CYTORI THERAPEUTICS, INC.

(Exact name of Registrant as Specified in Its Charter)

DELAWARE		33-0827593
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
3020 CALLAN ROAD, SAN DIEGO, CALIFORNIA		92121
(Address of principal executive offices)		(Zip Code)

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Item 1.  Financial Statements

CYTORI THERAPEUTICS, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

(UNAUDITED)

 

		As of September 30, 2011				As of December 31, 2010
Assets
Current assets:
Cash and cash equivalents		$	40,803,000			$	52,668,000
Accounts receivable, net of reserves of $265,000 and $306,000 in 2011 and 2010, respectively			1,967,000				2,073,000
Inventories, net			4,153,000				3,378,000
Other current assets			702,000				834,000
Total current assets			47,625,000				58,953,000
Property and equipment, net			1,788,000				1,684,000
Restricted cash and cash equivalents			350,000				350,000
Investment in joint venture			306,000				459,000
Other assets			1,330,000				566,000
Intangibles, net			247,000				413,000
Goodwill			3,922,000				3,922,000
Total assets		$	55,568,000			$	66,347,000
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable and accrued expenses		$	6,374,000			$	6,770,000
Current portion of long-term obligations			69,000				6,453,000
Total current liabilities			6,443,000				13,223,000
Deferred revenues, related party			4,281,000				5,512,000
Deferred revenues			5,118,000				4,929,000
Warrant liability			1,273,000				4,987,000
Option liability			1,850,000				1,170,000
Long-term deferred rent			468,000				398,000
Long-term obligations, net of discount, less current portion			24,209,000				13,255,000
Total liabilities			43,642,000				43,474,000
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value; 5,000,000 shares authorized; -0- shares issued and outstanding in 2011 and 2010			-				-
Common stock, $0.001 par value; 95,000,000 shares authorized; 54,834,683 and 51,955,265 shares issued and 54,834,683 and 51,955,265 shares outstanding in 2011 and 2010, respectively			55,000				52,000
Additional paid-in capital			247,413,000				232,819,000
Accumulated deficit			(235,542,000	)			(209,998,000	)
Total stockholders’ equity			11,926,000				22,873,000
Total liabilities and stockholders’ equity		$	55,568,000			$	66,347,000

 

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

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CYTORI THERAPEUTICS, INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(UNAUDITED)

 

		For the Three Months Ended September 30,								For the Nine Months Ended September 30,
		2011				2010				2011				2010
Product revenues:
Related party		$	—			$	581,000			$	—			$	590,000
Third party			2,134,000				938,000				5,908,000				5,286,000
			2,134,000				1,519,000				5,908,000				5,876,000
Cost of product revenues			942,000				920,000				2,893,000				2,733,000
Gross profit			1,192,000				599,000				3,015,000				3,143,000
Development revenues:
Development, related party			—				—				1,231,000				2,122,000
Research grant and other			5,000				65,000				19,000				93,000
			5,000				65,000				1,250,000				2,215,000
Operating expenses:
Research and development			2,830,000				2,480,000				8,948,000				7,026,000
Sales and marketing			3,618,000				2,932,000				10,560,000				7,356,000
General and administrative			3,538,000				3,060,000				11,230,000				9,331,000
Change in fair value of warrant liability			(1,536,000	)			1,803,000				(3,714,000	)			(1,824,000	)
Change in fair value of option liability			570,000				(20,000	)			680,000				180,000
Total operating expenses			9,020,000				10,255,000				27,704,000				22,069,000
Operating loss			(7,823,000	)			(9,591,000	)			(23,439,000	)			(16,711,000	)
Other income (expense):
Interest income			3,000				3,000				7,000				6,000
Interest expense			(489,000	)			(759,000	)			(1,923,000	)			(1,288,000	)
Other income (expense), net			25,000				(27,000	)			(36,000	)			(152,000	)
Equity loss from investment in joint venture			(51,000	)			(43,000	)			(153,000	)			(98,000	)
Total other expense			(512,000	)			(826,000	)			(2,105,000	)			(1,532,000	)
Net loss		$	(8,335,000	)		$	(10,417,000	)		$	(25,544,000	)		$	(18,243,000	)
Basic and diluted net loss per common share		$	(0.15	)		$	(0.23	)		$	(0.48	)		$	(0.40	)
Basic and diluted weighted average common shares			53,900,250				45,905,580				52,775,861				45,185,774

 

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

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CYTORI THERAPEUTICS, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)

		For the Nine Months Ended September 30,
		2011				2010
Cash flows from operating activities:
Net loss		$	(25,544,000	)		$	(18,243,000	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			621,000				772,000
Amortization of deferred financing costs and debt discount			471,000				449,000
Provision for doubtful accounts			274,000				428,000
Change in fair value of warrant liability			(3,714,000	)			(1,824,000	)
Change in fair value of option liability			680,000				180,000
Share-based compensation expense			2,578,000				2,294,000
Equity loss from investment in joint venture			153,000				98,000
Increases (decreases) in cash caused by changes in operating assets and liabilities:
Accounts receivable			(168,000	)			(452,000	)
Inventories			(775,000	)			(476,000	)
Other current assets			132,000				(104,000	)
Other assets			(764,000	)			(64,000	)
Accounts payable and accrued expenses			(396,000	)			(72,000	)
Deferred revenues, related party			(1,231,000	)			(2,122,000	)
Deferred revenues			189,000				29,000
Long-term deferred rent			70,000				302,000
Net cash used in operating activities			(27,424,000	)			(18,805,000	)
Cash flows from investing activities:
Purchases of property and equipment			(458,000	)			(473,000	)
Cash invested in restricted cash			—				(350,000	)
Investment in joint venture			—				(330,000	)
Net cash used in investing activities			(458,000	)			(1,153,000	)
Cash flows from financing activities:
Principal payments on long-term debt			(4,460,000	)			(5,454,000	)
Proceeds from long-term debt			9,444,000				20,000,000
Debt issuance costs and loan fees			(719,000	)			(559,000	)
Proceeds from exercise of employee stock options and warrants			2,849,000				7,050,000
Proceeds from sale of common stock and warrants			9,038,000				17,314,000
Costs from sale of common stock and warrants			(135,000	)			(518,000	)
Net cash provided by financing activities			16,017,000				37,833,000
Net increase (decrease) in cash and cash equivalents			(11,865,000	)			17,875,000
Cash and cash equivalents at beginning of period			52,668,000				12,854,000
Cash and cash equivalents at end of period		$	40,803,000			$	30,729,000
Supplemental disclosure of cash flows information:
Cash paid during period for:
Interest		$	1,458,000			$	724,000
Final payment fee on long-term debt			419,000				205,000
Supplemental schedule of non-cash investing and financing activities:
Fair value of warrants allocated to additional paid in capital		$	267,000			$	279,000
Capital equipment lease		$	85,000			$	—

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

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CYTORI THERAPEUTICS, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

September 30, 2011

(UNAUDITED)

1.	Basis of Presentation

Our accompanying unaudited consolidated condensed financial statements as of September 30, 2011 and for the three and nine months ended September 30, 2011 and 2010 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements.  Our consolidated condensed balance sheet at December 31, 2010 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations of Cytori Therapeutics, Inc., and our subsidiaries (the Company) have been included.  Operating results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.  These financial statements should be read in conjunction with the consolidated financial statements and notes therein included in our annual report on Form 10-K for the year ended December 31, 2010.

2.	Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period.  Our most significant estimates and critical accounting policies involve recognizing revenue, evaluating goodwill for impairment, valuing our put option arrangement with Olympus Corporation, valuing warrants, determining the assumptions used in measuring share-based compensation expense, valuing our deferred tax assets, assessing how to report our investment in Olympus-Cytori, Inc., and valuing allowances for doubtful accounts and inventories.

Actual results could differ from these estimates.  Current economic conditions, including illiquid credit markets and volatile equity markets, contribute to the inherent uncertainty of such estimates.  Management’s estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the periods they are determined to be necessary.

3.	Capital Availability

We incurred net losses of $8,335,000 and $25,544,000 for the three and nine months ended September 30, 2011 and $10,417,000 and $18,243,000 for the three and nine months ended September 30, 2010, respectively.  We have an accumulated deficit of $235,542,000 as of September 30, 2011.  Additionally, we have used net cash of $27,424,000 and $18,805,000 to fund our operating activities for the nine months ended September 30, 2011 and 2010, respectively .   To date these operating losses have been funded primarily from outside sources of invested or borrowed capital.

Management recognizes the need to generate positive cash flows in future periods and/or to obtain additional capital from various sources. In the continued absence of positive cash flows from operations, no assurance can be given that we can generate sufficient revenue to cover operating costs or that additional financing will be available to us and, if available, on terms acceptable to us in the future.

During 2011 and 2010, we expanded our commercialization activities while simultaneously pursuing available financing sources to support operations and growth.  We have had, and we may continue to have, an ongoing need to raise additional cash from outside sources to fund our operations.  If we cannot do so when required, we would need to reduce our research, development, and administrative operations, including reductions of our employee base, in order to offset lack of available funding.   We continue to evaluate available financing opportunities as part of our normal course of business.

 

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4.	Recently Adopted Accounting Pronouncements

In October 2009, the FASB issued an update to the revenue recognition topic of the Codification.  The update addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence; (b) third-party evidence; or (c) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. In addition, this guidance significantly expands required disclosures related to a vendor’s multiple-deliverable revenue arrangements. The update 2009-13 is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and early adoption is permitted.  The adoption of this standard did not have a material impact on our consolidated condensed financial statements.

In April 2010, the FASB issued additional guidance for revenue recognition to provide criteria that should be met for determining whether the milestone method of revenue recognition is appropriate. A vendor can recognize as revenue, in its entirety, consideration that is contingent upon achievement of a milestone in the period in which the milestone is achieved only if the milestone meets all criteria to be considered substantive. The guidance for milestone method of revenue recognition is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010.  The adoption of this standard did not have a material impact on our consolidated condensed financial statements.

In January 2010, the FASB issued an update which provides guidance to improve disclosures about fair value measurements. This guidance amends previous guidance on fair value measurements to add new requirements for disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurement on a gross basis rather than on a net basis as previously required. This update also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. This guidance is effective for annual and interim periods beginning after December 15, 2009, except for the requirement to provide the Level 3 activities of purchases, sales, issuances, and settlements on a gross basis, which will be effective for annual and interim periods beginning after December 15, 2010. Early application is permitted and, in the period of initial adoption, entities are not required to provide the amended disclosures for any previous periods presented for comparative purposes. This update did not have a material impact on our consolidated condensed financial statements.

In March 2010, the FASB issued an update to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify an award with such a feature as a liability if it otherwise qualifies as equity. Affected entities are required to record a cumulative catch-up adjustment for all awards outstanding as of the beginning of the annual period in which the guidance is adopted. This update did not have a material impact on our consolidated condensed financial statements.

In May 2011, the FASB revised the fair value measurement and disclosure requirements to align the requirements under GAAP and International Financial Reporting Standards (“IFRS”). The guidance clarifies the FASB’s intent about the application of existing fair value measurements and requires enhanced disclosures, most significantly related to unobservable inputs used in a fair value measurement that is categorized within Level 3 of the fair value hierarchy. The guidance is effective prospectively during interim and annual periods beginning after December 15, 2011. We do not expect the adoption of this guidance to have a material impact on our consolidated condensed financial statements.

In September 2011, the FASB issued an update that allows companies to assess qualitative factors to determine whether they need to perform the two-step quantitative goodwill impairment test. Under the option, an entity no longer would be required to calculate the fair value of a reporting unit unless it determines, based on that qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The guidance is effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011 although early adoption is permitted. As of September 30, 2011, we have not elected to adopt the new guidance early, and when adopted, this guidance is not expected to have a significant impact on our consolidated condensed financial statements.

5.	Short-Term Investments

We invest excess cash in money market funds, highly liquid debt instruments of financial institutions and corporations with strong credit ratings, and in United States government obligations. We have established guidelines relative to diversification and maturities to maintain safety and liquidity. These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates.   After considering current market conditions, and in order to minimize our risk, management has elected to invest all excess funds in money market funds and other highly liquid investments that are appropriately classified as cash equivalents as of September 30, 2011 and December 31, 2010.

 

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6.	Restricted Cash and Cash Equivalents

Restricted cash consists of cash and cash equivalents held in a letter of credit account pursuant to a lease agreement entered into on April 2, 2010 for leasing of property at 3020 and 3030 Callan Road, San Diego, California.  The lease agreement required us to execute a letter of credit for $350,000 naming the landlord as a beneficiary.  The letter of credit was issued in July 2010 and required us to maintain $350,000 as restricted cash for the duration of the lease, which expires October 31, 2015.

7.	Warrant Liability

We account for certain common stock purchase warrants with exercise price reset features in accordance with the applicable FASB guidance.  Under this guidance, warrants with these reset features are accounted for as fair value liabilities, with changes in fair value now included in net earnings (loss).

The fair value of the liability associated with the warrants with this reset feature decreased to $1,273,000 as of September 30, 2011, which resulted in a $1,536,000 and $3,714,000 gain from the change in fair value of warrants for the three and nine months ended September 30, 2011, respectively.

Since these warrants do not qualify for hedge accounting, all future changes in the fair value of the warrants will be recognized currently in earnings until such time as the warrants are exercised or expire. These warrants are not traded in an active securities market, and as such, we estimated the fair value of these warrants using option pricing model using the following assumptions:

		As of September 30, 2011				As of December 31, 2010
Expected term		1.87 years				2.61 years
Common stock market price		$	2.95			$	5.19
Risk-free interest rate			0.25	%			0.82	%
Expected volatility			68.96	%			86.03	%
Resulting fair value (per warrant)		$	0.65			$	2.50

Expected volatility is based primarily on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the expected term of the warrants. We believe this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. We currently have no reason to believe future volatility over the expected remaining life of these warrants is likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is the interest rate for treasury constant maturity instruments published by the Federal Reserve Board that is closest to the expected term of the warrants.   The fair value of these warrants also incorporates our assumptions about future equity issuances and their impact to the down-round protection feature.

8.        Long-term Debt

On September 9, 2011 we entered into a Second Amendment to the Amended and Restated Loan and Security Agreement (loan agreement) with General Electric Capital Corporation (GECC), Silicon Valley Bank (SVB) and Oxford Finance Corporation (together, the “Lenders”), pursuant to which the Lenders increased the prior term loan made to the Company to a principal amount of $25.0 million (Term Loan), subject to the terms and conditions set forth in the loan agreement.  The Term Loan accrues interest at a fixed rate of 9.87% per annum.  Pursuant to the loan agreement, we are required to make (i) twelve (12) equal consecutive monthly principal payments of $20,833 on the first day of each calendar month, commencing on October 1, 2011, (ii) twenty-nine (29) equal consecutive monthly principal payments of $825,000 on the first day of each calendar month, commencing on October 1, 2012, and (iii) and one (1) final principal payment of $825,000 on March 1, 2015. In addition, the maturity date of the Term Loan has been extended until March 1, 2015, and at maturity of the Term Loan, the Company will make a final payment fee equal to 5% ($1,250,000) of the Term Loan.  We may incur additional fees if we elect to prepay the Term Loan.  In connection with the Term Loan, on September 9, 2011, we issued to the Lenders warrants to purchase up to an aggregate of 132,891 shares of our common stock at an exercise price of $3.01 per share.  These warrants are immediately exercisable and will expire on September 9, 2018.

The Term Loan amended the Amended and Restated Loan and Security Agreement, of which an aggregate balance of approximately $15.6 million remained outstanding along with a prorated final payment fee of $419,000. The net proceeds of the Term Loan, after payment of lender fees and expenses, were approximately $8.6 million.

 

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We accounted for this amendment as debt modification since the terms of the amended Term Loan and the Original Term Loan were not substantially different and as present value of cash flows of the modified instrument (using a net method of comparing the present value of cash flows related to the lowest common principal balance between the old and the new loans) was within 10% of the original debt instrument.  Accordingly, the fees associated with the amended Term Loan of $300,000 and the existing unamortized debt discount from the Original Term Loan of $332,000 will be amortized as an adjustment of interest expense over the term of the Amended Term Loan using the effective interest method.

We allocated the aggregate proceeds of the Term Loan between the warrants and the debt obligations based on their relative fair values.  The fair value of the warrants issued to the Lenders is calculated utilizing the Black-Scholes option-pricing model. We are amortizing the relative fair value of the warrants as a discount of $267,000 over the term of the loan using the effective interest method, with an effective interest rate of 13.63%. If the maturity of the debt is accelerated due to an event of default, then the amortization would be accelerated. The Term Loan is collateralized by the tangible assets of the company, including a security interest in substantially all of its existing and after-acquired assets, excluding its intellectual property assets; provided however, that if the Company does not maintain certain cash ratios, the security interest automatically will be deemed to include the Company’s intellectual property assets.  As of September 30, 2011, we were in compliance with our financial and non-financial covenants.

9.	Revenue Recognition

Product Sales

We recognize revenue from product sales when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable and (iv) collection of the resulting accounts receivable is reasonably assured.

For all sales, we use a binding purchase order or a signed agreement as evidence of an arrangement.  Revenue for these product sales is recognized upon delivery to the customer, as all risks and rewards of ownership have been substantively transferred to the customer at that point.  For sales to customers who arrange for and manage the shipping process, we recognize revenue upon shipment from our facilities.  Shipping and handling costs that are billed to our customers are classified as revenue.  The customer’s obligation to pay and the payment terms are set at the time of delivery and are not dependent on the subsequent use or resale of our products.

For sales prior to January 1, 2011 that included multiple deliverables, we allocated revenue based on the relative fair values of the individual components.  When more than one element such as product maintenance or technical support services were included in an arrangement, we allocated revenue between the elements based on each element’s relative fair value, provided that each element met the criteria for treatment as a separate unit of accounting (an item is considered a separate unit of accounting if it has value to the customer on a standalone basis and there is objective and reliable evidence of the fair value of the undelivered items).  Fair value is generally determined based upon the price charged when the element is sold separately.  In the absence of fair value for a delivered element, we allocated revenue first to the fair value of the undelivered elements and allocated the residual revenue to the delivered elements.  Fair values for undelivered elements were determined based on vendor-specific objective evidence as well as market participant quotes for similar services.  In the absence of fair value for an undelivered element, the arrangement was accounted for as a single unit of accounting, resulting in a deferral of revenue recognition for delivered elements until all undelivered elements have been fulfilled.  Deferred service revenue is recognized ratably over the period the services are provided.

Beginning in 2011, for sales that include multiple deliverables, such as sales of our StemSource® Cell Bank, we account for products or services (deliverables) separately rather than as a combined unit.  Stem cell banks typically consist of a complex array of equipment and services, including one or more StemSource® devices, a cryogenic freezer, measuring and monitoring equipment, and a database patient tracking system. In addition, we provide installation and training services concurrent with the installation of the bank as well as web hosting, technical and maintenance services, generally for a period of up to one year, subsequent to the date of sale.  The FASB guidance of the Codification establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence (“VSOE”); (b) third-party evidence (“TPE”); or (c) management estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method.  For our cell bank sales, we establish relative selling prices for all deliverables based on vendor-specific quotes for comparable services when available.  In the absence of VSOE, we use competitor’s products or services considered largely interchangeable with our own or management best estimates.  A substantial amount of consulting services are provided to customers before the equipment installation and training has been completed.  Because these services are typically billed separately and have standalone value to the customer, we treat them as a separate unit of accounting and recognize them as they are earned.  The equipment installation and initial training activities are treated as a single unit of accounting, and future services such as web hosting and ongoing maintenance are deferred and recognized into income during the year following the installation.  There would have been no material impact to our financial statements in 2010 had we applied this guidance retrospectively.  The units of accounting we attribute to our cell bank sales have not changed from our prior methodology, and the pattern and timing of revenue recognition is not affected by the new guidance.

 

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Concentration of Significant Customers

 

For the nine months ended September 30, 2011, our sales were concentrated in one direct customer and one distributor, which in aggregate comprised 31% of our revenue recognized for the nine months ended September 30, 2011.  Our Asia-Pacific and North America region sales accounted for 68% of our revenue recognized for the nine months ended September 30, 2011.  Additionally, one distributor and one direct customer accounted for 28% of total outstanding accounts receivable as of September 30, 2011.

 

For the nine months ended September 30, 2010, our sales were concentrated in two direct customers and one distributor, which in aggregate comprised 34% of our revenue recognized for the nine months ended September 30, 2010.  Our Asia-Pacific and North America region sales accounted for 84% of our revenue recognized for the nine months ended September 30, 2010.  Additionally, one distributor accounted for 29% of total outstanding accounts receivable as of September 30, 2010.

Research and Development

We earn revenue for performing tasks under research and development agreements with both commercial enterprises, such as Olympus and Senko, and governmental agencies like the National Institutes of Health (“NIH”).  Revenue earned under development agreements is classified as either research grant or development revenues depending on the nature of the arrangement.  Revenues derived from reimbursement of direct out-of-pocket expenses for research costs associated with grants are recorded as research grant and other within development revenues.  Research grant revenue is recorded at the gross amount of the reimbursement.  The costs associated with these reimbursements are reflected as a component of research and development expense in our statements of operations.  Additionally, research and development arrangements we have with commercial enterprises such as Olympus and Senko are considered a key component of our central and ongoing operations.  Accordingly, when recognized, the inflows from such arrangements are presented as revenues in our statements of operations.

We received funds from Olympus and Olympus-Cytori, Inc. during 2005 and 2006.   We recorded upfront fees totaling $28,311,000 as deferred revenues, related party.  In exchange for these proceeds, we agreed to (a) provide Olympus-Cytori, Inc. an exclusive and perpetual license to our Celution® System device technology and certain related intellectual property, and (b) provide future development contributions related to commercializing the Celution® System platform.  The license and development services are not separable and as a result the recognition of this deferred amount requires achievement of service related milestones, under a proportional performance methodology.  If and as such revenues are recognized, deferred revenue will be decreased.  Proportional performance methodology was elected due to the nature of our development obligations and efforts in support of the Joint Venture (“JV”), including product development activities and regulatory efforts to support the commercialization of the JV products. The application of this methodology uses the achievement of R&D milestones as outputs of value to the JV.  We received up-front, non-refundable payments in connection with these development obligations, which we have broken down into specific R&D milestones that are definable and substantive in nature, and which will result in value to the JV when achieved.  As our research and development efforts progress, we periodically evaluate,  and modify if necessary, the milestone points in our proportional performance model to ensure that revenue recognition accurately reflects our best estimate of substantive value deliverable to the JV.  Revenue will be recognized as the above mentioned R&D milestones are completed.  Of the amounts received and deferred, we recognized development revenues of $0 and $1,231,000 for the three and nine months ended September 30, 2011, respectively.  During 2010, we recognized revenues of $0 and $2,122,000 for the three and nine months ended September 30, 2010, respectively.  All related development costs are expensed as incurred and are included in research and development expense on our statements of operations.

Under a Distribution Agreement with Senko, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  We have also earned or will be entitled to earn additional payments under the Distribution Agreement based on achieving certain defined and substantive research and development milestones.

Of the amounts received and deferred with respect to Senko, we did not recognize any development revenues in the three and nine months ended September 30, 2011 or 2010, respectively.

 

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10.	Inventories

Inventories are carried at the lower of cost or market, determined on the first-in, first-out (FIFO) method.

Inventories consisted of the following:

		September 30,				December 31,
		2011				2010
Raw materials		$	2,250,000			$	2,311,000
Work in process			622,000				410,000
Finished goods			1,281,000				657,000
		$	4,153,000			$	3,378,000

11.	Long-Lived Assets

We assess certain long-lived assets, such as property and equipment and intangible assets other than goodwill, for potential impairment when there is a change in circumstances that indicates carrying values of assets may not be recoverable.  Such long-lived assets are deemed to be impaired when the undiscounted cash flows expected to be generated by the asset (or asset group) are less than the asset’s carrying amount.  Any required impairment loss would be measured as the amount by which the asset’s carrying value exceeds its fair value, and would be recorded as a reduction in the carrying value of the related asset and a charge to operating expense.  During the three and nine months ended September 30, 2011 and 2010, we had no impairment losses associated with our long-lived assets.

12.	Share-Based Compensation

During the third quarter of 2011, we made a company-wide option grant to our non-executive employees to purchase an aggregate of up to 197,700 shares of our common stock, subject to a four-year vesting schedule. The grant date fair value of the awards was $2.34 per share.  The resulting share-based compensation expense of $463,000, net of estimated forfeitures, will be recognized as expense over the employees’ respective vesting periods.

During the first quarter of 2011, we issued to our directors, executive officers and certain non-executive employees options to purchase an aggregate of up to 692,500 shares of our common stock, with four-year vesting for our officers and employees and two-year vesting for our directors. The grant date fair value of the awards granted to our officers and employees was $3.46 and to our directors was $3.15 per share. The resulting share-based compensation expense of $2,375,000, net of estimated forfeitures, will be recognized as expense over the respective vesting periods.

We granted 246,225 performance-based restricted stock awards under the 2004 Equity Incentive Plan in February 2011. The awards provide employees until January 1, 2012 to achieve certain performance goals established by the Compensation Committee. The performance goals are weighted based on the following achievements: obtaining certain FDA clearance or approval (40%), achieving a targeted revenue increase for the fiscal year ended December 31, 2011 (20%), and entering into a major collaboration for development and/or commercialization of the Company’s products (40%).  To the extent that any of the performance goals are partially achieved, the Compensation Committee maintains the discretion to continue the vesting of all or a portion of the awards following January 1, 2012.  Once earned, the awards will remain unvested until January 1, 2013. Termination of employment prior to vesting will result in the forfeiture of any earned (as well as unearned) awards.  No compensation expense was recognized related to these awards during the three and nine months ended September 30, 2011 because the Compensation Committee has not determined that the performance criteria have been met, nor has it exercised its discretion in determining if partial awards will be granted.

 

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The following table summarizes activity with respect to such awards during the nine months ended September 30, 2011:

		Shares				Weighted Average Grant Date Fair Value
Outstanding at January 1, 2011			0
Granted			246,225			$	5.82
Vested			0
Cancelled / Forfeited			0
Outstanding at September 30, 2011			246,225			$	5.82
Vested at September 30, 2011			0

During the first quarter of 2010, we issued to our directors, executive officers and certain non-executive employees options to purchase an aggregate of up to 1,155,000 shares of our common stock, with four-year vesting for our officers and employees and two-year vesting for our directors. The grant date fair value of the awards granted to our officers and employees was $4.07 and to our directors was $4.16 per share. The resulting share-based compensation expense of $4,713,000, net of estimated forfeitures, will be recognized as expense over the respective vesting periods.

13.	Loss per Share

Basic per share data is computed by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted per share data is computed by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding during the period increased to include, if dilutive, the number of additional common shares that would have been outstanding as calculated using the treasury stock method. Potential common shares were related entirely to outstanding but unexercised options and warrants for all periods presented.

We have excluded all potentially dilutive securities, including unvested performance-based restricted stock, from the calculation of diluted loss per share attributable to common stockholders for the three and nine months ended September 30, 2011 and 2010, as their inclusion would be antidilutive.  Potentially dilutive common shares excluded from the calculations of diluted loss per share were 19,503,013 for the three and nine month periods ended September 30, 2011 and 18,851,641 for the three and nine month periods ended September 30, 2010, respectively.

14.	Commitments and Contingencies

We have entered into agreements, which have provisions for cancellation, with various clinical research organizations for pre-clinical and clinical development studies. Under the terms of these agreements, the vendors provide a variety of services including, but not limited to, conducting pre-clinical and clinical development research, recruiting and enrolling patients, monitoring studies, and data analysis. Payments under these agreements typically include fees for services and reimbursement of expenses. The timing of payments due under these agreements is estimated based on current schedules of pre-clinical and clinical studies in progress.  As of September 30, 2011, we have pre-clinical research study obligations of $109,000 (which are expected to be fully completed within a year) and clinical research study obligations of $12,100,000 ($2,900,000 of which are expected to be completed within a year).

We are subject to various claims and contingencies related to legal proceedings.  Due to their nature, such legal proceedings involve inherent uncertainties including, but not limited to, court rulings, negotiations between affected parties, and governmental actions.  Management assesses the probability of loss for such contingencies and accrues a liability and/or discloses the relevant circumstances, as appropriate.  Management believes that any liability to us or other remedy that may arise as a result of currently pending legal proceedings will not have a material adverse effect on our financial condition, liquidity, or results of operations as a whole.

During 2008, we entered into a supply agreement with minimum purchase requirements clause.  As of September 30, 2011, we have remaining minimum purchase obligations of $425,000, all of which is expected to be completed within a year.

During 2010, we entered into lease of 60,118 square feet at 3020 and 3030 Callan Road, San Diego, California.  The related lease agreement bears monthly rent at a rate of $1.75 per square foot, with annual increase of $0.05 per square foot.  The lease term is 64 months, commencing on July 1, 2010 and expiring on October 31, 2015.  Additionally, we’ve entered into several lease agreements for international office locations and corporate housing for our employees on international assignments. As of September 30, 2011, we have remaining lease obligations of $5,763,000 ($1,531,000 of which are expected to be completed within a year).

 

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Refer to note 15 for a discussion of our commitments and contingencies related to our transactions with Olympus, including (a) our obligation to the Joint Venture in future periods and (b) certain put and call rights embedded in the arrangements with Olympus.

15.	Transactions with Olympus Corporation

Initial Investment by Olympus Corporation in Cytori

In 2005, we entered into a common stock purchase agreement with Olympus in which we received $11,000,000 in cash proceeds.  We received an additional $11,000,000 from Olympus in August 2006 for the issuance of approximately 1,900,000 shares of our common stock at $5.75 per share.  We received an additional $6,000,000 from Olympus in August 2008 for the issuance of 1,000,000 unregistered shares of our common stock at $6.00 per share and 500,000 common stock warrants (with an original exercise price of $8.50 per share) under a private placement offering.

As of September 30, 2011, Olympus holds approximately 7.3% of our issued and outstanding shares.  Additionally, Olympus has a right, which it has not yet exercised, to designate a director to serve on our Board of Directors.

Formation of the Olympus-Cytori Joint Venture

In 2005, we entered into a joint venture and other related agreements (the “Joint Venture Agreements”) with Olympus.  The Joint Venture is owned equally by Olympus and us.  We have determined that the Joint Venture is a variable interest entity or VIE, but that Cytori is not the VIE’s primary beneficiary.  Accordingly, we have accounted for our interests in the Joint Venture using the equity method of accounting, since we can exert significant influence over the Joint Venture’s operations.  At September 30, 2011, the carrying value of our investment in the Joint Venture is $306,000.  We are under no obligation to provide additional funding to the Joint Venture, but may choose to do so.  We made no cash contributions to the Joint Venture during the three and nine months ended September 30, 2011.  We contributed $330,000 during the three and nine months ended September 30, 2010.

Put/Calls and Guarantees

The Shareholders’ Agreement between Cytori and Olympus provides that in certain specified circumstances of our insolvency or if we experience a change in control, Olympus will have the rights to (i) repurchase our interests in the Joint Venture at the fair value of such interests or (ii) sell its own interests in the Joint Venture to Cytori (the “Put”) at the higher of (a) $22,000,000 or (b) the Put’s fair value.

At September 30, 2011 and December 31, 2010, the estimated fair value of the Put was $1,850,000 and $1,170,000, respectively.  Fluctuations in the Put value are recorded in the consolidated condensed statements of operations as a component of change in fair value of option liabilities. The estimated fair value of the Put has been recorded as a long-term liability in the caption option liability in our consolidated condensed balance sheets.

The valuations of the Put were completed using an option pricing theory based simulation analysis (i.e., a Monte Carlo simulation).  The valuations are based on assumptions as of the valuation date with regard to the market value of Cytori and the estimated fair value of the Joint Venture, the expected correlation between the values of Cytori and the Joint Venture, the expected volatility of Cytori and the Joint Venture, the bankruptcy recovery rate for Cytori, the bankruptcy threshold for Cytori, the probability of a change of control event for Cytori, and the risk free interest rate.

 

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The following assumptions were employed in estimating the value of the Put:

		September 30, 2011				December 31, 2010
Expected volatility of Cytori			74.70	%			73.00	%
Expected volatility of the Joint Venture			74.70	%			73.00	%
Bankruptcy recovery rate for Cytori			28.00	%			28.00	%
Bankruptcy threshold for Cytori		$	9,983,000			$	5,842,000
Probability of a change of control event for Cytori			3.45	%			3.43	%
Expected correlation between fair values of Cytori and the Joint Venture in the future			99.00	%			99.00	%
Risk free interest rate			1.92	%			3.30	%

The Put has no expiration date.  Accordingly, we will continue to recognize a liability for the Put and mark it to market each quarter until it is exercised or until the arrangements with Olympus are amended.

16.	Fair Value Measurements

Fair value measurements are market-based measurements, not entity-specific measurements.  Therefore, fair value measurements are determined based on the assumptions that market participants would use in pricing the asset or liability.  We follow a three-level hierarchy to prioritize the inputs used in the valuation techniques to derive fair values.  The basis for fair value measurements for each level within the hierarchy is described below:

 

·

Level 1: Quoted prices in active markets for identical assets or liabilities.

·

Level 2: Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets.

·

Level 3: Valuations derived from valuation techniques in which one or more significant inputs are unobservable in active markets.

 

The following table provides a summary of the recognized assets and liabilities that we measure at fair value on a recurring basis:

		Balance as of				Basis of Fair Value Measurements
		September 30, 2011				Level 1				Level 2				Level 3
Assets:
Cash equivalents		$	32,646,000			$	32,646,000			$	—			$	—
Liabilities:
Put option liability		$	(1,850,000	)		$	—			$	—			$	(1,850,000	)
Warrant liability		$	(1,273,000	)		$	—			$	—			$	(1,273,000	)

		Balance as of				Basis of Fair Value Measurements
		December 31, 2010				Level 1				Level 2				Level 3
Assets:
Cash equivalents		$	39,807,000			$	39,807,000			$	—			$	—
Liabilities:
Put option liability		$	(1,170,000	)		$	—			$	—			$	(1,170,000	)
Warrant liability		$	(4,987,000	)		$	—			$	—			$	(4,987,000	)

 

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We use quoted market prices to determine the fair value of our cash equivalents, which consist of money market funds and therefore these are classified in Level 1 of the fair value hierarchy.

We value our put liability (see note 15) using an option pricing theory based simulation analysis (i.e., a Monte Carlo simulation). Assumptions are made with regard to the market value of Cytori and the estimated fair value of the Joint Venture, the expected correlation between the values of Cytori and the Joint Venture, the expected volatility of Cytori and the Joint Venture, the bankruptcy recovery rate for Cytori, the bankruptcy threshold for Cytori, the probability of a change of control event for Cytori, and the risk free interest rate.  Because some of the inputs to our valuation model are either not observable quoted prices or are not derived principally from or corroborated by observable market data by correlation or other means, the put option liability is classified as Level 3 in the fair value hierarchy.

The following table summarizes the change in our Level 3 put option liability value:

		Nine months ended				Three months ended
Put option liability		September 30, 2011				September 30, 2011
Beginning balance		$	(1,170,000	)		$	(1,280,000	)
Decrease (increase)  in fair value recognized in operating expenses			(680,000	)			(570,000	)
Ending balance		$	(1,850,000	)		$	(1,850,000	)

		Nine months ended				Three months ended
Put option liability		September 30, 2010				September 30, 2010
Beginning balance		$	(1,140,000	)		$	(1,340,000	)
Decrease (increase)  in fair value recognized in operating expenses			(180,000	)			20,000
Ending balance		$	(1,320,000	)		$	(1,320,000	)

Common stock purchase warrants issued in connection with our August 2008 private equity placement do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the option pricing model.  Some of the significant inputs are observable in active markets, such as common stock market price, volatility, and risk free rate.  The fair value of these warrants also incorporate our assumptions about future equity issuances and their impact to the down-round protection feature. Because some of the inputs to our valuation model are either not observable quoted prices or are not derived principally from or corroborated by observable market data by correlation or other means, the warrant liability is classified as Level 3 in the fair value hierarchy.

The following table summarizes the change in our Level 3 warrant liability value:

		Nine months ended				Three months ended
Warrant liability		September 30, 2011				September 30, 2011
Beginning balance		$	(4,987,000	)		$	(2,809,000	)
Decrease (increase)  in fair value recognized in operating expenses			3,714,000				1,536,000
Ending balance		$	(1,273,000	)		$	(1,273,000	)

		Nine months ended				Three months ended
Warrant liability		September 30, 2010				September 30, 2010
Beginning balance		$	(6,272,000	)		$	(2,645,000	)
Decrease (increase)  in fair value recognized in operating expenses			1,824,000				(1,803,000	)
Ending balance		$	(4,448,000	)		$	(4,448,000	)

No other assets or liabilities are measured at fair value on a recurring basis, or have been measured at fair value on a non-recurring basis subsequent to initial recognition, on the accompanying consolidated condensed balance sheet as of September 30, 2011.

17.	Fair Value

Financial Instruments

We disclose fair value information about all financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate fair value. The disclosures of estimated fair value of financial instruments at September 30, 2011 and December 31, 2010, were determined using available market information and appropriate valuation methods. Considerable judgment is necessary to interpret market data and develop estimated fair value. The use of different market assumptions or estimation methods may have a material effect on the estimated fair value amounts.

 

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The carrying amounts for cash and cash equivalents, accounts receivable, inventories, other current assets, accounts payable, accrued expenses and other liabilities approximate fair value due to the short-term nature of these instruments.

We utilize quoted market prices to estimate the fair value of our fixed rate debt, when available.  If quoted market prices are not available, we calculate the fair value of our fixed rate debt based on a currently available market rate assuming the loans are outstanding through maturity and considering the collateral. In determining the current market rate for fixed rate debt, a market spread is added to the quoted yields on federal government treasury securities with similar terms to the debt.

At September 30, 2011 and December 31, 2010, the aggregate fair value and the carrying value of the Company’s fixed rate debt were as follows:

		September 30, 2011								December 31, 2010
		Fair Value				Carrying Value				Fair Value				Carrying Value
Fixed rate debt		$	24,050,000			$	24,163,000			$	19,782,000			$	19,679,000

Carrying value includes $2,087,000 and $1,321,000 of debt discount as of September 30, 2011 and December 31, 2010, respectively.

Nonfinancial Assets and Liabilities

We apply fair value techniques on a non-recurring basis associated with: (1) valuing potential impairment losses related to goodwill which are accounted for pursuant to the authoritative guidance for intangibles—goodwill and other; and (2) valuing potential impairment losses related to long-lived assets which are accounted for pursuant to the authoritative guidance for property, plant and equipment.

All of our goodwill is associated with regenerative cell technology, and we determine the fair value of this reporting unit based on a combination of inputs including the market capitalization of the Company, as well as Level 3 inputs such as discounted cash flows which are not observable from the market, directly or indirectly. We conduct our goodwill impairment analysis annually as of November 30 each year, or upon the occurrence of certain triggering events. No such triggering events occurred during the three and nine months ended September 30, 2011.  Historically, the fair value has significantly exceeded the carrying value.

We test for the impairment of our long-lived assets when triggering events occur and such impairment, if any, is measured at fair value. The inputs for fair value of our long lived assets would be based on Level 3 inputs as data used for such fair value calculations would be based on discounted cash flows using market place participant assumptions.  No triggering events occurred during the three and nine months ended September 30, 2011.

18.	Stockholders’ Equity

Common Stock

On June 19, 2009, we entered into a common stock purchase agreement with Seaside 88, LP relating to the offering and sale of a total of up to 7,150,000 shares of our common stock.   The agreement required us to issue and Seaside to buy 275,000 shares of our common stock once every two weeks, subject to the satisfaction of customary closing conditions.  Upon completion of our scheduled closings pursuant to the agreement with Seaside 88, LP in June 2010, we raised approximately $30,172,000 in aggregate gross proceeds from this transaction from the sale of 7,150,000 shares of our common stock between June 2009 and June 2010, of which $17,314,000 in gross proceeds from the sale of 3,300,000 shares was raised during 2010.  We have accounted for each of the completed closings as a component of stockholders’ equity.

In October 2010, we entered into an underwriting agreement with Jefferies & Company, relating to the issuance and sale of 4,600,000 shares of our common stock.  This price to the public in this offering was $4.50 per share and the underwriter agreed to purchase the shares from us at a price of $4.23 per share.  The transaction was completed on October 13, 2010, raising approximately $20,700,000 in gross proceeds before deducting underwriting discounts and commissions and other offering expenses payable by us.

On December 13, 2010 we raised $10,000,000 in gross proceeds from a sale of 1,428,571 shares of unregistered common stock to Astellas Pharma Inc. for $7.00 per share in a private stock placement.  Pursuant to the terms of the purchase agreement, we granted Astellas Pharma Inc. a two year right of first refusal to enter into a development and commercialization collaboration with us regarding the use of our technology, on a worldwide basis, for the treatment of liver conditions. In addition, we have agreed to use reasonable efforts to file a registration statement with the Securities and Exchange Commission to register the shares of common stock for resale upon the request of Astellas Pharma Inc.  We also granted Astellas Pharma Inc. a non-voting observer seat on our Board of Directors and the right to designate a representative member to our Scientific Advisory Board.  The $10,000,000 in total proceeds we received exceeded the market value of our stock at the completion of the purchase agreement.  The $2,526,000 difference between the proceeds received and the fair market values of our common stock was recorded as a component of deferred revenues in the accompanying balance sheets.  This difference was recorded as deferred revenue since, conceptually, the excess proceeds represent a value paid by Astellas Pharma Inc. attributable to the scientific advisory board seat, the non-voting observer seat on our Board of Directors, and the two year right of first refusal  to enter into a development and commercialization collaboration with us regarding the use of our technology, on a worldwide basis, for the treatment of liver conditions, rather than an additional equity investment in Cytori.  The recognition of this deferred amount is expected to occur upon the earlier of the expiration of the two year period or the termination of the agreement.

 

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On July 11, 2011, we entered into a common stock purchase agreement with Seaside 88, LP relating to the offering and sale of a total of up to 6,326,262 shares of our common stock.  The agreement requires us to issue and Seaside to buy 1,326,262 shares of our common stock at an initial closing and 250,000 shares of our common stock once every two weeks, commencing 30 days after the initial closing, for up to an additional 20 closings, subject to the satisfaction of customary closing conditions. At the initial closing, the offering price was $4.52, which equaled to 88% of our common stock’s volume-weighted average trading prices, or VWAP, during the ten-day trading period immediately prior to the initial closing date, raising approximately $6,000,000 in gross proceeds. At subsequent closings, the offering price will equal 90.25% of our common stock’s volume-weighted average trading prices during the ten-day trading period immediately prior to each subsequent closing date.  We raised approximately $9,038,000 in gross proceeds from the sale of 2,326,262 shares in our scheduled closings through September 30, 2011. 

Warrant Adjustments

Our closings with Seaside 88, LP through September 30, 2011, our October 2010 offering of 4,600,000 shares of our common stock and our December 2010 sale of 1,428,571 shares of our common stock triggered an adjustment to the exercise price and number of shares issuable under the warrants issued to investors in our August 2008 private placement financing.  As a result, as of September 30, 2011, the common stock warrants issued on August 11, 2008 are currently exercisable for 1,953,363 shares of our common stock at an exercise price of $5.93 per share.

Other Related Party Transactions

As of September 30, 2011 and December 31, 2010, Green Hospital Supply, Inc., our distribution partner in Japan and a related party, was a beneficial owner of 5.5% and 5.8%, respectively, of our outstanding shares of common stock.

During the three and nine months ended September 30, 2011, we incurred approximately $54,000 and $116,000, respectively, and $43,000 and $163,000 during the three and nine months ended September 30, 2010, respectively, in royalty costs in connection with our sales of our Celution® 800/CRS System products to the European and Asia-Pacific reconstructive surgery market, pursuant to our License/Commercial Agreement with the Olympus -Cytori, Inc. joint venture.  As of September 30, 2011 and December 31, 2010, Olympus Corporation was a beneficial owner of 7.3% and 7.7%, respectively, of our outstanding shares of common stock.

19.	Subsequent Events

We have evaluated events after the balance sheet date of September 30, 2011 and up to the date we filed this report.

Subsequent to the quarter ended September 30, 2011, we completed three scheduled closings with Seaside 88, LP during the period of October 1, 2011 through our filing date raising in aggregate approximately $2,023,000 in gross proceeds from the sale of 750,000 shares of our common stock in connection with the agreement we entered into with Seaside 88, LP on July 11, 2011.

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) includes the following sections:

 

·

Overview that discusses our operating results and some of the trends that affect our business.

·

Results of Operations that includes a more detailed discussion of our revenue and expenses.

·

Liquidity and Capital Resources which discusses key aspects of our statements of cash flows, changes in our financial position and our financial commitments.

·

Significant changes since our most recent Annual Report on Form 10-K in the Critical Accounting Policies and Significant Estimates that we believe are important to understanding the assumptions and judgments underlying our financial statements.

 

You should read this MD&A in conjunction with the financial statements and related notes in Item 1 and our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains certain statements that may be deemed “forward-looking statements” within the meaning of United States of America securities laws.  All statements, other than statements of historical fact, that address activities, events or developments that we intend, expect, project, believe or anticipate and similar expressions or future conditional verbs such as will, should, would, could or may occur in the future are forward-looking statements. Such statements are based upon certain assumptions and assessments made by our management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate.

These statements include, without limitation, statements about  our anticipated expenditures, including those related to clinical research studies and general and administrative expenses; the potential size of the market for our products, future  development and/or expansion of our products and therapies in our markets, our ability to generate  product revenues or effectively manage our gross profit margins; our ability to obtain regulatory clearance; expectations as to our future performance; the “Liquidity and Capital Resources” section of this report, including our potential need for additional financing and the availability thereof; and the potential enhancement of our cash position through development, marketing, and licensing arrangements.   Our actual results will likely differ, perhaps materially, from those anticipated in these forward-looking statements as a result of various factors, including: our need and ability to raise additional cash, our joint ventures, risks associated with  laws or regulatory requirements applicable to us, market conditions, product performance, potential litigation, and competition within the regenerative medicine field, to name a few. The forward-looking statements included in this report are subject to a number of additional material risks and uncertainties, including but not limited to the risks described our filings with the Securities and Exchange Commission and under the “Risk Factors” section in Part II below.

We encourage you to read our Risk Factors descriptions carefully.  We caution you not to place undue reliance on the forward-looking statements contained in this report.  These statements, like all statements in this report, speak only as of the date of this report (unless an earlier date is indicated) and we undertake no obligation to update or revise the statements except as required by law.  Such forward-looking statements are not guarantees of future performance and actual results will likely differ, perhaps materially, from those suggested by such forward-looking statements.

Overview

Cytori develops, manufactures, and commercializes innovative medical devices, which enable physicians to practice regenerative medicine and cell therapy worldwide. We have invested more than $200 million into the design and development of our core device, the Celution® System. This device offers patients real-time access to the stem and regenerative cells residing naturally within their own adipose (fat) tissue. These stem and regenerative cells may potentially be used across multiple diseases or conditions resulting from a lack of blood supply (ischemia). Two areas where we are concentrating our efforts include: 1) soft tissue defect repair and enhancement; and 2) cardiovascular disease.

The primary business model is based on the sale of our systems and single-use cartridges, which generate recurring revenues on a per-procedure, single-use basis. Cytori is actively selling three product lines:

 

·

The Celution® family, which is approved in Europe with a CE Mark designation. The approved indications for use include processing of adipose tissue to extract stem and progenitor cells for the re-implantation into the same patient for breast reconstruction, aesthetic body contouring, and treatment of certain wounds related to Crohn’s fistulas.

 

 

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·

The StemSource® family of laboratory equipment, which is available worldwide for use in research and stem cell banking.

·

The PureGraft™ family of products, which are approved in the U.S. and Europe for the preparation of autologous fat grafts for use in aesthetic body contouring.

 

Cytori’s strategy is to pursue market access in our lead breast reconstruction and cardiovascular applications.  We have shifted our sales efforts to focus primarily on selling our approved products into the hospital market for reconstructive surgery in Europe and Asia Pacific while working towards obtaining reimbursement in select countries in Europe starting with the United Kingdom. In addition, we continue to generate revenues by opportunistically selling our products in Europe and Asia Pacific for use in elective cosmetic and reconstructive procedures, as well as research and banking.

We believe it is strategically valuable to invest a significant portion of our research and development efforts and resources into seeking Celution® System indications-for-use in cardiovascular disease worldwide. We have completed two European clinical trials, one for chronic myocardial ischemia (PRECISE) and one for acute myocardial infarction (APOLLO). Based on the outcome from the PRECISE study, we are seeking an indication-for-use in Europe for no-option chronic myocardial ischemia patients. If we were to receive an indication-for-use in these no-option patients, we would begin cultivating near-term customer relationships and sales with select European hospitals, which would involve a related investment in sales and marketing activities, as a lead up to a full product launch upon attainment of reimbursement. A multi-center pivotal trial investigating the use of the device and its cell output as a treatment for heart attacks in Europe is currently enrolling. In the U.S., we are seeking to initiate a Pre-Market Approval (PMA) study of the Celution® System for cardiovascular disease, initially for chronic myocardial ischemia.

We also offer two ancillary product lines, StemSource® and PureGraft™.  StemSource® product is being sold as lab equipment outside the US,  where it may be integrated into a comprehensive cell or tissue bank at the customer’s facility.  Our PureGraft™ product line for autologous fat grafting is complementary to our cosmetic and reconstructive surgery business.

For the remainder of 2011, we will continue to pursue market access by seeking various expanded regulatory and marketing approvals of the Celution® System family of products around the globe, as well as reimbursement in the EU. In the U.S. we are pursuing three parallel strategies, which include: the aforementioned goal of commencing a U.S. cardiac PMA study; seeking a Humanitarian Device Exemption (HDE) for a pediatric orphan indication known as Parry-Romberg's Disease, which is characterized by facial wasting in teenage girls, and for which there is currently no generally accepted treatment. In addition, we are in the process of appealing our 510(K) clearance applications for the Celution® System.  The European approval process for the next-generation Celution® System, Celution® One, remains slow but on track.  This version of the system is tailored for the hospital market and will initially be used  as part of our ongoing and anticipated cardiovascular disease clinical trials. We are also seeking to register or gain market approval for our products in various emerging markets, including Asia and South America.

Olympus Partnership

On November 4, 2005, we entered into a strategic development and manufacturing joint venture agreement and other related agreements with Olympus.  As part of the terms of the JV Agreements, we formed a joint venture, Olympus-Cytori, Inc. (Joint Venture), to develop and manufacture future generation devices based on our Celution ® System platform.

Under the Joint Venture Agreements:

 

·

Olympus paid $30,000,000 for its 50% interest in the Joint Venture.  Moreover, Olympus simultaneously entered into a License/Joint Development Agreement with the Joint Venture and us to develop a second generation commercial system and manufacturing capabilities.

·

We licensed our device technology, including the Celution ® System platform and certain related intellectual property, to the Joint Venture for use in future generation devices.  These devices will process and purify adult stem and regenerative cells residing in adipose (fat) tissue for various therapeutic clinical applications.  In exchange for this license, we received a 50% interest in the Joint Venture, as well as an initial $11,000,000 payment from the Joint Venture; the source of this payment was the $30,000,000 contributed to the Joint Venture by Olympus.  Moreover, upon receipt of a CE mark for the first generation Celution ® System platform in January 2006, we received an additional $11,000,000 development milestone payment from the Joint Venture.

 

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Put/Calls and Guarantees

The Shareholders’ Agreement between Cytori and Olympus provides that in certain specified circumstances of insolvency or if we experience a change in control, Olympus will have the rights to (i) repurchase our interests in the Joint Venture at the fair value of such interests or (ii) sell its own interests in the Joint Venture to Cytori (the “Put”) at the higher of (a) $22,000,000 or (b) the Put’s fair value.

As of September 30, 2011, the estimated fair value of the Put was $1,850,000.  Fluctuations in the estimated Put value are recorded in the statements of operations as a component of change in fair value of option liability.  The estimated fair value of the Put has been recorded as a long-term liability on the consolidated condensed balance sheets in the caption option liability.

The Put has no expiration date.  Accordingly, we will continue to recognize a liability for the Put and mark it to market each quarter until it is exercised or until the arrangements with Olympus are amended.

Olympus-Cytori Joint Venture

The Joint Venture currently has exclusive access to our Celution ® System device technology for the development, manufacture, and supply of such systems to us.  Once a second generation Celution® System is developed and approved by regulatory agencies, the Joint Venture will exclusively supply us with these systems at a formula-based transfer price.  We have retained all marketing rights (subject to our various distribution agreements) to sell the Celution ® System devices for all therapeutic applications of adipose stem and regenerative cells.

We have worked closely with Olympus’ team of scientists and engineers to design the future generations of the Celution ® System so that it will contain certain product enhancements and so it can be manufactured in a streamlined manner.

In August 2007, we entered into a License and Royalty Agreement with the Joint Venture which provides us the ability to commercially launch the Celution ® System platform earlier than we could have otherwise done so under the terms of the Joint Venture Agreements.  Subsequently, in November 2007, we amended the License/Commercial Agreement to substantially incorporate the terms of the Royalty Agreement (effective on the expiration of the Royalty Agreement) to continue to allow us to manufacture the Cytori-developed Celution ® System platform, including the Celution ® 800/CRS, until such  time as the Joint Venture’s products are commercially available for the same market served by the Cytori platform, subject to a reasonable royalty that will be payable to the Joint Venture for all such sales.

We account for our investment in the Joint Venture under the equity method of accounting.

Other Related Party Transactions

In August 2008, we received $6,000,000 from Olympus in a private placement of 1,000,000 unregistered shares of our common stock and a warrant to purchase an additional 500,000 shares of our common stock at an original exercise price of $8.50 per share.  The purchase price was $6.00 per unit (with each unit consisting of one share and 50% warrant coverage).  The warrant is exercisable anytime after February 11, 2009 and will expire on August 11, 2013.

Thin Film Japan Distribution Agreement

In 2004, we sold the majority of our Thin Film business to MAST Biosurgery AG (MAST).  We retained all rights to Thin Film business in Japan (subject to a purchase option of MAST, which expired in May 2007), and we received back from MAST a license of all rights to Thin Film technologies in the spinal field, exclusive at least until 2012, and the field of regenerative medicine, non-exclusive on a perpetual basis.

In the third quarter of 2004, we entered into a Distribution Agreement with Senko Medical Trading Company (Senko).  Under this agreement, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  Specifically, the license covers Thin Film products with the following indications: anti-adhesion; soft tissue support; and minimization of the attachment of soft tissues.  The Distribution Agreement with Senko commences upon “commercialization.”  Commercialization will occur when one or more Thin Film product registrations are completed with the Japanese Ministry of Health, Labour and Welfare, or MHLW.  Following commercialization, the Distribution Agreement has a duration of five years and is renewable for an additional five years after reaching mutually agreed minimum purchase guarantees.

 

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We received a $1,500,000 upfront license fee from Senko.  We have recorded the $1,500,000 received as a component of deferred revenues in the accompanying consolidated condensed balance sheet.  Half of the license fee is refundable if the parties agree commercialization is not achievable and a proportional amount is refundable if we terminate the arrangement, other than for material breach by Senko, before three years post-commercialization.

Under the Distribution Agreement, we will also be entitled to earn additional payments from Senko based on achieving defined milestones.  On September 28, 2004, we notified Senko of completion of the initial regulatory application to the MHLW for the Thin Film product.  As a result, we became entitled to a nonrefundable payment of $1,250,000, which we received in October 2004 and recorded as a component of deferred revenues.  We did not recognize any development revenues with respect to Senko during the three and nine months ended September 30, 2011 or 2010.  To date we have recognized a total of $371,000 in development revenues (all of which was recognized prior to 2008) related to this agreement.

Results of Operations

Our overall net losses for the three and nine months ended September 30, 2011 were $8,335,000 and $25,544,000 as compared to the losses for the three and nine months ended September 30, 2010 were $10,417,000 and $18,243,000, respectively.  The fluctuation in the losses for the three and nine months ended September 30, 2011 as compared to the losses for the three and nine months ended September 30, 2010 is primarily due to the non-cash fair value estimates of our warrant liability, recognition of non-cash development revenue of $1,231,000 during first quarter of 2011 as compared to recognition of non-cash development revenue of $2,122,000 of during first quarter of 2010, offset by an increase in operating expenses.

Product revenues

Product revenues consisted of revenues primarily from our Celution ® System products and StemSource ® Cell Banks.

The following table summarizes the components for the three and nine months ended September 30, 2011 and 2010:

		For the three months ended September 30,								For the nine months ended September 30,
		2011				2010				2011				2010
Related party		$	—			$	581,000			$	—			$	590,000
Third party			2,134,000				938,000				5,908,000				5,286,000
Total product revenues		$	2,134,000			$	1,519,000			$	5,908,000			$	5,876,000
% attributable to Green Hospital Supply, Inc.			—				37.8	%			—				9.9	%
% attributable to Olympus			—				0.5	%			—				0.1	%

Beginning in March of 2008, we began sales and shipments of our Celution ® 800/CRS System to the European and Asia-Pacific reconstructive surgery markets and during 2010 we began sales of our PureGraft™ System in the United States and Europe.  Assuming all other applicable revenue recognition criteria have been met, revenue for these product sales is recognized upon delivery to the customer, as all risks and rewards of ownership have been substantively transferred to the customer at that point.  For product sales to customers who arrange for and manage all aspects of the shipping process, we recognize revenue upon shipment from our facilities.  Beginning in 2011, for product sales that include a combination of equipment, services, or other multiple deliverables that will be provided in the future, we defer an estimate based on relative selling price method for those future deliverables from product revenue until such deliverables have been provided or earned.  Shipping and handling costs that are billed to our customers are classified as revenue.

Our product sales in the current year were significantly impacted by the major earthquake, tsunami and the aftermath that occurred in Japan in March.  A significant portion of our customer base is located in Japan and thus the natural disaster affected our sales during the three and nine months ended September 30, 2011.

The future .  We expect product sales in Japan to improve as the country recovers from the March disaster.  We expect to continue to generate product revenues from Celution® 800/CRS and consumable sales in Europe and we expect to continue to generate product revenues from StemSource® cell bank sales and Celution® System translational medical sales in Japan through direct sales and through our distribution partner Green Hospital Supply, and we also expect to generate PureGraft™ System sales in the US and Europe. Additionally, we expect to have Thin Film product revenues, pending regulatory approval, when commercialization of the Thin Film products in Japan occurs and we begin Thin Film shipments to Senko.

 

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Cost of product revenues

Cost of product revenues relate primarily to Celution ® System products and StemSource ® Cell Banks and includes material, manufacturing labor, and overhead costs.  The following table summarizes the components of our cost of revenues for the three and nine months ended September 30, 2011 and 2010:

		For the three months ended September 30,								For the nine months ended September 30,
		2011				2010				2011				2010
Cost of product revenues		$	926,000			$	906,000			$	2,842,000			$	2,690,000
Share-based compensation			16,000				14,000				51,000				43,000
Total cost of product revenues		$	942,000			$	920,000			$	2,893,000			$	2,733,000
Total cost of product revenues as % of product revenues			44.1	%			60.6	%			49.0	%			46.5	%

 

 

The future.  We expect to continue to see variation in our gross profit margin as the product mix comprising revenues fluctuates.  Additionally, we expect to incur costs related to our MacroPore products if and when commercialization is achieved for our Japan Thin Film product line.

   

Development revenues

   

The following table summarizes the components of our development revenues for the three and nine months ended September 30, 2011 and 2010:

We recognize deferred revenues, related party, as development revenue when certain performance obligations are met (i.e., using a proportional performance approach).  During the quarter ended March 31, 2011, we recognized $1,231,000 of revenue associated with our arrangements with Olympus as a result of achieving a product development milestone related to the preproduction development of the next-generation Celution® One System.  During the quarter ended March 31, 2010, we recognized $2,122,000 of revenue associated with our arrangements with Olympus as a result of achieving two milestones, one in product development, and one clinical milestone related to the assessment of trial outcomes at 6 months in one of our cardiac trials.

The future :  We may recognize additional development revenues during 2011, as the anticipated completion for the next milestone of our Joint Venture and other Olympus performance obligations is in 2011.  If we are successful in completing these activities, we may recognize approximately $100,000 in development revenues during the remainder of 2011.  The exact timing of when amounts will be reported in revenue will depend on internal factors (for instance, our ability to complete certain contributions and obligations that we have agreed to perform) as well as external considerations, including obtaining certain regulatory clearances and/or approvals related to the Celution® System.  The cash for these contributions and obligations was received when the agreement was signed and no further related cash payments will be made to us.

We will continue to recognize revenue from the Thin Film development work we are performing on behalf of Senko, based on the relative fair value of the milestones completed as compared to the total efforts expected to be necessary to obtain regulatory clearance from the MHLW.  We are still awaiting regulatory clearance from the MHLW in order for initial commercialization to occur.  Accordingly, we expect to recognize approximately $1,129,000 (consisting of $879,000 in deferred revenues plus a non-refundable payment of $250,000 to be received upon commercialization) in revenues associated with this milestone arrangement if and when regulatory approval is achieved.  Moreover, we expect to recognize $500,000 per year associated with deferred Senko license fees over a three-year period following commercialization, if achieved, as the refund rights associated with the license payment expire.

 

Research and development expenses

Research and development expenses include costs associated with the design, development, testing and enhancement of our products, regulatory fees, the purchase of laboratory supplies, pre-clinical studies and clinical studies.  The following table summarizes the components of our research and development expenses for the three and nine months ended September 30, 2011 and 2010: