S-1/A 1 ds1a.txt S-1 AMENDMENT THREE(333-83678) As filed with the Securities and Exchange Commission on May 13, 2002 Registration No. 333-83678 ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------------- AMENDMENT NO. 3 TO FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 ----------------- KYPHON INC. (Exact name of Registrant as specified in its charter) ----------------- Delaware 3841 77-0366069 (State or other jurisdiction of (Primary Standard Industrial (I.R.S. Employer incorporation or organization) Classification Code Number) Identification Number) 1350 Bordeaux Drive, Sunnyvale, California 94089, (408) 548-6500 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) ----------------- Gary L. Grenter Chief Executive Officer Kyphon Inc. 1350 Bordeaux Drive, Sunnyvale, California 94089, (408) 548-6500 (Name, address, including zip code, and telephone number, including area code, of agent for service) ----------------- Copies to: David J. Saul, Esq. Laura A. Berezin, Esq. Peter S. Heinecke, Esq. Cooley Godward LLP Philip H. Oettinger, Esq. Five Palo Alto Square Wilson Sonsini Goodrich & Rosati 3000 El Camino Real Professional Corporation Palo Alto, California 94306 650 Page Mill Road (650) 843-5000 Palo Alto, California 94304 (650) 493-9300 ----------------- Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. [_] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] __________ If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] __________ If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] __________ If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [_] THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION ACTING PURSUANT TO SAID SECTION 8(a) MAY DETERMINE. ================================================================================ The information in this prospectus is not complete and may be changed. We may not sell these securities until the Securities and Exchange Commission declares our registration statement effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to completion, dated May 13, 2002 6,000,000 Shares [LOGO] Kyphon, Inc. KYPHON INC. Common Stock $______ per share -------------------------------------------------------------------------------- . Kyphon Inc. is offering 6,000,000 . This is our initial public shares. offering, and no public market currently exists for our shares. . We anticipate that the initial . Trading symbol: Nasdaq National public offering price will be Market - KYPH between $13.00 and $15.00 per share. ----------------- This investment involves risk. See "Risk Factors" beginning on page 5. ================================================================================

Per Share Total --------- ----- Public offering price...................................... $ $ Underwriting discount...................................... $ $ Proceeds to Kyphon Inc..................................... $ $

================================================================================ The underwriters have a 30-day option to purchase up to 900,000 additional shares of common stock from us to cover over-allotments, if any. Neither the Securities and Exchange Commission nor any state securities commission has approved of anyone's investment in these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. U.S. Bancorp Piper Jaffray Banc of America Securities LLC Bear, Stearns & Co. Inc. The date of this prospectus is , 2002. KYPHON ARTWORK -- EDGAR DESCRIPTIONS FRONT COVER Balloons for Bones(TM) [Three step-by-step images illustrating the use of the KyphX(R)Inflatable Bone Tamp in the spine] [Image 1 shows the KyphX(R)Inflatable Bone Tamp inserted into the fractured vertabra] The KyphX(R) Bone Access System allows the surgeon to create a working channel into the fractured bone. [Image 2 shows the KyphX(R) Inflatable Bone Tamp inside of the vertebra with balloons fully inflated] The KyphX(R)Inflatable Bone Tamp is inflated. [Image 3 shows the KyphX(R) Inflatable Bone Tamp being removed from the vertabra and a cavity within the vertabra where the balloons have been deflated] The KyphX(R) Inflatable Bone Tamp is deflated and removed, and the surgeon completes the fracture repair. Lenticular card attachment. A 5 x 7 inch card, similar to a hologram, animates the use of our instruments to repair spine fractures. The card may be detached from the prospectus. The card illustrates, and is attached on top of, the step-by-step process described above. TABLE OF CONTENTS

Page ---- Summary........................................................ 1 Risk Factors................................................... 5 Information Regarding Forward-Looking Statements............... 12 Use of Proceeds................................................ 13 Dividend Policy................................................ 13 Capitalization................................................. 14 Dilution....................................................... 15 Selected Financial Data........................................ 17 Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................... 18 Business....................................................... 26 Management..................................................... 42 Related Party Transactions..................................... 53 Principal Stockholders......................................... 54 Description of Capital Stock................................... 56 Shares Eligible for Future Sale................................ 59 Underwriting................................................... 61 Legal Matters.................................................. 64 Experts........................................................ 64 Where You Can Find More Information............................ 64 Index to Consolidated Financial Statements..................... F-1

----------------- You should rely only on the information contained in this prospectus. We have not, and the underwriters have not, authorized any other person to provide you with different information. This prospectus is not an offer to sell, nor is it seeking an offer to buy, these securities in any state where the offer or sale is not permitted. The information in this prospectus is complete and accurate as of the date on the front cover, but the information may have changed since that date. SUMMARY The items in the following summary are described in more detail later in this prospectus. This summary provides an overview of selected information and does not contain all the information you should consider. Therefore, you should also read the more detailed information set out in this prospectus, the financial statements and the related notes appearing elsewhere in this prospectus. Our Business We develop medical devices for orthopedic applications using our proprietary balloon technology. Our initial marketing focus is on surgeons who repair spine fractures caused by osteoporosis, a disease characterized by bone deterioration. These fractures are the most common type of spine fracture. Our first commercial products, comprising our KyphX instruments, provide surgeons with tools to help repair a fracture during minimally-invasive spine surgeries. Alternative treatments include highly-invasive surgical procedures as well as therapies designed simply to manage pain rather than to repair the spine fracture. In January 1999, we initiated limited direct sales of our KyphX instruments to several major medical centers. In May 2000, we commenced full commercial introduction of our KyphX instruments in the United States. From our inception through March 31, 2002, we recognized approximately $57.0 million in revenue from the sale of our instruments and incurred approximately $46.4 million in losses. As of March 31, 2002, we had trained 1,748 physicians in the United States, Europe and Korea in the use of our KyphX instruments and these physicians had used our instruments in over 13,000 spine surgeries. The KyphX instruments we currently market consist of the KyphX Inflatable Bone Tamp, the KyphX Inflation Syringe, the KyphX Bone Access System and the KyphX Bone Filler Device. A conventional bone tamp is an orthopedic instrument used to move and compact bone. The KyphX Inflatable Bone Tamp, our proprietary balloon, is used by surgeons to move and compact bone in order to create a void within the bone. We have received clearance from the U.S. Food and Drug Administration for the KyphX Inflatable Bone Tamp, as a conventional bone tamp to move and compact bone in the spine, hand, leg, arm and heel. The KyphX Inflation Syringe is a 510(k)-cleared product that we currently obtain from a contract supplier. We believe that we are not required to obtain FDA clearance for the other KyphX products that we currently market as manual orthopedic surgical instruments. We also have obtained CE Mark for our products, which allows us to sell them in Europe. Our Target Market Each year, there are approximately 700,000 spine fractures due to osteoporosis in the United States. Of these, approximately 260,000 fractures are diagnosed, and most are treated, in the hospital or at home, with conservative treatment options such as bed rest, pain medication and back braces. These fractures result in approximately 150,000 hospitalizations costing over $1.6 billion annually. In the United States, 16% of women and five percent of men over the age of 50 have one or more diagnosed spine fractures caused by osteoporosis. These fractures can result in an increased risk of death, significant pain, reduced respiratory function and impaired quality of life. When treating a patient with a spine fracture, an orthopedic surgeon's primary objective is to repair the fracture by returning the bone to its pre-fracture position. Osteoporotic spine fractures are difficult to repair because the bone has deteriorated. Conventional procedures are major open surgeries, and the metal instruments used in these procedures are not optimally designed to manipulate deteriorated bone. While these open procedures can successfully return bone towards its pre-fracture position, because of the deteriorated condition of osteoporotic bone, metal implants used to fix the bone in place can fail to hold. In addition, because of their highly-invasive nature, these procedures are rarely performed. Pain-management therapies, including medication, bed rest and 1 back braces, cannot repair spine fractures, but treat only the symptoms of the fracture. An interventional pain- management therapy, commonly referred to as vertebroplasty, is not designed to repair the fracture, but instead freezes the fractured bone in its compressed position to reduce pain. KyphX Instruments for Use During Minimally-Invasive Spine Surgery Spine fracture surgeries using our KyphX instruments are minimally invasive and involve the insertion of two of our disposable proprietary balloon devices into the fractured bone. The surgeon inflates our balloons to compact and move the deteriorated bone. As a result of the inflation of the balloons, the collapse caused by the fracture may be reversed. This reversal will be more difficult if the bone has previously healed in its fractured position. The balloons are then removed, and the newly-created cavity is filled with the surgeon's choice of bone filler material, stabilizing the fractured area. Bone cement, a plastic polymer, is the bone filler material most commonly used to fill the cavity created by our instruments. Once inserted, this material hardens in place, stabilizing the fractured area. Although surgeons may use bone cement in the spine if they feel it is in the best interest of the patient, we may not promote bone cement for this use unless further regulatory approvals are obtained. Currently, there is no bone filler that has specifically been approved for use with KyphX instruments to repair spine fractures. We intend to seek regulatory approval this year to initiate a clinical study designed to support FDA approval that would allow us to promote the use of bone cement as a bone filler material in conjunction with our cleared KyphX instruments in a specific minimally-invasive spine procedure. Based upon published reports of clinical results, discussions with surgeons who have used our instruments, and our own research, we believe that the use of our KyphX instruments during minimally-invasive spine surgery may lead to significant patient benefits, including the following: . restoration of collapsed vertebrae; . reduction of spine deformities; . reduction of pain; and . enhanced quality of life. Surgeries using our instruments may result in serious complications, including chronic pain; follow-up surgery; infection; unintended damage to the bone or tissue; bleeding; bowel, lung or nerve injury; paralysis; and death. Although our KyphX Bone Tamp has been cleared by the FDA, before we can promote and market any benefits resulting from a specific procedure using our KyphX instruments, we must document these benefits in clinical studies and receive additional FDA approvals or clearances. We are adapting our products for orthopedic applications in the wrist. Our goal is to establish our proprietary balloon technology as the standard of care in orthopedic applications. As of March 31, 2002, we had 12 U.S. issued patents, eight issued foreign patents, 32 pending U.S. patent applications and 74 pending foreign applications. 2 The Offering Common stock offered by us.............. 6,000,000 shares Common stock outstanding after the offering.............................. 35,644,570 shares Assumed initial public offering price... $14.00 per share Use of proceeds......................... We intend to use the net proceeds from this offering to repay outstanding convertible promissory notes, for sales and marketing initiatives, for clinical studies and reimbursement efforts, for product research and development and for general corporate purposes. For more detailed information, see "Use of Proceeds." Nasdaq National Market symbol........... KYPH The number of shares of common stock to be outstanding after the offering is based on 29,644,570 shares outstanding as of March 31, 2002 and excludes: . 6,646,201 shares issuable upon exercise of outstanding options under our 1996 Stock Option Plan at a weighted average exercise price of $1.02 per share; . 43,360 shares issuable upon exercise of outstanding warrants at a weighted average exercise price of $2.04 per share; . 51,926 shares issuable pursuant to the automatic conversion of a convertible promissory note held by J & A Group, LLC, at an assumed initial public offering price of $14.00 per share; . 104,761 shares issuable upon exercise of warrants related to outstanding convertible promissory notes, based upon an assumed initial public offering price of $14.00 per share; and . 3,450,000 shares to be reserved for future issuance under our 2002 Stock Plan, 2002 Employee Stock Purchase Plan and 2002 Director Option Plan. Except as otherwise noted, all information in this prospectus: . assumes no exercise of the underwriters' over-allotment option to purchase up to 900,000 shares; and . reflects the conversion of all of our shares of outstanding preferred stock into 26,151,288 shares of our common stock immediately prior to the completion of this offering. Corporate Information We were incorporated in Delaware in January 1994 and commenced operations in September 1996. Our principal executive offices are located at 1350 Bordeaux Drive, Sunnyvale, California 94089, and our telephone number is (408) 548-6500. Our Internet address is www.kyphon.com. The information contained on our website is not part of this prospectus. Kyphon(R), KyphX(R), Balloons for Bones(TM) and the Kyphon logo are our trademarks. All other trademarks or service marks appearing in this prospectus are the property of their respective companies. 3 Summary Financial Data (in thousands, except share and per share data) The following table sets forth our summary financial data. This data has been derived from our audited consolidated financial statements for the years ended December 31, 1999, 2000 and 2001, and from our unaudited consolidated financial statements for the three-month periods ended March 31, 2001 and 2002, and as of March 31, 2002 included elsewhere in this prospectus. You should read this information in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements and the related notes included elsewhere in this prospectus.

Three Months Ended Years Ended December 31, March 31, --------------------------------- ----------------------- 1999 2000 2001 2001 2002 -------- ---------- ----------- ---------- ----------- Consolidated Statements of Operations Data: Net sales..................................... $ 261 $ 6,076 $ 36,073 $ 6,275 $ 14,594 Cost of goods sold............................ 519 3,606 8,108 1,643 2,270 -------- ---------- ----------- ---------- ----------- Gross profit (loss)........................... (258) 2,470 27,965 4,632 12,324 Operating expenses: Research and development................... 1,996 4,516 7,859 1,768 1,961 Sales and marketing........................ 1,264 11,399 27,891 4,989 9,148 General and administrative................. 1,875 5,343 9,720 2,011 2,568 -------- ---------- ----------- ---------- ----------- Total operating expenses............... 5,135 21,258 45,470 8,768 13,677 Loss from operations.......................... (5,393) (18,788) (17,505) (4,137) (1,353) Other and interest income (expense), net...... 222 1,086 (309) 90 (315) -------- ---------- ----------- ---------- ----------- Net loss...................................... $ (5,171) $ (17,702) $ (17,814) $ (4,047) $ (1,668) ======== ========== =========== ========== =========== Net loss per common share, basic and diluted.. $ (12.96) $ (15.55) $ (9.06) $ (2.43) $ (0.58) ======== ========== =========== ========== =========== Weighted-average shares used in computing net loss per common share, basic and diluted.... 399,150 1,138,547 1,966,828 1,662,284 2,859,781 ======== ========== =========== ========== =========== Pro forma net loss per common share, basic and diluted (unaudited)......................... $ (0.63) $ (0.06) =========== =========== Weighted-average shares used in computing pro forma net loss per common share, basic and diluted (unaudited)......................... 28,258,116 29,049,958 =========== ===========

In the pro forma as adjusted column of the balance sheet data below, we have adjusted the balance sheet data as of March 31, 2002, to reflect the conversion of preferred stock into common stock upon the closing of this offering and to give effect to our receipt of the estimated net proceeds of $77.0 million from the sale of 6,000,000 shares of common stock we are offering for sale under this prospectus at an assumed initial public offering price of $14.00 per share after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

As of March 31, 2002 -------------------- Pro Forma Actual As Adjusted -------- ----------- Consolidated Balance Sheet Data: Cash and cash equivalents............................................ $ 2,640 $ 79,660 Working capital (deficit)............................................ (5,161) 71,859 Total assets......................................................... 21,209 98,229 Convertible promissory notes......................................... 14,000 14,000 Long-term obligations, net........................................... 31 31 Redeemable convertible preferred stock............................... 37,975 -- Deferred stock-based compensation, net............................... (18,945) (18,945) Total stockholders' equity (deficit)................................. (36,945) 78,050

4 RISK FACTORS You should carefully consider the risks described below before participating in this offering. If any of the following risks actually occur, our business, financial condition, operating results or cash flows could be materially harmed. As a result, the trading price of our common stock could decline, and you might lose all or part of your investment. Risks Related to Our Business Unless we obtain additional FDA approvals, we will not be able to promote the use of our instruments in specific surgical procedures or the benefits of any surgical procedures using our instruments in the United States, and our ability to grow our business could be harmed. In October 2000, we received a warning letter from the FDA challenging the promotional claims that we were making for our KyphX instruments. It was the FDA's position that our regulatory clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body, or for any specific surgical procedures. The FDA also stated that we could not promote any clinical benefits of surgical procedures using our instruments until we obtained additional regulatory approvals related to the benefits. After discussions and correspondence with the FDA, we agreed to abide by these restrictions and revised our promotional campaign accordingly. Subsequently, we obtained an additional clearance to promote the KyphX Inflatable Bone Tamp specifically for use as a conventional bone tamp in the reduction of fractures and/or creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus. Until we conduct appropriate clinical studies supporting the use of bone cement as a bone filler material for use in the spine and documenting the clinical benefits of procedures using our instruments, if any, and receive prior FDA approval, we will not be allowed to promote our instruments for any treatment benefits or promote, or train physicians in performing, specific procedures with bone cement in the spine using our instruments. If we fail to obtain these additional necessary regulatory approvals, our ability to generate revenues will be harmed. In the United States, we are not permitted to promote, or train physicians in, the use of our KyphX instruments with bone cement in the spine, unless we obtain additional FDA approvals. As the FDA's position is that we may not train physicians about specific procedures in the spine, we limit our training and education of physicians to the specialized skills involved in the proper use of our instruments. Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position that we cannot promote the use of bone cement, or train surgeons to use bone cement, with our instruments unless bone cement is specifically approved for use in the spine with our instruments. We instruct our trainers, both physician faculty consultants and employees, not to discuss the use of any bone filler material, including bone cement, with our instruments. However, they may respond to questions about bone cement that are raised by physician participants during a training program. Although we believe our training methods are proper, if the FDA determines that our training constitutes promotion of an unapproved use, they can request that we modify our training or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty. If we are unable to initiate and complete a clinical study to support regulatory approval to market the use of bone cement for use with our instruments in spine fracture surgery or to document resulting benefits, our future competitive position and revenue will be harmed. We intend to seek regulatory approval this year to initiate a clinical study designed to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared instruments in a specific minimally-invasive spine procedure. However, there are many risks associated with conducting the clinical study, including our ability to: . identify an appropriate supplier of bone cement to be used in the study; . negotiate a long-term contract with the supplier; 5 . obtain FDA approval of our study protocol; . enroll patients; . avoid adverse patient outcomes; and . demonstrate safety and efficacy. Any of these factors could delay, limit or prevent our successful completion of a clinical study and our regulatory approval. If we are unable to obtain FDA approval for the use of bone cement with our KyphX instruments in spine surgery, our future competitive position and revenues will be harmed. Our failure to obtain or maintain necessary regulatory clearances or approvals could hurt our ability to commercially distribute and market our KyphX instruments. Our KyphX instruments are considered medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an exemption applies, each medical device that we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. The FDA's 510(k) clearance process usually takes from three to 12 months, but may take longer. The premarket approval process generally takes from one to three years from the time the application is filed with the FDA, but it can be significantly longer and can be significantly more expensive than the 510(k) clearance process. Although we have obtained 510(k) clearance for the KyphX Inflatable Bone Tamp to help repair fractures in specific sites in the spine, hand, leg, arm and heel, our 510(k) clearance can be revoked if safety or effectiveness problems develop. We also may be required to obtain 510(k) clearance or premarket approval to market additional instruments or for new indications for our KyphX instruments. Before we can market any bone cement product for use with our instruments in spine surgery, we must first obtain regulatory approval. We cannot be certain that we would obtain 510(k) clearance or premarket approval in a timely manner or at all. Delays in obtaining clearances or approvals will adversely affect our revenue and future profitability. Modifications to our marketed devices may require new 510(k) clearances or premarket approvals or may require us to cease marketing or recall the modified devices until clearances are obtained. Any modification to a 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or, possibly, premarket approval. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can review any manufacturer's decision. We have modified aspects of our KyphX instruments, but we believe that new 510(k) clearances are not required. The FDA may not agree with any of our decisions not to seek new clearances or approvals. If the FDA requires us to seek 510(k) clearance or premarket approval for any modification to a previously cleared instrument, we may be required to cease marketing or to recall the modified device until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties. If we fail to comply with Quality System regulations, our manufacturing operations could be delayed, and our product sales and profitability could suffer. Our manufacturing processes and those of our suppliers are required to comply with the FDA's Quality System regulations, which cover the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our instruments. The FDA enforces its Quality System regulations through periodic unannounced inspections. We have never been through a Quality System inspection, and we cannot assure you that we would pass. If we fail a Quality System inspection, our operations could be disrupted and our manufacturing delayed. Failure to take adequate corrective action in response to an adverse Quality System inspection could force a shut-down of our manufacturing operations and a recall of our instruments, which would cause our instrument sales and business to suffer. 6 We have limited operating experience and a history of net losses and may never achieve or maintain profitability. We have a limited operating history upon which you can evaluate our business. We commenced commercial sales of our KyphX instruments in May 2000. We have incurred losses every year since we began operations. In particular, we incurred losses of $5.2 million in 1999, $17.7 million in 2000 and $17.8 million in 2001. As of March 31, 2002, we had an accumulated deficit of approximately $46.4 million. Even if we are able to generate significant revenues from our instrument sales, we will continue to have operating losses based on our plans to expand our sales force, both domestically and internationally, and devote substantial resources to our continuing research and development efforts and clinical studies. It is possible that we will never generate sufficient revenues from instrument sales to achieve profitability. If reimbursement for the procedures using our instruments becomes difficult to obtain or is not available in sufficient amounts, our instruments may not be widely adopted. In some cases, physicians performing a procedure using our instruments have not been reimbursed. Widespread adoption of our instruments by the medical community is unlikely to occur if physicians do not receive sufficient reimbursement from payors for their services in performing the procedures using our instruments. Currently, there is no specific procedure code under which reimbursement to physicians is available for procedures performed using our KyphX instruments. Physicians must report procedures using our instruments under an unlisted current procedural terminology, or CPT, code, and hospitals receive reimbursement for an inpatient stay. Physicians have obtained reimbursement for the use of our products in 46 states and in the District of Columbia. Until a specific code is granted, physician reimbursement from large insurance companies and Medicare may be unavailable or difficult to obtain in some states. In particular, there are four states, Illinois, Michigan, Minnesota and Wisconsin, where Medicare medical directors have refused to provide physician reimbursement, and we do not expect these states to consider reimbursement without additional clinical data. In addition, the absence of FDA approval specifically allowing us to promote the use of bone cement in the spine may affect the availability of reimbursement for spine surgeries in which our instruments are used. Future regulatory action by a government agency or negative clinical results may diminish reimbursement coverage for both the physician and hospital. Finally, reimbursement differs from state to state, and some states may not reimburse for a procedure in an adequate amount, if at all. If physicians are unable to obtain adequate reimbursement for procedures in which our KyphX instruments are used, we may be unable to sell our instruments and our business could suffer. Adverse changes in reimbursement procedures by domestic and international payors may impact our ability to market and sell our instruments. Even if the use of our instruments is reimbursed by private payors and Medicare, adverse changes in payors' policies toward reimbursement for the procedure would harm our ability to market and sell our instruments. We are unable to predict what changes will be made in the reimbursement methods used by payors. We cannot be certain that under prospective payment systems, such as those utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our instruments will be justified and incorporated into the overall cost of the procedure. Even if we fulfill international regulatory requirements to market our instruments, our success will be partly dependent upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. In addition, health care cost containment efforts similar to those we face in the United States are prevalent in many of the other countries in which we intend to sell our instruments, and these efforts are expected to continue. Although we intend to seek international reimbursement approvals, we may not obtain approvals in a timely manner, if at all. 7 To be commercially successful, we will have to convince physicians that using our instruments to repair spine fractures is an effective alternative to existing therapies and treatments. We believe that physicians will not widely adopt our instruments unless they determine, based on experience, clinical data and published peer reviewed journal articles, that the use of our KyphX instruments provides an effective alternative to conventional means of treating spine fractures. Patient studies or clinical experience may indicate that treatment with our instruments does not provide patients with sustained benefits. Further, because some of the data has been produced in studies that involve small patient groups, the data may not be reproduced in wider patient populations. In addition, we believe that continued recommendations and support for the use of KyphX instruments by influential physicians are essential for widespread market acceptance. If our KyphX instruments do not continue to receive support from these physicians or from long-term data, surgeons may not use, and hospitals may not purchase, our instruments. Because injuries that occur during spine surgery can be significant, we are subject to an increased risk of product liability lawsuits. If we are sued in a product liability action, we could be forced to pay substantial damages. We manufacture medical devices that are used on patients in spine surgery procedures. Spine surgery involves significant risk of serious complications, including bleeding, nerve injury, paralysis and death. Consequently, companies that produce instruments for use in the spine are subject to a significant risk of product liability litigation. If our instruments are found to have caused or contributed to any injury, we could be held liable for substantial damages, and our current product liability coverage limits may not be adequate to protect us from any liabilities we might incur. In addition, we may require increased product liability coverage if sales of our instruments increase. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all. Our reliance on suppliers could limit our ability to meet demand for our products in a timely manner or within our budget. We are dependent upon outside suppliers to provide us with our KyphX Inflation Syringe, as well as other key components necessary for the manufacture of our products. Because we obtain components through purchase orders rather than long-term supply agreements and generally do not maintain large volumes of inventory, the disruption or termination of the supply of components could lead to: . a significant increase in manufacturing costs associated with the need to obtain replacement components; . our inability to meet demand for our instruments, which could lead to customer dissatisfaction and damage our reputation; and . delays associated with regulatory qualifications required for use of replacement suppliers. Any one of these results could harm our sales and profits and make it difficult to meet our business goals. If we do not effectively manage our growth, our existing infrastructure may become strained, and we will be unable to increase sales of our KyphX instruments or generate significant revenue growth. Our sales force has increased from 31 employees in October 2000 to 92 employees in March 2002. The growth that we have experienced, and in the future may experience, provides challenges to our organization, requiring us to rapidly expand our personnel and manufacturing operations. We may not be able to hire sufficient personnel to meet our growth goals. As a result, our failure to recruit additional sales personnel may result in our inability to meet our projections. Future growth may strain our infrastructure, operations, product development and other managerial and operating resources. If our business resources become strained, we may not be able to deliver instruments in a timely manner. 8 Because we face significant competition from other medical device companies with greater resources than we have, we may be unable to maintain our competitive position and sales of our instruments may decline. The market for medical devices is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Our industry also includes large pharmaceutical companies that are developing drug products that may reduce the incidence of osteoporosis and, therefore, the market for our instruments. Our ability to compete successfully depends in part on our ability to respond quickly to medical and technological change and user preference through the development and introduction of new products that are of high quality and that address patient and surgeon requirements. We compete with many larger companies that enjoy several competitive advantages, including: . established distribution networks; . established relationships with health care providers and payors; . additional lines of products, and the ability to bundle products to offer higher discounts or other incentives to gain a competitive advantage; and . greater resources for product development, sales and marketing and patent litigation. At any time, other companies may develop additional competitive products. If we are unable to compete effectively against existing or future competitors, sales of our instruments will decline. The amount that we raise in this offering may not be adequate, and we may be unable to obtain future capital on satisfactory terms. We may require financing in addition to the net proceeds of this offering. We cannot assure you that additional financing will be available on a timely basis on terms acceptable to us, or at all, or that any financing will not be dilutive to stockholders. If adequate funds are not available, we may have to delay development or commercialization of our instruments or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize for ourselves. We also may have to reduce the marketing, customer support or other resources devoted to our instruments. If we are unable to prevent third parties from using our intellectual property, our ability to compete in the market will be harmed. We believe that the proprietary technology embodied in our instruments and methods gives us a competitive advantage. Maintaining this competitive advantage is important to our future success. We rely on patent protection, as well as on a combination of copyright, trade secret and trademark laws, to protect our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. For example, our patents may be challenged, invalidated or circumvented by third parties. Our patent applications may not issue as patents at all or in a form that will be advantageous to us. We may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by consultants, vendors, former employees and current employees, despite the existence of nondisclosure and confidentiality agreements and other contractual restrictions. Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. If our intellectual property rights are not adequately protected, we may be unable to keep other companies from competing directly with us, which could result in a decrease in our market share. Enforcement of our intellectual property rights to prevent or inhibit appropriation of our technology by competitors can be expensive and time-consuming to litigate or otherwise dispose of and can divert management's attention from carrying on with our core business. 9 Our instruments could infringe on the intellectual property rights of others, which may lead to costly litigation, payment of substantial damages or royalties and/or our inability to use essential technologies. The medical device industry has been characterized by extensive litigation and administrative proceedings regarding patents and other intellectual property rights. Whether an instrument infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our competitors may assert that our instruments and methods infringe their patents. In addition, they may claim that their patents have priority over ours because their patents issued first. Because patent applications can take many years to issue, there may be applications now pending of which we are unaware, which may later result in issued patents that our instruments or methods may infringe. There could also be existing patents that one or more of our instruments or methods may inadvertently be infringing of which we are unaware. As the number of competitors in the market for minimally-invasive spine disorder treatments grows, the possibility of a patent infringement claim against us increases. Infringement and other intellectual property claims, with or without merit, can be expensive and time-consuming to litigate or otherwise dispose of and can divert management's attention from carrying on with our core business. In addition, if we lose an intellectual property litigation matter, a court could require us to pay substantial damages and/or royalties and/or prohibit us from using essential technologies. Also, although we may seek to obtain a license under a third party's intellectual property rights to bring an end to any claims or actions asserted or threatened against us, we may not be able to obtain a license on reasonable terms or at all. Risks Related to this Offering Our principal stockholders have significant voting power and may take actions that may not be in the best interests of our other stockholders. After this offering, our officers, directors and principal stockholders will together control approximately 57% of our outstanding common stock. If these stockholders act together, they will be able to control our management and affairs in all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control and might adversely affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders. Anti-takeover provisions in our certificate of incorporation, our bylaws and Delaware law could discourage a takeover. Provisions of our certificate of incorporation, bylaws and Delaware law may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. See "Management--Board of Directors" and "Description of Capital Stock--Anti-takeover Effects of Provisions of Our Charter and Bylaws" and "--Section 203 of the General Corporation Law of the State of Delaware." A sale of a substantial number of shares of our common stock may cause the price of our common stock to decline. Sales of a substantial number of shares of our common stock in the public market following this offering could harm the market price of our common stock. As additional shares of our common stock become available for resale in the public market, the supply of our common stock will increase, which could decrease the price. There will be approximately 29,611,237 additional shares of common stock eligible for sale beginning 180 days after the effective date of this prospectus upon the expiration of lock-up arrangements between our stockholders and underwriters. 10 Our common stock has not been publicly traded, and we expect that the price of our common stock will fluctuate substantially. Prior to this offering, there has been no public market for shares of our common stock. An active public trading market may not develop following completion of this offering or, if developed, may not be sustained. The price of the shares of common stock sold in this offering will be determined by negotiation between the underwriters and us. This price will not necessarily reflect the market price of the common stock following this offering. The market price of the common stock following this offering will be affected by a number of factors, including: . regulatory or reimbursement developments in the United States or other countries; . product liability claims or other litigation; . the announcement of new products or product enhancements by us or our competitors; . quarterly variations in our or our competitors' results of operations; . changes in earnings estimates or recommendations by securities analysts; . developments in our industry; and . general market conditions and other factors, including factors unrelated to our operating performance or the operating performance of our competitors. New investors will experience immediate and substantial dilution in the value of their common stock following this offering. If you purchase shares of our common stock in this offering, you will incur immediate and substantial dilution in pro forma net tangible book value. If the holders of outstanding options exercise those options, you will incur further dilution. See "Dilution." 11 INFORMATION REGARDING FORWARD-LOOKING STATEMENTS This prospectus, including the sections entitled "Summary," "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business," may contain forward-looking statements. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry's actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. These risks and other factors include those listed under "Risk Factors" and elsewhere in this prospectus. We believe that the section entitled "Risk Factors" includes all material risks that could harm our business. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "intends," "potential," "continue" or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. We believe that it is important to communicate our future expectations to our investors. However, there may be events in the future that we are not able to accurately predict or control and that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Investors are cautioned that all forward-looking statements involve risks and uncertainties, and actual results may differ materially from those discussed as a result of various factors, including those factors described in the "Risk Factors" section of this prospectus. Potential investors should not place undue reliance on our forward-looking statements. Before you invest in our common stock, you should be aware that the occurrence of the events described in the "Risk Factors" section and elsewhere in this prospectus could harm our business, prospects, operating results and financial condition. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. 12 USE OF PROCEEDS We estimate that the net proceeds from the sale of the 6,000,000 shares of common stock that we are selling in this offering will be approximately $77.0 million based on an assumed initial public offering price of $14.00 per share, and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us. If the underwriters' over-allotment option is exercised in full, we estimate that we will receive net proceeds of approximately $88.7 million. Of the net proceeds that we will receive from this offering, we expect to use approximately: . $13.3 million for repayment of outstanding convertible promissory notes held by affiliates, plus accrued interest (see "Related Party Transactions"); . $27.0 million for sales and marketing initiatives to support the ongoing commercialization of our KyphX instruments; . $2.0 million for support of clinical studies and reimbursement efforts; and . $3.0 million for product research and development. We intend to use the remainder of the net proceeds for general corporate purposes. We may also use a portion of the net proceeds for potential strategic acquisitions of technologies or companies and investments in third parties. However, we currently do not have any specific plans or agreements with regard to acquisitions or investments. The amounts actually expended for these purposes may vary significantly and will depend upon a number of factors, including the amount of our future revenues, expenses and the other factors described under "Risk Factors." Pending these uses, we intend to invest the net proceeds of this offering primarily in short-term, investment-grade, interest-bearing instruments and government securities. DIVIDEND POLICY Since our incorporation, we have never declared or paid any cash dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. 13 CAPITALIZATION The following table sets forth our capitalization as of March 31, 2002. It also sets forth our capitalization: . on a pro forma basis to give effect to the automatic conversion of our preferred stock into 26,151,288 shares of common stock immediately prior to the completion of this offering; and . on a pro forma as adjusted basis to give effect to the conversion of our preferred stock into common stock and to reflect our receipt of the net proceeds from the sale of 6,000,000 shares of common stock at an assumed initial public offering price of $14.00 per share, less underwriting discounts and commissions and estimated offering expenses payable by us.

As of March 31, 2002 -------------------------------- Pro Forma Actual Pro Forma As Adjusted -------- --------- ----------- (in thousands, except share data (unaudited) Long-term obligations...................................................... $ 31 $ 31 $ 31 -------- -------- -------- Redeemable convertible preferred stock, $0.001 par value; 26,438,116 shares authorized, actual; 26,151,288 shares issued and outstanding, actual; no shares issued and outstanding, pro forma and pro forma as adjusted....... 37,975 -- -- -------- -------- -------- Stockholders' equity (deficit): Preferred stock, $0.001 par value; no shares authorized, issued or outstanding, actual and pro forma; 5,000,000 shares authorized, no shares issued or outstanding, pro forma as adjusted..................... -- -- -- Common stock, $0.001 par value; 40,000,000 shares authorized, actual; 120,000,000 shares authorized, pro forma and pro forma as adjusted; 3,493,282 shares issued and outstanding, actual; 29,644,570 shares issued and outstanding, pro forma; 35,644,570 shares issued and outstanding, pro forma as adjusted...................................... 3 30 36 Additional paid-in capital................................................. 28,372 66,320 143,333 Deferred stock-based compensation, net..................................... (18,945) (18,945) (18,945) Accumulated other comprehensive loss....................................... (14) (14) (14) Accumulated deficit........................................................ (46,360) (46,360) (46,360) -------- -------- -------- Total stockholders' equity (deficit).................................... (36,945) 1,030 78,050 -------- -------- -------- Total capitalization................................................ $ 1,062 $ 1,062 $ 78,081 ======== ======== ========

The outstanding share information in the table above is based on the number of shares of our common stock outstanding as of March 31, 2002. This table excludes: . 6,646,201 shares issuable upon exercise of outstanding options under our 1996 Stock Option Plan at a weighted average exercise price of $1.02 per share; . 43,360 shares issuable upon exercise of outstanding warrants at a weighted average exercise price of $2.04 per share; . 51,926 shares issuable pursuant to the automatic conversion of a convertible promissory note held by J & A Group, LLC, at an assumed initial public offering price of $14.00 per share. The impact of the automatic conversion of the convertible promissory note on the March 31, 2002 balance sheet would be to increase common stock and additional paid-in capital by $52 and $699,948, respectively, and to increase the number of shares outstanding by 51,926 shares. Had this conversion occurred as of January 1, 2002, interest expense and the accumulated deficit would have been decreased by $17,500; . 104,761 shares issuable upon exercise of warrants related to outstanding convertible promissory notes, based upon an assumed initial public offering price of $14.00 per share; and . 3,450,000 shares to be reserved for issuance under our 2002 Stock Plan, 2002 Employee Stock Purchase Plan and 2002 Director Option Plan. This table should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related notes included elsewhere in this prospectus. 14 DILUTION The pro forma net tangible book value of our common stock as of March 31, 2002 was approximately $1.0 million, or $0.03 per share. Pro forma net tangible book value per share represents our total tangible assets less our total liabilities, divided by the number of shares of our common stock outstanding after giving effect to the conversion of all outstanding shares of our preferred stock into common stock. Dilution in pro forma net tangible book value per share represents the difference between the amount per share paid by purchasers of shares of our common stock in this offering and the pro forma net tangible book value per share of our common stock immediately afterwards. After giving effect to the sale of 6,000,000 shares of our common stock in this offering at an assumed initial public offering price of $14.00 per share, and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us, our net tangible book value would be $78.1 million, or approximately $2.19 per share. This represents an immediate increase in net tangible book value of $2.16 per share to existing stockholders and an immediate dilution in net tangible book value of $11.81 per share to new investors purchasing our common stock in this offering. The following table illustrates the per share dilution to new investors: Assumed initial public offering price per share............................................... $14.00 Pro forma net tangible book value per share as of March 31, 2002........................... 0.03 Increase in pro forma net tangible book value per share attributable to this offering...... 2.16 ---- Pro forma net tangible book value per share after this offering............................... 2.19 ------ Dilution per share to new investors........................................................... $11.81 ====== The following table sets forth, on a pro forma basis as of March 31, 2002, the differences between the number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid by existing stockholders and by the new investors, before deducting the underwriting discounts and commissions and estimated offering expenses payable by us, at an assumed initial public offering price of $14.00 per share.

Shares Purchased Total Consideration ----------------- ------------------- Average Price Number Percent Amount Percent Per Share ---------- ------- ------------ ------- ------------- Existing stockholders.................. 29,644,570 83.17% $ 40,451,012 32.50% $ 1.36 New investors.......................... 6,000,000 16.83% 84,000,000 67.50% $14.00 ---------- ------ ------------ ------ Total............................... 35,644,570 100.00% $124,451,012 100.00% ========== ====== ============ ======

Assuming the exercise in full of all options and warrants outstanding as of March 31, 2002, the conversion of the convertible promissory notes and the exercise of the warrants related to outstanding convertible promissory notes, the number of shares purchased by existing stockholders would be increased by 6,846,248 shares to 36,490,818 shares, total consideration paid by them would be increased by approximately $6.9 million to $47.3 million and the average price per share paid by them would be reduced by $0.06 per share to $1.30 per share. If the underwriters exercise their over-allotment option in full, the percentage of shares of common stock held by existing stockholders will decrease to approximately 81.12% of the total number of shares of our common stock outstanding after this offering, and the number of shares held by new investors will be increased to 6,900,000, or approximately 18.88% of the total number of shares of our common stock outstanding after this offering. The table above assumes no exercise of options or warrants after March 31, 2002. The number of shares of our common stock outstanding as of March 31, 2002 excludes: . 6,646,201 shares issuable upon exercise of outstanding options under our 1996 Stock Option Plan at a weighted average exercise price of $1.02 per share; 15 . 43,360 shares issuable upon exercise of outstanding warrants at a weighted average exercise price of $2.04 per share; . 51,926 shares issuable pursuant to the automatic conversion of a convertible promissory note held by J & A Group, LLC, at an assumed initial public offering price of $14.00 per share; . 104,761 shares issuable upon exercise of warrants related to outstanding convertible promissory notes, based upon an assumed initial public offering price of $14.00 per share; and . 3,450,000 shares to be reserved for issuance under our 2002 Stock Plan, 2002 Employee Stock Purchase Plan and 2002 Director Option Plan. 16 SELECTED FINANCIAL DATA We were incorporated in Delaware in January 1994 and commenced operations in September 1996. From 1994 until 1996, our activities focused on raising capital. From 1996 until 1998, our activities focused on development of our KyphX instruments. The following consolidated statements of operations data for the years ended December 31, 1999, 2000 and 2001 and consolidated balance sheet data as of December 31, 2000 and 2001 have been derived from our audited consolidated financial statements and the related notes, which are included elsewhere in this prospectus. The statement of operations data for the three months ended March 31, 2001 and 2002 and the balance sheet data as of March 31, 2002 are derived from our unaudited consolidated financial statements included in this prospectus. The statements of operations data for the years ended December 31, 1997 and 1998 and the balance sheet data as of December 31, 1997, 1998 and 1999 were derived from our audited financial statements, which do not appear in this prospectus. When you read this selected financial data, it is important that you also read the historical consolidated financial statements and related notes included in this prospectus, as well as the section of this prospectus related to "Management's Discussion and Analysis of Financial Condition and Results of Operations." Historical results are not necessarily indicative of future results.

Three Months Ended Years Ended December 31, March 31, ----------------------------------------------------- ----------------------- 1997 1998 1999 2000 2001 2001 2002 -------- -------- -------- ---------- ----------- ---------- ----------- (in thousands, except share and per share data) Consolidated Statements of Operations Data: Net sales.................................. $ -- $ -- $ 261 $ 6,076 $ 36,073 $ 6,275 $ 14,594 Cost of goods sold......................... -- -- 519 3,606 8,108 1,643 2,270 -------- -------- -------- ---------- ----------- ---------- ----------- Gross profit (loss)........................ -- -- (258) 2,470 27,965 4,632 12,324 Operating expenses: Research and development................ 763 1,694 1,996 4,516 7,859 1,768 1,961 Sales and marketing..................... -- 87 1,264 11,399 27,891 4,989 9,148 General and administrative.............. 384 872 1,875 5,343 9,720 2,011 2,568 -------- -------- -------- ---------- ----------- ---------- ----------- Total operating expenses............. 1,147 2,653 5,135 21,258 45,470 8,768 13,677 Loss from operations....................... (1,147) (2,653) (5,393) (18,788) (17,505) (4,137) (1,353) Other and interest income (expense), net... 3 10 222 1,086 (309) 90 (315) -------- -------- -------- ---------- ----------- ---------- ----------- Net loss................................... $ (1,144) $ (2,643) $ (5,171) $ (17,702) $ (17,814) $ (4,047) $ (1,668) ======== ======== ======== ========== =========== ========== =========== Net loss per common share, basic and diluted................................... $(716.00) $ (14.11) $ (12.96) $ (15.55) $ (9.06) $ (2.43) $ (0.58) ======== ======== ======== ========== =========== ========== =========== Weighted-average shares used in computing net loss per common share, basic and diluted................................... 1,598 187,316 399,150 1,138,547 1,966,828 1,662,284 2,859,781 ======== ======== ======== ========== =========== ========== =========== Pro forma net loss per common share, basic and diluted (unaudited)................... $ (0.63) $ (0.06) =========== =========== Weighted-average shares used in computing pro forma net loss per common share, basic and diluted (unaudited)............. 28,258,116 29,049,958 =========== ===========

As of As of December 31, March --------------------------------------------- 31, 1997 1998 1999 2000 2001 2002 ------- ------- ------- -------- -------- -------- (in thousands) Consolidated Balance Sheet Data: Cash, cash equivalents and short-term investments................... $ 2,366 $ 8,123 $25,318 $ 8,898 $ 3,352 $ 2,640 Working capital (deficit)................. 2,103 7,632 24,725 10,213 (5,623) (5,161) Total assets.............................. 2,507 8,637 26,292 15,195 18,287 21,209 Convertible promissory notes.............. -- -- -- -- 12,000 14,000 Long-term obligations, net................ 95 308 209 132 43 31 Redeemable convertible preferred stock.... 3,479 11,718 34,156 38,024 38,024 37,975 Deferred stock-based compensation, net.... -- -- (768) (6,781) (16,082) (18,945) Total stockholders' deficit............... (1,352) (3,917) (9,014) (25,134) (37,667) (36,945)

17 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our financial statements and related notes appearing elsewhere in this prospectus. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of selected factors, including those set forth under "Risk Factors" and elsewhere in this prospectus. We believe that the section entitled "Risk Factors" includes all material risks that could harm our business. Overview We develop medical devices for orthopedic applications using our proprietary balloon technology. From inception in 1994 until 1998, our operations consisted primarily of start-up activities, including development of our KyphX instruments, recruiting personnel and raising capital. Currently, our KyphX instruments consist of our KyphX Inflatable Bone Tamp, KyphX Inflation Syringe, KyphX Bone Access Systems and KyphX Bone Filler Device. We have obtained clearance from the U.S. Food and Drug Administration, or FDA, for our KyphX Inflatable Bone Tamp to help repair fractures in specific sites in the spine, hand, leg, arm and heel. We believe that we are not required to obtain FDA clearance for our other KyphX products when promoted and sold as manual orthopedic surgical instruments. In May 2000, we commenced full commercial introduction of our KyphX instruments. From inception to March 31, 2002, we recognized $57.0 million in revenue from sales of our products. As of March 31, 2002, we had trained 1,748 physicians in the United States, Europe and Korea in the use of our KyphX instruments and these physicians had used our instruments in over 13,000 surgeries. Since inception, we have been unprofitable. We incurred net losses of approximately $5.2 million in 1999, $17.7 million in 2000, $17.8 million in 2001 and $1.7 million for the three months ended March 31, 2002. As of March 31, 2002, we had an accumulated deficit of approximately $46.4 million. Activities related to commercializing our KyphX instruments, enhancing physician reimbursement and initiating clinical studies, together with our general and administrative expenses, will cause our expenses to increase. As we proceed with commercialization, we will require additional sales and marketing resources, data from proposed clinical studies and greater physician reimbursement acceptance by payors. We currently market our instruments in the United States through a direct sales organization to physicians who perform spine surgery, including orthopedic spine surgeons and neurosurgeons. We have European operations headquartered in Belgium. We sell directly in some European countries and use distributors and agents in other European countries and in Korea. Our future growth depends on increased penetration of our current market and on identifying new markets in which we can leverage our proprietary balloon technology. To the extent any current or additional markets do not materialize or grow in accordance with our expectations, our sales could be lower than expected. We intend to seek regulatory approval this year to initiate a clinical study designed to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared KyphX instruments in a specific minimally-invasive spine procedure and to determine the benefits, if any, resulting from that procedure. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses and disclosures at the date of the financial statements. On an on-going basis, we evaluate our estimates, including those related to accounts receivables, inventories, income taxes and deferred stock-based compensation. We use authoritative 18 pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue from product sales is recognized upon receipt of a valid purchase order, shipment of the products to customers and when collection of the receivables is deemed probable. We maintain an accounts receivable allowance for an estimated amount of losses that may result from customers' inability to pay for product purchased. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We write down our inventory by estimating the potential for future loss based on a variety of factors, including the quantity of particular items, their prospect for replacement or obsolescence, the remaining shelf life and the difference between cost and market. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. We have established a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We account for income taxes under the provisions of Statement of Financial Accounting Standards, or SFAS, No. 109, "Accounting for Income Taxes." Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. We have estimated the fair value of our common stock, which we used to measure the fair value of stock options granted to employees and non-employees. We account for stock-based compensation for our employees using the intrinsic value method of Accounting Principles Board, or APB, Opinion No. 25, "Accounting for Stock Issued to Employees," and Financial Accounting Standards Board, or FASB, Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB Opinion No. 25," and we account for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services." Under these methods, deferred stock-based compensation is determined and is being amortized to expense. Results of Operations Three Months Ended March 31, 2001 and March 31, 2002 Net Sales. Net sales generated from sales of our products increased from approximately $6.3 million in the three months ended March 31, 2001 to approximately $14.6 million in the three months ended March 31, 2002. The increase in net sales resulted from an increase in the number of procedures performed by trained physicians. In the three months ended March 2001 and 2002, 99% and 95%, respectively, of net sales were recognized in the United States. Cost of Goods Sold. Cost of goods sold consists of material, labor and overhead costs. Cost of goods sold increased from approximately $1.6 million in the three months ended March 31, 2001 to approximately $2.3 million in the three months ended March 31, 2002. The increase in the cost of goods sold resulted primarily from higher material, labor and overhead costs associated with increased sales volume of our products. As a percentage of revenue, costs of goods sold decreased from 26% in the three months ended March 31, 2001 to 16% in the three months ended March 31, 2002 as a result of fixed overhead costs being spread over higher production volume. Research and Development. Research and development expenses consist of costs of product research, product development, regulatory and clinical functions and personnel. These expenses increased from approximately $1.8 million in the three months ended March 31, 2001 to approximately $2.0 million in the three months ended March 31, 2002. The increase was primarily attributable to increased personnel costs of $176,000 and amortization of deferred stock-based compensation of $170,000, offset by decreased clinical trial costs of $200,000. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses will continue to increase in the future. 19 Sales and Marketing. Sales and marketing expenses consist of personnel costs, physician training programs and marketing activities. These expenses increased from approximately $5.0 million in the three months ended March 31, 2001 to approximately $9.1 million in the three months ended March 31, 2002 as we continued to build our sales and marketing organization in conjunction with increased product sales. The increase in sales and marketing expenses related primarily to the costs of hiring, training and compensating additional direct selling representatives of approximately $2.1 million, increased travel expenditures of $724,000, increased expenditures related to advertising and promotional activities of $452,000 and amortization of deferred stock-based compensation of $403,000. As we continue to commercialize our KyphX instruments, we expect to significantly increase our sales and marketing efforts and expenditures. General and Administrative. General and administrative expenses consist of personnel costs, professional service fees, expenses related to intellectual property rights and general corporate expenses. These expenses increased from approximately $2.0 million in the three months ended March 31, 2001 to approximately $2.6 million in the three months ended March 31, 2002. The increase in general and administrative expenses resulted primarily from the amortization of deferred stock-based compensation of $439,000 and increased administrative expenditures of $104,000. We expect general and administrative expenses to increase in the future as we add personnel, continue to expand our patent portfolio and incur reporting and investor-related expenses as a public company. Other and Interest Income (Expense), Net. Other and interest income (expense), net, decreased from $90,000 in the three months ended March 31, 2001 to ($315,000) in the three months ended March 31, 2002 due to lower cash, cash equivalent and short-term investment balances and increased interest expense associated with outstanding convertible promissory notes. Years Ended December 31, 1999, 2000 and 2001 Net Sales. Net sales generated from sales of our products increased from approximately $261,000 in 1999 to approximately $6.1 million in 2000 as we commenced limited sales to physicians in 1999 and began a full commercial launch of our KyphX instruments in May 2000. Procedures performed in 1999 were almost exclusively in the United States. Net sales increased to approximately $36.1 million in 2001. The increases in net sales in 2000 and 2001 resulted from an increase in the number of procedures performed by trained physicians. In each of 2000 and 2001, 98% of net sales were recognized in the United States and 2% were recognized in Europe. Cost of Goods Sold. Cost of goods sold increased from approximately $519,000 in 1999 to approximately $3.6 million in 2000. The increase in cost of goods sold in 2000 resulted from the expansion of our manufacturing operations into a larger leased facility in April 2000 and higher material, labor and overhead costs associated with increased sales volume of our products. As a percentage of revenue, cost of goods sold expenses decreased from 199% in 1999 to 59% in 2000. Cost of goods sold increased to approximately $8.1 million in 2001. The increase in cost of goods sold in 2001 resulted primarily from higher material, labor and overhead costs associated with increased sales volume of our products and $210,000 in amortization of deferred stock-based compensation. As a percentage of revenue, cost of goods sold decreased from 59% in 2000 to 22% in 2001, primarily as a result of fixed overhead costs being spread over higher production volume. Research and Development. Research and development expenses increased from approximately $2.0 million in 1999 to approximately $4.5 million in 2000. The increase was primarily attributable to increased personnel costs of $994,000, amortization of deferred stock-based compensation of $318,000, higher facilities expenses of $278,000 associated with the move into our larger leased facility and additional product testing and development expenditures of $169,000. Research and development expenses increased to approximately $7.9 million in 2001. The increase in 2001 was primarily attributable to clinical trial consulting costs of $1.3 million, amortization of deferred stock-based compensation of $752,000, increased personnel costs of $728,000, additional product testing and development expenditures of $321,000 and higher facilities expenses of $223,000. 20 Sales and Marketing. Sales and marketing expenses increased from approximately $1.3 million in 1999 to approximately $11.4 million in 2000 as we continued to build our sales and marketing organization in conjunction with increased product sales. The increase in 2000 resulted primarily from increased personnel costs of $4.7 million, increased sales travel expenses of $2.0 million, higher physicians training costs of $1.2 million and increased advertising and promotional expenses of $1.2 million. Sales and marketing expenses increased to approximately $27.9 million in 2001. The increase in sales and marketing expenses in 2001 related primarily to the costs of hiring, training and compensating additional direct selling representatives of $8.2 million, higher physicians training costs of $1.6 million, increased expenditures of $1.6 million related to advertising and promotional activities and amortization of deferred stock-based compensation of $644,000. General and Administrative. General and administrative expenses increased from approximately $1.9 million in 1999 to approximately $5.3 million in 2000. The increase in 2000 resulted primarily from increased legal, accounting and reimbursement consulting fees of $1.5 million, increased personnel expenses of $935,000 and higher facilities costs of $302,000. General and administrative expenses increased to approximately $9.7 million in 2001. Increases in general and administrative expenses in 2001 resulted primarily from increased personnel costs of $2.2 million related to our growth in operations and amortization of deferred stock-based compensation of $2.2 million offset by reduced expenditures. Other and Interest Income (Expense), Net. Other and interest income (expense), net, increased from approximately $222,000 in 1999 to approximately $1.1 million in 2000 due to higher cash, cash equivalent and short-term investment balances as a result of the sale of redeemable convertible preferred stock and lower interest expenses due to lower balance on our equipment financing. Other and interest income (expense), net, decreased to approximately ($309,000) in 2001 due to lower cash, cash equivalent and short-term investment balances and increased interest expense associated with outstanding convertible promissory notes. Deferred Stock-Based Compensation We record deferred stock-based compensation for financial reporting purposes as the difference between the exercise price of options granted to employees and the deemed fair value of our common stock at the time of grant. Deferred stock-based compensation is amortized to cost of goods sold, research and development expense, sales and marketing expense and general and administrative expense. Deferred stock-based compensation recorded through March 31, 2002 was approximately $23.4 million, with accumulated amortization of approximately $5.5 million. The remaining approximately $17.9 million will be amortized over the vesting periods of the options, generally four years from the date of grant. We expect to record amortization expense for deferred stock-based compensation as follows:

Period Amount ---------------------- ------------ Second quarter of 2002 $1.4 million Third quarter of 2002 $1.4 million Fourth quarter of 2002 $1.4 million 2003 $5.7 million 2004 $4.8 million 2005 $3.2 million

All option amounts are being amortized using a straight-line method. Stock-based compensation expense related to stock options granted to non-employees is recognized as the stock options are earned. The stock-based compensation expense will fluctuate as the deemed fair market value of our common stock fluctuates. In connection with the grant of stock options to non-employees, we recorded deferred stock-based compensation of $3.7 million through March 31, 2002, of which $2.7 million has been amortized to expense as of March 31, 2002. 21 Income Taxes Realization of deferred tax assets is dependent upon the uncertainty of the timing and amount of future earnings, if any. Accordingly, full deferred tax asset valuation allowances have been established as of December 31, 2000 and 2001 to reflect these uncertainties. As of December 31, 2001, we had federal and state net operating loss carryforwards of approximately $48.6 million and federal and state tax credit carryforwards of approximately $565,000. The net operating loss and tax credit carryforwards will expire at various dates through 2021, if not utilized. Utilization of the net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code. This annual limitation may result in the expiration of net operating loss and tax credit carryforwards before utilization. Additionally, we had $2.2 million of net operating losses in Belgium, which can be carried forward indefinitely, absent any changes in control. Quarterly Results of Operations The following table sets forth our operating results for each of the eight quarters indicated below. This data has been derived from unaudited financial statements that, in the opinion of our management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this information when read in conjunction with our annual audited financial statements and the related notes. The amount and timing of our operating expenses may fluctuate significantly in the future as a result of a variety of factors. These operating results are not necessarily indicative of results for any future period.

Quarter Ended ---------------------------------------------------------------------------------------------- June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, 2000 2000 2000 2001 2001 2001 2001 2002 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- (in thousands except share and per share data) Net sales........................ $ 691 $ 1,954 $ 3,107 $ 6,275 $ 9,298 $ 9,722 $ 10,778 $ 14,594 Cost of goods sold............... 850 1,087 1,089 1,643 2,116 2,076 2,273 2,270 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Gross profit (loss).............. (159) 867 2,018 4,632 7,182 7,646 8,505 12,324 Operating expenses: Research and development........ 970 1,354 1,460 1,768 2,467 2,073 1,550 1,961 Sales and marketing............. 2,422 3,351 4,087 4,989 6,031 7,396 9,475 9,148 General and administrative...... 1,112 1,141 2,178 2,011 3,277 2,103 2,329 2,568 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total operating expenses......... 4,504 5,846 7,725 8,768 11,776 11,572 13,355 13,677 Loss from operations............. (4,663) (4,979) (5,707) (4,137) (4,594) (3,925) (4,850) (1,353) Other and interest income (expense), net.................. 46 702 131 90 8 (86) (321) (315) ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net loss......................... $ (4,617) $ (4,277) $ (5,576) $ (4,047) $ (4,586) $ (4,011) $ (5,170) $ (1,668) ========== ========== ========== ========== ========== ========== ========== ========== Net loss per common share, basic and diluted..................... $ (4.32) $ (3.53) $ (3.92) $ (2.43) $ (2.36) $ (1.92) $ (2.37) $ (0.58) ========== ========== ========== ========== ========== ========== ========== ========== Weighted-average shares used in computing net loss per common share, basic and diluted........ 1,068,911 1,211,199 1,423,947 1,662,284 1,946,475 2,088,138 2,182,801 2,859,781 ========== ========== ========== ========== ========== ========== ========== ==========

22 Liquidity and Capital Resources From inception through May 2001, we financed our operations primarily through private sales of redeemable convertible preferred stock yielding net proceeds of $38.0 million. In June 2001, we entered into a loan agreement, as amended, for the sale of up to $20.0 million in aggregate principal amount of convertible promissory notes. As of March 31, 2002, we had issued to affiliates a total of $14.0 million in aggregate principal amount of convertible promissory notes under the loan agreement. Per the loan agreement, as amended, in the event that we have not completed an initial public offering or an equity financing prior to June 30, 2002, the outstanding convertible promissory notes and any accrued interest will automatically convert into shares of preferred stock at a conversion price of $3.50 per share. Upon completion of this offering, we plan to repay the principal and interest on outstanding convertible promissory notes with an aggregate principal amount of $13.3 million. The principal and interest on the remaining convertible promissory note, which is held by J & A Group, LLC, will automatically convert into 52,774 shares of common stock, based upon an assumed initial public offering price of $14.00 per share, and assuming an effective date of May 31, 2002. To a lesser extent, we also financed our operations through equipment financing loans, which totaled $121,000 in principal outstanding at March 31, 2002. As of March 31, 2002, we had $2.6 million of cash and cash equivalents and a working capital deficit of $5.2 million. Cash Used in Operations. Net cash used in operations was approximately $4.9 million in 1999, $18.3 million in 2000, $13.0 million in 2001 and $2.8 million for the three months ended March 31, 2002. For those periods, cash used in operations was attributable primarily to net losses after adjustment for non-cash charges related to depreciation and amortization of deferred stock-based compensation, and increases in accounts receivable and inventories. These increases in use of cash in operations were offset in part by increases in accounts payable, accrued compensation and other accrued liabilities also resulting from the upward trend in business activities in years 1999, 2000 and 2001. Cash Used in Investing Activities. Net cash used in investing activities was approximately $1.5 million in 1999, $799,000 in 2000, $1.6 million in 2001 and $487,000 for the three months ended March 31, 2002. For each of these periods, cash used in investing activities reflected purchases of property and equipment. In 1999 and 2000, it also reflected net purchases of short-term investments. Cash Provided by (Used in) Financing Activities. Net cash provided by financing activities was approximately $22.3 million in 1999, $4.0 million in 2000, $9.1 million in 2001 and $2.6 million for the three months ended March 31, 2002. Cash provided during 1999 and 2000 was attributable to proceeds from the issuance of redeemable convertible preferred and common stock and debt obligations. Cash provided during 2001 and the first three months of 2002 included proceeds from the convertible promissory notes issued pursuant to the loan agreement, offset partially by the related party note receivable loan. Equipment Financing. In 1997 and 1998, we entered into two equipment financing lines totaling $650,000. Both of these lines have expired, and the 1997 line has been repaid. The interest rates for these financings range from 11.8% to 12.8% per year and provide for aggregate monthly payments of $10,000. As of March 31, 2002, the principal balance outstanding on the 1998 line totaled $121,000. We have granted a security interest to the lenders in all equipment covered by this line. We have issued warrants to the lenders in connection with these lines for the purchase of up to 18,360 shares of common stock at a weighted-average exercise price of $0.62 per share. See "Description of Capital Stock." Convertible Promissory Notes. Between June 2001 and February 2002, we raised $13.3 million through the sale of convertible promissory notes to several of our affiliates pursuant to a loan agreement. Upon the closing of this offering, the principal and accrued interest on these notes must either be repaid or converted into our common stock, at our option. In addition, in November 2001, we raised $700,000 through the sale of a convertible promissory note to one affiliate pursuant to the same loan agreement. The principal and accrued interest due on this note will automatically convert into our common stock at the initial public offering price at the closing of this offering. Under the terms of the loan agreement, we must issue warrants to purchase shares of 23 our common stock at an exercise price of $0.01 per share to the holders of the convertible promissory notes. We intend to repay with the proceeds of this offering all of the notes that do not automatically convert, and as a result, the warrants will be exercisable for an aggregate of 106,456 shares, based upon an assumed initial offering price of $14.00 per share and assuming an effective date of May 31, 2002. We will allocate the gross proceeds received from the convertible promissory notes to the convertible promissory notes and the warrants, based on their relative fair values. Based upon an assumed initial offering price of $14.00 per share on an assumed effective date of May 31, 2002, this allocation would result in $12.7 million of the proceeds being assigned to the convertible promissory note and $1.3 million being assigned to the warrants. We valued the warrants using the Black-Scholes pricing model. We will recognize the allocated value of the warrants of $1.3 million immediately as interest expense. Based on the difference between the effective conversion price of the proceeds allocated to the convertible promissory notes and the deemed fair market value of the common stock at the effective date, we determined that the allocated value of the convertible promissory notes contained a beneficial conversion feature. The beneficial conversion feature, amounting to $1.3 million, represents additional interest yield on the convertible promissory notes and also will be recognized immediately as interest expense. We expect to increase capital expenditures consistent with our anticipated growth in manufacturing, infrastructure and personnel. We also may increase our capital expenditures as we expand our product lines or invest to address new markets. We believe that the net proceeds from this offering, together with our current cash and investment balances and cash generated from operations, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. If existing cash and cash generated from operations are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities or obtain an additional credit facility. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of debt securities, these securities could have rights senior to those associated with our common stock, and could contain covenants that would restrict our operations. Any additional financing may not be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to reduce the scope of our planned product development and marketing efforts. Quantitative and Qualitative Disclosures About Market Risk Our exposure to interest rate risk at March 31, 2002 is related to our investment portfolio and our borrowings. Fixed rate investments and borrowings may have their fair market value adversely impacted from changes in interest rates. Floating rate investments may produce less income than expected if interest rates fall, and floating rate borrowings will lead to additional interest expense if interest rates increase. Due in part to these factors, our future investment income may fall short of expectations due to changes in U.S. interest rates. We invest our excess cash in debt instruments of the U.S. government and its agencies and in high quality corporate issuers. Due to the short-term nature of these investments, we have assessed that there is no material exposure to interest rate risk arising from our investments. We have operated mainly in the United States, and 100%, 98%, 98% and 95% of our sales were made in U.S. dollars in 1999, 2000, 2001 and the three months ended March 31, 2002, respectively. Accordingly, we have not had any material exposure to foreign currency rate fluctuations. Our sales to European customers are denominated in euro, and our investment in our Belgium subsidiary is recorded in euro. As euro-denominated investments are translated monthly, fluctuations of exchange rates between euro and the U.S. dollar either increase or decrease the value of those investments. If permanent changes occur in exchange rates after an investment is made, the investment's value will increase or decrease accordingly. These fluctuations are recorded within stockholders' equity (deficit) as a component of accumulated other comprehensive income. Also, as our subsidiary maintains investments denominated in other than euro currency, exchange rate fluctuations will occur. 24 Recently Issued Accounting Pronouncements In July 2001, the FASB issued SFAS No. 141, "Business Combinations," which establishes financial accounting and reporting for business combinations and supersedes APB Opinion No. 16, "Business Combinations," and FASB Statement No. 38, "Accounting for Preacquisition Contingencies of Purchased Enterprises." SFAS No. 141 requires that all business combinations be accounted for using one method, the purchase method. The provisions apply to all business combinations initiated after June 30, 2001. In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets," which establishes financial accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion No. 17, "Intangible Assets." SFAS No. 142 addresses how intangible assets that are acquired individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition, and after they have been initially recognized in the financial statements. The provisions of SFAS No. 142 were effective for fiscal years beginning after December 15, 2001. We adopted SFAS No. 142 during the first quarter of fiscal 2002, and the adoption of SFAS No. 142 had no material impact on our financial reporting and related disclosures. In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations," which is effective for us beginning fiscal 2003. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made, with the associated asset retirement costs capitalized as part of the carrying amount of the long-lived asset. We do not expect the adoption of SFAS No. 143 to have a material impact on our financial position and results of operations. In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which is effective for fiscal years beginning after December 15, 2001 and interim periods within those fiscal periods. SFAS No. 144 supersedes FASB Statement No. 121 and parts of APB Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions Relating to Extraordinary Items." However, SFAS No. 144 retains the requirement of APB Opinion No. 30 to report discontinued operations separately from continuing operations and extends that reporting to a component of an entity that either has been disposed of (by sale, by abandonment or in a distribution to owners) or is classified as held for sale. SFAS No. 144 addresses financial accounting and reporting for the impairment of certain long-lived assets and for long-lived assets to be disposed of. We do not expect the adoption of SFAS No. 144 to have a material impact on our financial position and results of operations. 25 BUSINESS Overview We develop medical devices for orthopedic applications using our proprietary balloon technology. Our initial marketing focus is on surgeons who repair spine fractures caused by osteoporosis. Our first commercial products, comprising our KyphX instruments, provide surgeons with tools to help repair fractures during minimally-invasive spine surgeries. Currently available spine fracture treatments are either highly invasive or are simply pain-management therapies that do not repair the fracture. Each year, there are approximately 700,000 spine fractures due to osteoporosis in the United States. Osteoporosis is a disease that primarily affects women over the age of 50 and that is characterized by bone deterioration, leading to an increased susceptibility to spine fractures. These fractures can result in an increased risk of death, significant pain, reduced respiratory function and impaired quality of life. As of March 31, 2002, we had trained 1,748 physicians in the United States, Europe and Korea in the use of our KyphX instruments, and these physicians had used our instruments in over 13,000 spine surgeries. We believe, and intend to demonstrate in clinical studies, that use of our KyphX instruments during minimally-invasive spine surgery may lead to significant patient benefits, including the ability to reverse the collapse of the bone caused by the spine fracture. Reversal of collapsed bone in the spine can potentially reduce spine deformity, increase mobility and improve respiratory function in patients. Risks of procedures using our instruments include the same risks common to performing surgery using anesthesia and to performing surgery on older patients. In addition, like other spine surgeries, these procedures may result in serious complications, including bleeding, nerve injury, paralysis and death. In May 2000, we commenced full commercial introduction of our KyphX instruments in the United States. We devote significant resources to supporting our sales and marketing team, training and educating physicians and supporting reimbursement and clinical activities related to our products. As of March 31, 2002, we had 12 U.S. issued patents, eight issued foreign patents, 32 pending U.S. patent applications and 74 pending foreign applications. We are adapting our products for orthopedic applications in the wrist. Our goal is to establish our proprietary balloon technology as the standard of care in orthopedic applications. Anatomy of the Spine The spinal column contains 24 bones called vertebrae. Each vertebra consists of a large block of bone, called the vertebral body, which helps maintain upright posture. The vertebral body consists of soft inner, or cancellous, bone surrounded by a thin outer shell of hard bone. Each vertebra also has bone segments that extend out from the vertebral body, called the posterior elements, which surround and protect the spinal cord. [ILLUSTRATION OF TOP VIEW OF VERTEBRAE] [ILLUSTRATION OF SIDE VIEW OF VERTEBRAE] 26 Consequences of Spine Fractures When the spine is structurally weakened, routine downward pressure can cause a vertebral body to collapse and fracture. These fractures are referred to as vertebral body compression fractures. The vertebral body generally fractures at the front, which can subsequently cause the spine to tilt forward. Over time, these fractures can result in a curved deformity of the spine and a forward stooped posture called kyphosis. Spine fractures are caused primarily by deterioration of the inner cancellous bone due to osteoporosis. Other causes of spine fractures include trauma, tumors and infection. [ILLUSTRATION OF WOMAN WITH FRACTURED VERTEBRA AND KYPHOSIS] Unrepaired spine fractures can result in serious physical and emotional consequences, including: . Increased Risk of Mortality. In a 2000 study of 6,459 women with osteoporosis followed for 3.8 years, those women who sustained a spine fracture during the study were 8.7 times more likely to die than those women who did not experience a fracture. . Acute and Chronic Pain. About one-third of the spine fractures caused by osteoporosis are accompanied by severe acute back pain. In addition, the spine deformity caused by these fractures can change the position of muscles and ligaments, leading to chronic pain. In a 1998 study of 7,223 women over the age of 65, those who had a single unrepaired spine fracture that had set in its collapsed position were two times more likely to suffer back pain than equivalently-aged women without spine deformity. . Health Effects Resulting from Organ Compression. Fractured and collapsed vertebrae shorten and curve the spine, moving the ribs down toward the pelvis and compressing the chest and stomach. Compression of the lungs can create new, or worsen already existing, respiratory disorders, including lung disease and pneumonia. A German and a Canadian study published in the 1990s, involving a total of 108 participants, demonstrated that patients with spine fractures showed a statistically significant decrease in lung capacity that correlated with spine deformity. In addition, kyphosis can lead to compression of the stomach and a resultant reduced appetite and weight loss. . Functional Limitation. Spine fractures can cause prolonged or permanent disability, reducing mobility and impairing other physical functions. Patients with spine fractures can require significant assistance, including the use of walkers or other aids, during normal physical activities. In a 2001 study of 1,395 post-menopausal women, patients with one or more unrepaired spine fractures scored significantly lower on a standardized test for physical function than those who had no fractures. The loss in quality of life increased with additional fractures. 27 . Increased Risk of Additional Fractures. The change in alignment of the spine can shift a patient's center of balance, increasing the risk of falls and additional fractures, particularly of the spine and the hip. In a 1991 study of 1,098 post-menopausal women followed for 4.7 years, the presence of one spine fracture increased the risk of subsequent spine fractures by five times. The presence of two or more spine fractures increased the risk of additional spine fractures by 12 times in the same timeframe. In addition, a 2001 study prospectively following 6,788 women over the age of 50 for the incidence of osteoporotic fractures found that one or more spine fractures increased the risk of hip fracture by 4.5 times, while the presence of two or more spine fractures increased the risk of hip fracture by 7.2 times. . Emotional Effects. Studies have demonstrated that the physical deformity caused by spine fractures, and the resulting fear of falling, can create patient anxiety and clinical depression, leading to a reduction in normal daily and social activities. Market Opportunity for the Treatment of Spine Fractures An estimated 700,000 spine fractures due to osteoporosis occur in the United States each year, of which approximately 440,000 go undiagnosed or untreated. The remaining 260,000 fractures are managed in the hospital or at home predominantly with conservative treatment options such as bed rest, pain medication and back braces. Approximately 150,000 people in the United States are hospitalized due to pain associated with spine fractures, resulting in costs estimated to be in excess of $1.6 billion annually. The number of fractures caused by osteoporosis is increasing primarily due to the aging of the population. Existing Means for the Treatment of Spine Fractures When treating a patient with a spine fracture, an orthopedic surgeon's primary objective, as with any fracture, is to reduce the fracture, that is, to return the bone to its pre-fracture position. While surgeons can use conventional orthopedic surgical techniques to reduce and otherwise repair spine fractures, these procedures are highly invasive and especially risky for elderly patients. As a result, physicians rarely refer their patients for surgical procedures to repair spine fractures, but instead prescribe therapies and treatments designed to simply manage the pain. Conventional Spine Surgery Spine surgery is complex and risky due to the proximity of the surgical site to the spinal cord and major organs. Conventional spine surgery can repair fractured vertebrae and restore height, but is highly invasive and involves significant risks. These surgeries involve making long incisions in the patient's chest so that large stainless steel instruments can move the fractured bones back into their normal position. However, the instruments used in these surgeries are not optimally designed to manipulate deteriorated bone. The fractured bones are then held in place by metal implants, which, in the case of elderly patients with osteoporosis, can fail to hold due to the softness of the inner cancellous bone to which they are attached. As a result, this surgery is performed in very limited circumstances. The invasiveness of conventional spine surgery may lead to death, spinal cord injury, extensive post-operative hospital stays and prolonged bed rest for recovery. Additional complications may include bowel, lung and nerve damage, pain, bleeding, infection and blood clots. Pain Management Therapies Due to the limitations of conventional orthopedic surgery for patients with spine fractures, the majority of these patients are treated with conservative pain management therapies. These methods do not involve surgical intervention and do not repair the fractured spine. These pain management therapies can comprise many techniques, alone or in combination, including: . bed rest, in the hospital or at home; . prescription and over-the-counter pain medication; 28 . back braces; . home health care; . physical therapy; . exercise; and . chiropractic care. These therapies are designed to provide pain relief while the fractured vertebra slowly sets in its collapsed form. Periods of treatment can be lengthy, resulting in expensive hospital stays and follow-up. These therapies can also worsen the underlying problem. For example, bed rest is known to cause bone and muscle loss, making recovery more difficult in elderly patients, and potentially leading to additional fractures. In addition, doctors report that patient compliance with these therapies is low because of the: . prolonged nature of treatment; . patients' reluctance to wear back braces; . difficulty and pain associated with exercise and physical therapy; and . inadequate pain reduction. In addition, physicians may stabilize the fractured area by a treatment that has become known as vertebroplasty. Vertebroplasty does not repair the spine fracture, but simply reduces the associated pain. Because vertebroplasty freezes the vertebral body in its collapsed position, patients may continue to suffer the physical, emotional and quality of life problems associated with unrepaired spine fractures. In vertebroplasty, a physician, typically an interventional radiologist, places one or two large needles into the fractured vertebra, and injects bone filler material into the collapsed vertebral body. The bone filler most commonly used in vertebroplasty is bone cement, which the FDA has not specifically approved for use as a bone filler in the spine. Because the vertebral body is in a collapsed position, this procedure requires the use of thin bone filler material that is injected under high pressure in order to effectively penetrate the inner spaces of the deteriorated bone. Once injected, the bone filler material hardens and fixes the bone in its collapsed position. Our KyphX Instruments Our KyphX instruments provide surgeons with tools to help repair fractures during minimally-invasive spine surgery. Our instruments have also been used in open surgical procedures. Minimally-invasive spine fracture surgeries using our KyphX instruments involve the insertion of two of our disposable proprietary balloon devices into the fractured bone. The surgeon inflates our balloons to compact and move the deteriorated bone. As a result of the inflation of the balloons, the collapse caused by the fracture may be reversed. This reversal will be more difficult if the bone has previously healed in its fractured position. The balloons are then removed, and the newly-created cavity is stabilized by filling it with the surgeon's choice of bone filler material, which can include bone cement, a plastic polymer that hardens in place. We believe that surgeons typically use a relatively thick bone cement at low pressure and under manual control. Although bone cement may be used by surgeons if they feel it is in the best interest of the patient, we may not promote bone cement for use in the spine without additional regulatory approval. Currently, there is no bone filler that has specifically been approved for use with the KyphX instruments to repair spine fractures. We have trained 1,748 physicians, including 200 in Europe and 35 in Korea, in the use of our KyphX instruments. These physicians have used our instruments in over 13,000 surgeries involving spine fractures. 29 Based upon published reports of clinical results, discussions with surgeons who have used our instruments, and our own research, we believe that the use of our KyphX instruments during minimally-invasive spine surgery may lead to significant clinical outcomes, including the following: . restoration of collapsed vertebrae; . reduction of spinal deformities; . reduction of pain; and . enhanced quality of life. Currently, our FDA clearance permits us to promote in the United States our KyphX Inflatable Bone Tamp, a device used to move and compact bone, for use as a conventional bone tamp for the reduction of fractures and/or the creation of a void in cancellous bone in the spine, hand, tibia (a leg bone), radius (an arm bone) and calcaneus (the heel bone). Before we can promote and market in the United States the use of our KyphX instruments in any specific procedure, or claim any treatment benefits from any procedure, we must conduct clinical studies to document the benefits, if any, and receive FDA approval. We intend to seek regulatory approval this year to initiate clinical studies that are designed to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared KyphX instruments in a specific minimally-invasive spine procedure and to determine the benefits resulting from that procedure. We cannot assure you that our studies, if completed, will demonstrate to the FDA's satisfaction any treatment benefits from spine fracture repair procedures using the KyphX Inflatable Bone Tamp or that the FDA will approve any treatment benefit claims in a timely fashion, if at all. If we fail to obtain additional FDA approvals that will allow us to promote the treatment benefits of the KyphX Inflatable Bone Tamp, our ability to expand the commercialization of our products will be impaired. Risks of spine fracture surgery performed with our KyphX instruments include the same risks common to performing surgery using anesthesia and performing surgery on elderly patients. In addition, as with other spine surgeries, surgeries using our instruments may result in serious complications, including chronic pain; follow-up surgery; infection; unintended damage to the bone or tissue; bleeding; bowel, lung or nerve injury; paralysis; and death. Use of bone filler material by surgeons to fill the void created using our KyphX Inflatable Bone Tamp may also lead to these complications, as a result of leakage of the bone filler material into the spinal canal or surrounding tissue. The Use of KyphX Instruments During Minimally-Invasive Spine Surgery Spine fracture surgeries using our KyphX instruments are minimally invasive and are generally performed by spine-focused orthopedic surgeons and neurosurgeons. A surgeon first creates a working channel from the patient's back into the fractured vertebral body using our KyphX Bone Access System. [ILLUSTRATION OF KYPHX INSTRUMENTS IN USE, STEP 1] 30 The surgeon then inserts two of our proprietary disposable KyphX Inflatable Bone Tamps into the fractured bone and carefully inflates them with fluid using X-ray images to monitor the procedure. Surgeons can control inflation volume and pressure using our KyphX Inflation Syringe. Inflation of the balloons compacts the soft inner bone creating a cavity. When possible, this inflation also pushes the hard outer bone up toward its natural position, reducing the fracture. [ILLUSTRATION OF KYPHX INSTRUMENTS IN USE, STEP 2] The KyphX Inflatable Bone Tamps are then removed, and the surgeon chooses a bone filler material to insert into the void. Using the KyphX Bone Filler Device, the surgeon deliver