SECURITIES AND EXCHANGE COMMISSION

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Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2004

Commission File No.: 0-51149

Emageon Inc.

Registrant’s telephone number, including area code:
(205) 980-9222

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Securities Registered Pursuant to Section 12(b) of the Act:
None

Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $0.001 Par Value Per Share
(Title of Class)

     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 o NO þ

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES o NO þ

     The Registrant’s common stock began trading on the Nasdaq National Market on February 9, 2005 and was not traded on the last business day of the Registrant’s most recently completed second fiscal quarter. The aggregate market value of the common stock held by non-affiliates of the Registrant was $264,086,989 at March 28, 2005 based on the closing sale price of $17.58 per share for the common stock on such date on the Nasdaq National Market.

          The number of shares of the Registrant’s common stock outstanding at March 28, 2005 was 20,020,232.

 

TABLE OF CONTENTS

 

PART I

ITEM 1: BUSINESS

Overview

     We provide an enterprise-level information technology solution for the clinical analysis and management of digital medical images within health care provider organizations. Our solution consists of advanced visualization and image management software, comprehensive support services and third-party components. Our web-enabled advanced visualization software provides physicians across the enterprise — in multiple medical specialties and at any network access point — with tools to manipulate and analyze images in 2D and 3D. We enable physicians to better understand internal anatomic structure and pathology, which can improve clinical diagnoses, disease screening and therapy planning. We believe our solution improves physician productivity and patient care, enhances customer revenue opportunities, automates complex, mission-critical medical imaging workflow, and maximizes our customers’ return on investment in capital equipment and clinical information systems.

     We sell our solution to multi-hospital networks, community hospitals, physician clinics and diagnostic imaging centers. Health care providers produce growing volumes of medical imaging data that must be analyzed, managed and stored efficiently and cost-effectively. We focus on developing corporate-level relationships with large multi-facility organizations, which result in substantial cross-selling opportunities and represent an important competitive advantage for us. Since our first commercial implementation in December 2000, we have implemented our solution at facilities affiliated with some of the largest multi-facility health care providers in the U.S. Our customers with ten or more facilities include Allina Hospitals and Clinics, Ascension Health, Aurora Health Care, BJC Healthcare, Baptist Health System, Inc., Catholic Healthcare West, Kaiser Foundation Hospitals and Sisters of Mercy Health Systems.

     Demand for advanced visualization and image management solutions is growing as the number and size of imaging exams increase due to accelerating physician adoption of advanced imaging, the growing health care needs of an aging U.S. population and the increasing sophistication of imaging devices such as computed tomography (CT), magnetic resonance imaging (MRI) and positron emission tomography (PET). We do not believe existing film-based workflow or department-level PACS are sufficient to meet this growing demand.

     A typical installation of our solution at a single hospital involves a multi-million dollar investment by our customer over a multi-year contract period. As of December 31, 2004, we had $118.2 million in contracted backlog, consisting primarily of fees for contracted future installations and for the support of existing installations, compared with a contracted backlog of $82.7 million at December 31, 2003. We expect to recognize approximately $49.9 million from our current contracted backlog during fiscal year 2005 and substantially all of the approximately $68.4 million remaining by December 31, 2009.

     We were founded in December 1998 as an Alabama corporation and reincorporated in Delaware in January 2000.

Subsequent Events

     On February 14, 2005, we closed our initial public offering of 5,000,000 shares of our common stock at a price of $13.00 a share. On February 18, 2005, we closed the exercise of the underwriters’ over-allotment option and sold an additional 750,000 shares of our common stock at a price of $13.00. Total proceeds from the initial sale and the sale pursuant to the exercised over-allotment option (net of underwriting discount and estimated offering expenses) were approximately $67.5 million.

     Following the closing of our initial public offering, on February 18, 2005, we utilized $4.0 million of the proceeds to pay the entire balance of borrowings under our subordinated notes issued in June 2004.

Industry Background

     Based on industry data, we believe more than 500 million imaging procedures were performed in the U.S.

 

in 2003, producing as much as 12.5 billion megabytes of data. Healthcare providers need digital infrastructure, storage and image management capabilities to alleviate the operating strain created by medical image records.

     Frost & Sullivan, a leading healthcare consulting and research firm, estimated in a 2004 report, that the total U.S. medical imaging market, including capital equipment and technology, would reach $12.6 billion in 2004. They report that information technology spending associated with medical imaging accounted for approximately 15% of the total medical imaging market in 2003 and estimate that it will grow at an average compound annual growth rate of 15% from 2002 through 2008. A survey conducted by the Healthcare Financial Management Association in 2003 found that 71% of U.S. hospitals anticipate making capital expenditures for digital radiography systems in the next five years.

     The need to improve clinical care and eliminate inefficiencies in existing paper-based methods, including film-based image management, continues to drive investment in clinical information technology. The federal government recently announced several initiatives to accelerate information technology adoption rates within the health care system, including the Presidential appointment of a national health care information technology office and a recommitment to the President’s Information Technology Advisory Committee. The health care information technology market continues to grow more rapidly than other segments of the technology industry, according to a February 2004 release from Sheldon I. Dorenfest & Associates. Dorenfest estimates that health care information technology spending amounted to $23.6 billion in 2003 and will increase to $30.5 billion by 2006.

     We believe the rapid expansion in the number and complexity of medical images and the need to automate complex, manual workflow processes are driving health care providers to invest in systems that maximize their return on capital investments in expensive imaging devices and clinical information technology. We facilitate the convergence of imaging technology and clinical automation at the enterprise level by enhancing analysis, integration and automation of medical imaging data.

Our Opportunity

     Managing the visualization, distribution and storage of medical images remains one of the least automated, mission-critical processes within health care provider organizations. According to a May 2004 release by IMV, a market research firm, only 7% of hospitals were operating on a filmless basis in their radiology departments. Effective image management can shorten report turnaround times, lower the potential for manual error in data entry and filing, increase staff efficiency, eliminate costs associated with traditional radiological workflow and improve overall diagnostic and clinical quality. We believe the following factors have collectively increased the demand for our solution:

     Increasing Number of Imaging Exams. The number of imaging exams performed each year is increasing as a result of a number of factors, including increased physician use of advanced imaging as a non-invasive diagnostic and clinical tool, lowered costs of imaging devices and increased health care needs of an aging U.S. population. For instance, in two October 2003 releases, IMV estimated that MRI exams grew 21% between 2001 and 2002, while CT exams grew 15% over the same period. Frost & Sullivan estimates that the number of PET exams will grow at a compound annual growth rate of approximately 21.3% from 2002 through 2009.

     Increasing Size and Complexity of Imaging Exams. Technological advancements are increasing the size and complexity of individual imaging exams. For example, new CT scanners produce 20 times as much data as prior models, with exams consisting of thousands of individual images yielding 500 to 1,000 megabytes of data per exam, versus only 25 to 50 megabytes just two years ago. The increasing prevalence of fusion techniques used to combine images from multiple imaging devices increases the complexity of many exams. The rapid growth in the data size of medical images means that medical images also consume a greater share of hospital resources.

     Need for Advanced Visualization Tools. Because the output of a cross-sectional imaging device, such as a CT scanner, may consist of thousands of “sliced” 2D images, physicians need sophisticated software tools to model those images in 3D and allow the viewing of a “virtual” patient at all angles. Physicians can benefit from computer-created 3D images and eliminate the need to mentally reconstruct 2D images into a single useful 3D image. This improves diagnostic capabilities, treatment and non-invasive surgical planning. Sophisticated new tools, such as 3D volumetric imaging, maximum intensity projection (MIP), multi-planar reformat (MPR) and surface shading, are

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increasingly essential to present medical images in a manner that is valuable to the physician for diagnosis and treatment planning. Moreover, some surgical specialists will not perform a complex surgery without first performing pre-operative 3D planning.

     Need for Complete Electronic Health Records. Health care providers are implementing clinical information systems to automate clinical documentation and integrate patient information into electronic health records. However, these clinical information systems typically lack the sophistication or capability to incorporate digital medical images into patient health records. Incomplete electronic health records can result in delayed diagnosis, billing errors and inefficient workflow. A complete electronic health record, which includes medical images, enhances the benefits of investment in clinical information technology.

     Shortcomings of Film-Based Image Management. Many health care providers still use film to capture medical images from devices such as X-ray machines, which may produce three to four images per typical exam, and CT scanners, which can produce 1,000 images per exam. A film-based system has numerous inefficiencies, including complex exam scheduling, redundant patient data entry, the possibility of misplaced or misfiled notations and case histories, physical films and files that must be copied often or moved among the technologist, the specialist physician and the treating physician, and substantial storage space requirements. Each of these inefficiencies has the potential to increase the total cost per exam.

     Limitations of Current Methodologies for Managing Digital Medical Images. Current digital medical image management systems, which correct some of the inefficiencies of film-based imaging, have traditionally consisted of specialized services and technologies tied to specific department-level requirements. For example, a typical PACS installation is a department-level installation with dedicated hardware components primarily designed to address the image storage and distribution needs of a small number of physicians in a single department. While PACS may offer substantial automation benefits within such a single department over traditional film-based imaging workflow, they do not offer the full potential of an integrated, enterprise-level digital image management solution and these systems also typically do not integrate with clinical and administrative systems without expensive custom programming. Many hospitals that have embraced image automation have had to purchase multiple PACS and software tools for various departments and imaging devices, which presents integration challenges and requires significant investment. Many PACS were developed prior to the recent growth in the use of 3D imaging techniques and do not easily scale to handle the data volume of current imaging devices. PACS visualization tools are typically only 2D and are not distributable across the network except in a very rudimentary manner.

Our Solution

     We provide an enterprise-level information technology solution for the clinical analysis and management of digital medical images within health care provider organizations.

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     With our solution, our customers and their constituents, including physicians, technologists and nurses, can improve overall clinical and diagnostic quality and eliminate much of the labor and other costs of dealing with film, disparate department-level information systems, exam scheduling and redundant data entry. We also help to alleviate heavy burdens on a health care provider’s staff by automating medical image workflow for physicians and technologists. We believe our solution provides the benefits of current department-level PACS, including increased automation and better efficiency over traditional film-based methods, with added enterprise-level connectivity and advanced visualization tools that are not available with a typical PACS installation.

     We have designed our solution to offer benefits to the following groups:

     Our solution offers the following:

     Single-Source, Enterprise-Level Image Management. Our solution provides a single data repository for medical images created by digital imaging devices and related patient data across a single or multi-facility enterprise, whether from radiology, cardiology, pathology or other departments. This single repository serves as a central point of workflow and content management for those images. Our solution catalogues, archives and routes these images through our software, combining centralized control over sensitive patient imaging records with increased availability to physicians and other authorized users, in multiple medical specialties and at any network access point. Our solution integrates with our customers’ existing clinical information and administrative systems, serving as the patient’s visual medical record repository, reducing the risk of billing errors and lowering the average cost per exam through automation of complex and manual film-based imaging workflow.

     Advanced Visualization Technology. Our solution quickly delivers web-enabled software toolsets and images to physicians throughout the enterprise for diagnostic analysis and treatment planning. Our advanced visualization software allows physicians to create 2D and 3D views of human anatomy based on the output of imaging devices and to manipulate, navigate within and compare imaging exams in order to better visualize and understand internal anatomic structure and pathology. Improvements in the visualization of medical images can lead to improved clinical diagnosis, disease screening and treatment planning by physicians. Physicians can access our advanced visualization software from any network access point, including home, office or throughout the health care

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facility. Our intelligent user interface automatically adjusts for the specialty of each physician, the preferences of each user, the type of imaging device used to create the image, and the particular body part and tissue type being examined. We are developing enhancements and additional functionality to our advanced visualization software, which was acquired in May 2003 when we merged with Ultravisual Medical Systems Corporation, to further meet the clinical needs of numerous clinical specialties, including cardiology, emergency medicine, neurology, oncology, orthopedics, pathology and radiology.

     Open Standards-Based Software. We believe that our use of open standards has enabled us to design software that stores and manages information faster and with fewer hardware resources than competitive systems, a benefit we believe is becoming increasingly important as the data size of many imaging exams grows. We have designed our software to make full use of the DICOM standard for medical image data. We believe our commitment to open standards, such as DICOM and the standard protocol for the storage of text-based patient information, Health Level 7 (HL7), means that our software will be compatible with new imaging device technologies and other clinical information systems that conform to these standards. We lower our customers’ total costs by eliminating the need for translation to and from non-standard or proprietary communication methods which often require the purchase of additional hardware and software.

     Effective Implementation, User Adoption and Support Services. We focus on delivering effective implementation, user adoption and support services as an integral part of our solution. During the implementation phase of our solution, we use proven project management principles, including change management and adult learning techniques, to facilitate rapid and complete adoption by our customer. After implementation, we monitor system and user behaviors and, when appropriate, intervene to make the adjustments we consider necessary to prevent anticipated problems from occurring. Additionally, we use tools that measure the ultimate success of our customers’ implementation, including providing reports on productivity, operating performance and return on investment. We believe our focus on implementation and support services ensures that our customers’ investments in our solution is well managed and achieves the customers’ financial and operational objectives.

Our Strategy

     Our goal is to become the industry leader in enterprise-level information technology solutions for the clinical analysis and management of digital medical images. Key elements of our strategy include:

     Expand Our Market Share by Attracting New Customers. We believe a full range of health care organizations, from stand-alone imaging centers to multi-site hospital systems, represent a largely underserved market for our solution. Our current base of over 90 installed facilities represents a small portion of the prospective customers for our solution. We are expanding our sales and marketing efforts so that we may pursue new customers. As we pursue new customers, we intend to continue focusing our efforts on the large, multi-site health care providers that typically recognize the greatest benefits and fastest return on an investment in our solution and represent the largest individual sales opportunities. We believe our position as a sole source provider of an advanced visualization and image management solution, together with our implementation expertise and our installed base of nationally recognized reference customers will help us attract new customers.

     Increase Penetration With Existing Customers. We believe that using our successful relationships with existing multi-facility health care customers to expand our penetration within those organizations and selling additional functionality to our existing installed base are effective ways to increase our operating margins by reducing the average cost of sales and increasing the total revenue from existing customers.

	•	Increase Installations with Existing Multi-Facility Customers. As of December 31, 2004, we had customer relationships with 15 multi-facility health care providers that control over 250 hospitals. Our initial contracts with these customers often provide for implementation at only a portion of the facilities managed by the parent company. We believe there are significant opportunities to expand our installed base at facilities that are part of multi-facility systems in which we have some level of customer relationship with the parent company or with an individual facility within the multi-facility system.
	•	Cross-Sell to Existing Customers. We are also in a strong position to sell additional functionality to our existing customers, including advanced visualization tools for image-intensive medical specialties that may

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not have been part of the initial sale. Typically our initial sale to a customer is for medical image management. As follow-on sales opportunities, we offer our advanced visualization software and additional functionality to radiologists and other specialty groups within the organization. We believe that our excellent customer relationships increase our customers’ comfort in purchasing new products or enhanced functionality from us.

     Enhance Our Product Offerings. We believe developing or acquiring additional functionality for our existing software, including improved advanced visualization products for multiple specialties, such as orthopedics, cardiology and pathology, will further strengthen our position in the market. Further enhancements to our advanced visualization software should assist us in selling our solution to multi-hospital systems and expanding our existing customer relationships. We also plan to invest further in workflow and integration software to speed integration with existing clinical information systems, including electronic health record systems.

     Continue to Deliver Superior Implementation, User Adoption and Customer Support Services. As a single-source provider of advanced visualization and image management solutions, we believe the quality of our implementation, user adoption and support services helps to differentiate us from our competition. We have designed our systems, services and pricing strategies around this belief. We expect to continue to invest in, refine and develop new services to provide our customers with the highest level of services available and to provide us with a base of recurring revenue. We believe delivering superior services will enable us to capture increased market share and enhance our existing customer relationships, thereby increasing our competitiveness.

     Maintain Our Open-Standards Focus. We believe our commitment to open standards, such as DICOM and HL7, lowers our development costs, accelerates our time to market, lowers our customers’ total cost of ownership, improves speed and quality of our solution’s integration and differentiates us from our competition. By designing our solution around open standards, we believe we maximize our solution’s integration with our customers’ existing clinical information technology systems and imaging devices, which reduces our customers’ total cost of ownership. We also believe our open-standards model lowers the hardware costs associated with implementing our solution because it enables our customers to use relatively inexpensive, off-the-shelf hardware to visualize, analyze and manipulate images. We plan to continue this commitment, which we believe enables our customers to maximize their return on investment in both current and future imaging devices, computer hardware and clinical information technology systems.

Our Product and Service Offerings

      We provide an enterprise-level information technology solution for the clinical analysis and management of digital medical images within health care provider organizations. Our solution consists of advanced visualization and image management software, comprehensive support services and third-party components.

Software

      Our solution includes three principal software components: UltraVisual, UltraStructure and UltraConnect.

     UltraVisual. UltraVisual is our suite of software tools for the advanced visualization and analysis of digital medical images by physicians and medical professionals. We acquired the software technology underlying UltraVisual when we merged with Ultravisual Medical Systems Corporation in May 2003. UltraVisual components include graphics and image processing modules that present information to physicians and medical professionals using relevant multi-specialty tools through a dynamic user interface. Physicians can manipulate 2D and 3D image-related content in a variety of ways including organization, rotation, inversion, magnification and enhancement of images in a collaborative environment for sharing findings with other physicians or medical professionals. UltraVisual helps physicians better visualize and understand internal anatomic structure and pathology. Additional benefits of UltraVisual include:

	•	Sophistication. UltraVisual makes use of complex processing techniques such as multi-planar reformat (MPR) and volumetric imaging for 3D imaging applications.
	•	Integration. Imaging tools include integrated 2D and 3D viewing methods that can be used simultaneously

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		with the same image or images on the same computer.
	•	Ease of Use. UltraVisual is intuitive and user-friendly so physicians can easily adapt its use into their current practice patterns.
	•	Application to Numerous Clinical Specialties. The user interface automatically adjusts for the type of physician using the system, user preferences, the type of imaging device used to create the image (such as CT, X-ray or MRI), and the particular body part and tissue type being imaged.
	•	Platform Compatibility. UltraVisual uses a common personal computer graphics standard, allowing off-site physicians to use inexpensive personal computers and permitting the enterprise to make use of lower-priced workstations with off-the-shelf graphics hardware.
	•	Web-enabled. Physicians or other authorized users have secure access to images and advanced visualization tools at any network access point.

     UltraStructure. UltraStructure is our image archival and distribution management software. UltraStructure supports the DICOM standard for digital medical images enabling a high level of scalability that facilitates fast, efficient access to storage and retrieval of such images in enterprise applications. UltraStructure includes auto-routing and predictive capabilities that improve workflow in a clinical environment by performing time intensive tasks in anticipation of their need, thereby minimizing network traffic and facilitating responsiveness across the enterprise.

     UltraStructure employs a distributed architecture that enables administrative changes without the need to shut down the system, minimizes system memory requirements, increases the speed of access to images through a relational database and provides customized reporting capabilities. In a distributed multi-hospital environment, UltraStructure also manages local “caches” at remote sites, which provide local image acquisition and temporary storage for rapid retrieval. Permanent image data is simultaneously stored at the centralized long-term archive. Each remote cache also acts as a proxy server to provide a view of images throughout the enterprise, no matter where the image was originally generated. The use of a local cache ensures that no individual facility is dependent on the wide-area network for the sourcing of locally created images.

     Additional benefits of UltraStructure include:

	•	Comprehensive Management System. UltraStructure is a broad solution for the management of a health care provider’s digital medical images, from storage to workflow automation.
	•	Multi-Site and Multi-Department. UltraStructure permits authorized users to access images from any network access point, including home, office or throughout the health care facility. It handles images created by multiple hospital departments and multiple image devices.
	•	Enterprise-Level Scalability. We can install UltraStructure as a single facility application or as an enterprise-level solution to support the medical image management needs of large multi-facility health care providers. By using predictive technologies and local caching of images, UltraStructure provides optimal network speed and availability.
	•	Fault Tolerance. We deploy UltraStructure in a fault tolerant configuration on redundant server clusters with redundant storage systems. We support either full backup and recovery or mirrored archives in two different locations, enabling uninterrupted operation in the event of the loss of one archive.
	•	Open Standards. Unlike many competitive image management systems, UltraStructure has been designed using an open standards architecture that leads to better integration with imaging devices and clinical information systems, improves the speed and reliability of transfers of medical image data and provides a lower total cost of ownership by avoiding unnecessary translation overhead.

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     UltraConnect. UltraConnect is our standards-based software used to manage integration and data migration between our solution and other health information systems throughout the enterprise. UltraConnect utilizes a DICOM imaging device worklist, which automates technologist workflow, prioritizing and managing processes based on other systems such as admissions. In addition, UltraConnect includes tools that enable the integration of our solution with electronic health records and other information systems such as voice recognition. The benefits of UltraConnect include the rapid and systematic integration of the patient’s digital medical images with the rest of the enterprise’s clinical and administrative information systems without the need for custom programming, integration services, or third-party translation devices.

Service and Support

     We believe that our implementation, user adoption and support services differentiate us strategically from our competitors. Large-scale infrastructure information technology installations can present special challenges to an enterprise, regardless of its size or sophistication. According to a 2001 report by the Standish Group, only 28% of all IT projects undertaken in large corporations succeed. We believe this is often due to inadequate implementation and support services and believe that our service model better meets the installation and investment objectives of our customers.

     Our “Customer Success Program” includes the following components:

	•	Adoption Success Management (ASM). ASM is our services program that facilitates rapid and complete adoption by all relevant constituents during the implementation phase, which typically lasts three to four months. We have designed ASM to maximize the user implementation experience, promote behavioral change at all levels and increase the probability of complete implementation success. Our ASM approach incorporates proven project management principles including change management, user adoption, adult learning and metrics-based success techniques to ensure that customers’ investments in our solution are well managed and achieves the customers’ financial and operational objectives.
	•	Total Solution Management (TSM). TSM is an ongoing set of support services to ensure that our systems are highly available and optimally configured for the user community. Through continuous remote monitoring of our solution, we can analyze system and user behaviors and, when appropriate, intervene and make the necessary adjustments to prevent anticipated problems from occurring. We provide standard 24-hour service and support for our software and any third-party components we provide as part of our solution. Under our TSM program, we provide many services we believe are not typically included as part of a comprehensive information technology installation, including interaction with third-party component vendors, monitoring storage requirements and general program oversight. Our standard contracts with customers typically provide for a 99% guarantee of system availability and a 98% guarantee of component availability with penalty provisions if our solution fails to meet the guarantees. Our 99% system availability guarantee covers our solution as a whole, while the component guarantee covers each individual component, as in certain circumstances a component may fail without affecting system availability.
	•	Enterprise Performance Monitoring (EPM). EPM is an enterprise-level performance monitoring tool that we use to measure the ultimate success of our customers’ implementation, including full adoption and effective use of the systems we provide. Our EPM service includes:

	•	quarterly and annual reporting of system performance metrics such as percentage uptime, storage capacity and projected utilization;
	•	operational performance metrics such as radiology technologist productivity and studies read per radiologist; and
	•	financial performance metrics, such as return on investment, cost per study, and value-based comparisons to film-based analog workflow.

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     We can provide revenue mix analysis services, using data combined from hospital information systems and the enterprise’s imaging environment data, to understand and prioritize key equipment and physician revenue producers for a hospital. This analysis can provide critical data to hospital administrators for capital and technology investment planning initiatives.

Third-Party Components

    Our solution typically includes the installation and implementation of platform components that we procure from third parties. We believe that providing third-party components helps us deliver a comprehensive solution that meets the needs of our customers. Some of the third-party components we provide include:

	•	Servers. Our software and the database run on a cluster of standard servers, typically consisting of six or more redundant servers.
	•	Data Storage. We support industry standard storage configurations, including fault-tolerant RAID (redundant array of independent disks) systems.
	•	Backup/Recovery. Our solution typically includes a tape library-based backup and recovery system that provides backup for our database, configuration files and the digital medical images. Alternatively, we also offer an optional configuration with mirrored archives in two different locations, enabling uninterrupted operation in the event of the loss of one archive.
	•	Workstations and Monitors. Customers typically implement our advanced visualization software using standard personal computer workstations and high-resolution monitors for visualization within the facility.
	•	Database. Our software applications operate on Oracle™ database technology and other standard relational database applications.
	•	Computed Radiography. We also offer computed radiography devices, which are manufactured by Eastman Kodak Company and Fujifilm Medical Systems USA, Inc. Computed radiography devices convert analog X-ray images into digital images.

Our Technology

    We believe the following technologies and strategies help us to compete more effectively:

	•	Native DICOM Compatibility. We have written our software to exploit the capabilities of the DICOM standard for medical image storage and workflow management, as promulgated by the American College of Radiology and the National Electronic Manufacturer’s Association. DICOM is an industry standard that defines the data elements, communication protocols, storage formats and workflow methods associated with medical imaging data and processes. Our software stores and manages medical images using native DICOM communications, preserves the DICOM information associated with the image and follows DICOM workflow methods. Using native DICOM communication means our solution does not require “translation” devices for converting the DICOM information into a proprietary storage or other format. We believe our commitment to DICOM as the underlying protocol for our software is a competitive advantage, delivering faster streaming, more efficient storage of the image and the ability to integrate our software to new imaging devices that output information using DICOM.
	•	Proprietary DICOM-Toolkit. While DICOM is an industry standard protocol for medical image data management and storage, the software toolsets used to process, manage and use DICOM information are generally unique to particular software vendors. Unlike many of our competitors who license DICOM-toolkits from third parties, we have developed and own a DICOM-toolkit that we believe permits us to more rapidly integrate DICOM-based information into our software. We believe that the ownership and continued development of our DICOM-toolkit is a core technology strategy, in part because it reduces reliance on third-party software.

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	•	Commitment to the IHE Technical Framework. We support and are a leader in the implementation of the Integrated Healthcare Enterprise (IHE) technical framework. The Radiological Society of North America and the Healthcare Information and Management Systems Society created IHE, which represents a consortium of over 30 companies in the radiology and health care information systems fields. The IHE technical framework is a protocol for the integration of DICOM image information and HL7 text-based patient information. We believe our commitment to IHE helps to ensure that our software integrates seamlessly with HL7-based billing and patient record information systems implemented at our customer sites.
	•	Compatibility with the OPEN GL Graphics Standard. Our advanced visualization software performs sophisticated 3D rendering and other graphics intensive functions that provide physicians the ability to view 3D medical images for diagnosis and treatment planning. Historically, workstations and graphics hardware that could perform the advanced rendering and other graphics functions needed for advanced visualization functionality were cost prohibitive for widespread use. Our advanced visualization software uses the OPEN GL graphics standard, which permits our customers, or off-site physicians affiliated with our customers, to purchase inexpensive personal computers and graphics hardware to perform sophisticated image analysis.
	•	Component-Based Software Engineering. Our software architecture is based on a component-based services model. Our software development framework supports common and domain specific components that can be plugged in while the system is operating. By building flexible, dynamic, reusable components, we gain great flexibility to add functionality to our system and increase the reliability of our system because we can remedy problems at the component level rather than being forced to address issues throughout the entire application.
	•	“Green Design” Philosophy. We call our software design philosophy “green design” after the environmental philosophy of “reduce, recycle, and reuse.” We recognize that every enterprise network configuration has finite computing resources, so we attempt to use those resources as efficiently as possible to produce the best performing system with available resources. “Green design” is our attempt to optimize these resources. As a result of our “green design” philosophy, we believe our products yield better performance and scalability with greater fault tolerance than competitive offerings on the same hardware.

Customers

     Our customers range in size from single imaging centers to large multi-facility healthcare networks. As of December 31, 2004, we had installed our solution in 94 hospitals or other health care facilities, 72 of which are members of multi-facility networks with which we have customer relationships. Since we acquired the UltraVisual software in May 2003, we have implemented UltraVisual in less than 45% of our current installed customer base, which represents a significant growth opportunity for us. Our customers include members of the following multi-facility networks with ten or more facilities: Allina Hospitals and Clinics, Ascension Health, Aurora Health Care, BJC Healthcare, Baptist Health System, Inc., Catholic Healthcare West, Kaiser Foundation Hospitals and Sisters of Mercy Health Systems.

     Contracted implementations for Ascension Health constituted 35.1% of our contracted backlog as of December 31, 2004.

Sales and Marketing

     We use a direct sales model, with sales representatives who have substantial experience in health care-related direct sales. Our sales representatives undergo rigorous training in our products as well as the needs of each constituent group within our potential customers. During our sales cycle for a typical customer we might, at various times, present to the Chief Information Officer, the Director of Radiology or Cardiology, the Chief Financial Officer, the Chief Medical Officer, the Chief Operating Officer and the Chief Executive Officer. We also typically must present to several key physicians representing the specialties that are expected to use our system such as radiologists, cardiologists, emergency room physicians, neurosurgeons and orthopedists. Each of these constituents may have different priorities and evaluation criteria, and our direct sales representatives must be capable of presenting a compelling business case to each.

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     Our sales representatives are supported by our sales support and marketing communications team, which provides technical, demonstration, lead generation, market development and proposal assistance.

Research and Development

    As of December 31, 2004, we had 55 employees who are primarily dedicated to research and development activities. In addition to our employees, we also utilize contractors and consultants on a routine basis to perform specified research and development activities. We also utilize clinical advisory boards and end-user focus groups that are organized by area of expertise to advise us on the clinical functionality of our solution. We have focused our research and development mission on the continued evolution of an intelligent, fault tolerant, highly scalable image management and visualization system for mission-critical medical image management applications. We adhere to a philosophy of open standards-based solutions. We believe that we fulfill a critical technology and performance void in current generation systems. We further believe we have designed our visualization platform in a way that enables us to add new functionality more quickly and more economically than traditional methods of building software, providing us with a competitive advantage over many other industry participants. We are focusing our research and development efforts on:

	•	improving physician and technologist workflow;
	•	developing and refining visualization capabilities including new 3D and analysis applications; and
	•	data storage, retrieval, integration and comparison of past and current images.

    We follow a formal product development process and employ dedicated product development personnel. Under our formal product development process, internal and external (customer) requests for added features or functionality are forwarded to our strategy and architecture team. This team evaluates and prioritizes these potential product enhancements taking into account expected costs, anticipated value to the customer, regulatory requirements, timing and resource availability. After our strategy and architecture team approves these enhancements, our engineering team develops them and subjects them to quality testing and documentation requirements before we make them generally available to our customers.

    We incurred company-sponsored research and development expenses of $2.4 million, $4.1 million and $5.3 million in 2002, 2003 and 2004, respectively.

Competition

    The markets for the digital medical image management and visualization systems that we offer are highly competitive. Many customers purchase products and services from us and from our competitors as well. We compete with companies that fall into four primary categories:

	•	companies that manufacture and sell digital imaging devices such as GE Healthcare, Siemens Medical Solutions and Philips Medical Systems, who may integrate some of the functionality provided by our products into their equipment or bundle it with the equipment sale;
	•	companies that have traditionally sold imaging films such as Eastman Kodak Company and Fujifilm Medical Systems USA, Inc.;
	•	companies that have traditionally sold health care information technology applications such as Cerner Corp., IDX Systems Corp. and McKesson Corp.; and
	•	a number of smaller companies that sell department-level PACS or specialty visualization tools.

    Many of our current and potential competitors have significantly greater name recognition and more established distribution networks and relationships with health care providers. To compete effectively, we often must persuade the prospective customer to separate its purchasing decisions with respect to imaging equipment from

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its purchasing decisions with respect to archival and visualization tools, because many of our competitors offer imaging devices that they package or bundle with licensed or owned image management applications.

    Our ability to compete successfully will depend on a number of factors both within and outside our control, including:

	•	product innovation;
	•	product quality and performance;
	•	customer service and support;
	•	the experience of our sales, marketing and service professionals;
	•	rapid development of new products and features;
	•	price;
	•	continued active involvement in the development of DICOM and other standards-based medical communication protocols; and
	•	product and policy decisions announced by competitors.

Intellectual Property

     We rely generally on a combination of trade secret and copyright law, employee and third-party nondisclosure agreements and other protective measures to protect intellectual property rights pertaining to all of our software technology. In addition, we have filed patent applications to protect certain aspects of our software technology. Although we have filed these patent applications, no patents have been issued, and we cannot yet enforce our rights in those aspects of our software technology under patent law.

     As filed in the U.S., Europe, and Japan, our patent applications generally relate to DICOM-type image transmission and, in particular, to methods and apparatus for streaming DICOM-type images via a network.

     In addition, we have also filed a patent application in the U.S. that generally relates to a method and system for storing, communicating and displaying image data. In particular, this application relates to methods and systems for storing image data on a server, communicating at least a portion of the image data from the server to a client via a network, and displaying images at the client using the communicated data.

     We have an exclusive, worldwide, royalty-bearing license from the UAB Research Foundation for certain technology used in our UltraStructure software. We pay a nominal royalty for this license.

     We do not own all of the software and hardware used in our solution, but we have all of the licenses from third parties we believe are necessary to offer our current solution. As we develop new products and new versions of products, it may be necessary to renegotiate with such third parties to make sure our licenses are complete and valid. In such a case, our existing third-party licensors may not be willing to make the needed licenses available on terms acceptable to us, but we believe in most cases there are alternative vendors from whom we could obtain hardware, other components or any necessary licenses for software.

     Emageon^®, UltraVisual^®, UltraStructure^TM, UltraConnect^TM and our logo are our trademarks or service marks. All other trademarks, trade names and service marks appearing in this prospectus are the property of their respective owners.

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Employees

     As of December 31, 2004, we had 199 employees, 55 of whom were primarily engaged in research and development, 32 of whom were primarily engaged in sales and marketing, 95 of whom were primarily engaged in providing technical support services and 17 of whom were primarily engaged in administration and finance. 122 of these employees are located at our corporate headquarters in Birmingham, Alabama; 37 of these employees are located at our offices in Madison, Wisconsin; and the remainder of our employees are located at customer locations or in regional support offices. None of our employees is a party to a collective bargaining agreement, and we consider our relationship with our employees to be good.

Government Regulation

     We market, sell, and distribute our products in the heavily regulated U.S. health care industry. Our business operations and financial arrangements in this industry may be subject to a complex array of federal laws and regulations governing medical devices. We are also subject to laws and regulations governing reimbursement and referrals because our products are used in diagnosing and treating Medicare and Medicaid patients. Moreover, a number of states have adopted their own versions of such laws and regulations, though these may vary significantly from one state to the next. Violation of such federal and state laws and regulations can result in civil and criminal penalties involving substantial fines and imprisonment.

     Food and Drug Administration. Our advanced visualization software products are medical devices subject to extensive regulation by the Food and Drug Administration, or FDA, pursuant to the federal Food, Drug, and Cosmetic Act, as amended, or the FDA Act. Each device that we wish to distribute commercially in the U.S., unless otherwise exempt, requires regulatory clearance prior to commercial distribution.

     The FDA cleared UltraVisual, and its use for mammography imaging, through the 510(k) notification process. We have applied, and will continue to apply for, 510(k) clearance for additional clinical uses of UltraVisual. This process requires submission of a pre-market notification demonstrating that the proposed device is substantially equivalent, in terms of intended use, safety and efficacy, to a so-called “predicate device,” which is a device that has already received 510(k) clearance or was used in the marketplace prior to May 28, 1976. A device is substantially equivalent to a predicate device if it has the same intended use as the predicate and either (i) the same technological characteristics of the predicate, or (ii) different technological characteristics that do not raise new questions of safety and effectiveness, and the device is as safe and effective as the marketed device. Clearance under the 510(k) process typically takes 90 days to over a year from the date of a complete filing, depending on the number of questions the FDA has concerning the submission. Some applications may never receive clearance because the FDA raises safety issues or requests additional data that may not be economical to produce. Therefore, there is the risk that FDA clearance for any of our future devices, or for further clinical uses of our existing devices, may be delayed or not cleared. There is also the risk that FDA clearance, once received, may contain a more restrictive conditions of use than we would like. Moreover, the FDA is always free to subsequently withdraw any clearance previously granted.

     For cases where the 510(k) approval process is not available, the FDA’s other approval process, the pre-market approval process, or PMA, is a more costly, lengthy and uncertain process than the 510(k) process briefly described above. The PMA application requires human clinical trial data to enable the FDA to evaluate whether the PMA contains sufficient, valid scientific evidence that the device is safe and effective for its intended use. The PMA process generally requires one to several years from the date the applicant submits the device for FDA review, if, in fact, the FDA ever approves the device. Even then, the FDA may condition its approval on stringent limitations regarding the indicated uses for which the device may be marketed. To date, our software and related comprehensive solutions have not required approval under the PMA process. However, we cannot assure you that our products will not require PMA approval in the future, or, in such an event, that such approval would be forthcoming.

     Failure to comply with applicable regulatory requirements can result in enforcement action by the FDA, which may include any of the following sanctions:

•

fines, injunctions, and civil or criminal penalties;

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	•	recall, seizure or removal of authority to distribute our products;
	•	operating restrictions, partial suspension or total shutdown of production;
	•	refusing our request for 510(k) clearance or PMA of new products;
	•	withdrawing 510(k) clearance or PMAs that are already granted; and
	•	criminal prosecution.

     The FDA can conduct announced and unannounced inspections of our facilities at any time. The FDA has never inspected our facilities. We believe that our manufacturing operations, and those of our suppliers, comply with the FDA’s Quality System Regulations and current good manufacturing practices. The FDA, however, has never reviewed that compliance directly and might disagree.

     Medical device manufacturers and device user facilities are required to complete Medical Device Reports (MDRs) upon the occurrence of MDR reportable events. For device manufacturers, an MDR reportable event is one about which a manufacturer has received or becomes aware of information that reasonably suggests that one of its marketed devices caused or contributed to a death or serious injury, or has malfunctioned and the device, or a similar device marketed by the manufacturer, would likely cause or contribute to a death or serious injury if the malfunction were to recur. The FDA lists MDRs on its Manufacturer and User Facility Device Experience (MAUDE) Database. The filing by manufacturers or user facilities of a significant number of MDRs with the FDA could potentially cause the FDA to commence post-marketing investigations, which could revise device labeling, include warnings, restrict use, or could even lead to a withdrawal of marketing clearances or approvals. We have filed, either due to customer complaints or through internal reviews, three MDRs in 2004. The MDR reportable event in each of these instances was a malfunction, and the MDRs were isolated and unrelated to each other. In accordance with standard procedure, the FDA posted these reports onto the MAUDE database. We have taken all corrective and preventive actions required to be taken according to our corrective and preventive action process. The FDA has never requested any follow up investigation or inquiry regarding any of the filed MDRs.

     HIPAA Privacy and Security Regulations. The HIPAA Privacy Rule prohibits a covered entity from using or disclosing an individual’s protected health information unless the use or disclosure is authorized by the individual or is specifically required or permitted under the Privacy Rule. The Privacy Rule has imposed a complex system of requirements on covered entities for complying with this basic standard. Failure to comply with the Privacy Rule or the Security Rule is punishable by civil monetary penalties that can range up to $25,000 for multiple violations in a given year. Basic criminal penalties can include fines of up to $50,000 and imprisonment of up to 1 year. However, criminal penalties increase substantially if the offense occurs under false pretenses or with the intent to sell, transfer, or use individually identifiable health information for commercial advantage, for personal gain, or with malicious harm.

     The Security Rule requires most covered entities to achieve compliance by April 21, 2005. Under the Security Rule, covered entities must establish administrative, physical, and technical safeguards to protect the confidentiality, integrity, and availability of electronic protected health information maintained or transmitted by them or by others on their behalf.

     The HIPAA Privacy and Security Rules apply directly only to covered entities such as health plans, health care clearinghouses, and health care providers who engage in HIPAA-defined standard electronic transactions. We are not a covered entity, but our customers are. In order to provide to a customer certain services that may involve the use or disclosure of protected health information, the HIPAA Privacy and Security Rules require our customers to enter into business associate agreements with us. Such agreements must provide adequate written assurances:

	•	as to how we will use and disclose the protected health information;
	•	that we will implement reasonable administrative, physical and technical safeguards to protect such information from misuse;

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	•	that we will enter into similar agreements with our agents and subcontractors that have access to the information;
	•	that we will report security incidents and other inappropriate uses or disclosures of the information; and
	•	that we will assist the covered entity with certain of its duties under the Privacy Rule.

     In addition to requiring us to provide these adequate written assurances, the business associate agreements with our customers also impose significant privacy and information security requirements on us, and we cannot assure you that we will not in the future be subject to liability in connection with those business associate agreements.

     In addition to the HIPAA Privacy and Security Rules, most states have enacted patient confidentiality laws which protect against the disclosure of confidential medical information, and many are considering further legislation in this area. Such state laws, if more stringent than HIPAA requirements, are not preempted by the federal requirements.

     Government Reimbursement. Our customer base consists of health care providers, all of whom are subject to regulation by a number of governmental agencies, including those which administer Medicare and Medicaid programs. Accordingly, our customers are sensitive to legislative and regulatory changes in, and limitations on, the government health care programs and changes in reimbursement. During recent years, there have been numerous federal legislative and administrative actions that have affected the Medicare and Medicaid programs, including past adjustments that have reduced payments to hospitals and other health care providers. It is likely that the federal government will consider and could implement future reductions in Medicare reimbursement or other changes that adversely affect our health care customer base. Any such changes could adversely affect our own financial condition by reducing the capital expenditure budgets of our customers.

     Fraud and Abuse. A number of federal laws, loosely referred to as fraud-and-abuse laws, are used to prosecute health care providers, physicians and others that fraudulently or wrongfully obtain reimbursement that increases costs to any federal health care program. Given the breadth of these laws and regulations, we cannot assure you that they will not be found applicable to our business or the financial arrangements through which we market, sell, and distribute our products. These include federal anti-kickback and self-referral laws and regulations.

	•	Anti-Kickback Law. The anti-kickback provisions of the Social Security Act prohibit the exchange of anything of value with the intent to encourage utilization of items or services payable under a federal health care program. Courts have construed the anti-kickback law to mean that a financial arrangement will violate such law if even one of the purposes of one of the parties is to encourage patient referrals or other Medicare/Medicaid business, regardless of whether legitimate purposes also exist for the arrangement. Penalties for federal anti-kickback violations are severe. Conviction can result in up to five years imprisonment, a $25,000 fine per offense, and exclusion from participation under federal health care programs. Violators may also be assessed civil monetary penalties ranging from $10,000 to $50,000 per offense, as well as damage assessments equal to three times the total amount of the kickback. We believe that all of our arrangements with physicians and health care facilities have been fully lawful. But given the broad sweep of the federal anti-kickback law, we cannot assure you that all such arrangements will be found compliant with such law if examined by government regulators, to the extent that such regulators determine that any of our arrangements are subject to such law.
	•	Stark Law. The Ethics in Patient Referrals Act, known as the “Stark Law,” also prohibits certain types of referral arrangements between physicians and health care entities. Physicians are prohibited under the original Stark Law, its subsequent Stark II amendment, and the Stark implementing regulations from referring patients for “designated health services” reimbursed under the Medicare and Medicaid programs to entities with which they have a financial relationship or an ownership interest, unless such referrals fall within a Stark exception. Violations of the statute can result in civil monetary penalties of up to $15,000 per improper referral and exclusion from the Medicare and Medicaid programs. We do not believe that our arrangements with physician consultants or other health care providers violate the Stark Law, but we cannot

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		provide assurances to such effect, nor can we assure you that we will not in the future be subject to Stark Law penalties.
	•	State Law. Various states have enacted equivalents of the foregoing federal statutory and regulatory provisions. These state law equivalents would apply to items or services reimbursed by any third-party payor, including commercial payors. Many of these laws vary significantly from state to state, rendering compliance a costly and uncertain endeavor.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     Some of the statements made under the headings “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Annual Report on Form 10-K contain forward-looking statements which reflect our plans, beliefs and current views with respect to, among other things, future events and financial performance. We often identify these forward-looking statements by the use of forward-looking words such as “believe”, “expect”, “potential”, “continue”, “may”, “will”, “should”, “could”, “would”, “seek”, “predict”, “intend”, “plan”, “estimate”, “anticipate” or the negative version of those words or other comparable words. Any forward-looking statements contained in this Annual Report are based upon our historical performance and on current plans, estimates and expectations. The inclusion of this forward-looking information should not be regarded as a representation by us or any other person that the future plans, estimates or expectations contemplated by us will be achieved. Such forward-looking statements are subject to various risks and uncertainties. In addition, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe these factors include, but are not limited to, those described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Factors”.

     These cautionary statements should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this Annual Report. Moreover, we operate in a continually changing business environment, and new risks and uncertainties emerge from time to time. Management cannot predict these new risks or uncertainties, nor can it assess the impact, if any, that any such risks or uncertainties may have on our business or the extent to which any factor, or combination of factors, may cause actual results to differ from those projected in any forward-looking statement. Accordingly, the risks and uncertainties to which we are subject can be expected to change over time, and we undertake no obligation to update publicly or review the risks or uncertainties described herein. We also undertake no obligation to update publicly or review any of the forward-looking statements made in this Annual Report, whether as a result of new information, future developments or otherwise.

     If one or more of the risks or uncertainties referred to in this prospectus materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we projected. Any forward-looking statements you read in this prospectus reflect our current views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, financial condition, growth strategy and liquidity. You should specifically consider the factors identified in this Annual Report that could cause actual results to differ.

ITEM 2: PROPERTIES

     Our principal offices occupy approximately 32,000 square feet of leased office space in Birmingham, Alabama, under a lease that expires in March 2010. We also maintain a research and development facility consisting of approximately 6,500 square feet of leased office space in Madison, Wisconsin, under a lease expiring in February 2006. We believe our current facilities are adequate for our current needs and that suitable additional space will be available as and when needed.

ITEM 3: LEGAL PROCEEDINGS

     We are not currently a party to any material legal proceedings.

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ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of our security holders during the fourth quarter ended December 31, 2004.

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PART II

ITEM 5: MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market for Common Stock

    Our common stock began trading on the Nasdaq National Market under the symbol “EMAG” on February 9, 2005. Prior to such date, there was no established public trading market for our common stock. On March 28, 2005, the closing price of our common stock on the Nasdaq National Market was $17.58.

    As of March 28, 2005, we had 169 holders of record of our common stock.

Dividends

     We have not declared or paid any cash dividends on our common stock and do not anticipate paying cash dividends on our common stock for the foreseeable future. Instead, we currently intend to retain all future earnings, if any, for use in the operation of our business and to fund future growth. Any future decision to declare and pay dividends will be at the discretion of our board of directors, after taking into account our financial results, capital requirements and other factors it may deem relevant. Covenants in our debt agreements currently prohibit us from paying dividends or making other distributions.

Use of Proceeds from the Sale of Registered Securities

     Our initial public offering of common stock was effected through a Registration Statement on Form S-1 (File No. 333-120621) that was declared effective by the Securities and Exchange Commission on February 8, 2005, pursuant to which we sold all 5,750,000 shares of our common stock registered. We received net proceeds of approximately $67.5 million. We used $4.0 million of the net proceeds to repay borrowings outstanding under our subordinated notes on February 18, 2005. Our initial public offering of common stock commenced on February 8, 2005 and was completed after all of the shares of common stock that were registered were sold. The managing underwriters in our initial public offering were Wachovia Capital Markets, LLC and Piper Jaffray & Co. The aggregate offering price of the 5,750,000 shares registered and sold was $74.8 million. From this amount, we paid $5.2 million in underwriting discounts and commissions, and we incurred an additional $2.0 million of other transaction expenses. Approximately $1.3 million of those transaction expenses were incurred during the year ended December 31, 2004. None of the expenses were paid, directly or indirectly, to directors, officers or persons owning 10% or more of our common stock, or to our affiliates.

Recent Sales of Unregistered Securities

     The following information relates to all securities issued or sold by us in the last fiscal year that were not registered under the Securities Act.

     Between January 1 and December 31, 2004, we granted stock options to purchase 462,188 shares of common stock with exercise prices ranging from $4.70 to $7.17 per share, to employees, directors and consultants pursuant to our stock option plans. During the same period, we issued an aggregate of 22,972 shares of our common stock pursuant to the exercise of stock options issued pursuant to our stock option plans. Each of the stock certificates we issued in such transactions contained a restrictive legend permitting transfer of the securities only upon registration under the Securities Act or pursuant to an exemption from registration. We claimed exemption from registration under the Securities Act for the sales and issuances of such securities under Section 4(2) of the Securities Act in that such sales and issuances did not involve a public offering or under Rule 701 promulgated under the Securities Act, in that they were offered and sold either pursuant to written compensatory plans or pursuant to a written contract relating to compensation.

     We claimed exemption from registration under the Securities Act for the sale and issuance of securities in the transactions described below by virtue of Section 4(2) and/or Regulation D promulgated under the Securities Act

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as transactions not involving any public offering. All of the purchasers of unregistered securities for which we relied on Regulation D represented that they were accredited investors as defined under the Securities Act. All other purchasers for which we relied on Section 4(2) represented, or were determined by us to have had, the requisite knowledge, sophistication and experience in business and financial matters so as to be capable of evaluating the merits and risks of their investment in us. In addition, in