CYNOSURE INC
Risk Factors.         The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this Annual Report or presented elsewhere by management from time to time.   Risks Related to Our Business and Industry           We have a history of operating losses, and we may not     maintain profitability.         Although we were profitable in 2004 and 2005, we incurred operating losses for three of the last five years. Our net losses were approximately $6.0 million in 2001, $1.9 million in 2002 and $0.5 million in 2003. We may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to maintain profitability, the market value of our stock will decline, and you could lose all or a part of your investment.           If we fail to obtain Alexandrite rods or our air cooling     system from our sole suppliers, our ability to manufacture and     sell our products and components would be impaired.         We use Alexandrite rods to manufacture the lasers for our Apogee products. We depend exclusively on Northrop Grumman SYNOPTICS to supply Alexandrite rods to us, and we are aware of no alternative supplier meeting our quality standards. We offer our SmartCool® treatment cooling systems for use with our laser aesthetic treatment systems, and we depend exclusively on Zimmer Elektromedizin GmbH to supply SmartCool systems to us. Both Alexandrite lasers and our SmartCool systems are important to our business.        We do not have long-term arrangements with Northrop Grumman SYNOPTICS or Zimmer Elektromedizin for the supply of Alexandrite rods or SmartCool systems, but instead purchase from them on a purchase order basis. Northrop Grumman SYNOPTICS and Zimmer Elektromedizin are not required, and may not be able or willing, to meet our future requirements at current prices, or at all. Any extended interruption in our supplies of Alexandrite rods or our SmartCooltreatment cooling systems could materially harm our business.  24    Table of Contents          We compete against companies that have longer operating     histories, more established products and greater resources than     we do, which may prevent us from achieving further market     penetration or improving operating results.         Competition in the aesthetic laser industry is intense. Our products compete against products offered by public companies, such as Candela Corporation, Cutera, Inc., Laserscope, Lumenis Ltd., Palomar Medical Technologies, Inc. and Syneron Medical Ltd., as well as several smaller specialized private companies, such as Radiancy, Inc. and Thermage, Inc. Some of these competitors have significantly greater financial and human resources than we do and have established reputations, as well as worldwide distribution channels and sales and marketing capabilities that are larger and more established than ours. Additional competitors may enter the market, and we are likely to compete with new companies in the future. We also face competition from medical products, such as BOTOX® and collagen injections, and surgical and non-surgical aesthetic procedures, such as face lifts, sclerotherapy, electrolysis, microdermabrasion and chemical peels. We may also face competition from manufacturers of pharmaceutical and other products that have not yet been developed. As a result of competition with these companies, products and procedures, we could experience loss of market share and decreasing revenue as well as reduced prices and profit margins, any of which would harm our business and operating results.        Our ability to compete effectively depends upon our ability to distinguish our company and our products from our competitors and their products. Factors affecting our competitive position include:            •       product performance and design;         •       ability to sell products tailored to meet the applications needs     of clients and patients;         •       quality of customer support;         •       product pricing;         •       product safety;         •       sales, marketing and distribution capabilities;         •       success and timing of new product development and     introductions; and         •       intellectual property protection.         Some of our competitors have more established products and customer relationships than we do, which could inhibit our further market penetration efforts. For example, we have encountered, and expect to continue to encounter, situations where, due to pre-existing relationships, potential customers determine to purchase additional products from our competitors. If we are unable to compete effectively, our business and operating results will be harmed.        In addition, some of our current and potential competitors have significantly greater financial, research and development, manufacturing and sales and marketing resources than we have. Our competitors could utilize their greater financial resources to acquire other companies to gain enhanced name recognition and market share, as well as to acquire new technologies or products that could effectively compete with our product lines.           If we do not continue to develop and commercialize new     products and identify new markets for our products and     technology, we may not remain competitive, and our revenues and     operating results could suffer.         The aesthetic laser and light-based treatment system industry is subject to continuous technological development and product innovation. If we do not continue to be innovative in the development of new products and applications, our competitive position will likely deteriorate as other companies successfully design and commercialize new products and applications. Accordingly, our success depends in part on developing new and innovative applications of laser and other light-based technology and identifying new markets for and applications of existing products and technology. If we are unable to develop and  25    Table of Contents  commercialize new products and identify new markets for our products and technology, our products and technology could become obsolete and our revenues and operating results could be adversely affected.        To remain competitive, we must:            •       develop or acquire new technologies that either add to or     significantly improve our current products;         •       convince our target customers that our new products or product     upgrades would be attractive revenue-generating additions to     their practices;         •       sell our products to non-traditional customers, including     primary care physicians, gynecologists and other specialists;         •       identify new markets and emerging technological trends in our     target markets and react effectively to technological     changes; and         •       maintain effective sales and marketing strategies.            If our new products do not gain market acceptance, our     revenues and operating results could suffer.         The commercial success of the products and technology we develop will depend upon the acceptance of these products by providers of aesthetic procedures and their patients and clients. It is difficult for us to predict how successful recently introduced products, or products we are currently developing, will be over the long term. If the products we develop do not gain market acceptance, our revenues and operating results could suffer.        We expect that many of the products we develop will be based upon new technologies or new applications of existing technologies. It may be difficult for us to achieve market acceptance of some of our products, particularly the first products that we introduce to the market based on new technologies or new applications of existing technologies.           If demand for our aesthetic treatment systems by     non-traditional physician customers and spas does not develop as     we expect, our revenues will suffer and our business will be     harmed.         Our revenues from non-traditional physician customers and spa purchasers of our products have increased significantly since January 1, 2004. We believe, and our growth expectations assume, that we and other companies selling lasers and other light-based aesthetic treatment systems have only begun to penetrate these markets and that our revenues from selling to these markets will continue to increase. If our expectations as to the size of these markets and our ability to sell our products to participants in these markets are not correct, our revenues will suffer and our business will be harmed.           We rely upon third party suppliers for the components and     subassemblies of many of our products, making us vulnerable to     supply shortages and price fluctuations, which could harm our     business.         Many of the components and subassemblies that comprise our aesthetic treatment systems are currently manufactured for us by a limited number of suppliers. In addition, one third party supplier assembles and tests many of the components and subassemblies for our Apogee, Cynergy, Acclaim and VStarproduct families. We do not have long-term contracts with any of these third parties, including the third party supplier that assembles many of our components and subassemblies, for the supply of parts or services. Any interruption in the supply of components or subassemblies, or our inability to obtain substitute components or subassemblies from alternate sources at acceptable prices in a timely manner, or our inability to obtain assembly and testing services, could impair our ability to meet the demand of our customers, which would have an adverse effect on our business and operating results.  26    Table of Contents          We sell our products in numerous international markets.     Our operating results may suffer if we are unable to manage our     international operations effectively.         We sell our products in 48 foreign countries, and we therefore are subject to risks associated with having international operations. Sales outside of North America accounted for 58% of our revenue for 2003, 45% of our revenue for 2004 and 41% of our revenue in 2005.        Our international sales are subject to a number of risks, including:            •       foreign certification and regulatory requirements;         •       difficulties in staffing and managing our foreign operations;         •       import and export controls; and         •       political and economic instability.            Revenue from our international sales could be adversely     affected by fluctuations in currency exchange rates, which would     cause our operating results to suffer.         We face risks associated with changes in foreign currency exchange rates. Revenues outside of North America that were recorded in U.S. dollars represented approximately 39% of our total 2005 revenues outside of North America. Substantially all of the remaining 61% of our total 2005 revenues outside of North America were sales in euros, British pounds and Japanese yen. Since we report our financial position and results of operations in U.S. dollars, our reported results of operations may be adversely affected by changes in the exchange rate between these currencies and the U.S. dollar. We have not historically engaged in hedging activities relating to our non-U.S. dollar operations. We may incur negative foreign currency translation charges as a result of changes in currency exchange rates, which could cause our operating results to suffer.           We rely on third party distributors to market, sell and     service a significant portion of our products. If these     distributors do not commit the necessary resources to     effectively market, sell and service our products or if our     relationships with these distributors are disrupted, our     business and operating results may be harmed.         In North America, the United Kingdom, Germany, Spain, France, Japan and China, we sell our products through our internal sales organization. Outside of these markets, we sell our products through third party distributors. Our sales and marketing success in these other markets depends on these distributors, in particular their sales and service expertise and relationships with the customers in the marketplace. Sales of our aesthetic treatment systems by third party distributors represented 21% of our revenue in 2003, 13% of our revenue in 2004 and 17% of our revenue in 2005. We do not control these distributors, and they may not be successful in marketing our products. Third party distributors may terminate their relationships with us, or fail to commit the necessary resources to market and sell our products to the level of our expectations. Currently, we have written distributor agreements in place with 16 of our 19 third party distributors. The third party distributors with which we do not have written distributor agreements may terminate their relationships with us and stop selling and servicing our products with little or no notice. If current or future third party distributors do not perform adequately, or if we fail to maintain our existing relationships with these distributors or fail to recruit and retain distributors in particular geographic areas, our revenue from international sales may be adversely affected and our operating results could suffer.           Because we do not require training for users of our     products, and sell our products to non-physicians, there exists     an increased potential for misuse of our products, which could     harm our reputation and our business.         Federal regulations allow us to sell our products to or on the order of practitioners licensed by law to use or order the use of a prescription device. The definition of “licensed practitioners” varies from state to  27    Table of Contents  state. As a result, our products may be purchased or operated by physicians with varying levels of training and, in many states, by non-physicians, including nurse practitioners, chiropractors and technicians. Outside the United States, many jurisdictions do not require specific qualifications or training for purchasers or operators of our products. We do not supervise the procedures performed with our products, nor do we require that direct medical supervision occur. We and our distributors offer product training sessions, but neither we nor our distributors require purchasers or operators of our products to attend training sessions. The lack of required training and the purchase and use of our products by non-physicians may result in product misuse and adverse treatment outcomes, which could harm our reputation and expose us to costly product liability litigation.           Product liability suits could be brought against us due to     a defective design, material or workmanship or due to misuse of     our products. These lawsuits could be expensive and time     consuming and result in substantial damages to us and increases     in our insurance rates.         If our products are defectively designed, manufactured or labeled, contain defective components or are misused, we may become subject to substantial and costly litigation by our customers or their patients or clients. Misusing our products or failing to adhere to operating guidelines for our products can cause severe burns or other damage to the eyes, skin or other tissue. We are routinely involved in claims related to the use of our products. Product liability claims could divert management’s attention from our core business, be expensive to defend and result in sizable damage awards against us. Our current insurance coverage may not be sufficient to cover these claims. Moreover, in the future, we may not be able to obtain insurance in amount or scope sufficient to provide us with adequate coverage against potential liabilities. Any product liability claims brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing continuing coverage, could harm our reputation in the industry and reduce product sales. We would need to pay any product losses in excess of our insurance coverage out of cash reserves, harming our financial condition and adversely affecting our operating results.           We may incur substantial expenses if our past practices     are shown to have violated the Telephone Consumer Protection     Act.         We previously used facsimiles to disseminate information about our clinical workshops to large numbers of customers and potential customers. These facsimiles were transmitted by third parties retained by us, and were sent to recipients whose facsimile numbers were supplied by us as well as other recipients whose facsimile numbers we purchased from other sources. In May 2005, we stopped sending unsolicited facsimiles to customers and potential customers.        Under the federal Telephone Consumer Protection Act, or TCPA, recipients of unsolicited facsimile “advertisements” are entitled to damages of up to $500 per facsimile for inadvertent violations and up to $1,500 per facsimile for knowing or willful violations. Recipients of unsolicited facsimile advertisements may seek enforcement of the TCPA in state courts. The TCPA also permits states to initiate a civil action in a federal district court to enforce the TCPA against a party who engages in a pattern or practice of violations of the TCPA. In addition, complaints may be filed with the Federal Communications Commission, which has the power to assess penalties against parties for violations of the TCPA.        In May 2005, we were sued in Massachusetts state court by Dr. Ari Weitzner, individually and as putative representative of a purported class under the TCPA. The lawsuit alleges that we violated the TCPA by sending unsolicited advertisements by facsimile. Although we are continuing to investigate the number of facsimiles transmitted during the period for which the plaintiff in the lawsuit seeks class certification, and the number of these facsimiles that were “unsolicited” within the meaning of the TCPA, we expect the number of unsolicited facsimiles to be very large.        We are vigorously defending the Weitzner lawsuit, but litigation is subject to numerous uncertainties and we are unable to predict the ultimate outcome of this matter. Even if we prevail in this lawsuit, other individual or class action claims may be brought against us alleging past violations of the TCPA. Moreover, the amount of any potential liability in connection with this lawsuit or other possible lawsuits  28    Table of Contents  will depend, to a large extent, on whether a class in a class action lawsuit is certified and, if one is certified, on the scope of the class, neither of which we can predict at this time.        We have not recorded a liability related to this lawsuit or other possible future lawsuits. However, we may determine in the future that an accrual is required, and we may be required to pay damages in respect of this lawsuit or other possible future lawsuits arising out of our past transmission of facsimiles, any of which could materially and adversely affect our results of operations, cash flows and financial condition. Regardless of the outcome, this lawsuit or other possible future lawsuits may cause us to incur significant expenses and divert the attention of our management and key personnel from our business operations.        We have tendered a claim with respect to the Weitzner lawsuit to our general liability insurance carrier and coverage has been disputed. Although the carrier has previously provided coverage for several small individual claims brought against us under the TCPA, the carrier has denied coverage for this claim. Even if coverage is determined to apply, since the potential liability under this claim and other possible future claims could be substantial, our coverage may not be sufficient to satisfy any damages that we may be required to pay.           Our financial results may fluctuate from quarter to     quarter, which makes our results difficult to predict and could     cause our results to fall short of expectations.         Our financial results may fluctuate as a result of a number of factors, many of which are outside of our control. For these reasons, comparing our financial results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our future quarterly and annual expenses as a percentage of our revenues may be significantly different from those we have recorded in the past or which we expect for the future. Our financial results in some quarters may fall below our expectations or the expectations of market analysts or investors. Any of these events could cause our stock price to fall. Each of the risk factors listed in this “Risk Factors” section, and the following factors, may adversely affect our financial results:            •       continued availability of attractive equipment leasing terms for     our customers, which may be negatively influenced by interest     rate increases;         •       increases in the length of our sales cycle; and         •       reductions in the efficiency of our manufacturing processes.            If there is not sufficient demand for the procedures     performed with our products, practitioner demand for our     products could decline, which would adversely affect our     operating results.         Most procedures performed using our aesthetic treatment systems are elective procedures that are not reimbursable through government or private health insurance. The cost of these elective procedures must be borne by the patient. As a result, the decision to undergo a procedure that utilizes our products may be influenced by a number of factors, including:            •       patient awareness of procedures and treatments;         •       the cost, safety and effectiveness of the procedure and of     alternative treatments;         •       the success of our and our customers’ sales and marketing     efforts to purchasers of these procedures; and         •       consumer confidence, which may be affected by economic and other     conditions.         If there is not sufficient demand for the procedures performed with our products, practitioner demand for our products would be reduced, which would adversely affect our operating results.  29    Table of Contents          Our business and operations are experiencing rapid growth.     If we fail to effectively manage our growth, our business and     operating results could be harmed.         We have experienced significant growth in the scope of our operations and the number of our employees. For example, our revenue increased from $27.1 million in 2003 to $56.3 million in 2005, and the number of our employees increased from 138 at the beginning of 2003 to 184 as of December 31, 2005. This growth has placed significant demands on our management, as well as our financial and operational resources. If we do not effectively manage our growth, the efficiency of our operations and the quality of our products could suffer, which could adversely affect our business and operating results. To effectively manage this growth, we will need to continue to:            •       implement appropriate operational, financial and management     controls, systems and procedures;         •       expand our manufacturing capacity and scale of production;         •       expand our sales, marketing and distribution infrastructure and     capabilities; and         •       provide adequate training and supervision to maintain high     quality standards.            We may be unable to attract and retain management and     other personnel we need to succeed.         Our success depends on the services of our senior management and other key research and development, manufacturing, sales and marketing employees. The loss of the services of one or more of these employees could have a material adverse effect on our business. We consider retaining Michael R. Davin, our president and chief executive officer, to be key to our efforts to develop, sell and market our products and remain competitive. We have entered into an employment agreement with Mr. Davin; however, the employment agreement is terminable by him on short notice and may not ensure his continued service with our company. Our future success will depend in large part upon our ability to attract, retain and motivate highly skilled employees. We cannot be certain that we will be able to do so.           Any acquisitions that we make could disrupt our business     and harm our financial condition.         From time to time, we evaluate potential strategic acquisitions of complementary businesses, products or technologies, as well as consider joint ventures and other collaborative projects. We may not be able to identify appropriate acquisition candidates or strategic partners, or successfully negotiate, finance or integrate any businesses, products or technologies that we acquire. We do not have any experience with acquiring companies or products. Any acquisition we pursue could diminish our cash available to us for other uses or be dilutive to our stockholders, and could divert management’s time and resources from our core operations.           El.En. has substantial control over us. In addition,     El.En. and our executive officers and directors have the ability     to control all matters submitted to stockholders for     approval.         In addition to the factors discussed above regarding El.En.’s ability to control the election of a majority of the members of our board of directors, El.En. and our executive officers and directors, in the aggregate, beneficially own approximately 40% of our outstanding common stock. As a result, if these stockholders were to act together, they would be able to control all matters submitted to our stockholders for approval. For example, these persons could control any amendment of our certificate of incorporation and bylaws and approval of any merger, consolidation or sale of all or substantially all of our assets. This concentration of voting power could delay or prevent an acquisition of our company on terms that other stockholders may desire. Please also see the discussion under “— Risks Related to Our Relationship with El.En. — El.En. has substantial control over us and could delay or prevent a change of control.”  30    Table of Contents          Provisions in our corporate charter documents and under     Delaware law may delay or prevent attempts by our stockholders     to change our management and hinder efforts to acquire a     controlling interest in us.         Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:            •       a dual class capital structure that allows El.En. to control the     election of a majority of the members of our board of directors;         •       the classification of the members of our directors who are     elected by holders of our class A common stock and     class B common stock, voting together as a single class;         •       limitations on the removal of directors who are elected by     holders of our class A common stock and class B common     stock, voting together as a single class;         •       advance notice requirements for stockholder proposals and     nominations;         •       the inability of class A stockholders to act by written     consent or to call special meetings; and         •       the ability of our board of directors to designate the terms of     and issue new series of preferred stock without stockholder     approval, which could be used to institute a “poison     pill” that would work to dilute the stock ownership of a     potential hostile acquirer, effectively preventing acquisitions     that have not been approved by our board of directors.         The affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation, and the right of the holders of shares of our class B common stock to elect a majority of the members of our board of directors may not be modified without the approval of the holders of at least a majority of the shares of our class B common stock outstanding. In addition, absent approval of our board of directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least 75% of the voting power of our shares of capital stock entitled to vote and the affirmative vote of holders of at least a majority of the shares of class B common stock outstanding.        In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company.           Our stock price may be volatile.         Our class A common stock price may be volatile. The stock market in general has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. The market price for our class A common stock may be influenced by many factors, including:            •       the success of competitive products or technologies;         •       regulatory developments in the United States and foreign     countries;         •       developments or disputes concerning patents or other proprietary     rights;         •       the recruitment or departure of key personnel;         •       variations in our financial results or those of companies that     are perceived to be similar to us;   31    Table of Contents           •       market conditions in the our industry and issuance of new or     changed securities analysts’ reports or     recommendations; and         •       general economic, industry and market conditions.            A significant portion of our total outstanding shares are     restricted from immediate resale but may be sold into the market     in the near future. This could cause the market price of our     class A common stock to drop significantly, even if our     business is doing well.         Sales of a substantial number of shares of our class A common stock, including shares of our class B common stock that have been converted into shares of our class A common stock, in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our class A common stock. We also intend to register all shares of our class A common stock that we may issue under our employee benefit plans.   Risks Related to Our Relationship with El.En.           El.En. has substantial control over us and could delay or     prevent a change of control.         El.En., our largest stockholder, is able to control the election of a majority of the members of our board of directors. El.En. owns 76% of our outstanding class B common stock, which comprises 35% of our aggregate outstanding common. Until El.En. beneficially owns less than 20% of the aggregate number of shares of our class A common stock and class B common stock outstanding or less than 50% of the number of shares of our class B common stock outstanding, El.En., as holder of a majority of the shares of our class B common stock, will have the right:            •       to elect a majority of the members of our board of directors;         •       to approve amendments to our bylaws adopted by our class A     and class B stockholders, voting as a single class; and         •       to approve amendments to any provisions of our restated     certificate of incorporation relating to the rights of holders     of common stock, the powers, election and classification of the     board of directors, corporate opportunities and the rights of     holders of class A common stock and class B common     stock to elect and remove directors, act by written consent and     call special meetings of stockholders.    In addition, the holders of shares of our class B common stock will vote with our class A stockholders for the election of the remaining directors.        Because El.En. is the holder of a majority of the shares of our class B common stock, El.En.’s approval will be required for any of the actions described above. In addition, because El.En. will be able to control the election of a majority of our board, and because of its substantial holdings of our capital stock, El.En. will likely have the ability to delay or prevent a change of control of our company that may be favored by other directors or stockholders and otherwise exercise substantial control over all corporate actions requiring board or stockholder approval.           We currently depend on El.En. for our Cynergy PL,     PhotoLight, PhotoSilk Plus and TriActive LaserDermology     products. If our distribution agreements with El.En. terminate,     we will no longer be able to sell these products, and our     business will be harmed.         El.En. manufactures and owns the intellectual property rights to the Cynergy PL, PhotoLight, PhotoSilk Plus and TriActive LaserDermology products. We distribute these products pursuant to distribution agreements we have with El.En. These agreements provide us with exclusive worldwide distribution rights for our Cynergy PL product, and exclusive North American distribution rights for our PhotoLight, PhotoSilk and TriActive LaserDermology products. In 2005, we derived 7% of our revenues from our distribution relationship with El.En., and in 2004, we derived 4% of our revenues from this relationship. Although we have distribution rights for the PhotoLight, PhotoSilk Plus, Cynergy PL and  32   Table of Contents  TriActive LaserDermology products during the terms of the agreements, El.En. may discontinue production of these products at any time and must make reasonable efforts to provide one year’s notice to us prior to such discontinuation. Additionally, El.En. may not be able or willing to provide these products to us after the expiration of those agreements. El.En. may change the prices that we pay for these products on 30 days’ notice to us. Additionally, El.En. may terminate the distribution agreement for the PhotoLight, PhotoSilk Plus and TriActive LaserDermology systems if we do not meet annual minimum purchase obligations specified in the agreements. If El.En. ceases production of these products, is unable or unwilling to sell these products to us after the expiration of the distribution agreements, terminates the agreements or increases the prices that we pay for the products, we may not be able to replace them with similar products in a timely manner or on comparable terms, and our business could be adversely affected.           El.En. and its subsidiaries market and sell products that     compete with our products, and any competition by El.En. could     have a material adverse effect on our business.         El.En. is a leading laser manufacturer in Europe and a leading light-based medical device manufacturer worldwide. El.En. and its subsidiaries develop and produce laser systems with scientific, industrial, commercial and medical applications. Although we have exclusive North American distribution rights for our PhotoLight, PhotoSilk Plus and TriActive LaserDermology products, El.En. may compete with us in North America with its other products. In the event that our distribution agreements with El.En. terminate, El.En. may compete with us in North America with these products. El.En. markets, sells, promotes and licenses products that compete with our products outside of North America. El.En. has significantly greater financial, technical and human resources than we have and is better equipped to research, develop, manufacture and commercialize products. In addition, El.En. has more extensive experience in light-based technologies. Our business could be materially and adversely affected by competition from El.En.           Conflicts of interest may arise between us and El.En., and     these conflicts might ultimately be resolved in a manner     unfavorable to us.         For financial reporting purposes, our financial results are included in El.En.’s consolidated financial statements. One of our directors, Andrea Cangioli, and the spouse of one of our directors, Leonardo Masotti, are also officers or directors of El.En. These two directors own or have an interest in substantial amounts of El.En. stock. Ownership interests of our directors in El.En. stock, or service as a director of our company while at the same time serving as, or being the spouse of, a director or officer of El.En., could give rise to conflicts of interest when a director or officer is faced with a decision that could have different implications for the two companies.        Conflicts may arise with respect to possible future distribution and research and development arrangements with El.En. or another El.En. affiliated company in which the terms and conditions of the arrangements are subject to negotiation between us and El.En. or such other El.En. affiliated company. These potential conflicts could also arise, for example, over matters such as:            •       the nature, timing, marketing, distribution and price of our     products and El.En.’s products that compete with each other;         •       intellectual property matters; and         •       business opportunities that may be attractive to both El.En. and     us.         In order to address potential conflicts of interest between us and El.En., our restated certificate of incorporation contains provisions regulating and defining the conduct of our affairs as they may involve El.En. and El.En. affiliated companies and El.En.’s officers and directors who serve as our directors. These provisions recognize that we and El.En. and El.En. affiliated companies engage and may continue to engage in the same or similar business activities and lines of business and will continue to have contractual and business relations with each other. These provisions expressly permit El.En. and its affiliated  33   Table of Contents  companies to compete against us and narrowly limit corporate opportunities that El.En. or its directors or officers who serve as our directors must make available to us.           Our class A share price may decline because of future     sales of our shares by El.En.         El.En. may sell all or part of the shares of our class B common stock that it owns, at which time those shares would automatically convert into shares of our class A common stock. El.En. is not subject to any contractual obligation to maintain its ownership position in our shares, except that it has agreed with the lead-managing underwriter of our December 2005 initial public offering, Citigroup Global Markets Inc., that it will not, without Citigroup’s prior consent, sell or otherwise dispose of any shares of our common stock until December 9, 2007, other than:            •       up to 33% of the shares of our common stock that it beneficially     owned on December 8, 2005, the date of the prospectus     relating to our initial public offering, until June 9,     2007; and         •       up to an additional 33% of the shares of our common stock that     it beneficially owned on December 8, 2005 during the period     between June 9, 2007 and December 9, 2007.         Consequently, El.En. may not maintain its ownership of our common stock. Sales by El.En. of substantial amounts of our common stock in the public market could adversely affect prevailing market prices for our class A common stock.           If El.En. sells the shares of our stock held by it and no     longer has control over us, our commercial relationship with     El.En. may be adversely affected.         El.En. has advised us that it currently does not intend to sell its shares of our common stock in the foreseeable future. However, El.En.’s plans and intentions may change at any time and, other than El.En.’s agreement with the underwriters discussed above not to sell more than specified amounts of shares of our common stock before December 9, 2007, El.En. is not subject to any contractual obligation to maintain an ownership position in our shares.        If El.En. sells our shares and no longer has control over us, El.En. will cease to include our financial results in its consolidated financial statements, and El.En.’s interests may differ significantly from ours. If this occurs, our commercial relationship with El.En., from which we derived 7% of our revenues in 2005 and 4% of our revenues in 2004, may be adversely affected, which, in turn, could have a material adverse effect on our business. For example, if El.En. does not have a continuing interest in our financial success, it may be more inclined to compete with us in North America and in other markets, not to enter into future commercial agreements with us or to terminate or not renew our existing distribution agreements. If any of these events were to occur, it could harm our business.   Risks Related to Intellectual Property           If we infringe or are alleged to infringe intellectual     property rights of third parties, our business could be     adversely affected.         Our products may infringe or be claimed to infringe patents or patent applications under which we do not hold licenses or other rights. Third parties may own or control these patents and patent applications in the United States and abroad. These third parties could bring claims against us that would cause us to incur substantial expenses and, if successfully asserted against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us, we could be forced to stop or delay manufacturing or sales of the product that is the subject of the suit.        As a result of patent infringement claims, or in order to avoid potential claims, we may choose or be required to seek a license from the third party and be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we were able to obtain a license, the rights may be nonexclusive, which could result in our competitors gaining access to the same intellectual property. Ultimately, we could be forced to cease some aspect of our business operations if, as  34   Table of Contents  a result of actual or threatened patent infringement claims, we are unable to enter into licenses on acceptable terms. This could harm our business significantly.        There has been substantial litigation and other proceedings regarding patent and other intellectual property rights in our industry. In addition to infringement claims against us, we may become a party to other types of patent litigation and other proceedings, including interference proceedings declared by the United States Patent and Trademark Office and opposition proceedings in the European Patent Office, regarding intellectual property rights with respect to our products and technology. The cost to us of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the costs of such litigation or proceedings more effectively than we can because of their greater financial resources. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time.           A third party has asserted that we need a license to its     patents in order for us to continue selling many of our     products.         On July 2, 2004, Palomar Medical Technologies, Inc. sent us a letter proposing to enter into negotiations with us regarding the grant of a nonexclusive license under specified United States and foreign patents owned or licensed by Palomar with respect to our Apogee Elite, Apogee 5500, PhotoLight and Acclaim 7000 products, and also with respect to our SmartEpil II product, which we no longer offer. In subsequent letters from Palomar dated September  14, 2004 and March 24, 2005, Palomar reiterated its willingness to negotiate a license under these patents and, in its March 24, 2005 letter, stated that it continues to believe that we need a license under these patents for each of the products listed in the July 2, 2004 letter, as well as for our PhotoSilk, PhotoSilk Plus, Cynergy, Cynergy PL and Cynergy III systems. We have not entered into negotiations with Palomar with respect to such a license.        In February 2002, Palomar filed a lawsuit against one of our competitors, Cutera, Inc., alleging that by making, using, selling or offering for sale its hair removal products, Cutera willfully and deliberately infringed one of the patents that Palomar has asserted against us in its letters to us. This litigation between Palomar and Cutera is ongoing. Palomar may also bring suit against us claiming that some or all of our products violate patents owned or licensed by Palomar. Litigation is unpredictable, and we may not prevail in successfully defending or asserting our position. If Palomar takes legal action against us, and if we do not prevail, we may be ordered to pay substantial damages for past sales and an ongoing royalty for future sales of products found to infringe Palomar’s patents or we could be ordered to stop selling any products that are found to infringe Palomar’s patents.           If we are unable to obtain or maintain intellectual     property rights relating to our technology and products, the     commercial value of our technology and products will be     adversely affected and our competitive position could be     harmed.         Our success and ability to compete depends in part upon our ability to obtain protection in the United States and other countries for our products by establishing and maintaining intellectual property rights relating to or incorporated into our technology and products. We own a variety of patents and patent applications in the United States and corresponding patents and patent applications in many foreign jurisdictions. To date, however, our patent estate has not stopped other companies from competing against us, and we do not know how successful we would be should we choose to assert our patents against suspected infringers. Our pending and future patent applications may not issue as patents or, if issued, may not issue in a form that will be advantageous to us. Even if issued, patents may be challenged, narrowed, invalidated or circumvented, which could limit our ability to stop competitors from marketing similar products or limit the length of term of patent protection we may have for our products. Changes in either patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property or narrow the scope of our patent protection.  35   Table of Contents          If we are unable to protect the confidentiality of our     proprietary information and know-how, the value of our     technology and products could be adversely affected.         In addition to patented technology, we rely upon unpatented proprietary technology, processes and know-how, particularly with respect to our Alexandrite and pulse dye lasers. We generally seek to protect this information in part by confidentiality agreements with our employees, consultants and third parties. These agreements may be breached, and we may not have adequate remedies for any such breach. In addition, our trade secrets may otherwise become known or be independently developed by competitors.   Risks Related to Government Regulation           If we fail to obtain and maintain necessary U.S. Food     and Drug Administration clearances for our products and     indications or if clearances for future products and indications     are delayed or not issued, our business would be harmed.         Our products are classified as medical devices and are subject to extensive regulation in the United States by the Food and Drug Administration, or FDA, and other federal, state and local authorities. These regulations relate to manufacturing, labeling, sale, promotion, distribution, importing and exporting and shipping of our products. In the United States, before we can market a new medical device, or a new use of, or claim for, an existing product, we must first receive either 510(k) clearance or premarket approval from the FDA, unless an exemption applies. Both of these processes can be expensive and lengthy and entail significant user fees, unless exempt. The FDA’s 510(k) clearance process usually takes from three to 12 months, but it can last longer. The process of obtaining premarket approval is much more costly and uncertain than the 510(k) clearance process. It generally takes from one to three years, or even longer, from the time the premarket approval application is submitted to the FDA until an approval is obtained.        In order to obtain premarket approval and, in some cases, a 510(k) clearance, a product sponsor must conduct well controlled clinical trials designed to test the safety and effectiveness of the product. Conducting clinical trials generally entails a long, expensive and uncertain process that is subject to delays and failure at any stage. The data obtained from clinical trials may be inadequate to support approval or clearance of a submission. In addition, the occurrence of unexpected findings in connection with clinical trials may prevent or delay obtaining approval or clearance. If we conduct clinical trials, they may be delayed or halted, or be inadequate to support approval or clearance, for numerous reasons, including:            •       FDA, other regulatory authorities or an institutional review     board may place a clinical trial on hold;         •       patients may not enroll in clinical trials, or patient     follow-up may not     occur, at the rate we expect;         •       patients may not comply with trial protocols;         •       institutional review boards and third party clinical     investigators may delay or reject our trial protocol;         •       third party clinical investigators may decline to participate in     a trial or may not perform a trial on our anticipated schedule     or consistent with the clinical trial protocol, good clinical     practices, or other FDA requirements;         •       third party organizations may not perform data collection and     analysis in a timely or accurate manner;         •       regulatory inspections of our clinical trials or manufacturing     facilities may, among other things, require us to undertake     corrective action or suspend or terminate our clinical trials,     or invalidate our clinical trials;         •       changes in governmental regulations or administrative     actions; and         •       the interim or final results of the clinical trials may be     inconclusive or unfavorable as to safety or effectiveness.   36    Table of Contents       Medical devices may be marketed only for the indications for which they are approved or cleared. The FDA may not approve or clear indications that are necessary or desirable for successful commercialization. Indeed, the FDA may refuse our requests for 510(k) clearance or premarket approval of new products, new intended uses or modifications to existing products. Our clearances can be revoked if safety or effectiveness problems develop.           After clearance or approval of our products, we are     subject to continuing regulation by the FDA, and if we fail to     comply with FDA regulations, our business could suffer.         Even after clearance or approval of a product, we are subject to continuing regulation by the FDA, including the requirements that our facility be registered and our devices listed with the agency. We are subject to Medical Device Reporting regulations, which require us to report to the FDA if our products may have caused or contributed to a death or serious injury or malfunction in a way that would likely cause or contribute to a death or serious injury if the malfunction were to recur. We must report corrections and removals to the FDA where the correction or removal was initiated to reduce a risk to health posed by the device or to remedy a violation of the Federal Food, Drug, and Cosmetic Act caused by the device that may present a risk to health, and maintain records of other corrections or removals. The FDA closely regulates promotion and advertising and our promotional and advertising activities could come under scrutiny. Since 1994, we have received five untitled letters from the FDA regarding alleged violations caused by our promotional activities. We have responded to these letters and the FDA has found our responses acceptable. If the FDA objects to our promotional and advertising activities or finds that we failed to submit reports under the Medical Device Reporting regulations, for example, the FDA may allege our activities resulted in violations.        The FDA and state authorities have broad enforcement powers. Our failure to comply with applicable regulatory requirements could result in enforcement action by the FDA or state agencies, which may include any of the following sanctions:            •       untitled letters, warning letters, fines, injunctions, consent     decrees and civil penalties;         •       repair, replacement, refunds, recall or seizure of our products;         •       operating restrictions or partial suspension or total shutdown     of production;         •       refusing or delaying our requests for 510(k) clearance or     premarket approval of new products or new intended uses;         •       withdrawing 510(k) clearance or premarket approvals that have     already been granted; and         •       criminal prosecution.         If any of these events were to occur, they could harm our business.           Federal regulatory reforms may adversely affect our     ability to sell our products profitably.         From time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the clearance or approval, manufacture and marketing of a device. In addition, FDA regulations and guidance are often revised or reinterpreted by the agency in ways that may significantly affect our business and our products. It is impossible to predict whether legislative changes will be enacted or FDA regulations, guidance or interpretations changed, and what the impact of such changes, if any, may be.           We have modified some of our products without FDA     clearance. The FDA could retroactively determine that the     modifications were improper and require us to stop marketing and     recall the modified products.         Any modifications to one of our FDA-cleared devices that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or a premarket approval. We may be required to submit extensive pre-clinical and clinical data depending  37    Table of Contents  on the nature of the changes. We may not be able to obtain additional 510(k) clearances or premarket approvals for modifications to, or additional indications for, our existing products in a timely fashion, or at all. Delays in obtaining future clearances or approvals would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would harm our revenue and operating results. We have made modifications to our devices in the past and may make additional modifications in the future that we believe do not or will not require additional clearances or approvals. If the FDA disagrees, and requires new clearances or approvals for the modifications, we may be required to recall and to stop marketing the modified devices, which could harm our operating results and require us to redesign our products.           If we fail to comply with the FDA’s Quality System     Regulation and laser performance standards, our manufacturing     operations could be halted, and our business would     suffer.         We are currently required to demonstrate and maintain compliance with the FDA’s Quality System Regulation, or QSR. The QSR is a complex regulatory scheme that covers the methods and documentation of the design, testing, control, manufacturing, labeling, quality assurance, packaging, storage and shipping of our products. Because our products involve the use of lasers, our products also are covered by a performance standard for lasers set forth in FDA regulations. The laser performance standard imposes specific record keeping, reporting, product testing and product labeling requirements. These requirements include affixing warning labels to laser products as well as incorporating certain safety features in the design of laser products. The FDA enforces the QSR and laser performance standards through periodic unannounced inspections. We have been, and anticipate in the future being, subject to such inspections. Our failure to comply with the QSR or to take satisfactory corrective action in response to an adverse QSR inspection or our failure to comply with applicable laser performance standards could result in enforcement actions, including a public warning letter, a shutdown of or restrictions on our manufacturing operations, delays in approving or clearing a product, refusal to permit the import or export of our products, a recall or seizure of our products, fines, injunctions, civil or criminal penalties, or other sanctions, such as those described in the preceding paragraphs, any of which could cause our business and operating results to suffer.           If we fail to comply with state laws and regulations, or     if state laws or regulations change, our business could     suffer.         In addition to FDA regulations, most of our products are also subject to state regulations relating to their sale and use. These regulations are complex and vary from state to state, which complicates monitoring compliance. In addition, these regulations are in many instances in flux. For example, federal regulations allow our prescription products to be sold to or on the order of “licensed practitioners,” that is, practitioners licensed by law to use or order the use of a prescription device. Licensed practitioners are defined on a state-by-state basis. As a result, some states permit non-physicians to purchase and operate our products, while other states do not. Additionally, a state could change its regulations at any time to prohibit sales to particular types of customers. We believe that, to date, we have sold our prescription products only to licensed practitioners. However, our failure to comply with state laws or regulations and changes in state laws or regulations may adversely affect our business.           We or our distributors may be unable to obtain or maintain     international regulatory qualifications or approvals for our     current or future products and indications, which could harm our     business.         Sales of our products outside the United States are subject to foreign regulatory requirements that vary widely from country to country. In many countries, our third party distributors are responsible for obtaining and maintaining regulatory approvals for our products. We do not control our third party distributors, and they may not be successful in obtaining or maintaining these regulatory approvals. In addition, the FDA regulates exports of medical devices from the United States.        Complying with international regulatory requirements can be an expensive and time consuming process, and approval is not certain. The time required to obtain foreign clearances or approvals may be  38    Table of Contents  longer than that required for FDA clearance or approval, and requirements for such clearances or approvals may differ significantly from FDA requirements. Foreign regulatory authorities may not clear or approve our products for the same indications cleared or approved by the FDA. The foreign regulatory approval process may include all of the risks associated with obtaining FDA clearance or approval in addition to other risks. Although we or our distributors have obtained regulatory approvals in the European Union and other countries outside the United States for many of our products, we or our distributors may be unable to maintain regulatory qualifications, clearances or approvals in these countries or obtain qualifications, clearances or approvals in other countries. For example, we are in the process of seeking regulatory approvals from the Japanese Ministry of Health, Labour and Welfare for the direct sale of our products into that country. If we are not successful in doing so, our business will be harmed. We may also incur significant costs in attempting to obtain and in maintaining foreign regulatory clearances, approvals or qualifications.        Foreign regulatory agencies, as well as the FDA, periodically inspect manufacturing facilities both in the United States and abroad. If we experience delays in receiving necessary qualifications, clearances or approvals to market our products outside the United States, or if we fail to receive those qualifications, clearances or approvals, or if we fail to comply with other foreign regulatory requirements, we and our distributors may be unable to market our products or enhancements in international markets effectively, or at all. Additionally, the imposition of new requirements may significantly affect our business and our products. We may not be able to adjust to such new requirements.           New regulations may limit our ability to sell to     non-physicians, which could harm our business.         Currently, we sell our products primarily to physicians and, outside the United States, to aestheticians. In addition, we recently began marketing our products to the growing aesthetic spa market, where non-physicians under physician supervision perform aesthetic procedures at dedicated facilities. However, federal, state and international regulations could change at any time, disallowing sales of our products to aestheticians, and limiting the ability of aestheticians and non-physicians to operate our products. Any limitations on our ability to sell our products to non-physicians or on the ability of aestheticians and non-physicians to operate our products could cause our business and operating results to suffer.             Item 1B.  Unresolved Staff Comments         Not applicable.             Item 2.  Properties         In July 2005, we moved our executive offices and our manufacturing, research and development and warehouse operations to a new 55,000 square foot facility that we lease in Westford, Massachusetts. The lease on this facility expires in March 2012. In addition, we lease an aggregate of approximately 5,300 square feet of space at six other locations in Europe and the Asia/ Pacific region that we use for sales and service purposes.             Item 3.  Legal Proceedings         On May 24, 2005, Dr. Ari Weitzner, individually and as putative representative of a purported class, filed a complaint against us under the Telephone Consumer Protection Act, or TCPA, in Massachusetts Superior Court in Middlesex County seeking monetary damages, injunctive relief, costs and attorneys fees. The complaint alleges that we violated the TCPA by sending unsolicited advertisements by facsimile to the plaintiff and other recipients without the prior express invitation or permission of the recipients. Under the TCPA, recipients of unsolicited facsimile advertisements are entitled to damages of up to $500 per facsimile for inadvertent violations and up to $1,500 per facsimile for knowing or willful violations. Although we are continuing to investigate the number of facsimiles transmitted during the period for which the plaintiff in the lawsuit seeks class certification and the number of these facsimiles that were  39    Table of Contents  “unsolicited” within the meaning of the TCPA, we expect the number of unsolicited facsimiles to be very large. We are vigorously defending the lawsuit and have filed initial briefs and motions with the court.        In addition, we are subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcomes of these matters, including the matter described above, are currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations or cash flows.             Item 4.  Submission of matters to a Vote of Security     Holders.         In December 2005, our stockholders authorized by written consent the following actions in connection with our initial public offering:            •       the removal of our then current directors from office;         •       the adoption and approval of an amendment to our by-laws to     provide for the classification of our board of directors;         •       the election of Thomas H. Robinson, Paul F. Kelleher and Michael     R. Davin as our classified directors;         •       the election of Ettore V. Biagioni, Andrea Cangioli, Leonardo     Masotti and George J. Vojta as our class B directors;         •       the adoption and approval of our restated certificate of     incorporation;         •       the adoption of our amended and restated by-laws;         •       the ratification of an amendment to our 2004 Stock Option Plan     to increase the number of shares of common stock available under     the plan from 1,500,000 to 1,850,000;         •       the adoption of our 2005 Stock Incentive Plan, which became     effective at the effective date of our initial public     offering; and         •       the ratification of Ernst & Young LLP as our     independent auditors for the fiscal year ended December 31,     2005.         All such actions were effected pursuant to an action by written consent of our stockholders in compliance with Section 228 of the Delaware General Corporation Law. We received the requisite consents on December 9, 2005.        The written consent was adopted by holders of 6,220,935 shares of our common stock out of 6,242,877 shares issued and outstanding as of December 9, 2005.       PART II             Item 5.  Market for Registrant’s Common Equity, Related     Stockholder Matters and Issuers Purchases of Equity     Securities    Market Price of and Dividends on Our Common Stock and Related Stockholder Matters.        Our Class A common stock began trading on The Nasdaq National Market under the symbol “CYNO” on December 9, 2005. The following table sets forth, for the period indicated, the high and low sales closing prices of our Class A common stock on The Nasdaq National Market.                 Year Ended December 31, 2005   High   Low                     Fourth Quarter (from December 9 to December 31)         $22.35        $18.93          On March 20, 2006, the closing price per share of our Class A common stock was $18.44, as reported on The Nasdaq National Market, and we had approximately 50 stockholders of record.  40    Table of Contents       We have never paid or declared any cash dividends on our common stock. We currently intend to retain earnings, if any, to finance the growth and development of our business. Payment of future dividends, if any, will be at the discretion of our board of directors.   Recent Sales of Unregistered Securities; Uses of Proceeds From Registered Securities           Recent Sales of Unregistered Securities         In April 2005, we issued an aggregate of 495,000 shares of our common stock at a price per share of $3.00 to individual investors, including certain of our executive officers. No underwriters were involved in the foregoing sales of securities and the securities were issued to a combination of foreign and U.S. investors in reliance upon the exemption from the registration requirements of the Securities Act, as set forth in Section 4(2) under the Securities Act and Rule 506 of Regulation D promulgated thereunder relating to sales by an issuer not involving any public offering, to the extent an exemption from such registration was required.        During 2005, we granted stock options under our stock option plans for an aggregate of 408,700 shares of our common stock (net of exercises, expirations and cancellations) at exercise prices of $3.00 to $15.00 per share. In 2005, options to purchase 36,198 shares of stock were exercised at an exercise price of $3.00 per share. The issuances of stock options and the shares of common stock issuable upon the exercise of the options were issued pursuant to written compensatory plans or arrangements with our employees, directors and consultants, in reliance on the exemption provided by Section 3(b) of the Securities Act and Rule 701 promulgated thereunder. All recipients either received adequate information about us or had access, through employment or other relationships, to such information.           Use of Proceeds from Registered Securities         On December 13, 2005, we completed an initial public offering of 5,750,000 shares of our class A common stock at a price to the public of $15.00 per share. We sold 4,750,000 shares of the class A common stock, including an over-allotment option of 750,000 shares, and El.En., the selling stockholder in the offering, sold 1,000,000 of the shares. The offer and sale of all of the shares in the initial public offering were registered under the Securities Act of 1933, as amended, pursuant to a registration statement on Form S-1 (File No. 333-127463), which was declared effective by the Securities and Exchange Commission on November 8, 2005. Citigroup Global Markets Inc., UBS Securities LLC, Jefferies & Company, Inc. and Needham & Company, LLC were the managing underwriters of the initial public offering. The offering commenced on December 8, 2005 and did not terminate until after the sale of all of the securities registered in the registration statement.        We received aggregate net proceeds of approximately $64.0 million, after deducting underwriting discounts and commission of approximately $5.0 and expenses of the offering of approximately $2.3 million. None of the underwriting discounts and commissions or offering expenses were incurred or paid to directors or officers of ours or their associates or to persons owning 10 percent or more of our common stock or to any affiliates of ours. From the effective date of the registration statement through December 31, 2005, we have not spent any of the net proceeds of our initial public offering, which have been invested in cash and cash equivalents.  41   Table of Contents              Item 6.  Selected Consolidated Financial Data         You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and the related notes which are included elsewhere in this Annual Report and the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this Annual Report. We have derived the consolidated statement of operations data for the years ended December 31, 2003, 2004 and 2005 and the consolidated balance sheet data as of December 31, 2004 and 2005 from our audited consolidated financial statements, which are included elsewhere in this Annual Report. We have derived the consolidated statement of operations data for the years ended December 31, 2001 and 2002 and the consolidated balance sheet data as of December 31, 2001, 2002 and 2003 from our audited consolidated financial statements, which are not included in this Annual Report. Our historical results for any prior period are not necessarily indicative of results to be expected for any future period.                                                       Year Ended December 31,               2001   2002   2003   2004   2005                               (In thousands, except per share data)     Consolidated Statement of Operations Data:                                                  Revenues    $ 22,389     $ 21,678     $ 25,525     $ 40,364     $ 56,262           Revenues from related party      677       1,284       1,600       1,269        —                                             Total revenues      23,066       22,962       27,125       41,633       56,262           Cost of revenues      12,158       13,198       14,207       20,465       25,843                                             Gross profit      10,908       9,764       12,918       21,168       30,419           Operating expenses:                                                    Sales and marketing      7,007       5,777       8,720       12,590       17,230             Research and development      3,216       2,379       2,481       3,139       3,173             General and administrative      4,496       3,979       3,766       4,092       4,999             Stock-based compensation       —        —       76       136       406                                             Total operating expenses      14,719       12,135       15,043       19,957       25,808                                             (Loss) income from operations      (3,811 )     (2,371 )     (2,125 )     1,211       4,611           Interest income (expense), net      40       (25 )     (62 )     (122 )     89           Gain on sale of investment       —        —        —       3,019        —           Other (expense) income, net      (1,417 )     298       1,822       976       (368 )                                           (Loss) income before provision (benefit) for income taxes and     minority interest      (5,188 )     (2,098 )     (365 )     5,084       4,332           Provision (benefit) for income taxes      779       (301 )     72       (276 )     102           Minority interest in net income of subsidiary      48       70       63       64       70                                             Net (loss) income    $ (6,015 )   $ (1,867 )   $ (500 )   $ 5,296     $ 4,160                                             Basic net (loss) income per share    $ (1.25 )   $ (0.35 )   $ (0.09 )   $ 0.93     $ 0.64                                             Diluted net (loss) income per share    $ (1.25 )   $ (0.35 )   $ (0.09 )   $ 0.92     $ 0.54                                             Basic weighted average common shares outstanding      4,808       5,272       5,530       5,700       6,522                                             Diluted weighted average common shares outstanding      4,808       5,272       5,530       5,773       7,715                                        42   Table of Contents                                                    As of December 31,               2001   2002   2003   2004   2005                               (In thousands)     Consolidated Balance Sheet Data:                                                  Cash and cash equivalents    $ 473     $ 3,290     $ 2,111     $ 4,028     $ 64,646           Working capital      5,439       6,262       4,572       10,678       79,227           Total assets      14,548       15,979       18,228       28,001       100,168           Capital lease obligation, net of current portion      328       123       81       476       814           Retained (deficit) earnings      (619 )     (2,486 )     (2,986 )     2,310       6,470           Total stockholders’ equity      7,679       7,890       7,288       14,640       83,151                 Item 7.  Management’s Discussion and Analysis of Financial     Condition and Results of Operations    Company Overview        You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes and other financial data included elsewhere in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review Item 1A of this Annual Report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.   Company Overview        We develop and market aesthetic treatment systems used by physicians and other practitioners that incorporate laser and light-based energy sources. As of December 31, 2005, we had sold more than 4,900 aesthetic treatment systems worldwide.        We were incorporated in July 1991. In 2002, El.En. S.p.A., an Italian company that itself and through subsidiaries develops and markets laser systems for medical and industrial applications, acquired a majority of our capital stock. In September 2003, we recruited a new management team that has implemented a comprehensive reorganization of our company, including:            •       redesigning many of our existing products;         •       introducing innovative new products and technologies;         •       streamlining and rationalizing our manufacturing processes;         •       reorganizing and expanding our research and development, sales     and marketing and distribution capabilities; and         •       enhancing our customer service network.         Since the beginning of 2004, we have introduced 10 new aesthetic treatment systems, including our four flagship products:            •       the Apogee Elite system, our flagship product for hair     removal, in March 2004;         •       the Cynergy system, our flagship product for the     treatment of vascular lesions, in February 2005;         •       the PhotoSilk Plus system, our flagship product for skin     rejuvenation through the treatment of shallow vascular lesions     and pigmented lesions, in February 2005; and         •       the TriActive LaserDermology system, our flagship product     for the temporary reduction of the appearance of cellulite, in     February 2004.   43   Table of Contents  As a result of our product development efforts, we incurred increased research and development expenses in absolute dollars, although not as a percentage of revenues, during each of 2003 and 2004.        We have expanded our direct sales and marketing organization from 22 employees as of December 31, 2003 to 58 employees as of December 31, 2005. In addition, we have expanded our distribution relationships and had 19 distributors covering 31 countries as of December 31, 2005. In January 2005, we launched a separate CynosureSpa brand with product offerings, tailored marketing and sales personnel focused exclusively on the aesthetic spa market. As a result of these activities, we incurred increased sales and marketing expenses in absolute dollars, and as a percentage of revenues, during each of 2004 and 2005.        We recently redesigned or introduced a number of our products, including our Apogee, Cynergy, Acclaim and VStar product families, so that they are built in a modular fashion using fewer components. We began shipping these redesigned products in the second quarter of 2005. We believe that this new approach allows our platform technology to be easily upgradeable, increases the scalability and efficiency of our production process and facilitates improvements in field service diagnosis and repair. We expect that the new modular design of these products will reduce our direct labor and inventory costs and result in lower cost of revenues as a percentage of revenues.        In November 2000, we purchased a 20% equity interest, which we subsequently increased to 40%, in Sona MedSpa International, Inc., formerly known as Sona International Corporation, an operator and franchisor of spa franchises. Also in November 2000, we entered into a supply and revenue sharing arrangement with Sona MedSpa pursuant to which we provided our aesthetic treatment systems to Sona MedSpa and its franchisees and received a share of their revenues from procedures using our products. We also guaranteed the lease obligations for two facilities operated by Sona MedSpa. In May 2004, we sold our equity interest in Sona MedSpa to third parties and also sold to Sona MedSpa a portion of the aesthetic treatment systems previously provided by us under the supply and revenue sharing arrangement. We recognized a gain of $3.0 million from the sale of our equity interest and an additional $1.2 million in revenue from the sale of the systems to Sona MedSpa in connection with the transaction. Also in May 2004, we entered into an amended supply and revenue sharing arrangement with Sona MedSpa pursuant to which we continue to sell systems to Sona MedSpa and its franchisees and receive a share of their revenues from procedures using our systems. In October 2005, we entered into a preferred vendor agreement with Sona MedSpa whereby we sold certain of these systems to Sona for approximately $1.3 million which we recorded as deferred revenue in 2005 as the fee was not fixed at the time of sale.        During the period in which we held our equity interest in Sona MedSpa, we accounted for our investment using the equity method of accounting and recognized our share of Sona MedSpa’s income or loss as a component of other income (expense). We recognized other expense of $0.2 million in 2002 for our share of Sona MedSpa’s loss and recognized other income of $0.7 million in 2003 and $0.2 million in 2004 for our share of Sona MedSpa’s income.        We also sell our lasers on an original equipment manufacturer basis to third parties with whom we collaborate in connection with surgical uses of our laser products. In addition, until 2004, we had a distributor relationship with El.En. pursuant to which we sold a veterinary laser product in the United States supplied by El.En.   Financial Operations Overview           Revenues         We generate revenues primarily from sales of our products and parts and accessories and, to a lesser extent, from services, including product warranty revenues, and from our revenue sharing arrangement with Sona MedSpa. In 2005, we derived approximately 92% of our revenues from sales of our products, 6% of our revenues from service and 2% of our revenues from our revenue sharing arrangement. In 2004, we derived approximately 87% of our revenues from sales of our products, 6% of our revenues from service and 7% of our revenues from our revenue sharing arrangement. Generally, we recognize revenues from the  44    Table of Contents  sales of our products upon delivery to our customers, revenues from service contracts and extended product warranties ratably over the coverage period, revenues from service in the period in which the service occurs and revenues from our revenue sharing arrangement in the period the procedures are performed.        We sell our products directly in North America, four European countries, Japan and China and use distributors to sell our products in other countries where we do not have a direct presence. In 2005, we derived 41% and in 2004 we derived 45% of our revenues from sales of our products outside North America. As of December 31, 2005, we had 31 sales employees in North America, 8 sales employees in four European countries, Japan and China and distributors in 31 countries. The following table provides revenue data by geographical region for the years ended December 31, 2004 and 2005:                             Percentage of       Revenues               Year Ended       December 31,               2004   2005                 Region                          North America      55 %     59 %         Europe      24       23           Asia/ Pacific      16       12           Other      5       6                           Total      100 %     100 %                          See Note 3 to our consolidated financial statements included in this Annual Report for revenues and asset data by geographic region.           Cost of Revenues         Our cost of revenues consists primarily of material, labor and manufacturing overhead expenses and includes the cost of components and subassemblies supplied by third party suppliers. Cost of revenues also includes service and warranty expenses, as well as salaries and personnel-related expenses for our operations management team, purchasing and quality control.           Sales and Marketing Expenses         Our sales and marketing expenses consist primarily of salaries, commissions and other personnel-related expenses for employees engaged in sales, marketing and support of our products, trade show, promotional and public relations expenses and management and administration expenses in support of sales and marketing. We expect our sales and marketing expenses to increase in absolute dollars, though we do not expect them to increase significantly as a percentage of revenues, as we expand our sales, marketing and distribution capabilities.           Research and Development Expenses         Our research and development expenses consist of salaries and other personnel-related expenses for employees primarily engaged in research, development and engineering activities and materials used and other overhead expenses incurred in connection with the design and development of our products. We expense all of our research and development costs as incurred. We expect our research and development expenditures to increase in absolute dollars, though we do not expect them to increase significantly as a percentage of revenues, as we continue to devote resources to research and develop new products and technologies.  45   Table of Contents          General and Administrative Expenses         Our general and administrative expenses consist primarily of salaries and other personnel-related expenses for executive, accounting and administrative personnel, professional fees and other general corporate expenses. We expect our general and administrative expenses to increase in absolute dollars and as a percentage of revenues as a result of our becoming a public company.           Stock-Based Compensation         Our stock-based compensation consists of expenses related to stock-based awards to employees and non-employees. We currently account for our stock-based awards to employees using the intrinsic-value method. Under the intrinsic-value method, compensation expense is measured on the date of grant as the difference between the deemed fair market value of our common stock for accounting purposes and the option exercise price multiplied by the number of options granted. In May 2005, we recorded $1.7 million of deferred stock-based compensation in connection with options granted at that time, which we are amortizing over the vesting periods of the options. Stock-based awards to non-employees are currently expensed under the fair value method using the Black-Scholes option pricing model. We will adopt SFAS 123(R) in the first quarter of fiscal 2006, which requires us to expense all stock-based awards under the fair value method.           Interest (Expense) Income, net         Interest expense consists primarily of interest due on short-term indebtedness owed to El.En. and capitalized leases. Interest income consists primarily of interest earned on cash and cash equivalents.           Provision for Income Taxes         As of December 31, 2005, we had state tax credits of $0.5 million to offset future tax liability and state net operating losses of approximately $0.4 million to offset future taxable income. If not utilized, these credit carryforwards will expire at various dates through 2019, and the net operating losses will expire at various dates through 2024. In addition, the future utilization of our net operating loss carryforwards may be limited based upon changes in ownership pursuant to regulations promulgated under the Internal Revenue Code. We also had foreign net operating losses of approximately $3.0 million available to reduce future foreign income taxes, which will expire at various times beginning in 2006.  46    Table of Contents  Results of Operations   Year Ended December 31, 2004 and 2005        The following table contains selected statement of operations data, which serves as the basis of the discussion of our results of operations for the years ended December 31, 2004 and 2005:                                                               Year Ended   Year Ended   Change       December 31, 2004   December 31, 2005   2004 to 2005                           As a % of       As a % of           Amount   Revenues   Amount   Revenues   $ Change   % Change                                   (Dollars in thousands)         Revenues    $ 41,633       100 %   $ 56,262       100 %   $ 14,629       35 %         Cost of revenues      20,465       49       25,843       46       5,378       26                                                   Gross profit      21,168       51       30,419       54       9,251       44           Operating expenses:                                                            Sales and marketing      12,590       30       17,230       31       4,640       37             Research and development      3,139       8       3,173       6       34       1             General and administrative      4,092       10       4,999       9       907       22             Stock-based compensation      136       —       406       1       270       199                                                   Total operating expenses      19,957       48       25,808       46       5,851       29                                                   Income from operations      1,211       3       4,611       8       3,400       281           Interest (expense) income, net      (122 )     —       89       —       211       173           Gain on sale of investment      3,019       7       —       —       (3,019 )     (100 )         Other income (expense), net      976       2       (368 )     (1 )     (1,344 )     (138 )                                                 Income before (benefit) provision for income taxes and minority     interest      5,084       12       4,332       8       (752 )     (15 )         (Benefit) provision for income taxes      (276 )     (1 )     102       —       378       137           Minority interest in net income of subsidiary      64       —       70       —       6       9                                                   Net income    $ 5,296       13 %   $ 4,160       7 %   $ (1,136 )     (21 )%                                                     Revenues         Total revenues for the year ended December 31, 2004 included $1.3 million of revenues from a related party. There were no revenues from a related party in 2005. For purposes of the following discussion, we refer to revenues and revenues from related party on a combined basis. Revenues in the year ended December 31, 2005 exceeded revenues in 2004 by $14.6 million, or 35%. The increase in revenues was attributable to a number of factors:            •       Revenues from the sale of products in North America increased     $14.5 million, or 109%, to $27.8 million in 2005 as     compared to $13.3 million in 2004. The increase was     attributable to an increase in the number of product units sold     and a higher average selling price due to a favorable change in     product mix. The increase in North American revenues resulted in     part from the reorganization and expansion of our North American     sales organization, including the hiring of 14 additional direct     sales employees between December 31, 2004 and 2005. The     increase also resulted from the introduction of new products,     particularly our Apogee Elite system at the end of the     first quarter of 2004. Revenues from sales of products     introduced since 2004 totaled $24.5 million, or 88%, of     total North American product revenues in 2005.         •       Revenues from sales of products outside of North America     increased $3.7 million, or 26%, to $17.7 million in     2005 as compared to $14.0 million in 2004. The increase was     mainly attributable to   47   Table of Contents                an increase in sales in Europe of $2.2 million, or 26%,     over 2004, resulting from a favorable change in product mix and     our increased focus on direct selling, for which we receive     higher average selling prices as compared to sales through     distributors, including the opening of our direct sales office     in Spain in the second half of 2004.         •       Revenues from original equipment manufacturer and other     relationships and our revenue sharing arrangement decreased     $3.7 million, or 49%, to $3.8 million in 2005 as     compared to $7.5 million in 2004. The decrease was mainly     attributable to non-recurring revenues of $1.2 million from     the purchase of aesthetic treatment systems by Sona MedSpa in     May 2004 in connection with the sale of our equity interest in     Sona MedSpa, a $1.5 million decrease in our revenue sharing     arrangement and a $1.1 million decrease in sales of a     product we distributed that was supplied by El.En. in 2004 but     that we did not distribute in 2005.         •       Revenues from the sale of parts and accessories and services     increased $0.2 million, or 3%, to $7.0 million in 2005     as compared to $6.8 million in 2004. The increase was     primarily attributable to an increase of revenues generated from     service contracts.            Cost of Revenues         Cost of revenues increased $5.4 million, or 26%, to $25.8 million in 2005, as compared to $20.5 million in 2004. The increase in the cost of revenues was primarily attributable to an increase in direct labor, overhead and material costs associated with increased sales of our products. Our cost of revenues decreased as a percentage of revenues to 46% in 2005 from 49% in 2004, resulting in an increase in our gross margin of 3% between the two years. The improved margin resulted primarily from higher average selling prices of our products due to a favorable change in product mix, in part as a result of the introduction of our Apogee Elite system in the first quarter of 2004, as well as increased direct sales in North America. We derived all of our North American product revenues from direct sales.           Sales and Marketing         Sales and marketing expenses increased $4.6 million, or 37%, to $17.2 million in 2005, as compared to $12.6 million in 2004. The increase was primarily attributable to an increase of $2.8 million in personnel costs and travel expenses associated with the expansion of our North American direct sales organization and $0.6 million in personnel costs and travel expenses associated with our international subsidiaries. Promotional costs increased $1.1 million, primarily due to our increased number of clinical workshops, trade shows and promotional efforts. As a percentage of revenues, sales and marketing expenses increased to 31% in 2005 from 30% in 2004.           Research and Development         Research and development expenses remained relatively flat at $3.2 million in 2005, as compared to $3.1 million in 2004. In 2005, our research and development expenses were attributable to project research costs and product engineering expenses related to the introduction of our new Cynergy system in the first quarter of 2005 and ongoing development of new products. In 2004, our research and development expenses were attributable to project research costs and product engineering expenses related to the introduction of our new Apogee Elite, Apogee 5500 NL and Acclaim 7000 NL products in the first quarter of 2004 and our ongoing development of new products. As a percentage of revenues, research and development expenses decreased to 6% in 2005 from 8% in 2004.           General and Administrative         General and administrative expenses increased $0.9 million, or 22%, to $5.0 million in 2005 from $4.1 million in 2004. The increase was primarily attributable to a $0.4 million increase in our international subsidiaries’ administrative expenses, primarily in connection with our opening an office in Spain in the second half of 2004, as well as a $0.2 million increase in personnel expenses associated with becoming a  48    Table of Contents  public company and $0.2 million increase in legal expenses associated with patent filing costs. As a percentage of revenues, general and administrative expenses decreased to 9% in 2005 from 10% in 2004.           Stock-Based Compensation         Stock-based compensation related to employee stock-based awards was $0.5 million in 2005 compared to $0.1 million in 2004. Stock-based compensation related to non-employee option grants was $0.2 million in 2005.           Interest (Expense) Income, net; Gain on Sale of Investment     and Other Income (Expense), net         Interest (expense) income, net increased to $89,000 in income in 2005 from $0.1 million in expense in 2004. The increase resulted from interest income earned on higher cash balances available for investment due to our initial public offering in December 2005. In 2004, we recorded a gain of $3.0 million on the sale of our 40% equity interest in Sona MedSpa. We had no similar gain in 2005. Other income (expense) decreased to $0.4 million in expense in 2005 from $1.0 million in income in 2004. The decrease was partially attributable to an increase in foreign currency transaction losses of $0.8 million and to a $0.2 million decrease in our equity interest in Sona MedSpa for 2005 as compared to 2004 as a result of the sale of such interest. The decrease in other income (expense) is also attributable to $0.3 million in other income that we realized in 2004 in connection with a settlement with an insurer.           Provision (Benefit) for Income Taxes         In 2005, we recorded an income tax provision of $0.1 million. In 2004, we recorded an income tax benefit of $0.3 million. In 2005, we reduced the valuation allowance related to certain temporary differences and recorded a deferred tax asset of approximately $1.3 million as realization of these assets became probable in 2005 based on our future projections of our taxable income. In the second half of 2004, we received $0.5 million of refund claims, which was recorded as an income tax benefit. In 2004, we utilized all of our available U.S. federal net operating loss carryforwards.  49    Table of Contents  Years Ended December 31, 2003 and 2004        The following table contains selected statement of operations data, which serves as the basis of the discussion of our results of operations for the years ended December 31, 2003 and 2004 (in thousands, except for percentages):                                                             Year Ended December 31,   Year Ended December 31,   Change       2003   2004    2003 to 2004                           As a % of       As a % of           Amount   Revenues   Amount   Revenues   $ Change   % Change                                   (Dollars in thousands)         Revenues    $ 27,125       100 %   $ 41,633       100 %   $ 14,508       53 %         Cost of revenues      14,207       52       20,465       49       6,258       44                                                   Gross profit      12,918       48       21,168       51       8,250       64           Operating expenses:                                                          Sales and marketing      8,720       32       12,590       30       3,870       44           Research and development      2,481       9       3,139       8       658       27           General and administrative      3,766       14       4,092       10       326       9           Stock-based compensation      76       —       136       —       60       79                                                   Total operating expenses      15,043       55       19,957       48       4,914       33                                                   (Loss) income from operations      (2,125 )     (8 )     1,211       3       3,336       157           Interest expense, net      (62 )     —       (122 )     —       (60 )     (97 )         Gain on sale of investment      —       —       3,019       7       3,019       —           Other income, net      1,822       7       976       2       (846 )     (46 )                                                 (Loss) income before provision (benefit) for income taxes and     minority interest      (365 )     (1 )     5,084       12       5,449       1,493           Provision (benefit) for income taxes      72       —       (276 )     (1 )     (348 )     (483 )         Minority interest in net income of subsidiary      63       —       64       —       1       2                                                   Net (loss) income    $ (500 )     (2 )%   $ 5,296       13 %   $ 5,796       1,159 %                                                     Revenues         Total revenues for the year ended December 31, 2003 included $1.6 million, and for the year ended December 31, 2004 included $1.3 million, of revenues from related party. For purposes of the following discussion, we refer to revenues and revenues from related party on a combined basis. Revenues in 2004 exceeded revenues in 2003 by $14.5 million, or 53%. The increase in revenues was attributable to a number of factors:            •       Revenues from the sale of products in North America increased     $6.2 million, or 86%, to $13.4 million in 2004 as     compared to $7.2 million in 2003. The increase was     attributable to an increase in the number of products sold and a     higher average selling price due to a favorable change in     product mix. The increase in North American revenues resulted in     part from the reorganization and expansion of our North American     sales organization, including the hiring of new sales management     and 10 additional direct sales employees between November 2003     and the end of 2004. The increase also resulted from the     introduction of new products, particularly our Apogee Elite     system at the end of the first quarter of 2004. Revenues     from sales of products introduced in 2004 totaled     $9.8 million, or 74%, of total North American product     revenues in 2004.         •       Revenues from sales of products outside of North America     increased $2.4 million, or 20.7%, to $14.0 million in     2004 as compared to $11.6 million in 2003. The increase was     primarily attributable   50    Table of Contents                to an increase in sales in Europe of $3.3 million, or 65%,     over 2003, resulting from our introduction of new products and     our increased focus on direct selling in 2004, for which we     receive higher average selling prices as compared to sales     through distributors, partially offset by a $1.0 million     decrease in revenues from product sales in the Asia/ Pacific     region, which was primarily attributable to the discontinuation     of a product distributed in the region.         •       Revenues from original equipment manufacturer and other     relationships and our revenue sharing arrangement increased     $4.8 million, or 200%, to $7.2 million in 2004 as     compared to $2.4 million in 2003. The increase was mainly     attributable to a $3.6 million increase in revenues from     our revenue sharing arrangement with Sona MedSpa, reflecting     growth in Sona MedSpa’s business, a different revenue     sharing formula in the amended supply and revenue sharing     arrangement entered into in May 2004 and non-recurring revenues     of $1.2 million from the purchase of aesthetic treatment     systems by Sona MedSpa in May 2004 in connection with the sale     of our equity interest in Sona MedSpa, and a $0.9 million     increase in sales of a product we formerly distributed supplied     by El.En. in 2003 and 2004.         •       Revenues from the sale of parts and accessories and services     increased $1.1 million, or 20%, to $6.7 million in     2004 as compared to $5.6 million in 2003. The increase was     primarily attributable to an increase in revenues generated from     service contracts, reflecting increased service contract     marketing efforts by us.            Cost of Revenues         Cost of revenues increased $6.3 million in 2004, or 44%, to $20.5 million as compared to $14.2 million in 2003. The increase in cost of revenues was primarily attributable to an increase in direct labor, overhead and material costs associated with increased sales of our products. Our cost of revenues decreased as a percentage of revenues to 49% in 2004 from 52% in 2003, resulting in an increase in our gross margin of 3% between the two periods. The improved margin resulted from higher average selling prices of our products due to a favorable change in product mix, in part as a result of the introduction of our Apogee Elite system in the first quarter of 2004, as well as increased direct sales in North America and Europe, from which we receive higher average selling prices as compared to sales through distributors. In 2004, we derived 63% of our international product revenues from direct sales by us or our subsidiaries compared to 52% of our international product revenues in the same period in 2003. We derived all of our North American product revenues from direct sales.           Sales and Marketing         Sales and marketing expenses increased $3.9 million, or 44%, to $12.6 million in 2004, as compared to $8.7 million in 2003. The increase was attributable to an increase of $1.9 million in personnel costs and travel expenses associated with the expansion of our North American direct sales organization, an increase of $0.9 million in personnel costs and travel expenses associated with our international subsidiaries and an increase of $0.5 million in clinical research expenses. Promotional costs increased $0.7 million, primarily due to our increased number of clinical workshops, trade shows and promotional efforts, including product launch expenses incurred in connection with the introduction of our Apogee Elite, Apogee 5500 NL, Acclaim 7000 NL and TriActive LaserDermology systems in early 2004. As a percentage of revenues, sales and marketing expenses decreased to 30% in 2004 from 32% in 2003.           Research and Development         Research and development expenses increased $0.7 million, or 27%, to $3.1 million in 2004 as compared to $2.5 million in 2003. The increase was primarily attributable to expenses related to the development and introduction of our Apogee Elite, Apogee 5500 NL and Acclaim 7000 NL systems in 2004 and the development of our Cynergy and Cynergy III systems that were introduced in 2005. In 2003, our research and development expenses were attributable to project research costs and product engineering expenses related to the introduction of our Apogee 5500 and Acclaim 7000 products that were introduced  51    Table of Contents  in 2003 and the development of our Apogee Elite, Apogee 5500 NL and Acclaim 7000 NL products which were introduced in 2004. As a percentage of revenues, research and development expenses decreased to 8% in 2004 from 9% in 2003.           General and Administrative         General and administrative expenses increased $0.3 million, or 9%, to $4.1 million in 2004 as compared to $3.8 million in 2003. The increase was attributable to a $0.2 million increase in audit expenses and a $0.1 million increase in consulting expenses relating to our reorganization by the new management team. As a percentage of revenues, general and administrative expenses decreased to 10% in 2004 from 14% in 2003.           Stock-Based Compensation         In connection with employee stock purchase rights granted under our 2003 Stock Compensation Plan, we recorded stock-based compensation of $0.1 million in 2004 and $76,000 in 2003. The 2003 Stock Compensation Plan terminated on December 31, 2004 and we do not expect any additional stock-based compensation related to this plan.           Interest Expense, net; Gain on Sale of Investment and     Other Income (Expense), net         Interest expense increased to $0.1 million in 2004 from $62,000 in 2003. The increase resulted from an increase in short-term notes payable for the 2004 period. Gain on sale of investment was $3.0 million in 2004; we did not record a similar gain in 2003. The gain on sale of investment in 2004 resulted from the non-recurring sale of our equity interest in Sona MedSpa. Other income, net decreased to $1.0 million in income in 2004 from $1.8 million in income in 2003. The decrease is attributable to the $0.6 million decrease in our equity interest in Sona MedSpa in 2004 as compared to 2003, reflecting the sale of such interest in May 2004, combined with a $0.5 million decrease in foreign currency transaction gains, partially offset by $0.3 million realized in connection with a settlement with an insurer.           (Benefit) Provision for Income Taxes         During 2004, we recorded an income tax benefit of $0.3 million compared to an income tax provision of $72,000 recorded in 2003. The increase in our income tax benefit was due to the receipt of $0.5 million of refund claims in the second half of 2004, which was recorded as an income tax benefit, partially offset by an increase in the proportion of our taxable income from foreign locations for which we did not have available loss carryforwards in 2004 as compared to 2003. We did not apply for or receive any refund claims in 2003.   Liquidity and Capital Resources        We require cash to pay our operating expenses, make capital expenditures and pay our long-term liabilities. Since our inception, we have funded our operations through private placements of equity securities, short-term borrowings and funds generated from our operations. In December 2005, we completed our initial public offering of our class A common stock at a price to the public of $15.00 per share. We sold 5,750,000 shares of our class A common stock, including an over-allotment option of 750,000 shares, and El.En. the selling stockholder in the offering, sold 1,000,000 of the shares. We received aggregate net proceeds of approximately $64.0 million, after deducting underwriting discounts and commission of approximately $5.0 million and expenses of the offering of approximately $2.3 million.        At December 31, 2005, our cash and cash equivalents were $64.6 million as compared to $4.0 million at December 31, 2004. Our cash and cash equivalents are highly liquid investments with maturity of 90 days or less at date of purchase and consist of time deposits and investments in money market funds with commercial banks and financial institutions and United States government obligations.  52   Table of Contents          Cash Flows         Net cash used in operating activities was $1.0 million for the year ended December 31, 2005. This resulted primarily from net income for the period of $4.2 million, increased by approximately $2.2 million in depreciation and stock-based compensation expense and decreased by approximately $1.9 million in deferred income tax benefits. Net changes in working capital items decreased cash from operating activities by approximately $5.5 million principally related to an increase in inventory for anticipated future sales and in preparation for our transition to modular assembly and contract manufacturing. Net cash used in investing activities was $2.4 million for the year ended December 31, 2005, which consisted primarily of $2.8 million used for fixed asset purchases and the payment of a $0.2 million security deposit relating to the lease for our new corporate headquarters offset by the receipt of $0.5 million released from escrow as part of the sale of our investment in Sona MedSpa. Net cash provided from financing activities during the year ended December 31, 2005 was $63.6 million, principally relating to net proceeds of $64.0 million from our initial public offering offset by repayment of $.3 million of a note payable to a related party.        Net cash provided by operating activities was $1.3 million for the year ended December 31, 2004. This resulted primarily from net income of $5.3 million increased by $1.3 million in depreciation and amortization, reduced by a $3.0 million gain from the sale of our equity interest in Sona MedSpa and a $2.3 million decrease in working capital primarily attributable to an increase in accounts receivables from increased sales and inventory for anticipated future sales. Net cash provided by investing activities was $0.3 million for the year ended December 31, 2004 resulting primarily from $3.1 million in net proceeds from the sale of our investment in Sona MedSpa, offset in large part by $2.8 million in capital expenditures. Net cash provided by financing activities was $0.1 million for the year ended December 31, 2004 resulting primarily from proceeds of $2.1 million from the sale of common stock and $0.5 million of proceeds from a note payable to El.En., offset by payments of $2.0 million on short-terms loans and payments of $0.2 million on capital lease obligations.        Net cash used in operating activities was $0.3 million for the year ended December 31, 2003. This primarily resulted from net loss of $0.5 million and a $0.4 million decrease in working capital primarily attributable to an increase in accounts receivables from increased sales and inventory for anticipated future sales, partially offset by $1.3 million in depreciation and amortization. Net cash used in investing activities was $1.2 million for the year ended December 31, 2003 and consisted of $0.9 million in capital expenditures and $0.2 million relating to an equity investment. Net cash provided in financing activities was $0.7 million for the year ended December 31, 2003 and resulted primarily from proceeds of $1.4 million from the sale of common stock to El.En. and $0.7 million in proceeds from notes payable to El.En., offset by $1.3 million for the repurchase of common stock from several minority stockholders and payments of $0.3 million on capital lease obligations.        We expect to generate positive cash flows from operations in the future. Our future capital requirements depend on a number of factors, including the rate of market acceptance of our current and future products, the resources we devote to developing and supporting our products and continued progress of our research and development of new products. We expect our capital expenditures over the next 12 months generally to be consistent with our capital expenditures during the prior 12 months.        We believe that our current cash and cash equivalents and cash generated from operations, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the foreseeable future.           Contractual Obligations         Our major outstanding contractual obligations relate to our capital leases from equipment financings and our facilities leases. In addition, we guaranteed the lease obligations for two facilities that are operated by Sona MedSpa and will be obligated to pay these leases if Sona MedSpa can not or does not make the  53   Table of Contents  required lease payments. We have summarized in the table below our fixed contractual cash obligations as of December 31, 2005.                                                     Payments Due by Period                   Less Than   One to   Three to   More Than       Total   One Year   Three Years   Five Years   Five Years                               (In thousands)         Capital lease obligations, including interest    $ 1,322     $ 384     $ 660     $ 278     $ —           Operating leases      5,292       824       1,558       1,619       1,291           Short-term indebtedness, including interest      161       161       —       —       —           Lease guarantees      342       92       147       85       18                                             Total contractual cash obligations    $ 7,117     $ 1,461     $ 2,365     $ 1,982     $ 1,309                                         Off Balance Sheet Arrangements        Since inception, we have not engaged in any off balance sheet financing activities.   Critical Accounting Policies and Estimates        The discussion and analysis of our financial condition and results of operations set forth above are based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates and judgments, including those described below. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities, and the reported amounts of revenues and expenses, that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.        We believe the following critical accounting policies require significant judgment and estimates by us in the preparation of our financial statements.           Revenue Recognition and Deferred Revenue         In accordance with Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements, we recognize revenue from sales of aesthetic treatment systems and accessories when each of the following four criteria are met:            •       delivery has occurred;         •       there is persuasive evidence of an agreement;         •       the fee is fixed or determinable; and         •       collection is reasonably assured.         Revenue from the sale of service contracts is deferred and recognized on a straight-line basis over the contract period as services are provided. We are party to a revenue sharing arrangement with an operator and franchisor of spa franchises and recognize revenue from this arrangement in the period in which the procedures are performed.        We defer until earned payments that we receive in advance of product delivery or performance of services. When we enter into arrangements with multiple elements, which may include sales of products together with service contracts and warranties, we allocate revenue among the elements based on each element’s fair value in accordance with the principles of Emerging Issues Task Force Issue Number 00-21,  54    Table of Contents  Revenue Arrangements with Multiple Deliverables. This allocation requires us to make estimates of fair value for each element.           Accounts Receivable and Concentration of Credit     Risk         Our accounts receivable balance, net of allowance for doubtful accounts, was $13.6 million as of December 31, 2005, compared with $8.4 million as of December 31, 2004. The allowance for doubtful accounts as of December 31, 2005 was $0.7 million and as of December 31, 2004 was $0.5 million. We maintain an allowance, or reserve, for doubtful accounts based upon the aging of our receivable balances, known collectibility issues and our historical experience with losses. While our credit losses have historically been within our expectations and the allowances established, we may not continue to experience the same credit losses that we have in the past, which could cause our provisions for doubtful accounts to increase. We work to mitigate bad debt exposure through our credit evaluation policies, reasonably short payment terms and geographical dispersion of sales. Our revenues include export sales to foreign companies located principally in Europe, the Asia/ Pacific region and the Middle East. We obtain letters of credit for foreign sales that we consider to be at risk.           Inventories and Allowance for Obsolescence         We state all inventories at the lower of cost or market value, determined on a first-in, first-out method. We monitor standard costs on a monthly basis and update them annually and as necessary to reflect changes in raw material costs and labor and overhead rates. Our inventory balance was $14.1 million as of December 31, 2005 compared to $9.9 million as of December 31, 2004. Our inventory allowance as of December 31, 2005 was $1.0 million and as of December 31, 2004 was $0.8 million. We provide inventory allowances when conditions indicate that the selling price could be less than cost due to physical deterioration, usage, obsolescence, reductions in estimated future demand and reductions in selling prices. We balance the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology and customer demand levels. Unfavorable changes in market conditions may result in a need for additional inventory reserves that could adversely impact our gross margins. Conversely, favorable changes in demand could result in higher gross margins when we sell products.           Product Warranty Costs and Provisions         We provide a one-year parts and labor warranty on end-user sales of our aesthetic treatment systems. Distributor sales generally include a warranty on parts only. We estimate and provide for future costs for initial product warranties at the time revenue is recognized. We base product warranty costs on related material costs, technical support labor costs and overhead. We provide for the estimated cost of product warranties by considering historical material, labor and overhead expenses and applying the experience rates to the outstanding warranty period for products sold. As we sell new products to our customers, we must exercise considerable judgment in estimating the expected failure rates and warranty costs. If actual product failure rates, material usage, service delivery costs or overhead costs differ from our estimates, we would be required to revise our estimated warranty liability. The following table sets forth activity in the accrued warranty account for each of the three years ended December 31, 2003, 2004 and 2005:                                     2003   2004   2005                         Balance at beginning of year    $ 863     $ 1,252     $ 1,610           Charged to expense      1,317       1,606       2,538           Costs incurred      (928 )     (1,248 )     (1,883 )                               Balance at end of year    $ 1,252     $ 1,610     $ 2,265                                     Stock-Based Compensation         Until December 31, 2005, we followed Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and related interpretations, in accounting for our stock-based  55    Table of Contents  compensation plans, rather than the alternative fair value method provided for under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, or SFAS No. 123. In 2005, some grants of stock options were made at exercise prices less than the deemed fair value of our common stock for accounting purposes and, as a result, we recorded this intrinsic value as deferred stock-based compensation. This deferred stock-based compensation is being amortized to expense over the vesting period of the stock options. In the notes to our financial statements, we provide pro forma disclosures in accordance with SFAS No. 123 that reflect the effect on net (loss) income as if we had applied the fair value provisions of SFAS No. 123. We account for transactions in which services are received from non-employees in exchange for equity instruments based on the fair value of such services received or of the equity instruments issued, whichever is more reliably measured, in accordance with SFAS No. 123 and the Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, or EITF Issue No. 96-18.        Accounting for equity instruments granted or sold by us under APB 25, SFAS No. 123 and EITF Issue No. 96-18 required fair value estimates of the equity instrument granted or sold. If our estimates of the fair value of these equity instruments for accounting purposes are too high or too low, our expenses may have been overstated or understated. We estimated the fair value of the equity instruments for accounting purposes based upon consideration of factors we deemed to be relevant at the time. Prior to our initial public offering in December 2005, market factors historically considered in valuing stock and stock option grants include pricing of private sales of our common stock to investors, comparative values of public companies discounted for the risk of limited liquidity provided for in the shares we are issued and the effect of certain events that had occurred between the time of such private sales and such grants.        Prior to our initial public offering, the fair value of our capital stock for accounting purposes was determined by our management and board of directors. In making that determination, our management and board of directors drew on the knowledge of our officers and directors who have experience with companies in the medical device sector. At the time we granted stock options in October and November 2004 and April and May 2005, we did not perform or obtain contemporaneous valuations for our common stock because our efforts were focused on the continuing reorganization of our operations and the managerial resources for doing so were limited. However, in connection with our preparation of financial statements for our initial public offering and solely for the purposes of accounting for employee stock-based compensation, our board of directors considered whether the options granted in October and November 2004 and April and May 2005 had deferred stock-based compensation elements that should be reflected in our financial statements. In making this determination, we have reviewed the valuation methodologies outlined in the AICPA’s Practice Aid Valuation of Privately-Held-Company Equity Securities Issues as Compensation, which we refer to as the practice aid, and we believe that the valuation methodologies we have employed are consistent with the practice aid.        With respect to the October and November 2004 option grants, our board of directors noted that we sold shares of our common stock in October 2004 to investors who had not previously purchased shares of our common stock and considered the pricing of those shares to be a strong indicator of the fair value of our common stock. In addition, our board of directors noted that during October and November 2004 we did not consider an initial public offering or other liquidity event to be likely to occur during the ensuing three to four months. As a result, our board of directors determined that the October and November 2004 option grants were granted with an exercise price per share equal to or in excess of the fair value of our common stock at the time of grant.        With respect to the April and May 2005 option grants, our board of directors noted that the fair value of the common stock subject to those options, as determined by our board of directors at the time of grant, was significantly less than the valuations that investment banking firms were discussing with us in connection with our preparation for our initial public offering. Our board of directors concluded that we should not ignore the discrepancies in valuation in evaluating whether those stock options had deferred stock-based compensation elements.  56    Table of Contents       As a result, in August 2005 our board of directors decided to determine retrospectively the fair value of our common stock as of the stock option grant dates in April and May 2005. In making these retrospective determinations, our board of directors considered a number of factors, including the October 2004 sales of our common stock to investors, our operating and financial performance, the increasing likelihood that we would pursue a public offering and valuation indications for our common stock received from investment bankers, the lack of liquidity in our common stock and trends in the market for medical device company stocks, and established per share fair values for our common stock of $7.59 in April 2005 and $9.09 in May 2005. We recorded deferred stock-based compensation of approximately $1.7 million and recognized $264,000 of amortization of deferred stock-based compensation in 2005 as a result of this retrospective valuation. As of December 31, 2005, we had approximately $1.4 million of deferred stock-based compensation, all of which relates to unvested options. We expect to record amortization of this deferred stock-based compensation of $0.4 million in each of 2006, 2007 and 2008 and $0.2 million in 2009, in each case subject to employee terminations.        In September 2005, we performed another retrospective valuation of our common stock as of the May 2005 option grant date. The September 2005 retrospective determination of the fair value of our common stock was based on a discounted average value of two generally accepted valuation approaches: a market multiple approach and an income approach. The average was then reduced by a 5% marketability discount factor to reflect the illiquid nature of private company equity securities such as our common stock. The May 2005 grant date fair value as determined by the September 2005 valuation was $9.10 per share, which we believe supports the $9.09 fair value determined by the retrospective valuation performed by our management and our board of directors in August 2005.        We use the Black-Scholes option pricing model to determine the fair value of each option grant to non-employees. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, this option pricing model requires the use of highly subjective assumptions, including expected stock price volatility. These assumptions reflect our best estimates, but these items involve inherent uncertainties based on market conditions that are generally outside of our control.        The determination of the fair value of our common stock has involved significant judgments, assumptions, estimates and complexities that impact the amount of deferred stock-based compensation recorded and the resulting amortization in future periods. If we had made different assumptions, the amount of our deferred stock-based compensation, stock-based compensation expense, gross margin, net income and net income per share amounts could have been significantly different. We believe that we have used reasonable methodologies, approaches and assumptions consistent with the practice aid to determine the fair value of our common stock and that stock-based deferred compensation and related amortization have been recorded properly for accounting purposes.           Income Taxes         We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under this method, we determine deferred tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. The tax consequences of most events recognized in the current year’s financial statements are included in determining income taxes currently payable. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenues, expenses, gains and losses, differences arise between the amount of taxable income and pretax financial income for a year and between the tax bases of assets or liabilities and their reported amounts in the financial statements. Because we assume that the reported amounts of assets and liabilities will be recovered and settled, respectively, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in a taxable or a deductible amount in some future years when the related liabilities are settled or the reported amounts of the assets are recovered, giving rise to a deferred tax asset. We then assess the likelihood that  57    Table of Contents  our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance.           Recent Accounting Pronouncements         In December 2004, the Financial Accounting Standards Board issued SFAS Statement No. 123 (revised 2004), Share-Based Payment, or SFAS 123(R), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. SFAS 123(R) supersedes APB 25 and amends FASB Statement No. 95, Statement of Cash Flows. SFAS 123(R) requires companies to measure compensation costs for share-based payments to employees, including stock options, at fair value and expense such compensation over the service period beginning with the first interim or annual period after December 15, 2005. The pro forma disclosures previously permitted under SFAS 123(R) will no longer be an alternative to financial statement recognition. We will adopt SFAS 123(R) in the first quarter of fiscal 2006. Under SFAS 123(R), companies must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition methods include prospective and retroactive adoption options. Upon adoption, Cynosure will apply the provisions of SFAS 123(R) to all unvested awards and to future awards.        The adoption of SFAS 123(R)’s fair value method will have a significant impact on the Cynosure’s result of operations, although it will have no impact on Cynosure’s overall financial position. The impact of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future.        In November 2004, the Financial Accounting Standards Board issued SFAS Statement No. 151, Inventory Costs, an Amendment of Accounting Principles Board Opinion No. 43, Chapter 4, or SFAS 151. SFAS 151 requires that items such as idle facility expense, freight, handling costs and wasted materials be recognized as current-period charges rather than being included in inventory regardless of whether the costs meet the criterion of abnormal as defined in Accounting Principles Board Opinion No. 43. SFAS 151 is applicable for inventory costs incurred during fiscal years beginning after June 15, 2005. We adopted this pronouncement on January 1, 2006 and we do not expect the adoption with have a material impact on our financial condition or results of operation.             Item 7A.  Quantitative and Qualitative Disclosures About Market     Risk         Our exposure to market risk is currently confined to our cash and cash equivalents that have maturities of less than 90 days. We currently do not hedge interest rate exposure. We have not used derivative financial instruments for speculation or trading purposes. Because of the short-term maturities of our cash and cash equivalents, we do not believe that an increase in market rates would have any significant impact on the realized value of our investments.        A significant portion of our operations is conducted through operations in countries other than the United States. Revenues from our international operations that were recorded in U.S. dollars represented approximately 39% of our total international revenues for the year ended December 31, 2004. Substantially all of the remaining 61% were sales in euros, British pounds and Japanese yen. Since we conduct our business in U.S. dollars, our main exposure, if any, results from changes in the exchange rate between these currencies and the U.S. dollar. Our functional currency is the U.S. dollar. Our policy is to reduce exposure to exchange rate fluctuations by having most of our assets and liabilities, as well as most of our revenues and expenditures, in U.S. dollars, or U.S. dollar linked. Therefore, we believe that the potential loss that would result from an increase or decrease in the exchange rate is immaterial to our business and net assets.             Item 8.  Consolidated Financial Statements and Supplementary     Data         Refer to page F-1.   58   Table of Contents            Item 9.  Changes in and Disagreements with Accountants on     Accounting and Financial Disclosure         Not applicable.             Item 9A.  Controls and Procedures         Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2005. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2005, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.        No change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.             Item 9B.  Other Information         None.       PART III             Item 10.  Directors and Executive Officers of the Registrant         Incorporated by reference from the information in our proxy statement for the 2006 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.             Item 11.  Executive Compensation         Incorporated by reference from the information in our proxy statement for the 2006 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.             Item 12.  Security Ownership of Certain Beneficial Owners and     Management and Related Stockholder Matters         Incorporated by reference from the information in our proxy statement for the 2006 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.  59    Table of Contents            Item 13.  Certain Relationships and Related Transactions         Incorporated by reference from the information in our proxy statement for the 2006 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.             Item 14.  Principal Accountant Fees and Services         Incorporated by reference from the information in our proxy statement for the 2006 Annual Meeting of Stockholders, which we will file with the Securities and Exchange Commission within 120 days of the end of the fiscal year to which this report relates.       PART IV             Item 15.  Exhibits, Financial Statements Schedules         (a) 1. Financial Statements. The financial statements annexed to this report begin on page F-1.        2. Financial Statements Schedules. The financial statement schedules annexed to this report beginning on page F-1 are incorporated by reference.        3. Exhibits. The Exhibit Index annexed to this report is incorporated by reference.  60   Table of Contents      SIGNATURES        Pursuant to the requirements of Section 13 or 15(d) 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.                CYNOSURE, INC.             By:       /s/ Michael R. Davin                            Michael R. Davin          President, Chief Executive Officer and          Chairman of the Board of Directors         Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the following persons on behalf of the registrant in the capacities and on the dates indicated.                     Signature   Title   Date                        /s/ Michael R. Davin Michael R. Davin        President, Chief Executive Officer and Chairman of the Board of     Directors (Principal Executive Officer)        March 21, 2006            /s/ Timothy W. Baker Timothy W. Baker        Executive Vice President and     Chief Financial Officer     (Principal Financial Officer and     Principal Accounting Officer)        March 21, 2006            /s/ Ettore V. Biagioni Ettore V. Biagioni        Director        March 21, 2006            /s/ Andrea Cangioli Andrea Cangioli        Director        March 21, 2006            /s/ Paul F. Kelleher Paul F. Kelleher        Director        March 21, 2006            /s/ Leonardo Masotti Leonardo Masotti        Director        March 21, 2006            /s/ Thomas H. Robinson Thomas H. Robinson        Director        March 21, 2006            /s/ George J. Vojta George J. Vojta        Director        March 21, 2006    61    Table of Contents  CYNOSURE, INC.   INDEX TO FINANCIAL STATEMENTS                     Consolidated Financial Statements of Cynosure, Inc.                    Report of Independent Registered Public Accounting Firm      F-2             Consolidated Balance Sheets      F-3             Consolidated Statements of Operations      F-4             Consolidated Statements of Stockholders’ Equity and     Comprehensive (Loss) Income      F-5             Consolidated Statements of Cash Flows      F-6             Notes to Consolidated Financial Statements      F-7       Consolidated Financial Statements of Sona International     Corporation(1)                    Report of Independent Auditor      F-26             Consolidated Financial Statements at December 31, 2003 and 2002,     and for each of the two years in the period ended December 31,     2003:                    Consolidated Balance Sheets      F-27             Consolidated Statements of Income and Retained Earnings      F-28             Consolidated Statements of Cash Flows      F-29             Notes to Consolidated Financial Statements      F-30       Consolidated Financial Statements of Sona International,     Inc.(1)                    Report of Independent Registered Public Accounting Firm      F-36             Consolidated Financial Statements at December 31, 2004 and     for the year ended December 31, 2004:                    Consolidated Balance Sheet      F-37             Consolidated Statement of Operations and Accumulated Deficit      F-38             Consolidated Statement of Cash Flows      F-39             Notes to Consolidated Financial Statements      F-40                 (1)       From November 2000 until May 2004, Cynosure, Inc. held an equity     investment in Sona MedSpa International Inc., an operator and     franchisor of spa franchises formerly known as Sona     International Corporation and Sona International, Inc. Cynosure     accounted for the investment using the equity method of     accounting. The consolidated financial statements of Sona     International Corporation and Sona International, Inc. have been     included pursuant to Rule 3-09 of Regulation S-X under     the Securities Act of 1933, as amended.   F-1    Table of Contents  REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM   The Board of Directors and Stockholders   Cynosure, Inc.        We have audited the accompanying consolidated balance sheets of Cynosure, Inc. as of December 31, 2004 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive (loss) income and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements as of and for the year ended December 31, 2003 of Sona International Corporation (a corporation in which the Company had a 40% interest), have been audited by another auditor whose report has been furnished to us, and our opinion on the consolidated financial statements, insofar as it relates to the amounts included for Sona International Corporation, is based solely on the report of the other auditor. In the consolidated financial statements, the Company’s equity in the net income of Sona International Corporation is stated at $737,000 for the year then ended.        We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditor provide a reasonable basis for our opinion.        In our opinion, based on our audits and the report of the other auditor the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cynosure, Inc. at December 31, 2004 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States.                /s/ Ernst & Young LLP      Boston, Massachusetts   February 8, 2006  F-2    Table of Contents  CYNOSURE, INC.   CONSOLIDATED BALANCE SHEETS   (In thousands, except per share data)                                 December 31,               2004   2005                ASSETS         Current assets:                            Cash and cash equivalents    $ 4,028     $ 64,646             Accounts receivable (net of allowance of $460 and $696     respectively)      8,410       13,552             Amounts due from related parties (Notes 5 and 6)      —       72             Inventories      9,871       14,140             Prepaid expenses and other current assets      962       737             Deferred income taxes      —       1,804                           Total current assets      23,271       94,951           Property and equipment, net      3,733       4,424           Other noncurrent assets      997       793                           Total assets    $ 28,001     $ 100,168                          LIABILITIES AND STOCKHOLDERS’ EQUITY         Current liabilities:                            Short-term loan    $ 205     $ 161             Accounts payable      3,786       3,509             Amounts due to related party (Note 6)      900       960             Accrued expenses      6,433       7,173             Deferred revenue      848       3,626             Capital lease obligation      118       295             Note payable to related party      303       —                           Total current liabilities      12,593       15,724           Capital lease obligation, net of current portion      476       814           Deferred revenue, net of current portion      —       123           Other noncurrent liability      —       42           Minority interest in consolidated subsidiary      292       314           Commitments and Contingencies (Note 12)                          Stockholders’ equity:                            Preferred stock, $0.001 par value                              Authorized — 5,000 shares as of December 31,     2005                              Issued — no shares as of December 31, 2005      —       —             Common stock, $0.01 par value                              Authorized — 15,000 shares as of     December 31, 2004                              Issued — 6,279 shares as of December 31, 2004      63       —             Class A and Class B common stock, $0.001 par value                              Authorized — 70,000 shares as of     December 31, 2005                              Issued — 11,065 shares as of December 31,     2005      —       11             Additional paid-in capital      12,990       79,070             Notes receivable from stockholders      (3 )     —             Retained earnings      2,310       6,470             Deferred stock-based compensation      —       (1,426 )           Accumulated other comprehensive loss      (433 )     (687 )           Treasury stock, 36 shares, at cost      (287 )     (287 )                         Total stockholders’ equity      14,640       83,151                           Total liabilities and stockholders’ equity    $ 28,001     $ 100,168                       The accompanying notes are an integral part of these consolidated financial statements.  F-3    Table of Contents  CYNOSURE, INC.   CONSOLIDATED STATEMENTS OF OPERATIONS   (In thousands, except per share data)                                       Year Ended December 31,               2003   2004   2005                         Revenues    $ 25,525     $ 40,364     $ 56,262           Revenues from related party (Note 5)      1,600       1,269       —                                 Total revenues      27,125       41,633       56,262           Cost of revenues(1)      14,207       20,465       25,843                                 Gross profit      12,918       21,168       30,419           Operating expenses:                                    Sales and marketing      8,720       12,590       17,230             Research and development      2,481       3,139       3,173             General and administrative      3,766       4,092       4,999             Stock-based compensation(2)      76       136       406                                 Total operating expenses      15,043       19,957       25,808                                 (Loss) income from operations      (2,125 )     1,211       4,611           Interest (expense) income, net      (62 )     (122 )     89           Gain on sale of investment      —       3,019       —           Other income (expense), net      1,822       976       (368 )                               (Loss) income before (benefit) provision for income taxes and     minority interest      (365 )     5,084       4,332           Provision (benefit) for income taxes      72       (276 )     102           Minority interest in net income of subsidiary      63       64       70                                 Net (loss) income    $ (500 )   $ 5,296     $ 4,160                                 Basic net (loss) income per share    $ (0.09 )   $ 0.93     $ 0.64                                 Diluted net (loss) income per share    $ (0.09 )   $ 0.92     $ 0.54                                 Basic weighted average common shares outstanding      5,530       5,700       6,522                                 Diluted weighted average common shares outstanding      5,530       5,773       7,715                                                                         (1) Includes stock-based compensation of:    $ 10     $ 46     $ 63                                 (2) Stock-based compensation is attributable to the following     categories:                                      Sales and marketing      32       37       276               Research and development      20       83       26               General and administrative      24       16       104                                 76       136       406                                   Total stock-based compensation    $ 86     $ 182     $ 469                             The accompanying notes are an integral part of these consolidated financial statements.  F-4    Table of Contents     CYNOSURE, INC.   CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS) INCOME   (In thousands)                                                                                                                         Class A and B                                           Common Stock   Common Stock                                                                                               Additional   Notes Receivable   Retained   Deferred   Accumulated Other   Treasury Stock   Total               $0.01 Par       $0.001 Par   Paid-In   from   (Deficit)   Stock-Based   Comprehensive       Stockholders   Comprehensive       Shares   Value   Shares   Value   Capital   Stockholders   Earnings   Compensation   Income (Loss)   Shares   Cost   Equity   (Loss) Income                                                                 Balance at December 31, 2002      5,566     $ 56       —     $ —     $ 10,716     $ (130 )   $ (2,486 )   $ —     $ 21       (36 )   $ (287 )   $ 7,890                   Additional consideration from parent company for purchase of     ownership interest (Note 8)      —       —       —       —       145       —       —       —       —       —       1,317       1,462                   Repurchase of common stock      —       —       —       —       —       —       —       —       —       —       (1,317 )     (1,317 )                 Repayment of notes receivable from stockholders      —       —       —       —       —       127       —       —       —       —       —       127                   Issuance of stock purchase rights      —       —       —       —       86       —       —       —       —       —       —       86                   Net loss      —       —       —       —       —       —       (500 )     —       —       —       —       (500 )   $ (500 )         Cumulative translation adjustment      —       —       —       —       —       —       —       —       (460 )     —       —       (460 )     (460 )                                                                                           Balance at December 31, 2003      5,566       56       —       —       10,947       (3 )     (2,986 )     —       (439 )     (36 )     (287 )     7,288     $ (960 )                                                                                           Sale of common stock      638       6       —       —       1,862       —       —       —       —       80       240       2,108                   Issuance of common stock in connection with stock purchase rights      75       1       —       —       226       —       —       —       —       —       —       227                   Repurchase of common stock      —       —       —       —       —       —       —       —       —       (80 )     (240 )     (240 )                 Revaluation of stock purchase rights      —       —       —       —       (45 )     —               —       —       —       —       (45 )                 Net income      —       —       —       —       —       —       5,296       —       —       —       —       5,296     $ 5,296           Cumulative translation adjustment      —       —       —       —       —       —       —       —       6       —       —       6       6                                                                                                                                                                                           $ 5,302                                                                                             Balance at December 31, 2004      6,279       63       —       —       12,990       (3 )     2,310       —       (433 )     (36 )     (287 )     14,640                   Sale of common stock      —       —       —       —       —       —       —       —       —       495       1,485       1,485                   Repurchase of common stock      —       —       —       —       —       —       —       —       —       (495 )     (1,485 )     (1,485 )                 Issuance of common stock from public offering, net of offering     costs of $2,239      —       —       4,750       5       64,019       —       —       —       —       —       —       64,024                   Conversion of common stock      (6,279 )     (63 )     6,279       6       57       —       —       —       —       —       —       —                   Issuance of stock options to non- employees      —       —       —       —       205       —       —       —       —       —       —       205                   Deferred stock- based compensation in connection with stock     options issued to employees      —       —       —       —       1,690       —       —       (1,690 )     —       —       —       —                   Amortization of stock-based compensation      —       —       —       —       —       —       —       264       —       —       —       264                   Repayment of note receivable from stockholders      —       —       —       —       —       3       —       —       —       —       —       3                   Exercise of stock options      —       —       36       —       109       —       —       —       —       —       —       109                   Net income      —       —       —       —       —       —       4,160       —       —       —       —       4,160     $ 4,160           Cumulative translation adjustment      —       —       —       —       —       —       —       —       (254 )     —       —       (254 )     (254 )                                                                                           Balance at December 31, 2005      —     $ —       11,065     $ 11     $ 79,070     $ —     $ 6,470     $ (1,426 )   $ (687 )     (36 )   $ (287 )   $ 83,151     $ 3,906                                                                                         The accompanying notes are an integral part of these consolidated financial statements.  F-5    Table of Contents  CYNOSURE, INC.   CONSOLIDATED STATEMENTS OF CASH FLOWS   (In thousands)                                         Year Ended December 31,               2003   2004   2005                     Operating activities                                  Net (loss) income    $ (500 )   $ 5,296     $ 4,160           Reconciliation of net (loss) income to net cash (used in)     provided by operating activities:                                    Depreciation and amortization      1,306       1,323       1,769             Gain on sale of investment      —       (3,019 )     —             Stock-based compensation expense      86       182       469             Equity in investment income      (737 )     (154 )     —             Deferred income taxes      —       —       (1,846 )           Minority interest in consolidated subsidiary      50       (101 )     22             Changes in operating assets and liabilities:                                      Accounts receivable      (1,358 )     (3,054 )     (5,506 )             Due from related party      (262 )     262       (72 )             Inventories      (719 )     (3,884 )     (4,078 )             Net book value of demonstration inventory sold      126       1,068       315               Prepaid expenses and other current assets      259       25       (275 )             Accounts payable      42       1,176       (242 )             Due to related party      259       (342 )     60               Accrued expenses      1,179       2,369       1,255               Deferred revenue      15       109       2,901               Other noncurrent liability      —       —       42                                 Net cash (used in) provided by operating activities      (254 )     1,256       (1,026 )     Investing activities                                  Purchases of property and equipment      (939 )     (2,758 )     (2,782 )         Net proceeds from the sale of investment      —       3,058       500           Purchase of investment      (243 )     (15 )     —           Increase in other noncurrent assets      —       —       (165 )                               Net cash (used in) provided by investing activities      (1,182 )     285       (2,447 )     Financing activities                                  Payments on short-term loan and note payable to related party      (14 )     (2,042 )     (347 )         Deposit received for purchase of common stock from investors      —       413       (413 )         Deposit paid for repurchase of common stock      —       (413 )     413           Proceeds from exercise of stock options      —       —       109           Proceeds from sale of common stock      1,462       2,108       1,485           Proceeds from initial public offering      —       —       64,024           Proceeds from note payable to related party      733       500       —           Repurchase of common stock      (1,317 )     (240 )     (1,485 )         Payments received on stockholder notes      127       —       3           Payments on capital lease obligation      (310 )     (233 )     (185 )                               Net cash provided by financing activities      681       93       63,604           Effect of exchange rate changes on cash and cash equivalents      (424 )     283       487                                 Net (decrease) increase in cash and cash equivalents      (1,179 )     1,917       60,618           Cash and cash equivalents, beginning of year      3,290       2,111       4,028                                 Cash and cash equivalents, end of year    $ 2,111     $ 4,028     $ 64,646                             Supplemental cash flow information                                  Cash paid for interest    $ 28     $ 37     $ 127                                 Cash paid for taxes    $ —     $ —     $ 1,777                                 Income tax refunds received    $ 218     $ 515     $ —                                 Noncash investing and financing activities:                                    Inventory acquired via note payable to related party    $ 1,119     $ —     $ —                                   Assets acquired under capital lease    $ 117     $ 595     $ 700                                   Deferred compensation associated with stock option grants to     employees    $ —     $ —     $ 1,690                                   Proceeds from the sale of investment held in escrow    $ —     $ 500     $ —                                   Transfer of fixed assets to inventory in connection with October     2005 Sona sale    $ —     $ —     $ 448                             The accompanying notes are an integral part of these consolidated financial statements.  F-6    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS         1.  Nature of the Business         Cynosure, Inc. (Cynosure or the Company) develops, manufactures and markets aesthetic treatment systems that are used by physicians and other practitioners to perform non-invasive procedures to remove hair, treat vascular lesions, rejuvenate skin through the treatment of shallow vascular lesions and pigmented lesions and temporarily reduce the appearance of cellulite. Cynosure markets and sells its products primarily to the dermatology, plastic surgery and general medical markets, both domestically and internationally. Cynosure is a Delaware corporation, incorporated on July 10, 1991, located in Westford, Massachusetts.        In May 2002, Cynosure sold 3,327,960 shares of common stock (representing a 60% ownership interest) to El.En. S.p.A. (El.En.) for approximately $9.8 million in cash. As a consequence, the results of Cynosure are consolidated in the financial statements of El.En. Final consideration of $1.5 million from the sale was received in May 2003 (see Note 8). During 2004, El.En. acquired 2,190,834 additional shares of Cynosure’s common stock from the Company and certain minority stockholders, increasing its ownership percentage of Cynosure to approximately 87%.        In December 2005, Cynosure completed it’s initial public offering (IPO) of class A common stock at a price to the public of $15.00 per share. Cynosure sold 5,750,000 shares of class A common stock, including an over-allotment option of 750,000 shares, and El.En., the selling stockholder in the offering, sold 1,000,000 of the shares. Cynosure received aggregate net proceeds of approximately $64.0 million, after deducting underwriting discounts and commission of approximately $5.0 million and expenses of the offering of approximately $2.3 million. El.. En.’s ownership percentage of Cynosure as of December 31, 2005 is 35%.         2.  Summary of Significant Accounting Policies         Significant accounting policies followed in the preparation of these consolidated financial statements are as follows:           Management Estimates         The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures at the date of the financial statements and during the reporting period. Components particularly subject to estimation include the allowance for doubtful accounts, inventory reserves and accrued warranties. On an ongoing basis, management evaluates its estimates. Actual results could differ from these estimates.           Principles of Consolidation         The accompanying consolidated financial statements include the accounts of Cynosure, Inc. and its wholly owned subsidiaries: Cynosure GmbH, Cynosure S.A.R.L., Cynosure UK Limited and Cynosure KK. Cynosure has a 52% interest in Suzhou Cynosure Medical Devices, Co., located in the People’s Republic of China, and the related financial statements have been consolidated. All significant intercompany balances and transactions have been eliminated.           Cash and Cash Equivalents         Cynosure considers all short-term, highly liquid investments with original maturities at the time of purchase of 90 days or less to be cash equivalents. Cash equivalents consist of money-market funds.  F-7    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)           Accounts Receivable and Concentration of Credit     Risk         Management works to mitigate its concentration of credit risk with respect to accounts receivable through its credit evaluation policies, reasonably short payment terms and geographical dispersion of sales. Revenue includes export sales to foreign companies located principally in Europe, the Asia/ Pacific region and the Middle East. Cynosure obtains letters of credit for foreign sales considered by management to be at risk. Cynosure maintains reserves for potential credit losses based upon the aging of its receivable balances, known collectibility issues and its historical experience with losses. In the event that it is determined that the customer may not be able to meet its full obligation to Cynosure, Cynosure records a specific allowance to reduce the related receivable to the amount that Cynosure expects to recover given all information present. One customer accounted for 13% of revenues in 2004 and 12% and 13% of accounts receivable as of December 31, 2004 and 2005, respectively. No customer accounted for 10% or greater of revenue during 2003 or 2005. Accounts receivable allowance activity consisted of the following for the years ended December 31:                                     2003   2004   2005                       (In thousands)         Balance at beginning of year    $ 705     $ 484     $ 460           Additions      176       160       243           Deductions      (397 )     (184 )     (7 )                               Balance at end of year    $ 484     $ 460     $ 696                                     Inventory         Cynosure states all inventories at the lower of cost or market, determined on a first-in, first-out method. Inventory includes material, labor and overhead and consists of the following:                             December 31,               2004   2005                   (In thousands)         Raw materials    $ 2,381     $ 2,579           Work in process      2,413       2,259           Finished goods      5,077       9,302                         $ 9,871     $ 14,140                            Included in finished goods are lasers used for demonstration purposes. Cynosure’s policy is to include demonstration lasers as inventory for a period of up to one year after production at which time the demonstration lasers are either sold or transferred to fixed assets at the lower of cost or market and depreciated over their estimated useful life. Similar to any other finished goods in inventory, Cynosure accounts for such demonstration inventory in accordance with the policy for excess and obsolescence review of Cynosure’s entire inventory.        Cynosure’s policy is to establish inventory reserves when conditions exist that suggest that inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for products and market conditions. Cynosure regularly evaluates the ability to realize the value of inventory based on a combination of factors including the following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future market values and new product introductions. Assumptions used in determining management’s estimates of future product demand may prove to be incorrect; in which case the provision required for excess and obsolete inventory would have to be adjusted in the future. If inventory is determined to be overvalued, Cynosure recognizes such costs as cost of goods  F-8    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   sold at the time of such determination. Although Cynosure performs a detailed review of its forecasts of future product demand, any significant unanticipated changes in demand could have a significant impact on the value of Cynosure’s inventory and reported operating results. Inventory reserve activity consisted of the following for the years ended December 31:                                     2003   2004   2005                       (In thousands)         Balance at beginning of year    $ 1,182     $ 797     $ 812           Additions      379       529       581           Deductions      (764 )     (514 )     (374 )                               Balance at end of year    $ 797     $ 812     $ 1,019                                  Cynosure purchases a significant raw material component from one vendor, who is the sole manufacturer of this component. A delay in the production capabilities of this vendor could cause a delay in Cynosure’s manufacturing, and a possible loss of revenues, which would adversely affect operating results.           Property and Equipment         Property and equipment are recorded at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Assets under capital leases and leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the respective lease term. Included in property and equipment are certain lasers that are used for demonstration purposes, as well as lasers to which Cynosure continues to hold title that are placed at customer locations under a revenue-sharing arrangement. Maintenance and repairs are charged to expense as incurred. Cynosure continually evaluates whether events or circumstances have occurred that indicate that the estimated remaining useful life of its long-lived assets may warrant revision or that the carrying value of these assets may be impaired. Cynosure evaluates the realizability of its long- lived assets based on profitability and cash flow expectations for the related asset. Any write-downs are treated as permanent reductions in the carrying amount of the assets. Based on this evaluation, Cynosure believes that, as of each of the balance sheet dates presented, none of the Cynosure’s long-lived assets was impaired.           Revenue Recognition and Deferred Revenue         Cynosure generates revenue from the sale of aesthetic treatment systems that are used by physicians and other practitioners to perform various non-invasive aesthetic procedures. These systems incorporate a broad range of laser and other light-based energy sources. Cynosure offers service and warranty contracts in connection with these sales.        Cynosure recognizes revenue in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104). Cynosure recognizes revenue from sales of its treatment systems and accessories upon delivery, provided there are no uncertainties regarding customer acceptance, the fee is fixed or determinable, and collectibility of the related receivable is reasonably assured. Revenues from the sales of service and warranty contracts are deferred and recognized on a straight-line basis over the contract period as services are provided. Payments received by Cynosure in advance of product delivery or performance of services are deferred until earned. Multiple-element arrangements are evaluated in accordance with the principles of Emerging Issues Task Force (EITF) Issue Number 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21), and Cynosure allocates revenue among the elements based upon each element’s relative fair value.  F-9    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        Cynosure has also entered into a revenue sharing arrangement with Sona MedSpa whereby Cynosure receives a percentage of the revenues related to the cosmetic procedures performed at Sona MedSpa locations. Cynosure recognizes this revenue in the period the procedure is performed. During the years ended December 31, 2003, 2004 and 2005, Cynosure recognized approximately $1,600,000, $2,402,000 and $1,241,000, respectively, under this revenue sharing arrangement.        In accordance with the provisions of EITF Issue Number 00-10, Accounting for Shipping and Handling Costs (EITF 00-10), Cynosure records shipping and handling costs billed to its customers as a component of revenue, and the underlying expense as a component of cost of revenue. Shipping and handling costs included as a component of revenue totaled $165,000, $210,000 and $327,000 for the years ended December 31, 2003, 2004 and 2005, respectively. Shipping and handling costs included as a component of cost of revenue totaled $165,000, $210,000 and $445,000 for the years ended December 31, 2003, 2004 and 2005, respectively.           Product Warranty Costs         Cynosure provides a one-year parts and labor warranty on end-user sales of lasers. Distributor sales generally include a warranty on parts only. Estimated future costs for initial product warranties are provided for at the time of revenue recognition. The following table sets forth activity in the accrued warranty account:                                     Years Ended December 31,               2003   2004   2005                       (In thousands)         Balance at beginning of year    $ 863     $ 1,252     $ 1,610           Charged to expense      1,317       1,606       2,538           Costs incurred      (928 )     (1,248 )     (1,883 )                               Balance at end of year    $ 1,252     $ 1,610     $ 2,265                                     Research and Development         Research and development costs consist of salaries and other personnel-related expenses of employees primarily engaged in research, development and engineering activities and materials used and other overhead expenses incurred in connection with the design and development of Cynosure’s products. These costs are expensed as incurred.           Advertising Costs         Cynosure expenses advertising costs as incurred. Advertising costs totaled $97,000, $252,000 and $405,000 for the years ended December 31, 2003, 2004 and 2005, respectively.           Foreign Currency Translation         The financial statements of Cynosure’s foreign subsidiaries are translated from local currency into U.S. dollars using the current exchange rate at the balance sheet date for assets and liabilities, and the average exchange rate prevailing during the period for revenue and expenses. The functional currency for Cynosure’s foreign subsidiaries is considered to be the local currency for each entity and, accordingly, translation adjustments for these subsidiaries are included in accumulated other comprehensive income (loss) within stockholders’ equity. Certain intercompany and third party foreign currency-denominated transactions generated foreign currency transaction gains (losses) of approximately $864,000, $558,000 and  F-10    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   ($278,000) during 2003, 2004 and 2005, respectively, which are included in other income in the consolidated statements of operations.           Comprehensive (Loss) Income         Comprehensive (loss) income is the change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. Accumulated other comprehensive loss consists entirely of cumulative translation adjustments.           Fair Value of Financial Instruments         The carrying value of Cynosure’s financial instruments, which include cash equivalents, accounts receivable, accounts payable, accrued expenses, short-term loan, note payable to related party and capital leases, approximates their fair value at December 31, 2004 and 2005.           Stock-Based Compensation         Cynosure accounts for its stock-based awards to employees using the intrinsic-value method prescribed in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations. Under the intrinsic-value method, compensation expense is measured on the date of grant as the difference between the deemed fair market value of Cynosure’s common stock for accounting purposes and the option exercise price multiplied by the number of options granted. Generally, Cynosure grants stock options with exercise prices equal to the fair market value for accounting purposes of its common stock; however, to the extent that the deemed fair market value for accounting purposes of the common stock exceeds the exercise price, Cynosure records deferred stock-based compensation and amortizes the expense over the vesting schedule of the options, generally four years. The fair value for accounting purposes of Cynosure’s common stock is determined by the Company’s board of directors. Prior to the completion of the Cynosure’s IPO, Cynosure’s board of directors considers objective and subjective factors in determining the fair value of Cynosure’s common stock for accounting purposes. During the year ended December 31, 2005, Cynosure granted stock options with exercise prices less than the deemed fair market value of common stock for accounting purposes and, as a result, recorded deferred stock-based compensation of approximately $1.7 million. Cynosure also provides the disclosure requirements of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123 (SFAS 148). Stock-based awards to non-employees are accounted for under the provisions of SFAS No. 123 Accounting for Stock-Based Compensation (SFAS 123) and EITF Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (EITF 96-18).  F-11    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        If compensation cost had been determined for stock options granted to employees based on the fair value of the awards at the date of grant in accordance with the provisions of SFAS 123, Cynosure’s net (loss) income would have been the pro forma amount indicated below:                                     Year Ended December 31,               2003   2004   2005                       (In thousands, except       per share data)         Net (loss) income:                                  As reported    $ (500 )   $ 5,296     $ 4,160           Add: Stock-based employee compensation expense included in     determination of net loss, net of tax      56       118       171           Less: Total stock-based employee compensation expense determined     under the fair value-based method, net of tax      (215 )     (611 )     (636 )                               Pro forma net (loss) income:    $ (659 )   $ 4,803     $ 3,695                                 Basic net (loss) income per share — as reported    $ (0.09 )   $ 0.93     $ 0.64                                 Diluted net (loss) income per share — as reported    $ (0.09 )   $ 0.92     $ 0.54                                 Basic net (loss) income per share — pro forma    $ (0.12 )   $ 0.84     $ 0.57                                 Diluted net (loss) income per share — pro forma    $ (0.12 )   $ 0.83     $ 0.48                                  For the purpose of SFAS 123 pro forma disclosures, Cynosure uses the Black-Scholes option pricing model to determine the fair value of each option granted to Cynosure employees. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including expected stock price volatility. Because Cynosure’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.        The key assumptions used to apply this pricing model and the related weighted average fair values are as follows:                                     Year Ended December 31,               2003   2004   2005                         Risk-free interest rate      1.30 %     3.44 %     3.88 %         Expected dividend yield      —       —       —           Expected lives      1.5 years       5 years       5 years           Expected volatility      75 %     75 %     75 %         Weighted average fair value    $ 0.90     $ 1.90     $ 7.06               Income Taxes         Cynosure provides for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (SFAS 109). SFAS 109 recognizes tax assets and liabilities for the cumulative effect of all temporary differences between the financial statement carrying amounts and the tax basis of assets and liabilities, and are measured using the enacted tax rates that will be in effect when these differences are expected to  F-12    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   reverse. Valuation allowances are provided if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.           Net (Loss) Income per Common Share         Basic net (loss) income per share is determined by dividing net (loss) income by the weighted average common shares outstanding during the period. Diluted net income per share is determined by dividing net income by the diluted weighted average shares outstanding during the period. Diluted weighted average shares reflect the dilutive effect, if any, of common stock options based on the treasury stock method. The reconciliation of basic and diluted weighted average shares outstanding is as follows:                                     Years Ended December 31,               2003   2004   2005                       (In thousands)         Basic weighted average common shares outstanding      5,530       5,700       6,522           Weighted average common equivalent shares      —       73       1,193                                 Diluted weighted average common shares outstanding      5,530       5,773       7,715                                  For the years ended December 31, 2003 and 2004, options to purchase approximately 165,000 and 123,000, were excluded from the calculation of diluted weighted average common shares outstanding as their effect was antidilutive. There were no antidilutive shares for the year ended December 31, 2005.           Recent Accounting Pronouncements         On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)), which is a revision of SFAS 123. SFAS 123(R) supersedes APB 25, and amends SFAS No. 95, Statement of Cash Flows (SFAS 95). Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123(R) is effective for the Company beginning January 1, 2006. Upon adoption, Cynosure will follow the modified prospective approach apply the provisions of SFAS 123(R) to all unvested awards and to future awards.        The adoption of SFAS 123(R) ’s fair value method will have a significant impact on the Cynosure’s result of operations, although it will have no impact on Cynosure’s overall financial position. The impact of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future.        In November 2004, the FASB issued Statement of SFAS No. 151, Inventory Costs (SFAS 151), an amendment of APB Opinion No. 43, Chapter 4. The amendments made by SFAS 151 will improve financial reporting by requiring that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recognized as current-period charges, and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 24, 2004. Cynosure is currently evaluating the impact that adoption of SFAS 151 will have on its financial positions and results of operations.         3.  Segment and Geographic Information         In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131), operating segments are identified as components of an enterprise about which  F-13    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   separate discrete financial information is available for evaluation by the chief operating decision maker, or decision-making group, in making decisions how to allocate resources and assess performance. Cynosure’s chief decision-maker, as defined under SFAS 131, is a combination of the Chief Executive Officer and the Chief Financial Officer. Cynosure views its operations and manages its business as one segment, aesthetic treatment products and services.        The following table represents total revenue by geographic destination:                                     Year Ended December 31,               2003   2004   2005                       (In thousands)         United States    $ 11,375     $ 21,996     $ 28,867           Europe      6,477       9,901       12,725           Asia/ Pacific      6,728       6,515       7,059           Other      2,545       3,221       7,611                               $ 27,125     $ 41,633     $ 56,262                                  Net assets by geographic area are as follows:                             December 31,               2004   2005                   (In thousands)         United States    $ 17,205     $ 86,323           Europe      (1,116 )     (1,812 )         Asia/ Pacific      (501 )     (264 )         Eliminations      (948 )     (1,096 )                       $ 14,640     $ 83,151                            Long-lived assets by geographic area are as follows:                             December 31,               2004   2005                   (In thousands)         United States    $ 5,100     $ 5,488           Europe      281       278           Asia/ Pacific      77       124           Eliminations      (728 )     (673 )                       $ 4,730     $ 5,217                            No individual country within Europe or Asia/ Pacific represented greater than 10% of total revenue or net assets for any period presented.  F-14    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)         4.  Balance Sheet Accounts            Property and Equipment         Property and equipment consists of the following at December 31:                                       Estimated               Useful   2004   2005       Life               (Years)   Cost   Cost                           (In thousands)         Equipment      3-5     $ 1,706     $ 2,134           Furniture and fixtures      5       394       629           Computer equipment and software      3       1,608       1,695           Leasehold improvements      5       340       631           Demonstration equipment      3       3,725       5,167           Revenue sharing lasers      3       2,430       1,133                                         10,203       11,389             Less accumulated depreciation and amortization              (6,470 )     (6,965 )                                     $ 3,733     $ 4,424                                  Depreciation expense relating to property and equipment was $1,235,000, $1,275,000 and $1,733,000 for the years ended December 31, 2003, 2004 and 2005, respectively. As of December 31, 2004 and 2005, the cost of assets recorded under capitalized leases was approximately $872,000 and $1,676,000, and the related accumulated amortization was approximately $260,000 and $581,000, respectively. Amortization expense of assets recorded under capitalized leases is included as a component of depreciation expense.           Accrued Expenses         Accrued expenses consist of the following at December 31:                             2004   2005                   (In thousands)         Accrued payroll and taxes    $ 1,504     $ 1,278           Accrued employee benefits      380       428           Accrued warranty costs      1,610       2,265           Stock purchase deposit      413       —           Accrued commissions      339       801           Accrued legal fees      562       67           Accrued other      1,625       2,334                         $ 6,433     $ 7,173                             5.  Investment in Sona MedSpa         As of December 31, 2003, Cynosure had invested $1,500,000 in the Series A preferred stock of Sona MedSpa International, Inc. (Sona MedSpa), a company that owns and operates hair removal clinics in the United States. Cynosure’s equity investment represented a 40% equity ownership which Cynosure accounted for under the equity method of accounting, which required classification of Sona MedSpa as a related party.  F-15    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        Selected Sona MedSpa financial information for the year ended December 31, 2003 is as follows:                     2003               (In thousands)         Assets    $ 3,296                     Liabilities    $ 2,284                     Net revenue    $ 5,066                     Net income    $ 1,313                      The Company recognized $737,000 and $154,000 as the Company’s share of Sona MedSpa’s (loss) income as a component of other (expense) income for the years ended December 31, 2003 and 2004, respectively.        In May 2004, Cynosure sold its 40% equity interest in Sona MedSpa for $3.6 million, resulting in a $3.0 million gain. Of the sales price, $2.6 million was received in cash and $1.0 million was deposited in escrow to be received in three installments over the next 18 months. As of December 31, 2005, all amounts deposited in escrow were released to Cynosure.        In connection with the original investment in Sona MedSpa, Cynosure also entered into a revenue sharing arrangement with Sona MedSpa whereby Cynosure provided lasers to Sona MedSpa and, in return, received a percentage of the revenues related to the aesthetic procedures performed at Sona MedSpa locations. Simultaneous with the sale of Cynosure’s equity investment, Cynosure sold certain lasers previously placed in Sona MedSpa clinics to Sona MedSpa for $1.2 million, which is included in revenues. Cynosure also entered into an amended laser placement and revenue sharing arrangement with the new owners of Sona MedSpa. Effective May 24, 2004, Cynosure had no ongoing ownership interest in Sona MedSpa and Sona MedSpa was no longer considered a related party.        In October 2005, Cynosure entered into a preferred vendor agreement with Sona MedSpa whereby Cynosure sold certain of these systems to Sona Medspa for approximately $1.3 million which was recorded as deferred revenue as of December 31, 2005 as the fee was not fixed at the time of sale.        During the years ended December 31, 2003, 2004 and 2005, Cynosure recognized approximately $1,600,000, $2,402,000 and $1,241,000, respectively, under the revenue sharing arrangement of which $1,600,000 and $1,269,000 are presented as related party revenues in the accompanying consolidated statement of operations for the year ended December 31, 2003 and for the period in 2004 prior to the sale of the equity interest. During 2000 and 2001, Cynosure agreed to guarantee certain Sona MedSpa lease commitments (see Note 12).         6.  Related Party Transactions         Purchases of inventory from El.En. during the years ended December 31, 2003, 2004 and 2005 were approximately $1,648,000, $2,142,000 and $2,423,000, respectively. As of December 31, 2004 and 2005, amounts due to related party for these purchases were approximately $900,000 and $960,000. Cynosure had a note payable totaling $303,437, including accrued interest, at December 31, 2004 to El. En., which was paid in full in 2005. Amounts due from El.En. as of December 31, 2005 are $72,000 which represent services performed by Cynosure. There were no amounts due from El.En. as of December 31, 2004.        During 2003, Cynosure made an investment in a private company that represents an approximate 2% ownership interest in the entity. During the years ended December 31, 2003, 2004 and 2005, Cynosure recognized revenue of $87,000, $251,000 and $365,000, respectively, related to laser sales to this entity. Cynosure’s investment of $257,000 is carried at the lower of cost or fair value.  F-16    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)         7.  Short-term Loan         Cynosure’s short-term loan consists of a line of credit with a bank which expires on May 11, 2006 and bears interest at 5.11%. There are no amounts available for borrowing at December 31, 2005 and the note is due in full on May 11, 2006.         8.  Stockholders’ Equity            Common Stock Authorized         In connection with the Cynosure IPO in December 2005, Cynosure restated it’s certificate of incorporation to create a dual class capital structure by authorizing $0.001 par value class A and class B common stock and reclassifying all of Cynosure’s shares of previously existing $0.01 par value common stock into shares of class B common stock. In addition, each outstanding option to purchase shares of common stock automatically became an option to purchase an equal number of shares of our class B common stock, with no other changes to the term of the option. Cynosure has authorized 61,500,000 shares of $0.001 par value class A common stock and 8,500,000 shares of $0.001 par value class B common stock. As of December 31, 2005, there were 5,887,258 shares of class A common stock issued and 5,177,958 shares of class B common stock issued.        The rights, preferences and privileges of each class of common stock are as follows:           Voting Rights         The holders of class A common stock and class B common stock have identical rights and will be entitled to one vote per share with respect to each matter presented to Cynosure stockholders on which the holders of common stock are entitled to vote, except for the approval rights of the holders of the class B common stock applicable to specified amendments to Cynosure’s certificate of incorporation and amendments of Cynosure’s bylaws by stockholders and except with respect to the election and removal of directors. El.En., Cynosure’s largest stockholder, is able to control the election of a majority of the members of Cynosure’s board of directors. El.En. owns 76% of Cynosure’s outstanding class B common stock, which comprises 35% of Cynosure’s aggregate outstanding common stock. Until El.En. beneficially owns less than 20% of the aggregate number of shares of Cynosure’s class A common stock and class B common stock outstanding or less than 50% of the number of shares of Cynosure’s class B common stock outstanding, El.En., as holder of a majority of the shares of Cynosure’s class B common stock, will have the right:            •       to elect a majority of the members of Cynosure’s board of     directors;         •       to approve amendments to our bylaws adopted by Cynosure’s     class A and class B stockholders, voting as a single     class; and         •       to approve amendments to any provisions of Cynosure’s     restated certificate of incorporation relating to the rights of     holders of common stock, the powers, election and classification     of the board of directors, corporate opportunities and the     rights of holders of class A common stock and class B     common stock to elect and remove directors, act by written     consent and call special meetings of stockholders.    In addition, the holders of shares of Cynosure’s class B common stock will vote with Cynosure’s class A stockholders for the election of the remaining directors.  F-17    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)           Conversion         Cynosure’s class A common stock is not convertible into any other shares of Cynosure’s capital stock.        Each share of class B common stock is convertible into one share of class A common stock at any time at the option of the holder. In addition, each share of class B common stock shall convert automatically into one share of class A common stock upon any transfer of such share of class B common stock, whether or not for value.           Dividends         Subject to preferences that may apply to any shares of preferred stock outstanding at the time, the holders of class A common stock and class B common stock shall be entitled to share equally, on a per share basis, in any dividends that Cynosure’s board of directors may determine to issue from time to time.           Liquidation Rights         In the event of our liquidation or dissolution, the holders of class A common stock and class B common stock shall be entitled to share equally, on a per share basis, in all assets remaining after the payment of all debts and other liabilities and subject to the prior rights of any outstanding preferred stock.           Issuances of Common Stock         In December 2005, Cynosure completed its IPO of 4,000,000 shares of common stock at $15.00 per share and sold an additional 750,000 shares of common stock at $15.00 per share as a result of the exercise of the over-allotment option by the underwriters of the IPO. The sale of the 4,750,000 shares of common stock in connection with the IPO resulted in net proceeds to Cynosure of approximately $64,024,000 after deducting underwriting discounts and offering-related expenses.        During October and November 2004, Cynosure entered into Stock Subscription Agreements (the Agreements) with certain accredited investors for the purchase of 575,000 shares of Cynosure common stock at $3.00 per share. The purchase price was payable in two installments, 50% upon execution of the subscription agreement and 50% due April 1, 2005. Certain of the subscription agreements required a single payment due April 15, 2005. The first installment payment of $413,000 is recorded as a stock purchase deposit included as a component of accrued expenses in the accompanying balance sheet. The common stock sold under the Agreements was issued in April 2005.        In connection with the signing of the stock subscription agreements, Cynosure entered into a Stock Purchase Agreement with El.En. to purchase 575,000 shares of Cynosure common stock at $3.00 per share to be delivered to the accredited investors pursuant to the subscription agreements. The payment terms of the Stock Purchase Agreement mirror those of the subscription agreement. The first installment payment of $413,000 is recorded as a stock purchase deposit in the other non-current assets section of the balance sheet. The common stock was purchased in April 2005 and recorded as a reduction of additional paid-in capital.        During May 2002, Cynosure signed an agreement with El.En. to sell 3,327,960 shares of its common stock for a total purchase price calculated via a formula based on 2001 and 2002 revenue and operating results, as defined. An initial payment of $9,828,000 (net of issuance costs) was received in May 2002. In May 2003, Cynosure completed its sale to El.En. The total purchase price for the 60% ownership share was $11,290,000 (net of issuance costs). The final payment of $1,462,000 (net of issuance costs) was received in May 2003 and, in turn, was partially used to purchase the ownership interests of several minority owners. The payment of $1,317,000 to minority stockholders is reflected as an increase in the cost of treasury stock in the statements of stockholders’ equity.  F-18    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)           Preferred Stock         Cynosure has authorized 5,000,000 shares of $0.001 par value preferred stock. The Board of Directors has full authority to issue this stock and to fix the voting powers, preference rights, qualifications, limitations, or restrictions thereof, including dividend rights, conversion rights, redemption privileges and liquidation preferences and the number of shares constituting any series or designation of such series.         9.  Stock-Based Compensation            1992 Stock Option Plan         In February 1992, the Board of Directors adopted, and the stockholders approved, the 1992 Stock Option Plan (the 1992 Plan). The 1992 Plan provided for the grant of incentive stock options (ISOs), as well as nonstatutory options. The Board of Directors administered the 1992 Plan and had sole discretion to grant options to purchase shares of the Company’s common stock.        The Board of Directors determined the term of each option, option price, number of shares for which each option was granted, whether restrictions would be imposed on the shares subject to options and the rate at which each option was exercisable. The exercise price for options granted was determined by the Board of Directors, except that for ISOs, the exercise price could not be less than the fair market value per share of the underlying common stock on the date granted (110% of fair market value for ISOs granted to holders of more than 10% of the voting stock of the Cynosure). The term of the options were set forth in the applicable option agreements, except that in the case of ISOs, the option term was not to exceed ten years (five years for ISOs granted to holders of more than 10% of voting stock of the Cynosure). A maximum of 2,250,000 shares of common stock were reserved for issuance in accordance with the 1992 Plan. Options granted under the 1992 Plan vested either (i) over a 50-month period at the rate of 24% after the first year and 2% each month thereafter until fully vested or (ii) after eight years with acceleration of vesting if certain performance measures were met, as defined in the agreements. All options granted under the 1992 Plan to date were issued at fair market value as determined by the Board of Directors. The 1992 Plan expired on the tenth anniversary of the date of its adoption by the Board of Directors in February 2002. Options outstanding as of this date continue to have force and effect in accordance with the provisions of the instruments evidencing such options.           2003 Stock Compensation Plan         In July 2003, the Board of Directors approved the 2003 Stock Compensation Plan (the 2003 Plan), which granted nine Cynosure executives the right to purchase up to a maximum of 550,000 shares of Cynosure’s common stock at an exercise price of $2.00 per share. The deemed fair value of Cynosure’s common stock for accounting purposes on the date of grant was $2.25. As a result, Cynosure recorded compensation expense for the difference between the purchase price and the deemed fair value over the period the rights vest. The number of shares each executive can purchase was determined by a service ratio, which is determined by the number of whole or partial months an executive is employed by Cynosure relative to a stated service period, determined on an individual participant basis. Once the right to purchase the shares is vested, the executives are obligated to purchase shares on the earlier of (1) an acquisition of Cynosure, (2) 180 days following an initial public offering of Cynosure’s common stock or (3) December 31, 2004. If neither of the first two events occurred, Cynosure or El.En. had the discretionary right to purchase the rights at the then-fair value of the common stock determined by a formula dependent upon operating results. Furthermore, one executive had a put right requiring either Cynosure or El.En. to purchase the common stock at a price determined by the formula previously noted.        During 2003, Cynosure recorded $86,000 of compensation expense associated with the 2003 Plan. For the year ended December 31, 2004, Cynosure recorded approximately $122,000 of cash and $182,000 of  F-19    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   non-cash stock-based compensation expense, respectively, associated with the 2003 Plan. A portion of the 2004 stock-based compensation expense resulted from Cynosure issuing 75,855 shares of common stock to certain executives, in lieu of acquiring stock purchase rights from the executives, who were active employees of Cynosure as of October 1, 2004, effectively terminating the 2003 Plan. All vested rights for executives who were no longer employees of Cynosure as of October 1, 2004 expired unexercised.           2004 Stock Option Plan         In October 2004, the Board of Directors adopted and the stockholders approved the 2004 Stock Option Plan (the 2004 Plan). The 2004 Plan provided for the grant of ISOs, as well as nonstatutory options. The Board of Directors administers the 2004 Plan and had sole discretion to grant options to purchase shares of Cynosure’s common stock.        The Board of Directors determines the term of each option, option price, number of shares for which each option is granted, whether restrictions would be imposed on the shares subject to options and the rate at which each option is exercisable. The exercise price for options granted is determined by the Board of Directors, except that for ISOs, the exercise price could not be less than the fair market value per share of the underlying common stock on the date granted (110% of fair market value for ISOs granted to holders of more than 10% of the voting stock of Cynosure). The term of the options is set forth in the applicable option agreement, except that in the case of ISOs, the option term cannot exceed ten years. As of December 31, 2005, a maximum of 1,791,001 shares of common stock are reserved for issuance in accordance with the 2004 Plan. Options granted under the Plan vested either (i) over a 48-month period at the rate of 25% after the first year and 6.25% each quarter thereafter until fully vested or (ii) over a vesting period determined by the Board of Directors. As of December 31, 2005, there are no shares available for future grant under the 2004 Plan.        In April and May 2005, Cynosure granted 10,000 and 358,200 options, respectively, to purchase common stock under the 2004 Plan. At the time of grant, these options were believed to have been issued at fair market value. Subsequently, the Board of Directors determined the April and May 2005 option grants were issued below the deemed fair market value for accounting purposes as supported by a retrospective valuation conducted by Cynosure and recorded approximately $1.7 million of deferred stock-based compensation expense which is being amortized over the vesting period of the options. During the year ended December 31, 2005, Cynosure amortized approximately $264,000 related to this deferred stock-based compensation expense.        In May 2005, Cynosure granted approximately 18,000 options to non-employees under the 2004 Plan. In connection with this grant, Cynosure recorded $205,000 of stock-based compensation expense.           2005 Stock Incentive Plan         In August 2005, the Board of Directors adopted the 2005 Stock Incentive Plan (the 2005 Plan) which was approved by our stockholders in December 2005. The 2005 Plan provided for the grant of ISOs, as well as nonstatutory options. The Board of Directors administers the 2005 Plan and had sole discretion to grant options to purchase shares of Cynosure’s common stock.        The Board of Directors determines the term of each option, option price, number of shares for which each option is granted, whether restrictions would be imposed on the shares subject to options and the rate at which each option is exercisable. The exercise price for options granted is determined by the Board of Directors, except that for ISOs, the exercise price could not be less than the fair market value per share of the underlying common stock on the date granted (110% of fair market value for ISOs granted to holders of more than 10% of the voting stock of Cynosure). The term of the options is set forth in the applicable option agreement, except that in the case of ISOs, the option term cannot exceed ten years. The number  F-20    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   of shares of class A common stock reserved for issuance under the 2005 stock incentive plan is 558,999 shares. Options granted under the Plan vested either (i) over a 48-month period at the rate of 25% after the first year and 6.25% each quarter thereafter until fully vested or (ii) over a vesting period determined by the Board of Directors. As of December 31, 2005, there are 536,499 shares available for future grant under the 2005 Plan.        Stock option activity under the 1992 Plan, the 2004 Plan and the 2005 Plan is as follows:                                               Weighted-       Number of   Exercise Price   Average Exercise       Options   Range   Price                         Outstanding, December 31, 2002      165,438       $3.00 -   4.00     $ 3.33             Forfeited      (42,884 )     3.25 -   3.50       3.29                                 Outstanding, December 31, 2003      122,554       3.00 -   4.00       3.34             Granted      1,422,459       3.00       3.00             Forfeited      (64,755 )     3.00 -   3.50       3.29                                 Outstanding, December 31, 2004      1,480,258       3.00 -   4.00       3.02             Granted      408,700       3.00 -  15.00       5.04             Exercised      36,198       3.00       3.00             Forfeited      (31,582 )     3.00 -   4.50       3.43                                 Outstanding, December 31, 2005      1,821,178       $3.00 - $15.00     $ 3.46                                 Exercisable, December 31, 2005      574,828       $3.00 - $ 4.50     $ 3.08                                 Exercisable, December 31, 2004      317,973       $3.00 - $ 4.00     $ 3.07                                 Exercisable, December 31, 2003      70,317       $3.00 - $ 4.00     $ 3.41                                  The following table summarizes information about stock options outstanding:           December 31, 2005                                          Weighted-               Average           Options   Remaining   Options   Exercise Price   Outstanding   Contractual Life   Exercisable                         $3.00      1,382,342       8.77       509,842           $3.25      31,901       4.42       31,901           $3.50      7,438       5.60       7,438           $4.00      7,647       3.61       7,647           $4.50      369,350       9.38       18,000           $15.00      22,500       9.94       0                                 1,821,178       8.80       574,828                            F-21    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)           December 31, 2004                                          Weighted-               Average           Options   Remaining   Options   Exercise Price   Outstanding   Contractual Life   Exercisable                         $3.00      1,423,743       9.77       263,743           $3.25      38,447       5.76       37,581           $3.50      9,838       6.67       8,419           $4.00      8,230       4.54       8,230                                 1,480,258       9.61       317,973                                   10.  Income Taxes         As of December 31, 2005, Cynosure had state tax credits of approximately $500,000 to offset future tax liability, and state net operating losses of approximately $425,000 to offset future taxable income. If not utilized, these credit carryforwards will expire at various dates through 2019, and the losses will expire through 2024. Cynosure also had foreign net operating losses of approximately $2,992,000 available to reduce future foreign taxable income which will expire at various times through 2024. Foreign net operating losses in Germany do not expire. Cynosure has a net deferred tax asset before consideration of valuation allowances arising principally from foreign net operating loss and state credit carryforwards, accruals and other reserves. Based upon the weight of the available evidence, it is more likely than not that a portion of the deferred tax assets will not be realized and, accordingly, that amount has been fully reserved.        Significant components of Cynosure’s net deferred tax assets as of December 31, 2004 and 2005 are as follows:                               2004   2005                   (In thousands)         Deferred tax assets (liabilities):                            Domestic net operating loss and tax credit carryforwards    $ 1,024     $ 516             Foreign net operating loss carryforwards      1,046       1,166             Reserves and allowances      1,438       1,321             Depreciation      (314 )     (65 )           Other temporary differences      187       590           Valuation allowance for deferred tax assets      (3,381 )     (1,682 )                         Net deferred tax assets    $ —     $ 1,846                            The net change in valuation allowance from the prior year is primarily due to the realization in 2005 that the deferred tax assets related to certain temporary differences will more likely than not be realized based on future projections of taxable income. The valuation allowance as of December 31, 2005 relates to state tax credit carryforwards and foreign net operating loss carryforwards.  F-22    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        (Loss) income before income tax (benefit) provision and minority interest consists of the following:                                       2003   2004   2004                         Domestic    $ 144     $ 4,124     $ 4,156           Foreign      (509 )     960       176                                   Total    $ (365 )   $ 5,084     $ 4,332                                  In 2004, Cynosure applied for a $515,000 refund claim, of which $476,000 was carried back to its 1997 U.S. income tax return filings and the remainder carried back to its 1998 U.S. income tax return filings. This amount was received in 2004 and was recorded as a net income tax benefit in the 2004 statement of operations.        The (benefit) provision for income taxes consists of:                                       2003   2004   2005                       (In thousands)         Current:                                    Federal    $ —     $ (491 )   $ 1,573             State      72       215       119             Foreign      —       —       256                                 Total current      72       (276 )     1,948           Deferred:                                    Federal      —       —       (1,660 )           State      —       —       (186 )           Foreign      —       —       —                                 Total deferred      —       —       (1,846 )                             $ 72     $ (276 )   $ 102                                  A reconciliation of the federal statutory rate to Cynosure’s effective tax rate is as follows for the years ended December 31:                                       2003   2004   2005                         Income tax (benefit) provision at federal statutory rate:      (34.0 )%     34.0 %     34.0 %         Increase (decrease) in tax resulting from —                                    State taxes      —       —       1.8             Nondeductible expenses      7.9       1.0       0.9             Change in valuation allowance      38.5       (42.1 )     (38.5 )           Stock-based compensation      7.9       1.3       3.7             Other      (0.6 )     0.4       0.5                                 Effective income tax rate      19.7 %     (5.4 )%     2.4 %                                 11.  401(k) Plan         Cynosure sponsors the Cynosure 401(k) defined contribution plan. Participation in the plan is available to all employees of Cynosure who meet certain eligibility requirements. The Plan is qualified under Section 401(k) of the Internal Revenue Code, and is subject to contribution limitations as set  F-23    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   annually by the Internal Revenue Service. Employer matching contributions are at Cynosure’s discretion. There were no employer matches for the years ended December 31, 2003, 2004 or 2005.         12.  Commitments and Contingencies            Lease Commitments         Cynosure leases its U.S. operating facility and certain foreign facilities under noncancelable operating lease agreements expiring through March 2012. Rent expense for the years ended December 31, 2003, 2004 and 2005 was approximately $720,000, $789,000 and $913,000 respectively.        Cynosure leases certain equipment and vehicles under operating and capital lease agreements with payments due through December 2010.        Commitments under Cynosure’s lease arrangements are as follows, in thousands:                             Operating   Capital       Leases   Leases                     2006    $ 824     $ 384           2007      791       335           2008      767       326           2009      795       216           2010      824       61           Thereafter      1,291       —                           Total minimum lease payments    $ 5,292     $ 1,322                           Less amount representing interest              (213 )                         Present value of obligations under capital leases            $ 1,109           Current portion of capital lease obligations              295                           Capital lease obligations, net of current portion            $ 814                               Lease Guarantees         During 2000 and 2001, Cynosure guaranteed the lease obligations for two locations that are operated by Sona MedSpa, and will be obligated to pay these leases if Sona MedSpa cannot make the required lease payments. Minimum lease payments guaranteed by Cynosure as of December 31, 2005 are as follows, in thousands:                       Years Ending December 31,                  2006    $ 92           2007      93           2008      54           2009      42           2010      42           Thereafter      19                   $ 342                F-24    Table of Contents  CYNOSURE, INC.   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)           Litigation         On May 24, 2005, Dr. Ari Weitzner, individually and as putative representative of a purported class, filed a complaint against Cynosure under the federal Telephone Consumer Protection Act, or TCPA, in Massachusetts Superior Court in Middlesex County seeking monetary damages, injunctive relief, costs and attorneys fees. The complaint alleges that Cynosure violated the TCPA by sending unsolicited advertisements by facsimile to the plaintiff and other recipients without the prior express invitation or permission of the recipients. Under the TCPA, recipients of unsolicited facsimile advertisements are entitled to damages of up to $500 per facsimile for inadvertent violations and up to $1,500 per facsimile for knowing or willful violations. Although Cynosure is continuing to investigate the number of facsimiles transmitted during the period for which the plaintiff in the lawsuit seeks class certification and the number of these facsimiles that were “unsolicited” within the meaning of the TCPA, Cynosure expects the number of unsolicited facsimiles to be very large. Cynosure is vigorously defending the lawsuit and has filed initial briefs and motions with the court. Cynosure is not able to estimate the amount or range of loss that could result from an unfavorable outcome of the lawsuit as the matter is still in the early stages of the proceedings.        From time to time, Cynosure is subject to various claims, lawsuits, disputes with third parties, investigations and pending actions involving various allegations against Cynosure incident to the operation of its business, principally product liability. Each of these matters is subject to various uncertainties, and it is possible that some of these matters may be resolved unfavorably to Cynosure. Cynosure establishes accruals for losses that management deems to be probable and subject to reasonable estimate. Cynosure management believes that the ultimate outcome of these matters will not have a material adverse impact on Cynosure’s consolidated financial position, results of operations or cash flows.         13.  Summary Selected Quarterly Financial Data (Unaudited)         The following table sets forth certain unaudited consolidated quarterly statement of operations data for the eight quarters ended December 31, 2005. This information is unaudited, but in the opinion of management, it has been prepared substantially on the same basis as the audited consolidated financial statements and all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to state fairly the unaudited consolidated quarterly results of operations. The results of operations for any quarter are not necessarily indicative of the results of operations for any future period.                                             Quarter Ended               March 31,   June 30,   Sept. 30,   Dec. 31,       2004   2004   2004   2004                             Revenues    $ 7,477     $ 11,694     $ 10,236     $ 12,226           (Loss) income from operations    $ (777 )   $ 1,071     $ 833     $ 84           Net (loss) income    $ (368 )   $ 3,979     $ 931     $ 754           Basic net (loss) income per share    $ (0.07 )   $ 0.72     $ 0.17     $ 0.12           Diluted net (loss) income per share    $ (0.07 )   $ 0.72     $ 0.17     $ 0.12                                                 Quarter Ended               March 31,   June 30,   Sept. 30,   Dec. 31,       2005   2005   2005   2005                             Revenues    $ 12,258     $ 12,822     $ 15,041     $ 16,141           Income from operations    $ 575     $ 693     $ 1,632     $ 1,711           Net income    $ 237     $ 288     $ 1,106     $ 2,529           Basic net income per share    $ 0.04     $ 0.05     $ 0.18     $ 0.34           Diluted net income per share    $ 0.03     $ 0.04     $ 0.15     $ 0.29      F-25    Table of Contents  T. James Hammond   Certified Public Accountant   4460 Corporation Lane, Suite 307   Virginia Beach, VA 23462   Phone 757-473-0666 Fax 757-456-9438   Email: tjhcpa@verizon.net   INDEPENDENT AUDITOR’S REPORT   Sona International Corporation   Chesapeake, VA   Officers & Directors:        I have audited the accompanying consolidated balance sheets of Sona International Corporation as of December 31, 2003 and December 31, 2002, the related consolidated statements of income and retained earnings and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. My responsibility is to express an opinion on these consolidated financial statements based on my audit.        I conducted my audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that I plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. I believe that my audit provides a reasonable basis for my opinion.        In my opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sona International Corporation as of December 31, 2003 and December 31, 2002, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.                /s/ T. James Hammond           Virginia Beach, Virginia   February 4, 2004   Member of the American Institute and the Virginia Society of Certified Public Accountants  F-26    Table of Contents  SONA INTERNATIONAL CORPORATION   CONSOLIDATED BALANCE SHEETS                                   December 31,               2003   2002                ASSETS     Current Assets                            Cash    $ 1,463,831     $ 351,854             Accounts Receivable — Trade      460,182       109,274             Accounts Receivable — Related Parties      62,425       40,687             Accounts Receivable — Stockholder      3,375       0             Note Receivable      55,099       127,251             Prepaid Franchise Incentive      218,906       38,700             Inventory      80,446       41,373             Prepaids      41,671       96,074             Prepaid Laser Costs      162,252       181,580                           Total Current Assets      2,548,187       986,793       Fixed Assets                            Property, Plant and Equipment      543,752       298,489             Intangible Assets      69,577       84,461                         Total Fixed Assets      613,329       382,950       Other Assets                            Deposits      18,301       5,702                           Total Other Assets      18,301       5,702                             Total Assets    $ 3,179,817     $ 1,375,445                          LIABILITIES AND STOCKHOLDERS’ EQUITY     Current Liabilities                            Accounts Payable    $ 325,359     $ 79,590             Current Maturities Long Term Debt      32,543       33,608             Due from Stockholder      0       1,325             Accrued Liabilities      347,377       152,909             Accrued Income Taxes      13,729       0             Deferred Income Taxes      45,384       0             Deferred Franchise Fees      373,553       217,840             Deferred Laser Fees      896,848       1,000,807                           Total Current Liabilities      2,034,793       1,486,079                       Long Term Liabilities                            Installment Notes Payable      133,910       191,279                           Total Long-Term Liabilities      133,910       191,279                       Stockholders’ Equity                            Common Stock      1,910       1,910             Preferred Stock      1,500,000       1,500,000             Retained Earnings      (490,796 )     (1,803,823 )                         Total Stockholders’ Equity      1,011,114       (301,913 )                           Total Liabilities and Stockholders’ Equity    $ 3,179,817     $ 1,375,445                       See Independent Auditor’s Report and Notes to Consolidated Financial Statements.  F-27    Table of Contents  SONA INTERNATIONAL CORPORATION   CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS   For the Years Ended December 31, 2003 and 2002                                 2003   2002                 Sales                            Franchise Sales    $ 2,470,056     $ 184,500             Laser Royalties      843,702       399,849             Product Sales — Franchise      274,558       80,880             Clinic Sales      1,477,734       1,886,926                         Total Sales      5,066,050       2,552,155       Cost of Sales      751,900       705,588                       Gross Profit      4,314,150       1,846,567       Operating Expenses      3,412,562       2,343,559                       Income from Operations      901,588       (496,992 )     Other Income and Expenses                              Interest Expense      (17,413 )     (35,336 )             Interest Income      13,613       883               Gain on Sale of Clinic      473,917       421,942                         Total Other Income and Expenses      470,117       387,489                       Income Before Taxes      1,371,705       (109,503 )                     Income Taxes                              State Corp Income Tax      13,294       0               Deferred Income Tax Expense      45,384       0                         Total Income Taxes      58,678       0       Net Income      1,313,027       (109,503 )     Beginning Retained Earnings      (1,803,823 )     (1,694,320 )                     Ending Retained Earnings    $ (490,796 )   $ (1,803,823 )                     See Independent Auditor’s Report and Notes to Consolidated Financial Statements.  F-28    Table of Contents  SONA INTERNATIONAL CORPORATION   CONSOLIDATED STATEMENTS OF CASH FLOWS   December 31, 2003 and 2002                                 2003   2002                 Cash flows from operating activities                              Net income (loss)    $ 1,313,027     $ (109,503 )                             Adjustments to reconcile net income to net cash provided by     operating activities:                            Depreciation and amortization      105,172       122,397             (Gain) loss on disposal of clinic      (473,917 )     1,148             (Increase) decrease in accounts receivable      (376,021 )     (80,432 )           (Increase) decrease in prepaid expenses      (106,475 )     (195,429 )           (Increase) decrease in inventories      (39,073 )     (4,693 )           (Increase) decrease in other assets      0       (127,251 )           Increase (decrease) in accounts payable      244,444       18,737             Increase (decrease) in accrued liabilities      208,197       210,722             Increase (decrease) in deferred income tax      45,384       0             Increase (decrease) in deferred revenue      526,332       585,667                         Total Adjustments      134,043       530,866                         Net cash provided (used) by operating activities      1,447,070       421,363                       Cash flow from investing activities:                              Cash payments for the purchase of property      (387,320 )     (24,401 )             Cash payments for intangible assets      10,000       (89,111 )             Cash received (paid) for deposits      (12,599 )     3,671               Cash proceeds for the sale of property      0       109,466                         Net cash provided (used) by investing activities      (389,919 )     (375 )     Cash flow from financing activities:                              Principal payments on long-term debt      (20,075 )     (119,817 )             Proceeds from sale on note receivable      74,901       0                         Net cash provided (used) by financing activities      54,826       (119,817 )                     Net increase (decrease) in cash and equivalents      1,111,977       301,171       Cash and equivalents, beginning of year      351,854       50,683                       Cash and equivalents, end of year    $ 1,463,831     $ 351,854                       Supplemental disclosures of cash flow information:                          Cash paid during the year for:                              Interest Expense    $ 17,413     $ 35,336               Income Tax Expense    $ 13,294     $ 0       See Independent Auditor’s Report and Notes to Consolidated Financial Statements.  F-29    Table of Contents  SONA INTERNATIONAL CORPORATION   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS   For the years ended December 31, 2003 and 2002   Note 1 — Business and Organization        Sona International Corporation, through its wholly owned subsidiaries (Sona Laser Centers, Inc. and National Franchise Realty, Inc.), sells franchises for laser hair removal centers. The Company also owns and operates two laser hair removal centers. Beginning in January 2004 the Company will also offer laser skin rejuvenation and related skin care products.   Note 2 — Summary of Significant Accounting Policies        Sale of franchises — The franchise contracts require a series of payments by new franchises from the date of signing of the contract until the opening of a clinic. The Company recognizes revenue from these payments when all services required by the contract have been provided to the franchisee. Advance payments for services not yet provided are recorded as deferred revenue.        Continuing franchise revenue — Franchises pay a continuing laser placement, servicing, marketing and consulting fee based on their revenue. The continuing fees are recognized as they become receivable from the franchise. A portion of these fees are paid to the laser manufacturer under a laser placement agreement. The Company recognizes revenue for the net amount of these fees received less fees paid to the laser manufacturer.        Product sales — The Company sells two products which enhance the laser hair removal process, The price charged to franchises and affiliates for these products is at a price above the cost of the product to the Company. Company owned centers sell these products to its customers at a retail price higher than the price to franchisees and affiliates.        Revenue from services performed in Company owned laser hair removal centers is recognized when services are performed. The Company offers discounts for pre-payment of future services. The payment for future services net of the related discount is recorded as deferred income. Revenue is recognized when the services are performed.        Expense of Lasers — The Company pays for its lasers under a laser placement agreement, which requires the Company to pay the laser manufacturer a percentage of service fees collected. Laser costs under this agreement are recognized as expense when services are performed. Laser costs associated with deferred services are held as prepaid laser costs until the related services are performed.        Inventories — Inventory is recorded at cost using first-in first-out method.        Cash and cash equivalents — For purposes of the statement of cash flows, the Company considers all short-term debt securities purchased with a maturity of three months or less to be cash equivalents.        Concentration of credit risk — At December 31, 2003 and at various times during the period then ended, the Company had deposits with a financial institution of more than $100,000, which is the limit currently insured by the Federal Deposit Insurance Corporation.  F-30    Table of Contents  SONA INTERNATIONAL CORPORATION   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        Fixed assets — Fixed assets are valued at cost and are depreciated using the declining balance method over the economic useful life of the assets, which ranges from three to seven years.                               2003   2002                     Furniture and office equipment    $ 328,774     $ 131,712           Software & development      17,955       7,965           Leasehold improvements      388,314       304,016                           Subtotal      735,043       443,693           Less accumulated depreciation      (191,291 )     (157,030 )                         543,752       286,663           Assets not in service      0       11,826                             Total    $ 543,752     $ 298,489                            For federal income tax purposes, depreciation is computed using the modified accelerated cost recovery system. Expenditures for major renewals and the betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation expenses for 2003 and 2002 were $80,288 and $103,294 respectively.        Intangible assets — Intangible assets include the costs of acquiring capital and the cost of developing the franchise agreements. The costs of capital are the costs incurred to acquire the series A preferred stock. Amortization expenses for 2003 and 2002 were $24,883 and $22,140 respectively.                             2003   2002                     Cost of capital    $ 47,228     $ 47,228           Franchise cost      70,736       60,736                           117,964       107,964           Accumulated amortization      (48,386 )     (23,503 )                       $ 69,578     $ 84,461                            Fair value of financial instruments — The carrying values of cash and accounts payable approximate their fair values principally because of the short-term maturities of these instruments.        Estimates — The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts and disclosures. Accordingly, actual results could differ from those estimates.   Note 3 — Sale of Branch Operation        The Company sold its Richmond branch in 2002. The gain on the sale is reported net of tax effect. The company financed the sale. The note was for $150,000 payable with a monthly payment based on a 60 month amortization at 8%. The contract requires acceleration of principal payments if certain sales volumes are net, and a balloon payment on the first anniversary date of the note. The purchase is in default as of December 31, 2003. A reserve for bad debts has been established for the note and other related receivables.        The Company sold its Charlotte branch in 2003. The gain on the sale is reported net of tax effect. The company financed the sale. The note was for $175,000 at 7% interest. Payment is based on percent of prior month sales. The balance at December 31, 2003 is $100,099. The purchaser assumed notes payable of $95,927 and deferred liabilities of $391,772 for services not rendered to current clients.  F-31    Table of Contents  SONA INTERNATIONAL CORPORATION   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   Note 4 — Leasehold Notes Payable        The Company capitalizes the cost of leasehold improvements at the clinics. The improvements are financed by the owners of the properties. The notes are amortized over the term of the leases                                                       Long-Term Portion       Monthly   Interest           Payment   Rate   2003   2002                             Ranco Road Assoc    $ 898       10.00     $ 35,406     $ 42,265           Ranco Road Assoc      203       10.00       8,412       9,926           Friendly Assoc. LP      687       12.00       40,375       43,566           309 South Sharon      2,035       12.00       0       97,993           E3 LLC      775       11.00       44,738       0                                         Sub total                      128,931       193,750           Less Current Portion                      (17,699 )     (24,948 )                                                   $ 111,232     $ 168,802                                        Maturities of leasehold notes for the next five years are as follows:                       2004    $ 22,144           2005    $ 23,569           2006    $ 25,152           2007    $ 26,913           2008    $ 24,955       Note 5 — Capitalized Equipment Leases        The Company has capitalized leases on office equipment. Lease terms vary but are primarily five years in duration.                                                     Long-Term Portion       Monthly   Interest           Payment   Rate   2003   2002                             Dell Leasing    $ 254       17.85 %   $ 3,433     $ 5,092           Great American      94       14.08 %     1,961       2,757           Dell Leasing      108       15.75 %     1,640       2,597           Great American      82       13.36 %     1,910       2,644           Great American      94       9.00 %     2,379       3,330           IOS Capital      67       13.50 %     1,279       1,636           IOS Capital      67       13.50 %     1,279       1,636           IOS Capital      67       13.50 %     1,310       1,658           IOS Capital      67       13.50 %     1,430       1,724           Great American      106       17.80 %     2,399       3,460           Great American      133       14.40 %     3,606       4,603           HPSC      457       9.03 %     14,896       0                                                       37,522       31,137           Less Current Portion                      (14,844 )     (8,660 )                                                   $ 22,678     $ 22,477                                  F-32    Table of Contents  SONA INTERNATIONAL CORPORATION   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)                         Maturities of long term leases:                    2004    $ 13,388             2005    $ 8,628            The Company sold the Richmond clinic during 2002. The equipment leases were not assignable. The Company remains liable on three Richmond leases. It has an offsetting note receivable from the buyers of the Richmond clinic in the amount of $7,435. The purchaser of the Richmond clinic is in default of the purchase agreement.   Note 6 — Leases        The Company leases space for its main office and for each of the clinics. The lease terms for the clinics are for seven to ten years. Rent expense is net of capitalized leasehold notes. Most leases include annual increases of 3%-5%.        Minimum lease payments for the next five years:                       2004    $ 205,988           2005    $ 207,886           2006    $ 214,277           2007    $ 221,837           2008    $ 175,521       Note 7 — Income Taxes        The Company had net operating loss carryforwards which were used in 2003. It has $68,121 available for future years. The Company has a deferred tax liability of $45,384 resulting from timing differences in depreciation expense. Income tax expense consists of:                         Currently payable                    Federal    $ 0             State      13,729           Deferred Federal      45,384             State      0                       Total    $ 59,113                 Note 8 — Stockholders’ Equity        On September 22, 2000 the founder and sole shareholder at that time voluntarily reduced his number of common shares held from 100 to 41. On this date the Company also sold 19 shares of common stock to members of management of the Company for $100 per share.        On October 27, 2000 the Company authorized 200 shares of Series A Preferred Stock. The preferred stock is equal to or senior to common stock of the Company with respect to dividend, redemption and liquidation rights. All preferred stock has equal voting rights with common stock. Preferred stock is convertible into an equal number of common stock shares at the option of the holder. However, should the Company consummate a public offering of at least $10 million at a price of at least $10 per share the preferred stock outstanding at that time must convert to common stock. Based on an amendment to the shareholders agreement dated April 30, 2002, after December 31, 2005 a preferred stockholder may purchase additional common stock shares outstanding at the then current fair market value.  F-33    Table of Contents  SONA INTERNATIONAL CORPORATION   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        On October 31, 2000 the Company entered into a Series A Preferred Stock Purchase Agreement (the “Agreement”) with Cynosure, Inc. (“Cynosure”), in accordance with this Agreement, the Company issued 40 shares of Series A Preferred Stock to Cynosure for its investment in the Company of $1,500,000 over three closings. The initial closing was October 31, 2000 in which the Company issued Cynosure 15 shares of Class A Preferred Stock in return for $600,000. Between January 1 and December 31, 2001 Cynosure invested $900,000 in the Company in return for an additional 25 shares of Class A Preferred Stock.   Note 9 — Transactions with Related Parties        The company has an exclusive laser placement agreement and a consulting agreement with Cynosure, Inc., a minority investor in the Company. The laser placement agreement requires Cynosure to place lasers of the latest available Cynosure technology in all franchises and Company owned laser centers. Cynosure must maintain the lasers in good working order. In return, the Company exclusively uses Cynosure lasers and pays Cynosure fees based on cash collected for laser hair removal services. Sona paid Cynosure $322,012 in 2003 and $492,438 in 2002 for Company owned centers.        Sona has entered into an agreement to purchase two products from companies owned by major shareholders. The products enhance the laser treatments. The agreements are not exclusive and require the related companies to sell the products to Sona at preferred pricing and pay Sona a royalty for using its name in one of the products, Sona purchased $43,349 of products from the related companies in 2003 and $59,445 in 2002.   Note 10 — Commitments and Contingencies        The Company is subject to certain government regulations at the federal and state levels in relation to the performance of its laser hair removal procedures.        The Company may be exposed to professional liability and other claims by providing laser hair removal procedures to the public. The Company maintains professional liability insurance on each of its centers. Each center also has an independent contractor as medical director, who is a physician and these physicians are required to carry their own professional liability insurance. The Company also maintains professional liability coverage for its directors and officers and general liability insurance.   Note 11 — Franchise Agreements        The Company has franchise agreements for 50 markets for which 11 centers have opened for business at December 31, 2003 and 21 centers were in various stages of development. The Company also has a license agreement for 1 market in which 1 center has opened for business at December 31, 2003.  F-34    Table of Contents  SONA INTERNATIONAL CORPORATION   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   Note 12 — Advertising        Advertising is expensed as incurred. No advertising costs are capitalized.   Note 13 — Profit Sharing Plan        The Company has established a qualified profit sharing plan for all eligible employees. The Company contributed $75,000 to the plan for 2003.   Note 14 — Accrued Expenses        Accrued expenses consist of the following at December 31:                             2003   2002                     Accrued revenue share    $ 232,070     $ 68,898           Accrued other      115,307       84,011                         $ 347,377     $ 152,909                      F-35    Table of Contents  Lattimore Black Morgan & Cain PC   Certified Public Accountants and Business Advisors   REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM   The Stockholders of   Sona International, Inc. and subsidiaries:        We have audited the accompanying consolidated balance sheet of Sona International, Inc. and subsidiaries as of December 31, 2004, and the related consolidated statements of operations and accumulated deficit and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.        We conducted our audit in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sona International, Inc. and subsidiaries as of December 31, 2004, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.                /s/ Lattimore Black Morgan & Cain, P.C.      Brentwood, Tennessee   June 2, 2005, except for Note 16, as to which the date is March 23, 2006  F-36   Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   Consolidated Balance Sheet   December 31, 2004                      ASSETS         Current assets:                    Cash    $ 130,746             Marketable securities      200,000             Accounts receivable, less allowance for doubtful accounts of     approximately $546,000      1,657,108             Inventories      739,855             Prepaid expenses      287,203             Current portion of notes receivable      115,406                         Total current assets      3,130,318           Property and equipment, net      3,521,296           Deposits      27,887           Notes receivable, excluding current portion      246,722                   $ 6,926,223                    LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)         Current liabilities:                    Current installments of long-term debt    $ 145,993             Advisory service fee due to related party      90,726             Accounts payable      908,265             Accrued expenses      1,688,608             Income taxes      35,445             Deferred revenue      1,382,799                         Total current liabilities      4,251,836           Long-term debt, excluding current installments      513,809           Subordinated debt — related party      3,814,444                         Total liabilities      8,580,089                     Stockholders’ equity (deficit):                    Series A Convertible Participating Redeemable Preferred     stock, no par value; 200 shares authorized, 40 shares     issued and outstanding      1,500,000             Common stock, no par value; 1,000 shares authorized,     60 shares issued and outstanding      1,910             Accumulated deficit      (3,155,776 )                       Total stockholders’ equity (deficit)      (1,653,866 )                 $ 6,926,223                 See accompanying notes to the consolidated financial statements.  F-37    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   Consolidated Statement of Operations and Accumulated Deficit   Year Ended December 31, 2004                         2004                 Revenues:                    Franchise fee revenue    $ 5,851,917             Company owned centers — revenue      2,138,435             Product revenues      1,515,617                         Total revenues      9,505,969           Expenses:                    Sales and marketing expense      1,687,985             Employment expense      3,878,337             General and administrative expense, including bad debt expense     of $604,407      2,963,450             Product costs, including $644,407 paid to related parties      1,424,977             Rent expense      391,465             Professional fees expense, including $90,726 to a related party      776,365             Travel and entertainment expense      657,359             Other operating expense      20,620                         Total operating expenses      11,800,558                         Loss from operations      (2,294,589 )                   Other income (expense):                    Interest expense      370,663             Interest income      9,552             Other income (expense)      26,165                         Total other income (expense)      (334,946 )                       Loss before income taxes      (2,629,535 )         Income taxes      35,445                         Net loss      (2,664,980 )         Accumulated deficit at beginning of year      (490,796 )                   Accumulated deficit at end of year    $ (3,155,776 )               See accompanying notes to the consolidated financial statements.  F-38    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   Consolidated Statement of Cash Flows   Year Ended December 31, 2004                         2004                 Cash flows from operating activities:                    Net loss    $ (2,664,980 )         Adjustments to reconcile net income to cash flows used by     operating activities:                      Depreciation and amortization      792,991               Provision for doubtful accounts      604,407             (Increase) decrease in operating assets:                    Accounts and notes receivable      (2,042,562 )           Inventories      (659,409 )           Prepaid expenses      135,626             Other assets      59,990               Increase (decrease) in operating liabilities:                    Advisory service fee due to related party      90,726             Accounts payable      582,906             Accrued expenses      1,341,231             Income taxes      (23,668 )           Deferred revenue      112,398                       Total adjustments      994,636                       Net cash used by operating activities      (1,670,344 )                   Cash flows from investing activities:                    Purchases of property and equipment      (3,770,535 )           Purchase of marketable securities      (200,000 )                     Net cash used by investing activities      (3,970,535 )                   Cash flows from financing activities:                    Proceeds from long-term debt      527,573             Proceeds from subordinated debt, net      3,814,444             Payments of long-term debt      (34,223 )                     Net cash provided by financing activities      4,307,794                       Decrease in cash and cash equivalents      (1,333,085 )         Cash at beginning of year      1,463,831                     Cash at end of year    $ 130,746                     Supplemental disclosures of cash flow information:                    Cash paid during the year for:                    Interest    $ 28,418                       Income taxes    $ —                 See accompanying notes to the consolidated financial statements.  F-39    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS   December 31, 2004         1.  Nature of operations         Sona International, Inc. and its wholly owned subsidiaries (Sona Laser Centers, Inc. and National Franchise Realty, Inc.), (collectively, the “Company”) develop, operate and franchise laser hair removal and skin rejuvenation centers, through out the United States of America.         2.  Summary of significant accounting policies               (a)  Principles of consolidation         These consolidated financial statements include the accounts of the Sona International, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.              (b)  Marketable securities         Securities consist of a certificate of deposit and are classified as held to maturity.              (c)  Receivables and credit policies         Accounts receivable are uncollateralized customer obligations due under normal trade terms requiring payment within 30 days from invoice date. Notes receivable are generally collateralized by equipment sold to franchisees and are collectible monthly over various terms. Late or interest charges on delinquent accounts are not recorded until collected. The carrying amount of accounts and notes receivable is reduced by a valuation allowance, if necessary, which reflects management’s best estimate of the amounts that will not be collected. The allowance is estimated based on management’s knowledge of its customers, historical loss experience and existing economic conditions.              (d)  Inventories         Inventories consist of products used in the laser hair removal and skin rejuvenation process and are stated at the lower of cost, determined on a first-in, first-out (FIFO) basis, or market (net realizable value).              (e)  Property and equipment         Property and equipment is stated at cost. Depreciation is provided over the assets’ estimated useful lives using the straight-line method ranging from three to seven years. Leasehold improvements are amortized over the shorter of their estimated lives or the respective lease terms.              (f)  Income taxes         The amount provided for income taxes is based upon the amounts of current and deferred taxes payable or refundable at the date of the consolidated financial statements as a result of all events recognized in the consolidated financial statements as measured by the provisions of enacted tax laws.        Deferred income taxes are recognized for differences between the basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the expected amount to be realized.  F-40    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS — (Continued)              (g)  Revenue recognition         Company-owned centers — revenue includes the sale of laser hair removal or skin rejuvenation services and are recognized when the services are performed. Revenue from the sale of products are recognized at the time of product delivery.        Franchise operations — Revenue from franchising activities is recognized based on the terms of the underlying agreements and are included in franchise fee revenue.        Development agreements — In general, the Company’s development agreements provide for the development of a specified number of centers within a defined geographic territory in accordance with a schedule of opening dates. Development schedules cover specified periods of time and typically have benchmarks for the number of centers to opened at six to twelve month intervals. Development agreement fees are collected when the related agreements are executed, are nonrefundable and are included in franchise fee revenue.        Franchise fees — In general, the Company’s franchise agreements provide for the payment of a one-time fee associated with the opening of a new center and an ongoing royalty based on a percentage of center sales and are included in franchise fee revenue.        Development fees and franchise fees are recorded as deferred revenue when received and are recognized as revenue when the centers covered are opened or all material services or conditions relating to the fees have been substantially performed or satisfied by the Company. Royalties are recognized as income monthly when franchisees report their revenues.        The Company provides lasers to its franchisees and Company owned centers under a laser placement agreement whereby revenues from the use of the lasers are shared with the laser manufacturer.              (h)  Advertising and promotion costs         Advertising and promotion costs are expensed as incurred.              (i)  Realization of long-lived assets         Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicated that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.              (j)  Use of estimates         The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.              (k)  New accounting pronouncement         In January 2003, the Financial Accounting Standards Board issued Financial Interpretation No. 46, Consolidation of Variable Interest Entities. This interpretation addresses consolidation by business  F-41    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   enterprises of variable interest entities (“VIE”). In December 2003, the FASB issued FIN No. 46(R) , Consolidation of Variable Interest Entities — an interpretation of ARB 51 (revised December 2003), which replaced FIN No. 46. FIN No. 46(R) was primarily issued to clarify the required accounting for interests in VIEs. FIN No. 46(R) will be effective January 1, 2005 for the Company. Management is currently assessing the impact of FIN No. 46(R) on the Company’s consolidated financial position and results of operations.         3.  Credit risk and other concentrations         The Company generally maintains cash and cash equivalents on deposit at banks in excess of federally insured amounts. The Company has not experienced any losses in such accounts and management believes the Company is not exposed to any significant credit risk related to cash and cash equivalents.         4.  Property and equipment         A summary of property and equipment as of December 31, 2004 is as follows:                     2004                 Furniture and office equipment    $ 3,788,796           Software and development costs      53,307           Leasehold improvements      622,822                     Subtotal      4,464,925           Less accumulated depreciation and amortization      (943,629 )                   Total    $ 3,521,296                       5.  Income taxes         The provision for income taxes during 2004 is as follows:                       2004                 Current tax expense:                    Federal    $ —             State      35,445                       Total current tax expense      35,445                     Deferred tax expense:                    Federal      —             State      —                       Total deferred tax expense      —                       Total provision for income taxes    $ 35,445                      The actual income tax expense differs from the expected income tax expense because Sona Laser Centers, Inc. has taxable income in the State of Tennessee and Tennessee does not allow reporting taxable income on a consolidated basis.  F-42    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        Deferred income taxes as of December 31, 2004 include the following amounts of deferred income tax assets and liabilities:                                       2004               Current   Long-term   Total                         Deferred income tax assets    $ 355,000     $ 903,000     $ 1,258,000           Deferred income tax liabilities      —       (608,000 )     (608,000 )         Valuation allowance      (355,000 )     (295,000 )     (650,000 )                                 Net    $ —     $ —     $ —                                  The deferred income tax assets result primarily from the allowance for doubtful accounts, accrued severance and vacation costs and federal and state net operating loss carryforwards The deferred tax liabilities result primarily from the use of accelerated methods of depreciation of property and equipment for income tax purposes.        The valuation allowance was established to reduce the deferred income tax asset to the amount that will more likely than not be realized. This reduction is provided due to the uncertainty of the Company’s ability to utilize the federal and state net operating loss carryforwards before they expire. The valuation allowance increased approximately $650,000 in 2004.        At December 31, 2004, the Company had federal and state net operating loss carryforwards of approximately $2,508,000 and $777,000, which will begin to expire in 2023 and 2018, respectively.         6.  Long-term debt         A summary of long-term debt as of December 31, 2004 is as follows:                     2004                 Note payable due in monthly installments of $13,882, including     interest at a fixed rate of 5.1%, through 2007; secured by a     guaranty of the majority stockholder and marketable securities    $ 390,320           Leasehold notes payable due in various monthly installments due     between 2008 and 2010, plus interest at fixed rates ranging from     10.0% to 12.0%; secured by certain real property      236,186           Obligations due in various monthly installments due between 2005     and 2006, plus interest at fixed rates ranging from 9.0% to     17.9%; secured by certain equipment      33,296                     Total long-term debt      659,802           Less current installments      145,993                     Long-term debt, excluding current installments    $ 513,809                F-43    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        A summary of future maturities of long-term debt as of December 31, 2004 is as follows:                 Year   Amount                 2005    $ 145,993           2006      216,180           2007      199,863           2008      43,384           2009      22,963           Thereafter      31,419                   $ 659,802                      The provisions of the note payable place certain restrictions and limitations upon the Company. These include restrictions or limitations on the payment of dividends, capital expenditures, advances to related parties and affiliates, investments, sales or rentals of property, and additional borrowings. The Company was in compliance with these provisions at December 31, 2004.         7.  Subordinated debt         The Company has entered into a subordinated debt agreement with SONA Holdings, LLC, the Company’s majority stockholder. The agreement requires a lump-sum payment of unpaid principal and interest due on May 24, 2007. Included in interest expense for the year ended December 31, 2004 is non-cash interest totaling approximately $342,000 related to the subordinated debt agreement.         8.  Stockholders agreement         Holders of the Company’s common stock are entitled to vote upon the election of directors and upon any other matter submitted to the stockholders for a vote. Each share of common stock issued and outstanding shall be entitled to one vote. Holders of the Company’s common stock are entitled to dividend and liquidation rights subject the rights of holders of the Company’s Series A Convertible Participating Redeemable Preferred Stock (as described in Note 9).        On May 24, 2004, SONA Holdings, LLC purchased 96% of the outstanding shares of common stock and 100% of the outstanding shares of the Series A Convertible Participating Redeemable Preferred Stock from stockholders in exchange for cash of approximately $6,219,000 and members interest valued at approximately $2,781,000 or a total of $9,000,000. This transaction did not affect the reporting period or the reporting entity. Two stockholders owning one share of common stock each (4% in total) dissented from the sale to SONA Holdings, LLC. This dissent is the subject of litigation between the Company and these two stockholders. Management does not believe this litigation will have a material impact on the Company’s financial position.         9.  Convertible participating preferred stock         The Company has authorized the issuance of 200 shares of preferred stock, all of which have been designated as Series A Convertible Participating Redeemable Preferred Stock (“Preferred Stock”). The Preferred Stock is entitled to the same voting rights as common stockholders, one vote per share. Holders of the Preferred Stock shall have the right, at their option and at any time, to convert shares of the Preferred Stock into an equal number of shares of the Company’s common stock. The Preferred Stock shall participate in any and all dividends declared by the Board of Directors and paid with respect to the common stock treating each share of Preferred Stock as being equal to the number shares of common stock.  F-44    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS — (Continued)        The Preferred Stock is also entitled to redemption rights. The Company upon receipt of written request for redemption from the holder of the Preferred Stock will redeem the shares of Preferred Stock in immediately available, legal funds at the greater of the (1) Preferred Stock purchase price or (2) fair market value of the shares of Preferred Stock as determined in good faith by the Company’s board of directors.        In the event of liquidation, the Preferred Stock shall be first entitled, before any distribution or payment is made with respect to the common stock, an amount equal to the greater of, on a per share basis, (i) the original purchase price of the Preferred Stock, which the original purchase price shall be determined by dividing the full amount invested in the Company by the holders of the Preferred Stock or (ii) the amount of per share of Preferred Stock as would be payable had each share been converted to common stock prior to liquidation.         10.  Related party transactions         The Company has an exclusive laser placement agreement and a consulting agreement with Cynosure, Inc. (“Cynosure”), a former stockholder of the Company. The laser placement agreement requires Cynosure to place lasers of the latest available Cynosure technology in all franchisees and Company-owned laser centers. Cynosure must maintain the lasers in good working order. In return, the Company exclusively uses Cynosure lasers and pays Cynosure fees based on cash collected for laser hair removal services. The Company paid Cynosure $177,047 in 2004 for Company owned centers.        The Company has entered into an agreement to purchase two products from companies owned by former stockholders. The products enhance the laser treatments. The agreements are not exclusive and require the related companies to sell the products to the Company at preferred pricing and pay the Company a royalty for using its name in one of the products. The Company purchased $467,360 in 2004 of products from the related companies.        On May 24, 2004, the Company entered in a advisory services agreement with Carousel Capital Company, LLC, a related party, to provide consulting services through May 24, 2011 at an annual advisory fee of $150,000 per year. For the year ended December 31, 2004, the Company accrued and expensed approximately $91,000 related to this advisory agreement.         11.  Franchise agreements         The Company has entered into franchise agreements for 46 markets. At December 31, 2004, 31 centers were open for business and 15 centers were in various stages of development.         12.  Profit-sharing plan         The Company provides a qualified profit-sharing plan for all eligible employees. The Company contributed approximately $102,000 to the plan for 2004.         13.  Commitments and contingencies         The Company leases space for its main office and warehouse facilities and for each of the Company-owned clinics or centers under operating lease agreements that expire at various dates through 2011. Rent  F-45    Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   expense under these leases was $391,465 in 2004. At December 31, 2004, the Company is obligated under operating lease agreements to make future minimum lease payments as follows:                 Year   Amount                 2005    $ 596,380           2006      636,912           2007      650,588           2008      616,333           2009      521,694           Thereafter      333,974            The Company is subject to certain governmental regulations at the federal and state levels in relation to the performance of its laser hair removal and skin rejuvenation procedures.        The Company may be exposed to professional liability and other claims by providing laser hair removal procedures and skin rejuvenation to the public. The Company maintains professional liability insurance on each of its centers. Each center also has an independent contractor as medical director, who is a physician and these physicians are required to carry their own professional liability insurance. The Company also maintains professional liability coverage for its directors and officers and general liability insurance.        Four members of management are employed pursuant to long-term employment agreements. The agreements contain termination provisions both for cause and without cause and for a change in control. The agreements provide that the executives will not compete with the Company or induce any employee to leave the Company for periods ranging from 12 to 18 months following the expiration or earlier termination of the agreement. Approximate future minimum payments under these employment agreements are $561,000 in 2005 and 2006, $409,000 in 2007, and $161,000 from 2008 to 2010.        The Company has a letter of credit outstanding with a bank at December 31, 2004 totaling approximately $55,000.         14.  Advertising         Advertising costs of $1,687,985 were expensed during 2004.         15.  Accrued Expenses         Accrued expenses included the following items which exceeded 5% of current liabilities at December 31, 2004:                     2004                 Revenue share due to Cynosure, Inc.     $ 585,626                     Accrued salary and wages    $ 448,177                       16.  Subsequent Event         During late 2005 and early 2006, seven franchisees of the Company filed lawsuits or arbitrations (collectively the “Actions”) in which they allege various claims, including violations of state franchise laws, fraud and negligent misrepresentation by the Company. These Actions seek rescission of their franchise agreements with the Company and also seek compensatory damages ranging from $600,000 to $4,500,000 per Action. The franchisees are also seeking treble and punitive damages. The Company is vigorously defending each Action. Of the seven Actions, five were originally filed as lawsuits and the  F-46   Table of Contents  SONA INTERNATIONAL, INC. AND SUBSIDIARIES   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS — (Continued)   Company has filed, or will file, motions to dismiss or stay the litigation pending arbitration in each case. To date, the courts have granted two of these motions, one motion is pending, another will be filed within the next month, and the last lawsuit was dismissed by stipulation of the parties. The remaining two original Actions were filed as arbitrations. The current status is therefore two pending lawsuits, three filed arbitrations, and two former lawsuits which may be refiled as arbitrations.        These franchisees have discontinued paying the Company the royalty fees due in accordance with their respective franchise agreements. While management of the Company believes these lawsuits are without merit and is vigorously defending them, an adverse outcome may have a material impact on the operating results and the financial position of the Company, which would raise substantial doubt about the ability of the Company to continue as a going concern.  F-47    Table of Contents  EXHIBIT INDEX                 Exhibit       Number   Description             3 .1        Restated Certificate of Incorporation of the Registrant     (Incorporated by reference to the exhibits to the     Registrant’s Registration Statement on Form S-1     (333-127463))         3 .4        Amended and Restated Bylaws of the Registrant (Incorporated by     reference to the exhibits to the Registrant’s Registration     Statement on Form S-1 (333-127463))         4 .1        Specimen certificate evidencing shares of class A common     stock (Incorporated by reference to the exhibits to the     Registrant’s Registration Statement on Form S-1     (333-127463))         10 .1*        1992 Stock Option Plan (Incorporated by reference to the     exhibits to the Registrant’s Registration Statement on     Form S-1 (333-127463))         10 .2*        2004 Stock Option Plan, as amended (Incorporated by reference to     the exhibits to the Registrant’s Registration Statement on     Form S-1 (333-127463))         10 .3*        2005 Stock Incentive Plan (Incorporated by reference to the     exhibits to the Registrant’s Registration Statement on     Form S-1 (333-127463))         10 .4*        Employment Agreement, dated September 2003, between the     Registrant and Michael Davin (Incorporated by reference to the     exhibits to the Registrant’s Registration Statement on     Form S-1 (333-127463))         10 .5*        Employment Agreement, dated January 1, 2003, between the     Registrant and George Cho (Incorporated by reference to the     exhibits to the Registrant’s Registration Statement on     Form S-1 (333-127463))         10 .6*        Employment Agreement, dated September 2003, between the     Registrant and Douglas Delaney (Incorporated by reference to the     exhibits to the Registrant’s Registration Statement on     Form S-1 (333-127463))         10 .7†        Distribution Agreement, effective as of January 1, 2005,     between the Registrant and El.En. S.p.A. (Incorporated by     reference to the exhibits to the Registrant’s Registration     Statement on Form S-1 (333-127463))         10 .8†        Distribution Agreement, effective as of January 1, 2005,     between the Registrant and El.En. S.p.A. (Incorporated by     reference to the exhibits to the Registrant’s Registration     Statement on Form S-1 (333-127463))         10 .9        Promissory Note, dated October 1, 2004, between the     Registrant and El.En. S.p.A. (Incorporated by reference to the     exhibits to the Registrant’s Registration Statement on     Form S-1 (333-127463))         10 .10        Lease, dated January 31, 2005, between Glenborough     Fund V, Limited Partnership and the Registrant     (Incorporated by reference to the exhibits to the     Registrant’s Registration Statement on Form S-1     (333-127463))         10 .11        Reimbursement Agreement among the Registrant, El.En. S.p.A. and     BRCT, Inc. (Incorporated by reference to the exhibits to the     Registrant’s Registration Statement on Form S-1     (333-127463))         10 .12*        Option Agreement, dated December 17, 2003, between El.En.     and Michael Davin (Incorporated by reference to the exhibits to     the Registrant’s Registration Statement on Form S-1     (333-127463))         10 .13*        Option Agreement, dated May 13, 2005, between El.En. and     Michael Davin (Incorporated by reference to the exhibits to the     Registrant’s Registration Statement on Form S-1     (333-127463))         21 .1        Subsidiaries of the Registrant         23 .1        Consent of Ernst & Young LLP         23 .2        Consent of T. James Hammond, CPA         23 .3        Consent of Lattimore Black Morgan & Cain, PC      Table of Contents                Exhibit       Number   Description                 31 .1        Certification of the Principal Executive Officer         31 .2        Certification of the Principal Financial Officer         32 .1        Certification of the Chief Executive Officer Pursuant to     Section 906 of the Sarbanes-Oxley Act of 2002         32 .2        Certification of the Chief Financial Officer Pursuant to     Section 906 of the Sarbanes-Oxley Act of 2002               *       Management contract or compensation plan or arrangement required     to be filed as an exhibit pursuant to Item 15(c) of     Form 10-K.          †       Confidential treatment granted as to certain portions, which     portions have been omitted and filed separately with the     Securities and Exchange Commission.        EX-21.1 2 b58511ciexv21w1.txt EX-21.1 SUBSIDIARIES OF THE REGISTRANT                                                                       Exhibit 21.1  SUBSIDIARY                                         JURISDICTION OF INCORPORATION - ----------                                         -----------------------------  Cynosure France                                    France  Cynosure GmbH                                      Germany  Cynosure K.K.                                      Japan  Cynosure UK Ltd.                                   United Kingdom  Cynosure U.K. Ltd. Sucursal Espana                 Spain  Suzhou Cynosure Medical Devices Company Ltd.       China    EX-23.1 3 b58511ciexv23w1.txt EX-23.1 CONSENT OF ERNST & YOUNG LLP                                                                        EXHIBIT 23.1              CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM   We consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-130237) pertaining to the Cynosure 1992 Stock Option Plan, Cynosure 2004 Stock Option Plan, and the Cynosure 2005 Stock Option Plan of our report dated February 8, 2006, with respect to the consolidated financial statements of Cynosure, Inc. included in the Annual Report (Form 10-K) for the year ended December 31, 2005.  /s/ Ernst & Young LLP  Boston, Massachusetts March 24, 2006     EX-23.2 4 b58511ciexv23w2.txt EX-23.2 CONSENT T. JAMES HAMMOND, CPA                                                                        EXHIBIT 23.2                             CONSENT OF ACCOUNTING FIRM  I consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-130237) pertaining to the Cynosure 1992 Stock Option Plan, Cynosure 2004 Stock Option Plan, and the Cynosure 2005 Stock Option Plan of my report dated February 4, 2004, with respect to the consolidated financial statements of Sona International Corporation included in the Annual Report (Form 10-K) for the year ended December 31, 2005.  /s/ T. James Hammond, CPA  Virginia Beach, Virginia March 24, 2006     EX-23.3 5 b58511ciexv23w3.txt EX-23.3 CONSENT OF LATTIMORE BLACK MORGAN & CAIN PC                                                                        EXHIBIT 23.3              CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM   We consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-130237) pertaining to the Cynosure 1992 Stock Option Plan, Cynosure 2004 Stock Option Plan, and the Cynosure 2005 Stock Option Plan of our report dated June 2, 2005, except for Note 16, as to which the date is March 23, 2006, with respect to the consolidated financial statements of Sona International, Inc. as of December 31, 2004, and for the year ended December 31, 2004, included in the Cynosure, Inc. Annual Report (Form 10-K) for the year ended December 31, 2005.  /s/ Lattimore Black Morgan & Cain PC Lattimore Black Morgan & Cain PC March 27, 2006    EX-31.1 6 b58511ciexv31w1.htm EX-31.1 SECTION 302 CERTIFICATION OF THE C.E.O.    exv31w1       Exhibit 31.1   CERTIFICATIONS   I, Michael R. Davin, certify that:        1. I have reviewed this Annual Report on Form 10-K of Cynosure, Inc.;        2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;        3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;        4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:                     a) Designed such disclosure controls and procedures, or     caused such disclosure controls and procedures to be designed     under our supervision, to ensure that material information     relating to the registrant, including its consolidated     subsidiaries, is made known to us by others within those     entities, particularly during the period in which this report is     being prepared;                   b) [Not Applicable];                   c) Evaluated the effectiveness of the registrant’s     disclosure controls and procedures and presented in this report     our conclusions about the effectiveness of the disclosure     controls and procedures, as of the end of the period covered by     this report based on such evaluation; and                   d) Disclosed in this report any change in the     registrant’s internal control over financial reporting that     occurred during the registrant’s most recent fiscal quarter     (the registrant’s fourth fiscal quarter in the case of an     annual report) that has materially affected, or is reasonably     likely to materially affect, the registrant’s internal     control over financial reporting; and         5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):                     a) All significant deficiencies and material weaknesses in     the design or operation of internal control over financial     reporting which are reasonably likely to adversely affect the     registrant’s ability to record, process, summarize and     report financial information; and                   b) Any fraud, whether or not material, that involves     management or other employees who have a significant role in the     registrant’s internal control over financial reporting.                 /s/ Michael R. Davin                 Michael R. Davin          Chairman, President and Chief Executive Officer    Date: March 27, 2006       EX-31.2 7 b58511ciexv31w2.htm EX-31.2 SECTION 302 CERTIFICATION OF THE C.F.O.    exv31w2       Exhibit 31.2   CERTIFICATIONS   I, Timothy W. Baker, certify that:        1. I have reviewed this Annual Report on Form 10-K of Cynosure, Inc.;        2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;        3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;        4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:                     a) Designed such disclosure controls and procedures, or     caused such disclosure controls and procedures to be designed     under our supervision, to ensure that material information     relating to the registrant, including its consolidated     subsidiaries, is made known to us by others within those     entities, particularly during the period in which this report is     being prepared;                   b) [Not Applicable];                   c) Evaluated the effectiveness of the registrant’s     disclosure controls and procedures and presented in this report     our conclusions about the effectiveness of the disclosure     controls and procedures, as of the end of the period covered by     this report based on such evaluation; and                   d) Disclosed in this report any change in the     registrant’s internal control over financial reporting that     occurred during the registrant’s most recent fiscal quarter     (the registrant’s fourth fiscal quarter in the case of an     annual report) that has materially affected, or is reasonably     likely to materially affect, the registrant’s internal     control over financial reporting; and         5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):                     a) All significant deficiencies and material weaknesses in     the design or operation of internal control over financial     reporting which are reasonably likely to adversely affect the     registrant’s ability to record, process, summarize and     report financial information; and                   b) Any fraud, whether or not material, that involves     management or other employees who have a significant role in the     registrant’s internal control over financial reporting.                 /s/ Timothy W. Baker                 Timothy W. Baker          Executive Vice President,          Chief Financial Officer and Treasurer    Date: March 27, 2006       EX-32.1 8 b58511ciexv32w1.htm EX-32.1 SECTION 906 CERTIFICATION OF THE C.E.O.    exv32w1       Exhibit 32.1   CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,   AS ADOPTED PURSUANT TO   SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002        In connection with the Annual Report on Form 10-K of Cynosure, Inc. (the “Company”) for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, Michael R. Davin, Chairman, President and Chief Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, that:                     (1) the Report fully complies with the requirements of     Section 13(a) or 15(d) of the Securities Exchange Act of     1934; and                   (2) the information contained in the Report fairly     presents, in all material respects, the financial condition and     results of operations of the Company.                 /s/ Michael R. Davin                 Michael R. Davin          Chairman, President and Chief Executive Officer    Date: March 27, 2006       EX-32.2 9 b58511ciexv32w2.htm EX-32.2 SECTION 906 CERTIFICATION OF THE C.F.O.    exv32w2       Exhibit 32.2   CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,   AS ADOPTED PURSUANT TO   SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002        In connection with the Annual Report on Form 10-K of Cynosure, Inc. (the “Company”) for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, Timothy W. Baker, Executive Vice President, Chief Financial Officer and Treasurer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, that:                     (1) the Report fully complies with the requirements of     Section 13(a) or 15(d) of the Securities Exchange Act of     1934; and                   (2) the information contained in the Report fairly     presents, in all material respects, the financial condition and     results of operations of the Company.                 /s/ Timothy W. Baker                 Timothy W. Baker          Executive Vice President,          Chief Financial Officer and Treasurer    Date: March 27, 2006       -----END PRIVACY-ENHANCED MESSAGE-----