The Company's current strategic focus for future growth is on the rapidly growing Regional Anesthesia market, with particular emphasis on the Company's pain relief products marketed under its ON-Q® brand. The Company intends to continue its sales and marketing efforts to further penetrate the United States post-surgical pain relief market with its ON-Q products.
The Company is also seeking to expand its strategic focus to include general surgical site care management in addition to its leadership position in Regional Anesthesia for post-surgical pain management. To that end, on December 13, 2007, the Company announced that it entered into a binding letter of intent to acquire AcryMed Incorporated ("AcryMed"), a privately held Oregon-based developer of innovative infection control and wound healing products. The agreement contemplated the merger of a new subsidiary of the Company into AcryMed, with AcryMed being the surviving corporation as a wholly owned subsidiary of the Company. AcryMed shareholders will receive approximately $25.0 million in cash from the Company in the merger. The Company completed the acquisition of AcryMed on February 15, 2008.
Discontinued Operations of InfuSystem
On September 29, 2006, the Company signed a definitive agreement to sell InfuSystem to HAPC for $140 million in the form of cash and a secured note, subject to certain purchase price adjustments based on the level of working capital. On September 18, 2007, the Company amended the definitive agreement resulting in a new purchase price of $100 million (subject to working capital adjustments in the definitive agreement) plus a contingent payment right to the Company of up to a maximum of $12 million (the "Earn-Out"). The Earn-Out provides that HAPC will make an additional cash payment (the "Additional Payment") to the Company of up to $12 million based on the compound annual growth rate ("CAGR") of HAPC's net consolidated revenues over the three year period ending December 31, 2010. If HAPC's net consolidated revenues for the fiscal year ending December 31, 2010 ("FY 2010") are less than 2.744 times InfuSystem's 2007 net revenues, excluding InfuSystem's revenues related to the Company's ON-Q® product line (the "40% CAGR Target"), no Additional Payment will be due. If HAPC's net consolidated revenues for FY 2010 equal or exceed 3.375 times InfuSystem's 2007 net revenues, excluding InfuSystem's revenues related to the Company's ON-Q product line (the "50% CAGR Target"), the Company will receive the full $12 million Additional Payment. If HAPC's net consolidated revenues for FY 2010 are between the 40% and 50% CAGR Targets, the Company will receive an Additional Payment equal to $3 million plus a pro rata portion of the remaining $9 million.
On October 19, 2007, the Company purchased approximately 2.8 million shares of common stock of HAPC at $5.97 per share through private transactions with third parties totaling approximately $17 million. With the shares purchased as of that date, the Company owned approximately 15% of the issued and outstanding HAPC common stock and disclosed its intentions to vote such shares in favor of the acquisition. As of November 13, 2007, the latest date reported by HAPC, the 2.8 million shares held by the Company constitute approximately 16.5% of the issued and outstanding common stock of HAPC.
On October 22, 2007, because HAPC was unable to obtain the approval of its stockholders of the acquisition by such date, a termination fee of $3.0 million pursuant to the definitive agreement, as amended, became unconditionally due and owing to the Company, regardless of whether or not the transaction was subsequently consummated.
On October 24, 2007, the shareholders of HAPC approved the acquisition of InfuSystem. The sale was completed on October 25, 2007 and the Company received the $100 million purchase price at the closing in a combination of (i) cash equal to $67.3 million and (ii) a secured promissory note with a principal amount equal to $32.7 million. In addition to the $67.3 million in cash, the Company at closing received the $3.0 million termination fee discussed above and fees totaling approximately $2.6 million at closing in connection with the secured promissory note, including a facility fee of $1.8 million, a ticking fee of approximately $0.7 million and an annual administrative fee of $75,000. The termination fee is recognized as part of the gain from the sale. Pursuant to the definitive agreement and in connection with the Company's commitment to the secured promissory note, ticking fees were due and payable to the Company equal to a rate between 0.50% and 1.00% per annum of the maximum amount of the secured promissory note, which was $75.0 million. The facility and ticking fees are recorded as deferred finance income and amortized over the life of the secured promissory note. The administrative fee is recorded as deferred finance income and amortized on a monthly basis over the period of one year. The Company also received

reimbursement of approximately $0.9 million by HAPC of certain divestiture expenses incurred in the current and prior years by the Company directly resulting from the sale transaction, including legal, audit and other professional fees, pursuant to the definitive agreement. The reimbursement of divestiture expenses is recorded in discontinued operations.
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting for Impairment or Disposal of Long-Lived Assets ("SFAS 144"), we have reclassified the results of InfuSystem as discontinued operations, reclassifying previously reported results to reflect all prior periods on a comparable basis. Summarized financial information for InfuSystem is as follows:

                                                    Year Ended December 31,
                                              2007(1)(2)      2006(2)        2005
                                                     (Amounts in thousands)
       Operating revenues                    $     25,001     $ 31,716     $ 28,525

       Operating income                      $      7,764     $  7,007     $  7,445
       Income taxes                                 2,939        3,963        2,861

       Income from discontinued operations   $      4,825     $  3,044     $  4,584

(1) Includes financial results for InfuSystem for the period January 1, 2007 through October 25, 2007, which was the date the sale of InfuSystem was consummated.

(2) InfuSystem recorded approximately $2,090,000 of divestiture expenses during the year ended December 31, 2006. In October 2007, at the closing of the sale of InfuSystem, the Company received reimbursement of approximately $946,000 by HAPC of certain divestiture expenses incurred in 2006 and 2007 by the Company directly resulting from the sale transaction, including legal, audit and other professional fees. Since the reimbursement of $946,000 included payments for services incurred for 2006, divestiture expenses recorded during the year ended December 31, 2007 resulted in a net credit of approximately $245,000.

Consolidated Results of Operations for the Year Ended December 31, 2007 Compared to the Year Ended December 31, 2006
Revenues
Net product sales from continuing operations increased 24%, or $22.9 million, to $116.5 million for the year ended December 31, 2007 from $93.6 million for the year ended December 31, 2006.
Management has chosen to organize the enterprise around differences in products and services, which is the level at which the Company's management regularly reviews operating results to make decisions about resource allocation and segment performance. The Company's products are predominately assembled from common subassembly components in a single integrated manufacturing facility, and operating results are reviewed by management on a combined basis including all products as opposed to several operating segments. The Company believes it is most meaningful for the purposes of revenue analyses, however, to group the product lines into two categories representing specific clinical applications
- Regional Anesthesia and IV Infusion Therapy. Regional Anesthesia product revenues increased 32%, or $21.7 million, to $89.6 million for the year ended December 31, 2007 from $67.9 million for the year ended December 31, 2006. This increase was primarily due to increased clinical usage of the ON-Q PainBuster® Post-Operative Pain Relief System and C-bloc® Continuous Nerve Block System by surgeons in the United States. Revenue from the C-bloc Continuous Nerve Block Systems increased 141%, or $9.3 million, to $15.9 million for the year ended December 31, 2007 compared to the prior year, primarily due to improved customer awareness of clinical efficacy and favorable reimbursement from third parties. The average selling price for the year ended December 31, 2007 was comparable to the prior year. Other Regional Anesthesia products include the Soaker® Catheter and the SilverSoakertm Catheter. Sales of IV Infusion Therapy products, which include the Company's intravenous elastomeric pumps, mechanical infusion devices and disposables, increased 4%, or $1.1 million, to $26.8 million for the year ended December 31, 2007 from $25.7 million for the year ended December 31, 2006. The increase primarily resulted from

increased unit sales of IV Infusion Therapy products to B. Braun Medical Inc., a domestic distributor, offset in part by a decrease in unit sales to international distributors, including B. Braun Medical S.A. (France). The average selling price for the year ended December 31, 2007 was comparable to the prior year. The Company has a distribution agreement with B. Braun Medical S.A., a manufacturer and distributor of pharmaceuticals and infusion products, to distribute the Company's elastomeric infusion pumps in Western Europe, Eastern Europe, the Middle East, Asia Pacific, South America and Africa. Cost of Revenues
Cost of revenues from continuing operations increased 22%, or $5.7 million, to $32.0 million for the year ended December 31, 2007 from $26.3 million for the year ended December 31, 2006. The increase was primarily due to higher sales volume. As a percentage of net product sales, product cost of revenues decreased for the year ended December 31, 2007 by approximately one percentage point compared to the prior year. The decrease in cost of revenues is primarily due to the favorable change in sales mix toward high-margin Regional Anesthesia products.
Selling and Marketing Expenses
Selling and marketing expenses from continuing operations increased 25%, or $14.2 million, to $71.9 million for the year ended December 31, 2007 from $57.7 million for the year ended December 31, 2006. This increase was primarily attributable to increases in compensation and related expenses ($4.6 million), commissions ($4.4 million), travel and entertainment expenses ($1.8 million), consulting ($1.2 million), advertising and promotions expenses ($0.7 million), employee training expenses ($0.2 million) and marketing samples ($0.1 million). As reflected above, the increases in selling and marketing expenses for the year ended December 31, 2007 were primarily due to costs related to the realignment and expansion of the Company's direct sales force in the United States. In a transaction that was effective as of January 1, 2002, I-Flow re-acquired from Ethicon Endo-Surgery, Inc. the contractual rights to distribute ON-Q products on a direct basis. Since that time, ON-Q revenues have increased rapidly, and the Company's primary strategy in the Regional Anesthesia market has been to rapidly increase market awareness of the clinical and economic advantages of ON-Q technology through a combination of clinical studies, sales force expansion and marketing programs. The increases in commissions, compensation and related expenses, travel and entertainment expenses, employee training expenses and marketing samples were directly related to the increase in revenue, an increase in the number of quota-carrying sales representatives, and changes in the Company's direct sales force and sales management. As of December 31, 2007, the Company employed approximately 320 people in its sales organization in support of its ON-Q sales effort compared to 280 people at December 31, 2006, an increase of approximately 14%.
As a percentage of net revenues, selling and marketing expenses decreased by approximately one percentage point for the year ended December 31, 2007 versus the prior year because net revenues increased at a rate that outpaced the increase in selling and marketing expenses described above. General and Administrative Expenses
General and administrative expenses from continuing operations increased 18%, or $2.7 million, to $17.7 million for the year ended December 31, 2007 from $15.0 million for the year ended December 31, 2006. This increase was primarily attributable to increases in non-cash compensation expense related to the amortization of deferred compensation ($1.3 million), accounting fees ($0.7 million) and legal fees ($0.5 million).
As a percentage of net revenues, general and administrative expenses decreased by approximately one percentage point for the year ended December 31, 2007 versus the prior year because net revenues increased at a rate that outpaced the increase in general and administrative expenses described above. Product Development Expenses
Product development expenses from continuing operations include research and development for new products and the cost of obtaining and maintaining regulatory approvals of products and processes. Product development expenses increased 9%, or $0.2 million, to $2.7 million for the year ended December 31, 2007 from $2.4 million for

the year ended December 31, 2006. The increase in expense was primarily due to an increase in the amortization of patents and increase in compensation and related expenses that resulted from an increase in the number of headcount. The Company will continue to incur product development expenses as it continues its efforts to introduce new technology and cost-efficient products into the market, and these expenses are also expected to increase as a result of the recent acquisition of AcryMed.
Impairment Loss on Investments
For the year ended December 31, 2007, the Company recognized an other-than-temporary impairment of $6.1 million on its investment in HAPC common stock. In October 2007, the Company purchased approximately 2.8 million shares of common stock of HAPC at $5.97 per share through private transactions with third parties totaling approximately $17 million in connection with the then-pending sale of InfuSystem. With the shares purchased as of that date, the Company owned approximately 15% of the issued and outstanding HAPC common stock and disclosed its intentions to vote such shares in favor of the acquisition. As of November 13, 2007, the latest date reported by HAPC, the 2.8 million shares held by the Company constitute approximately 16.5% of the issued and outstanding common stock of HAPC. Since the time the shares of HAPC common stock were purchased by the Company, the share price of HAPC common stock has significantly decreased from the Company's purchase price of $5.97 per share. As of December 31, 2007, the Company has determined that the decline in the fair value of the investment in HAPC common stock was other than temporary based primarily on the significant decline in the market value and its intent to sell the investment in the short-term. As such, the Company recorded the impairment loss and established a new cost basis in the investment as of December 31, 2007 in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities ("SFAS 115").
Interest, Net
Interest and other income, net, from continuing operations increased 160%, or $1.5 million, to $2.4 million for the year ended December 31, 2007 from $0.9 million for the year ended December 31, 2006. The increase was primarily due to increased investment income from higher cash and cash equivalents and short-term investments balances. The Company's cash and cash equivalents and short-term investments increased by approximately $76.1 million from prior year due to the cash proceeds received from the sale of InfuSystem in October 2007. Income Taxes
Income tax benefit from continuing operations decreased to $2.5 million for the year ended December 31, 2007 from $17.6 million for the year ended December 31, 2006. The decrease for the year ended December 31, 2007 was due to a release of the valuation allowance for deferred tax assets with an incremental tax benefit of approximately $16.8 million that was recorded during the year ended December 31, 2006. The remaining valuation allowance relates to temporary timing differences that are not currently determined to be more likely than not to be realized. The income tax benefit was consistent with the guidance in SFAS No. 109, Accounting for Income Taxes, which addresses financial accounting for deferred tax assets. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance when it is more likely than not, based on available evidence, that projected future taxable income will be insufficient to recover the deferred tax assets. In the event the Company is unable to operate at a profit and unable to generate sufficient future taxable income, it would be required to increase the valuation allowance against all of its deferred tax assets.
In the design and improvement of its products, I-Flow incurs research and development costs that qualify for federal and state tax credits. An increase in credits occurred during the current year due to an additional analysis regarding the expenses that qualify for state and federal research and development credits.
The Company's effective tax rate for the year ended December 31, 2007 was a tax benefit of 21.8% compared to a tax benefit rate of 253.4% for the year ended December 31, 2006. The change in the effective tax rate is primarily the result of the valuation allowance release for the year ended December 31, 2006, which allowed a majority of the Company's deferred tax assets to be recognized.

Consolidated Results of Operations for the Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005
Revenue
Net product sales from continuing operations increased 30%, or $21.5 million, to $93.6 million for the year ended December 31, 2006 from $72.1 million for the year ended December 31, 2005.
Regional Anesthesia product revenues increased 36%, or $18.0 million, to $67.9 million for the year ended December 31, 2006 from $49.9 million for the year ended December 31, 2005. This increase was primarily due to increased clinical usage of the ON-Q PainBuster Post-Operative Pain Relief System and C-bloc Continuous Nerve Block System by surgeons in the United States and an increase of 11% in the average selling price during the year ended December 31, 2006 compared to the same period in the prior year. The increase in average selling price was due to a favorable shift in the product mix towards products with higher average selling prices, such as the C-bloc Continuous Nerve Block System. Revenue from the C-bloc Continuous Nerve Block System increased 174%, or $4.2 million, to $6.6 million for the year ended December 31, 2006 from $2.4 million in the prior year, primarily due to improved customer awareness of clinical efficacy and favorable reimbursement from third parties.
Sales of IV Infusion Therapy products, which include the Company's intravenous elastomeric pumps, mechanical infusion devices and disposables, increased 15%, or $3.4 million, to $25.7 million for the year ended December 31, 2006 from $22.3 million for the year ended December 31, 2005. The increase primarily resulted from increased unit sales of IV Infusion Therapy products to U.S. and international distributors, including B. Braun Medical Inc. in the United States and B. Braun Medical S.A. (France) internationally. Cost of Revenues
Cost of revenues from continuing operations increased 34%, or $6.6 million, to $26.3 million for the year ended December 31, 2006 from $19.7 million. The increase was primarily due to higher sales volume. As a percentage of net product sales, product cost of revenues increased for the year ended December 31, 2006 by approximately one percentage point compared to the prior year.
Selling and Marketing Expenses
Selling and marketing expenses from continuing operations increased 16%, or $7.8 million, to $57.7 million for the year ended December 31, 2006 from $49.9 million for the year ended December 31, 2005. This increase was primarily attributable to increases in commissions ($3.5 million), compensation and related expenses ($3.1 million), travel and entertainment expenses ($1.0 million), marketing samples ($0.5 million) and non-cash compensation expense related to the amortization of deferred compensation ($0.5 million), partially offset by a decrease of $1.2 million in advertising and promotions expense.
As reflected above, the increases in selling and marketing expenses for the year ended December 31, 2006 were primarily due to costs related to the realignment and expansion of the Company's direct sales force in the United States. The increases in commissions, compensation and related expenses, travel and entertainment expenses and marketing samples were directly related to the increase in revenue, an increase in the number of quota-carrying sales representatives, and changes in the Company's direct sales force and sales management. As of December 31, 2006, the Company employed approximately 280 people in its sales organization in support of its ON-Q sales effort compared to 250 people at December 31, 2005, an increase of approximately 12%. The Company recognized stock-based compensation costs related to selling and marketing expenses of approximately $2.4 million and $1.9 million during the years ended December 31, 2006 and 2005, respectively. The adoption of SFAS No. 123-revised 2004, Share-Based Payment ("SFAS 123R"), in fiscal 2006 did not have a significant impact on stock-based compensation expense for selling and marketing expenses because the Company was required to recognize such expenses under the prior accounting guidance for the stock awards issued to the sales force since they were generally granted with an exercise price below fair market value.

As a percentage of net revenues, selling and marketing expenses decreased by approximately 7% for the year ended December 31, 2006 versus the prior year because net revenues increased at a rate that outpaced the increase in selling and marketing expenses described above.
General and Administrative Expenses
General and administrative expenses from continuing operations decreased 9%, or $1.3 million, to $15.0 million for the year ended December 31, 2006 from $16.3 million for the year ended December 31, 2005. This decrease was primarily attributable to decreases in non-cash compensation expense related to the amortization of deferred compensation ($2.8 million) and legal fees ($0.5 million), partially offset by increases in compensation and related expenses ($1.1 million) and insurance expense ($0.3 million).
The decrease in non-cash compensation expense related to the amortization of deferred compensation was primarily due to the upward repricing and acceleration of the out-of-the-money stock options on November 9, 2005, offset in part by the adoption of SFAS 123R in fiscal 2006. The primary purposes of upward repricing and acceleration of the out-of-the-money stock options were to comply with new deferred compensation tax laws, to promote employee motivation, retention and the perception of option value and to avoid recognizing future compensation . . .