You should read the following discussion and analysis of financial condition and results of operations together with our unaudited financial statements and the related notes included elsewhere in this quarterly report. This discussion and analysis contains forward-looking statements about our business and operations, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. Our actual results may differ materially from those we currently anticipate as a result of many important factors, including the

factors we describe under "Risk Factors" and elsewhere in our annual report on Form 10-K for the year ended December 31, 2011, as updated by this quarterly report.

Overview

Kips Bay Medical, Inc. ("we", "us", "our" or the "Company") was incorporated in the state of Delaware on May 1, 2007. We are a medical device company focused on manufacturing and commercializing our external saphenous vein support technology, or eSVS Mesh, for use in coronary artery bypass grafting, or CABG, surgery. Our eSVS Mesh is a nitinol mesh sleeve that, when placed over a saphenous vein graft during CABG surgery, is designed to improve the structural characteristics and long-term performance of the saphenous vein graft. CABG surgery is one of the most commonly performed surgeries in the United States. In CABG procedures, surgeons harvest blood vessels, including the internal mammary artery from the chest wall and the saphenous vein from the leg, and attach the harvested vessels to bypass, or provide blood flow around, blocked coronary arteries. We believe the use of our eSVS Mesh with saphenous vein grafts in CABG surgery will improve the long-term outcome of CABG procedures, including maintained openness, or patency, and improved blood flow characteristics through the saphenous vein graft, resulting in a reduced need for costly and potentially complicated reoperations or revascularization procedures.

Our eSVS Mesh is a novel product and we are not aware of the establishment of any specific or supplemental reimbursements for our eSVS Mesh. Given certain budgetary pressures in Europe, our sales to date have been limited. In November 2011 we commenced enrollments in our first post-market study of the eSVS Mesh in Europe. The intent of this study is to develop clinical data to further support the marketing and reimbursement of the eSVS Mesh.

The U.S Food and Drug Administration ("FDA") has reviewed and disapproved our most recent amendment to our application for an investigational device exemption ("IDE") in March 2011. At that time the FDA indicated that they intended to review our IDE information with outside experts before they provide further guidance to the Company. Due to internal delays, the FDA did not begin this review until August 2011. In September 2011 the FDA advised us that we had not provided sufficient data to support our request for an IDE for our eSVS Mesh.

In April 2012, we provided additional information on our eSVS Mesh to the FDA under a Pre-IDE submission. This Pre-IDE submission allowed the FDA to determine if the additional information gathered by the Company is adequate to answer questions raised by the FDA in their disapproval of our most recent amendment to our application for an IDE. In July 2012, the FDA responded to our Pre-IDE submission and advised us that we were allowed to proceed with filing an application for an IDE to include four U.S. sites in our clinical feasibility study of our eSVS Mesh device currently being pursued in Europe. We submitted this application on July 18, 2012.

We continue to pursue a feasibility trial in Europe. This trial is a multi-center, randomized study of external saphenous vein support using our eSVS Mesh in CABG Surgery and is titled the "eMESH I" study. The objective of this study is to demonstrate the initial safety and performance of our eSVS Mesh for use as an external saphenous vein graft support device during coronary artery bypass procedures sufficient to allow the FDA to approve an IDE for a larger pivotal study, which is required to demonstrate clinical effectiveness and support a request for approval to sell our eSVS Mesh in the U.S. We are currently working through the ethics committee review and approval process at our selected study sites in Europe.

Upon completion of this study, we expect to request an IDE for a pivotal study in the U.S. However, we could be delayed by adverse clinical results or regulatory complications, and we may never receive U.S. marketing approval.

As of June 30, 2012, we had an accumulated deficit of $27.0 million. We expect our losses to continue as we pursue commercialization of and further regulatory approvals for our eSVS Mesh. Prior to completing our IPO, we had financed our operations primarily through the private placement of convertible debt and equity securities.

Critical Accounting Policies and Estimates

Our significant accounting policies and estimates are disclosed in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Note 2 to our Audited Consolidated Financial

Statements, included in Part II, Item 8, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. The critical accounting policies used in the preparation of the financial statements as of June 30, 2012 have remained unchanged from December 31, 2011.

Results of Operations



Comparison of the Three and Six Months Ended June 30, 2012 to the Three and Six
Months Ended July 2, 2011 (in thousands)



                          Three Months Ended                    Six Months Ended
                   June 30,     July 2,     Percent     June 30,     July 2,     Percent
                     2012         2011       Change       2012         2011       Change
Net sales          $      57    $     48        18.8 %  $     110    $    158       (30.4 )%
Cost of sales            (25 )       (21 )      19.0          (49 )       (58 )     (15.5 )
Gross profit              32          27        18.5           61         100       (39.0 )
Operating
expenses:
Research and
development              667         387        72.4        1,150         821        40.1
Selling,
general and
administrative           752         689         9.1        1,574       1,242        26.7
Total operating
expenses               1,419       1,076        31.9        2,724       2,063        32.0
Other income
(expense):
Interest income            4           5       (20.0 )          9           9           -
Net loss           $  (1,383 )  $ (1,044 )      32.5 %  $  (2,654 )  $ (1,954 )      35.8 %

Cost of sales, research and development and selling, general and administrative expenses include non-cash stock-based compensation expense as a result of our issuance of stock options and restricted stock grants. We expense the fair value of equity awards over their vesting periods. The terms and vesting schedules for share-based awards vary by type of grant and the employment status of the grantee. The awards granted through June 30, 2012 vest upon time-based conditions. We expect to record additional non-cash compensation expense in the future, which may be significant. The following table summarizes the stock-based compensation expense in our statements of comprehensive income for the three and six months ended June 30, 2012 and July 2, 2011 (in thousands):

                                                Three Months Ended                      Six Months Ended
                                        June 30, 2012        July 2, 2011        June 30, 2012     July 2, 2011
Cost of sales                          $            14     $              12    $            29    $          21
Research and development                            11                   (35 )               66               43
Selling, general and administrative                107                    70                217              123
Total stock-based compensation         $           132     $              47    $           312    $         187

Net Sales and Gross Profit

Our net sales increased 18.8% to $57,000 in the second quarter of 2012, and decreased 30.4% to $110,000 for the first six months of 2012 as compared with the respective periods in the prior year. Our gross profit increased 18.5% to $32,000 in the second quarter of 2012 and decreased 39.0% to $61,000 for the first six months of 2012 as compared with the respective periods in the prior year. The increase in net sales in the current quarter resulted from increased demand from our distributors. However, the overall decrease in net sales for the six months of 2012 reflects the impact of limited reimbursements available to hospitals and the continuing effects of budget difficulties in certain European countries. We expect sales to continue at modest levels until additional clinical study data is available.

Research and Development

Our research and development expenses increased 72.4% from $387,000 in the second quarter of 2011 to $667,000 in the second quarter of 2012. Research and development expenses increased 40.1% from $821,000 in the six months ended July 2, 2011 to $1.2 million in the six months ended June 30, 2012. These increases are due to

increases in clinical study and product development activities related to our eSVS Mesh. In November 2011 we began enrolling patients in a post market study and also began recruiting European sites to participate in a feasibility study for the FDA. During 2012, we also commenced product development efforts intended to support expanding our product labeling to include the use of alternate sealants and to allow physicians to use our eSVS Mesh in performing sequential grafts. We expect that our research and development costs will continue to increase as we continue human clinical trials in Europe and initiate trials in the U.S. The most significant costs will be incurred for human clinical trials in the U.S., which cannot begin until the FDA approves our IDE.

Selling, General and Administrative

Our selling, general and administrative ("SG&A") expenses increased 9.1% to $752,000 from $689,000 in the three months ended June 30, 2012 and July 2, 2011, respectively. SG&A expenses increased 26.7% to $1.6 million from $1.2 million in the six months ended June 30, 2012 and July 2, 2011, respectively. These increases were driven by a combination of factors which include: compliance costs associated with becoming a public company in February 2011, costs associated with the expansion of our management team, professional service fees and costs incurred to support our commercial sales activity. The increased costs related to the expansion of our management team, both as part of becoming a public company and to support our commercial sales, included approximately $95,000 of increased stock-based compensation expenses in the first half of 2012. We expect SG&A expenses to remain relatively stable as we continue to pursue our international sales and marketing efforts.

Interest Income

Interest income decreased $1,000 in second quarter of 2012 and remained unchanged during the first six months of 2011, compared to the same periods in the prior year. The decrease resulted from a decrease in our cash, cash equivalents and short-term investments in the second quarter of 2012 as compared with the second quarter of 2011.

Liquidity and Capital Resources

The following table summarizes our liquidity and capital resources as of June 30, 2012 and December 31, 2011 and for each of the six months ended June 30, 2012 and July 2, 2011 and is intended to supplement the more detailed discussion that follows (in thousands):

Liquidity and Capital Resources   June 30, 2012    December 31, 2011
Cash and cash equivalents                 2,330   $             6,211
Short-term investments                    4,535                 2,957
Working capital                           7,724                 9,940




                                                                    Six Months Ended
Cash Flow Data                                               June 30, 2012      July 2, 2011
Cash provided by (used in):
Operating activities                                        $        (2,308 )  $       (6,253 )
Investment activities                                                (1,708 )          (6,910 )
Financing activities                                                    135            13,632
Net increase (decrease) in cash and cash equivalents        $        (3,881 )  $          469

Cash and Cash Equivalents

Our total cash resources, including short-term investments, as of June 30, 2012 were $6.9 million compared to $9.2 million as of December 31, 2011. As of June 30, 2012, we had $430,000 in current liabilities and $7.7 million in net working capital. As of December 31, 2011, we had $260,000 in current liabilities and $9.9 million in net working capital. We incurred a net loss of $2.7 million and had negative cash flow from operating activities of $2.3 million for the six months ended June 30, 2012.

As we continue to pursue regulatory approvals, develop additional clinical data, continue the process of commercialization in international markets and develop additional applications for our eSVS Mesh, we expect to

continue to incur substantial and increasing losses, which will continue to generate negative net cash flows from operating activities.

We market our eSVS Mesh in select European and other international markets. We continue to generate moderate levels of sales which we believe reflect the cost pressures in the health care industry and our need to develop additional clinical data for the eSVS Mesh.

On October 24, 2011, we entered into a common stock purchase agreement (the "Purchase Agreement") with Aspire Capital Fund, LLC, an Illinois limited liability company ("Aspire"), which provides that, upon the terms and subject to the conditions and limitations set forth therein, Aspire is committed to purchase up to an aggregate of $20.0 million of shares of our common stock (the "Purchase Shares") over a three year period at purchase prices determined in accordance with the Purchase Agreement. Pursuant to the terms of the Purchase Agreement, we have filed and maintain a registration statement on Form S-1 with the SEC under which we have registered 3,164,357 shares of our common stock for resale by Aspire. Without approval from our stockholders, this amount, which includes the Commitment Shares issued to Aspire at the signing of the Purchase Agreement, is the maximum number of shares which we may sell to Aspire.

In the future, we may seek to raise additional funds through various sources, such as equity and debt financings, or through strategic collaborations and license agreements. We can give no assurances that we will be able to secure such additional sources of funds to support our operations, or if such funds are available to us, that such additional financing will be sufficient to meet our needs. We expect that our current cash, cash equivalents and short-term investments will be sufficient to fund our planned operations for at least the next 12 months, and we have no current intention to enter into a credit facility or loan agreement. We do not anticipate any adverse effects stemming from the lack of available credit facilities at this time.

Net Cash Used in Operating Activities

Net cash used in operating activities was $2.3 million and $6.3 million in the six months ended June 30, 2012 and July 2, 2011, respectively. The net cash used in each of these periods primarily reflects the net loss for those periods, offset in part by depreciation, non-cash stock-based compensation and the effects of changes in operating assets and liabilities. Net cash used in operating activities for the six months ended July 2, 2011 included a $5.0 million milestone payment to Medtronic, Inc.

Net Cash Used in Investment Activities

Net cash used in investment activities was $1.7 million and $6.9 million in the six months ended June 30, 2012 and July 2, 2011, respectively. Cash used in investment activities is related primarily to the purchase of short-term investments and capital equipment. During 2012, such purchases were partially offset by the sales and maturities of short-term investments.

Net Cash Provided by Financing Activities

Net cash provided by financing activities was $135,000 and $13.6 million in the six months ended June 30, 2012 and July 2, 2011, respectively. Net cash provided by financing activities resulted from the sale of common stock under our common stock purchase agreement with Aspire Capital in the current year and our initial public offering in the prior year.

Capital Requirements

We expect that our existing resources as of the date of this quarterly report, to be sufficient to fund our planned operations for at least the next 12 months. However, we may require significant additional funds earlier than we currently expect in order to conduct additional clinical trials to obtain regulatory approvals of our eSVS Mesh. To the extent that we raise additional capital through the sale of equity or convertible debt securities, stockholders' interest will be diluted, and the terms may include liquidation or other preferences that adversely affect the rights of our current stockholders. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions such as incurring additional debt, making capital expenditures or

declaring dividends. Any of these events could adversely affect our ability to achieve our product development and commercialization goals and harm our business.

If adequate funds are not available, we may be required to terminate, significantly modify or delay our development programs, reduce our planned commercialization efforts, or obtain funds through collaborators that may require us to relinquish rights to our technologies or product candidates that we might otherwise seek to develop or commercialize independently. We may elect to raise additional funds even before we need them if the conditions for raising capital are favorable.

Off-Balance Sheet Arrangements

We have not engaged in any off-balance sheet activities as defined in Regulation S-K Item 303(a)(4).

Special Note Regarding Forward-Looking Statements

This quarterly report contains forward-looking statements that involve risks and uncertainties. In some cases, you can identify forward-looking statements by the following words: "anticipate," "believe," "continue," "could," "estimate," "expect," "intend," "may," "ongoing," "plan," "potential," "predict," "project," "should," "will," "would," or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words. The forward-looking statements in this quarterly report include, but are not limited to, statements regarding uses for and benefits of our technology, the timing of and strategy for governmental approvals and product introductions, the commencement and cost of preclinical trials and post-market studies, our expectations regarding continued and increasing operating losses, moderate sales levels, increased research and development expenses, stable SG&A expenses, continued negative net cash flow from operations, our expected use of proceeds from our initial public offering, the adequacy of our capital resources to fund planned operations, our ability to raise additional funds and operating and capital requirement expectations. These statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry's results, levels of activity, performance or achievements to be materially different from the information expressed or implied by these forward-looking statements. Although we believe that we have a reasonable basis for each forward-looking statement contained in this quarterly report, we caution you that these statements are based on a combination of facts and factors currently known by us and our projections of the future, about which we cannot be certain. Many important factors affect our ability to achieve our objectives, including:

†          our ability to commercialize our eSVS Mesh technology;

†          our ability to obtain and maintain foreign and domestic regulatory
approvals of our eSVS Mesh technology;

†          our ability to obtain coverage and reimbursement from third-party
payors for our eSVS Mesh technology and the extent of such coverage;

†          the successful development of our distribution and marketing
capabilities;

†          our ability to attract and retain scientific, regulatory, and sales
and marketing support personnel;

†          our ability to obtain and maintain intellectual property protection
for our eSVS Mesh technology;

†          any future litigation regarding our business, including product
liability claims;

†          changes in governmental laws and regulations relating to healthcare;

†          the availability and cost of third-party products and the ability of
our suppliers to timely meet our demands;

†          changes affecting the medical device industry;

†          general and economic business conditions; and

†          the other risks described under Item 1A.  "Risk Factors" in our

You should read these risk factors and the other cautionary statements made in this quarterly report as being applicable to all related forward-looking statements wherever they appear in this quarterly report. We cannot assure you that the forward-looking statements in this quarterly report will prove to be accurate. Furthermore, if our forward-looking statements prove to be inaccurate, the inaccuracy may be material. You should read this quarterly report completely. Other than as required by law, we undertake no obligation to update these forward-looking statements, even though our situation may change in the future.