This is the initial public offering of Restore Medical, Inc. No public market current exists for our common stock. We are offering 4,000,000 shares of our common stock. We anticipate that the initial public offering price will be between $9.00 and $11.00 per share.

     An investment in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below and all the other information contained in this prospectus, including our financial statements and related notes, before you decide whether to purchase our common stock. The market price of our common stock could decline due to any of these risks and uncertainties, and you may lose part or all of your investment.

      The first commercially available product based on our proprietary palatal implant technology is our patented Pillar System. Our success depends both on the medical community’s acceptance and adoption of our Pillar System as a minimally-invasive treatment for individuals suffering from mild to moderate OSA and socially disruptive and habitual snoring and heightening public awareness of the prevalence of OSA to increase the number of undiagnosed sufferers of OSA who seek treatment. Currently, a relatively limited number of ENTs and oral maxillofacial surgeons regularly perform the Pillar Procedure. We cannot predict how quickly, if at all, the medical community will accept our Pillar System, or, if accepted, the extent of its use. For us to be successful, our physician customers must:

      Currently, our only product is our Pillar System. We expect that sales of our Pillar System will account for substantially all of our revenues for the foreseeable future. We currently market and sell our Pillar System in the United States and in 12 countries in Asia Pacific, Europe, the Middle East and South Africa. Because the Pillar Procedure is different from current surgical and non-surgical treatments for mild to moderate OSA and snoring, we cannot assure you that physicians will perform the Pillar Procedure, and demand for our Pillar System may decline or

      Since we commenced operations in 1999, we have incurred net losses primarily from costs relating to the development and commercialization of our Pillar System. As of March 31, 2006, we had an accumulated deficit of $41.2 million. We expect to significantly increase our investment in our sales and marketing and research and development activities and, therefore, we expect to incur net losses through at least 2008. This business strategy may not be successful, and we may not become profitable in any future period. If we do become profitable, we cannot be certain that we will be able to sustain or increase profitability on a quarterly or annual basis.

      Our limited history of sales of our Pillar System, together with our history of losses, make prediction of future operating results difficult. You should not rely on our past revenue growth as any indication of future growth rates or operating results. The price of our common stock likely will fall in the event our operating results do not meet the expectations of analysts and investors. Comparisons of our quarterly operating results are an unreliable indication of our future performance because they are likely to vary significantly based on many factors, including:

      We have conducted, and continue to conduct, a number of clinical studies of the use of our Pillar System to treat patients suffering from mild to moderate OSA and snoring in the United States, Europe, Hong Kong and Singapore. We are in the process of obtaining two-yearfollow-up data on patients who participated in a snoring clinical study in the United States; three-yearfollow-up data on patients who participated in a snoring clinical study in Europe; two-yearfollow-up data on patients who participated in an OSA clinical study in Europe; and one-yearfollow-up data on patients who participated in an OSA clinical study in the United States. In addition, we are involved in a number of ongoing clinical studies evaluating clinical outcomes from the use of the Pillar Procedure, including prospective, randomized, placebo-controlled studies, as well as clinical studies that are structured to obtain clearance from the FDA and the EU for expanded clinical indications for use of our Pillar System.

      We cannot assure you that these clinical studies will continue to demonstrate that our Pillar System provides long-term clinical effectiveness for individuals suffering from mild to moderate OSA or snoring, nor can we assure you that the use of our Pillar System will prove to be safe and effective in clinical studies under United States or international regulatory guidelines for any expanded indications. Additional clinical studies of our Pillar System may identify significant clinical, technical or other obstacles that will have to be overcome prior to obtaining clearance from the applicable regulatory bodies to market our Pillar System for such expanded indications. If further studies of our Pillar System indicate that the Pillar Procedure is not a safe and effective treatment of mild to moderate OSA or snoring, our ability to market our Pillar System, and generate substantial revenue from additional sales of our Pillar Systems, may be materially limited.

      Individuals selected to participate in these further clinical studies must meet certain anatomical and other criteria to participate. We cannot assure you that an adequate number of individuals can be enrolled in clinical studies on a timely basis. Further, we cannot assure you that the clinical studies will be completed as planned. A delay in the analysis and publication of the positive outcomes data from these clinical studies, or the presentation or publication of negative outcomes data from these clinical studies, including data related to approval of our Pillar System for expanded indications, may materially impact our ability to increase revenues through sales and negatively impact our stock price.

      Generally, the Pillar Procedure is paid for entirelyout-of-pocket by patients, whether the patient is being treated for OSA or snoring. Third-party healthcare insurers typically consider any snoring treatment to be an elective cosmetic procedure, and do not cover payment for such procedures. We believe that all treatments for snoring, including the Pillar Procedure, will continue to be considered elective procedures, and therefore, procedures for which patients will

      The cost of treatments for OSA, such as CPAP, and most surgical procedures generally are reimbursed by third-party healthcare insurers. The Pillar Procedure currently does not, and may not in the future, qualify for reimbursement for the treatment of OSA. Our ability to generate revenue from additional sales of our Pillar System for the treatment of OSA may be materially limited by the extent to which reimbursement of the Pillar Procedure for the treatment of mild to moderate OSA is available in the future. In addition, third-party healthcare insurers are increasingly challenging the prices charged for medical products and procedures. In the event that we are successful in our efforts to obtain reimbursement for the Pillar Procedure, any changes in this reimbursement system could materially affect our ability to continue to grow our business.

      Reimbursement and healthcare payment systems in international markets vary significantly by country and reimbursement for the Pillar Procedure may not be available at all under either government or private reimbursement systems. If we are unable to achieve reimbursement approvals in international markets, it could have a negative impact on market acceptance of our Pillar System and potential revenue growth in the markets in which these approvals are sought.

      Our products and manufacturing activities are subject to extensive regulation by a number of governmental agencies, including the FDA, the EU, and comparable international regulatory bodies. We are required to:

      Compliance with the rules and regulations of these various regulatory bodies may delay or prevent us from introducing any new models of our Pillar System or other new products. In addition, government regulations may be adopted that could prevent, delay, modify or rescind regulatory clearance or approval of our products.

      We are required to demonstrate compliance with the FDA’s and EU’s quality system regulations. The FDA and the EU enforce their quality system regulations through pre-approval and periodic post-approval inspections by representatives from the FDA and the designated notified body for the EU, respectively. These regulations relate to product testing, vendor qualification, design control and quality assurance, as well as the maintenance of records and documentation. If we fail to conform to these regulations, the FDA or the EU may take actions that could seriously harm our business. These actions include sanctions, including temporary or permanent suspension of our operations, product recalls and marketing restrictions. A recall or other regulatory action could substantially increase our costs, damage our reputation and materially affect our operating results.

      The majority of patients being treated today for OSA, domestically and internationally, are initially referred to pulmonologists by their primary care physicians. Pulmonologists typically administer a polysomnography, or overnight sleep study, to diagnose the presence and severity of OSA. If an individual is diagnosed with OSA or snoring by a pulmonologist, the

      The market for treating sleep disordered breathing is highly competitive and the Pillar Procedure must compete with more established products, treatments and surgical procedures, which may limit our growth and negatively affect our business. Many of our competitors have an established presence in the field of treating sleep disordered breathing and have established relationships with pulmonologists, sleep clinics and ENTs, which play a significant role in determining which product, treatment or procedure is recommended to the patient. We believe certain of our competitors are attempting to develop innovative approaches and new products for diagnosing and treating OSA and other sleep disordered breathing conditions. We cannot predict the extent to which ENTs, oral maxillofacial surgeons, primary care physicians or pulmonologists would or will recommend our Pillar System over new or other established devices, treatments or procedures.

      In addition, we have limited resources with which to market, develop and sell our Pillar System. Many of our competitors have substantially greater financial and other resources than we do, including larger research and development staffs who have more experience and capability in conducting research and development activities, testing products in clinical trials, obtaining regulatory approvals and manufacturing, marketing, selling and distributing products. Some of our competitors may achieve patent protection, regulatory approval or product commercialization more quickly than we do, which may decrease our ability to compete. If we are unable to be competitive in the market for sleep disordered breathing, our revenues will decline, negatively affecting our business.

      The medical device industry is subject to rapid technological innovation and, consequently, the life cycle of any particular product can be short. Alternative products, procedures or other discoveries and developments to treat OSA and snoring may render our Pillar System obsolete. Furthermore, the greater financial and other resources of many of our competitors may permit them to respond more rapidly than we can to technological advances. If we fail to develop new technologies, products or procedures to upgrade or improve our existing Pillar System to respond to a changing market before our competitors are able to do so, our ability to market our products and generate substantial revenues may be limited.

      Our international sales are subject to several risks, including:

      The occurrence of any of these events could seriously harm our future international sales and our ability to successfully commercialize our products in international markets, thereby limiting our growth and revenues.

      We currently market and sell the Pillar System internationally in 12 countries in Asia Pacific, Europe, the Middle East and South Africa through third-party distributors, with the exception of Germany where we sell directly to certain physician customers. We began selling the Pillar System internationally during 2005, and as of December 31, 2005 sales of Pillar Systems to Shanghai Sanjiu Technology Development Co., Ltd., our international distributor in China, represented approximately 11% of our total worldwide net sales. A decision by these third-party distributors to discontinue selling our Pillar Systems or reduce their future purchases of Pillar Systems could significantly reduce our future sales revenue.

      The timing and extent of our future growth in sales revenue depends, in part, on our ability to continue to increase the number of US physicians performing the Pillar Procedure, as well as expanding the number of Pillar Procedures performed by these physicians. Similarly, our international distributors must continue to increase the number of physicians performing the Pillar Procedure in their territories, as well as expanding the number of Pillar Procedures performed by these physicians. To the extent one or more of our large US physician customers or international distributors fails to pay us for Pillar Systems on a timely basis, we may be required to discontinue selling to these organizations and find new customers and/or replacement distributors, which could reduce our future sales revenue and negatively impact our liquidity.

      Our success depends, in part, on our ability to obtain and maintain patent protection for the Pillar Procedure and our Pillar System and their components and processes. Our success further depends on our ability to obtain and maintain trademark protection for our name and mark; to preserve our trade secrets and know-how; and to operate without infringing the intellectual property rights of others. We currently have issued or pending patents in several countries, including in the United States, Germany, Great Britain, Norway, Hong Kong, Singapore, Canada, China, the EU, Japan, South Korea, Australia, Indonesia, Malaysia and Taiwan, as well as pending Patent Cooperation Treaty applications. We cannot assure you that any of our pending

      In addition to patents, we rely on trademarks to protect the recognition of our company and product in the marketplace. We have trademark registrations for our name and mark principally in the United States, as well as registrations or pending applications in China, the EU, Indonesia and Singapore, and accordingly may not have protection for our name and mark in other jurisdictions. We also rely on trade secrets, know-how, and proprietary knowledge that we seek to protect, in part, through confidentiality agreements with employees, consultants and others. We cannot assure you that our proprietary information will not be shared, our confidentiality agreements will not be breached, that we will have adequate remedies for any breach, or that our trade secrets will not otherwise become known to or independently developed by competitors.

      There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry, and our competitors and others may initiate intellectual property litigation, including as a means of competition. Intellectual property litigation is complex and expensive and outcomes are difficult to predict. We cannot assure you that we will not become subject to patent infringement claims or litigation, or interference proceedings, to determine the priority of inventions. Litigation or regulatory proceedings also may be necessary to enforce our patent or other intellectual property rights. We may not always have the financial resources to assert patent infringement suits or to defend ourselves from claims. An adverse result in any litigation could subject us to liabilities, or require us to seek licenses from or pay royalties to others that may be substantial. Furthermore, we cannot predict the extent to which the necessary licenses would be available to us on satisfactory terms, if at all.

      The manufacture and sale of medical products entail significant risk of product liability claims. The medical device industry, in general, has been subject to significant medical malpractice litigation. Any product liability claims, with or without merit, could result in costly litigation, reduced sales, cause us to incur significant liabilities and divert our management’s

      We purchase components for our Pillar System from a variety of vendors on a purchase order basis; we have no long-term supply contracts with any of our vendors. While it is our goal to have multiple sources to procure certain key components, in some cases it is not economically practical or feasible to do so. To mitigate this risk, we maintain an awareness of

      We currently market and sell our Pillar System to ENTs and to a limited number of oral maxillofacial surgeons. The commercial success of our Pillar System ultimately depends upon a number of factors, including the number of physicians who perform the Pillar Procedure, the number of Pillar Procedures performed by these physicians, the number of patients who become aware of the Pillar Procedure by self-referral or referrals by their primary care physicians, the number of patients who elect to undergo the Pillar Procedure, and the number of patients who, having successfully undergone the Pillar Procedure, endorse and refer the Pillar Procedure to other potential patients. The Pillar Procedure may not gain significant increased market acceptance among implanting physicians, patients, third-party healthcare insurers and managed care providers. Primary care physicians may elect to refer individuals suffering from sleep disordered breathing to pulmonologists or other physicians who treat sleep disordered breathing rather than to ENTs or oral maxillofacial surgeons, and these physicians may not recommend the Pillar Procedure to patients for any number of reasons, including safety and clinical efficacy, the availability of alternative procedures and treatment options, or inadequate levels of reimbursement. In addition, while positive patient experiences can be a significant driver of future sales, it is impossible to influence the manner in which this information is transmitted and received, the choices potential patients may make and the recommendations that treating physicians make to their patients.

      We have limited experience in marketing and selling our Pillar System through a direct sales organization in the United States and through third-party distributors internationally. We currently sell directly to certain physician customers in Germany, and are in the process of identifying an independent third-party distributor for the German market. We may not be able to maintain a suitable sales force in the United States or suitable number of third-party distributors outside the United States, or enter into or maintain satisfactory marketing and distribution arrangements with others. Our marketing and sales efforts may not be successful in increasing awareness and sales of our Pillar System.

      It is critical to the success of our sales efforts that there is an increasing number of physicians familiar with, trained in, and proficient in the use of our Pillar System. Currently, physicians learn to use our system through hands-on,on-site training by our representatives in conjunction with performing the Pillar Procedures. However, to receive this training, physicians must be aware of the Pillar Procedure as a treatment option for mild to moderate OSA and snoring and be interested in using the Pillar Procedure in their practice. We cannot predict the extent to which physicians will dedicate the time and energy necessary for adequate training in the use of our Pillar System, have the knowledge of or experience in the clinical outcomes of the Pillar Procedure or feel comfortable enough performing the Pillar Procedure to recommend it to their patients. Even if a physician is well versed in the Pillar Procedure, he or she may be unwilling to require patients to pay for the Pillar Procedureout-of-pocket. If physicians do not

      We manufacture our Pillar System at one facility using certain specialized equipment. Although we have contingency plans in effect for certain natural disasters, as well as other unforeseen events that could damage our facility or equipment, any such events could materially interrupt our manufacturing operations. In the event of such an occurrence, we have business interruption insurance to cover lost revenues and profits. However, such insurance would not compensate us for the loss of opportunity and potential adverse impact on relations with existing customers created by an inability to produce our products.

      If we are unable to attract, train and retain highly-skilled technical, managerial, product development, sales and marketing personnel, we may be at a competitive disadvantage and unable to develop new products or increase revenue. The failure to attract, train, retain and effectively manage employees could negatively impact our research and development, sales and marketing and reimbursement efforts. In particular, the loss of sales personnel could lead to lost sales opportunities as it can take several months to hire and train replacement sales personnel. Uncertainty created by turnover of key employees could adversely affect our business.

      To achieve increased revenue levels, complete clinical studies and develop future products, we believe that we will be required to periodically expand our operations, particularly in the areas of sales and marketing, clinical research, reimbursement, research and development, manufacturing and quality assurance. As we expand our operations in these areas, management will face new and increased responsibilities. To accommodate any growth and compete effectively, we must continue to upgrade and improve our information systems, as well as our procedures and controls across our business, and expand, train, motivate and manage our work force. Our future success will depend significantly on the ability of our current and future management to operate effectively. Our personnel, systems, procedures and controls may not be adequate to support our future operations. If we are unable to effectively manage our expected growth, this could have a material adverse effect on our business, financial condition and results of operations.

      We have never operated as a public company. As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act, together with new rules subsequently implemented by the Securities and Exchange Commission, or SEC, and the Nasdaq National Market, have imposed various new requirements on public companies, including requiring certain corporate governance practices. Our management and other personnel will need to devote a substantial amount of time to these new compliance requirements. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly. For example, we expect these new rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to incur substantial costs to maintain the same or similar coverage.

      In addition, the Sarbanes-Oxley Act requires, among other things, that we maintain effective internal controls for financial reporting and disclosure controls and procedures. In particular, commencing in 2007, we must perform system and process evaluation and testing of our internal controls over financial reporting to allow management and our independent registered public accounting firm to report on the effectiveness of our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. Our testing, or the subsequent testing by our independent registered public accounting firm, may reveal deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses. During their audit of our financial statements for fiscal 2005, our independent registered public accounting firm determined that there were material weaknesses in our internal controls over financial reporting during fiscal 2005 because we lacked personnel with adequate technical accounting expertise to identify and account for unusual and complex debt and equity accounting matters, and lacked policies and procedures to ensure information was properly communicated to the accounting department to ensure timely and accurate financial reporting. We have substantially remediated the material weakness associated with the accounting for unusual and complex debt and equity instruments by reviewing and analyzing all historical instruments, applying the appropriate accounting treatment to the transactions associated with these instruments, and correcting errors in our historical financial statements. We also used independentthird-party expert valuations to support the valuation of certain of these instruments and will continue to independently value such instruments until they expire or are otherwise converted. In recognition of the need to improve our technical and financial statement preparation and reporting expertise, we recently hired a chief financial officer with extensive public accounting and public company financial reporting experience, and we intend to supplement his experience with a controller who will also have the appropriate level of technical accounting and financial statement preparation and reporting experience. Finally, we have substantially remediated the weakness regarding the internal communication of accounting matters over the past year by implementing a series of internal operating and control procedures to ensure we accurately account for the financial impact of our business operations and prepare the requisite accounting statements in accordance with SEC and US GAAP. Our compliance with Section 404 will require that we incur substantial accounting expense and expend significant management efforts. If we are not able to comply with the requirements of Section 404 in a timely manner, if the steps taken to remedy the material weaknesses previously identified by our independent registered public accounting firm are not effective or if our independent registered public accounting firm identifies additional deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses, the market price of our stock could decline and we could be subject to sanctions or investigations by Nasdaq, the SEC or other regulatory authorities.

      The timing and amount of our working capital and capital expenditure requirements may vary significantly depending on numerous factors, including the other risk factors described in this prospectus. Additional financing may not be available on terms favorable to us, or at all. Any additional capital we raise through the sale of equity or convertible debt securities may dilute your percentage ownership of our common stock. Furthermore, any new equity securities we issue could have rights, preferences and privileges superior to our common stock. Capital raised through debt financings could require us to make periodic interest payments and could impose potentially restrictive covenants on the conduct of our business.

      Prior to this offering, you could not buy or sell our common stock publicly. We cannot predict the extent to which investors’ interests will lead to an active trading market for our common stock or whether the market price of our common stock will be volatile following this offering. The market for medical device stocks has been extremely volatile. The following factors, most of which are outside of our control, could cause the market price of our common stock to decrease significantly from the price you pay in this offering:

      In the past, securities class action litigation often has been initiated against a company following a period of volatility in the market price of the company’s securities. If class action litigation is initiated against us, we will incur substantial costs and our management’s attention will be diverted from our operations. All of these factors could cause the market price of our stock to decline, and you may lose some or all of your investment.

      The trading market for our common stock will rely in part on the research and reports that equity research analysts publish about us and our business. We do not control these analysts or the content and opinions included in their reports. The price of our common stock could decline if one or more equity research analysts downgrade our common stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.

      If our existing stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could decrease significantly. The perception in the public market that our stockholders might sell shares of common stock could also depress the market price of our common stock. Substantially all of our existing stockholders prior to this offering are subject tolock-up agreements with the underwriters that restrict their ability to transfer their stock for at least 180 days after the date of this prospectus. Upon expiration of thelock-up agreements, 11,251,225 shares of our common stock will be eligible for sale in the public market. The market price of our common stock may drop significantly when the restrictions on resale of these shares lapse and our existing stockholders are able to sell shares of our common stock into the market.

      Following the offering, we also intend to increase the number of our registered shares of common stock by filing registration statements with the SEC covering (a) all of the shares of our common stock subject to options outstanding, but not exercised, at the close of the offering and (b) all of the shares available for future issuance under our stock incentive plan. In addition, upon completion of this offering, the holders of our preferred stock, including shares issuable upon exercise of outstanding warrants to purchase preferred stock, will hold an aggregate of 10,730,462 shares of common stock and have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. If we were to include in a company-initiated registration statement shares held by those holders pursuant to the exercise of their registration rights, the sale of those shares could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

      A decline in the price of shares of our common stock might impede our ability to raise capital through the issuance of additional shares of our common stock or other equity securities, and may cause you to lose part or all of your investment.

      Substantially all of our net proceeds from this offering will be used, as determined by management in its sole discretion, for working capital and general corporate purposes, including expanding our domestic and international marketing and sales organizations and programs, increasing our efforts to develop new products or technologies and increasing our clinical study initiatives. We have not yet determined the allocation of those net proceeds among the various uses described in this prospectus. Our management will have broad discretion over the use and investment of the net proceeds of this offering. You will not have the opportunity, as part of your investment decision, to assess whether our proceeds are being used appropriately. Pending the use of our proceeds, they may be placed in investments that do not produce income or that lose value.

      Our charter and bylaws and Section 203 of the Delaware General Corporation Law contain provisions that might enable our management to resist a takeover of our company. These provisions might discourage, delay or prevent a change in the control of our company or a

      If you purchase shares of our common stock in this offering, you will experience immediate dilution of $7.64 per share (based on the mid-point of the initial public offering price range set forth on the cover page of this prospectus), because the price that you pay will be substantially greater than the adjusted net tangible book value per share of common stock that you acquire. This dilution is due in large part to the fact that our earlier investors paid substantially less than the price of the shares being sold in this offering when they purchased their shares of our capital stock. If the underwriters exercise their over-allotment option, or if outstanding options to purchase our common stock are exercised, you will experience additional dilution.

      This prospectus contains forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. These statements are only predictions. The outcome of the events described in these forward-looking statements is subject to known and unknown risks, uncertainties and other factors that may cause our, our customers’ or our industry’s actual results, levels of activity, performance or achievements expressed or implied by these forward-looking statements, to differ. “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business,” as well as other sections in this prospectus, discuss some of the factors that could contribute to these differences.

      The forward-looking statements made in this prospectus relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

      This prospectus also contains market data related to our business and industry. These market data include projections that are based on a number of assumptions. While we believe these assumptions to be reasonable and sound as of the date of this prospectus, if these assumptions turn out to be incorrect, actual results may differ from the projections based on these assumptions. As a result, our markets may not grow at the rates projected by these data, or at all. The failure of these markets to grow at these projected rates may have a material adverse effect on our business, results of operations, financial condition and the market price of our common stock.

      We intend to use the net proceeds of this offering for working capital and general corporate purposes, including expanding our domestic and international marketing and sales organizations and programs, increasing our new product development efforts and increasing our clinical study initiatives. We have not yet determined with certainty the manner in which we will allocate these net proceeds. The amounts and timing of these expenditures will vary depending upon a number of factors, including the amount of cash generated by our operations, competitive and technological developments and the rate of growth, if any, of our business.

      Pending the uses described above, we intend to invest the net proceeds in United States government securities and other short-term, investment-grade, interest-bearing instruments.

      We have never declared or paid any cash dividends on our common stock and do not anticipate paying cash dividends on our common stock. We anticipate that we will retain all of our future earnings, if any, for use in the development and expansion of our business and for general corporate purposes. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon our financial condition and operating results.

      You should read this capitalization table together with the financial statements and related notes appearing elsewhere in this prospectus, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the other financial information included elsewhere in this prospectus.

      The preceding table excludes, on an as-adjusted basis, 768,680 shares of common stock issuable upon the exercise of warrants outstanding as of March 31, 2006 on an as-if converted basis and at a weighted average exercise price of $1.60 per share, 1,384,698 shares of common stock issuable upon the exercise of options outstanding as of March 31, 2006 at a weighted average exercise price of $1.09 per share, and 1,834,372 shares of common stock available for future issuance upon completion of this offering under our stock incentive plans.

      If you invest in our common stock, your ownership interest will be diluted to the extent of the difference between the initial public offering price per share of common stock and the adjusted net tangible book value per share of common stock immediately after this offering. Our net tangible book value as of March 31, 2006 was $(41.4) million, or $(48.34) per share of common stock. Net tangible book value per share is determined by dividing (a) our total tangible assets less our total liabilities (including convertible participating preferred stock) by (b) the number of shares of common stock outstanding.

      After giving effect to (a) the conversion of all of the outstanding shares of our preferred stock into shares of common stock upon completion of this offering, (b) conversion of preferred stock warrants into common stock warrants upon completion of this offering and (c) our sale of 4,000,000 shares of common stock at an assumed initial public offering price of $10.00 per share (the mid-point of the initial public offering price range set forth on the cover page of this prospectus), after deducting estimated underwriting discounts and commissions and offering expenses, and the application of the net proceeds from such sale, our adjusted net tangible book value as of March 31, 2006 would have been $35.9 million, or $2.36 per share. This amount represents an immediate increase in net tangible book value to our existing stockholders of $50.70 per share and an immediate dilution to new investors of $7.64 per share. The following table illustrates this per share dilution:

      If the underwriters exercise their over-allotment option to purchase additional shares in this offering, our adjusted net tangible book value at March 31, 2006 would have been $41.5 million, or $2.62 per share, representing an immediate increase in net tangible book value to our existing stockholders of $50.96 per share and an immediate dilution to new investors of $7.38 per share.

      The following table summarizes as of March 31, 2006, on an adjusted basis reflecting the conversion of all of the outstanding shares of our preferred stock into 10,395,299 shares (on a post-split basis) of common stock upon completion of this offering, the number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid by our existing stockholders and by new investors, based upon an assumed initial public offering price of $10.00 per share (the mid-point of the initial public offering price range set forth on the cover page of this prospectus) and before deducting estimated underwriting discounts and commissions and offering expenses payable by us.

      As of March 31, 2006, there were options outstanding to purchase a total of 1,384,698 shares of common stock. Those options had a weighted average exercise price of $1.09 per share. As of March 31, 2006, there were warrants outstanding to purchase on anas-if converted basis a total of 768,680 shares of common stock. Those warrants had a weighted average exercise price of $1.60 per share. Assuming the exercise in full of all our outstanding options and warrants, adjusted net tangible book value at March 31, 2006 would be $2.22 per share, representing additional dilution per share to new investors of $0.14 per share. The following table assumes the exercise of all outstanding options and warrants as of March 31, 2006:

      The selected financial data set forth below should be read in conjunction with the financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information appearing elsewhere in this prospectus. The statement of operations data for the years ended December 31, 2003, 2004 and 2005 and the balance sheet data as of December 31, 2004 and 2005 are derived from financial statements audited by KPMG LLP, and included elsewhere in this prospectus. The statement of operations data for the yearsyear ended December 31, 2001, 2002, and the balance sheet data as of December 31, 2001, 2002, 2003 are derived from our unaudited financial statements not included in this prospectus. The statement of operations data for the year ended December 31, 2001 is derived from our audited financial statements not included in this prospectus. The statement of operations data for the three months ended March 31, 2005 and 2006, and the balance sheet data as of March 31, 2006 have been derived from our unaudited financial statements, which are included elsewhere in this prospectus. Our unaudited financial statements include, in the opinion of our management, all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of those statements. The historical results are not necessarily indicative of the results to be expected for any future periods.

      In the preceding table, cost of revenue and operating expenses include stock-based compensation expense as follows:

     The following discussion and analysis should be read in conjunction with the financial statements and related notes and the other financial information appearing elsewhere in this prospectus. Some of the information contained in this discussion and analysis or set forth elsewhere in this prospectus, including information with respect to our plans and strategy, contains forward-looking statements that involve risk, uncertainties and assumptions. You should review the “Risk Factors” section of this prospectus for a discussion of important factors that could cause actual results to differ materially from those described in or implied by the forward-looking statements contained in the following discussion and analysis and elsewhere in this prospectus.

      We develop, manufacture and market our proprietary Pillar System, a simple, innovative, minimally-invasive, implantable medical device to treat sleep disordered breathing, which includes OSA and snoring. During the Pillar Procedure, a physician implants three small, braided, proprietary polyester inserts into the muscle of the soft palate to stiffen it and add structural support. This stiffening minimizes or eliminates the palatal tissue vibration that can cause snoring and the collapse that can obstruct the upper airway and cause OSA. We believe the Pillar Procedure is a safe, clinically effective, long-lasting, low-risk procedure with minimal pain or complications that offers significant benefits to both patients and physicians over other available treatment options for mild to moderate OSA and snoring.

      We anticipate that our cost of sales generally will increase during those quarters in which our sales increase. Our cost of sales also may increase if we incur additional manufacturing costs in anticipation of the commercial introduction of new products or introduce significant enhancements or improvements to the design of our current Pillar System. Furthermore, we expect our gross margins may decrease in those quarters in which we generate a higher percentage of our revenues from the sale of our products in international markets, or in which we initiate sales of a new product or product line.

      We market and sell our Pillar System primarily to ENTs, and to a lesser extent, oral maxillofacial surgeons. In the future, we intend to expand our marketing efforts to other physicians who treat sleep disordered breathing. We receive orders directly from physicians over the telephone and through purchase orders from physicians or distributors. Our products are manufactured and shipped from our facility in St. Paul, Minnesota to either physicians or distributors, and we invoice our customers and generally recognize revenue upon shipment.

      Generally, patients pay the entire cost for the Pillar Procedureout-of-pocket, whether the patient is being treated for OSA or snoring. The cost of treatments for OSA such as CPAP and most surgical procedures generally are reimbursed by third-party healthcare insurers, including Medicare. We have begun the process of seeking third-party reimbursement approval for the

      We intend to grow our business by continuing to penetrate our existing markets, and by introducing our product to other physicians who treat sleep disordered breathing as an alternative treatment for their patients who are unable or unwilling to comply with CPAP therapy or seek a safe and clinically effective alternative. We will seek to achieve these goals by expanding our current direct sales force of 12 individuals in the United States, increasing distribution of our products internationally beyond the 12 markets where our Pillar System currently is marketed and sold and bringing new products and technologies to ENTs and oral maxillofacial surgeons.

      To date, our product development efforts have been primarily focused on improving the clinical performance and manufacturability of our Pillar System, thereby reducing the cost of producing our Pillar System. In the future, our product development initiatives will include introducing improvements and enhancements to the design and functionality of our Pillar System, designing new implantable products to treat other areas of upper airway obstruction that cause or contribute to sleep breathing disorders and introducing or distributing accessory product offerings for diagnosing or treating sleep disordered breathing.

      We entered into a five-year lease agreement in 2005 for our current manufacturing and office facilities which we believe will allow us to meet the anticipated increased demand for our products, expand our business activities and increase manufacturing efficiencies. We currently sublease space to two tenants, which partially offsets our overall facility costs, while providing additional space for future expansion.

      We have never operated as a public company. As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act, together with new rules subsequently implemented by the SEC and the Nasdaq National Market, have imposed various new requirements on public companies, including requiring certain corporate governance practices. Our management and other personnel will need to devote a substantial amount of time to these new compliance requirements. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly.

      The commercial success of our Pillar System ultimately depends upon a number of factors, including the number of physicians who perform the Pillar Procedure, the number of Pillar Procedures performed by these physicians, the number of patients who become aware of the Pillar Procedure as a treatment option, the number of patients who elect to undergo the Pillar Procedure, and the number of patients who, having successfully undergone the Pillar Procedure, endorse and refer the Pillar Procedure to other potential patients. We believe that the Pillar Procedure offers physicians a clinically-effective, economically attractive, in-office procedure to treat their patients who are afflicted with mild to moderate OSA and snoring.

      Our financial statements are prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The application of GAAP requires that we make estimates that affect our reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ significantly from these estimates.

      We believe that of our significant accounting policies, which are described in Note 1 to our financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations.

      We generate revenue from the sale of our Pillar System. Revenue is generated from sales to physician customers in the US and Germany and third-party distributors internationally. We generally do not sell our Pillar System to hospitals or healthcare institutions.

      The evidence of an arrangement generally consists of a purchase order issued by the customer or pursuant to a distribution agreement. For existing physician customers, the evidence of an arrangement may consist of a verbal phone order in situations in which normal business practices do not require a purchase order.

      Delivery to the customer occurs when the customer takes title to the product. Generally, title passes upon shipment from our facility, but may occur when the product is received by the customer based on the terms of the agreement with the customer.

      The price for each sale is fixed and agreed with the customer prior to shipment and is generally based on established list prices.

      A provision for estimated sales returns on domestic product sales is recorded in the same period as the related revenue is recorded. The provision for estimated sales returns, if any, is based on an analysis of historical sales returns as adjusted for specifically identified estimated changes in historical return activity. Sales terms to our international distributors do not contain a right to return product purchased from us. We have allowed only limited product returns from US physician customers and international distributors in connection with our release of a redesigned Pillar delivery system during 2005. We have a corporate policy of not accepting product returns for non-defective Pillar Systems from any customer, except in extraordinary circumstances which we review on a case-by-case basis. We will, however, provide physician

      Our standard payment terms for customers are net 30 to 60 days in the United States and net 30 to 120 days internationally. If we deem the facts and circumstances surrounding a customer’s order justify alternative payment terms, we may grant extended payment terms on a customer-by-customer basis.

      Collectability is evaluated prior to shipment. Our customers typically are physicians, clinics and hospitals, and are generally deemed creditworthy; however, if we have collection concerns, we will require prepayment of the order.

      In estimating the collectability of our accounts receivable, we analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends, and changes in customer payment terms. We record allowances in the period when the net revenues are recognized based on anticipated future events. If there are unanticipated future events, this allowance may need to be adjusted. On a monthly basis, we determine the amount of this reserve based on a review of slow-paying accounts, as well as accounts with changed circumstances indicating that the balance due and owing to us is unlikely to be collectible.

      We replace any defective Pillar System that is returned to us at no charge to the customer provided the returned unit is not past its product expiration date (which typically is two to three years from the date of sterilization). We also will provide a replacement Pillar System at no charge to the physician customer in the event a patient treated by the physician with a Pillar Procedure experiences a partial extrusion of the Pillar insert, either at or subsequent to the time of implant. As of December 31, 2005, we maintained a reserve of $5,591 to account for this “warranty expense.” We adjust our estimated warranty expense accrual each month based on historical warranty claims experience, and record adjustments in an amount equal to the standard cost of the replacement Pillar Systems provided to physician customers. Actual warranty expense claims in the future could exceed our current warranty expense accrual if there is an increase in our historical experience of (a) defective Pillar System units given that many of the Pillar Systems sold in 2004 and all of the Pillar Systems sold in 2005 are not beyond their two to three-year product expiration date, and/or (b) the commercially reported partial extrusion rate of Pillar inserts which has been less than 1%.

      Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a full valuation allowance on our net deferred tax assets as of December 31, 2004 and 2005, respectively, due to uncertainties related to our ability to utilize our deferred tax assets in the foreseeable future. These deferred tax assets primarily consist of certain net operating loss carry forwards and research and development tax credits.

      We measurePrior to the adoption of SFAS No. 123R on January 1, 2006, we measured compensation costs for options issued or modified under our stock-based compensation plans using the intrinsic-value method of accounting. We recordUnder the intrinsic-value method, we recorded deferred compensation expense within stockholders’ deficit for stock options awarded to employees and directors to the extent that the option exercise price iswas less than the fair market value of common stock on the date of grant. Recorded deferred compensation iswas amortized to compensation expense on a straight-line basis over the vesting period of the underlying stock option grants.

      Subsequent to the commencement of the initial public offering process, we determined that certain of the stock options granted for the years ended December 31, 2003, 2004 and 2005 were granted with exercise prices below the reassessed fair value of the common stock on the date of grant. With respect to these options, we recorded deferred stock-based compensation costs of $0, $205,668 and $2,498,152 for the years ended December 31, 2003, 2004 and 2005, respectively. Net amortization of deferred stock-based compensation totaled $0, $39,483 and $559,584 for the years ended December 31, 2003, 2004 and 2005, respectively. We

      To determine these stock-based compensation costs, we estimated the fair market value of our common stock based upon several factors, including progress and milestones attained in our business, sales of preferred stock, changes in valuation of existing comparable public companies,other equity instruments using a probability weighted probability analysis of fairthe following four scenarios, which include probability weighting and assumptions that contain a number of judgments and assumptions that were developed by management.

      Under the Private Company Scenario, we assumed that we would remain an independent operating company. Under this scenario we used three commonly accepted methodologies to determine equity valuation which include 1) the Discounted Cash Flow Method; 2) the Guideline Public Company Method; and 3) the Merger and Acquisition Method. For the Discounted Cash Flow Method, we estimated five years of cash flows and applied a 40% per annum discount rate to determine present value. The 40% discount rate was derived from two independent valuation studies covering venture-backed companies. A terminal value fromwas calculated using expected EBITDA multiples of 11 to 14. The Guideline Public Company Method analyzed the price multiple at which equity securities of four publicly traded respiratory and 12 medical technology companies have traded relative to their sales and EBITDA. We applied a forward looking sales multiple of 4.0 to 5.0 times and a forward looking EBITDA multiple of 11.0 to 12.0 times to our forecasted 2008 results and discounted to a present value using a discount rate of 40%. For the Merger and Acquisition Method, we reviewed revenue and EBITDA multiples of sales transactions of 40 various medical technology companies, including respiratory companies. For the 40 sample transactions selected we calculated a median enterprise value of $66 million. We then compared our 2008 anticipated EBITDA to the median EBITDA for the sample and determined that a 12 to 14 multiple was appropriate to apply to our 2008 forecasted EBITDA.

      Under the Initial Public Offering Scenario, we assumed a future IPO on December 31, 2007. A sales multiple of 4.0 to 5.0 times was applied to management’s 2008 revenue projections to determine an initial public offering, sale ofenterprise value.

      Under the company, continued private company operations and company dissolution scenarios, andSales/ Merger Scenario, we estimated the trailing twelve-month EBITDA at the expected valuation that the company would obtain in an initial public offering. In subsequent periods and prior to the effectivetransaction date of this offering,June 30, 2008 and multiplied that by an estimated EBITDA of 12.0 to 14.0 times, the fair value ofmultiple determined in the common stock will be determined by management using the factorsMerger and Acquisition method discussed above.

      Under the Dissolution Scenario, we assumed our dissolution and subjective. If we had made different assumptions,the allocation of our deferred stock-based compensation amount, our stock-based compensation expense, ourremaining net lossassets on December 31, 2006.

      We then applied a probability weighting to each scenario on each measurement date ranging from 9% to 50% for the Initial Public Offering Scenario, 35% to 72% for the Sales or Merger Scenario, and net loss per share could have been significantly different.10% to 13% to the Private Company Scenario and 5% to 6% to the Dissolution Scenario to determine an enterprise value in 2004 and 2005, respectively.

      Under GAAP, companies are permitted to use an alternative method of valuing stock options which is based on the fair value of the stock option on the date of grant. This method generally results in the recording of a greater expense related to stock options. Recent changesOn January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R. We will apply the provisions of SFAS No. 123R to new stock option grants and to stock option grants that are modified, repurchased, or cancelled after December 31, 2005 using the prospective method of transition. We will continue to apply the intrinsic-value method to determine compensation expense for stock options granted prior to the accounting rulesadoption of SFAS No. 123R.

      Determining the appropriate fair value model and calculating the fair value of share-based payment awards require allthe input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We use the Black-Scholes model to value our stock option awards. We use historical data of publicly-traded peer companies to use aestimate expected volatility. The assumptions used in calculating the fair value method to recordof share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and management uses different assumptions, share-based compensation expense related to stock options. Wecould be materially different in the future. In addition, we are required to adopt this changeestimate the expected term and forfeiture rate, and only recognize expense for those shares expected to vest. If the actual forfeiture rate is materially different from the estimate, share-based compensation expense could be significantly different from what has been recorded in the first quarter ofcurrent period. No stock options were granted during the three-month period ended March 31, 2006. It is expected that the adoption of this change will have a material negative impact on future earnings.

      As of March 31, 2006, we had outstanding stock options to acquire an aggregate of 1,384,698 shares of common stock. Of those outstanding common stock options, 675,766 shares had vested as of March 31, 2006, and 708,932 shares were unvested.

      We evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets may warrant revision, or that the remaining balance of these assets may not be recoverable. When deemed necessary, we complete this evaluation by comparing the carrying amount of the assets against the estimated undiscounted future cash

      We conduct an annual review of our long-lived assets to determine if any assets have no or limited future value or if the value of an asset has changed during the year. In addition, as a result of the historical losses for our business, we further analyzed the effect of our launch of a newly designed Pillar delivery system in 2005 on the carrying value of our long-lived assets. Using the accumulated information from this analysis, no material asset impairment charges were recorded. Asset impairment evaluations are, by nature, highly subjective.

      All series of our outstanding preferred stock are convertible at any time into common stock at the option of the holder. The conversion price of all outstanding preferred stock is subject to weighted average anti-dilution protection. During 2003, the conversion price of Series A and Series B was adjusted from $1.00 and $3.00 per share to $0.898 and $2.6571, respectively. At December 31, 2005, our Series A, Series B, Series C and Series C-1 preferred stock were convertible into 417,594, 2,362,770, 3,807,837 and 1,249,416 shares (on a post-split basis) of common stock, respectively. At December 31, 2005, the conversion price of Series A, Series B, Series C and Series C-1 was $0.898, $2.6571, $2.62$1.796, $5.3142, $5.24 and $2.62, respectively.$5.24, respectively (on a post-split basis). There were no changes in the per share conversion prices during 2005. All series of our preferred stock and warrants for our preferred stock are mandatorily convertible into common stock upon a qualified initial public offering, as defined in our certificate of incorporation. Our stockholders have approved an amendment to our certificate of incorporation to adjust the conversion price of the Series C and Series C-1 preferred stock from $2.62$5.24 to $1.74$3.48 per share (on a post-split basis), to be effective immediately prior to the conversion of all outstanding shares of our preferred stock upon completion of this offering, in consideration for a modification of the definition of a “qualified” initial public offering such that this offering triggers the mandatory conversion of our preferred stock into common stock. As this offering will constitute a “qualified” initial public offering, all outstanding shares of preferred stock and warrants for preferred stock will be converted into either common stock or warrants for common stock, respectively, upon completion of this offering. As a result of the change in the conversion price of Series C and Series C-1 preferred stock, the outstanding common stock upon completion of this offering will increase by

      Preferred stockholders have the same voting rights as common stockholders. Preferred stockholders have one vote for each share of common stock into which their shares of preferred stock are convertible as determined by the current conversion price. As a result of the preferred stockholders’ board of directors’ representation and voting rights, they effectively control our affairs, including our liquidation. No class of preferred stock has redemption rights.

      If we issue equity or convertible instruments that are not subject to defined carve out provisions below the then applicable conversion price for each preferred stock series, the conversion price to common stock will be adjusted on a weighted average basis.

      Upon declaration by our board of directors, Series C and Series C-1 stockholders are entitled to a non-cumulative dividend of $0.21 per annum (8%) prior to the payment of dividends on Series A and Series B and common stock. After the payment of the Series C and Series C-1 dividend and prior to the payment of dividends to common stockholders, Series A and Series B stockholders are entitled to a non-cumulative dividend of $0.08 and $0.24 per annum (8% for each class), respectively. After all preferred stock dividend preferences have been paid, the common stockholders participate with preferred stockholders on an as-if converted basis.

      Series C has senior liquidation rights of $5.24 per share prior to Series C-1’s liquidation preference of $5.24 per share, and prior to the combined Series A and Series B pari passu liquidation preference of $1.00 and $3.00 per share, respectively. After all of the above liquidation preferences have been paid, any remaining liquidation proceeds are paid to common stockholders and all classes of preferred stock on an as-if converted basis. However, Series A, Series B, Series C and Series C-1 stockholders are limited to aggregate liquidation proceeds of $3.00, $9.00, $7.86 and $7.86, respectively, per share, with the remaining proceeds paid to common stockholders.

      We began selling Pillar Systems internationally through distributors in January 2005, and for the year ended December 31, 2005, approximately $1.4 million, or 30% of our total worldwide revenue, was generated from international sales. Because the Pillar Procedure is a relatively new clinical procedure to treat snoring and mild to moderate OSA, our distributors invest significant time and resources to develop the market for the Pillar Procedure in their respective territories, including training, marketing and selling Pillar Systems to ENT physicians who will perform the Pillar Procedure.

      Our international distribution agreements each contain provisions requiring our distributors to purchase an annual minimum number of Pillar Systems. Typically, we negotiate and include annual minimum purchase requirements for the first year of the distribution agreement, and we agree to negotiate future annual minimum purchase requirements based upon the sales results and market conditions in each individual territory.

      The time between an international distributor’s initial stocking order and subsequent re-orders of Pillar Systems, as well as the size of individual Pillar System orders, varies by territory based on a number of factors. These factors include the geographical size and economic development of a territory, the prevalence of sleep disordered breathing patients in the territory, the potential number of physicians who may be interested in performing Pillar Procedures, and the number of snoring and OSA patients who are willing to pay for the Pillar Procedure out-of-pocket as the Pillar Procedure typically is not covered by government or private medical insurance in international markets.

      During 2005, most of our distributors purchased Pillar Systems from us on a quarterly basis to minimize international freight charges and product importation fees. Seven of our international distributors made only an initial purchase of Pillar Systems pursuant to binding distribution agreements at various times during 2005, representing approximately 33% of our total international revenue during 2005. Our five other international distributors re-ordered Pillar Systems anywhere from two months to six months following their initial order, representing approximately 67% of our total international revenue during 2005. Pillar Systems purchased by our three largest distributors during 2005 represented approximately 75% of our total international sales for the year ended December 31, 2005. Total international sales in the last

      We have not historically had full visibility of the levels of Pillar System inventory held by our international distributors, and have relied upon each of our international distributors to manage their respective inventory levels of Pillar Systems at any particular time, including the time at which they choose to re-order Pillar Systems. However, the very nature of establishing international distribution for a new, novel medical device product may result in distributors purchasing inventory in excess of theirnear-term demand until more mature sales cycles are established. At March 31, 2006, seven of our international distributors which represent $1,330,330$1,330,600 and $475,210 of our international sales for the year ended December 31, 2005 and the quarter ended March 31, 2006, respectively, had an average of approximately six to seven weeks of inventory on hand prior to receiving their shipments for the first quarter of 2006.

      In the fourth quarter of 2005, we contractually agreed to expand the territory distribution rights for one of these distributors from nine to twelve countries. Our two largest distributors informed us that they had less than 90 days and 60 days, respectively, of Pillar System sales in their inventory at the time we shipped product to fill their fourth quarter orders. Based on our discussions with our largest distributors, as well as discussions with our other distributors, we believe the Pillar System inventories purchased by our distributors are sufficient and not in excess of the quantities required for the early stage development of the sleep disordered breathing markets in their respective territories. We do not contractually offer our international distributors the right to return Pillar Systems purchased from us, and we do not anticipate granting any special product return rights in 2006 to our international distributors for Pillar Systems purchased in 2005 or the three-month period ended March 31, 2006.

     Net Sales. Net sales increased by $849,318, or 94%, to $1,752,472 for the three months ended March 31, 2006 from $903,154 in the same period in 2005. The increase in net sales during 2006 was attributable to the increased sale of our Pillar Systems, both in the United States and international markets.

     Research and development expenses.Research and development expenses increased by $93,962, or 18% to $613,034 in the three months ended March 31, 2006 from $519,072 for the comparable period in 2005. This increase was attributable to increased compensation expense of $85,231 due to the hiring of our Vice President of Research and Development in the fourth quarter of 2005 and an increase in stock-based compensation of $21,651 over the same period in the prior year. In future quarters, we expect research and development expenditures will increase as new product development projects are initiated, and as we increase the number of post-market clinical studies of the Pillar Procedure.

     General and administrative expenses. General and administrative expenses increased by $768,542, or 103%, to $1,517,578 for the three months ended March 31, 2006 from $749,036 for the three months ended March 31, 2005. The increase is due to an increase of $406,941 in audit and consulting fees incurred during the first three months of 2006 in preparation for our planned initial public offering. In addition, compensation expense increased by $329,174 in the first three months of 2006 due to an increase in stock-based compensation of $208,115 from $77,091 in the first quarter of 2005. The increase in stock-based compensation included $190,804 of expense related to the severance agreement with our former Vice President of Finance.

     Preferred stock warrant loss. In the three months ended March 31, 2006, we recognized a loss of $162,707 related to the change in fair value of our preferred stock warrants subject to redemption compared to a loss of $174,271 in 2005 for the change in fair value during the same period in 2005.

     Net Sales. Net sales increased by $3.9 million, or 414%, from $944,816 in 2004 to $4.9 million in 2005. The net sales increase in 2005 was attributable to the increased sale of our Pillar Systems, both in the United States and international markets. United States net sales increased by $2.5 million, or 265%, from $936,956 in 2004 to $3.4 million in 2005. The total number of Pillar System units sold increased by 25,877, or 471%, from 5,494 units in 2004 to 31,371 units in 2005. The number of units sold in the United States increased by 10,859 or 199%, from 5,452 units in 2004 to 16,311 units in 2005. The number of units sold internationally increased by 15,018 from 42 units in 2004 to 15,060 units in 2005. The growth in United States net sales was primarily driven by an increase in the number of direct United States sales representatives, the number of new physician customers performing Pillar Procedures and the average number of Pillar Procedures performed by our physician customers. We first began selling our Pillar System for the treatment of snoring in April 2003 and continued under that indication until October 2004 when we began selling our Pillar System under both the snoring and mild to moderate OSA indications. The United States average selling price, or ASP, for the three Pillar inserts used in each Pillar Procedure increased from $540 in 2004 to $645 in 2005 as a result of a price increase in October 2004.

      International net sales increased from $7,860 in 2004 to $1.4 million in 2005. We commercially introduced our Pillar System into international markets beginning in January 2005 through independent third-party distributors. At the end of 2005, our Pillar System was marketed and sold in 12 international markets in Asia Pacific, Europe, the Middle East and South Africa. Due to the market development investment and distribution costs incurred by our international third-party distributors, our international ASP is typically approximately 50% of United States ASP.

     Cost of sales and gross margin. Cost of sales increased by $850,585, or 108%, from $790,805 in 2004 to $1.6 million in 2005. This increase was due to the increase in our Pillar Systems sold in 2005. As a percentage of net sales, cost of sales decreased from 84% in 2004 to 34% in 2005. As a percentage of net sales, gross margin improved from 16% in 2004 to 66% in 2005. The improvement in the gross margin percent in 2005 was the result of significant reductions in the cost of our Pillar System following our launch of a redesigned second generation delivery system in May 2005, as well as increased volume-related production efficiencies. We expect that as volume continues to increase gross margins will continue to improve as a result of economies of scale.

     Research and development expenses. Research and development expenses decreased by $412,616, or 18%, from $2.3 million in 2004 to $1.9 million in 2005. This decrease was attributable to a reduction in research and development personnel and the transfer of resources

     General and administrative expenses. General and administrative expenses increased by $789,961, or 37%, from $2.1 million in 2004 to $2.9 million in 2005. This increase was primarily attributable to increases in payroll and other benefit expenses of $738,688$738,715 due to increased headcount, including the hiring of our new President and CEO in 2005, as well as the resignation of his predecessor, including stock-based compensation expenses of $433,688. As a percentage of net sales, general and administrative expenses decreased from 227% in 2004 to 61% in 2005. The decrease as a percentage of net sales was mainly due to the rapid expansion of sales without the need for a proportional increase in staff. We expect general and administrative expenses will increase in 2006 due to the costs of being a public company, which may include the use of more consultants and increased staff.

     Sales and marketing expenses. Sales and marketing expenses increased by $941,577, or 23%, from $4.0 million in 2004 to $5.0 million in 2005. This increase was primarily attributable to increased payroll and other benefit expenses for additional sales and marketing personnel. We also incurred $227,983 of increased expenses associated with initiating our efforts to obtain a reimbursement code and coverage policies for the Pillar Procedure from the United States government and private third-party health insurers in 2005. However, this increased spending on reimbursement was offset by a reduction in other marketing expenses of $229,748,$229,705, primarily related to expenses incurred in 2004 for the initial design, development and production of marketing programs to commercially launch the FDA clearance of the mild to moderate OSA indication for the Pillar Procedure. As a percentage of net sales, sales and marketing expenses were 428% in 2004, compared to 103% in 2005. The decrease in sales and marketing expenses as a percentage of net sales was due to the significant increase in sales generated by the expanded sales and marketing programs. We expect sales and marketing spending will increase in 2006, but decrease as a percentage of net sales.

     Interest income. Interest income declined by $36,651, or 22%, from $169,072 in 2004 to $132,421 in 2005. This decrease was attributable to a decline in the amounts invested in short term investments purchased with the funds received from the sale of Series C and Series C-1 preferred stock during 2004. Over the next year, we anticipate interest income will increase due to the increase in short term investments using the proceeds from this offering.

     Interest expense. Interest expense decreased by $401,304, or 94%, from $426,120 in 2004 to $24,816 in 2005. This decrease was due to all of our debt either being converted into Series C-1 preferred stock or repaid in 2004 and no further debt being assumed until December 2005.

     Other income (expense). Other income (expense) decreased by $1.6 million, or 154%, from $1.0 million of income in 2004 to $553,125 of expense in 2005. This decrease was primarily due to the conversion of the 2003 bridge loans into Series C-1 preferred stock, resulting in a gain of $870,692 in 2004 from the extinguishment of an embedded derivative upon conversion. In addition, in 2004, we recognized a benefit of $128,465 related to the change in fair value of our preferred stock warrants subject to redemption compared to expense of $572,023 in 2005 for this change in fair value.

     Net sales. Net sales increased by $576,615, or 157%, from $368,201 in 2003 to $944,816 in 2004. The total number of Pillar System units sold increased by 3,560, or 184%,

     Cost of sales and gross margin (loss). Cost of sales increased by $378,489, or 92%, from $412,316 in 2003 to $790,805 in 2004. This increase in cost of sales was due to a higher number of our Pillar Systems sold in 2004, offset by reduced costs from volume-related production savings. As a percentage of net sales, cost of sales decreased from 112% in 2003 to 84% in 2004. As a percentage of net sales, gross margin (loss) improved from (12)% in 2003 to 16% in 2004. The improvement in gross margin was driven by increased Pillar System sales and increased volume-related production efficiencies.

     Research and development expenses. Research and development expenses decreased by $1.0 million, or 31%, from $3.3 million in 2003 to $2.3 million in 2004. This decrease was primarily attributable to $992,188 of our Pillar System product development costs incurred in 2003, and the decision to suspend research and development work on future products in 2004 to focus on the development, redesign and commercialization of the Pillar delivery system for commercial introduction in 2005.

     General and administrative expenses. General and administrative expenses increased by $145,320, from $2.0 million in 2003 to $2.1 million in 2004. This increase was primarily related to an increase in payroll, benefits and recruiting costs of $367,904$379,856 due to increased headcount, including the hiring of a vice president of finance in 2004. The increased headcount was offset by a decrease in consulting expenses of $258,332 as consultants were replaced with these new full-time employees in 2004. As a percentage of net sales, general and administrative expenses decreased from 544% in 2003 to 227% in 2004. The decrease in general and administrative expenses as a percentage of net sales was mainly due to the rapid expansion of sales without the need for a proportionate increase in staff.

     Sales and marketing expenses. Sales and marketing expenses increased by $1.7 million, or 73%, from $2.3 million in 2003 to $4.0 million in 2004. This increase was primarily attributable to $414,946 of increased payroll expenses related to the separation and replacement of sales management personnel and the addition of marketing personnel, increased commissions of $325,309$327,635 on higher sales volumes, and $661,243 of increased advertising and promotional spending and professional services. In 2004, we also initiated private third-party healthcare insurer and Medicare reimbursement strategies resulting in $109,374 in expenses in 2004 compared to $0 in 2003. As a percentage of net sales, sales and marketing expenses were 634% in 2003 compared to 428% in 2004. The decrease in sales and marketing expenses as a percentage of net sales was primarily due to the significant increase in sales generated by our 2004 expanded sales and marketing programs.

     Interest income. Interest income increased by $136,925, or 426%, from $32,147 in 2003 to $169,072 in 2004. This increase was attributable to an increase in short-term investments purchased with the funds received from the sale of Series C preferred stock during 2004.

     Interest expense. Interest expense decreased by $2.2 million, or 84%, to $426,120 in 2004 from $2.7 million in 2003. This decrease was primarily due to the $1.5 million of interest

      Interest expense on the convertible bridge loans and Comerica Bank Loan decreased by $434,570, or 76%, to $140,184 from $574,754. In the first quarter of 2004, the 2003 convertible bridge loans were converted into Series C-1 preferred stock, and we also retired a loan from Comerica Bank in the third quarter of 2004. The remaining change in interest expense of $289,846 related to the impact of modifications to the bridge loans in 2003.

     Other income (expense). Other income increased by $388,599, or 62%, to $1.0 million in 2004 as compared to $629,814 in 2003. The change primarily relates to a $232,184 increase in the put option gain on the 2003 bridge loan embedded derivative and an increase in the gain on preferred stock warrants of $119,187. We recorded a gain of $683,508$638,508 in 2003 due to a change in the estimated fair market value of the embedded put option. We recognized a gain of $870,692 in 2004 for the remaining carrying value of the embedded put option due to the extinguishment of the embedded derivative in 2004 upon converting the 2003 convertible bridge loan to Series C-1 preferred stock.

      Since our inception we have funded our operations primarily through issuances of convertible preferred stock and related warrants, which provided us with aggregate gross proceeds of $39.9 million.

      As of March 31, 2006, we had total cash, cash equivalents and marketable securities of $4.3 million. Based upon our anticipated working capital requirements, we will be required to raise capital to maintain operations at current and anticipated levels through 2006. During the first quarter of 2006, we initiated efforts to raise up to $50 million to finance current operations and provide for general corporate purposes, including expanding domestic and international marketing and sales organizations and programs, increasing product development efforts and increasing our clinical study initiatives. Our future capital requirements will depend upon a number of factors, including, but not limited to, the amount of cash generated by operations, competitive and technological developments and the rate of growth of the business. Although we have been successful in raising funds in the past, there is no assurance that any such financings or borrowings can be obtained in the future on terms acceptable to us. In the event that we are unable to raise capital in the near term, we believe cash, cash equivalents, investments and cash provided by operating activities, together with the term debt facility, described below, will be sufficient to fund working capital and capital resource needs through at least 2006, if reductions are made to our expansion plans for sales and marketing programs and limitations are made to product development and clinical study initiatives.

      Net cash provided by financing activities was $2.0 million during 2005, as compared to net cash provided by financing activities during 2004 of $16.1 million, primarily consisting of net proceeds from the issuance of Series C preferred stock of $18.6 million and proceeds of $5,587

      In March 2005, we entered into a term debt agreement with a maximum principal draw-down of $5.0 million, which was amended on March 3, 2006 to provide for a maximum principal draw-down of $8.0 million. We accessed $2.0 million in December 2005, $1.0 million in February 2006 and an additional $3.0 million in March 2006. We are able to draw the remaining $2.0 million any time prior to June 30, 2006. In March 2005, we issued an initial warrant to purchase 95,420 shares of Series C-1 preferred stock, which represented 5% of the initial loan amount of $5.0 million. We are required to issue additional warrants to purchase that number of shares of Series C-1 preferred stock equal to 4% of the amount of each draw up to $5.0 million. In connection with the term debt loan amendment on March 3, 2006, we issued an additional warrant to purchase 103,053 shares of Series C-1 preferred stock. All Series C-1 preferred stock warrants will convert into warrants for common stock upon completion of this offering. Interest on the loan accrues at a variable rate of prime plus 3% and is payable monthly, with principal due at the maturity date of December 31, 2008 and an additional final payment in an amount equal to 5% of the original loan principal. The term debt loan is collateralized by substantially all of our assets, provided that the security interest in our intellectual property will be released upon completion of this offering, or in the event this offering does not occur, upon the closing of at least $10.0 million of additional preferred equity. As of December 31, 2005, we were in compliance with all of the financial and other covenants contained in the term debt loan agreement.

      To the extent that funds generated by this public offering, together with existing cash and marketable securities, cash from operations and funds available under our term debt loan, are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Although we are currently not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all.

      The following table aggregates all contractual commitments and commercial obligations that affect our financial condition and liquidity position at December 31, 2005.