As filed with the Securities and Exchange Commission on June 17, 2005

Registration No. 333-114078

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

POST-EFFECTIVE AMENDMENT NO. 1
ON FORM S-1
TO
FORM S-3

REGISTRATION STATEMENT UNDER
THE SECURITIES ACT OF 1933

VITAL IMAGES, INC.

(Exact Name of Registrant as Specified in Its Charter)

Minnesota

(State or Other Jurisdiction of incorporation or organization)

7372

(Primary Standard Industrial Classification Code Number)

42-1321776

(I.R.S. Employer Identification No.)

5850 Opus Parkway, Suite 300

Minnetonka, Minnesota 55343

Telephone: (952) 487-9500

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

Michael H. Carrel

5850 Opus Parkway, Suite 300

Minnetonka, Minnesota 55343

Telephone: (952) 487-9500

Facsimile: (952) 487-9530

(Name, address, including zip code, and telephone number, including area code, of agent for service)

Copies of communications to:

Michele D. Vaillancourt, Esq.

Winthrop & Weinstine, P.A.

225 South Sixth Street, Suite 3500

Minneapolis, Minnesota 55402

Telephone: (612) 604-6400

Facsimile: (612) 604-6800

Approximate date of commencement of proposed sale to the public:

From time to time after the effective date of this Post-Effective Amendment No. 1
on Form S-1 to Form S-3 Registration Statement.

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ý

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration number of earlier effective registration statement for the same offering.   o

If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box.  o

(1)       No registration fee is required because the registration fee was paid when the Registration Statements on Form S-3, Registration Nos. 333-106328 and 333-114078, were filed.

Explanatory Note:  Pursuant to Rule 429 under the Securities Act of 1933, this is a combined registration statement which relates to the registration under the following Registration Statements on Form S-3, as amended (“Registration Statements”), of the resale of a total of 2,234,597 shares of the Registrant’s common stock: (i) the Registration Statement on Form S-3 filed by the Registrant, Registration No. 333-106328, which became effective on September 29, 2003 and was filed to register the resale by the selling shareholders named in such Registration Statement of 1,500,000 shares of the Registrant’s common stock, and (ii) the Registration Statement on Form S-3 filed by the Registrant, Registration No. 333-114078, which was filed to register the resale by the selling shareholders named in such Registration Statement of 734,597 shares of the Registrant’s common stock.  This Post-Effective Amendment No. 1 on Form S-1 to Form S-3 is being filed to convert the Registration Statements into a Registration Statement on Form S-1.

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

The information in this prospectus is not complete and may be changed.  The selling shareholders may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective.  This prospectus is not an offer to sell these securities and it is not soliciting offers to buy these securities in any state where the offer or sale is not permitted.

Prospectus

2,234,597 Shares

VITAL IMAGES, INC.

Common Stock

This prospectus is part of a registration statement of Vital Images, Inc. filed with the Securities and Exchange Commission for the resale of shares of our common stock we issued to former shareholders of HInnovation, Inc. in our acquisition of HInnovation, Inc. completed in February 2004.  As part of the acquisition, we agreed to register for resale by the selling shareholders the shares of common stock we issued or may issue in the acquisition.  We are also registering the resale of shares of our common stock sold by us to selling shareholders in our private placement completed in June 2003.  As part of the private placement, we agreed to register for resale by the selling shareholders the shares sold by us in the placement.  In addition, we are registering the resale of outstanding shares and shares subject to warrants that we issued in connection with our December 1999 private placement.  This prospectus will be used by the selling shareholders to sell up to 2,234,597 shares of our common stock.  This means:

•                  The selling shareholders may sell their shares of common stock from time to time.

•                  For information on the methods of sale of the common stock, you should refer to the section of this prospectus entitled “Plan of Distribution” beginning on page 68.

•                  Vital Images will not receive any of the proceeds from the sale of the shares by the selling shareholders.

•                  You should read this prospectus and any prospectus supplement carefully in its entirety before you invest in shares of our common stock.

•                  We have agreed with the former shareholders of HInnovation, Inc. that they will pay one-half and we will pay one-half of the fees and expenses up to and including $50,000 related to the registration and resale of their shares, and we will pay the fees and expenses in excess of $50,000.

Our common stock is currently traded on The NASDAQ National Market under the symbol “VTAL.” On                  , 2005, the last reported sale price for our common stock reported on The NASDAQ National Market was $                  per share.

Investing in our common stock involves a high degree of risk.  See “Risk Factors” beginning on page 3 for certain risks you should consider before purchasing any shares.

Neither the Securities and Exchange Commission or any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus.  Any representation to the contrary is a criminal offense.

The date of this prospectus is                               , 2005.

TABLE OF CONTENTS

We have not authorized any dealer, salesperson or other person to give any information or represent anything not contained or incorporated by reference in this prospectus.  Neither Vital Images nor the selling shareholders have authorized anyone to provide you with information that is different.  This prospectus may be used only in states where it is legal to sell these securities.  The information contained or incorporated by reference in this prospectus may be accurate only on the date of this prospectus.

PROSPECTUS SUMMARY

The following information is qualified in its entirety by the more detailed information and financial statements included in this prospectus.  This prospectus contains forward-looking statements that involve risks and uncertainties and that are qualified in their entirety by the cautions and risk factors included or incorporated by reference in this prospectus.  Purchasers of shares of common stock are cautioned that our actual results may differ significantly from the results discussed in the forward-looking statements.  Factors that could cause or contribute to such differences include those factors discussed in the prospectus under “Risk Factors.”

Vital Images, Inc.

We are a provider of enterprise-wide advanced visualization and analysis solutions for use in clinical diagnosis, disease screening applications and therapy planning.  Our technology uses high-speed volume visualization and analysis, as well as network communications based on DICOM and Internet protocols.  Vitrea® 2, or our flagship software, rapidly creates accurate, interactive 2D, 3D and 4D images from 2D information generated by standard computed tomography (“CT”), magnetic resonance (“MR”) and positron emission tomography (“PET”) scanners.  ViTALConnect™, our Web-enabled medical diagnostic tool, allows physicians anywhere, anytime access to interactive 2D, 3D and 4D advanced visualization.

Our strategy is to address the growing interest among radiologists, cardiologists, oncologists and other specialists to improve their workflow and productivity.  Our products provide clinical benefits and allow physicians to collaborate with their peers via Web and picture archiving and communications systems (“PACS”)-based solutions.  PACS enable hospitals and clinics to acquire, distribute and archive medical images and diagnostic reports, eliminating the need for film and enhancing productivity.

We offer two primary software products, Vitrea and ViTALConnect.  Vitrea is our flagship advanced visualization product for radiological and surgical applications.  Vitrea provides image clarity, processing speed, and simplicity and allows clinicians to screen for disease, diagnose less invasively, and plan treatments more accurately.  We offer several optional modules so clinicians can customize their Vitrea workstations for their specialties.  These modules include the following: 3D Angio, Automated Vessel Measurements, CT Brain Perfusion, CT Cardiac, CT Colon, Fusion7D™, ImageChecker™ CT, Lung, SoftRead, Vessel Probe, and VScore.  Vitrea 2 is offered both as a stand-alone software package and as part of an integrated software and hardware system, consisting of Vitrea 2 software installed on a computer workstation.  We licensed approximately 1,900 copies of Vitrea and Vitrea 2 to hospitals, clinics, imaging centers and other sites.

As specialists outside the radiology department increasingly rely on Vitrea as a diagnostic and communications tool, demand for access to advanced visualization is growing across the healthcare enterprise.  To address this market opportunity, we are forming strategic distribution partnerships with PACS providers and promoting the capabilities of ViTALConnect, our thin-client Web-based solution.

ViTALConnect allows physicians and other users to access 2D, 3D and 4D enterprise-wide advanced visualization capabilities, including the ability to measure, rotate, analyze and segment images, all with a personal computer using a Web-enabled browser, thus allowing access to advanced visualization from anywhere and at any time, including critical patient situations.  With ViTALConnect, users can employ a PC or notebook computer to process, analyze, review and distribute multi-dimensional medical images securely over the Web.  In addition, a collaboration mode lets several physicians in different locations confer while interacting with the same images in real time.

Our enterprise-wide advanced visualization and analysis software solutions are used with medical diagnostic equipment, primarily in clinical diagnosis, disease screening and therapy planning.  Our software

1

applies proprietary computer graphics and image processing technologies to a wide variety of data supplied by CT, MR and PET scanners to allow medical clinicians to create 2D, 3D and 4D views of human anatomy and to non-invasively navigate within these images to better visualize and understand internal structures and pathologies.  We market Vitrea 2 and ViTALConnect both as standalone software packages and as part of integrated software and hardware systems to radiologists, surgeons, primary care physicians and medical researchers.  We market our products directly to end-user customers, such as hospitals and clinics, and to diagnostic imaging companies, digital imaging equipment manufacturers and PACS companies, who sell our products in conjunction with products they either manufacture or acquire from third parties.

Our products work with equipment from all major manufacturers of diagnostic imaging systems, including Toshiba Medical Systems Corporation, GE Medical Systems, Siemens Medical Systems, Inc. and Philips Medical Systems, and can be integrated into PACS, such as those marketed by McKesson Information Systems, Sectra and Stentor.

We were founded and incorporated in Iowa in September 1988, and we re-incorporated in Minnesota in March 1997.  Our principal executive offices are located at 5850 Opus Parkway, Suite 300, Minnetonka, MN 55343 (telephone (952) 487-9500, facsimile (952) 487-9510, e-mail – info@vitalimages.com ).  From May 24, 1994 through May 11, 1997, we were a wholly-owned subsidiary of Bio-Vascular, Inc., which is now known as Synovis Life Technologies, Inc.

Summary Financial Information

The Offering

This prospectus relates to the resale of 1,934,597 outstanding shares of common stock and up to an additional 300,000 shares that we may issue as described below.  Of the outstanding shares, 58,335 shares were issued in connection with our private placement in December 1999.  An additional 1,500,000 of the outstanding shares were issued in connection with our private placement completed in June 2003.  We issued the remaining 376,262 outstanding shares to former shareholders of HInnovation, Inc. in our acquisition of HInnovation, Inc. completed in February 2004.  We must issue up to an additional 300,000 shares of common stock to these shareholders upon the achievement of a performance milestone as provided in our Acquisition Agreement and Plan of Reorganization with HInnovation, Inc. dated January 8, 2004.  The number of additional shares issued will depend on the market value of our common stock at the time of issuance, but the maximum number of shares we must issue is 300,000 shares.

2

RISK FACTORS

An investment in our common stock involves a high degree of risk.  You should carefully consider the following risk factors in addition to the other information set forth in this prospectus before making your investment decision.

We may not be able to maintain profitable operations on an annual basis.

For the three months ended March 31, 2005, we had operating income of $1,371,000.  For the years ended December 31, 2004, 2003 and 2002, we had operating income of $514,000, $1.9 million and $677,000.  However, we had an operating loss of $1.1 million for the year ended December 31, 2001, and we incurred operating losses for each year prior to that since 1990, with the exception of the fiscal year ended October 31, 1995.  As of March 31, 2005, our accumulated deficit was $10.3 million.  Our ability to maintain profitability will depend on, among other things, our abilities to maintain the technological competitiveness of our current products, develop new products, successfully market our products, respond to competitive developments, and attract and retain qualified sales, technical and management personnel.  We may not be able to continue to achieve profitable operations on an annual basis.

If our Vitrea 2 software does not continue to gain market acceptance, our financial results would be adversely affected.

Our success depends on our ability to successfully market our Vitrea 2 and ViTALConnect software for clinical use and on the ability and willingness of physicians to use enterprise-wide advanced visualization software in disease screening, clinical diagnosis and therapy planning.  The enterprise-wide advanced visualization software offered by Vitrea 2 and ViTALConnect represent new alternatives to the conventional methods traditionally used for viewing medical images in a clinical setting.  The acceptance of Vitrea 2 and ViTALConnect by physicians and other clinicians will depend on our ability to educate those users as to the speed, ease-of-use and other benefits offered by the Vitrea 2 and ViTALConnect systems, as well as our timely introduction of new features and functions.  There can be no assurance that users will prefer enterprise-wide advanced visualization software over less expensive two-dimensional medical imaging software or that we will succeed in our efforts to further develop, commercialize and achieve market acceptance for Vitrea 2 and ViTALConnect or for any other product in the clinical setting.

Nearly all of our revenue is from sales of our Vitrea 2 system.  Sales of our Vitrea 2 system represented 95% of our total revenue for the three months ended March 31, 2005, 95% of total revenue for the year ended December 31, 2004, 96% of total revenue for 2003 and 98% of total revenue for 2002.  A decline in the sales of the system would have a material adverse effect on our results of operations and financial condition.

Revenue from sales and servicing of the Vitrea 2 system constituted 95% of our total revenue for the three months ended March 31, 2005, 95% of total revenue for year ended December 31, 2004, 96% of our total revenue for the year ended December 31, 2003, and 98% of our total revenue for the year ended December 31, 2002.  We anticipate that revenue from the sale of Vitrea 2 will continue to account for a substantial portion of our revenue for the foreseeable future.  As such, the failure of physicians to accept Vitrea 2 would have a material adverse impact on our business, financial condition and results of operations.

We depend upon growth in the enterprise-wide advanced visualization industry.  If that market does not grow as we expect, our business, financial condition and results of operations would be adversely affected.

3

The enterprise-wide advanced visualization industry in which we market our products is still developing due to:

•                  the fairly recent availability of high performance computers at reduced prices;

•                  the recent adoption of industry standards for the generation, transmission and storage of medical imaging data; and

•                  changing medical practices.

Historically, there has been a perception that enterprise-wide advanced visualization was too slow or difficult for clinical use.  This perception was due largely to the relatively slower processing speed of workstations available in the past.  We believe that the recent advances in the affordability of high performance computers and in the development of industry standards for the generation, transmission and storage of imaging data will provide opportunities for growth in the enterprise-wide advanced visualization industry.  However, given the uncertainties associated with the developing stage of this industry, there can be no assurance that it will continue to develop in the manner we anticipate.  Accordingly, there can be no assurance that the enterprise-wide advanced visualization industry will provide growth opportunities for us and our software products or that our business strategies will be successful as the enterprise-wide advanced visualization industry continues to evolve.  Ultimately, if the enterprise-wide advanced visualization industry fails to develop as we expect, our business, results of operations and financial condition will be materially and adversely affected.

We participate in a highly competitive industry.  If we fail to compete effectively, our results of operations and financial condition would be adversely affected.

We face intense competition in the enterprise-wide advanced visualization industry.  We expect technology to continue to develop rapidly, and our success will depend to a large extent on our ability to maintain a competitive position with our products.  Our competitors in the enterprise-wide advanced visualization industry include large, established manufacturers of CT and MR imaging equipment.  Companies such as GE Healthcare, Siemens Medical Systems, Inc. and Philips Medical Systems typically offer their own enterprise-wide advanced visualization software and workstations as part of their integrated imaging and scanner systems.  Our software works on the products offered by each of these companies.  In order to win business against the equipment manufacturers, we must convince customers to buy our enterprise-wide advanced visualization software separately from their purchase of imaging equipment, instead of buying integrated systems from our competitors.

In addition to having a competitive advantage in marketing enterprise-wide advanced visualization tools as an integrated part of their imaging products, our competitors have significantly greater capital and staffing resources for research and development that are critical to success in the rapidly changing enterprise-wide advanced visualization industry; more recognizable brand names; and more well-established marketing and distribution networks.  Although price has been less significant than other factors, increasing competition may result in price reductions and reduced gross margins.  Additionally, we face competition from other entities, such as other software suppliers and PACS vendors.  We may not be able to compete effectively with such manufacturers or competing entities.

Our products may become obsolete or non-competitive, which would result in reduced revenue and profit margins.

The enterprise-wide advanced visualization market is characterized by rapid innovation and technological change.  We may be unable to compete effectively in the marketplace, and products developed by our competitors may render our products obsolete or non-competitive.  Similarly, our competitors may succeed

4

in developing or marketing products that are viewed as providing superior clinical performance or are less expensive than our current or future products.

Our sales to Toshiba Medical Systems Corporation accounted for 55% of our total revenue for the three months ended March 31, 2005, 50% of our total revenue for the year ended December 31, 2004, 42% of our total revenue for 2003, and 34% of total revenue for 2002.  A reduction in sales to Toshiba for any reason could have a material adverse effect on our operating results and financial condition.

One of our principal distribution channels is to sell our Vitrea 2 medical imaging software in connection with medical imaging equipment sold by Toshiba.  Our sales to Toshiba accounted for 55% of our total revenue for the three months ended March 31, 2005, 50% of our total revenue for the year ended December 31, 2004, 42% of our total revenue for the year ended December 31, 2003, and 34% of total revenue for the year ended December 31, 2002.  Toshiba’s account receivable represented 42% of our accounts receivable at March 31, 2005, 23% of our accounts receivable at December 31, 2004 and 7% at December 31, 2003.  Management believes a limited number of large customers may continue to account for a significant portion of our revenue during any given period for the foreseeable future.  Except for our marketing and distribution agreements with Toshiba, the Surgical Navigation Technologies, Inc. division of Medtronic, Inc., E-Z-EM, Inc. and McKesson Information Solutions LLC, we currently have no long-term purchase or other agreements with any of our customers, and we generally make sales pursuant to purchase orders.  A reduction, delay or cancellation of orders from one or more of our significant customers, or our inability to collect accounts receivable from these customers, likely would have a material adverse effect on our operating results.

Under an agreement with R2 Technology, Inc., certain minimum revenue must be generated due to our marketing efforts from the sale of R2 Technology, Inc. products.  If less than the minimum revenue required is generated, we must pay to R2 Technology, Inc. the difference between the minimum required revenue and the lower actual revenue.

On April 21, 2005, we entered into an agreement with R2 Technology, Inc. (“R2”) to market R2’s lung nodule CAD software product in conjunction with our products.  Under the agreement, certain minimum revenue must be generated due to our marketing efforts from the sale of R2 products over a 12-quarter period, beginning with the quarter ended September 30, 2005.  If, for any quarter, the actual revenue generated from our marketing efforts is less than the minimum revenue required for the quarter, we are obligated to pay to R2 an amount of cash equal to the difference.  Any such payments could have a negative effect on our results of operations and financial condition.

We may experience fluctuations in operating results, which may result in volatility in the price of our common stock.

We may experience significant fluctuations in future annual and quarterly operating results.  If these fluctuations occur, they may result in volatility in the price of our common stock.  Quarterly revenue and operating results may fluctuate as a result of a variety of factors that are outside of our control including, but not limited to:

•                  the timing of significant orders,

•                  the timing of product enhancements and new product introductions by us or our competitors;

•                  the pricing of our products;

•                  changes in customers’ budgets; and

5

•                  competitive conditions.

We are subject to government regulation, which can result in additional costs or restrict our ability to market our products.

Our products are subject to regulation by the U.S. Food and Drug Administration (the “FDA”) and by comparable agencies in foreign countries.  In the United States, the FDA regulates the development, introduction, manufacturing, labeling and record keeping procedures for medical devices, including 3D medical imaging software and systems.  The process of obtaining marketing clearance from the FDA for new products and new applications for existing products can be time-consuming and expensive.  All of our current products have received marketing clearance from the FDA pursuant to 510(k) pre-market notifications.  Vitrea 2, ViTALConnect and our add-on options have been cleared to be marketed for use with CT, MR and PET scanners.  The FDA may not grant clearance with respect to our future products or enhancements, or future FDA reviews may involve delays that could adversely affect our ability to market such future products or enhancements.  In addition, our future products or enhancements may be subject to a more lengthy and expensive pre-market approval process with the FDA.

Even if we obtain regulatory clearances and approvals to market a product from the FDA, these clearances and approvals may entail limitations on the indicated uses of the product.  Product clearances and approvals by the FDA can also be withdrawn due to failure to comply with regulatory standards or the occurrence of unforeseen problems following initial approval.  The FDA could also limit or prevent the distribution of our products and has the power to require the recall of such products.  FDA regulations depend heavily on administrative interpretation, and future interpretations made by the FDA or other regulatory bodies may adversely affect us.  The FDA may inspect our facilities and operations to determine whether we are in compliance with various regulations relating to specification, development, documentation, validation, testing, quality control and product labeling.  If the FDA determines that we are in violation of such regulations, it could impose civil penalties, including fines, recall or seize products and, in extreme cases, impose criminal sanctions.

We market our products both domestically and internationally.  International regulatory bodies have established varying regulations governing product standards, packaging requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements.  Our inability or failure to comply with the varying regulations, or the imposition of new regulations, could restrict our ability to sell our products internationally and could adversely affect our business.

The imposition of requirements under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) could adversely affect our business.

The HIPAA regulations are causing our customers to request that we sign “business associate” agreements with them.  A “business associate” is a person or entity that performs certain functions or activities that involve the use or disclosure of protected health information on behalf of, or that provides services to, a covered entity.  By law, the HIPAA Privacy Rule applies only to covered entities—health plans, health care clearinghouses, and certain health care providers.  However, most health care providers do not carry out all of their health care activities and functions by themselves.  Instead, they often use the services of a variety of other persons or businesses.  The Privacy Rule allows covered providers and health plans to disclose protected health information to these “business associates” if the providers or plans obtain satisfactory assurances that the business associate will use the information only for the purposes for which it was engaged by the covered entity, will safeguard the information from misuse, and will help the covered entity comply with some of the covered entity’s duties under the Privacy Rule.  Covered entities may disclose protected health information to an entity in its role as a business associate only to help the covered entity carry out its health care functions—not for the business associate’s independent use or purposes, except as needed for the proper management and administration of the business associate.  These agreements are necessary for us in the normal course of

6

servicing and supporting our products.  If we are not willing to or are unable to enter into a business associate agreement with current and potential customers, such customers may not purchase our products or services, which would have a material adverse effect on our business, financial condition and results of operations.

The protection of our intellectual property may be uncertain, and we may face possible claims of others.

Although we have received patents and have filed patent applications with respect to certain aspects of our technology, we generally do not rely only on patent protection with respect to our products and technologies.  We also rely on a combination of trade secret and copyright law, employee and third-party nondisclosure agreements and other protective measures to protect intellectual property rights pertaining to our products and technologies.  Such measures may not provide meaningful protection of our trade secrets, know-how or other intellectual property in the event of any unauthorized use, misappropriation or disclosure.  Others may independently develop similar technologies or duplicate our technologies.  In addition, to the extent that we apply for any patents, such applications may not result in issued patents or, if issued, such patents may not be valid or of value.  We do not believe that our products and technologies infringe any existing patents or intellectual property rights of third parties.  However, our products and technologies may infringe existing patents or intellectual property rights of third parties.  The costs of prosecuting or defending an intellectual property claim could be substantial and could adversely affect our business, even if we were ultimately successful in prosecuting or defending any such claims.  If our products or technologies are found to infringe the rights of a third party, we could be required to pay significant damages or license fees or cease production, any of which could have a material adverse effect on our business.

We have product liability insurance ($11,000,000 per occurrence and $12,000,000 in total) and errors and omissions coverage ($11,000,000 per occurrence and in total).  Our insurance coverage may not be adequate to pay products liability claims, which could have a material adverse effect on our financial condition.

The manufacture and sale of products used in the practice of medicine entail significant risk of product liability claims.  We currently maintain product liability insurance in the amount of $11,000,000 per occurrence and $12,000,000 in total and errors and omissions coverage in the amount of $11,000,000 per occurrence and in total.  However, our coverage limits may not be adequate to protect us from any liabilities we might incur in connection with claims made with respect to our products.  Further, we may not be able to maintain the same level of coverage in the future.  We may also need increased product liability coverage as we release additional products and updates.  Such insurance is expensive and may not be available on acceptable terms, if at all.  A successful product liability claim or series of such claims against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition and results of operations.

If we fail to attract and retain qualified personnel, our business would be harmed.

Our ability to enhance and develop markets for our current products and to introduce new products to the marketplace depends on our ability to attract and retain qualified scientific and management personnel.  We compete for such personnel with other companies, academic institutions, government entities and organizations, many of which have substantially greater capital resources, name recognition, and research and development capabilities.  There can be no assurance that we will be successful in recruiting or retaining such personnel.  We may not be able to recruit and retain such personnel, which would have a material adverse effect on our business.

7

If we do not effectively manage changes in our business, these changes could place a significant strain on our management and operations and, as a result, our business might not succeed.

Our ability to grow successfully requires an effective planning and management process.  The expansion and growth of our business could place a significant strain on our management systems, infrastructure and other resources.  To manage growth successfully, we must continue to improve and expand our systems and infrastructure in a timely and efficient manner.  In addition, the success of any acquisition, such as our acquisition of HInnovation, Inc., will depend on our ability to successfully integrate the acquired business with our business.  Our controls, systems, procedures and resources may not be adequate to support a changing and growing company.  If our management fails to respond effectively to changes and growth in our business, including acquisitions, such failure could have a material adverse effect on our business, financial condition and results of operations.

If we are unable to successfully address the material weaknesses in our internal controls, our ability to report our financial results on a timely and accurate basis may be adversely affected.

In connection with their audit of our combined consolidated financial statements for the year ended December 31, 2004, our independent registered public accounting firm reported a material weakness related to the accuracy and completeness of deferred revenue for maintenance and services, which resulted in the restatement of the Company’s consolidated financial statements for the year ended December 31, 2003 and for the first and second quarters of 2004.  A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Our independent registered public accounting firm reported that we did not maintain effective internal control over financial reporting as of December 31, 2004 because we did not maintain effective controls over (i) the accuracy and completeness of maintenance and services revenues and deferred revenues, (ii) the existence of property and equipment, and (iii) the review and approval of quarterly financial results and related disclosures, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Because of the material weaknesses discussed above, management has concluded that we did not maintain effective internal control over financial reporting as of December 31, 2004 based on the criteria in Internal Control – Integrated Framework.

During the first quarter of 2005, we implemented the following remediation steps to address the material weaknesses described above:

•                  The process of recognizing revenue related to maintenance and services has been redesigned to ensure more timely receipt of information from operational areas to ensure revenue is recognized in the appropriate period.

•                  New procedures have been established to address the tagging and tracking of fixed assets to ensure that property and equipment can be adequately accounted for.

•                  Controls related to the quarterly financial reporting process are being closely monitored to ensure they are operating as designed.  This material weakness was related to the third quarter of 2004.  Although the controls related to the review and approval of fourth quarter results did operate as designed, the controls have not operated for a sufficient period of time to demonstrate that they operate effectively.

In addition, we have added a number of additional personnel to our finance and accounting staff to ensure that all of the material weaknesses described above are appropriately remediated in a timely manner.

8

The additional personnel include a new Senior Director of Finance, a new Controller, and a new Manager of Financial Reporting and Senior Staff Accountant, all of whom have strong public accounting and public company experience.  We believe that these remediation steps will correct the material weaknesses described above.

We cannot provide assurance that the measures we have taken to date or any future measures will adequately remediate the material weakness reported by our independent registered public accounting firm.  In addition, we cannot be certain that additional material weaknesses in our internal controls will not be discovered in the future.  Any failure to remediate the material weakness reported by our independent registered public accounting firm or to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results, cause us to fail to meet our reporting obligations or result in material misstatements in our financial statements.  Any such failure also could adversely affect the results of the periodic management evaluations and annual auditor attestation reports regarding the effectiveness of our internal control over financial reporting that is required in our Annual Report on Form 10-K for the year ending December 31, 2005 to be filed in early 2006 or in our future Annual Reports on Form 10-K.  Inadequate internal controls could also cause investors to lose confidence in our reported financial information, which could cause our stock price to decline.

We depend on third-party reimbursement.  A reduction or other change in reimbursement from third parties could negatively affect our business.

Our products are purchased by hospitals, clinics, imaging centers and other users, which bill various third party payers, such as government health programs, private health insurance plans, managed care organizations and other similar programs, for the health care goods and services provided to their patients.  There are currently Current Procedural Terminology (CPT) reimbursement codes for most of the diagnostic procedures that use our products.  However, the amount of such reimbursement varies by location and is subject to change.  Payers may deny reimbursement if they determine that a product used in a procedure was not used in accordance with established payer protocol regarding cost-effective treatment methods or was used for an unapproved indication.  Third party payers are increasingly challenging the prices charged for medical services and, in some instances, have put pressure on service providers to lower their prices or reduce their services.  We are unable to predict what changes will be made in the reimbursement methods used by third party healthcare payers.  Third-party payors may not consider as cost effective the procedures in which our products are used.  Reimbursement for such procedures may not be available or, if available, payers’ low reimbursement levels may adversely affect our ability to sell our products on a profitable basis.  In addition, there have been and may continue to be proposals by legislators, regulators and third party payers to curb further these costs in the future.  A failure by hospitals and other users of our products to obtain reimbursement from third party payers, changes in third party payers’ policies toward reimbursement for procedures using our products or legislative action could have a material adverse effect on our business, financial condition and results of operations.

Health care reform may negatively impact our business.

The levels of revenue and profitability of medical technology companies may be affected by the efforts of government and third party payers to contain or reduce the costs of health care through various means.  In the United States, there have been, and we expect that there will continue to be, a number of federal, state and private proposals to control health care costs.  These proposals may contain measures intended to control public and private spending on health care as well as to provide universal public access to the health care system.  If enacted, these proposals may result in a substantial restructuring of the health care delivery system.  Significant changes in the nation’s health care system could have a substantial impact on the manner in which we conduct business and could have a material adverse effect on our business, financial condition and results of operations.

9

We may issue shares of preferred stock without the consent of our holders of common stock, which could adversely affect the rights of the holders of our common stock.

Our Articles of Incorporation authorize our board of directors, without any action by the holders of our common stock, to establish the rights and preferences of up to 5,000,000 shares of currently undesignated preferred stock.  These shares of preferred stock could possess voting and conversion rights that could adversely affect the voting power of the holders of the common stock and may have the effect of delaying, deferring or preventing a change in control of Vital Images.  No shares of preferred stock or other senior equity securities are currently designated, and currently we have no plan to designate or issue any such securities.

We are subject to certain laws and plans which may discourage takeover attempts that could be beneficial for shareholders.

We are subject to anti-takeover provisions of the Minnesota Business Corporation Act.  In addition, we have adopted a Shareholder Rights Plan (the “Rights Agreement”) designed to protect against unsolicited attempts to acquire Vital Images.  These measures may deter or discourage takeover attempts and other changes in control that are not approved by our board of directors, and they may have a depressive effect on any market for our common stock.  As a result, our shareholders may lose opportunities to dispose of their shares at the higher prices typically available in takeover attempts or that may be available under a merger proposal.  In addition, these measures may have the effect of permitting our current directors to retain their positions and place them in a better position to resist changes that shareholders may wish to make if they are dissatisfied with the conduct of our business.

We have never paid any cash dividends and, therefore, our shareholders’ only opportunity to achieve a return on their investment in Vital Images is if the price of our common stock appreciates.

We have not paid cash dividends on our common stock in the past, and we do not intend to do so in the foreseeable future.  Consequently, our shareholders’ only opportunity to achieve a return on their investment in Vital Images will be if the market price of our common stock appreciates and they sell their shares at a profit.  There is no guaranty that the price of our common stock that will prevail in the market after any sales by the selling shareholders under this prospectus will ever exceed the price that a buyer of the shares will pay.

Our directors may not be held personally liable for certain actions, which could discourage shareholder suits against them.

As permitted by Minnesota law, our Articles of Incorporation provide that members of our board of directors shall not be personally liable to us or our shareholders for monetary damages for breach of fiduciary duty as a director, with certain exceptions.  These provisions may discourage shareholders from bringing suit against a director for breach of fiduciary duty and may reduce the likelihood of derivative litigation brought by shareholders on our behalf against a director.  In addition, our Bylaws provide for mandatory indemnification of directors and officers to the fullest extent permitted by Minnesota law.

The exercise of outstanding warrants and options may adversely affect our stock price.

As of March 31, 2005, we had outstanding options to purchase 2,176,691 shares of our common stock and outstanding restricted stock awards for 36,180 shares.  Options to purchase 1,428,360 were exercisable on that date, and none of the restricted stock awards were vested on that date.  These options are likely to be exercised at a time when the market price for our common stock is higher than the exercise prices of the options.  If holders of these outstanding options and restricted stock awards sell the common stock received upon exercise of the options or the vesting of the awards, it may have a negative effect on the market price of our common stock.

10

FORWARD-LOOKING INFORMATION

Vital Images desires to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 and is filing this cautionary statement in connection with the Reform Act.  This prospectus and any other written or oral statements made by or on our behalf may include forward-looking statements that reflect our current views with respect to future events and future financial performance. Certain statements in this prospectus are “forward-looking statements” within the meaning of Section 27(a) of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  You can identify these forward-looking statements by our use of the words “believes,” “anticipates,” “forecasts,” “projects,” “could,” “plans,” “expects,” “may,” “will,” “would,” “intends,” “estimates” and similar expressions, whether in the negative or affirmative. We wish to caution you that any forward-looking statements made by us or on our behalf are subject to uncertainties and other factors that could cause such statements to be wrong. We cannot guarantee that we actually will achieve these plans, intentions or expectations.  Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements that we make.  These statements are only predictions and speak only of our views as of the date the statements were made. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, and/or performance of achievements.  We do not assume any obligation to update or revise any forward-looking statements that we make, whether as a result of new information, future events or otherwise.

Factors that may impact forward-looking statements include, among others, our abilities to maintain the technological competitiveness of our current products, develop new products, successfully market our products, respond to competitive developments, develop and maintain partnerships with providers of complementary technologies, manage our costs and the challenges that may come with growth of our business, and attract and retain qualified sales, technical and management employees.  We are also affected by the growth and regulation of the enterprise-wide advanced visualization industry, including the acceptance of enterprise-wide advanced visualization by hospitals, clinics, and universities, and reimbursement and regulatory practices by Medicare, Medicaid, and private third-party payer organizations.  We are also affected by other factors identified in our filings with the Securities and Exchange Commission, some of which are set forth in the section entitled “Risk Factors” in this prospectus (and many of which we have discussed in prior filings).  Although we have attempted to list comprehensively these important factors, we also wish to caution investors that other factors may prove to be important in the future in affecting our operating results.  New factors emerge from time to time, and it is not possible for us to predict all of these factors, nor can we assess the impact each factor or combination of factors may have on our business.

USE OF PROCEEDS

The selling shareholders will sell all of the common stock covered by this prospectus and receive the proceeds from sale of the shares.  We will not receive any of the proceeds from such sales.  We will pay certain expenses related to the registration of the shares of common stock.

MARKET FOR COMMON STOCK

Vital Images’ common stock is listed on The NASDAQ National Market under the symbol “VTAL.”  The table below shows the high and low per share closing sale prices of our common stock as reported by The NASDAQ Stock Market for each of the periods indicated.  Such prices reflect inter-dealer prices, do not include adjustments for retail mark-ups, markdowns or commissions, and may not necessarily represent actual transactions.

11

On                       , 2005, the last reported sale price for our common stock was $               .

DIVIDEND POLICY

We have never paid or declared any cash dividends on our common stock and do not intend to pay dividends on our common stock in the near future.  To date, we have incurred cumulative operating losses and presently expect to retain our future anticipated earnings to finance the development and expansion of our business.

CAPITALIZATION

The following table sets forth our capitalization as of March 31, 2005.  None of the columns shown below reflect the following:

•                  2,178,341 shares of common stock issuable as of March 31, 2005 upon the exercise of outstanding stock options; or

•                  1,322,836 shares of common stock available for issuance as of March 31, 2005 under our 1997 Stock Option and Incentive Plan and 1997 Director Stock Option Plan.

12

UNAUDITED PRO FORMA COMBINED FINANCIAL INFORMATION

The Unaudited Pro Froma Combined Consolidated Statement of Operations for the year ended December 31, 2004 combine historical Vital Images, Inc. and HInnovation, Inc. statements of operations as if the acquisition of HInnovation, which occurred on February 18, 2004, had been completed on January 1, 2004 for purposes of the presentation of the Unaudited Pro Forma Combined Consolidated Statement of Operations.

The total purchase price of the HInnovation acquisition was approximately $12.6 million.  We acquired all of the outstanding common stock of HInnovation in exchange for $5.8 million in cash paid and 376,262 newly-issued shares of common stock issued to the stockholders of HInnovation. The common stock was valued at $6.1 million for accounting purposes.  We incurred approximately $400,000 in direct costs of the acquisition and assumed $400,000 of liabilities.  We did not assume any stock options or warrants.  In addition, the transaction included a maximum of $6.0 million of contingent milestone payments comprised of $3.0 million in common stock and $3.0 million in cash.  As of December 31, 2004, no contingent payments had been earned.  The first milestone was not met before the February 2005 deadline.  As a result, the potential maximum contingent consideration was reduced to $4.5 million, which consists of $3.0 million in common stock and $1.5 million in cash.

The purchase price was allocated to the identified assets of HInnovation.  A third-party appraisal firm assisted us with the valuation of the identified intangible assets.  The valuation resulted in the allocation of $6.9 million to identifiable intangibles, which will be amortized over periods ranging from three to seven years.  The valuation also resulted in the identification of $1.0 million of acquired in-process research and development costs (“IPR&D”), which was immediately expensed on the closing date and represents a non-deductible charge for income tax purposes.

At the time of acquisition, HInnovation had development projects in process, including the collaboration module of its Web-based product (the “Collaboration Module Project”). The Collaboration Module Project involves the design and development of innovative features for Web-based consultation meetings with interactive and synchronized viewing of full-quality images, annotation and mouse movement.  The Collaboration Module Project includes significant and innovative advancements to the HInnovation software platform in the areas of network synchronization of high quality images and user privilege management for online collaboration. The design, verification and other processes involved in the Collaboration Module Project require tools and skills that are new to HInnovation.  The appraisal referenced above estimated that $1.0 million of the purchase price represents the fair value of purchased IPR&D related to the Collaboration Module Project, that it has not yet reached technological feasibility and that it has no alternative future uses. This amount was expensed as a non-recurring, non-tax-deductible charge upon consummation of the acquisition.  This amount is not reflected as an expense in the unaudited pro forma combined consolidated statement of operations as it is a non-recurring charge upon consummation of the acquisition.

The Unaudited Pro Forma Combined Consolidated Statement of Operations for the year ended December 31, 2004 does not purport to represent what the actual financial condition or results of operations of the combined businesses would have been if the acquisition of HInnovation had occurred on the dates indicated in the Unaudited Pro Forma Combined Consolidated Statement of Operations nor does this information purport to project our results or financial position for any future periods.

The Unaudited Pro Forma Consolidated Statement of Operations has been prepared from, and should be read in conjunction with, our audited consolidated financial statements for the fiscal year ended December 31, 2004 and the related notes included elsewhere in this prospectus.

13

UNAUDITED PRO FORMA COMBINED CONSOLIDATED STATEMENT OF OPERATIONS

Year Ended December 31, 2004

VITAL IMAGES, INC. NOTES TO UNAUDITED PRO FORMA COMBINED CONSOLIDATED STATEMENT OF OPERATIONS

NOTE 1. BASIS OF PRESENTATION

The Unaudited Pro Forma Combined Consolidated Statement of Operations included herein has been prepared

14

by Vital Images, Inc., without audit, pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and certain footnote disclosures normally included in the financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations.  However, we believe that the disclosures are adequate to make the information presented not misleading.

NOTE 2. PRELIMINARY PURCHASE PRICE ALLOCATION

The total purchase price is as follows:

The allocation of the total purchase price is as follows:

In-process research and development costs of $1.0 million were expensed in the period in which the acquisition was consummated.  The Unaudited Pro Forma Combined Consolidated Statement of Operations does not include the in-process research and development costs of $1.0 million, as it is considered a non-recurring charge.

NOTE 3. PRO FORMA ADJUSTMENTS

The accompanying Unaudited Pro Forma Combined Consolidated Statement of Operations has been prepared as if the acquisition had been completed as of the beginning of the year ended December 31, 2004 and reflects the following pro forma adjustments:

(1)          The amortization of intangibles for the period of January 1, 2004 through the acquisition date of February 18, 2004.

(2)          The in-process research and development costs associated with the acquisition, which were not tax deductible.

(3)          The tax benefit of the amortization of intangibles.

(4)          The adjustment of weighted-average shares outstanding for the Vital Images shares issued in the acquisition.

15

SELECTED FINANCIAL DATA

(1)          Includes a net tax benefit of $6,313 resulting from the reversal of Vital Images’ valuation allowance for its net deferred tax assets, net of other current year state and federal income taxes.

(2)          Includes $1,000 of acquired in-process research and development charge relating to the acquisition of HInnovation, Inc. in February 2004.

16

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Executive Summary

Vital Images achieved significant growth in the first quarter of 2005 and in the year ended December 31, 2004.  Our balance sheet remains strong:  total cash, cash equivalents and marketable securities were $32.9 million as of March 31, 2005 compared to $35.7 million as of December 31, 2004; working capital was $33.3 million as of March 31, 2005 compared to $31.0 million as of December 31, 2004; and working capital included deferred revenue of $9.7 million as of March 31, 2005 and $8.1 million as of December 31, 2004.

For the three months ended March 31, 2005, total revenue increased 45% to $11.3 million compared to $7.8 million in the first quarter of 2004.  Pretax income for the first quarter of 2005 was $1.5 million, which included amortization of identified intangibles of $351,000 and a charge related to our operating lease for our old office facility of $493,000.  We recorded net income of $1.0 million, or $0.08 per diluted share, in the first quarter of 2005 compared to a net loss of $1.4 million, or $0.12 per diluted share, in the first quarter of 2004, which included a write-off of in-process research and development costs of $1.0 million related to the HInnovation, Inc. acquisition, which closed in February 2004.  Operating costs in the first quarter of 2005 included a bad debt expense recovery of $184,000 relating to a partial recovery of an outstanding receivable that was written off in the first quarter of 2004; the recovery resulted in a $684,000 change in bad debt expense from the first quarter of 2004 to the first quarter of 2005.

Total revenue increased 32% to $36.1 million in 2004 compared to $27.3 million in 2003.  Operating income was $514,000 in 2004, which included amortization of identified intangibles of $1.1 million and an acquired in-process research and development charge of $1.0 million related to the acquisition of HInnovation, compared to $1.9 million in 2003.

We recorded net income of $296,000, or $0.02 per diluted share, in 2004 compared to $8.5 million of net income, or $0.71 per diluted share, in 2003.  Full-year earnings for 2003 include a net tax benefit of $6.3 million, or $0.53 per diluted share.

Throughout our history, a significant portion of our revenue has been generated from the U.S. computed tomography (“CT”) market.  Going forward, we anticipate a growing contribution from other sources, including an expanding picture archive and communication systems (“PACS”) market, sales of Web-based products and our installed customer base.  In February 2004, we acquired HInnovation, Inc., a privately-held provider of software solutions that allow physicians to use PCs or notebook computers to access 2D, 3D and 4D medical imaging applications securely over the Internet, which represents another step towards expanding our presence in the PACS and Web-based markets.

Overview

We develop, market and support enterprise-wide advanced visualization software for use primarily in clinical diagnosis, disease screening and therapy planning.  Our software applies proprietary computer graphics and image processing technologies to a wide variety of data supplied by CT, magnetic resonance (“MR”) and positron emission tomography (“PET”) scanners.  Our products allow clinicians to create 2D, 3D and 4D views of human anatomy and to non-invasively navigate within these images to better visualize and understand internal structures and pathologies.  We believe that our high-speed visualization technology and customized protocols cost-effectively bring 3D visualization and analysis into the routine, day-to-day practice of medicine.  Vital Images, which operates in a single business segment, markets its products to healthcare providers and to manufacturers of diagnostic imaging systems and PACS through a direct sales force in the United States and independent distributors in international markets.

17

On October 28, 1996, the board of directors of Bio-Vascular, Inc. (“Bio-Vascular”), now known as Synovis Life Technologies, Inc., the former parent company of Vital Images, approved a plan to spin off and establish Vital Images as an independent, publicly-owned company.  On May 12, 1997, Bio-Vascular distributed all of the shares of Vital Images to the stockholders of Bio-Vascular, and on that date Vital Images began operating as an independent public company.  All Bio-Vascular stockholders of record as of May 5, 1997 received one share of Vital Images common stock for each two shares of Bio-Vascular stock held on that date, and cash in lieu of fractional shares.  Vital Images’ common stock is currently listed on The NASDAQ National Market under the symbol VTAL.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of financial condition and results of operations are based upon Vital Images’ audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  The notes to the consolidated financial statements contained in this prospectus describe Vital Images’ significant accounting polices used in the preparation of the consolidated financial statements.

We continually evaluate our critical accounting policies and estimates.  We believe the critical accounting polices listed below reflect significant judgments, estimates and assumptions used in the preparation of our consolidated financial statements.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from extending credit to our customers.  In judging the adequacy of the allowance for doubtful accounts, we consider multiple factors, including historical bad debt experience, the general economic environment, the need for specific client reserves and the aging of our receivables.  This provision is included in operating expenses as a general and administrative expense in the consolidated statements of operations.  A considerable amount of judgment is required in assessing these factors.  If the factors utilized in determining the allowance do not reflect future performance, then a change in the allowance for doubtful accounts would be necessary in the period such determination has been made which would impact future results of operations.  As of March 31, 2005, the allowance for doubtful accounts was $583,000 for gross accounts receivable of $14.6 million.

Deferred Taxes

Significant judgment is required in determining the realizability of our deferred tax assets.  We must assess the likelihood that our net deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance.  To the extent we establish a valuation allowance, we must include an expense within the tax provision in the statement of operations.  As of March 31, 2005, the consolidated balance sheet included net deferred tax assets of $9.3 million.

Our methodology for determining the realizability of our deferred tax assets involves estimates of future taxable income from our core business, the estimated impact of future tax deductions from the exercise of stock options outstanding as of each balance sheet date, and the expiration dates and amounts of net operating loss carryforwards and other tax credits.  These estimates are projected through the life of the related deferred tax

18

assets based on assumptions which management believes to be reasonable and consistent with current operating results.

Although we had cumulative pre-tax income for financial reporting purposes for the three years ended December 31, 2004, we did not pay any significant income taxes over that period due to tax deductions from the exercise of stock options as well as our utilization of net operating losses.  In assessing the realizability of our deferred tax assets as of each balance sheet date, we considered evidence regarding our ability to generate sufficient future taxable income to realize our deferred tax assets. The primary evidence considered included the cumulative pre-tax income for financial reporting purposes for the past three years; the cumulative tax operating loss for the past three years; the estimated impact of future tax deductions from the exercise of stock options outstanding as of each balance sheet date; and the estimated future taxable income based on historical operating results.

After giving consideration to these factors, we concluded that it was more likely than not that tax loss carryforwards that expire in 2005 and other tax credits that expire within the next four years will not be utilized due to the estimated future tax deductions from the exercise of stock options outstanding as of December 31, 2004.  As a result, we recorded a valuation allowance of $183,000 for the year ended December 31, 2004.  We also recorded a full valuation allowance of $43,000 relating to 2004 foreign net operating losses that are subject to uncertainty regarding utilization.

As of March 31, 2005, we updated our analysis to reflect the necessary changes in estimates and determined that no increase in the valuation allowance was necessary related to previously recorded deferred tax assets.

We also concluded that it was more likely than not that the net deferred tax assets of $9.3 million as of March 31, 2005 and the estimated future tax deductions from the exercise of stock options outstanding as of March 31, 2005 would be utilized prior to expiring.  Based on this conclusion, we would require approximately $40 million in cumulative future taxable income to be generated at various times over the next 20 years to realize the related net deferred tax assets of $9.3 million as of March 31, 2005 as well as the estimated future tax deductions from the exercise of stock options outstanding and in-the-money as of March 31, 2005.

If we adjust our estimates of future taxable income or tax deductions from the exercise of stock options, or if our stock price increases significantly without an increase in taxable income, we may need to establish additional valuation allowances, which could materially impact our financial position and results of operations.

Long-Lived Assets

We review long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  Events or changes in circumstances that indicate the carrying amount may not be recoverable include, but are not limited to, a significant decrease in the market value of the business or asset acquired, a significant adverse change in the extent or manner in which the business or asset acquired is used, or a significant adverse change in the business climate.  If such events or changes in circumstances are present, the undiscounted cash flows method is used to determine whether the asset is impaired.  Cash flows would include the estimated terminal value of the asset and exclude any interest charges.  To the extent the carrying value of the asset exceeds the undiscounted cash flows over the estimated remaining life of the asset, the impairment is measured using the discounted cash flows.  The discount rate utilized would be based on management’s best estimate of the related risks and return at the time the impairment assessment is made.

19

Our long-lived assets consisted of property and equipment of $5.3 million, licensed technology of $300,000 and other intangible assets subject to amortization of $5.5 million as of March 31, 2005.

Goodwill and Other Intangible Assets with Indefinite Lives

We account for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.”  Under SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized to expense and must be reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill.  Vital Images operates as one reporting unit and therefore compares the book value to the market value (market capitalization plus a control premium).  If the market value exceeds the book value, goodwill is considered not impaired, thus the second step of the impairment test is not necessary.  If Vital Images’ book value exceeds the market value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any.  The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of the goodwill with the book value of the goodwill.  If the carrying value of the goodwill exceeds the implied fair value of the goodwill, an impairment loss would be recognized in an amount equal to the excess.  Any loss recognized cannot exceed the carrying amount of goodwill.  After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill is its new accounting basis.  Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed.  We completed the annual goodwill impairment assessment as of December 31, 2004, upon which no impairment was recorded.

Commitments and Contingencies

In April 2005, we entered into a new agreement with R2 Technology, Inc. (“R2”) to market R2’s lung nodule CAD software product to our customers.  The new agreement replaces our November 2002 agreement with R2.  Under the new agreement, all previous commitments were cancelled and replaced with a new commitment.  Beginning in the third quarter of 2005, we have committed to R2 certain minimum revenues from the sale of R2 products over a 12-quarter period.  We will receive a commission from R2 as consideration for our marketing efforts and access to our customers.  This commission will be the only revenue we will recognize under the new agreement.  The new agreement states that to the extent the quarterly minimum revenue commitments are not met, we will pay R2 the difference between the minimum revenue commitment and the actual revenues achieved (shortfall payments).  The maximum total revenue commitment over the 12-quarter period beginning in the third quarter of 2005 is $5.0 million.  However, beginning in the second quarter of 2006, the quarterly minimum revenue commitments will be reduced i) to the extent revenue generated by R2 under this agreement is below the minimum revenue commitment or ii) to the extent R2 is unable to generate revenue outside of its relationship with us.  If R2 generates no revenue under this agreement, the estimated maximum shortfall payments would total approximately $2.5 million.

Based on current estimates, management believes it is probable that the minimum revenue commitments will be met such that we will earn commissions under this arrangement that will exceed direct selling costs and that we will not take a loss on this agreement.  However, this is a subjective determination, and any changes to these estimates could have an adverse impact on our financial position and results of operations.

We are subject to the possibility of various loss contingencies in the normal course of business.  We accrue for loss contingencies when a loss is estimable and probable.  In March 2004, we signed a non-cancelable operating lease for a new office facility in Minnetonka, Minnesota.  The new lease term started in February 2005 and expires in January 2012.  We moved into the Minnetonka location and moved out of our Plymouth, Minnesota location in February 2005.  Our office facility in Plymouth expires on July 31, 2005 with the exception of a small portion of the space that is under lease until May 31, 2006.  Under the terms of the new

20

lease, the Minnetonka lessor will pay the monthly base rent payments and taxes and operating cost rent obligation payments for our former office facility in Plymouth beginning in February 2005.  In accordance with generally accepted accounting principles, we recorded a lease loss of $493,000 for the estimated lease payments to be made by the Minnetonka landlord to the Plymouth landlord as well as estimated other costs to be paid by us to the Plymouth landlord.  Any changes to these estimates could have an impact on our financial position and results of operations.

Revenue Recognition

We follow specific and detailed guidelines in determining the proper amount of revenue to be recorded; however, certain judgments affect the application of our revenue recognition policy.  Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from period to period.

The significant judgments for revenue recognition typically involve whether collectibility can be considered probable and whether fees are fixed or determinable.  In addition, our transactions often consist of multiple element arrangements, which must be analyzed to determine the relative fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized.

We license our software and sell products and services to end-users and also indirectly through original equipment manufacturers (“OEMs”) and independent distributors (collectively “Resellers”).  Terms offered by us do not generally differ based on whether the customer is an end-user or a Reseller.  We offer terms that require payment within 30 to 90 days after product delivery.  We do not generally offer rights of return, acceptance clauses or price protection to our customers.  In rare situations where we provide rights of return or acceptance clauses, revenue is deferred until the clause expires.

License fees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale of system hardware, including peripheral equipment.  Maintenance and service revenue is derived from software maintenance and from telephone support, installation, training and engineering services.  Our software licenses are always sold as part of an arrangement that includes maintenance and support and often installation and training services.

Engineering services consist of software modification or development services that are sold separately to OEMs.  We generally sell hardware as part of a system sale, but we occasionally sell hardware as part of a system upgrade or additional product sale.

We recognize revenue in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time to time by the AICPA and SEC Staff Accounting Bulletin No. 104.  We recognize revenue when it is realized or realizable and earned.  We consider revenue realized or realizable and earned when we have persuasive evidence of an arrangement, the product has been shipped or the services have been provided to the customer, the sales price is fixed or determinable, and collectibility is probable.  Provided all other revenue recognition criteria are met, license revenue from Resellers is recognized on a sell-in or sell-through basis depending on the arrangement with the Reseller.  We recognize revenue from Resellers on a sell-in basis provided the Reseller i) assumes all risk of the purchase, ii) has the ability and obligation to pay regardless of receiving payment from the end user, and iii) has a history of timely payments.

We evaluate the credit worthiness of all customers.  In circumstances where we do not have experience selling to a customer and lack adequate credit information to conclude that collection is probable, revenue is

21

deferred until the arrangement fees are collected and all other revenue recognition criteria in the arrangement have been met.

In addition to the aforementioned general policy, the following are the specific revenue recognition policies for services and multiple-element arrangements.

Software and Hardware – Revenue from license fees and hardware is recognized when shipment of the product has occurred, none of our significant obligations with regard to implementation remain and our services are not considered essential to the functionality of other elements of the arrangement.  See also “—Multiple Element Arrangements” below for further information.

Services – Revenue from maintenance and support arrangements is deferred and recognized ratably over the term of the maintenance and support arrangements.  Revenue from training and installation services is recognized as the services are provided to customers.  Revenue from engineering services, where we are performing significant customization or modification of software, is recognized using contract accounting on a percentage-of-completion basis.  We record revenue by reference to actual hours incurred to date and the estimated hours remaining to complete the services.

Multiple-Element Arrangements – We enter into arrangements with customers that include a combination of software products, system hardware, specified upgrades, maintenance and support, or installation and training services.  For such arrangements, we recognize revenue using the residual value method.  We allocate the total arrangement fee among the various elements of the arrangement based on the relative fair value of each of the undelivered elements determined by vendor-specific objective evidence.  The fair value of maintenance and support services is based upon the renewal rate for continued service arrangements.  The fair value of installation and training services is established based upon separate pricing for the services.  In software arrangements for which we do not have vendor-specific objective evidence of fair value for all elements, revenue is deferred until the earlier of when vendor-specific objective evidence is determined for the undelivered elements (residual method) or when all elements for which we do not have vendor-specific objective evidence of fair value have been delivered.

The following table sets forth information from our Statements of Operations, expressed as a percentage of total revenue.

22

Results of Operations

Three Months Ended March 31, 2005 and 2004

Revenue.  Total revenue increased 45% to $11.3 million in the first quarter of 2005 from $7.8 million in the same period in 2004.  The revenue growth was driven by significant increases in software license fees through distribution partners and direct sales, and maintenance and service revenue from an increasing customer base.  Revenue through our distribution partnership with Toshiba Medical Systems Corporation (“Toshiba”) was $6.2 million, or 55% of total revenue, in the first quarter of 2005, compared to $5.4 million, or 68% of revenue, in the first quarter of 2004.  The remaining increases were driven by direct sales and continued growth in maintenance and service revenue from an increasing customer base.

License fee revenue increased 32% to $7.3 million from $5.5 million in the first quarter of 2004.  The increase in software license fee revenue was driven by an increase in the number of Vitrea^®2 licenses sold and an increase in the number of Vitrea software add-on options sold.  Sales from Vitrea^® 2 software options increased 27% to $4.1 million, or 36% of license fee revenue, compared to $3.2 million, or 41% of revenue, in the first quarter of 2004, while the Vessel Probe, CT Cardiac and CT Colon options continue to lead option sales.  The number of options sold increased to approximately 625 for the three months ended March 31, 2005 from approximately 490 for the three months ended March 31, 2004.

23

Maintenance and services revenue increased 69% to $3.4 million for the first three months of 2005 compared to $2.0 million for the first quarter of 2004.  Of the $1.4 million increase for the first quarter of 2005 compared to the same period in 2004, $1.1 million consisted of an increase in maintenance revenue, $126,000 consisted of increased training revenue and $73,000 consisted of increased installation revenue.  The increases in all categories of maintenance and service revenue were due to a significant increase in our customer base and improved pricing.  The increase in training revenue in the first quarter of 2005 was due in part to the introduction of the offsite regional training program and overall increased sales of Vitrea^® 2.

Hardware revenue increased $356,000 to $643,000 in the first quarter of 2005 from $287,000 in the first quarter of 2004.  The increase was primarily due to overall increased sales of hardware in the first quarter of 2005.

Gross margin.  Our gross margin was 76% in the first quarter of 2005, compared to 70% in the first quarter of 2004 and 71% for the year ended December 31, 2004.  Improved margins were primarily associated with maintenance and services revenue growth and lower than expected costs related to our training services.  We anticipate that these gross margin rates are not sustainable in the long-term.  In order to maintain similar levels of service going forward, we will continue to invest in our training and customer support areas.

License fee gross margin increased to 85% from 82% for the three months ended March 31, 2005 and 2004, respectively.  Sales directly to end users increased as a percentage of revenue, versus sales through distribution relationships with partners such as Toshiba.  License sales through strategic partnerships carry a slightly lower margin than sales directly to end users.  Included in the cost of revenue for license fees in the first quarter of 2005 are royalty expenses of $375,000 and amortization of intangibles of $279,000 related to the HInnovation acquisition, versus $427,000 and $142,000 in the same period in 2004, respectively.  We pay royalties to third parties who supply technology that is embedded into our products.  Management expects that as additional new products and features are developed, we will continue to increase our use of such third party technology.  In addition, we sell third party software products, including lung visualization products and a fusion technology product, and gross margin earned on third party software products is considerably less than the gross margins we earn on our own internally-developed software products.  As a result, license fee gross margins will continue to fluctuate based on the composition of the customers as well as the amount of third party software products sold and third party technology that is embedded into our products.

Maintenance and services gross margins increased to 63% from 45% for the three months ended March 31, 2005 and 2004, respectively.  The increased maintenance and services gross margin was due in part to changes in pricing structure and an increase in maintenance and services revenue from Toshiba in the first quarter of 2005 compared with the first quarter of 2004, with minimal associated cost increases.  We plan to increase our cost infrastructure primarily through additional personnel during 2005 to support our growing customer base.

Hardware gross margins increased to 43% from 15% for the three months ended March 31, 2005 and 2004, respectively.  Hardware gross margins have been and will continue to be volatile based on the composition of the customers and mix of third party hardware sold.

Sales and marketing.  Sales and marketing expenses increased to $3.4 million for the three months ended March 31, 2005 from $2.7 million for the three months ended March 31, 2004, a 27% increase.  The increase was due to increases in commission expense resulting from significantly higher revenues. Commission expense increased $302,000 to $873,000 compared to $571,000 for the three months ended March 31, 2004.  In addition, the number of total sales and marketing personnel increased from 45 at March 31, 2004 to 55 at March 31, 2005.  Due to this increase in the number of personnel, employment related costs, travel and entertainment expenses and overhead allocation expenses increased $186,000 for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004.

24

We expect sales and marketing costs to increase in future periods as a result of the hiring of additional sales and marketing personnel and increased marketing activities for our products.

Research and development.  Research and development expenses increased 6% to $1.8 million for the three months ended March 31, 2005, compared with $1.7 million for the same period last year.  The increase in expenses was primarily due to increased salaries and benefits expense from the addition of personnel, which increased $97,000 to $1.2 million from $1.1 million for the period ended March 31, 2004.  Research and development expenses for the three months ended March 31, 2004 also included $192,000 of costs related to severance for our former vice-president of engineering and two other employees.

We anticipate that research and development costs will increase in future periods as we develop software tools for applications with large potential markets, such as cardiovascular disease, disease screening applications such as colon cancer, and surgical and therapy planning.  We are making significant investments in tools that offer increased productivity, flexibility and efficiency for our customers.

General and administrative.  General and administrative expenses decreased 8% to $1.6 million for the three months ended March 31, 2005, compared with $1.7 million in the first quarter of 2004.  General and administrative expenses in the first quarter of 2005 included a bad debt expense recovery of $184,000 relating to a partial recovery of an outstanding receivable that was written off in the first quarter of 2004; the recovery resulted in a $684,000 change in bad debt expense from the first quarter of 2004 to the first quarter of 2005.  In addition, legal and audit related fees increased $119,000 in the first quarter of 2005 compared to the first quarter of 2004, primarily due to costs related to compliance with the requirements of the Sarbanes-Oxley Act of 2002.  Costs for contract labor and temporary workers increased $93,000 in the first quarter of 2005 compared to the same period in 2004.  Salaries and benefits expense increased $209,000 to $728,000 in the first quarter of 2005 from $519,000 in the first quarter of 2004 due primarily to increased personnel in the finance and accounting department.  In the first quarter of 2005, we also paid severance to our former Chief Financial Officer in the amount of $105,000.

We anticipate that general and administrative expenses will increase in future periods due to growing compliance requirements and increasing infrastructure costs as the business grows.

Other items.  Loss on operating lease – In March 2004, we signed a non-cancelable operating lease for a new office facility in Minnetonka, Minnesota.  The new lease term started in February 2005 and expires in January 2012.  We moved into the Minnetonka location and moved out of our Plymouth, Minnesota location in February 2005.  Our office facility in Plymouth expires on July 31, 2005 with the exception of a small portion of the space that is under lease until May 31, 2006.  Under the terms of the new lease, the Minnetonka lessor will pay the monthly base rent payments and taxes and operating cost rent obligation payments for our former office facility in Plymouth beginning in February 2005.  In the first quarter of 2005, we recorded a lease loss of $493,000 related to the abandonment of the Plymouth office facility.  The estimated lease payments to be made by the Minnetonka landlord to the Plymouth landlord are considered a lease incentive and recorded as an immediate charge and deferred rent, which is amortized as a reduction of rent expense through the term of the lease.

Acquired in-process research and development – Results for the first quarter of 2004 included a $1.0 million write-off of in-process research and development costs related to the HInnovation acquisition.

Interest income.  Interest income increased to $163,000 from $65,000 for the three months ended March 31, 2005 and 2004, respectively, due to increasing interest rates and to a higher average balance of cash, cash equivalents and marketable securities during the period in 2005 compared with the same period in 2004.

25

Income taxes.  Our quarterly consolidated effective income tax rate was 33.3% for the three months ended March 31, 2005, which is based on our estimated effective income tax rate for fiscal 2005, compared to 14.2% for the same period in 2004 and the consolidated effective income tax rate of 66.5% for fiscal 2004.  The 2005 effective income tax rate is anticipated to be lower than our combined federal and state statutory rates of 38% as a result of research and development credits, which are a direct reduction of taxes.  The 2004 effective income tax rate was impacted by the $1.0 million in-process research and development costs related to the HInnovation acquisition, which was not tax deductible.

The provision for income taxes consists of provisions for federal and state income taxes.  Losses incurred by our China subsidiary are not recognized as a benefit to the provision for income taxes because such losses are fully reserved, as it has been determined that it is more likely than not that no tax benefit will be realized relating to these losses in the future.  The consolidated income tax rate is a composite rate reflecting the earnings in the various locations and the applicable rates.

We review our annual effective income tax rate on a quarterly basis and make changes as necessary.  The estimated annual effective income tax rate may fluctuate due to changes in forecasted annual operating income; changes to the valuation allowance for net deferred tax assets; changes to actual or forecasted permanent book to tax differences; impacts from future tax settlements with state, federal or foreign tax authorities; or impacts from tax law changes. In addition, we identify items which are not normal and recurring in nature and treat these as discrete events.  The tax effect of discrete items is booked entirely in the quarter in which the discrete event occurs.

Our effective income tax rate can be volatile because based on the level of operating income achieved, the level of research and development credits available to us, the mix between our U.S. operating results, for which we record income taxes, and our foreign operating results, for which we do not record an income tax benefit due to the uncertainty of realizing these tax benefits in future years in our foreign jurisdictions.  Based on current estimates, we anticipate an effective tax rate of 30% to 35% for fiscal 2005.  Any future valuation allowance recorded on our net deferred tax assets of $9.3 million as of March 31, 2005 would have an adverse effect on our tax provision and results of operations.

Years Ended December 31, 2004 and 2003

Revenue.  Total revenue increased 32% to $36.1 million in 2004 from $27.3 million in 2003.  Total revenue increased 29% to $27.3 million in 2003 from $21.1 million in 2002.  The revenue growth was driven by the increase in our core revenue components of software license fees and maintenance and service revenue.  License fee revenue increased 31% to $24.1 million from $18.4 million in 2003 and increased 29% to $18.4 million in 2003 from $14.2 million in 2002.  The increase in software license fee revenue was driven by an increase in the number of Vitrea 2 licenses sold, principally to Toshiba Medical Systems Corporation (“Toshiba”), and an increase in the number of Vitrea add-on options sold.  In addition, the sale of third-party software products increased to $1.8 million in 2004 from $194,000 in 2003.  The installed base of Vitrea customers increased from approximately 850 at December 31, 2002, to approximately 1,300 at December 31, 2003, and to approximately 1,900 at December 31, 2004.  The number of Vitrea add-on modules we sold increased from approximately 660 in 2002, to 1,200 in 2003, and to 2,400 in 2004.

Maintenance and services revenue increased 39% to $9.5 million for 2004 compared to $6.8 million for 2003 and increased 70% to $6.8 million in 2003 from $4.0 million in 2002.  Of the $2.7 million increase for 2004 compared to 2003, $2.0 million consisted of an increase in maintenance revenue and $1.1 million was an increase in training revenue.  The increases for 2004 were partially offset by a $380,000 decrease in engineering services rendered under product development agreements with Medtronic Surgical Navigation Technologies (“SNT”), E-Z-EM, Inc. and Toshiba and a $44,000 decrease in installation revenue due to Toshiba performing its own installations of Vitrea 2. The increase in training revenue in 2004 was due in part to the introduction of

26

the offsite regional training program.  Maintenance revenue increased $2.8 million from 2002 to 2003.  Maintenance revenue increased in all periods primarily due to an increased customer base and improved pricing.

For 2004, we generated 57% revenue growth from the sale of Vitrea 2 options, including VScore™, CT Colonography, Automated Vessel Measurements and CT Cardiac.  The sale of Vitrea 2 options totaled $14.1 million for 2004 compared with $9.0 million for 2003 and $6.0 million for 2002.  For 2004, software license fee revenue from sales to Toshiba totaled $12.9 million compared with $8.3 million for 2003 and $6.0 million for 2002.  Toshiba represented 50%, 42% and 34% of total revenue in 2004, 2003 and 2002, respectively.

Hardware revenue increased 23% to $2.5 million in 2004 from $2.1 million in 2003.  The increase from 2003 to 2004 was due to price increases in hardware and overall increases in sales of Vitrea licenses.  Hardware revenue decreased 28% to $2.1 million in 2003 from $2.9 million in 2002.  The decrease from 2002 to 2003 was due to a decrease in the number of complete system sales and lower unit pricing for hardware platforms shipped in 2003.

Gross Margin.  Our gross margin was 71% in 2004, down from 74% in 2003, in part due to the increase in the cost of third-party software, which is up $1.1 million over 2003.  In addition, $976,000 of expense was incurred due to amortization of intangibles throughout the year related to the HInnovation acquisition that was charged to cost of revenue.  These factors led to reduced software margins of 83% in 2004, compared to 90% in 2003.  Maintenance and services margins were 51% in 2004, up from 45% in 2003, in part due to changes in pricing structure for maintenance and training services.  Hardware margins were 30% in 2004 compared to 28% in 2003.  Gross margin in 2003 increased to 74% from 70% in 2002, as total revenue included higher margin license revenue and less hardware revenue, which carries a lower margin.

Sales and Marketing.  Sales and marketing expenses were $12.2 million, $9.3 million and $6.8 million for 2004, 2003 and 2002, respectively.  The increases were mostly due to increases in compensation costs as a result of additional personnel required to drive and support recent growth and increased sales commissions as a result of increased revenue.  Compensation costs, including commissions, increased $1.8 million from 2003 to 2004 and $1.5 million from 2002 to 2003, due to more sales and marketing personnel and higher commissions related to the increase in revenue.  There were 53, 42, and 33 sales and marketing personnel as of December 31, 2004, 2003 and 2002, respectively.  Due to the increase in the number of personnel from 2003 to 2004, travel and entertainment expenses increased $440,000.  Tradeshow, advertising and marketing brochure costs increased $425,000 and $65,000 from 2003 to 2004 and 2002 to 2003, respectively, because we attended more tradeshows and increased our presence at tradeshows by purchasing more booth space.

From 2002 to 2003, there was a $356,000 increase in expenses related to utilizing outside consultants to help sell and promote Vitrea 2 and related options for 2003 as compared to 2002.  We expect sales and marketing costs to increase in future periods as a result of the cost of additional sales and marketing personnel and increased sales of our product.

Research and Development.  Research and development expenses were $6.3 million, $5.2 million and $4.1 million in 2004, 2003 and 2002, respectively.  Of the $1.2 million expense increase from 2003 to 2004, $677,000 was due to increased compensation costs resulting from additional personnel supporting software and product development and additional employees related to our acquisition of HInnovation, Inc.  Total research and development personnel increased from 38 at December 31, 2003 to 50 at December 31, 2004.

Due to more training and increased personnel, training and hiring costs increased $64,000 from 2002 to 2003, respectively.  There was a $189,000 expense increase due to a decrease in expenses classified in cost of revenue in connection with engineering services provided to certain third parties under various product development agreements in 2003 as compared to 2002.  We anticipate that research and development costs will

27

increase in future periods as we develop software tools for applications with large potential markets, such as cardiovascular disease, disease screening applications such as colon cancer, and surgical and therapy planning.

General and Administrative.  General and administrative expenses were $5.6 million, $3.8 million, and $3.2 million in 2004, 2003 and 2002, respectively.  Of the $1.8 million increase from 2003 to 2004, $404,000 was due to an increase in compensation costs related to additional personnel.  Fees related to accounting, legal, consulting, regulatory filings and temporary worker services increased $518,000 in 2004.  These fees were primarily due to costs related to implementation of Section 404 of the Sarbanes-Oxley Act of 2002, as well as additional costs incurred as a result of a restatement at the end of the third quarter of 2004.  In addition, bad debt expense increased $580,000 during 2004 as a result of reserves established for specific accounts in the first quarter of 2004.  Total general and administrative personnel increased from 21 at December 31, 2003 to 23 at December 31, 2004.

Legal fees increased $227,000 during 2003 as compared to 2002 due to business development, patent work and SEC filings related to the registration statement covering the resale of shares from a private placement in June 2003.  Registration and filing fees increased $104,000 in 2003 as compared to 2002, which includes a $100,000 NASDAQ National Market registration fee.  This registration fee was paid for the first time in June 2003 when our common stock qualified for listing on the NASDAQ National Market.  These increases were partially offset by a $230,000 decrease due to severance costs paid in 2002 to our former chief executive officer.  We believe that general and administrative expenses will increase in future periods due to increased infrastructure costs as the business grows and as the legal and regulatory environment continues to place increased emphasis on administrative functions.

Operating Income.  The increased revenue from Vitrea 2 and add-on software options and related service revenues, net of the increased expenses attributable to the development of our infrastructure and the development and promotion of the Vitrea 2 product, resulted in operating income of $514,000 for 2004 compared with $1.9 million for 2003 and $677,000 for 2002.

Operating income was $514,000 in 2004, which included amortization of identified intangibles of $1.1 million and an acquired in-process research and development charge of $1.0 million related to the acquisition of HInnovation, compared to $1.9 million in 2003.

Interest Income.  There was $368,000 of interest income for 2004, compared with $214,000 in 2003 and $135,000 in 2002.  These increases were primarily due to increases in cash, cash equivalents and marketable securities.  The increases in cash, cash equivalents and marketable securities were due to the increased cash flows from operations from 2002 to 2003 and from 2003 to 2004 and the $19.0 million of cash generated from the private placement in June 2003.

Income Taxes.  Our methodology for determining the realizability of our deferred tax assets involves estimates of future taxable income from our core business, the estimated impact of future tax deductions from the exercise of stock options outstanding as of December 31, 2004, and the expiration dates and amounts of net operating loss carryforwards and other tax credits. These estimates are projected through the life of the related deferred tax assets based on assumptions which management believes to be reasonable and consistent with current operating results.

Although we had cumulative pre-tax income for financial reporting purposes for the three years ended December 31, 2004, we did not pay any significant income taxes over that period due to tax deductions from the exercise of stock options as well as utilization of net operating losses.  In assessing the realizability of our deferred tax assets as of December 31, 2004, we considered evidence regarding our ability to generate sufficient future taxable income to realize our deferred tax assets. The primary evidence considered included the cumulative pre-tax income for financial reporting purposes for the past three years; the cumulative tax operating

28

loss for the past three years; the estimated impact of future tax deductions from the exercise of stock options outstanding as of December 31, 2004; and the estimated future taxable income based on historical operating results.

After giving consideration to these factors, we concluded that it was more likely than not that tax loss carryforwards that expire in 2005 and other tax credits that expire within the next four years will not be utilized due to the estimated future tax deductions from the exercise of stock options outstanding as of December 31, 2004.  As a result, we recorded a valuation allowance of $183,000 for the year ended December 31, 2004.  We also recorded a valuation allowance of $43,000 relating to 2004 foreign net operating losses that are subject to uncertainty regarding utilization and, therefore, a full valuation allowance was recorded.

We also concluded that it was more likely than not that the net deferred tax assets of $9.1 million as of December 31, 2004 and the estimated future tax deductions from the exercise of stock options outstanding as of December 31, 2004 would be utilized prior to expiring.  Based on this conclusion, we would require approximately $42 million in cumulative future taxable income to be generated at various times over the next 20 years to realize the related net deferred tax assets of $9.1 million as of December 31, 2004 as well as the estimated future tax deductions from the exercise of stock options outstanding and in-the-money as of December 31, 2004.

If we adjust our estimates of future taxable income or tax deductions from the exercise of stock options, or if our stock price increases significantly without a corresponding increase in taxable income, we may need to establish additional valuation allowances, which could materially impact our financial position and results of operations.

During 2003, we concluded that it is more likely than not that substantially all of our net deferred tax assets would be realized, and we reversed substantially all of our valuation allowance for net deferred tax assets, which resulted in the recording of a net tax benefit in 2003.  The reversal of the deferred tax assets valuation allowance is based upon our historical operating performance and management’s expectation that we will generate taxable income of at least $25 million in future periods to allow us to realize our deferred tax assets resulting from the tax benefits associated with our net operating loss carryforwards and a significant portion of our research and development tax credit carryforwards, as well as certain other tax benefits related to book and tax income timing differences. The reversal of the valuation allowance resulted in a tax benefit of $7.2 million.  This reversal net of other current year state and federal income taxes resulted in a net tax benefit of $6.5 million in 2003.

Our effective income tax rate is volatile based on the level of operating income achieved, the level of research and development credits available to us, the mix between our U.S. operating results, for which we record income taxes, and our foreign operating results, for which we do not record an income tax benefit due to the uncertainty of realizing these tax benefits in future years in our foreign jurisdictions.  Based on current estimates, we anticipate an effective tax rate of 36% to 39% for fiscal 2005.  Any future valuation allowance recorded on our net deferred tax assets of $9.1 million as of December 31, 2004 would have an adverse effect on our tax provision and operating results.

The income tax provision for 2002 consists solely of certain state minimum fees.  As a result of our history of generating net operating losses, we had established a valuation allowance to completely reserve for our deferred tax asset at December 31, 2002.

29

Liquidity and Capital Resources

As of March 31, 2005, we had $32.9 million in cash, cash equivalents, and marketable securities, working capital of $33.3 million and no borrowings, as compared to $35.7 million in cash, cash equivalents, and marketable securities, working capital of $31.0 million and no borrowings as of December 31, 2004.

Operating Activities

During the three months ended March 31, 2005, cash used in operations was $1.6 million, which consisted of a decrease of $4.4 million from changes in working capital accounts offset by $2.8 million increase from other operating activities.  Changes in the working capital accounts primarily related to a $5.7 million increase in accounts receivable due to an increase in days’ sales outstanding on an annualized basis to 113 days as of March 31, 2005 from 67 days as of December 31, 2004 (based on the fourth quarter on an annualized basis).  The increase in days’ sales outstanding was primarily due to a significant increase of $3.7 million in current accounts receivable to $9.9 million from $6.2 million, as the majority of sales were closed in the second half of the first quarter of 2005 and payment was not due until the second quarter of 2005.  Another component of the increase in days’ sales outstanding included a deterioration of accounts receivable aging.  Other significant changes in working capital accounts consisted of:  an increase of $1.6 million in deferred revenue due to increased sales and customer base; a decrease of $1.6 million in accrued liabilities due to the payout of the 2004 annual bonus in the first quarter of 2005 as well as the payout of accrued commissions as of December 31, 2004 in the first quarter of 2005; and an increase of $1.2 million in deferred rent relating to payments and estimated payments to be made by our Minnetonka landlord for our benefit.

During the three months ended March 31, 2004, cash provided by operations was $553,000, which consisted of an increase of $31,000 from changes in working capital accounts and an increase of $522,000 for other operating activities.  Changes in the working capital accounts primarily related to an increase of $1.2 million in accounts receivable due to increased revenues. Other significant changes in working capital accounts consisted of an increase of $829,000 in deferred revenue due to increased sales and customer base in the first quarter of 2004.

Investing Activities

We used cash of $2.2 million and $12.1 million for investing activities during the first three months of 2005 and 2004, respectively.

We used $2.1 million and $147,000 of cash for property and equipment purchases during first three months of 2005 and 2004, respectively.  The purchases in the first quarter of 2005 were related to our move to a new office facility in February 2005, which included expenditures for leasehold improvements, furniture and equipment.  Management anticipates that we will continue to purchase property and equipment as necessary in the normal course of business.  The amount and timing of these purchases and the related cash outflows in future periods is difficult to predict and depends on a number of factors, including the hiring of employees and the rate of change of computer hardware.

We used $3.1 million and $6.9 million of cash to purchase marketable securities during first three months of 2005 and 2004, respectively.  We realized $3.0 million and $1.5 million of proceeds from sales of marketable securities during the first three months of 2005 and 2004, respectively.  The marketable securities are invested in U.S. government obligations, U.S. government agency obligations, corporate commercial obligations and certificates of deposits.

30

Financing Activities

Cash provided by financing activities totaled $1.1 million and $526,000 for the three months ended March 31, 2005 and 2004, respectively.  The cash provided by financing for the first three months of 2005 and 2004 resulted from the sale of common stock under our stock plans.

We have never paid or declared any cash dividends and do not intend to pay dividends in the near future.

The following summarizes our contractual obligations due each period, including purchase commitments as of March 31, 2005 and the effect such obligations are expected to have on our liquidity and cash flow: