Item 1A.  Risk Factors” and elsewhere in this Form 10-K; (b) our reports and registration statements filed from time to time with the Securities and Exchange Commission (“SEC”); and (c) other announcements we make from time to time.

—	A generator to provide the appropriate stimulation to the vagus nerve;
—	A lead that is attached to both the generator and the vagus nerve;
—	Associated equipment to assist with necessary implantation surgery;
—	Equipment to assist with setting the stimulation parameters particular to the patient;
—	Appropriate instruction manuals; and
—	Magnets to suspend or induce stimulation manually.

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Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable insurance coverage, coding and reimbursement for the device, the implant procedure and follow-up care.  Currently, we have broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy. Because there are currently no favorable national coverage policies and only a few regional coverage policies for VNS Therapy for depression, we have assisted physicians and patients with obtaining case-by-case approvals since FDA approval in July 2005. Any long-term growth in sales for the treatment of depression is dependent on obtaining favorable national and regional coverage policies for VNS Therapy for depression.  In May 2007, the Centers for Medicare and Medicaid Services (“CMS”) (formerly, the Healthcare Financing Administration) issued a final determination of non-coverage with respect to reimbursement of VNS Therapy for depression.

In February 2008, we announced that, after consulting with clinical and reimbursement experts, we have developed a plan, including the conduct of an additional randomized clinical trial, or possibly more than one such clinical trial, to obtain reimbursement coverage for our depression indication.  We also announced a plan to transfer our depression business to a separate entity, in which we expect to maintain at least a minority interest.  We have engaged an investment bank to assist us in identifying a financial partner to provide the funding necessary to execute this plan.

Our clinical development program has included pilot and pivotal studies in using VNS Therapy (a) as an adjunctive therapy for reducing the frequency of seizures in patients over 12 years of age with partial onset seizures that are refractory to antiepileptic drugs and (b) as an adjunctive treatment of patients 18 years of age and older with chronic or recurrent depression who are in a major depressive episode. We have also conducted or provided support for small pilot studies for the use of VNS Therapy in the treatment of Alzheimer’s disease, anxiety, bulimia, fibromyalgia, obesity, obsessive-compulsive disorder, multiple sclerosis and other indications. These studies have been conducted to determine the safety and effectiveness of VNS Therapy in these new indications and to determine which new indications might be considered for pivotal studies and, therefore, are an important component of our clinical research activities.

Proprietary protection for our products is important to our business.  We maintain a policy of seeking U.S. and foreign patents on selected inventions, acquiring licenses under selected patents of third parties, and entering into invention and confidentiality agreements with our employees, vendors and consultants with respect to technology that we consider important to our business.  We also rely on trade secrets, unpatented know-how and continuing technological innovation to develop and maintain our competitive position.

We are actively engaged in determining how we can license intellectual property rights to third parties in order to optimize our portfolio. This includes the assessment and determination of which of our intellectual property rights for particular indications we do not have immediate plans to develop and identifying whether these rights should be licensed to third parties. It also involves the assessment of the intellectual property rights of third parties in order to determine whether we should attempt to acquire those rights through a license. We recently granted rights to Ethicon Endo-Surgery, Inc. to use our technology to treat obesity.

Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development and clinical trials and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. We have also made significant investments in recent periods in connection with sales and marketing activities in the U.S. and clinical research costs associated with new indications development, most notably depression. As of April 25, 2008, we had incurred an accumulated deficit of approximately $269.2 million.  We are focused on advancing the clinical foundation as a basis for establishing, maintaining and extending reimbursement for VNS Therapy. This may involve increased investment in clinical trials.

 

 

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VNS Therapy Epilepsy Indication Overview

Epilepsy is a disorder of the brain characterized by recurrent seizures that are categorized as either partial or generalized at onset. Patients who continue to have unsatisfactory seizure control or intolerable side effects after treatment with appropriate antiepileptic therapies for a reasonable period of time are said to suffer from refractory epilepsy. For reasons that are not clear, partial onset seizures are generally more refractory to existing therapies than generalized seizures. Epilepsy is the second most prevalent neurological disorder in the world. It is estimated that approximately 2.7 million individuals in the U.S. have epilepsy, with approximately 125,000 new cases diagnosed each year, and we estimate that there are in excess of 3.0 million individuals with epilepsy in Western Europe with over 150,000 new cases diagnosed each year.  In addition, it is estimated that approximately 50% of patients with epilepsy suffer from partial onset seizures and that over 30% of these patients continue to suffer from seizures in spite of treatment with antiepileptic drugs. There are three standard types of treatment available to persons with epilepsy: anti-epileptic drug therapy, VNS Therapy and surgery. Antiepileptic drugs serve as a first-line treatment and are prescribed for virtually all individuals being treated for epilepsy. When drug therapy is not effective, VNS Therapy may be considered.  Surgery may also be an option for some patients. There are a number of other treatments under development for the treatment of epilepsy, including direct deep brain stimulation (“DBS”) and the Responsive Neurostimulator System (“RNStm”), but these treatments are not currently approved for commercial distribution.

VNS Therapy for Epilepsy

The VNS Therapy System is indicated as an adjunctive treatment for patients who are refractory to antiepileptic drugs. In the two randomized, parallel, double-blind, active-controlled studies that led to FDA approval of our epilepsy indication, the patients who received adjunctive VNS Therapy had a mean seizure reduction of approximately 24% and 28% during the three-month acute phase of the studies. Additionally, many patients, including some who reported no change or an increase in seizure frequency, also reported a reduction in seizure severity. Long-term follow-up data derived from an uncontrolled protocol on the 440 patients in five studies showed that efficacy was maintained and, for many patients, improved over time during treatment with the VNS Therapy System. Analysis of the pooled data showed that the median percentage seizure reduction was 44% after 24 months of treatment and was sustained at that level at 36 months. In the treatment of refractory epilepsy, the side effects associated with the VNS Therapy System are generally mild, localized and related to the period of time in which stimulation is activated. The side effects include voice alteration, neck discomfort, increased cough, shortness of breath and difficulty swallowing. The VNS Therapy System has not typically been associated with the debilitating central nervous system side effects that frequently accompany antiepileptic drugs. Additionally, side effects of VNS Therapy typically decrease over time. To date, over 48,000 patients worldwide have been treated with the VNS Therapy System for epilepsy.

 

 

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VNS Therapy Depression Indication Overview

Major depressive disorder is one of the most prevalent and serious illnesses in the U.S. It affects nearly 19 million Americans 18 years of age or older every year. Recently published data indicate that approximately one-third of patients with major depressive disorder will not achieve a remission of their depressive symptoms after four well-delivered, optimized treatment steps using standard antidepressant therapies. According to the World Health Organization, based on years lived with disability, depression is the leading cause of disability for the general population. Depression interferes with a person’s ability to function, feel pleasure or maintain interest in everyday living. It is associated with increased mortality due to suicide and other co-morbid general medical conditions or general medical conditions that co-exist with the depressive disorder. Total annual costs for depression in the U.S. are estimated to exceed $80 billion, including $26 billion in annual direct treatment costs. Standard treatment methods for depression include antidepressant drugs, psychotherapy and electroconvulsive therapy (“ECT”). First-line therapy often consists of an antidepressant drug. For patients who do not respond adequately to initial antidepressant treatment, physicians will often switch to a different drug or use two or more drugs in combination. Physicians usually reserve ECT for patients who have not had an adequate response to multiple trials of antidepressant drugs or when they determine a rapid response to treatment is desirable. There are a number of other neuromodulation treatments under development for the treatment of depression, including repetitive transcranial

magnetic stimulation (“rTMS”) and DBS, but these treatments are not currently approved for commercial distribution.

VNS Therapy for Depression

The VNS Therapy System is indicated as an adjunctive treatment for patients 18 years of age or older who have chronic or recurrent treatment-resistant depression who are experiencing a major depressive episode and have not had an adequate response to four or more adequate antidepressant treatments. In Canada and the European Union, VNS Therapy is indicated for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or treatment-intolerant major depressive episode. The FDA approved the depression indication for the VNS Therapy System based on (a) a long-term uncontrolled trial (the “Pivotal Trial”) of adjunctive VNS Therapy that showed significant, sustained improvement of depressive symptoms over one and two years, and (b) a comparison of the 12-month outcomes in the Pivotal Trial with the 12-month outcomes among a non-randomized, but well-matched, group of patients who received only standard treatments for their depression. After one year of adjunctive VNS Therapy in the Pivotal Trial, response to treatment ranged from 22% to 37% (depending on which outcome was measured). Moreover, 60% of the patients who responded after three months of adjunctive VNS Therapy were still responders at one year and 70% of the three-month responders were responders at the two-year evaluation. For those patients who were responders at the one-year evaluation, 69% were still responders at the two-year evaluation. VNS Therapy was generally well tolerated in the depression clinical studies.  The most commonly reported adverse events were similar to those observed in patients being treated with VNS Therapy for epilepsy. These side effects tended to occur during stimulation, tended to be reported as mild or moderate and tended to be reported less frequently over time.

FDA Post-Approval Study Commitments and Other Clinical Research Studies

As a condition of approval for the VNS Therapy System’s depression indication, the FDA requires us to conduct two post-approval clinical studies. One is a 460-patient randomized, controlled study that compares outcomes for different levels of vagus nerve stimulation. The other is a patient registry that will include 500 patients experiencing “treatment as usual” (as defined in the study) plus adjunctive VNS Therapy and 500 patients experiencing only treatment as usual. Both studies are actively enrolling patients. To maintain timely progress in the 460-patient dosing study, we announced a program in early 2007 whereby we are donating the VNS Therapy Systems and paying for the facility- and surgery-related costs (at a negotiated rate) for patients being enrolled in the dosing study.

 

 

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We are also sponsoring post-marketing studies in refractory epilepsy and supporting a variety of studies to improve the fundamental understanding of how VNS Therapy works. The E-06 Study is an open randomized post-marketing study being conducted in Europe to assess the efficacy and safety of adjunctive VNS versus adjunctive new anti-epileptic drug AED treatment in children with refractory seizures. The European Indication for Use allows children under the age of 12 to be implanted with VNS Therapy. The PuLsE Study is an open prospective randomized long-term effectiveness post-marketing study being conducted in Europe and Canada comparing best medical practice with or without adjunctive VNS Therapy in patients 16 years or older with pharmaco-resistant partial epilepsy. Both studies are actively enrolling patients. We expect to continue to invest in future research activities as appropriate.

VNS Therapy System

VNS Therapy is the first treatment approved by the FDA for both medically refractory epilepsy and depression. The safety profiles for VNS Therapy and the VNS Therapy System, including the implant procedure, are well established in clinical studies of refractory epilepsy and depression and in commercial use in over 52,000 patients.

The VNS Therapy System is a proprietary, integrated system consisting of an implantable generator that delivers an electrical signal to an implantable lead attached to the left vagus nerve. The vagus nerve is the longest of the cranial nerves, extending from the brain stem through the neck to organs in the chest and abdomen. The left vagus nerve has been shown to have influence over numerous areas of the brain. Preclinical studies and mechanism-of-action research suggest that intermittent stimulation of the left vagus nerve in the neck modulates a number of structures and alters blood flow bilaterally in several areas of the brain. These studies have also shown that stimulation of the left cervical vagus nerve is effective in suppressing the intensity or frequency of seizures and results in persistent or carryover antiepileptic effects, which increase with chronic intermittent stimulation. The mechanism-of-action research associated with our depression studies has shown stimulation of the left vagus nerve results in modulation of areas of the brain thought to be important in the regulation of mood.

The VNS Therapy System consists of a pulse generator, a bipolar lead, a programming wand and software and a tunneling tool. The pulse generator and bipolar lead are surgically implanted in a procedure that takes from 60 to 90 minutes, during which time the patient is under general, regional or, rarely, local anesthesia. The pulse generator is surgically implanted in a subcutaneous pocket in the upper left chest. The bipolar lead is connected to the pulse generator and attached to the vagus nerve in the lower left side of the patient’s neck.

The VNS Therapy System delivers stimulation on a chronic, intermittent basis. The initial stimulation parameters that we typically recommend are a 30-second period of stimulation, which we refer to as ON time, followed by a five-minute period without stimulation, which we refer to as OFF time. To optimize patient treatment, the current pulse width, amplitude and frequency and stimulation ON and OFF intervals of the pulse generator can be adjusted non-invasively by the treating physician with a handheld computer using our programming wand and software. In addition, epilepsy patients can use a small, handheld magnet provided with the VNS Therapy System to activate or deactivate stimulation manually. On-demand therapy can be useful for those epilepsy patients who sense an oncoming seizure and has been reported by a number of patients to abort or reduce the severity or duration of seizures. The magnet can also be used to provide epilepsy patient control of stimulation side effects by allowing the patient to deactivate stimulation temporarily.

Pulse Generator.  The pulse generator is an implantable, programmable signal generator designed to be coupled with the bipolar lead to deliver electrical signals to the vagus nerve. The pulse generator is a battery powered device. Shortly before or upon depletion of the battery, the pulse generator may be removed and a new generator implanted in a short, outpatient procedure.

The Model 102, 102R, DemiPulse™  and DemiPulse™ Duo VNS Therapy pulse generators, the only pulse generators we currently offer in the U.S., are similar in design and manufacture to a cardiac pacemaker. The generators are comprised of one printed circuit board and a battery hermetically sealed in a titanium case. Standard components are assembled on printed circuit boards using surface-mount technology. The assembled circuit boards are then tested and mounted with the battery in the titanium case, which is laser welded. A header to which the bipolar lead connects is added and each unit is subject to final release testing prior to being sterilized.

 

 

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Bipolar Lead.  The bipolar lead conveys the electrical signal from the pulse generator to the vagus nerve. The lead incorporates electrodes, which are self-sizing and flexible, minimizing mechanical trauma to the nerve and allowing body fluid interchange within the nerve structure. The lead’s two electrodes and anchor tether wrap around the vagus nerve and the connector end is tunneled subcutaneously to the chest where it attaches to the pulse generator. The leads are available in two sizes of inner spiral diameter to ensure optimal electrode placement on different size nerves.

Programming Wand and Software.  Our programming wand and proprietary software are used to interrogate the device and to transmit programming information from a handheld computer  to the pulse generator via electromagnetic signals. Programming capabilities include modification of the pulse generator’s programmable parameters (pulse width, amplitude, frequency and ON and OFF intervals) and storage and retrieval of telemetry data.

Tunneling Tool.  The tunneling tool is a single use, sterile, disposable surgical tool designed to be used during surgical placement of the bipolar lead. The tool is used for subcutaneous tunneling of the lead assembly between the nerve site in the neck and the pulse generator site in the chest.

Accessory Pack.  The accessory pack includes two resistor assemblies used to test the function of the device prior to implantation, the bipolar lead tie-downs and one hex screwdriver.

Product Development

Our product development efforts are directed toward improving the VNS Therapy System, improving its efficacy  and developing new products that provide additional features and functionality while improving cost effectiveness.

In May 2005, we received approval from KEMA Registered Quality, Inc. (“KEMA”) to market our DemiPulse and DemiPulse Duo VNS Therapy System generators in the member countries of the European Union for the approved epilepsy and depression indications for use. The DemiPulse generator is the next generation single-connector VNS Therapy System generator, and the DemiPulse Duo generator is the next generation dual-connector VNS Therapy System generator for use in patients whose physicians have elected replacement of their previous dual-connector generator at the end of its battery life. Both the DemiPulse and DemiPulse Duo generators are capable of delivering greater functionality and are smaller and lighter than the previous models. We submitted the Premarket Approval Application Supplement (“PMA-S”) for both the DemiPulse and the DemiPulse Duo generators to the FDA in January 2007 and initiated limited release in Europe in May 2007. We received FDA approval  in July 2007, initiated limited release in the U.S. in late 2007 and commenced commercial release in May 2008.

The VNS Therapy Perenniatm Lead was approved by the FDA in May 2006 and by KEMA in August 2006. Functionally, the new lead is the same as its predecessor, the Model 302 Lead, but it incorporates a new design and is constructed from more durable components. Mechanical tests conducted in a laboratory setting have shown the Perennia Lead to be more robust than its predecessor.

We are conducting ongoing product development programs to enhance the VNS Therapy System pulse generator, the bipolar lead and programming software. We will be required to file for the appropriate U.S. and international regulatory approvals, and some projects may require clinical trials, in connection with the introduction of new and improved products.

 

 

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Manufacturing and Sources of Components and Raw Materials

We manufacture our products at the manufacturing facility located in our corporate headquarters in Houston, Texas. We purchase many of the components and raw materials used in manufacturing these products from various suppliers.  For reasons of quality, product availability and expense control, certain components and raw materials are purchased from sole source suppliers. We work closely with our suppliers, including our sole source suppliers, to ensure continuity of supply and quality. Due to the FDA’s rigorous quality requirements regarding the manufacture of medical devices, including the VNS Therapy System, we may not be able to change suppliers or identify alternate suppliers quickly or easily. Although component or raw material supply has not historically been an issue, any reduction or interruption in supply could adversely impact our business.

Our manufacturing operations are required to comply with the FDA’s Quality System Regulation (“QSR”).  The QSR is promulgated under section 520 of the Food, Drug and Cosmetic Act, which requires manufacturers to have a quality system for the design and production of medical devices. The regulation also requires that:

—	various specifications and controls be established for devices;
—	devices be designed under a quality system to meet these specifications;
—	devices be manufactured under a quality system;
—	finished devices meet these specifications;
—	devices be correctly implanted, checked and serviced;
—	quality data be analyzed to identify and correct quality problems; and
—	complaints be processed.

Thus, the QSR helps assure that medical devices are safe and effective for their intended use. In addition, certain international markets have regulatory, quality assurance and manufacturing requirements that may be more or less rigorous than those in the U.S. Specifically, we have authorized KEMA to ensure that we are in compliance with the requirements of International Standards Organization 13485:2003, “Medical devices — Quality management systems — Requirements for regulatory purposes” and the European Council Directive 90/385/CEE relating to Active Implantable Medical Devices (“AIMD”). KEMA is an entity that confirms that a company’s products and quality systems are compliant, and serves as our notified body within the scope and framework of the European Council Directive 90/385/CEE relating to AIMD, audits us on an annual basis for such compliance.

Marketing and Sales

U.S.

We market and sell our products for refractory epilepsy and depression through separate direct sales and marketing forces.

Epilepsy Sales

 In the U.S., our sales and marketing plan focuses on creating awareness and demand for the VNS Therapy System among epileptologists and neurologists who treat refractory epilepsy, implanting surgeons, nurses, third-party payers, hospitals and patients and their families.

 

 

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To reach each of these groups, we conduct direct selling activities using a specialized sales force consisting of:

—	sales personnel with medical device, pharmaceutical, or nursing experience;
—	field clinical engineers and marketing personnel focused on educational and promotional marketing programs; and
—	reimbursement specialists and case managers experienced in patient education, insurance verification and authorization issues.

In addition to our direct selling activities, we facilitate and support peer-to-peer interactions such as symposia, conference presentations, journal articles and patient support groups to provide experienced clinicians and patients the opportunity to share their perspectives on the VNS Therapy System with others.

Depression Sales

During fiscal year 2008, we restructured our sales organization to establish separate sales groups for the epilepsy and depression indications. We experienced a significant sales decline in depression in fiscal year 2008, in part, as a result of the May 2007 negative coverage determination by CMS. As previously announced, we have a plan to obtain favorable coverage policies.  This plan includes an additional clinical trial or trials and the intention to transfer our depression business to another entity, in which we plan to retain at least a minority interest.

We do not anticipate any meaningful sales growth in depression until we obtain favorable coverage policies for VNS Therapy in depression.  Favorable coverage policies are not expected until we have completed additional clinical trial(s), and submitted further evidence of the efficacy of VNS Therapy for depression.  This evidence is not expected to be available until at least 2011.

International

We market and sell our products in approximately 71 countries through a combination of a direct sales force in certain European countries and independent distributors elsewhere.  Our objectives include increasing sales and expanding the number of countries where VNS Therapy can be made available to patients.

The VNS Therapy System is currently sold by a direct sales force in Austria, Belgium, Denmark, France, Germany, Luxemburg, The Netherlands, Norway, Spain, Sweden, Switzerland and the United Kingdom. The sales price in each direct country is based on local market conditions, including public and private reimbursement, and is generally lower than the sales price in the U.S.

We have distribution agreements with independent distributors covering a number of other territories including Canada, Mexico, Australia, and parts of Central and South America, Asia, Middle East and Europe. The distribution agreements generally grant the distributor exclusive rights for the particular territory for a specified period of time, generally one to three years.  Under the terms of the agreement and local law, we may be required to compensate the distributor in the event that the agreement is terminated by us or is not renewed upon expiration. The distributor generally assumes responsibility for obtaining regulatory and reimbursement approvals for the relevant territory and agrees to certain minimum marketing and sales expenditures and purchase commitments. Under the terms of the distributor agreements, no product return rights are granted to the distributor, and no additional product performance issues exist for us after shipment to the distributor. Our pricing to distributors is generally fixed under the terms of the distribution agreements, but may change at our election, with as little as 30 days prior notice under most agreements. Sales incentives, if provided, are recorded as a reduction of net sales in the same period net sales are recognized.

 

 

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Third-Party Reimbursement in the U.S. Market

We sell the VNS Therapy System to hospitals and ambulatory surgery centers (“ASCs”) on payment terms that are generally 30 days from shipment date. Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable coding, reimbursement and coverage for the VNS Therapy System, the associated implant procedure and follow-up care. Favorable reimbursement coverage allows our customers to invoice and get paid by third party payers for the costs of purchasing the VNS Therapy System and the associated surgery and patient care. Reimbursement or payment rates were largely unchanged over the past year, with a slight increase in the Medicare allowable amount. With respect to epilepsy, the coverage environment was largely unchanged, with virtually all technology assessments being favorable and most third-party payers having favorable coverage policies.

Coverage for VNS Therapy in depression has been difficult to obtain.  As a result, we have announced our plan to transfer our depression business to a separate entity and to seek a financial partner to fund one or more new clinical trials.

We employ case managers, available through our reimbursement hotline, to help with coverage, coding and reimbursement issues on a case-by-case basis and/or policy level.

The implant procedure, including the cost of the device (approximately $21,000 for a DemiPulse model VNS Therapy System), hospital charges and physician fees, generally costs between $23,000 and $38,000.

Medicare

Under the current CMS policy, VNS Therapy is covered for patients with medically refractory partial onset seizures for whom surgery is not recommended or for whom surgery has failed. However, in May 2007, CMS issued its Decision Memorandum for Vagus Nerve Stimulation for Treatment of Resistant Depression (CAS-00313R), concluding that Medicare coverage is not available for VNS Therapy as a treatment for depression. For additional information, see “General” above.

Medicaid

Medicaid programs generally cover hospital inpatient and outpatient services that are medically necessary and appropriate. With respect to epilepsy, most state Medicaid agencies have developed their own coverage policy for VNS Therapy or have adopted the national CMS coverage policy, although payment amounts vary from state to state. With respect to depression, a small number of Medicaid programs provide coverage for VNS Therapy on a case-by-case basis, but most are still evaluating a coverage policy or have issued a non-coverage policy. CMS’s non-coverage determination on Medicare coverage for the treatment of depression has made gaining coverage with Medicaid programs more difficult.

Medicaid reimbursement mechanisms vary state by state. Medicaid policy and payment methodologies change on a regular basis, so we are engaged in vigilant and ongoing work to ensure continued access and acceptable reimbursement for patients covered by Medicaid programs.

Private Payers

Private payers (commercial, managed care and other third-party payers) generally cover hospital inpatient and outpatient services that are considered to be medically necessary. Currently, private payers account for 50% to 60% of patients implanted with the VNS Therapy System. As with other payers, many private payers have developed clinical guidelines for coverage or adopted the national CMS coverage policy for use of VNS Therapy in epilepsy. As of the end of fiscal year 2008, coverage for VNS Therapy for depression is still very limited. Only a few plans have issued favorable coverage policies for VNS Therapy in depression, and approximately 300 plans have approved one or more case-by-case requests. Most plans have either no policy or a non-coverage policy with respect to coverage for depression. Following the May 2007 CMS national non-coverage determination for depression, we have had difficulty expanding or even maintaining coverage among private payers.

 

 

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As stated above, we believe it will be necessary to undertake at least one additional clinical trial to provide further evidence  to support coverage for VNS Therapy for depression. This trial will take several years to complete, and we cannot give any assurances that, if we undertake an additional trial, private payers will provide, expand or maintain coverage for VNS Therapy in depression once such additional clinical trial work is completed.

Payment rates vary among third-party plans based on contracts and payment methods of specific providers. Audits of providers have revealed that the average reimbursement rates for VNS Therapy-related procedures are generally acceptable to the providers.

In deciding to cover a new product or therapy, private payers base their initial coverage decisions on several factors, including, but not limited to:

—	the status of the FDA’s review of the product;
—	CMS’s national coverage determinations, as well as local coverage determinations by Medicare contractors;
—	BlueCross BlueShield Technology Evaluation Center recommendations;
—	the product’s safety and efficacy;
—	the number of studies performed and peer-reviewed articles published with respect to the product; and
—	how the product and therapy compare to alternative therapies.

Payment for VNS Therapy Outside the US

Payment by customers for VNS Therapy Systems outside the U.S. varies on a country-by-country basis and depends on the method of product distribution chosen by the company for that country. In almost all countries, governments are involved in setting the final price to be paid, which is generally lower than the price paid to the company in the U.S. market. In fiscal year 2008, our international net sales accounted for 22% of total net sales, and the three largest individual country markets were France, Great Britain and Germany. In those countries, we sell directly to hospitals, and the amount received may vary in each market within that country.  Total sales are also affected by national and local health budgets.

Increasing prices for the VNS Therapy System, or setting a higher price for new models, such as the DemiPulse and DemiPulse Duo generators, can be a difficult and time-consuming process, in some instances involving submissions to government agencies.

Although the VNS Therapy System has been approved for commercial distribution in European Union countries and Canada for the treatment of chronic or recurrent depression, we do not anticipate significant sales volumes until reimbursement approvals are achieved in these countries for this indication. We are continuing to pursue appropriate reimbursement approvals for these countries.

 

 

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Competition

We believe that in the fields of refractory epilepsy and depression, existing and future drug therapies are and will continue to be the primary competition for the VNS Therapy System. We may also face competition from other medical device companies for the treatment of partial seizures and depression. Medtronic, Inc., for example, continues to conduct clinical studies involving an implantable signal generator used with an invasive deep brain probe for the treatment of neurological disorders including epilepsy and depression, and has received FDA approval for the device for the treatment of essential tremor and Parkinson’s Disease. St. Jude Medical, Inc. has also announced that it will conduct a trial of a similar device for the treatment of depression. We could also face competition from other large medical device and pharmaceutical companies that have the technology, experience and capital resources to develop alternative devices for the treatment of epilepsy and depression. Many of our competitors have substantially greater financial, manufacturing, marketing and technical resources than we have. In addition, the healthcare industry is characterized by extensive research efforts and rapid technological progress. Our competitors may develop technologies, obtain patents and regulatory approval for products that are more effective in treating epilepsy or depression than our current or future products. In addition, advancements in surgical techniques could make surgery a more attractive therapy for epilepsy or depression. The development by others of new treatment methods with novel antiepileptic and depression drugs, medical devices or surgical techniques for epilepsy or depression could render the VNS Therapy System noncompetitive or obsolete.

We believe that the primary competitive factors within the epilepsy and depression treatment markets are the efficacy and safety of the treatment relative to alternative therapies, physician and patient acceptance of the product and procedure, availability of third-party reimbursement, quality of life improvements and product reliability. We also believe that the VNS Therapy System compares favorably with competitive products as to these factors.

While no other device therapies have been specifically approved for depression, a well-established array of antidepressant drugs, typically combined with other antidepressants of complementary action or with atypical antipsychotic drugs and/or mood stabilizers, are frequently used for refractory patients. For severe patients or those at acute risk for suicide, ECT is often used. These treatment modalities may pose a competitive threat in the near term, to the extent that they may delay a decision to offer VNS Therapy to depression patients. As other forms of neurostimulation are investigated and developed for epilepsy or depression, these may emerge as competition for VNS patient candidates. Less invasive procedures like rTMS and magnetic seizure therapy (“MST”) may compete for a similar place in the depression treatment market. Finally, ECT is undergoing refinements in technique to increase specificity and reduce the cognitive deficit side effects; if successful, the tolerability and patient acceptance of ECT could improve in the future. These neurostimulation techniques could prove to be more effective, more predictable, or more rapidly acting than VNS Therapy.

We face similar competition with respect to the development and sale of VNS Therapy as a treatment for the other disorders we are evaluating, including, but not limited to fibromyalgia, multiple sclerosis, Alzheimer’s disease, anxiety, obsessive-compulsive disorders and bulimia.

Patents, Licenses and Proprietary Rights

Including the patents referred to in the agreements described above, as of April 25, 2008, we owned or licensed 40 U.S. patents and 78 pending U.S. patent applications, covering various aspects of the VNS Therapy System, potential improvements to the VNS Therapy System and methods of treatment for a variety of disorders through electrical stimulation of the vagus nerve or other cranial nerves. In addition to epilepsy and neuropsychiatric disorders (including depression), other method patents cover the fields of eating disorders (including obesity and bulimia), endocrine disorders, migraine headaches, dementia, motility disorders, sleep disorders, coma, chronic pain, cardiac disorders and hypertension. We have filed counterparts of certain of our key U.S. patent applications in certain international jurisdictions and currently own or license 25 patents issued by the European Patent Office or other international authorities and 97 patent applications pending in the European Patent Office or before other national or international authorities.

 

 

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We have an exclusive license agreement with Jacob Zabara, Ph.D., a co-founder and consultant to us, pursuant to which we currently maintain exclusive licenses on five U.S. method patents (and such international counterparts that have been or may be issued) covering the VNS Therapy System for vagus nerve and other cranial nerve stimulation for the control of movement disorders (including epilepsy), neuropsychiatric disorders (including depression) and other disorders. We believe that these patents give us an advantage by limiting competition in VNS to treat refractory epilepsy and depression globally. The license agreement will give us coverage until expiration of the licensed patents in July 2011 for movement disorders and May 2011 for neuropsychiatric disorders. Pursuant to the license agreement, we are obligated to pay Dr. Zabara a royalty equal to 3.0% of net sales through July 2011, after which royalties will be reduced to 1.0% for the duration of any remaining patents covering licensed products.

Effective December 13, 2007, we licensed from Southern Illinois University the exclusive rights to three additional U.S. patents pertaining to VNS for the treatment of traumatic brain injury, modulating brain neural plasticity, and improving memory and learning.

We cannot assure you that patents will issue from any of the pending applications or if patents issue, that they will be of sufficient scope or strength to provide meaningful protection for our technology. Notwithstanding the scope of the patent protection available to us, a competitor could develop treatment methods or devices that are not covered by our patents.

We believe that the patents we own and license provide us with protection in the U.S. in the field of cranial nerve stimulation, including VNS for the control of epilepsy, neuropsychiatric disorders (including clinical depression), eating disorders (including obesity and bulimia), anxiety disorders, dementia (including Alzheimer’s Disease), traumatic brain injury and additional indications for which method patents have been issued. The protection provided by our international patents is not as strong as that provided by our U.S. patents due to differences in patent laws. In particular, European and other countries prohibit patents covering methods for treatment of the human body by surgery or therapy.

There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry. In the future, we may need to engage in litigation to enforce patents issued or licensed to us, to protect our trade secrets or know-how, to defend us against claims of infringement of the rights of others or to determine the scope and validity of the proprietary rights of others. Litigation could be costly and could divert our attention from other functions and responsibilities. Adverse determinations in litigation could subject us to significant liabilities to third parties, could require us to seek licenses from third parties and could prevent us from manufacturing, selling or using the VNS Therapy System, any of which could severely harm our business. We are not currently a party to any patent litigation or other litigation regarding proprietary rights and are not aware of any challenge to our patents or proprietary rights.

Licenses Granted by Us to Other Persons

Effective December 17, 2007, we entered into an Exclusive Patent License Agreement (the “EES License Agreement”) with Ethicon Endo-Surgery, Inc. (“EES”), granting EES an exclusive, worldwide license, with the right to grant non-exclusive sublicenses, for a specified field of use (treatment by means of nerve stimulation for weight reduction or for hypertension or diabetes in patients having a body mass index of 25 or more) under nine U.S. patents and nine U.S. patent applications, and future related patents and international counterparts. Under the terms of the EES License Agreement, EES paid us a non-refundable fee of $9.5 million. EES also agreed to pay us a royalty on future net sales of products covered by any of the subject patents, and EES will reimburse us for future patent-related expenses associated with the filing, prosecution, and maintenance of the licensed patents and patent applications. EES has also been granted a right of first refusal to negotiate any license under any patent rights acquired by us within the specified field of use and offered for licensing.

 

 

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Product Liability and Insurance

The manufacture and sale of our products subjects us to the risk of product liability claims. We are currently named as a defendant in three product liability lawsuits alleging liability on the basis of negligence and negligent misrepresentation. As the manufacturer of a medical device, we likely will be named in the future as a defendant in other product liability lawsuits. We do not believe that the VNS Therapy Systems involved in existing lawsuits are defective or that VNS Therapy Systems involved in future lawsuits are likely to be defective or otherwise have caused or are likely to cause injury to patients who are or may be involved in these lawsuits; however, the outcome of litigation is inherently unpredictable and could result in an adverse judgment and an award of substantial and material damages against us. We establish a liability reserve on our balance sheet in an amount less than our self-insured retention for all matters that we believe are probable of payment as a result of a judgment or settlement. Although we maintain product liability insurance in amounts that we believe to be reasonable, coverage limits may prove not to be adequate in some circumstances. Product liability insurance is expensive and in the future may be available only at significantly higher premiums or not be available on acceptable terms, if at all. A successful claim brought against us in excess of our insurance coverage could severely harm our business and consolidated results of operations and financial position.

In November 2006, we sent physicians a safety alert letter warning of a software anomaly that can cause the VNS Therapy System’s pulse generator to deliver an output current of eight milliamps during an interrupted programming session.  This amount of output current is within the range of currents originally approved by the FDA as safe and effective, but it is higher than is recommended for use.  The FDA classified this anomaly as a Class II recall and approved our decision to address this situation by means of the safety alert letter.  Although an event can be painful until stimulation is terminated by application of a magnet to the device, we are not aware of any permanent injury to a patient as a consequence of an event; however, additional events could occur and could result in injuries and claims with material adverse consequences to our business.

In August 2007, we published a field notification regarding the potential for dissolution of the lead in the area of a lead fracture if stimulation continues after the fracture.  Lead dissolution has been associated with localized pain, inflammation and vocal cord dysfunction in some patients.  The field notification advised physicians to program the generator to zero output current if a lead fracture is suspected. The FDA approved our decision to address it by means of a technical bulletin/safety alert letter. A related claim with material adverse consequences to our business could be asserted.

In October 2007, we sent physicians a safety alert letter warning of a software anomaly that can cause the screen on a Model 250 Handheld Programmer to freeze during an interrogation.  The anomaly is limited to versions of the Model 250 Programmer using a Dell X5 handheld computer.  A screen freeze does not produce a direct adverse health consequence, but could result in an indirect adverse health consequence as a result of delay in programming the generator.  The FDA classified this anomaly as a Class III recall and approved our decision to address this situation by means of the safety alert letter.  We are not aware of any permanent injuries as a result of this anomaly, but a claim with material adverse consequences to our business could be asserted in the future.

We may in the future identify other product defects, and any such defects may result in legal claims with material adverse consequences to our business.

In February 2008, we sent physicians a safety alert letter warning of a software anomaly that can cause the VNS Therapy DemiPulse and DemiPulse Duo generators to reset (set the output current to zero) during a magnet swipe or in the presence of a strong electric field.  The FDA approved our decision to address this situation by means of a safety alert letter.  We are not aware of any permanent injuries as a result of this anomaly, but a claim with material adverse consequences to our business could be asserted in the future.

We endeavor to maintain executive and organization liability insurance in a form and with aggregate coverage limits that we believe are adequate for our business purposes, but our coverage limits may prove not to be adequate in some circumstances. In addition, executive and organization liability insurance is expensive and in the future may be available only at significantly higher premiums or not be available on acceptable terms, if at all.

 

 

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Employees

As of May 30, 2008, we had approximately 438 full-time employees.  We believe that the success of our business depends, in part, on our ability to attract and retain qualified personnel. We believe our relationship with our employees is generally good, although we have had to undertake significant reductions in personnel over the last two fiscal years. We are also engaged in an ongoing effort to identify, hire, manage and maintain the talent necessary to meet the company’s objectives. However, we cannot assure you that we will be successful in hiring or retaining qualified personnel. The loss of key personnel, or the inability to hire or retain qualified personnel, could significantly harm our business.

Financial Information About Segments and Geographical Areas

We operate our business as a single segment with similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, regulatory environments and shared infrastructures. We are a neurostimulation business focused on creating new markets, improving our products, developing other indications for VNS Therapy covered by our method patents and expanding our business into other neuromodulation opportunities.

Our financial information, including our net sales and long-lived assets by geographical area, is included in the Consolidated Financial Statements and the related Notes beginning on page F-1.

Website and Availability of Public Filings with the SEC

Our internet address is www.cyberonics.com. We make available free of charge on or through our website our proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and reports relating to beneficial ownership of our securities filed or furnished pursuant to Section 16 of the Exchange Act, as soon as reasonably practicable after electronically filing such material with the SEC. Our website also contains the charters for each standing committee of our Board of Directors, our Business Practice Standards, our Code of Ethics, our Corporate Governance Guidelines and our Financial Code of Ethics.

Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements, and other information regarding our company filed electronically with the SEC.

We may from time to time provide important disclosures to investors by posting them in the investor relations section of our website, as allowed by SEC rules. Information on our website is not incorporated into this Form 10-K.

Item 1A.  Risk Factors

Our common stock price constantly changes.

Our common stock is traded on the NASDAQ Global Market under the ticker symbol “CYBX.” The price of stock on that trading market fluctuates, and we expect that the market price of our common stock will continue to fluctuate. For example, during the fiscal year ended April 25, 2008, our stock traded from a high of $22.38 to a low of $9.59 per share. Our stock price may be affected by a number of factors, some of which are beyond our control, including, without limitation:

 

 

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—	changes in the general conditions of the economy including the valuation of the dollar versus other currencies;
—	regulatory activities and announcements;
—	governmental enforcement initiatives related to medical device companies;
—	changes in market conditions and valuations of medical device companies in general;
—	national and regional coverage determinations by third-party payers, including private insurance companies, Medicare, state Medicaid programs and other international bodies responsible for coverage determinations;
—	results of studies regarding the safety and efficacy of our VNS Therapy treatment for various indications including epilepsy, depression, fibromyalgia, multiple sclerosis, obesity, bulimia, Alzheimer’s disease, anxiety, obsessive-compulsive and other disorders;
—	results of studies regarding the safety and efficacy of drugs or devices that are potential competitors to our VNS Therapy System;
—	quarterly variations in our sales and operating results;
—	announcements of significant contracts, acquisitions or capital commitments;
—	our ability to find a partner to develop VNS Therapy for depression and the terms of any agreement with that partner;
—	our ability to find licensees for some of our technology and the terms or any licenses we grant;
—	changes in financial estimates by securities analysts;
—	additions or departures of key management or other personnel;
—	risks and costs associated with the previously disclosed inquiries by the SEC staff and the U.S. Attorney and any litigation relating thereto or to our stock option grants, procedures and practices;
—	the potential identification of material weaknesses in our internal controls over financial reporting;
—	uncertainties associated with governmental and regulatory inquiries; and
—	uncertainties associated with litigation.

In addition, the stock market in recent years has experienced broad price and volume fluctuations that have often been unrelated to the operating performance of companies. These broad market fluctuations have also adversely affected, and may continue to adversely affect, the market price of our common stock.

We were not profitable in fiscal year 2008, and we have been profitable for only eight fiscal quarters since our inception in 1987.

Through April 25, 2008, we incurred an accumulated deficit of approximately $269.2 million. We continue to incur substantial expenses, including: