UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 - --------------------------------------------------------------------------- FORM 10-K - --------------------------------------------------------------------------- (MARK ONE) /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO __________ COMMISSION FILE NUMBER 000-50884 - --------------------------------------------------------------------------- STEREOTAXIS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 94-3120386 (STATE OR OTHER JURISDICTION OF INCORPORATION (I.R.S. EMPLOYER OR ORGANIZATION) IDENTIFICATION NUMBER) 4041 FOREST PARK AVENUE ST. LOUIS, MO 63108 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE) (314) 615-6940 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001 Par Value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K, or any amendment to this Form 10-K. / / Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes / / No /X/ The initial public offering of the registrant's common stock was completed on August 12, 2004, prior to which date there was no public market in the registrant's common equity. The number of outstanding shares of the registrant's common stock on February 28, 2004 was 27,206,460. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the Registrant's next Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K. STEREOTAXIS, INC. INDEX TO ANNUAL REPORT ON FORM 10-K PAGE ---- PART I. Item 1. Business 3 Item 2. Properties 28 Item 3. Legal Proceedings 28 Item 4. Submission of Matters to a Vote of Security Holders 28 PART II. Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Registrant Purchases of Equity Securities 29 Item 6. Selected Financial Data 30 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 30 Item 7a. Quantitative and Qualitative Disclosures About Market Risk 54 Item 8. Financial Statements and Supplementary Data 55 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 80 Item 9a. Controls and Procedures 80 Item 9b. Other Information 80 PART III. Item 10. Directors and Executive Officers of the Registrant 80 Item 11. Executive Compensation 81 Item 12. Security Ownership of Certain Beneficial Owners and Management 81 Item 13. Certain Relationships and Related Transactions 81 Item 14. Principal Accounting Fees and Services 81 PART IV. Item 15. Exhibits and Financial Statement Schedules 82 SIGNATURES 83 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS 85 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 56 INDEX TO EXHIBITS 86 2 PART I ITEM 1. BUSINESS FORWARD-LOOKING STATEMENTS This annual report on Form 10-K, including the sections entitled "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations", contains forward-looking statements. These statements relate to, among other things: * our business strategy; * our value proposition; * the ability of physicians to perform certain medical procedures with our products safely, effectively and efficiently; * the adoption of our products by hospitals and physicians; * the market opportunity for our products, including expected demand for our products; * the timing and prospects for regulatory approval of our additional disposable interventional devices; * our plans for hiring additional personnel; * our estimates regarding our capital requirements; and * any of our other plans, objectives, expectations and intentions contained in this annual report that are not historical facts. These statements relate to future events or future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as "may", "will", "should", "could", "expects", "plans", "intends", "anticipates", "believes", "estimates", "predicts", "potential" or "continue" or the negative of such terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. These statements are only predictions. Factors that may cause our actual results to differ materially from our forward-looking statements include, among others, changes in general economic and business conditions and the risks and other factors set forth in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Factors that May Affect Future Results" and elsewhere in this annual report on Form 10-K. Our actual results may be materially different from what we expect. We undertake no duty to update these forward-looking statements after the date of this annual report, even though our situation may change in the future. We qualify all of our forward-looking statements by these cautionary statements. OVERVIEW We design, manufacture and market an advanced cardiology instrument control system for use in a hospital's interventional surgical suite, or "cath lab", that we believe revolutionizes the treatment of coronary artery disease and arrhythmias by enabling important new therapeutic solutions and enhancing the efficiency and efficacy of existing catheter-based, or interventional, procedures. Our Stereotaxis System allows physicians to more effectively navigate proprietary catheters, guidewires and stent delivery devices, both our own and those we are co-developing 3 with strategic partners, through the blood vessels and chambers of the heart to treatment sites and then to effect treatment. This is achieved using computer-controlled, externally applied magnetic fields that precisely and directly govern the motion of the internal, or working, tip of the catheter, guidewire or stent delivery device. We believe that our Stereotaxis System represents a revolutionary technology in the cath lab, bringing precise remote digital instrument control and programmability to the cath lab, and has the potential to become the standard of care for a broad range of complex cardiology procedures. We believe that our Stereotaxis System is the only technology to be commercialized that allows remote, computerized control of catheters, guidewires and stent delivery devices directly at their working tip. To our knowledge, we have no direct competitors in this field. We also believe that our technology represents an important advance in the ongoing trend toward digital instrumentation in the cath lab and provides substantial, clinically important improvements and cost efficiencies over manual interventional methods, which require years of physician training and often result in long and unpredictable procedure times and sub-optimal therapeutic outcomes. We began commercial shipments in 2003, following U.S. and European regulatory approval of the core components of the Stereotaxis System, and had revenues of approximately $18.8 million in 2004 and $5.0 million in 2003. As of December 31, 2004, we had sold and delivered 30 Stereotaxis Systems, including 20 in the U.S. and 10 internationally, and physicians have used these systems to perform approximately 1,100 cardiology procedures. We also had purchase orders and other commitments for an additional $20 million of our Stereotaxis Systems. There can be no assurance that we will recognize revenue in any particular period or at all because some of our purchase orders and other commitments are subject to contingencies that are outside our control. In addition, these orders and commitments may be revised, modified or canceled, either by their express terms, as a result of negotiations or by project changes or delays. The Stereotaxis System is designed primarily for the interventional treatment of coronary artery disease, or interventional cardiology, and for the interventional treatment of abnormal heart rhythms known as arrhythmias, or electrophysiology. Our Stereotaxis System consists of the following proprietary components: * our NIOBE cardiology magnet system, which utilizes permanent magnets to navigate catheters, guidewires and stent delivery devices through complex paths in the blood vessels and chambers of the heart to carry out treatment; * our NAVIGANT advanced user interface, or physician control center, which physicians use to visualize and track procedures and to provide instrument control commands that govern the motion of the working tip of the catheter, guidewire or stent delivery device; * our CARDIODRIVE automated catheter advancer, which is used to remotely advance and retract the catheter in the patient's heart; and * our suite of interventional catheters, guidewires and stent delivery devices, which we refer to as disposable interventional devices. The Stereotaxis System is designed to be installed in both new and replacement cath labs worldwide. We currently have regulatory clearance to market our NIOBE cardiology magnet system, our NAVIGANT advanced user interface, our CARDIODRIVE automated catheter advancer and various disposable interventional devices in the U.S. and in the European Union, and we anticipate applying through Siemens and J&J to begin clinical trials in Japan in 2005. Current and potential purchasers of our Stereotaxis System include leading research and academic hospitals as well as medium and high volume commercial and regional medical centers around the world. We estimate that there are more than 750 new and replacement cardiology cath labs being installed worldwide each year. We also estimate that the initial imaging equipment and installation costs for a new or replacement cardiology cath lab today can range as high as $2 million, for a total cardiology cath lab installation market potentially in excess of $1.5 billion per year. 4 The market for cardiovascular medical devices worldwide exceeds $12 billion per year and is estimated to be growing at 12% annually. Physicians are currently performing approximately 1.8 million interventional cardiology procedures and approximately 800,000 electrophysiology procedures worldwide each year. This procedure base continues to grow, due to patient demand for less invasive procedures, cost containment pressure and an increasing incidence of coronary artery disease and arrhythmias. While the Stereotaxis System potentially has broad applicability for many of these procedures, we believe that it can provide significant advantages relative to manual interventional methods for approximately 15% of interventional cardiology procedures, or approximately 270,000 procedures annually, including procedures for stent delivery and the treatment of complex lesions. In electrophysiology, we believe that the Stereotaxis System can provide significant advantages for approximately 30% of procedures, or about 240,000 procedures annually, including procedures for ablation and the placement of pacing leads. As a result, we believe that the Stereotaxis System can provide substantial clinical benefits compared to manual interventional methods in more than 500,000 worldwide annual procedures. The Stereotaxis System is designed to address the needs of patients, hospitals, physicians, and third-party payors on a cost-effective basis by: * meeting patient demands for less invasive procedures, while improving patient safety and outcomes; * enabling new procedures in interventional cardiology and electrophysiology that currently cannot be performed, or are extremely difficult to perform, with manual methods; * enhancing the productivity of existing complex interventional procedures, by both shortening procedure times and making them more predictable, thereby improving cath lab scheduling efficiency and lowering total costs; * decreasing the number of disposable interventional devices used per procedure, thereby potentially lowering provider costs; * providing ease of use and lowering physician skill barriers for complex cardiology procedures; and * decreasing exposure to x-ray fluoroscopy fields for patients and physicians and reducing the use of contrast dye injections, both of which are potentially harmful. We have alliances with each of Siemens AG Medical Solutions, Philips Medical Systems and Biosense Webster, a subsidiary of Johnson & Johnson. Through these alliances, we are integrating our Stereotaxis System with Siemens' and Philips' market leading digital imaging and J&J's 3D catheter location sensing technology, and developing compatible disposable interventional devices, in order to continue to introduce new solutions to the cath lab. Together, Siemens and Philips have a combined installed base of more than 2,200 cardiology cath labs in the U.S., while J&J has the leading market position in 3D catheter location sensing technology, an important technology in complex electrophysiology ablation procedures. The Siemens and Philips alliances provide for coordination of our sales and marketing with that of our partners to facilitate co-placement of integrated systems. In addition, Siemens and Philips have agreed to provide worldwide service for our integrated systems. In connection with these alliances, Siemens invested $10 million and J&J invested $9.5 million in our equity in private placements prior to our initial public offering, and Philips agreed to make payments of up to $7.5 million relating to the integration of its x-ray fluoroscopy system with the Stereotaxis System. The core elements of our Stereotaxis System are protected by an extensive patent portfolio, as well as substantial know-how and trade secrets. BACKGROUND Traditionally, cardiac procedures have been performed via open chest heart bypass surgery. This procedure is very invasive, requiring cutting open the rib cage and spreading it apart in order to gain access to the heart. This 5 enables the physician to directly view the patient's heart during the procedure and to operate manually. Additionally, the patient is typically placed on a heart lung bypass device. While generally very effective, the procedure is highly traumatic for the patient, and usually requires a long hospital stay, followed by a significant period of convalescence. Conventional cardiac surgery is also expensive, with a procedure cost that can range as high as $100,000. Minimally invasive surgical procedures for cardiology were devised to mitigate many of the drawbacks of bypass surgery while maintaining essential elements of visualization and instrument control. These procedures utilize an endoscope for visualization, which is inserted through an incision in the patient's body. While these minimally invasive surgical techniques have been used for a number of cardiac procedures, in most instances they have not been as effective as conventional cardiac surgery. As a result, bypass surgery, despite its drawbacks, has remained the predominant method for cardiac surgical procedures. Interventional cardiology represents the next, and most recent, step in the evolution of less invasive cardiac procedures. These procedures are performed in the cath lab, where real-time x-ray imaging, often enhanced by the injection of contrast dye, provides visualization enabling physicians to insert and navigate guidewires, catheters and stent delivery devices into the vasculature or open chambers of the heart to deliver therapy. Instrument control in typical interventional cardiology procedures for the treatment of coronary artery disease requires the physician to manually manipulate the external end of a long, slender guidewire in order to indirectly control and position the working tip of the instrument. This requires significant skill and, depending upon the type and location of the lesion being treated, can be very difficult and time consuming. The guidewire is typically used for navigation to the treatment site, after which a catheter or stent delivery device is threaded over the guidewire to perform the necessary treatment. Guidewires are also typically used to place pacemaker leads used in cardiac resynchronization therapy for the treatment of congestive heart failure. In electrophysiology mapping and ablation procedures, physicians use specialized catheters that are manually navigated using a system of mechanical control cables to map the patient's heart, and then to ablate the heart tissue to eliminate arrhythmias. This also requires significant skill, and, depending on the type and location of the arrhythmia, can be very difficult and time consuming to perform. Interventional cardiology and electrophysiology procedures have proven to be very effective at treating coronary artery disease and arrhythmias at sites accessible through the vasculature without the patient trauma, complications, recovery times and cost generally associated with open surgery. With the advent of drug-eluting stents, the number of potential patients who could benefit from interventional cardiology procedures has grown. However, major challenges associated with manual approaches to interventional cardiology and electrophysiology persist. In interventional cardiology, these challenges include difficulty in navigating the disposable interventional device through tortuous vasculature and crossing certain types of complex lesions to deliver drug-eluting stents to effect treatment. As a result, numerous patients who could be candidates for an interventional approach continue to be referred to bypass surgery. In electrophysiology, these challenges include precisely navigating the tip of the mapping and ablation catheter to the treatment site on the heart wall and maintaining tissue contact throughout the cardiac cycle to effect treatment, and, for atrial fibrillation, performing complex ablations within the left atrium of the heart. As a result, large numbers of patients are referred to palliative drug therapy that can have harmful side effects. We believe the Stereotaxis System represents a revolutionary step in the trend toward highly effective, but less invasive, cardiac procedures. As the first technology to permit direct, computerized control of the working tip of a disposable interventional device, the Stereotaxis System enables physicians to perform cardiac procedures interventionally that historically would have been very difficult or impossible to perform in this way and significantly improves the efficiency of existing complex procedures in the cath lab. 6 THE GROWING IMPORTANCE OF THE CATH LAB We believe that the cath lab's position as a hospital profit center, coupled with the growth of interventional procedures, has made it possible for decision-makers to justify large expenditures on capital equipment for use within the cath lab. As a result, hospitals with cath labs have tended to be early adopters of new technologies. There has also been a major trend toward using digital rather than analog instrument systems in the cath lab, resulting in the rapid replacement of analog electrophysiology recording systems with digital recording systems and the current rapid replacement of analog x-ray fluoroscopy systems with digital x-ray fluoroscopy systems. Additionally, new sources of diagnostic information such as 3D catheter location sensing technology and catheter-based ultrasound are being introduced to the cath lab. As a result, interventional procedures require physicians to analyze large quantities of information from many disparate imaging and information sources. We believe that the Stereotaxis System provides an important link in completing the digital transformation of the cath lab, because it is the only system that integrates the visualization and information systems in the cath lab with digital control of the working tip of catheters, guidewires and stent delivery devices. Furthermore, because the Stereotaxis System brings precise remote digital instrument control and programmability to the cath lab, we believe it can displace conventional manual control of disposable interventional devices for complex cardiology procedures in the same way that digital control, or "fly by wire" technology, replaced mechanical control of the modern jet airplane. Interventional techniques are routinely used in interventional cardiology to treat partially occluded coronary arteries with balloon angioplasty and to place coronary stents, and in electrophysiology to treat certain types of arrhythmias. In the U.S. there are more than 1.1 million interventional cardiology procedures performed for the treatment of coronary artery disease each year, which represents approximately 60% of the total number of such procedures performed on a worldwide basis. Each year in the U.S., there are also more than 500,000 electrophysiology procedures for treatment of arrhythmia, including more than 340,000 electrophysiology mapping procedures and more than 160,000 ablation procedures, which represents approximately 65% of the total number of electrophysiology procedures performed on a worldwide basis. Interventional treatments are also emerging for atrial fibrillation and congestive heart failure, and industry estimates indicate that the U.S. procedure base for these diseases has the potential to grow rapidly if more effective interventional treatments are available. There are approximately 3,700 cardiology cath labs in the U.S. installed at approximately 1,900 hospitals. Based on procedure volume, we estimate that there are over 2,000 cardiology cath labs located throughout the rest of the world. We estimate that there are more than 750 new and replacement cardiology cath labs installed each year worldwide. CURRENT CHALLENGES IN THE CATH LAB Although great strides have been made in applying manual interventional techniques, significant challenges remain that reduce cath lab productivity and limit both the number of complex procedures and the types of diseases that can be treated. These challenges primarily involve the limitations of manual instrument control and the lack of integration of the information systems used by physicians in the cath lab. As a result, many complex procedures in interventional cardiology are referred to highly invasive bypass surgery and many complex cases in electrophysiology are treated with palliative drug therapy. LIMITATIONS OF INSTRUMENT CONTROL Navigation in the blood vessels and the chambers of the heart can be difficult because the path that a disposable interventional device must follow to arrive at the treatment site and deliver therapy can be complex and tortuous. Physicians using manual methods often utilize a range of different catheters and guidewires in succession in an attempt to find the right device or devices for the procedure being performed. 7 Manually controlled catheters, guidewires and stent delivery devices, even in the hands of the most skilled specialist, have inherent instrument control limitations. In traditional interventional procedures, the device is manually manipulated by the physician who twists and pushes the external end of the instrument in an iterative process to thread the instrument through the blood vessels to the treatment site. Manual control of the working tip becomes increasingly difficult as more turns are required to navigate the instrument to the treatment site, as the blood vessels to be navigated become smaller and less accessible or more blocked, and as greater precision is required to carry out therapy at the treatment site. LACK OF INTEGRATION OF INFORMATION SYSTEMS While sophisticated imaging, mapping and location-sensing systems have provided visualization for interventional procedures and allowed interventional physicians to treat more complex conditions, the substantial lack of integration of these information systems requires the physician to mentally integrate and process large quantities of information from different sources in real time during an interventional procedure. For example, a physician ablating heart tissue to eliminate an arrhythmia will often be required to mentally integrate information from a number of sources, including: * real-time x-ray fluoroscopy images; * a real-time location-sensing system providing the 3D location of the catheter tip; * a pre-operative map of the electrical activity or anatomy of the patient's heart; * real-time recording of electrical activity of the heart; and * temperature feedback from an ablation catheter. Each of these systems displays data differently, requiring physicians to continuously reorient themselves to the different formats and displays as they shift their focus from one data source to the next while at the same time manually controlling the interventional instrument. THE STEREOTAXIS VALUE PROPOSITION The Stereotaxis System addresses the current challenges in the cath lab by providing precise computerized control of the working tip of the interventional instrument and by integrating this control with the visualization and information systems used during interventional cardiology and electrophysiology procedures, on a cost justified basis. We believe that the Stereotaxis System is the only technology to be commercialized that allows remote, computerized control of disposable interventional devices directly at their working tip. We believe that the Stereotaxis System will: * Expand the market by enabling new treatments for major diseases and permitting the treatment of more complex existing cases. Treatment of a number of major diseases, including chronic totally occluded coronary arteries and atrial fibrillation, is highly problematic using conventional catheter-based techniques. Additionally, many patients with multi-vessel disease and certain complex arrhythmias are often referred to other therapies because of the difficulty in controlling the working tip of disposable interventional devices. As a result, these patients are typically referred to more invasive surgeries or largely ineffective drug therapy. Because the Stereotaxis System provides precise, computerized control of the working tip of disposable interventional devices, we believe that it will potentially enable chronic totally occluded coronary arteries and atrial fibrillation to be treated interventionally on a much broader scale than today, and may permit physicians to predictably treat complex cases involving partially occluded coronary arteries and arrhythmias. * Improve outcomes by optimizing therapy. Difficulty in controlling the working tip of disposable interventional devices leads to sub-optimal results in many procedures. Precise instrument control is necessary for 8 treating a number of cardiac conditions, including arrhythmias, where precise placement of an ablation catheter against a beating inner heart wall is necessary, and congestive heart failure, where precise navigation within the coronary venous system for optimal placement of pacemaker leads is required. Precise and correct navigation and placement of expensive drug-eluting stents also have a significant impact on procedure costs and outcomes. We believe the Stereotaxis System can enhance procedure results by improving navigation of disposable interventional devices to treatment sites, and by effecting more precise treatments once these sites are reached. * Enhance hospital efficiency by reducing and standardizing procedure times, disposables utilization and staffing needs. Interventional procedure times currently range from several minutes to many hours as physicians often engage in repetitive, "trial and error" maneuvers due to difficulties with manually controlling the working tip of disposable interventional devices. By reducing both navigation time and the time needed to carry out therapy at the target site, we believe that the Stereotaxis System can reduce complex interventional procedure times compared to manual procedures. We believe the Stereotaxis System can also reduce the variability in procedure times compared to manual methods. Greater standardization of procedure times allows for more efficient cath lab scheduling. We also believe that additional cost savings from the Stereotaxis System result from decreased use of multiple catheters and guidewires in procedures compared with manual methods and also from decreased staff requirements during procedures, which further enhances the rate of return to hospitals. * Improve the efficacy of complex cardiology procedures by enhancing physician skill levels. Training required for physicians to carry out manual interventional procedures typically takes years, over and above the training required to become a specialist in cardiology, leading to a shortage of interventional physicians for more complex procedures. The Stereotaxis System can allow procedures that previously required the highest levels of manual dexterity and skill to be performed effectively by a broader range of interventionalists, with more standardized outcomes. In addition, interventional physicians can be trained to use the Stereotaxis System in a relatively short period of time. The Stereotaxis System can also be programmed to carry out sequences of complex navigation automatically. * Improve patient and physician safety by reducing procedure times and minimizing x-ray exposure and the use of contrast dye injections. During conventional catheter-based procedures, both the physician, who stands by the patient table to manually control the catheter, and the patient are exposed to the potentially harmful x-ray fluoroscopy field. This exposure can be minimized by reducing procedure times. Reducing procedure times is also beneficial to the patient because there is a direct correlation between complication rates and procedure length. Shorter procedure times and improved navigation result in reduced use of contrast dye injections which are potentially harmful to the patient. The Stereotaxis System can further improve physician safety by enabling them to conduct procedures remotely from an adjacent control room, which reduces their exposure to harmful radiation and helps alleviate orthopedic problems that often result from wearing heavy lead vests to shield them from x-ray exposure during procedures. BUSINESS STRATEGY Our goal is to establish the Stereotaxis System as the standard of care for complex interventional procedures in cardiology by bringing magnetic instrument control into standard interventional clinical practice. The key elements of our strategy for achieving this goal are to: * Leverage the efficiency and productivity improvements enabled by our system to present a compelling economic justification to hospitals. We believe our system enhances the rate of return to hospitals by optimizing cath lab economics, reducing procedure times, disposable interventional device usage and staffing requirements during procedures. This allows us to present a compelling economic justification to hospitals for the purchase of our systems. 9 * Integrate our system with our key strategic partners' products and leverage our partnerships to assist in further development, commercialization, sales and service of our products. We are integrating our system with Siemens' and Philips' widely used imaging equipment and J&J's advanced 3D catheter location sensing technology to provide seamless integration of instrument control and visualization and a toolkit of disposable interventional devices that we believe will enable new therapeutic solutions in the cath lab. We have also entered into a manufacturing and supply agreement with Lake Region Manufacturing, one of the world's leading manufactures of guidewires for use in interventional medicine, to provide high volume capability for guidewires. We intend to continue leveraging the sales, distribution, service and maintenance expertise of our strategic partners to facilitate co-placement of integrated systems and disposable interventional devices and to support and maintain our equipment at installed sites. See "Business--Collaborations" for a further description of our strategic partnerships. We intend to selectively expand the number of co-marketing agreements that we have with major companies in the cath lab market in order to augment the effectiveness of our direct sales force and distribution network, and to add distributors to extend coverage to key areas outside the U.S. We also intend to selectively enter into additional licensing, development and manufacturing partnerships with major disposables companies in order to expand the number of magnetically controlled disposable interventional devices that can be used with the Stereotaxis System. We will continue to outsource major components and sub-assemblies of our equipment to maximize manufacturing flexibility and lower fixed costs, while maintaining quality control by completing final system assembly and inspection in-house. * Provide an essential digital link in the cath lab between imaging systems and instrument control. We intend to maintain an open architecture approach to connectivity in the cath lab in order to encourage the major imaging companies to consider Stereotaxis an essential ingredient for digital integration and automation in the cath lab. We believe that integrating our system with key imaging and visualization technologies using an open architecture approach is a key element in establishing our system as the standard of care for complex interventional procedures. * Expand clinical applications for, and utilization of, our technology. We intend to pursue clinical research with leading interventional cardiologists and electrophysiologists in order to further develop and expand the range of clinical applications for magnetic instrument control in the field of cardiology. We also intend to provide comprehensive training and educational programs for physicians regarding the use and benefits of our system in order to increase the overall utilization of our technology. We believe that we can build on our experience in the cardiology field to expand the scope of our technology to other major clinical areas where there are potential unmet needs for better device navigation and control. * Capitalize on our technology leadership to enhance our competitive position. We intend to enhance and maintain our technology leadership with focused research and development. We also intend to build on our "first mover" advantage to establish Stereotaxis as the preferred approach for cath lab automation, by providing continuous improvement of our technology and user-friendly software. We will continue to protect our intellectual property through additions to our already significant patent portfolio in order to cover the key aspects of our technology, including new magnet designs, catheter and guidewire designs, remote control systems, systems integration and automation and software development. OVERVIEW OF THE STEREOTAXIS SYSTEM Our proprietary Stereotaxis System provides the physician with precise remote digital instrument control through user friendly "point and click" and/or joystick-operated technology, which can be operated either from beside the patient table, as in traditional interventional procedures, or from a room adjacent to the patient and outside the x-ray fluoroscopy field. The NIOBE cardiology magnet system navigates disposable interventional devices to the treatment site through complex paths in the blood vessels and chambers of the heart to carry out treatment using computer controlled, externally applied magnetic fields to directly govern the motion of the working tip of these devices, each of which has a magnetically sensitive tip that predictably responds to magnetic fields generated by our system. Because the working tip of the disposable interventional device is directly controlled by 10 these external magnetic fields, the physician has the same degree of control regardless of the number or type of turns, or the distance traveled, by the working tip to arrive at its position in the blood vessels or chambers of the heart, which results in highly precise digital control of the working tip of the disposable interventional device while still giving the physician the option to manually advance the catheter. Through our alliances with Siemens, Philips and J&J, this precise digital instrument control has been integrated with the visualization and information systems used during interventional cardiology and electrophysiology procedures in order to provide the physician with a fully-integrated and automated information and instrument control system. We have integrated our Stereotaxis System with Siemens' digital x-ray fluoroscopy system, and we have completed the initial integration with Philips' digital x-ray fluoroscopy system. In addition, we are integrating the Stereotaxis System with J&J's 3D catheter location sensing technology, to provide accurate real-time information as to the 3D location of the working tip of the instrument, and with J&J's ablation tip technology. We believe that the combination of these features will provide more effective instrument control and therapy delivery. The components of the Stereotaxis System are identified and described below: SYSTEMS NIOBE Cardiology Magnet System. Our NIOBE cardiology magnet system utilizes two permanent magnets mounted on articulating or pivoting arms that are enclosed within a stationary housing, with one magnet on either side of the patient table, inside the cath lab. These magnets generate magnetic navigation fields that are less than 10% of the strength of fields typically generated by MRI equipment and therefore require significantly less shielding, and cause significantly less interference, than MRI equipment. NAVIGANT Advanced User Interface. The NAVIGANT advanced user interface is an integrated information and control center that consolidates the key information sources used by interventional cardiologists and electrophysiologists and allows these physicians to provide instrument control directions to precisely govern the motion of the working tip of disposable interventional devices. The NAVIGANT advanced user interface consists of: * configurable display screens located both next to the patient table inside the cath lab and in the adjacent control room, outside the x-ray fluoroscopy field, that provide advanced visualization and information integration to the physician; * sophisticated embedded device software and system control algorithms that are integrated with our disposable interventional devices to facilitate ease of use and improved navigation of these devices; * computer joystick or mouse control which the physician uses to direct the motion of the working tip of the disposable interventional device, either from inside the cath lab or from the adjacent control room; and * a software package designed for interventional cardiology or electrophysiology, or both, as well as optional application software tailored for specific clinical procedures. CARDIODRIVE Automated Catheter Advancer. Where the physician is conducting the procedure from the adjacent control room, the CARDIODRIVE automated catheter advancer is used to advance and retract the catheter in the patient's heart while the NIOBE magnets precisely steer the working tip of the device. We have received the FDA clearance and the CE Mark necessary for us to market the NIOBE cardiology magnet system, the NAVIGANT advanced user interface and the CARDIODRIVE automated catheter advancer in the U.S. and Europe. 11 DISPOSABLES AND OTHER ACCESSORIES Our system is designed to use a toolkit of proprietary disposable interventional devices. The toolkit currently consists of: * our suite of CRONUS(R) coronary guidewires suitable for use in interventional cardiology procedures for the introduction and placement of over-the-wire therapeutic devices, such as biventricular pacing leads used in cardiac resynchronization therapy for treating congestive heart failure; * our TANGENT(R) electrophysiology mapping catheter used to locate aberrant electrical signals in the heart; * our HELIOS(R) electrophysiology ablation catheter used for certain arrhythmia treatments; and * the Celcius ablation and Navistar mapping and catheters co-developed with J&J, as described below. We have received the FDA clearance and the CE Mark necessary for us to market our suite of CRONUS coronary guidewires and our electrophysiology mapping catheter in the U.S. and Europe. In addition, we have received the CE Mark for our HELIOS electrophysiology ablation catheter and, in the U.S., we have completed clinical trials in 2004 and expect to subsequently file for a PMA. Through our alliance with J&J, we are co-developing a range of ablation catheters that can be navigated with our system, with and without J&J's 3D catheter location sensing technology. We are also developing disposable interventional devices for other applications. In addition, we have developed plastic software keys, or smart chips, that allow our system to recognize specific disposable interventional devices in order to prevent unauthorized use of our system. In March 2005, we announced the first commercial use of our Stereotaxis system with the Celcius(TM) RMT ablation catheter, the Navistar(TM) RMT mapping and ablation catheter and the CARTO(TM) RMT mapping and ablation system in Europe. These products, which had recently received CE Marking authorization in Europe and other countries that recognize the CE Mark, are the first products to be commercialized pursuant to our strategic alliance with J&J. We expect that approvals in the United States will follow in 2005 and that Biosense Webster will continue to develop other magnetically enabled catheters into 2006. We believe that we can adapt most disposable interventional devices for use with our system by using our proprietary technology to add an inexpensive micro-magnet at their working tip. This micro-magnet is activated by an external magnetic field, which allows interventional devices with tip dimensions as small as 14 thousandths (0.014) of an inch to be oriented and positioned in a predictable and controllable fashion. We believe this approach to bringing digital control to disposable interventional devices using embedded magnets can simplify the overall design of these devices and reduce their manufacturing costs because mechanical controls are no longer required. CLINICAL APPLICATIONS We have initially focused our clinical and commercial efforts on applications of the Stereotaxis System in complex interventional cardiology procedures for the treatment of coronary artery disease, and in electrophysiology procedures for the treatment of arrhythmias. Our system potentially has broad applicability in other areas, such as interventional neurosurgery, interventional neuroradiology, peripheral vascular, pulmonology, urology, gynecology and gastrointestinal medicine, and our patent portfolio has been structured to permit expansion into these areas. INTERVENTIONAL CARDIOLOGY Nearly half a million people die annually from coronary artery disease, a condition in which the formation of plaque in the coronary arteries obstructs the supply of blood to the heart, making this the leading cause of death in the U.S. Despite various attempts to reduce risk factors, each year over one million patients undergo interventional 12 procedures in an attempt to open blocked vessels and another half a million patients undergo open heart surgery to bypass blocked coronary arteries. Blockages within a coronary artery, often called lesions, are categorized by degree of obstruction as partial occlusions, non-chronic total occlusions and chronic total occlusions. Lesions are also categorized by the degree of difficulty with which they can be opened as simple or complex. If the blockage is in an easy to reach location, it can typically be treated by pushing a guidewire through the portion of the vessel that is blocked with plaque, expanding a small balloon to compress the plaque against the artery walls in order to open the artery, and then finally deploying a stent, which is a small metal scaffold, to help keep the artery open. If a blockage is located within tortuous vasculature, however, the physician must navigate the guidewire through a series of sharp turns, making the blockage very difficult to reach. Even if such lesions are reached, delivering a balloon or stent to the treatment site through tortuous anatomy can be difficult. In addition, complex lesions, such as chronic total occlusions, longer lesions, and lesions located within smaller diameter vessels, are often very difficult or time consuming to open with manual interventional techniques. Physicians are currently performing approximately 1.8 million interventional cardiology procedures worldwide each year, and we estimate that approximately 15%, or 270,000, of these procedures are complex and therefore require longer procedure times and may have sub-optimal outcomes. We believe that our system can substantially benefit this subset of complex interventional cardiology procedures, including procedures involving: * Complex partial occlusions, complex non-chronic total occlusions and chronic total occlusions. Treatment of these complex lesions is generally more problematic due to the difficulty in steering and pushing a guidewire through them. Because our system provides precise computerized control of the working tip of a guidewire, it can enable physicians to more easily locate small openings in, and to advance a guidewire across, these lesions. Also, our magnetically steerable microcatheter can help steer a variety of conventional wire products, some of which are designed to cross complex lesions, but which otherwise lack the controlled steering needed to avoid perforating the vessel wall. The ability to cross complex lesions such as chronic total occlusions has grown increasingly important due to the effectiveness of drug eluting stents in treating these lesions. Since approximately one-fifth of patients referred to bypass surgery have chronic total occlusions, we believe a significant number of patients could be treated interventionally instead of surgically if more of these lesions could be opened for stenting. * Tortuous Anatomy. We estimate that between 10 and 15% of all interventional procedures require physicians to navigate a disposable interventional device through a series of sharp turns in the patient's vasculature. Navigating through tortuous anatomy using manual interventional techniques can be very time consuming and physicians often cannot reach the lesion or manipulate the balloon or stent across the lesion once it is reached. Because our system allows the working tip of disposable interventional devices to be precisely oriented regardless of the number of turns that have occurred, our technology allows physicians to more effectively navigate these devices through complex vasculature and deliver balloons and stents to treatment sites for therapy. * Stent placement. The likelihood of restenosis, or re-blockage of cleared arteries, is greatly increased in multi-vessel diseased patients whose blockages are typically more diffusely distributed throughout longer lengths of the vessel. As a result, these patients are often referred to invasive bypass surgery. We expect that drug-eluting stents, which dramatically reduce the likelihood of restenosis, will enable patients with more complex lesions to be treated interventionally rather than with bypass surgery. In order to treat this new group of patients, however, physicians will need to place stents in more challenging or remote locations. By using externally applied magnetic fields to precisely direct a stent through a patient's vasculature, we believe that our system allows these devices to be more easily navigated to these difficult to reach treatment sites. 13 * Small Vessels. Based on our interpretation of various medical studies, we have determined that diabetic patients usually comprise about 20 to 30% of U.S. hospital's interventional procedure volume. These patients generally have smaller vessels, which often contain longer lesions with more diffusely distributed blockages, as well as tortuous anatomy, making guidewire navigation and stent delivery extremely difficult. We believe that these patients can benefit significantly from the improved disposable interventional device navigation enabled by our system. ELECTROPHYSIOLOGY The rhythmic beating of the heart results from the transmission of electrical impulses through the heart. When these electrical impulses are mis-timed or uncoordinated, the heart fails to function properly, resulting in complications that can range from fatigue to stroke or death. Over four million people in the U.S. currently suffer from the resulting abnormal heart rhythms, which are known as arrhythmias. Drug therapies for arrhythmias often fail to adequately control the arrhythmia and may have significant side effects. Consequently, physicians have increasingly sought more permanent, non-pharmacological, solutions for arrhythmias. The most common interventional treatment for arrhythmias, and in particular tachyarrhythmias, where the patient's heart rate is too high or irregular, is an ablation procedure in which the diseased tissue giving rise to the arrhythmia is isolated or destroyed. Prior to performing an electrophysiology ablation, a physician typically performs a diagnostic procedure in which the electrical signal patterns of the heart wall are "mapped" to identify the heart tissue generating the aberrant electrical signals. Following the mapping procedure, the physician may then use an ablation catheter to disable the aberrant signal or signal path, restoring the heart to its normal rhythm. In cases where an ablation is anticipated, physicians will choose an ablation catheter and perform both the mapping and ablation with the same catheter. Based on an analysis of industry data, we have determined that physicians are currently performing approximately 800,000 electrophysiology procedures worldwide each year, including approximately 500,000 electrophysiological mapping procedures, approximately 240,000 ablation procedures and approximately 60,000 other procedures such as treatment of atrial fibrillation and congestive heart failure. We believe the Stereotaxis System is particularly well-suited for those electrophysiology procedures which are time consuming or which can only be performed by highly experienced physicians, which we estimate to be approximately 30% of all electrophysiology procedures performed worldwide each year. We estimate that the number of these complex procedures is growing at a rate of approximately 12% per year. These procedures include: * Lengthy Ablations. For the more routine but lengthy mapping and ablation procedures, our system offers the unique benefit of automating the procedure and directing catheter movement from the control room, saving the physician time and helping to avoid unnecessary exposure to high doses of radiation. * Atrial Fibrillation. A common cause of sustained abnormal heart rhythm, atrial fibrillation, is a particular type of arrhythmia characterized by rapid, disorganized contractions of the heart's upper chambers, the atria, which lead to ineffective heart pumping and blood flow and can be a major risk factor for stroke. The majority of potential patients cannot benefit from manual catheter-based procedures for atrial fibrillation because they are extremely complex and are performed by only the most highly skilled electrophysiologists. They also typically have much longer procedure times than conventional ablation cases and success rates that are only in the 50% to 80% range. We believe that our system can allow these procedures to be performed by a broader range of electrophysiologists and, by automating some of the more complex ablation routines, can standardize and reduce procedure times and significantly improve outcomes. 14 * Bi-Ventricular Pacing. Congestive heart failure is a potentially fatal condition in which the heart muscle is damaged to the point that it is unable to provide adequate blood flow rate through the body. A new therapy, dual chamber cardiac resynchronization therapy, or bi-ventricular pacing, has shown promise in the treatment of a certain type of congestive heart failure in which the left and right sides of the left ventricle do not contract at the same time. The procedure used to carry out this therapy involves the placement of a pacemaker lead into the coronary venous system of the heart. Interventional treatment of this patient population is growing rapidly but the placement of the venous pacing lead with manual interventional technologies is highly challenging and time consuming, and less than optimal lead placement can contribute to poor outcomes. The unpredictability of procedure times also makes efficient cath lab scheduling very difficult in these cases. We estimate that approximately 50,000 biventricular pacing leads are currently placed per year worldwide. Industry estimates indicate, however, that if there were a more effective method of placing these pacing leads, more than 700,000 congestive heart failure patients per year in the U.S. would be eligible for the procedure. We believe that our system can address the current challenges in electrophysiology by permitting the physician to remotely navigate disposable interventional devices from a control room outside the x-ray field. Our system also allows for more predictable and efficient navigation of these devices to the treatment site, including the left atrium for atrial fibrillation procedures, and enables appropriate contact force to be maintained to effect ablations on the wall of the beating heart. We also believe that our system will significantly lower the skill barriers required for physicians to perform complex electrophysiology procedures and, additionally, improve cath lab efficiency and reduce disposable interventional device utilization. INTERVENTIONAL NEURORADIOLOGY, NEUROSURGERY AND OTHER INTERVENTIONAL APPLICATIONS Physicians used a predecessor to our NIOBE system to conduct a number of procedures for the treatment of brain aneurysms, a condition in which a portion of a blood vessel wall balloons and which can result in debilitating or fatal hemorrhagic strokes. Traditional treatment for brain aneurysms involves highly invasive open brain surgery. Interventional procedures have evolved for filling the aneurysm with platinum micro-coils delivered to the site in order to reduce blood flow within the aneurysm. We believe that the Stereotaxis System has the potential to be adapted for use in the interventional treatment of brain aneurysms, by enabling physicians to reach a broader range of aneurysm targets, and by making procedure times for these cases more predictable. The Stereotaxis System also has a range of potential applications in minimally invasive neurosurgery, including biopsies and the treatment of tumors, treatment of vascular malformations and, when deliverables are commercialized by third parties, delivery of pharmacological compounds and deep brain stimulators. We have successfully conducted what we believe to be the first human surgical procedures ever conducted using computerized control in our neurosurgery program by navigating complex pathways through brain tissue to multiple target sites. The Stereotaxis System also has applicability in the respiratory, gastro-intestinal and genito-urinary systems, for diagnosis and treatment of diseases affecting the lungs, prostate, kidneys, colon and small intestine. We do not anticipate any significant revenue from these programs in the near term. COLLABORATIONS We have entered into collaborations with four technology leaders in the global cath lab market, Siemens, Philips, J&J and Lake Region Manufacturing, that we believe will aid us in commercializing our Stereotaxis System. We believe our two imaging partners, Siemens and Philips, have a combined installed base of more than 2,200 cardiology cath labs in the U.S. 15 We believe that these collaboration arrangements are favorable to Stereotaxis because they: * provide for the integration of our system with market leading digital imaging and 3D catheter location sensing technology, as well as disposable interventional devices; * allow us to leverage the sales, distribution, service and maintenance expertise of our strategic partners; and * enable operational flexibility by not requiring us to provide any of our strategic partners with a right of first refusal in the event that another party wants to acquire us or with board representation where a strategic partner has made a debt or equity investment in us. IMAGING PARTNERS Siemens Alliance. In June 2001, we entered into an alliance with Siemens, a global leader in cath lab equipment sales, including x-ray fluoroscopy systems. Under this alliance, we successfully integrated our Stereotaxis System with Siemens' digital fluoroscopy system to provide advanced cath lab visualization and instrument control through user-friendly computerized interfaces. We also coordinate our sales efforts with Siemens to co-place integrated systems at leading hospital sites in the U.S. and Europe. Under this alliance and under a separate services agreement, Siemens provides site planning, project management, equipment maintenance and support services for our products directly to our customers. To date, all of our systems placed for clinical use have been integrated with Siemens' digital fluoroscopy systems. In May 2003, we entered into an expanded alliance with Siemens, under which we are collaborating to produce what we believe will be market leading technology to provide physicians with real-time 3D visualization of a patient's anatomy during a procedure by integrating pre-operative MRI and CT data with x-ray fluoroscopic data. We also agreed to integrate our instrument control technology with Siemens' imaging technology in order to develop new solutions in cardiology and, potentially, in interventional radiology. Where Siemens' proprietary technology is incorporated into products being co-developed under this expanded alliance, there are restrictions on our ability to use that technology to sell Stereotaxis Systems integrated with other third party x-ray imaging systems. These restrictions expire no later than December 31, 2005. We have also entered into a separate development agreement for the Japanese market under which Siemens will coordinate regulatory approval and distribute, install and service our Stereotaxis Systems, whether integrated with the x-ray system of Siemens, or other third parties, in Japan. We have also entered into a software distribution agreement with Siemens under which we have the right to sublicense Siemens' 3D pre-operative image navigation software as part of our NAVIGANT advanced user interface. Concurrently with entering into the expanded alliance, Siemens invested $10 million in our Series E preferred stock in 2003. Siemens also held a $2 million note convertible into Stereotaxis common stock, which was issued by us in connection with the purchase of certain of Siemens' intellectual property in August 2003. Both the Series E preferred stock and this note were converted into our common stock in connection with our IPO in August 2004. See "Certain Relationships and Related Party Transactions". Philips Alliance. In October 2003, we entered into an alliance with Philips, another recognized global leader in cath lab sales, pursuant to which we agreed to integrate our Stereotaxis System with Philips' digital x-ray fluoroscopy system to achieve seamless integration of our instrument control technology and Philips' digital x-ray imaging on a user friendly basis. We also agreed with Philips to identify areas of concentration for bringing new solutions to integration of information sources and instrument control in the cath lab in cardiology and neurology. Under this alliance, we will coordinate our sales efforts with Philips in order to co-place our integrated systems. Philips also agreed to pay our engineering and other costs of the integration and related research and development work, and agreed to purchase a maximum of three promotional integrated Stereotaxis Systems from us for installation at agreed upon "centers of excellence." Additionally, Philips has agreed to pay various co-placement fees to Stereotaxis for each of the first 70 systems integrated with Philips that are shipped commercially. The total amount 16 that we are entitled to receive from Philips under this agreement for research and development costs, co-placement fees and the purchase of our promotional integrated Stereotaxis Systems is capped at $7.5 million. DISPOSABLES PARTNERS J&J Alliance. We entered into an alliance with J&J in May 2002 pursuant to which we agreed to integrate J&J's advanced Biosense 3D catheter location sensing technology, which we believe has the leading market position in this important field of visualization for electrophysiology procedures, with our instrument control system, and to jointly develop associated location sensing electrophysiology mapping and ablation catheters that are navigable with the Stereotaxis System. We believe that these integrated products will provide physicians with the elements required for effective complex electrophysiology procedures: highly accurate information as to the exact location of the catheter in the body and highly precise control over the working tip of the catheter. We also agreed to coordinate our sales force efforts with J&J in order to place J&J Biosense CARTO Systems and our Stereotaxis Systems that, together with the co-developed catheters, will comprise the full integration of our instrument control and 3D location sensing technologies in the cath lab. We expanded this alliance in November 2003 to include the parallel integration of our instrument control technology with J&J's full line of non-location sensing mapping and ablation catheters that are relevant to our targeted applications in electrophysiology. The co-developed catheters will be manufactured and distributed by J&J, and each of the parties agreed to contribute to the resources required for their development. We are entitled to royalty payments from J&J, payable quarterly based on a profit formula for sales of the co-developed catheters, and our revenue share increases under certain circumstances. Under this alliance, we agreed to certain restrictions on our ability to co-develop and distribute catheters competitive with those we are developing with J&J and granted J&J certain notice and discussion rights for product development activities we undertake relating to localization and magnetically enabling interventional disposable devices in cardiology fields outside of electrophysiology and mapping. In connection with our expanded alliance, J&J also invested $9.5 million in our Series E-1 preferred stock in 2003. This preferred stock was converted into our common stock in connection with our IPO in August 2004. Either party may terminate this alliance in certain specified "change of control" situations, although the termination would not be effective until one year after the change of control and then would be subject to a wind-down period during which J&J would continue to supply co-developed catheters to us or to our customers for three years (or, for non-location sensing mapping and ablation catheters, until our first sale of a competitive product after a change of control, if earlier than three years). If we terminate the agreement under this provision, we must pay a termination fee to J&J equal to 5% of the total equity value of Stereotaxis in the change of control transaction, up to a maximum of $10 million. We also agreed to notify J&J if we reasonably consider that we are engaged in substantive discussions in respect of the sale of the company or substantially all of our assets. See "Certain Relationships and Related Party Transactions". Lake Region. We entered into an agreement with Lake Region Manufacturing, Inc., one of the world's leading manufacturers of guidewires for the development and production of magnetically enabled guidewires in January 2005. The agreement provides Stereotaxis with the wherewithal to increase both the availability and the technological sophistication of its guidewires to better meet customer needs. RESEARCH AND DEVELOPMENT Our research and development team consists of 49 people focused on system and disposable interventional device development. We have assembled an experienced group of engineers and physicists with recognized expertise in magnetics, software, control algorithms, systems integration and disposable interventional device modeling and design. 17 Our research and development efforts are focused in three major areas: * continuing to enhance our existing system through ongoing product and software development; * designing new proprietary disposable interventional devices for use with our system; and * developing next generation versions of our system. Our research and development team collaborates with our strategic partners, Siemens, Philips, and J&J, to integrate our Stereotaxis System's open architecture platform with key imaging, location sensing and information systems in the cath lab. We have also collaborated with a number of highly regarded interventional physicians in key clinical areas and have entered into agreements with a number of universities and research institutions, which serve to increase our access to world class physicians and scientists and to expand our name recognition in the medical community. We have historically spent a significant portion of our capital resources on research and development, incurring $18.4 million in 2004, $13.9 million in 2003 and $14.7 million in 2002 in research and development expenses. CUSTOMER SERVICE AND SUPPORT Stereotaxis has contracted with Siemens to provide worldwide maintenance and support services to our customers for our integrated products. This allows us to leverage Siemens' extensive maintenance and support infrastructure for direct, on-site technical support activities, including its call center, customer support engineers and service parts logistics and delivery. It also provides a single point of contact for the customer and allows us to focus on providing installation, training, and back-up technical support. We have followed the same strategy with Philips and intend to do the same with other potential collaboration partners in the future. Our back-up technical support includes a combination of on-line, telephone and on-site technical assistance services 24 hours a day, seven days a week. We have also hired service and support engineers with networking and medical equipment expertise, and have outsourced a portion of our support services. We offer several different levels of support to our customers, including basic hardware and software maintenance, extended product maintenance, and rapid response capability for both parts and service. MANUFACTURING NIOBE SYSTEMS Our manufacturing strategy for our NIOBE system is to sub-contract the manufacture of major components and to complete the final assembly and testing of those components in-house in order to control quality. This permits us to focus on our core competencies in magnet design, magnetic physics, magnetic instrument control and navigational algorithms. Approximately 8,000 square feet of our St. Louis, Missouri facility is dedicated to systems assembly, testing and inspection. DISPOSABLE INTERVENTIONAL DEVICES Our manufacturing strategy for disposable interventional devices is to outsource their manufacture through subcontracting and through our alliance with J&J and to expand partnerships for other interventional devices. We currently maintain pilot level manufacturing capability along with strong relationships with component level suppliers. We also manufacture prototype disposables to facilitate product development. We have approximately 5,000 square feet allocated to disposables manufacturing, assembly, testing and inspection with approximately 1,300 square feet of clean rooms in Maple Grove, Minnesota. We have also entered into a manufacturing agreement with Lake Region Manufacturing to provide high volume capability for guidewires. 18 SOFTWARE The software components of the Stereotaxis System, including control and application software, are developed both internally and with integrated modules we purchase or license. We perform final testing of software products in-house prior to their commercial release. GENERAL Our manufacturing facilities operate under processes that meet the FDA's requirements under the Quality System Regulation, or QSR. In 2003, the FDA audited our Maple Grove, Minnesota facility for regulatory compliance, and no deficiencies were noted. A European regulatory agency audited each facility in 2001, found them to be in compliance with the requirements of ISO 9001, and issued a formal certification from the ISO Registrar in January of 2002. If we fail to remain in compliance with the FDA or ISO 9001 standards, we may be required to cease all or part of our operations for some period of time until we can demonstrate that appropriate steps have been taken to comply with such standards. We cannot be certain that our facilities will comply with the FDA or ISO 9001 standards in future audits by regulatory authorities. Our products require a number of complex operations, including multiple fabrication and assembly processes. We purchase both custom and off-the-shelf components from a number of certified suppliers and subject them to stringent quality processes. We apply periodic quality reviews of our suppliers and have established a supplier selection approval process. Some of the components necessary for the assembly of our products are supplied by a single supplier. Establishing additional or replacement suppliers for certain of those components cannot be done quickly. The disruption of the supply of components could cause a significant increase in the costs of these components, which could affect our profitability. We purchase components through both short and long-term supply arrangements and generally do not maintain large volumes of inventory. We currently have a long-term supply agreement for the supply of the permanent magnet assemblies used in our Stereotaxis System. We believe we have the ability to double our manufacturing capacity within six months to accommodate a significant increase in sales volume of our Stereotaxis System. Lead times for materials and components ordered by us and our contract manufacturers vary and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. We and our contract manufacturers acquire materials, complete standard subassemblies and assemble fully configured systems based on sales forecasts. If orders do not match forecasts, we and our contract manufacturers may have excess or inadequate inventory of materials and components. See "Factors That May Affect Future Results" for a discussion of various risks associated with our manufacturing strategy. SALES AND MARKETING We market our products in the U.S. and Europe through a direct sales force of senior sales specialists, supported by account managers that provide training, clinical support, and other services to our customers. In addition, our strategic alliances form an important part of our sales and marketing strategy. We leverage the sales forces of Siemens and Philips to co-market integrated systems on a worldwide basis. This approach allows us to coordinate our marketing efforts with our strategic partners while still dealing directly with the customer. J&J will exclusively distribute our electrophysiology mapping and ablation catheters, co-developed pursuant to our alliance with them. We intend to increase our sales personnel and the number of account managers significantly over the next 24 months and to enter into distribution and sales representative arrangements to market our products in the rest of the world. 19 Our sales and marketing process has two important steps: (1) selling systems directly and through co-marketing agreements with our imaging partners, Siemens and Philips and through distributors; and (2) leveraging our installed base of systems to drive recurring sales of disposable interventional devices, software and service. Step One: System sales. Our system sales strategy involves both direct selling, through our own sales force, and co-marketing with our strategic imaging partners, by leveraging these relationships to identify new or replacement cath labs being installed and then co-marketing integrated systems to the customer. Siemens and Philips have a major share of the cath lab installation market and therefore compete for a substantial number of potential cath lab installations on a worldwide basis, which gives us access to a large number of potential customers. These customers fall into three broad categories: * leading research institutions with physician thought leaders who are interested in performing complex new procedures enabled by our system; * high-volume commercial institutions interested in the efficiency benefits of our system; and * medium volume regional centers that are competing intensely for patients, attempting to minimize referrals of complex cases to other centers and focusing on gaining market share in their regional markets. Once we have identified potential customers, we approach capital equipment sales in five stages that bring significant predictability to our sales process. This allows us to measure the progress of each account in discrete steps through our sales funnel, and tailor our sales activity at each stage. The five-stage process includes the following, and has taken an average of 18 months for our 30 systems delivered to date: * Build initial customer interest: presentation of our value proposition; * Gain commitment: formal proposal with cost justification rationale; * Secure capital budget allocation: customer begins formal budget approval process for system acquisition; * Receive institutional approval: customer completes budget approval process and executes purchase order; and * System installation: installation begins as part of overall cath lab construction or refurbishment. As of December 31, 2004, we had received purchase orders and other commitments for approximately $20 million of our Stereotaxis Systems. There can be no assurance that we will recognize revenue in any particular period or at all because some of our purchase orders and other commitments are subject to contingencies that are outside of our control. In addition, these orders and commitments may be revised, modified or canceled, either by their express terms, as a result of negotiations or by project changes or delays. All of our systems placed to date have been integrated with Siemens' digital x-ray fluoroscopy systems. We have several purchase orders with a commitment for installation with Philips and we anticipate installing systems integrated with Philips' digital x-ray fluoroscopy system beginning in early 2005. Step Two: Recurring sales of disposable interventional devices, software and service. Each of our systems utilizes proprietary disposable interventional devices, both our own and those we are co-developing with strategic partners, as well as software tailored to specific clinical applications. We provide training and clinical support to users of our systems in order to increase their familiarity with system features and benefits, and thereby increase usage. More frequent usage should result in increased consumption of disposable interventional devices and software. While a basic one-year warranty is included with each system, we believe service contracts providing for enhanced levels of support and service beyond the basic warranty will become an important additional source of revenue. Our relationships with physician thought leaders in the fields of interventional cardiology and electrophysiology are an important component of our selling efforts. These relationships are typically built around research 20 collaborations, and they enable us to better understand and articulate the most useful features and benefits of our system, and to develop new solutions to long-standing challenges in interventional medicine. We will continue to seek support and collaboration from highly regarded physicians in order to perform important research and accelerate market awareness and adoption of our systems. REIMBURSEMENT We believe that substantially all of the procedures, whether commercial or in clinical trials, conducted in the U.S. with the Stereotaxis System have been reimbursed to date and that substantially all commercial procedures in Europe have been reimbursed. We expect that third-party payors will reimburse, under existing billing codes, our line of guidewires, as well as our line of ablation catheters and those on which we are collaborating with J&J. We expect healthcare facilities in the U.S. to bill various third-party payors, such as Medicare, Medicaid, other government programs and private insurers, for services performed with our products. We believe that procedures performed using our products, or targeted for use by products that do not yet have regulatory clearance or approval, are generally already reimbursable under government programs and most private plans. Accordingly, we believe providers in the U.S. will generally not be required to obtain new billing authorizations or codes in order to be compensated for performing medically necessary procedures using our products on insured patients. We cannot assure you that reimbursement policies of third-party payors will not change in the future with respect to some or all of the procedures using the Stereotaxis System. See "Factors That May Affect Future Results" for a discussion of various risks associated with reimbursement from third-party payors. INTELLECTUAL PROPERTY Our strategy is to patent the technology, inventions and improvements that we consider important to the development of our business. As a result, we believe that we have an extensive patent portfolio that protects the fundamental scope of our technology, including our magnet technology, navigational methods, procedures, systems, disposables interventional devices and our 3D integration technology. As of December 31, 2004, we had 42 issued U.S. patents, eight exclusively licensed U.S. patents, one exclusively licensed non-U.S. patent and three non- exclusively licensed U.S. patents. In addition, we had 69 pending U.S. patent applications, 17 pending non-U.S. patent applications, and six Patent Cooperation Treaty applications. We also have a number of invention disclosures under consideration and several applications that are being prepared for filing. Accordingly, we anticipate that the number of pending U.S. patent applications will increase. Our patent portfolio covering magnet systems, including our NIOBE cardiology magnet system, is comprised of eight issued patents and 11 pending applications. We have 16 issued patents and 19 pending applications covering methods of magnetically controlling magnetic medical devices, including the fundamental method of magnetically orienting and mechanically advancing devices in the body. In addition, we have 10 issued patents and 18 pending applications covering disposable interventional devices, including electrophysiology catheters, guidewires, atherectomy devices, neuro and other devices and our CARDIODRIVE automated catheter advancer. Finally, we have 19 pending patent applications for our disposable interventional devices, interfaces and navigation techniques that cover non-magnetic medical navigation. The patent positions of medical device companies, including ours, can be highly uncertain and involve complex and evolving legal and factual questions. One or more of the above patent applications may be denied. In addition, our issued patents may be challenged, based on prior art circumvented or otherwise not provide protection for the products we develop. Furthermore, we may not be able to obtain patent licenses from third parties required for the development of new products for use with our system. We also note that U.S. patents and patent applications may be subject to interference proceedings and U.S. patents may be subject to reexamination proceedings in the U.S. Patent and Trademark Office (and foreign patents may be subject to opposition or comparable proceedings in the corresponding foreign patent office), which proceedings could result in either loss of the patent or denial of the patent 21 application or loss or reduction in the scope of one or more of the claims of the patent or patent application. In addition, such interference, reexamination and opposition proceedings may be costly. In the event that we seek to enforce any of our owned or exclusively licensed patents against an infringing party, it is likely that the party defending the claim will seek to invalidate the patents we assert, which, if successful could result in the entire loss of our patent or the relevant portion of our patent and not just with respect to that particular infringer. Any litigation to enforce or defend our patents rights, even if we were to prevail, could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations. It would be technically difficult and costly to reverse engineer our Stereotaxis System, which contains numerous complex algorithms that control our disposable devices inside the magnetic fields generated by the Stereotaxis System. We further believe that our patent portfolio is broad enough in scope to enable us to obtain legal relief if any entity not licensed by us attempted to market disposable devices that can be navigated by the NIOBE system. We have developed plastic software keys, or smart chips, that allow our system to recognize specific disposable interventional devices in order to prevent unauthorized use of our system. We anticipate that these smart chips will be an important part of our disposable interventional device strategy going forward. We have also developed substantial know-how in magnet design, magnetic physics and magnetic instrument control that was developed in connection with the development of the Stereotaxis System, which we maintain as trade secrets. This centers around our proprietary magnet design, which is a critical aspect of our ability to design, manufacture and install a cost-effective cardiology magnet system that is small enough to be installed in a standard cath lab. We seek to protect our proprietary information by requiring our employees, consultants, contractors, outside partners and other advisers to execute nondisclosure and assignment of invention agreements upon commencement of their employment or engagement, through which we seek to protect our intellectual property. These agreements to protect our unpatented technology provide only limited and possibly inadequate protection of our rights. Third parties may therefore be able to use our unpatented technology, reducing our ability to compete. In addition, employees, consultants and other parties to these agreements may breach them and adequate remedies may not be available to us for their breaches. Many of our employees were previously employed at universities or other medical device companies, including our competitors or potential competitors. We could in the future be subject to claims that these employees or we have used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. Even if we are successful in defending against these claims, litigation could result in substantial costs and divert the attention of management and key personnel from our business operations. We also generally seek confidentiality agreements from third parties that receive our confidential data or materials. Our commercial success will depend in part on obtaining and maintaining patent protection and trade secret protection of our technologies and products as well as successfully defending these patents against third-party challenges. Some of our technology was co-developed with third parties and these third parties may claim rights in our intellectual property. We may also be liable for patent infringement by third parties whose products we use or combine with ours and for which we have no right to indemnification. In addition, many countries, including certain European countries, have compulsory licensing laws under which a patent owner may be compelled to grant licenses to third parties in some circumstances (for example, the patent owner has failed to "work" the invention in that country, or the third party has patented improvements). Many countries also limit the enforceability of patents against government agencies or government contractors. In these countries, the patent owner may have limited remedies, which could materially diminish the value of the patent. We will only be able to protect our technologies from unauthorized use by third parties to the extent that valid and enforceable patents or trade secrets cover them. We expect to face expensive and time-consuming infringement actions, validity challenges and other intellectual property claims and proceedings, which are frequent in the medical device industry, and which divert management's 22 attention from our business. There are other risks associated with our patent portfolio and other intellectual property. Please refer to "Factors That May Affect Future Results" for a more complete description of these risks. University of Virginia. We have exclusively licensed six patents related to the field of magnetically guiding an element through the body and viewing it for medical use from the University of Virginia Patent Foundation. The UVA patents address earlier versions of our system which we do not believe are essential to the protection of our current business activities, although one of these patents could be construed to cover some of our current activities. To date, we have expensed a five percent royalty on sales of products that might arguably be covered by this patent and our business model assumes continued payment of this royalty to UVA. However, we have become aware of prior art that caused us to question the validity of this patent, and as a result, we have initiated re-examination of the patent in the U.S. Patent and Trademark Office. If this reexamination finds the patent partially or completely invalid, our royalty obligations under the license agreement could be reduced or eliminated. We believe that our other patents would be sufficient to protect our technology in that event. COMPETITION The markets for medical devices are intensely competitive and are characterized by rapid technological advances, frequent new product introductions, evolving industry standards and price erosion. We consider our primary competition to be existing manual catheter-based interventional techniques and surgical procedures. To our knowledge, we are the only company that has commercialized remote, digital and direct control of the working tip of catheters and guidewires for interventional use. Our success depends in part on convincing hospitals and physicians to convert existing interventional procedures to computer-assisted procedures. We expect to face competition from companies that are developing new approaches and products for use in interventional procedures, including robotic approaches that may be directly competitive with our technology. Many of these companies have an established presence in the field of interventional cardiology, including the major imaging, capital equipment and disposables companies that are currently selling products in the cath lab. We also face competition from companies who currently market or are developing drugs or gene therapies to treat the conditions for which our products are intended. We believe that the primary competitive factors in the market we address are capability, safety, efficacy, ease of use, price, quality, reliability and effective sales, support, training and service. The length of time required for products to be developed and to receive regulatory and reimbursement approval is also an important competitive factor. We believe Stereotaxis has an important "first mover" advantage in establishing clinical standards in these areas. See "Factors That May Affect Future Results" for a discussion of other competitive risks facing our business. GOVERNMENT REGULATION The healthcare industry, and thus our business, is subject to extensive federal, state, local and foreign regulation. Some of the pertinent laws have not been definitively interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. In addition, these laws and their interpretations are subject to change. Both federal and state governmental agencies continue to subject the healthcare industry to intense regulatory scrutiny, including heightened civil and criminal enforcement efforts. As indicated by work plans and reports issued by these agencies, the federal government will continue to scrutinize, among other things, the billing practices of healthcare providers and the marketing of healthcare products. The federal government also has increased funding in recent years to fight healthcare fraud, and various agencies, such as the U.S. Department of 23 Justice, the Office of Inspector General of the Department of Health and Human Services, or OIG, and state Medicaid fraud control units, are coordinating their enforcement efforts. We believe that we have structured our business operations and relationships with our customers to comply with all applicable legal requirements. However, it is possible that governmental entities or other third parties could interpret these laws differently and assert otherwise. We discuss below the statutes and regulations that are most relevant to our business and most frequently cited in enforcement actions. U.S. FOOD AND DRUG ADMINISTRATION, OR FDA, REGULATION The Food and Drug Administration strictly regulates the medical devices we produce under the authority of the Federal Food, Drug and Cosmetic Act, or FFDCA, the regulations promulgated under the FFDCA, and other federal and state statutes and regulations. The FFDCA governs, among other things, the pre-clinical and clinical testing, design, manufacture, safety, efficacy, labeling, storage, record keeping, post market reporting and advertising and promotion of medical devices. Our medical devices are categorized under the statutory framework described in the FFDCA. This framework is a risk-based system which classifies medical devices into three classes from lowest risk (Class I) to highest risk (Class III). In general, Class I and II devices are either exempt from the need for FDA clearance or cleared for marketing through a premarket notification, or 510(k), process. Our devices that are considered to be general tools, such as our NIOBE cardiology magnet system and our suite of guidewires, or that provide diagnostic information, such as our TANGENT electrophysiology mapping catheters, are subject to 510(k) requirements. These devices are cleared for use as general tools which have utility in a variety of interventional procedures. Our therapeutic devices, such as our HELIOS ablation catheters, are subject to the premarket application, or PMA, process. If clinical data is needed to support a marketing application for our devices, generally, an investigational device exemption, or IDE, is assembled and submitted to the FDA. The FDA reviews and must approve the IDE before the study can begin. In addition, the study must be approved by an Institutional Review Board covering each clinical site. When all approvals are obtained, we initiate a clinical study to evaluate the device. Following completion of the study, we collect, analyze, and present the data in an appropriate submission to the FDA, either a 510(k) or PMA. Under the 510(k) process, the FDA determines whether or not the device is "substantially equivalent" to a predicate device. In making this determination, the FDA compares both the new device and the predicate device. If the two devices are comparable in intended use, safety, and effectiveness, the device may be cleared for marketing. Under the PMA process, the FDA examines detailed data relating to the safety and effectiveness of the device. This information includes design, development, manufacture, labeling, advertising, pre-clinical testing, and clinical study data. Prior to approving the PMA, the FDA generally will conduct an inspection of the facilities producing the device and one or more clinical sites where the study was conducted. The facility inspection evaluates the company's readiness to commercially produce and distribute the device. The inspection includes an evaluation of compliance under the Quality System Regulation (QSR). Under certain circumstances, the FDA may convene an advisory panel meeting to seek review of the data presented in the PMA. If the FDA's evaluation is favorable, the PMA is approved, and we can market the device in the U.S. The FDA may approve the PMA with conditions, such as post-market surveillance requirements. We evaluate changes made following 510(k) clearance or PMA approval for significance and if appropriate, make a subsequent submission to the FDA. In the case of a significant change being made to a 510(k) device, we submit a new 510(k). For a PMA device, we will either need approval through a PMA supplement or will need to notify the FDA. 24 For our 510(k) devices, we design the submission to cover multiple models or variations in order to minimize the number of submissions. For our PMA devices, we rely upon the PMA approvals of our strategic partners to utilize the PMA supplement regulatory path rather than pursue an original PMA. Because of the differences in the amount of data and numbers of patients in clinical trials, a PMA supplement process is often much shorter than the amount of time and data required for approval of an original PMA. Currently our NIOBE cardiology magnet system, NAVIGANT advanced user interface, CARDIODRIVE automated catheter advancer, family of CRONUS coronary guidewires, and TANGENT electrophysiology mapping catheter have been cleared by the FDA to be used in interventional procedures. In addition, we have received the CE Mark for our HELIOS electrophysiology ablation catheter and, in the U.S., we have completed clinical trials in 2004 and expect to subsequently file a PMA. We are subject to risks associated with U.S. government regulation. See "Factors That May Affect Future Results" for a discussion of the specific regulatory risks associated with our business. FOREIGN REGULATION In order for us to market our products in other countries, we must obtain regulatory approvals and comply with extensive safety and quality regulations in other countries. These regulations, including the requirements for approvals or clearance and the time required for regulatory review, vary from country to country. Failure to obtain regulatory approval in any foreign country in which we plan to market our products may harm our ability to generate revenue and harm our business. The primary regulatory environment in Europe is that of the European Union, which consists of 25 countries encompassing most of the major countries in Europe. The European Union requires that manufacturers of medical products obtain the right to affix the CE Mark to their products before selling them in member countries of the European Union. The CE Mark is an international symbol of adherence to quality assurance standards and compliance with applicable European medical device directives. In order to obtain the right to affix the CE Mark to products, a manufacturer must obtain certification that its processes meet certain European quality standards. Compliance with the Medical Device Directive, as certified by a recognized European Notified Body, permits the manufacturer to affix the CE Mark on its products and commercially distribute those products throughout the European Union. We have received the right to affix the CE Mark to each of our products that has received 510(k) clearance in the U.S. and also for our HELIOS ablation catheter. We are pursuing the right to affix the CE mark to certain guidewires that have received 510(k) clearance in the U.S. If we modify existing products or develop new products in the future, including new devices, we will need to apply for permission to affix the CE Mark to such products. We will be subject to regulatory audits, currently conducted biannually, in order to maintain any CE Mark permissions we have already obtained. We cannot be certain that we will be able to obtain permission to affix the CE Mark for new or modified products or that we will continue to meet the quality and safety standards required to maintain the permissions we have already received. If we are unable to maintain permission to affix the CE Mark to our products, we will no longer be able to sell our products in member countries of the European Union. In addition, through Siemens, we intend to submit an application for regulatory approval to commence a clinical study in 2005 with the Japanese Ministry of Health, Labor and Welfare for commercial use of the Stereotaxis System in Japan. Siemens has agreed to coordinate the regulatory approval process and act as distributor for our NIOBE cardiology magnet system and NAVIGANT advanced user interface in Japan, and we have begun to formulate our clinical plans for regulatory approval. We are currently formulating our clinical and regulatory plans for China and anticipate using Siemens to coordinate regulatory approval and distribute our products in China. We will evaluate regulatory approval in other foreign countries on an opportunistic basis. 25 ANTI-KICKBACK STATUTE The federal healthcare program Anti-Kickback Statute prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual, or furnishing or arranging for a good or service, for which payment may be made under a federal healthcare program such as the Medicare and Medicaid programs. The definition of "remuneration" has been broadly interpreted to include anything of value, including for example gifts, discounts, the furnishing of supplies or equipment, credit arrangements, payments of cash and waivers of payments. Several courts have interpreted the statute's intent requirement to mean that if any one purpose of an arrangement involving remuneration is to induce referrals of federal healthcare covered business, the statute has been violated. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs. In addition, some kickback allegations have been claimed to violate the Federal False Claims Act, discussed in more detail below. The Anti-Kickback Statute is broad and prohibits many arrangements and practices that are lawful in businesses outside of the healthcare industry. Recognizing that the Anti-Kickback Statute is broad and may technically prohibit many innocuous or beneficial arrangements, Congress authorized the OIG to issue a series of regulations, known as the "safe harbors" which it did, beginning in July of 1991. These safe harbors set forth provisions that, if all their applicable requirements are met, will assure healthcare providers and other parties that they will not be prosecuted under the Anti-Kickback Statute. The failure of a transaction or arrangement to fit precisely within one or more safe harbors does not necessarily mean that it is illegal or that prosecution will be pursued. However, conduct and business arrangements that do not fully satisfy each applicable safe harbor may result in increased scrutiny by government enforcement authorities such as the OIG. Many states have adopted laws similar to the Anti-Kickback Statute. Some of these state prohibitions apply to referral of patients for healthcare items or services reimbursed by any source, not only the Medicare and Medicaid programs. Government officials have focused their enforcement efforts on marketing of healthcare services and products, among other activities, and recently have brought cases against sales personnel who allegedly offered unlawful inducements to potential or existing customers in an attempt to procure their business. As part of our compliance program, we review our sales contracts and marketing materials to help assure compliance with the Anti-Kickback Statute and similar state laws. However, we cannot rule out the possibility that the government or other third parties could interpret these laws differently and assert otherwise. HIPAA The Health Insurance Portability and Accountability Act of 1996, or HIPAA, created two new federal crimes: healthcare fraud and false statements relating to healthcare matters. The healthcare fraud statute prohibits knowingly and willfully executing a scheme to defraud any healthcare benefit program, including private payors. A violation of this statute is a felony and may result in fines, imprisonment or exclusion from government sponsored programs. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services. A violation of this statute is a felony and may result in fines or imprisonment. In addition to creating the two new federal healthcare crimes, HIPAA also establishes uniform standards governing the conduct of certain electronic healthcare transactions and protecting the security and privacy of individually identifiable health information maintained or transmitted by healthcare providers, health plans and healthcare clearinghouses. Two standards have been promulgated under HIPAA: the Standards for Privacy of 26 Individually Identifiable Health Information, which restrict the use and disclosure of certain individually identifiable health information, and the Standards for Electronic Transactions, which establish standards for common healthcare transactions, such as claims information, plan eligibility, payment information and the use of electronic signatures. In addition, the Security Standards will require covered entities to implement certain security measures to safeguard certain electronic health information by April 21, 2005. Although we believe we are not a covered entity and therefore do not need to comply with these standards, our customers generally are covered entities and frequently ask us to comply with certain aspects of these standards. While the government intended this legislation to reduce administrative expenses and burdens for the healthcare industry, our compliance with certain provisions of these standards may entail significant and costly changes for us. If we fail to comply with these standards, it is possible that we could be subject to criminal penalties. In addition to federal regulations issued under HIPAA, some states have enacted privacy and security statutes or regulations that, in some cases, are more stringent than those issued under HIPAA. In those cases, it may be necessary to modify our operations and procedures to comply with the more stringent state laws, which may entail significant and costly changes for us. We believe that we are in compliance with such state laws and regulations. However, if we fail to comply with applicable state laws and regulations, we could be subject to additional sanctions. FEDERAL FALSE CLAIMS ACT Another trend affecting the healthcare industry is the increased use of the federal False Claims Act and, in particular, actions under the False Claims Act's "whistleblower" or "qui tam" provisions. Those provisions allow a private individual to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. The government must decide whether to intervene in the lawsuit and to become the primary prosecutor. If it declines to do so, the individual may choose to pursue the case alone, although the government must be kept apprised of the progress of the lawsuit. Whether or not the federal government intervenes in the case, it will receive the majority of any recovery. If the individual's litigation is successful, the individual is entitled to no less than 15%, but no more than 30%, of whatever amount the government recovers. In recent years, the number of suits brought against healthcare providers by private individuals has increased dramatically. In addition, various states have enacted laws modeled after the federal False Claims Act. When an entity is determined to have violated the federal False Claims Act, it may be required to pay up to three times the actual damages sustained by the government, plus civil penalties of between $5,500 to $11,000 for each separate false claim. There are many potential bases for liability under the federal False Claims Act. Liability arises, primarily, when an entity knowingly submits, or causes another to submit, a false claim for reimbursement to the federal government. Although simple negligence should not give rise to liability, submitting a claim with reckless disregard or deliberate ignorance of its truth or falsity could result in substantial civil liability. The False Claims Act has been used to assert liability on the basis of inadequate care, improper referrals, and improper use of Medicare numbers when detailing the provider of services, in addition to the more predictable allegations as to misrepresentations with respect to the services rendered. We are unable to predict whether we could be subject to actions under the False Claims Act, or the impact of such actions. However, the costs of defending claims under the False Claims Act, as well as sanctions imposed under the Act, could significantly affect our financial performance. CERTIFICATE OF NEED LAWS In approximately two-thirds of the states, a certificate of need or similar regulatory approval is required prior to the acquisition of high-cost capital items or various types of advanced medical equipment, such as our Stereotaxis System. At present, many of the states in which we sell Stereotaxis Systems have laws that require institutions located in those states to obtain a certificate of need in connection with the purchase of our system, and some of our purchase orders are conditioned upon our customer's receipt of necessary certificate of need approval. Certificate of need laws were enacted to contain rising health care costs, prevent the unnecessary duplication of health resources, and increase 27 patient access for health services. In practice, certificate of need laws have prevented hospitals and other providers who have been unable to obtain a certificate of need from acquiring new equipment or offering new services. A further increase in the number of states regulating our business through certificate of need or similar programs could adversely affect us. Moreover, some states may have additional requirements. For example, we understand that California's certificate of need law also incorporates seismic safety requirements which must be met before a hospital can acquire our Stereotaxis System. EMPLOYEES As of December 31, 2004, we had 140 employees, 49 of whom were engaged directly in research and development, 30 in manufacturing and service, 12 in regulatory, clinical affairs and quality activities, 35 in sales and marketing activities and 14 in general administrative and accounting activities. None of our employees is covered by a collective bargaining agreement, and we consider our relationship with our employees to be good. ITEM 2. PROPERTIES We lease approximately 31,000 square feet of manufacturing and office space in St. Louis, Missouri. The St. Louis facility is leased through December 31, 2005. On November 18, 2004, we entered into an office lease agreement under which we will lease space in a new building to be constructed in St. Louis. Once the building is completed, we will move our current St. Louis, Missouri operations to the leased space in the new building. The lease for the new premises is effective December 1, 2005 and has a term of ten years, with two renewal options of three years each. The minimum annual rental under the terms of the lease ranges from approximately $705,000 in 2006 to approximately $1,177,000 in 2015, including rent for expansion space provided for in the lease. We also lease approximately 10,000 square feet in Maple Grove, Minnesota. The Minnesota facility is leased through December 31, 2006. We believe that the Minnesota facility will be adequate to meet our needs through 2006. ITEM 3. LEGAL PROCEEDINGS We are involved from time to time in various lawsuits and claims arising in the normal course of business. Although the outcomes of these lawsuits and claims are uncertain, we do not believe any of them will have a material adverse effect on our business, financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 2004. 28 ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES PRICE RANGE OF COMMON STOCK Our common stock has been traded on The Nasdaq Stock Market under the symbol "STXS" since August 12, 2004. The following table sets forth the high and low closing prices of our common stock for the periods indicated and reported by Nasdaq. QUARTER HIGH LOW ------- ---- --- YEAR ENDED DECEMBER 31, 2004: August 12, 2004 to September 30, 2004 $12.44 $7.50 Fourth Quarter 10.89 8.43 As of February 28, 2005, there were approximately 176 stockholders of record of our common stock, although we believe that there is a significantly larger number of beneficial owners of our common stock. DIVIDEND POLICY We have never declared or paid any cash dividends. We currently expect to retain earnings for use in the operation and expansion of our business, and therefore do not anticipate paying any cash dividends for the next several years. The information required by this item regarding equity compensation is incorporated by reference to the information set forth in Item 12 of this Annual Report on Form 10-K. USE OF PROCEEDS FROM IPO We effected the initial public offering of our common stock pursuant to a Registration Statement on Form S-1 (File No. 333-115253) that was declared effective by the Securities and Exchange Commission on August 11, 2004 and pursuant to which shares were offered on August 12, 2004. The net proceeds from the offering, after an underwriting discount and other expenses, were approximately $41.4 million. We have begun to use, and intend to continue to use, the net proceeds of the offering for general corporate purposes, including: working capital; continued sales, marketing and clinical support initiatives relating to the commercialization of our products; and continued research and development. Pending other uses, we have invested the remaining net proceeds of the offering primarily in short-term, investment grade, interest-bearing instruments. 29 ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data has been derived from, and should be read in conjunction with our consolidated financial statements and the accompanying notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report. The selected data in this section is not intended to replace the consolidated financial statements. Historical results are not indicative of the results to be expected in the future. YEAR ENDED DECEMBER 31, 2004 2003 2002 2001 2000 ----------------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS DATA: Sales $ 18,816,860 $ 5,014,877 $ 18,900 $ - $ - Cost of Sales 10,672,262 4,051,313 39,760 - - ----------------------------------------------------------------------------------------- Gross Profit 8,144,598 963,564 (20,860) - - ----------------------------------------------------------------------------------------- Operating costs and expenses: Research and development 18,437,108 13,886,462 14,742,015 14,359,131 8,871,585 General and administrative 6,315,987 5,028,142 4,528,637 2,645,563 1,625,621 Sales and marketing 10,964,925 5,999,310 2,230,565 951,280 386,229 ----------------------------------------------------------------------------------------- Total operating costs and expenses 35,718,020 24,913,914 21,501,217 17,955,974 10,883,435 ----------------------------------------------------------------------------------------- Loss from operations (27,573,422) (23,950,350) (21,522,077) (17,955,974) (10,883,435) Interest and other income, net 315,953 (86,487) 63,419 950,776 1,334,319 ----------------------------------------------------------------------------------------- Net loss $ (27,257,469) $(24,036,837) $(21,458,658) $(17,005,198) $ (9,549,116) ========================================================================================= Basic and diluted net loss per share (1) $ (2.38) $ (18.37) $ (19.21) $ (23.01) $ (20.64) ========================================================================================= Shares used in computing basic and diluted net loss per share 11,470,310 1,308,805 1,117,301 739,088 462,616 ========================================================================================= CONSOLIDATED BALANCE SHEET DATA: Cash, cash equivalents and short-term investments $ 45,648,834 $ 26,480,612 $ 28,834,123 $ 30,452,205 $ 24,712,254 Working Capital 49,672,005 22,764,719 25,483,149 26,660,162 22,859,357 Total Assets 71,187,756 37,323,419 32,920,872 31,750,413 25,170,000 Long-term debt, less current maturities 1,000,000 2,243,768 2,281,321 - - Accumulated deficit (114,673,234) (87,415,765) (63,378,928) (41,920,270) (24,915,072) Total stockholders' equity $ 58,394,468 $ 25,266,428 $ 24,006,646 $ 27,476,496 $ 23,255,756 (1) The one-for-3.6 reverse stock split effective as of July 2004 has been reflected in the calculation of the basic and diluted net loss per share for all periods presented above. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our financial statements and notes thereto included in this report on Form 10-K. Operating results are not necessarily indicative of results that may occur in future periods. This report includes various forward-looking statements that are subject to risks and uncertainties, many of which are beyond our control. Our actual results could differ materially from those anticipated in these forward looking statements as a result of various factors, including those set forth below under the caption "Factors That May Affect 30 Future Results." Forward-looking statements discuss matters that are not historical facts. Forward-looking statements include, but are not limited to, discussions regarding our operating strategy, sales and marketing strategy, regulatory strategy, industry, economic conditions, financial condition, liquidity and capital resources and results of operations. Such statements include, but are not limited to, statements preceded by, followed by or that otherwise include the words "believes," "expects," "anticipates," "intends," "estimates," "projects," "can," "could," "may," "will," "would," or similar expressions. For those statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You should not unduly rely on these forward-looking statements, which speak only as of the date on which they were made. They give our expectations regarding the future but are not guarantees. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law. OVERVIEW Stereotaxis designs, manufactures and markets an advanced cardiology instrument control system for use in a hospital's interventional surgical suite to enhance the treatment of coronary artery disease and arrhythmias. The Stereotaxis System is designed to enable physicians to complete more complex interventional procedures by providing image guided delivery of catheters and guidewires through the blood vessels and chambers of the heart to treatment sites. This is achieved using computer-controlled, externally applied magnetic fields that govern the motion of the working tip of the catheter or guidewire, resulting in improved navigation, shorter procedure time and reduced x-ray exposure. The core components of the Stereotaxis system have received regulatory clearance in the U.S. and Europe. We believe that our system represents a revolutionary technology in the interventional surgical suite, or "cath lab", and has the potential to become the standard of care for a broad range of complex cardiology procedures. We also believe that our system is the only technology to be commercialized that allows remote, computerized control of catheters and guidewires directly at their working tip. We also believe that our technology represents an important advance in the ongoing trend toward digital instrumentation in the cath lab and provides substantial, clinically important improvements and cost efficiencies over manual interventional methods, which require years of physician training and often result in long and unpredictable procedure times and sub-optimal therapeutic outcomes. From our inception in June 1990 through 2002, our principal activities were obtaining capital, business development, performing research and development activities, funding prototype development, funding clinical trials and funding collaborations to integrate our products with other interventional technologies. Accordingly, we were classified as a development stage company for accounting purposes through December 31, 2002. Our initial focus was on the development of neurosurgical applications for our technology, including delivery of devices to specific sites within the brain. During that time, we primarily devoted our resources primary to developing prototypes and performing research and development activities in this area. Following receipt of FDA approval to begin human clinical trials in the field of brain biopsies, we successfully completed our initial human clinical procedures in this area in late 1998. Over the next two years, we shifted our primary focus to developing applications for our technology to treat cardiovascular diseases because of the significantly larger market opportunities for such applications. During 2003, following receipt of marketing clearance from the FDA for our current system, we emerged from the development stage and began to generate revenue from the placement of investigational systems and the commercial launch of our cardiology system in the U.S. and Europe. In August 2004, we completed an initial public offering in which we issued and sold 5,500,000 shares of common stock. In September 2004, the underwriters exercised an option to purchase 462,352 additional shares. In connection with the initial public offering (including the over-allotment option exercise), we received approximately $41.4 million in net proceeds. Prior to our initial public offering, we funded our operations primarily through private equity financings, supplemented by bank financing. Since our inception, we have generated significant losses. As of December 31, 2004, we had incurred cumulative net losses of approximately $114.7 million. We expect to incur 31 additional losses through the first half of 2006 as we continue the development and commercialization of our products, conduct our research and development activities and advance new products into clinical development from our existing research programs. We expect to use substantial financial resources from our initial public offering to expand our sales and marketing and customer support activities. We have alliances with each of Siemens AG Medical Solutions, Philips Medical Systems and Biosense Webster, Inc., a subsidiary of J&J, through which we are integrating our Stereotaxis System with market leading digital imaging and 3D catheter location sensing technology, as well as disposable interventional devices, in order to continue to develop new solutions in the cath lab. Each of these alliances provides for coordination of our sales and marketing activities with those of our partners. In addition, Siemens and Philips have agreed to provide worldwide service for our integrated systems. Siemens and J&J also invested in our convertible preferred stock, which was converted into common stock as a result of the initial public offering. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. We review our estimates and judgments on an on-going basis. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. We believe the following accounting policies are critical to the judgments and estimates we use in preparing our financial statements. REVENUE RECOGNITION We recognize systems revenue from system sales made directly to end users upon installation, provided there are no uncertainties regarding acceptance, persuasive evidence of an arrangement exists, the sales price is fixed or determinable, and collection of the related receivable is reasonably ensured. When installation is required for revenue recognition, the determination of acceptance is made by the Company's employees based on criteria set forth in the terms of the sale. Revenue from system sales made to distributors is recognized upon shipment since these arrangements do not include an installation element or right of return privileges. If uncertainties exist regarding collectability, the Company recognizes revenue when those uncertainties are resolved. Amounts collected prior to satisfying the above revenue recognition criteria are reflected as deferred revenue. Co-placement fees from strategic partners for the Company's collaboration in certain sales and marketing efforts will be recognized as revenue when earned under the terms of the respective agreements. Revenue from services, whether sold individually or as a separable unit of accounting in a multi-element arrangement, is deferred and amortized over the service period, which is typically one year. Revenue from services is derived primarily from the sale of annual product maintenance plans. The Company recognizes revenue from disposable device sales or accessories upon shipment, and an appropriate reserve for returns is established. Other revenue represents a system sale for which the cost of production was charged to research and development costs in 2002 and 2001. For arrangements with multiple deliverables, we allocate the total revenue to each deliverable based on its relative fair value in accordance with the provisions of Emerging Issues Task Force (EITF) Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables" and recognize revenue for each separate element as the above criteria are met. 32 STOCK-BASED COMPENSATION We account for employee and director stock options using the intrinsic-value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations and have adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. Stock options issued to non-employees, principally individuals who provide scientific advisory services, are recorded at their fair value as determined in accordance with SFAS No. 123 and EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and amortized over the service period. Stock compensation expense, which is a noncash charge, results from stock option grants made to employees at exercise prices below the deemed fair value of the underlying common stock, and from stock option grants made to non-employees at the fair value of the option granted. The fair value of options granted was determined using the Black-Scholes valuation method which gives consideration to the estimated value of the underlying stock at the date of grant, the exercise price of the option, the expected dividend yield and volatility of the underlying stock, the expected life of the option and the corresponding risk-free interest rate. When we were a private company, the deemed fair value of the underlying common stock was determined by management and the Board of Directors based on their best estimates using information from preferred stock financing transactions or other significant changes in the business. Stock compensation expense is amortized over the vesting period of the underlying option, generally two to four years. Unearned deferred compensation for non-employees is periodically remeasured through the vesting date. The amount of deferred compensation expense to be recorded in future periods may decrease if unvested options for which we have recorded deferred compensation are subsequently cancelled or expire, or may increase if the fair market value of our stock increases or we make additional grants of non-qualified stock options to members of our scientific advisory board or other non-employees. DEFERRED INCOME TAXES We account for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes. Under this method, deferred assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. We have established a valuation allowance against the entire amount of our deferred tax assets because we are not able to conclude, due to our history of operating losses, that it is more likely than not that we will be able to realize any portion of the deferred tax assets. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable losses, limitations imposed by Section 382 of the Internal Revenue Code and projections for future losses over periods which the deferred tax assets are deductible, management determined that a 100% valuation allowance of deferred tax assets was appropriate. 33 VALUATION OF INVENTORY We value our inventory at the lower of the actual cost of our inventory, as determined using the first-in, first-out (FIFO) method, or its current estimated market value. We periodically review our physical inventory for obsolete items and provide a reserve upon identification of potential obsolete items. INTANGIBLE ASSETS Intangible assets are comprised of purchased technology with a finite life. The acquisition cost of purchased technology is capitalized and amortized over its useful life in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. We review the assigned useful life on an on-going basis for consistency with the period over which cash flows are expected to be generated from the asset and consider the potential for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The process of estimating useful lives and evaluating potential impairment is subjective and requires management to exercise judgment in making assumptions related to future cash flows and discount rates. RESULTS OF OPERATIONS COMPARISON OF THE YEARS ENDED DECEMBER 31, 2004 AND 2003 Revenues. Revenues increased to $18.8 million for the year ended December 31, 2004 from $5.0 million for the year ended December 31, 2003, an increase of approximately 275%. Revenues from sales of systems increased to $17.2 million for the year ended December 31, 2004 from $3.8 million for the year ended December 31, 2003, an increase of approximately 352%. Revenues from the sale of systems increased primarily because we sold 22 systems in 2004 compared to eight systems in 2003 and because of an increase in average selling price. Revenues from sales of disposable interventional devices, service and accessories increased to $1.6 million for the year ended December 31, 2004 from $481,000 for the year ended December 31, 2003, an increase of approximately 232%. This increase was attributable to the increased base of installed systems. Cost of Revenues. Cost of revenues increased to $10.7 million for the year ended December 31, 2004 from $4.1 million for the year ended December 31, 2003, an increase of approximately 163%. This increase in cost of revenues was attributable primarily to the increased number of systems sold and associated cost of goods sold for those systems, offset by an approximate 17% reduction in average cost per system recognized. As a percentage of our revenues, cost of revenues, excluding "Other revenue," was 57% in the year ended December 31, 2004 compared to 95% in the year ended December 31, 2003. The improvement in the cost of revenue as a percentage of revenues was primarily a result of previously mentioned cost reduction as well as an increase in average selling price per system. Research and Development Expenses. Research and development expenses increased to $18.4 million for the year ended December 31, 2004 from $13.9 million for the year ended December 31, 2003, an increase of approximately 33%. The increase was due principally to an increase in the number of research and development projects with our strategic partners, primarily related to disposable interventional devices, further development of the Niobe platform technology, and salary and benefits for additional personnel performing research activities. In addition, during the year ended December 31, 2004 we recognized an offset to our development expenses under our agreement with Philips relating to the integration of our system with Philips' digital x-ray fluoroscopy system. Any payments received from Philips in excess of amounts recognized as earned are included in accrued liabilities on the balance sheet. 34 General and Administrative Expenses. General and administrative expenses increased to $6.3 million for the year ended December 31, 2004 from $5.0 million for the year ended December 31, 2003, an increase of 26%. The increase was due to an increase in our business activity related to the commercialization of our products, including personnel and clinical trials as well as legal and other costs. Sales and Marketing Expenses. Sales and marketing expenses increased to $11.0 million for the year ended December 31, 2004 from $6.0 million for the year ended December 31, 2003, an increase of approximately 83%. The increase related primarily to increased salary, benefits and travel expenses associated with hiring additional sales personnel and expanded marketing programs. Interest Income. Interest income increased approximately 116% to $811,000 for the year ended December 31, 2004 from $375,000 for the year ended December 31, 2003. Interest income increased due to greater invested balances and higher realized rates on short-term investments during the year ended December 31, 2004. Interest Expense. Interest expense remained relatively unchanged as the average borrowings and average rates were relatively unchanged. COMPARISON OF THE YEARS ENDED DECEMBER 31, 2003 AND 2002 Revenues. We generated $5.0 million in revenue in 2003 compared to $18,900 in 2002. This increase in revenues was attributable to the commencement of commercial sales of our systems following regulatory approval in 2003. As described above, we recognized revenue in 2003 from the sale of eight systems, including one predecessor system for which the cost of production was charged to research and development for previous years. This system, which is reflected as "other revenue" in our financial statements, is similar to a prototype in that it was placed prior to our receipt of FDA approval and was developed and installed primarily to demonstrate the effectiveness of our new technology. Because of uncertainties regarding whether payment would be ultimately received for this system, the full cost was expensed to research and development during the system's construction, principally during 2001. In 2003, following acceptance and the commencement of commercial use, the customer paid for the predecessor system. As a result, we recognized revenue in 2003 upon payment for the system. Cost of Revenues. Cost of revenues increased to $4.1 million in 2003 from $39,800 in 2002. This increase in cost of revenues was attributable primarily to the commencement of sales of our NIOBE system and associated cost of goods sold for those systems. As a percentage of our revenues, cost of revenues, excluding "Other revenue," was 95% in the year ended December 31, 2003. In 2002, our cost of revenues greatly exceeded our revenues because we did not have commercial revenues from the sale of systems in 2002. Research and Development Expenses. Research and development expenses decreased to $13.9 million in 2003 from $14.7 million in 2002, a decrease of approximately 6%. Our research and development expenses were higher in 2002 primarily because we were developing prototypes required for regulatory approval of our products. General and Administrative Expenses. General and administrative expenses increased to $5.0 million in 2003 from $4.5 million in 2002, an increase of approximately 11%. The increase from 2002 to 2003 was directly attributable to personnel additions made to support the commercial launch of our products in 2003. Sales and Marketing Expenses. Sales and marketing expenses increased to $6.0 million in 2003 from $2.2 million in 2002, an increase of approximately 169%. The increase related primarily to increased salary, benefits and travel expenses associated with the hiring of additional sales personnel and the expansion of our marketing programs. Interest Income. Interest income decreased to $375,000 for 2003 from $434,000 for 2002, a decrease of approximately 14%. The decrease was primarily the result of lower interest rates realized on balances invested. 35 Interest Expense. Interest expense increased to $462,000 for 2003 from $371,000 for 2002, an increase of approximately 25%. The increase was primarily the result of higher interest expense from increased borrowings under various Silicon Valley Bank lines of credit. INCOME TAXES Realization of deferred tax assets is dependent upon future earnings, the timing and amount of which are uncertain. Accordingly, net deferred tax assets have been fully offset by valuation allowances as of December 31, 2004, 2003 and 2002 to reflect these uncertainties. As of December 31, 2004, we had federal and state net operating loss carryforwards of approximately $108.1 million and federal research and development credit carryforwards of approximately $2.1 million. The net operating loss and research and development credit carryforwards will expire on various dates beginning in 2005 through 2024, respectively, if not utilized. We may not be able to utilize certain of these loss carryforwards and credits prior to their expiration. Of the $108.1 million net operating loss, $5.6 million is limited as to its use prior to December 31, 2007. LIQUIDITY AND CAPITAL RESOURCES Prior to our initial public offering, we financed our operations almost entirely from the private sale of equity securities, totaling approximately $127 million net of offering expenses. To a much lesser extent, we also financed our operations through working capital and equipment financing loans. We raised funds from these sources because, as a developing company, we were not able to fund our activities solely from the cash provided by our operations. In August 2004, we completed an initial public offering in which we issued and sold 5,500,000 shares of common stock. In September 2004, the underwriters exercised their option to purchase an additional 462,352 shares. In connection with the initial public offering and over-allotment exercise, we received approximately $41.4 million in net proceeds. At December 31, 2004, we had working capital of approximately $49.7 million, compared to $22.8 million at December 31, 2003. Liquidity refers to the liquid financial assets available to fund our business operations and pay for near-term obligations. These liquid financial assets consist of cash and cash equivalents, as well as investments. In addition to our cash and cash equivalent balances, we maintained $28.7 million and $5.1 million of investments in corporate debt securities, U.S. government agency notes and commercial paper at December 31, 2004 and 2003, respectively. The following table summarizes our cash flow by operating, investing and financing activities for each of years ended December 31, 2004, 2003 and 2002 (in thousands): 2004 2003 2002 ---- ---- ---- Cash Flow provided by (used in) Operating Activities $(31,814) $(24,469) $(22,029) Cash Flow provided by (used in) Investing Activities (29,654) (7,182) 1,480 Cash Flow provided by (used in) Financing Activities 57,019 24,174 20,719 Net cash (used in) operating activities. We used approximately $31.8 million, $24.5 million and $22.0 million of cash in operating activities during the year ended December 31, 2004, 2003 and 2002, respectively, primarily as a result of operating losses during these periods. Cash used for working capital purposes increased to $5.9 million during the year ended December 31, 2004 from $1.4 million during the year ended December 31, 2003 primarily as a result of an increase in accounts receivable from increased sales and billings for sales deposits from customers offset 36 by an increase in deferred revenue related to installed systems on which revenue has not yet been recognized and from deposits received from customers. Net cash provided by (used in) investing activities. We used approximately $29.7 million of cash for investing activities during the year ended December 31, 2004, substantially all for the purchase of investments, compared to $7.2 million during the year ended December 31, 2003. The 2003 investing activities included purchases of property, plant and equipment of approximately $2.1 million. Cash from investing activities of $1.5 million during the year ended December 31, 2002 was substantially all from the sale of short-term investments. Net cash provided by financing activities. We received approximately $57.0 million from financing activities during the year ended December 31, 2004, primarily as a result of the completion of our initial public offering (and exercise by the underwriters of their over-allotment option) in August and September 2004 and the sale of our Series E-2 preferred stock and related common stock warrants in January and February 2004. We also realized $2.0 million in proceeds from the issuance of long-term debt from our equipment loan with Silicon Valley Bank and repaid approximately $2.6 million of equipment loans and revolving credit facility. We received approximately $24.2 million from financing activities during 2003, primarily as a result of the sale of our Series D-2 preferred stock and related common stock warrants and from the sale of our Series E and E-1 preferred stock in January, June and December 2003. We received approximately $20.7 million from financing activities during 2002, primarily as a result of the sale of our Series D-1 and D-2 preferred stock and related common stock warrants in January and December 2002. As of December 31, 2004, we had outstanding balances under various equipment loan agreements with Silicon Valley Bank, consisting of an aggregate of $1.9 million. In April 2004, we entered into an amendment to our working capital revolving line of line of credit to increase our borrowing capacity from $3.0 to $8.0 million. As of December 31, 2004 we had no outstanding borrowings under this working capital line of credit and had borrowing capacity of $8.0 million, subject to collateralization by qualifying receivables and inventory balances with a maturity of April 2006. These credit facilities with Silicon Valley Bank are secured by substantially all of our assets. The credit agreements include customary affirmative, negative and financial covenants. For example, we are restricted from incurring additional debt, disposing of or pledging our assets, entering into merger or acquisition agreements, making certain investments, allowing fundamental changes to our business, ownership, management or business locations, and from making certain payments in respect of stock or other ownership interests, such as dividends and stock repurchases. Under our loan arrangements, we are required to maintain a ratio of "quick" assets (cash, cash equivalents, accounts receivable and short-term investments) to current liabilities minus deferred revenue of at least 1.5 to 1. We were also required to maintain a minimum tangible net worth of at least $50.0 million as of the end of each calendar month. Effective November 3, 2004, this minimum tangible net worth requirement was amended to $30 million. We are also required under the credit agreements to maintain our primary operating account and the majority of our cash and investment balances in accounts with the lender. We are in compliance with all covenants of this agreement. In August 2003, we issued a $2.0 million cumulative convertible pay-in-kind 8%, 3-year note to Siemens pursuant to an agreement under which we purchased certain technology. The outstanding principal, together with accrued and unpaid interest, of $2.17 million automatically converted into 271,739 shares of common stock upon the closing of our initial public offering, at a conversion price equal to $8.00 per share, the initial price to the public of our shares of common stock in the offering. We expect to have negative cash flow from operations through at least the first half of 2006. Throughout 2005, we expect to continue the development and commercialization of our products, the continuation of our research and development programs and the advancement of new products into clinical development. We have substantially increased the overall level of our research and development expenses from their levels in 2003 as a result of the 37 alliance agreements described above and otherwise, and we expect that these expenses will continue at substantially their current levels in the near term. In addition, our selling, general and administrative expenses will continue to increase in order to support our product commercialization efforts and to implement procedures required by our status as a public company. Until we can generate significant cash flow from our operations, we expect to continue to fund our operations with existing cash resources that were primarily generated from the proceeds of our initial public offering, private sales of our equity securities and working capital and equipment financing loans. In the future, we may finance future cash needs through the sale of other equity securities, strategic collaboration agreements and debt financings. We cannot accurately predict the timing and amount of our utilization of capital, which will depend on a number of factors outside of our control. While we believe our existing cash, cash equivalents and investments will be sufficient to fund our operating expenses and capital equipment requirements through at least the next 12 months, we cannot assure you that we will not require additional financing before that time. We also cannot assure you that such additional financing will be available on a timely basis on terms acceptable to us or at all, or that such financing will not be dilutive to our stockholders. If adequate funds are not available to us, we could be required to delay development or commercialization of new products, to license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize ourselves or to reduce the marketing, customer support or other resources devoted to our products, any of which could have a material adverse effect on our business, financial condition and results of operations. OFF-BALANCE SHEET ARRANGEMENTS We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As a result, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships. CONTRACTUAL OBLIGATIONS The following table summarizes all significant contractual payment obligations by payment due date: PAYMENTS BY PERIOD (IN THOUSANDS) UNDER 1 - 3 3 - 5 OVER CONTRACTUAL OBLIGATIONS 1 YEAR YEARS YEARS 5 YEARS TOTAL Long-term debt (1) $ 910 $1,000 $ - $ - $ 1,910 Operating leases 792 1,493 1,638 6,550 10,473 Capital leases 11 9 7 - 27 Research and alliance agreements 6,160 1,679 350 - 8,189 ------------------------------------------------------------ Total $7,873 $4,181 $1,995 $6,550 $20,599 ============================================================ (1) We have not included interest payable on our revolving credit agreement in these amounts because it is calculated at a variable rate. 38 RECENT ACCOUNTING PRONOUNCEMENTS In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment". SFAS No. 123(R) supersedes APB Opinion No. 25, which requires recognition of an expense when goods or services are provided. SFAS No. 123(R) requires the determination of the fair value of the share-based compensation at the grant date and the recognition of the related expense over the period in which the share-based compensation vests. We are required to adopt the provisions of SFAS No. 123(R) effective July 1, 2005. These new accounting rules will lead to a decrease in reported earnings and we have not yet determined the exact impact SFAS No. 123(R) will have on our financial statements. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs," an amendment of ARB No. 43. The amendments clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after the date SFAS No. 151 was issued. The adoption of SFAS No. 151 is not expected to have a material impact on the Company's financial statements. FACTORS THAT MAY AFFECT FUTURE RESULTS HOSPITAL DECISION-MAKERS MAY NOT PURCHASE OUR STEREOTAXIS SYSTEM OR MAY THINK THAT IT IS TOO EXPENSIVE. The market for our products and related technology is not well established. To achieve continued sales, hospitals must purchase our products, and in particular, our NIOBE cardiology magnet system. The NIOBE cardiology magnet system, which is the core of our Stereotaxis System, is a novel device, and hospitals and physicians are traditionally slow to adopt new products and treatment practices. Moreover, the Stereotaxis System is an expensive piece of capital equipment, representing a significant portion of the cost of a new or replacement cath lab. If hospitals do not widely adopt our Stereotaxis System, or if they decide that it is too expensive, we may never become profitable. Any failure to sell as many Stereotaxis Systems as our business plan requires could also have a seriously detrimental impact on our results of operations, financial condition and cash flow. PHYSICIANS MAY NOT USE OUR PRODUCTS IF THEY DO NOT BELIEVE THEY ARE SAFE AND EFFECTIVE. We believe that physicians will not use our products unless they determine that the Stereotaxis System provides a safe, effective and preferable alternative to interventional methods in general use today. Currently, there is only limited clinical data on the Stereotaxis System with which to assess safety and efficacy. If longer-term patient studies or clinical experience indicate that treatment with our system or products is less effective, less efficient or less safe than our current data suggest, our sales would be harmed, and we could be subject to significant liability. Further, unsatisfactory patient outcomes or patient injury could cause negative publicity for our products, particularly in the early phases of product introduction. In addition, physicians may be slow to adopt our products if they perceive liability risks arising from the use of these new products. It is also possible that as our products become more widely used, latent defects could be identified, creating negative publicity and liability problems for us and adversely affecting demand for our products. If physicians do not use our products, we likely will not become profitable or generate sufficient cash to survive as a going concern. 39 OUR COLLABORATIONS WITH SIEMENS, PHILIPS AND J&J MAY FAIL, OR WE MAY NOT BE ABLE TO ENTER INTO ADDITIONAL PARTNERSHIPS OR COLLABORATIONS IN THE FUTURE. We are collaborating with Siemens, Philips and J&J to integrate our instrument control technology with their respective imaging products or disposable interventional devices and to co-develop additional disposable interventional devices for use with our Stereotaxis System. For the immediate future, a significant portion of our revenues from system sales will be derived from these integrated products. In addition, each of Siemens and Philips has agreed to provide post-installation maintenance and support services to our customers for our integrated systems. Our product commercialization plans could be disrupted, leading to lower than expected revenue and a material and adverse impact on our results of operations and cash flow, if: * any of our collaboration partners delays or fails in the integration of its technology with our Stereotaxis System as planned; * any of our collaboration partners does not co-market and co-promote our integrated products diligently or does not provide maintenance and support services as we expect; or * we become involved in disputes with one or more of our collaboration partners regarding our collaborations. Siemens, Philips and J&J, as well as some of our other collaborators, are large, global organizations with diverse product lines and interests that may diverge from our interests in commercializing our products. Accordingly, our collaborators may not devote adequate resources to our products, or may experience financial difficulties, change their business strategy or undergo a business combination that may affect their willingness or ability to fulfill their obligations to us. In particular, we have had only limited experience with respect to the integration of our system with Philips' imaging products. The failure of one or more of our collaborations could have a material adverse effect on our financial condition, results of operations and cash flow. In addition, if we are unable to enter into additional partnerships in the future, or if these partnerships fail, our ability to develop and commercialize products could be impacted negatively and our revenues could be adversely affected. YOU MAY HAVE DIFFICULTY EVALUATING OUR BUSINESS AND OPERATING RESULTS BECAUSE WE ARE STILL IN THE EARLY STAGES OF COMMERCIALIZING OUR PRODUCTS. We have been engaged in research and product development since our inception in 1990. Our initial focus was on the development of neurosurgical applications for our technology, and during the first several years following our inception, we devoted our resources primarily to developing prototypes and performing research and development activities in this area. Starting around 1998, we shifted our primary focus over the next two years to developing applications for our technology to treat cardiovascular disease and, in 2003, began limited commercial shipments of products we developed for treatment in this area. To date, our investments in our products have produced relatively little revenue, and our operating expenses are high relative to that revenue. Our lack of a significant operating history also impairs an investor's ability to make a comparative evaluation of us, our products and our prospects. 40 WE HAVE LIMITED EXPERIENCE SELLING, MARKETING AND DISTRIBUTING PRODUCTS, WHICH COULD IMPAIR OUR ABILITY TO INCREASE REVENUES. We currently market our products in the U.S. and Europe through a direct sales force of sales specialists, supported by account managers that provide training, clinical support, and other services to our customers. If we are unable to increase our sales force significantly in the foreseeable future, we may be unable to generate the revenues we have projected in our business plan. Factors that may inhibit our sales and marketing efforts include: * our inability to recruit and retain adequate numbers of qualified sales and marketing personnel; * the inability of sales personnel to obtain access to or persuade adequate numbers of hospitals and physicians to purchase and use our products; * unforeseen costs associated with maintaining and expanding an independent sales and marketing organization; and * increased government scrutiny with respect to marketing activities in the health care industry. In addition, if we fail to effectively use distributors or contract sales persons for distribution of our products where appropriate, our revenues and profitability would be adversely affected. WE MAY LOSE OR FAIL TO ATTRACT PHYSICIAN "THOUGHT LEADERS". Our research and development efforts and our marketing strategy depend heavily on obtaining support and collaboration from highly regarded physicians at leading commercial and research hospitals. If we are unable to gain such support and collaboration, our ability to market the Stereotaxis System and, as a result, our financial condition, results of operations and cash flow could be materially and adversely affected. WE MAY NOT BE ABLE TO RAPIDLY TRAIN PHYSICIANS IN NUMBERS SUFFICIENT TO GENERATE ADEQUATE DEMAND FOR OUR PRODUCTS. In order for physicians to learn to use the Stereotaxis System, they must attend one or more training sessions. Market acceptance could be delayed by lack of physician willingness to attend training sessions or by the time required to complete this training. An inability to train a sufficient number of physicians to generate adequate demand for our products could have a material adverse impact on our financial condition and cash flow. CUSTOMERS MAY CHOOSE TO PURCHASE COMPETING PRODUCTS AND NOT OURS. Our products must compete with established manual interventional methods. These methods are widely accepted in the medical community, have a long history of use and do not require the purchase of an additional expensive piece of capital equipment. In addition, many of the medical conditions that can be treated using our products can also be treated with existing pharmaceuticals or other medical devices and procedures. Many of these alternative treatments are widely accepted in the medical community and have a long history of use. We also face competition from companies that are developing drugs or other medical devices or procedures to treat the conditions for which our products are intended. The medical device and pharmaceutical industries make significant investments in research and development, and innovation is rapid and continuous. For example, we are aware that two private companies are developing non-magnetic assisted navigation devices that could compete directly with the Stereotaxis System. However, to the best of our knowledge, these products have not been commercialized. If these or other new products or technologies emerge that provide the same or superior benefits as our products at equal or lesser cost, it could render our products obsolete or unmarketable. We cannot be certain that 41 physicians will use our products to replace or supplement established treatments or that our products will be competitive with current or future products and technologies. Most of our other competitors also have longer operating histories, significantly greater financial, technical, marketing and other resources, greater name recognition and a larger base of customers than we do. In addition, as the markets for medical devices develop, additional competitors could enter the market. We cannot assure you that we will be able to compete successfully against existing or new competitors. Our revenues would be reduced or eliminated if our competitors develop and market products that are more effective and less expensive than our products. IF WE ARE UNABLE TO FULFILL OUR CURRENT PURCHASE ORDERS AND OTHER COMMITMENTS ON A TIMELY BASIS OR AT ALL, WE MAY NOT BE ABLE TO ACHIEVE FUTURE SALES GROWTH. We currently have outstanding purchase orders and other commitments for our systems. There can be no assurance that we will recognize revenue in any particular period or at all because some of our purchase orders and other commitments are subject to contingencies that are outside our control. In addition, these orders and commitments may be revised, modified or canceled, either by their express terms, as a result of negotiations or by project changes or delays. The installation process for a Stereotaxis System is long and involves multiple stages, the completion of many of which are outside of our control. If we experience any failures or delays in completing the installation of these systems, our reputation would suffer and we may not be able to sell additional systems. Substantial delays in the installation process also increase the risk that a customer would attempt to cancel a purchase order. This would have a negative effect on our revenues and results of operations. WE WILL LIKELY EXPERIENCE LONG AND VARIABLE SALES CYCLES, WHICH COULD RESULT IN SUBSTANTIAL FLUCTUATIONS IN OUR QUARTERLY RESULTS OF OPERATIONS. We anticipate that our system will continue to have a lengthy sales cycle because it consists of a relatively expensive piece of capital equipment, the purchase of which requires the approval of senior management at hospitals, inclusion in the hospitals' cath lab budget process for capital expenditures, and, in some instances, a certificate of need from the state or other regulatory approval. In addition, assembly and installation of the system has typically taken six to eight months after a customer agreed to purchase a system. Assembly and installation could take even longer if our system is part of a larger construction project at the customer site. These factors may contribute to substantial fluctuations in our quarterly operating results, particularly in the near term and during any other periods in which our sales volume is relatively low. As a result, in future quarters our operating results could fall below the expectations of securities analysts or investors, in which event our stock price would likely decrease. IF THE MAGNETIC FIELDS GENERATED BY OUR SYSTEM ARE NOT COMPATIBLE WITH, OR INTERFERE WITH, OTHER WIDELY USED EQUIPMENT IN THE CATH LAB, SALES OF OUR PRODUCTS WOULD BE NEGATIVELY AFFECTED. Our system generates magnetic fields that directly govern the motion of the internal, or working, tip of disposable interventional devices. If other equipment in the cath lab or elsewhere in a hospital is incompatible with the magnetic fields generated by our system, or if our system interferes with such equipment, we may be required to install additional shielding, which may be expensive and which may not solve the problem. For example, in two hospitals where we installed our system, it interfered with equipment located in adjacent rooms. In order to correct these particular situations, we installed additional shielding and made other adjustments to our equipment. Although we have modified our shielding approach, if magnetic interference is a problem at additional institutions, it would increase our installation costs at those institutions and could limit the number of hospitals that would be willing to purchase and install our systems, either of which would adversely affect our financial condition, results of operations and cash flow. 42 THE USE OF OUR PRODUCTS COULD RESULT IN PRODUCT LIABILITY CLAIMS THAT COULD BE EXPENSIVE, DIVERT MANAGEMENT'S ATTENTION AND HARM OUR REPUTATION AND BUSINESS. Our business exposes us to significant risks of product liability claims. The medical device industry has historically been litigious, and we could face product liability claims if the use of our products were to cause injury or death. The coverage limits of our product liability insurance policies may not be adequate to cover future claims, and we may be unable to maintain product liability insurance in the future at satisfactory rates or adequate amounts. A product liability claim, regardless of its merit or eventual outcome, could divert management's attention, result in significant legal defense costs, significant harm to our reputation and a decline in revenues. OUR COSTS COULD SUBSTANTIALLY INCREASE IF WE RECEIVE A SIGNIFICANT NUMBER OF WARRANTY CLAIMS. We generally warrant each of our products against defects in materials and workmanship for a period of 12 months from the acceptance of our product by a customer. We have only a limited history of commercial placements from which to judge our rate of warranty claims. If product returns or warranty claims increase, we could incur unanticipated additional expenditures for parts and service. In addition, our reputation and goodwill in the cath lab market could be damaged. While we have established reserves for liability associated with product warranties, unforeseen warranty exposure in excess of those reserves could materially and adversely affect our financial condition, results of operations and cash flow. WE MAY NOT GENERATE CASH FROM OPERATIONS NECESSARY TO COMMERCIALIZE OUR EXISTING PRODUCTS AND INVEST IN NEW PRODUCTS. If we require additional funds to meet our working capital and capital expenditure needs in the future, we cannot be certain that we will be able to obtain additional financing on favorable terms or at all. If we need additional capital and cannot raise it on acceptable terms, we may not be able to, among other things: * enhance our existing products or develop new ones; * expand our operations; * hire, train and retain employees; or * respond to competitive pressures or unanticipated capital requirements. Our failure to do any of these things could result in lower revenues and adversely affect our financial condition and results of operations, and we may have to curtail or cease operations. WE HAVE INCURRED SUBSTANTIAL LOSSES IN THE PAST AND MAY NOT BE PROFITABLE IN THE FUTURE. We have incurred substantial net losses since inception, and we expect to incur substantial additional and increasing net losses for at least the next several years as we seek additional regulatory approvals, launch new products and generally scale up our sales, marketing and manufacturing operations to commercialize our products. We had net losses of approximately $27.3 million in 2004, $24.0 million in 2003, $21.5 million in 2002, and at December 31, 2004 we had an accumulated deficit of approximately $114.7 million. A small portion of our accumulated deficit is attributable to investments in development of products for neurosurgical applications, which was our primary focus in the first several years after our inception in 1990. Because we may not be successful in completing the development or commercialization of our technology in these areas, your return on these investments may be limited. Moreover, the extent of our future losses and the timing of profitability are highly uncertain, and we may never achieve profitable operations. If we require more time than we expect to generate significant revenues and achieve profitability, we may not be able to continue our operations. Our failure to achieve profitability could negatively impact the market price of our common stock. Even if we do become profitable, we may not be able to 43 sustain or increase profitability on a quarterly or annual basis. Furthermore, even if we achieve significant revenues, we may choose to pursue a strategy of increasing market penetration and presence at the expense of profitability. OUR RELIANCE ON CONTRACT MANUFACTURERS AND ON SUPPLIERS, AND IN SOME CASES, A SINGLE SUPPLIER, COULD HARM OUR ABILITY TO MEET DEMAND FOR OUR PRODUCTS IN A TIMELY MANNER OR WITHIN BUDGET. We depend on contract manufacturers to produce most of the components of our systems and other products. We also depend on various third party suppliers for the magnets we use in our NIOBE cardiology magnet systems and for our guidewires and electrophysiology catheters. In addition, some of the components necessary for the assembly of our products are currently provided to us by a single supplier, including the magnets for our NIOBE cardiology magnet system, and we generally do not maintain large volumes of inventory. Our reliance on these third parties involves a number of risks, including, among other things, the risk that: * we may not be able to control the quality and cost of our system or respond to unanticipated changes and increases in customer orders; * we may lose access to critical services and components, resulting in an interruption in the manufacture, assembly and shipment of our systems; and * we may not be able to find new or alternative components for our use or reconfigure our system and manufacturing processes in a timely manner if the components necessary for our system become unavailable. If any of these risks materialize, it could significantly increase our costs and impair product delivery. In addition, if these manufacturers or suppliers stop providing us with the components or services necessary for the operation of our business, we may not be able to identify alternate sources in a timely fashion. Any transition to alternate manufacturers or suppliers would likely result in operational problems and increased expenses and could delay the shipment of, or limit our ability to provide, our products. We cannot assure you that we would be able to enter into agreements with new manufacturers or suppliers on commercially reasonable terms or at all. Additionally, obtaining components from a new supplier may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product sales. Any disruptions in product flow may harm our ability to generate revenues, lead to customer dissatisfaction, damage our reputation and result in additional costs or cancellation of orders by our customers. We also rely on our collaboration partner, J&J, to manufacture a number of disposable interventional devices for use with our Stereotaxis System. If J&J cannot manufacture sufficient quantities of disposable interventional devices to meet customer demand, or if their manufacturing processes are disrupted, our revenues and profitability would be adversely affected. RISKS ASSOCIATED WITH INTERNATIONAL MANUFACTURING AND TRADE COULD NEGATIVELY IMPACT THE AVAILABILITY AND COST OF OUR PRODUCTS BECAUSE OUR MAGNETS, ONE OF OUR KEY SYSTEM COMPONENTS, ARE SOURCED FROM JAPAN. We purchase the permanent magnets for our NIOBE cardiology magnet system from a manufacturer that uses material produced in Japan, and certain of the production work for these magnets is performed for this manufacturer in China. In addition, we purchase our magnets for our disposable interventional devices directly from a manufacturer in Japan, and a number of other components for our system in foreign jurisdictions, including components sourced locally in connection with installations. Any event causing a disruption of imports, including the imposition of import restrictions, could adversely affect our business. The flow of components from our vendors could also be adversely affected by financial or political instability in any of the countries in which the goods we purchase are manufactured, if the instability affects the production or export of product components from those countries. Trade restrictions in the form of tariffs or quotas, or both, could also affect the importation of those product components and could increase the cost and reduce the supply of products available to us. In addition, decreases in 44 the value of the U.S. dollar against foreign currencies could increase the cost of products we purchase from overseas vendors. WE HAVE LIMITED EXPERIENCE IN MANUFACTURING AND ASSEMBLING OUR PRODUCTS AND MAY ENCOUNTER PROBLEMS AT OUR MANUFACTURING FACILITIES OR OTHERWISE EXPERIENCE MANUFACTURING DELAYS THAT COULD RESULT IN LOST REVENUE. We do not have extensive experience in manufacturing, assembling or testing our products on a commercial scale. In addition, for our NIOBE cardiology magnet systems, we subcontract the manufacturing of major components and complete the final assembly and testing of those components in-house. As a result, we may be unable to meet the expected future demand for our Stereotaxis System. We may also experience quality problems, substantial costs and unexpected delays in our efforts to upgrade and expand our manufacturing, assembly and testing capabilities. If we incur delays due to quality problems or other unexpected events, we will be unable to produce a sufficient supply of systems necessary to meet our future growth expectations In addition, we are manufacturing a limited number of our disposable interventional devices ourselves in a pilot manufacturing program and intend to continue to subcontract the manufacture of others to third parties. In order to do so, we will need to retain qualified employees for our assembly and testing operations. In addition, we are dependent on the facilities we lease in St. Louis, Missouri and Maple Grove, Minnesota in order to manufacture and assemble certain products. We could encounter problems at either of these facilities, which could delay or prevent us from assembling or testing our products or maintaining our pilot manufacturing capabilities or otherwise conducting operations. We are also moving our St. Louis operations to new facilities in the St. Louis area in 2005. Moving to a new facility could disrupt our systems assembly or testing activities and divert the attention of our management and other key personnel from our business operations. WE MAY BE UNABLE TO PROTECT OUR TECHNOLOGY FROM USE BY THIRD PARTIES. Our commercial success will depend in part on obtaining patent and other intellectual property right protection for the technologies contained in our products and on successfully defending these rights against third party challenges. The patent positions of medical device companies, including ours, can be highly uncertain and involve complex and evolving legal and factual questions. We cannot assure you that we will obtain the patent protection we seek, that any protection we do obtain will be found valid and enforceable if challenged or that it will confer any significant commercial advantage. U.S. patents and patent applications may also be subject to interference proceedings and U.S. patents may be subject to reexamination proceedings in the U.S. Patent and Trademark Office, and foreign patents may be subject to opposition or comparable proceedings in the corresponding foreign patent office, which proceedings could result in either loss of the patent or denial of the patent application or loss, or reduction in the scope of one or more of the claims of, the patent or patent application. In addition, such interference, reexamination and opposition proceedings may be costly. Thus, any patents that we own or license from others may not provide any protection against competitors. Our pending patent applications, those we may file in the future or those we may license from third parties may not result in patents being issued. If issued, they may not provide us with proprietary protection or competitive advantages against competitors with similar technology. Some of our technology was developed in conjunction with third parties, and thus there is a risk that a third party may claim rights in our intellectual property. Outside the U.S., we rely on third-party payment services for the payment of foreign patent annuities and other fees. Non-payment or delay in payment of such fees, whether intentional or unintentional, may result in loss of patents or patent rights important to our business. Many countries, including certain countries in Europe, have compulsory licensing laws under which a patent owner may be compelled to grant licenses to third parties (for example, the patent owner has failed to "work" the invention in that country, or the third party has patented improvements). In addition, many countries limit the enforceability of patents against government agencies or government contractors. In these countries, the patent owner may have limited remedies, which could materially diminish the value of the patent. We also cannot assure you that we will be able to develop additional patentable technologies. If we fail to obtain adequate patent protection for our technology, or if any 45 protection we obtain becomes limited or invalidated, others may be able to make and sell competing products, impairing our competitive position. Our trade secrets, nondisclosure agreements and other contractual provisions to protect unpatented technology provide only limited and possibly inadequate protection of our rights. As a result, third parties may be able to use our unpatented technology, and our ability to compete in the market would be reduced. In addition, employees, consultants and others who participate in developing our products or in commercial relationships with us may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for the breach. Our competitors may independently develop similar or alternative technologies or products that are equal or superior to our technology and products without infringing any of our patent or other intellectual property rights, or may design around our proprietary technologies. In addition, the laws of some foreign countries do not protect intellectual property rights to the same extent as do the laws of the U.S., particularly in the field of medical products and procedures. THIRD PARTIES MAY ASSERT THAT WE ARE INFRINGING THEIR INTELLECTUAL PROPERTY RIGHTS. Successfully commercializing our products will depend in part on not infringing patents held by third parties. It is possible that one or more of our products, including those that we have developed in conjunction with third parties, infringes existing patents. We may also be liable for patent infringement by third parties whose products we use or combine with our own and for which we have no right to indemnification. In addition, because patent applications are maintained under conditions of confidentiality and can take many years to issue, there may be applications now pending of which we are unaware and which may later result in issued patents that our products infringe. Whether a product infringes a patent involves complex legal and factual issues and may not become clear until finally determined by a court in litigation. Our competitors may assert that our products infringe patents held by them. Moreover, as the number of competitors in our market grows, the possibility of a patent infringement claim against us increases. If we were not successful in obtaining a license or redesigning our products, we could be subject to litigation. If we lose in this kind of litigation, a court could require us to pay substantial damages or prohibit us from using technologies essential to our products covered by third-party patents. An inability to use technologies essential to our products would have a material adverse effect on our financial condition, results of operations and cash flow and could undermine our ability to continue operating as a going concern. EXPENSIVE INTELLECTUAL PROPERTY LITIGATION IS FREQUENT IN THE MEDICAL DEVICE INDUSTRY. Infringement actions, validity challenges and other intellectual property claims and proceedings, whether with or without merit, can be expensive and time-consuming and would divert management's attention from our business. We have incurred, and expect to continue to incur, substantial costs in obtaining patents and may have to incur substantial costs defending our proprietary rights. Incurring such costs could have a material adverse effect on our financial condition, results of operations and cash flow. WE MAY NOT BE ABLE TO OBTAIN ALL THE LICENSES FROM THIRD PARTIES NECESSARY FOR THE DEVELOPMENT OF NEW PRODUCTS. As we develop additional disposable interventional devices for use with our system, we may find it advisable or necessary to seek licenses from third parties who hold patents covering technology used in specific interventional procedures. If we cannot obtain those licenses, we could be forced to try to design around those patents at additional cost or abandon the product altogether, which could adversely affect revenues and results of operations. If we have to abandon a product, our ability to develop and grow our business in new directions and markets would be adversely affected. 46 OUR PRODUCTS AND RELATED TECHNOLOGIES CAN BE APPLIED IN DIFFERENT INDUSTRIES, AND WE MAY FAIL TO FOCUS ON THE MOST PROFITABLE AREAS. The Stereotaxis System is designed to have the potential for expanded applications beyond interventional cardiology and electrophysiology, including interventional neurosurgery, interventional neuroradiology, peripheral vascular, pulmonology, urology, gynecology and gastrointestinal medicine. However, we have limited financial and managerial resources and therefore may be required to focus on products in selected industries and to forego efforts with regard to other products and industries. Our decisions may not produce viable commercial products and may divert our resources from more profitable market opportunities. Moreover, we may devote resources to developing products in these additional areas but may be unable to justify the value proposition or otherwise develop a commercial market for products we develop in these areas, if any. In that case, the return on investment in these additional areas may be limited, which could negatively affect our results of operations. WE MAY BE SUBJECT TO DAMAGES RESULTING FROM CLAIMS THAT OUR EMPLOYEES OR WE HAVE WRONGFULLY USED OR DISCLOSED ALLEGED TRADE SECRETS OF THEIR FORMER EMPLOYERS. Many of our employees were previously employed at universities or other medical device companies, including our competitors or potential competitors. We could in the future be subject to claims that these employees or we have used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel. A loss of key research personnel or their work product could hamper or prevent our ability to commercialize certain potential products, which could severely harm our business. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management. Incurring such costs could have a material adverse effect on our financial condition, results of operations and cash flow. IF WE OR OUR STRATEGIC PARTNERS FAIL TO OBTAIN OR MAINTAIN NECESSARY FDA CLEARANCES FOR OUR MEDICAL DEVICE PRODUCTS, OR IF SUCH CLEARANCES ARE DELAYED, WE WILL BE UNABLE TO CONTINUE TO COMMERCIALLY DISTRIBUTE AND MARKET OUR PRODUCTS. Our products are medical devices that are subject to extensive regulation in the U.S. and in foreign countries where we do business. Unless an exemption applies, each medical device that we wish to market in the U.S. must first receive either 510(k) clearance or pre-market approval, or PMA, from the U.S. Food and Drug Administration pursuant to the Federal Food, Drug, and Cosmetic Act. The FDA's 510(k) clearance process usually takes from four to 12 months, but it can take longer. The process of obtaining PMA approval is much more costly, lengthy and uncertain, generally taking from one to three years or even longer. Although we have 510(k) clearance for our current Stereotaxis System, including a limited number of disposable interventional devices, and are able to market our system commercially in the U.S., our business model relies significantly on revenues from additional disposable interventional devices for which there is no current FDA clearance or approval. We cannot market our unapproved disposable interventional devices in the U.S. until the necessary clearance or approvals from the FDA have been received and can only place these devices with research institutions for permitted investigational use. In addition, we are working with third parties with whom we are co-developing disposable products. In some cases, these companies are responsible for obtaining appropriate regulatory clearance for these disposable devices. If these clearances or approvals are not received or are substantially delayed, we may not be able to successfully market our system to as many institutions as we currently expect, which could have a material adverse impact on our financial condition, results of operations and cash flow. Furthermore, obtaining 510(k) clearances, pre-market approvals, or PMAs, or premarket approval supplements, or PMA supplements, from the FDA could result in unexpected and significant costs for us and consume management's time and other resources. The FDA could ask us to supplement our submissions, collect non-clinical 47 data, conduct clinical trials or engage in other time-consuming actions, or it could simply deny our applications. In addition, even if we obtain a 510(k) clearance or PMA or PMA supplement approval, the clearance or approval could be revoked or other restrictions imposed if post-market data demonstrates safety issues or lack of effectiveness. We cannot predict with certainty how, or when, the FDA will act. Obtaining regulatory approvals in foreign markets entails similar risks and uncertainties and can involve additional product testing and additional administrative review periods. If we are unable to obtain the necessary regulatory approvals, our financial condition and cash flow may be adversely affected. Also, a failure to obtain approvals may limit our ability to grow domestically and internationally. IF WE OR OUR STRATEGIC PARTNERS FAIL TO OBTAIN REGULATORY APPROVALS IN OTHER COUNTRIES FOR PRODUCTS UNDER DEVELOPMENT, WE WILL NOT BE ABLE TO COMMERCIALIZE THESE PRODUCTS IN THOSE COUNTRIES. In order to market our products outside of the U.S., we and our strategic partners must establish and comply with numerous and varying regulatory requirements of other countries regarding safety and efficacy. Approval procedures vary among countries and can involve additional product testing and additional administrative review periods. The time required to obtain approval in other countries might differ from that required to obtain FDA approval. The regulatory approval process in other countries may include all of the risks detailed above regarding FDA approval in the U.S. Regulatory approval in one country does not ensure regulatory approval in another, but a failure or delay in obtaining regulatory approval in one country may negatively impact the regulatory process in others. Failure to obtain regulatory approval in other countries or any delay or setback in obtaining such approval could have the same adverse effects described above regarding FDA approval in the U.S. In addition, we are relying on our strategic partners in some instances to assist us in this regulatory approval process in countries outside the U.S. and Europe, for example, in Japan. WE MAY FAIL TO COMPLY WITH CONTINUING REGULATORY REQUIREMENTS OF THE FDA AND OTHER AUTHORITIES AND BECOME SUBJECT TO SUBSTANTIAL PENALTIES. Even after product approval, we must comply with continuing regulation by the FDA and other authorities, including the FDA's Quality System Regulation, or QSR, requirements, labeling and promotional requirements and medical device adverse event and other reporting requirements. For example, as a result of our own ongoing quality testing, in January 2004 we voluntarily recalled our CRONUS guidewires. Any failure to comply with continuing regulation by the FDA or other authorities could result in enforcement action that may include suspension or withdrawal of regulatory approvals, recalling products, ceasing product marketing, seizure and detention of products, paying significant fines and penalties, criminal prosecution and similar actions that could limit product sales, delay product shipment and harm our profitability. Additionally, any modification to an FDA 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance. Device modifications to a PMA approved device or its labeling may require either a new PMA or PMA supplement approval, which could be a costly and lengthy process. In the future, we may modify our products after they have received clearance or approval, and we may determine that new clearance or approval is unnecessary. We cannot assure you that the FDA would agree with any of our decisions not to seek new clearance or approval. If the FDA requires us to seek clearance or approval for any modification, we also may be required to cease marketing or recall the modified product until we obtain FDA clearance or approval which could also limit product sales, delay product shipment and harm our profitability. In addition, Congress could amend the Federal Food, Drug and Cosmetic Act, and the FDA could modify its regulations promulgated under this law in a way so as to make ongoing regulatory compliance more burdensome and difficult. In many foreign countries in which we market our products, we are subject to regulations affecting, among other things, product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. Many of these regulations are similar to those of the FDA. In addition, in many countries the national health or social security organizations require our products to be qualified before procedures performed using our products become eligible for reimbursement. Failure to receive, or delays in the receipt of, 48 relevant foreign qualifications could have a material adverse effect on our business, financial condition and results of operations. Due to the movement toward harmonization of standards in the European Union, we expect a changing regulatory environment in Europe characterized by a shift from a country-by-country regulatory system to a European Union-wide single regulatory system. We cannot predict the timing of this harmonization and its effect on us. Adapting our business to changing regulatory systems could have a material adverse effect on our business, financial condition and results of operations. If we fail to comply with applicable foreign regulatory requirements, we may be subject to fines, suspension or withdrawal of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution. OUR SUPPLIERS OR WE MAY FAIL TO COMPLY WITH THE FDA QUALITY SYSTEM REGULATION. Our manufacturing processes must comply with the FDA's quality system regulation, or QSR, which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging and shipping of our products. The FDA enforces the QSR through inspections. We cannot assure you that we would pass such an inspection. Failure to pass such an inspection could force a shut down of our manufacturing operations, a recall of our products or the imposition of other sanctions, which would significantly harm our revenues and profitability. Further, we cannot assure you that our key component suppliers are or will continue to be in compliance with applicable regulatory requirements and will not encounter any manufacturing difficulties. Any failure to comply with the FDA's QSR by us or our suppliers could significantly harm our available inventory and product sales. SOFTWARE DEFECTS MAY BE DISCOVERED IN OUR PRODUCTS. Our products incorporate sophisticated computer software. Complex software frequently contains errors, especially when first introduced. Because our products are designed to be used to perform complex interventional procedures, we expect that physicians and hospitals will have an increased sensitivity to the potential for software defects. We cannot assure you that our software will not experience errors or performance problems in the future. If we experience software errors or performance problems, we would likely also experience: * loss of revenue; * delay in market acceptance of our products; * damage to our reputation; * additional regulatory filings; * product recalls; * increased service or warranty costs; and/or * product liability claims relating to the software defects. IF WE FAIL TO COMPLY WITH HEALTH CARE REGULATIONS, WE COULD FACE SUBSTANTIAL PENALTIES AND OUR BUSINESS, OPERATIONS AND FINANCIAL CONDITION COULD BE ADVERSELY AFFECTED. While we do not control referrals of health care services or bill directly to Medicare, Medicaid or other third-party payors, due to the breadth of many health care laws and regulations, we cannot assure you that they will not apply to our business. We could be subject to health care fraud and patient privacy regulation by both the federal government and the states in which we conduct our business. The regulations that may affect our ability to operate include: * the federal healthcare program Anti-Kickback Law, which prohibits, among other things, persons from soliciting, receiving or providing remuneration, directly or indirectly, to induce either the referral of an individual, for an item or service or the purchasing or ordering of a good or service, for which payment may be made under federal health care programs such as the Medicare and Medicaid programs; 49 * federal false claims laws which prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other third-party payors that are false or fraudulent, and which may apply to entities like us which provide coding and billing advice to customers; * the federal Health Insurance Portability and Accountability Act of 1996, or HIPAA, which prohibits executing a scheme to defraud any health care benefit program or making false statements relating to health care matters and which also imposes certain requirements relating to the privacy, security and transmission of individually identifiable health information; * state law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers, and state laws governing the privacy of health information in certain circumstances, many of which differ from each other in significant ways and often are not preempted by HIPAA, thus complicating compliance efforts; and * federal self-referral laws, such as STARK, which prohibits a physician from making a referral to a provider of certain health services with which the physician or the physician's family member has a financial interest. If our operations are found to be in violation of any of the laws described above or any other governmental regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines and the curtailment or restructuring of our operations. Any penalties, damages, fines, curtailment or restructuring of our operations could adversely affect our ability to operate our business and our financial results. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management's attention from the operation of our business. Moreover, to achieve compliance with applicable federal and state privacy, security, and electronic transaction laws, we may be required to modify our operations with respect to the handling of patient information. Implementing these modifications may prove costly. At this time, we are not able to determine the full consequences to us, including the total cost of compliance, of these various federal and state laws. THE APPLICATION OF STATE CERTIFICATE OF NEED REGULATIONS AND COMPLIANCE WITH FEDERAL AND STATE LICENSING REQUIREMENTS COULD SUBSTANTIALLY LIMIT OUR ABILITY TO SELL OUR PRODUCTS AND GROW OUR BUSINESS. Some states require health care providers to obtain a certificate of need or similar regulatory approval prior to the acquisition of high-cost capital items such as our Stereotaxis System. In many cases, a limited number of these certificates are available. As a result of this limited availability, hospitals and other health care providers may be unable to obtain a certificate of need for the purchase of our Stereotaxis System. Further, our sales cycle for the Stereotaxis System is typically longer in certificate of need states due to the time it takes our customers to obtain the required approvals. In addition, our customers must meet various federal and state regulatory and/or accreditation requirements in order to receive payments from government-sponsored health care programs such as Medicare and Medicaid, receive full reimbursement from third party payors and maintain their customers. Any lapse by our customers in maintaining appropriate licensure, certification or accreditation, or the failure of our customers to satisfy the other necessary requirements under government-sponsored health care programs, could cause our sales to decline. HOSPITALS OR PHYSICIANS MAY BE UNABLE TO OBTAIN REIMBURSEMENT FROM THIRD-PARTY PAYORS FOR PROCEDURES USING THE STEREOTAXIS SYSTEM, OR REIMBURSEMENT FOR PROCEDURES MAY BE INSUFFICIENT TO RECOUP THE COSTS OF PURCHASING OUR PRODUCTS. We expect that U.S. hospitals will continue to bill various third-party payors, such as Medicare, Medicaid and other government programs and private insurance plans, for procedures performed with our products, including the 50 costs of the disposable interventional devices used in these procedures. If in the future our disposable interventional devices do not fall within U.S. reimbursement categories and our procedures are not reimbursed, or if the reimbursement is insufficient to cover the costs of purchasing our system and related disposable interventional devices, the adoption of our systems and products would be significantly slowed or halted, and we may be unable to generate sufficient sales to support our business. Our success in international markets also depends upon the eligibility of our products for reimbursement through government-sponsored health care payment systems and third-party payors. In both the U.S. and foreign markets health care cost-containment efforts are prevalent and are expected to continue. These efforts could reduce levels of reimbursement available for procedures involving our products and, therefore, reduce overall demand for our products as well. A failure to generate sufficient sales could have a material adverse impact on our financial condition, results of operations and cash flow. WE MAY LOSE OUR KEY PERSONNEL OR FAIL TO ATTRACT AND RETAIN ADDITIONAL PERSONNEL. We are highly dependent on the principal members of our management and scientific staff, in particular Bevil J. Hogg, our President and Chief Executive Officer, Michael P. Kaminski, our Chief Operating Officer and William M. Kelley, one of our directors. Mr. Kelley has extensive experience in the medical device industry, and we believe his industry contacts enable us to have proposals reviewed by key hospital decision-makers earlier in the sales process than may otherwise be the case. In order to pursue our plans and accommodate planned growth, we may choose to hire additional personnel. Attracting and retaining qualified personnel will be critical to our success, and competition for qualified personnel is intense. We may not be able to attract and retain personnel on acceptable terms given the competition for qualified personnel among technology and healthcare companies and universities. The loss of any of these persons or our inability to attract and retain other qualified personnel could harm our business and our ability to compete. In addition, Douglas M. Bruce, our Senior Vice President, Research & Development, coordinates our scientific staff and the research and development projects they undertake; the loss of Mr. Bruce or other members of our scientific staff may significantly delay or prevent product development and other business objectives. OUR GROWTH WILL PLACE A SIGNIFICANT STRAIN ON OUR RESOURCES, AND IF WE FAIL TO MANAGE OUR GROWTH, OUR ABILITY TO DEVELOP, MARKET AND SELL OUR PRODUCTS WILL BE HARMED. Our business plan contemplates a period of substantial growth and business activity. This growth and activity will likely result in new and increased responsibilities for management personnel and place significant strain upon our operating and financial systems and resources. To accommodate our growth and compete effectively, we will be required to improve our information systems, create additional procedures and controls and expand, train, motivate and manage our work force. We cannot be certain that our personnel, systems, procedures and controls will be adequate to support our future operations. Any failure to effectively manage our growth could impede our ability to successfully develop, market and sell our products. WE FACE CURRENCY AND OTHER RISKS ASSOCIATED WITH INTERNATIONAL SALES. We intend to continue to devote significant efforts to marketing our systems and products outside of the U.S. This strategy will expose us to numerous risks associated with international operations, which could adversely affect our results of operations and financial condition, including the following: * currency fluctuations that could impact the demand for our products or result in currency exchange losses; * export restrictions, tariff and trade regulations and foreign tax laws; * customs duties, export quotas or other trade restrictions; * economic and political instability; and * shipping delays. 51 In addition, contracts may be difficult to enforce and receivables difficult to collect through a foreign country's legal system. RISKS RELATED TO OUR COMMON STOCK OUR PRINCIPAL STOCKHOLDERS CONTINUE TO OWN A LARGE PERCENTAGE OF OUR VOTING STOCK, AND THEY HAVE THE ABILITY TO SUBSTANTIALLY INFLUENCE MATTERS REQUIRING STOCKHOLDER APPROVAL. As of December 31, 2004, our executive officers, directors and individuals or entities affiliated with them beneficially own or control a substantial percentage of the outstanding shares of our common stock. Accordingly, these executive officers, directors and their affiliates, acting as a group, will have substantial influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction. These stockholders may also delay or prevent a change of control, even if such a change of control would benefit our other stockholders. This significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors' perception that conflicts of interest may exist or arise. WE HAVE NEVER PAID DIVIDENDS ON OUR CAPITAL STOCK, AND WE DO NOT ANTICIPATE PAYING ANY CASH DIVIDENDS IN THE FORESEEABLE FUTURE. We have paid no cash dividends on any of our classes of capital stock to date and we currently intend to return our future earnings to fund the development and growth of our business. In addition, the terms of our loan agreement prohibit us from declaring dividends without the prior consent of our lender. As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future. OUR CERTIFICATE OF INCORPORATION AND BYLAWS, DELAWARE LAW AND ONE OF OUR ALLIANCE AGREEMENTS CONTAIN PROVISIONS THAT COULD DISCOURAGE A TAKEOVER. Our certificate of incorporation and bylaws and Delaware law contain provisions that might enable our management to resist a takeover. These provisions may: * discourage, delay or prevent a change in the control of our company or a change in our management; * adversely affect the voting power of holders of common stock; and * limit the price that investors might be willing to pay in the future for shares of our common stock. In addition, under our alliance with J&J, either party may terminate the alliance under certain circumstances involving a "change of control" of Stereotaxis. Any termination must be effected within 90 days of the change of control, but would be effective one year after the change of control. If we terminate under this provision, we must pay a termination fee to J&J equal to 5% of the total equity value of Stereotaxis in the change of control transaction, up to a maximum of $10 million. We also agreed to notify J&J if we reasonably consider that we are engaged in substantive discussions in respect of the sale of the company or substantially all of our assets. These provisions may similarly discourage a takeover and negatively affect our share price as described above. SALES OF A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK IN THE PUBLIC MARKET, OR THE PERCEPTION THAT THEY MAY OCCUR, MAY DEPRESS THE MARKET PRICE OF OUR COMMON STOCK. Sales of substantial amounts of our common stock in the public market, or the perception that substantial sales may be made, could cause the market price of our common stock to decline. These sales might also make it more difficult for us to sell equity securities at a time and price that we deem appropriate. 52 As of December 31, 2004, we had outstanding 27,187,042 shares of common stock. EVOLVING REGULATION OF CORPORATE GOVERNANCE AND PUBLIC DISCLOSURE MAY RESULT IN ADDITIONAL EXPENSES AND CONTINUING UNCERTAINTY. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ National Market rules are creating uncertainty for public companies. We are presently evaluating and monitoring developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional compliance costs we may incur or the timing of such costs. These new or changed laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by courts and regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. Maintaining appropriate standards of corporate governance and public disclosure may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. In addition, if we fail to comply with new or changed laws, regulations and standards, regulatory authorities may initiate legal proceedings against us and our business and reputation may be harmed. OUR FUTURE OPERATING RESULTS MAY BE BELOW SECURITIES ANALYSTS' OR INVESTORS' EXPECTATIONS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. The revenue and income potential of our products and our business model are unproven, and we may be unable to generate significant revenues or grow at the rate expected by securities analysts or investors. In addition, our costs may be higher than we, securities analysts or investors expect. If we fail to generate sufficient revenues or our costs are higher than we expect, our results of operations will suffer, which in turn could cause our stock price to decline. Our results of operations will depend upon numerous factors, including: * demand for our products; * the performance of third-party contract manufacturers and component suppliers; * our ability to develop sales and marketing capabilities; * the success of our collaborations with Siemens, Philips and J&J and others; * our ability to develop, introduce and market new or enhanced versions of our products on a timely basis; * our ability to obtain regulatory clearances or approvals for our new products; and * our ability to obtain and protect proprietary rights. Our operating results in any particular period may not be a reliable indication of our future performance. In some future quarters, our operating results may be below the expectations of securities analysts or investors. If this occurs, the price of our common stock will likely decline. WE EXPECT THAT THE PRICE OF OUR COMMON STOCK COULD FLUCTUATE SUBSTANTIALLY, POSSIBLY RESULTING IN CLASS ACTION SECURITIES LITIGATION. We have only been publicly traded since August 12, 2004. A limited number of our shares trade actively in the market. The market price of our common stock will be affected by a number of factors, including: * actual or anticipated variations in our results of operations or those of our competitors; * the receipt or denial of regulatory approvals; 53 * announcements of new products, technological innovations or product advancements by us or our competitors; * developments with respect to patents and other intellectual property rights; * changes in earnings estimates or recommendations by securities analysts or our failure to achieve analyst earnings estimates; and * developments in our industry. The stock prices of many companies in the medical device industry have experienced wide fluctuations that have often been unrelated to the operating performance of these companies. Following periods of volatility in the market price of a company's securities, stockholders have often instituted class action securities litigation against those companies. Class action securities litigation, if instituted against us, could result in substantial costs and a diversion of our management resources, which could significantly harm our business. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We have exposure to currency fluctuations. We operate mainly in the U.S. and Europe and we expect to continue to sell our products outside of the U.S. We expect to transact this business primarily in U.S. dollars and in Euros, although we may transact business in other currencies to a lesser extent. Future fluctuations in the value of these currencies may affect the price competitiveness of our products. In addition, because we have a relatively long installation cycle for our systems, we will be subject to risk of currency fluctuations between the time we execute a purchase order and the time we deliver the system and collect payments under the order, which could adversely affect our operating margins. We have not hedged exposures in foreign currencies or entered into any other derivative instruments. As a result, we will be exposed to some exchange risks for foreign currencies. For example, if the currency exchange rate were to fluctuate by 10%, our revenues could be affected by as much as 2 to 3%. We also have exposure to interest rate risk related to our investment portfolio and our borrowings. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our invested cash without significantly increasing the risk of loss. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since the majority of our investments are in short-term debt instruments. We invest our excess cash primarily in U.S. government securities and marketable debt securities of financial institutions and corporations with strong credit ratings. These instruments generally have maturities of two years or less when acquired. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions. Accordingly, we believe that while the instruments we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments. We do not believe that inflation has had a material adverse impact on our business or operating results during the periods covered by this report. 54 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENTS INDEX TO FINANCIAL STATEMENTS PAGE ---- Report of Ernst & Young LLP, Independent Registered Public Accounting Firm 56 Balance Sheets at December 31, 2004 and 2003 57 Statements of Operations for the years ended December 31, 2004, 2003 and 2002 58 Statements of Stockholders' Equity for the years ended December 31, 2004, 2003 and 2002 59 Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002 62 Notes to the Financial Statements 63 Schedule II--Valuation and Qualifying Accounts 85 All other schedules have been omitted because they are not applicable or the required information is shown in the Financial Statements or the Notes thereto. 55 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Stereotaxis, Inc. We have audited the accompanying balance sheets of Stereotaxis, Inc. (the "Company") as of December 31, 2004 and 2003, and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company's management. Our audit also included the financial statement schedule listed in the Index at Item 15(a). Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Stereotaxis, Inc. at December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP St. Louis, Missouri February 18, 2005 56 STEREOTAXIS, INC. BALANCE SHEETS DECEMBER 31, 2004 2003 -------------------------------- ASSETS Current assets: Cash and cash equivalents $ 16,907,516 $ 21,356,247 Short-term investments 28,741,318 5,124,365 Accounts receivable, net of allowance for uncollectible accounts of $146,223 and $116,725 in 2004 and 2003, respectively 8,621,205 559,721 Current portion of long-term receivables 168,795 155,331 Inventories 4,673,994 4,430,228 Prepaid expenses and other current assets 2,351,058 876,264 -------------------------------- Total current assets 61,463,886 32,502,156 Property and equipment, net 1,557,847 2,309,467 Intangible assets, net 1,811,111 1,944,444 Long-term receivables 337,590 465,993 Other assets 120,697 101,359 Long-term investments 5,896,625 - -------------------------------- Total assets $ 71,187,756 $ 37,323,419 ================================ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current maturities of long-term debt $ 910,434 $ 2,289,314 Accounts payable 2,129,473 1,697,497 Accrued liabilities 5,710,216 4,936,233 Deferred contract revenue 3,041,758 814,393 -------------------------------- Total current liabilities 11,791,881 9,737,437 Long-term debt, less current maturities 1,000,000 2,243,768 Other liabilities 1,407 75,786 Stockholders' equity: Convertible preferred stock, issued in series, par value $0.001; 10,000,000 and 65,000,000 shares authorized at 2004 and 2003, respectively; 61,055,286 shares issued and outstanding at 2003; liquidation preference of $146,819,436 at 2003 - 61,055 Common stock, par value of $0.001; 100,000,000 and 80,000,000 shares authorized at 2004 and 2003, respectively; 27,187,042 and 1,515,150 shares issued at 2004 and 2003, respectively 27,187 1,515 Additional paid-in capital 174,143,587 113,921,587 Deferred compensation (671,950) (835,801) Treasury stock, 36,519 and 18,316 shares at 2004 and 2003, respectively (162,546) (17,750) Notes receivable from sale of stock (173,432) (448,413) Accumulated deficit (114,673,234) (87,415,765) Accumulated other comprehensive loss (95,144) - -------------------------------- Total stockholders' equity 58,394,468 25,266,428 -------------------------------- Total liabilities and stockholders' equity $ 71,187,756 $ 37,323,419 ================================ See accompanying notes. 57 STEREOTAXIS, INC. STATEMENTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2004 2003 2002 -------------------------------------------------- Systems revenue $ 17,219,080 $ 3,808,036 $ - Disposables, service and accessories revenue 1,597,780 480,941 18,900 Other revenue - 725,900 - -------------------------------------------------- Total revenue 18,816,860 5,014,877 18,900 Costs of revenue 10,672,262 4,051,313 39,760 -------------------------------------------------- Gross profit (loss) 8,144,598 963,564 (20,860) Operating expenses: Research and development 18,437,108 13,886,462 14,742,015 Sales and marketing 10,964,925 5,999,310 2,230,565 General and administrative 6,315,987 5,028,142 4,528,637 -------------------------------------------------- Total operating expenses 35,718,020 24,913,914 21,501,217 -------------------------------------------------- Operating loss (27,573,422) (23,950,350) (21,522,077) Interest income 811,049 375,361 434,470 Interest expense (495,096) (461,848) (371,051) -------------------------------------------------- Net loss $(27,257,469) $(24,036,837) $(21,458,658) ================================================== Net loss per common share: Basic and diluted $ (2.38) $ (18.37) $ (19.21) ================================================== Weighted average shares used in computing net loss per common share: Basic and diluted 11,470,310 1,308,805 1,117,301 ================================================== See accompanying notes. 58 STEREOTAXIS, INC. STATEMENTS OF STOCKHOLDERS' EQUITY Convertible Preferred Stock Common Stock ----------------------------------------- Additional Comprehensive Paid-In Deferred Treasury Income (Loss) Shares Amount Shares Amount Capital Compensation Stock ------------- ---------- ------- --------- ------ ------------------------------------- Balance at December 31, 2001 $ - 43,488,275 $43,488 1,261,800 $1,262 $70,837,047 $(1,059,508) $(2,156) Issuance of Series D-3 convertible preferred stock at $2.17 per share, net of issuance costs of $287,262 - 7,940,951 7,941 - - 15,352,459 - - Exercise of stock warrants - 205,791 206 - - 289,365 - - Exercise of stock options - - - 128,123 128 94,210 - - Interest receivable from sale of stock - - - - - - - - Deferred compensation - - - - - 98,474 (98,474) - Stock-based compensation - - - - - - 483,638 - Payments of notes receivable from sale of stock - - - - - - - - Issuance of warrants to purchase common stock - - - - - 1,584,202 - - Issuance of warrants to purchase convertible preferred stock in connection with long-term debt - - - - - 192,637 - - Net Loss (21,458,658) - - - - - - - Other comprehensive income (loss): Unrealized loss on short term investments - - - - - - - - ------------ Comprehensive Loss $(21,458,658) - - - - - - - ------------------------------------------------------------------------------------------------- Balance at December 31, 2002 51,635,017 $51,635 1,389,923 $1,390 $88,448,394 $(674,344) $(2,156) Notes Accummulated Receivable Other Total From Sale Accummulated Comprehensive Stockholders' Of Stock Deficit Income (Loss) Equity ---------------------------------------------------------- Balance at December 31, 2001 $(423,172) $(41,920,270) $ - $ 27,476,691 Issuance of Series D-3 convertible preferred stock at $2.17 per share, net of issuance costs of $287,262 - - - 15,360,400 Exercise of stock warrants - - - 289,571 Exercise of stock options - - - 94,338 Interest receivable from sale of stock (28,758) - - (28,758) Deferred compensation - - - - Stock-based compensation - - - 483,638 Payments of notes receivable from sale of stock 12,585 - - 12,585 Issuance of warrants to purchase common stock - - - 1,584,202 Issuance of warrants to purchase convertible preferred stock in connection with long-term debt - - - 192,637 Net Loss - (21,458,658) - (21,458,658) Other comprehensive income (loss): Unrealized loss on short term investments - - - - Comprehensive Loss - - - - ---------------------------------------------------------- Balance at December 31, 2002 $(439,345) $(63,378,928) $ - $ 24,006,646 See accompanying notes. 59 STEREOTAXIS, INC. STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED) Convertible Preferred Stock Common Stock ----------------------------------------- Additional Comprehensive Paid-In Deferred Income (Loss) Shares Amount Shares Amount Capital Compensation ------------- ---------- ------- --------- ------ --------------------------- Issuance of Series D-2 convertible preferred stock at $2.17 per share, net of issuance costs of $17,953 $ - 2,764,978 $2,765 - $ - $ 5,454,716 $ - Issuance of Series E convertible preferred stock at $2.93 per share, net of issuance costs of $605,106 - 3,412,970 3,413 - - 9,391,481 - Issuance of Series E-1 convertible preferred stock at $2.93 per share, net of issuance costs of $403,931 - 3,242,321 3,242 - - 9,092,827 - Exercise of options - - - 125,227 125 328,933 - Repurchase of common stock - - - - - - - Interest receivable from sale of stock - - - - - - - Deferred compensation - - - - - 653,625 (653,625) Stock-based compensation - - - - - - 492,168 Payments from notes receivable from sale of stock - - - - - - - Issuance of warrants to purchase common stock - - - - - 551,611 - Net loss (24,036,837) - - - - - - Other comprehensive income (loss): Unrealized loss on short term investments - - - - - - - ------------ Comprehensive Loss $(24,036,837) - - - - - - --------------------------------------------------------------------------------------- Balance at December 31, 2003 61,055,286 $61,055 1,515,150 $1,515 $113,921,587 $(835,801) Notes Accummulated Receivable Other Total Treasury From Sale Accummulated Comprehensive Stockholders' Stock Of Stock Deficit Income (Loss) Equity ------------------------------------------------------------------------ Issuance of Series D-2 convertible preferred stock at $2.17 per share, net of issuance costs of $17,953 $ - $ - $ - $ - $ 5,457,481 Issuance of Series E convertible preferred stock at $2.93 per share, net of issuance costs of $605,106 - - - - 9,394,894 Issuance of Series E-1 convertible preferred stock at $2.93 per share, net of issuance costs of $403,931 - - - - 9,096,069 Exercise of options - - - - 329,058 Repurchase of common stock (15,594) - - - (15,594) Interest receivable from sale of stock - (21,653) - - (21,653) Deferred compensation - - - - - Stock-based compensation - - - - 492,168 Payments from notes receivable from sale of stock - 12,585 - - 12,585 Issuance of warrants to purchase common stock - - - - 551,611 Net loss - - (24,036,837) - (24,036,837) Other comprehensive income (loss): Unrealized loss on short term investments - - - - - Comprehensive Loss - - - - - ------------------------------------------------------------------------ Balance at December 31, 2003 $(17,750) $(448,413) $(87,415,765) $ - $ 25,266,428 See accompanying notes. 60 STEREOTAXIS, INC. STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED) Convertible Preferred Stock Common Stock --------------------------------------------- Additional Comprehensive Paid-In Deferred Income (Loss) Shares Amount Shares Amount Capital Compensation ------------- ----------- -------- ---------- ------ --------------------------- Issuance of Series E-2 convertible preferred stock at $10.55 per share, net issuance costs of $85,523 $ - 5,380,830 $ 5,381 - $ - $ 14,087,572 $ - Issuance of warrants to purchase common stock - - - - - 1,603,493 - Amortization of stock-based compensation - - - - - - 654,501 Payments of notes receivable from sale of stock - - - - - - - Interests receivable from sale of stock - - - - - - - Conversion of convertible preferred stock into common stock - (66,436,116) (66,436) 19,282,324 19,282 47,154 - Conversion of convertible promissory note - - - 271,739 272 2,173,646 - Repurchase of common stock - - - - - - - Issue of common stock - - - (13) - (103) - Issuance of common stock upon filing of initial public offering and underwriter over-allotment, net of issuance costs of $2,919,794 - - - 5,962,352 5,963 41,434,041 - Exercise of stock warrants - - - 20,104 20 (20) - Exercise of stock options - - - 135,386 135 385,567 - Payments of interest on notes receivable - - - - - - - Stock-based compensation - - - - - 490,650 (490,650) Net Loss (27,257,469) - - - - - - Other comprehensive income (loss) - - - - - - - Unrealized loss on short term investments (95,144) - - - - - - ------------ Comprehensive Loss $(27,352,613) - - - - - - ============= --------------------------------------------------------------------------- Balance at December 31, 2004 - $ - 27,187,042 $27,187 $174,143,587 $(671,950) =========================================================================== Notes Accumulated Receivable Other Total Treasury From Sale Accumulated Comprehensive Stockholders' Stock Of Stock Deficit Income (Loss) Equity ---------------------------------------------------------------------- Issuance of Series E-2 convertible preferred stock at $10.55 per share, net issuance costs of $85,523 $ - $ - $ - $ - $14,092,953 Issuance of warrants to purchase common stock - - - - 1,603,493 Amortization of stock-based compensation - - - - 654,501 Payments of notes receivable from sale of stock - 239,560 - - 239,560 Interests receivable from sale of stock - 10,212 - - 10,212 Conversion of convertible preferred stock into common stock - - - - - Conversion of convertible promissory note - - - - 2,173,918 Repurchase of common stock (144,899) - - - (144,899) Issue of common stock 103 - - - - Issuance of common stock upon filing of initial public offering and underwriter over-allotment, net of issuance costs of $2,919,794 - - - - 41,440,004 Exercise of stock warrants - - - - - Exercise of stock options - - - - 385,702 Payments of interest on notes receivable - 25,209 - - 25,209 Stock-based compensation - - - - - Net Loss - - (27,257,469) - (27,257,469) Other comprehensive income (loss) - - - - - Unrealized loss on short term investments - - - (95,144) (95,144) Comprehensive Loss - - - - - ---------------------------------------------------------------------- Balance at December 31, 2004 $(162,546) (173,432) $(114,673,234) $(95,144) $58,394,468 ====================================================================== See accompanying notes. 61 STEREOTAXIS, INC. STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, 2004 2003 2002 -------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss $(27,257,469) $(24,036,837) $(21,458,658) Adjustments to reconcile net loss to cash used in operating activities: Depreciation 754,710 447,786 406,766 Amortization 133,333 55,556 - Stock-based compensation 452,130 492,168 483,638 Loss on asset disposal 42,425 - - Changes in operating assets and liabilities: Accounts receivable (8,061,484) (123,575) (80,550) Notes receivable 114,939 (621,324) - Inventories (243,766) (2,069,621) (2,360,607) Prepaid expenses and other current assets (1,272,409) (405,987) (368,106) Other assets (19,338) 18,778 (77,337) Accounts payable 431,976 192,136 169,638 Accrued liabilities 773,983 2,379,901 468,440 Deferred revenue 2,227,365 (837,607) 826,000 Other 109,735 39,232 (38,159) -------------------------------------------------- Net cash used in operating activities (31,813,870) (24,469,394) (22,028,935) CASH FLOWS FROM INVESTING ACTIVITIES Sale of equipment 1,489,904 - - Purchase/disposal of equipment (1,535,420) (2,057,671) (308,512) Sale of available-for-sale investments 6,936,710 - 1,788,105 Purchase of available-for-sale investments (36,545,431) (5,124,365) - -------------------------------------------------- Net cash (used in) provided by investing activities (29,654,237) (7,182,036) 1,479,593 CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from long-term debt 2,000,000 1,829,690 3,874,627 Payments under long-term debt (2,622,647) (2,482,240) (688,995) Proceeds from issuance of stock and warrants, net of issuance costs 57,522,153 24,829,113 17,521,148 Purchase of treasury stock (90) (15,594) - Payments received on notes receivable from sale of common stock 119,960 12,585 12,585 -------------------------------------------------- Net cash provided by financing activities 57,019,376 24,173,554 20,719,365 -------------------------------------------------- Net increase (decrease) in cash and cash equivalents (4,448,731) (7,477,876) 170,023 Cash and cash equivalents at beginning of period 21,356,247 28,834,123 28,664,100 -------------------------------------------------- Cash and cash equivalents at end of period $ 16,907,516 $ 21,356,247 $ 28,834,123 ================================================== Supplemental disclosures of cash flow information: Noncash items: Acquisition of purchased technology upon issuance of convertible note payable $ - $ 2,000,000 $ - ================================================== Conversion of note payable and accrued interest to common stock $ 2,173,918 $ - $ - ================================================== Acquisition of treasury shares in lieu of payment of notes receivable $ 144,809 $ - $ - ================================================== Interest paid $ 422,085 $ 394,287 $ 371,051 ================================================== See accompanying notes. 62 NOTES TO FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS Stereotaxis, Inc. (the Company) designs, manufactures, and markets an advanced cardiology instrument control system for the interventional treatment of coronary artery disease and arrhythmias. The Company also markets and sells various disposable interventional devices, including catheters, guidewires and stent delivery devices, for use in conjunction with its system. By 2003, the Company had received U.S. and European regulatory approval for the core components of its system. Prior to 2003, the Company's principal activities involved obtaining capital, business development, performing research and development activities, and funding prototype development. As such, the Company was classified as a development-stage company from its inception on June 13, 1990 through December 31, 2002. During 2003, the Company emerged from the development- stage and began to generate revenue from the commercial launch of its systems. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CASH AND CASH EQUIVALENTS The Company considers all short-term deposits purchased with original maturities of three months or less to be cash equivalents. The Company places its cash with high-credit-quality financial institutions and invests primarily in money market accounts. INVESTMENTS In accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities, the Company's investment securities are classified as available-for-sale and are carried at market value, which approximates cost. Realized gains or losses, calculated based on the specific identification method, were not material for the years ended December 31, 2004, 2003 and 2002. Interest and dividends on securities classified as available-for-sale are included in interest income. ACCOUNTS RECEIVABLE AND ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Accounts receivable primarily include amounts due from hospitals and medical centers for acquisition of magnetic systems and associated disposable device sales. Credit is granted on a limited basis, with most balances due within 30 days of billing. The provision for bad debts is based upon management's assessment of historical and expected net collections considering business and economic conditions and other collection indicators. FINANCIAL INSTRUMENTS Financial instruments consist of cash and cash equivalents, short-term investments, accounts receivable, accounts payable and long-term debt. The carrying value of such amounts reported at the applicable balance sheet dates approximates fair value. INVENTORY The Company values its inventory at the lower of cost, as determined using the first-in, first-out (FIFO) method, or market. The Company periodically reviews its physical inventory for obsolete items and provides a reserve upon identification of potential obsolete items. 63 PROPERTY AND EQUIPMENT Property and equipment consist primarily of laboratory, office, and computer equipment and leasehold improvements and are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives or life of the base lease term, ranging from one to five years. LONG-LIVED ASSETS If facts and circumstances suggest that a long-lived asset may be impaired, the carrying value is reviewed. If this review indicates that the carrying value of the asset will not be recovered, as determined based on projected undiscounted cash flows related to the asset over its remaining life, the carrying value of the asset is reduced to its estimated fair value. INTANGIBLE ASSETS Intangible assets consist of purchased technology arising out of collaboration with a strategic investor valued at the cost of acquisition on the acquisition date and amortized over its estimated useful life of 15 years. Accumulated amortization at December 31, 2004 and 2003 is $188,889 and $55,556, respectively. Amortization expense in 2004 and 2003 is $133,333 and $55,556, respectively, as determined under the straight-line method. The estimated future amortization of intangible assets is $133,333 annually through June 2019. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the 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 income and loss during the reporting period. Actual results could differ from those estimates. REVENUE AND COSTS OF REVENUE The Company recognizes systems revenue from system sales made directly to end users upon installation, provided there are no uncertainties regarding acceptance, persuasive evidence of an arrangement exists, the sales price is fixed or determinable, and collection of the related receivable is reasonably ensured. When installation is required for revenue recognition, the determination of acceptance is made by the Company's employees based on criteria set forth in the terms of the sale. Revenue from system sales made to distributors is recognized upon shipment since these arrangements do not include an installation element or right of return privileges. If uncertainties exist regarding collectability, the Company recognizes revenue when those uncertainties are resolved. Amounts collected prior to satisfying the above revenue recognition criteria are reflected as deferred revenue. Co-placement fees from strategic partners for the Company's collaboration in certain sales and marketing efforts will be recognized as revenue when earned under the terms of the respective agreements. Revenue from services, whether sold individually or as a separable unit of accounting in a multi-element arrangement, is deferred and amortized over the service period, which is typically one year. Revenue from services is derived primarily from the sale of annual product maintenance plans. The Company recognizes revenue from disposable device sales or accessories upon shipment, and an appropriate reserve for returns is established. Other revenue represents a system sale for which the cost of production was charged to research and development costs in 2002 and 2001. Costs of revenue include direct product costs, installation labor, estimated warranty costs, and training and product maintenance costs. The Company also includes in cost of revenue any expected loss related to executed contracts in the period in which the loss becomes known. In the years ended December 31, 2004, 2003 and 2002, the 64 Company incurred $103,494, $278,320 and $33,580, respectively, for costs in excess of contractual revenues, primarily on certain system sales. RESEARCH AND DEVELOPMENT COSTS Internal research and development costs, including clinical and regulatory costs incurred prior to receiving Food and Drug Administration approval, are expensed in the period incurred. Directed research performed by hospitals (which, at times, may also be customers) at the Company's request are expensed in the period such services are provided. Amounts paid for directed research were $481,949, $128,424, and $100,041 in 2004, 2003, and 2002, respectively. Amounts receivable from strategic partners under research reimbursement agreements are recorded as a contra-research and development expense in the period reimbursable costs are incurred. Advance receipts or other unearned reimbursements are included in accrued liabilities on the accompanying balance sheet until earned. STOCK-BASED COMPENSATION As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, the Company has elected to follow Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for stock-based employee compensation. Under APB No. 25, if the exercise price of the Company's employee and director stock options equals or exceeds the estimated fair value of the underlying stock on the date of grant and the number of options is not variable, no compensation expense is recognized. Options are variable if the options are forfeitable when performance milestones described in the option agreements may not occur. When the exercise price of the employee or director stock options is less than the estimated fair value of the underlying stock (intrinsic value) at the date of grant or for variable options through the vesting or forfeiture date, the Company records deferred compensation for the intrinsic value and amortizes the amount to expense over the service period on a straight-line basis. Deferred compensation for variable options granted to employees and directors is periodically remeasured through the vesting or forfeiture date. Stock options issued to nonemployees, including individuals for scientific advisory services, are recorded at their fair value as determined in accordance with SFAS No. 123 and Emerging Issues Task Force (EITF) No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction With Selling, Goods or Services, and recognized over the service period. Deferred compensation for options granted to nonemployees is periodically remeasured through the vesting or forfeiture date. 65 The following table illustrates the effect on net loss if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation: YEAR ENDED DECEMBER 31, -------------------------------------------------- 2004 2003 2002 -------------------------------------------------- Net loss, as reported $(27,257,469) $(24,036,837) $(21,458,658) Add total stock-based compensation cost included in net loss 452,130 492,168 483,638 Deduct total stock-based compensation expense under fair value method (2,873,162) (1,793,447) (1,104,659) -------------------------------------------------- Pro forma net loss $(29,678,501) $(25,338,116) $(22,079,679) ================================================== Net loss per share, basic and diluted, as reported $ (2.38) $ (18.37) $ (19.21) Net loss per share, basic and diluted, pro forma $ (2.59) $ (19.36) $ (19.76) The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for the years ended 2004, 2003 and 2002: dividend yield of 0%, expected volatility ranging from 70% to 120%, risk-free interest rates ranging from 1.09% to 5.28%, and an initial expected life ranging from six to ten years. The weighted average fair value of the options at grant date was $7.49, $5.94, and $4.75, for 2004, 2003 and 2002, respectively. Future pro forma results of operations may be materially different from amounts reported, as future years will include the effects of additional stock option grants. Option valuation models require the input of highly subjective assumptions. Because the Company's employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models may not accurately reflect the fair value of employee stock options. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment". SFAS No. 123(R) supersedes APB Opinion No. 25 and requires recognition of an expense when goods or services are provided. SFAS No. 123(R) requires the determination of the fair value of the share- based compensation at the grant date and the recognition of the related expense over the period in which the share-based compensation vests. The Company intends to adopt the provisions of SFAS No. 123(R) effective July 1, 2005. These new accounting rules will lead to a decrease in reported earnings and the Company has not yet determined the exact impact SFAS No. 123(R) will have on its financial statements. NET LOSS PER SHARE Basic loss per common share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Diluted loss per share is computed by dividing the loss for the period by the weighted average number of common and common equivalent shares outstanding during the period. The Company has excluded all preferred stock, outstanding options and warrants, and shares subject to repurchase from the calculation of diluted loss per common share because all such securities are antidilutive for all periods presented. 66 INCOME TAXES In accordance with SFAS No. 109, Accounting for Income Taxes, a deferred income tax asset or liability is determined based on the difference between the financial statement and tax basis of assets and liabilities as measured by the enacted tax rates that will be in effect when these differences reverse. The Company provides a valuation allowance against net deferred income tax assets unless, based upon available evidence, it is more likely than not the deferred income tax assets will be realized. PATENT COSTS Costs related to filing and pursuing patent applications are expensed as incurred, as recoverability of such expenditures is uncertain. CONCENTRATIONS OF RISK The majority of the company's cash, cash equivalents and investments are deposited with one major financial institution in the United States of America. Deposits in this institution exceed the amount of insurance provided on such deposits. One customer, Siemens, accounted for $3,996,568, or 21%, of total net sales for the year ended December 31, 2004. We did not have one customer accounting for 10% or more of our total net sales for the year ended December 31, 2003. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) generally represents all changes in stockholders' equity except those resulting from investments by stockholders, and includes the Company's unrealized losses on marketable securities of $95,144 at December 31, 2004. RECLASSIFICATIONS Certain amounts in the prior year financial statements have been reclassified to conform to current year presentation. 67 3. INVESTMENTS The following table summarizes available-for-sale securities included in short and long-term investments as of the respective dates: DECEMBER 31, 2004 DECEMBER 31, 2003 ----------------- ----------------- FAIR FAIR COST UNREALIZED VALUE COST UNREALIZED VALUE -------------------------------------------------------------------------------------------------- GAINS LOSSES GAINS LOSSES -------- --------- ----- ------ Short-term investments: Corporate debt $ 6,895,637 $ - $(276,708) $ 6,618,929 $5,124,365 $ - $ - $5,124,365 U.S. government agency 12,044,291 102,617 - 12,146,908 - - - - Commercial paper 9,838,684 136,797 - 9,975,481 - - - - -------------------------------------------------------------------------------------------------- Total short-term investments 28,778,612 239,414 (276,708) 28,741,318 5,124,365 - - 5,124,365 Long-term investments: Corporate debt 1,919,737 - (42,876) 1,876,861 - - - - U.S. government agency 4,034,738 1,088 (16,062) 4,019,764 - - - - -------------------------------------------------------------------------------------------------- Total long-term investments 5,954,475 1,088 (58,938) 5,896,625 - - - - -------------------------------------------------------------------------------------------------- Total $34,733,087 $240,502 $(335,646) $34,637,943 $5,124,365 $ - $ - $5,124,365 ================================================================================================== The Company views its available-for-sale portfolio as available for use in its current operations. The following is a summary of the cost and estimated fair value of available-for-sale securities at December 31, 2004, by maturity date: 2004 FAIR COST VALUE ----------------------------- Mature in less than 1 year $28,778,612 $28,741,318 Mature in one year 5,954,475 5,896,625 ----------------------------- Total $34,733,087 $34,637,943 ============================= 68 4. INVENTORY Inventory consists of: DECEMBER 31, 2004 2003 ----------------------------- Raw Materials $ 1,401,591 $ 975,052 Work in Process 498,174 487,344 Finished Goods 2,886,984 3,073,584 Reserve for obsolescence (112,755) (105,752) ----------------------------- $ 4,673,994 $ 4,430,228 ============================= 5. PROPERTY AND EQUIPMENT Property and equipment consist of the following: DECEMBER 31, 2004 2003 ----------------------------- Equipment $ 2,972,314 $ 1,806,186 Equipment held for lease - 1,533,094 Leasehold improvements 380,062 309,213 ----------------------------- 3,352,376 3,648,493 Less accumulated depreciation 1,794,529 1,339,026 ----------------------------- $ 1,557,847 $ 2,309,467 ============================= Equipment held for lease at December 31, 2003 consisted of medical devices provided to customers under a prepaid operating lease arrangements, whereby the Company was the lessor. Amounts prepaid under the five-year operating leases are included in deferred revenue until earned over the term of the lease. During 2004, the Company sold all equipment held for lease. Depreciation expense for the years ended December 31, 2004, 2003 and 2002 is $628,725, $447,786, and $406,766, respectively. 6. RELATED PARTY TRANSACTIONS In the normal course of business, the Company has entered into an agreement with Biosense Webster, Inc., a subsidiary of Johnson and Johnson and an investor, under which the Company jointly develops integrated systems and certain disposable interventional devices. Amounts paid to this investor under this agreement totaled $3,417,522 and $972,190 in 2004 and 2003, respectively. In addition, the Company is entitled to receive royalty payments from the investor based on a profit formula pertaining to sales of certain disposable devices. The Company has not received any royalty payments to date under this agreement. In the event that the Company elects to terminate this agreement in certain specified change of control situations, the strategic investor would be entitled to a termination payment of 5% of the total equity value of the Company in the change of control transaction up to a maximum of $10 million. 69 7. ACCRUED LIABILITIES Accrued liabilities consist of the following: DECEMBER 31, 2004 2003 --------------------------- Accrued salaries, bonus, and benefits $2,006,700 $1,570,063 Accrued research and development 1,446,201 727,143 Accrued legal and other professional fees 623,411 968,532 Other 1,633,904 1,670,495 --------------------------- $5,710,216 $4,936,233 =========================== 8. LONG-TERM DEBT Long-term debt consists of the following: DECEMBER 31, 2004 2003 --------------------------- Revolving credit agreement, due June 2006 $ - $1,250,000 Term note, due December 2004 - 711,469 Term note, due September 2005 243,768 571,613 Term note, due June 2007 1,666,666 - Pay-in-kind note, due August 2006 - 2,000,000 --------------------------- 1,910,434 4,533,082 Less current maturities 910,434 2,289,314 --------------------------- $1,000,000 $2,243,768 =========================== In January 2002, the Company entered into a term note due in December 2004 with its primary lender for $2,000,000 (January 2002 term note). In conjunction with the January 2002 term note, the Company issued its primary lender warrants to purchase 14,081 shares of Company's common stock at a price per share of $7.81. The total proceeds under the January 2002 term note of $2,000,000 were allocated between the term note and the warrants based on an estimate of each security's fair value at the date of issuance. Under the January 2002 term note, the Company was required to make equal payments of principal and interest, at 10%, through December 2004 plus a final payment of 4% of the original note. The warrants expire after five years and can be exercised at any time. The fair value assigned to the warrants of $92,793 was reflected in additional paid-in capital on the balance sheet and amortized to interest expense over the life of the January 2002 term note. Fair value was determined utilizing the Black-Scholes valuation method, assuming a volatility of 120%, a risk-free interest rate of 3% and an expected life of five years. In March 2002, the Company entered into a revolving line of credit agreement (Revolving Credit Agreement) with a maximum borrowing capacity of $2,000,000, limited to the value of qualifying receivable and inventory balances, with its primary lender. In conjunction with the Revolving Credit Agreement, the Company issued its primary lender warrants to purchase 10,241 shares of the Company's common stock at a price per share of $7.81. The Revolving Credit Agreement was amended in July 2003 to increase the maximum borrowing capacity to $3,000,000, and in April 2004 to increase the maximum borrowing capacity to $8,000,000. Borrowings under the Revolving Credit Agreement are subject to monthly interest at the lender's prime rate plus 1.25%, subject 70 to a minimum interest rate of 5.25%, and are due in full in April 2006. The Company is required to maintain a ratio of "quick" assets (cash, cash equivalents, accounts receivable and short term investments) to current liabilities (less deferred revenue) of at least 1.5 to 1. In November, 2004, the Agreement was amended to require that the Company maintain a minimum tangible net worth of at least $30.0 million. Remaining available borrowing capacity at December 31, 2004 is $8,000,000. The warrants issued in conjunction with the Revolving Credit Agreement expire after five years and can be exercised at any time. The fair value assigned to the warrants of $67,264 is reflected in additional paid-in capital on the balance sheet and amortized to interest expense over the 12-month life of the Revolving Credit Agreement. Fair value was determined utilizing the Black-Scholes valuation method, assuming a volatility of 120%, a risk-free interest rate of 3% and an expected life of five years. In October 2002, the Company entered into a term note due in September 2005 with its primary lender for $1,000,000 (October 2002 term note). In conjunction with the October 2002 term note, the Company issued its primary lender warrants to purchase 5,000 shares of the Company's common stock at a price per share of $7.81. The total proceeds under the October 2002 term note of $1,000,000 were allocated between the term note and the warrants based on an estimate of each security's fair value at the date of issuance. Under the October 2002 term note, the Company is required to make equal payments of principal and interest, at 10%, through September 2005 plus a final payment of 3% of the original note. The warrants expire after five years and can be exercised at any time. The fair value assigned to the warrants of $32,580 was reflected in additional paid-in capital on the balance sheet and amortized to interest expense over the life of the October 2002 term note. Fair value was determined utilizing the Black-Scholes valuation method, assuming a volatility of 120%, a risk-free interest rate of 3% and an expected life of five years. In April 2004, the Company entered into a term note due in June 2007 with its primary lender for $2,000,000, which was drawn down in June 2004 (April 2004 term note). The Company is required to make equal payments of principal and interest, at 7%, through June 2007. The January 2002 term note, Revolving Credit Agreement, October 2002 term note and April 2004 term note (collectively, the Credit Agreements) are secured by substantially all of the Company's assets. The Credit Agreements also include certain equity level covenants and require the Company to maintain minimum liquidity levels. The Company is also required under the Credit Agreements to maintain its primary operating account and the majority of its cash and investment balances in accounts with the primary lender. In August 2003, the Company issued a $2,000,000 cumulative convertible pay-in-kind 8%, three-year note to a strategic partner pursuant to an agreement between the parties to transfer certain purchased technology to the Company, which is treated as a noncash activity in the accompanying statement of cash flows. The balance of the note, including accrued and unpaid interest, was automatically converted into shares of common stock immediately prior to the closing of the initial public offering of the Company's common stock at a conversion price equal to the gross per share proceeds to such offering, prior to deduction of underwriting commissions and discounts. As of December 31, 2003, $67,561 of interest was accrued on this note. Upon the closing of the Company's initial public offering of its stock in August 2004, this note was converted into 271,739 shares of common stock. Contractual principal maturities of long-term debt at December 31, 2004 are as follows: 2005 $ 910,434 2006 666,667 2007 333,333 ---------- $1,910,434 ========== 71 9. LEASE OBLIGATIONS The Company leases its facilities under operating leases. For the years ended December 31, 2004, 2003, and 2002 rent expense was $857,533, $660,901, and $569,079, respectively. In November 2004, the Company entered into an office lease agreement under which the Company will lease space in a new building. The Company intends to move its current headquarters to the new facilities in St. Louis, MO. The escalating lease is effective December 1, 2005 and has a term of ten years. The future minimum lease payments under noncancelable leases as of December 31, 2004 are as follows: OPERATING YEAR LEASE - --------------------------------------------------------- 2005 $ 792,239 2006 784,992 2007 707,561 2008 747,766 2009 890,272 Beyond 2009 6,550,023 ----------- Total minimum lease payments $10,472,853 =========== 10. STOCKHOLDERS' EQUITY INITIAL PUBLIC OFFERING On August 12, 2004, the Company completed an initial public offering in which it sold 5,500,000 shares of its common stock at $8.00 per share for proceeds of approximately $38.0 million, net of underwriting discounts and other offering costs. Upon the closing of the offering, all of the Company's outstanding shares of convertible preferred stock converted into 19,282,325 shares of common stock including 827,953 shares issued as a result of anti-dilution provisions with respect to certain series of our preferred stock. On September 3, 2004, the underwriters exercised an over-allotment option to purchase an additional 462,352 shares, resulting in net cash proceeds of approximately $3.4 million. COMMON STOCK In July 2004 the Company completed a 1-for-3.6 reverse stock split affecting all of its outstanding shares of common stock. As a result of this split, the conversion conversion ratio of our convertible preferred stock into common stock was adjusted accordingly. Upon the closing of the initial public offering of the Company's stock all of the shares of preferred stock automatically converted into shares of common stock. The holders of common stock are entitled one vote for each share held and to receive dividends whenever funds are legally available and when declared by the Board of Directors subject to the prior rights of holders of all classes of stock having priority rights as dividends. No dividends have been declared or paid as of December 31, 2004. 72 The Company has reserved shares of common stock for the exercise of warrants, the issuance of options granted under the Company's stock option plan and its stock purchase plan as follows: DECEMBER 31, 2004 2003 ---------------------------- Convertible preferred stock - 16,959,801 Warrants 1,135,526 894,204 Stock option plan 2,439,765 1,975,265 Employee Stock Purchase Plan 277,777 - ---------------------------- 3,853,068 19,829,270 ============================ The Company has outstanding shares of common stock that are subject to the Company's right to repurchase at the original issuance price upon the occurrence of certain events as defined in the agreements related to the sale of such stock. As of December 31, 2004 and 2003, shares subject to repurchase were 8,681 and 55,497, respectively. CONVERTIBLE PREFERRED STOCK Upon the closing of the Company's initial public offering in August 2004, all of the outstanding shares of convertible preferred stock converted into 19,282,325 shares of common stock As of December 31, 2003, the Company had convertible preferred stock outstanding as follows: PRICE PAID LIQUIDATION VALUE DATE ISSUED SERIES PER SHARE NUMBER OF SHARES DECEMBER 31, 2003 - ----------------------------------------------------------------------------------------------------------------------- December 1990 A $0.50 400,000 $ 461,667 April 1993 A 0.45 2,222,222 2,216,666 September 1994 A 1.00 50,000 49,875 December 1994 B 0.72 4,139,117 5,611,952 April 1995 B 0.72 520,833 669,705 November 1996-February 1997 B 0.72 2,352,949 2,860,793 June-December 1998 C 1.50 11,999,987 27,737,470 April 2000 D 2.17 11,751,147 34,849,985 November-December 2001 D-1 2.17 10,052,020 26,357,234 October 2002 C 1.50 205,791 345,986 December 2002 D-2 2.17 7,940,950 19,026,849 January 2003 D-2 2.17 2,764,979 6,550,002 June 2003 E 2.93 3,412,970 10,541,668 December 2003 E-1 2.93 3,242,321 9,539,584 ---------------------------------------- 61,055,286 $146,819,436 ======================================== As a result of our reverse 1-for-3.6 common stock split in July 2004, the conversion ratio for preferred shares into common shares was automatically adjusted accordingly. Prior to the conversion of preferred stock to common stock in conjunction with our initial public offering in August 2004, preferred stockholders were entitled to cumulative dividends at the rate of $0.05, $0.07, $0.15, $0.217, $0.217, $0.217, $0.293, $0.293, and $0.293 per share per annum (post split basis) on each outstanding share of Series A, B, C, D, D-1, D-2, E, E-1, and E-2 preferred stock as adjusted for stock splits and recapitalizations, if declared by the Board of Directors, payable in preference to common stock dividends. No dividends have been declared or paid by the Company. 73 Prior to the conversion of preferred stock to common stock in conjunction with our initial public offering in August 2004, preferred shareholders were entitled to certain liquidation preferences. Preferred shares' liquidation value equaled the original purchase price plus amounts equal to all dividends in arrears. Cumulative dividends in arrears totaled $0 and $32,171,521 at December 31, 2004 and 2003, respectively; however, as mentioned above, no dividends have been declared. Prior to the conversion of preferred stock into common stock, holders of common stock were entitled to their pro-rata share of the assets of the Company after liquidation payments were made to the preferred stockholders. As of December 31, 2004, all of the Company's preferred shares had been converted to common shares. NOTES RECEIVABLE At December 31, 2004 and 2003, an officer of the Company, consultants, members of the Board of Directors, and employees have outstanding promissory notes including accrued and unpaid interest totaling $173,432 and $448,413, respectively, related to the sale of common stock to such individuals. The notes are full-recourse and are also secured by the underlying stock. These notes bear interest at a range from 4.5% to 8.0% per annum and are due from 2005 through 2006. These notes receivable are reflected on the balance sheets as a component of stockholders' equity. STOCK OPTION PLANS In 2002, the Board of Directors adopted a stock incentive plan (the 2002 Stock Incentive Plan) and a nonemployee directors' stock plan (2002 Director Plan). In 1994, the Board of Directors adopted the 1994 Stock Option Plan. At December 31, 2004 and 2003, the Board of Directors has reserved a total of 2,439,765 and 1,975,265 respectively, shares of the Company's common stock to provide for current and future grants under the 2002 Stock Incentive Plan and the 2002 Director Plan and for all current grants under the 1994 Stock Option Plan. In 2002, the Board of Directors adopted a provision providing for an annual increase in the number of shares reserved for stock options of the lesser of 3.25% of outstanding common shares or 833,333 shares, on January 1 of each year through January 1, 2007. The 2002 Stock Incentive Plan allows for the grant of incentive stock options and non-qualified stock options to employees, Board members, and consultants. Options granted under the 2002 Stock Incentive Plan expire no later than ten years from the date of grant. The exercise price of each incentive stock option shall not be less than 100% of the fair value of the stock subject to the option on the date the option is granted. The exercise price of each non-qualified option shall not be less than 85% of the fair value of the stock subject to the option on the date the option is granted. The vesting provisions of individual options may vary, but incentive stock options generally vest 25% on the first anniversary of each grant and 1/48 per month over the next three years. Non-qualified stock options generally vest ratably over a period of two to four years. The 2002 Director Plan allows for the grant of non-qualified stock options to the Company's nonemployee directors. Options granted under the 2002 Director Plan expire no later than ten years from the date of grant. The exercise price of options under the 2002 Director Plan shall not be less than 100% of the fair value of the stock subject to the option on the date the option is granted. The options generally vest 100% on the first anniversary of each grant. The 1994 Stock Option Plan allows for the grant of incentive stock options and non-qualified stock options to employees, Board members, and consultants to the Company. Options granted under the 1994 Stock Option Plan expire no later than ten years from the date of grant. The exercise price of each incentive stock option shall be not less than 100% of the fair value of the stock subject to the option on the date the option is granted. The exercise price of each non-qualified option shall be not less than 85% of the fair value of the stock subject to the option on the date the option is granted. The vesting provisions of individual options may vary but in each case will provide for vesting of at least 20% of the total number of shares subject to the option per year. 74 Options granted may be exercised prior to vesting, in which case the related shares would be subject to repurchase by the Company at original purchase price until vested. In February 2002, the Compensation Committee of the Board of Directors resolved to remove any performance or milestone related provisions of certain stock option arrangements. The intrinsic value of these options related to the unvested portion of these options is being amortized to compensation expense over the remaining vesting period. In addition, in February 2002, the Board accelerated vesting on certain stock options granted to certain advisors to the Company and to nonemployee Board members. As of December 31, 2004, 2003, and 2002, 1,362,239, 683,906, and 237,077 options were vested and outstanding under all stock plans, respectively. A summary of the options outstanding is as follows: WEIGHTED NUMBER OF RANGE OF AVERAGE PRICE SHARES EXERCISE PRICE PER SHARE --------------------------------------------------- Outstanding, December 31, 2001 746,219 $0.14-$1.62 $1.14 Granted 775,694 $4.75-$5.94 $4.96 Exercised (128,123) $0.25-$1.62 $2.39 Forfeited (103,268) $0.54-$5.94 $0.72 --------- Outstanding, December 31, 2002 1,290,522 $0.14-$5.94 $3.35 Granted 635,972 $5.94 $5.94 Repurchased 14,323 $1.08-$1.37 $1.09 Exercised (125,227) $0.25-$5.94 $2.57 Forfeited (139,370) $0.54-$5.94 $4.33 --------- Outstanding, December 31, 2003 1,676,220 $0.25-$5.94 $4.29 Granted 935,553 $4.75-$11.54 $7.49 Repurchased 115 $0.78 $0.78 Exercised (135,387) $0.25-$5.94 $2.84 Forfeited (223,331) $0.54-$7.02 $6.33 --------- Outstanding, December 31, 2004 2,253,170 $0.25-$11.54 $5.50 ========= As of December 31, 2004 and 2003, the weighted average remaining contractual life of the options outstanding was 8.1 years and 8.0 years, respectively. DEFERRED COMPENSATION For the years ended December 31, 2004, 2003, and 2002, the Company recorded stock-based compensation expense related primarily to grants of non-qualified options to consultants and other nonemployees of $452,130, $492,168, and $483,638, respectively. As further described in Note 2, the Company records stock-based compensation expense to non-employees under EITF No. 96-18 based on the fair value of the equity instrument issued as determined using the Black-Scholes valuation method. As of December 31, 2004, deferred compensation of $671,950 is expected to be expensed over the term of the underlying options in future years as follows: 2005 $422,574 2006 223,135 2007 26,241 -------- Total $671,950 ======== 75 Deferred compensation is recorded as a separate component of stockholders' equity. As of December 31, 2004 and 2003, $610,093 and $688,851, respectively, of deferred compensation is subject to periodic remeasurement. In 2003, the Company recognized additional deferred compensation of $360,297 related to modification of an option grant to allow an employee to retain and continue to vest in outstanding options upon change to nonemployee status. WARRANTS As of December 31, 2004, the Company has issued warrants to purchase 418,819 shares of common stock at $7.81 per share exercisable through December 2006, warrants to purchase 446,063 shares of common stock at $7.81 exercisable through December 2007 and warrants to purchase 298,936 shares of common stock at $10.55 per share exercisable through February 2009. All such warrants were issued in connection with a corresponding issuance of convertible preferred stock and were credited to additional paid-in capital at their fair value with a corresponding reduction to preferred offering proceeds. During 2004, warrants for 57,604 were exercised under a cashless exercise provision of the warrant agreements for a net issuance of 20,104 shares of common stock. Additionally, in connection with closing its credit agreements in 2002, the Company issued to its primary lender warrants to purchase 29,322 shares of its common stock at $7.81 per share exercisable through various times in 2007. These warrants were accounted for as described in Note 8. The fair values of all warrants were estimated using the Black-Scholes valuation method. 11. INCOME TAXES The provision for income taxes consists of: YEAR ENDED DECEMBER 31, 2004 2003 2002 ------------------------------------------------ Deferred: Federal $ 9,502,076 $ 8,683,446 $ 7,521,820 State and local 950,374 879,474 861,391 ------------------------------------------------ 10,452,450 9,562,920 8,383,211 Valuation allowance (10,452,450) (9,562,920) (8,383,211) ------------------------------------------------ $ - $ - $ - ================================================ 76 The provision for income taxes varies from the amount determined by applying the U.S. federal statutory rate to income before income taxes as a result of the following: YEAR ENDED DECEMBER 31, 2004 2003 2002 --------------------------------- U.S. statutory income tax rate 34.0% 34.0% 34.0% State and local taxes, net of federal tax benefit 3.6% 3.6% 3.6% Permanent differences between book and tax and other (1.5%) 0.3% 0.5% Research credits 2.2% 2.3% 0.9% Valuation allowance (38.3%) (40.2%) (39.0%) --------------------------------- Effective income tax rate 0.0% 0.0% 0.0% ================================= In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable losses, limitations imposed by Section 382 of the Internal Revenue Code and projections for future losses over periods which the deferred tax assets are deductible, management determined that a 100% valuation allowance of deferred tax assets was appropriate. The components of the deferred tax asset are as follows: DECEMBER 31, 2004 2003 ------------------------------- Current accruals $ 664,869 $ 1,212,564 Depreciation and amortization 815,785 833,002 Deferred compensation 685,653 540,246 Net operating loss carryovers 40,718,018 30,418,180 Research and development credit carryovers 2,697,032 2,077,280 ------------------------------- 45,581,357 35,081,272 Valuation allowance (45,581,357) (35,081,272) ------------------------------- $ - $ - =============================== As of December 31, 2004, the Company has federal net operating loss carryforwards of $108,127,100. The net operating loss carryforwards will expire at various dates beginning in 2005, approximately $2,093,000 will expire between 2005 and 2009 and approximately $106,034,000 will expire between 2010 and 2024, if not utilized. As of December 31, 2004, the Company had federal research and development credit carryforwards of $2,697,000, which will expire at various dates beginning in 2006 through 2024, if not utilized. Of the $108.1 million net operating loss, approximately $5.6 million is limited as to its use prior to December 31, 2007. 12. RESTRUCTURING CHARGE During 2002, the Company decided to discontinue its embolic product line. This resulted in the Company incurring total restructuring expenses, included in research and development, of approximately $267,000, consisting 77 primarily of employee severance costs and cancellation of contract research agreements. The Company utilized this entire accrual in 2003. 13. NET LOSS PER SHARE The following is a reconciliation of the numerator (net loss) and the denominator (number of shares) used in the basic and diluted earnings per share calculations: YEAR ENDED DECEMBER 31, 2004 2003 2002 -------------------------------------------------- Basic and diluted: Net loss $(27,257,469) $(24,036,837) $(21,458,658) Weighted average common shares outstanding 11,502,781 1,424,216 1,326,537 Less weighted average shares subject to repurchase 32,471 115,411 209,236 -------------------------------------------------- Weighted average shares used in basic and diluted net loss per share 11,470,310 1,308,805 1,117,301 ================================================== Net loss per share $ (2.38) $ (18.37) $ (19.21) ================================================== The following table sets forth the number of common shares that could result from conversion or exercise of the following instruments as of the year ended: DECEMBER 31, 2004 2003 2002 ---------------------------------------------- Preferred stock (as if converted) - 16,959,801 14,343,060 Options to purchase common stock 2,253,170 1,676,220 1,290,523 Common stock subject to repurchase 8,681 55,498 168,250 Warrants 1,135,526 894,204 779,022 ---------------------------------------------- 3,397,377 19,585,723 16,580,855 ============================================== 14. EMPLOYEE BENEFIT PLAN Beginning in 2002, the Company offered employees the opportunity to participate in a 401(k) plan. The Company matches employee contributions dollar for dollar up to 3% of the employee's salary during the employee's period of participation. For the years ended December 31, 2004, 2003, and 2002, the Company expensed $361,008, $264,965, and $222,081, respectively, related to the plan. 15. COMMITMENTS AND CONTINGENCIES The Company at times becomes a party to claims in the ordinary course of business. Management believes that the ultimate resolution of pending or threatened proceedings will not have a material effect on the financial position, results of operations, or liquidity of the Company. 78 16. QUARTERLY DATA (UNAUDITED) The following tabulations reflect the unaudited quarterly results of operations for the years ended December 31, 2004 and 2003: BASIC AND DILUTED NET GROSS NET LOSS PER SALES PROFIT LOSS SHARE ---------------------------------------------------------------- 2004 First quarter $3,073,891 $ 591,477 $(7,849,997) $(5.34) Second quarter 3,908,934 1,413,917 (8,366,093) (5.46) Third quarter 5,713,611 2,984,093 (5,317,489) (0.34) Fourth quarter 6,120,424 3,155,111 (5,723,890) (0.21) 2003 First quarter $ 386,073 $ (114,864) $(4,905,670) $(3.96) Second quarter 1,742,967 660,400 (4,846,292) (3.77) Third quarter 1,040,932 439,310 (6,194,112) (4.68) Fourth quarter 1,844,905 (21,282) (8,090,763) (5.83) 17. SEGMENT INFORMATION The Company considers reporting segments in accordance with SFAS 131, Disclosures about Segments of an Enterprise and Related Information. The Company's system and disposable devices are developed and marketed to a broad base of hospitals in the United States and Europe. Management considers all such sales to be part of a single operating segment. Geographic revenues are as follows: YEAR ENDED DECEMBER 31, 2004 2003 2002 ------------------------------------------ United States $12,578,610 $3,577,899 $18,900 International 6,238,250 1,436,978 - ------------------------------------------ Total $18,816,860 $5,014,877 $18,900 ========================================== All of the Company's long-lived assets are located in the United States. 79 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Disclosure Controls and Procedures: The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), as of the end of the period covered by this report. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures provided reasonable assurance that the disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the report that it files or submits under the Exchange Act. Internal Control Over Financial Reporting: The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of the Company's internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Based on that evaluation, there has been no such change during the period covered by this report. ITEM 9B. OTHER INFORMATION None. PART III Certain information required by Part III is omitted from this Report on Form 10-K since we intend to file our definitive Proxy Statement for our next Annual Meeting of Stockholders, pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended (the "Proxy Statement"), no later than April 30, 2005, and certain information to be included in the Proxy Statement is incorporated herein by reference. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by this item concerning our executive officers and directors is incorporated by reference to the information set forth in the section entitled "Directors and Executive Officers" in our Proxy Statement. Information regarding Section 16 reporting compliance is incorporated by reference to the information set forth in the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" in our Proxy Statement. Our Board of Directors adopted a Code of Business Conduct and Ethics for all of our directors, officers and employees effective August 1, 2004. Stockholders may request a free copy of our Code of Business Conduct and Ethics from our Chief Financial Officer as follows: Stereotaxis, Inc. Attention: James M. Stolze 4041 Forest Park Avenue St. Louis, MO 63108 314-615-6940 To the extent required by law or the rules of the Nasdaq National Market, any amendments to, or waivers from, any provision of the Code of Business Conduct and Ethics will be promptly disclosed publicly. To the extent 80 permitted by such requirements, we intend to make such public disclosure by posting the relevant material on our website (www.stereotaxis.com) in accordance with SEC rules. ITEM 11. EXECUTIVE COMPENSATION The information required by this item regarding executive compensation is incorporated by reference to the information set forth in the sections titled "Executive Compensation" in our Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item regarding security ownership of certain beneficial owners and management is incorporated by reference to the information set forth in the section titled "Security Ownership of Certain Beneficial Owners and Management" in our Proxy Statement. The following table summarizes certain information regarding our securities that may be issued pursuant to our equity compensation plans as of December 31, 2004. NUMBER OF SECURITIES REMAINING AVAILABLE FOR FUTURE ISSUANCE UNDER NUMBER OF SECURITIES TO WEIGHTED-AVERAGE EQUITY COMPENSATION BE ISSUED UPON EXERCISE EXERCISE PRICE OF PLANS (EXCLUDING OF OUTSTANDING OPTIONS, OUTSTANDING OPTIONS, SECURITIES REFLECTED IN PLAN CATEGORY WARRANTS AND RIGHTS (1) WARRANTS AND RIGHTS COLUMN (A))(1) ------------- ----------------------- -------------------- ----------------------- (a) (b) (c) Equity compensation plans approved by security holders 3,388,696 $6.52 464,372 Equity compensation plans not approved by security holders - - - --------- ----- ------- Total 3,388,696 $6.52 464,372 ========= ===== ======= (1) Includes 277,777 shares reserved for issuance under the 2004 Employee Stock Purchase Plan. Excludes automatic annual increases to shares by which on January 1 of 2005, 2006 and 2007, the lesser of (i) 3.25% of the total outstanding shares as of each such date or (ii) 833,333 shares will be allocated to the 2002 Stock Incentive Plan. Number of shares of common stock is subject to adjustment for changes in capitalization for stock splits, stock dividends and similar events. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS The information required by this item regarding certain relationships and related transactions is incorporated by reference to the information set forth in the section titled "Certain Relationships and Related Party Transactions" in our Proxy Statement. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES The information required by this item regarding principal accounting fees and services is incorporated by reference to the information set forth in the section titled "Principal Accounting Fees and Services" in our Proxy Statement. 81 PART IV ITEM 15: EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) The following documents are filed as part of this Annual Report on Form 10-K (1) Financial Statements--See Index to the Financial Statements at Item 8 of this Report on Form 10-K. (2) The following financial statement schedule of Stereotaxis, Inc. is filed as part of this Report and should be read in conjunction with the financial statements of Stereotaxis, Inc.: -- Schedule II: Valuation and Qualifying Accounts. All other schedules have been omitted because they are not applicable, not required under the instructions, or the information requested is set forth in the consolidated financial statements or related notes thereto. (3) Exhibits See Exhibit Index appearing on page 86. 82 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. STEREOTAXIS, INC. (Registrant) By: /s/ BEVIL J. HOGG ---------------------------- Bevil J. Hogg, President and Date: March 28, 2005 Chief Executive Officer KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Bevil J. Hogg and James M. Stolze, and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities to sign any and all amendments to this Annual Report on Form 10-K and any other documents and instruments incidental thereto, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents and/or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE - --------------------------------------- --------------------------------------- ---------------- /s/ FRED A. MIDDLETON - --------------------------------------- Chairman of the Board of Directors March 28, 2005 FRED A. MIDDLETON /s/ BEVIL J. HOGG - --------------------------------------- President and Chief Executive Officer March 28, 2005 BEVIL J. HOGG (principal executive officer) /s/ JAMES M. STOLZE - --------------------------------------- Vice President and Chief Financial March 28, 2005 JAMES M. STOLZE Officer (principal financial officer and principal accounting officer) /s/ ABHI ACHARYA - --------------------------------------- Director March 28, 2005 ABHI ACHARYA /s/ CHRISTOPHER ALAFI - --------------------------------------- Director March 28, 2005 CHRISTOPHER ALAFI /s/ JOHN C. APLIN - --------------------------------------- Director March 28, 2005 JOHN C. APLIN 83 /s/ DAVID W. BENFER - --------------------------------------- Director March 28, 2005 DAVID W. BENFER /s/ RALPH G. DACEY, JR. - --------------------------------------- Director March 28, 2005 RALPH G. DACEY, JR. /s/ GREGORY R. JOHNSON - --------------------------------------- Director March 28, 2005 GREGORY R. JOHNSON /s/ WILLIAM M. KELLEY - --------------------------------------- Director March 28, 2005 WILLIAM M. KELLEY /s/ RANDALL D. LEDFORD - --------------------------------------- Director March 28, 2005 RANDALL D. LEDFORD /s/ ABHIJEET J. LELE - --------------------------------------- Director March 28, 2005 ABHIJEET J. LELE /s/ WILLIAM C. MILLS III - --------------------------------------- Director March 28, 2005 WILLIAM C. MILLS III /s/ DAVID J. PARKER - --------------------------------------- Director March 28, 2005 DAVID J. PARKER 84 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002 ADDITIONS BALANCE AT CHARGED TO BALANCE AT BEGINNING COST AND THE END OF YEAR EXPENSES DEDUCTIONS OF YEAR ------------------------------------------------------------ ALLOWANCE FOR DOUBTFUL ACCOUNTS AND RETURNS: Year ended December 31, 2004 $116,725 $151,971 $(122,473) $146,223 Year ended December 31, 2003 1,650 117,707 (2,632) 116,725 Year ended December 31, 2002 - 3,850 (2,200) 1,650 ALLOWANCE FOR INVENTORIES VALUATION: Year ended December 31, 2004 $105,752 $ 59,844 $ (52,841) $112,755 Year ended December 31, 2003 84,580 89,895 (68,723) 105,752 Year ended December 31, 2002 - 84,580 - 84,580 85 EXHIBIT INDEX NUMBER DESCRIPTION 3.1 Restated Articles of Incorporation of the Company, incorporated by reference to Exhibit 3.1 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 3.2 Restated Bylaws of the Company, incorporated by reference to Exhibit 3.2 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 4.1 Form of Specimen Stock Certificate, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.1. 4.2 Fourth Amended and Restated Investor Rights Agreement, dated December 17, 2002 by and among Registrant and certain stockholders, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.2. 4.3 Joinder Agreement to Series D-2 Preferred Stock Purchase Agreement, Fourth Amended and Restated Investor Rights Agreement and Amendment to Second Amended and Restated Stockholders' Agreement dated January 21, 2003 by and among Registrant and certain stockholders, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.3. 4.4 Joinder and Amendment to Second Amended and Restated Stockholders' Agreement and Fourth Amended and Restated Investor Rights Agreement, dated May 27, 2003 by and among Registrant and certain stockholders incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.4. 4.5 Second Joinder and Amendment to Second Amended and Restated Stockholders' Agreement and Fourth Amended and Restated Investor Rights Agreement, dated December 22, 2003 by and among Registrant and certain stockholders, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.5. 4.6 Third Joinder and Amendment to Second Amended and Restated Stockholders' Agreement and Fourth Amended and Restated Investor Rights Agreement, dated January 28, 2004 by and among Registrant and certain stockholders, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.6. 4.7 Form of Warrant Agreement issued to Series D-1 investors, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.7. 4.8 Warrant Agreement issued to Silicon Valley Bank dated January 31, 2002, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.8. 86 4.9 Form of Warrant Agreement issued to Series D-2 investors, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.9. 4.10 Form of Warrant Agreement issued to Series E-2 investors, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.10. 4.11 Warrant Agreement issued to Silicon Valley Bank dated March 19, 2002, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.11. 4.12 Warrant Agreement issued to Silicon Valley Bank dated September 30, 2002, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 4.12. 10.1 1994 Stock Option Plan, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.1. 10.2# Form of Incentive Stock Option Agreement under the 2002 Stock Incentive Plan, , incorporated by reference to Exhibit 10.1 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 10.3 2002 Stock Incentive Plan, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.2. 10.4# Form of Non-Qualified Stock Option Agreement under the 2002 Stock Incentive Plan, incorporated by reference to Exhibit 10.2 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 10.5 2004 Employee Stock Purchase Plan, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.3. 10.6# Form of Non-Qualified Stock Option Agreement under the 2002 Non-Employee Director Plan, incorporated by reference to Exhibit 10.3 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 10.7 2002 Non-Employee Directors' Stock Plan, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.4. 10.8# Form of Restricted Stock Agreement under the 2002 Stock Incentive Plan, incorporated by reference to Exhibit 10.4 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 10.9 Employment Agreement dated June 23, 1997 between Bevil J. Hogg and the Registrant, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.5. 87 10.10# Form of Notice of Performance Share Award under the 2002 Stock Incentive Plan, incorporated by reference to Exhibit 10.5 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 10.11 Employment Agreement dated April 4, 2001 between Douglas M. Bruce and the Registrant, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.6. 10.12# Form of Subscription Agreement for the 2004 Employee Stock Purchase Plan, incorporated by reference to Exhibit 10.6 of the Registrant's Form 10-Q (File No. 000-50884) for the fiscal quarter ended September 30, 2004. 10.13 Employment Agreement dated February 16, 2001 between Melissa Walker and the Registrant, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.7. 10.14 Employment Agreement dated April 17, 2002 between Michael P. Kaminski and the Registrant, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.8. 10.15 Summary of Non-Employee Directors' Compensation 10.16 Collaboration Agreement dated June 8, 2001 between the Registrant and Siemens AG, Medical Solutions, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.9. 10.17+ Extended Collaboration Agreement dated May 27, 2003 between the Registrant and Siemens AG, Medical Solutions, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.10. 10.18+ Development and Supply Agreement dated May 7, 2002 between the Registrant and Biosense Webster, Inc., incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.11. 10.19+ Amendment to Development and Supply Agreement dated November 3, 2003 between the Registrant and Biosense Webster, Inc., incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.12. 10.20+ Supply Agreement dated July 1, 2003 between the Registrant and Magnet Sales & Manufacturing Inc., incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.13. 10.21 Form of Indemnification Agreement between the Registrant and its directors and executive officers, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.14. 10.22 Lease, having an effective date of August 15, 2001, between the Registrant and Emerging Technologies Building II, LLC, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.15. 88 10.23+ Letter Agreement, dated September 12, 2003, between the Registrant and Philips Medizin Systeme G.m.b.H., incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.16. 10.24 Letter Agreement and Employment Agreement dated May 26, 2004 between James M. Stolze and the Registrant, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.17. 10.25+ Software Distribution Agreement dated March 3, 2004 between the Registrant and Siemens Aktiengesellschaft, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.18. 10.26+ Third Party Service Agreement dated August 5, 2002 between the Registrant and Siemens Medical Solutions USA, Inc., incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.19. 10.27+ Research Agreement between the Registrant, Siemens AG and Landesbetrieb Krankenhauser, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.20. 10.28 Loan and Security Agreement dated January 31, 2002 between the Registrant and Silicon Valley Bank, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.21. 10.29 Loan Modification Agreement dated May 14, 2002 between the Registrant and Silicon Valley Bank, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.22. 10.30 Second Loan Modification Agreement dated July 11, 2002 between the Registrant and Silicon Valley Bank, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.23. 10.31 Loan and Security Agreement dated September 30, 2002 between the Registrant and Silicon Valley Bank, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.24. 10.32 Second Loan Modification Agreement dated September 30, 2002 to Equipment Loan and Security Agreement dated January 31, 2002 and Third Loan Modification Agreement to Revolving Loan and Security Agreement dated March 19, 2002, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.25. 10.33 Third Loan Modification Agreement dated December 31, 2002 to Equipment Loan and Security Agreement dated January 31, 2002 and Fourth Loan Modification Agreement to Revolving Loan and Security Agreement dated March 19, 2002 and First Loan Modification Agreement to Equipment Loan and Security Agreement dated September 30, 2002 between the Registrant and Silicon Valley Bank, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.26. 10.34 Fourth Loan Modification Agreement dated April 2003 to Equipment Loan and Security Agreement dated January 31, 2002 and Fifth Loan Modification Agreement to Revolving Loan and Security Agreement dated 89 March 19, 2002 and Second Loan Modification Agreement to Equipment Loan and Security Agreement dated September 30, 2002, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.27. 10.35 Loan and Security Agreement dated April 30, 2004 between the Registrant and Silicon Valley Bank, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.28. 10.36+ Distributor Agreement dated September 17, 2003 between the Registrant and AB Medica, incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.29. 10.37 Promissory Note dated November 20, 2001 by Douglas M. Bruce payable to the order of Stereotaxis, Inc., incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.30. 10.38+ Japanese Market Development Agreement dated May 18, 2004 between the Registrant, Siemens Aktiengesellschaft and Siemens Asahi Medical Technologies Ltd., incorporated by reference to the Registration Statement on Form S-1 (File No. 333-115253) originally filed with the Commission on May 7, 2004, as amended thereafter, at exhibit 10.32. 10.39* Office Lease dated November 15, 2004 between the Registrant and Cortex West Development I, LLC 23.1 Consent of Ernst & Young LLP 31.1 Rule 13a-14(a)/15d-14(a) Certification (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, executed by Chief Executive Officer). 31.2 Rule 13a-14(a)/15d-14(a) Certification (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, executed by Chief Financial Officer). 32.1 Section 1350 Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by Chief Executive Officer). 32.2 Section 1350 Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by Chief Financial Officer) - -------------- # Indicates management contract or compensatory plan + Confidential treatment granted as to certain portions, which portions are omitted and filed separately with the Securities and Exchange Commission. * Confidential treatment requested as to certain portions, which portions are omitted and filed separately with the Securities and Exchange Commission. 90

EXHIBIT 10.15 STEREOTAXIS, INC. SUMMARY OF NON-EMPLOYEE DIRECTORS' COMPENSATION (EFFECTIVE APRIL, 2005) 1. BOARD OF DIRECTORS (BASE COMPENSATION): Cash Compensation Annual Retainer Directors - $18,000 Chairman - $24,000 Per meeting fee - $1,500 (in-person), $500 (telephonic) Stock Options or Other Equity Instrument Initial Grant - 15,000 to vest over 2 year period Annual Grant - 7,500 for Directors, 15,000 for Chairman 2. COMMITTEES OF THE BOARD (ADDITIONAL COMPENSATION): Audit Committee - --------------- Annual Retainer Committee Members - $2,500 Chairman and/or Designated Financial Expert - $7,500 Stock Options or Other Equity Instrument Annual Grant - 5,000 for Chairman and/or Designated Financial Expert Compensation Committee and Nominating/Governance Committee - ---------------------------------------------------------- Annual Retainer Committee Members - $2,500 Chairman - $5,000 Stock Options or Other Equity Instruments Annual Grant - 2,500 for Chairman Annual retainers are paid quarterly in advance. Per-meeting fees are paid after the meeting.

Exhibit 10.39 OFFICE LEASE ------------ ARTICLE 1 - PARTIES AND REFERENCE DATA -------------------------------------- As used in this Lease the following terms shall have the following meanings: 1.1. Landlord: CORTEX WEST DEVELOPMENT I, LLC, a Missouri limited -------- liability company, having as its address for notice purposes c/o CORTEX, 1401 South Brentwood Boulevard, Suite 675, St. Louis, Missouri 63144. 1.2. Tenant: Stereotaxis, Inc., a Delaware corporation, having as ------ its address for notice purposes prior to the Commencement Date 4041 Forest Park Boulevard, St. Louis, Missouri 63108, Attn: Chief Financial Officer and from and after the Commencement Date 4320 Forest Park Boulevard, St. Louis, Missouri 63108, Attn: Chief Financial Officer. 1.3. Date of this Lease: November 15, 2004 ------------------ 1.4. Intentionally Omitted --------------------- 1.5. Design Completion Date (Exhibit B): January 15, 2005. ---------------------------------- 1.6. Commencement Date (of this Lease): The earlier of (i) the --------------------------------- first day of December, 2005 or (ii) the date Tenant begins operating its business in the Premises; subject, however, to Section 3.1 and 3.2 of this Lease. 1.7. Term: Ten (10) Lease Years. As used in this Lease, the term ---- "Lease Year" means a twelve (12) month period during the term of this Lease (as it may be extended), the first Lease Year beginning on the Commencement Date if the Commencement Date is the first day of a month, or if the Commencement Date is not the first day of a month then on the first day of the calendar month next following the Commencement Date and including the period of time from the Commencement Date to the first day of the month next following the Commencement Date. 1.8. Building: The office building to be constructed in the City of -------- St. Louis, Missouri, to be known and numbered as 4320 Forest Park Boulevard, St. Louis, Missouri 63108, including the land upon which it is situated (the "Property"). The Building will have three (3) floors plus a mechanical penthouse and consist of approximately 175,000 gross square feet, subject to final measurement of the number of usable square feet in the Premises in accordance with BOMA Standards. The west wing will have approximately * square feet on each floor. Tenant will have exclusive use of a minimum of 100 parking spaces on the Property as of the Commencement Date or such lesser number of parking spaces on the Property as may be determined by Tenant in its discretion from time to time. 1.9. Premises: All of the first and second floors of the west wing -------- of the Building provided that the Premises shall not include until occupied by Tenant any of such space in excess of approximately * total rentable square feet of office space (the "Office Space") and approximately * total rentable square feet of assembly space (the "Assembly Space") as generally shown in Exhibit A-1 * - REDACTED TEXT - CONFIDENTIAL TREATMENT REQUESTED; OMITTED PORTIONS HAVE BEEN FILED SEPARATELY WITH THE SECURITIES AND EXCHANGE COMMISSION. and A-2 attached to this Lease and as improved in accordance with the provisions of Exhibit B attached to this Lease. The Office Space shall be generally located on the first and second floors and the Assembly Space shall be located on the first floor. Upon completion of construction of the Building, Landlord shall cause the usable area of the Premises to be measured by Landlord's licensed architect or engineer using the current version of the Standard Method for Measuring Floor Area in Office Buildings published by the Building Owners and Managers Association International (the "BOMA Standards"); provided, however, that the rentable area of the Premises shall be calculated by multiplying the usable area of the Premises by 1.12 and the BOMA Standards shall not be used in calculating the rentable area of the Premises. The Annual Base Rent set forth in Section 1.11 and the Monthly Base Rent set forth in Section 1.12 hereof shall be adjusted to reflect the rentable area of the Premises as so calculated. Tenant shall have the right to have such measurement verified by Tenant's independent licensed architect or engineer. The additional space for the Premises in excess of the initial Office Space and the initial Assembly Space shall be included in the Premises on the date Tenant begins use of all or a portion of such space and Rent and other charges shall commence to be payable for such space as of the date of such first use by Tenant at the rate per rentable square foot set forth below for additional Office Space. The Assembly Space at the below stated rent for the Assembly Space shall be limited to * rentable square feet at such rent. However, Tenant may take additional Assembly Space in excess of * rentable square feet at the below stated rent for Office Space. 1.10. Permitted Use: General office usage, testing, including ------------- animal testing (limited to testing on dogs, pigs and sheep), and assembly of medical devices and any other uses incidental thereto; provided, however, that if Landlord shall lease any space within the Building (including consent by Landlord to any assignment or subletting which expands the permitted uses within the Building) for uses other than the foregoing uses, then the Permitted Use hereunder shall be similarly expanded to include such other uses (excluding any retail in the Building, leases for amenities to serve the tenants of the Building and leases to vendors of tenants in the Building). 1.11. Annual Base Rent: Amounts as follows per rentable square foot ---------------- in the Premises: - ------------------------------------------------------------------------------------------------ LEASE YEAR ANNUAL BASE RENT ANNUAL BASE RENT FOR OFFICE SPACE FOR ASSEMBLY SPACE - ------------------------------------------------------------------------------------------------ 1 through 2 $ * per r.s.f. $ ** per r.s.f. - ------------------------------------------------------------------------------------------------ 3 through 4 $ * per r.s.f. $ ** per r.s.f. - ------------------------------------------------------------------------------------------------ 5 through 6 $ * per r.s.f. $ ** per r.s.f. - ------------------------------------------------------------------------------------------------ 7 through 8 $ * per r.s.f. $ ** per r.s.f. - ------------------------------------------------------------------------------------------------ 9 through 10 $ * per r.s.f. $ ** per r.s.f. - ------------------------------------------------------------------------------------------------ *Subject to a maximum of * rentable square feet of Assembly Space and subject to change to the Annual Base Rent for Office Space if assembly use is discontinued and changed to office use. Tenant expressly reserves the right to change or reconfigure all or any part of the Assembly Space to Office Space; provided, however, in the event of any such change or reconfiguration, the rent for such changed space shall become the Base Rent for Office Space, Landlord shall not be obligated to provide any leasehold improvements or leasehold improvement allowance, and any such change or reconfiguration shall be subject to the provisions of Article 11 of this Lease. 2 1.12. Monthly Base Rent Installment: The following amounts (subject ----------------------------- to adjustment in accordance with Section 1.9) during the following periods within the Term: - -------------------------------------------------------------------------- LEASE YEAR MONTHLY BASE RENT MONTHLY BASE RENT FOR OFFICE SPACE** FOR ASSEMBLY SPACE** - -------------------------------------------------------------------------- 1 through 2 $* $* - -------------------------------------------------------------------------- 3 through 4 $* $* - -------------------------------------------------------------------------- 5 through 6 $* $* - -------------------------------------------------------------------------- 7 through 8 $* $* - -------------------------------------------------------------------------- 9 through 10 $* $* - -------------------------------------------------------------------------- **Subject to adjustment pursuant to Section 1.9 of this Lease and Exhibit B to this Lease. 1.13. Public Liability Insurance Required: Two Million Dollars. ----------------------------------- 1.14. Security Deposit: Fifty Thousand and 00/100 Dollars ---------------- ($50,000.00). 1.15. Expense Stop: $7.50 per rentable square foot per year. The ------------ Expense Stop shall not be reduced if tax abatement or similar tax relief is granted for the Building or Property. Landlord agrees to exercise reasonable efforts to obtain tax abatement for the Building, but such tax abatement shall not be a condition to the Lease. 1.16. Intentionally Omitted. --------------------- 1.17. Number of Parking Spaces: Two and one half (2.5) undesignated ------------------------ and unreserved parking spaces on the Property around the Building for each 1,000 rentable square feet included in the Premises (including any expansion of the Premises) for the periods of time during the Term at no charge to Tenant or to Tenant's guests, and unreserved visitor parking being made available at a location and upon conditions determined by Landlord, subject to the provisions of Section 21.17 hereof. If Landlord has not acquired the land shown on the Site Plan attached hereto as Exhibit J prior to the Commencement Date, then Landlord shall obtain alternative parking within two (2) blocks of the Building and Tenant shall be entitled to the exclusive use of the one hundred (100) parking spaces currently owned by Landlord and located on the Property. 1.18. Leasing Brokers: None. --------------- 1.19. Exhibits: The following Exhibits attached to this Lease are -------- incorporated herein by this reference: A-1. Floor Plan of First Floor A-2. Floor Plan of Second Floor A-3. Floor Plan of Expansion Space (First Expansion Space and Second Expansion Space--total space for both) B. Work to be Performed on the Premises by Landlord C. Building Rules D. Memorandum of Occupancy E. Lease Estoppel Certificate F. Subordination, Non-Disturbance and Attornment Agreement G. Janitorial Services Schedule H. Memorandum of Lease I. Schematic Layout of the Premises J. Site Plan 3 ARTICLE 2 - DEMISING CLAUSE --------------------------- Landlord, for and in consideration of the rents, covenants and agreements hereinafter mentioned and hereby agreed to be paid, kept and performed by Tenant, does hereby lease to Tenant, and Tenant does hereby lease from Landlord, the Premises on the terms and conditions contained herein. ARTICLE 3 - TERM AND POSSESSION ------------------------------- 3.1. Term. The Term shall commence on the Commencement Date and ---- shall continue for the Term, unless earlier terminated as provided herein, provided that the Term shall include any period of beneficial occupancy for purposes of operating a business prior to the Commencement Date and all of the obligations of the parties under this Lease shall commence on the date of such beneficial occupancy for purposes of operating a business, except that Base Rent shall be equitably prorated based upon the portion of the Premises beneficially occupied. 3.2. Delay in Occupancy. If the Premises are not ready for ------------------ occupancy on the Commencement Date this Lease shall nevertheless continue in effect, but the Commencement date shall be delayed until the Premises are ready for Tenant's occupancy, and Landlord shall have no other liability whatsoever on account thereof, except as expressly provided herein. Rent shall not be abated if the Premises are not ready for occupancy because of or resulting from: (a) the failure to complete the installation of special items specified by Tenant after the Design Completion Date, (b) any delay resulting from Tenant's failure to make timely selection of colors or materials or to submit plans on or prior to the Plan Submission Date in accordance with Exhibit B, (c) changes or additions by Tenant to the Approved Plans (as defined in Exhibit B), or (d) revisions requested by Tenant to the Approved Plans or rebidding requested by Tenant of the work contemplated by the Approved Plans to contractors after the Design Completion Date (the foregoing events are herein called a "Tenant Delay"). The Premises shall be deemed ready for occupancy if a certificate or temporary certificate of occupancy has been issued for the Premises and only insubstantial details of construction, decoration or mechanical adjustments remain to be done which will not interfere with the operation of Tenant's business. On the date on which Tenant takes possession of the Premises (or as soon as practicable thereafter), the parties shall execute a Memorandum of Occupancy in the form attached hereto as Exhibit D confirming the Commencement Date and setting forth any incomplete items (if any), but failure to execute such document shall not in any manner affect the obligations of the parties hereunder. Notwithstanding the foregoing if the Premises are not ready for occupancy on or prior to December 1, 2005 (which delivery date shall not be subject to force majeure) and if the cause for the Premises not being ready for occupancy is not a Tenant Delay, then Landlord shall indemnify and hold harmless Tenant from and against any claims, losses, and expenses (including, without limitation, reasonable attorney's fees and expenses) relating to the cost of occupancy of real estate by Tenant (including, without limitation, claims by Tenant's existing lessor for consequential or other 4 damages and holdover rent under its existing lease, dated August 15, 2001, with Emerging Technologies Building II, LLC at 20 South Sarah Street) sustained by Tenant as a result of such failure to deliver the Premises on or prior to December 1, 2005. Should the Premises fail to be delivered on or prior to May 1, 2006 and should such failure not be due to a Tenant Delay, Tenant shall have the right by written notice to Landlord given prior to May 1, 2006 to terminate this Lease without liability in which event the Security Deposit shall be returned to Tenant. 3.3. Renewal Option. Tenant, upon giving Landlord not less than one -------------- hundred eighty (180) days prior written notice in each instance, shall have the right to renew the Term with respect to all space in the Building then under lease to Tenant for two (2) additional three (3) year periods at a rental equal to the Fair Market Value Rental Rate (as defined below) for comparable office buildings in the vicinity of the Building. At such time as Tenant notifies Landlord of Tenant's desire to renew this Lease, Landlord shall within fifteen (15) days thereafter notify Tenant of Landlord's interpretation of the Fair Market Value Rental Rate. Tenant may accept the rate as quoted, or elect to enter into negotiations with Landlord for a period not to exceed sixty (60) days, during which both parties will negotiate on a diligent, good faith basis to arrive at an agreement concerning the Fair Market Value Rental Rate. Should an agreement not be reached by both parties during said sixty (60) day period, then the Fair Market Value Rental Rate shall be determined as provided in this section. Within ten (10) days following the end of such sixty (60) day period, each party shall appoint an independent appraiser having the designation of MAI and is knowledgeable with respect to valuation of rental rates in the geographic area of the Building. Each appraiser shall be asked to give such appraiser's professional opinion as to the Fair Market Value Rental Rate for the Premises. Each appraiser shall be asked to deliver such appraiser's opinion simultaneously to Landlord and Tenant within fifteen (15) days after the appointment of such appraiser. If a party fails to appoint an appraiser, then the Fair Market Value Rental Rate shall be determined by the single appraiser appointed. If the opinions of the Fair Market Value Rental Rate differ by no more than ten (10) percent of the lower of such Rates, then the average of the Fair Market Value Rental Rates contained in such opinions shall be the Fair Market Value Rental Rate for the relevant renewal term. Otherwise, the two (2) appraisers shall appoint a third appraiser to give such third appraiser's professional opinion as to the Fair Market Value Rental Rate which shall be no lower than the lower of the two (2) prior opinions and no higher than the higher of the two (2) prior opinions. The determination of such third appraiser of the Fair Market Value Rental Rate shall govern; provided, however, that in no event shall the Fair Market Value Rental Rate be less than the Annual Base Rent for the prior term of this Lease (the initial term or any renewal term, as the case may be). The cost of the appraiser appointed by Landlord shall be paid by Landlord. The cost of the appraiser appointed by Tenant shall be paid by Tenant. The cost of the third appraiser, if any, shall be shared equally by Landlord and Tenant. Tenant may exercise the second renewal option only if Tenant has exercised the first renewal option. 3.4. Early Entry. Landlord shall endeavor, so long as Tenant is ----------- using labor compatible with Landlord's labor forces at the Property at that time, to permit Tenant, at its option, along with its contractors, subcontractors and agents, to enter the Premises at any time during the four (4) weeks immediately prior to the scheduled Commencement Date and in any event no less than three (3) weeks prior to the scheduled Commencement Date and Tenant, along with its contractors, subcontractors and agents, shall be permitted to enter the First Expansion Space and the Second Expansion Space at any time during the two (2) weeks prior to the scheduled commencement date with respect to the First Expansion Space and Second Expansion Space, as the case may be or if available at an earlier date, provided such entry and work shall be in harmony with Landlord's 5 contractors, and with no obligation on the part of Tenant to pay rent or other costs during such period of occupancy, for the purpose of constructing Tenant's improvements, installing furniture, fixtures and equipment (including telephone equipment) as well as non-Building standard leasehold improvements. Tenant and its contractors shall have free use of such electricity, heating, ventilation and air conditioning and elevator service as may be available during the period of such early entry for installation of Tenant's improvements. All provisions of this Lease (with the exception of the obligation to pay Rent) shall be applicable during any such early entry of the Premises, the First Expansion Space or the Second Expansion Space, as the case may be. All installations made by Tenant and work performed by Tenant in the Premises during such early entries shall be at the sole risk of Tenant. Tenant's entry into the Premises prior to the Commencement Date shall not cause any delay in Landlord's work in the Premises and if such a delay is caused, the Commencement Date shall be accelerated by one (1) day for each day of such delay caused by Tenant, whether or not Landlord's work is complete as of such accelerated Commencement Date. 3.5. First Expansion. Landlord shall lease to Tenant and Tenant --------------- shall lease from Landlord an additional approximately 8,000 rentable square feet in the Building (the "First Expansion Space") commencing at the beginning of the fourth Lease Year. The First Expansion Space shall be the remainder of the unleased area on the first and second floors of the west wing and the balance on the third floor of the west wing of the Building in a location approved by Landlord and Tenant in the area shown on Exhibit A-3. Tenant may, upon one hundred eighty (180) days prior written notice, request delivery of the First Expansion Space at any time following the Commencement Date, but the First Expansion Space shall, in any event, become a part of the Premises without further action of the parties and Tenant shall become obligated to pay Rent and other charges hereunder for the First Expansion Space at the rental rates and upon the other terms and conditions of this Lease (including, without limitation, the Expense Stop) upon the earlier of: (a) the date of occupancy of the First Expansion Space by Tenant, or (b) the first day of the thirty seventh (37th) month of the Term of this Lease provided Landlord has substantially completed the buildout of the First Expansion Space in accordance with plans approved by Landlord and Tenant and the same are ready for occupancy. It is understood and agreed that any portion of the First Expansion Space taken by Tenant before the required take-down as of the thirty seventh (37th) month of the term of the Lease shall be counted towards the 8,000 square feet for the First Expansion Space. By way of example only, if Tenant has leased an additional 6,000 square feet on the second floor of the west wing on the twenty fifth (25th) month after the Commencement Date, then Tenant shall be obligated under this Section 3.5 to take only an additional 2,000 rentable square feet on the remainder of the west wing (if any). Tenant shall deliver to Landlord Tenant's schematic layout for the First Expansion Space at least ninety (90) days prior to the beginning of the fourth Lease Year containing information sufficient for Landlord to prepare plans and specifications for the improvement of the First Expansion Space. Should Tenant fail to deliver such schematic layout for the First Expansion Space on or prior to such date, then the rent for the First Expansion Space shall commence to be payable on the first day of the thirty seventh (37th) month of the term of this Lease notwithstanding that the build out of the First Expansion Space may be incomplete. 3.6. Second Expansion. Landlord shall lease to Tenant and Tenant ---------------- shall lease from Landlord an additional approximately 8,000 rentable square feet in the Building (the "Second Expansion Space") commencing at the beginning of the sixth Lease Year. The Second Expansion Space shall be in a location approved by Landlord and Tenant, but contiguous to the Premises in the area shown on Exhibit A-3. Tenant may, upon one hundred eighty (180) days prior written notice, request delivery of the Second Expansion Space at any time following the Commencement Date, 6 but the Second Expansion Space shall, in any event, become a part of the Premises without further action of the parties and Tenant shall become obligated to pay Rent and other charges hereunder for the Second Expansion Space at the rental rates and upon the other terms and conditions of this Lease (including, without limitation, the Expense Stop) upon the earlier of: (a) the date of occupancy of the Second Expansion Space by Tenant, or (b) the first day of the sixty first (61st) month of the Term of this Lease provided Landlord has substantially completed the buildout of the Second Expansion Space in accordance with plans approved by Landlord and Tenant and the same are ready for occupancy. It is understood and agreed that any additional space leased by Tenant before the required take-down of the Second Expansion Space as of the sixty first (61st) month of the term of the Lease shall be counted towards the 8,000 square feet for the Second Expansion Space so long as Tenant has leased all of the First Expansion Space. By way of example only, if Tenant has leased an additional 3,000 square feet in the Building (excluding the * rentable square feet leased initially or in connection with the expansion pursuant to Section 3.5) on the fifty first (51st) month after the Commencement Date, then Tenant shall be obligated under this Section 3.6 to take only an additional 5,000 rentable square feet contiguous to the then existing Premises. Tenant shall deliver to Landlord Tenant's schematic layout for the Second Expansion Space at least ninety (90) days prior to the beginning of the sixth Lease Year containing information sufficient for Landlord to prepare plans and specifications for the improvement of the Second Expansion Space. Should Tenant fail to deliver such schematic layout for the Second Expansion Space on or prior to such date, then the rent for the Second Expansion Space shall commence to be payable on the first day of the sixty first (61st) month of the term of this Lease notwithstanding that the build out of the Second Expansion Space may be incomplete. 3.7. Expansion Space Improvement Allowance. Landlord shall provide ------------------------------------- to Tenant a leasehold improvement allowance for each of the First Expansion Space and the Second Expansion Space equal to $3.50 per rentable square foot for each Lease Year remaining in the initial term of this Lease as of the expected commencement date with respect to the lease of such additional space in respect of which Tenant does not have the option to terminate this Lease pursuant to Section 3.8 hereof, subject to Tenant's right to waive the provisions of Section 3.8 hereof described below in this section. By way of example only, if Tenant elects to lease an additional 6,000 rentable square feet on the second floor of the west wing following the second Lease Year, then Landlord shall provide a leasehold improvement allowance of $3.50 multiplied by the number of years remaining in the term of this Lease in respect of which Tenant does not have an option to terminate this Lease pursuant to Section 3.8 hereof; provided, however, that if Tenant waives the provisions of Section 3.8 hereof, then Landlord shall provide a leasehold improvement allowance of $3.50 multiplied by the number of years remaining in the initial term of this Lease (exclusive of renewal terms). Notwithstanding the foregoing, Landlord shall not be obligated to provide a leasehold improvement allowance in respect of any portion of the First Expansion Space or Second Expansion Space in which leasehold improvements (consistent with the scope of the leasehold improvements made at the beginning of the term of this Lease) have been made prior to the date on which such portion becomes a portion of the Premises. 3.8. Termination Option-Unavailability of Space. Tenant shall have ------------------------------------------ the option exercisable by written notice given at least one (1) year in advance and delivered at any time during the term following the end of the sixth (6th) Lease Year to terminate this Lease at the end of the twelfth (12th) month succeeding the month in which such notice is given only in the event that Landlord is unable to deliver such additional space within the Building as Tenant shall deem necessary in Tenant's sole discretion as to which Tenant has given Landlord at least one hundred 7 eighty (180) days advance notice of Tenant's need for such additional space. This option to terminate shall expire, lapse and become void upon the first day of the eighth (8th) Lease Year. Should Tenant elect to terminate the Lease pursuant to the options set forth in this section, then on the termination date, and as a condition to such termination, Tenant shall pay to Landlord a termination fee in an amount equal to one hundred twenty (120) percent of Landlord's unamortized expense of improving the Premises for Tenant as described in Exhibit B hereto (and inclusive of the leasehold improvement allowance described in Section 3.7 hereof), computed on a straight line basis over ten (10) years. 3.9. Termination Option-Change of Control. Tenant shall have the ------------------------------------ option exercisable by written notice given at least one (1) year in advance and delivered at any time during the term following the end of the fifth (5th) Lease Year to terminate this Lease at the end of the twelfth (12th) month succeeding the month in which such notice is given only in the event that majority control of Tenant is changed at any time during the term of this Lease. Should Tenant elect to terminate the Lease pursuant to the option set forth in this section, then on the termination date, and as a condition to such termination, Tenant shall pay to Landlord all rent and other charges accrued through the date of termination plus a termination fee in an amount equal to fifty percent (50%) of the Base Rent payable by Tenant during the balance of the then existing term (initial term, or a renewal term as the case may be) of this Lease, and Tenant shall vacate and surrender the Premises to Landlord in accordance with Article 16 of this Lease. 3.10. Lapse of Options. The options set forth in Sections 3.3 and ---------------- 3.8 shall be exercisable only so long as no uncured event of default by Tenant has occurred under this Lease and shall lapse and become void should Tenant assign its interest in this Lease in whole or in part or should Tenant sublet the Premises in whole or in part, in either case to an entity which is not a Tenant Affiliate or a Qualified Assignee (each as defined in Section 8.3 hereof); provided, however, that if Landlord consents to such assignment or subletting, such options shall not lapse in such event. ARTICLE 4 - RENT ---------------- 4.1. Annual Base Rent. Tenant shall pay the Annual Base Rent to ---------------- Landlord at the location designated from time to time by Landlord in the Monthly Base Rent Installment in advance on or prior to the first day of each and every month during the Term without setoff or deduction whatsoever, except as may be specifically provided in this Lease. The rent for any partial month shall be prorated on the basis of thirty (30) days to the month and shall be paid on the first day of such partial period. 4.2. Adjustments to Annual Base Rent. The Annual Base Rent shall be ------------------------------- adjusted from time to time in accordance with this section to reflect increases in the expense of operating the Building ("Expenses"). The Annual Base Rent including the adjustments made pursuant to this section is referred to in this Lease as the "Rent". If the Expenses for any calendar year during the Term exceed the Expense Stop (the "Base Amount"), Annual Base Rent shall be adjusted to include Tenant's Pro Rata Share (as defined below) of such excess. As soon as practicable after the end of each calendar year (or portion thereof) during the Term, and no later than 120 days after the end of each calendar year, Landlord will provide Tenant with a written notice ("Statement") setting forth the amount of any adjustments to Annual Base Rent together with a statement of Expenses of operating the Building for the previous calendar year. Within thirty (30) days following receipt of the Statement, Tenant shall pay to Landlord: (a) the adjustment to Annual Base Rent for the 8 previous calendar year after credit for any estimated payments which Tenant has made pursuant to this section; and (b) an estimated adjustment to Annual Base Rent for the months which have elapsed in the current calendar year based on the previous calendar year's increase in Expenses and Landlord's good faith projection of the increase in Expenses during the current calendar year after credit for any estimated payments made by Tenant pursuant to this section. Commencing with the month following the month in which the Statement is dated and continuing until such time as Tenant receives Landlord's next Statement, the Monthly Base Rent Installments shall be adjusted to include Tenant's Pro Rata Share of any Expenses in excess of the Base Amount based on Landlord's good faith projection of Expenses for the current calendar year. The adjusted portion of the payments of Annual Base Rent shall be credited against the actual Expenses as shown in Landlord's next Statement. If the next Statement shows that Tenant has overpaid and if Tenant is not then in monetary default, Landlord shall credit such overpayment against the next accruing payments of Rent until the overpayment is reduced to zero (and at the expiration or earlier termination of the Lease, Landlord shall pay to Tenant any remaining portion of overpayment). The obligation to pay the adjustments to Annual Base Rent shall survive any termination of the Term. Notwithstanding anything contained in this Section 4.2, the Annual Base Rent payable by Tenant shall in no event at any time be less than the Annual Base Rent specified in Article 1 hereof. 4.3. Expenses. Expenses shall mean all expenses and costs of -------- administering, repairing, managing, replacing, and operating the Building incurred by Landlord, including, without limitation, the following costs: (a) wages of all employees at or below the grade of Building manager (including employment taxes and fringe benefits); (b) janitorial labor and materials; (c) costs of building security personnel and materials; (d) electricity, gas, sewer, water, trash disposal and other utilities; (e) maintenance and repairs (including maintenance and service contracts) ; (f) landscaping maintenance; (g) insurance premiums; (h) real estate and personal property taxes assessed on the Building and personal property of Landlord therein, including, without limitation, any decreases in taxes resulting from Landlord's obtaining real estate tax relief for the Building and any increases in real estate taxes resulting from the expiration of any real estate tax relief obtained for the Building, and further including any tax imposed as a substitute for or supplement to presently existing real estate and/or personal property taxes; (i) reasonable expenses of Landlord in attempting to reduce or limit real estate and/or personal property taxes (any refunds to be credited against taxes in the year received); (j) capital improvements to the extent necessary to comply with applicable governmental rules and regulations enacted after the Commencement Date, such costs to be amortized over a reasonable period of time in accordance with generally accepted accounting principles; (k) expense of building management fees not to exceed the market rate for similar buildings; and (l) capital expenses which reduce any component cost of Expenses (such cost to be reasonably amortized in accordance with generally accepted accounting principles by Landlord and Expenses to include only the cost as so amortized by Landlord during the calendar year for which such computation is made and not to exceed the reduction in Expenses resulting from such capital expense). Expenses shall not include: (u) advertising expense for the Building; (v) charges incurred by a tenant for work performed or services delivered to such tenant at the request of such tenant and not to all tenants of the Building; (w) costs of alterations of any tenant's premises; (x) principal and interest payments on loans made on the security of the Building; (y) costs of capital expenditures (except as provided above in this section); (z) leasing commissions; costs incurred to make major repairs or replacements of any defective initial construction of the Building and related appurtenances as determined by Landlord regardless of how such costs are characterized under generally accepted accounting principles; legal expenses incurred in connection with the preparation or negotiation of leases or other related documents with tenants or prospective tenants of the 9 Building, or in connection with disputes with any such tenants; costs of repairs or other work occasioned by fire or other casualty of an insurable nature or by means of eminent domain; costs for sculptures or other art; costs incurred in connection with the removal or cleanup of hazardous substances or materials from the Building or property; costs incurred in connection with renovating or otherwise improving or decorating space to be leased to tenants; any costs, fines or penalties incurred by reason of actual or alleged violations by Landlord of any governmental law or regulation. Actual Expenses, including the Base Amount, shall be adjusted by Landlord to reflect a ninety five (95) percent serviced and leased Building for the purpose of making the adjustment to Annual Base Rent, if the actual occupancy is less than ninety five percent (95%) for all or part of the year. Expenses shall not include cleaning, trash removal and janitorial service for the Assembly Space and Landlord shall reimburse Tenant for the actual cost incurred by Tenant in providing such service to the Assembly Space in an amount not to exceed $1.35 per rentable square foot in the Assembly Space and upon delivery of reasonable documentation supporting such cost. Tenant may request that Landlord provide such service to the Assembly Space, in which event Landlord shall do so, and in which event Expenses shall include such service to the Assembly Space. 4.4. Tenant's Pro Rata Share. As used herein Tenant's Pro Rata ----------------------- Share shall be a fraction, the numerator of which is the usable area of the Premises for the applicable portion of the Term and the denominator of which is the total usable area of the Building. The details of such computation and appropriate supporting data shall be furnished by Landlord in its first Statement to Tenant. 4.5. Calculation of Areas. The usable areas of the Premises and the -------------------- Building shall be computed using the standards of the Building Owners and Managers Association International current as of the date of this Lease. 4.6. Audit Rights. Tenant shall have the right, at Tenant's sole ------------ cost and expense, to audit Landlord's records of Expenses for the Building provided that all of the following criteria have been met: (1) no audit shall be conducted during the months of January, February or March of any calendar year (Tenant's auditor shall make an appointment with the Landlord's audit supervisor designated by Landlord. Landlord and Tenant shall reasonably cooperate to arrange a mutually acceptable time within sixty (60) days of Tenant's request. Notwithstanding the foregoing, Landlord shall not be required to accommodate Tenant's auditors if other tenants have scheduled audits prior to Tenant's request on the date proposed by Tenant); (2) before conducting any audit, Tenant must pay the full amount of Expenses billed and must not be in default of any other provision of this Lease; (3) Tenant may review only those records of Landlord that are specifically related to Expenses. (Without limiting the generality of the foregoing, Tenant may not review any other leases, cross easement agreements or Landlord's tax returns or financial statements.); (4) in conducting an audit, Tenant shall utilize an independent certified public accountant experienced in auditing office building records, subject to Landlord's reasonable prior approval; (5) the audit shall be conducted in St. Louis at a location determined by Landlord, which shall be, at Landlord's discretion, at the principal office of Landlord or its property manager; (6) upon receipt thereof, Tenant shall deliver to Landlord a copy of the audit report and all accompanying data; (7) Tenant shall keep confidential all agreements involving the rights provided in this section and the results of any audits conducted hereunder. (Notwithstanding the foregoing, Tenant shall be permitted to furnish the foregoing information to its auditors to the extent that this information is required to perform their audit services for Tenant but whom shall also agree with Landlord in writing to be bound to confidentiality as hereinabove provided.); (8) the audit shall be conducted in accordance 10 with generally accepted rules of auditing practices; (9) Tenant may not conduct an audit more often than once each calendar year; (10) Tenant may audit records with respect to each Lease Year only once; and (11) no audit shall cover a period of time in excess of the three (3) Lease Years immediately preceding the audit. If Tenant objects to Landlord's determination of Expenses, Tenant shall so advise Landlord, stating with specificity its reasons therefor. If Landlord and Tenant are unable, despite their good faith reasonable efforts, to agree upon the amount of Expenses, then, within thirty (30) days of Landlord's receipt of Tenant's objections thereto, either party may submit the matter to arbitration with a mutually acceptable third-party arbitration service. Tenant shall be entitled, upon three (5) days prior written notice, and during normal business hours at Landlord's office or such other place in the area in which the Building is located as Landlord may reasonably designate, to inspect and examine and/or have a reputable independent CPA or consultant selected by Tenant audit the books and records of Landlord relating to the determination of Expenses. If the audit discloses that the amount of Expenses billed to Tenant was incorrect, the appropriate party shall pay to the other party the deficiency or overpayment, as applicable. All costs and expenses of the audit shall be paid by Tenant unless the audit shows that Landlord overstated or understated Expenses for the subject calendar year by more than three percent (3%), in which case, Landlord shall pay all costs and expenses of the audit (not to exceed $2,000.00). Landlord shall maintain accurate and complete books and records evidencing Expenses for a period of not less than five (5) years after Landlord issues a statement for any calendar year. The books and records shall be located in the Building or another reasonable location in the area in which the Building is located. ARTICLE 5 - SECURITY DEPOSIT ---------------------------- Tenant concurrently with its execution of this Lease has deposited with Landlord the Security Deposit to be held to guarantee the faithful performance by Tenant of all of its obligations under this Lease. Any interest earned thereon shall be the property of Landlord. Unless and until Tenant is in default with respect to any provision hereof, the Security Deposit shall be the property of Tenant. If Tenant defaults with respect to any provision of this Lease, Landlord may expend the whole or any part of the Security Deposit for the payment of any amount which Landlord may expend by reason of such default. If any portion or all of the Security Deposit is so used, Tenant shall, within ten (10) days after demand therefor, deposit cash with Landlord in an amount sufficient to restore the security deposit to its original amount and failure to do so shall be a breach of this Lease. If Tenant shall not be in default under this Lease (beyond any applicable cure period), the Security Deposit shall be returned to Tenant at the end of the thirty sixth (36th) month after the Commencement Date. If Tenant is in default (beyond any applicable cure period as of such date), then Landlord shall hold the Security Deposit until the end of the Term and return to Tenant at the end of the Term any portion of the Security Deposit remaining after reimbursement to Landlord of any costs incurred due to any default; provided that Landlord may retain the Security Deposit (if not required to be released to Tenant after the 36th month) until such time as all amounts due from Tenant hereunder have been paid in full. In the event of a transfer of the Building, Landlord shall pay over the Security Deposit to Landlord's transferee to be held under the terms of this Lease and Landlord shall be released from all liability for the return of the Security Deposit. Under no circumstances shall the Security Deposit be interpreted as being part of the Rent. 11 ARTICLE 6 - PERMITTED USE ------------------------- Tenant shall use and occupy the Premises only for the Permitted Use. Tenant shall comply, and shall use reasonable good faith effort to cause all persons permitted by Tenant to come upon the Premises to comply, with the Building Rules and with such reasonable modifications thereof as may be made from time to time in accordance with the terms of this Lease. Landlord shall not be liable for any nonobservance of such rules by any other person, but Landlord shall take reasonable steps to enforce such observance. All deliveries to the Premises shall be subject to the reasonable control of Landlord as to place and time of deliveries. Tenant shall not make or permit to be made any use of the Premises which is forbidden by applicable law or governmental regulation or which may be unreasonably dangerous to persons or property or which may be in conflict with or invalidate or increase the premium cost of any policy of insurance carried on the Building. If Landlord permits a use of the Premises which would increase the cost of insurance coverage on the Premises and/or Building by Landlord (which permission Landlord may refuse to give in its sole discretion), as a condition to such permission Tenant shall pay all of such increase in the cost of insurance. ARTICLE 7 - SERVICES -------------------- 7.1. Standard Services. Landlord at its expense shall furnish: (a) ----------------- heat and air conditioning to provide a seasonable temperature (subject to governmental regulations) for Tenant's use of the Premises under normal business operations; (b) sewer/plumbing service and cold water from the public supply for drinking, lavatory and toilet purposes and hot water for kitchen and lavatory purposes from regular Building supply drawn through fixtures installed by Landlord; (c) janitor service and customary cleaning in and about the Office Space, Monday through Friday (holidays excepted) in accordance with the Schedule of Janitorial Services attached hereto as Exhibit G (Tenant shall not engage any janitor or cleaning services for the Office Space without Landlord's prior written consent); (d) passenger elevator service in common with other tenants at all times (freight elevator service will be made available by Landlord upon reasonable notice by Tenant); (e) window washing of all windows in the Premises, both inside and out, at reasonable intervals; (f) electrical service at those points of connection provided and installed by Landlord and in the manner and to the extent deemed by Landlord to be standard; and (g) natural gas. Landlord shall maintain and operate the Building consistent with other Class A office buildings within the St. Louis Greater Metropolitan Area. 7.2. Over standard Services. "Normal Business Hours" are from 7:00 ---------------------- A.M. to 7:00 P.M. on Mondays through Fridays, and from 7:00 A.M. to 1:00 P.M. on Saturdays. If Tenant occupies the Premises after Normal Business Hours, Tenant shall reimburse Landlord for the increased expenses of providing utilities and other services necessary to operate the Building during such hours, including but not limited to, increased expenses for heating, air conditioning, security service, Building employees, overtime and any unusual janitorial service. Normal electrical consumption on the Premises is as follows: (i) electricity drawn from Building standard receptacles and Building standard lighting: 4.0 watts per rentable square foot in the Premises per hour; and (ii) Building standard heating, ventilating and air conditioning electrical consumption: 4.0 watts per rentable square foot in the Premises per hour. No other tenant of the Building shall be given more power without charge. Landlord shall cause separate meter(s) to be installed, at Landlord's option and expense, to measure the electricity consumed in the Assembly Space and Tenant shall pay to Landlord as Additional Rent any electricity consumed in the Assembly Space in excess of normal electrical consumption as described in the immediately prior sentence. Any amount of electricity in excess of such amounts consumed on the Premises shall be paid for by Tenant. Landlord reserves 12 the right to hire a consulting utility engineer to determine consumption on the Premises or to install submeters to determine electrical consumption on the Premises at the expense of Landlord. A master meter if desired by Tenant may be installed at Tenant's expense. Landlord shall have access to such metering devices at all reasonable times and shall prepare a separate monthly statement of the utilities used by such equipment based on the utility rates established from time to time by the public utility furnishing such service. Tenant shall pay the amounts shown on such statements to Landlord within ten (10) days of receipt. Should Tenant fail to promptly pay for such service, Landlord may discontinue furnishing such service, which shall not be deemed an eviction (actual or constructive) or a disturbance of Tenant's possession, use and quiet enjoyment of the Premises. Tenant agrees that Landlord shall not be liable for damages resulting from such discontinuance, nor shall Tenant be relieved from the performance of any of its covenants or obligations under this Lease. Landlord, by furnishing any of the above services, shall not be deemed to have warranted the same to be free from any interruption or discontinuance that is beyond the reasonable control of the Landlord or which may result from occasional damage or malfunctions of equipment or distribution facilities. Any such interruption or discontinuance shall not constitute an eviction (actual or constructive) or a disturbance of Tenant's possession, use or quiet enjoyment of the Premises. Tenant agrees that Landlord shall not be liable for damages resulting from any such interruption or discontinuance, nor shall Tenant be relieved of the performance of any of its covenants or obligations under this Lease; provided, however, that if such interruption or discontinuance is within the reasonable control of Landlord and continues for more than 5 business days, then rent shall abate in proportion to the area of the Premises made unusable by such interruption until such service is restored. 7.3. Access to Premises. So long as no uncured default by Tenant ------------------ has occurred hereunder and subject to applicable laws and ordinances, Tenant shall be entitled to access and use the Premises on a twenty four (24) hours per day, seven (7) days per week, basis subject to such reasonable security provisions as may be promulgated by Landlord. ARTICLE 8 - SUBLETTING AND ASSIGNMENT ------------------------------------- 8.1. Subletting and Assignment Prohibited. Tenant shall not by ------------------------------------ operation of law or otherwise, without Landlord's prior written consent, which shall not be unreasonably withheld, conditioned or delayed so long as the proposed use conforms to the Permitted Use, have the right to assign, hypothecate, mortgage, encumber or convey this Lease or any interest in or under it, or to sublet, or otherwise permit occupancy by any other person or entity of all or any portion of the Premises. For the purposes of this section any transfer of an ownership interest in an entity tenant (other than an entity tenant whose stock is publicly traded) in which a transfer of control of the entity is effected shall be deemed to be an assignment of this Lease. Any document purporting to sublet the Premises or assign Tenant's interest in this Lease shall be of no force or effect unless the same shall bear the written consent of Landlord. No subtenant or assignee shall use the Premises for any purpose other than the Permitted Use. No permitted sublease or assignment shall in any way release Tenant from its primary liability under this Lease. If Tenant desires the consent of Landlord to sublease or assign, at least thirty (30) but no more than one hundred twenty (120) days prior to the date on which Tenant desires the assignment or sublease to be effective (the "Transfer Date") Tenant must submit the proposed sublease or assignment to Landlord for its approval, together with the following documents: (a) a detailed description of the portion of the Premises proposed to be sublet (which must be a single, self-contained unit comprised of not less than 3,000 rentable square feet (the "Space")); (b) a complete financial statement of the subtenant or assignee with an 13 authorization to verify the same; (c) a declaration by the subtenant or assignee as to the type of business to be carried out and the number of employees to occupy the Space; (d) payment of a $800.00 fee for processing of the sublease or assignment documents; (e) proof of payment of all leasing commissions, if applicable; and (f) executed lease estoppel certificates from Tenant and the proposed subtenant or assignee in the Building standard form. If Tenant is permitted to sublease or assign at a Base Rent in excess of that provided for herein, all of such excess shall be paid by Tenant to Landlord as received. Landlord shall not consent to an assignment of this Lease or a subletting of all or any portion of the Premises if (i) an uncured default by Tenant under this Lease shall exist or (ii) prior to the end of the fifth Lease Year only for a rent of less than $20.00 per rentable square foot if the Building is not 95% or more leased. Upon any assignment or subletting other than to a Tenant Affiliate or Qualified Assignee, the provisions of the last sentences of Sections 1.8 and 1.17 hereof shall lapse and become void and thereafter Landlord shall be obligated only to provide the number of parking spaces on the Property required by the formula contained in the first sentence of Section 1.17 hereof. 8.2. Option to Terminate. This section shall not apply to an ------------------- assignment or subletting to a Tenant Affiliate or a Qualified Assignee, or any subletting of less than 2,500 square feet to a subtenant having a business relationship with Tenant other than the sublease. If Tenant notifies Landlord of Tenant's desire to assign or sublet, Landlord shall have the option to terminate this Lease as to the entire Premises in the case of an assignment or as to the Space in the case of a sublease. Landlord may exercise such option on or before the expiration of twenty (20) days following Landlord's receipt of Tenant's notice of its desire to assign or sublet. Should Landlord exercise such option this Lease shall terminate as to the Space as of the Transfer Date as if such date were the expiration date of the Term. Within 10 business days after Tenant's receipt of Landlord's notice to exercise its option to terminate this Lease, Tenant may rescind its notice to assign or sublease. 8.3. Permitted Transfers. The consent of the Landlord need not be ------------------- obtained if the assignment or sublease does not change the use of the Premises and is to any present or future affiliate (including any wholly-owned subsidiary thereof) of Tenant, or to any unaffiliated new entities that may be formed by Tenant pursuant to a corporate reorganization or merger, including any subsidiary or affiliated entity thereof (collectively a "Tenant Affiliate"). Tenant shall give Landlord written notice of any assignment to a Tenant Affiliate, including the effective date of the assignment ("Effective Date"). No such sublease or assignment shall release Tenant from Tenant's liability under this Lease. Tenant shall not be required to obtain Landlord's consent to sell ownership interests in Tenant or to sell substantially all of the assets of Tenant (including the assignment of this Lease pursuant to such a sale) to another entity so long as the use of the Premises shall not change and the net worth of the transferee entity is equal to or better than that of Tenant as of the Commencement Date (a "Qualified Assignee"). Tenant on the Commencement Date shall provide Landlord with sufficient documentation evidencing the net worth of Tenant as of the Commencement Date. ARTICLE 9 - QUIET POSSESSION AND SUBORDINATION ---------------------------------------------- Landlord covenants and agrees with Tenant that so long as Tenant is not in default hereunder beyond any applicable notice and cure periods, Tenant shall peaceably and quietly enjoy the Premises through the Term without hindrance or molestation by anyone claiming through or under Landlord, subject, however, to the terms of this Lease. This Lease shall be made subject and 14 subordinate to all present financial encumbrances on the Building by execution by Landlord, Tenant and the holder of any deed of trust on the Building of a Subordination Non-Disturbance and Attornment Agreement ("SNDA") substantially in the form attached hereto as Exhibit F, which Landlord and Tenant agree to execute and deliver. Landlord, within ninety (90) days following the Commencement Date (or within sixty (60) days following execution thereof, if earlier), shall obtain execution of the SNDA by the holder of any deed of trust on the Building, shall cause the SNDA to be recorded in the land records of St. Louis City, Missouri, and shall deliver a copy of the recorded SNDA to Tenant. Thereafter, upon the request of Landlord, Tenant agrees to execute additional SNDAs with future lenders to Landlord on the condition that such SNDAs are substantially in the form of the SNDA attached hereto. ARTICLE 10 - LANDLORD'S RESERVED RIGHTS --------------------------------------- Landlord reserves the following rights: (a) to change the name or street address of the Building; (b) to maintain signs on the exterior of the Building so long as such signs do not block the view from the Premises; (c) to designate or approve (not to be unreasonably withheld) all sources furnishing Building related services to tenants; (d) during the Term (if Tenant has as uncured default) to display "for rent" signs on and exhibit and otherwise prepare the Premises for reoccupancy; (e) to retain passkeys to all doors within and into the Premises; (f) during the last 180 days of the Term to exhibit the Premises to prospective lessees; (g) to grant to anyone the exclusive right to conduct any particular business in the Building; (h) to close the Building on legal holidays and to effect such reasonable security measures as Landlord may deem appropriate and in the best interests of the Building and tenants; subject, however, to Tenant's right to admittance under such reasonable security regulations as Landlord may prescribe from time to time; (i) to approve the weight, size and location of safes or other heavy objects, which objects may be moved in, about or out of the Building or Premises only at such times and in such manner as Landlord shall direct, and in all events at Tenant's sole risk and responsibility; (j) to exclude from the Building all disorderly persons, persons under the influence of alcohol or a controlled substance, idlers and peddlers, solicitors, and persons entering in crowds or in such unusual numbers as to cause inconvenience to the tenants of the Building; and (k) to take any and all measures necessary or desirable for the operation, safety, protection or preservation of the Building, including repairs, alterations, decorations, additions or improvements, whether structural or otherwise, in and about the Building or any part thereof, and during the continuance of any such work to temporarily close doors, entry ways, public spaces and corridors in the Building and to interrupt or temporarily suspend Building services or facilities. Landlord may enter upon the Premises and may exercise any or all of the foregoing rights without being deemed guilty of an eviction (actual or constructive) or disturbance of Tenant's use or possession and without being liable in any manner to Tenant and without abatement of Rent or affecting of Tenant's obligations hereunder; provided, however, that Landlord shall at all times in exercising its rights under this Article 10 exercise its best efforts to minimize any disruption to the operation of Tenant's business. ARTICLE 11 - ALTERATIONS AND IMPROVEMENTS ----------------------------------------- Tenant shall not, without the prior written consent of Landlord, make any structural, electrical, mechanical or plumbing alterations, improvements or additions to the Premises (hereinafter referred to as a "Change"). If Landlord consents to a Change it may impose such conditions with respect thereto as Landlord reasonably deems appropriate, including without limitation, requiring Tenant to furnish insurance against liabilities which may arise out of such work 15 and the plans and specifications together with all necessary permits for such Change. The work necessary to make the Change shall be done at Tenant's expense by employees or contractors reasonably approved by Landlord and compatible with the employees then working in the Building. Tenant shall promptly pay, when due, the cost of all such work and of all decorating required by reason thereof. Tenant shall also pay to Landlord an amount sufficient to reimburse Landlord for all actual, out of pocket expenses arising from Landlord's involvement with such work. Upon completion of such work, Tenant shall deliver to Landlord, if payment is made directly to contractors, evidence of payment, contractors affidavits and full and final waivers of all liens for labor, services or materials. Tenant shall defend and hold Landlord and the Building harmless from all costs, damages and liens and expenses related to such work. In connection with such work Tenant shall never be deemed an agent of Landlord. All work done by Tenant or its contractors shall be done in a first class workmanlike manner using only good grades of materials and shall comply with all applicable codes, rules and regulations, union and insurance requirements. Any Change shall (without compensation to Tenant) become Landlord's property at the termination of the Term, and shall, unless Landlord conditions Landlord's consent to the Change upon the removal of the Change at the termination or expiration of this Lease, be relinquished to Landlord in good condition, ordinary wear excepted. ARTICLE 12 - REPAIRS AND REPLACEMENTS ------------------------------------- Landlord, at its expense, shall maintain and keep in good condition (similar to other Class A office buildings) the Premises and Building, except for damage to the Premises or Building caused by acts or omissions of Tenant, its agents, employees, contractors, guests or invitees, in which event (subject to the provisions of Section 19.2 hereof) Tenant will bear the cost of such maintenance, repair or replacement to the extent not covered by Landlord's insurance, and Landlord shall cause the Building to comply with all applicable laws and regulations, including, without limitation, the Americans with Disability Act. Tenant, at its expense, shall keep the Premises in a safe and tenantable condition and in first class order and appearance and shall cause the Premises to comply with all applicable laws, codes and ordinances relating to Tenant's particular use of the Premises, including, without limitation, the Americans with Disabilities Act. If Tenant does not do so (after notice to Tenant and a reasonable opportunity to cure) Landlord may (but need not) restore the Premises to a safe and tenantable condition, and Tenant shall pay the cost thereof forthwith upon being billed by Landlord. This section shall not apply to damage or destruction and condemnation proceedings otherwise provided for in this Lease. ARTICLE 13 - DESTRUCTION OR DAMAGE ---------------------------------- If a substantial portion of the Premises or the Building be rendered untenantable, inaccessible or unsafe by fire or other casualty, and if it is reasonably anticipated that even though undertaken and pursued with all due diligence it will require more than six (6) months to repair the damaged area from the date of the casualty, or if the Building or Premises are damaged by an uninsured casualty either Landlord or Tenant may terminate this Lease as of the date of such casualty by written notice to the other party given within sixty (60) days after such occurrence. If neither party elects to terminate this Lease, Landlord shall proceed with all due diligence to repair the damaged area at Landlord's expense to substantially the same condition as existed immediately prior to the casualty, and the Rent shall equitably abate until the Premises are fully restored. If the Premises are not fully restored within 60 days after the period of time reasonably anticipated by Landlord to be required to repair the Premises, then Tenant shall have the right to terminate this 16 Lease by providing Landlord with 30 days prior written notice. If the Premises are not repaired within such 30 day period, this Lease shall terminate. If this Lease is terminated pursuant to this section, Rent shall be apportioned on a per diem basis and paid to the date of the casualty. If the Premises are partially damaged by fire or other casualty but are not rendered substantially untenantable, then Landlord shall proceed with all due diligence to repair the Premises and the Rent shall equitably abate until the Premises are fully restored. ARTICLE 14 - EMINENT DOMAIN --------------------------- If the whole of the Building or the whole of the Premises shall be taken by the exercise of the power of eminent domain or pursuant to any transfer in lieu of the exercise of such power (hereinafter called a "Condemnation Proceeding") then this Lease shall terminate as of the date of the taking of possession by or the vesting of title in the condemning authority (such date being hereinafter called the "Taking Date"). If less than the whole of the Building or less than the whole of the Premises shall be taken in a Condemnation Proceeding, Tenant may at its option terminate this Lease as of the Taking Date by giving notice of its exercise of such option within sixty (60) days after the Taking Date, provided that as a result of such taking the Premises (or the remaining portion thereof) may no longer be adequately used for the Permitted Use. If a portion of the Premises shall be taken and Tenant shall not exercise its option to terminate this Lease or if such taking shall not give rise to such option to terminate, then this Lease shall terminate on the Taking Date only as to that portion of the Premises so taken but shall remain in full force and effect with respect to that portion of the Premises not so taken, Landlord shall diligently pursue to completion the repair of the remaining Premises to be operable as a single unit, and the Rent and other charges payable by Tenant hereunder shall be reduced in the ratio in which the diminution of the rentable square footage of the Premises following the Taking Date shall bear to the rentable square footage thereof immediately prior to such Taking Date. Except as otherwise ordered by the court in a Condemnation Proceeding, all income, rent, awards or interest derived from any Condemnation Proceeding shall belong to and be the property of Landlord; provided, however, Tenant shall be entitled to pursue a separate award for its moving expenses, loss of business or goodwill and loss of personal property. ARTICLE 15 - HOLDING OVER ------------------------- If Tenant without the consent of Landlord retains possession of the Premises or any part thereof after termination of the Term, Tenant shall pay to Landlord Rent at a rate equal to one hundred thirty seven percent (137%) of the rate payable for the month immediately preceding the commencement of said holding over computed on a per month basis for each month or part thereof (without reduction for any partial month) that Tenant remains in possession, and in addition thereto, Tenant shall pay Landlord all direct and consequential damages sustained by reason of Tenant's retention of possession. Such retention of possession shall constitute a tenancy at sufferance on a month-to-month basis, terminable in accordance with law. ARTICLE 16 - SURRENDER OF POSSESSION ------------------------------------ Upon the termination of the Term Tenant shall immediately surrender the Premises (together with any Changes) to Landlord in good order, repair and condition, ordinary wear and casualty losses for which Tenant is not responsible excepted, and shall remove all office furniture and equipment, trade fixtures and other items of Tenant's property on the Premises. Tenant shall 17 pay Landlord upon demand the cost of repairing any damage to the Premises and to the Building caused by any such removal. If Tenant fails or refuses to remove any such property from the Premises, Tenant shall be conclusively presumed to have abandoned the same and Landlord may dispose of the same without incurring any liability therefor and Tenant shall reimburse Landlord for the cost of such disposition. The provisions of this article shall survive the expiration or earlier termination of this Lease. ARTICLE 17 - DEFAULT AND REMEDIES --------------------------------- If Tenant shall default in the payment of any installment of the Rent or in the payment of any other sum required to be paid by Tenant under this Lease and such default shall continue for five (5) days after written notice to Tenant that such payment is past due (provided that such notice need be given only once in any twelve (12) month period during the Term), or if Tenant shall default in the observance or performance of any of the other covenants or conditions in this Lease which Tenant is required to observe or perform and such default shall continue for thirty (30) days after written notice to Tenant (or such longer period of time as may be reasonably required to effectuate the cure provided Tenant has commenced the cure within such 30 day period and diligently prosecutes the same to completion), or if the interest of Tenant in this Lease shall be levied upon under execution or other legal process, or if any voluntary petition in bankruptcy or for corporate reorganization or any similar relief shall be filed by Tenant, or if any involuntary petition in bankruptcy shall be filed against Tenant under any federal or state bankruptcy or insolvency act and shall not have been dismissed within ninety (90) days following the filing thereof, or if a receiver shall be appointed for Tenant or any of the property of Tenant by any court and such receiver shall not be dismissed within ninety (90) days from the date of appointment, or within three (3) years following the Commencement Date the Premises are abandoned or vacant (for a period of more than 90 days) for a cause other than a casualty, or if Tenant shall make an assignment for the benefit of creditors, then Landlord may treat the occurrence of any one or more of the foregoing events as a breach of this Lease and thereupon at its option may, without notice or demand of any kind to Tenant or any other person, exercise one or more of the following described remedies, in addition to all other rights and remedies provided at law or in equity: (a) Landlord may terminate this Lease, in which event Landlord may immediately repossess the Premises and be entitled to recover, in addition to any other sums or damages for which Tenant may be liable to Landlord, as damages, an amount, if any, equal to the Rent which would have been payable during any period of rent-free occupancy provided to Tenant by this Lease, the cost of all leasing commissions paid by Landlord in connection with this Lease, the cost to Landlord of the initial leasehold improvements to the Premises, and all other amounts paid to or on behalf of Tenant in connection with Tenant's entry into this Lease and occupancy of the Premises (including without limitation any moving cost allowance, payments on lease(s) assumed by Landlord, payment for preparation of floor plans and the like), including Landlord's interest expense thereon, all of which amounts shall be amortized over the term of the Lease, and Tenant shall only be responsible for the portion which has not yet amortized at the time of termination, together with a sum of money equal to the excess of the Rent provided to be paid by Tenant for the balance of the Term over the fair market rental value of the Premises, after deduction of all reasonably anticipated expenses of reletting for said period. Should the fair market rental value of the Premises after deduction of all anticipated expenses of reletting for the balance of the then existing Term exceed the Rent to be paid by Tenant for the balance of the Term, Landlord 18 shall have no obligation to pay to Tenant the excess or any part thereof or to credit such excess or any part thereof against any other sums or damages for which Tenant may be liable to Landlord. (b) Landlord may terminate Tenant's right of possession and may repossess the Premises by forcible entry (to the extent permitted by law) or unlawful detainer suit, by taking peaceful possession, or otherwise without terminating this Lease, in which event Landlord shall exercise its reasonable efforts to relet the same for the account of Tenant, for such rent and upon such terms as shall be reasonably satisfactory to Landlord. For the purpose of such reletting, Landlord is authorized to decorate, repair, remodel or alter the Premises. If Landlord shall fail to relet the Premises, Tenant shall pay to Landlord a sum equal to the amount of the Rent due for each month as the same becomes due and payable for the balance of the Term. If the Premises are relet and a sufficient sum shall not be realized from such reletting after payment of the reasonable costs and expenses of all decoration, repairs, remodeling, alterations and additions and the expenses of such reletting (including broker's fees) (provided, however, that such costs and expenses shall be amortized over the term of any new lease of the Premises, and Tenant shall only be responsible for the portion amortizing during the remainder of the Lease Term) to satisfy the Rent provided for in this Lease and the amounts recoverable by Landlord from Tenant pursuant to subparagraph (a) of this paragraph, Tenant shall satisfy and pay the same upon demand therefor from time to time. Landlord may file suit to recover any sums falling due from time to time and no suit or recovery of any portion due Landlord hereunder shall be any defense to any subsequent action brought for any amount not previously reduced to judgment in favor of Landlord. Landlord shall use reasonable efforts to mitigate its damages upon a default by Tenant. No waiver of any default by Tenant shall be implied from any omission by Landlord to take any action on account of said default if such default persists or shall be repeated, and no express waiver shall affect any default other than the default specified in the express waiver and then only for the time and to the extent therein stated. No failure of Landlord to exercise any power given Landlord hereunder or to insist upon strict compliance with any obligation hereunder and no custom or practice of the parties at variance with the terms hereof shall constitute a waiver of Landlord's right to demand exact compliance with the terms hereof. The provisions of this section shall survive any termination of this Lease. ARTICLE 18 - BANKRUPTCY ----------------------- If a petition is filed by or against Tenant for relief under Title 11 of the United States Code, as amended (the "Bankruptcy Code"), and Tenant (including for purposes of this section Tenant's successor in bankruptcy, whether a trustee or Tenant as debtor in possession) assumes and proposes to assign, or proposes to assume and assign, this Lease pursuant to the provisions of the Bankruptcy Code to any person or entity who has made or accepted a bona fide offer to accept an assignment of this Lease on the terms acceptable to Tenant, then notice of the proposed assignment setting forth (a) the name and address of the proposed assignee, (b) all of the terms and conditions of the offer and proposed assignment, and (c) the adequate assurance to be furnished by the proposed assignee of its future performance under this Lease, shall be given to Landlord by Tenant no later than twenty (20) days after Tenant has made or received such offer, but in no event later than ten (10) days prior to the date on which Tenant applies to a court of competent jurisdiction for authority and 19 approval to enter into the proposed assignment. Landlord shall have the prior right and option, to be exercised by notice to Tenant given at any time prior to the date on which the court order authorizing such assignment becomes final and non-appealable, to take an assignment of this Lease upon the same terms and conditions, and for the same consideration, if any, as the proposed assignee, less any brokerage commission which may otherwise be payable out of the consideration to be paid by the proposed assignee for the assignment of this Lease. If this Lease is assigned pursuant to the provisions of the Bankruptcy Code, Landlord: (i) may require from the assignee a deposit or other security for the performance of its obligations under this Lease in an amount substantially the same as would have been required by Landlord upon the initial leasing to a tenant similar to the assignee; and (ii) shall be entitled to receive as additional Rent, any amounts received by Tenant in connection with such assignment. Any person or entity to which this Lease is assigned pursuant to the provisions of the Bankruptcy Code shall be deemed without further act or documentation to have assumed all of the Tenant's obligations arising under this Lease on and after the date of such assignment. Any such assignee shall upon demand execute and deliver to Landlord an instrument confirming such assumption. No provision of this Lease shall be deemed a waiver of Landlord's rights or remedies under the Bankruptcy Code to oppose any assumption and/or assignment of this Lease, or to regain possession of the Premises if this Lease has neither been assumed nor rejected within sixty (60) days after the date of the order for relief or within such additional time as a court of competent jurisdiction may have fixed. Notwithstanding anything in this Lease to the contrary, all amounts payable by Tenant to or on behalf of Landlord under this Lease, whether or not expressly denominated as rent, shall constitute rent for the purposes of Section 502 (b) (6) of the Bankruptcy Code. ARTICLE 19 - INSURANCE AND WAIVER OF RECOVERY --------------------------------------------- 19.1. Tenant's Insurance. Tenant shall at all times during the Term ------------------ maintain in full force and effect with respect to the Premises public liability insurance having the limits set forth in Article 1 hereof, and workmen's compensation and employer's liability insurance in form and amount required by law, each in the standard form generally of use in the State of Missouri in a company reasonably satisfactory to Landlord. Such insurance shall be subject to modification or cancellation only upon thirty (30) days notice to each certificate holder. Tenant, at or prior to the Commencement Date, and thereafter not less than five (5) days prior to the expiration of any such policy, shall furnish Landlord with a certificate of insurance in such coverage, such certificate to be in a form reasonably acceptable to Landlord and any mortgagee of the Building and, at the request of Landlord, to name Landlord and any such mortgagee as an additional insured as their interests may appear (or in the case of a mortgagee, by means of a standard mortgagee endorsement) . Tenant shall pay to Landlord any increase in the cost of Landlord's insurance attributable to Tenant's use of the Premises. The insurance required above may be carried under blanket or umbrella type coverage. All insurance required by this Section 19.1 shall be with an insurance company licensed to do business in the State where the Premises are located with a general policyholder's rating of not less than "A-" and a financing rating of not less than Class "VIII", as rated by the most current available "Bests" Insurance Reports, and shall be primary and non-contributing. 19.2. Landlord's Insurance. Landlord shall at all times during the -------------------- Term maintain in full force and effect (i) with respect to the Building (other than the Premises) public liability insurance having a limit of not less than $2,000,000 insuring Landlord and Tenant against claims for personal injury and death, (ii) all-risk insurance, with vandalism and earthquake coverage, on the Building in an amount equal to one hundred percent (100%) of the full replacement cost of the Building 20 (exclusive of footings and foundations), and (iii) workmen's compensation and employer's liability insurance in form and amount required by law, each in the standard form generally of use in the State of Missouri. Upon request, Landlord shall furnish Tenant with a certificate of insurance in such coverage. The insurance required above may be carried under blanket or umbrella type coverage. All insurance required by this Section 19.2 shall be with an insurance company licensed to do business in the State where the Premises are located with a general policyholder's rating of not less than "A-" and a financing rating of not less than Class "VIII", as rated by the most current available "Bests" Insurance Reports, and shall be primary and non-contributing. 19.3 Mutual Waiver of Recovery. Landlord and Tenant hereby mutually ------------------------- waive any and all rights of recovery against one another based upon the negligence of either Landlord or Tenant or their agents or employees for real or personal property loss or damage occurring to the Premises or to the Building or any part thereof or any personal property located therein from perils which are able to be insured against in standard fire and extended coverage, vandalism and malicious mischief and sprinkler leakage insurance contracts (commonly referred to as "All Risk") issued in the State of Missouri (whether or not such insurance actually is carried). Landlord and Tenant shall request their insurance carriers to consent to a waiver of all rights of subrogation against each other by inclusion of such a clause in their respective policies or by endorsements thereto. Subject to the foregoing waiver, Tenant shall defend and indemnify Landlord and save it harmless from and against any and all claims against Landlord arising from (a) Tenant's use of the Premises or the conduct of its business or from any activity, work or thing done, permitted or suffered by Tenant in or about the Premises or Building, (b) the nonperformance of any covenant or agreement on Tenant's part to be performed pursuant to the terms of this Lease or (c) any willful act or negligence of Tenant or of any of its agents, contractors, employees, invitees or licensees, and from and against all costs, reasonable counsel fees, expenses and liabilities incurred in any such claim or in any action or proceeding brought thereon; and in case any action or proceeding be brought against Landlord by reason of any such claim, Tenant upon notice from Landlord, covenants to resist or defend at Tenant's expense such action or proceeding by counsel reasonably satisfactory to Landlord; provided that the foregoing provision shall not be construed to make Tenant responsible for loss, damage, liability or defense resulting from (i) Landlord's negligence or willful misconduct, or that of its employees, agents or contractors, or (ii) injuries to third parties caused solely by the negligence of Landlord or its contractors, licensees, employees, guests and invitees. Subject to the foregoing waiver, Landlord shall defend and indemnify Tenant and save it harmless from and against any and all claims against Tenant arising from (a) Landlord's use of the Building or the conduct of its business or from any activity, work or thing done, permitted or suffered by Landlord in or about the Building, (b) the nonperformance of any covenant or agreement on Landlord's part to be performed pursuant to the terms of this Lease or (c) any willful act or negligence of Landlord or of any of its agents, contractors, employees, invitees or licensees, and from and against all costs, reasonable counsel fees, expenses and liabilities incurred in any such claim or in any action or proceeding brought thereon; and in case any action or proceeding be brought against Tenant by reason of any such claim, Landlord upon notice from Tenant, covenants to resist or defend at Landlord's expense such action or proceeding by counsel reasonably satisfactory to Tenant; provided that the foregoing provision shall not be construed to make Landlord responsible for loss, damage, liability or defense resulting from (i) Tenant's negligence or willful misconduct, or that of its employees, agents or contractors, or (ii) injuries to third parties caused solely by the negligence of Tenant or its contractors, licensees, employees, guests and invitees. 21 It is expressly understood and agreed that none of Landlord's covenants, undertakings and agreements under this Lease are made or intended as personal covenants, undertakings or agreements by Landlord, and any liability for damage or breach or nonperformance by Landlord shall be collectible only out of Landlord's interest in the Building (including the rents derived therefrom), and no personal liability is assumed by or at any time may be asserted against Landlord. ARTICLE 20 - TAXES ON TENANT'S PROPERTY --------------------------------------- If the leasehold improvements in the Premises, whether installed and/or paid for by Landlord or Tenant and whether or not affixed to the real property so as to become a part thereof, are assessed for real property tax purposes at a valuation higher than the valuation at which leasehold improvements conforming to Landlord's building standard work in other space in the Building are assessed, then the real property taxes and assessments levied against Landlord or the property by reason of such excess assessed valuation shall be deemed to be taxes levied against personal property of Tenant and shall be payable by Tenant. If the records of the City Assessor are available and sufficiently detailed to serve as a basis for determining whether said leasehold improvements are assessed at a higher valuation than Landlord's building standard work, such records shall be binding on both Landlord and Tenant. If the records of the City Assessor are not available or sufficiently detailed to serve as a basis for making said determination, the actual cost of construction shall be used. ARTICLE 21 - MISCELLANEOUS -------------------------- 21.1. Expenses. In the event either party institutes legal -------- proceedings against the other for breach of or interpretation of any of the terms, conditions or covenants of this Lease, the party against whom a judgment is entered shall pay all reasonable costs and expenses relative thereto, including reasonable attorneys' fees of the prevailing party. In order to secure the payment of Rent hereunder and all of Tenant's other obligations hereunder, Landlord shall and does have a first lien upon any rents from any permitted subtenant of Tenant. 21.2. Late Payments. All amounts due Landlord under this Lease ------------- shall be considered past due for the purposes hereof on the fifth day after the due date and shall bear interest from such date until paid at an annual rate equal to four percent (4%) in excess of the then publicly announced Prime Rate of the United States money center banks (as published in the Wall Street Journal or a successor publication), which rate shall change as and when such Prime Rate shall be changed by such banks or the highest lawful rate, whichever is less. 21.3. Notices. Any notice or other communication which either party ------- is required or desires to give to the other party shall be in writing and shall be given personally against signed receipt or by United States registered or certified mail, postage prepaid, return receipt requested, or by overnight courier such as Federal Express, addressed to the respective addresses of the parties set forth in Article 1 hereof. Any such notice or other communication shall be deemed to have been delivered on the earlier to occur of the date of receipt or the date of first attempt to deliver, as shown by the records of the carrier. Either party may change its address for notices by notice to the other party in the manner provided in this section. 21.4. Transfer by Landlord. Landlord has the right to transfer its -------------------- interest in the Building and in this Lease, and upon any such transfer Landlord shall automatically be released from all 22 liability under this Lease arising after the date of such transfer, and Tenant shall look solely to such transferee for the performance of Landlord's obligations hereunder from and after the date of such transfer. Landlord may assign its interest in this Lease to a mortgage lender as additional security provided that such assignment shall not release Landlord from its obligations hereunder and Tenant shall continue to look solely to Landlord for the performance of Landlord's obligations hereunder. 21.5. Binding Effect, Etc. This Lease, together with the Exhibits ------------------- referenced in Article 1, constitutes the entire agreement between the parties with respect to the subject matter hereof, may be amended only in a writing signed by the parties, and shall be binding upon the parties hereto and their respective heirs, personal representatives, executors, successors and permitted assigns, as the case may be. Headings and captions contained in this Lease are for convenience of reference only. All terms used in this Lease shall be deemed to refer to the masculine, feminine, neuter, singular or plural, as the context may require. This Lease shall be governed by and enforced in accordance with the laws of the State of Missouri. The invalidity or unenforceability of any provision of this Lease shall not affect or impair any other provision. 21.6. Brokers. Each of the parties hereto warrants to the other ------- that it has not obligated the other party for any finders', brokers' or other agents' fees in connection with this Lease and Tenant shall indemnify and hold Landlord harmless from and against any and all claims for such fees alleged to have been incurred by Tenant. 21.7. Estoppel Certificate. Tenant from time to time, upon not less -------------------- than ten (10) business days prior written request by Landlord, will promptly deliver to Landlord a duly executed and completed Lease Estoppel Certificate substantially in the form attached hereto as Exhibit E. Landlord, upon not less than twenty (20) days prior written request from Tenant, shall furnish a statement in writing to Tenant covering the matters set forth in Exhibit E, to the extent applicable to Landlord. 21.8. Memorandum of Lease. At the request of either Landlord or ------------------- Tenant the parties shall execute and the requesting party may at its expense record a Memorandum of Lease substantially in the form of that attached hereto as Exhibit H. 21.9. Force Majeure. Any prevention, delay or stoppage due to ------------- strikes, lockouts, labor disputes, acts of God, inability to obtain labor or materials, governmental restrictions, regulations or controls (other than delays which could or should have been anticipated or expected), enemy or hostile government action, civil commotion, terrorism, fire or other casualty or other causes beyond the reasonable control of the party required to perform shall excuse the performance by such party for a period equal to any such prevention, delay or stoppage, except for the obligations imposed with regard to Rent and other charges to be paid pursuant to this Lease (unless otherwise provided in this Lease), and the obligation of Landlord to deliver the Premises by December 1, 2005. 21.10. Termination. This Lease may be terminated only in accordance ----------- with its terms, and no unilateral termination by Tenant or voluntary surrender of this Lease by Tenant shall be effective unless such termination or surrender shall be accepted by Landlord in writing. 21.11. Relationship. Nothing contained in this Lease shall be ------------ deemed to constitute or be construed to create any relationship between Landlord and Tenant other than that of lessor and lessee. 23 21.12. Corporate Authority. Tenant hereby covenants and warrants ------------------- that (a) it is duly authorized to do business in the State of Missouri; (b) the person executing this Lease on behalf of Tenant is an officer of Tenant duly authorized by Tenant to sign and execute this Lease on its behalf; and (c) this Lease is a valid and binding obligation of Tenant, enforceable in accordance with its terms. 21.13. No Offer. Submission of the form of this Lease for -------- examination shall not bind Landlord in any manner, and no lease or other obligation of Landlord shall arise until this instrument is signed by both Landlord and Tenant and delivery is made to each party. 21.14. No Air Rights. No rights to any view or to light or air over ------------- any property, whether belonging to Landlord or any other person, are granted to Tenant by this Lease. 21.15. Lender Requirements. If a lender requires as a condition to ------------------- its lending funds, the repayment of which is to be secured by a financial encumbrance on the Building, that certain modifications be made to this Lease, which modifications will not require Tenant to pay any additional amounts or otherwise materially change the rights or obligations of Tenant hereunder, Tenant shall, upon Landlord's reasonable request, execute appropriate instruments effecting such modifications. 21.16. Application of Payments. Landlord shall have the right to ----------------------- apply payments received from Tenant pursuant to this Lease (regardless of Tenant's designation of such payments) to satisfy obligations of Tenant hereunder in such order and amounts as Landlord in its sole discretion may elect. 21.17. Parking. Landlord shall make available for Tenant's use in ------- the parking area described in Section 1.16 hereof on the basis set forth in Section 1.16 the number of parking spaces as set forth in Section 1.16 hereof. Landlord reserves the right to close, rearrange or relocate the parking area on notice to Tenant so long as at least one hundred (100) parking spaces are available exclusively to Tenant at all times on the Property. Landlord will make visitor parking on the Property available for use by visitors to the Building in areas designated by Landlord from time to time at no charge to Tenant or any approved visitors. Landlord may from time to time publish reasonable rules pertaining to the use of the parking areas and Tenant shall be responsible for enforcing compliance with such rules by Tenant's employees, agents, contractors and visitors. Landlord may revoke Tenant's parking privileges in the event of noncompliance with such rules after written notice of such noncompliance is given to Tenant, a reasonable cure period is afforded, and such noncompliance persists. All parking spaces shall be used only for the personal automobiles of Tenant and its employees and guests (no commercial trucks, motor homes and the like). Overnight parking is not permitted without in each case Landlord's prior consent. Upon Landlord's request, Tenant promptly shall furnish Landlord the names, vehicle descriptions and vehicle license numbers of each authorized user of Tenant's parking spaces. Tenant shall be liable for all costs and expenses suffered or incurred by Landlord in the towing of illegally parked vehicles of Tenant, its employees, agents, contractors or guests. 21.18. Damage to Property. Notwithstanding any other provision ------------------ hereof to the contrary, Landlord or its agents shall not be liable for any damage to property entrusted to employees or agents of Landlord, nor for loss of or damage to any property by theft or otherwise, nor for any 24 injury or damage to persons or property resulting from fire, explosion, falling plaster, steam, gas, electricity, water or rain which may leak from any part of the Building or from the pipes, appliances or plumbing works therein or from the roof, street or sub-surface or from any other place or resulting from dampness or any other cause whatsoever, except to the extent caused by the negligence or willful misconduct of Landlord. Landlord or its agents shall not be liable for interference with the light or other incorporeal hereditaments, nor shall Landlord be liable for any latent defect in the Premises or in the Building; provided, however, that Landlord shall repair, at its cost, any latent defects discovered by Landlord or Tenant before or within two (2) years following the Commencement Date. Tenant shall give prompt notice to Landlord in case of fire or accidents in the Premises or in the Building or of defects therein or in the fixtures or equipment. In no event shall Landlord be liable for any consequential damages based on or resulting from any act or omission of Landlord relative to this Lease and its obligations under this Lease. Tenant assumes responsibility for taking reasonable and necessary measures to protect its property from theft, robbery and pilferage. 21.19. Confidentiality. The terms and conditions of this Lease may --------------- not be disclosed by Tenant to third parties without the prior written consent of Landlord, except attorneys, accountants and other financial advisors, as well as lenders, investors or prospective lenders or investors who agree to keep the terms confidential. 21.20. Signage. Nothing shall be displayed, painted or affixed by ------- Tenant on any part of the exterior or interior of the Building (except within the Premises) without the prior consent of Landlord, and then only of such color, size, style and material as shall be approved by Landlord. Nothing shall be placed in the Premises which may be visible from the exterior of the Building or other premises within the Building (including window treatments) without the prior written consent of Landlord. Landlord shall prescribe standard Building signage design specifications for all tenant entry doors and Tenant shall pay for, use and remove at the expiration or termination of this Lease such signage. Tenant shall pay for the proper removal of such signage (and any other signage identifying Tenant permitted by Landlord) and for the cost of the restoration of the affected area. Landlord shall provide to Tenant at Tenant's expense significant signage on the exterior of the Building in such form as Landlord and Tenant shall mutually approve, such approval not to be unreasonably withheld, delayed or conditioned. 21.21. Locks. No additional or replacement locks or other security ----- devices shall be placed on any door of the Premises without the prior written consent of Landlord, which shall not be unreasonably withheld, and Tenant shall not permit duplicate keys or entry devices to be made. Additional keys and/or entry devices shall be procured from Landlord and paid for by Tenant. Tenant shall be solely responsible for the security of keys and/or other entry devices to the Premises. All keys and/or entry devices furnished to Tenant shall be surrendered to Landlord at the termination of the Term. 21.22. Notice to Lender. In the event of any default on the part of ---------------- Landlord, Tenant shall give notice by certified mail to any holder of a financial encumbrance covering the Building, whose address shall have been furnished to Tenant, and shall offer such holder a reasonable opportunity to cure the default, including time to obtain possession of the Building, by power of sale or a judicial foreclosure, if such should prove necessary to effect a cure. 25 21.23. Time. Time is of the essence with respect to the performance ---- and observance of all of the terms, covenants and conditions hereof. ARTICLE 22 - ENVIRONMENTAL LEASE PROVISIONS ------------------------------------------- 22.1. Compliance with Laws. Tenant represents and warrants that it -------------------- will comply with all federal, state, and local environmental, safety and health laws, statutes, ordinances, regulations, rules, guidances, and orders (the "Environmental Laws") and will maintain all necessary permits, approvals, and licenses and has made all necessary registrations and notifications in connection with the operation of the Premises. 22.2. Restriction on Certain Uses. Tenant shall not cause or permit --------------------------- the Premises to be used for any business or activity involving the generation, storage, use, treatment, transportation, disposal or distribution of any pollutant, contaminant, hazardous substance or material, hazardous chemical, toxic substance, hazardous waste, infectious or medical waste (including but not limited to those types of medical wastes identified in 42 U.S.C. 6992a (a) (1) through (11)), solid waste, radioactive material, hazardous chemical, toxic chemical, extremely hazardous substance, petroleum, including crude oil or any fraction thereof, or asbestos- containing material (the "Hazardous Materials") without the prior written consent of Landlord. Landlord hereby acknowledges and agrees that Tenant may use certain Hazardous Materials in the ordinary and customary course of its business, so long as such use is in compliance with all applicable Environmental Laws. 22.3. Notification. Tenant shall give Landlord immediate notice of ------------ any release of Hazardous Materials on, under or from the Premises which is in violation of, or is required to be reported under any Environmental Law, and shall give Landlord written notice within three (3) days after Tenant learns or first has reason to believe that any report, notice, action, claim, or complaint has been made or threatened by any person, entity, or agency concerning the presence, use, release, or disposal of any Hazardous Materials on, under or from the Premises. 22.4. Inspection of Premises. Landlord may from time to time, upon ---------------------- reasonable notice to Tenant, conduct or engage an independent contractor to conduct an environmental audit of the Premises. The environmental audit may include: (a) a physical inspection of the Premises; (b) sampling and analysis of soil, groundwater, surface waters, or any Hazardous Materials; and (c) a review of Tenant's compliance with all Environmental Laws including all documents related thereto. All costs and expenses incurred by Landlord in connection with the environmental audit shall be paid by Landlord, except where such environmental audit reveals that the Premises or any surrounding property has become contaminated due to operations or activities attributable to Tenant, then all of the costs and expense of such audit shall be paid by Tenant. 22.5 Remediation. Upon identification of environmental ---------- contamination or the unpermitted release of Hazardous Materials on, under or from the Premises which was not caused by Tenant, its agents, employees, contractors, or invitees, Landlord will promptly and diligently undertake, at its own expense, any and all repair or remediation necessary to comply with all Environmental Laws and to satisfy all appropriate governmental agencies and upon completion thereof shall provide to Tenant a "no further action letter" or environmental audit evidencing the completion of such remediation. In the event Tenant is unable to occupy all or any portion of the Premises due to any such environmental contamination, Rent due hereunder shall abate proportionately. 26 22.6. Indemnification by Tenant. Tenant agrees to indemnify, ------------------------- defend, and hold harmless Landlord and its agents, from and against any claims, demands, penalties, fines, liabilities, settlements, losses, damages, interest, penalties, costs, response costs or expenses (including, but not limited to, fees for attorneys, consultants, and other experts) (the "Losses") of whatever kind or nature, arising out of or in any way related to: (a) the presence, storage, generation, treatment, disposal, release, or threatened release of any Hazardous Materials on, under or from the Premises; (b) any personal injury, disease, illness, death, property damage (real or personal) or damage to natural resources or the environment arising out of or related to Hazardous Materials on, under or from the Premises; or (c) any violation of any Environmental Law for which Tenant, its agents, employees, contractors, or invitees are responsible. This indemnification shall not apply where the Losses are caused by the negligence or willful misconduct of Landlord, its agents, employees, contractors, or invitees. This provision is in addition to any other obligations Tenant may have to Landlord at law or in equity and shall survive termination of this Lease. The foregoing indemnification shall apply regardless of the basis of liability or legal principle involved including, but not limited to, claims based on strict liability. 22.7. Indemnification by Landlord. Landlord agrees to indemnify, --------------------------- defend, and hold harmless Tenant and its agents, from and against any claims, demands, penalties, fines, liabilities, settlements, losses, damages, interest, penalties, costs, response costs or expenses (including, but not limited to, fees for attorneys, consultants, and other experts) (the "Losses") of whatever kind or nature, arising out of or in any way related to: (a) the presence, storage, generation, treatment, disposal, release, or threatened release of any Hazardous Materials on, under or from the Building; (b) any personal injury, disease, illness, death, property damage (real or personal) or damage to natural resources or the environment arising out of or related to Hazardous Materials on, under or from the Building; or (c) any violation of any Environmental Law for which Landlord, its agents, employees, contractors, or invitees are responsible. This indemnification shall not apply where the Losses are caused by the negligence or willful misconduct of Tenant, its agents, employees, contractors, or invitees. This provision is in addition to any other obligations Landlord may have to Tenant at law or in equity and shall survive termination of this Lease. The foregoing indemnification shall apply regardless of the basis of liability or legal principle involved including, but not limited to, claims based on strict liability. 22.8. Landlord represents and warrants that (i) based solely on the environmental audit entitled Phase I Environmental Site Assessment for the Markwort Property dated January 9, 2004 and performed by Professional Service Industries, Inc. prepared for BJC Health System and the environmental audit entitled Phase II Investigation for Markwort Property dated February 17, 2004 prepared by Environmental Operations, Inc. for BJC HealthCare the land upon which the Building will be constructed contains no Hazardous Materials to the knowledge of Landlord; (ii) as of the Commencement Date use of the Premises for general office and assembly uses are permissible uses under all applicable zoning codes, laws, rules and regulations; and (iii) to Landlord's actual knowledge there is no claim, suit, litigation, proceeding or action pending or threatened against Landlord or any other party that relates to the Building and/or the use or ownership thereof, and, to Landlord's actual knowledge, there is no basis for any such claim, suit, litigation, proceeding or action (with the exception of eminent domain proceedings to obtain additional parking area for the Building). 27 IN WITNESS WHEREOF, the undersigned have caused this Lease to be signed and delivered on their behalf as of the day and year stated in Article 1 above. TENANT: LANDLORD: STEREOTAXIS, INC., CORTEX WEST DEVELOPMENT I, LLC, a a Delaware corporation Missouri limited liability company By: Center of Research Technology and Entrepreneurial Expertise, a Missouri non-profit corporation, sole member By: /s/ James M. Stolze By: /s/ John Dubinsky ---------------------------- -------------------------------- Print Name: James M. Stolze Print Name: John Dubinsky -------------------- ------------------------ Title: VP & CFO Title: President ------------------------- ----------------------------- 28 EXHIBIT A-1 ----------- FLOOR PLAN OF FIRST FLOOR ------------------------- A-1 EXHIBIT A-2 ----------- FLOOR PLAN OF SECOND FLOOR -------------------------- A-2 EXHIBIT A-3 ----------- FLOOR PLAN OF EXPANSION SPACE (FIRST EXPANSION AND SECOND --------------------------------------------------------- EXPANSION--AGGREGATE SPACE FOR BOTH ----------------------------------- A-3 EXHIBIT B --------- WORK TO BE PERFORMED ON THE PREMISES BY LANDLORD ------------------------------------------------ Landlord and Tenant have agreed upon a schematic layout of the Premises which is attached to this Lease as Exhibit I. Landlord shall prepare, or cause to be prepared at its expense, within thirty five (35) days after the date of this Lease Design Development Drawings for the Premises (the "DD Drawings") which shall contain the following information: 1. Floor plans illustrating the following physical characteristics of the space: hard wall locations, door locations, locations of sound attenuation, labeled rooms with major/critical dimensions, casework locations, equipment locations (copiers, printers, faxes, mail machines, industrial machines, etc.), and preliminary electrical outlet locations. 2. Reflected ceiling plans illustrating the following items: location of ceiling types (acoustic, drywall and specialty ceilings) and light fixture types and locations 3. Finish boards illustrating the following: all major materials in the space, field carpet, accent carpet, stone or ceramic tiles, acoustical ceiling types, paint colors, door species and finish, typical hardware samples (lever handles, cabinet pulls, etc.) in their proposed finish, and light fixture cut sheets. 4. Interior elevations illustrating the following: typical office front elevations and elevations of all major casework in areas such as copy rooms, mail rooms, coffee bars, kitchens, restrooms, and lunch rooms. 5. Perspective renderings illustrating the three dimensional and material aspects of major spaces including lobby/monumental stair, board room and typical office area. Tenant shall notify Landlord within five (5) days of any objections it has to the DD Drawings. Tenant and Landlord shall work together diligently to address such objections until satisfactorily resolved by Landlord and Tenant. To this end Tenant agrees to attend (on short advance notice) and to actively participate in design development meetings and to make decisions binding on Tenant when requested to do so in design development meetings. On or before the Design Completion Date, Tenant and Landlord shall endeavor to approve the DD Drawings (the "Approved Drawings"). Tenant shall not be entitled to disapprove the DD Drawings if the DD Drawings are in all material respects consistent with the schematic layout of the Premises attached to this Lease and include a design and finishes which are consistent with those in the following two (2) office buildings: the building in which Clayco Construction is located at 2199 Interbelt Business Center Drive, St. Louis County, Missouri, and the building in which Novus International, Inc. is located at 530 Maryville Centre Drive, St. Louis County, Missouri. In the event Tenant has attended, actively participated in and has made decisions w hen requested to do so in design development meetings and if Landlord and Tenant cannot agree on the DD Drawings on or prior to the Design Completion Date, and if such failure to agree is not based on specialty items, then either party may terminate this Lease by notice to the other party given on or prior to January 30, 2005 in which event the Security Deposit shall promptly be returned to Tenant. B-1 In accordance with such Approved Drawings, Landlord shall then construct the improvements to the Premises and all such improvements shall comply with all laws and regulations, including, but not limited to, the Americans with Disabilities Act. All such improvements shall be at Landlord's cost provided, however, that upgrades from Building standard, specialty items, furniture, telecom and data wiring (labor and material) shall be paid for by Tenant. All improvements and work to be done on the Premises pursuant to the Approved Drawings shall be performed solely by Landlord or its designated contractors. If Tenant subsequently requests changes to the Approved Drawings, Tenant shall be responsible for all increased costs and expenses associated with such changes, including without limitation the cost of preparing the revisions to the plans. No such changes shall be made without the prior written approval of Landlord after a written request has been made by Tenant. B-2 EXHIBIT C --------- BUILDING RULES -------------- C-1 EXHIBIT D --------- MEMORANDUM OF OCCUPANCY ----------------------- D-1 EXHIBIT E --------- LEASE ESTOPPEL CERTIFICATE -------------------------- E-1 EXHIBIT F --------- FORM OF SUBORDINATION AND NON-DISTURBANCE AGREEMENT --------------------------------------------------- F-1 EXHIBIT G --------- CLEANING SPECIFICATIONS ----------------------- G-1 EXHIBIT H --------- MEMORANDUM OF LEASE ------------------- H-1 EXHIBIT I --------- SCHEMATIC LAYOUT OF THE PREMISES -------------------------------- I-1 EXHIBIT J --------- SITE PLAN --------- J-1

Exhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in the Registration Statements (Form S-8) pertaining to the Stereotaxis, Inc. 2004 Employee Stock Purchase Plan, the Stereotaxis, Inc. 2002 Stock Incentive Plan, the Stereotaxis, Inc. 2002 Non-Employee Directors' Stock Plan, and the Stereotaxis, Inc. 1994 Stock Plan (No. 333-115253) of our report dated February 18, 2005, with respect to the consolidated financial statements and schedule of Stereotaxis, Inc. included in this Annual Report (Form 10-K) for the year ended December 31, 2004. St. Louis, Missouri March 22, 2005

EXHIBIT 31.1 Certification of Principal Executive Officer I, Bevil J. Hogg, certify that: 1. I have reviewed this annual report on Form 10-K of Stereotaxis, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Reserved - not effective (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. /s/ BEVIL J. HOGG Date: March 28, 2005 ------------------------------------- Bevil J. Hogg President and Chief Executive Officer Stereotaxis, Inc. (Principal Executive Officer)

EXHIBIT 31.2 Certification of Principal Financial Officer I, James M. Stolze, certify that: 1. I have reviewed this annual report on Form 10-K of Stereotaxis, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Reserved - not effective (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. /s/ JAMES M. STOLZE Date: March 28, 2005 ------------------------------------------ James M. Stolze Vice President and Chief Financial Officer Stereotaxis, Inc. (Principal Financial Officer)

EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the annual report of Stereotaxis, Inc. (the "Company") on Form 10-K for the period ended December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Bevil J. Hogg, President and Chief Executive Officer of the Company, certify, pursuant to Rule 13a-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ BEVIL J. HOGG Date: March 28, 2005 ------------------------------------- Bevil J. Hogg President and Chief Executive Officer Stereotaxis, Inc.

EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the annual report of Stereotaxis, Inc. (the "Company") on Form 10-K for the period ended December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, James M. Stolze, Vice President and Chief Financial Officer of the Company, certify, pursuant to Rule 13a-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ JAMES M. STOLZE Date: March 28, 2005 ----------------------------------------- James M. Stolze Vice President and Chief Financial Officer Stereotaxis, Inc. 94

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