UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Commission file number: 0-22340

PALOMAR MEDICAL TECHNOLOGIES, INC.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  o   No  ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  o   No  ý

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý   No  o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

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

Large accelerated filer o    Accelerated filer ý    Non-accelerated filer o    Smaller reporting company o

                          (Do not check if a smaller
                reporting company)

Indicate by check mark if the registrant is a shell company, in Rule 12b(2) of the Exchange Act. Yes o No ý

The aggregate market value of the voting stock (common stock) held by non-affiliates of the registrant as of the close of business on June 30, 2007 was $500,079,257. The number of shares outstanding of the registrant’s common stock as of the close of business on March 4, 2008 was 18,338,012.

DOCUMENTS INCORPORATED BY REFERENCE

         Part III incorporates by reference certain information from the registrant’s definitive proxy statement for its 2008 annual meeting of stockholders, which is expected to be filed on or before April 29, 2008.

Table of Contents

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        Palomar, a Delaware corporation, was organized in 1987 to design, manufacture, market and sell lasers and other light-based products and related disposable items and accessories for use in medical and cosmetic procedures. We became a public company in December 1992. We obtained FDA clearance to market our EpiLaser® ruby laser hair removal system in March 1997 and were well positioned to focus on what we believed was the most promising product in our core laser business. Under the direction of a new board and management team, we undertook a program in 1997, which was completed in May of 1998, of exiting from all non-core businesses and investments and focusing only on those businesses which we believed held the greatest promise for maximizing stockholder value. Our exclusive focus became the use of lasers and other light-based products in dermatology and cosmetic procedures.

        We became the first company to receive FDA clearance for a diode laser for hair removal and for leg vein treatment, the LightSheer™ diode laser system. The LightSheer was the first generation of high-powered diode lasers designed for hair removal, and like our EpiLaser and other prior hair removal products, the LightSheer incorporated technology protected by patents licensed exclusively to us from the General Hospital Corporation doing business as Massachusetts General Hospital.

        On February 14, 2003, we entered into a Development and License Agreement with Gillette to complete development and commercialize a home-use, light-based hair removal device for women. On June 28, 2004, we announced with Gillette that we completed the initial phase of our agreement and that both parties would move into the next phase. In conjunction with entering this next phase, the parties amended the agreement to provide for additional development funding to further technical innovations. In September 2006, we announced that Gillette had made the decision to move into the next phase of our agreement. On December 8, 2006, we became the first company to receive a 510(k) over-the-counter (OTC) clearance from the FDA for a new, patented, home-use, light-based hair removal device. OTC clearance allows the product to be marketed and sold directly to consumers without a prescription. Under our agreement, Gillette paid us $2.5 million following our receipt of the OTC clearance as we were obligated to perform additional services and remain exclusive with Gillette during a twelve month period. In February 2007, we announced an amendment to our agreement with Gillette to include the development and commercialization of an additional light-based hair removal device for home-use, and we also announced that we had executed an Amended and Restated Joint Development Agreement to incorporate other prior amendments and several new amendments to allow for more open collaboration through commercialization. On December 21, 2007, we announced an amendment to our agreement with Gillette to extend the “Launch Decision” from January 7, 2008 until February 29, 2008 to enable the parties to enter into negotiations for a potential new agreement to replace the existing agreement. On March 3, 2008, we announced with The Procter & Gamble Company (“P&G”) that we had entered into a License Agreement with The Procter & Gamble Company and its wholly owned subsidiary The Gillette Company under which we granted a non-exclusive license to certain patents and technology to commercialize home-use light-based hair removal devices for women. This License Agreement replaced the Development and License Agreement entered into with Gillette in 2003 which was amended and restated in February 2007.

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        On February 18, 2004, we announced that we were awarded a $2.5 million research contract by the United States Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae, or PFB, commonly known as “razor bumps.” On October 25, 2005, we announced that we were awarded additional funding of $888,000 for a total of $3.4 million and a twelve month contract extension. On September 1, 2006, we were awarded additional funding of $440,000 for a total of $3.8 million and an additional five month extension until April 30, 2007. Since April 30, 2007, the contract has been extended on multiple occasions and currently has been extended through March 31, 2008.

        On September 1, 2004, we entered into a Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. to develop, clinically test and potentially commercialize home-use, light-based devices for (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. On August 22, 2007, we signed an amendment to our agreement with Johnson & Johnson to provide for additional development funding for certain development activities.

        We have two operating subsidiaries. Palomar Medical Products, Inc. is located at our headquarters in Burlington, Massachusetts and oversees the manufacture and sale of our laser and lamp-based systems currently on the market. Palomar Medical Technologies BV is located in Amsterdam, The Netherlands, and markets our products in Europe, Middle East, and Africa as well as provides certain services of our products for those regions.

Market for Aesthetic Procedures

        The market for light-based aesthetic procedures has seen significant growth over the past decade, particularly in the last several years. Many factors are likely responsible for this growth including the aging population of the United States and other industrialized nations along with a desire to look and feel younger and a rising discretionary income with which to pay for such procedures. Consumers often undergo aesthetic procedures to improve their self-image and self-esteem, or to appear competitive in an ever-younger workforce. Another important factor is the sophistication of the equipment for light-based aesthetic procedures. Technological advancements made to the equipment have improved safety, ease of use, efficacy, and cost which has in turn grown our customer base. Our traditional customers have been plastic surgeons and dermatologists. However, increased consumer demand and technological advancements as well as managed care and reimbursement restrictions in the United States and similar constraints outside the United States, have motivated non-traditional customers such as general practitioners, gynecologists, surgeons, and others to offer aesthetic procedures. Such procedures have the advantage of being provided on a fee-for-service basis. In addition, technological advances have reduced both treatment and recovery times and made a broader variety of treatments for different cosmetic issues possible, further increasing consumer demand.

Business Strategy

        With our strong focus on both the professional and consumer markets, we believe we are positioned to capitalize on the ever expanding market for improving personal appearance. Our strategy is three-fold: growth of our professional business, driving our technology into the mass consumer markets, and executing our intellectual property enforcement strategy.

Growth of Professional Business.

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Driving Our Technology into Consumer Market . We direct significant resources toward driving our technology into the mass consumer markets, including with both Johnson & Johnson Consumer Companies, Inc. and The Procter & Gamble Company, and its wholly owned subsidiary The Gillette Company.

Intellectual Property Enforcement . We are executing on our intellectual property enforcement strategy. We have a portfolio of patents in a number of areas. In the light-based hair removal area, we enforced a patent against Cutera, Inc. in a lawsuit which was successfully concluded in June 2006. In October 2006, we announced that Cynosure agreed to take a license to our hair removal patents. Several other competitors, Lumenis, Iridex, Ellipse A/S (formerly Danish Dermatologic Development A/S), and New Star Lasers, Inc. (d/b/a CoolTouch, Inc.), also pay us royalties on sales of hair removal products. In July 2006, we again tested the light-based hair removal patents when we sued Alma Lasers, Inc. for patent infringement. This lawsuit was successfully concluded in March 2007 with Alma admitting that their products infringe our patents and that the patents are both valid and enforceable. In August 2006, we filed suit against Candela Corporation for infringement of these hair removal patents. We are reviewing various strategies with additional parties, including granting additional licenses and further litigation, if necessary, which would seek money damages as well as injunctions. (For more information about our patent litigation, see Item 3 Legal Proceedings and Note 7 of Notes to our Consolidated Financial Statements.)

Financial Information About Industry Segments

        We conduct business in one industry segment, medical and cosmetic products and services.

Principal Products

        We research, develop, manufacture, market, sell and service light-based products used to perform procedures addressing medical and cosmetic concerns. We offer a comprehensive range of products based on proprietary technologies that include, but are not limited to:

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         Lux Platform. With increasing market acceptance of light-based treatments for new applications, we recognized the need for a cost effective platform that could expand with the needs of our customers. In 2001, we announced the first product with the Lux Platform: the EsteLux® Pulsed Light System. In March 2003, we introduced the higher priced MediLux™ Pulsed Light System with the same six handpieces, but also with higher power, faster repetition rate and a new snap-on connector for faster changes between handpieces. In February 2004, we enhanced the upgrade opportunities for our customers with the introduction of the StarLux® Pulsed Light and Laser System with increased power, a computer controlled touch screen, instant handpiece recognition, active contact cooling, and a long pulse Nd:YAG laser handpiece, the Lux1064™. In February 2005, we introduced a new infrared handpiece, the LuxIR™. In June 2006, we introduced and began shipping the Lux1540™ Fractional Laser handpiece. In February 2007, we introduced the StarLux® 500 Pulsed Light and Laser System with 70% more power and increased functionality and speed of treatment as compared to the original StarLux System. Capable of achieving higher peak and average power for greater efficacy with increased contact cooling for added safety and comfort, the StarLux 500 offers customers faster treatment times, more flexibility and improved results. The StarLux 500 supports the suite of StarLux handpieces, as well as several handpieces introduced in 2007 and early 2008, the LuxDeepIR™ handpiece, and the LuxYs™ handpiece, and two new handpieces, the Lux2940 fractional handpiece for ablative treatment and the Lux1440 fractional handpiece for non-ablative treatment.

         Customers can invest in their first Lux system with one handpiece then purchase additional handpieces as their practice grows and upgrade into a more powerful Lux system when ready. The Lux platform enables us to custom tailor products to fit almost any professional medical office or spa location and provide customers with the comfort that the system is able to grow with their practice.

        In addition to being cost effective and upgradeable, the platform includes many technological advances. For example, the platform includes our Smooth Pulse technology, a safe and comfortable treatment that spreads power evenly over the entire pulse of light allowing us to provide optimal wavelengths for faster results in fewer treatments. By contrast, many competitive systems deliver a power spike at the beginning of each pulse which can cause injury at the most effective wavelengths. The Smooth Pulse technology extends the life of the light source. We sell replacement handpieces to existing customers providing a reoccurring revenue stream.

        The Lux pulsed light handpieces combine the latest technology with simple, streamlined engineering that is both effective and economical. Long pulse widths and AccuSpectrum™ filtering provide increased safety and efficacy. Efficacy is further improved through our Photon Recycling process which increases the effective fluence by capturing light scattered out of the skin during treatments and redirecting it back into the treatment target. Offering one of the largest spot sizes in the market and high repetition rates allows for fast coverage which is especially important when removing hair from large areas such as legs and backs. A back or a pair of legs can be treated in approximately thirty minutes, and a smaller area, such as the underarms, in even less time. The system’s simple operation opens its applications to a wider band of worldwide users.

         EsteLux. During 2001, we received FDA clearance to market and sell the Palomar EsteLux™ Pulsed Light System. In 2002 and 2003, we offered six handpieces for the EsteLux system: LuxY, LuxG, LuxR, LuxRs, LuxB and LuxV. These handpieces emit pulses of intense light to treat unwanted hair, solar lentigo (sunspots), rosacea, actinic bronzing, spider veins, birthmarks, telangiectasias, acne and more. The LuxY handpiece is used for hair removal for large body areas and for pigmented lesion treatments. The LuxG handpiece delivers the RejuveLux™ process — photofacial treatments that remove pigmented and vascular lesions to improve skin tone and texture. The LuxR handpiece can be used to remove hair on all skin types, from the fairest to the darkest, including deep tans. Likewise, the LuxRs handpiece can be used to remove hair on all skin types, but it has concentrated power in each pulse resulting in permanent hair reduction in fewer treatments. The LuxB handpiece provides effective treatment of lighter pigmented lesions on fair skin as well as leg and spider veins, and the LuxV handpiece treats pigmented lesions and mild to moderate acne. With these complimentary handpieces, the Lux Platform is one of the most affordable and multifaceted systems in the market.

         MediLux. In March 2003, we launched the Palomar MediLux™ Pulsed Light System with the six handpieces also available on the EsteLux. The MediLux provides increased power, a faster repetition rate and a snap-on connector making it easier to switch among handpieces and provide treatments tailored to each individual being treated.

         StarLux 300. In February 2004, we launched the StarLux® 300 Laser and Pulsed Light System, and in June 2004, we began shipping this system. The StarLux 300 has a single power supply capable of operating both lasers and lamps. The StarLux 300 includes increased power, active contact cooling and a full color touch screen for easy operation. The StarLux 300 operates five of the EsteLux / MediLux handpieces, namely the LuxY, LuxG, LuxR, LuxRs, and LuxV. In addition, the increased power of the StarLux 300 allows for the operation of a long pulse Nd:YAG laser handpiece, the Lux1064™. In January 2005, the Lux1064 laser handpiece received FDA clearance for a variety of applications, including but not limited to removal of pigmented and vascular lesions, including visible leg veins. The Lux1064 is a high power laser handpiece featuring Smooth Pulse technology and Active Contact Cooling while also providing multiple spot sizes.

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        Our patented Active Contact Cooling technology sends a chilled water supply through the StarLux 300 handpieces, thus cooling the skin before, during, and after treatment. This feature is designed to ensure safety and comfort during treatment. The StarLux 300’s high-powered treatments deliver long-lasting and even permanent results. The StarLux 300 full-color screen allows easy finger-touch operation and instant handpiece recognition while providing constant feedback on operating parameters.

        In 2005, we introduced and began shipping a new infrared handpiece, the LuxIR, for deep tissue heating for relief of muscle and joint pain. In 2006, we received FDA clearance for the LuxIR handpiece for soft tissue coagulation and began marketing the LuxIR for skin tightening through soft tissue coagulation.

        In 2006, we introduced and began shipping the Lux1540™ Fractional Laser handpiece for soft tissue coagulation. In 2007, we received FDA clearance for the Lux1540 for non-ablative skin resurfacing. The Lux1540 delivers light in an array of high precision microbeams which create narrow, deep columns of tissue coagulation that penetrate well below the epidermis and into the dermis, while sparing the tissue surrounding the columns from damage.

        In February 2007, we introduced the LuxYs™ Pulsed Light handpiece for permanent reduction of lighter, finer hair.

         StarLux 500. In February 2007, we launched the StarLux® 500 Laser and Pulsed Light System, and began shipping in March 2007. The StarLux 500 provides 70% more power and increased functionality and speed of treatment as compared to the StarLux 300. The StarLux 500 operates all the handpieces available for the StarLux 300 System as well as the LuxDeepIR™ handpiece. The LuxDeepIR Fractional handpiece is an upgrade of the LuxIR Fractional handpiece and includes advanced cooling, contact sensors and longer pulse duration for improved safety and efficacy. In addition, in December 2007, we began shipping the Lux2940™ Fractional handpiece for ablative skin resurfacing, and in February 2008, we announced the Lux1440™ Fractional handpiece for faster non-ablative skin resurfacing.

         Q-YAG 5. During 2001, we received FDA clearance to market and sell the Palomar Q-YAG 5™ system for tattoo and pigmented lesion removal. The Palomar Q-YAG 5 is a Q-switched, frequency-doubled Neodymium laser. The combination of wavelengths allows users to treat a full spectrum of colors and inks, and the system’s design lowers costs and allows broader use of the instrument. The single wavelength is ideal for treating darker tattoo inks and dermal-pigmented lesions, such as Nevi of Ota common in Japan and other Pacific Rim countries. The mixed wavelength is better suited for brighter colors and epidermal-pigmented lesions, such as solar lentigines. In addition, the mixed wavelength permits brighter, more superficial and deeper and darker target areas to be treated simultaneously. The Palomar Q-YAG 5 incorporates the laser into the handpiece making it smaller and lighter than competitive systems, which is especially desirable for mobile and/or small physician offices. These attributes reduce the cost, increase the reliability of the system and eliminate costly optics and service problems that are common with other high power Q-Switched lasers.

         Legacy Products. We no longer sell the EpiLaser™ or E2000™ hair removal laser systems, the RD-1200™ Q-switched ruby laser, SLP1000® Diode Laser System or the NeoLux Pulsed Light System. However, we continue to service these systems. The service of the RD-1200, Epilaser and E2000 have been contracted out to a third party service provider, and we have the option of contracting out the service of the SLP1000 systems to this same party.

Global Distribution

        We currently employ a global network of strategic distributors throughout Europe, Japan, Australia, South and Central America, the Far East, and the Middle East. As of December 31, 2007, we utilized 40 distributors in 50 countries. To improve our international sales and marketing efforts, in January 2008, we executed an international distribution agreement with the Swedish company Q-MED AB, the producer of Restylane, one of the most popular and widely distributed dermal fillers in the world. Q-MED sells Restylane globally through a network of fully owned sales companies, partners and distributors. The transition from our existing distributors to Q-MED shall be on a country-by-country basis as the companies agree on the terms of each transition. We plan to work with Q-MED and current distributors to determine how each distributor might successfully work with Q-MED during and after each country is transitioned.

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        To further improve our international sales and marketing efforts, we opened a new subsidiary in The Netherlands. We use this location to coordinate various marketing and distribution activities in Europe, Middle East and Africa as well as provide certain services for our products sold in Europe.

        The following table shows product revenue relating to our international sales activities during each of the last three fiscal years by geographic region:

Products Under Development

        We are engaged in developing products for the dermatology and cosmetic market. Products under development include lasers, lamps and other light-based products for the removal of unwanted hair, tattoos, pigmented lesions, leg vein and other vascular lesions, acne, fat, cellulite, and skin rejuvenation, including skin resurfacing, skin tone and texture as well as other cosmetic applications. We perform our own research and we also fund research at various institutions throughout the world. Product development is performed by scientists and engineers at our headquarters. We direct resources at both new products for existing markets such as the removal of unwanted hair, vascular and pigmented lesions and tattoos, acne and skin resurfacing, and other products for new markets, such as fat reduction, including the treatment of cellulite.

Production, Sources and Availability of Materials

        Our manufacturing operations are located in Burlington, Massachusetts. We maintain control of and manufacture most key subassemblies in-house. Manufacturing consists of the assembly and testing of components purchased from outside suppliers and contract manufacturers. Each fully assembled system is subjected to a rigorous set of tests prior to shipment to the end user. We have obtained ISO 13485 2003, CDN MDR, and Council Directive 93/42/EEC approvals. We are registered with the Federal Food and Drug Administration.

        We depend and will depend upon a number of outside suppliers for components used in our manufacturing process. Most of our components and raw materials are available from a number of qualified suppliers. If our suppliers are unable to meet our requirements on a timely basis, production could be interrupted until an alternative source of supply is obtained.

Patents and Licenses

        Our success and ability to compete are dependent on our ability to develop and maintain proprietary technology and operate without infringing on the proprietary rights of others. We rely on a combination of patents, trademarks, trade secret and copyright laws and contractual restrictions to protect our proprietary technology. These legal protections afford only limited protection for our technology. We are presently the exclusive licensee of two United States patents and the non-exclusive licensee of three United States patents as well as corresponding foreign patents and pending applications owned by Massachusetts General Hospital, and we are the joint owner with Massachusetts General Hospital of seven other United States patents as well as corresponding United States pending applications and foreign patents and pending applications. In addition, we are the sole owner of twenty-six United States patents as well as corresponding and non-corresponding United States pending applications and foreign patents and pending applications, and have rights to other patents under exclusive and non-exclusive licenses.

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        We seek to limit disclosure of our intellectual property by requiring employees, consultants and any third party with access to our proprietary information to execute confidentiality agreements with us and often agreements that include assignment of rights provisions to us. Due to rapid changes in technology, we believe that factors such as the technological and creative skills of our personnel, new product developments and enhancements to existing products are as important as the various legal protections of our technology to establishing and maintaining a leadership position.

        Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of the products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. Litigation may be necessary to enforce intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Any such resulting litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that our means of protecting proprietary rights will be adequate or that our competitors will not independently develop similar technology. Any failure by us to meaningfully protect our proprietary rights could have a material adverse effect on our business, operating results and financial condition.

        Management believes that none of our current products infringe upon valid claims of patents owned by third parties. However, there have been claims made against us and there can be no assurance that third parties will not make further claims of infringement with respect to our current or future products. Any such claims, with or without merit, could be time-consuming to defend, result in costly litigation, divert our attention and resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all. A successful claim of intellectual property infringement against us and our failure or inability to license the infringed technology or develop or license technology with comparable functionality could have a material adverse effect on our business, financial condition and operating results. (For more information about our patent litigation, see Item 3 Legal Proceedings and Note 7 of Notes to our Consolidated Financial Statements.)

Backlog

        Generally, we do not maintain a high level of backlog. As a result, we do not believe that our backlog at any particular time is indicative of future sales levels.

Competition

        The market in which we are engaged is subject to intense competition and rapid technological change. Our competitors include but are not limited to: Candela, Inc., Cutera, Inc., Cynosure, Inc., Syneron, Inc., Lumenis, Inc., Alma, Inc., Iridex, Inc., Reliant Technologies, Inc., and other smaller competitors. Some of our competitors have greater financial, marketing, and technical resources than we have. Moreover, some competitors have developed, and others may attempt to develop, products with applications similar to that of ours. We expect that there may be further consolidation of companies within the light-based industry via acquisitions, partnering arrangements or joint ventures. We compete primarily on the basis of technology, product performance, price, quality, reliability, distribution and customer service. To remain competitive, we will be required to continue to develop new products and periodically enhance our existing products.

Food and Drug Administration Regulations

        All of our current products are light-based devices, which are subject to FDA regulations for clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new product or a new use of or claim for an existing product can be marketed in the United States, we must obtain clearance from the FDA. The types of medical devices that we seek to market in the United States generally must receive either “510(k) clearance” or “PMA approval” in advance from the FDA pursuant to the Federal Food, Drug, and Cosmetic Act. The FDA’s 510(k) clearance process usually takes from three to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain and generally takes from one to three years or even longer. To date, the FDA has deemed our products eligible for the 510(k) clearance process. We believe that most of our products in development will receive similar treatment. However, we cannot be sure that the FDA will not impose the more burdensome PMA approval process upon one or more of our future products, nor can we be sure that 510(k) clearance or PMA approval will ever be obtained for any product it proposes to market and failure to do so could adversely affect our ability to sell products.

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Number of Employees

        As of December 31, 2007, we employed 252 people. We are not subject to any collective bargaining agreements, have not experienced a work stoppage and consider our relations with our employees to be good.

Available Information

        Our internet site is www.palomarmedical.com . You can access our Investor Relations webpage through our internet site by clicking on the “Investors” link to the heading “SEC Filings.” We make available free of charge, on or through our Investor Relations webpage, our proxy statements, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (“Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. We also make available, through our Investor Relations webpage, via a link to the SEC’s internet site, statements of beneficial ownership of our equity securities filed by our directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act. We have also made our Code of Conduct available through our internet site by clicking on the “Corporate Governance” link under “Investors.”

Item 1A. Risk Factors

         This report contains forward-looking statements that involve risks and uncertainties, such as statements of our objectives, expectations and intentions. The cautionary statements made in this report should be read as applicable to all forward-looking statements wherever they appear in this report. Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include those discussed below, as well as those discussed elsewhere in this report.

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 light-based (both lasers and lamps) 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. We compete in the development, manufacture, marketing, sales and servicing of light-based devices with numerous other companies, some of which have substantially greater direct worldwide sales capabilities. Our products also face competition from medical products, prescription drugs and cosmetic procedures, such as electrolysis and waxing.

Our products are subject to numerous medical device regulations. Compliance is expensive and time-consuming. Without necessary clearances, we may be unable to sell products and compete effectively. 

        All of our current products are light-based devices, which are subject to FDA regulations for clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new product or a new use of or claim for an existing product can be marketed in the United States, we must obtain clearance from the FDA. In the event that we do not obtain FDA clearances, our ability to market products in the United States and revenue derived there from may be adversely affected.  The types of medical devices that we seek to market in the U.S. generally must receive either “510(k) clearance” or “PMA approval” in advance from the FDA pursuant to the Federal Food, Drug, and Cosmetic Act. The FDA’s 510(k) clearance process can be expensive and usually takes from three to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain and generally takes from one to three years or even longer from the time the pre-market approval application is submitted to the FDA until an approval is obtained.

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        In order to obtain pre-market 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;

governmental regulations may change or administrative actions may occur that cause delays; and

the interim or final results of the clinical trials may be inconclusive or unfavorable as to safety or effectiveness.

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 pre-market approval of new products, new intended uses or modifications to existing products. Our clearances can be revoked if safety or effectiveness problems develop.

        To date, the FDA has deemed our products eligible for the 510(k) clearance process. We believe that our products in development will receive similar treatment. However, we cannot be sure that the FDA will not impose the more burdensome PMA approval process upon one or more of our future products, nor can we be sure that 510(k) clearance or PMA approval will ever be obtained for any product we propose to market, and our failure to do so could adversely affect our ability to sell our products.

        We often seek FDA clearance for additional indications for use. Clinical trials in support of such clearances for additional indications may be costly and time-consuming. In the event that we do not obtain additional FDA clearances, our ability to market products in the United States and revenue derived therefrom may be adversely affected. Medical devices may be marketed only for the indications for which they are approved or cleared, and if we are found to be marketing our products for off-label, or non-approved, uses we might be subject to FDA enforcement action or have other resulting liability.

        Our products are subject to similar regulations in many international markets. Complying with these regulations is necessary for our strategy of expanding the markets for sales of our products into these countries. Compliance with the regulatory clearance process in any country is expensive and time consuming.  Regulatory clearances may necessitate clinical testing, limitations on the number of sales and limitations on the type of end user, among other things.  In certain instances, these constraints can delay planned shipment schedules as design and engineering modifications are made in response to regulatory concerns and requests.  We may not be able to obtain clearances in each country in a timely fashion or at all, and our failure to do so could adversely affect our ability to sell our products in those countries.

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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 we must maintain records of other corrections or removals. The FDA closely regulates promotion and advertising and our promotional and advertising activities could come under scrutiny. 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:

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 pre-market approval of new products or new intended uses; and

criminal prosecution.

If any of these events were to occur, they could harm our business.

We have modified some of our products and sold them under prior 510(k) clearances. The FDA could retroactively decide the modifications required new 510(k) clearances and require us to cease marketing and/or recall the modified products.

        Any modification to one of our 510(k) 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. We may be required to submit pre-clinical and clinical data depending on the nature of the changes. We may not be able to obtain additional 510(k) clearances or pre-market 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 into the market in a timely manner, which in turn would harm our revenue and operating results. We have modified some of our marketed devices, but we believe that new 510(k) clearances are not required. We cannot be certain that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any modification, we also may be required to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.

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 may also be subject to state regulations.   State regulations, and changes to state regulations, may prevent sales to particular end users or may restrict use of the products to particular end users or under particular supervision which may decrease revenues or prevent growth of revenues.

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        Our products may also be subject to state regulations.   Federal regulation allows our products to be sold to and used by licensed practitioners as determined on a state-by-state basis which complicates monitoring compliance. As a result, in some states non-physicians may purchase and operate our products. In most states, it is within a physician’s discretion to determine whom they can supervise in the operation of our products and the level of supervision. However, some states have specific regulations as to appropriate supervision and who may be supervised. A state could disagree with our decision to sell to a particular type of end user or change regulations to prevent sales to particular types of end users or change regulations as to supervision requirements. In several states applicable regulations are in flux.  Thus, state regulations and changes to state regulations may decrease revenues or prevent growth of revenues. 

Outside of the United States, we rely on third party distributors to market and sell a large portion of our products. Due to our January 2008 international distribution agreement with Q-MED AB, we will be terminating or changing our relationship with our current distributors as we transition to Q-MED as our exclusive distributor outside of North America. During this transition period, current distributors may not commit the necessary resources to effectively market and sell our products and we may not be able to collect receivables due for past sales to these distributors and our business and operating results may be harmed. Our relationship with Q-MED may not be successful and our business and operating results may be harmed.

        In the United States, we sell our products through our internal sales organization. Outside of this market, 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. On January 9, 2008, we announced our international distribution agreement with the Swedish company Q-MED AB, the producer of Restylane, one of the most popular and widely distributed dermal fillers in the world. Q-MED sells Restylane globally through a network of fully owned sales companies, partners and distributors. The transition from our current distributors to Q-MED shall be on a country-by-country basis as the companies agree on the terms of each transition. We plan to work with Q-MED and current distributors to determine how each distributor might successfully work with Q-MED during and after the time each country is transitioned. The relationship with most, if not all, of our current distributors will be terminated or changed. During this transition period, our relationship with current distributors may be damaged such that they may not commit the necessary resources to effectively market and sell our products and may leave us with a greater collection risk on our outstanding receivables from these distributors. In addition, the transition to and our future relationship with Q-MED may not be successful. If the current distributors do not perform adequately or if our agreement with Q-MED is unsuccessful, our revenue from international sales may be adversely affected and our operating results could suffer.

Because we do not require training for all 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 state law. The definition of “licensed practitioners” varies from state to 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. Our products come with an operator’s manual. 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.

Achieving complete compliance with FDA regulations is difficult, and if we fail to comply, we could be subject to FDA enforcement action or our business could suffer.

        We are subject to inspection and market surveillance by the FDA to determine compliance with regulatory requirements. The FDA’s regulatory scheme is complex, especially the Quality System Regulation, which requires manufacturers to follow elaborate design, testing, control, documentation, and other quality assurance procedures. Because some of our products involve the use of lasers, those 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 Quality System Regulation and laser performance standards through periodic unannounced inspections. We have been, and anticipate in the future being, subject to such inspections. The complexity of the Quality System Regulation makes complete compliance difficult to achieve. Also, the determination as to whether a Quality System Regulation violation has occurred is often subjective. If the FDA finds that we have failed to comply with the Quality System Regulation or other applicable requirements or failed to take satisfactory corrective action in response to an adverse Quality System Regulation inspection or comply with applicable laser performance standards, the agency can institute a wide variety of enforcement actions, including a public warning letter or other stronger remedies, such as fines, injunctions, criminal and civil penalties, recall or seizure of our products, operating  restrictions, partial suspension, or total shutdown of our production, refusing to permit the import or export of our products, delaying or refusing our requests for 510(k) clearance or PMA approval of new products, withdrawing product approvals already granted or criminal prosecution, any of which could cause our business and operating results to suffer.

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Our effective income tax rate may vary significantly.

        Unanticipated changes in our tax rates could affect our future results of operations. Our future effective tax rates could be unfavorably affected by changing interpretations of existing tax laws or regulations, changes in estimates of prior years’ items, changes in the valuation of our deferred tax assets, future levels of research and development spending, deductions for employee stock option exercises being different than what we projected, and changes in overall levels of income before taxes.

Failure to manage our relationships with third party researchers effectively may limit our access to new technology, increase the cost of licensing new technology, and divert management attention from our core business.

        We are dependent upon third-party researchers over whom we do not have absolute control to satisfactorily conduct and complete research on our behalf.  We are also dependent upon third-party researchers to grant us licensing terms, which may or may not be favorable, for products and technology they may develop. We provide research funding, light technology and optics know-how in return for licensing rights with respect to specific dermatologic and cosmetic applications and patents. In return for certain exclusive license rights, we are subject to due diligence obligations in order to maintain such exclusivity.  Our success will be dependent upon the results of research with our partners and meeting due diligence obligations. We cannot be sure that third-party researchers will agree with our interpretation of the terms of our agreements, that we will meet our due diligence obligations, or that such research agreements will provide us with marketable products in the future or that any of the products developed under these agreements will be profitable for us. 

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.

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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 continue to increase. We believe, and our growth expectations assume, that we and other companies selling light-based (lasers and lamps) 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.

If there is not sufficient consumer 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 client. As a result, the decision to undergo a procedure that utilizes our products may be influenced by a number of factors, including:

consumer 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.

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 increased growth in the scope of our operations and the number of our employees. 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.

Failure to receive shipments of critical components could reduce revenues and reduced reliability of critical components could increase expenses.

         We develop light-based systems that incorporate third-party components and we purchase some of these components from small, specialized vendors that are not well capitalized. We do not have long-term contracts with some of these third parties for the supply of parts. A disruption in the delivery of these key components, 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 or testing services could prevent us from manufacturing products and result in a decrease in revenue.  We depend on an acceptable level of reliability for purchased components.  Reliability below expectations for key components could have an adverse affect on inventory and inventory reserves. Any extended interruption in our supplies of third party components could materially harm our business.

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We forecast sales to determine requirements for components and materials used in our products and if our forecasts are incorrect, we may experience either delays in shipments or increased inventory costs.

        To manage our manufacturing operations with our suppliers, we forecast anticipated product orders and material requirements to predict our inventory needs and enter into purchase orders on the basis of these requirements. Our limited historical experience may not provide us with enough data to accurately predict future demand. If our business expands, our demand for components and materials would increase and our suppliers may be unable to meet our demand. If we overestimate our component and material requirements, we will have excess inventories, which would increase our expenses. If we underestimate our component and material requirements, we may have inadequate inventories, which could interrupt, delay, or prevent delivery of our products to our customers.

Our proprietary technology has only limited protections which may not prevent competitors from copying our new developments. This may impair our ability to compete effectively. We may expend significant resources enforcing our intellectual property rights to prevent such copying, and our intellectual property could be determined to be not infringed, invalid or unenforceable.

        Our business could be materially and adversely affected if we are not able to adequately protect our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, licenses and confidentiality agreements to protect our proprietary rights. We own and license a variety of patents and patent applications in the United States and corresponding patents and patent applications in many foreign jurisdictions. 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.

        We have granted certain patent licenses to several competitors, and in return for those license grants, we receive a significant ongoing royalty revenue stream. A few of these competitors entered into license agreements only after we sued them for patent infringement. We are currently enforcing these patents against Candela Corporation and intend to enforce against other competitors in the future. We do not know how successful we will be in asserting our patents against Candela or other suspected infringers. Whether or not we are successful in the pending lawsuit, litigation consumes substantial amounts of our financial resources and diverts management’s attention away from our core business. Public announcements concerning this litigation that are unfavorable to us may in the future result in significant declines in our stock price. An adverse ruling or judgment in this matter could result in a loss of our significant ongoing royalty revenue stream and could also have a material adverse effect on license agreements with other companies both of which could have a material adverse effect on our business and results of operation and cause our stock price to decline significantly. (For more information about our patent litigation, see Item 3 Legal Proceedings and Note 7 of Notes to our Consolidated Financial Statements.)

        In addition to patented technology, we rely upon unpatented proprietary technology, processes and know-how. We generally enter into agreements with our employees and third parties with whom we work, including but not limited to consultants and vendors, to restrict access to, and distribution of, our proprietary information and define our intellectual property ownership rights. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our technology, proprietary information and know-how and we may not have adequate remedies for any such breach. Monitoring unauthorized use of our technology is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If competitors are able to use our technology, our ability to compete effectively could be harmed and the value of our technology and products could be adversely affected. Costly and time consuming lawsuits may be necessary to enforce and defend patents issued or licensed exclusively to us, to protect our trade secrets and/or know-how or to determine the enforceability, scope and validity of others’ intellectual property rights. Such lawsuits may result in patents issued or licensed exclusively to us to be found invalid and unenforceable. In addition, our trade secrets may otherwise become known or our competitors also may independently develop technologies that are substantially equivalent or superior to our technology and which do not infringe our patents.

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Claims by others that our products infringe their patents or other intellectual property rights could prevent us from manufacturing and selling some of our products or require us to pay royalties or incur substantial costs from litigation or development of non-infringing technology.

         In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights.  The light-based cosmetic and dermatology industry in particular is characterized by a large number of patents and related litigation regarding patents and other intellectual property rights. Because our resources are limited and patent applications are maintained in secrecy for a period of time, we can conduct only limited searches to determine whether our technology infringes any patents or patent applications. Any claims for patent infringement, regardless of merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause shipment delays, require us to develop non-infringing technology or to enter into royalty or licensing agreements. 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. Although patent and intellectual property disputes in the light-based industry have often been settled through licensing or similar arrangements, costs associated with such arrangements may be substantial and often require the payment of ongoing royalties, which could have a negative impact on gross margins. There can be no assurance that necessary licenses would be available to us on satisfactory terms, or that we could redesign our products or processes to avoid infringement, if necessary. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling some of our products. This could have a material adverse effect on our business, results of operations and financial condition.

        Candela Corporation has filed two patent infringement lawsuits against us. (For more information about our patent litigation, see Item 3 Legal Proceedings and Note 7 of Notes to our Consolidated Financial Statements.) Litigation with Candela is expected to be expensive and protracted, and our intellectual property position may be weakened as a result of an adverse ruling or judgment. Whether or not we are successful in the pending lawsuits, litigation consumes substantial amounts of our financial resources and diverts management’s attention away from our core business. Public announcements concerning this litigation that are unfavorable to us may in the future result in significant declines in our stock price. An adverse ruling or judgment in this matter could cause our stock price to decline significantly.

We may not be able to successfully collect licensing royalties.

         Material portions of our revenues consist of royalties from sub-licensing patents licensed to us on an exclusive basis by Massachusetts General Hospital. If we are unable to collect our licensing royalties, our revenues will decline.

Quarterly revenue or operating results could cause the price of our common stock to fall.

         Our quarterly revenue and operating results are difficult to predict and may swing sharply from quarter to quarter.  If our quarterly revenue or operating results fall below the expectations of investors or public market analysts, the price of our common stock could fall substantially. Our quarterly revenue is difficult to forecast for many reasons, some of which are outside of our control.  For example, many factors are related to market supply and demand, including potential increases in the level and intensity of price competition between our competitors and us, potential decrease in demand for our products and possible delays in market acceptance of our new products.  Other factors are related to our customers and include changes in or extensions of our customers’ budgeting and purchasing cycles and changes in the timing of product sales in anticipation of new product introductions or enhancements by us or our competitors.   Factors related to our operations may also cause quarterly revenue or operating results to fall below expectations, including our effectiveness in our manufacturing process, unsatisfactory performance of our distribution channels, service providers, or customer support organizations, and timing of any acquisitions and related costs.

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Managing our relationships with The Procter & Gamble Company (and its wholly owned subsidiary The Gillette Company), Johnson & Johnson Consumer Companies, Inc., and future development partners may divert the attention of key technical personnel and management from the core business.   If, pursuant to rights in their respective agreements with us, any of these parties should end their relationship with us, our stock price could fall, and we may be unable to bring home-use devices to the market.

        We believe that our relationships with The Procter & Gamble Company (and its wholly owned subsidiary The Gillette Company) and Johnson & Johnson Consumer Companies, Inc. represent unique opportunities to bring light-based devices to the mass market. Significant resources and the attention of key technical personnel and management have been and may continue to be directed to the development and commercialization of such devices even though such devices will not likely be commercialized for several years, if ever.  In addition, we cannot be sure that these parties will agree with our interpretation of the terms of the agreements, that the agreements will provide us with marketable products in the future or that we will receive payments for any of the products developed under the agreements.  During the terms of the agreements, Procter & Gamble and Johnson & Johnson have the ability to choose not to continue and may terminate the agreements.  If either Procter & Gamble or Johnson & Johnson should terminate their agreements with us, we will not receive certain payments, and the price of our common stock could fall significantly.  In that event, we may proceed to develop and commercialize the devices on our own or with a third party.  However, there can be no assurance that we will be able to successfully implement such a strategy.  In addition, after commercialization of such devices, Procter & Gamble and Johnson & Johnson are to pay us a percentage of net sales of such devices. Certain of these percentages of net sales are only owed if the devices are covered by valid patents.  There can be no assurance that valid patents will cover the devices in any or all countries, in which the devices will be manufactured, used or sold.  This could have a material adverse effect on our business, results of operations and financial condition. 

The expense and potential unavailability of liability insurance coverage for our customers could adversely affect our ability to sell our products and our financial condition.

        Some of our customers and prospective customers have had difficulty in procuring or maintaining liability insurance to cover their operation and use of our products. Medical malpractice carriers are withdrawing coverage in some states or substantially increasing premiums. If this trend continues or worsens, our customers may discontinue using our products, and potential customers may elect not to purchase laser and other light-based products.

The reduced availability of consumer financing could have a material adverse effect on our results of operations.

        Prior to selling to a new customer, we require proof of financing. Availability of financing is dependent on the lending practices of financial institutions, financial markets, governmental policies, and economic conditions, all of which are largely beyond our control. The reduced availability of financing from third party lenders for our customers could affect our sales volume and have a material adverse effect on our results of operations.

We may be unable to attract and retain key executives and research and development personnel that we need to succeed.

         As a small company with approximately 250 employees, our success depends on the services of key employees in executive and research and development positions. The loss of the services of one or more of these employees could have a material adverse effect on our business.  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.

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.

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        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. Furthermore, in the event that any of our products prove to be defectively designed and manufactured, we may be required to recall and redesign such products. 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 face risks associated with product warranties.              

        We could incur substantial costs as a result of product failures for which we are responsible under warranty obligations.

Because we derive a significant amount of our revenue from international sales, we are susceptible to currency fluctuations, long payment cycles, credit risks and other risks associated with conducting business overseas.

         We sell a significant amount of our products and services outside the U.S.  International product revenue, consisting of sales from our distributors in Japan, Europe, Australia, AsiaPacific Rim and South and Central America and sales shipped directly to international locations from the United States, and we expect that international sales will continue to be significant.  As a result, a major part of our revenues and operating results could be adversely affected by risks associated with international sales, including but not limited to political and economic instability and difficulties in managing our foreign operations.  In particular, longer payment cycles common in foreign markets, credit risk and delays in obtaining necessary import or foreign certification or regulatory approvals for products may occur.  In addition, significant fluctuations in the exchange rates between the U.S. dollar and foreign currencies could cause us to lower our prices and thus reduce our profitability, or could cause prospective customers to push out orders to later dates because of the increased relative cost of our products in the aftermath of a currency devaluation or currency fluctuation.

We may not be able to sustain or increase profitability and we may seek additional financing to grow the business.

        Although we have generated a profit in recent years, we have a history of losses. We may not be able to sustain or increase profitability on a quarterly or annual basis. If our operating results fall below the expectations of investors or public market analysts, the price of our common stock could decline.

        We may determine, depending upon the opportunities available, to seek additional debt or equity financing to fund the costs of expansion.  Additionally, if we incur indebtedness to fund increased levels of accounts receivable, finance the acquisition of capital equipment, or if we issue debt securities in connection with any acquisition we will be subject to risks associated with incurring substantial additional indebtedness.

The liquidity of our investments may decrease.

        As of December 31, 2007, we held approximately $41.9 million of auction-rate securities. Recently, there have been disruptions in the market for auction-rate securities. All of our securities held as of December 31, 2007 succeeded in at least the first auction subsequent to December 31, 2007. During 2008, we have had some auctions fail. In the event that we are unable to sell the underlying securities at or above our carrying value, these securities may not provide us a liquid source of cash in the future.

Our common stock could be further diluted by the conversion of outstanding options and warrants.

        In the past, we have issued and still have outstanding convertible securities in the form of options and warrants.  We may continue to issue options, warrants and other equity rights as compensation for services and incentive compensation for our employees, directors and consultants or others who provide services to us. We have a substantial number of shares of common stock reserved for issuance upon the conversion and exercise of these securities. Such a conversion would dilute our stockholders and could adversely affect the market price of our common stock.

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Our charter documents, Delaware law and our shareholder rights plan may discourage potential takeover attempts.

         Our Second Restated Certificate of Incorporation and our By-laws contain provisions that could discourage takeover attempts or make more difficult the acquisition of a substantial block of our common stock. Our By-laws require a stockholder to provide to our Secretary advance notice of director nominations and business to be brought by such stockholder before any annual or special meeting of stockholders, as well as certain information regarding such nomination and/or business, the stockholder and others known to support such proposal and any material interest they may have in the proposed business. They also provide that a special meeting of stockholders may be called only by the affirmative vote of a majority of the board of directors. These provisions could delay any stockholder actions that are favored by the holders of a majority of our outstanding stock until the next stockholders’ meeting. In addition, the board of directors is authorized to issue shares of our common stock and preferred stock that, if issued, could dilute and adversely affect various rights of the holders of common stock and, in addition, could be used to discourage an unsolicited attempt to acquire control of us.

        We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person becomes an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 may limit the ability of stockholders to approve a transaction that they may deem to be in their best interests. These provisions of our Second Restated Certificate of Incorporation, By-laws and the Delaware General Corporation Law could deter certain takeovers or tender offers or could delay or prevent certain changes in control or our management, including transactions in which stockholders might otherwise receive a premium for their shares over the then current market price.

        In April 1999, we adopted a shareholder rights plan or “poison pill.” This is intended to protect shareholders from unfair or coercive takeover practices. 

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. 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.

Our stock price may be volatile.

        Our 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 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 foreign countries;

the recruitment or departure of key personnel;

variations in our financial results or those of companies that are perceived to be similar to us;

market conditions in our industry and issuance of new or changed securities analyst’s reports or recommendations; and

general economic, industry and market conditions.

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        As of March 4, 2008, we had 3,115 holders of record of common stock. This does not include holdings in street or nominee names.

        We have not paid dividends to our common stockholders since our inception and do not plan to pay dividends to our common stockholders in the foreseeable future. We intend to retain substantially all earnings to finance our operations. On August 13, 2007, we announced the approval of a stock repurchase program under which our management is authorized to repurchase up to one million shares of our common stock. As of December 31, 2007, we repurchased 105,000 shares of common stock at an average price of $28.73. We did not repurchase any of our common stock during the fourth quarter of 2007. We may buy back additional shares of our common stock on the open market from time to time.

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Performance Graph

        The following graph compares our cumulative total stockholder return (Common Stock price appreciation plus dividends, on a reinvested basis) over the last five fiscal years with the NASDAQ Stock Market Total Return Index and the NASDAQ Medical Devices Stocks Index.

Comparison of Five Year Cumulative Total Return *
Palomar Medical Technologies, Inc., NASDAQ Stock
Market Total Return, and NASDAQ Medical Devices Stocks

* Hypothetical $100 invested on December 31, 2002 in Palomar Medical Technologies, Inc. Stock, NASDAQ Stock Market Total Return Index, and NASDAQ Medical Devices Stock Index, assuming reinvestment of dividends, if any.

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         These risks and uncertainties are beyond our control and, in many cases; we cannot predict the risks and uncertainties that could cause our actual results to differ materially from those indicated by the forward-looking statements. When used in this document, the words “assumptions,” “believes,” “plans,” “expects,” “anticipates,” “intends,” “continue,” “may,” “will,” “could,” “should,” “future,” “potential,” “estimate,” or the negative of such terms and similar expressions as they relate to us or our management are intended to identify forward-looking statements. We undertake no obligation to release publicly the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

         The following discussion should be read in conjunction with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 8 of this Annual Report. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

Critical accounting policies

        Our policies are more fully described in Note 1 of Notes to our Consolidated Financial Statements. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments.

         Revenue Recognition.   We recognize revenue in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104). SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) is based on management’s judgments regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of those fees. Should changes in conditions cause management to determine that these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. We recognize product revenues upon shipment. If a product sale does not meet all of the above criteria, the revenue from the sale is deferred until all criteria are met. Provisions are made at the time of revenue recognition for any applicable warranty costs expected to be incurred.

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        Periodically, we sell products together with a product upgrade option that requires that the customer pay an upgrade fee at the time of exercise, has no refund provisions and includes an expiration date on the upgrade option. In accordance with Emerging Issues Task Force Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple Deliverables, we defer the fair value ascribed to the upgrade option until the expiration of the upgrade option or the exercise of the upgrade option and shipment of the product upgrade.

        Revenues from the sale of service contracts is deferred and recognized on a straight-line basis over the life of the service contract. Revenues from services administered by us that are not covered by a service contract are recognized as the services are provided. In certain instances, we sell products together with service contracts. We recognize revenue on such multiple-element arrangements in accordance with SAB 104 and EITF 00-21, based on the relative fair market value of each element.

        We generally recognize royalty revenue from licensees upon receipt of cash payments since the royalty amounts are not determinable at the end of a quarter. Licensees are obligated to make payments between 30 and 45 days after the end of each quarter. If at the end of a quarter royalty revenue from licensees are determinable, we record royalty revenue during the period earned. Periodically, as we sign on new licensees, we recognize back-owed royalties in the period in which it is determinable and earned. We have the right under our license agreements to engage independent auditors to review the royalty calculations. The amounts owed as a result of these audits may be higher or lower than previously recognized.

        We have funded product development revenue from the development agreements with Gillette, Johnson & Johnson and the United States Department of the Army. For both Gillette and Johnson & Johnson, we have received payments in accordance with the work plans that were developed with both Gillette and Johnson & Johnson. Revenue is recognized under the contracts as costs are incurred and services are rendered. Any amounts received in advance of costs incurred and services rendered are recorded as deferred revenue. Payments are not refundable if the development is not successful.

        We provide services under a $3.8 million research contract with the United States Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs are incurred and the services are rendered. Our revenue from the contract is subject to government audit.

         Accounts Receivable Reserves. Allowances for doubtful accounts are based on estimates of losses related to customer receivable balances. In establishing the appropriate provisions for customer receivable balances, we make assumptions with respect to their future collectibility. Our assumptions are based on an individual assessment of a customer’s credit quality as well as subjective factors and trends, including the aging of receivable balances. Generally, these individual credit assessments occur prior to the inception of the credit exposure and at regular reviews during the life of the exposure and consider (a) a customer’s ability to meet and sustain their financial commitments; (b) a customer’s current and projected financial condition; (c) the positive or negative effects of the current and projected industry outlook; and (d) the economy in general. Once we consider all of these factors, a determination is made as to the probability of default. An appropriate provision is made, which takes into account the severity of the likely loss on the outstanding receivable balance based on our experience in collecting these amounts. Our level of reserves for our customer accounts receivable fluctuates depending upon all of the factors mentioned above. We provide a general reserve for doubtful accounts based on the aging of our accounts receivable balances, historical experiences of write-offs and defaults.

        We also record a provision for estimated sales returns and allowances on product and service related sales in the same period as the related revenues are recorded. These estimates are based on the specific facts and circumstances of particular orders, analysis of credit memo data, and other known factors. If the data we use to calculate these estimates do not properly reflect reserve requirements, then a change in the allowances would be made in the period in which such a determination is made and revenues in that period could be adversely affected.

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         Inventory Reserves. As a designer and manufacturer of high technology equipment, we may be exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited to, technological changes in our markets, our ability to meet changing customer requirements, competitive pressures in products and prices, reliability and replacement of and the availability of key components from our suppliers. Our policy is to establish inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon our assumptions about future demand for our products and market conditions. Included in our inventory are demonstration products that are used by our sales organization. We account for such products as we do with any other finished goods item in our inventory in accordance with the review of our entire inventory. We regularly evaluate our ability to realize the value of our 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 our 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, we would be required to recognize such as cost of goods sold at the time of such determination. Although we perform a detailed review of our forecasts of future product demand, any significant unanticipated changes in demand could have a significant impact on the value of our inventory and our reported operating results. Additionally, purchasing requirements and alternative usage avenues are explored within these processes to mitigate inventory exposure. When recorded, our reserves are intended to reduce the carrying value of our inventory to its net realizable value.

         Warranty Provision. We typically offer a one-year warranty for all of our base products. We provide for the estimated cost of product warranties at the time product revenue is recognized. Factors that affect our warranty reserves include the number of units sold, historical and anticipated rates of warranty repairs and the cost per repair. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our estimated warranty obligation is affected by ongoing product failure rates, specific product class failures outside of our baseline experience, material usage and service delivery costs incurred in correcting a product failure. If actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Assumptions and historical warranty experience are evaluated to determine the appropriateness of such assumptions. We assess the adequacy of the warranty provision and we may adjust this provision if necessary.

         Stock-Based Compensation. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R). SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employee s (APB 25), and amends SFAS No. 95, Statement of Cash Flows . Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires share-based payments to employees, including grants of employee stock options and stock-settled stock appreciation rights (SAR), to be recognized in the income statement based on their fair values at the date of grant. Pro forma disclosure is no longer an alternative.

        On January 1, 2006, we adopted SFAS 123(R) using the modified prospective method as permitted under SFAS 123(R). Under this transition method, compensation cost recognized in 2006 includes compensation cost for all share-based payments granted prior to but not yet vested as of December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123. In accordance with the modified prospective method of adoption, our results of operations and financial position for prior periods have not been restated.

        As permitted under SFAS 123 and SFAS 123(R), we use the Black-Scholes option pricing model to estimate the fair value of stock option and SAR grants. Key input assumptions used to estimate the fair value of stock options and SARs include the exercise price of the award, the expected option term, the expected volatility of our stock over the option or SAR’s expected term, the risk-free interest rate over the option or SAR’s expected term and our expected annual dividend yield. Expected volatilities are based on historical volatilities of our common stock and other factors; the expected life represents the weighted average period of time that options or SARs granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option or SAR. Our assumed dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends.

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        If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods, or if we decide to use a different valuation model, the stock-based compensation expense we recognize in future periods may differ significantly from what we have recorded in the current period and could materially affect our income from operations, net income, and earnings per share. It may also result in a lack of comparability with other companies that use different models, methods, and assumptions. 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. These characteristics are not present in our option and SAR grants. Existing valuation models, including the Black-Scholes model, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options and SARs, may expire with little or no intrinsic value compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, the value realized from these instruments may be significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. The guidance in SFAS 123(R) is relatively new and the application of these principles may be subject to further interpretation and refinement over time.

        Prior to December 31, 2005, we followed the provisions of SFAS  123, “Accounting for Stock-Based Compensation”. The provisions of SFAS 123 allowed companies to either expense the estimated fair value of stock options or to continue to follow the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), but disclose the pro forma effects on net income had the fair value of the options been expensed. We elected to apply APB 25 in accounting for our stock option incentive plans.

        In accordance with APB 25 and related interpretations, compensation expense for stock options was recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to employees was equal to the fair market value of our common stock at the date of grant, thereby resulting in no recognition of compensation expense by us prior to December 31, 2005.

         Income taxes. We record deferred tax assets and liabilities based on the net tax effects of tax credits, operating loss carryforwards and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

        We regularly review deferred tax assets for recoverability taking into consideration such factors as historical losses, projected future taxable income and the expected timing of the reversals of existing temporary differences. SFAS No. 109, “Accounting for Income Taxes”, requires us to maintain a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. For 2006, we removed the valuation allowance related to deferred tax assets based on the conclusion that there was sufficient positive evidence to support that it was more likely than not that the deferred tax asset would be realized. This resulted in a non-cash, $7.6 million tax benefit recorded through our 2006 provision for income taxes.

        In addition to the tax assets described above, we have deferred tax assets totaling $20.5 million, resulting from the exercise of employee stock options. In accordance with SFAS  109 and SFAS 123(R), recognition of these assets would occur upon utilization of these deferred tax assets to reduce taxes payable and would result in a credit to additional paid-in capital within stockholders’ equity rather than the provision for income taxes. For 2007, 2006 and 2005 the impact to paid-in capital resulting from the exercise of employee stock options was $4.8 million, $1.2 million and $180,000, respectively.

        In evaluating the potential exposure associated with the various tax filing positions, we accrue charges for possible exposures. Based on the annual evaluations of tax positions, we believe we have appropriately filed our tax returns and accrued for possible exposures. To the extent we were to prevail in matters for which accruals have been established or be required to pay amounts in excess of reserves, our effective tax rate in a given financial period might be materially impacted.

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Overview

        We are engaged in research, development, manufacturing and distribution of proprietary light-based systems for hair removal and other cosmetic treatments. Since our inception, we have been able to develop a differentiated product mix of light-based systems for cosmetic treatments through our research and development as well as with our partnerships throughout the world. We are continually developing and testing new indications to further the advancement in cosmetic light-based treatments.

        During 2007, we continued to strengthen our presence in the international market. Part of our strategy was to establish a subsidiary in The Netherlands which markets our products in Europe, Middle East, and Africa as well as provides certain services of our products for those regions. As a result of this new subsidiary and other initiatives, we were able to increase our product sales outside of North America to 29% of product revenues as compared to 19% in 2006.

        Our total revenues for the year ended December 31, 2007, decreased by 2% as compared to the same period in 2006. This decrease was driven by a decline in royalty revenues as we received one-time back-owed royalties of approximately $26.3 million in 2006 as compared to $3.1 million in 2007. Offsetting the decrease in royalty revenues, product revenues increased by 12% and funded product development revenues increased by 74% as compared to the same period in 2006.

        Although we considered 2007 to be a very challenging year, we were able to strengthen our balance sheet. Our cash and investment position increased by 27% and stockholders’ equity grew by 24%. Our current ratio is now 8.2x, up from 6.0x at the end of 2006.

        Sales from our Lux family of products remained strong throughout 2007. The Lux line of products consists of the StarLux Laser and Pulsed Light System, the MediLux™ and the EsteLux® Pulsed Light Systems, including a base unit and multiple, optional handpieces. The Lux family of products contains some of the most versatile systems in the market today. The investments that we made in the past into new technologies have paid off as the demand for our Lux family continued to increase in 2007.

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Results of operations

Year 2007 Compared to Year 2006

        The following table contains selected income statement information, which serves as the basis of the discussion of our results of operations for the years ended December 31, 2007 and 2006, respectively (in thousands, except for percentages):

         Product revenues . Sales of our StarLux Laser and Pulsed Light Systems, including a base unit and multiple, optional handpieces were the leading contributor to our increase in product revenues. Product revenues were favorably impacted by an increase of 15% in sales related to the StarLux Laser and Pulsed Light System and an increase of 52% in revenue related to customer service, offset by a decrease of 51% related to the other “Lux” family of products, which includes the MediLux and EsteLux, and a decrease of 8% from sales related to the Q-Yag 5 product line as compared to the same period in 2006. StarLux product sales increased as more customers opted for the higher powered, faster and more versatile StarLux systems and related handpieces that are capable of utilizing both laser and lamp-based applications to treat various cosmetic conditions. The decline in revenues from other Lux products was directly attributable to the customer acceptance of the StarLux product line and its additional laser and light-based handpieces.

        International product revenue, consisting of revenue from our distributors in Japan, Europe, Australia, AsiaPacific Rim and South and Central America and our sales shipped directly to international customers, was 29% of total product revenue for the year ended 2007 in comparison to 19% for the same period in 2006.

         Royalty revenues. Royalty revenues decreased during 2007 in comparison to the same period in 2006, mainly due to the $26.3 million in back-owed royalties received in 2006 versus the $3.1 million received in 2007. Excluding back-owed royalties in both periods, royalty revenues increased by 139%. This increase is attributed to the execution of new patent license agreements with Cutera and Cynosure in the second and fourth quarters of 2006, respectively, and Alma in the second quarter of 2007.

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         On April 2, 2007, we announced the resolution of our patent infringement and trade dress lawsuit against Alma Lasers, Inc. through the execution of a Settlement Agreement, a Non-Exclusive Patent License Agreement and a Trade Dress Settlement Agreement. Under the Patent License Agreement, we granted Alma a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the professional field, excluding the consumer field. Alma admitted that their products infringe these patents and that these patents are valid and enforceable. In addition, Alma agreed not to challenge the infringement, validity and enforceability of these patents in the future. Alma will pay for royalties and interest due on past sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2003 and a trade dress fee plus interest on past sales of their Harmony and Aria systems. The amounts due to us are being determined based on an audit by an independent accounting firm. We have begun to recognize royalty revenue as the amounts become determinable. Under our license agreement with the Massachusetts General Hospital, we pay to the Massachusetts General Hospital 40% of all patent royalty and interest thereof from Alma. Starting on March 30, 2007, Alma began paying us royalties on sales of its existing and any new light-based hair removal systems later developed. For the year ended December 31, 2007, we recognized $3.1 million for back-owed royalties from Alma.

        On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement. Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing license to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the professional field, excluding the consumer field. Cutera admitted that their products infringe the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications and that these patents are valid and enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability of the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the future. Cutera paid us $22 million as an estimated payment for royalties due on past sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2000 through March 31, 2006, interest and reimbursement of our legal costs. Cutera subsequently informed us that they believed the actual liability for past royalties, interest and legal costs was $19.6 million, versus the actual payment of $22 million. We recorded the difference of $2.4 million as deferred revenue at June 30, 2006 to be applied against future amounts owed, which was fully recognized as royalty revenue as of December 31, 2006. The final amounts due were subject to audit by an independent accounting firm which was completed during the fourth quarter of 2006, resulting in an additional $648,000 of royalty and interest. Starting on April 1, 2006, Cutera began paying us royalties on sales of its existing and any new light-based hair removal systems later developed. For the year ended December 31, 2006, we recognized $14.2 million for back-owed royalties from Cutera.

         On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with Laserscope and terminated our prior license agreement with them. Under the new license agreement, Laserscope pays us a royalty on sales of its current light-based hair removal products, including the Lyra and Gemini Laser Systems and the Solis IPL System, as well as on sales of new light-based hair removal systems developed in the future. As a result of a royalty audit of Laserscope’s product sales from January 1, 2001 through June 30, 2006, there was an increase in the third quarter 2006 royalty revenue of $2.2 million for back-owed royalties. For the year ended December 31, 2006, we recognized $2.2 million for back-owed royalties from Laserscope. American Medical Systems Holdings, Inc. acquired Laserscope in July of 2006 and subsequently sold the assets of Laserscope’s aesthetic division to Iridex Corporation, effective in the first quarter of 2007. As a result, the license agreement between Palomar and Laserscope has been assigned to Iridex. Iridex has assumed all of Laserscope’s rights and obligations under the license agreement.

         On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement with Cynosure, Inc. Under this Agreement, we granted to Cynosure a non-exclusive, royalty bearing license to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications. In return, Cynosure granted us a non-royalty bearing (fully paid-up), non-exclusive license to eight Cynosure patents and patent applications, including counterparts. Cynosure also paid us $10 million on November 7, 2006 as royalties on sales of their laser and lamp-based hair removal systems made before October 1, 2006. Starting on October 1, 2006, Cynosure began paying us royalties on sales of its existing and any new light-based hair removal systems later developed. For the year ended December 31, 2006, we recognized $10 million of back-owed royalty revenue from Cynosure.

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         Funded product development revenues. Funded development revenue increased during 2007 as compared to the same period in 2006. Funded product development revenue is generated from the development agreements with Gillette, Johnson & Johnson, and the United States Department of the Army.

         During 2007, we recognized approximately $3.8 million and $2.5 million of funded product development revenue from Gillette and Johnson & Johnson, respectively. During 2006, we recognized approximately $1.1 million and $1.5 million of funded product development revenue from Gillette and Johnson & Johnson, respectively. The increase in funded product development revenue from Gillette during 2007 was the result of the $2.5 million go decision payment following FDA OTC clearance in December 2006 which was recognized throughout 2007 as we were obligated to perform additional services and remain exclusive with Gillette during that period in consideration for this payment. The increase was also attributable to the $1.2 million amendment in February 2007 which was recognized throughout the remainder of 2007 as costs were incurred and services were provided.

        During 2007 and 2006, we recognized approximately $390,000 and $1.3 million, respectively, of funded product development revenues from the United States Department of the Army. We provide services under a $3.8 million research contract with the United States Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs are incurred and the services are rendered.

         Other revenues. Other revenues of $894,000 during the year ended December 31, 2007 were related to the recognition of a portion of the trade dress infringement associated with the settlement of our lawsuit with Alma.

         Cost of product revenues. The cost of product revenues increased both in absolute dollars and as a percentage of product revenue to 32% in 2007 from 29% in 2006. The increase was attributed to a shift in product sales to outside North America where we sell our products at fixed transfer prices and by a shift in product mix to the higher priced StarLux 500 Laser and Pulsed Light System and additional handpieces, offset by a $1.7 million reduction related to royalties due to Massachusetts General Hospital after finalizing licensing negotiations. Additionally, in 2006, cost of product revenues included a net decrease as a result of a $762,000 non-recurring adjustment made to product royalties offset by the write-off of certain customer service loaner inventory of $145,000.

         Cost of royalty revenues . As a percentage of royalty revenues, the cost of royalty revenues was consistent at 40% in accordance with our license agreement with Massachusetts General Hospital for the years ended December 31, 2007 and 2006. The decrease in the cost of royalty revenues in absolute dollars during 2007 as compared to 2006 is attributed to the decrease in royalty revenue recognized from our licensees, mainly due to the change in back-owed royalties received in 2006 as compared to 2007.

         Research and development expense. The increase in research and development expense is a direct result of our spending related to the Johnson & Johnson and Gillette agreements and our continued commitment to introducing new platforms and enhancing our current family of products, offset by reduced expenses related to the research contract with the United States Department of the Army in 2007.

        For our research and development agreement with Gillette, costs related to payroll and payroll related expenses increased by $404,000, material costs increased by $228,000 and other clinical, consulting and overhead expenses increased by $165,000 as compared to the same period in 2006.

        For our joint development agreement with Johnson & Johnson costs related to payroll and payroll related expenses increased by $159,000, material costs increased by $544,000, and other clinical, consulting and overhead expenses decreased by $26,000 as compared to the same period in 2006.

        For our research agreement with the United States Department of the Army, costs related to payroll and payroll related expenses decreased by $544,000, material costs decreased by $176,000 and other clinical, consulting and overhead expenses decreased by $97,000 as compared to the same period in 2006.

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        Expenses relating to the introduction of new products, enhancements made to our current family of products and research and development overhead increased by $2.0 million in comparison to the same period in 2006. This increase is attributed to increases in payroll and payroll related expenses, material costs, other clinical, consulting and overhead expenses.

         Selling and marketing expense. The increase in selling and marketing expense is primarily comprised of $780,000 from payroll and payroll related expenses, $657,000 from tradeshows and workshops, $324,000 from consultants, and approximately $600,000 relating to other sales and marketing costs in comparison to the same period in 2006. Included in these increases are expenses of approximately $824,000 related to our new subsidiary in Amsterdam, The Netherlands which markets our products in Europe, Middle East, and Africa.

         General and administrative expense. The increase in general and administrative expense is mainly attributed to increases in our corporate legal expenses of $5.1 million which excludes a $3.8 million reimbursement (net of payments owed to the Massachusetts General Hospital) from Cutera in 2006, offset by a $227,000 reimbursement (net of payments owed to the Massachusetts General Hospital) from Alma in 2007. The remaining increase is primarily comprised of $1.2 million from bad debt expense, $356,000 from payroll and payroll related expenses and $1.0 million from other costs offset by a decrease to incentive compensation of $1.3 million related to our 2007 incentive compensation plan as compared to the same period in 2006.

         Interest income. In comparison to the same period in 2006, interest income increased due to the growth in our cash balances and $259,000 (net of payments owed to the Massachusetts General Hospital) received related to back-owed royalties from a new patent license agreement in 2007, offset by $1.2 million (net of payments owed to the Massachusetts General Hospital) received related to back-owed royalties in 2006.

         Other income. Other income for the year ended December 31, 2007 includes $500,000 cash received related to the expiration of a standstill agreement and the foreign exchange gain (loss) as a result of transactions in currencies other than the U.S. dollar.

         Provision (benefit) for income taxes . The income tax provision for the year ended December 31, 2007 was 38% as compared to an income tax benefit of 10% for the year ended December 31, 2006. In 2007, our effective tax rate was less than the combined federal and state statutory rates because of the benefit of research and development credits generated. In the fourth quarter of 2006, based on current and preceding years’ results of operations and anticipated profit levels in future periods, we believed that it was more likely than not that our deferred tax assets would be realized in the future and, accordingly, that it was appropriate to release the valuation allowance recorded against those deferred tax assets. In reaching this conclusion, we weighed both negative and positive evidence regarding the realizability of these deferred tax assets and considered the extent to which the evidence could be objectively verified.

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         Product revenues . Sales of our StarLux Laser and Pulsed Light Systems, including a base unit and multiple, optional handpieces were the leading contributor to our increase in product revenues. Product revenues were favorably impacted by an increase of 59% in sales related to the StarLux Laser and Pulsed Light System and an increase of 49% in revenue related to customer service, offset by a decrease of 44% related to the other “Lux” family of products, which includes the MediLux and EsteLux, and a decrease of 40% from sales related to the Q-Yag 5 product line as compared to the same period in 2005. StarLux product sales increased as more customers opted for the higher powered, faster and more versatile StarLux systems that are capable of utilizing both laser and lamp-based applications to treat various cosmetic conditions. Customer service revenue increased as an increased number of customers purchased replacement handpieces. The decline in revenues from other Lux products was directly attributable to the customer acceptance of the StarLux product line and its additional laser and light-based handpieces.

        International product revenue, consisting of revenue from our distributors in Japan, Europe, Australia, AsiaPacific Rim and South and Central America and our sales shipped directly to international customers was 19% of total product revenue for the year ended 2006 in comparison to 23% for the same period in 2005. While international product sales increased in absolute dollars in 2006 compared to 2005, they declined as a percentage of revenues due to the much larger increase in domestic product sales.

         Royalty revenues. Royalty revenues increased during 2006 in comparison to the same period in 2005. This increase is attributed to the execution of a new patent license agreement with Cynosure, a royalty audit of Laserscope providing back-owed royalties from Laserscope’s product sales from January 1, 2001 through June 30, 2006 and the settlement of our patent infringement lawsuits against Cutera, offset by Lumenis making its final installment for back-owed royalties during the fourth quarter in 2005.

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        For the year ended December 31, 2005, we recognized $2.2 million for back-owed royalties from Lumenis, respectively.

         On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement. Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing license to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the professional field, excluding the consumer field. Cutera admitted that their products infringe the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications and that these patents are valid and enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability of the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the future. Cutera paid us $22 million as an estimated payment for royalties due on past sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2000 through March 31, 2006, interest and reimbursement of our legal costs. Cutera subsequently informed us that they believed the actual liability for past royalties, interest and legal costs was $19.6 million, versus the actual payment of $22 million. We recorded the difference of $2.4 million as deferred revenue at June 30, 2006 to be applied against future amounts owed, which was fully recognized as royalty revenue as of December 31, 2006. The final amounts due were subject to audit by an independent accounting firm which was completed during the fourth quarter of 2006, resulting in an additional $648,000 of royalty and interest. Starting on April 1, 2006, Cutera began paying us royalties on sales of its existing light-based hair removal systems, and Cutera will pay us royalties on sales of its later developed light-based hair removal systems. For the year ended December 31, 2006, we recognized $14.2 million for back-owed royalties from Cutera.

        On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with Laserscope and terminated our prior license agreement with them. Under the new license agreement, Laserscope pays us a royalty on sales of its current light-based hair removal products, including the Lyra and Gemini Laser Systems and the Solis IPL System, as well as on sales of new light-based hair removal systems developed in the future. As a result of a royalty audit of Laserscope’s product sales from January 1, 2001 through June 30, 2006, there was an increase in the third quarter 2006 royalty revenue of $2.2 million for back-owed royalties. For the years ended December 31, 2006, we recognized $2.2 million for back-owed royalties from Laserscope. American Medical Systems Holdings, Inc. acquired Laserscope in July of 2006 and subsequently sold the assets of Laserscope’s aesthetic division to Iridex Corporation, effective in the first quarter of 2007. As a result, the license agreement between Palomar and Laserscope has been assigned to Iridex. Iridex has assumed all of Laserscope’s rights and obligations under the license agreement.

        On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement with Cynosure, Inc. Under this Agreement, we granted to Cynosure a non-exclusive, royalty bearing license to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications and foreign counterparts. In return, Cynosure granted us a non-royalty bearing (fully paid-up), non-exclusive license to eight Cynosure patents and patent applications, including counterparts. Cynosure also paid us $10 million on November 7, 2006 as royalties on sales of their laser and lamp-based hair removal systems made before October 1, 2006. Starting on October 1, 2006, Cynosure began paying us royalties on sales of its light-based hair removal systems as well as future developed hair removal systems. For the year ended December 31, 2006, we recognized $10 million of back-owed royalty revenue from Cynosure.

         Funded product development revenues. Funded development revenue decreased during 2006 as compared to the same period in 2005. Funded product development revenue is generated from the development agreements with Gillette, Johnson & Johnson and the United States Department of the Army.

        During 2006, we recognized approximately $1.1 million and $1.5 million of funded product development revenue from Gillette and Johnson & Johnson, respectively. During 2005, we recognized approximately $2.8 million and $1.6 million of funded product development revenue from Gillette and Johnson & Johnson, respectively. The decrease in funded product development from Gillette during 2006 was the result of the completion of the development phase under the agreement that culminated with FDA clearance in December 2006. Upon FDA clearance, Gillette made a $2.5 million payment in December 2006, which will be recorded as revenue over a 12 month period, as we are obligated to perform additional services and remain exclusive to Gillette during that period in consideration for this payment.

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        During 2006 and 2005, we recognized approximately $1.3 million and $1.0 million, respectively, of funded product development revenues from the United States Department of the Army. We provide services under a $3.8 million research contract with the United States Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs are incurred and the services are rendered.

         Cost of product revenues. The cost of product revenues increased in absolute dollars, but decreased as a percentage of product revenue to 29% in 2006 from 32% in 2005. The increase in absolute dollars was attributed to a shift in product mix to the higher priced StarLux Laser and Pulsed Light System, additional handpieces and a shift in product sales to North America and by a net decrease in cost of product revenues as a result of a non-recurring adjustment made to product royalties of $762,000 offset by the write-off of certain customer service loaner inventory of $145,000.

         Cost of royalty revenues . As a percentage of royalty revenues, the cost of royalty revenues was consistent at 40% in accordance with our license agreement with Massachusetts General Hospital for each period in comparison to the same periods in 2005. The increase in the cost of royalty revenues in absolute dollars during 2006 as compared to 2005 are attributed to the increase in royalty revenue recognized from our licensees.

         Research and development expense. The increase in research and development expense is a direct result of our spending related to the Johnson & Johnson agreement and the research contract with the United States Department of the Army and our continued commitment to introducing new platforms and enhancing our current family of products, offset by a decrease in spending under the Gillette agreement in 2006.

        For our research and development agreement with Gillette, costs related to payroll and payroll related expenses decreased by $698,000, material costs decreased by $484,000 and other clinical, consulting and overhead expenses decreased by $857,000 as compared to the same period in 2005.

        For our research agreement with the United States Department of the Army, costs related to payroll and payroll related expenses increased by $69,000, material costs increased by $72,000 and other clinical, consulting and overhead expenses increased by $81,000 as compared to the same period in 2005.

        For our joint development agreement with Johnson & Johnson, costs related to payroll and payroll related expenses increased by $40,000 and material costs, other clinical, consulting and overhead expenses increased by $314,000 as compared to the same period in 2005.

        Expenses relating to the introduction of new products, enhancements made to our current family of products and research and development overhead increased by $4.2 million in comparison to the same period in 2005. This increase is attributed to increases in payroll and payroll related expenses, material costs, other clinical, consulting and overhead expenses.

         Selling and marketing expense. The increase in selling and marketing expense is primarily comprised of $1.8 million from payroll and payroll related expenses, approximately $1.5 million relating to tradeshows, consultants and other sales and marketing costs, $160,000 related to the write-off of certain demo inventory and by an increase of approximately $1.6 million relating to commission expense in comparison to the same period in 2005. Domestic commission increased by approximately $2.0 million correlating with our increased domestic product revenue offset by a decrease of $452,000 in commissions related to European and Far East commissions.

         General and administrative expense. The decrease in general and administrative expense is mainly attributed to decreases in our corporate legal expenses of $3.0 million and other costs of approximately $1.2 million offset by increases to incentive compensation of $2.3 million related to our incentive compensation plan of 2006, an increase in payroll and payroll related expenses of $711,000, and an increase in bad debt expense of $872,000 as compared to the same period in 2005. This decrease in legal costs is mainly attributed to the settlement of our patent infringement lawsuits against Cutera where Cutera reimbursed us approximately $3.8 million (net of payments owed to the Massachusetts General Hospital) for legal expenses incurred in connection with the patent infringement lawsuits.

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         Interest income. Interest income increased due to the increase in cash balances and the settlement of our patent infringement lawsuits against Cutera where Cutera paid us approximately $1.2 million (net of what was paid to the Massachusetts General Hospital) in interest in comparison to the same period in 2005.

         Provision (benefit) for income taxes . The income tax benefit for fiscal year 2006 was approximately $5.0 million, which consisted of a $7.6 million non-cash federal and state valuation allowance release offset by federal and state income taxes of approximately $2.6 million. Based on current and preceding years’ results of operations and anticipated profit levels in future periods, we believe that it is more likely than not that our deferred tax assets will be realized in the future and, accordingly, that it was appropriate to release the valuation allowance recorded against those deferred tax assets. In reaching this conclusion, we weighed both negative and positive evidence regarding the realizability of these deferred tax assets and considered the extent to which the evidence could be objectively verified.

        During 2005, we provided approximately a 3% effective tax rate for anticipated federal alternative minimum taxes and minimum state income taxes due for 2005.

Liquidity and capital resources

        The following table sets forth, for the periods indicated, a year-over-year comparison of key components of our liquidity and capital resources (in thousands):

        Additionally, our cash and investment position, accounts receivable, inventories and working capital are shown below for the periods indicated (in thousands).

        As of December 31, 2007, we had $132 million in cash and cash equivalents and available-for-sale investments. We believe that our current cash balances and expected future cash flows will be sufficient to meet our anticipated cash needs for working capital, capital expenditures, and other activities for at least the next twelve months. As of December 31, 2007, we had no borrowings or debt.

        Cash provided by operating activities decreased for the twelve months ended December 31, 2007 compared to the same period in 2006. This decrease primarily reflects the effects of a decrease in net profit, offset by a decrease in working capital requirements. Cash from (used in) investing activities increased during 2007 compared to the same period in 2006. These amounts primarily reflect cash used for purchases of property and equipment, purchases of available-for-sale investments offset by proceeds from the sale of available-for-sale investments. Cash provided by financing activities decreased for the twelve month period ended December 31, 2007 compared to the same period in 2006. This decrease was primarily due to a decrease in exercises of stock options and a buyback of treasury stock, offset by an increase in tax benefits from the exercise of stock options.

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        We anticipate that capital expenditures for 2008 will total approximately $1 million consisting primarily of leasehold improvements, machinery, equipment, computers, and peripherals. We expect to finance these expenditures with cash on hand.

        Effective as of February 14, 2003, we entered into a Development and License Agreement with Gillette to complete the development and commercialize a home-use, light-based hair removal device for women. (See Note 11 for more information.)

        In the first quarter of 2004, we began providing services under a research contract with the United States Department of the Army to develop a light-based self-treatment device for PFB. (See Note 13 for more information.)

        On June 17, 2004, we reached a settlement agreement with Lumenis resolving on-going litigation concerning both patent infringement and contractual matters. (See Note 14 for more information.)

        Effective as of September 1, 2004, we entered into a Joint Development and License Agreement with Johnson & Johnson to develop and commercialize home-use, light based devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. (See Note 12 for more information.)

        On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera, Inc. through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement. (See Note 15 for more information.)

        On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with Laserscope and terminated our prior license agreement with them. (See Note 16 for more information.)

        On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement with Cynosure, Inc. (See Note 17 for more information.)

        On April 2, 2007, we announced the resolution of our patent infringement and trade dress lawsuit against Alma Lasers, Inc. through the execution of a Settlement Agreement, a Non-Exclusive Patent License Agreement and a Trade Dress Settlement Agreement. (See Note 18 for more information.)

        On August 13, 2007, our Board of Directors approved a stock repurchase program under which our management is authorized to repurchase up to one million shares of our common stock. The timing and actual number of shares purchased will depend on a variety of factors such as price, corporate and regulatory requirements, alternative investment opportunities and other market conditions. Stock repurchases under this program, if any, will be made using our cash resources, and may be commenced or suspended at any time or from time to time at management's discretion without prior notice. During the year ended December 31, 2007, we used $3.0 million to purchase 105,000 shares of our common stock at an average price of $28.73.

Off-balance sheet arrangements

        We do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as variable interest or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2007, we were not involved in any unconsolidated transactions.

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Contractual obligations

        We are a party to license agreements, as amended, with Massachusetts General Hospital whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of certain products as well as 40% of royalties received from third parties. Royalty expense in 2007 totaled approximately $5.9 million.

        We are obligated to make future payments under various contracts, including non-cancelable inventory purchase commitments and our operating lease relating to our Burlington, Massachusetts manufacturing, research and development and administrative offices.

        On January 18, 2006, we signed an amendment to our lease to add an additional 12,000 square feet. Rent expense, including this new lease, will total approximately $1.165 million per year, expiring in August 2009.

        On July 30, 2007, we signed an amendment to our lease to add an additional 13,600 square feet. Rent expense, including this new lease, will total approximately $1.3 million per year, expiring in August 2009.

        The following table summarizes our estimated contractual cash obligations as of December 31, 2007, excluding royalty and employment obligations because they are variable and/or subject to uncertain timing (in thousands):

Recently issued accounting standards

        In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 effective January 1, 2007.

        In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157).  This Statement defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements.  SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements.  SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.  We are currently assessing the impact that SFAS 157 may have on our consolidated financial position, results of operations, and cash flows.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

        Our primary market risk exposures are in the areas of interest rate risk and foreign currency exchange risk.

         Our investment portfolio of cash equivalents and debt securities is subject to interest rate fluctuations, but we believe this risk is immaterial because of the short-term nature of these investments. At December 31, 2007, we held $41.9 million in auction-rate securities (ARS). These ARS are classified as available-for-sale securities on our consolidated balance sheets and are high quality securities. Subsequent to December 31, 2007, several of our securities failed at auction. However, all of the securities which were held on December 31, 2007 succeeded in at least the first auction subsequent to December 31, 2007. As of February 29, 2008, we held $23.5 million in ARS which failed in their last auction.

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        Our international subsidiary in The Netherlands conducts business in both local and foreign currencies and therefore, we are exposed to foreign currency exchange risk resulting from fluctuations in foreign currencies. This risk could adversely impact our results and financial condition. We believe our current exposure to fluctuations in foreign currency exchange rates is immaterial. We have not entered into any foreign currency exchange and option contracts to reduce our exposure to foreign currency exchange risk and the corresponding variability in operating results as a result of fluctuations in foreign currency exchange rates.

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See accompanying notes to consolidated financial statements.

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See accompanying notes to consolidated financial statements.

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