SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20459
 
FORM 10-Q
 
(Mark One) 
xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended JuneSeptember 30, 2010
or
oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                          to
 
COMMISSION FILE NUMBER 0-20970
 
VISION-SCIENCES, INC.
(Exact name of registrant as specified in its charter)
 
Delaware13-3430173
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification Number)
40 Ramland Road South, Orangeburg, NY10962
(Address of principal executive offices)(Zip Code)
 
(845) 365-0600
(Registrant’s telephone number, including area code)
 

(Former name, former address, and
former fiscal year if changed since last report)
 
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 requirement for the past 90 days. Yes x    No o
 
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate website, if any every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x  No  o

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, non-accelerated filer, or smaller reporting company. See definitions of “accelerated filer”, “large accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company x
 
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).         Yes o    No x
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of August 11,November 10, 2010
 
Common Stock, par value of $0.0137,593,05637,708,815
(Title of Class)(Number of Shares)

 
 
 

VISION-SCIENCES, INC.
TABLE OF CONTENTS
 
Part I.Financial Information 
 Item 1.Financial Statements 
  Condensed Consolidated Balance Sheets3
  Condensed Consolidated Statements of Operations4
  Condensed Consolidated Statement of Stockholders’ Equity5
  Condensed Consolidated Statements of Cash Flows6
  Notes to Condensed Consolidated Financial Statements7
 Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations1315
 Item 3.Quantitative and Qualitative Disclosures about Market Risk2027
 Item 4.Controls and Procedures2027
    
Part II.Other Information 
 Item 1.Legal Proceedings2128
 Item 1A.Risk Factors2128
 Item 2.Unregistered Sales of Equity Securities and Use of Proceeds2128
 Item 3.Defaults Upon Senior Securities2128
 Item 4.(Removed and Reserved)Submission of Matters to a Vote of Stockholders2129
 Item 5.Other Information2129
 Item 6.Exhibits2229
 Signatures2330

 
2
 

PART I—FINANCIAL INFORMATION
 
Item 1: Financial Statements
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(In thousands, except per share amounts)
 
 June 30,  March 31,  September 30,  March 31, 
 2010  2010  2010  2010 
ASSETS (unaudited)     (unaudited)    
Current assets:            
Cash and cash equivalents $2,305  $2,540  $4,480  $2,540 
Short-term investments  497   447   -   447 
Accounts receivable, net of allowance for doubtful accounts of $117     
and $347, respectively  1,780   1,147 
Accounts receivable, net of allowance for doubtful accounts of $115 and $347, respectively  1,591    1,147  
Inventories, net  3,915   4,175   4,635   4,175 
Prepaid expenses and other current assets  309   886   222   886 
Total current assets  8,806   9,195   10,928   9,195 
                
Property and equipment, at cost:                
Machinery and equipment  3,816   3,584   4,090   3,584 
Furniture and fixtures  225   225   226   225 
Leasehold improvements  357   357   359   357 
  4,398   4,166   4,675   4,166 
Less—accumulated depreciation and amortization  2,425   2,237   2,609   2,237 
Total property and equipment, net  1,973   1,929   2,066   1,929 
Other assets, net of accumulated amortization of $85 and $84,     
respectively  78   79 
Deferred debt cost, net of accumulated amortization of $58     
and $31, respectively  356   296 
Other assets, net of accumulated amortization of $87 and $84, respectively   76   79 
Deferred debt cost, net of accumulated amortization of $94 and $31, respectively   320   296 
Total assets $11,213  $11,499  $13,390  $11,499 
                
LIABILITIES AND STOCKHOLDERS' EQUITY                
Current liabilities:                
Capital lease obligations $46  $55  $39  $55 
Accounts payable  832   867   1,658   867 
Accrued expenses  795   984   713   984 
Accrued compensation  1,047   1,107   1,085   1,107 
Advances from customers  3,777   - 
Total current liabilities  2,720   3,013   7,272   3,013 
Line of credit—related party  4,500   2,500   4,500   2,500 
Capital lease obligations, net of current portion  51   61   41   61 
Total liabilities  7,271   5,574   11,813   5,574 
                
Commitments and Contingencies (Note 6)                
Stockholders’ equity:                
Preferred stock, $0.01 par value—        
Authorized—5,000 shares        
issued and outstanding—none  -   - 
Common stock, $0.01 par value—        
Authorized—50,000 shares        
issued and outstanding—37,593 shares and 36,856 shares     
at June 30, 2010 and March 31, 2010, respectively  376   369 
Preferred stock, $0.01 par value—Authorized—5,000 shares issued and outstanding—none
  -   - 
Common stock, $0.01 par value—Authorized—50,000 shares issued and outstanding—37,709 shares and 36,856 shares, respectively
  377   369 
Additional paid-in capital  82,447   81,968   83,095   81,968 
Accumulated deficit  (78,881)  (76,412)  (81,895)  (76,412)
Total stockholders’ equity  3,942   5,925   1,577   5,925 
Total liabilities and stockholders’ equity $11,213  $11,499  $13,390  $11,499 
 
See accompanying notes to condensed consolidated financial statements.
 
 
3
 
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(In thousands, except per share amounts)
(Unaudited)
 
  Three Months Ended 
  June 30, 
  2010  2009 
       
Net sales $2,632  $3,318 
Cost of sales  1,943   2,530 
Gross profit  689   788 
         
Selling, general, and administrative expenses  2,478   2,482 
Research and development expenses  598   786 
Loss from operations  (2,387)  (2,480)
         
Interest income  2   50 
Interest expense  (55)  - 
Debt cost expense  (27)  - 
Other, net  1   (28)
Loss before provision for income taxes  (2,466)  (2,458)
Income tax provision  3   10 
Net loss $(2,469) $(2,468)
         
Net loss per common share - basic and diluted $(0.07) $(0.07)
         
Shares used in computing net loss        
per common share  36,856   36,854 
  Three Months Ended  Six Months Ended 
  September 30,  September 30, 
  2010  2009  2010  2009 
             
Net sales $2,325  $2,889  $4,957  $6,207 
Cost of sales  1,684   2,424   3,627   4,954 
Gross profit  641   465   1,330   1,253 
                 
Selling, general, and administrative expenses  2,795   2,707   5,273   5,189 
Research and development expenses  732   897   1,330   1,683 
Loss from operations  (2,886)  (3,139)  (5,273)  (5,619)
                 
Interest income  1   21   3   71 
Interest expense  (90)  (46)  (145)  (46)
Debt cost expense  (36)  -   (63)  - 
Other, net  (1)  -   -   (28)
Loss before provision for income taxes  (3,012)  (3,164)  (5,478)  (5,622)
Income tax provision  2   6   5   16 
Net loss $(3,014) $(3,170) $(5,483) $(5,638)
                 
Net loss per common share - basic and diluted $(0.08) $(0.09) $(0.15) $(0.15)
                 
Shares used in computing net loss per common share
  36,901   36,854   36,879   36,851 
 
See accompanying notes to condensed consolidated financial statements.
 
 
4
 
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Statements of Stockholders’ Equity
(In thousands, except per share amounts)
(Unaudited)

 Common Stock  Additional     Total 
 Number  $0.01  Paid-in  Accumulated  Stockholders’ 
 of Shares  Par Value  Capital  Deficit  Equity 
Balance at March 31, 2009 36,818  $368  $80,031  $(63,988) $16,411 
Exercise of stock options 38   1   42   -   43 
Issuance of stock warrants -   -   327   -   327 
Stock-based compensation expense -   -   1,568   -   1,568 
Net loss -   -   -   (12,424)  (12,424)
Balance at March 31, 2010 36,856   369   81,968   (76,412)  5,925 
Issuance of stock warrants -   -   87   -   87 
Issuance of restricted stock awards 737   7   -   -   7 
Stock-based compensation expense -   -   392   -   392 
Net loss -   -   -   (2,469)  (2,469)
Balance at June 30, 2010 37,593  $376  $82,447  $(78,881) $3,942 
  Common Stock          
  
Number
of Shares
  $
0.01
Par Value
  
Additional
Paid-in Capital
  
Accumulated
Deficit
  
Total Stockholders’
 Equity
 
Balance at March 31, 2009  36,818  $368  $80,031  $(63,988) $16,411 
Exercise of stock options  38   1   42   -   43 
Issuance of stock warrants  -   -   327   -   327 
Stock-based compensation expense  -   -   1,568   -   1,568 
Net loss  -   -   -   (12,424)  (12,424)
Balance at March 31, 2010  36,856   369   81,968   (76,412)  5,925 
Exercise of stock options  98   1   108   -   109 
Issuance of stock warrants  -   -   87   -   87 
Issuance of restricted stock awards  755   7   -   -   7 
Stock-based compensation expense  -   -   932   -   932 
Net loss  -   -   -   (5,483)  (5,483)
Balance at September 30, 2010  37,709  $377  $83,095  $(81,895) $1,577 

See accompanying notes to condensed consolidated financial statements.

 
5
 
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
 
 Three Months Ended 
 June 30,  
Six Months Ended
September 30,
 
 2010  2009  2010  2009 
Cash flows from operating activities:            
Net loss $(2,469) $(2,468) $(5,483) $(5,638)
Adjustments to reconcile net loss to net cash used in operating activities:                
Depreciation and amortization  189   150   375   305 
Stock-based compensation expense  392   321   932   916 
Provision for (gains) losses on accounts receivable  (178)  12 
Restricted stock awards (non-cash charge)  7   - 
Provision for (recovery of) bad debt expenses  (180)  31 
Debt cost expense  27   -   63   - 
Loss on sale of investments  -   28   -   28 
Changes in assets and liabilities:                
Accounts receivable  (455)  (697)  (264)  (64)
Inventories  38   (37)  (909)  137 
Prepaid expenses and other current assets  577   44   664   56 
Other assets  -   (3)  -   (23)
Accounts payable  (35)  150   791   74 
Accrued expenses  (189)  (114)  (271)  (175)
Accrued compensation  (60)  (152)  (22)  10 
Advances from customers  3,777   - 
Net cash used in operating activities  (2,163)  (2,766)  (520)  (4,343)
Cash flows from investing activities:                
Purchase of short-term investments  (149)  -   (149)  (2,572)
Proceeds from short-term investment sales/maturities  99   981   596   5,998 
Purchase of property and equipment  (10)  (183)  (60)  (431)
Net cash (used in) provided by investing activities  (60)  798 
Net cash provided by investing activities  387   2,995 
Cash flows from financing activities:                
Advance on line of credit—related party  2,000   -   2,000   - 
Payments of capital leases  (19)  (9)  (36)  (15)
Proceeds from issuance of restricted stock awards  7   - 
Exercise of stock options  -   41   109   41 
Net cash provided by financing activities  1,988   32   2,073   26 
Net decrease in cash and cash equivalents  (235)  (1,936)
Net increase (decrease) in cash and cash equivalents  1,940   (1,322)
Cash and cash equivalents from continuing operations, beginning of period $2,540  $1,975  $2,540  $1,975 
Cash and cash equivalents from discontinued operations, beginning of period $-  $8  $-  $8 
Cash and cash equivalents from discontinued operations, end of period $-  $11  $-  $- 
Cash and cash equivalents from continuing operations, end of period $2,305  $36  $4,480  $661 
                
Supplemental disclosure of cash flow information:                
Cash paid during the period for:                
Interest $4  $14  $56  $- 
Income taxes $21  $10  $23  $16 
                
Non-cash financing activities:                
Transfers of inventory to fixed assets for use as demonstration equipment $222  $-  $449  $- 
Issuance of stock warrants with revolving loan agreement $87  $- 
Issuance of stock warrants with line of credit—related party $87  $- 

See accompanying notes to condensed consolidated financial statements.

 
6
 
 
Vision-Sciences, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited, in thousands except per share amounts)
 
Note 1.     Basis of Presentation
 
Vision-Sciences, Inc. and Subsidiaries (the “Company” – which may be referred to as “our”, “us” or “we”) have prepared the condensed consolidated financial statements included herein according to generally accepted accounting principles in the United States of America (“U.S. GAAP”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and include, in the opinion of management, all adjustments that we consider necessary for a fair presentation of such information.  We have condensed or omitted certain information and footnote disclosures normally included in financial statements pursuant to those rules and regulations. We believe, however, that our disclosures are adequateade quate to m akemake the information presented not misleading. The results for the interim periods presented are not necessarily indicative of results to be expected for the full fiscal year. Please read these condensed consolidated financial statements in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2010.

Note 2.     The Company and Summary of Significant Accounting Policies

Company Overview

We design, develop, manufacture, and market products for endoscopy - the science of using an instrument, known as an endoscope to provide minimally invasive access to areas not readily visible to the human eye. Our products are sold throughout the world through direct sales representatives in the United States and independent distributors for the rest of the world. Our largest geographic markets are the United States and Europe. Pursuant to our agreement dated as of September 22, 2010, with the Endoscopy Division of Stryker Corporation (“Stryker”), we will supply to Stryker our flexible video and fiber cystoscopes and related EndoSheath products (the “Stryker Agreement”) (See Note 9. Advances from Customers for additional information).

 
We were incorporated in Delaware, and are the successor to operations originally begun in 1987. In December 1990, Machida Incorporated (“Machida”), which became our wholly-owned subsidiary whichin December 1990, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries. Another one of our subsidiaries, Vision Sciences Ltd., an Israeli corporation, was established in 1998, but has been inactive since the fiscal year ended March 31, 2002. We own the registered trademarks Vision Sciences®, Slide-On®, EndoSheath®, and The Vision System®. Not all products referenced in this report are approved or cleared for sale, distribution, or use.

Liquidity and Capital Resources

We have incurred losses since our inception, and losses are expected to continue through at least fiscal years 2011 and 2012. We have funded the losses principally with cash flow from operations, funding of advances under a three-year $5.0 million revolving loan agreement (the “Loan”) with our Chairman, Lewis C. Pell (the “Lender”), proceeds from public and private equity financings, payments from Medtronic related to the sale of certain assets related to our ENT EndoSheath technology business, and the sale of other assets. We have also received an aggregate of $3.9 million of deposits from two customers (the “Prepayments”) during the three months ended September 30, 2010 to support anticipated orders, which are expected to ship by the end of fiscal 2011. We believe that our cash, short-term investments,including t he Prepayments, and $0.5 million of capital available, subject to certain conditions, under the Loan will be sufficient to fund our working capital, capital expenditures, and future operating losses until September 30,December 31, 2011. However, if our performance expectations fall short (including regaining sales or profits historically generated from Medtronic)Medtronic and generating expected sales from Stryker and SpineView) or our expenses exceed expectations, we will need to either secure additional financing or reduce expenses or a combination thereof; ourcombination. Our failure to do so under these circumstances would have a material adverse impact on our prospects and financial condition. There can be no assurance that any contemplated external financing will be available on terms acceptable to us, if at all, or that we will be able to reduce our expenses.

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Summary of Significant Accounting Policies

Our condensed consolidated financial statements are prepared in accordance with U.S. GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable, based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are any differences (other than nominal differences) between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The accounting policies thatth at reflect our more significant estimates, judgments, and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

• Revenue recognition
• Stock-based compensation expense
• Allowances for doubtful accounts
• Inventory obsolescence reserves
• Other contingencies

7

The accompanying condensed consolidated financial statements reflect the accounts of the Company. All significant inter-company accounts and transactions have been eliminated in consolidation.

Accounting Standards Updates Not Yet Effective

In January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASC Update 2010-06”), an update to ASC 820. This update provides amendments to add new requirements for disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. It also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASC Update 2010-06 became effective for us with the reporting period beginning January 1, 2010, except for the disclosure on the roll forward activities for Level 3 measurements, which will become effective for us with the reporting period beginning April 1, 2011 (our fiscal year 2012). We do not expect that the provisions of the update will have a material effect on our results of operations, financial position, or liquidity.

Note 3.     Basic and Diluted Net Loss per Common Share

Basic net loss per share is calculated by dividing the net loss by the weighted average number of common shares outstanding. For all periods presented, the diluted net loss per common share is the same as basic net loss per common share, as the inclusion of other shares of stock issuable pursuant to stock options and warrants would be anti-dilutive. Stock options, warrants, and restricted stock of 7,996,9448,072,989 shares and 6,095,8706,359,284 shares as of JuneSeptember 30, 2010 and 2009, respectively, were excluded from the calculation of fully diluted loss per share sinceas their inclusion would have been anti-dilutive.

Note 4.     Inventories

Inventories are stated at the lower of cost or market using the first-in, first-out (“FIFO”) method and consist of the following:
 
 June 30,  March 31, 
 2010  2010  
September 30,
2010
  
March 31,
2010
 
Raw materials $3,185  $3,330  $3,375  $3,330 
Work in process  384   269   667   269 
Finished goods  346   576   593   576 
 $3,915  $4,175  $4,635  $4,175 

Raw materials include components purchased from independent suppliers. Most purchased components are available from multiple sources, with the exception of certain key components which are supplied to us by key suppliers, with whom we have long-term supply arrangements, but no long-term supply agreements.

Note 5.     Financial Instruments

Short-Term Investments

We classify investments with original maturities of greater than 90 days in certificates of deposit as short-term investments. We intend to hold these investments to maturity. Our short-term investments are carried at amortized cost in our condensed consolidated balance sheets.

8
The following table summarizes these securities classified as held to maturity.

  June 30, 2010  March 31, 2010 
  Amortized     Amortized    
Held to maturity less than one year: Cost  Fair Value  Cost  Fair Value 
Certificates of deposit $497  $497  $447  $446 
Total short-term investments $497  $497  $447  $446 

  September 30, 2010  March 31, 2010 
Held to maturity less than one year: 
Amortized
Cost
  Fair Value  
Amortized
Cost
  Fair Value 
Certificates of deposit $-  $-  $447  $446 
Total short-term investments $-  $-  $447  $446 
Fair Value Measurements

The carrying amounts reflected in our condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, other current assets, accounts payable, accrued expenses, accrued compensation, and capital lease obligations approximate fair value due to their short-term nature. The fair value of the line of credit is based on its demand value, which is equal to its carrying value.

8

Note 6.     Commitments and Contingencies

Line of Credit – Related Party

On November 9, 2009, we entered into a Loan with the Lender. Any amounts drawn against the Loan (an “Advance”) accrue interest at a per annuman annual rate of 7.5%. The Lender receives an availability fee equal to a per annum rate of 0.5% on the unused portion of the Loan calculated based on the difference between the average annual principal amount of the outstanding Advances under the Loan and the maximum advance of $5.0 million. The availability of advances under the Loan is subject to customary conditions. Subject to the terms of the Loan, we will be required to prepay all amounts outstanding under the Loan in the event ofupon a change of control of the Company and we will be required to prepay part or all of the amounts outstanding in the eventif we secure other financing or consummate a sale or license of assets, in each case resulting in net proceeds to us of $5.0 million or greater.

In connection with the Loan, the Lender received  a five-year warrant (the “Initial Warrant Shares”) to purchase up to 272,727 shares of our common stock at an exercise price of $1.375 per share (representing 7.5% warrant coverage, or approximately 0.7% of our outstanding common stock), which was immediately vested upon issuance. In addition, we issued a second five-year warrant (the “Additional Warrant Shares”) to purchase up to an additional 378,788 shares of our common stock at an exercise price of $1.65 per share (representing up to an additional 12.5% warrant coverage, or approximately 1.0% of our outstanding common stock) which vests at the time that each Advance is made in an amount equal to (i) the product of the amount of the Additional Warrant Shares multiplied by (ii) a ra tio,ratio, (A) the numerator of which shall beis the amount of the new Advance and (B) the denominator of which shall beis $5.0 million. A portion of the Additional Warrant Shares has vested on the date of the $2.5 million Advance on March 29, 2010 and the $2.0 million Advance on June 29, 2010.

The following table summarizes Advances taken on the Loan and warrant issuances:
Month
Amount of
Advance
Number of
Warrant Shares
Vested
Fair Value of
Warrant Shares
on Date Vested
June 2010$2.0 million151,515$87 thousand
March 2010$2.5 million189,394 $106 thousand
November 2009n/a272,727 $221 thousand
On the date of issuance, the fair value of the Initial and Additional Warrant Shares was approximately $221 thousand and $249 thousand, respectively. We defer costs associated with securing a line-of-credit or revolving loan agreement over the applicable term. These costs are amortized as debt cost expense in our condensed consolidated statement of operations. Accordingly, we recorded the $221 thousand associated with the Initial Warrant Shares as a deferred debt cost asset with a corresponding amount as additional paid-in capital. The cost is being amortized on a straight-line basis over the three-year term of the Loan.

The following table summarizes Advances taken on the Loan and warrant issuances:
Number ofFair Value of
Amount ofWarrant SharesWarrant Shares
MonthAdvanceVestedon Date Vested
June 2010$2.0 million151,515$87 thousand
March 2010$2.5 million189,394 $106 thousand
November 2009n/a272,727 $221 thousand
We recorded the fair value associated with the Additional Warrant Shares as a deferred debt cost asset with a corresponding amount as additional paid-in capital. The cost is being amortized over the remaining life of the Loan using the effective interest method. WeDuring the three and six months ended September 30, 2010, we recorded approximately $27$36 thousand and $63 thousand, respectively, as debt cost expense related to the amortization of the deferred debt cost for the Initial and Additional Warrant Shares in our condensed consolidated statement of operations in the three months ended June 30, 2010.operations.

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At JuneSeptember 30, 2010, we had $4.5 million in outstanding borrowings under the Loan, which is reflected as line of credit – related party on our condensed consolidated balance sheet. The $5.0 million revolving loan expires in November 2012, at which time we must repay all borrowings under the Loan. WeDuring the three and six months ended September 30, 2010, we recorded approximately $51$87 thousand and $138 thousand, respectively, as interest expense related to the availability fee and accrued interest on outstanding borrowings in our condensed consolidated statement of operations duringoperations. At September 30, 2010, we had $0.1 million in accrued interest related to the three months ended June 30, 2010.Loan, which is included in accrued expenses on our condensed consolidated balance sheet.

Note 7.     Stock-Based Awards

Stock Option Plans

We maintain the following equity incentive plans:

·  The 2000 Stock Incentive Plan (the “2000 Plan”), approved by stockholders in August 2000, authorized 4,500,000 shares of common stock covering several different types of awards, including stock options, restricted shares, stock appreciation rights, and performance shares.
·  The 2007 Stock Incentive Plan (the “2007 Plan”), approved by stockholders in August 2007, authorized 4,000,000 shares of common stock covering several different types of awards, including stock options, restricted shares, stock appreciation rights, and other stock-based awards. OurOn July 12, 2010, our Board approved, subject to stockholder approval atand on September 2, 2010, our upcoming annual meeting,stockholders approved an amendment to the 2007 Plan to increase the authorized shares issuable under the plan to 5,000,000 shares of common stock.
·  The 2003 Director Option Plan (the “2003 Plan”), approved by stockholders in July 2003 and amended in August 2008, authorized 450,000 shares of common stock covering the annual automatic grant of 10,000 stock options per outside director per year. The 2003 Plan also provides for granting newly elected or appointed outside directors a one-time grant of 10,000 stock options.
9

The stock option plans provide that options may be granted at an exercise price of 100% of fair market value of our common stock on the date of grant, may be exercised in full or in installments, at the discretion of the Board of Directors, and must be exercised within ten years from date of grant. We recognize stock-based compensation expense on a straight-line basis over the requisite service period based on fair values, generally four years. We use historical data to estimate expected employee behaviors related to option exercises and forfeitures and included these expected forfeitures as a part of the estimate of stock-based compensation expense as of the grant date.

Stock-Based Compensation Expense

We account for stock-based awards issued to employees in accordance with the provisions of ASC 718 (Topic 718, Compensation – Stock Compensation). We recognize stock-based compensation expense on a straight-line uniform basis over the service period of the award, which is generally four years for employees. Stock-based awards issued to consultants are accounted for in accordance with the provisions of ASC 718 and ASC 505-50 (Subtopic 50 “Equity-Based Payments to Non-Employees” of Topic 505, Equity). Options granted to consultants are periodically revalued as the options vest, and are recognized as an expense over the related period of service or the vesting period, whichever is longer.

Stock-based compensation expense for the three and six months ended JuneSeptember 30, 2010 and 2009 was recorded in our condensed consolidated statement of operations as follows:

  
Three Months Ended
September 30,
  
Six Months Ended
September 30,
 
  2010  2009  2010  2009 
Cost of sales $61  $130  $137  $203 
Selling, general, and administrative expenses  460   466   746   646 
Research and development expenses  19   (1)  49   67 
  Total stock-based compensation expense $540  $595  $932  $916 
  
Three Months Ended
June 30,
 
  2010  2009 
Cost of sales $76  $73 
Selling, general, and administrative expenses  286   180 
Research and development expenses  30   68 
  Total stock-based compensation expense $392  $321 
         
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The fair value of the stock options granted was estimated on the date of grant using a Black-Scholes valuation model that used the weighted average assumptions noted in the following table. The risk-free interest rate assumption we use is based upon United States Treasury interest rates appropriate for the expected life of the awards. The expected life (estimated period of time that we expect employees, consultants and directors to hold their stock options) was estimated based on historical rates for two group classifications, (i) employees and consultants and (ii) outside directors. Expected volatility was based on historical volatility of our stock price for a period equal to the stock option’s expected life and calculated on a daily basis. The expected dividend rate is zero since we do not currently pay cash dividends on our common stock and do not anticipate doing so in the foreseeable future. Under the provisions of ASC 718, members of the Board are considered employees for calculation of stock-based compensation expense.

 Three Months Ended
 June 30,
 2010 2009
Risk-free interest rate3.08% 2.30%
Expected life (in years)6.58 6.23
Expected volatility83% 87%
Expected dividend yield-- --

       
  
Three Months Ended
September 30,
  
Six Months Ended
September 30,
 
  2010  2009  2010  2009 
Risk-free interest rate  2.30%  2.75%  2.77%  2.46%
Expected life (in years)  7.23   6.25   6.76   6.24 
Expected volatility  86%  88%  86%  87%
Expected dividend yield  --   --   --   -- 
The following table summarizes stock options activity for the threesix months ended JuneSeptember 30, 2010:

          Weighted 
       Weighted  Average 
 Number  Exercise  Average  Remaining 
 of Shares  Price Range  Exercise Price  Contractual Life 
Outstanding at March 31, 2010 6,264,685  $0.79 – $5.10  $1.91   5.84 
Granted 382,500  $0.96 – $1.03   0.97     
Exercised -   –   –     
Canceled (39,036) $1.22 – $3.73   1.64     
Outstanding at June 30,  2010 6,608,149  $0.79 – $5.10  $1.86   5.87 
Vested and expected to vest at June 30, 2010 5,732,040  $0.79 – $5.10  $1.77   5.48 
Exercisable at June 30, 2010 4,322,470  $0.79 – $5.10  $1.64   4.42 
 
  
Number
of Shares
  
Exercise
Price Range
  
Weighted
Average
Exercise Price
  
Weighted
Average
Remaining
Contractual Life
 
Outstanding at March 31, 2010  6,264,685  $0.79 – $5.10  $1.91   5.84 
Granted  552,500  $0.96 – $1.39   1.02     
Exercised  (97,912) $1.10 – $1.28   1.11     
Canceled  (52,926) $1.22 – $4.88   1.82     
Outstanding at September 30,  2010  6,666,347  $0.79 – $5.10  $1.85   5.80 
Vested and expected to vest at September 30, 2010  5,857,478  $0.79 – $5.10  $1.77   5.47 
Exercisable at September 30, 2010  4,635,683  $0.79 – $5.10  $1.70   4.64 

At JuneSeptember 30, 2010, unrecognized stock-based compensation expense related to stock options was approximately $1.8$1.6 million and is expected to be recognized over a weighted average period of approximately 2.52.4 years.

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The weighted average fair value of options granted during the three months ended JuneSeptember 30, 2010 and 2009 was $0.72$0.87 per share. The weighted average fair value of options granted during the six months ended September 30, 2010 and 2009 was $0.79 and $0.88 per share, respectively.

The total intrinsic value (the excess of the market price over the exercise price) was approximately $25$401 thousand for stock options outstanding, $16$306 thousand for stock options exercisable, and $23$378 thousand for stock options vested and expected to vest as of JuneSeptember 30, 2010. The total intrinsic value for stock options exercised during the three months ended JuneSeptember 30, 20092010 was approximately $6$21 thousand. There were no stock options exercised during the three months ended JuneSeptember 30, 2010.2009. The total intrinsic value for stock options exercised during the six months ended September 30, 2010 and 2009 was approximately $21 thousand and $6 thousand, respectively.

We do not expect to realize any tax benefits from future disqualifying dispositions, if any, because we currently have a full valuation allowance against our deferred tax assets.

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Stock Warrants

The following table summarizes stock warrants activity related to the Loan with the Lender for the threesix months ended JuneSeptember 30, 2010:

     Weighted 
  Number  Average 
  of Shares  Exercise Price 
Nonvested at March 31, 2010  189,394  $1.65 
Granted  -   – 
Vested  (151,515)  1.65 
Forfeited  -   – 
Nonvested at June 30, 2010  37,879  $1.65 
Vested at June 30, 2010  613,636  $1.53 

  
Number
of Shares
  
Weighted Average
Exercise Price
 
Nonvested at March 31, 2010  189,394  $1.65 
Granted  -   – 
Vested  (151,515)  1.65 
Forfeited  -   – 
Nonvested at September 30, 2010  37,879  $1.65 
Vested at September 30, 2010  613,636  $1.53 
At JuneSeptember 30, 2010, unrecognized debt cost expense related to the Initial and Additional Warrant Shares was approximately $356$320 thousand, which is expected to be recognized over a weighted average period of approximately 2.42.1 years.

Restricted Stock

We granted 737,280755,127 shares of restricted stock to management during the threesix months ended JuneSeptember 30, 2010. The restrictions for these restricted stock awards vestlapse after certain Company (revenue and loss from operations) and individual milestones are met followed by a three-year graded vesting schedule. If the Company milestones are not met, regardless of whether the individual meets his or her performance milestones, the restricted stock awards are forfeited.

The following table summarizes restricted stock activity for the threesix months ended JuneSeptember 30, 2010:

    Weighted 
 Number  Average 
 of Shares  Grant Price  
Number
of Shares
  
Weighted
Average
Grant Price
 
Nonvested at March 31, 2010  -   –   -   – 
Granted  737,280  $0.97   755,127  $0.97 
Vested  -   –   -   – 
Forfeited  -   –   -   – 
Nonvested at June 30, 2010  737,280  $0.97 
Vested at June 30, 2010  -   – 
Nonvested at September 30, 2010  755,127  $0.97 
Vested at September 30, 2010  -   – 

At JuneSeptember 30, 2010, unrecognized stock-based compensation expense related to nonvested awards was approximately $690$628 thousand, which is expected to be recognized over a weighted average period of approximately 3.73.4 years.

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Note 8.     Segment Information

We have two reportable segments, medical and industrial. Each of these operating segments has unique characteristics.

Our medical segment designs, manufactures and sells our advanced line of endoscopy-based products, including our state-of-the-art flexible endoscopes, and our Slide-On EndoSheath technology referred to as a sheath or EndoSheath disposable, for a variety of specialties and markets.

Our industrial segment, through our wholly-owned subsidiary Machida, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries. A borescope is an instrument that uses optical fibers for the visual inspection of narrow cavities.  Our borescopes are used to inspect aircraft engines, casting parts and ground turbines, among other items.

Management evaluates the revenue and profitability performance of each of our product lines to make operating and strategic decisions. We have no intersegment revenue.

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The following table presents key financial highlights, by reportable segments:

Three months ended June 30, Medical  Industrial  Adjustments *  Consolidated 
2010            
Net sales to external customers $2,119  $513  $-  $2,632 
Gross profit  522   167   -   689 
Operating loss  (2,300)  (87)  -   (2,387)
Interest expense, net  (53)  -   -   (53)
Depreciation and amortization  185   4   -   189 
Stock-based compensation expense  352   40   -   392 
Total assets  10,927   2,297   (2,011)  11,213 
Expenditures for property and equipment  10   -   -   10 
                 
2009                
Net sales to external customers $2,605  $713  $-  $3,318 
Gross profit  440   348   -   788 
Operating (loss) income  (2,616)  136   -   (2,480)
Interest income, net  50   -   -   50 
Depreciation and amortization  145   5   -   150 
Stock-based compensation expense  307   14   -   321 
Total assets  18,207   2,272   (3,224)  17,255 
Expenditures for property and equipment  183   -   -   183 
                 
  June 30,         
* Adjustments  2010   2009         
  Intercompany eliminations $(1,239) $(1,810)        
  Investment in subsidiaries  (772)  (1,414)        
  Total assets $(2,011) $(3,224)        
Three months ended September 30, Medical  Industrial  Adjustments *  Consolidated 
2010            
Net sales to external customers $1,721  $604  $-  $2,325 
Gross profit  447   194   -   641 
Operating loss  (2,838)  (48)  -   (2,886)
Interest expense, net  (89)  -   -   (89)
Depreciation and amortization  179   7   -   186 
Stock-based compensation expense  522   18   -   540 
Total assets  13,124   2,253   (1,987)  13,390 
Expenditures for fixed assets  50   -   -   50 
                 
2009                
Net sales to external customers $2,248  $641  $-  $2,889 
Gross profit  293   172   -   465 
Operating loss  (3,066)  (73)  -   (3,139)
Interest expense, net  (25)  -   -   (25)
Depreciation and amortization  150   5   -   155 
Stock-based compensation expense  539   56   -   595 
Total assets  15,625   2,268   (3,194)  14,699 
Expenditures for fixed assets  241   -   -   241 
                 
Six months ended September 30,                
2010                
Net sales to external customers $3,840  $1,117  $-  $4,957 
Gross profit  969   361   -   1,330 
Operating loss  (5,138)  (135)  -   (5,273)
Interest expense, net  (142)  -   -   (142)
Depreciation and amortization  364   11   -   375 
Stock-based compensation expense  874   58   -   932 
Expenditures for fixed assets  60   -   -   60 
                 
2009                
Net sales to external customers $4,853  $1,354  $-  $6,207 
Gross profit  733   520   -   1,253 
Operating (loss) income  (5,682)  63   -   (5,619)
Interest income, net  25   -   -   25 
Depreciation and amortization  295   10   -   305 
Stock-based compensation expense  846   70   -   916 
Expenditures for fixed assets  431   -   -   431 

  September 30, 
* Adjustments  2010   2009 
  Intercompany eliminations $(1,215) $(1,779)
  Investment in subsidiaries  (772)  (1,415)
  Total adjustments $(1,987) $(3,194)
 
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Note 9.     Advances from Customers

Exclusive Urology Supply Agreement with Stryker

On September 22, 2010, we signed a three-year agreement under which we will become the exclusive supplier to Stryker of Stryker-branded flexible video and fiber cystoscopes. These cystoscopes will employ our patented slide-on EndoSheath technology, which will be co-branded Stryker and Vision-Sciences. We will also supply Stryker with flexible ureteroscopes upon launch of this product line, expected to occur during calendar 2011. Stryker will initially have the exclusive rights to distribute products, including cystoscopes, urology EndoSheath technology, and ureteroscopes manufactured by us, in North and Latin America, South America, China and Japan and 12 months post-launch, throughout the rest of the world.

Subject to the terms of the Stryker Agreement, Stryker agreed to pay us a prepayment of $5 million, of which we received $2.5 million at signing and $2.5 million is due on or before March 31, 2011. The initial $2.5 million was recorded as an advance from customer in our condensed consolidated balance sheet at September 30, 2010. We will apply the payment to amounts due from Stryker for purchases of scopes and EndoSheath technology and recognize the associated revenue in accordance with our revenue recognition policy until the $5 million is exhausted. Stryker will thereafter continue to pay us for products supplied. The purchase price for the products will be based on our cost to manufacture plus a margin specified in the Stryker Agreement. There is no required minimum amount of scopes and EndoSheath product s which Stryker is required to purchase from us. There can be no assurance that they will purchase an amount of products in order for us to retain all or any portion of the prepayment or that we will not be required to refund all or a portion of the prepayments to Stryker.  If we are required to refund any amounts paid to us, it will have a material adverse effect on our financial condition.

SpineView Development and Supply Agreement

On June 19, 2008, we entered into a Development and Supply Agreement with SpineView, Inc. (the “SpineView Agreement”), pursuant to which we were to develop and supply a CCD-based video endoscope to SpineView for use with SpineView’s products. On September 30, 2010, we received a prepayment of $1.4 million from SpineView for the initial, firm stocking order of 50 SpineView spinoscope sytems. We recorded this prepayment as an advance from customer in our condensed consolidated balance sheet at September 30, 2010. During the three months ended September 30, 2010, we recognized $0.1 million in revenue for delivery of SpineView spinoscope systems. We will continue to apply the payment to amounts due from SpineView for purchases of scopes and recognize the associated revenue until the remaining $1.3 million is exhausted. SpineView will thereafter continue to pay us for products supplied.

Mr. Pell, our Chairman, is the Chairman of the SpineView board and an investor in SpineView. Messrs. Katsumi Oneda and John J. Rydzewski, members of our Board, are also investors in SpineView. Our policy with respect to transactions in which any of our directors or officers may have an interest, requires that such transaction (i) be on terms no less favorable to us than could be obtained from unaffiliated third parties and (ii) be approved by a majority of the uninterested, outside members of the Board.

At a Board meeting held on May 29, 2008, the Board reviewed the terms of the final draft of the SpineView Agreement, outside of the presence of Messrs. Pell and Oneda. The remaining (uninterested) members of our Board determined that the SpineView Agreement was fair, properly negotiated, and would be at least as favorable to us as could have been obtained from unaffiliated third parties, and accordingly, after discussion, it was approved. Mr. Rydzewski was neither an investor in SpineView nor a member of our Board at that time, and has no other relationship with SpineView.

14

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995, which are subject to various risks and uncertainties that could cause our actual results to differ materially from those expressed or implied in such statements. Such factors include, but are not limited to, further weakening of economic conditions that could adversely affect the level of demand for our products; our ability to satisfactorily distribute our ENT endoscopes without an arrangement with Medtronic; our ability to sell products to Stryker in at least the amounts necessary to retain the prepayments from Stryker to us; pricing pressures, including cost-containment measures which could adversely affect the price of, or demand for, our products; availability of parts on acceptable terms; our ability to design new products and the success of such new products; changes in foreign exchange markets; changes in financial markets and changes in the competitive environment. Examples of forward-looking statements include statements about expectations about future financial results, future products and future sales of new and existing products, future expenditures, and capital resources to meet anticipated requirements. Generally, words such as “expect” “believe”, “anticipate”, “may”, “will”, “plan”, “intend”, “estimate”, “could”, and other similar expressions are intended to identify forward-looking statements. The forward-looking statements are based on our future plans, strategies, projections and predictions and involve risks and uncertainties, and our actual results may differ significantly from those discussed in the forward-looking statements. Factors that mightmig ht cause such a difference could include the availability of capital resources; the availability of third-party reimburs ement;reimbursement; government regulation; the availability of raw material components; our ability to satisfactorily distribute our ENT endoscopes without an arrangement with Metronic;Medtronic; our dependence on certain distributors and customers; our ability to affect expected sales to Stryker; competition; technological difficulties; general economic conditions and other risks detailed in this Quarterly Report on Form 10-Q and any subsequent periodic filings we make with the Securities and Exchange Commission (“SEC”). While we believe the assumptions underlying such forward-looking statements are reasonable, there can be no assurance that future events or developments will not cause such statements to be inaccurate. All forward-looking statements contained in this report are qualified in their entirety by this cautionary statement. We do not undertake an obligation to update our forward-lookingforward-look ing statements to reflect future events or circumstances.

Registered Trademarks, Trademarks and Service Marks
 
Vision-Sciences, Inc. owns the registered trademarks Vision Sciences®, Slide-On®, EndoSheath®, and The Vision System®. Not all products referenced in this report are approved or cleared for sale, distribution, or use.

Executive Summary

We design, develop, manufacture, and market products for endoscopy – the science of using an instrument, known as an endoscope - to provide minimally invasive access to areas not readily visible to the human eye. We operate in two segments, medical and industrial. Our medical segment designs, manufactures, and sells our advanced line of endoscopy-based products, including our state-of-the-art flexible fiber and video endoscopes and our Slide-On EndoSheath technology, for a variety of specialties and markets. Our industrial segment, through our wholly-owned subsidiary, Machida, Inc. (“Machida”), designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine-manufacturing and aircraft engin e-maintenance industries. A borescope is an instrument that uses optical fibers for the visual inspection of narrow cavities.

Medical Segment Areas

Within our medical segment we target four main areas for our fiber and video endoscopes and our EndoSheath technology: ENT (ear, nose, and throat), urology, gastroenterology (“GI”), and pulmonology. Within the ENT area, we manufacture ENT endoscopes and, for the past three fiscal years, had sold these scopes exclusively to Medtronic Xomed, Inc., the ENT subsidiary of Medtronic, Inc. (“Medtronic”) for use by ENT physicians. On February 11, 2010, we announced that Medtronic will no longer serve as the distributor for our ENT endoscopes effective April 1, 2010. Since April 1, 2010, we have sold our ENT endoscopes through our direct sales force in the U.S. and through distributors internationally. We manufacture our TNE (trans-nasal esophagoscopy) endoscopes and market them to ENT and GI physician s. We are also exploring the potential of marketing TNE endoscopes to bariatric surgeons. Within the urology area, we manufacture, market, and sell our cystoscopes and EndoSheath technology to urologists and other urology-gynecology related physicians. Pursuant to our agreement dated as of September 22, 2010, with the Endoscopy Division of Stryker Corporation (“Stryker”), we will supply to Stryker our flexible video and fiber cystoscopes and related EndoSheath products (the “Stryker Agreement”) (See Exclusive Urology Supply Agreement with Stryker section below for additional information). Within the GI area, we manufacture, market, and sell our TNE scopes and EndoSheath technology to GI physicians, primary care physicians, and others with a GI focus as part of their practice. We manufacture, market, and sell our recently released bronchoscope (an endoscope that allows detailed viewing of the lungs) and EndoSheath technology for bronchoscopy to pulmonologists, oncologists, thoracic surgeons, and other pulmonology-related physicians.

 
1315
 

Value Proposition and Strategy
 
We believe our technology delivers significant value to our customers – doctors, clinics and hospitals – through reduced capital, staff and service costs, and increased patient throughput, practice revenue, and profitability. Our EndoSheath technology allows our customers to buy fewer endoscopes to service their patients and enables them to schedule more patient appointments in a single day. Our single-use EndoSheath technology provides a sterile barrier between patients and our reusable endoscopes, eliminating the need for time-consuming reprocessing routines necessary with conventional endoscopes. Our endoscopes are therefore typically ready for the next procedure in ten minutes, unlike conventional endoscopes which may take from 45 minutes to a day to reprocess. We believe our EndoSheath technology is the solution to the challenges and problems with conventional flexible endoscopes.  By offering a technology that provides simpler and quicker endoscope reprocessing and sterility derived from use of a single-use disposable sheath, we have removed the limitations of conventional flexible endoscopy.

Our current strategic focus is to transform ourselves from a research and development-focused company to a sales and marketing-driven Company, with the primary goal of increasing top-line revenue and margins.  We intend to do this by:

·  Growing our direct sales force in the U.S. and enhancing our international distribution network;
·  Expanding our downstream marketing efforts to end customers, including expanding our communications, advertising and branding;
·  Increasing our clinical study activity in order to have peer-reviewed papers published which outline the benefits of our products;
·  Targeting teaching hospitals and academic institutions as potential customers and reference and training centers;
·  Leveraging our existing technology platform to explore new potential products and procedures in markets where we currently sell; and
·  Exploring potential distribution arrangements with strategic partners.

New Product Releases
 
We continue to enhance our current family of videoscopes and improve and refine their manufacturing. With respect to our fiberscope line of products, in the first quarter of fiscal 2011, we launched our 4000 Series bronchoscope which is inserted down the mouth or nose into the lungs, providing visualization of the lungs and the ability to perform a variety of diagnostic and therapeutic procedures.

Exclusive Urology Supply Agreement with Stryker

On September 22, 2010, we signed a three-year agreement under which we will become the exclusive supplier to Stryker of Stryker-branded flexible video and fiber cystoscopes. These cystoscopes will employ our patented slide-on EndoSheath technology, which will be co-branded Stryker and Vision-Sciences. We will also supply Stryker with flexible ureteroscopes upon launch of this product line, expected to occur during calendar 2011. Stryker will initially have the exclusive rights to distribute products, including cystoscopes, urology EndoSheath technology, and ureteroscopes manufactured by us, in North and Latin America, South America, China and Japan and 12 months post-launch, throughout the rest of the world.

Subject to the terms of the Stryker Agreement, Stryker agreed to pay us a prepayment of $5 million, of which we received $2.5 million at signing and $2.5 million is due on or before March 31, 2011. The initial $2.5 million was recorded as an advance from customer in our condensed consolidated balance sheet at September 30, 2010. We will apply the payment to amounts due from Stryker for purchases of scopes and EndoSheath technology and recognize the associated revenue in accordance with our revenue recognition policy until the $5 million is exhausted. Stryker will thereafter continue to pay us for products supplied. The purchase price for the products will be based on our cost to manufacture plus a margin specified in the Stryker Agreement. There is no required minimum amount of scopes and EndoSheath product s which Stryker is required to purchase from us. There can be no assurance that they will purchase an amount of products in order for us to retain all or any portion of the prepayment or that we will not be required to refund all or a portion of the prepayments to Stryker.  If we are required to refund any amounts paid to us, it will have a material adverse effect on our financial condition.

Line of Credit – Related Party

On November 9, 2009, we entered into a three-year $5.0 million revolving loan agreement (the “Loan”) with our Chairman, Lewis C. Pell (the “Lender”). Any amounts drawn against the Loan (an “Advance”) accrue interest at a per annum rate of 7.5%. The Lender receives an availability fee equal to a per annuman annual rate of 0.5% on the unused portion of the Loan calculated based on the difference between the average annual principal amount of the outstanding Advances under the Loan and the maximum advance of $5.0 million. The availability of advances under the Loan is subject to customary conditions. Subject to the terms of the Loan, we will be required to prepay all amounts outstanding under the Loan in the event ofupon a change of control of the Company and we will be required to prepay part or all of the amountsam ounts outstanding in the eventif we secure other financing or consummate a sale or license of assets, in each case resulting in net proceeds to us of $5.0 million or greater.

16
In connection with the Loan, the Lender received  a five-year warrant (the “Initial Warrant Shares”) to purchase up to 272,727 shares of our common stock at an exercise price of $1.375 per share (representing 7.5% warrant coverage, or approximately 0.7% of our outstanding common stock), which was immediately vested upon issuance. The second five-year warrant (the “Additional Warrant Shares”) to purchase up to an additional 378,788 shares of our common stock at an exercise price of $1.65 per share (representing up to an additional 12.5% warrant coverage, or approximately 1.0% of our outstanding common stock) vests at the time that each Advance is made in an amount equal to (i) the product of the amount of the Additional Warrant Shares multiplied by (ii) a ratio, (A) the numerator of w hich shall bewhich is the amount of the new Advance and (B) the denominator of which shall beis $5.0 million. A portion of the Additional Warrant Shares has vested on the date of the $2.5 million Advance on March 29, 2010 and the $2.0 million Advance on June 29, 2010.

On the date of issuance, the fair value of the Initial and Additional Warrant Shares was approximately $221 thousand and $249 thousand, respectively. We defer costs associated with securing a line-of-credit or revolving loan agreement over the applicable term. These costs are amortized as debt cost expense in our condensed consolidated statement of operations.

We took Advances of $2.0 million and $2.5 million in June 2010 and March 2010, respectively. At JuneSeptember 30, 2010, we had $4.5 million in outstanding borrowings under the Loan, which is reflected as line of credit – related party on our condensed consolidated balance sheet. The $5.0 million revolving loan expires in November 2012, at which time we must repay all borrowings under the Loan.

14SpineView Development and Supply Agreement

On June 19, 2008, we entered into a Development and Supply Agreement with SpineView, Inc. (the “SpineView Agreement”), pursuant to which we were to develop and supply a CCD-based video endoscope to SpineView for use with SpineView’s products. On September 30, 2010, we received a prepayment of $1.4 million from SpineView for the initial, firm stocking order of 50 SpineView spinoscope sytems. During the three months ended September 30, 2010, we recognized $0.1 million in revenue for delivery of SpineView spinoscope systems. We will continue to apply the payment to amounts due from SpineView for purchases of scopes and recognize the associated revenue until the remaining $1.3 million is exhausted. SpineView will thereafter continue to pay us for products supplied.

Mr. Pell, our Chairman, is the Chairman of the SpineView board and an investor in SpineView. Messrs. Katsumi Oneda and John J. Rydzewski, members of our Board, are also investors in SpineView. Our policy with respect to transactions in which any of our directors or officers may have an interest, requires that such transaction (i) be on terms no less favorable to us than could be obtained from unaffiliated third parties and (ii) be approved by a majority of the uninterested, outside members of the Board.

At a Board meeting held on May 29, 2008, the Board reviewed the terms of the final draft of the SpineView Agreement, outside of the presence of Messrs. Pell and Oneda. The remaining (uninterested) members of our Board determined that the SpineView Agreement was fair, properly negotiated, and would be at least as favorable to us as could have been obtained from unaffiliated third parties, and accordingly, after discussion, it was approved. Mr. Rydzewski was neither an investor in SpineView nor a member of our Board at that time, and has no other relationship with SpineView.

Subsequent Event

On October 4, 2010, we announced that we have been awarded a Federal Supply Schedule ("FSS") Contract from the General Services Administration ("GSA") for our flexible endoscopy product lines as an approved vendor. The contract period is from October 15, 2010 through October 14, 2015. This GSA contract enables all federal healthcare facilities, including the Veterans Administration, Indian Health Service, and Department of Defense facilities, to order our technology. The GSA contract covers our flexible video and fiber endoscopes, which utilize our pioneering EndoSheath Technology. While certain of our products will be available for purchase by the GSA, there can be no assurance of the amount, if any, of products will be purchased.

Results of Operations

Three months ended JuneSeptember 30, 2010 compared to the three months ended JuneSeptember 30, 2009 (in thousands, except percentages)

Net Sales

Net sales decreased $0.7$0.6 million, or 21%20%, in the firstsecond quarter of fiscal 2011 to $2.6$2.3 million compared to $3.3$2.9 million in the firstsecond quarter of fiscal 2010. During the firstsecond quarter of fiscal 2011, our medical segment’s net sales of $2.1$1.7 million decreased by $0.5 million, or 19%23%, primarily attributable to lower sales to Medtronic of our ENT fiberscopes ($0.60.5 million). Our industrial segment’s net sales of $0.5$0.6 million decreased by $0.2 million,$37 thousand, or 28%6%, primarily attributable to lower repair sales of our borescopes ($0.2 million) compared to the same period last year.42 thousand).

17
In the medical segment, we track sales of endoscopes and EndoSheath disposables by market. We also track sales of peripherals and accessories which can be sold to more than one market. Sales by segment, market, and by category for the three months ended JuneSeptember 30, 2010 and 2009 were as follows:
  
Three Months Ended
September 30,
       
Market/Category 2010  2009  Difference  Percentage 
ENT and TNE $590  $1,007  $(417)  -41%
Urology  699   520   179   34%
Bronchoscopy  54   136   (82)  -60%
SpineView  74   -   74   n/m*
Repairs, peripherals, and accessories  304   585   (281)  -48%
Total medical sales  1,721   2,248   (527)  -23%
Borescopes  416   411   5   1%
Repairs  188   230   (42)  -18%
Total industrial sales  604   641   (37)  -6%
Net sales $2,325  $2,889  $(564)  -20%
______________________
* Not meaningful

  Three Months Ended       
  June 30,       
Market/Category 2010  2009  Difference  Percentage 
ENT and TNE $434  $1,187  $(753)  -63%
Urology  945   738   207   28%
Bronchoscopy  417   196   221   113%
Repairs, peripherals, and accessories  323   484   (161)  -33%
Total medical sales  2,119   2,605   (486)  -19%
Borescopes  366   560   (194)  -35%
Repairs  147   153   (6)  -4%
Total industrial sales  513   713   (200)  -28%
Net sales $2,632  $3,318  $(686)  -21%
Medical Segment
Medical Segment – ENT and TNE Markets
Sales to the ENT and TNE markets include both our ENT and TNE endoscopes and EndoSheath disposables and were as follows:
  
Three Months Ended
September 30,
       
ENT/TNE Market 2010  2009  Difference  Percentage 
Endoscopes $583  $974  $(391)  -40%
    Slide-On EndoSheaths  7   33   (26)  -79%
Total ENT/TNE market $590  $1,007  $(417)  -41%
 
Net sales to the ENT and TNE markets decreased $0.4 million, or 41%, in the second quarter of fiscal 2011 to $0.6 million compared to $1.0 million in the second quarter of fiscal 2010. The decrease in net sales was primarily attributable to lower sales to Medtronic of our fiberscopes ($0.5 million).

Medical Segment – Urology Market

Sales to the urology market include urology endoscopes and EndoSheath disposables and were as follows:
  
Three Months Ended
September 30,
       
Urology Market 2010  2009  Difference  Percentage 
Endoscopes $322  $176  $146   83%
    Slide-On EndoSheaths  377   344   33   10%
Total urology market $699  $520  $179   34%
Net sales to the urology market increased $0.2 million, or 34%, in the second quarter of fiscal 2011 to $0.7 million compared to $0.5 million in the second quarter of fiscal 2010. The increase in net sales was primarily attributable to higher sales of our videoscopes ($0.1 million).

18
Medical Segment – Bronchoscopy Market

Sales to the bronchoscopy market include bronchoscopy endoscopes and EndoSheath disposables and were as follows:
  
Three Months Ended
September 30,
       
Bronchoscopy Market 2010  2009  Difference  Percentage 
Endoscopes $44  $131  $(87)  -66%
    Slide-On EndoSheaths  10   5   5   100%
Total bronchoscopy market $54  $136  $(82)  -60%
Net sales to the bronchoscopy market decreased $82 thousand, or 60%, in the second quarter of fiscal 2011 to $54 thousand compared to $136 thousand in the second quarter of fiscal 2010. The decrease in net sales was primarily attributable to lower sales of our videoscopes ($57 thousand).

Medical Segment – Repairs, Peripherals, and Accessories
Net sales of repairs, peripherals, and accessories decreased $0.3 million, or 48%, in the second quarter of fiscal 2011 to $0.3 million compared to $0.6 million in the second quarter of fiscal 2010. The decrease was primarily attributable to lower sales volume of peripherals and accessories for our ENT endoscopes ($0.3 million).
Industrial Segment
Net sales of industrial products of $0.6 million decreased $37 thousand, or 6%, in the second quarter of fiscal 2011 compared to the same period last year. The decrease was primarily attributable to lower repair sales ($42 thousand). This segment’s products are mature, and therefore, we expect future sales to remain relatively flat.
Gross Profit (Net Sales Less Cost of Sales)
Gross profit from our two reportable segments was as follows:
  
Three Months Ended
September 30,
       
Gross Profit 2010  2009  Difference  Percentage 
Medical $447  $293  $154   53%
  As percentage of net sales  26%  13%  13%    
Industrial  194   172   22   13%
  As percentage of net sales  32%  27%  5%    
Gross profit $641  $465  $176   38%
Gross margin percentage  28%  16%  12%    
Gross profit increased $0.2 million, or 38%, in the second quarter of fiscal 2011 to $0.6 million from $0.5 million in the second quarter of fiscal 2010, primarily attributable to favorable manufacturing overhead absorption ($0.3 million). Gross margin percentage increased 12% in the second quarter of fiscal 2011 to 28% of net sales from 16% of net sales in the second quarter of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing overhead absorption in the second quarter of fiscal 2011 compared to the same period last year ($0.3 million, or 13% gross margin percentage impact).

19

Gross Profit – Medical Segment
Gross profit in our medical segment increased $0.2 million, or 53%, in the second quarter of fiscal 2011 to $0.4 million from $0.3 million in the second quarter of fiscal 2010, primarily attributable to favorable manufacturing overhead absorption ($0.1 million). Gross margin percentage increased 13% in the second quarter of fiscal 2011 to 26% of net sales from 13% of net sales in the second quarter of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing overhead absorption and lower scrap inventory in the second quarter of fiscal 2011 compared to the same period last year ($0.2 million, or 13% gross margin percentage impact on our medical segment gross profit).
Gross Profit – Industrial Segment
Gross profit in our industrial segment increased $22 thousand, or 13%, in the second quarter of fiscal 2011 to $194 thousand from $172 thousand in the second quarter of fiscal 2010, primarily attributable to favorable manufacturing overhead absorption ($154 thousand) partially offset by a higher inventory reserve and increased cost of sales for repairs ($104 thousand). Gross margin percentage increased 5% in the second quarter of fiscal 2011 to 32% of net sales from 27% of net sales in the second quarter of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing overhead absorption, partially offset by a higher inventory reserve and increased cost of sales for repairs ($50 thousand, or 7% gross margin percentage impact on our industrial segment gross profit).
Operating Expenses

Total operating expenses decreased $0.1 million, or 2%, in the second quarter of fiscal 2011 to $3.5 million from $3.6 million in the second quarter of fiscal 2010. Selling, general, and administrative (“SG&A”) expenses increased $0.1 million, or 3%, while research and development (“R&D”) expenses decreased $0.2 million, or 18%, compared to the same period last year.

Operating expenses, by segment, were as follows:
  
Three Months Ended
September 30,
       
Operating Expenses 2010  2009  Difference  Percentage 
SG&A expenses            
Medical $2,553  $2,462  $91   4%
Industrial  242   245   (3)  -1%
Total SG&A expenses  2,795   2,707   88   3%
R&D expenses                
Medical  732   897   (165)  -18%
Industrial  -   -   -   - 
Total R&D expenses  732   897   (165)  -18%
Total operating expenses $3,527  $3,604  $(77)  -2%
SG&A Expenses – Medical Segment

SG&A expenses in our medical segment increased $0.1 million, or 4%, in the second quarter of fiscal 2011 to $2.6 million, primarily attributable to higher sales commissions ($0.1 million).
SG&A Expenses – Industrial Segment

SG&A expenses in our industrial segment decreased $3 thousand, or 1%, in the second quarter of fiscal 2011 to $242 thousand, primarily attributable to lower stock-based compensation expense ($28 thousand), which was partially offset by higher sales commissions ($22 thousand).

R&D Expenses – Medical Segment
R&D expenses in our medical segment decreased $0.2 million, or 18%, in the second quarter of fiscal 2011 to $0.7 million, primarily attributable to lower manufacturing overhead allocations ($0.2 million).

R&D Expenses – Industrial Segment
There were no material R&D expenses incurred by our industrial segment during the second quarter of fiscal 2011 or 2010.

20
Other (Expense) Income
Other (expense) income was as follows:

  
Three Months Ended
September 30,
       
Other (Expense) Income 2010  2009  Difference  Percentage 
Interest income $1  $21  $(20)  -95%
Interest expense  (90)  (46)  (44)  -96%
Debt cost expense  (36)  -   (36)  n/m*
Other, net  (1)  -   (1)  n/m*
Other expense $(126) $(25) $(101)  -404%
______________________
* Not meaningful

Interest Income
Interest income decreased $20 thousand, or 95%, in the second quarter of fiscal 2011 primarily attributable to lower cash and short-term investments balances.
Interest Expense
Interest expense increased $44 thousand, or 96%, in the second quarter of fiscal 2011 primarily attributable to the interest associated with the Advances of $4.5 million on the Loan.

Debt Cost Expense
In the second quarter of fiscal 2011, we recorded debt cost expense of $36 thousand associated with the issuance of the Initial and Additional Warrant Shares.

Other, Net
In the second quarter of fiscal 2011, we recorded other expense of $1 thousand primarily attributable to foreign exchange translation losses ($6 thousand), which were partially offset by receipt of a settlement for a former 401(k) investment fund ($4 thousand).

Net Loss
Net loss was as follows:
  
Three Months Ended
September 30,
       
Net Loss 2010  2009  Difference  Percentage 
Loss before provision for income taxes $(3,012) $(3,164) $(152)  -5%
Income tax provision  2   6   (4)  -67%
Net loss $(3,014) $(3,170) $(156)  -5%
Loss Before Provision for Income Taxes

Loss before provision for income taxes decreased $0.2 million, or 5%, in the second quarter of fiscal 2011 to $3.0 million, primarily attributable to a higher gross profit ($0.2 million).

Income Tax Provision

We recorded a provision for state income taxes of $2 thousand and $6 thousand in the second quarter of fiscal 2011 and 2010, respectively.

Net Loss

Net loss decreased $0.2 million, or 5%, in the second quarter of fiscal 2011 to $3.0 million, primarily attributable to a higher gross profit ($0.2 million).

21
Six months ended September 30, 2010 compared to the six months ended September 30, 2009 (in thousands, except percentages)

Net Sales

Net sales decreased $1.3 million, or 20%, in the first half of fiscal 2011 to $5.0 million compared to $6.2 million in the first half of fiscal 2010. During the first half of fiscal 2011, our medical segment’s net sales of $3.8 million decreased by $1.0 million, or 21%, primarily attributable to lower sales to Medtronic of our fiberscopes ($1.2 million). Our industrial segment’s net sales of $1.1 million decreased by $0.2 million, or 18%, primarily attributable to lower sales of our borescopes ($0.2 million).

In the medical segment, we track sales of endoscopes and EndoSheath disposables by market. We also track sales of peripherals and accessories which can be sold to more than one market. Sales by segment, market, and by category for the six months ended September 30, 2010 and 2009 were as follows:
  
Six Months Ended
September 30,
       
Market/Category 2010  2009  Difference  Percentage 
ENT and TNE $1,024  $2,194  $(1,170)  -53%
Urology  1,644   1,258   386   31%
Bronchoscopy  471   332   139   42%
SpineView  74   -   74   n/m*
Repairs, peripherals, and accessories  627   1,069   (442)  -41%
Total medical sales  3,840   4,853   (1,013)  -21%
Borescopes  782   971   (189)  -19%
Repairs  335   383   (48)  -13%
Total industrial sales  1,117   1,354   (237)  -18%
Net sales $4,957  $6,207  $(1,250)  -20%
______________________
* Not meaningful

Medical Segment
 
Medical Segment – ENT and TNE Markets
 
Sales to the ENT and TNE markets include both our ENT and TNE endoscopes and EndoSheath disposables and were as follows:

 
Three Months Ended
June 30,
        
Six Months Ended
September 30,
       
ENT/TNE Market 2010  2009  Difference  Percentage  2010  2009  Difference  Percentage 
Endoscopes $422  $1,158  $(736)  -64% $1,005  $2,132  $(1,127)  -53%
Slide-On EndoSheaths  12   29   (17)  -59%  19   62   (43)  -69%
Total ENT/TNE market $434  $1,187  $(753)  -63% $1,024  $2,194  $(1,170)  -53%
 
Net sales to the ENT and TNE markets decreased $0.8$1.2 million, or 63%53%, in the first quarterhalf of fiscal 2011 to $0.4$1.0 million compared to $1.2$2.2 million in the first quarterhalf of fiscal 2010. The decrease in net sales was primarily attributable to lower sales to Medtronic of our fiberscopes ($0.61.2 million).

 
1522
 
 
Medical Segment – Urology Market

Sales to the urology market include urology endoscopes and EndoSheath disposables and were as follows:

  
Three Months Ended
June 30,
       
Urology Market 2010  2009  Difference  Percentage 
Endoscopes $482  $372  $110   30%
    Slide-On EndoSheaths  463   366   97   27%
Total urology market $945  $738  $207   28%
  
Six Months Ended
September 30,
       
Urology Market 2010  2009  Difference  Percentage 
Endoscopes $804  $548  $256   47%
    Slide-On EndoSheaths  840   710   130   18%
Total urology market $1,644  $1,258  $386   31%
 
Net sales to the urology market increased $0.2$0.4 million, or 28%31%, in the first quarterhalf of fiscal 2011 to $0.9$1.6 million compared to $0.7$1.3 million in the first quarterhalf of fiscal 2010. The increase in net sales was primarily attributable to higher sales of our fiberscopes ($0.1 million) and EndoSheath disposables ($0.10.2 million).

Medical Segment – Bronchoscopy Market

Sales to the bronchoscopy market include bronchoscopy endoscopes and EndoSheath disposables and were as follows:
 
  
Three Months Ended
June 30,
       
Bronchoscopy Market 2010  2009  Difference  Percentage 
Endoscopes $394  $182  $212   116%
    Slide-On EndoSheaths  23   14   9   64%
Total bronchoscopy market $417  $196  $221   113%
  
Six Months Ended
September 30,
       
Bronchoscopy Market 2010  2009  Difference  Percentage 
Endoscopes $438  $313  $125   40%
    Slide-On EndoSheaths  33   19   14   74%
Total bronchoscopy market $471  $332  $139   42%
 
Net sales to the bronchoscopy market increased $0.2$0.1 million, or 113%42%, in the first quarterhalf of fiscal 2011 to $0.4$0.5 million compared to $0.2$0.3 million in the first quarterhalf of fiscal 2010. The increase in net sales was primarily attributable to higher sales of our videoscopes ($0.1 million) and digital processing units, a component of our videoscope product line ($0.1 million).

Medical Segment – Repairs, Peripherals, and Accessories
 
Net sales of repairs, peripherals, and accessories decreased $0.2$0.4 million, or 33%41%, in the first quarterhalf of fiscal 2011 to $0.3$0.6 million compared to $0.5$1.1 million in the first quarterhalf of fiscal 2010. The decrease was primarily attributable to lower sales volume of peripherals and accessories for our ENT endoscopes ($0.20.5 million).
 
Industrial Segment
 
Net sales of industrial products of $0.5$1.1 million decreased $0.2 million, or 28%18%, in the first quarterhalf of fiscal 2011 compared to the same period last year. The decrease was primarily attributable to lower sales of our borescopes ($0.2 million). This segment’s products are mature, and therefore, we expect future sales to remain relatively flat.

16

Gross Profit (Net Sales Less Cost of Sales)
 
Gross profit from our two reportable segments was as follows:

 
Three Months Ended
June 30,
        
Six Months Ended
September 30,
       
Gross Profit 2010  2009  Difference  Percentage  2010  2009  Difference  Percentage 
Medical $522  $440  $82   19% $969  $733  $236   32%
As percentage of net sales  25%  17%  8%      25%  15%  10%    
Industrial  167   348   -181   -52%  361   520   -159   -31%
As percentage of net sales  33%  49%  -16%      32%  38%  -6%    
Gross profit $689  $788  $(99)  -13% $1,330  $1,253  $77   6%
Gross margin percentage  26%  24%  2%      27%  20%  7%    
 
23
Gross profit decreasedincreased $0.1 million, or 13%6%, in the first quarterhalf of fiscal 2011 to $0.7$1.3 million from $0.8 million incompared to the first quarter of fiscal 2010,same period last year, primarily attributable to favorable manufacturing overhead absorption and lower scrap inventory ($0.5 million), partially offset by the loss in gross profit from the lower sales ($0.7volume (decrease in net sales of $1.3 million). Gross margin percentage increased 2%7% in the first quarterhalf of fiscal 2011 to 26%27% of net sales from 24%20% of net sales in the first quarterhalf of fiscal 2010. The higher gross margin percentage was primarily attributable to lower scrap inventoryfavorable manufacturing overhead absorption in the first quarterhalf of fiscal 2011 compared to the same period last year ($0.10.4 million, or 2%7% gross margin percentage impact).

 
Gross Profit – Medical Segment
 
Gross profit in our medical segment increased $0.1$0.2 million, or 19%32%, in the first quarterhalf of fiscal 2011 to $0.5$1.0 million from $0.4$0.7 million in the first quarterhalf of fiscal 2010, primarily attributable to a higher gross margin percentage (up 8%)favorable manufacturing overhead absorption ($0.2 million). Gross margin percentage increased 8%10% in the first quarterhalf of fiscal 2011 to 25% of net sales from 17%15% of net sales in the first quarterhalf of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing overhead absorption and lower scrap inventory in the first quarterhalf of fiscal 2011 compared to the same period last year ($0.10.4 million, or 3%9% gross margin percentage impact on our medical segment gross profit).
 
Gross Profit – Industrial Segment
 
Gross profit in our industrial segment decreased $0.2 million, or 52%31%, in the first quarterhalf of fiscal 2011 to $0.2$0.4 million from $0.3$0.5 million in the first quarterhalf of fiscal 2010, primarily attributable to lowerincreased cost of sales for repairs ($0.2 million) and a lower gross margin percentage (down 16%). Gross margin percentage decreased 16%6% in the first quarterhalf of fiscal 2011 to 33%32% of net sales from 49%38% of net sales in the first quarterhalf of fiscal 2010. The lower gross margin percentage was primarily attributable to a higher inventory reserve and increased cost of sales for repairs, partially offset by favorable manufacturing supplies expense and unfavorable purchase price varianceoverhead absorption ($0.1 million,27 thousand, or 12%3% gross margin percentage impact on our industrial segment gross profit).
 
Operating Expenses

Total operating expenses decreased $0.2$0.3 million, or 6%4%, in the first quarterhalf of fiscal 2011 to $3.1$6.6 million compared to $3.3from $6.9 million in the first quarterhalf of fiscal 2010. Selling, general, and administrative (“SG&A”) expenses were flatincreased $0.1 million, or 2%, while research and development (“R&D”) expenses decreased $0.2$0.4 million, or 24%21%, compared to the same period last year.

Operating expenses, by segment, were as follows:

  
Three Months Ended
June 30, 
       
Operating Expenses 2010  2009  Difference  Percentage 
SG&A expenses            
Medical $2,224  $2,270  $(46)  -2%
Industrial  254   212   42   20%
Total SG&A expenses  2,478   2,482   (4)  0%
R&D expenses                
Medical  598   786   (188)  -24%
Industrial  -   -   -   - 
Total R&D expenses  598   786   (188)  -24%
Total operating expenses $3,076  $3,268  $(192)  -6%

17
  
Six Months Ended
September 30,
       
Operating Expenses 2010  2009  Difference  Percentage 
SG&A expenses            
Medical $4,777  $4,732  $45   1%
Industrial  496   457   39   9%
Total SG&A expenses  5,273   5,189   84   2%
R&D expenses                
Medical  1,330   1,683   (353)  -21%
Industrial  -   -   -   - 
Total R&D expenses  1,330   1,683   (353)  -21%
Total operating expenses $6,603  $6,872  $(269)  -4%

SG&A Expenses – Medical Segment

SG&A expenses in our medical segment decreased $46increased $45 thousand, or 2%1%, in the first quarterhalf of fiscal 2011 to $2.2$4.8 million, primarily attributable to lower bad debt expense as a result of the collection of fully reserved accounts receivablehigher sales commissions ($190185 thousand), partially offset by higherlower consulting expenses for vacation pay ($90 thousand) and attending more trade shows and conventions ($47149 thousand).
 
SG&A Expenses – Industrial Segment

SG&A expenses in our industrial segment increased $42$39 thousand, or 20%9%, in the first quarterhalf of fiscal 2011 to $0.3$0.5 million, primarily attributable to higher stock-based compensation expenserepair costs for demonstration equipment ($2826 thousand).

R&D Expenses – Medical Segment
 
R&D expenses in our medical segment decreased $188 thousand,$0.4 million, or 24%21%, in the first quarterhalf of fiscal 2011 to $0.6$1.3 million, primarily attributable to lower manufacturing overhead allocations ($98 thousand) and lower stock-based compensation expense ($38 thousand)0.3 million).

24
R&D Expenses – Industrial Segment
 
There were no material R&D expenses incurred by our industrial segment during the first quarterhalf of fiscal 2011 or 2010.

Other (Expense) Income
 
Other (expense) income was as follows:

  
Six Months Ended
September 30,
       
Other (Expense) Income 2010  2009  Difference  Percentage 
Interest income $3  $71  $(68)  -96%
Interest expense  (145)  (46)  (99)  -215%
Debt cost expense  (63)  -   (63)  n/m*
Other, net  -   (28)  28   100%
Other expense $(205) $(3) $(202)  -6733%
______________________
  
Three Months Ended
June 30,
       
Other (Expense) Income 2010  2009  Difference  Percentage 
Interest income $2  $50  $(48)  -96%
Interest expense  (55)  -   (55)  n/m*
Debt cost expense  (27)  -   (27)  n/m*
Other, net  1   (28)  29   104%
Other (expense) income $(79) $22  $(101)  -459%
______________________
* Not meaningful

 Interest Income
 
Interest income decreased $48$68 thousand, or 96%, in the first quarterhalf of fiscal 2011 primarily attributable to lower cash and short-term investments balances.
 
Interest Expense
 
Interest expense increased $55$99 thousand in the first quarterhalf of fiscal 2011 primarily attributable to the interest associated with the Advances of $4.5 million on the Loan.

Debt Cost Expense
 
In the first quarterhalf of fiscal 2011, we recorded debt cost expense of $27$63 thousand associated with the issuance of the Initial and Additional Warrant Shares.

Other, Net
 
Other, net increased $29 thousand, or 104%, inIn the first quarterhalf of fiscal 2011 primarily attributable to2010, we recorded a loss on the sale of investments of $28 thousand that was recorded in the first quarter of fiscal 2010, which was not repeated in the current fiscal year.thousand.
 
18

Net Loss
 
Net loss was as follows:

 
Three Months Ended
June 30,
        
Six Months Ended
September 30,
       
Net Loss 2010  2009  Difference  Percentage  2010  2009  Difference  Percentage 
Loss before provision for income taxes $(2,466) $(2,458) $(8)  0% $(5,478) $(5,622) $(144)  -3%
Income tax provision  3   10   (7)  -70%  5   16   (11)  -69%
Net loss $(2,469) $(2,468) $(1)  0% $(5,483) $(5,638) $(155)  -3%
                
Loss Before Provision for Income Taxes

Loss before provision for income taxes remained flat at $2.5decreased $0.1 million, or 3%, in the first quarterhalf of fiscal 2011 compared to the same period last year.$5.5 million, primarily attributable to a higher gross profit ($0.1 million).

Income Tax Provision

We recorded a provision for state income taxes of $3$5 thousand and $10$16 thousand in the first quarterhalf of fiscal 2011 and 2010, respectively. We incurred a net operating loss (“NOL”) for the first half of fiscal 2011 and expect to have a NOL for the entire fiscal year. As a result, no income tax provision was recorded for federal income tax purposes.

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Net Loss

Net loss remained flat at $2.5decreased $0.2 million, or 3%, in the first quarterhalf of fiscal 2011 compared to the same period last year.$3.0 million, primarily attributable to a higher gross profit ($0.1 million).

Liquidity and Capital Resources

At JuneSeptember 30, 2010, our principal source of liquidity was working capital of approximately $6.1$3.7 million, including $2.8$4.5 million in cash and short-term investments. Our cash and cash equivalents decreased $0.2increased $1.9 million during the first quarterhalf of fiscal 2011 as compared to $1.9a decrease of $1.3 million in the first quarterhalf of fiscal 2010. The lower decreaseincrease was primarily attributable to the proceeds received from an Advance on the Loan with our Chairmancustomers for deferred revenue arrangements during the first quarterhalf of fiscal 2011 ($2.03.9 million), which was not available to us in the first quarter of fiscal 2010..

In the first quarterhalf of fiscal 2011, we used $2.2$0.5 million of net cash in our operating activities compared to $2.8$4.3 million in the first quarterhalf of fiscal 2010. The lower cash used in operations was primarily attributable to the receipt of a carryback refund claimproceeds from customers for an alternative minimum tax net operating lossdeferred revenue arrangements during the first quarterhalf of fiscal 2011 ($0.43.9 million).

In the first quarterhalf of fiscal 2011, we used $0.1provided $0.4 million of net cash in our investing activities compared to $0.8$3.0 million provided from our investing activities in the first quarterhalf of fiscal 2010. The decrease was primarily attributable to reduced proceeds yielded from sales and maturities of our short-term investments ($0.95.4 million).

In the first quarterhalf of fiscal 2011, we provided $2.0$2.1 million of net cash from our financing activities compared to $32$26 thousand in the first quarterhalf of fiscal 2010. The increase was primarily attributable to the proceeds from an Advance on the Loan during the first quarter of fiscal 2011 ($2.0 million).

We have incurred losses since our inception, and losses are expected to continue through at least fiscal years 2011 and 2012. We have funded the losses principally with cash flow from operations, funding of advances under the Loan, proceeds from public and private equity financings, payments from Medtronic related to the sale of certain assets related to our ENT EndoSheath technology business, and the sale of other assets. We have also received $3.9 million of deposits from two customers (the “Prepayments”) during the three months ended September 30, 2010 to support anticipated orders, which are expected to ship by the end of fiscal 2011. We believe that our cash, short-term investments,including the Prepayments, and $0.5 million of capital available, subject to certain conditions, under the Loan will be sufficient to fund our working capital,cap ital, capital expenditures, and future operating losses until September 30,December 31, 2011. However, if our performance expectations fall short (including regaining sales or profits historically generated from Medtronic)Medtronic and generating expected sales from Stryker and SpineView) or our expens esexpenses exceed expectations, we will need to either secure additional financing or reduce expenses or a combination thereof, and in such instance, thecombination. Our failure to do so would have a material adverse impact on our prospects and financial condition. There can be no assurance that any contemplated external financing will be available on terms acceptable to us, if at all, or that we will be able to reduce expenses.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.

 
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Item 3.  Quantitative and Qualitative Disclosures About Market Risk

We are a smaller reporting company, as defined in Rule 12b-2 of the Exchange Act, and are not required to provide the information required by this item.

Item 4.  Controls and Procedures

Disclosure Controls and Procedures

We have evaluated, under the supervision and with the participation of our senior management, including our Interim Chief Executive Officer (“Interim CEO”) and Chief Financial Officer (“CFO”), the effectiveness of the design and operation of our disclosure controls and procedures as of JuneSeptember 30, 2010. Based upon the foregoing, our Interim CEO and CFO concluded that our disclosure controls and procedures were effective as of JuneSeptember 30, 2010.
  
Changes in Internal Controls Over Financial Reporting
Changes in Internal Controls Over Financial Reporting
 
There have been no changes in our internal controls over financial reporting during the three months ended JuneSeptember 30, 2010 that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting.

 
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PART II—OTHER INFORMATION

Item 1.  Legal Proceedings
 
None
 
Item 1A.  Risk Factors
 
There have been no material changes from the information discussed in Part I, Item 1A. Risk Factors, on page 19 of our Annual Report on Form 10-K for the year ended March 31, 2010, except for the information discussed below. You should carefully consider the risks and uncertainties we discussed in our Form 10-K and the risks described below in this quarterly report before deciding to invest in, or retain, shares of our common stock. These are not the only risks and uncertainties that we face. Additional risks and uncertainties that we do not currently know about or that we currently believe are immaterial, or that we have not predicted, may also harm our business operations or adversely affect us. If any of these risks or uncertainties actually occurs, our busi ness, financial condition, operating results, or liquidity could be materially harmed.

We have a history of operating losses and we may not achieve or maintain profitability in the future

We have incurred substantial operating losses since our inception and there can be no assurance that we will achieve a profitable level of operations in the future. We anticipate a negative cash flow during fiscal years 2011 and 2012, because of spending for research and development, increasing our global network of independent sales representatives and distributors, investing in a direct sales force for the North American market, general business operations, and capital expenditures. As of JuneSeptember 30, 2010, we had cash and cash equivalents including short-term investments, totaling approximately $2.8$4.5 million. We expect that our current balance of cash short-term investments,(including the remaining amounts of Prepayments) and $0.5 million of capital available, subject to certain conditions, under the Loan will be sufficient to fund our operations until September 3 0, 2011.December 31, 2011 . However, if our performance expectations fall short (including regaining sales or profits historically generated from Medtronic)Medtronic and generating expected sales from Stryker and SpineView) or our expenses increase, we will need to either secure additional financing or reduce expenses or a combination thereof, and in such instance, the failure to do so would have a material adverse impact on our financial condition. There can be no assurance that any contemplated external financing will be available on terms acceptable to us, if at all.

Our risk related to the supply agreement with Stryker

Pursuant to our agreement with Stryker, we will supply to Stryker our flexible video and fiber cystoscopes and related EndoSheath products for a term of three years. We will also supply Stryker with flexible ureteroscopes upon launch of this product line, expected to occur during calendar 2011. Stryker will initially have the exclusive rights to distribute these products in North and Latin America, South America, China and Japan, and 12 months post-launch, throughout the rest of the world. There can be no assurance that Stryker   will purchase any products from us or will succeed in marketing and selling these products. If they do not purchase such products or are unsuccessful in marketing or selling these products, will not be able to distribute those products to others and could g enerate little or no revenue from the Stryker agreement. Stryker also agreed to prepay $5 million in anticipation of ordering scopes and EndoSheath products from us, of which $2.5 million has been prepaid as of September 30, 2010. There is no required minimum purchase amount which Stryker is required to buy from us. Although we expect that they will order sufficient quantities of products to fully utilize these prepayments, if they do not do so by the end of the term, we would be required to return any unused amount which they prepaid to us. This would include amounts that we used to purchase parts and components, of which we will not receive compensation or reimbursement.  If we are required to refund any amounts paid to us, it will have a material adverse effect on our liquidity, ability to fund working capital and our financial condition. There can be no assurance that we will have available funds to do so. 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
 
N/A
 
Item 3.  Defaults Upon Senior Securities
 
N/A
 
Item 4.  (Removed and Reserved)
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N/AItem 4.  Submission of Matters to a Vote of Stockholders
Our fiscal 2010 Annual Meeting of Stockholders was held on September 2, 2010 for the purpose of electing two Class I Directors to serve a three-year term, to ratify the appointment of EisnerAmper LLP (formerly Amper, Politziner & Mattia, LLP) as our independent registered public accountants, and to amend our 2007 Stock Incentive Plan.

Lewis C. Pell and John J. Rydzewski were elected to serve as Class I Directors. Votes cast for the election of directors were as follows:

Election of Class I Directors
 Lewis C. PellFor:20,679,686 Withheld:2,174,896
 John J. RydzewskiFor:22,774,517Withheld: 80,065
                                                                                                                                                ; 
The vote on the ratification of the appointment of EisnerAmper LLP (formerly Amper, Politziner & Mattia, LLP) as the independent registered public accountants was as follows:
 For:32,174,401Against:63,648
   Abstain:10,598
The vote on the amendment of our 2007 Stock Incentive Plan was as follows:
 For:20,516,734Against:2,336,248
   Abstain:1,600
David W. Anderson, Warren Bielke, Lothar Koob, and Katsumi Oneda continued to serve as members of our Board of Directors after the annual meeting.

Item 5.  Other Information

N/A

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Item 6.  Exhibits

Exhibits
  
10.12007 Stock Incentive Plan, as amended (Filed as Appendix A to the Company’s Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on July 22, 2010 and incorporated herein by reference from such Schedule 14A).
10.2Supply Agreement dated September 22, 2010 between Vision-Sciences, Inc. and Stryker Corporation.  Confidential portions of this exhibit have been omitted pending a request for confidential treatment pursuant to Rule 24b-2 of the Securities and Exchange Act of 1934. Such confidential portions have been confidentially submitted separately to the Securities and Exchange Commission. (Filed as an Exhibit to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 28, 2010  and incorporated by reference herein from such Form 8-K).
31.1 Certifications of Interim Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32 Certification of Interim Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes Oxley Act of 2002.

 
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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
VISION-SCIENCES, INC.
Date:  August 11,November 10, 2010
By:
/s/ Warren Bielke
Warren Bielke
Interim Chief Executive Officer (Duly Authorized Officer)
Date:  August 11,November 10, 2010
By:/s/ Katherine L. Wolf
Katherine L. Wolf
Chief Financial Officer
and EVP, Corporate Development
(Principal Financial Officer and
Principal Accounting Officer)


 
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VISION-SCIENCES, INC.
 
EXHIBIT INDEX
 
Exhibit                      Description of Exhibit 

31.1Certifications of Interim Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32Certification of Interim Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
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