VirtualScopics (VSCP) 10-Q 2012 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period endedSeptember 30, 2012_______________________________________

¨ 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: 000-52018______________________________________________________________

VirtualScopics, Inc.

(Exact name of registrant as specified in its charter)

Delaware	04-3007151
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

500 Linden Oaks, Rochester, New York	14625
(Address of principal executive offices)	(Zip Code)

(585)249-6231

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).                                                                                   xYes¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer¨	Accelerated filer¨
Non-accelerated filer¨(Do not check if a smaller reporting company)	Smaller reporting companyx

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes¨Nox

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of October 31, 2012, there were 29,747,762 shares of the registrant’s common stock, $0.001 par value, outstanding.

VIRTUALSCOPICS, INC.

TABLE OF CONTENTS

		Page Numbers
PART I	FINANCIAL INFORMATION
	ITEM 1: Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2012 (unaudited) and December 31, 2011	1
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2012 and 2011 (unaudited)	2
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2011 (unaudited)	3
	Notes to Condensed Consolidated Financial Statements  (unaudited)	4-17
	ITEM 2: Management's Discussion and Analysis of Financial Condition and Results of Operations	18-26
	ITEM 4: Controls and Procedures	26
PART II	OTHER INFORMATION
	ITEM 1: Legal Proceedings	27
	ITEM 2: Unregistered Sales of Equity Securities and Use of Proceeds	27
	ITEM 3: Defaults Upon Senior Securities	27
	ITEM 4: Mine Safety Disclosures	27
	ITEM 5: Other Information	27
	ITEM 6: Exhibits	27-28

i

PART 1: FINANCIAL INFORMATION

ITEM 1. Financial Statements

VirtualScopics, Inc. and Subsidiary

Condensed Consolidated Balance Sheets

	September 30,			December 31,
	2012			2011
	(Unaudited)
Assets
Current assets
Cash	$	8,060,832		$	5,737,009
Accounts receivable, net		2,728,663			2,435,496
Prepaid expenses and other current assets		406,438			361,376
Total current assets		11,195,933			8,533,881
Patents, net		1,497,922			1,582,938
Property and equipment, net		418,976			514,230
Other assets		10,856			27,140
Total assets	$	13,123,687		$	10,658,189
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable and accrued expenses	$	913,262		$	843,275
Accrued payroll		474,099			759,470
Unearned revenue		240,266			421,486
Derivative liabilities		57,610			156,596
Total current liabilities		1,685,237			2,180,827
Commitments and Contingencies
Stockholders' Equity
Convertible preferred stock, $0.001 par value; 15,000,000 shares authorized;
Series A 8,400 shares authorized; issued and outstanding, 2,190 shares at September 30, 2012 and December 31, 2011; liquidation preference $1,000 per share		2			2
Series B 6,000 shares authorized; issued and outstanding, 600 shares at September 30, 2012 and December 31, 2011; liquidation preference $1,000 per share		1			1
Series C-1 3,000 shares authorized; issued and outstanding, 3,000 and 0 shares at September 30, 2012 and December 31, 2011, respectively; liquidation preference $1,000 per share		3			-
Series C-2 3,000 shares authorized; issued and outstanding, 0 shares at September 30, 2012 and December 31, 2011; liquidation preference $1,000 per share		-			-
Common stock, $0.001 par value; 85,000,000 shares authorized;  issued and outstanding, 29,747,762 and 29,370,687 shares at September 30, 2012 and December 31, 2011, respectively		29,748			29,371
Additional paid-in capital		21,599,404			17,882,936
Accumulated deficit		(10,190,708	)		(9,434,948	)
Total stockholders' equity		11,438,450			8,477,362
Total liabilities and stockholders' equity	$	13,123,687		$	10,658,189

See notes to condensed consolidated financial statements.

1

VirtualScopics, Inc. and Subsidiary

Condensed Consolidated Statements of Operations

(unaudited)

	For the Three Months Ended  September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
Revenues	$	3,095,080		$	3,047,704		$	9,487,055		$	9,973,568
Reimbursement revenues		233,137			221,103			879,181			807,142
Total revenues		3,328,217			3,268,807			10,366,236			10,780,710
Cost of services		1,633,024			1,551,078			5,270,148			5,056,183
Cost of reimbursement revenues		233,137			221,103			879,181			807,142
Total cost of services		1,866,161			1,772,181			6,149,329			5,863,325
Gross profit		1,462,056			1,496,626			4,216,907			4,917,385
Operating expenses
Research and development		414,913			352,454			1,171,589			1,081,372
Sales and marketing		314,991			259,684			961,714			878,514
General and administrative		684,052			751,315			2,202,368			2,404,102
Depreciation and amortization		101,393			113,614			320,003			364,062
Total operating expenses		1,515,349			1,477,067			4,655,674			4,728,050
Operating (loss) income		(53,293	)		19,559			(438,767	)		189,335
Other income (expense)
Other income		1,044			1,671			2,174			15,903
Other expense		(7,206	)		(6,724	)		(12,920	)		(24,665	)
Unrealized (loss) gain on change in fair value of the derivative liabilities		(19,794	)		548,420			(306,247	)		509,621
Total other (expense) income		(25,956	)		543,367			(316,993	)		500,859
Net (loss) income		(79,249	)		562,926			(755,760	)		690,194
Preferred stock deemed dividend		-			-			1,806,919			-
Preferred stock dividends		42,000			12,000			95,333			36,989
Net (loss) income available to common  stockholders	$	(121,249	)	$	550,926		$	(2,658,012	)	$	653,205
Weighted average basic shares outstanding		29,747,762			29,329,816			29,608,684			28,809,385
Weighted average diluted shares outstanding		29,747,762			35,524,658			29,608,684			33,471,117
Basic and diluted (loss) earnings per share	$	0.00		$	0.02		$	(0.09	)	$	0.02

See notes to condensed consolidated financial statements.

2

VirtualScopics, Inc. and Subsidiary

Condensed Consolidated Statements of Cash Flows

(unaudited)

	For the Nine Months Ended September 30,
	2012			2011
Cash flows from operating activities
Net (loss) income	$	(755,760	)	$	690,194
Adjustments to reconcile net (loss) income to net cash  (used in) provided by operating activities:
Depreciation and amortization		320,003			364,062
Gain on the disposal of assets		-			(12,500	)
Stock-based compensation		465,888			670,449
Fair value adjustment of derivative liabilities		306,247			(509,621	)
Changes in operating assets and liabilities
Accounts receivable		(293,167	)		8,850
Prepaid expenses and other assets		(28,778	)		(171,937	)
Accounts payable and accrued expenses		(21,471	)		(316,708	)
Accrued payroll		(285,371	)		(313,717	)
Unearned revenue		(181,220	)		427,595
Total adjustments		282,131			146,473
Net cash (used in) provided by operating activities		(473,629	)		836,667
Cash flows from investing activities
Purchase of property and equipment		(123,157	)		(378,473	)
Acquisition of patents		(16,576	)		(10,514	)
Net cash used in investing activities		(139,733	)		(388,987	)
Cash flows from financing activities
Proceeds from the exercise of warrants		262,500			105,001
Proceeds from the exercise of stock options		20,200			92,383
Withholding taxes paid on cashless exercise of stock options		-			(11,722	)
Proceeds from the issuance of Series C-1 preferred stock and warrant, net of issuance costs		2,666,485			-
Cash dividends on Series B preferred stock		(12,000	)		(36,989	)
Net cash provided by financing activities		2,937,185			148,673
Net increase in cash		2,323,823			596,353
Cash
Beginning of period		5,737,009			4,576,060
End of period	$	8,060,832		$	5,172,413
Supplemental disclosure of cash flow information
Non-cash financing activity:
Issuance of restricted awards in settlement of accrued liability for for board fees	$	-		$	30,250
Cashless exercise of stock options and warrants	$	-		$	772
Accrued dividends on Series B and C-1 preferred stock	$	83,333		$	-
Reclassification of derivative liabilities upon exercise of warrants to additional paid in capital	$	-		$	1,783,710
Reclassification of derivative liabilities to additional paid in capital in connection with the Series C-1 preferred stock issuance	$	405,233		$	-

See notes to condensed consolidated financial statements.

3

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

NOTE 1 -Nature of Business and Basis of Presentation

Nature of Business

The Company’s headquarters are located in Rochester, New York. The Company has created a suite of image analysis software tools and applications which are used in detecting and measuring specific anatomical structures and metabolic activity using medical images. The Company’s developed proprietary software provides measurement capabilities designed to improve pharmaceutical and medical device research and development and improve clinical medical image analysis.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been condensed in certain respects and should, therefore, be read in conjunction with the audited consolidated financial statements and notes related thereto contained in the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2011. In the opinion of management, these financial statements contain all adjustments necessary for a fair presentation for the interim period, all of which were normal recurring adjustments. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results to be expected for the full year ending December 31, 2012.

On August 29, 2012, the Company received a written notice from the Nasdaq Stock Market indicating that its common stock was not in compliance with minimum bid price required for continued listing on the Nasdaq Capital Market. In accordance with section 5810(c)(3)(A) of the Nasdaq Marketplace Rules, the Company has until February 25, 2013 to regain compliance by maintaining a bid price of common stock at a close of $1.00 or higher for a minimum of 10 consecutive business days, or such longer period as Nasdaq may determine to show the ability to maintain long-term compliance. The Company’s intention is to maintain its listing on Nasdaq and is currently assessing its options to regain compliance.

NOTE 2 -Summary of Certain Significant Accounting Policies

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, VirtualScopics, LLC. All significant intercompany balances and transactions have been eliminated in consolidation.

Derivative Financial Instruments

The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks. The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated statements of operations. For stock-based derivative financial instruments, the Company uses the Black-Scholes option valuation model to value the derivative instruments at inception and on subsequent valuation dates. The warrants issued with the Company’s Series B preferred stock, and to the placement agent in the Series B financing, did not have fixed settlement provisions because their exercise prices may be lowered if the Company issues securities at lower prices in the future. The Company was required to include the reset provisions in order to protect the warrant holders from the potential dilution associated with future financings. Accordingly, the warrants are recognized as a derivative instrument.

4

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

Although the Company determined the warrants include an implied downside protection feature, it performed a Monte-Carlo simulation and concluded that the value of the warrants between each feature is de minimus and the use of the Black-Scholes valuation model is considered to be a reasonable method to value the warrants. The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date (Note 5).

Revenue Recognition

The Company recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when an agreement exists, services and products have been performed, prices are fixed or determinable, and collectability is reasonably assured. Revenues are reduced for estimated discounts and other allowances, if any.

The Company provides advanced medical image analysis on a per analysis basis, and recognizes revenue when the image analysis is completed. Revenue related to project, data and site management services is recognized as the services are rendered and in accordance with the terms of the contract. Consulting revenue is recognized once the services are rendered and typically charged as an hourly rate.

Occasionally, the Company has provided software development services to its customers, which may require development, modification, and customization. Software development revenue is billed on a fixed price basis and recognized upon delivery of the software and acceptance by the customer on a completed contract basis. The Company does not sell software licenses, upgrades or enhancements, or post-contract customer services.

Reimbursements received and related costs incurred for out-of-pocket expenses are separately reported as revenue and cost of services, respectively, in the financial statements.

5

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited) 

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period that includes the enactment date. A valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and the reversal of deferred tax liabilities during the period in which related temporary differences become deductible. The benefit of tax positions taken or expected to be taken in the Company’s income tax returns are recognized in the consolidated financial statements if such positions are more likely than not of being sustained.

Research and Development

Research and development expense relates to the development of new applications and processes including improvements and enhancements to existing software applications. These costs are expensed as incurred.

Fair Value of Financial Instruments

Fair value of financial instruments is defined as an exit price, which is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date. The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level of pricing observability. Financial assets and liabilities with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and require less judgment in measuring fair value. Conversely, financial assets and liabilities that are rarely traded or not quoted have less price observability and are generally measured at fair value using valuation models that require more judgment. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency of the asset, liability or market and the nature of the asset or liability. The Company has categorized its financial assets and liabilities measured at fair value into a three-level hierarchy. See Note 5 – Derivative Liabilities for a further discussion regarding the Company’s measurement of financial assets and liabilities at fair value.

Preferred Stock

The Company applies the accounting standards for distinguishing liabilities from equity when determining the classification and measurement of its preferred stock. Preferred shares subject to mandatory redemption are classified as liability instruments and are measured at fair value. Conditionally redeemable preferred shares (including preferred shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, preferred shares are classified as stockholders’ equity.

6

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited) 

Convertible Instruments

The Company applies the accounting standards for derivatives and hedging and for distinguishing liabilities from equity when accounting for hybrid contracts that feature conversion options. The accounting standards require companies to bifurcate conversion options from their host instruments and account for them as free standing derivative financial instruments according to certain criteria. The criteria includes circumstances in which (i) the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract, (ii) the hybrid instrument that embodies both the embedded derivative instrument and the host contract is not re-measured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur and (iii) a separate instrument with the same terms as the embedded derivative instrument would be considered a derivative instrument. The derivative is subsequently marked to market at each reporting date based on current fair value, with the changes in fair value reported in results of operations.

Conversion options that contain variable settlement features such as provisions to adjust the conversion price upon subsequent issuances of equity or equity linked securities at exercise prices more favorable than that featured in the hybrid contract generally result in their bifurcation from the host instrument.

The Company accounts for convertible debt instruments when the Company has determined that the embedded conversion options should not be bifurcated from their host instruments in accordance with ASC 470-20 “Debt with Conversion and Other Options”. The Company records, when necessary, discounts to convertible notes for the intrinsic value of conversion options embedded in debt instruments based upon the differences between the fair value of the underlying common stock at the commitment date of the note transaction and the effective conversion price embedded in the note. Debt discounts under these arrangements are amortized over the term of the related debt. The Company also records, when necessary, deemed dividends for the intrinsic value of the conversion options embedded in preferred stock based upon the difference between the fair value of the underlying common stock at the commitment date of the transaction and the effective conversion price embedded in the preferred stock.

Common Stock Purchase Warrants and Other Derivative Financial Instruments

The Company classifies as equity any contracts that (i) require physical settlement or net-share settlement or (ii) provides a choice of net-cash settlement or settlement in the Company’s own shares (physical settlement or net-share settlement) providing that such contracts are indexed to the Company's own stock as defined in ASC 815-40 "Contracts in Entity's Own Equity" (“ASC 815-40”). The Company classifies as assets or liabilities any contracts that (i) require net-cash settlement (including a requirement to net cash settle the contract if an event occurs and if that event is outside the Company’s control) or (ii) gives the counterparty a choice of net-cash settlement or settlement in shares (physical settlement or net-share settlement).  The Company assesses classification of common stock purchase warrants and other free standing derivatives at each reporting date to determine whether a change in classification between assets and liabilities or equity is required.

7

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

Recently Issued and Adopted Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board issued accounting updates to Accounting Standards Codification 820, Fair Value Measurements Topic — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, which provide clarifying guidance on how to measure fair value and additional disclosure requirements. The amendments prohibit the use of blockage factors at all levels of the fair value hierarchy and provide guidance on measuring financial instruments that are managed on a net portfolio basis. Additional disclosure requirements include transfers between Levels 1 and 2; and for Level 3 fair value measurements, a description of our valuation processes and additional information about unobservable inputs impacting Level 3 measurements. The updates were effective March 1, 2012 and are to be applied prospectively. The adoption of this guidance did not have an impact on our financial condition, results of operations or cash flows.

NOTE 3 -Stock-Based Compensation

For the three and nine months ended September 30, 2012 and 2011, the Company’s condensed consolidated statements of operations reflect stock-based compensation expense for stock options granted under its long-term stock incentive plans and allocated as follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012		2011
Cost of service revenues	$	18,039	$	14,446	$	44,796	$	38,465
Research and development		17,110		32,430		59,622		96,642
Sales and marketing		2,851		4,988		7,109		14,105
General and administrative		105,945		151,257		346,236		493,494
Total stock-based compensation	$	143,945	$	203,121	$	457,763	$	642,706

Stock options issued under the Company’s long-term incentive plans are granted with an exercise price equal to no less than the market price of the Company’s stock at the date of grant and expire up to ten years from the date of grant. These options generally vest over a three or four-year period.

8

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

The fair value of stock options granted was determined on the grant date using assumptions for risk free interest rate, the expected term, expected volatility, and expected dividend yield. The risk free interest rate is based on U.S. Treasury zero-coupon yield curve over the expected term of the option. The expected term assumption is determined using the weighted average midpoint between the vesting and expiration term for all individuals within the grant. Through the second quarter of 2012, the Company had estimated its expected volatility from an index of historical stock prices of comparable entities whose share prices were publicly traded and averaged with the Company’s historical stock prices, excluding the first ten months due to the discreet and non-recurring nature of the trading. Beginning in the third quarter of 2012, the Company estimated its expected volatility using only its own historical stock prices, continuing to exclude the first ten months due to the discreet and non-recurring nature of the trading, as management determined this assumption to be a better indicator of value. The Company’s model includes a zero dividend yield assumption, as the Company has not historically paid nor does it anticipate paying dividends on its common stock. The Company’s model does not include a discount for post-vesting restrictions, as the Company has not issued awards with such restrictions. The periodic expense is then determined based on the valuation of the options, and at that time an estimated forfeiture rate is used to reduce the expense recorded. The Company’s estimate of pre-vesting forfeitures is primarily based on the Company’s historical experience and is adjusted to reflect actual forfeitures as the options vest. The following assumptions were used to estimate the fair value of options granted for the nine months ended September 30, 2012 and 2011 using the Black-Scholes option-pricing model:

	September 30,
	2012			2011
Risk free interest rate		1.1	%		2.6	%
Expected term (years)		6.3			6.2
Expected volatility		57.6	%		55.1	%
Expected dividend yield		-			-

A summary of the employee stock option activity for the nine months ended September 30, 2012 is as follows:

	Number of Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term
Options outstanding at January 1, 2012		5,768,690		$	1.33
Granted		395,303			1.14
Exercised		(20,000	)		1.01
Cancelled/Forfeited		(94,073	)		1.52
Expired		(76,132	)		1.90
Options outstanding at September 30, 2012		5,973,788			1.30		5.87
Options exercisable at September 30, 2012		4,207,391			1.32		4.96

The weighted-average grant-date fair value of options granted during the nine months ended September 30, 2012 and 2011 was $245,754 and $745,908, respectively. There were 20,000 options exercised resulting in cash proceeds of $20,200 during the nine months ended September 30, 2012 and 76,986 options exercised resulting in cash proceeds of $92,383 during the nine months ended September 30, 2011.

9

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited) 

NOTE 4 -Stockholders’ Equity

On April 3, 2012, the Company and Merck Global Health Innovation Fund, LLC (“GHI”) entered into a Series C Preferred Stock and Warrant Purchase Agreement (the “Purchase Agreement”) under which the Company agreed to sell GHI up to 6,000 shares of the Company’s Series C Preferred Stock and warrants to purchase up to 2,722,632 shares of common stock at an exercise price of $1.2043 per share (the “Series C Warrants”) for a purchase price of $6,000,000 in two separate closings. The Series C Preferred Stock is convertible, at GHI’s election, into shares of the Company’s common stock at a conversion rate, which is determined by dividing (i) the stated value per share of $1,000, plus, if consented to by the Company, all accrued and unpaid dividends, by (ii) the conversion price of $1.2043. The conversion price of the Series C Preferred Stock and exercise price of the Series C Warrants is subject to customary anti-dilution provisions. The financing is part of an initiative by GHI to provide funding for the Company’s efforts to expand its quantitative imaging technology into the personalized medicine market.

The initial closing under the Purchase Agreement took place on April 3, 2012 at which the Company sold to GHI 3,000 shares of Series C-1 Preferred Stock which are initially convertible into 2,491,073 shares of common stock and Series C-1 Warrants which are exercisable to purchase 1,361,316 shares of common stock for a purchase price of $3,000,000, net of issuance costs of approximately $334,000. The warrants contain a seven year term and become exercisable on September 30, 2012. The terms of the financing provide for a second closing of $3,000,000 of Series C-2 Preferred Stock, if, among other things, certain milestones are met toward the development of its quantitative imaging center on or before April 3, 2013.

The Series C-1 Preferred Stock has a 4% cumulative dividend and is senior in liquidation preference to the existing preferred stock and common stock. The Series C-1 holders elected to accrue the dividends making the dividends payable on the earlier of the liquidation of the corporation according to the Series C Certificate of Designation or upon the conversion of the Series C-1 into common stock. Subject to certain exceptions, the Series B holders are only entitled to be paid dividends, if full dividends are first paid or concurrently paid to the holders of the Series C-1 Preferred Stock. As of September 30, 2012, dividends payable to Series B and C-1 convertible preferred stockholders amounted to $24,000 and $59,333, respectively and are included in accounts payable and accrued expenses on the Company’s condensed consolidated balance sheet.

In accordance with ASC 470, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” the Series C-1 convertible preferred stock was considered to have an embedded beneficial conversion feature because the conversion price was less than the fair value of the Company’s common stock at the issuance date. This beneficial conversion feature is calculated after the warrants have been valued with proceeds allocated on a relative fair value basis. The value of the beneficial conversion feature was calculated using, among other factors, the Company’s closing stock price of $1.54 on April 3, 2012 resulting in the recognition of a one-time non-cash deemed dividend of $1,806,919 during the quarter ended June 30, 2012.

10

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

The issuance of the Series C-1 Preferred Stock triggered certain anti-dilution provisions of the Company’s warrants issued in 2007 in connection with the sale of our Series B Preferred Stock (the “Series B Warrants”). As a result, the exercise price of certain outstanding Series B Warrants was reduced from $1.3849 to $1.2043 per share and an additional 74,174 warrants were issued.

As part of the financing, the Company also agreed with certain holders of the majority of the outstanding Series B Warrants to amend and restate the terms of those warrants. As a result of the amended and restated terms, among other things, the anti-dilution adjustment provision, which required the Company to reduce the exercise price of the Series B Warrants if the Company had issued shares at a lower price, contained in the agreements was eliminated. As of September 30, 2012, the Company had 214,229 warrants outstanding subject to the anti-dilution adjustment provision.

Common Stock Warrant Exercise

During the nine months ended September 30, 2012, the Company issued 357,075 shares of common stock upon the exercise of a fixed-price warrant held by the University of Rochester at an exercise price of $0.74 per share, with the Company receiving aggregate proceeds of $262,500.

Restricted Stock Awards

A restricted stock award entitles the recipient to receive shares of unrestricted common stock upon vesting of the award. The fair value of each restricted stock award is determined upon granting of the shares and the related compensation expense is recognized ratably over the vesting period and charged to the operations as non-cash compensation expense. Shares contained in the unvested portion of a restricted stock awards are forfeited upon termination of employment, unless otherwise agreed. The fair value of restricted stock issued under the Plan is determined based on the closing price of the Company’s common stock on the grant date.

The Company incurred $8,125 and $27,743 in compensation expense in the first nine months of 2012 and 2011, respectively, related to the restricted stock awards for services by Board members for those respective periods. As of September 30, 2012, accrued expenses includes $74,799 of accrued stock awards representing 54,017 shares of common stock granted but not yet issued to directors for their services on the board. The Company did not issue any of its common stock in settlement of accrued stock awards during the nine months ended September 30, 2012.

NOTE 5 - Derivative Liabilities

Derivative liabilities resulting from certain warrants issued in connection with the Company’s Series B financing were valued using the Black-Scholes option valuation model and the following assumptions on the following dates:

11

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

	September 30,  2012			December 31,  2011
Series B warrants:
Risk-free interest rate		0.23	%		0.33	%
Expected volatility		72.05	%		47.71	%
Expected life (in years)		1.94			2.69
Expected dividend yield		-			-
Number of warrants		214,229			902,038
Fair value	$	57,610		$	156,596

The risk-free interest rate was based on rates established by the Federal Reserve. The Company’s policy for expected volatility is disclosed in Note 3 Stock-Based Compensation. The expected life of the warrants was determined by the expiration date of the warrants. The expected dividend yield was based upon the fact that the Company has not historically paid dividends on its common stock, and does not expect to pay dividends on its common stock in the future.

The fair value of these warrant liabilities was $57,610 at September 30, 2012. The net change in fair value during 2012 is $98,986 of which $306,247 is reported in our condensed consolidated statement of operations as an unrealized loss on the change in fair value of the derivative liabilities and $405,233 is a reclassification of the fair value of the derivative liabilities to equity in connection with the Series C-1 Preferred Stock and Warrant financing. The fair value of the derivative liabilities are re-measured at the end of every reporting period and upon the exercise of the warrant. The change in fair value is reported in the consolidated statement of operations as an unrealized gain or loss on the change in fair value of the derivative liability.

Fair Value Measurement

Valuation Hierarchy

ASC 820, “Fair Value Measurements and Disclosures,” establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

12

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

The following table provides the liabilities carried at fair value measured on a recurring basis as of September 30, 2012:

			Fair Value Measurements at September 30, 2012
	Total Carrying Value at  September 30, 2012		Quoted  prices in  active markets  (Level 1)		Significant other observable inputs  (Level 2)		Significant unobservable inputs (Level 3)
Derivative liabilities	$	57,610	$	-	$	-	$	57,610

The carrying amounts of cash, accounts receivable, accounts payable, and accrued liabilities approximate their fair value due to their short maturities. The Company measures the fair value of financial assets and liabilities based on the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.

Level 3 liabilities are valued using unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the derivative liabilities. For fair value measurements categorized within Level 3 of the fair value hierarchy, the Company’s accounting department, who reports to the Chief Financial Officer, determines its valuation policies and procedures.  The development and determination of the unobservable inputs for Level 3 fair value measurements and fair value calculations are the responsibility of the Company’s accounting department and are approved by the Chief Financial Officer. 

Level 3 Valuation Techniques

Level 3 financial liabilities consist of the derivative liabilities for which there is no current market for these securities such that the determination of fair value requires significant judgment or estimation.  Changes in fair value measurements categorized within Level 3 of the fair value hierarchy are analyzed each period based on changes in estimates or assumptions and recorded as appropriate.

The Company uses the Black-Scholes option valuation model to value Level 3 financial liabilities at inception and on subsequent valuation dates.  This model incorporates transaction details such as the Company’s stock price, contractual terms, maturity, risk free rates, as well as, volatility.

A significant decrease in the volatility or a significant decrease in the Company’s stock price, in isolation, would result in a significantly lower fair value measurement. Changes in the values of the derivative liabilities are recorded in Change in Fair Value of Derivative Liabilities within Other Income (Expense) on the Company’s Condensed Consolidated Statements of Operations.

13

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

As of September 30, 2012, there were no transfers in or out of level 3 from other levels in the fair value hierarchy.

The following table sets forth a summary of the changes in the fair value of the Company’s Level 3 financial liabilities that are measured at fair value on a recurring basis:

	For the three months ended September 30,					For the nine months ended September 30,
	2012		2011			2012			2011
Beginning balance	$	37,816	$	864,797		$	156,596		$	2,609,708
Net unrealized loss (gain) on the derivative liabilities		19,794		(548,420	)		306,247			(509,621	)
Reclassification to equity		-		-			(405,233	)		(1,783,710	)
Ending balance	$	57,610	$	316,377		$	57,610		$	316,377

NOTE 6 –(Loss) Earnings Per Share

Basic earnings and loss per share are computed by dividing the net income or loss applicable to common shares by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period. Potential common shares consist of the incremental common shares issuable upon the exercise of stock options (using the treasury stock method) and the conversion of the Company’s convertible preferred stock and warrants (using the if-converted method). Diluted loss per share excludes the shares issuable upon the conversion of preferred stock, the exercise of stock options and warrants from the calculation of net loss per share in those periods in which their effect would be antidilutive.

14

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited)

The following table reconciles the numerator and denominator for the calculation

	For the Three Months Ended						For the Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
Basic (loss) earnings per share
Net (Loss) Income	$	(79,249	)	$	562,926		$	(755,760	)	$	690,194
Preferred stock deemed dividend		-			-			(1,806,919	)		-
Preferred stock dividends		(42,000	)		(12,000	)		(95,333	)		(36,989	)
Net (loss) income available to common stockholders	$	(121,249	)	$	550,926		$	(2,658,012	)	$	653,205
Weighted average basic shares Outstanding		29,747,762			29,329,816			29,608,684			28,809,385
(Loss) Earnings per basic share:
Net (Loss) Income	$	0.00		$	0.02		$	(0.03	)	$	0.02
Preferred stock deemed dividend		0.00			0.00			(0.06	)		0.00
Preferred stock dividends		0.00			0.00			0.00			0.00
Net (loss) income available to common stockholders	$	0.00		$	0.02		$	(0.09	)	$	0.02
Dilutive (loss) earnings per share
Net (Loss) Income	$	(79,249	)	$	562,926		$	(755,760	)	$	690,194
Preferred stock deemed dividend		-			-			(1,806,919	)		-
Preferred stock dividends		(42,000	)		-			(95,333	)		-
Net (loss) income available to common stockholders	$	(121,249	)	$	562,926		$	(2,658,012	)	$	690,194
Weighted average basic shares Outstanding		29,747,762			29,329,816			29,608,684			28,809,385
Weighted average effect of dilutive  securities:
Employee stock options		-			663,512			-			1,725,645
Convertible preferred stock		-			2,316,700			-			2,316,700
Warrants		-			214,630			-			619,387
Weighted average diluted shares  outstanding		29,747,762			32,524,658			29,608,684			33,471,117
(Loss) Earnings per diluted share:
Net (Loss) Income	$	0.00		$	0.02		$	(0.03	)	$	0.02
Preferred stock deemed dividend		0.00			0.00			(0.06	)		0.00
Preferred stock dividends		0.00			0.00			0.00			0.00
Net (loss) income available to  common stockholders	$	0.00		$	0.02		$	(0.09	)	$	0.02
Securities excluded from the weighted  average dilutive common shares  outstanding because their inclusion would have been anti-dilutive:
Preferred Stock		4,807,773			-			4,807,773			-
Stock options		5,979,796			2,400,552			5,979,796			1,283,726
Warrants		2,425,341			582,424			2,425,341			87,813

15

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited) 

NOTE 7 -Income Taxes

The Company has significant net operating loss and business credit carryovers which are subject to a valuation allowance due to the uncertain nature of the realization of the losses. The Internal Revenue Code imposes certain limitations on the utilization of net operating loss carryovers and other tax attributes after a change in control. The Company does not believe it has encountered ownership changes which could significantly limit the possible utilization of such carryovers. It is not anticipated that limitations, if any, would have a material impact on the condensed consolidated balance sheet as a result of offsetting changes in the deferred tax valuation allowance. Based on all available evidence, the Company believes that its deferred tax assets should be fully reserved as of September 30, 2012 because it is still currently more likely than not that the benefits of the Company’s deferred tax assets will not be realized in future periods. The Company will continue to assess the likelihood of recognizing a portion of its deferred tax assets and will make an assessment of whether it should reduce the valuation allowance.

The Company will recognize interest and penalties accrued related to unrecognized tax benefits as components of its income tax provision. As of September 30, 2012, the Company does not have any interest and penalties accrued related to unrecognized tax benefits.

NOTE 8 -Concentration of Credit Risk

The Company’s top two customers accounted for approximately 45% and 10% of total revenue for the nine months ended September 30, 2012. One customer accounted for 59% of total revenue for the nine months ended September 30, 2011.

The Company’s top two customers accounted for approximately 40% and 11% of total revenue for the three months ended September 30, 2012. One customer accounted for 58% of total revenue for the three months ended September 30, 2011.

Two customers accounted for approximately 43% and 11% of accounts receivable as of September 30, 2012 as compared to the largest customer accounting for 66% of accounts receivable as of September 30, 2011.

NOTE 9 –Commitments and Contingencies

In June 2012, the Company renewed its lease for approximately 19,500 square feet of office space at the corporate headquarters in Rochester, New York. The lease term is for five years with a lease commencement date of July 1, 2012. The base annual rent under the lease is $309,075, and increases two percent (2%) per year over the term of the lease.

16

VirtualScopics, Inc. and Subsidiary

Notes to Condensed Consolidated Financial Statements

(unaudited) 

NOTE 10 –Related Party

In April 2012, the Company issued Merck Global Health Innovation Fund, LLC (a wholly-owned subsidiary of Merck & Co, Inc. (“Merck”)) 3,000 shares of Series C-1 Preferred Stock which are initially convertible into 2,491,073 shares of common stock and Series C-1 Warrants which are exercisable to purchase 1,361,316 shares of common stock. Revenues generated from Merck were $1,208,761 and $558,148 for the nine months ended September 30, 2012 and 2011, respectively and $382,913 and $202,171 for the three months ended September 30, 2012 and 2011, respectively. The accounts receivable balance due from Merck was $333,551 and $186,550 as of September 30, 2012 and December 31, 2011, respectively.

NOTE 11 -Subsequent Events

The Company evaluates events that have occurred after the balance sheet date but before the financial statements are issued. Based upon the evaluation, the Company did not identify any recognized or non-recognized subsequent events that would have required adjustment or disclosure in the condensed consolidated financial statements.

17

ITEM 2: Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with VirtualScopics’ condensed consolidated balance sheets as of September 30, 2012 and December 31, 2011 and the related condensed consolidated statements of operations and cash flows for the three and nine months ended September 30, 2012 and 2011, included elsewhere in this report. This discussion contains forward-looking statements, the accuracy of which involves risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons including, but not limited to, those discussed under the heading “Forward Looking Statements” below and elsewhere in this report. We disclaim any obligation to update information contained in any forward-looking statements.

Overview

VirtualScopics, Inc. is a leading provider of imaging solutions to accelerate drug and medical device development. We have developed a robust software platform for analysis and modeling of both structural and functional medical images. In combination with our industry-leading experience and expertise in advanced imaging biomarker measurement, this platform provides a uniquely clear window into the biological activity of drugs and devices in clinical trial patients, allowing pharmaceutical, biotechnology and medical device companies to make better decisions faster. Additionally, our technology is believed to help curtail trials that are not likely to be beneficial and to avoid mistaken termination of compounds that are likely to prove efficacious, as well as allow our customers to expedite compounds that are demonstrating response. This is done through:

· improved precision in the measurement of existing imaging-based biomarkers resulting in shorter observation periods, with beneficial cost savings within a clinical trial;

· new imaging biomarkers, which are better correlated with disease states, again reducing trial length and therefore costs; and

· reduced processing time for image data analysis through automation.

In addition, we believe our technology helps reduce aggregate clinical development costs through:

· improved precision for existing biomarkers, thus requiring smaller patient populations and lower administrative costs; and

· new biomarkers that serve as better correlates, leading to better early screening and elimination of weak drug candidates in pre-clinical trials.

In July 2000, VirtualScopics was formed after being spun out of the University of Rochester and in June 2002, VirtualScopics purchased the underlying technology and patents created by VirtualScopics’ founders from the University of Rochester. VirtualScopics owns all rights to the patents underlying its technology.

18

Revenues since inception have been derived primarily from image analysis services in connection with pharmaceutical drug trials. For these services, we have been concentrating in the areas of oncology and musculoskeletal diseases. We have also derived a portion of revenue from consulting services and pharmaceutical drug trials in the neurology and cardiovascular therapeutic areas. Revenues are recognized as the services are performed and as images are analyzed.

We continue to submit proposals and bids for new contracts, however, there can be no assurance that we will secure contracts from these efforts or that any such contracts or any of our existing contracts will not be cancelled by a customer.

Additionally, once we enter into a new contract for participation in a drug trial, there are several factors that can affect whether we will realize the full benefits under the contract, and the time over which we will realize that revenue. Customers may not continue our services due to many reasons including lack of demonstrated efficacy with their compounds in development. Furthermore, the contracts may contemplate performance over multiple years. Therefore, revenue may not be realized in the fiscal year in which the contract is signed or awarded. Recognition of revenue under the contract may also be affected by the timing of patient recruitment and image site identification and training.

We have also begun pursuing the application of one of our technologies into the personalized medicine market. Specifically, we believe there could be further benefit of our blood flow and vascular permeability software tool in assisting patients and oncologists in determining whether an anti-angiogenic therapy is having the desired effect. We believe this application will assist oncologists with treatment planning for patients undergoing anti-angiogenic cancer therapies. We have begun the regulatory process for obtaining 510(k) clearance from the FDA for our application to be used as a tool to analyze Dynamic Contrast-Enhanced Magnetic Resonance Images (DCE-MRI). On April 3, 2012, we entered into an agreement with Merck Global Health Innovation Fund, LLC, or GHI, for equity financing of up to $6,000,000. The transaction is part of an investment by GHI to provide funding for our efforts to expand our quantitative imaging technology into the personalized medicine market. We completed the first closing on April 3, 2012 for financing of $3,000,000 less issuance costs of approximately $334,000. We plan to use the proceeds from the financing from GHI to develop this personalized medicine initiative and establish our IT and software platform to create a quantitative imaging center. We also plan to use the proceeds to further validate our blood perfusion module, which is our first personalized medicine application. We will continue to assess the best mechanism for channeling our quantitative imaging software applications into the market; however, there can be no assurance that approval will be granted or we will experience significant demand for our services.

Results of Operations

Results of Operations for Quarter Ended September 30, 2012 Compared to Quarter Ended September 30, 2011

19

Revenues

We had revenues of $3,328,000 for the quarter ended September 30, 2012 compared to $3,269,000 for the comparable period in 2011, representing a $59,000, or 2% increase. The slight increase was related to higher image analysis services in 2012 compared to 2011. In July of this year we hired two individuals to augment our sales efforts in Europe and the US West Coast. We believe these individuals will help enable us to better attack the market and provide us greater visibility in those regions. In addition to hiring sales representatives, we have reorganized our sales function which will allow our sales personnel more time to pursue opportunities and interface with existing and prospective customers. Although the amount of new project awards has been slower than we experienced in previous years, we have seen an increasing number of requests for proposals throughout 2012, in particular through the PPD channel. We believe that this increase in requests for proposals and our strategic alliance with PPD, Inc. will help increase the level of business activity from what we have experienced in 2011 and 2012, however, we anticipate that the slowdown in project awards that we’ve been experiencing will continue to have an impact on our revenue growth for the remainder of 2012.

During the third quarter of 2012, we performed work on 93 different projects, in connection with our pharmaceutical drug trials in the fields of oncology, osteoarthritis and various other therapeutic areas. This compares to 103 projects during the same period in 2011. During the third quarter of 2012, 72% of our business was in oncology services and 18% in musculoskeletal, the remaining 10% was in other therapeutic areas. This compares to 73%, 23% and 4%, respectively, in 2011. During the third quarter of 2012, 75% of the revenues were derived from Phase II and III studies compared to 71% during the comparable period in 2011. The gross margin we are able to realize on our revenues is impacted by the nature of the service mix during the reported quarter, as well as the therapeutic area and phase of study. Incoming image processing and image analysis activities tend to produce higher margins, while we are experiencing lower margins within our project management and site initiation activities. Therefore, our margins may vary from quarter to quarter depending on the mix of services.

Gross Profit

We had a gross profit of $1,462,000 for the third quarter of 2012 compared to $1,497,000 for the comparable period in 2011, representing a $35,000, or 2%, decline. Our gross profit margin was 44% during the quarter ended September 30, 2012 compared to 46% during the third quarter of 2011. Excluding reimbursed charges, which yield no margin, our gross margin was 47% for the third quarter of 2012 compared to 49% in the third quarter of 2011. Our margins declined year over year due to the 30% increase in our staff throughout 2011 within our operations group in order to better support the mix of projects we are experiencing.

Research and Development

Research and development costs increased in the quarter ended September 30, 2012 by $62,000, or 18%, to $415,000, when compared to the quarter ended September 30, 2011. The increase resulted from the hiring within our software development group in late 2011 and our work to support our personalized medicine applications including our 510k filing with the FDA. We now have three dedicated software developers working on our personalized medicine platform. Our other research and development efforts center around refining our processes through the use of our software platform in order to allow for greater reporting capabilities by our customers and to gain efficiencies which we believe will better allow us to standardize our processes as we scale the business. We believe the investments in personnel we made within our development group will better enable us to efficiently deliver on Phase III studies and enhance our productivity. Additionally, we continue to invest in the commercialization of new imaging techniques across modalities and therapeutic areas to best serve our customers.

20

Sales and Marketing

Sales and marketing costs increased in the quarter ended September 30, 2012 by $55,000, or 21%, to 315,000 when compared to the quarter ended September 30, 2011. The increase was the result of hiring two experienced sales individuals to cover the European and West Coast US territories during the third quarter of 2012. Currently, there are 6 individuals within our sales and marketing department. Our sales and marketing initiatives encompass attendance and presentations at leading industry conferences, frequent educational webinars and active calling on existing and new customers.

General and Administrative

General and administrative expenses for the quarter ended September 30, 2012 were $684,000, a decrease of $67,000 or 9%, when compared to the quarter ended September 30, 2011. The decrease was mainly attributed to lower stock compensation charges and reductions in IT expenses during the third quarter of 2012 as compared to the same period in 2011. General and administrative expenses include both personnel and non-personnel costs. Departments included within general and administrative function are finance, information technology, quality, human resources and the CEO position. Non-payroll related costs included within general and administration include stock option expense, audit and legal fees, regulatory and compliance fees, Nasdaq listing fees, board fees, non-capitalizable hardware and software costs and licenses and non-sales related travel costs.

Depreciation and Amortization

Depreciation and amortization charges were $101,000 for the quarter ended September 30, 2012 compared to $114,000 during the quarter ended September 30, 2011. The reduction is due to the complete amortization of our right to use an MRI unit at the University of Rochester during the quarter ended September 30, 2011. Offsetting this reduction was higher depreciation charges related to recent capital purchases, including the purchase and installation cost of an ERP system.

Other (Expense) Income

Other expense for the quarter ended September 30, 2012 was $26,000 compared to other income of $543,000 for the quarter ended September 30, 2011. During the third quarter of 2012, we recognized a marked to market loss of $20,000, relating to the increase in fair value of warrants that were issued in connection with our 2007 Series B offering (see Financial Statement Note 4) compared to a non-cash marked to market gain of $548,000 for the quarter ended September 30, 2011. The aggregate decrease of $569,000 when compared to the third quarter of 2011 is attributable to the lower average price of our common stock during the third quarter of 2012 compared to the third quarter of 2011 and the decrease in the number of derivative instruments outstanding due to the elimination of the anti-dilution adjustment provision in certain Series B warrants as part of the Series C-1 financing.As of September 30, 2012, the Company had 214,229 warrants outstanding subject to the anti-dilution adjustment provision as compared to the 902,038 at September 30, 2011.

21

Net (Loss) Income

Net loss for the quarter ended September 30, 2012 was $79,000 compared to net income of $563,000 for the quarter ended September 30, 2011. The decrease in our net income was primarily related to the non-cash loss recognized for the marked to market adjustment for certain warrants outstanding during the third quarter of 2012 as compared to the gain recognized in the third quarter of 2011.

Results of Operations for the Nine Months Ended September 30, 2012 Compared to the Nine Months Ended September 30, 2011

Revenues

Our revenues for the nine months ended September 30, 2012 were $10,366,000, a decrease of $414,000 or 4% over the first nine months of 2011. The decrease was related to a reduced level of new project awards in 2011 and 2012 due to general market conditions and delays in study initiations and recruitment within existing studies. In July of this year we hired two individuals to augment our sales efforts in Europe and the US West Coast. We believe these individuals will help enable us to better attack the market and provide us greater visibility in those regions. In addition to hiring sales representatives, we have reorganized our sales function which will allow our sales personnel more time to pursue opportunities and interface with existing and prospective customers. Although the amount of new project awards has been slower than we experienced in previous years, we have seen an increasing number of requests for proposals throughout 2012, in particular through the PPD channel. We believe that this increase in requests for proposals and our strategic alliance with PPD, Inc. will help increase the level of business activity from what we have experienced in 2011 and 2012, however, we anticipate that the slowdown in project awards that we’ve been experiencing will continue to have an impact on our revenue growth for the remainder of 2012.

We performed services for a total of 114 projects in the first nine months of 2012, as compared to 127 in the first nine months of 2011. During the first nine months of 2012, 75% of our revenues were generated from Phase II/III projects compared to 75% during the first nine months of 2011. We expect that a majority of our revenues from pharmaceutical and medical device clinical trials will be derived from Phase II and III studies throughout the remainder of 2012.

Gross Profit

We had a gross profit of $4,217,000 for the nine months ended September 30, 2012 compared to $4,917,000 for the comparable period in 2011, representing a $700,000, or 14%, decline. Our gross margin for the nine months ended September 30, 2012 was 41% compared to 46% for the first nine months of 2011. Our gross margin fluctuations are largely a result of the mix of services performed during a given period and the decrease in revenues. Historically, we have experienced lower margins in our musculoskeletal projects than our oncology projects. Also impacting our 2012 margins is the increase in the amount of staff we employ in our operations group by 30% in order to better support the mix of projects we are experiencing.

22

Research and Development

Total research and development expenditures were $1,172,000 in the first nine months of 2012 compared to $1,081,000 for the comparable period in 2011, an increase of 8%. The increase was due to consultant and professional fees related to the continued development of the personalized medicine applications. Our other research and development efforts center around refining our processes through the use of our software platform in order to gain efficiencies which we believe will better allow us to standardize our processes as we scale the business. Additionally, we continue to invest in the commercialization of new imaging techniques across many modalities and therapeutic areas to best serve our customers and the demand in the market.

Sales and Marketing

Sales and marketing costs for the nine months ended September 30, 2012 were $962,000 compared to $879,000 for the first nine months of 2011, an increase of 9%. The increase was the result of hiring two experienced sales individuals to cover the European and West Coast US territories during the third quarter of 2012. Our sales and marketing efforts include conference attendance and presentations, technically-focused webinars, customer webinars and related travel along with advertising in key scientific journals and occasional consulting and other costs associated with market research activities. During the third quarter of 2012, we have hired two seasoned sales individuals to cover the European and West Coast US territories. Currently, there are 6 individuals within our sales and marketing department.

General and Administrative

General and administrative expenses for the nine months ended September 30, 2012 were $2,202,000, a decrease of $202,000 or 8%, over the first nine months of 2011.The decrease is largely driven by a reduction in non-cash stock compensation costs and general cost controls during the first nine months of 2012. General and administrative expenses include both personnel and non-personnel costs. Departments included within general and administrative function are finance, information technology, quality, human resources and the CEO position. Non-payroll related costs included within general and administration include stock option expense, audit and legal fees, regulatory and compliance fees, Nasdaq listing fees, board fees, non-capitalizable hardware and software costs and licenses and non-sales related travel costs.

Depreciation and Amortization

Depreciation and amortization charges were $320,000 for the nine months ended September 30, 2012 compared to $364,000 during the first nine months of September 30, 2011. The slight reduction is due to the complete amortization of our right to use an MRI unit at the University of Rochester. Offsetting this reduction was higher depreciation charges related to recent capital purchases, including the purchase and installation cost of the financial and accounting component of an ERP system.

23

Other (Expense) Income

Other expense for the nine months ended September 30, 2012 was $317,000 compared to other income of $501,000 in the same period in 2011. The increase in other expense was a reflection of the recognition of a marked to market loss of $306,000 related to the increase in fair value of certain warrants that were issued in connection with our 2007 Series B offering (see Financial Statement Note 4). During the first nine months of 2011, we recognized an unrealized gain of $510,000 due to the decrease in fair value of those warrants. The aggregate decrease of $818,000 when compared to the first nine months of 2011 is attributable to the higher average price of our common stock during the first nine months of 2012 compared to the first nine months of 2011 and the decrease in the number of derivative instruments outstanding due to the elimination of the anti-dilution adjustment provision in certain Series B warrants as part of the Series C-1 financing.As of September 30, 2012, the Company had 214,229 warrants outstanding subject to the anti-dilution adjustment provision as compared to the 902,038 at September 30, 2011.

Net (Loss) Income

Our net loss for the nine months ended September 30, 2012 was $756,000 compared to a net income of $690,000 for the same period in 2011. The decrease in our net income was primarily related to the non-cash loss recognized for the marked to market adjustment for certain warrants outstanding during the first nine months of 2012 as compared to the gain recognized in 2011 and the decrease in revenues and gross profit in 2012.

Liquidity and Capital Resources

Our working capital as of September 30, 2012 was approximately $9,511,000 compared to $6,353,000 as of December 31, 2011. The increase in working capital was primarily a result of the financing agreement with GHI that resulted in the receipt of net proceeds of approximately $2,700,000.

Net cash used in operating activities totaled $474,000 in the nine months ended September 30, 2012 compared to net cash provided by operating activities of $837,000 in the comparable 2011 period. The decrease is mostly due to the increase in the net loss for the nine months ended September 30, 2012 compared to the prior period as well as the timing of advance payments on new projects and receipts from customers in the first nine months of 2012 as compared to the first nine months of last year. Our days sales outstanding increased to 68 in the nine months ending September 30, 2012 as compared to 66 at December 31, 2011 due to increasingly longer payment terms required by our larger customers. We do not expect, nor have we experienced, significant write-offs within our receivables.

We invested $140,000 in the purchase of equipment and the acquisition of patents in the first nine months of 2012, compared to $389,000 for the investment in these items in the first nine months of 2011. The decrease reflects investments in our IT and IS infrastructure in the first nine months of 2011 for the acquisition of a new IT storage system that did not reoccur in 2012.

24

Cash provided by our financing activities in the nine months ended September 30, 2012 was $2,937,000 compared to cash provided of $149,000 in the nine months ended September 30, 2011. The increase is a result of proceeds from the exercise of options and warrants during the first nine months of 2012, and the closing of the financing agreement with Merck GHI.

We currently expect that existing cash will be sufficient to fund operations for the next 12 months. If in the next 12 months our plans or assumptions change or prove to be inaccurate, or if we are unable to meet the milestones for the second closing of the investment by GHI, we may be required to seek additional capital through public or private debt or equity financings. If we need to raise additional funds, we may not be able to do so on terms favorable to us, or at all. If we cannot raise sufficient funds on acceptable terms, we may have to curtail our level of expenditures and our rate of expansion.

Off Balance Sheet Arrangements

We have no off-balance sheet arrangements (other than the consulting agreements and operating leases) that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital resources or capital expenditures that is material to investors.

Forward Looking Statements

Certain statements made in this discussion are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include statements that address activities, events or developments that we expect, believe or anticipate may occur in the future, including the following risk factors:

· adverse economic conditions;

· inability to raise sufficient additional capital to operate our business;

· unexpected costs, lower than expected sales and revenues, and operating defects;

· adverse results of any legal proceedings;

· the volatility of our operating results and financial condition;

· inability to attract or retain qualified senior management personnel, including sales and marketing, and scientific personnel;

· the risk that we may not meet the milestones for the second closing of our financing with GHI for funds to pursue our personalized medicine initiative; and

· other specific risks that may be referred to in this report.

25

All statements, other than statements of historical facts, included in this report including, without limitation, statements regarding our strategy, future operations, financial position, estimated revenue or losses, projected costs, prospects and plans and objectives of management are forward-looking statements. When used in this report, the words “may,” “believe,” “anticipate,” “intend,” “estimate,” “expect,” “project,” “plan,” “could,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. All forward-looking statements speak only as of the date of this report. We do not undertake any obligation to update any forward-looking statements or other information contained in this report. Existing stockholders and potential investors should not place undue reliance on these forward-looking statements. Although we believe that our plans, intentions and expectations reflected in or suggested by the forward-looking statements in this report are reasonable, we cannot assure our stockholders or potential investors that these plans, intentions or expectations will be achieved. We disclose important factors that could cause our actual results to differ materially from our expectations under the heading entitled “Risk Factors” in our annual report on Form 10-K for the fiscal year ended December 31, 2011 filed with the Securities and Exchange Commission (“SEC”) and elsewhere in this report. These risk factors qualify all forward-looking statements attributable to us or persons acting on our behalf.

ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain a set of disclosure controls and procedures, as defined in Section 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

Notwithstanding the foregoing, there can be no assurance that the Company’s disclosure controls and procedures will detect or uncover all failures of persons within the Company to disclose material information otherwise required to be set forth in the Company’s periodic reports. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable, not absolute, assurance of achieving their control objectives.

Changes in Internal Controls Over Financial Reporting

An evaluation was performed under the supervision of the Company’s management, including the CEO and CFO, as required under Exchange Act Rule 13a-15(d) and 15d-15(d) of whether any change in the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) occurred during the fiscal quarter ended September 30, 2012. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that no change in the Company’s internal controls over financial reporting occurred during the fiscal quarter ended September 30, 2012 that has materially affected or is reasonably likely to materially affect the Company’s internal control over financial reporting.

26

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings

None

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.   Defaults upon Senior Securities

Not applicable.

Item 4.   Mine Safety Disclosures.

Not applicable.

Item 5.   Other Information

None

Item 6.    Exhibits

Exhibit 31.1     Certification of Chief Executive Officer as required by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 31.2     Certification of Chief Financial Officer as required by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.1     Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act 0f of 2002.

Exhibit 32.2     Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act 0f of 2002.

Exhibit 101.CAL   XBRL Taxonomy Extension Calculation Linkbase.

Exhibit 101.DEF   XBRL Taxonomy Extension Definition Linkbase.

Exhibit 101.INS   XBRL Instance Document.

27

Exhibit 101.LAB   XBRL Taxonomy Extension Label Linkbase.

Exhibit 101.PRE   XBRL Taxonomy Extension Presentation Linkbase.

Exhibit 101.SCH   XBRL Taxonomy Extension Schema Linkbase.

28

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.

Dated:  November 14, 2012	VIRTUALSCOPICS, INC.
	/s/  Jeffrey Markin
	Jeffrey Markin
	President and Chief Executive Officer
	/s/  Molly Henderson
	Molly Henderson
	Chief Business and Financial Officer, Senior Vice President

29

Exhibit Index

Exhibit 31.1     Certification of Chief Executive Officer as required by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit  31.2     Certification of Chief Financial Officer as required by Rule 13a-14 or 15d-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1     Certification pursuant to 18 U.S.C. Section 1350 by the Chief Executive Officer, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2     Certification pursuant to 18 U.S.C. Section 1350 by the Chief Financial Officer, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 101.CAL   XBRL Taxonomy Extension Calculation Linkbase.

Exhibit 101.DEF   XBRL Taxonomy Extension Definition Linkbase.

Exhibit 101.INS   XBRL Instance Document.

Exhibit 101.LAB   XBRL Taxonomy Extension Label Linkbase.

Exhibit 101.PRE   XBRL Taxonomy Extension Presentation Linkbase.

Exhibit 101.SCH   XBRL Taxonomy Extension Schema Linkbase.

30