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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2002

or

Commission File Number 000-49804

Kyphon Inc.

(Exact name of Registrant as specified in its charter)

1350 Bordeaux Drive

Sunnyvale, California, 94089

(Address of principal executive offices, including Zip Code)

(408) 548-6500

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value

(Title of Class)

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

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

Indicate by check mark whether Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes  x  No  ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on June 28, 2002 (which is the last business day of registrant’s most recently completed second fiscal quarter), as reported on the NASDAQ National Market was approximately $189.1 million. Shares of Common Stock held by each executive officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

At March 14, 2003, the Registrant had 37,822,642 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Items 10, 11, 12 and 13 of Part III of this Form 10-K incorporates information by reference from the registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year.

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KYPHON INC.

FISCAL YEAR 2002 FORM 10K ANNUAL REPORT

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PART 1

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws. These statements include those concerning the following: our intentions, beliefs and expectations regarding our future success and results; the timing and success of our clinical trials and regulatory submissions; our belief that our cash and cash equivalents will be sufficient to satisfy our anticipated cash requirements; our operating results; our expectations regarding our revenues and customers; and our distributors and territorial expansion efforts. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties, see the “Business” section of this Form 10-K.

Kyphon undertakes no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-K.

ITEM 1.     BUSINESS

Overview

We develop medical devices to restore spinal anatomy using minimally invasive technology. Our initial marketing focus is on surgeons who repair spine fractures caused by osteoporosis. Our first commercial products, comprising our KyphX instruments, utilize our proprietary balloon technology. Surgeons use those tools to help repair fractures during minimally-invasive spine surgeries. Alternative spine fracture treatments are either highly invasive or are pain-management therapies that do not repair the fracture.

Each year, there are approximately 700,000 clinically diagnosed spine fractures due to osteoporosis in the United States and Europe in approximately 550,000 patients. Osteoporosis is a disease that primarily affects women over the age of 50 and that is characterized by bone deterioration, leading to an increased susceptibility to spine fractures. These fractures can result in an increased risk of death, significant pain, reduced respiratory function and impaired quality of life.

As of December 31, 2002, we had trained more than 2,700 physicians in the United States, Europe and South Korea in the use of our KyphX instruments, and these physicians had used our instruments in over 28,000 spine surgeries. Based on our experience to date and supported by published peer-reviewed physician journal articles, we believe that use of our KyphX instruments during minimally-invasive spine surgery leads to significant patient benefits, including the ability to reverse the collapse of the bone caused by the spine fracture. Reversal of collapsed bone in the spine can potentially reduce spine deformity, thereby increasing mobility and improving respiratory function in patients. Risks of procedures using our instruments include the same risks common to performing surgery using anesthesia and to performing surgery on older patients. In addition, like other spine surgeries, these procedures using our instruments may result in serious complications, including bleeding, nerve injury, paralysis and death.

In May 2000, we commenced full commercial introduction of our KyphX instruments in the United States. We devote significant resources to supporting our sales and marketing team, training and educating physicians and supporting reimbursement and clinical activities related to our products. As of December 31, 2002, we had 16 U.S. issued patents, 14 issued foreign patents, 34 pending U.S. patent applications, 111 pending foreign applications and 23 licensed patents.

In August 2002, we acquired the rights to 23 patents owned by Bonutti Research covering the use of inflatable devices for use in and around soft tissue in the spine. In February 2003, we acquired Sanatis GmbH, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. We intend to pursue the development and commercialization of spine products arising from these acquisitions to complement our existing KyphX instruments and leverage our spine sales force. The commercialization of products from these acquisitions will require research, development, and regulatory approvals and/or clearances, and may require clinical studies prior to market launch.

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Anatomy of the Spine

The spinal column contains 24 bones called vertebrae. Each vertebra consists of a large block of bone, called the vertebral body, that helps maintain upright posture. The soft tissue between each vertebrae is generally referred to as a spinal disc. The vertebral body consists of soft inner, or cancellous, bone surrounded by a thin outer shell of hard bone. Each vertebra also has bone segments that extend out from the vertebral body, called the posterior elements, that surround and protect the spinal cord.

Consequences of Spine Fractures

When the spine is structurally weakened, routine downward pressure can cause a vertebral body to collapse and fracture. These fractures are referred to as vertebral body compression fractures. The vertebral body generally fractures at the front, which can subsequently cause the spine to tilt forward. Over time, these fractures can result in a curved deformity of the spine and a forward stooped posture called kyphosis. Vertebral compression fractures are caused primarily by deterioration of the inner cancellous bone due to osteoporosis. Other causes of spine fractures include trauma, tumors and infection.

Unrepaired spine fractures can result in serious physical and emotional consequences, including:

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Market Opportunity for the Treatment of Spine Fractures

We believe an estimated 700,000 clinically diagnosed spine fractures due to osteoporosis occur in the United States and Europe each year. In the U.S. alone, we believe there are an additional 440,000 fractures that go undiagnosed or untreated. The majority of the diagnosed fractures are managed in the hospital or at home predominantly with conservative treatment options such as bed rest, pain medication and back braces. Approximately 150,000 people in the United States are hospitalized due to pain associated with spine fractures, resulting in costs estimated to be in excess of $1.6 billion annually. The number of fractures caused by osteoporosis is increasing primarily due to the aging of the population.

Alternative Means for the Treatment of Spine Fractures

When treating a patient with a spine fracture, an orthopedic surgeon’s primary objective, as with any fracture, is to reduce the fracture, that is, to return the bone to its pre-fracture position. While surgeons can use conventional orthopedic surgical techniques to reduce and otherwise repair spine fractures, these procedures are highly invasive and especially risky for elderly patients. As a result, physicians rarely refer their patients for surgical procedures to repair spine fractures, but instead prescribe therapies and treatments designed to simply manage the pain.

Conventional Spine Surgery

Spine surgery is complex and risky due to the proximity of the surgical site to the spinal cord and major organs. Conventional spine surgery can repair fractured vertebrae and restore height, but is highly invasive and involves significant risks. These surgeries involve making long incisions in the patient’s chest so that large stainless steel instruments can move the fractured bones back into their normal position. However, the instruments used in these surgeries are not optimally designed to manipulate deteriorated bone. The fractured bones are then held in place by metal implants, which, in the case of elderly patients with osteoporosis, can fail to hold due to the softness of the inner cancellous bone to which they are attached. As a result, this surgery is performed in very limited circumstances. The invasiveness of conventional spine surgery may lead to death, spinal cord injury, extensive post-operative hospital stays and prolonged bed rest for recovery. Additional complications may include bowel, lung and nerve damage, pain, bleeding, infection and blood clots.

Pain Management Therapies

Due to the limitations of conventional orthopedic surgery for patients with spine fractures, the majority of these patients are treated with conservative pain management therapies. These methods do not involve surgical intervention and do not repair the fractured spine. These pain management therapies can comprise many techniques, alone or in combination, including:

These therapies are designed to provide pain relief while the fractured vertebra slowly sets in its collapsed form. Periods of treatment can be lengthy, resulting in expensive hospital stays and follow-up. These therapies

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can also worsen the underlying problem. For example, bed rest is known to cause bone and muscle loss, making recovery more difficult in elderly patients, and potentially leading to additional fractures. In addition, doctors report that patient compliance with these therapies is low because of the:

In addition, physicians may stabilize the fractured area by a treatment that has become known as vertebroplasty. Vertebroplasty does not repair the spine fracture, but simply reduces the associated pain. Because vertebroplasty freezes the vertebral body in its collapsed position, patients may continue to suffer the physical, emotional and quality of life problems associated with unrepaired spine fractures.

In vertebroplasty, a physician, typically an interventional radiologist, places one or two large needles into the fractured vertebra, and injects bone filler material into the collapsed vertebral body. The bone filler most commonly used in vertebroplasty is bone cement, which the FDA has not specifically approved for use as a bone filler in the spine. Because the vertebral body is in a collapsed position, this procedure requires the use of thin bone filler material that is injected under high pressure in order to effectively penetrate the inner spaces of the deteriorated bone. Once injected, the bone filler material hardens and fixes the bone in its collapsed position.

Our Products

Kyphon provides surgeons with tools to help repair fractures during minimally-invasive spine surgery. Our instruments have also been used in open surgical procedures. We generally refer to our products as the KyphX instruments.

Minimally-invasive spine fracture surgeries using our KyphX instruments involve the insertion of two of our disposable proprietary balloon devices into the fractured bone. The surgeon inflates our balloons to compact and move the deteriorated bone. As a result of the inflation of the balloons, the collapse caused by the fracture may be reversed. This reversal will be more difficult if the bone has previously healed in its fractured position. The balloons are then removed, and the newly-created cavity is stabilized by filling it with the surgeon’s choice of bone filler material, which can include bone cement, a plastic polymer that hardens in place. We believe that surgeons typically use a relatively thick bone cement at low pressure and under manual control. Although bone cement may be used by surgeons if they feel it is in the best interest of the patient, we may not promote bone cement for use in the spine without additional regulatory approval. Currently, there is no bone filler that has specifically been approved for use with the KyphX instruments to repair spine fractures.

We have trained more than 2,700 physicians, including 500 in Europe and 50 in other international sites primarily South Korea, in the use of our KyphX instruments. These physicians have used our instruments in over 28,000 surgeries involving spine fractures.

Based upon published reports of clinical results, discussions with surgeons who have used our instruments, and our own research, we believe that the use of our KyphX instruments during minimally-invasive spine surgery may lead to significant clinical outcomes, including the following:

Currently, our FDA clearance permits us to promote in the United States our KyphX Inflatable Bone Tamp, a device used to move and compact bone, for use as a conventional bone tamp for the reduction of fractures and/

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or the creation of a void in cancellous bone in the spine, hand, tibia (a leg bone), radius (an arm bone) and calcaneus (the heel bone). Before we can promote and market in the United States the use of our KyphX instruments in any specific procedure, or claim any treatment benefits from any procedure, we may need to conduct clinical studies to document the benefits, if any, and receive FDA approval.

We are discussing alternatives to clinical trials, or least burdensome pathways, with the FDA to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared KyphX instruments in a specific minimally-invasive spine procedure and to determine the benefits resulting from that procedure. We cannot assure you that we will achieve consensus on such a pathway. If we do not achieve consensus, we will instead be seeking regulatory approval to initiate clinical studies. We cannot assure you that our studies, if completed, will demonstrate to the FDA’s satisfaction any treatment benefits from spine fracture repair procedures using the KyphX Inflatable Bone Tamp or that the FDA will approve any treatment benefit claims in a timely fashion, if at all. If we fail to obtain additional FDA approvals that will allow us to promote the treatment benefits of the KyphX Inflatable Bone Tamp, our ability to expand the commercialization of our products may be impaired.

Risks of spine fracture surgery performed with our KyphX instruments include the same risks common to performing surgery using anesthesia and performing surgery on elderly patients. In addition, as with other spine surgeries, surgeries using our instruments may result in serious complications, including chronic pain; follow-up surgery; infection; unintended damage to the bone or tissue; bleeding; bowel, lung or nerve injury; paralysis; and death. Use of bone filler material by surgeons to fill the void created using our KyphX Inflatable Bone Tamp may also lead to these complications, as a result of leakage of the bone filler material into the spinal canal or surrounding tissue.

The Use of KyphX Instruments During Minimally-Invasive Spine Surgery

Spine fracture surgeries using our KyphX instruments are minimally invasive and are generally performed by spine-focused orthopedic surgeons and neurosurgeons. A surgeon first creates a working channel through the patient’s back into the fractured vertebral body using our KyphX Bone Access System.

The surgeon then inserts two of our proprietary disposable KyphX Inflatable Bone Tamps into the fractured bone and carefully inflates them with fluid using X-ray images to monitor the procedure. Surgeons can control inflation volume and pressure using our KyphX Inflation Syringe. Inflation of the balloons compacts the soft inner bone creating a cavity. When possible, this inflation also pushes the hard outer bone up toward its natural position, reducing the fracture.

The KyphX Inflatable Bone Tamps are then removed, and the surgeon chooses a bone filler material to insert into the void. Using the KyphX Bone Filler Device, the surgeon delivers the chosen bone filler material into the void under manual control and low pressure to minimize the risk of material leaks.

Once the procedure is complete, the incisions are closed typically with a small number of stitches. These procedures are usually performed in the operating room, but may also be performed in an outpatient setting. Surgeons choose local or general anesthesia based on patient health and preference and the number of fractures to be treated. The entire surgical procedure is usually performed in about one hour per fracture treated. Because the patients are often older, they are usually admitted for observation in an overnight hospital stay.

Business Strategy

Our goal is to become the recognized leader in restoring spinal function through minimally invasive therapies. In particular, the key elements of our strategy are to:

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Products

We currently sell the following instruments for use in spine fracture procedures:

Bone Access Systems.    Bone Access Systems are sterile sets of small disposable surgical tools used to access and create a working channel into the fractured bone. One version contains a long guide pin, an instrument used to separate tissue and a small hand drill. In addition, it contains two small tubes through which other tools are passed and a proprietary handle that can be used with multiple KyphX tools. A second version combines the instrument used to separate tissue, the small tube through which other tools are passed and the proprietary handle into one tool. Alternative versions of this one tool can either be pushed or twisted into and through bone. All versions of the Bone Access System contain a sterile needle used to penetrate hard bone.

Inflatable Bone Tamp.    Our proprietary KyphX Xpander Inflatable Bone Tamps are disposable sterile devices that combine the functionality of a metal bone tamp with the engineering principles of medical balloon technologies. Unlike other medical balloons, however, our balloons are specially designed to be used in bone. Other currently available medical balloons are not used in bone because they are not appropriate in size, shape or durability, or are not designed to provide lifting force.

Conventional bone tamps are rigid stainless steel instruments that move fractured hard bone and compact soft bone using indirect mechanical force. While it is the goal of orthopedic surgeons to move a fractured area all at once, conventional bone tamps cannot do this without a large incision and without significant tissue and bone disruption. Unlike other bone tamps, the KyphX Xpander Inflatable Bone Tamp contains a balloon that can be placed inside a fractured bone through a narrow working channel and expanded to move fractured bone all at once. Once inside, the balloon portion of the KyphX Xpander Inflatable Bone Tamp is carefully inflated under X-ray monitoring. This inflation applies direct mechanical force to compact the soft inner bone and push up the broken hard outer bone.

Inflation Syringe.    Our KyphX Xpander Inflation Syringe is a disposable sterile device with a rotating handle and a built-in pressure gauge that precisely controls the inflation of our KyphX Xpander Inflatable Bone Tamp. The rotating handle allows the surgeon to deliver a measured volume of the fluid that inflates the balloon.

Bone Filler Device.    The KyphX Bone Filler Device is a disposable stainless steel nozzle with an inner rod and a plastic handle. Bone filler can be loaded into the nozzle and pushed into the void with the inner rod under low pressure and fine manual control.

Bone Biopsy Device.    Our KyphX Bone Biopsy Device is a disposable, stainless steel tube and rod that can be used to take biopsy samples of soft bone for further evaluation.

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Clinical Studies

We have initiated a clinical study in Europe and may conduct a clinical study in the United States. Although the two studies may have several common clinical assessments and clinical end points, they are intended to serve different purposes.

The U.S. clinical study, if needed, would generate additional clinical safety and effectiveness data to support FDA approval or market clearance for a bone cement as a bone filler material that would be used in conjunction with our KyphX instruments in a specific minimally-invasive surgery for the treatment of spine fractures. This approval or market clearance would allow us to promote a specific procedure using our KyphX instruments, and allow us to expand marketing claims to include treatment benefits, depending on whether the study results are accepted. We have begun to work with the FDA to evaluate potential alternatives to a clinical trial, or least burdensome alternatives, that would form the basis for approval or clearance of bone cement. The filing of an Investigational Device Exemption, or IDE is contingent upon the outcome of our discussions with the FDA. If an IDE is required and if it is approved and the clinical study initiated, we anticipate that the study patients will be enrolled over a period of time and subsequently followed for a period of up to two years. There is no assurance that we will reach agreement with FDA on an alternate risk-based regulatory strategy and may have to seek regulatory approval to initiate clinical studies.

The primary purpose for conducting the European study is to gather local clinical data to support our sales and marketing efforts as well as to support reimbursement of our KyphX instruments in various European countries. Clinical endpoints for the European clinical study may be similar to those of the U.S. clinical study if the U.S. study is initiated. We have initiated the European study and expect to continue patient enrollment throughout 2003. We will continue to monitor these patients with the goal of using local data to support our European marketing and reimbursement efforts.

In addition to the two clinical studies referenced above, Kyphon may conduct additional IDE and/or non-significant risk clinical studies to demonstrate specific clinical outcomes related to the treatment of patients with KyphX instruments and/or alternative bone fillers.

Reimbursement

Establishing reimbursement for any new medical technology is a challenge in the current environment of cost containment, managed care and Medicare. To successfully establish reimbursement coverage, we must prove that our technology improves health outcomes, such as quality of life or functional ability, and does so in a cost-effective manner.

Payment for patient care in the United States is generally made by private insurers. These insurers act on their own behalf or under contract with the U.S. government to administer the Medicare program. Medicare covers most of the medical care expenses of individuals over the age of 64. Approximately 90% of patients with spine fractures caused by osteoporosis are covered by Medicare, while the rest are covered by private insurers. Even when patients are not covered by Medicare, private insurers often follow the coverage and payment policies of Medicare.

For inpatient fracture reduction procedures, Medicare pays the hospital a prospectively determined amount based primarily on the patient’s diagnosis and the nature of the care provided during the hospital stay. We receive payment from the hospital for our instruments, and Medicare reimburses the hospital under this reimbursement system for its costs of admitting and treating the patient, including the purchase of our instruments, under existing applicable codes. The surgeon who performs the procedure is reimbursed under a different system that is based on procedure codes, called current procedural terminology, or CPT, codes. Currently, Medicare reimburses physicians who use our KyphX instruments on a state by state basis. This form of reimbursement is not uniform across all states because there is no CPT code or associated national payment

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rate relating to procedures using our instruments. As a result, unless a state has a published policy regarding reimbursement, physicians must report procedures using our instruments under an unlisted CPT code, submit their bills for review and request payment based on the time, work and risk involved in the procedure. We intend to continue to use the results of future clinical studies, peer-reviewed physician journal articles, and support from leading physicians who are familiar with our KyphX instruments to further support physician reimbursement for procedures using our instruments. In addition, it is possible that medical societies familiar with the Kyphoplasty procedure will apply for the establishment of a national payment rate through a CPT code. Based on our understanding of this process, it is not anticipated that a national CPT could be established prior to 2005, if at all.

Sales and Marketing

We market and sell our KyphX instruments through a direct sales force in the United States. Our target customer base includes the approximately 3,500 physicians who perform spine surgery, including orthopedic spine surgeons and neurosurgeons.

Our U.S. sales organization is currently comprised of 77 sales territories. Each territory is managed by a spine consultant who acts as the primary customer contact. These spine consultants have extensive experience selling medical devices, generally focusing on emerging technologies. Several of the larger territories are managed with the assistance of a spine associate. The associate provides case coverage support and participates in the education of primary care physicians. Our 105 U.S. sales professionals are led by 12 regional sales managers, two area directors and a vice president of sales. We expect we will need to continue to increase the size of our sales organization in order to increase sales and market penetration and to provide the significant, ongoing level of customer support required by our sales strategy. We have initiated a pilot program whereby selected representatives will call on primary care physicians to educate them about our instruments.

Our European operations are headquartered in Belgium with direct sales organizations in a few major European countries. We anticipate continuing to build direct sales organizations in the major European countries while establishing distributor or agency arrangements in smaller ones. We intend to follow a similar model in Europe to the one established in the United States, working with internationally recognized physicians initially as we expand our training, reimbursement and selling activities.

We have initiated the sales process in selected Asia-Pacific markets. We have selected a distributor in South Korea and have begun product introduction there. During 2003, we plan to formulate our clinical and regulatory plans for Japan. In addition, we plan to consider Canada and other selected South American and Asia-Pacific countries regarding potential product registration and selling activities.

Our sales and marketing programs focus on working with leading spine surgeons to champion and educate other surgeons on the use of our instruments. Additionally, we have implemented an ongoing educational process for primary care physicians to explain the applicability and use of our instruments.

Manufacturing

We inspect, assemble, test, package and sterilize components that have been manufactured by us or to our specifications by outside contractors. We inspect each lot of components and finished instruments to determine compliance with our specifications.

We believe our manufacturing operations are in compliance with regulations mandated by the FDA and the European Union. We have been an FDA-registered and California-licensed medical device manufacturer since 1998. We obtained our CE Mark in February 2000, and our facility is ISO 9001/EN 46001/ISO 13485 certified. We are subject to unannounced inspections by the FDA and the Food and Drug Branch of the California Department of Health Services, or CDHS, and these inspections may include the manufacturing facilities of our

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subcontractors. We have been inspected by the CDHS, the FDA and European auditors. There have been no significant audit findings as a result of these inspections. We cannot assure you that we comply with all applicable manufacturing regulations.

Most purchased components for our instruments are available from more than one supplier. There are no contractual obligations by suppliers to continue to supply to us, nor are we contractually obligated to purchase from a particular supplier. We have identified and qualified alternate suppliers for materials in our KyphX Inflatable Bone Tamp. For some of our other products, identification and qualification of alternate suppliers may take time.

We are currently increasing our manufacturing capabilities as we increase commercialization efforts. Manufacturers often experience difficulties in scaling up production, including problems with production yields and quality control and assurance. If we are unable to manufacture our instruments to keep up with demand, we would not meet expectations for growth of our business.

Research and Development

As of December 31, 2002, we had 14 employees dedicated to research and development. Through the recent acquisition of Sanatis GmbH, we have added two employees to our research and development team, whose efforts will primarily be focused on developing biomaterials for use with our instruments. The research and development group develops new products to address unmet market needs with the goal of enhancing revenue. The major focus of the group is to explore new technologies for use in orthopedic applications, including treatment of spine fractures. In addition, we intend to further develop balloon technology to treat various other bone disorders arising from trauma or cancer. We are currently developing the following products:

Unless an exemption is available, we will need approval or clearance from the FDA to promote or market any of these products in the United States. We cannot be certain that we will be able to obtain approval or clearance for these products.

Training

We devote significant resources to training and educating physicians in the use of our KyphX instruments. We limit our training and education of physicians to the specialized skills involved in the proper use of our instruments, because the FDA has taken the position that we may not train physicians about specific procedures in the spine. Specific procedures in which our instruments are used commonly involve bone cement to fill the void created by our instruments. Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position that we cannot promote the use of bone cement, or train surgeons to use bone cement, with our instruments unless bone cement is specifically approved for use in the spine. We instruct our trainers, both physician faculty consultants and employees, not to discuss the use of any bone filler material, including bone cement, with our instruments. However, if questions are posed by surgeons during training, we inform surgeons of the regulatory status of bone cement and its use with our products. Although we believe our training methods are proper, if the FDA determines that our training constitutes promotion of an unapproved use, they could request that we modify our training or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty.

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Competition

We compete with providers of non-surgical treatments, drugs to reduce pain, drugs to prevent osteoporosis, open surgical procedures and instruments for vertebroplasty. We believe the primary competitive factors that affect our instruments are cost, reimbursement status, efficacy and safety.

Osteoporosis drugs marketed and in development today generally reduce the risk of fracture by up to 70%. These drugs are made by large pharmaceutical companies such as Merck, Eli Lilly, Wyeth, Procter & Gamble, Novartis AG and Aventis Pharmaceuticals. These drugs and future drugs may further reduce the incidence of spine fractures.

We are aware of a number of major medical device companies that have developed or plan to develop instruments marketed for use with bone filler material to treat spine fractures. Competition among these companies is likely to increase the awareness and frequency of vertebroplasty and other alternative procedures.

Any products that we commercialize will be subject to intense competition. Many of our competitors and potential competitors in these markets have substantially greater financial, technical and marketing resources than we do, and they may succeed in developing products that would render our instruments obsolete or noncompetitive. In addition, many of these competitors have significantly greater experience and reputations than we do in their respective fields. Our ability to compete successfully will depend on our ability to develop proprietary instruments that reach the market in a timely manner, receive adequate reimbursement and are safer, less invasive and less expensive than alternatives available for the same condition. Current or future competitors may develop technologies and products that are more effective than ours. Because of the size of the potential market, we anticipate that companies will dedicate significant resources to developing competing procedures. Our technologies and instruments may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our competitors.

Patents and Proprietary Technology

We believe that in order to have a competitive advantage, we must develop and maintain the proprietary aspects of our technologies. As of December 31, 2002, we had 16 issued U.S. patents, 14 issued foreign patents, 34 pending U.S. patent applications, 111 pending foreign patent applications, and 23 licensed patents.

In August 2002, we entered into a patent sublicense agreement with Bonutti Research Inc. for the exclusive right to 23 U.S. patents issued to Dr. Peter Bonutti. Under the terms of the agreement, we acquired the exclusive right to develop minimally-invasive balloons and related products for use within joints, ligaments, tendons, or cartilage in the spine and the co-exclusive right to develop minimally-invasive balloons and related products for use in orthopedic applications in joints, ligaments, cartilage, nerves or tendons outside of the spine.

In February 2003, we acquired Sanatis GmbH, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. Sanatis has filed four patent applications covering inventions relating to calcium cement formulations and a cement delivery technology.

We require our employees, consultants and advisors to execute confidentiality agreements in connection with their employment, consulting or advisory relationships with us. We also require our employees, consultants and advisors who we expect to work on our products to agree to disclose and assign to us all inventions conceived during the work day, using our property or which relate to our business. Despite any measures taken to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Finally, our competitors may independently develop similar technologies. Because of the importance of our patent portfolio to our business, we may lose market share to our competitors if we fail to protect our intellectual property rights.

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The medical device industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. As the number of entrants into our market increases, the possibility of a patent infringement claim against us grows. While we make an effort to ensure that our products do not infringe other parties’ patents and proprietary rights, our products and methods may be covered by U.S. patents held by our competitors. In addition, our competitors may assert that future products we may market infringe their patents.

Government Regulation

Our products are medical devices subject to extensive regulation by the FDA under the Federal Food, Drug and Cosmetic Act. FDA regulations govern, among other things, the following activities that we will perform:

Each medical device that we wish to commercially distribute in the United States requires either 510(k) clearance or premarket approval from the FDA prior to marketing. Devices deemed to pose relatively less risk are placed in either class I or II, which requires the manufacturer to submit a premarket notification requesting permission for commercial distribution; this is known as 510(k) clearance. Some low-risk devices are exempted from this requirement. Devices deemed by the FDA to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously 510(k)-cleared device, are placed in class III requiring premarket approval.

510(k) Clearance Pathway.    To obtain 510(k) clearance, we must submit a premarket notification demonstrating that the proposed device is substantially equivalent in intended use and in safety and effectiveness to a previously 510(k)-cleared device or a device that was in commercial distribution before May 28, 1976 for which the FDA has not yet called for submission of premarket applications, or is a device that has been reclassified from class III to class II or I. The FDA’s 510(k) clearance pathway usually takes from three to 12 months, but it can last significantly longer.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or could require premarket approval. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any manufacturer’s decision. If the FDA disagrees with a manufacturer’s decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to seek 510(k) clearance or premarket approval. The FDA can also require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or premarket approval is obtained.

Our KyphX Inflatable Bone Tamp currently has 510(k) clearance for use as a conventional bone tamp for the reduction of fractures and/or the creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus. The KyphX Xpander Inflatable Bone Tamp is marketed pursuant to the 510(k) clearance for the KyphX Inflatable Bone Tamp. The KyphX Inflation Syringe and 11 Gauge Bone Access Needle are 510(k)-

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cleared products that we currently obtain from contract suppliers. We believe our KyphX Introducer Tool Kit, Osteo Introducer System, Advanced Osteo Introducer, Advanced Osteo Introducer System, Bone Biopsy Device, and KyphX Bone Filler Device, when sold as manual orthopedic surgical instruments, are exempt from clearance or approval requirements. Our products are not cleared for any specific surgical procedure or for use with bone cement in the spine. Our current 510(k) clearance does not permit us to promote any particular benefits obtained by using our instruments in surgery. Before we can promote the use of bone cement in the spine or promote benefits experienced by patients following procedures in which our instruments are used, we need to reach agreement with FDA on the data required and the regulatory pathway to follow. That agreement may result in the need to conduct one or more clinical studies to support any or all of the marketing applications.

In October 2000, we received a warning letter from the FDA challenging our promotional claims that we were making for our KyphX instruments. In that letter and subsequently, the FDA took the position that our initial 510(k) clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body or for any specific surgical procedures. The FDA also maintained we could not promote any clinical benefits for our products until we submitted and obtained additional regulatory approvals.

After discussions and correspondence with the FDA, we agreed to abide by these restrictions and revised our promotional campaign accordingly. Subsequently, we obtained our current 510(k) clearance to promote the KyphX Inflatable Bone Tamp as a conventional bone tamp in the reduction of fracture and/or creation of a void in cancellous bone in the spine, hand, tibia, and calcaneus. Therefore, at the present time, we do not promote any treatment benefit of, or promote, or train physicians in, any specific surgical procedures involving the use of our instruments or the use of our instruments with bone cement in the spine. In order to do so, we must reach agreement with FDA on whether further marketing applications are needed, and whether additional clinical data must be generated to support such applications. We have no basis on which to assume that an agreement will be reached without the need to do a study and/or file an IDE application, and we do not know whether such an IDE application if required will be approved in a reasonable time, if at all. The failure to obtain FDA approval of treatment benefits using our cleared products in specific procedures may significantly impair our ability to promote our products.

The FDA recently published a Public Health Web Notification entitled “Complications Related to the Use of Bone Cement in Vertebroplasty and Kyphoplasty Procedures.” The notification described complications relating to the use of bone cement in those procedures and indicated that the FDA was working with appropriate professional organizations and manufacturers of orthopedic devices to consider the regulatory options available to evaluate the long-term safety and effectiveness of bone cement in vertebroplasty and kyphoplasty procedures. Our discussions with FDA on the least burdensome alternatives have focused on those options.

Premarket Approval.    A premarket approval application, or PMA, must be submitted if the device cannot be cleared through the 510(k) process. A PMA must normally be supported by extensive data including, but not limited to, technical, preclinical, clinical studies, manufacturing and labeling to demonstrate to the FDA’s satisfaction the safety and effectiveness of the device.

After a PMA is filed, the FDA begins an in-depth review of the submitted information, which generally takes between one and three years, but may take significantly longer. During this review period, the FDA may request additional information or clarification of the information already provided. Also, in many cases, an advisory panel of experts from outside the FDA will be convened to review and evaluate the application and provide recommendations to the FDA as to the approvability of the device. In addition, the FDA will conduct a preapproval inspection of the manufacturing facility to ensure compliance with quality system regulations. New PMAs or PMA supplements are required for significant modifications to the manufacturing process, labeling and design of a device that is approved through the premarket approval process. PMA supplements in certain circumstances require submission of the same type of information as that contained in an original PMA, but limited in scope to the changes from the device covered by the original premarket approval. PMA supplements

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may not require extensive clinical data or review of the application by an advisory panel. We expect that any clinical benefit claims we wish to make about the KyphX instruments may require the submission and approval of a PMA by the FDA before we can make any such claims. We also believe that a premarket approval may be necessary before we can promote the use of bone cement or other bone filler material in conjunction with our KyphX instruments in any surgical procedure. The present discussion regarding alternative risk-based regulatory requirements reflecting the least burdensome concept could alter the need for a PMA, but we can provide no assurance that our discussions with the FDA will provide that result.

We cannot assure you that any future premarket approval submissions will be approved by the FDA in a timely fashion, if at all.

Clinical Studies. Clinical studies are almost always required to support a premarket application and are sometimes required for a 510(k) premarket notification. These studies may require submission of an application for an Investigational Device Exemption, or IDE. The IDE application must be supported by appropriate data, such as animal and laboratory testing results, showing that it is safe to test the device in humans and that the testing protocol is scientifically sound. The IDE must be approved in advance by the FDA for a specific number of patients unless the product is deemed a nonsignificant risk device eligible for more abbreviated IDE requirements. Clinical studies for significant risk devices may begin once the IDE application is approved by the FDA and the appropriate institutional review boards at the clinical trial sites.

Any clinical studies we sponsor must be conducted in accordance with FDA regulations. These clinical studies will require that we submit, and obtain FDA approval of, an IDE prior to commencing clinical studies. The results of any clinical studies we do conduct may not be sufficient for us to obtain any additional clearances or approvals or to support additional marketing claims for our KyphX instruments.

Postmarket.    After a device is placed on the market, numerous regulatory requirements apply. These include:

We are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. If the FDA finds that we have failed to comply, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions including:

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The FDA also has the authority to require us to repair, replace or refund the cost of any medical device that we have manufactured or distributed in certain circumstances.

International.    International sales of medical devices are subject to foreign government regulations, which vary substantially from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval, and the requirements may differ. The primary regulatory authority in Europe is that of the European Union, or EU, which consists of 15 countries encompassing most of the major countries in Europe. Other countries, such as Switzerland, have voluntarily adopted laws and regulations that mirror those of the EU with respect to medical devices. The EU has adopted numerous directives and standards regulating the design, manufacture, clinical trial, labeling and adverse event reporting for medical devices. Devices that comply with the requirements of a relevant directive will be entitled to bear CE conformity marking, indicating that the device conforms with the essential requirements of the applicable directives and, accordingly, can be commercially distributed throughout Europe. The method of assessing conformity varies depending on the class of the product, but normally involves a combination of self-assessment by the manufacturer and a third-party assessment by a “Notified Body.” This third-party assessment may consist of an audit of the manufacturer’s quality system and specific testing of the manufacturer’s product. An assessment by a Notified Body in one country within the EU is required in order for a manufacturer to commercially distribute the product throughout the EU. During this process, we must demonstrate compliance with designated manufacturing and quality requirements known as the “ISO” requirements.

We have obtained CE Marking permitting us to commercialize our current products in Europe. We are in the process of obtaining CE Marking with regard to a calcium phosphate biomaterial that we acquired with the acquisition of Sanatis GmbH. We have certification of our manufacturing facilities to ISO 9001/EN46001 quality system requirements. We had our annual inspection in February 2003 with no non-compliance reports issued, continuing our facility as ISO 9001/EN46001 certified. While no additional premarket approvals in individual EU countries are required, prior to marketing of a device bearing the CE Mark, practical complications with respect to market introduction may occur. For example, differences among countries have arisen with regard to labeling requirements.

Employees

As of December 31, 2002, we had a total of 305 employees, with 58 people in operations, 14 people in research and development, 148 people in sales and sales administration, 33 people in general and administrative, 22 people in clinical and regulatory, 23 people in marketing and professional education, and 7 people in reimbursement. None of our employees is represented by a labor union, and we believe our employee relations are good.

Available Information

We are subject to the reporting requirements under the Securities Exchange Act of 1934. Consequently, we are required to file reports and information with the Securities and Exchange Commission (SEC), including reports on the following forms: annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These reports and other information concerning the company may be accessed through the SEC’s website at http://www.sec.gov.

You may also find on our website at http://www.kyphon.com electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. Such filings are placed on our website as soon as reasonably possible after they are filed with the SEC.

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Risk Factors Affecting Operations and Future Results

Risks Related to Our Business

Unless we obtain additional FDA approvals, or otherwise reach agreement with the FDA on an alternate risk-based regulatory strategy, we will not be able to promote the use of our instruments in specific surgical procedures or the benefits of any surgical procedures (including procedures involving bone cement) using our instruments in the United States, and our ability to grow our business could be harmed.

In October 2000, we received a warning letter from the FDA challenging the promotional claims that we were making for our KyphX instruments. It was the FDA’s position that our regulatory clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body, or for any specific surgical procedures. The FDA also stated that we could not promote any clinical benefits of surgical procedures using our instruments until we obtained additional regulatory approvals related to the benefits. After discussions and correspondence with the FDA, we agreed to abide by these restrictions and revised our promotional campaign accordingly. Subsequently, we obtained our current 510(k) clearance to promote the KyphX Inflatable Bone Tamp as a conventional bone tamp in the reduction of fracture and/or creation of a void in cancellous bone in the spine, hand, tibia, and calcaneus. In order to promote the use of our devices in specific sites, for specific procedures and with certain resultant patient benefits, we must reach agreement with the FDA on whether further market clearances or approvals are needed and whether additional clinical data must be generated to support such clearance or approval. We have no basis on which to assume that an agreement will be reached without the need to conduct a clinical study and file one or more regulatory applications. If such an application or applications are filed, we can provide no assurance that they will be approved in a timely fashion, if at all. If we fail to obtain these additional necessary regulatory approvals, our ability to generate revenues may be harmed.

If the FDA finds that bone cement should not be used in the spine, our ability to sell and promote our instruments would be harmed, and our exposure to product liability litigation could increase.

In October 2002, the FDA published a Public Health Web Notification entitled “Complications Related to the Use of Bone Cement in Vertebroplasty and Kyphoplasty Procedures.” The notification states that reported complications related to vertebroplasty and kyphoplasty procedures, such as soft tissue damage and nerve root pain and compression, have resulted from leakage of bone cement, and that other complications include pulmonary embolism, respiratory and cardiac failure and death had been reported. The notification is subject to potential future revision at the sole discretion of the FDA. The content of a revised notification can not be predicted. The notification indicates that the FDA is working with appropriate professional organizations and manufacturers of orthopedic devices to consider the regulatory options available to evaluate the long-term safety and effectiveness of bone cement in vertebroplasty and kyphoplasty procedures. The notification requests that the healthcare community follow established procedures for reporting of deaths or serious injuries resulting from the use of medical devices, including bone cement. The notification, itself, may raise concerns with our customers, potential customers and reimbursement organizations, which could impact our ability to sell and promote our instrument. An increase in reports of deaths or serious injuries could lead to the FDA issuing safety alerts, health advisories, or FDA-mandated labeling changes restricting use of our instruments, including new warnings regarding their use or contraindicating their use with bone cement. In addition, increased reporting of adverse events would expose us to product liability litigation, and our current insurance coverage limits may not be adequate. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all.

In the United States, we are not permitted to promote, or train physicians in, the use of our KyphX instruments with bone cement in the spine, unless we obtain additional FDA approvals or otherwise reach agreement with FDA on limited training and promotion.

As the FDA’s position is that we may not train physicians about specific procedures in the spine, we limit our training and education of physicians to the specialized skills involved in the proper use of our instruments.

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Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position that we cannot promote the use of bone cement, or train surgeons to use bone cement, with our instruments unless bone cement is specifically approved for use in the spine with our instruments. We instruct our trainers, both physician faculty consultants and employees, not to discuss the use of any bone filler material, including bone cement, with our instruments. However, they may respond to unsolicited questions about bone cement that are raised by physician participants during a training program. Although we believe our training methods are proper, if the FDA determines that our training constitutes promotion of an unapproved use, they can request that we modify our training or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty.

If we are unable to obtain U.S. regulatory approval to market the use of bone cement for use with our instruments in spine fracture surgery or to document resulting benefits, or reach agreement with FDA on an alternate risk-based regulatory framework governing such claims, our future competitive position and revenue may be harmed.

We may need to seek regulatory approval to initiate a clinical study designed to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared instruments in a specific minimally-invasive spine procedure. There are many risks associated with conducting the clinical study, including our ability to:

Any of these factors could delay, limit or prevent our successful completion of a clinical study and our regulatory approval. If we are unable to obtain FDA approval for the use of bone cement with our KyphX instruments in spine surgery, our future competitive position and revenues may be harmed.

Our failure to obtain or maintain necessary regulatory clearances or approvals could hurt our ability to commercially distribute and market our KyphX instruments.

Our KyphX instruments are considered medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an exemption applies, each medical device that we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. The FDA’s 510(k) clearance process usually takes from three to 12 months, but may take longer. The premarket approval process generally takes from one to three years from the time the application is filed with the FDA, but it can be significantly longer and can be significantly more expensive than the 510(k) clearance process. Although we have obtained 510(k) clearance for the KyphX Inflatable Bone Tamp to help repair fractures in specific sites in the spine, hand, leg, arm and heel, our 510(k) clearance can be revoked if safety or effectiveness problems develop. We also may be required to obtain 510(k) clearance or premarket approval to market additional instruments or for new indications for our KyphX instruments. Before we can market any bone cement product for use with our instruments in spine surgery, we must first obtain regulatory approval. We cannot be certain that we would obtain 510(k) clearance or premarket approval in a timely manner or at all. Delays in obtaining clearances or approvals may adversely affect our revenue and future profitability.

Modifications to our marketed devices may require new 510(k) clearances or premarket approvals or may require us to cease marketing or recall the modified devices until clearances are obtained.

Any modification to a 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or, possibly, premarket approval. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can

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review any manufacturer’s decision. We have modified aspects of our KyphX instruments, but we believe that new 510(k) clearances are not required. The FDA may not agree with any of our decisions not to seek new clearances or approvals. If the FDA requires us to seek 510(k) clearance or premarket approval for any modification to a previously cleared instrument, we may be required to cease marketing or to recall the modified device until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties.

If we fail to comply with Quality System regulations, our manufacturing operations could be delayed, and our product sales and profitability could suffer.

Our manufacturing processes and those of our suppliers are required to comply with the FDA’s Quality System regulations, which cover the procedures and documentation of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our instruments. The FDA enforces its Quality System regulations through periodic unannounced inspections. The FDA conducted an inspection of our manufacturing facility in May 2002 and the FDA inspector made a single observation. We responded to the FDA in June 2002. There has been no further correspondence from the FDA regarding the inspection. If we fail a Quality System inspection, our operations could be disrupted and our manufacturing delayed. Failure to take adequate corrective action in response to an adverse Quality System inspection could force a shut-down of our manufacturing operations and/or a recall of our instruments, which would cause our instrument sales and business to suffer.

We have limited operating experience and a history of net losses and may never achieve or maintain profitability.

We have a limited operating history upon which you can evaluate our business. We commenced commercial sales of our KyphX instruments in May 2000. We have incurred losses every year since we began operations. In particular, we incurred losses of $17.7 million in 2000, $17.8 million in 2001 and $15.3 million in 2002. As of December 31, 2002, we had an accumulated deficit of approximately $60.0 million. Even if we are able to increase revenue from our instrument sales, we may have operating losses based on our plans to expand our sales and marketing efforts, both domestically and internationally, and devote substantial resources to our continuing research and development efforts and clinical studies. It is possible that we will never generate sufficient revenues from instrument sales to achieve profitability.

If reimbursement for the procedures using our instruments becomes difficult to obtain or is not available in sufficient amounts, our instruments may not be widely adopted.

In some cases, physicians performing a procedure using our instruments have not been reimbursed. Widespread adoption of our instruments by the medical community is unlikely to occur if physicians do not receive sufficient reimbursement from payors for their services in performing the procedures using our instruments. Currently, there is no specific procedure code under which reimbursement to physicians is available for procedures performed using our KyphX instruments. Physicians must report procedures using our instruments under an unlisted current procedural terminology, or CPT, code, and hospitals receive reimbursement for an inpatient stay. Physicians have obtained reimbursement from Medicare for the use of our products in all 50 states and in the District of Columbia. Until a specific CPT code is granted, physician reimbursement from Medicare may be difficult to obtain in some states. Future regulatory action by a government agency or negative clinical results may diminish reimbursement coverage for both the physician and hospital. Finally, reimbursement differs from state to state, and some states may not reimburse for a procedure in an adequate amount. If physicians are unable to obtain adequate reimbursement for procedures in which our KyphX instruments are used, we may be unable to sell our instruments and our business could suffer.

Adverse changes in reimbursement procedures by domestic and international payors may impact our ability to market and sell our instruments.

Even if the use of our instruments is reimbursed by private payors and Medicare, adverse changes in payors’ policies toward reimbursement for the procedure would harm our ability to market and sell our instruments. We

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are unable to predict what changes will be made in the reimbursement methods used by payors. We cannot be certain that under prospective payment systems, such as those utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our instruments will be justified and incorporated into the overall cost of the procedure.

Even if we fulfill international regulatory requirements to market our instruments, our success will be partly dependent upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. In addition, health care cost containment efforts similar to those we face in the United States are prevalent in many of the other countries in which we intend to sell our instruments, and these efforts are expected to continue. Although we intend to seek international reimbursement approvals, we may not obtain approvals in a timely manner, if at all.

To be commercially successful, we will have to convince physicians that using our instruments to repair spine fractures is an effective alternative to existing therapies and treatments.

We believe that physicians will not widely adopt our instruments unless they determine, based on experience, clinical data and published peer reviewed journal articles, that the use of our KyphX instruments provides an effective alternative to conventional means of treating spine fractures. Patient studies or clinical experience may indicate that treatment with our instruments does not provide patients with sustained benefits. Further, because some of the data has been produced in studies that involve small patient groups, the data may not be reproduced in wider patient populations. In addition, we believe that continued recommendations and support for the use of KyphX instruments by influential physicians are essential for widespread market acceptance. If our KyphX instruments do not continue to receive support from these physicians or from long-term data, surgeons may not use, and hospitals may not purchase, our instruments.

Because injuries that occur during spine surgery can be significant, we are subject to an increased risk of product liability lawsuits. If we are sued in a product liability action, we could be forced to pay substantial damages.

We manufacture medical devices that are used on patients in spine surgery procedures. Spine surgery involves significant risk of serious complications, including bleeding, nerve injury, paralysis and death. Consequently, companies that produce instruments for use in the spine are subject to a significant risk of product liability litigation. If our instruments are found to have caused or contributed to any injury, we could be held liable for substantial damages, and our current product liability coverage limits may not be adequate to protect us from any liabilities we might incur. In addition, we may require increased product liability coverage if sales of our instruments increase. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all.

Our reliance on suppliers could limit our ability to meet demand for our products in a timely manner or within our budget.

We are dependent upon outside suppliers to provide us with our KyphX Inflation Syringe, as well as other key components necessary for the manufacture of our products. Generally we obtain components through purchase orders rather than long-term supply agreements and do not maintain large volumes of inventory, the disruption or termination of the supply of components could lead to:

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Any one of these results could harm our sales and profits and make it difficult to meet our business goals.

If we do not effectively manage our growth, our existing infrastructure may become strained, and we will be unable to increase sales of our KyphX instruments or generate significant revenue growth.

Our direct sales organization has increased from 31 employees in October 2000 to 130 employees in December 2002. The growth that we have experienced, and in the future may experience, provides challenges to our organization, requiring us to rapidly expand our personnel and manufacturing operations. We may not be able to hire sufficient personnel to meet our growth goals. As a result, our failure to recruit additional sales personnel may result in our inability to meet our projections. Future growth may strain our infrastructure, operations, product development and other managerial and operating resources. If our business resources become strained, we may not be able to deliver instruments in a timely manner.

Because we face significant competition from other medical device companies with greater resources than we have, we may be unable to maintain our competitive position and sales of our instruments may decline.

The market for medical devices is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Our industry also includes large pharmaceutical companies that are developing drug products that may reduce the incidence of osteoporosis and, therefore, the market for our instruments. Our ability to compete successfully depends in part on our ability to respond quickly to medical and technological change and user preference through the development and introduction of new products that are of high quality and that address patient and surgeon requirements. We compete with many larger companies that enjoy several competitive advantages, including:

At any time, other companies may develop additional competitive products. If we are unable to compete effectively against existing or future competitors, sales of our instruments will decline.

If we are unable to prevent third parties from using our intellectual property, our ability to compete in the market will be harmed.

We believe that the proprietary technology embodied in our instruments and methods gives us a competitive advantage. Maintaining this competitive advantage is important to our future success. We rely on patent protection, as well as on a combination of copyright, trade secret and trademark laws, to protect our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. For example, our patents may be challenged, invalidated or circumvented by third parties. Our patent applications may not issue as patents at all or in a form that will be advantageous to us. We may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by consultants, vendors, former employees and current employees, despite the existence of nondisclosure and confidentiality agreements and other contractual restrictions. Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. If our intellectual property rights are not adequately protected, we may be unable to keep other companies from competing directly with us, which could result in a decrease in our market share. Enforcement of our intellectual property rights to prevent or inhibit appropriation of our technology by competitors can be expensive and time-consuming to litigate or otherwise dispose of and can divert management’s attention from our core business.

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Our instruments could infringe on the intellectual property rights of others, which may lead to costly litigation, payment of substantial damages or royalties and/or our inability to use essential technologies.

The medical device industry has been characterized by extensive litigation and administrative proceedings regarding patents and other intellectual property rights. Whether an instrument infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our competitors may assert that our instruments and methods infringe their patents. In addition, they may claim that their patents have priority over ours because their patents issued first. Because patent applications can take many years to issue, there may be applications now pending of which we are unaware, which may later result in issued patents that our instruments or methods may infringe. There could also be existing patents that one or more of our instruments or methods may inadvertently be infringing of which we are unaware. As the number of competitors in the market for minimally-invasive spine disorder treatments grow, the possibility of a patent infringement claim against us increases.

Infringement and other intellectual property claims, with or without merit, can be expensive and time-consuming to litigate or otherwise dispose of and can divert management’s attention from our core business. In addition, if we lose an intellectual property litigation matter, a court could require us to pay substantial damages and/or royalties and/or prohibit us from using essential technologies. Also, although we may seek to obtain a license under a third party’s intellectual property rights to bring an end to any claims or actions asserted or threatened against us, we may not be able to obtain a license on reasonable terms or at all.

We may become involved in litigation to protect our intellectual property rights.

We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights to protect these rights or further determine the scope and validity of our intellectual property protection. These claims could result in costly litigation and the diversion of management attention and resources away from our business.

Risks Related to the Public Market

Our principal stockholders have significant voting power and may take actions that may not be in the best interests of our other stockholders.

Our officers, directors and principal stockholders together control approximately 62.6% of our outstanding common stock as of March 14, 2003. If these stockholders act together, they will be able to control our management and affairs in all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control and might adversely affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders.

We may be unable to obtain future capital on satisfactory terms.

We believe our current cash, cash equivalents, investments, and cash generated from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. We may seek additional funds from public and private stock offerings, borrowings under lease lines of credit or other sources. We cannot assure you that additional financing will be available on a timely basis on terms acceptable to us, or at all, or that any financing will not be dilutive to stockholders. If adequate funds are not available, we may have to delay development or commercialization of our instruments or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize for ourselves. We also may have to reduce the marketing, customer support or other resources devoted to our instruments.

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Anti-takeover provisions in our certificate of incorporation, our bylaws and Delaware law could discourage a takeover.

Our basic corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. Those provisions might discourage, delay or prevent a change in the control of our company or a change in our management. The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.

Our common stock has recently become publicly traded, and we expect that the price of our common stock may fluctuate substantially.

We consummated the initial public offering of our common stock in May 2002. Accordingly, there has only been a public market for shares of our common stock since May 2002. An active public trading market may not develop or, if developed, may not be sustained. Further, we expect that the market price of our common stock may fluctuate substantially. The market price for the common stock may be affected by a number of factors, including:

ITEM 2.    PROPERTIES

Our operations are headquartered in a 42,500 square foot building in Sunnyvale, California. This facility is leased through March 2005 with an option to renew through 2010. We are actively looking at larger facilities and may move to a larger facility during 2003.

ITEM 3.    LEGAL PROCEEDINGS

We are not a party to any material litigation.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

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PART II

ITEM 5.    MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED

STOCKHOLDER MATTERS

We had our initial public offering on May 17, 2002. Our Common Stock is traded on the NASDAQ National Stock Market under the symbol “KYPH”. The following table shows the high and low closing sale prices of our Common Stock for each quarterly period since the date of our initial public offering as reported on the Nasdaq National Stock Market:

As of March 14, 2003, the closing price of our Common Stock on the NASDAQ National Stock Market was $10.48 per share, and the number of registered stockholders on record was 265.

Since our incorporation, we have never declared or paid any dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

In May 2002, we completed our initial public offering, including exercise of the underwriters’ over-allotment option, of 6,900,000 shares at an initial public offering price of $15.00 per share, for aggregate cash proceeds of approximately $103.4 million. Our managing underwriters for the offering were U.S. Bancorp Piper Jaffray Inc., Banc of America Securities LLC and Bear, Stearns & Co. Inc. In connection with the offering, we paid a total of approximately $7.2 million in underwriting discounts and commissions and $1.3 million in other offering costs. After deducting the underwriting discounts and commissions and the offering costs, our net proceeds from the offering, including the over-allotment option, were approximately $94.9 million.

Of the $94.9 million in net offering proceeds, through December 31, 2002, we have used $14.2 million for repayment of outstanding convertible promissory notes held by affiliates, plus accrued interest; $27.6 million for sales and marketing initiatives to support the ongoing commercialization of our KyphX instruments; $3.3 million for support of clinical studies and reimbursement efforts; $2.9 million for product research and development; $6.7 million for general corporate purposes and $12.3 million for the strategic acquisition of third party technology. All amounts represent estimates of direct or indirect payments of amounts to third parties. In addition, we have invested $24.7 million in debt securities. We are currently investing the remaining net proceeds from the offering for future use as additional working capital. Such remaining net proceeds have been invested in money market funds.

The Board of Directors approved a stock repurchase program on November 7, 2002 pursuant to which up to 2,000,000 shares of our outstanding common stock may be repurchased from time to time. The duration of the repurchase program is open-ended. Under the program, we may purchase shares of common stock through open market transactions at prices deemed appropriate by management. The purchases will be funded from available working capital. As of December 31, 2002, we had repurchased 30,000 shares pursuant to this repurchase program.

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ITEM 6.    SELECTED CONSOLIDATED FINANCIAL DATA

The following tables reflect selected consolidated financial data derived from our consolidated financial statements for each of the last five years. The consolidated statement of operations data for the years ended December 31, 2002, 2001 and 2000, and the consolidated balance sheet data as of December 31, 2002 and 2001 are derived from our audited consolidated financial statements included in this report. The consolidated statement of operations data for the years ended December 31, 1999 and 1998, and the consolidated balance sheet data as of December 31, 2000, 1999 and 1998 are derived from our audited consolidated financial statements not included in this report. Historical results are not necessarily indicative of future results. The selected financial data set forth below should be read in conjunction with our financial statements, the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report.

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ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and the related notes included in Item 8 of this Form 10-K. This discussion contains forward-looking statements. These statements are based on our current expectations, assumptions, estimates and projections about our business and our industry, and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s results, levels of activity, performance or achievement to be materially different from any future results, levels of activity, performance or achievements expressed or implied in or contemplated by the forward-looking statements. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of selected factors, including those set forth below under “Risk Factors Affecting Operations and Future Results”.

Overview

We develop medical devices to restore spinal anatomy using minimally invasive technology. Currently, our KyphX instruments consist of our KyphX Inflatable Bone Tamp, KyphX Inflation Syringe, KyphX Bone Access Systems, KyphX Bone Filler Device, and our KyphX Bone Biopsy Device. Our KyphX Inflatable Bone Tamp currently has 510(k) clearance for use as a conventional bone tamp for the reduction of fractures and/or the creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus. The KyphX Xpander Inflatable Bone Tamp is marketed pursuant to the 510(k) clearance for the KyphX Inflatable Bone Tamp. The KyphX Inflation Syringe and 11 Gauge Bone Access Needle are 510(k)-cleared products that we currently obtain from a contract supplier. We believe our KyphX Introducer Tool Kit, KyphX Osteo Introducer System, KyphX Advanced Osteo Introducer, KyphX Advanced Osteo Introducer System, KyphX Bone Biopsy Device, and KyphX Bone Filler Device, when sold as manual orthopedic surgical instruments, are exempt from clearance or approval requirements. In May 2000, we commenced full commercial introduction of our KyphX instruments. From inception to December 31, 2002, we recognized $118.7 million in revenue from sales of our products.

Since inception, we have been unprofitable. We incurred net losses of approximately $17.7 million in 2000, $17.8 million in 2001 and $15.3 million in 2002. As of December 31, 2002, we had an accumulated deficit of approximately $60.0 million. Activities related to commercializing our KyphX instruments, enhancing physician reimbursement and initiating clinical studies, together with our general and administrative expenses, will cause our expenses to increase. As we proceed with commercialization, we will require additional sales and marketing resources, data from proposed clinical studies and greater physician reimbursement acceptance by payors.

We currently market our instruments in the United States through a direct sales organization to physicians who perform spine surgery, including orthopedic spine surgeons and neurosurgeons. We have European operations headquartered in Belgium. We sell directly in some European countries and use distributors and agents in other European countries and in South Korea.

Our future growth depends on increased penetration of our current market and on identifying new markets in which we can leverage our minimally invasive technology. To the extent any current or additional markets do not materialize or grow in accordance with our expectations, our sales could be lower than expected. Surgeons typically use bone cement to fill the void created in a vertebral body by our instruments. The FDA recently published a Public Health Web Notification entitled “Complications Related to the Use of Bone Cement in Vertebroplasty and Kyphoplasty Procedures.” The notification highlighted various safety concerns and indicates that the FDA is working with appropriate professional organizations and manufacturers of orthopedic devices to consider the regulatory options available to evaluate the long-term safety and effectiveness of bone cement in vertebroplasty and kyphoplasty procedures.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally

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accepted in the United States. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses and disclosures at the date of the financial statements. On an on-going basis, we evaluate our estimates, including those related to accounts receivables, inventories, other intangibles and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue from product sales is recognized upon receipt of a valid purchase order, shipment of the products to customers and when collection of the receivables is deemed probable. We maintain an accounts receivable allowance for an estimated amount of losses that may result from customers’ inability to pay for product purchased. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We write down our inventories by estimating the potential for future loss based on a variety of factors, including the quantity of particular items, their prospect for replacement or obsolescence, the remaining shelf life and the difference between cost and market. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

We have established a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We account for income taxes under the provisions of Statement of Financial Accounting Standards, or SFAS No. 109, “Accounting for Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

Purchase accounting requires extensive accounting estimates and judgments to allocate the purchase price between in-process research and development, other identifiable intangible assets, tangible assets, and goodwill as required by generally accepted accounting principles in the United States. Purchased in-process research and development is defined as the value assigned to those projects for which the related products have not received regulatory approval and have no alternative future use. Determining the portion of the purchase price allocated to in-process research and development and other intangible assets requires us to make significant estimates. The amount of the purchase price allocated to purchased in-process research and development and other intangible assets is determined by estimating the future cash flows of each project or technology and discounting the net cash flows back to their present values. The discount rate used is determined at the time of the acquisition in accordance with accepted valuation methods. For purchased in-process research and development, these methodologies include consideration of the risk of the project not achieving commercial feasibility.

In June 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141 (“SFAS No. 141”), “Business Combinations,” and SFAS No. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets.” SFAS No. 141 requires the purchase method of accounting for all business combinations after June 30, 2001 and that certain acquired intangible assets in a business combination be recognized as assets separate from goodwill. SFAS No. 142 requires that goodwill and other intangibles determined to have an indefinite life are no longer to be amortized but are to be tested for impairment at least annually. We have adopted SFAS No. 142 as of January 1, 2002. We will evaluate goodwill for impairment on an annual basis and on an interim basis if events or changes in circumstances between annual impairment tests indicate that the asset might be impaired. We will also evaluate other intangible assets for impairment when impairment indicators are identified. In assessing the recoverability of the goodwill and other intangibles, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. These estimates include forecasted revenues, which are inherently difficult to predict. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets. Property, equipment, intangible and certain other long-lived assets are amortized over their useful lives. Useful lives are based on management’s estimates of the period that the assets will generate revenue.

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Results of Operations

Comparison of years ended December 31, 2002, 2001 and 2000

Net Sales.    Net sales generated from sales of our products were $76.3 million, $36.1 million, and $6.1 million in 2002, 2001 and 2000, respectively. The increases in net sales resulted from an increase in the number of trained physicians as well as an increase in the number of procedures performed by trained physicians. In 2002, 2001 and 2000, 93%, 98% and 98%, respectively, of net sales were recognized in the United States. No customer accounted for more than 10% of total net sales in 2002, 2001 and 2000.

Cost of Goods Sold.    Cost of goods sold consists of material, labor, subcontract, and overhead costs. Cost of goods sold were $10.4 million, $8.1 million and $3.6 million in 2002, 2001 and 2000, respectively. As a percentage of net sales, cost of goods sold were 14%, 22%, and 59% in 2002, 2001 and 2000, respectively. The decrease is a result of fixed overhead costs being spread over increased production volume and decreased unit costs, primarily as we switched to lower cost metal part suppliers and eliminated cleaning operations. The increase in cost of goods sold over the years from 2000 to 2002 resulted primarily from increased material, labor, subcontract, overhead costs and inventory provisions associated with increased sales volume of our products. We continue to expect cost of goods sold to increase as our sales grow.

Research and Development.    Research and development expenses consist of costs of product research, product development, regulatory and clinical functions and personnel. Research and development expenses were $10.1 million, $7.9 million and $4.5 million in 2002, 2001 and 2000, respectively. The increase in research and development expenses in 2002 from 2001 was primarily attributable to increased personnel costs of $1.0 million, increased amortization of deferred stock-based compensation of $832,000 and increased product testing and development expenditures of $429,000. The increase in 2001 from 2000 was primarily attributable to increased clinical trial consulting costs of $1.3 million, increased amortization of deferred stock-based compensation of $752,000, increased personnel costs of $728,000, increased product testing and development expenditures of $321,000 and increased facilities expenses of $223,000. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses will increase in the future.

Sales and Marketing.    Sales and marketing expenses consist of costs for personnel, physician training programs and marketing activities. Sales and marketing expenses were $43.5 million, $27.9 million and $11.4 million in 2002, 2001 and 2000, respectively. The increase in sales and marketing expenses in 2002 from 2001 related primarily to a $9.2 million increase in the costs of hiring, training and compensating additional direct selling representatives, increased expenditures related to advertising, promotion, trade shows and market research activities of $2.6 million, increased sales travel expenses of $1.5 million, and increased amortization of deferred stock-based compensation of $1.1 million. The increase in sales and marketing expenses in 2001 from 2000 related primarily to increased personnel costs of $8.2 million, increased physicians training costs of $1.6 million, increased advertising and promotional activities of $1.6 million and increased amortization of deferred stock-based compensation of $644,000. As we continue to commercialize our KyphX instruments, we expect to significantly increase our sales and marketing efforts and expenditures.

General and Administrative.    General and administrative expenses consist of personnel costs, professional service fees, expenses related to intellectual property rights and general corporate expenses. General and administrative expenses were $12.5 million, $9.7 million and $5.3 million in 2002, 2001 and 2000, respectively. The increase in general and administrative expenses in 2002 from 2001 resulted primarily from increased personnel costs of $1.0 million, including $500,000 in accrued severance cost, increased miscellaneous taxes, licenses and insurance expenditures of $1.0 million and increased legal, public company expenses, accounting and consulting fees of $845,000 offset partially by decreased amortization of deferred stock-based compensation of $910,000. The increase in general and administrative expenses in 2001 from 2000 resulted primarily from increased personnel costs of $2.2 million related to our growth in operations and amortization of deferred stock-based compensation of $2.2 million offset by reduced expenditures. We expect general and administrative expenses to increase in the future as we add personnel, continue to expand our patent portfolio and incur reporting and investor-related expenses as a public company.

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Purchased In-Process Research and Development.    In August 2002, we entered into a patent sublicense agreement with Bonutti Research Inc. for the exclusive right to 23 U.S. patents issued to Dr. Peter Bonutti. Under the terms of the agreement, we acquired the exclusive right to develop minimally-invasive balloons and related products for use within joints, ligaments, tendons, or cartilage in the spine and the co-exclusive right to develop minimally-invasive balloons and related products for use in orthopedic applications in joints, ligaments, cartilage, nerves or tendons outside of the spine. We paid $12.3 million in cash for the rights, all of which was immediately expensed to purchased in-process research and development in August 2002. The acquisition cost was immediately expensed to operations as the technology acquired will be used to develop products that have not been approved for sale by regulatory authorities, and the in-process projects to which the patents may apply had not yet reached technological feasibility and had no alternative future uses.

Other and Interest Income (Expense), Net.    Other and interest income (expense), net, were ($2.8) million, ($309,000), and $1.1 million in 2002, 2001 and 2000, respectively. The decrease in other and interest income, net in 2002 from 2001 includes non-cash interest expense of $3.1 million related to the beneficial conversion feature and the fair value of warrants issued in connection with the convertible promissory notes. In addition, increased interest expense resulted from outstanding convertible promissory notes offset partially by increased interest income from higher cash, cash equivalent and investments balances resulting from the proceeds of our initial public offering. Other and interest income (expense), net, decreased in 2001 from 2000 due to lower cash, cash equivalent and short-term investment balances and increased interest expense associated with outstanding convertible promissory notes.

Deferred Stock-Based Compensation

We recorded deferred stock-based compensation for financial reporting purposes as the difference between the exercise price of options granted to employees and the deemed fair value of our common stock at the time of grant. Deferred stock-based compensation is amortized to cost of goods sold, research and development expense, sales and marketing expense and general and administrative expense. Deferred stock-based compensation recorded through December 31, 2002 was $20.6 million, with accumulated amortization of $9.4 million. The remaining $11.2 million will be amortized over the vesting periods of the options, generally four years from the date of grant. All option amounts are being amortized using a straight-line method. We expect to record amortization expense for deferred stock-based compensation as follows:

Stock-based compensation expense related to stock options granted to non-employees is recognized as the stock options are earned. The stock-based compensation expense will fluctuate as the fair market value of our common stock fluctuates. In connection with the grant of stock options to non-employees, we recorded deferred stock-based compensation of $4.2 million through December 31, 2002, of which $3.5 million has been amortized to expense as of December 31, 2002.

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Income Taxes

Realization of deferred tax assets is dependent upon the uncertainty of the timing and amount of future earnings, if any. Accordingly, full deferred tax asset valuation allowances have been established as of December 31, 2002 and 2001 to reflect these uncertainties.

At December 31, 2002, we had approximately $28,500,000 and $24,400,000 in federal and state net operating loss carryforwards, respectively, to reduce future taxable income. The federal and state carryforwards have expiration dates beginning in 2012 and 2003, respectively, in each case if not utilized.

At December 31, 2002, we had research and development tax credits carryforwards of approximately $688,000 and $652,000 for federal and state income tax purposes, respectively. If not utilized, the federal research and development tax credit carryforwards will expire beginning in 2012. The state research and development tax credit can be carried forward indefinitely.

The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in certain situations where changes occur in the stock ownership of a company. Ownership changes, as defined, occurred on August 8, 1996, December 14, 1999 and May 17, 2002. In accordance with Internal Revenue Code Section 382, utilization of the carryforwards is subject to annual limitation. The annual limitation will not result in the expiration of net operating losses prior to utilization.

At December 31, 2002, we had approximately $300,000 of net operating losses in Belgium, which can be carried forward indefinitely, absent any changes in control.

Liquidity and Capital Resources

In May 2002, we received net proceeds of $94.9 million from our initial public offering of common stock. From inception through June 2001, we raised $38.0 million through private sales of redeemable convertible preferred stock. From July 2001 through February 2002, pursuant to a loan agreement, we issued to affiliates $14.0 million in promissory notes, all of which have either been repaid or converted into common stock. As of December 31, 2002, we had $49.9 million of cash and cash equivalents, $24.4 million of investments, and working capital of $83.5 million.

Cash Provided by (Used in) Operating Activities.    Net cash provided by operating activities was $937,000 in 2002 attributable primarily to the add back of $12.3 million write-off of in-process research and development charge, non-cash charges related to $6.3 million amortization of deferred stock-based compensation, and $3.1 million of non-cash interest expense offset partially by net loss of $15.3 million, and increases in accounts receivable and inventories due to increased sales. Net cash used in operations was $13.0 million in 2001 and $18.3 million in 2000. For 2001 and 2000, cash used in operations were attributable primarily to net losses after adjustment for non-cash charges related to depreciation and amortization of deferred stock-based compensation, and increases in accounts receivable and inventories as we increased our net sales. These increases in use of cash in operations were offset in part by increases in accounts payable, accrued compensation and other accrued liabilities as we increased our operating expenses.

Cash Used in Investing Activities.    Net cash used in investing activities was $39.5 million, $1.6 million and $799,000 in 2002, 2001 and 2000, respectively. Cash used in investing activities reflected purchases of property and equipment for all periods. During 2002, cash used for investing activities reflected the purchases of investments of $24.7 million and payment of $12.3 million in connection with the patent sublicense agreement. During 2000, cash used in investing activities also reflected net purchases of short-term investments.

Cash Provided by Financing Activities.    Net cash provided by financing activities was $85.0 million, $9.1 million and $4.0 million in 2002, 2001 and 2000, respectively. Cash provided during 2002 was attributable primarily from proceeds of $94.9 million from issuing common stock in our initial public offering partially offset

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by repayment of convertible promissory notes of $13.3 million. Cash provided during 2001 was primarily from the proceeds of convertible promissory notes. Cash provided during 2000 was primarily from proceeds from the issuance of redeemable convertible preferred stock.

Convertible Promissory Notes.    Between July 2001 and February 2002, we raised $13.3 million through the sale of convertible promissory notes to several of our affiliates pursuant to a loan agreement. We repaid the outstanding principal and accrued interest upon the closing of our initial public offering. In addition, in November 2001, we raised $700,000 through the sale of a convertible promissory note to one affiliate pursuant to the same loan agreement. The principal and accrued interest due on this note automatically converted into 49,090 shares of our common stock at the initial public offering price of $15.00 per share. As required by the terms of the loan agreement, upon the closing date of our initial public offering, we issued warrants exercisable for an aggregate of 99,334 shares of our common stock at an exercise price of $0.01 per share to the holders of the convertible promissory notes. As of December 31, 2002, warrants for an aggregate of 64,070 shares of our common stock remained outstanding and exercisable.

We allocated the gross proceeds received from the convertible promissory notes and accrued interest to the convertible promissory notes and the warrants, based on their relative fair values. This allocation resulted in $13.3 million of the proceeds being assigned to the convertible promissory note and $1.5 million being assigned to the warrants. We valued the warrants at the May 22, 2002 issuance date using the Black-Scholes pricing model. We recognized the allocated fair value of the warrants of $1.5 million as an immediate charge to interest expense. Based on the difference between the effective conversion price of the proceeds allocated to the convertible promissory notes and the fair market value of the common stock at the issuance date, we determined that the allocated value of the convertible promissory notes contained a beneficial conversion feature. The beneficial conversion feature, amounting to $1.6 million, represented additional interest yield on the convertible promissory notes and was also recognized as an immediate charge to interest expense.

The following table describes our commitments to settle contractual obligations in cash related to our facility lease not recorded on the balance sheet as of December 31, 2002 (in thousands):

We expect to increase capital expenditures consistent with our anticipated growth in manufacturing, infrastructure and personnel. We also may increase our capital expenditures as we expand our product lines or invest to address new markets.

We believe our current cash, cash equivalents, investments, and cash generated from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. If existing cash, cash equivalents, and cash generated from operations are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities or obtain an additional credit facility. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of debt securities, these securities could have rights senior to those associated with our common stock, and could contain covenants that would restrict our operations. Any additional financing may not be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to reduce the scope of our planned product development and marketing efforts.

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Recent Accounting Pronouncements

In April of 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” which is effective for fiscal years beginning after May 15, 2002. Under SFAS No. 145, gains and losses from the extinguishment of debt should be classified as extraordinary items only if they meet the criteria of Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions Relating to Extraordinary Items.” SFAS No. 145 also addresses financial accounting and reporting for capital leases that are modified in such a way as to give rise to a new agreement classified as an operating lease. We believe that the adoption of SFAS No. 145 will not have a material impact on our consolidated financial position or our results of operations.

In June of 2002, the FASB issued SFAS No. 146 (“SFAS No. 146”), “Accounting for Costs Associated with Exit or Disposal Activities,” which is effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under SFAS No. 146, a liability is required to be recognized for a cost associated with an exit or disposal activity when the liability is incurred. SFAS No. 146 applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a retirement or disposal activity covered by FASB Statements No. 143, “Accounting for Asset Retirement Obligations,” and No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. We believe that the adoption of SFAS No. 146 will not have a material impact on our consolidated financial position or our results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material impact on our consolidated financial position or on our results of operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires prominent disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation in both annual and interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. The adoption of SFAS No. 148 did not have a material impact on our consolidated financial position or on our results of operations.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We do not have any ownership in any variable interest entities as of December 31, 2002. We believe that the adoption of FIN 46 will not have a material impact on our consolidated financial position or on our results of operations.

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Our exposure to interest rate risk at December 31, 2002 is related to our investment portfolio and our borrowings. Fixed rate investments and borrowings may have their fair market value adversely impacted from changes in interest rates. Floating rate investments may produce less income than expected if interest rates fall, and floating rate borrowings will lead to additional interest expense if interest rates increase. Due in part to these factors, our future investment income may fall short of expectations due to changes in U.S. interest rates.

We invest our excess cash in debt instruments of the U.S. government and its agencies and in high quality corporate issuers. As a result, other than changes in interest income due to changes in interest rates, we do not believe that near-term changes in interest rates will have a material effect on our future results of operations. A hypothetical 10% increase or decrease in interest rates would not materially affect the fair value of our available-for-sale securities and the impact on our investment portfolio would be less than $100,000.

We have operated mainly in the United States, and 93%, 98%, and 98% of our sales were made in U.S. dollars in 2002, 2001, and 2000 respectively. To date, we have not had any material exposure to foreign currency rate fluctuations. The majority of our European sales are derived from European Union countries and are denominated in the Euro. Monthly income and expense from our European operations are translated using average rates and balance sheets are translated using month end rates. Differences are recorded within stockholders’ equity (deficit) as a component of accumulated other comprehensive income (loss).

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ITEM 8.    CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

KYPHON INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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REPORT OF INDEPENDENT ACCOUNTANTS

The Board of Directors and Stockholders

Kyphon Inc.

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Kyphon Inc. (the “Company”) and its subsidiaries at December 31, 2002 and 2001 and the results of their consolidated operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/    PRICEWATERHOUSECOOPERS LLP

San Jose, California

January 31, 2003,

except for Note 14, as to which the date is February 25, 2003

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KYPHON INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

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KYPHON INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

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KYPHON INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)