UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
   
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006March 31, 2007
   
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 000-51998
 
Restore Medical, Inc.
(Exact name of registrant as specified in its charter)
 
   
Delaware
41-1955715
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization) 41-1955715
(I.R.S. Employer
Identification No.)
2800 Patton Road
St. Paul, Minnesota 55113
(651) 634-3111
(Address and zip code of principal executive offices and registrant’s telephone number,
including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
 
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):
Large accelerated fileroAccelerated fileroLarge accelerated filero      Accelerated fileroNon-accelerated filerþ
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ
     Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: 15,364,28115,683,128 shares of Common Stock as of July 31, 2006.April 25, 2007.
 
 

 


 

Restore Medical, Inc.
Form 10-Q
Table of Contents
     
  Page
    
    
  2 
  3 
  4 
  5 
  11 
  2017 
  2017 
    
  2118 
  2118 
    
    
 Rule 13a-14(a)/15d-14(a)Section 302 Certification
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 Section 1350302 Certification of Chief Financial Officer
Section 906 Certification of Chief Executice Officer and Chief Financial Officer

1


PART I: FINANCIAL INFORMATION
Item 1. Condensed Financial Statements (Unaudited)
RESTORE MEDICAL, INC.
Condensed Balance Sheets
(Unaudited, in thousands, except per share amounts)
                
 June 30, December 31,  March 31, December 31, 
 2006 2005  2007 2006 
Assets
  
Current assets:  
Cash and cash equivalents $20,213 $3,397  $5,103 $11,377 
Short-term investments 9,850 248  14,181 12,463 
Accounts receivable, net of allowance for doubtful accounts of $60 2,011 1,240 
Accounts receivable, net of allowance for doubtful accounts of $24 and $86, respectively 879 1,262 
Related-party receivables 18 28  54 33 
Inventories 523 744  670 598 
Prepaid expenses 447 116  201 237 
Other current assets 36 54  34 10 
          
Total current assets 33,098 5,827  21,122 25,980 
Machinery and equipment, net 462 426  556 539 
Deferred debt issuance costs, net of accumulated amortization of $66 and $21, respectively 308 81 
Deferred offering costs  61 
Deferred debt issuance costs, net of accumulated amortization of $138 and $108, respectively 216 246 
          
Total assets $33,868 $6,395  $21,894 $26,765 
          
  
Liabilities, Convertible Participating Preferred Stock and Stockholders’ Equity (Deficit)
 
Liabilities and Stockholders’ Equity
 
Current liabilities:  
Accounts payable $373 $113  $130 $670 
Accrued expenses 832 645  498 939 
Accrued payroll and related expense 631 673  559 519 
Current portion of long-term debt, net of debt discount of $37 and $22, respectively 2,040 338 
Current portion of long-term debt, net of debt discount of $37 and $37, respectively 2,263 2,192 
          
Total current liabilities 3,876 1,769  3,450 4,320 
Long-term debt, net of debt discount of $55 and $44, respectively 3,919 1,619 
Long-term debt, net of debt discount of $29 and $37, respectively 2,268 2,863 
Other long-term liabilities 11 7  14 14 
Preferred stock warrants subject to redemption  835 
          
Total liabilities 7,806 4,230  5,732 7,197 
          
  
Convertible participating preferred stock: 
Series A, $0.01 par value: no shares authorized, issued and outstanding at June 30, 2006; 775,000 shares authorized and 750,000 shares issued and outstanding at December 31, 2005  747 
Series B, $0.01 par value: no shares authorized, issued and outstanding at June 30, 2006; 4,500,000 shares authorized and 4,185,411 shares issued and outstanding at December 31, 2005  13,507 
Series C, $0.01 par value: no shares authorized, issued and outstanding at June 30, 2006; 9,500,000 shares authorized and 7,615,675 shares issued and outstanding at December 31, 2005  18,723 
Series C-1, $0.01 par value: no shares authorized, issued and outstanding at June 30, 2006; 2,940,000 shares authorized and 2,498,833 shares issued and outstanding at December 31, 2005  6,231 
     
Total convertible participating preferred stock  39,208 
     
 
Stockholders’ equity (deficit): 
Preferred stock, $0.01 par value: 5,000,000 shares authorized, no shares issued and outstanding   
Common stock $0.01 par value: 50,000,000 shares authorized; issued and outstanding 15,364,156 and 855,926 shares, respectively 154 9 
Stockholders’ equity: 
Common stock $0.01 par value: 50,000,000 shares authorized; issued and outstanding 15,672,819 and 15,534,244 shares, respectively 157 155 
Additional paid-in capital 91,816 3,188  93,259 92,772 
Deferred stock-based compensation  (1,749)  (2,105)  (1,133)  (1,395)
Accumulated other comprehensive loss (14)  
Accumulated deficit  (64,145)  (38,135)  (76,121)  (71,964)
          
Total common stockholders’ equity (deficit) 26,062  (37,043)
Total stockholders’ equity 16,162 19,568 
          
Total liabilities, convertible participating preferred stock and stockholders’ equity (deficit) $33,868 $6,395 
Total liabilities and stockholders’ equity $21,894 $26,765 
          
See accompanying notes to condensedthe financial statements.

2


RESTORE MEDICAL, INC.
Condensed Statements of Operations
(Unaudited, in thousands, except share and per share amounts)
                        
 Three months ended Six months ended  Three months ended 
 June 30 June 30  March 31, 
 2006 2005 2006 2005  2007 2006 
Net sales $1,810 $1,162 $3,562 $2,065  $1,124 $1,752 
Cost of sales (1) 465 354 1,055 794  268 590 
              
Gross margin 1,345 808 2,507 1,271  856 1,162 
              
Operating expenses:  
Research and development (1) 807 416 1,420 935  1,052 613 
General and administrative (1) 945 858 2,461 1,606  1,315 1,517 
Sales and marketing (1) 2,415 1,236 4,292 2,345  2,734 1,876 
              
Total operating expenses 4,167 2,510 8,173 4,886  5,101 4,006 
              
Loss from operations  (2,822)  (1,702)  (5,666)  (3,615)  (4,245)  (2,844)
              
Other income (expense):  
Interest income 202 36 230 77  284 28 
Interest expense  (202)  (7)  (286)  (10)  (196)  (84)
Preferred stock warrant gain (loss) 663  (243) 500  (417)
Preferred stock warrant loss   (163)
Other, net 2  (2) 11    9 
              
Total other income (expense) 665  (216) 455  (350) 88  (210)
              
Net loss  (2,157)  (1,918)  (5,211)  (3,965) $(4,157) $(3,054)
              
 
Deemed dividend from revision of preferred stock conversion price (note 9) 20,799  20,799  
         
Net loss attributable to common stockholders $(22,956) $(1,918) $(26,010) $(3,965)
         
 
Basic and diluted net loss per common share before deemed dividend from revision of preferred stock conversion price $(0.26) $(1.57) $(1.08) $(3.27)
Effect of deemed dividend from revision of preferred stock conversion price  (2.48)   (4.30)  
         
Basic and diluted net loss per common share $(2.74) $(1.57) $(5.38) $(3.27) $(0.26) $(2.48)
              
  
Basic and diluted weighted average common shares outstanding 8,365,137 1,218,224 4,831,015 1,212,748  15,971,951 1,233,943 
  
(1) Includes stock-based compensation of:  
Cost of sales $17 $3 $25 $5  $23 $8 
Research and development 32 1 55 2  22 23 
General and administrative 261 193 546 270  465 285 
Sales and marketing 69 8 98 14  94 29 
              
 $379 $205 $724 $291  $604 $345 
      
         
See accompanying notes to condensedthe financial statements.

3


RESTORE MEDICAL, INC.
Condensed Statements of Cash Flows
(In thousands, unaudited)Unaudited, in thousands)
                
 Six months ended June 30  Three months ended March 31, 
 2006 2005  2007 2006 
Cash flows from operating activities:  
Net loss $(5,211) $(3,965) $(4,157) $(3,054)
Adjustments to reconcile net loss to net cash used in operating activities:  
Depreciation and amortization 92 68  57 45 
Stock-based compensation 724 291  604 345 
Preferred stock warrant (gain) loss  (500) 417 
Bad debt expense  5 
Preferred stock warrant loss  163 
Bad debt expense (recovery)  (11) 4 
Non-cash interest expense 60 7  39 22 
Change in operating assets and liabilities:  
Trade receivables  (771)  (431) 394  (419)
Related-party receivables 10 71   (21)  (42)
Inventories 221  (300)  (72) 220 
Prepaid expenses  (331)  (44) 36  (47)
Other current assets 18 2   (24)  (2)
Accounts payable 260 88   (540) 75 
Accrued expenses 187  (26)  (441) 588 
Accrued payroll and related expenses  (42) 252  40  (10)
Other long-term liabilities 4    2 
          
Net cash used in operating activities  (5,279)  (3,565)  (4,096)  (2,110)
          
Cash flows from investing activities:  
Maturities of short-term investments 1,047 4,783  10,181 250 
Purchase of short-term investments  (10,663)  (9)  (11,899)  (800)
Purchases of machinery and equipment  (96)  (94)  (74)  (51)
          
Net cash provided by (used in) investing activities  (9,712) 4,680 
Net cash used in investing activities  (1,792)  (601)
          
Cash flows from financing activities:  
Proceeds from issuance of long-term debt 4,000    4,000 
Decrease in deferred offering costs 61  
Repayments on long-term debt  (526)  (1,221)
Capital lease payments  (4)    (6)  (1)
Proceeds from stock options exercised 69 22  146  
Net proceeds from initial public offering 27,681  
          
Net cash provided by financing activities 31,807 22 
Net cash (used in) provided by financing activities  (386) 2,778 
          
Net increase in cash and cash equivalents 16,816 1,137 
Net (decrease) increase in cash and cash equivalents  (6,274) 67 
Cash and cash equivalents:  
Beginning of period 3,397 2,258  11,377 3,397 
          
End of period $20,213 $3,395  $5,103 $3,464 
          
Supplemental disclosure:  
Interest paid $225 $2  $157 $63 
Non-cash investing and financing activities: 
Value of common stock warrants issued with debt $273 $ 
Capital lease financing $33 $ 
Deemed dividend from revision of preferred stock conversion price $20,799 $ 
See accompanying notes to condensedSee accompanying notes to the financial statements.

4


RESTORE MEDICAL, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(unaudited)(Unaudited, in thousands, except share and per share amounts)
(1)Nature of Business
Restore Medical, Inc. (hereinafter “we,” “us” or the “Company”) develops and markets medical devices designed to treat sleep breathing disorders. In December 2002, we received Food and Drug Administration (FDA) 510(k) clearance to market and sell the Pillarâ palatal implant system (Pillar System) in the United States for the treatment of snoring. We received 510(k) clearance from the FDA in July 2004 to market and sell our Pillar System in the United States for mild to moderate obstructive sleep apnea (OSA). We received CE Mark certification to market and sell our Pillar System in Europe for snoring in May 2003 and for OSA in December 2004. International sales of our products are subject to regulatory requirements that vary widely from country to country. The Company markets and sells its products domestically through a direct sales force and internationally through independent distributors.
(2)Basis of Presentation
In the opinion of management, the accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States and reflect all adjustments, consisting solely of normal recurring adjustments, needed to fairly present the financial results for these interim periods. These financial statements include some amounts that are based on management’s best estimates and judgments. These estimates may be adjusted as more information becomes available, and any adjustment could be significant. The impact of any change in estimates is included in the determination of earnings in the period in which the change in estimate is identified. The results of operations for the second quarter ended June 30, 2006, are not necessarily indicative of the results that may be expected for the entire 2006 fiscal year.
According to the rules and regulations of the United States Securities and Exchange Commission, we have omitted footnote disclosures that would substantially duplicate the disclosures contained in our audited financial statements. These unaudited condensed financial statements should be read together with the financial statements for the year ended December 31, 2005, and footnotes thereto included in our Form S-1, Registration Statement No. 333-132368, filed May 12, 2006 with the United States Securities and Exchange Commission.
(3)Stock Options and Accounting for Stock-Based Compensation
(1) Nature of Business
Restore Medical, Inc. (hereinafter “we,” “us” or the “Company”) develops and markets medical devices designed to treat sleep disordered breathing. In December 2002, we received Food and Drug Administration (FDA) 510(k) clearance to market and sell the Pillarâ palatal implant system (Pillar System) in the United States for the treatment of snoring. We received 510(k) clearance from the FDA in July 2004 to market and sell our Pillar System in the United States for mild to moderate obstructive sleep apnea (OSA). We received CE Mark certification to market and sell our Pillar System in Europe for snoring in May 2003 and for mild to moderate OSA in December 2004. The Company markets and sells its products domestically through a direct sales force and internationally through independent distributors.
(2) Basis of Presentation
In the opinion of management, the accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and reflect all adjustments, consisting solely of normal recurring adjustments, needed to fairly present the financial results for these interim periods. These condensed financial statements include some amounts that are based on management’s best estimates and judgments. These estimates may be adjusted as more information becomes available, and any adjustment could be significant. The impact of any change in estimates is included in the determination of earnings in the period in which the change in estimate is identified. The results of operations for the first quarter ended March 31, 2007, are not necessarily indicative of the results that may be expected for the entire 2007 fiscal year.
According to the rules and regulations of the United States Securities and Exchange Commission, we have omitted footnote disclosures that would substantially duplicate the disclosures contained in our audited financial statements. These unaudited condensed financial statements should be read together with the financial statements for the year ended December 31, 2006, and footnotes thereto included in our Annual Report on Form 10-K, filed February 28, 2007, with the United States Securities and Exchange Commission.
(3) Stock Options and Accounting for Stock-Based Compensation
The Company has adopted the Restore Medical, Inc. 1999 Omnibus Stock Plan (the Plan) that includes both incentive stock options and nonqualified stock options to be granted to employees, officers, consultants, independent contractors, directors and affiliates of the Company. Incentive stock options must be granted at an exercise price not less than the fair market value of the common stock on the grant date. The options granted to participants owning more than 10% of the Company’s outstanding voting stock must be granted at an exercise price not less than 110% of fair market value of the common stock on the grant date. Options expire ten years from the date of grant and typically vest 25% after the first year of service with the remaining vesting 1/36th each month thereafter.

5


RESTORE MEDICAL, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS

(unaudited)
(Unaudited, in thousands, except share and per share amounts)
Stock option activity was as follows:
             
  Shares Shares Weighted Average
  Available for Under Exercise Price
  Grant Options Per Share
Balance, December 31, 2005  426,206   1,405,612  $1.09 
Authorized  1,387,500       
Granted  (1,019,700)  1,019,700   8.00 
Exercised     (65,645)  (1.05)
Cancelled  36,519   (36,519)  (2.06)
             
Balance, June 30, 2006  830,525   2,323,148  $4.11 
             
 
Exercisable as of June 30, 2006      752,677  $1.08 
                 
              Weighted 
              Average 
      Shares  Weighted Average  Remaining 
  Shares Available  Under  Exercise Price  Contractual Life 
  for Grant  Options  Per Share  in Years 
Balance, December 31, 2006  588,407   2,399,306  $4.17   8.4 
Granted  (700,770)  700,770   3.88   9.9 
Exercised     (131,658)  1.10     
Cancelled  457,082   (457,082)  6.97     
               
Balance, March 31, 2007  344,719   2,511,336  $3.74   8.4 
               
                 
Exercisable as of March 31, 2007      643,762  $1.17   6.5 
The following table summarizes information aboutconcerning unvested options outstanding, vested and exercisable at June 30, 2006:for the three months ended March 31, 2007:
             
      Weighted  
      average  
      remaining Number
  Number contractual vested and
Exercise price outstanding life in years exercisable
$0.40  19,500   3.7   19,500 
1.00  1,283,948   7.9   733,177 
8.00  1,019,700   9.9    
             
   2,323,148   8.7   752,677 
             
         
      Weighted average 
      grant date fair 
  Shares  value per share 
Non-vested at January 1, 2007  1,690,268  $3.85 
Granted  700,770   2.55 
Vested  (66,382)  3.06 
Forfeited  (457,082)  4.64 
        
Non-vested at March 31, 2007  1,867,574  $3.21 
        
On January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123(R),Share Based Payment(SFAS 123(R)) prospectively to new awards and to awards modified, repurchased or cancelled after December 31, 2005. Prior to the adoption of SFAS 123(R), we used the minimum-valueminimum value method of measuring equity share options for the pro forma disclosure under SFAS 123. We will continue to apply the intrinsic-value method for awards granted prior to the adoption of SFAS 123(R). The Company’s financial statements as of and for the sixthree months ended June 30,March 31, 2007 and 2006 reflect the impact of SFAS 123(R).
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. Since we are a newly public entity with nolimited historical data on volatility of our stock, the expected volatility is based on volatility of similar entities (referred to as guideline companies). In evaluating similarity, we considered factors such as industry, stage of life cycle, size and financial leverage. The expected term of options granted is determined using the “shortcut” method allowed by SAB 107. Under this approach, the expected term is presumed to be the mid-point between the vesting date and the end of the contractual term. The shortcut approach is not permitted for options granted, modified or settled after December 31, 2007. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. We use historical termination behavior to support estimated forfeiture rates. In addition, SFAS 123(R) requires us to reflect the benefits of tax

6


RESTORE MEDICAL, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS

(unaudited)(Unaudited, in thousands, except share and per share amounts)
the benefits of tax deductions in excess of recognized compensation cost to be reported as both a financing cash inflow and an operating cash outflow upon adoption. We have recognized no such tax benefits to date.
The following assumptions were used to estimate the fair value of stock option shares granted to employees during the six-monththree-month period ended June 30, 2006March 31, 2007 using the Black-Scholes option-pricing model:
     
  Granted to Granted to
  Employees Directors
Volatility 65% 65%
Risk-free interest rates 5.0% 5.0%
Expected option life 6.25 years 5.5 years
Stock dividend yield 0% 0%
Volatility65%
Risk-free interest rates5.0%
Expected option life6.40 years
Stock dividend yield0%
Forfeiture rate8%
There were no stock options issued to directors during the three-month period ended March 31, 2007. The Company continues to utilize an estimated forfeiture rate of 2% for director stock options outstanding.
The weighted average grant date fair value perof share of options granted during the sixthree months ended June 30, 2006 and 2005March 31, 2007 was approximately $5.13$2.55 per share. No options were granted during the three months ended March 31, 2006. The Company recorded cash received from the exercise of stock options of $146 and $4.24, respectively.did not recognize any related tax benefits during the three months ended March 31, 2007. Upon exercise, the Company issues new shares of stock. The totalaggregate intrinsic value of share options exercised during the sixthree months ended June 30,March 31, 2007 and 2006 and 2005 was approximately $428,000$298 and $51,000,$2, respectively. As of June 30, 2006,March 31, 2007 there was $4.7 million$4,027 of total unrecognized compensation costs related to outstanding options granted after the adoption of SFAS 123(R), which is expected to be recognized over a weighted average period of 3.93.1 years.
Prior to our initial public offering (IPO), certain stock options were granted with exercise prices that were below the estimated fair value of the common stock at the date of grant. We recorded deferred stock compensation of $2.5 million$2,500 for the period through December 31, 2005 (until the adoption of SFAS 123(R)), in accordance with Accounting Principles Board (APB) No. 25. As of June 30, 2006March 31, 2007, there was $1.7 million$1,133 of deferred stock-based compensation that will be amortized on a straight-line basis over a weighted average period of 3.02.3 years.
ForIn March 2006, the six-month period ended June 30, 2006, resultsCompany modified certain stock options held by one individual to accelerate the vesting period. The modified stock options resulted in $191 of operations reflectadditional compensation expense for newthe three months ended March 31, 2006. The following assumptions were used to estimate the fair value of the 27,180 common stock options modified during the three months ended March 31, 2006 using the Black-Scholes option-pricing model:
2006
Volatility67.5%
Risk-free interest rates4.6%
Expected option life90 Days
Stock dividend yield0%
On February 1, 2007, the Board of Directors of the Company approved an amendment to 247,750 stock options that were granted or modified under our stock incentive plans duringto eleven Company employees between May 15, 2006 and July 20, 2006 whereby the continued amortizationexercise price of such stock options was reduced from a weighted average $7.89 per share to $3.89 per share, which was the closing price of the deferred stock-based compensation for options granted prior to JanuaryCompany’s common stock on February 1, 2006.2007. All other terms

7


RESTORE MEDICAL, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS

(unaudited)(Unaudited, in thousands, except share and per share amounts)
(4)Net Loss per Share
Basic net loss per common share (Basic EPS) is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net loss per common share (Diluted EPS) is computed by dividing net loss by the weighted average number of common shares and dilutive potential common shares outstanding. Potential common shares consist of shares issuable upon the exercise of stock options and warrants. Diluted EPS is identical to Basic EPS since potential common shares are excluded from the calculation, as their effect is anti-dilutive. The weighted average shares outstanding for basic and diluted loss per share includes 378,122 shares of common stock underlying warrants to purchase common stock as such warrants are immediately exercisable and have an exercise price of $0.02 per share. The common stock underlying the warrants is considered outstanding in substance for EPS purposes. Historical outstanding potential common shares not included in diluted net loss per share attributable to common stockholders were 2,748,190 and 11,759,582 for the three and six months ended June 30, 2006 and 2005, respectively.
of the stock options, including vesting and termination dates, remained the same. The incremental fair value created by the amendment to the stock options of $113 will be recognized as compensation expense over the weighted average remaining vesting period of 3.4 years.
                 
  Three months ended June 30  Six months ended June 30 
  2006  2005  2006  2005 
Net loss attributable to common stockholders $(22,956) $(1,918) $(26,010) $(3,965)
                 
Weighted average common shares and equivalents outstanding:                
Common shares outstanding  7,987,015   840,102   4,452,893   834,626 
Warrants issued at a nominal exercise price  378,122   378,122   378,122   378,122 
             
Weighted average shares outstanding — basic and diluted  8,365,137   1,218,224   4,831,015   1,212,748 
             
                 
             
Net loss per share — basic and diluted $(2.74) $(1.57) $(5.38) $(3.27)
             
On March 6, 2007, the Company granted a total of 23,070 options to purchase common stock to two consultants. The terms of the agreements provided for immediate vesting of all options on the date of grant. The Black-Scholes option-pricing model was utilized and the assumptions were the same as stated in the table above for employees, except that the option life of ten years was utilized, which is the contractual term of the options. The total compensation expense recognized for these two grants was $64 for the three months ended March 31, 2007.
(5)Short-Term Investments in Debt Securities
Short-term investments in debt securities consisted of the following as of June 30, 2006 (in thousands):
(4) Net Loss per Share
             
  Cost  Unrealized  Fair 
  Basis  Losses  Value 
Held-to-maturity:            
Corporate debt securities $4,964  $  $4,964 
Mortgage-backed securities  4,900   (14)  4,886 
          
Total $9,864  $(14) $9,850 
          
Basic net loss per common share (Basic EPS) is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net loss per common share (Diluted EPS) is computed by dividing net loss by the weighted average number of common shares and dilutive potential common shares outstanding. Potential common shares consist of shares issuable upon the exercise of stock options and warrants. Diluted EPS is identical to Basic EPS since potential common shares are excluded from the calculation, as their effect is anti-dilutive. The weighted average shares outstanding for basic and diluted loss per share includes 378,122 shares of common stock underlying warrants to purchase common stock as such warrants are immediately exercisable and have an exercise price of $0.02 per share. The common stock underlying the warrants is considered outstanding in substance for EPS purposes. Historical outstanding potential common shares not included in diluted net loss per share attributable to common stockholders were 2,838,912 and 9,502,375 for the three months ended March 31, 2007 and 2006, respectively.
Net loss per share for the three months ended March 31, 2007 and 2006 is based on the weighted average shares outstanding as summarized in the following table:
         
  Three months ended March 31 
  2007  2006 
Weighted average common shares and equivalents outstanding:        
Common shares outstanding  15,593,829   855,821 
Warrants issued at a nominal exercise price  378,122   378,122 
       
Weighted average shares outstanding — basic and diluted  15,971,951   1,233,943 
       
(5) Short–term Investments in Debt Securities
     Short-term investments consisted of the following as of March 31, 2007:
     
  Cost 
Held-to-maturity: Corporate debt securities $11,777 
Available-for-sale: Mortgage-backed securities  2,404 
    
Total $14,181 
    

8


RESTORE MEDICAL, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS

(unaudited)(Unaudited, in thousands, except share and per share amounts)
(6)Comprehensive Loss
Comprehensive loss consists solely of unrecognized losses on investments. Comprehensive loss for the three and six months ended June 30, 2006 and 2005 are as follows (in thousands):
The carrying value of these instruments approximates fair market value. Declines in value of marketable securities classified as held-to-maturity are considered to be temporary. Unrealized gains and losses in marketable securities classified as available-for-sale are a component of other comprehensive income until realized.
                 
  Three months ended June 30  Six months ended June 30 
  2006  2005  2006  2005 
Net loss $(2,157) $(1,918) $(5,211) $(3,965)
Change in unrealized loss on investments  (14)     (14)   
             
Comprehensive loss $(2,171) $(1,918) $(5,225) $(3,965)
             
(6) Inventories
(7)Inventories
We state our inventories at the lower of cost or market, computed on a standard cost basis, with market being determined as the lower of replacement cost or net realizable value. Standard costs are monitored on a quarterly basis and updated as necessary to reflect changes in raw material costs and labor and overhead rates. Inventory write-downs are established when conditions indicate that the selling price could be less than cost due to physical deterioration, usage, obsolescence, reductions in estimated future demand and reductions in selling prices. Inventory write-downs are measured as the difference between the cost of inventory and estimated realizable value. Inventories at June 30, 2006 and December 31, 2005 were as follows (in thousands):
We state our inventories at the lower of cost or market, computed on a standard cost basis, with market being determined as the lower of replacement cost or net realizable value. Standard costs are monitored on a quarterly basis and updated as necessary to reflect changes in raw material costs and labor and overhead rates and production plans. Inventory write-downs are established when conditions indicate that the selling price could be less than cost due to physical deterioration, usage, obsolescence, reductions in estimated future demand and reductions in selling prices. Inventory write-downs are measured as the difference between the cost of inventory and estimated realizable value. Inventories at March 31, 2007 and December 31, 2006 were as follows:
                
 June 30, December 31,  March 31, December 31, 
 2006 2005  2007 2006 
Raw Materials $70 $113  $46 $57 
Work In Process 268 372  281 320 
Finished Goods 185 259  343 221 
          
 $523 $744  $670 $598 
          
(7) Long-Term Debt
Long-term debt consisted of the following as of March 31, 2007 and December 31, 2006:
         
      December 31, 
  March 31, 2007  2006 
Term loan (interest at prime plus 3% maturing December 2008), net of debt discount of $66 and $74, respectively $4,413  $4,930 
Capital lease for equipment (interest at 9.35%, monthly payments maturing September 2009)  17   18 
Capital lease for leasehold improvements (interest at 14.33%, monthly payments maturing March 2010)  25   27 
Capital lease for equipment (interest at 12.14%, monthly payments maturing July 2011)  76   80 
       
   4,531   5,055 
Less current portion, net of debt discount of $37 and $37, respectively  (2,263)  (2,192)
       
Total long-term debt $2,268  $2,863 
       
The term loan is payable over 30 consecutive monthly payments of principal and interest which began on July 1, 2006, with an additional final payment in an amount equal to 5% of the original loan due on December 31, 2008.

9


RESTORE MEDICAL, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS

(unaudited)(Unaudited, in thousands, except share and per share amounts)
(8) Long-Term DebtSignificant Customers
     Long-term debt consistsThe following table summarizes the number of customers who individually comprise greater than 10% of total net sales and their aggregate percentage of the Company’s total net sales for the three-month period ended:
         
  Number of  Percent of total 
  customers  net sales 
March 31, 2007  1   26%
March 31, 2006  1   11%
The following table summarizes the number of customers who individually comprise greater than 10% of total net accounts receivables and their aggregate percentage of the Company’s total net accounts receivables:
         
  Number of  Percent of total 
  customers  net receivables 
March 31, 2007  2   28%
December 31, 2006  2   26%
(9) Adoption of New Accounting Pronouncement
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109(FIN 48). FIN 48 clarifies the accounting for uncertainties in income taxes recognized in a company’s financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attributable for financial disclosure of tax positions taken or expected to be taken on a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted the provisions of FIN 48 as of June 30, 2006 and DecemberJanuary 1, 2007. The adoption of FIN 48 did not impact our financial position, results of operations or cash flows for the three months ended March 31, 2005 (in thousands):
         
  June 30,  December 31, 
  2006  2005 
Term loan (interest at prime plus 3% maturing December 2008), net of $55 debt discount at June 30, 2006 and $44 at December 31, 2005 $5,908  $1,933 
Capital lease for equipment (interest at 9.35%, monthly payments maturing September 2009)  21   24 
Capital lease for leasehold improvements (interest at 14.33%, monthly payments maturing March 2010)  30    
       
   5,959   1,957 
         
Less current portion, net of debt discount of $37 at June 30, 2006 and $22 at December 31, 2005  (2,040)  (338)
       
Total long-term debt $3,919  $1,619 
       
The term loan will be repaid over 30 consecutive monthly payments of principal and interest beginning on July 1, 2006, with an additional final payment in an amount equal to 5% of the original loan due on December 31, 2008.
(9)Stockholders’ Equity (Deficit)
On May 12, 2006, the Board of Directors approved a one-for-two reverse split of our issued or outstanding shares of common stock and preferred stock. All issued or outstanding common stock, preferred stock and per share amounts contained in the financial statements have been retroactively adjusted to reflect this reverse stock split.
On May 22, 2006, we sold 4,000,000 shares of common stock in an initial public offering (IPO) for aggregate gross proceeds of $32.0 million. After deducting the underwriters’ commissions and discounts and offering costs, we received net proceeds of approximately $27.7 million.
Prior to the completion of the IPO, we amended our Certificate of Incorporation to change the conversion price of the Series C and Series C-1 preferred stock from $5.24 per share to $3.48 per share (on a post-split basis). This change in conversion price was effective immediately prior to the conversion of all outstanding shares of our preferred stock upon the completion of our IPO, and was in consideration for a modification of the definition of a “qualified” offering such that our IPO triggered the mandatory conversion of our preferred stock into common stock. As a result of this change in the conversion price of Series C and Series C-1 preferred stock, the common stock outstanding upon completion of our IPO increased by 2,679,783 shares, including 122,091 common shares issuable pursuant to Series C-1 preferred stock warrants. For purposes of calculating net loss per share in the period in which the IPO was completed, net income available to common stockholders has been reduced by $20.8 million for the fair value of the additional common shares as a result of the change in the Series C and Series C-1 preferred stock conversion price. Upon completion of the IPO, all outstanding Series A, B, C and C-1 preferred stock automatically converted into 10,395,288 shares of common stock at the then current conversion prices.
2007.

10


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
AND RESULTS OF OPERATIONS

(unaudited)(Unaudited)
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
We develop, manufacture and market our proprietary and patented Pillar® palatal implant system or(“Pillar System”). The Pillar System anis a simple, innovative, minimally-invasive,minimally invasive, implantable medical device used to treat sleep disordered breathing, which includes mild to moderate obstructive sleep apnea, or OSA, and habitual or socially disruptive snoring. During the Pillar Procedureâ®, a physician implants three small, braided, proprietary polyester inserts into the muscle of the soft palate. These Pillar inserts, together with the body’s natural fibrotic response to the implanted Pillar inserts, add structural support and stiffen the soft palate, thereby minimizing or eliminating the palatal tissue vibration that can cause snoring and the collapse that can obstruct the upper airway and cause OSA. We currently market and sell our Pillar System to otolaryngologists (ear, nose and throat physicians, or ENTs) and to a limited number of oral maxillofacial surgeons. We believe the Pillar Procedure is a safe, clinically effective, long-lasting and low-risk procedure with minimal pain or complications that offers significant benefits to both patients and physicians over other available treatment options for snoring and mild to moderate OSA.options.
Our Pillar System was cleared by the United States Food and Drug Administration, or FDA, for snoring in December 2002 and for mild to moderatemild-to-moderate OSA in July 2004. Our Pillar System received CE Mark certification for both snoring and mild to moderate OSA from the European Commission in May 2003 and December 2004, respectively. We currently market and sell our Pillar System to otolaryngologists (ear, nose and throat physicians) and to a limited number of oral maxillofacial surgeons.
Application of Critical Accounting Policies and Use of Estimates
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. The application of GAAP requires that we make estimates that affect our reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ significantly from these estimates.
Revenue Recognition
We generate revenue from salesA description of our Pillar System to physician customersthe Company’s critical accounting policies that represent the more significant judgments and estimates used in the U.S. and third-party distributors internationally. We generally have not sold our Pillar System to hospitals or healthcare institutions, although such sales may occurpreparation of the Company’s financial statements was provided in the future.
Revenue is recognized when evidenceManagement’s Discussion and Analysis of an arrangement exists, delivery toFinancial Condition and Results of Operations section of the customer has occurred,Company’s Annual Report on Form 10-K for the selling price is fixed or determinable, and collectability is reasonably assured. For physician customers in the U.S., the evidence of an arrangement generally consists of a verbal phone order as their normal business practices do not require a purchase order. Our international distributors place orders pursuant to a distribution agreement. The price for each sale is fixed and agreed with the customer prior to shipment and is based on established list prices. Sales to our international distributors are made according to the contractual terms of each individual distribution agreement. Revenue for all domestic and international sales is recognized upon shipment of product from our facility when title passes to the customer. As noted below, we have, on a customer-by-customer basis, granted payment terms in excess of those specified in our international distribution agreements.
A provision for estimated sales returns on domestic product sales is recorded in the same period as the related revenue is recorded. The provision for estimated sales returns, if any, is based on an analysis of historical salesyear ended December 31, 2006.

11


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
AND RESULTS OF OPERATIONS

(unaudited)
returns as adjusted for specifically identified estimated changes in historical return activity. Sales terms to our international distributors do not contain a right to return product purchased from us.
In the U.S., as part of introducing our Pillar System to potential new physician customers, we offer physicians the opportunity to participate in our “practice introduction program,” or PI program, in which they can treat up to three patients using Pillar Systems that we provide at no charge to the physician. The costs associated with providing these Pillar Systems to U.S. physicians under our PI program are accounted for as a sales and marketing expense at the time of each practice introduction. During 2005, our international distributors were offered the opportunity to participate in an international PI program whereby we would provide marketing support payments for practice introductions conducted by the distributor. The support payments made to each distributor who participated in our 2005 international PI program were accounted for as a reduction of revenue to that distributor. During the first quarter of 2006, we amended substantially all of our international distribution agreements to change the structure of our international PI program. Under the modified program, we provide our international distributors with free product to undertake a PI program with physician customers in their respective territories rather than provide our international distributors with a marketing support payment for practice introductions performed. The free product that we provide is recorded as a cost of sales.
Our standard payment terms for customers are net 30 to 60 days in the United States and net 90 days internationally. If we determine the facts and circumstances surrounding a customer’s order justify alternative payment terms, we may grant extended payment terms on a customer-by-customer basis.
Collectability is evaluated prior to shipment. Our customers typically are physicians, clinics and distributors, and are generally deemed creditworthy; however, if we have collection concerns, we will require prepayment of the order.
Allowance for Doubtful Accounts
In estimating the collectability of our accounts receivable, we analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends, and changes in customer payment terms. In the normal course of our business, many of our international distributors pay us after their scheduled payment due date. In addition, on a case-by-case basis, we have allowed certain of our international distributors to extend the time of payment beyond their scheduled payment due date, or to make periodic partial payments of past-due amounts owing to us. We make adjustments to our allowance for doubtful accounts in the period when the net revenues are recognized based on anticipated future events. If there are unanticipated future events, this allowance may need to be adjusted. On a monthly basis, we determine the amount of this reserve based on a review of slow-paying accounts, as well as accounts with changed circumstances indicating that the balances due and owing to us are unlikely to be collectible.
Accounting for Income Taxes
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a full valuation allowance on our net deferred tax assets as of June 30, 2006 and December 31, 2005, respectively, due to uncertainties related to our ability to utilize our deferred tax assets in the foreseeable future. These deferred tax assets primarily consist of certain net operating loss carry forwards and research and development tax credits.

12


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

(unaudited)
Stock-Based Compensation
Prior to the adoption of SFAS No. 123(R) on January 1, 2006, we measured compensation costs for options issued or modified under our stock-based compensation plans using the intrinsic-value method of accounting. Under the intrinsic-value method, we recorded deferred compensation expense within stockholders’ deficit for stock options awarded to employees and directors to the extent that the option exercise price was less than the fair market value of common stock on the date of grant. Recorded deferred compensation was amortized to compensation expense on a straight-line basis over the vesting period of the underlying stock option grants.
Under GAAP, companies are permitted to use an alternative method of valuing stock options which is based on the fair value of the stock option on the date of grant. This fair value method generally results in the recording of a greater expense related to stock options. On January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R). We will apply the provisions of SFAS 123(R) to new stock option grants and to stock option grants that are modified, repurchased, or cancelled after December 31, 2005 using the prospective method of transition. We will continue to apply the intrinsic-value method to determine compensation expense for stock options granted prior to the adoption of SFAS 123(R).
Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We use the Black-Scholes model to value our stock option awards. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and management uses different assumptions, share-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected term and forfeiture rate, and only recognize expense for those shares expected to vest. If the actual forfeiture rate is materially different from the estimate, share-based compensation expense could be significantly different from what has been recorded in the current period.
     As of June 30, 2006, we had outstanding stock options to acquire an aggregate of 2,323,148 shares of common stock. Of those outstanding common stock options, 752,677 shares had vested as of June 30, 2006, and 1,570,471 shares were unvested.

13


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

(unaudited)(Unaudited)
Results of Operations (in thousands, except for average selling price)
Comparison of the Three Months Ended March 31, 2007 and Six -Month Periods Ended June 30, 2006 and 2005
Net Sales.Net sales increaseddecreased by $648,000,$628, or 56%36%, to $1,810,000$1,124 for the three months ended June 30, 2006March 31, 2007 from $1,162,000$1,752 in the same period in 2005. Net sales increased by $1,497,000, or 72%, to $3,562,000 for2006. The majority of the six months ended June 30, 2006 from $2,065,000decrease in the same period in 2005. The increase intotal net sales duringis the first six monthsresult of 2006 was attributable to the increased sale of our Pillar Systems, both in the United States andlower international markets.sales.
The following table summarizes the geographic dispersion of the Company’s revenue (in thousands):revenue:
                        
 Three months ended June 30 Six months ended June 30  Three months ended March 31, 
 2006 2005 2006 2005  2007 2006 
United States $1,399 $836 $2,552 $1,585  $1,013 $1,153 
Asia Pacific 158 236 649 384   491 
Europe 158 20 253 26  111 95 
Middle East 41 36 52 36 
South America 26  26  
South Africa 28 34 30 34 
All other markets  13 
              
 $1,810 $1,162 $3,562 $2,065  $1,124 $1,752 
              
Net sales in the United States increaseddecreased by $563,000,$140, or 67%12%, to $1,399,000$1,013 in the secondfirst quarter of 2007 compared to $1,153 in the first quarter of 2006. The decrease in domestic sales from the comparable quarter of 2006 comparedis due to $836,000the disruption caused by the restructuring of our sales organization and implementation of the sales and marketing strategies required to support our new integrated consultative sales approach that we initiated in the secondfourth quarter of 2005.2006. Net sales in the United States during the first quarter of 2007 increased on a sequential quarter basis by $967,000,$73 or 61%8%, to $2,552,000from $940 in the first six monthsfourth quarter of 2006 compared to $1,585,000 in the first six months of 2005. The growth in United States net sales during 2006 was primarily due to a larger number of physicians performing the Pillar Procedure, resulting in increased shipments of our Pillar System.2006. The United States average selling price for the three Pillar Systemsinserts used in each Pillar Procedure increased fromwas approximately $620 in the first six months of 2005 to $690 in the first sixthree months of 2006 due to a price increase initiated in October 2004 that resulted in a gradual increase to the new price level for existing customers.and 2007.
Net sales internationally increaseddecreased by $85,000$488 to $411,000 in the second quarter of 2006 compared to $326,000 in the second quarter of 2005. Net sales internationally increased by $530,000 to $1,010,000$111 in the first six monthsquarter of 20062007 compared to $480,000$599 in the first six monthsquarter of 2005. We commercially introduced our Pillar System into international markets beginning in January 2005 through independent third-party distributors. The increase in sales in both the three and six month periods of 2006 compared to 2005 was due primarily to sales to new third-party distributors. In addition, we recorded a $57,000 reduction in our sales reserve in the first six months of 2006 compared to an increase in the sales reserve of $45,000 in the first six months of 2005. The reduction to the sales reserve in the first six months of 2006 was due to a change we made in the terms of our international distributor agreements related to how we provide Pillar Systems to our international distributors for new practice introductions. As a result of the market development investment and distribution costs incurred by our international third-party distributors, our international average selling price typically is approximately 50% of our domestic average selling price.
We do not have complete visibility to the levels of Pillar System inventory held by our international distributors, and in certain territories, their respective sub-distributors. We rely on each of our international distributors to manage their respective inventory levels and the time at which they choose to re-order Pillar Systems. Most of

14


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

(unaudited)
our distributors purchase Pillar Systems from us on a quarterly basis to minimize international freight charges and product importation fees.
2006. Our two largest distributors, which cover the majority of the Asia Pacific market, accounted for 50%58%, or $505,000, of our international sales in the six months ended June 30, 2006. One of these distributors accounted for 38%, or $158,000,$348, of our international sales in the three months ended June 30,March 31, 2006. The other distributor did not order product from us, nor did we ship productDue to them during the three months ended June 30, 2006. Following our periodic business plan reviews withcurrent inventory levels at these two distributors in July 2006, we concluded the Pillar System inventory levels at each of these distributors increased in the first half of 2006 as a result ofresulting from delays in planned market launches, execution of certain market development activities and obtaining a required government pricing approval for the Pillar System in a key market. While our agreements with these two distributors include minimum quarterly purchase requirements, based on our assessment of current inventory levels, the expected timing of each distributor’s planned market, development activities and estimated sales, we dodid not expect to receive orders from either of these two distributors in the thirdfirst quarter of 2006, and as2007. As a result, international sales are expected to decreasedecreased in the thirdfirst quarter of 2007 as compared to the secondfirst quarter of 2006. OrdersThe timing of future orders from either distributor in the fourth quarter will depend upon the results of each distributor’s market development and sales activities. In addition, the Company’s decision to focus on our higher margin U.S. business and to significantly decrease the near-term investment in our international business contributed to decreased net sales during the current quarter.
Cost of sales and gross margin.Our cost of sales consists primarily of material, labor and manufacturing overhead expenses. Cost of sales also includes warranty expenses, as well as salaries and personnel-related expenses, including stock-based compensation, for our operations management team and quality control. Cost of sales increaseddecreased by $111,000,$322, or 31%55%, to $465,000$268 in the secondfirst quarter of 20062007 from $354,000$590 in the secondfirst quarter of 2005. As a percentage of net sales, cost of sales decreased to 26% in the second quarter of 2006 from 30% in the second quarter of 2005.2006. As a percentage of net sales, gross margin improved to 74% in the second quarter of 2006 from 70% in the second quarter of 2005. Cost of sales increased by $261,000, or 33%, to $1,055,00076% in the first six monthsquarter of 20062007 from $794,000 in the comparable period in 2005. As a percentage of net sales, cost of sales decreased to 30%66% in the first six monthsquarter of 2006 from 38% in the first six months of 2005. As a percentage of net sales, gross margin improved to 70% in the first six months of 2006 from 62% in the first six months of 2005. The increase in cost of sales in both the three and six month periods ending June 30, 2006 was due to the increase in the number of our Pillar Systems sold.2006. The improvement in the gross margin percent in both the three and six month periods ending June 30, 2006months ended March 31, 2007 was primarily the result of significant reductions in theour overhead cost of our Pillar System following our launch ofstructure and a redesigned second generation delivery system in May 2005, as well as increased volume-related production efficiencies. We expectrevenue mix that increased production volumes will result in further grossfavored higher margin improvement due to the leverage gained from economies of scale.U.S. sales.

12


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

(Unaudited)
Research and development expenses. Our research and development expenses consist of salaries and other personnel-related expenses, including stock-based compensation, for employees engaged in research, development and engineering activities and materials used and other overhead expenses incurred in connection with the design and development of our products. Research and development expenses increased by $391,000,$439, or 94%72%, to $807,000$1,052 in the secondfirst quarter of 20062007 from $416,000$613 in the secondfirst quarter of 2005.2006. The increase in expenses was primarily attributable to $178,000 of expenses related to additional clinical studies, increased compensation expense of $78,000 due primarily to the hiring of our Vice President of Research and Development in the fourth quarter of 2005 and an increase in stock-based compensation of $31,000 over the same period in the prior year. Research and development expenses increased by $485,000, or 52%, to $1,420,000 in the six months ended June 30, 2006 from $935,000 in the comparable period in 2005. This increase was primarily attributable to $260,000 of expenses$305 related to additional hiring within both our research and clinical studies, increased compensation expensedepartments in the third and fourth quarters of $145,000 due primarily to the hiring of our Vice President of Research2006, and Development noted above and ana combined increase in stock-based compensationprofessional services and clinical study fees of $53,000$96 over the same period in the prior year. In future quarters, we

15


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

(unaudited)
expect research and development expenditures will increase as we initiateour new product development projects progress, we undertake additional post-market clinical studies of the Pillar Procedure and we begin clinical studiestrials of new products.
General and administrative expenses.Our general and administrative expenses consist primarily of salaries and other personnel-related expenses, including stock-based compensation for executive, accounting and administrative personnel, professional fees and other general corporate expenses. General and administrative expenses increaseddecreased by $87,000,$202, or 10%13%, to $945,000$1,315 for the three months ended June 30, 2006March 31, 2007 from $858,000$1,517 for the three months ended June 30, 2005.March 31, 2006. The increase is due primarily to an increase of $100,000decrease in audit and professional fees and $68,000 in stock-based compensation offset by a reduction in wages of $96,000 due to severance expenses included in the second quarter of 2005. General and administrative expenses increased by $855,000, or 53%, to $2,461,000 for the six months ended June 30, 2006 from $1,606,000 for the six months ended June 30, 2005. The increase is due to an increase of $604,000a decrease in audit and professional fees of $478 compared to fees we incurred during the first six months of 2006 in connection with our initial public offering. In addition, stock-based compensation increasedIPO, offset primarily by $276,000 in the first six monthsincreases of 2006 compared to the same period in 2005. The increase$180 in stock-based compensation included $191,000 of expense related to the separation agreement with our former Vice President of Finance.and $81 in insurance expense.
Sales and marketing expenses.Our sales and marketing expenses consist primarily of salaries, commissions and other personnel-related expenses, including stock-based compensation, for employees engaged in sales, marketing and support of our products, trade show, co-marketing, promotional and public relations expenses and management and administration expenses in support of sales and marketing. Sales and marketing expenses increased by $1,179,000,$858, or 95%46%, to $2,415,000$2,734 for the three months ended June 30, 2006March 31, 2007 from $1,236,000$1,876 for the comparable period in 2005.2006. This increase was primarily attributable to additional compensation related expenses of $531,000$650 related to the hiring of additional sales and marketing personnel, including an increase in stock-based compensation of $61,000. In addition, advertising$65, and promotional expenses increased by $459,000 in connection with the development and launch of our consumer marketing programs. Sales and marketing expenses increased by $1,947,000, or 83%, to $4,292,000 for the six months ended June 30, 2006 from $2,345,000 for the comparable period in 2005. These additional sales and marketing expenses were attributable to increased compensation expenses of $844,000 related to the hiring of additional sales and marketing personnel including ana $188 increase in stock-based compensation of $84,000. In addition, advertising, promotional and promotional expenses increased by $731,000 in connection with the development and launch of our consumer marketing programs.travel expenses.
Interest income. Interest income increased by $166,000$256 to $202,000$284 for the three months ended June 30, 2006,March 31, 2007, from $36,000$28 for the three months ended June 30, 2005 and by $153,000 to $230,000 for the six months ended June 30, 2006 from $77,000 for the six months ended June 30, 2005. TheMarch 31, 2006. This increase is attributable to interest earned from the investment of the proceeds of our initial public offeringIPO completed in May 2006.
Interest expense. Interest expense increased by $195,000$112 to $202,000$196 for the three months ended June 30, 2006March 31, 2007 from $7,000$84 for the three months ended June 30, 2005 and increased by $276,000 to $286,000 for the six months ended June 30, 2006 from $10,000 for the six months ended June 30, 2005.March 31, 2006. The increase was due to interest expense resulting from draws on our loan facility with Lighthouse Capital Partners. ForPartners during the three months ended June 30,fourth quarter of 2005 we had not borrowed againstand the first quarter of 2006 prior to our loan facility with Lighthouse Capital Partners.IPO.
Preferred stock warrant gain (loss)loss. In the three months ended June 30,March 31, 2006, we recognized a gain of $663,000 relatedloss due to an increase in the change in estimated fair value of our preferred stock warrants subject to redemption compared to a loss of $243,000 for the change$163. Following our IPO in fair value of ourMay 2006, all preferred stock and preferred stock warrants during the same period in 2005. In the six months ended June 30, 2006, we recognized a gain of $500,000 relatedwere converted to the change in estimated fair value of our preferredcommon stock

16


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

(unaudited)
warrants subject to redemption compared to a loss of $417,000 in 2005 for the change in fair value during the same period in 2005. and common warrants.
Liquidity and Capital Resources
Since our inception and prior to May 2006, we have funded our operations primarily through issuances of convertible preferred stock and related warrants, which provided us with aggregate gross proceeds of $39.9 million. On May 22, 2006, we sold 4,000,000 shares of common stock in an initial public offering (IPO)IPO for aggregate gross proceeds of $32.0 million to finance current operations and provide for general corporate purposes, including expanding domestic and international marketing and sales organizations and programs, increasing product development efforts and increasing our clinical study initiatives. After deducting the underwriters’ commissions and discounts, we received net proceeds of approximately $27.7 million.

13


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

(Unaudited)
As of June 30, 2006,March 31, 2007, we had total cash, cash equivalents and marketable securities of $30.1$19.3 million. We believe that our current cash and cash equivalents and cash generated from operations will be sufficient to fund our working capital and capital resource needs for at least the next 2412 months.
Net cash used in operating activities was $5.3$4.1 million during the first sixthree months of 20062007 compared to $3.6$2.1 million in the first sixthree months of 2005.2006. Cash used in operating activities has historically resultedincreased by $2.0 million resulting from operating losses and changes in working capital reduced by non-cash interest expenses,expense, stock-based compensation and depreciation and increased by net increases in accounts receivable and inventories resulting from the growth of our business.depreciation.
Net cash used in investing activities was $9.7$1.8 million during the first sixthree months of 20062007 compared to $4.7 million provided by$601,000 used in investing activities in the first sixthree months of 2005.2006. During 2007 and 2006, cash used in investing activities was primarily related to the purchase of marketable securities with a portion from the proceeds of our IPO. During 2005, cash provided by investing activities was primarily related to theand sale of marketable securitiessecurities.
Net cash used in financing activities was $386,000 during the first three months of 2007 primarily consisting of the repayment of long-term debt, offset by proceeds from the purchaseissuance of $94,000 of capital equipment.
common stock. Net cash provided by financing activities was $31.8$2.8 million during the first sixthree months of 2006 primarily consisting of $27.7 millionthe issuance and repayment of net proceeds from our IPO and $4.0 million from debt financing. Net cash provided by financing activities was $22,000 during the first six months of 2005 consisting of net proceeds from the exercise of stock options.long-term debt.
As of June 30, 2006,March 31, 2007, we had outstanding long-term debt of $6.0$4.5 million pursuant to a term loan, which accrues interest at a rate equal to prime plus 3%. The term loan will beis being repaid over 30 consecutive monthly payments of principal and interest beginningwhich began on July 1, 2006, with an additional final payment in an amount equal to 5% of the original loan due on December 31, 2008. The term loan is collateralized by substantially all of our assets, excluding our intellectual property. As of March 31, 2007, we were in compliance with all of the covenants contained in the term loan agreement.
Our future capital requirements will depend upon a number of factors, including, but not limited to, the amount of cash generated by operations, competitive and technological developments and the rate of growth of our business.business and changes in competition and technologies. Although we have been successful in raising funds in the past, there is no assurance that any such financings or borrowings can be obtained in the future on terms acceptable to us.
Disclosures about Contractual Obligations and Commercial Commitments
The following table aggregates all contractual commitments and commercial obligations that affect our financial condition and liquidity position at March 31, 2007 (in thousands):
                         
      (remaining
9 months
        
Contractual Obligations Total in 2007) 2008 2009 2010 2011
Term-debt facility $4,477  $1,675  $2,802  $  $  $ 
Capital lease obligations  118   20   30   32   22   14 
Operating leases  1,130   181   276   384   289    
Deposit payable  5      5          
   
Total contractual cash obligations $5,730  $1,876  $3,113  $416  $311  $14 
             
The above contractual obligations exclude interest on the term facility and capital lease obligations.
Significant Customers
One customer individually accounted for 26% of our total sales for the three months ended March 31, 2007. A different customer individually accounted for 11% of our total sales for the three months ended March 31, 2006.

14


RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

(Unaudited)
New Accounting Standards
In June 30, 2006:2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109(FIN 48). FIN 48 clarifies the accounting for uncertainties in income taxes recognized in a company’s financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attributable for financial disclosure of tax positions taken or expected to be taken on a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted the provisions of FIN 48 as of January 1, 2007. The adoption of FIN 48 did not impact our financial position, results of operations or cash flows for the three months ended March 31, 2007.
In June 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force (EITF) regarding EITF Issue No. 06-03,How Taxes Collected from Customers and Remitted to Government Authorities Should be Presented in the Income Statement (That Is, Gross versus Net Presentation). This guidance requires that companies disclose their accounting policy related to sales tax and other similar taxes, which was effective for us beginning January 1, 2007. We report these taxes on a net basis, excluding them from revenue.
In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements(SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. The provisions of FAS 157 are effective for the fiscal year beginning after November 15, 2007. The Company is currently evaluating the impact of the provisions of FAS 157 on its financial statements and does not believe the impact of the adoption will be material.

In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115(SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value with the objective of improving financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently. The provisions of FAS 159 are effective for the fiscal year beginning after November 15, 2007. The Company is currently evaluating the impact of the provisions of FAS 159 on its financial statements and does not believe the impact of the adoption will be material.

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RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

(unaudited)
                         
      Payments Due by Period      
      2006        
      (remaining 6        
Contractual Obligations Total months) 2007 2008 2009 2010
Term-debt facility $6,000  $996  $2,202  $2,802  $  $ 
Capital lease obligations  51   6   13   15   14   3 
Operating leases  1,406   141   284   310   383   289 
Deposit payable  5      5          
   
Total contractual cash obligations $7,462  $1,143  $2,504  $3,127  $397  $292 
   
The above contractual obligations exclude interest on the term facility and capital lease obligations.(Unaudited)
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. All statements other than statements of historical facts are “forward-looking statements” for purposes of these provisions, including any projections of earnings, revenue or other financial items, any statement of the plans and objectives of management for future operations, any statements concerning proposed new product development, any statements regarding future economic conditions or performance and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “potential,” or “continue” or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained herein are reasonable, there can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, including, but not limited to the following factors:
the continued increase in the number of patients seeking treatment
the demand for snoring and mild to moderate OSA, both domestically and acceptance of our Pillar System to treat mild to moderate OSA and snoring by both physicians and patients;
the success of alternative therapies and surgical procedures to treat individuals suffering from sleep disordered breathing, and the possible future introduction of new products and treatments for sleep disordered breathing;
our ability to maintain current pricing for our Pillar System;
the expansion and rate of success of our direct sales force in the United States and our independent distributors internationally;
the successful completion of current and future clinical studies, the presentation and publication of positive outcomes data from these clinical studies and the increased adoption of the Pillar Procedure by physicians as a result of the data from these clinical studies;
actions relating to ongoing FDA and European Union compliance;
the size and timing of orders from physicians and independent distributors;
our ability to obtain reimbursement for the Pillar Procedure for the treatment of mild to moderate OSA in the future from third-party healthcare insurers;
the willingness of patients to pay out-of-pocket for the Pillar Procedure to treat snoring and, in the absence of reimbursement from third-party healthcare insurers, mild to moderate OSA;
unanticipated delays in the development and introduction of our future products and/or our inability to control costs;
seasonal fluctuations in revenue due to the elective nature of sleep-disordered breathing procedures and treatments, including the Pillar Procedure;
general economic conditions, as well as those specific to our customers and markets; and
other risks and factors identified from time to time in our reports and prospectuses filed with the Securities and Exchange Commission, including, without limitation, the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2006.
the demand for and acceptance of our Pillar System to treat snoring and mild to moderate OSA by both physicians and patients;
the success of alternative therapies and surgical procedures to treat individuals suffering from sleep disordered breathing, and the possible future introduction of new products and treatments for sleep disordered breathing;
our ability to continue current pricing for our Pillar System;
the expansion and rate of success of our direct sales force in the United States and our independent distributors internationally;
the successful completion of current and future clinical studies, the presentation and publication of positive outcomes data from these clinical studies, and the increased adoption of the Pillar Procedure by these physicians as a result of this clinical study data;
actions relating to ongoing FDA and European Union compliance;
the size and timing of orders from physician customers and independent distributors;
our ability to obtain reimbursement for the Pillar Procedure for the treatment of mild to moderate OSA in the future from third-party healthcare insurers;

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RESTORE MEDICAL, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

(unaudited)
the willingness of patients to pay out-of-pocket for the Pillar Procedure for the treatment of snoring and, in the absence of reimbursement from third-party healthcare insurers, for the treatment of mild to moderate OSA;
unanticipated delays in the development and introduction of our future products and/or an inability to control costs;
seasonal fluctuations in revenue due to the elective nature of all sleep-disordered breathing treatments, including the Pillar Procedure;
general economic conditions as well as those specific to our customers and markets; and
other risks and factors identified from time to time in our reports and prospectuses filed with the Securities and Exchange Commission.
All forward-looking statements and reasons why results may differ included in this report are made as of the date hereof, and we assume no obligation to update these forward-looking statements or reasons why actual results might differ.

19


RESTORE MEDICAL, INC.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
We invest our excessOur cash is invested in bank deposits and money market funds investment grade commercial paperdenominated in United States dollars. The carrying value of these cash equivalents approximates fair market value. Our investments in marketable securities are subject to interest rate risk and debt instrumentsour financial condition and results of operations could be adversely affected due to movements in interest rates. Due to the U.S. government and its agencies, and, by policy, restrict our exposure to any single corporate issuer by imposing concentration limits.short-term nature of these investments, a 1% change in market interest rates would have an impact of approximately $142,000 on an annual basis. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk-sensitive instruments, positions or transactions to any material extent. 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. Due to the short-term nature of these investments, a 1% change in market interest rates would have an impact of approximately $300,000 on an annual basis.
Although substantially all of our sales and purchases are denominated in U.S. dollars, in future fluctuations in the value of the U.S. dollar may affect the price competitivenessperiods, we believe a greater portion of our products outsiderevenues could be denominated in currencies other than the United States.States dollar, thereby increasing our exposure to exchange rate gains and losses on non-United States currency transactions. Historically, our only foreign denominated payments were for clinical expenditures. Foreign currency gains and losses associated with these expenditures have not been significant. We do not believe, however, that we currently have significant direct foreign currencyenter into forward exchange rate risk and have not hedged exposurescontracts to hedge exposure denominated in foreign currencies.currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we believe an increase in our currency exposure merits further review, we may consider entering into transactions to help mitigate that risk.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report (the “Evaluation Date”), we conductedcarried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, regardingof the effectiveness of the design and operation of our disclosure controls and procedures pursuant to(as defined in Rule 13a-15(b) under13a-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act)). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report,Evaluation Date, our disclosure controls and procedures arewere effective to ensure that information that is required to be disclosed by us in the reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported within the time periodperiods specified in the applicable rules of the Securities and Exchange Commission.forms, and (ii) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Changes in Internal Controls
During the most recent fiscal quarter, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonablereasonably likely to materially affect, our internal control over financial reporting.

2017


RESTORE MEDICAL, INC.
Part II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
In February 2007, we issued 6,917 shares of our common stock in connection with a cashless warrant exercise at an exercise price of $3.48 per share, with 29,002 warrants to purchase common stock being forfeited in the net exercise. All shares were issued pursuant to Section 4(2) of the Securities Act of 1933, as amended. The ability to exercise the warrants for common stock on a net share basis was included in the original warrant agreements.
On May 22, 2006, we completed our IPO of 4,000,000 shares of common stock (the IPO Shares). We sold the IPO Shares to the public at a price of $8.00 per share. Our sale of IPO Shares was registered under the Securities Act of 1933, as amended, onpursuant to a registration statement on Form S-1 (Registration Stmt. No. 333-132368), which was declared effective by the Securities and Exchange Commission on May 16, 2006. TheWe received net proceeds to us from the sale of the IPO Shares, after deducting the underwriting discount and offering expenses, wereof approximately $27.7 million. The net proceeds have been invested in money market funds, investment grade commercial paper and debt instruments of the U.S. government and its agencies. During the quarter ended June 30, 2006,March 31, 2007, we did not use anyused approximately $4.6 million of net proceeds from the IPO.IPO for general corporate purposes, including expanding domestic marketing and sales organizations and programs, increasing product development efforts and increasing our clinical study initiatives.
Item 6. Exhibits
The exhibits listed on the accompanying index to exhibits are filed or incorporated by reference (as stated therein) as part of this Quarterly Report on Form 10-Q.

2118


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.
     
 RESTORE MEDICAL, INC.
by:  /s/ Christopher R. Geyen   
  Christopher R. Geyen  
  by:/s/ Christopher R. GeyenSenior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 
 
 
 Christopher R. Geyen
 Chief Financial Officer
 (on behalf of the registrant and as chief financial and accounting officer)
August 2, 2006May 1, 2007

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Exhibit Index
   
Exhibit No Description
   
10.1Form of Principal Executive Officer and Principal Financial Officer Employment and Change in Control Agreement (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K Filed on March 30, 2007)
10.1Form of Executive Officer Employment and Change in Control Agreement (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K Filed on March 30, 2007)
31.1 Rule 13a-14(a)/15d-14(a) Certification
31.2 Rule 13a-14(a)/15d-14(a) Certification
32 Section 1350 Certifications

2320