents and short-term investments, and $33.6 million in debt outstanding as of March 31, 2018.

We are required to comply with a financial covenant relating to certain quarterly minimum Net Revenue requirements on a trailing twelve-month basis. The minimum Net Revenue requirements on a trailing twelve month basis for the remainder of 2018 is $41,428,108 for the period ending June 30, 2018, $43,427,626 for the period ending September 30, 2018, and $46,000,000 for the period ending December 31, 2018. As of March 31, 2018, we were not in compliance with this covenant. As disclosed in Note 10, we entered into an Amendment No. 2 to the Credit and Security Agreement with MidCap Financial Trust to revise the financial covenant. After the execution of the amendment, we were in compliance with the revised covenant. We expect to incur additional losses and negative cash flows for the foreseeable future as we continue to invest in our sales and marketing efforts and research and development activities to continue to grow our business.

If we are not able to perform according to our 2018 operating plan, our available capital resources may be consumed more rapidly than currently expected, and therefore may be required to raise additional funds. However, we may not be able to secure such financing in a timely manner or on favorable terms, if at all. Without additional funds, we may be forced to delay, scale back or eliminate some of our sales and marketing efforts, research and development activities, or other operations and potentially delay product development in an effort to provide sufficient funds to continue our operations.

We believe that our cash, cash equivalents and short-term investments as of March 31, 2018, and expected sales from our products together with additional funding available under our revolving credit facility will provide sufficient funds to enable us to meet our projected operating requirements for the next twelve months from the issuance of these financial statements. However, the uncertainty around the achievement of our plans to mitigate the risk of going concern, including future compliance with the financial covenant described above, raises substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Cash Flows

The following table summarizes our cash flows for the periods indicated:

During the three months ended March 31, 2018, net cash used in operating activities was $8.5 million, which consisted of a net loss of $11.2 million, adjusted by non-cash charges of $1.4 million and a net change of $1.3 million in our net operating assets and liabilities. The non-cash charges were primarily comprised of depreciation and amortization of $0.4 million and stock-based compensation of $1.0 million.  The increase in our net operating assets and liabilities was primarily due to a $1.3 million decrease in accounts receivable due to the timing of payments received, a $1.5 million increase in accrued liabilities in anticipation of severance and legal settlement payments, and a $0.2 million decrease in prepaid. The increase was offset by a $1.3 million in our inventory due to ramping production of PhotonBlade® in anticipation of customer demand in 2018 and restocking inventory levels after the high year-end sales in 2017. In addition, there was a $0.4 million decrease in accounts payable due to timing of payments. During the three months ended March 31, 2017, net cash used in operating activities was $10.8 million, which consisted of a net loss of $13.2 million plus offsetting non-cash adjustments of $2.7 million and a net change of $0.4 million in our net operating assets and liabilities. The net change in our net operating assets and liabilities were primarily due to a $1.1 million increase in our accounts payable balance due, in part, to the timing of payments made during the quarter. The balance was partially offset by a decrease in our accrued liabilities of $0.5 million. The increase to our inventory balances of $0.9 million was driven by the increase in our business as we ramped up manufacturing in preparation for the coming year. In addition, our accounts receivable balance increased by $0.3 million in-line with our increased sales. 

During the three months ended March 31, 2018, net cash used in investing activities was due to capital expenditures.

During the three months ended March 31, 2018, net cash provided by financing activities was primarily due to net proceeds of $21.7 million from our secondary offering in March 2018, offset by a reduction of $1.5 million in the draw-down under our revolving credit facility.

We believe that our existing cash and cash equivalents and short-term investments as of March 31, 2018, will be sufficient to meet our anticipated cash requirements for the next twelve months. Our expected future capital requirements may depend on many factors including customer sales, changes in our sales force, and the timing and extent of spending on the development of our technology to increase our product portfolio. We may seek funds through borrowings or through additional rounds of financing, including private or public equity or debt offerings and collaborative arrangements with corporate partners. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Any future debt financing into which we enter may impose upon us additional covenants that restrict our operations, including limitations on our ability to incur liens or additional debt, pay dividends, repurchase our common stock, make certain investments and engage in certain merger, consolidation or asset sale transactions. Any debt financing or additional equity that we raise may contain terms that are not favorable to us or our stockholders. If we raise additional funds through collaboration and licensing arrangements with third-parties, it may be necessary to relinquish some rights to our technologies or our devices, or grant licenses on terms that are not favorable to us.

Furthermore, we cannot be certain that additional funding will be available on acceptable terms, if at all. If we are unable to raise additional capital or generate sufficient cash from operations to adequately fund our operations, we may need to curtail planned activities to reduce costs. Doing so may harm our ability to execute on our business plan.

Off-Balance Sheet Arrangements

We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities.

Contractual Obligations

During the three months ended March 31, 2018, there were no material changes to our contractual obligations and commitments described under Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10‑K filed with the SEC on March 5, 2018.

ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Our operations are primarily within the United States. We are exposed to market risks in the ordinary course of our business. These risks primarily relate to interest rate, inflation risks, and changes in the general economic conditions in the countries where we conduct business. We had cash, cash equivalents, and short-term investments of $32.6 million and $21.0 million as of March 31, 2018 and December 31, 2017, respectively. 

Our short-term investments primarily consisted of corporate bonds. The cash and cash equivalents are held for working capital purposes. Our investments are made for capital preservation purposes. We do not enter into investments for trading or speculative purposes. Because of the short-term nature of the instruments in our portfolio, a sudden change in market interest rates would not be expected to have a material impact on our financial statements.

As of March 31, 2018 and December 31, 2017, we had total outstanding net debt of $33.6 million and $35.0 million, respectively. Our term loans with MidCap that were outstanding as of March 31, 2018 and December 31, 2017, accrue interest at a floating rate equal to 6.50% per annum, plus the greater of (i) 1.5% or (ii) one month LIBOR. Our accounts receivable facility accrues interest at a floating rate equal to 3.25% per annum, plus the greater of (i) 1.5% or (ii) one month LIBOR as amended. See Note 5, “Debt”, of the Notes to Condensed Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10‑Q for more details.

Foreign Currency Risk

In June 2017, we expanded sales to Asia and we expect to expand sales to Europe, however, as of March 31, 2018, our business has primarily been conducted in U.S. Dollars. As we begin to conduct transactions in foreign currencies, we may become increasingly subject to foreign currency risks related to our revenue and operating expenses denominated in currencies other than the U.S. dollars. As our international operations grow, our risks associated with fluctuation in currency rates will become greater, and we will continue to reassess our approach to managing this risk.

Inflation Risk

We do not believe that inflation has had a material effect on our business, financial condition or results of operations. Nonetheless, if our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.

ITEM 4.     CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The term “disclosure controls and procedures,” as defined in Rules 13a‑15(e) and 15d‑15(e) under the Exchange Act refers to controls and procedures that are designed to provide reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to provide reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated

to the company’s management, including its Chief Executive Officer and Chief Financial Officers, as appropriate to allow timely decisions regarding required disclosure.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2018, the end of the period covered by this Quarterly Report on Form 10‑Q. Based upon such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of such date.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13(a)‑15(d) and 15d‑15(d) under the Exchange Act that occurred during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Limitations on Effectiveness of Controls and Procedures

Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and our management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their control objectives.

PART II—OTHER INFORMATION

ITEM 1.     LEGAL PROCEEDINGS

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 us, our Chief Executive Officer, and our Chief Financial Officer. The complaint alleges that the defendants made false or misleading statements to investors regarding our business prospects. The complaint purports to assert claims for violation of Sections 10(b) and 20(a) of the Exchange Act of 1934, and SEC Rule 10b‑5 on behalf of a purported class consisting of all purchasers of our 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 plaintiff. The lead plaintiff filed an amended complaint on July 31, 2017. Defendants filed a motion to dismiss on September 14, 2017, and the lead plaintiff filed his opposition to the motion on October 30, 2017.  Defendants filed a reply brief on December 4, 2017. We intend to defend the litigation vigorously. Based on information currently available, we have determined that the amount of any possible loss or range of possible loss is not reasonably estimable.

In December 2016, Medtronic, which competes with us across multiple product lines, filed a civil complaint in the State Court of Minnesota against us, alleging tortious interference with contract, and two of our former sales employees, alleging breach of contract, misappropriation of trade secrets and breach of duty of loyalty. The complaint seeks unspecified monetary damages. In April 2018, we entered into an agreement with Medtronic, pursuant to which we agreed to pay $1.0 million to Medtronic, and Medtronic agreed to dismiss this complaint.

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

ITEM 1A. RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information contained in this Quarterly Report on Form 10‑Q, including our financial statements and the related notes thereto, before making a decision to invest in our common stock. The realization of any of the following risks could materially and adversely affect our business, financial condition, operating results and prospects. In that event, the price of our common stock could decline, and you could lose part or all of your investment.

Risks Related to Our Business and Industry 

We may be required to obtain additional funds to continue as a going concern. If we are unable to obtain sufficient funds, we may be unable to invest in our sales and marketing efforts and research and development activities in order to grow our business. Additionally, we may not be able to secure these funds on commercially reasonable terms, or at all.

We have experienced significant operating losses, and we expect to continue to incur operating losses for the next several years as we implement additional initiatives designed to grow our business, including, among other things, increasing sales and developing new devices. We incurred net losses of $11.2 million for the three months ended March 31, 2018 and $39.9 million and $40.6 million for the years ended December 31, 2017 and 2016, respectively. As of March 31, 2018, our accumulated deficit was $197.3 million. Our prior losses, combined with expected future losses, have had and will continue to have, for the foreseeable future, an adverse effect on our stockholders’ deficit and working capital. These factors raise substantial doubt about our ability to continue as a going concern for the one year period from the date of issuance of the financial statements, included elsewhere in this Quarterly Report on Form 10-Q. To date, we have financed our operations primarily through the sale of equity securities, certain debt-related financing arrangements and from sales of our approved devices. We have devoted substantially all of our resources to research and development of our devices, sales and marketing activities and certain clinical and quality assurance initiatives. Our ability to generate sufficient revenue from our existing devices or from any of our device candidates in development, and to transition to profitability and generate consistent positive cash flows, is uncertain. We will need to generate significant sales to achieve profitability, and we might not be able to do so. If our revenue grows more slowly than we anticipate or if we fail to continue to grow our revenue, or if our operating expenses are higher than we expect, we may not be able to

achieve profitability as anticipated, or ever, our financial condition will suffer and our stock price could decline. Even if we achieve profitability in the future, we may not be able to sustain profitability in subsequent periods.

Substantially all of our revenue to date has been generated from devices incorporating our Intelligent Photonics®  technology, and any decline in the sales of these devices or failure to gain market acceptance of these devices will negatively impact our business.

We have focused heavily on the development and commercialization of devices using our photonics technology platform for the illumination of certain open and minimal access surgeries. For the three months ended March 31, 2018 and for the years ended December 31, 2017 and 2016, our revenues of $9.5 million, $39.6 million, and $32.5 million, respectively, were derived entirely from sales of devices incorporating our Intelligent Photonics® technology. Because we expect our revenue to be derived substantially from sales of these devices for the foreseeable future, our ability to execute our growth strategy and become profitable will depend not only upon an increase in the number of hospitals using our devices, but also an increase in the number of specialties using our devices within those hospitals in which our devices are utilized. If our advanced photonics technology, and the devices that incorporate it, fail to achieve and maintain wide market acceptance for any reason, our business may be adversely affected, as we will be severely constrained in our ability to fund our operations and develop and commercialize improvements to existing and new product lines.

We introduced our PhotonBlade® device in 2017 and there can be no assurance on the level of market acceptance or revenue generated by this product. 

In the third quarter of 2016, we announced that we had received FDA 510(k) clearance for PhotonBlade®, a new device that integrates our Intelligent Photonics® technology into an advanced energy device used for cutting and coagulation of soft-tissue during surgical procedures. We initiated a limited launch of the PhotonBlade® device in the first quarter of 2017 to obtain feedback from initial users with a goal of launching the product more broadly in the middle of 2017. Shortly after the limited launch, we received a small number of customer complaints which related to possible unintended energy discharge from the device with the potential to cause tissue damage to patients. In June 2017, we initiated a voluntary recall of the device. We redesigned the device to correct the performance issues that prompted the recall and relaunched the product in September of 2017. We cannot be assured that we have successfully redesigned the PhotonBlade® so as to eliminate the performance issues that prompted the recall. Furthermore, in light of the recall, we cannot be assured that the redesigned PhotonBlade® will achieve market acceptance. We will be required to devote significant resources to relaunch and market the PhotonBlade® and cannot be assured that these activities will generate revenue as anticipated. If our redesign of the device fails to successfully eliminate the performance issue or if our revenue grows more slowly than we expect, our business and financials will be adversely affected.

Failure to achieve revenue targets under our credit facility with MidCap would constitute an event of default, which may require us to repay the amounts outstanding under the facility earlier than expected. 

As of March 31, 2018, we had borrowed $30.0 million in term loans and drawn down $4.4 million under our revolving credit facility. Our credit facility with MidCap requires us to comply with a financial covenant relating to certain quarterly minimum Net Revenue requirements on a trailing twelve month basis. The minimum Net Revenue requirements on a trailing twelve month basis for the remainder of 2018 is $41,428,108 for the period ending June 30, 2018, $43,427,626 for the period ending September 30, 2018, and $46,000,000 for the period ending December 31, 2018. In March 2018, we were not in compliance with the financial covenant. As disclosed in Item 5, we entered into an Amendment No. 2 to the Credit and Security Agreement with MidCap Financial Trust to revise the financial covenant. After the execution of the amendment, we were in compliance with the revised covenant.

If we do not comply with the financial covenant again in the future, it would constitute a breach of the credit agreements and may cause all of the outstanding indebtedness under our credit agreements, as amended, to become immediately due and payable. If the Company was unable to obtain a waiver for this default, the lenders may terminate all commitments to extend further credit and the agent, on behalf of the lenders, may proceed against the collateral in which we granted the agent and the lenders a security interest.

If we are unable to convince hospital facilities to approve the use of our devices, our sales may decrease. 

In the United States, in order for surgeons to use our devices, the hospital facilities in which surgeons treat patients will typically require us to receive approval from the facility’s Value Analysis Committee “VAC”. VACs typically review the comparative effectiveness and cost of medical devices used in the facility. The makeup and evaluation processes for VACs vary considerably, and it can be a lengthy, costly and time-consuming effort to obtain approval by the relevant VAC. For example, even if we have an agreement with a hospital system for the purchase of our devices, in most cases, we must obtain VAC approval by each hospital within the system to sell at that particular hospital. Additionally, hospitals typically require separate VAC approval for each specialty in which our device is used, which may result in multiple VAC approval processes within the same hospital even if such device has already been approved for use by a different specialty group. We often need VAC approval for each different device to be used by surgeons in each discrete specialty. In addition, hospital facilities and group purchasing organizations, or GPOs, which manage purchasing for multiple facilities, may also require us to enter into a purchasing agreement and satisfy numerous elements of their administrative procurement process, which can also be a lengthy, costly, and time-consuming effort. If we do not receive access to hospital facilities in a timely manner, or at all, via these VAC and purchasing contract processes, or otherwise, or if we are unable to secure contracts in a timely manner, or at all, our operating costs will increase, our sales may decrease, and our operating results may be harmed. Furthermore, we may expend significant effort and still be unable to obtain VAC approval or a purchase contract from hospitals or GPOs.

We must demonstrate to surgeons and hospitals the merits of our devices in order to facilitate greater adoption of our devices. 

Surgeons play a significant role in determining the devices used in the operating room and assisting in obtaining approval by the relevant VAC. Educating surgeons on the benefits of our devices requires a significant commitment by our marketing team and sales organization. Surgeons and hospitals may be slow to change their practices because of perceived risks arising from the use of new devices, lack of experience using new devices, lack of clinical data supporting the benefits of such devices or the cost of new devices. We cannot predict when, or if ever, there will be widespread adoption of our devices by surgeons and hospitals. If we are unable to educate surgeons and hospitals about the advantages of our devices as compared to alternatives, we may face challenges in obtaining approval by the relevant VAC, and we will not achieve significantly greater market acceptance of our devices, gain momentum in our sales activities, significantly grow our market share or grow our revenue, and our business and financial condition will be adversely affected.

Failure to retain existing accounts or attract new accounts could cause our revenue growth rates to decline.

In addition to adding new accounts, we must sell additional products and accessories to existing accounts and encourage them to maintain or increase their usage levels to increase our revenue. If our existing and prospective users do not perceive our products and accessories to be of sufficiently high value and quality, we may not be able to retain our current accounts or attract new ones.

Our accounts’ usage levels may decline or fluctuate as a result of a number of factors, including:

If we do not add new accounts, our reusable retractor revenue may decline, as reusable retractors are typically sold when we open new accounts.  In addition, our existing accounts could significantly curtail their usage and our revenue would be lower than expected and our operating results could suffer.

If we fail to develop and retain our direct sales force and independent sales agents, our business could suffer. 

We currently sell our devices through our direct sales representatives in the United States. Our direct sales force works with independent sales agents or agencies, which assist us in educating targeted surgeons. Our operating results

are dependent upon the sales and marketing efforts of our direct sales representatives. If our direct sales force fails to adequately promote, market and sell our devices, our sales may suffer.

As we launch new devices and increase our current marketing efforts with respect to existing devices and expand into new geographies, our future success will depend largely on our ability to continue to hire, train, retain and motivate skilled sales personnel with significant technical knowledge of our devices. We have made, and intend to continue to make, a significant investment in recruiting and training sales representatives. There is significant competition for sales personnel who are experienced in relevant medical device sales. Once hired, the training process is lengthy because of the significant education required to achieve the level of competency that surgeons expect from sales representatives with respect to understanding our devices. Upon completion of the training, our sales representatives typically require lead time in the field to grow their network of accounts and achieve the productivity levels we expect them to reach. If we are unable to attract, motivate, develop and retain a sufficient number of qualified sales personnel, or if our sales representatives do not achieve the productivity levels we expect them to reach, our revenue will not grow at the rate we expect and our financial performance will suffer. Also, to the extent we hire personnel from our competitors, we may have to wait until applicable non-competition provisions expire before deploying such personnel in restricted territories, or else incur costs to relocate personnel outside of such territories, and we may be subject to allegations that such new hires have been improperly solicited, or that they have divulged to us proprietary or other confidential information.

We operate in a highly competitive market segment. If our competitors are better able to market and develop devices than we are able to market or develop devices, our business will be adversely impacted.

The medical device industry is highly competitive. Any device we develop will have to compete for market acceptance and market share. We believe that the primary competitive factors in the surgical illumination and visualization, advanced energy and fluorescent imaging market segments are clinical safety and effectiveness, price, surgeon experience and comfort with use of particular illumination systems, reliability and durability, ease of use, device support and service, sales force experience and relationships. We face significant competition from competitors based in the United States and internationally in these market segments, and we expect the intensity of competition will increase over time. Many of the companies developing or marketing competing products enjoy several competitive advantages over us, including:

Our competitors may develop and patent processes or devices earlier than us, obtain regulatory clearance or approvals for competing devices more rapidly than us or develop more effective or less expensive devices or technologies that render our technology or devices obsolete or less competitive. We also face fierce competition in recruiting and retaining qualified sales, scientific, and management personnel. If our competitors are more successful than us in these matters, our business may be harmed.

Our ability to sell our devices at prices necessary to support our current business strategies depends on demonstrating that the benefits of devices incorporating our technology outweigh the increased cost of such devices compared to alternatives. 

Hospital and other healthcare provider customers that purchase our devices typically bill various third-party payors to cover all or a portion of the costs and fees associated with the surgical procedures in which our devices are used and bill patients for any deductibles or copayments. Supplies used in surgery, such as our devices, are typically not separately reimbursed by third-party payors, but are rather included in the overall reimbursement for the procedure involved. Because there is no separate reimbursement for medical devices and supplies used in surgical procedures, the additional cost associated with the use of our devices can impact the profit margin of the hospital or surgery center where the surgery is performed. If reimbursement is inadequate, hospitals may choose to use less expensive instruments. Some of our target customers may be unwilling to adopt our devices in light of the additional associated cost. Our success depends on our ability to convince such cost-restricted customers that the potential benefits of using our devices, such as reduced surgery time, reduced surgery blood transfusion, and reduced post-surgery complications, outweigh the additional cost of such devices.

It is difficult to forecast future performance and our financial results may vary from forecasts and may fluctuate from quarter to quarter. 

Our limited operating history and commercial experience make it difficult for us to predict future performance and growth as such forecasts are limited and subject to a number of uncertainties, including our ability to market our devices successfully, our ability to maintain or obtain regulatory clearances, unexpected or serious complications related to our devices or other factors discussed in these risk factors. A number of factors over which we have limited control may contribute to fluctuations in our financial results. These factors include, without limitation: