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Hemosense Inc – ‘10-K’ for 9/30/05

On:  Friday, 12/2/05, at 5:19pm ET   ·   For:  9/30/05   ·   Accession #:  1193125-5-235992   ·   File #:  1-32541

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 3: EX-31.1     Certification of Chief Executive Officer Pursuant   HTML     11K 
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended September 30, 2005

or

For the transition period from              to             

Commission File Number: 001-32541

HEMOSENSE, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (408) 719-1393

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value

(Title of Class)

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

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

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on September 30, 2005 (which is the last business day of registrant’s most recently completed fourth fiscal quarter), as reported on the American Stock Exchange was approximately $38.5 million. The registrant was not a reporting company as of March 31, 2005. Shares of Common Stock held by each executive officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of November 28, 2005, the registrant had outstanding 11,481,482 shares of common stock. The registrant does not have any non-voting common equity.

DOCUMENTS INCORPORATED BY REFERENCE

The registrant has incorporated by reference into Part III of this Annual Report on Form 10-K portions of its definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year covered by this Annual Report.

Table of Contents

HEMOSENSE, INC.

FORM 10-K

TABLE OF CONTENTS

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PART I

Certain statements in this Annual Report on Form 10-K are “forward-looking statements” within the meaning of federal securities laws. 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 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. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “potential”, “continue” or the negative of these terms or other comparable terminology. Forward-looking statements include, but are not limited to, the statement regarding: opportunities for revenue growth from expanding indications; the financial impact of our future royalty obligations; our ability to generate positive gross margins on our test strips; and future trends in revenue, cost of goods sold and operating expenses. In evaluating these statements, you should specifically consider various factors, including the risks outlined under “Factors Affecting Future Operating Results.” These factors may cause our actual results to differ materially from any forward-looking statements.

We were incorporated under the laws of the State of Delaware in March 1997 as CardioSense, Inc. We changed our name to HemoSense, Inc. in January 1998. Our principal executive offices are located at 651 River Oaks Parkway, San Jose, California 95134 and our telephone number at that location is (408) 719-1393. Information about our company is also available at our website at www.HemoSense.com, which includes links to reports we have filed with the Securities and Exchange Commission. The contents of our website are not incorporated by reference in this Annual Report on Form 10-K.

ITEM 1. Business

Overview

We develop, manufacture and sell easy-to-use, handheld blood coagulation monitoring systems for use by patients and healthcare professionals in the management of warfarin medication. Warfarin is an oral anticoagulation, or blood thinning, drug given to patients to prevent potentially lethal blood clots. Our product, the INRatio System, consists of a small, portable meter and disposable test strips and provides a quick and accurate measurement of a patient’s blood clotting time, known as a PT/INR value. The accurate measurement of the PT/INR value is critical to ensuring the safety and effectiveness of warfarin in maintaining a patient’s blood coagulation level within a therapeutic range. The INRatio System represents an alternative to the current laboratory-based standard of care, which generally involves monthly or less frequent testing and delayed results. The U.S. Centers for Medicare & Medicaid Services, or CMS, has observed that monthly testing is inadequate for the majority of patients on chronic warfarin therapy. More frequent testing helps maintain patients within their therapeutic range and may minimize adverse events, such as dangerous blood clots or serious bleeding, associated with insufficient or excessive anticoagulation. Numerous studies reviewed by CMS showed that frequent self-testing through the use of a home PT/INR monitor improves a patient’s time in therapeutic range. CMS approved Medicare coverage for weekly home PT/INR monitoring of patients with mechanical heart valves on warfarin. This decision went into effect in 2002 and, in the latter half of 2003, reimbursement payments began to reach service providers. Similar to the shift that has occurred in the standard of care for management of diabetes and blood glucose monitoring, we believe that the Medicare coverage decision and growing physician and patient awareness of the benefits of weekly PT/INR patient self-testing signal a shift in the standard of care for PT/INR testing from the clinical laboratory to point-of-care testing and, ultimately, patient self-testing.

Warfarin has been prescribed since the 1950s and is regarded as safe and effective when it is dosed correctly. It is the most widely prescribed oral anticoagulant besides aspirin. There are approximately three million people in the United States who take warfarin daily. In 2003, there were over 20 million prescriptions for warfarin written in the United States, either in generic form, or under its brand name Coumadin. Based upon Medicare claims data, there were 18.3 million PT/INR tests conducted on U.S. Medicare patients in 2003, comprised of approximately 13.4 million clinical laboratory tests and 4.9 million point-of-care or patient

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self-tests. By contrast, there were 13.8 million tests performed in 2000, consisting of 12.1 million clinical laboratory tests, and 1.7 million point-of-care tests. The total number of PT/INR tests increased by more than 30% over this three-year period, with 11% growth in the laboratory testing market, as compared with 190% growth in the point-of-care and patient self-test markets. We believe that similar trends have occurred with private insurance payors and in countries outside of the United States. In Germany, where reimbursement was established in 1996, more than 100,000 patients are performing PT/INR self-testing. As the global population ages and develops disorders requiring management of blood coagulation, and as weekly patient self-testing gains wider acceptance, we expect these trends in PT/INR testing to accelerate. We believe our INRatio System is well positioned to gain a meaningful share of the global market for PT/INR patient self-testing and point-of-care testing.

We have designed our INRatio System to address the needs of the emerging PT/INR patient self-testing and point-of-care markets. Our proprietary system requires one drop of blood from a patient’s finger to quickly and reliably determine the rate at which their blood coagulates by measuring changes in the blood’s electrical properties during the coagulation process. For ease of use, the INRatio System integrates into each disposable test strip clinical laboratory-like quality controls designed to ensure test-by-test accuracy. These controls are designed to verify the accuracy of each PT/INR test without the need for additional costly and time consuming steps requiring separate chemicals and test strips. Unlike test strips offered by competitors, our test strips can be stored for up to one year at room temperature rather than requiring refrigeration for long-term storage.

After receiving U.S. and European regulatory clearances in 2002, we commercially launched the INRatio System in March 2003 in the U.S. and certain European markets. Tests performed using our INRatio System in the point-of-care setting are currently reimbursed by Medicare for all patients on warfarin as is self-testing by mechanical heart valve patients on warfarin. We have established distribution agreements with several national and regional distributors of medical products, giving us access to over 1,000 U.S. sales representatives for the sale of the INRatio System. We are dependent upon these distributors for a substantial portion of our revenue, and the loss of any key distributors would have a material adverse effect on our business. Our distributors Quality Assured Services, Medline and Cardinal Health accounted for approximately 24%, 19% and 13%, respectively, of our total revenue in fiscal 2005. In addition, we have established international distribution agreements with 14 distribution partners covering 20 countries outside the United States. We own five issued U.S. patents, one issued European patent, and one pending European application. Three of the issued U.S. patents cover, and the pending European application relates to, the INRatio System and its method of measuring blood coagulation by monitoring changes in the electrical properties of the blood sample as it clots.

Background and Market

Blood Clotting Disorders

The formation of a blood clot, or thrombus, is a desirable and essential response to a wound, preventing a simple injury from becoming a potentially fatal bleeding event. However, blood clots can have unwanted effects when they block normal blood flow in the body. Both heart attacks and strokes occur when a vessel that supplies blood is blocked by a blood clot. Heart disease is the leading cause of death in the United States today with heart attacks as the most publicized outcome. Stroke is the third-leading cause and the leading cause of serious, long-term disability.

There are two types of patients requiring medication for potential blood clots; those with acute conditions requiring short-term therapy and those with chronic conditions requiring long-term therapy, often for life. Acute risks of blood clots can result from accidents or from certain surgical procedures, like knee or hip replacements. Typically, these patients are initially treated at a hospital with combinations of intravenous drugs that dissolve blood clots and blood thinning drugs. Often, these patients will continue treatment with an oral anticoagulant, such as warfarin, for several weeks following a hospital stay, until the blood clot risk has diminished. Long-term risks of blood clots result from chronic conditions and are typically treated with oral anticoagulation medications, including warfarin and aspirin. The most common chronic uses of warfarin are for patients with mechanical heart valves and patients with atrial fibrillation.

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While our INRatio System is primarily marketed to physicians treating and patients suffering from these two chronic conditions, it is also sold to physicians for the management of warfarin dosage in patients with an acute need for the medication.

Importance of Monitoring and Managing Warfarin Dosage

The safety and effectiveness of warfarin depends on maintaining the blood’s ability to coagulate within a narrow therapeutic range, which can be challenging if not actively managed. If there is too much warfarin in a patient’s bloodstream, there is a risk of hemorrhage, or uncontrolled internal or external bleeding, which can be fatal. If there is too little warfarin in the bloodstream, it will be ineffective in reducing the risks associated with blood clots from the underlying condition, such as a stroke or heart attack.

A patient’s warfarin dosage typically is managed by first giving a small starting dose and measuring the patient’s blood clotting time, adjusting the dose and measuring again, and so on, until the patient’s proper therapeutic dosage is achieved. When the correct dosage has been achieved, the anticoagulation effect of the drug will be within a safe and effective therapeutic range. The effectiveness of warfarin can vary between patients and within the same patient, depending upon a number of factors. Changes in diet, alcohol consumption, interaction with other drugs, a patient’s overall health and environmental factors can all affect the degree of anticoagulation caused by warfarin. These factors make it important for patients on warfarin to measure their blood clotting ability frequently to provide their physicians with the information necessary to maintain an appropriate level of warfarin. Prothrombin time, or PT, is an expression of the time it takes for blood to clot and reflects the anticoagulation effect of warfarin. The internationally recognized measurement standard for clotting time is known as PT/INR. INR is the International Normalized Ratio, which expresses PT in a common scale established by the World Health Organization. Higher PT/INR values indicate the blood will take more time to clot, whereas lower values indicate the blood will clot more quickly.

Clinical Laboratory and Point-of-care PT/INR Testing and their Limitations

Clinical Laboratory Testing. PT/INR measurements have traditionally been and are mostly still performed and analyzed in a clinical laboratory using sophisticated and costly high-volume screening equipment. Clinical laboratory tests accounted for 73% of all PT/INR tests performed in 2003 on Medicare patients. Clinical laboratory testing methods for PT/INR measurement are precise; however, these methods are inconvenient for the patient and the physician, and therefore not conducive to compliance. Clinical laboratory test results typically are not available until the following day, which could prevent a physician from properly advising a patient during

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their visit. In addition to being inconvenient for the patient, the delay in obtaining test results creates inefficiencies because the physician or nurse practitioner must perform patient call backs in order to advise patients of changes needed to their warfarin dosages.

Point-of-care Testing. Handheld devices for PT/INR point-of-care measurement have existed since 1987. However, we believe that physician adoption of these devices was limited due to mixed clinical results regarding their precision and accuracy. In contrast to PT/INR tests performed in a clinical laboratory, point-of-care PT/INR tests can use capillary blood from a finger stick and produce quick results because tests are performed using a real time PT/INR measurement device directly at the patient point-of-care, such as at a physician’s office, anticoagulation clinic or nursing home. The ability to obtain a quick PT/INR test result is valuable because it allows the healthcare professional to adjust warfarin dosage and suggest lifestyle changes with the patient during the same office visit. In addition, point-of-care PT/INR testing reduces time required and costs associated with the use of clinical laboratories that are not in close proximity to the physicians and patients. These costs include sample collection and processing steps, transportation costs, and the time spent by a physician or nurse practitioner performing patient call backs.

CMS reimburses both clinical laboratory and point-of-care PT/INR tests. However, as CMS has observed in its September 2001 National Coverage Decision Memorandum regarding PT/INR self-testing, clinical laboratory tests are generally performed only once every four to six weeks, due in large part to practical constraints of access and labor-intensiveness. In the Decision Memorandum, CMS indicated that monthly testing is inadequate for the majority of patients on chronic warfarin therapy, because the medication is highly individualized and affected by common variables like diet. More frequent testing helps to improve the time that patients spend within their therapeutic PT/INR range, which may minimize adverse events, such as dangerous blood clots or serious bleeding, associated with inadequate or excessive anticoagulation. CMS evaluated 11 clinical studies published in peer-reviewed journal articles, all of which found patients using home PT/INR monitors performed favorably compared to control groups treated at a medical facility. Seven of the eight studies that measured statistical significance showed statistically significant better time in therapeutic range, or TTR, for the patient self-testing group than for the group that received either usual care from a hospital or commercial laboratory, or point-of-care testing, regardless of testing frequency.

CMS Decision Memorandum Observations

The studies described by CMS consistently showed that the more frequently a patient was tested the more time that patient spent in their therapeutic range, leading CMS to observe “in order to achieve time in therapeutic range of greater than 90%, a patient most likely needs to be tested once a week.” CMS went on to note that “increased TTR leads to improved clinical outcomes, with reductions in thromboembolic and hemorrhagic events.”

The Emergence of a Patient Self-Testing Market

The confluence of improved technology, approval of reimbursement coverage and increased physician and patient awareness has led to the emergence of a patient self-testing market for warfarin users. By early 2000, the FDA had cleared three monitors for patient self-testing, but each instrument had limitations. Studies have

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demonstrated that the accuracy and reliability of newer devices for patient self-testing compared well with clinical laboratory testing. The patient self-testing market has emerged as government and private payors have begun to provide reimbursement. Medicare reimbursement for up to weekly PT/INR monitoring of anticoagulation management for warfarin patients with mechanical heart valves went into effect in 2002 following publication of the CMS Decision Memorandum. Several European countries have also implemented national reimbursement coverage of home PT/INR testing for chronic warfarin patients, including Germany, the United Kingdom, Denmark and the Netherlands.

Medicare reimburses for services provided to patients who perform PT/INR self-testing, similar to the Medicare reimbursement procedure for patients on pacemakers and Holter monitors. Our meters and test strips are distributed to Medicare patients without charge through a Medicare licensed facility known as an Independent Diagnostic Testing Facility, or IDTF, which may also monitor patient compliance and convey test results to the treating physician. Medicare provides a one-time reimbursement of $251 per patient for the cost associated with training patients in the proper use of our INRatio System. Medicare also provides for an annual total of over $1,900 per patient for physician review, monitoring service and the testing device. If all of the approximately 400,000 U.S. mechanical heart valve patients on warfarin performed weekly PT/INR self-testing, Medicare reimbursement for this population would be in excess of $800 million annually.

The Department of Veterans Affairs has sponsored a clinical study known as The Home INR Study, or THINRS, to evaluate weekly PT/INR patient self-testing for patients with atrial fibrillation or a mechanical heart valve. THINRS is a randomized, open-label, active control outcome study designed to compare weekly patient self-testing with conventional monthly monitoring in the clinic. This study commenced in 2003 and is expected to be completed in 2006. It is anticipated that 3,200 patients will be enrolled at 32 sites. The study participants must have atrial fibrillation or mechanical heart valves and be scheduled to receive warfarin for at least two years. Participants are assigned into either a weekly patient self-testing group or monthly conventional monitoring group. The study evaluates adverse event rates, time to first adverse event, time in therapeutic range for anticoagulation intensity, and total healthcare cost and utilization. We expect that results from this study will be influential in Medicare’s decision regarding reimbursement for PT/INR patient self-testing in atrial fibrillation. If Medicare were to commence reimbursement for PT/INR patient self-testing for the approximately 1.2 million atrial fibrillation patients currently on chronic warfarin, this will significantly increase the PT/INR patient self-testing market.

As more physicians, insurance providers and patients become aware of the healthcare benefits derived from more frequent PT/INR testing and the availability of simple and convenient PT/INR testing devices designed specifically for the patient self-testing market, we expect the PT/INR patient self-testing market to grow significantly.

The HemoSense Solution

We believe that the INRatio System represents a new generation of PT/INR testing devices designed specifically for use in both patient self-testing and by healthcare professionals at the point-of-care. We believe that physicians generally will not prescribe patient self-testing unless the physician is confident that the patient will be able to comply with the testing requirements. Many patients needing warfarin are Medicare patients, some of whom may have limited manual dexterity and may be challenged by complex test instructions and training. We believe that we offer a unique combination of factors that make our INRatio System a simple and straightforward patient self-testing PT/INR measurement device. These features also enable busy healthcare professionals to quickly train their patients in the use of our system as a tool for monitoring their warfarin therapy. Specifically, these features include:

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The ability of patients to home test with our INRatio System reduces the time and inconvenience required to manage warfarin by reducing or eliminating trips to the laboratory or doctor’s office for testing, both for the patient and, often, for the caregiver. In addition, the INRatio System’s patient-friendly design and functionality helps minimize the burden of PT/INR self-testing for patients. With PT/INR patient self-testing, patients play an active role in management of their warfarin dosage, which we believe encourages optimal patient compliance.

Our Strategy

Our objective is to become the leading provider of PT/INR patient self-testing and point-of-care testing systems and related products for the monitoring of patients on warfarin. We seek to improve therapeutic outcomes while dramatically reducing the need for inconvenient visits by patients to healthcare professionals for routine testing. To achieve these objectives, we are pursuing the following strategies:

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Our Products

Our INRatio System is an easy-to-use testing system designed specifically for patient self-testing that provides PT/INR test results using one small drop of blood from the patient’s finger. The INRatio System consists of a small, handheld meter and disposable test strips with integrated, laboratory-like quality control tests that are designed to assure the accuracy of PT/INR test results. We shipped our first commercial INRatio System in March 2003.

INRatio Meter

The INRatio meter contains a heater, digital user interface, and electronic components that measure the changes in resistance or impedance in a blood sample during the coagulation process. To ensure the proper functioning of its components, the INRatio meter performs a series of self-diagnostic tests every time the device is turned on. The meter has three buttons that control all of its functions and has a prominent, easy to read screen on which instructions and results are clearly displayed. The meter has the ability to store up to 60 PT/INR test results and contains a data port for interfacing with an optional printer. The meter is powered by four AA batteries and has an optional external A/C adapter. The user can choose to display messages in any of ten languages programmed into the meter.

INRatio Disposable Test Strips

The INRatio disposable test strips use our proprietary electrochemical technology to measure a patient’s PT/INR value and perform two laboratory-like quality control tests on a single test strip with a single drop, or approximately 15 microliters, of blood. The two quality control tests confirm standard PT/INR readings for the normal lower range, or low control, and the therapeutic upper range, or high control. This helps ensure that the meter and test strip are functioning properly and that the patient’s PT/INR test result will be accurate. The meter and a single test strip automatically perform all three tests each time a patient’s blood sample is applied to a test strip that has been inserted into the meter. When the INRatio meter detects an unacceptable quality control test result, it does not display a potentially incorrect PT/INR test result, but rather alerts the user to the error. We designed our proprietary test strips with on-board quality control tests and our meter with built-in electronic

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diagnostic tests to help ensure the accuracy of test results and to simplify the process by eliminating the need to use specialized control test liquids and additional test strips to obtain quality control test measurements. Our test strips do not require refrigeration and can be shipped and stored at room temperature for one year, which provides distribution advantages and improves patient convenience. INRatio test strips can only be used with the INRatio meter.

INRatio Accessories

We include all accessories needed for the use of the INRatio System in the patient self-testing and point-of-care environments, such as lancets.

Our Technology Platform

The INRatio System utilizes an electrochemical sensor to detect and measure changes in electrical impedance of a blood sample as it coagulates. The change is then recorded by the meter and converted to a PT/INR reading. When the meter is turned on, it performs an electronic diagnostic check, the first of a number of quality control tests performed by the INRatio System. Once the test strip is inserted into the meter, it is warmed to normal body temperature, and the meter alerts the user to apply the blood sample. After a drop of blood is applied to the sample well on the test strip, it is drawn by capillary action across the surface of the test strip and into the test area where it mixes with reagents that cause coagulation. The blood sample contacts separate electrodes which measure changes in impedance that occur during coagulation. As the reaction progresses, the electrical impedance increases and then gradually drops as the clotting process is completed. The elapsed time, in seconds, until the endpoint is reached is the raw PT time, which is then used to calculate the INR of the sample. The meter displays the patient’s PT/INR results generally within two minutes or less after the blood sample is applied.

Sales and Marketing

The market for the INRatio System includes patient self-testing, physician office practices, anticoagulation clinics, hospitals, long-term care facilities, nursing homes and home healthcare providers. We currently sell our INRatio meter and disposable test strips through distribution agreements in the United States and internationally. In the United States, our distribution agreements provide us with access to more than 1,000 sales representatives.

U.S. Distribution

We have agreements with five national medical device distribution companies: Quality Assured Services, Cardinal Health, Raytel, Medline and McKesson Medical. We also have agreements with four companies which provide regional distribution.

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International Distribution

We currently have 14 distribution agreements covering 20 countries internationally. These agreements generally provide that each distributor can sell into the professional and home-use markets within a country. Germany, as an exception, has two distributors covering the country. Our distribution agreements internationally include those with MicroMedical, IMed Partners and InaBattke KG in Germany; as well as agreements with distributors covering Australia, Austria, Belgium, China Denmark, Finland, Holland, Ireland, Israel, Italy, Lithuania, Luxembourg, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom. Germany is a particularly important international market for us because its medical and patient communities have been leaders in the adoption of patient self-testing. We intend to continue to enter into distribution agreements in other select countries where PT/INR patient self-testing and point-of-care testing are established medical practices. In emerging markets such as Asia, we intend to identify strategic partners as distributors of our product.

Sales and Marketing Organization

We intend to use a variety of marketing tools to build market awareness, drive product adoption, ensure continued usage and establish brand loyalty for the INRatio System by:

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As of November 15, 2005, we employ 31 people in sales and marketing. Sixteen salespeople are located in key locations throughout the United States working with distribution partners and healthcare providers. We employ five product specialists in the field that focus on training and product troubleshooting for large accounts. The nine remaining employees are located in the corporate office, including five within marketing and four in customer and technical service. We also employ a director of international business development in Europe to support our international distribution partners and healthcare providers.

Competition

The market for PT/INR patient self-testing and point-of-care diagnostics is intensely competitive, subject to rapid changes and new product introductions. We believe that two companies, Roche Diagnostics and International Technidyne Corporation, a division of Thoratec, currently account for over 90% of the worldwide sales of PT/INR point-of-care and patient self-testing devices. Both of these competitors use a meter and disposable strips or cartridges, to test blood obtained by lancing the finger or drawing blood from a vein. Both of these competitors are focused on expanding their presence in the patient self-testing market.

In addition to our current competitors, we expect to encounter new entrants to the market, particularly if increased reimbursement drives the adoption of patient self-testing and increased testing volume. Specifically, Inverness Medical Innovations has announced that it plans to introduce its own warfarin anticoagulation monitoring device later in 2006.

Our competitors enjoy several competitive advantages, including:

We believe the principal competitive factors in our market include:

Emerging Oral Anticoagulation Therapies

A number of pharmaceutical companies are working on the development of a new class of oral direct thrombin inhibitors, or DTIs, to replace older anticoagulants such as warfarin. In theory, these new oral DTIs

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should have very few drug/non-drug interactions and should not require the same level of monitoring that warfarin requires. One goal of current research in this area is the elimination of the need for PT/INR testing, which if successful could render our device obsolete. One oral DTI, AstraZeneca’s Exanta, is approved in Europe for preventing blood clots in connection with knee and hip replacements. However, in the fourth quarter of 2004, the FDA did not grant approval based on Exanta’s dangerous side effects to patients’ livers. As of yet, it is unknown whether oral DTIs will be approved in the United States or perform as well as warfarin, especially for the chronic user.

Manufacturing

The primary components of the INRatio System are the INRatio meter and the INRatio disposable test strips. We manufacture the INRatio test strips at our California headquarters and we contract with an electronic manufacturing services supplier to manufacture the INRatio meter. We offer other accessories as part of the INRatio System such as lancets, blood collection devices, power supplies, and printers. These supplies and accessories are manufactured by third parties and are not customized for the INRatio System.

Both the INRatio meter and test strips are manufactured using components and assemblies that have been supplied by outside vendors. The test strip manufacturing process includes reagent dispensing and drying steps, mechanical assembly, packaging and calibration. Plastic film substrates are purchased from outside vendors that perform printing, die cutting and laminating operations according to specifications we have established. These printed and cut films are shipped to our manufacturing facility where we perform an incoming quality control check prior to test strip assembly. The meter is manufactured by an electronic manufacturing services company that is responsible for procuring materials, assembly, and testing of the device according to our specifications. The meters are shipped to our manufacturing facility where we perform calibration, packaging and labeling.

We use contract manufacturing relationships to minimize our capital investment, help control costs, and take advantage of the expertise these third parties have in the production of these assemblies. We also purchase certain components and materials from single sources due to constraints resulting from intellectual property requirements, quality or cost reasons. Currently, those single sources are Dade Behring, which produces a reagent used in our test strips, Haematologic Technologies, which produces the control reagents and Plexus, which manufactures our meters. We have supply agreements in place with these single source suppliers that provide for notification and termination periods; however, because of the custom nature of the components and the FDA requirements for validation and verification of significant changes, a supply interruption from any of these suppliers would limit our ability to produce our systems and could have a material adverse effect on our business. Our agreement with Dade Behring is terminable upon 90 days notice. Prior to the expiration of the agreement in March 2007, we have the option to extend the term until January 2015, the date of the last expiring patent covered by the agreement, by making a payment of $2.5 million, if made prior to March 2006, or $2.75 million, if made prior to March 2007. Our agreement with Haematalogic Technologies is terminable upon 18 months notice and our agreement with Plexus is terminable upon 180 days notice.

Research and Development

We are determining the feature set for a new version of the INRatio meter that we believe would make our system even more attractive for the PT/INR patient self-testing market. The system design of the new version plans for a device that is smaller in size than our current INRatio meter. We expect this new product to utilize the current architecture of the INRatio disposable test strip and deliver the same patient-friendly feature set as the current INRatio meter. We believe that our next generation INRatio System could potentially be attractive for patients who are only on warfarin for a short period of time.

In addition, based on our initial specifications, we expect the new version could reduce our per-unit manufacturing costs at comparable volumes, using the same manufacturing technologies as the current INRatio System. Beyond investing in the design of a future version, we intend to continue developing a number of product enhancements for the current INRatio System. We are also developing an integrated communications

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capability for use in the professional setting that will provide an automated means to interface the INRatio meter to a data management system. Product development efforts related to the current INRatio System are focused on manufacturing process enhancements aimed at cost reduction and quality improvements, as well as functional enhancements. Specifically, we are designing process development and automation projects for our disposable test strip production line that we believe will significantly increase manufacturing capacity and reduce our costs.

We believe that our electrochemical technology has applications in other tests beyond the measurement of PT/INR values for patients on warfarin. We plan to conduct feasibility studies for additional coagulation parameters including APTT, or activated partial thromboplastin time, and ACT, or activated clotting time.

We have had research and development expenses of $1.3 million, $1.4 million and $1.7 million in fiscal 2005, 2004 and 2003, respectively.

Intellectual Property

Protection of our intellectual property is a priority for us. We plan to pursue and maintain patent protection in both the United States and Europe. We rely on a combination of patents, copyrights, trade secrets and nondisclosure agreements to protect our proprietary rights. Currently, we have five issued U.S. patents and one issued European patent, which has been validated in certain member states of the European Patent Convention, including Germany and Austria. In addition, we have one pending European patent application. Three of the issued U.S. patents cover the INRatio System and its method of measuring blood coagulation. They expire in 2017. Similarly, the pending European application contains claims that would cover our INRatio System and its method of measuring blood coagulation if it were to issue in its present form. The pending European application, if issued, would expire in 2018.

The medical device industry is characterized by the existence of a large number of patents and frequent litigation based on assertions of patent infringement. On June 22, 2005, we received a letter from Beckman Coulter claiming that our test strip includes intellectual property covered by one of their patents, U.S. Patent 5,418,141, and that we could require a license to the patent. After requesting more information from Beckman Coulter and performing an investigation on their assertion, we concluded that their patent does not cover our test strip and that we do not need to obtain a license from them. Together, our patents, patent application and licenses of patents protect aspects of our technologies. We believe that our patent and license position will provide us with sufficient rights to develop, sell and protect our product.

We also rely on trade secrets, technical know-how and continuing innovation to develop and maintain our competitive position. We seek to protect our proprietary information and other intellectual property by generally requiring our employees, consultants, contractors, outside scientific collaborators and other advisors to execute non-disclosure agreements on commencement of their employment or engagement.

In April 2003, Inverness Medical Innovations filed suit against us, alleging that disposable test strips for our INRatio System infringed certain patents held by Inverness. In July 2004, we entered into a settlement and mutual release agreement with Inverness pursuant to which we received a non-exclusive, perpetual, non-transferable worldwide license to the patent rights in exchange for a product royalty of 1.5% of net sales, which is subject to a cap on aggregate royalties payable of $5.0 million, which begins to accrue in July 2006 and the issuance to Inverness of a $1.0 million secured subordinated promissory note.

Government Regulation

Our products are medical devices subject to extensive regulation by the FDA and other regulatory bodies. FDA regulations govern, among other things, the following activities that we perform and will continue to perform to ensure that medical products distributed domestically and exported internationally are safe and effective for their intended uses:

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FDA’s Premarket Clearance and Approval Requirements

Unless an exemption applies, each medical device we wish to commercially distribute in the United States will require either prior 510(k) clearance or prior premarket approval from the FDA. The FDA classifies medical devices into one of three classes. Devices deemed to pose lower risk to the patient are placed in either class I or II, which requires the manufacturer to submit a premarket notification requesting permission for commercial distribution. This process is known as 510(k) clearance. Most class I devices are exempted from this requirement. Devices deemed by FDA to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously cleared 510(k) device or a pre-amendment class III device for which premarket approval applications, or PMAs, have not been required by the FDA, are placed in class III, requiring premarket approval. All of our current products are class II devices.

510(k) Clearance Pathway. To obtain 510(k) clearance, we must submit a premarket notification demonstrating that the proposed device is substantially equivalent to a previously cleared 510(k) device or a device that was in commercial distribution before May 28, 1976 for which the FDA has not yet called for the submission of PMAs. By statute and regulation, the FDA is required to clear, deny, or request additional information on a 510(k) premarket notification within 90 days of submission of the application. As a practical matter, 510(k) clearance often takes significantly longer. The FDA may require further information, including clinical data, to make a determination regarding substantial equivalence.

We received 510(k) clearance for our INRatio System for professional use in May 2002, and for use in patient self-testing in October 2002. The components of our system include the meter, test strips, blood lancets, blood collection device and power supplies. A printer, manufactured by a third-party, is available as an accessory.

Product Modifications

After a device receives 510(k) clearance, any modification 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 could require a premarket approval. The FDA requires each manufacturer to make this determination initially, but the FDA can review any of these decisions. We have modified various aspects of our INRatio System since receiving regulatory clearance, but we believe that new 510(k) clearances are not required for these modifications. If the FDA disagrees with our determination not to seek new 510(k) clearances, the FDA may require us to seek 510(k) clearance or premarket approval. The FDA also can require us to cease marketing and/or recall the modified device until 510(k) clearance or premarket approval is obtained. Also, in these circumstances, we may be subject to warning letters, significant regulatory fines or penalties, seizure or injunctive action, or criminal prosecution.

Premarket Approval Pathway. If the FDA denies 510(k) clearance for one of our products or if one of our products is not eligible for 510(k) clearance, we must follow the premarket approval pathway for that product

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before marketing commences. A PMA requires reasonable assurance of the safety and effectiveness of the device to the FDA’s satisfaction. A PMA must provide extensive pre-clinical and clinical trial data and also information about the device and its components, including, among other things, device design, manufacturing and labeling. After approval of a PMA, a new premarket approval or premarket approval supplement is required in the event of a significant modification to the device, its labeling or its manufacturing process. The premarket approval pathway is much more costly, lengthy and uncertain than 510(k) clearance. It generally takes from one to three years or even longer from submission of a complete application to PMA approval.

No device that we have developed has required premarket approval, nor do we currently expect that any future device or indication will require premarket approval.

Pervasive and Continuing FDA Regulation

After a device is placed on the market, numerous regulatory requirements apply. These include:

We will need to continue to invest significant time and other resources to ensure ongoing compliance with FDA quality system regulations and other postmarket regulatory requirements.

The FDA enforces the quality system regulations, or QSRs, through scheduled and through unannounced inspections. We recently underwent an inspection of our facilities by the FDA, which resulted in the issuance of an FDA Form 483 containing two observations. First, the inspector observed that we failed to timely file Medical Device Reports, or MDRs, for six of seven complaints the inspector reviewed claiming that our INRatio device took inaccurate readings none of which resulted in a patient injury. MDRs are required to be filed, even if an injury has not occurred, if our device may have caused or contributed to a death or serious injury or if it may have malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur. We categorize as complaints instances reported to us in which our device takes a reading that is different from what the user expected. For example, discrepant results can be different readings obtained by the user on separate occasions using either the same or another testing device. In addition to potential device malfunction, discrepant PT/INR test results can arise from a number of factors, such as failure to follow our instructions for use, a patient’s medication or diet between measurements, or variability in measurement results among different manufacturers’ instruments. Since we began selling our product, we have received complaints of discrepant test results representing approximately .01% of all test strips sold. At the time that we received the complaints reviewed by the FDA, our written procedure did not provide for the analysis of whether to file an MDR if the complaint solely involved discrepant results, without any resulting patient injury. In addressing the FDA’s observation, we have revised our MDR reporting procedure to now determine when discrepancies between measurements taken with our device and those taken with a clinical laboratory device should be classified as a malfunction and result in an MDR filing. As a result of this revised procedure, we will be filing an increased number of MDRs. The FDA’s second observation was that we had not properly defined and documented the

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procedures we employ to identify the statistical techniques for calibration of our test strips. This observation requires us to provide clarification of how our current strip calibration procedures are in conformity with standards applicable to PT/INR testing. We have filed a response to these observations that includes a description of and basis for our revised MDR reporting procedure, as well as the documentation of procedures employed to identify valid statistical techniques for our test strip calibration and our conformity to applicable standards. The FDA subsequently issued a Warning Letter on October 5, 2005. The Warning Letter indicates that the FDA believes that our response did not provide sufficient detail and documentation for the FDA to evaluate whether our corrective actions would be adequate to prevent recurrence of the observations. We have submitted a further written response to the FDA, which we believe addresses this concern. The FDA has accepted our response, but there can be no assurance that the FDA will not in the future impose more serious enforcement actions, which may include the following sanctions:

We are subject to unannounced inspections by the FDA and the Food and Drug Branch of the California Department of Health Services, and these inspections may include the manufacturing facilities of our subcontractors. Our most recent inspections by these agencies resulted in no observations.

CLIA waiver. The Clinical Laboratory Improvement Amendments, or CLIA, is intended to ensure the quality and reliability of clinical laboratories in the United States by mandating specific standards in the areas of personnel qualifications, administration, participation in proficiency testing, patient test management, quality control, quality assurance and inspections. The regulations promulgated under CLIA establish three levels of diagnostic tests: waiver, moderately complex and highly complex, and the standards applicable to a clinical laboratory depend on the level of tests it performs. A CLIA waiver is available to clinical laboratory test systems if they meet certain requirements established by the statute. Waived tests are exempt from quality standards and are defined as simple tests having an insignificant risk of an erroneous result. Following the 510(k) clearance of our self-testing submission, we applied for a CLIA waiver for professional use of our INRatio System and received that waiver in December 2002. For patient self-testing, the INRatio System was waived under a CLIA provision that provides that tests approved by the FDA for home use automatically qualify for CLIA waiver.

International

International sales of medical devices are subject to foreign government regulations, which vary substantially from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval, and the requirements may differ.

The primary regulatory environment in Europe is that of the European Union, which consists of 25 countries encompassing most of the major countries in Europe. Other countries, such as Switzerland, have voluntarily adopted laws and regulations that mirror those of the European Union with respect to medical devices. The European Union has adopted numerous directives and standards regulating the design, manufacture, clinical trials, labeling, and adverse event reporting for medical devices. Devices that comply with the requirements of a relevant directive will be entitled to bear CE conformity marking, indicating that the device conforms with the essential requirements of the applicable directives and, accordingly, can be commercially distributed throughout Europe. The method of assessing conformity varies depending on the class of the product, but normally involves a combination of self-assessment by the manufacturer and a third-party assessment by a “Notified Body.” This third-party assessment may consist of an audit of the manufacturer’s quality system and specific testing of the

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manufacturer’s product. An assessment by a Notified Body in one country within the European Union is required in order for a manufacturer to commercially distribute the product throughout the European Union. In November 2002, our INRatio System was certified by TÜV Rhineland Product Safety of Cologne, Germany, a Notified Body, under the European Union In-Vitro Diagnostic Directive allowing the CE conformity marking to be applied and marketing to commence throughout the European Union.

Third Party Reimbursement

Healthcare providers that purchase medical devices, such as the INRatio System, generally rely on third party payors, including Medicare and Medicaid programs and private payors, such as indemnity insurers, employer group health insurance programs and managed care plans, to reimburse all or part of the cost of the products and services they provide to patients. The INRatio System will be sold principally to independent diagnostic testing facilities, or IDTFs, anticoagulation clinics, and physician practices that receive reimbursement from these third parties. As a result, demand for the INRatio System is dependent in part on the coverage and reimbursement policies of these payors.

Medicare Coverage and Reimbursement for Anticoagulation Self-Testing

Medicare published a National Coverage Decision, or NCD, memorandum in May 2002, which provided certain coverage for Medicare beneficiaries with mechanical heart valves. This determination covered anticoagulation self-testing as a diagnostic testing service paid under the Physician Fee Schedule through IDTF and physician services.

To qualify for coverage under Medicare, the NCD requires patients with mechanical heart valves to have been on anticoagulation therapy for a minimum of three months, to undergo training on anticoagulation management and on the use of the self-monitoring device, and to perform tests according to the prescribing physician’s order, but no more frequently than once a week.

For eligible beneficiaries, Medicare provides reimbursement for training the beneficiary on anticoagulation management and proper use of the self-testing device, physician review of the test results and the equipment and supplies required to perform the test.

Medicare Point-of-care Reimbursement

Reimbursement for testing in a physician’s office has been covered as outpatient services and reimbursed under Current Procedural Terminology codes. These codes cover all in-vitro diagnostic tests regardless of how the test is performed. Additionally, the physician can bill for an office visit in conjunction with performing the test.

Government reimbursement encourages point-of-care over central laboratory testing by paying for patient evaluation and management when done in the physician office or an anticoagulation clinic under the supervision of a physician. Evaluation and management services include reviewing the patient history, examining the patient, reading and interpreting the test results, determining if dosage change is necessary, and counseling the patient. In contrast, if the physician’s staff or anticoagulation clinic does a venous draw, sends the sample to the lab and calls the patient with the results and advice, no evaluation and management reimbursement is allowed.

Private Payors

Many third party private payors, including indemnity insurers, employer group health insurance programs and managed care plans, presently provide coverage for the patient’s purchase or health professional’s use of medical equipment which may include our INRatio System. The scope of coverage and payment policies varies among third party payors and may vary by region for certain private payors. To date, only a few of these payors have issued a coverage decision for any warfarin monitoring indication. Despite this, many private payors have

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been reimbursing individual patients on warfarin based on the medical necessity when provided by their physician. The possibility exists that coverage policies of individual third party payors may change unpredictably over time.

International

Point-of-care testing and reimbursement in the international marketplace is in various stages of approval and penetration. Point-of-care reimbursement outside the United States differs country by country, with the most advanced coverage of home testing established in 1996 for the German market. In Germany, both meters and test strips are provided to the patients through mechanical heart valve patient training centers or pharmacies. The Nordic region and the Netherlands work similar modes through thrombosis centers, while the UK government only covers the supplies and not the meter.

Employees

As of November 15, 2005, we had 76 full-time equivalent employees, including 35 engaged in manufacturing operations and quality assurance, 5 in research and development, 31 in sales and marketing and 5 in general and administrative functions. None of our employees is represented by a labor union or is covered by a collective bargaining agreement. We have never experienced any employment-related work stoppages and consider our employee relations to be good.

Available Information

We are subject to the reporting requirements under the Securities Exchange Act of 1934. Consequently, we are required to file reports and information with the Securities and Exchange Commission (SEC), including reports on the following forms: annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. You can read our SEC filings, including the registration statement, over the Internet at the SEC’s web site at http://www.sec.gov. You may also read and copy any document we file with the SEC at its public reference facilities at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You may also obtain copies of the documents at prescribed rates by writing to the Public Reference Room of the SEC at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Please call the SEC at (202) 551-8090 for further information on the operation of the public reference facilities.

You may also find on our website at http://www.hemosense.com electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The contents of our website are not incorporated by reference in this Annual Report on Form 10-K. Our charter for our Audit, Compensation and Nominating Governance Committees and our Code of Ethics are available on our website. In the event that we grant a waiver under our Code of Ethics, to any of our officers and directors, we will publish it on our website.

ITEM 2: PROPERTIES

We maintain our headquarters in San Jose, California in a 15,250 square foot facility, which includes manufacturing, research and development, marketing and general administrative functions. The lease for this facility expires in April 2009. We have the option to extend this lease for an additional five years, and a right of first offer for an adjacent facility as space becomes available in that facility. We believe our existing facility is adequate to meet our needs through the initial lease term, and that suitable additional space will be available in the future on commercially reasonable terms.

ITEM 3: LEGAL PROCEEDINGS

We are not party to any material pending or threatened litigation

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

None.

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PART II

ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock began trading on June 28, 2005 and is quoted on the American Stock Exchange, AMEX, under the symbol “HEM.” The following table sets forth the quarterly high and low trading prices for our common stock as reported by the AMEX for the periods indicated.

As of November 28, 2005, the last reported sales price of our common stock on the American Stock Exchange was $8.10 per share, and the number of holders of record was approximately 60. We currently intend to retain any earnings to fund the development and growth of our business.

During fiscal 2005, we have issued and sold the following unregistered securities:

1. On February 7, 2005, we issued and sold to accredited investors an aggregate of 2,124,218 shares of our Series C-3 preferred stock at a purchase price of $1.58 per share for an aggregate purchase price of $3,356,264. In connection with this transaction, these investors also participated in the following stock exchanges:

2. On February 16, 2005, we issued to an existing stockholder an aggregate of 94,936 and 95,249 shares of our common stock in connection with the conversion of 1,898,734 shares of our Series B-2 preferred stock and 1,905,024 shares of our Series C-2 preferred stock held by such stockholder, respectively, into shares of our common stock.

3. On March 1, 2005, we issued to an accredited investor warrants to purchase an additional 189,874 shares of our Series C-3 preferred stock at $1.58 per share for an aggregate exercise price of $300,001. As of November 15, 2005, none of these warrants had been exercised.

4. On April 25, 2005, we sold nonconvertible promissory notes in the aggregate principal amount of $1.5 million to existing stockholders. In consideration for the purchase of these notes we issued to these stockholders warrants to purchase an aggregate of 54,542 shares of our common stock at $5.50 per share.

The sales and issuances of securities in the transactions described in paragraphs 1 through 4 above were deemed to be exempt from registration under the Securities Act in reliance upon the following exemptions:

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During fiscal 2005, we granted options to purchase 319,000 shares of common stock to employees, directors and consultants under our 1997 Stock Plan at an exercise price of $0.80 to $7.00 per share for an aggregate exercise price of $425,700. These option grants were deemed to be exempt from registration under the Securities Act in reliance upon Rule 701 promulgated under Section 3(b) of the Securities Act, as transactions pursuant to a written compensation benefit plan and contracts relating to compensation as provided under Rule 701.

We registered for the initial public offering of our common stock, par value $0.001 per share, on a Registration Statement on Form S-1 (Registration No. 333-123705), which was declared effective on June 28, 2005. On July 1, 2005 we completed the initial public offering of our common stock by selling 3.5 million shares at $5.50 per share. Additionally on July 27, 2005, the underwriters exercised their over-allotment option to purchase 12,207 shares at $5.50 per share. Gross proceeds from the offering were $19.3 million. Total expenses from the offering were $2.6 million, which included underwriting discounts and commissions of $1.3 million, and $1.3 million in other offering-related expenses. Net offering proceeds, after deducting total expenses were $16.7 million. Of the $16.7 million in net proceeds, through September 30, 2005, we have spent approximately, $1.9 million for sales and marketing initiatives to support the ongoing commercialization of our INRatio System, $453,000 for research and development activities, including support of product development, regulatory and clinical study initiatives, $1.5 million for repayment of outstanding principal and interest due from promissory notes bearing interest at the rate of 6% annually held by affiliates, plus accrued interest, and $2.4 for working capital and general corporate purposes. In addition, we invested the proceeds from the offering in short-term, investment grade, interest-bearing instruments.

Dividend Policy

We have never declared or paid any cash dividends on our capital stock, and we do not currently intend to pay any cash dividends on our common stock in the foreseeable future. We expect to retain future earnings, if any, to fund the development and growth of our business. The declaration of dividends is subject to the discretion of our board of directors and will depend on various factors, including our results of operations, financial condition, future prospects and any other factors deemed relevant by our board of directors. In addition, the terms of any current or future debt or credit facility may preclude us from paying dividends on our common stock.

Equity Compensation Plans

The information require by this item regarding equity compensation plans is incorporated by reference under the section entitled Equity Compensation Plan Information contained in our proxy statement for our 2006 meeting of stock holders

ITEM 6: SELECTED FINANCIAL DATA

The selected financial data set forth below are derived from our financial statements. The statement of operations data for the years ended September 30, 2005, 2004 and 2003, and the balance sheet data as of September 30, 2005 and 2004 are derived from our audited financial statements included elsewhere in this Form 10-K. The historical results are not necessary indicative of results expected for any future period. The data presented below has been derived from financial statements that have been prepared in accordance with

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accounting principles generally accepted in the United States of America and should be read with our financial statements, including the accompanying Notes to the Financial Statements, and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K.

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The following discussion of our financial conditions and results of operations should be read in conjunction with our financial statements and the notes to those financial statements appearing elsewhere in this prospectus. This discussion contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Risk Factors” and elsewhere in this prospectus, our actual results may differ materially from those anticipated in these forward-looking statements.

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Overview

We develop, manufacture and sell easy-to-use, handheld blood coagulation monitoring systems for use by patients and healthcare professionals in the management of warfarin medication. Our product, the INRatio System, measures the patient’s blood clotting time to ensure that patients with a propensity to form clots are maintained within the therapeutic range with the proper dosage of oral anticoagulant therapy. Our system is 510(k) cleared by the FDA for use by healthcare professionals as well as for patient self-testing. Our system is also CE marked in Europe. The INRatio System is targeted to both the professional, or point-of-care, market as well as the patient self-testing market, the latter being an opportunity that has emerged primarily following the establishment of Medicare reimbursement in 2002 for mechanical heart valve patients.

We believe the key factors underlying our past and anticipated future revenue growth include:

Currently, Medicare and private payors reimburse PT/INR testing in the point-of-care environment for all indications. Medicare reimburses patient self-testing only for patients with mechanical heart valves, while reimbursement policies among private payors vary. Our revenue growth is dependent on such reimbursement continuing without any significant erosion in the reimbursement amounts. We believe that there is a significant opportunity in patient self-testing for other indications, such as atrial fibrillation, in the event that reimbursement is expanded. If Medicare reimbursement for patient self-testing by atrial fibrillation patients is not established in a timely fashion or at all, our revenue growth will be substantially limited.

Our cost of goods sold represents the cost of manufacturing our products. Our meters are manufactured for us by an electronics manufacturing service company, and we incur direct labor costs to assemble meters into packaged kits at our facility. Our cost of goods sold for the meter also includes an allowance for product warranty obligations. Our disposable test strips are manufactured by us at our facility, and our cost of goods sold is comprised of cost of materials, direct labor, associated overhead, yield losses and lot rejects, royalties on sales, and license fee costs. Included in royalties on sales is a royalty payable in connection with our settlement with Inverness. While this royalty does not become payable until mid July 2006, we capitalized a portion of the settlement amount as prepaid royalties and are expensing that amount through mid July 2006, as a cost of goods sold and do not believe that our obligation to pay royalties after that will have an adverse effect on our results of operations.

The manufacturing cost structure for our test strips currently includes a large component of fixed costs which is being spread over production that has not been maximized. Increases in production volume will be a significant factor for cost reduction for our test strips. During the fourth quarter of fiscal 2005 we achieved a gross margin for the first time. We believe continuing volume increases and process improvements will sustain and enhance cost reductions for our products in the future.

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Comparison of Fiscal Years Ended September 30, 2005 and September 30, 2004

The following table sets forth our results of operations (in thousands) expressed as a percentage of total revenue. Our historical operating results are not necessarily indicative of the results for any future period.

Revenue. Revenue increased by $5.5 million, or 170%, from $3.3 million in 2004 to $8.8 million in 2005. INRatio Meters and accessories increased by $2.2 million, or 136%, from $1.6 million in 2004 to $3.8 million in 2005. Test strips revenue increased by $3.3 million, or 203%, from $1.6 million in 2004 to $5.0 million in 2005. Approximately 72% of the growth in revenue was derived from the United States and approximately 28% from outside the United States. The increase in United States revenue was the result of increased market penetration primarily attributable to the addition of distributors and increased field personnel. The international revenue increase was primarily attributable to the expansion of the European market. For fiscal year 2006, we expect revenue for both domestic and international to significantly increase as we continue to penetrate the worldwide markets for our products.

Cost of goods sold. Cost of goods sold increased by $4.3 million, or 85%, from $5.1 million in 2004 to $9.4 million in 2005. As a percentage of revenue, cost of goods sold decreased from 156% of sales in the year ended September 30, 2004 to 107% in the same period in 2005. During our fourth quarter of fiscal 2005 we achieved a gross margin for the first time. This was due to volume increases over earlier periods and process improvements. We expect that as volume continues to increase, these cost reductions will continue to improve into the future. The $4.3 million increase in the cost of goods sold, was primarily due to the increase in number of meters and test strips sold. Included in cost of goods sold are royalties and amortization of technology licenses which increased by $409,000, from $377,000 in 2004 to $786,000 in 2005. The increase in royalty payments was due to the increase in test strip sales and a full year of amortization in fiscal 2005 for two technology licenses obtained during fiscal year 2004. The increases were partially off set by improvements in statistical process control and other quality improvements which reduced the amount of material scrap. Additionally, in the latter portion of fiscal year 2005 process improvements reduced the cost of test strips to a point which allowed us to eliminate the need for a lower of cost or market provision. In fiscal 2004, our cost of goods sold included a lower of cost or market provision of $301,000.

Research and development expenses. Research and development expenses decreased by $139,000, or 10%, from $1.4 million in 2004 to $1.3 million in 2005. The decrease was completely attributable to the continuing

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transfer of resources from research and development to manufacturing during the first nine months of fiscal 2005. During the next fiscal year, we expect research and development expense will increase as new projects are initiated.

Sales and marketing expenses. Sales and marketing expenses increased by $1.5 million, or 29%, from $5.2 million in 2004 to $6.7 million in 2005. The increase was primarily attributable to $1.3 million of payroll and travel expenses for additional personnel, $474,000 for promotion programs and $71,000 in bad debt provisions. This was partially offset by $370,000 decrease in marketing consultants. As a percentage of revenue, sales and marketing expenses were 77% in the year ended September 30, 2005 compared to 160% in the same period in 2004. The decrease in sales and marketing expense as a percentage of revenue is due to the revenue increase relative to the marketing programs and efforts of the sales staff. We expect sales and marketing spending will increase in fiscal 2006 but to decrease as a percentage of revenue.

General and administrative expenses. General and administrative expenses increased by $463,000, or 31%, from $1.5 million in the fiscal year 2004 to $2.0 million in the fiscal year 2005. The increase was primarily attributable to payroll and other benefits increase of $330,000 primarily from increased head count. Additionally, professional services and insurance increase by $216,000 related to the cost of being a public company. The decreased need for other consultants resulted in a $99,000 decline as full-time personnel were hired. As a percentage of revenues, general and administrative expenses were 22% in the year ended September 30, 2005 compared to 46% in the same period in 2004. The decrease in general and administrative expenses as a percentage of revenue is due mainly to the rapid expansion of revenue which without the need for a proportional increase in staff. We expect general and administrative expenses will increase during fiscal year 2006 due the costs relating to being a public company for a full year which may include the use of more consultants and increased staff.

Interest Income. Interest income increased by $114,000, or 713%, from $16,000 in fiscal year 2004 to $130,000 in fiscal year 2005. The increase related to returns on short term investments purchased with a portion of the funds received from the initial public offering. Over the next year, we anticipate interest income will increase due to the increase short term investments purchased in July 2005 and the proceeds from the private placement in November 2005.

Interest expense. Interest expense increased by $1.0 million, or 313%, from $318,000 in fiscal 2004 to $1.3 million in fiscal 2005. The increase was attributable the full drawdown of a $7.5 million borrowings in January 2005, interest on $1.5 million short term notes payable which were repaid in July 2005 and accrued interest expense related to a note payable to Inverness Medical Innovations.

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Comparison of Fiscal Years Ended September 30, 2004 and September 30, 2003

The following table sets forth our results of operations (in thousands) expressed as a percentage of total revenue. Our historical operating results are not necessarily indicative of the results for any future period.

Revenue. Revenue increased by $2.8 million, or 661%, from $427,000 in 2003 to $3.3 million in 2004. Approximately 76% of the growth in revenue was derived from the United States and approximately 24% was derived from outside the United States. Revenue for meters and accessories increased by $1.3 million, or 453%, from $292,000 in 2003 to $1.6 million in 2004. Revenue for test strips increased by $1.6 million, or 1,114%, from $135,000 in 2003 to $1.7 million in 2004. We started selling our products in March 2003. The increase in United States revenue was primarily attributable to the addition of two national distributors and increased field personnel. The increase in international revenue was primarily attributable to the addition of nine distributors.

Cost of goods sold. Cost of goods sold increased by $3.5 million, or 233%, from $1.6 million in 2003 to $5.1 million in 2004. Cost of goods sold for meters and accessories increased by $649,000, or 446%, from $145,000 in 2003 to $794,000 in 2004. Cost of goods sold for test strips increased by $2.9 million, or 211%, from $1.4 million in 2003 to $4.3 million in 2004. The increase of $2.1 million was primarily due to the increase in number of meters and test strips sold. In addition, due to manufacturing scale up problems, several test strip lots and subassemblies with a manufacturing cost of $1.0 million were rejected and written-off in 2004. Royalties and amortization of technology licenses increased by $369,000, from $8,000 in 2003 to $377,000 in 2004 due to the increase in test strip sales and two technology licenses obtained in 2004. As a percentage of revenue, cost of goods sold decreased from 356% of sales in the year ended September 30, 2003 to 156% in the same period in 2004 due primarily to increased volume of test strip production without an equivalent increase in factory spending.

Research and development expenses. Research and development expenses decreased by $283,000, or 17%, from $1.7 million in 2003 to $1.4 million in 2004. The decrease was primarily attributable to the full year impact in 2004 of resources in research and development that were transferred to manufacturing in the middle of 2003. As a percentage of revenue, research and development expenses were 43% in the year ended September 30, 2004 compared to 394% in the same period in 2003 due primarily to the redirection of activities from development to manufacturing.

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Sales and marketing expenses. Sales and marketing expenses increased by $2.0 million, or 63%, from $3.2 million in 2003 to $5.2 million in 2004. The increase was primarily attributable to $1.7 million of payroll and travel expenses for additional personnel, $256,000 for marketing consultants and $110,000 for promotion programs. As a percentage of revenue, sales and marketing expenses were 160% in the year ended September 30, 2004 compared to 746% in the same period in 2003. This was primarily the result of leveraging distributors’ sales force to increase sales without a proportional increase in the Company’s head count.

General and administrative expenses. General and administrative expenses increased by $587,000, or 64%, from $912,000 in 2003 to $1.5 million in 2004. The increase of $319,000 was primarily attributable to increased administrative personnel and consultants, legal expenses of $125,000 related to an intellectual property infringement action, and $83,000 for increased coverage for liability and business insurance. As a percentage of revenues, general and administrative expenses were 46% in the year ended September 30, 2004 compared to 214% in the same period in 2003.

Interest and other expense, net. We recognized interest expense of $318,000 for the year ended September 30, 2004, an increase of $251,000 from $67,000 for the same period in 2003. The increase was attributable to interest expense on amounts drawn down against a debt line of $7.5 million which was put in place in March 2004, as well as interest expense related to a note payable.

Liquidity and Capital Resources

Since our inception, our operations have been primarily financed through the sale of equity securities, both public and private, bank equipment financing loans, debt capital and capital leases. As of September 30, 2005, our cash, cash equivalents and short term investments were $11.5 million. All of our cash equivalents and investments have original maturities of one year or less.

On November 5, 2005 the Company closed a private equity offering of 1,481,482 shares of the Company’s common stock at $6.75 per share. Gross proceeds from the offering were $10.0 million. Net proceeds were $9.2 million after offering expenses included underwriting discounts and commissions.

During the fiscal year ended September 30, 2005, our operating activities used cash of approximately $11.9 million, compared to approximately $9.5 million for the fiscal year ended September 30, 2004, an increase of $2.3 million. Cash used in operating activities increased by $2.3 million due to our increased net loss and additional investment in accounts receivable and inventory. The net loss for the current year (less depreciation and other non-cash items) used $253,000 more cash than last year. An additional $2.3 million was used for changes in current assets and liabilities. Cash used for expanding inventories was $1.6 million for the fiscal year 2005, an increase of $1.2 million from fiscal year 2004, due to material purchased to meet our expected future sales. The change in accounts receivable was $1.3 million for the fiscal year 2005, an increase of $407,000 from $773,000 used for the same period in 2004 due to higher sales during the fourth quarter of the current year. We expect future increases in revenue to result in increases in the need for working capital due to increases in accounts receivable and inventories but at a lower rate than the current year increases.

Our investing activities used cash of approximately $8.2 million during fiscal year 2005 compared to $429,000 for fiscal year 2004. Investing activities during fiscal 2005 primarily consisted of the purchase of short term investments with the proceeds of our initial public offering.

Cash provided by financing activities was approximately $23.2 million for fiscal year 2005 compared to $4.9 million provided during fiscal year 2004. The increase in cash provided was primarily due to $16.7 million from the sale of common stock in our initial public offering. Additionally we incurred net borrowing of $3.2 million of proceeds from draw downs against a debt line facility and $3.3 million in preferred stock proceeds.

For the year ended September 30, 2004, our operating activities used cash of approximately $9.5 million. This was an increase of $2.8 million from the cash used in operating activities of $6.7 million for the year ended

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September 30, 2003. This change was primarily due to a loss of $10.3 million in the year ended September 30, 2004 compared to a loss of $6.9 million in 2003. Offsetting the loss were adjustments for non-cash items which reduced cash used in operations in the year ended September 30, 2004 by $1.0 million compared to $270,000 in 2003. The change in accounts receivable was $773,000 for the year ended September 30, 2004, an increase of $639,000 from $134,000 for the same period in 2003, which was related to an increase in our sales. The change in inventories was $319,000 for the year ended September 30, 2004, an increase of $173,000 from $146,000 for the same period in 2003, which was due to an increase in our sales. During fiscal year 2003 we did not purchase any meters as we had a sufficient number in inventory. We did not commence purchasing meters again until the second quarter of fiscal year 2004.

For the year ended September 30, 2004, our investing activities used cash of approximately $429,000. This was an increase of $32,000 from cash used in investing activities of $397,000 for the year ended September 30, 2003 due to acquisitions of equipment.

For the year ended September 30, 2004, our financing activities generated $4.9 million. This was a decrease of $2.3 million from cash provided by financing activities of $7.2 million for the year ended September 30, 2003. The decrease was primarily due to proceeds from equity financing of $3.0 million for the year ended September 30, 2004 compared to $6.4 million for the year ended September 30, 2003. This decrease was offset by loan proceeds of $2.0 million, net of repayment of previous loans outstanding, for the year ended September 30, 2004 compared to $886,000 for the year ended September 30, 2003. In March 2004, we obtained a debt line from Lighthouse Capital Partners in the amount of $7.5 million to be drawn down over a 12-month period. During the draw down period interest-only payments were required to be made monthly on amounts drawn down and a usage fee was payable quarterly on unused amounts. As of March 1, 2005, we had drawn down the full amount of $7.5 million which is being amortized monthly over 36 months with a final payment of $937,500 due at the end of the term. In conjunction with the loan, we issued warrants to purchase Series C-3 preferred stock, which upon completion of our IPO, became exercisable for 118,670 shares of common stock at an exercise price of $6.32 per share. Upon receiving this credit line, we used the first draw down of $907,000 in March 2004 to repay the amount outstanding on the loans payable to Silicon Valley Bank. The Silicon Valley Bank loans were drawn down under a $1.75 million equipment financing line of credit obtained by us in July 2003. The Silicon Valley Bank loans amortized over a 36-month term and also included warrants to purchase Series C-3 preferred stock, which upon completion of our IPO, became exercisable for 8,307 shares of common stock at an exercise price of $6.32 per share.

During the fiscal year ended September 30, 2003, our operating activities used cash of approximately $11.9 million. The use of cash was due to our net loss of $6.9 million, increased accounts receivable and inventories. The increase in receivables related to higher sales during fiscal year 2003 and the increase in inventory was to support the anticipated demand for products in the next fiscal year. Cash used in investing activities of $397,000 related to the purchase of capital asset.

As of September 30, 2005, we had a long-term loan, a long-term note payable and capital lease obligations, commitments under a facility operating lease, equipment rental lease and non-cancelable purchase commitments. We had no other off-balance sheet items or commitments. Future payments under these obligations are included in the table below for each of the fiscal years ending September 30 (in thousands):

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During fiscal year 2005, we had drawn down an additional $4.6 million on the loan payable to lighthouse Capital. These draw downs resulted in us fully utilizing the debt line of $7.5 million that was available. As of September 30, 2005 we have made principal payments of $1.4 million relating to loan payable. In addition, in April 2005, we received $1.5 million in unsecured debt financing from certain preferred stockholders and in connection with that transaction issued to those stockholders warrants exercisable for shares of our common stock. This debt to preferred stockholders was repaid with interest in July 2005.

We believe that our existing cash and cash equivalents, proceeds from our private placement in November 2005 and cash generated from product sales, will be sufficient to meet our anticipated cash requirements for at least the next 12 months. Our future capital requirements are difficult to forecast and will depend on many factors, including:

If at any time sufficient capital is not available, either through existing capital resources or through raising additional funds, we may be required to delay, reduce the scope of, eliminate or divest one or more of our sales and marketing programs, research and development programs or our entire business. We may raise additional funds through public or private offerings, debt financings, capital leases, corporate collaborations or other means. Due to the uncertainty of financial markets, financing may not be available to us when we need it on acceptable terms or at all. Therefore, we may raise additional capital from time to time when market conditions are favorable, or if strategic considerations require us to do so, even if we have sufficient funds for planned operations.

Critical Accounting Policies and Estimates

We prepare our financial statements in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that

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affect the reported amounts of assets, liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies are as follows:

Concentration of Credit Risk

Financial instruments which potentially subject the Company to concentrations of risk consist principally of cash and cash equivalents and accounts receivable. The Company’s cash is invested in deposits with one financial institution. At times, cash deposits may be in excess of insured limits. Management believes that the financial institution which holds the Company’s cash and cash equivalents is financially sound and, minimal credit risk exists with respect to these investments.

Inventories

Inventories are stated at the lower of cost or market, cost being determined under a standard cost method, which approximates first-in, first-out basis.

The manufacturing cost of test strips previously exceeded their selling price. As a result, the Company recorded a charge to cost of goods sold on test strips inventory equal to the amount by which the manufacturing cost exceeds the average market selling price. Inventories are evaluated and any non-usable inventory is written off. In addition, the Company reserves for any inventory that may be potentially on-usable. Charges for such write-offs and reserves are recorded as a component of cost of goods sold. Changes in demand in the future could cause the Company to have additional write-offs and reserves.

Impairment of long-lived assets

The Company reviews long-lived assets, including property and equipment and intangibles, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value. The Company considers various valuation factors, principally discounted cash flows, to assess the fair values of long-lived assets. To date, the Company has not recorded any impairment losses.

Intangible Assets

Intangible assets are comprised of licensed technologies, carried at cost less accumulated amortization. Amortization is computed using a straight-line method over the shorter of the estimated useful lives or the term of the license agreements.

Revenue Recognition

We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, title has transferred to our customers, the price is fixed and determinable and collection is reasonably assured. Provisions for discounts to customers, returns or other adjustments are recorded as a reduction of revenue and provided for in the same period that the related product sales are recorded based upon analysis of historical discounts and returns. When terms of sale are Freight on Board, or FOB, shipping point, revenue is recognized at time of shipment and when the terms of sale are FOB receiving point, revenue is recognized when the products have reached the destination point and other criteria for revenue recognition have been met. Shipping and handling charges are invoiced to customers based on the amount of products sold. Shipping and handling fees are recorded as revenue and the related expense as cost of goods sold.

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We offer an early payment discount to certain customers. We provide certain customers product return rights in limited circumstances. To date, we have experienced no product returns and have determined that a reserve for product returns is not necessary. Future changes in our experience with product returns may cause us to make changes in our reserve for product returns. Our inability to accurately estimate product returns in the future may cause us to defer recognition of revenue. We will, from time to time, provide free products to customers. The cost of these free products is charged to cost of goods sold.

Allowance for Doubtful Accounts

While the Company has not had material bad debts written-off in the past, we analyze the collectibility of its accounts receivable, historical bad debts, customer concentrations, customer credit-worthiness, current economic trends, and changes in customer payment terms in evaluating whether an allowance needs to be made during the period.

Warranties

The Company records an accrual for estimated warranty costs when revenue is recognized. Warranty covers replacement costs of defective meters and related test strips. The warranty period is one year. The Company has processes in place to estimate accruals for warranty exposure. The processes include estimated failure rates and replacement costs, and known design changes. Although the Company believes it has the ability to reasonably estimate warranty expenses, unforeseen changes in factors impacting the estimate for warranty could occur and such changes could cause a material change in the Company’s warranty accrual estimate. Such a change would be recorded in the period in which the change was identified.

Income taxes

The Company accounts for income taxes under the liability method. Under this method, deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

Accounting for stock-based compensation

The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. The Company’s policy is to grant options with an exercise price equal to the estimated fair value of the Company’s stock on the grant date. Accordingly, no compensation cost has been recognized in the Company’s statement of operations for employee stock options. The Company provides additional pro forma disclosures as required under Statement of Financial Accounting Standard No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation, as amended by SFAS No 148, Accounting for stock-based compensation, transition and disclosure.

Under APB Opinion No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the estimated fair value of the Company’s stock and the exercise price. SFAS No. 123 defines a “fair value” based method of accounting for an employee stock option or similar equity instrument.

The Company accounts 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 which requires that such equity instruments are recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying equity instruments vest.

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Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which will replace SFAS No. 123 and APB 25. SFAS No. 123R addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. Under SFAS No. 123R, companies will no longer be able to account for share-based compensation transactions using the intrinsic method in accordance with APB 25, but will be required to account for such transactions using a fair-value method and recognize the expense in the consolidated statement of earnings. SFAS No. 123R is effective at the beginning of fiscal 2006.

In March 2005, the SEC issued Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”). SAB 107 provides guidance on the initial implementation of SFAS 123R. In particular, the statement includes guidance related to share-based payment awards for non-employees, valuation methods and selecting underlying assumptions such as expected volatility and expected term. SAB 107 also gives guidance on the classification of compensation expense associated with such awards and accounting for the income tax effects of those awards upon the adoption of SFAS 123R. We are currently assessing the guidance provided in SAB 107 in connection with the implementation of SFAS 123R.

Adoption of this statement is expected to have a significant impact on our financial statements as we will be required to expense the fair value of our stock option grants rather than disclose the impact on our net loss within our footnotes, as is our current practice. The full impact of SFAS 123R on our financial statements and related disclosures is still being evaluated by management but is expected to be material to our results of operations. Our actual share-based compensation expense in 2006 will be dependent on a number of factors, including the amount of awards granted and the fair value of those awards at the time of grant.

In June 2005, the FASB issued as final FSP No. FAS 150-5 “Issuers Accounting under FASB Statement No. 150 for Freestanding Warrants and Other Similar Instruments on Shares that are Redeemable”. The FSP clarifies that freestanding warrants and similar instruments on shares that are redeemable should be accounted for as liabilities under FASB Statement No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” regardless of the timing of the redemption feature or price, even though the underlying shares may be classified as equity. The FSP is effective for the first reporting period beginning after June 30, 2005. Although the Company does have outstanding warrants, the shares issued upon exercise of the warrants are not redeemable; consequently, the adoption of FSP No. FAS 150-5 has no impact on the Company’s results of operations or financial condition.

On June 7, 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements”. FAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. FAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. FAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. We do not believe that the adoption of FAS 154 will have a material effect on the Company’s financial position, results of operations or cash flows.

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Factors Affecting Future Operating Results

We have limited operating experience and a history of net losses. Unless we are able to significantly increase our revenue and reduce our costs, we may never achieve or maintain profitability.

We have a limited history of operations and have incurred net losses in each year since our inception. We received regulatory clearance to market our INRatio System in 2002 and began commercial sales in early 2003. During the past five fiscal years, we incurred net losses of $4.0 million in 2001, $4.7 million in 2002, $6.9 million in 2003, $10.3 million in 2004 and $11.7 million in 2005. As of September 30, 2005, we had an accumulated deficit of $47.2 million. We expect that our operating expenses will increase as we expand our business, devote additional resources to our research and development, sales and marketing efforts and incur the costs of being a public company.

Our common stock has been publicly traded for a short period of time, and we expect that the price of our common stock will fluctuate substantially.

Until June 2005, there was no public market for shares of our common stock. The market price for our common stock will be affected by a number of factors, including:

We have only been a public company for a short period of time. Changes in the price of our common stock will be unpredictable and any of these factors could cause our stock price to fluctuate substantially.

We will be unable to achieve profitability unless we increase revenue and decrease the cost of manufacturing our test strips.

We will need to both significantly increase the revenue we receive from sales of our product and, to the extent possible, reduce our costs in order to achieve profitability. It is possible that we will never generate sufficient revenue to achieve profitability. Our failure to achieve and maintain profitability would negatively affect our business and financial condition and the trading price of our common stock.

We may be unable to accurately predict our future performance, which could harm our stock price.

We provide guidance regarding future operating performance and our stock price is based, in part, upon those predictions. Because we have only recently become a publicly-traded company, it may be difficult for us to accurately predict our operating performance each quarter, and we believe that our quarterly results will fluctuate as a result of many factors outside of our control, such as:

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We believe that our stock price would decline if we are unable to meet or exceed our predicted performance.

We depend upon a single product. If our INRatio^® System fails to gain market acceptance our business will suffer.

The INRatio System is our only product. Sales of this product will account for substantially all of our revenue for the foreseeable future. We cannot be sure that we will be successful in convincing patients and healthcare professionals to use our product. Certain competitors have products that are established in our target markets, and we may not be able to convince users of those products to switch to the INRatio System. Healthcare professionals may be hesitant to recommend our product to their patients given our short operating history and the fact that we are a relatively small company. If our product fails to gain acceptance in the point-of-care and patient self-testing markets, our business will be harmed.

The performance of our product may not be perceived as being comparable with established laboratory methods, which may limit the market acceptance of our product.

The majority of PT/INR testing has historically been and continues to be performed by large hospital or commercial laboratories. Healthcare professionals responsible for managing patients on warfarin therapy have experience with and confidence in the results generated by these large laboratories. In addition, these professionals influence many treatment decisions, including aspects critical to our business such as how often testing is to be performed, who is to perform the testing, and where testing is to be performed. In some instances, these decision makers may determine that our INRatio System test results lack the clinical history and reliability of large laboratories. If we are unable to demonstrate to physicians’ satisfaction that the performance of our INRatio System closely matches the results produced by these laboratories, market acceptance of our product will be limited.

We recently completed an FDA inspection and received a Warning Letter, which could lead to regulatory enforcement action.

Our product and facilities are subject to continual review and periodic inspections by the FDA and other regulatory bodies. In particular, we are required to comply with quality system regulations, or QSR, and other regulations, which cover the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage, shipping and post market surveillance of our product. The FDA enforces the QSR through scheduled and through unannounced inspections. We recently underwent an inspection of our facilities by the FDA, which resulted in the issuance of an FDA Form 483 containing two observations. First, the inspector observed that we failed to timely file Medical Device Reports, or MDRs, for six of seven complaints the inspector reviewed claiming that our INRatio device took inaccurate readings. MDRs are required to be filed if our device malfunctions in a way that would likely cause or contribute to a death or serious injury if it were to recur. The second observation was that we had not properly defined and documented the procedures we employ to identify the statistical techniques for calibration of our test strips. We have filed a response to these observations. The FDA subsequently issued a Warning Letter on October 5, 2005. The Warning Letter indicates that the FDA believes that our response did not provide sufficient detail and documentation for the FDA to

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evaluate whether our corrective actions would be adequate to prevent recurrence of the observations. We have submitted a further written response to the FDA, which we believe addresses this concern. The FDA has accepted our response, but there can be no assurance that the FDA will not in the future impose more serious enforcement actions, which may include the following sanctions:

If any of these actions were to occur, it would harm our reputation and cause our product sales and profitability to suffer. Responding to inspectional observations may be time consuming and costly.

We are filing an increasing number of MDRs, which could harm market adoption of our product.

In order to correct an FDA observation during our recent inspection, we have revised our written procedure that describes when to file an MDR. Our revised procedure requires us to file MDRs for device malfunctions, including all allegations of inaccurate readings by our device. As a result, we have been filing, and expect to continue to file, an increased number of MDRs. MDRs are publicly available, and competitors could use this information in an attempt to disrupt our customer and potential customer relationships, which could harm market adoption of our product.

The success of our business is largely dependent upon the growth of the PT/INR patient self-testing market. If that market fails to develop as we anticipate, our results will be adversely affected

Our business plan is targeted at the emerging PT/INR patient self-testing market and our product has been designed to address that market. We cannot be sure that this market will grow as we anticipate. Such growth will require greater advocacy of patient self-testing from both healthcare professionals and patients than currently exists. Future research and clinical data may not sufficiently support patient self-testing as a safe or effective alternative to clinical laboratory testing or point-of-care testing, which could inhibit adoption of patient self-testing. If healthcare professionals fail to advocate self-testing for their patients or if patients do not become comfortable with it, self-testing may fail to become the standard practice for PT/INR measurement. If patient self-testing fails to be adopted at the rate we expect, our anticipated growth will be adversely affected and our results will suffer.

We operate in a highly competitive market and face competition from large, well-established medical device manufacturers with significant resources. If we fail to compete effectively, our business will suffer.

The market for point-of-care and patient self-testing PT/INR measurement systems is intensely competitive, subject to rapid change, new product introductions and other activities of industry participants. We currently compete directly against Roche Diagnostics, the largest diagnostic company in the world, and International Technidyne Corporation, a division of Thoratec. Together these two companies currently account for substantially all of the point-of-care and patient self-testing PT/INR measurement market. Several other companies, including Inverness Medical Innovations, have announced that they are developing new products that would compete directly against us, and we expect one or more new products to become available next year. In addition, other companies, including Johnson & Johnson and Beckman Coulter, have developed or acquired directly competitive products for the PT/INR market in the past, and while they are not current competitors, they could re-enter the market at any time. Additionally, these and other potential competitors hold intellectual

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property rights that could allow them to develop or sell the right to develop new products that could compete effectively with our INRatio System. All of these companies are larger than us and enjoy several competitive advantages, including: