You should read the following discussion in conjunction with our financial statements, including the notes thereto, at the end of this prospectus. Some of the information contained in this discussion, or set forth elsewhere in this prospectus contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of certain factors, including those set forth under "Risk Factors" and elsewhere in this prospectus.

 

Three months ended September 30, 2006 compared to three months ended September 30, 2005

Critical Accounting Policies and Estimates

The discussion and analysis of the Company’s financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, management evaluates past judgments and estimates, including those related to bad debts, inventories, accrued liabilities, and contingencies. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The accounting policies and related risks described in the Company’s annual report on Form 10-KSB as filed with the Securities and Exchange Commission on September 28, 2006 are those that depend most heavily on these judgments and estimates. As of September 30, 2006, there have been no material changes to any of the critical accounting policies contained therein except for the adoption of SFAS 123R as noted below.

 

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Share-Based Compensation

As part of our adoption of SFAS 123R as of July 1, 2006, we were required to recognize the fair value of share-based compensation awards as an expense. We apply the Black-Scholes option-pricing model in order to determine the fair value of stock options on the date of grant, and we apply judgment in estimating key assumptions that are important elements in the model such as the expected stock-price volatility, expected stock option life and expected forfeiture ratios. Our estimates of these important assumptions are based on historical data and judgment regarding market trends and factors. If actual results are not consistent with our assumptions and judgments used in estimating these factors, we may be required to record additional share-based compensation expense, which could be material to our results of operations.

Adoption of SFAS 123R

During December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123R, which requires companies to measure and recognize compensation expense for all share-based payments at fair value. Share-based payments include stock option and nonvested share grants. We grant options to purchase common stock to some of our employees and directors under various plans at prices equal to the market value of the stock on the dates the options were granted. We historically have accounted for stock options using the method prescribed in APB 25 whereby if stock options are granted at market price then no compensation cost is recognized, and disclosed the pro forma effect on net earnings assuming compensation cost had been recognized in accordance with SFAS 123. SFAS 123R, which was effective for us beginning on July 1, 2006, eliminates the ability to account for share-based compensation transactions using APB 25, and generally requires that such transactions be accounted for using prescribed fair-value-based methods. SFAS 123R permits public companies to adopt its requirements using one of two methods: (a) a “modified prospective” method in which compensation costs are recognized beginning with the effective date based on the requirements of SFAS 123R for all share-based payments granted or modified after the effective date, and based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date or (b) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits companies to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either for all periods presented or prior interim periods of the year of adoption. We have decided to adopt SFAS 123R using the modified prospective method.

During the three months ended September 30, 2006, we recognized $781,443 of compensation expense related to the expensing of stock options in accordance with SFAS 123R. Approximately $51,000, $12,000, $47,000, and $672,000 of this amount is included in cost of products sales, research and development, sales and marketing, and general and administrative expenses, respectively, in the accompanying consolidated statements of operations. As of September 30, 2006, total unrecognized compensation cost related to stock-based options was $944,407 and the related weighted-average period over which it is expected to be recognized is approximately 1.23 years.

Results of Operations

 

Three months ended September 30, 2006 compared to three months ended September 30, 2005

Revenues. The Company generated sales of $1,025,444 during the three months ended September 30, 2006, compared to sales of $210,915 during the three months ended September 30, 2005. The increase of $814,529 or 386% is due to increased sales volume of the Company’s ¹³¹Cs seed. During the three months ended September 30, 2006, the Company sold its ¹³¹Cs seed to 23 different medical centers as compared to 10 centers during the corresponding period of 2005.

Cost of product sales. Cost of product sales was $1,288,145 for the three months ended September 30, 2006 compared to cost of product sales of $720,166 during the three months ended September 30, 2005. The increase of $567,979 or 79% was due to the higher production levels during the three months ended September 30, 2006 which were related to the increase in sales volume over the corresponding period from 2005. The major components of the increase were wages, benefits and related taxes, materials, depreciation, third-party preload services, share-based compensation, and rent and occupancy expenses.  Wages, benefits, and related taxes increased about $201,000 to approximately $374,000 for the three months ended September 30, 2006 due to the hiring of additional production employees to support the higher production levels. Materials costs increased about $297,000 to approximately $421,000 in 2006, due to increased sales volumes. Depreciation expense increased about $42,000 to approximately $83,000 in 2006 due to the addition of equipment that was placed in service during the second half of the fiscal year ended June 30, 2006. Third-party preload services also increased by about $58,000 to approximately $74,000 for the three months ended September 30, 2006 due to the higher volume of sales. Share-based compensation expense was approximately $51,000 and $0 for the three months ended September 30, 2006 and 2005, respectively, as the Company implemented SFAS 123R on July 1, 2006. Rent and occupancy expenses were approximately $39,000 and $0 for the three months ended September 30, 2006 and 2005, respectively, as the Company moved into its independent production facility in the second half of fiscal year 2006. These increases were offset by lower payments to Pacific Northwest National Laboratory (“PNNL”) as the Company discontinued using PNNL’s facilities and personnel to manufacture its product during fiscal year 2006. For the three months ended September 30, 2005, the Company paid PNNL approximately $235,000 under a production contract. The Company has continued to use PNNL for certain analytical support functions and paid PNNL approximately $80,000 during the three months ended September 30, 2006.

 

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Gross loss.  Gross loss was $262,701 for the three month period ended September 30, 2006. This represents an improvement of $246,550 or 48% over the corresponding period of 2005’s gross loss of $509,251. The improvement in gross loss is due to higher revenues and greater production efficiency.

Research and development. Research and development expenses for the three month period ended September 30, 2006 were $245,598 which represents an increase of $219,816 or 853% over the research and development expenses of $25,782 for the corresponding period of 2005. The major components of the increase were wages, benefits and related taxes, protocol studies, consulting, and share-based compensation. Wages, benefits and related taxes were approximately $64,000 and $0 for the three months ended September 30, 2006 and 2005, respectively, as the Company hired research scientists. Protocol studies expenses increased about $73,000 to approximately $76,000 for the three-months ended September 30, 2006 as more patients were enrolled in these studies. Consulting expenses increased about $65,000 to approximately $88,000 as the Company continues to refine the production of isotopes. Share-based compensation expense was approximately $12,000 and $0 for the three months ended September 30, 2006 and 2005, respectively, as the Company implemented SFAS 123R on July 1, 2006.

Sales and marketing expenses. Sales and marketing expenses were $672,930 for the three months ended September 30, 2006. This represents an increase of $357,891 or 114% compared to the three months ended September 30, 2005’s expenditures of $315,039 for sales and marketing. During the three months ended September 30, 2006, approximately $392,000 was paid for wages, including payroll-related taxes, travel, office and other support expenses on behalf of our sales and marketing and customer service staff and approximately $47,000 represents share-based compensation expense. The balance was spent on advertising, market research, and trade shows and conferences. The increase over the prior year is due to increased sales and marketing personnel and increased expenses to market the Company’s ¹³¹Cs seeds through promotional materials and conventions and tradeshows as the Company continues its efforts to expand its market share.

 

General and administrative expenses. General and administrative expenses for the three months ended September 30, 2006 were $1,733,132 compared to general and administrative expenses of $960,949 for the corresponding period of 2005. The increase of $772,183 or 80% is primarily due to approximately $672,000 of share-based compensation expense related to the implementation of SFAS 123R on July 1, 2006, a one-time severance accrual of $288,000, approximately $100,000 of increased payroll costs due to a higher headcount, approximately $27,000 relating to investor relations expenses, and approximately $12,000 relating to higher insurance premiums due to the growth of the Company. These increased expenses were partially offset by a reduction in consulting fees of approximately $330,000 which represents merger consulting fees incurred in the three months ended September 30, 2005.

Operating loss. Due to our significant research and development expenditures, additional responsibilities as a reporting company, rapid structural growth, and product revenues not covering production costs, we have not been profitable, and have generated operating losses since our inception. In the three months ended September 30, 2006, the Company had an operating loss of $2,914,361 which is an increase of $1,103,340 or 61% over the operating loss of $1,811,021 for the three months ended September 30, 2005. Included in the operating loss for the three months ended September 30, 2006 is share-based compensation expense of $781,443 due to the implementation of SFAS 123R during the period and a one-time severance accrual of $288,000. Without these two expense items, our operating loss would have had a marginal decrease.

 

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Interest income. Interest income increased by $33,224 or 477% to $40,183 for the three months ended September 30, 2006. Interest income is mainly derived from excess funds held in certain near-liquid accounts.

Financing expense. Financing expense for the three months ended September 30, 2006 was $53,257 or a decrease of $102,371 or 66% from financing expense of $155,628 for the corresponding period in 2005. Included in financing expense is interest expense of approximately $31,000 and $104,000 for the three months ended September 30, 2006 and 2005, respectively. The decrease in interest expense is due to the conversion of debentures to common stock during the fiscal year ended June 30, 2006 partially offset by interest expense related to the Hanford Area Economic Investment Fund Committee (HAEIFC) loan that was entered into in June 2006. The remaining balance of financing expense represents the amortization of deferred financing costs which decreased due to the write-off in fiscal year 2006 of the deferred financing costs relating to the debentures that were converted to common stock partially offset by the amortization of the HAEIFC deferred financing costs.

Liquidity and capital resources. At September 30, 2006, cash and cash equivalents amounted to $5,160,557. During the three months ended September 30, 2006, the Company issued 2,063,000 shares of common stock at a price of $2.50 per share and 2,269,300 common stock warrants (including broker warrant commissions) with an exercise price of $3.00 per share pursuant to a round of institutional funding. This funding provided approximately $4.7 million, net of offering costs. Additionally, the Company issued 327,636 shares of common stock pursuant to the exercise of common stock options and preferred stock warrants, which were exchanged for common stock immediately upon exercise. The Company received $391,194 in cash pursuant to these exercises.

The Company had approximately $4.7 million cash on hand as of October 31, 2006. As of that date management believes that the Company’s monthly required cash operating expenditures were approximately $800,000. Management believes that assuming expenditures continue at approximately the same monthly rate and that it is able to fund a portion of its equipment purchases with the HAEIFC loan, that the Company’s cash on hand will fund operating expenditures through the beginning of March 2007. This is based on the Company attaining its current revenue targets and the ability to efficiently manufacture our product. If we should experience disruptions in our revenues then our monthly cash requirements would increase and necessitate that we obtain additional funding prior to February 2007.

Our growth plans for fiscal 2007 include expanding sales to new customers, growing sales volume with existing customers, and expanding production capability through the purchase of additional equipment. The Company has also begun a review of its current facilities and future needs. The Company continues to use PNNL to provide third-party assay of its products, but has otherwise vacated PNNL facilities. This review includes evaluating the Company’s need for space given its growth projections. It is anticipated that additional employees and production equipment will be needed to meet future growth. This will create the need for additional production and office space that would be leased through an operating lease.

IsoRay has three loans outstanding as of September 30, 2006. The first loan is from the Benton-Franklin Economic Development District (“BFEDD”) in an original principal amount of $230,000 and was funded in December 2004. It bears interest at eight percent and has a sixty month term with a final balloon payment. As of September 30, 2006, the principal balance owed was $201,312. This loan is secured by certain equipment, materials and inventory of IsoRay, and also required personal guarantees, for which the guarantors were issued approximately 70,455 shares of common stock. The second loan is a line of credit from Columbia River Bank, which provides credit in the amount of $375,000. It bears interest at a floating prime plus two percent rate, and is secured by certain accounts receivable and inventory and personal guarantees, for which the guarantors were issued approximately 107,401 shares of common stock. As of September 30, 2006, no balance was outstanding on the line of credit. The line of credit expires on March 1, 2007. The third loan is from the Hanford Area Economic Investment Fund Committee and was originated in June 2006. The loan has a total facility of $1,400,000 and bears interest at nine percent. As of September 30, 2006, the Company has taken only a partial draw of $418,670 on the facility and the remaining facility of $981,330 is available to use to purchase equipment. The principal balance owed on the loan as of September 30, 2006 was $414,327. This loan is secured by receivables, equipment, materials and inventory of IsoRay, and certain life insurance policies.

 

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The Company has certain capital leases for production and office equipment that expire at various times from March 2008 to April 2009. These leases currently call for total monthly payments of $19,361. The total of capital lease obligations at September 30, 2006 was $352,908.

At September 30, 2006, the Company had outstanding $455,000 of convertible debentures. These debentures could be converted into 109,639 shares of common stock at a conversion rate of $4.15 per share. Each debenture bears interest at an annual rate of eight percent (not compounded) with accrued interest paid quarterly. The debentures mature at various times from February 2007 to June 2007.

In February 2006, the Company signed a license agreement with International Brachytherapy s.a. (“IBt”) covering North America and providing the Company with access to IBt’s Ink Jet production process and its proprietary polymer seed technology for use in brachytherapy procedures using Cesium-131. The Company paid license fees of $275,000 during 2006 and another payment of $225,000 was to be made in August 2006 pursuant to the license agreement. Royalty payments based on net sales revenue are also required, with minimum quarterly royalties ranging from $100,000 to $200,000 and minimum annual royalties ranging from $400,000 to $800,000 over the term of the agreement. Management is engaged in further negotiations with IBt and may ultimately terminate this agreement, although management has not yet decided on a course of action.

As of the date of this report, the payment due in August 2006 has not been made as the Company has been in continued negotiations with IBt concerning the amount and timing of future royalty payments due to the low market acceptance of the polymer seed technology.

In September 2006, the Company entered into a settlement agreement with a former executive. As part of the settlement the Company agreed to pay the former executive $100,000 in September 2006 and $215,000 in January 2007. As of September 30, 2006 the remaining payment of $215,000 is accrued in accrued payroll.

Also in September 2006, the Company reached a preliminary settlement agreement, subject to approval of the Board of Directors, with its former Chief Financial Officer. The preliminary settlement calls for payments totaling $288,000, with the timing of these payments under negotiation.

The industry that the Company operates in is subject to product liability litigation. Through its production and quality assurance procedures, the Company works to mitigate the risk of any lawsuits concerning its product. The Company also carries product liability insurance to help protect it from this risk.

The Company expects to finance its future cash needs through the sale of equity securities, solicitation to warrant holders to exercise their warrants, and possibly strategic collaborations or debt financing or through other sources that may be dilutive to existing shareholders. If the Company needs to raise additional money to fund its operations, funding may not be available to it on acceptable terms, or at all. If the Company is unable to raise additional funds when needed, it may not be able to market its products as planned or continue development and regulatory approval of its future products. If the Company raises additional funds through equity sales, these sales may be dilutive to existing investors.

The Company has no off-balance sheet arrangements.

Going Concern Issues

 

Our financial statements have been prepared assuming we will continue as a going concern. We had net losses of $8,218,130 and $4,269,188 for the years ended June 30, 2006 and 2005 and an accumulated deficit of $13,546,261 at June 30, 2006. Our accumulated deficit at September 30, 2006 was $16,473,696. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Our financial statements do not include any adjustment that might result from the outcome of this uncertainty. Management plans to obtain the necessary financing and to continue to grow revenues in order to achieve profitability but no assurances can be given that management will be able to obtain additional financing or grow revenues to a profitable level.

 

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If we are unable to generate profits and unable to obtain additional financing to meet our working capital requirements, we may have to curtail our business or cease operations. Our continuation as a going concern is dependent upon our ability to generate sufficient cash flow to meet our obligations on a timely basis, to obtain additional financing, and, ultimately, to attain profitability. Should any of these events not occur, the accompanying financial statements will be adversely effected and we may have to cease operations.

Critical Accounting Policies and Estimates

The discussion and analysis of the Company’s financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, management evaluates past judgments and estimates, including those related to bad debts, inventories, accrued liabilities, and contingencies. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Accounts Receivable

Accounts receivable are stated at the amount that management of the Company expects to collect from outstanding balances. Management provides for probable uncollectible amounts through an allowance for doubtful accounts. Additions to the allowance for doubtful accounts are based on management’s judgment, considering historical write-offs, collections and current credit conditions. Balances which remain outstanding after management has used reasonable collection efforts are written off through a charge to the allowance for doubtful accounts and a credit to the applicable accounts receivable. Payments received subsequent to the time that an account is written off are considered bad debt recoveries.

Inventory

Inventory is reported at the lower of cost, determined using the weighted average method, or net realizable value.

Asset Retirement Obligation

SFAS No. 143, Asset Retirement Obligations, establishes standards for the recognition, measurement and disclosure of legal obligations associated with the costs to retire long-lived assets. Accordingly, under SFAS No. 143, the fair value of the future retirement costs of the Company’s leased assets are recorded as a liability on a discounted basis when it is incurred and an equivalent amount is capitalized to property and equipment. The initial recorded obligation, which has been discounted using the Company’s credit-adjusted risk free-rate, will be reviewed periodically to reflect the passage of time and changes in the estimated future costs underlying the obligation. The Company amortizes the initial amount capitalized to property and equipment and recognizes accretion expense in connection with the discounted liability over the estimated remaining useful life of the leased assets.

Revenue Recognition

The Company applies the provisions of SEC Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. SAB No. 104, which supersedes SAB No. 101, Revenue Recognition in Financial Statements, provides guidance on the recognition, presentation and disclosure of revenue in financial statements. SAB No. 104 outlines the basic criteria that must be met to recognize revenue and provides guidance for the disclosure of revenue recognition policies. The Company recognizes revenue related to product sales when (i) persuasive evidence of an arrangement exists, (ii) shipment has occurred, (iii) the fee is fixed or determinable, and (iv) collectibility is reasonably assured.

 

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Revenue for the fiscal years ended June 30, 2006 and 2005 was derived solely from sales of the ¹³¹Cs brachytherapy seed, which is used in the treatment of cancer. The Company recognizes revenue once an order has been received and shipped to the customer. Prepayments, if any, received from customers prior to the time that products are shipped are recorded as deferred revenue. In these cases, when the related products are shipped, the amount recorded as deferred revenue is recognized as revenue. The Company accrues for sales returns and other allowances at the time of shipment.

Legal Contingencies

In the ordinary course of business, the Company is involved in legal proceedings involving contractual and employment relationships, product liability claims, patent rights, and a variety of other matters. The Company records contingent liabilities resulting from asserted and unasserted claims against it, when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. The Company discloses contingent liabilities when there is a reasonable possibility that the ultimate loss will exceed the recorded liability. Estimating probable losses requires analysis of multiple factors, in some cases including judgments about the potential actions of third-party claimants and courts. Therefore, actual losses in any future period are inherently uncertain. Currently, the Company does not believe any of its pending legal proceedings or claims will have a material impact on its financial position or results of operations. However, if actual or estimated probable future losses exceed the Company’s recorded liability for such claims, it would record additional charges as other expense during the period in which the actual loss or change in estimate occurred.

    

Results of Operations

Financial Presentation

Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, requires that following a merger the accounting acquirer’s financial statements should be used for historical comparisons. Although the legal acquirer was Century Park Pictures Corporation (“Century”), for accounting purposes Medical was the acquirer and as such Medical’s historical financial statements are shown for comparative purposes. Also for accounting purposes, the merger was accounted for as though it happened on July 1, 2005.

The following sets forth a discussion and analysis of the Company’s financial condition and results of operations for the two years ended June 30, 2006. This discussion and analysis should be read in conjunction with our consolidated financial statements appearing elsewhere in this Prospectus. The following discussion contains forward-looking statements. Our actual results may differ significantly from the results discussed in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Risk Factors” of this Prospectus.

Year ended June 30, 2006 compared to year ended June 30, 2005

Product sales. Revenues for the year ended June 30, 2006 were $1,994,306, an increase of $1,792,575 over sales for the year ended June 30, 2005 of $201,731. All of the Company’s revenues were generated through sales of its ¹³¹Cs seeds. IsoRay began sales of its ¹³¹Cs seed on October 26, 2004 with one medical center customer. By June 30, 2006 the number of medical center customers who had ordered the ¹³¹Cs seed had grown to 26.

Gross loss. Gross loss was $1,820,816 for the year ended June 30, 2006 or an increase of $548,296 as compared to a gross loss of $1,272,520 for the year ended June 30, 2005.  Cost of products sold was $3,815,122 for the year ended June 30, 2006 or an increase of $2,340,871 over the $1,474,251 incurred for the year ended June 30, 2005. During the year ended June 30, 2006, the Company paid $868,650 to Pacific Northwest National Laboratory (PNNL) under our contract with them for use of their facilities and personnel to support production. During the fourth quarter of fiscal year 2006, we paid approximately $110,000 for quality assurance support and as a deposit to extend our contract through December 31, 2007. The Company is currently using PNNL for certain research and development and quality assurance activities. Also during fiscal 2006, the Company paid approximately $1 million in wages, benefits, and related taxes for production personnel and approximately $1.6 million in direct and indirect material costs. These costs increased due to a larger staff and material and supply costs related to an increase in sales during fiscal year 2006.

 

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Also included in cost of products sold during 2006 were over $109,000 for production and small tools, none of which individually exceeded the $2,500 threshold we use in determining whether to capitalize production equipment. These materials and small tools were needed to commence production in our independent production facility, the PEcoS-IsoRay Radioisotope Laboratory (“PIRL”). Most are long-lived items and will not need replacing in the next fiscal year. The Company has moved essentially all of its Cs-131 production operations to PIRL.

Research and development. Research and development expenses for the year ended June 30, 2006 were $450,425, an increase of $312,893 over research and development expenses of $137,532 for the year ended June 30, 2005. During 2006, $116,200 was spent on protocol studies of patients that have been implanted with the Company’s ¹³¹Cs brachytherapy seeds. Also during 2006, $144,588 was spent on research to improve Cs-131 production.

Sales and marketing expenses. Sales and marketing expenses were $1,420,500 for the year ended June 30, 2006. This represents an increase of $718,678 over the expense of $701,822 for the year ended June 30, 2005. During fiscal 2006, approximately $994,000 was spent on wages, travel, office, and other support expenses on behalf of the sales and marketing and customer service staff. The balance was spent on advertising, market research and trade shows and conferences. The increases are due to increased marketing of the Company’s ¹³¹Cs seed since introduction of our product to the market in October 2004.

General and administrative expenses. General and administrative expenses were $3,503,522 for the year ended June 30, 2006 or an increase of $1,632,197 as compared to $1,871,325 for the year ended June 30, 2005. Included in general and administrative expenses in 2006 is $330,000 relating to consulting fees for the reverse acquisition that was paid with the issuance of common stock (see “Description of Business”). The increases over the prior periods are due to supporting the Company’s increased manufacturing and sales activities. These activities have increased as the Company has only been manufacturing and selling its product since October 2004. Additionally, increased expenses in the 2006 fiscal year were due to compliance with SEC regulations following the July 28, 2005 merger. Significant components of general and administrative expenses include $838,797 in consulting expense, payroll and related expenses of $866,863 and professional fees, including accounting and legal fees of $522,318. Consulting services increased in connection with the establishment of the independent PIRL production facilities, which commenced production in the late Fall of 2005, and associated equipment installation, customization and validation; review and advice on business and capital strategies, and the addition of a medical director who serves as a consultant. Professional fees increased due to the Company’s July 28, 2005 merger, SEC compliance activities including the Company’s registration statement on Form SB-2 filed that was effective in June 2006, and other general business activities.

Operating loss. Due to the Company’s significant research and develop expenditures, additional responsibilities as a reporting company, rapid structural growth, and nominal product revenues, the Company has not been profitable, and has generated operating losses since inception. For the year ended June 30, 2006, the Company had an operating loss of $7,195,263. This represents an increased loss of $3,212,064 in comparison with the year ended June 30, 2005 operating loss of $3,983,199.

Interest income. Interest income increased by $49,350 to $51,744 for the year ended June 30, 2006. Interest income is mainly derived from excess funds held in certain near-liquid accounts.

Financing expense. Financing expense for the year ended June 30, 2006 includes $332,493 of interest expense incurred on long-term debt and convertible debentures outstanding. The interest expense increased over the prior year due to interest payments on the convertible debentures that were sold as part of the January 1, 2005 PPM, computed interest expense on the capital leases entered into during fiscal 2006, and interest expense on other loans that were initiated in January 2005. The remaining balance of financing expense represents amortization of deferred financing costs primarily related to the January 2005 issuance of common stock to guarantors of certain loans made to the Company, commissions and legal costs paid in conjunction with the issuance of convertible debentures, issuance of warrants as an inducement for a note payable, and costs associated with the initiation of the Hanford Area Economic Investment Fund Committee (HAEIFC) note payable. During 2006, $89,516 of deferred financing costs were expensed relating to debentures that were converted to common stock.

 

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Debt conversion expense. This amount of approximately $385,000 relates to the one-time, non-cash expense resulting from the short-term inducement offered to debenture holders to their convert debentures to common stock (see Note 11). This expense was recognized in accordance with Statement of Financial Accounting Standard No. 84, Induced Conversions of Convertible Debt.

Year ended June 30, 2005 compared to year ended June 30, 2004

Product sales. Revenues for the year ended June 30, 2005 were $201,731. The Company did not have any revenues for the year ended June 30, 2004. IsoRay began sales of its ¹³¹Cs seed on October 26, 2004 with one medical center customer. All of the Company’s sales in 2005 were generated through sales of its ¹³¹Cs seeds.

Gross loss. Gross loss was $1,272,520 and cost of products sold was $1,474,251 for the year ended June 30, 2005. The Company did not have any gross loss or cost of products sold for the year ended June 30, 2004. During the year ended June 30, 2005, the Company paid $574,225 to Pacific Northwest National Laboratory (PNNL) under our contract with them for use of their facilities and personnel to support production. The Company was using PNNL for production of its seeds and other activities.

Research and development. Research and development expenses for the year ended June 30, 2005 were $137,532 an increase of $95,206 over research and development expenses of $42,326 for the year ended June 30, 2004. The change is due to research to improve production of Cs-131 and other isotopes.

 

Sales and marketing expenses. Sales and marketing expenses were $701,822 for the year ended June 30, 2005. This represents an increase of $620,336 over the expense of $81,486 for the year ended June 30, 2004. Most of the 2005 expenses were spent on wages, travel, office, and other support expenses on behalf of the sales and marketing and customer service staff. The increases are due to hiring sales personnel during 2005 to market the Company’s ¹³¹Cs seed which was only introduced to the market in October 2004.

General and administrative expenses. General and administrative expenses were $1,871,325 for the year ended June 30, 2005 as compared to $650,161 for the year ended June 30, 2004. The increase is due to increased salaries for officers who were foregoing salaries or were paid under market and the hiring of additional staff as the Company began manufacturing and selling its product. Approximately $870,000 was spent on payroll, benefits, and related employment costs during fiscal year 2005. Other significant components of general and administrative expenses included about $178,000 in consulting services and $269,000 of professional fees. Consulting expenses increased as the Company hired advisors for operations, business and capital strategies. Professional fees increased due to the merger of the two predecessor companies into IsoRay Medical, Inc. as well as the Company’s private placements and other general business matters.

Operating loss. Due to the Company’s significant research and development expenditures, large general and administrative expenses and payroll related to properly staffing the Company for anticipated further growth coupled with nominal product revenues, the Company generated operating losses. For the year ended June 30, 2005, the Company had an operating loss of $3,983,199. This represents an increased loss of $3,209,226 in comparison with the year ended June 30, 2004 operating loss of $773,973.

Interest income. Interest income was $2,394 for the year ended June 30, 2005 which was an increase of $496 over interest income of $1,898 for the year ended June 30, 2004.

Financing expense. Financing expense for the year ended June 30, 2005 includes amortization of deferred financing costs and interest expense incurred on long-term debt and convertible debentures outstanding. The deferred financing costs relate primarily to the January 2005 issuance of common stock to guarantors of certain loans made to the Company and commissions and legal costs paid in conjunction with the issuance of convertible debentures. Amortization of these costs amounted to $76,746 during 2005. The remaining balance relates to interest expense which increased due to the issuance of the convertible debentures in 2005.

 

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Loss on disposal of fixed assets. This loss in 2005 relates to the write-off of certain rudimentary production equipment that was replaced by complex production equipment that improves the manufacturing process.

 

 

Our common stock is quoted on the OTC Bulletin Board under the symbol "ISRY.OB" and on the Pink Sheets under the symbol "ISRY.PK." There is limited trading activity in our securities, and there can be no assurance a regular trading market for our common stock will be sustained. We resumed trading on the Pink Sheets on August 18, 2005, after a period of no trading activity from February 18, 2005 until August 18, 2005. We also had a period of no trading activity from July 2003 until February 7, 2005. On November 2, 2005, we began trading on the OTC Bulletin Board. The following table sets forth, for the calendar periods indicated, the range of the high and low last reported bid prices of our common stock from October 1, 2004 through June 30, 2006, as reported by the Pink Sheets and the OTC Bulletin Board.  The quotations represent inter-dealer prices without retail mark-ups, mark-downs or commissions, and may not necessarily represent actual transactions.  The quotations may be rounded for presentation. There is an absence of an established trading market for the Company's common stock, as the market is limited, sporadic and highly volatile, which may affect the prices listed below.

The following table sets forth, for the fiscal quarters indicated, the high and low sales prices for our common stock as reported on the OTC Bulletin Board and the Pink Sheets.

Year ended June 30, 2007		High			Low
First quarter		$	3.50		$	2.50
Year ended June 30, 2006		High			Low
First quarter		$	5.95		$	1.00
Second quarter			8.25			4.50
Third quarter			7.25			6.20
Fourth quarter			6.40			3.25
Year ended June 30, 2005		High			Low
First quarter		$	N/A		$	N/A
Second quarter			*			*
Third quarter(1)			N/A			N/A

* Less than $0.01.

 

⁽¹⁾ Due to our change of fiscal year end from September 30 to June 30, our 2005 fiscal year was only nine months long.

  

The Company has never paid any cash dividends on its Common Stock and does not plan to pay any cash dividends in the foreseeable future.

As of September 30, 2006, we had approximately 890 shareholders of record, exclusive of shares held in street name.

Equity Compensation Plans

On May 27, 2005, the Company adopted the 2005 Stock Option Plan (the “Option Plan”) and the 2005 Employee Stock Option Plan (the “Employee Plan”), pursuant to which it may grant equity awards to eligible persons. On August 15, 2006, the Company adopted the 2006 Director Stock Option Plan (the “Director Plan”) pursuant to which it may grant equity awards to eligible persons. The Option Plan allows the Board of Directors to grant options to purchase up to 1,800,000 shares of common stock to directors, officers, key employees and service providers of the Company, and the Employee Plan allows the Board of Directors to grant options to purchase up to 2,000,000 shares of common stock to officers and key employees of the Company. The Director Plan allows the Board of Directors to grant options to purchase up to 1,000,000 shares of common stock to directors of the Company. Options granted under all of the Plans have a ten year maximum term, an exercise price equal to at least the fair market value of the Company’s common stock (based on the trading price on the OTC Bulletin Board) on the date of the grant, and with varying vesting periods as determined by the Board.

 

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As of June 30, 2006, the following options had been granted under the option plans.

Plan Category		Number of securities to be issued on exercise of outstanding options, warrants and rights #			Weighted-average exercise price of outstanding options, warrants, and rights $			Number of securities remaining available for future issuance under equity compensation plans
Equity compensation plans approved by shareholders			N/A			N/A			N/A
Equity compensation plans not approved by shareholders			3,257,592		$	2.11			333,982
Total			3,257,592		$	2.11			333,982

 

DESCRIPTION OF BUSINESS

 

General

 

Century was organized under Minnesota law in 1983. Century had no operations since its fiscal year ended September 30, 1999 through June 30, 2005.

 

On July 28, 2005, IsoRay Medical, Inc. became a wholly-owned subsidiary of Century pursuant to a merger. Century changed its name to IsoRay, Inc. In the merger, the Medical stockholders received approximately 82% of the then outstanding securities of the Company.

 

Medical, a Delaware corporation, was incorporated effective June 15, 2004 to develop, manufacture and sell isotope-based medical products and devices for the treatment of cancer and other diseases. Medical is headquartered in Richland, Washington.

Medical was formed for the purpose of combining the operations of IsoRay, Inc. (a former Washington corporation) (“IsoRay (WA)”) and its subsidiary, IsoRay Products LLC, two companies that shared common ownership and management with Medical. Medical’s management initiated a merger transaction effective October 1, 2004, to combine operations.

 

Business Operations

 

Overview

IsoRay is utilizing its patented radioisotope technology, experienced chemists and engineers, and management team to create a major therapeutic medical isotope and medical device company with a goal of providing improved patient outcomes in the treatment of prostate cancer and other solid tumor cancers. IsoRay began production and sales of its Food and Drug Administration (“FDA”) cleared product, the IsoRay ¹³¹Cs brachytherapy seed, in October 2004 for the treatment of prostate cancer. Management believes its technology will allow it to capture a leadership position in an expanded brachytherapy market. The more clinically beneficial characteristics of the Cesium-131 (Cs-131 or ¹³¹Cs) isotope are expected to decrease radiation exposure to the patient and reduce the severity and duration of side effects, while treating cancer cells as effectively, if not more so than other isotopes used in seed brachytherapy. Cesium-131 could also enable meaningful penetration in other solid tumor applications such as breast, lung, liver, brain and pancreatic cancer, expanding the total available market opportunity.

 

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Brachytherapy seeds are small devices used in an internal radiation therapy procedure. In recent years the procedure has become one of the primary treatments for prostate cancer and is now used more often than surgical removal of the prostate. The brachytherapy procedure places radioactive seeds as close as possible to (in or near) the cancer tumor (the word “brachytherapy” means close therapy). The seeds deliver therapeutic radiation by killing the tumor cells and cells located in the immediate vicinity of the tumor while minimizing exposure to adjacent healthy tissue. This allows doctors to administer a higher dose of radiation at one time than is possible with external beam radiation. Each seed contains a radioisotope sealed within a welded titanium capsule. Approximately 85 to 135 seeds are permanently implanted in the prostate in a 45-minute outpatient procedure. The isotope decays over time and the seeds become inert. The seeds may be used as a primary treatment or, in conjunction with other treatment modalities such as external beam radiation therapy, chemotherapy, or as treatment for residual disease after excision of primary tumors.

 

Management believes that the IsoRay ¹³¹Cs seed represents the first major advancement in brachytherapy technology in over 18 years with attributes that could make it the long term “seed of choice” for internal radiation procedures. The ¹³¹Cs seed has FDA clearance for treatment of malignant disease (e.g. cancers of the head and neck, brain, liver, lung, breast, prostate, etc.) and may be used in surface, interstitial, and intracavity applications for tumors with known radiosensitivity.

 

The ¹³¹Cs isotope appears to have specific advantages for treating cancer over Iodine-125 (I-125 or ¹²⁵I) and Palladium-103 (Pd-103 or ¹⁰³Pd), the other isotopes commonly used in brachytherapy procedures. IsoRay believes that the short half-life and higher dose rate characteristics of ¹³¹Cs will expand industry applications and facilitate meaningful penetration into the treatment of other forms of cancer such as breast cancer. The shorter half-life of 9.7 days for ¹³¹Cs (versus 17 days for ¹⁰³Pd and 60 days for ¹²⁵I) mitigates negative effects of long radiation periods on healthy tissue and is believed to reduce the duration of certain side effects. The higher initial dose rate is believed to be more effective on fast growing cancers by aggressively attacking cancer cells and disrupting cancer cell re-population cycles. The characteristics of ¹³¹Cs may result in the use of 10-30% fewer seeds per procedure compared to Pd-103, thereby reducing the total physical radiation dose to the patient and reducing the costs of the procedure for both third-party payers and the patient.

IsoRay and its predecessor companies have accomplished the following key milestones:

 

·	Treated 500th patient (September 2006);

·	Opened a new manufacturing and production facility (October 2005);

·	Deployed a direct sales force to the market (July 2004 - July 2005);

·	Developed a treatment protocol for prostate cancer with a leading oncologist (January 2005);

·	Treated the first patient (October 2004);

·	Commenced production of the 131Cs seed (August 2004);

·	Filed five additional patent applications for the 131Cs process (November 2003 - August 2004);

·	Obtained a Nuclear Regulatory Commission Sealed Source and Device Registration required by the Washington State Department of Health and the FDA (September 2004);

·	Received a Radioactive Materials License from the Washington State Department of Health (July 2004);

·	Implemented an ISO-9000 Quality Management System and production operating procedures (under continuing development);

·	Signed a Commercial Work for Others Agreement between Battelle (manager of the Pacific Northwest National Laboratory or PNNL) and IsoRay, allowing initial production of seeds through 2006  at PNNL (April 2004);

·	Raised over $23.0 M in debt and equity funding (September 2003 - August 2006)

·	Obtained favorable Medicare reimbursement codes for the Cs-131 brachytherapy seed (November 2003);

·	Obtained FDA 510(k) clearance to market the first product: the 131Cs brachytherapy seed (March 2003);

·	Completed initial radioactive seed production, design verification, computer modeling of the radiation profile, and actual dosimetric data compiled by the National Institute of Standards and Technology and PNNL (October 2002); and

·	Obtained initial patent for 131Cs isotope separation and purification (May 2000).

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Industry Information

 

Incidence of Prostate Cancer

 

Excluding skin cancer, prostate cancer is the most common form of cancer, and the second leading cause of cancer deaths in men. The American Cancer Society estimated there will be about 234,460 new cases of prostate cancer diagnosed and an estimated 27,350 deaths associated with the disease in the United States during 2006. Because of early detection techniques (e.g., screening for prostate specific antigen, or PSA) approximately 70% (164,100) of these cases are potentially treatable with monotherapy seed brachytherapy, when the cancers are still locally confined within the prostate. A substantial majority of these cases are potentially treatable with dual therapy using seed brachytherapy in combination with different variations of external beam radiation.

 

The prostate is a walnut-sized gland surrounding the male urethra, located below the bladder and adjacent to the rectum. The two most prevalent prostate diseases are benign prostatic hyperplasia (BPH) and prostate cancer. BPH is a non-cancerous enlargement of the innermost part of the prostate. Prostate cancer is a malignant tumor that begins most often in the periphery of the gland and, like other forms of cancer, may spread beyond the prostate to other parts of the body.

Prostate cancer incidence and mortality increase with age. Prostate cancer is found most often in men who are over the age of 50. More than seven out of ten men diagnosed with prostate cancer are over the age of 65. According to the American Cancer Society, approximately one man in six will be diagnosed with prostate cancer during his lifetime.

 

In addition to age, other risk factors are linked to prostate cancer, such as genetics. Men who have relatives that have been affected, especially if the relatives were young at the time of diagnosis, have an even higher risk of contracting the disease. Researchers have discovered that changes in certain genes, influenced by DNA mutations inherited from a parent, may cause some men to be more inclined to develop prostate cancer. It has also been suggested that environmental factors such as exposure to cancer-causing chemicals or radiation may cause DNA mutations in many organs. Another factor that may contribute to prostate cancer is diet, with diets high in fat and high in calcium possibly increasing the risk of prostate cancer.

 

The American Cancer Society recommends that men without symptoms, risk factors and who have a life expectancy of at least ten years, should begin regular annual medical exams at the age of 50, and believes that health care providers should offer as part of the exam the prostate-specific antigen (PSA) blood test and a digital rectal examination. The PSA blood test determines the amount of prostate specific antigen present in the blood. PSA is found in a protein secreted by the prostate, and elevated levels of PSA can be associated with either prostatitis (a noncancerous inflammatory condition) or a proliferation of cancer cells in the prostate. Transrectal ultrasound tests and biopsies are typically performed on patients with elevated PSA readings to confirm the existence of cancer.

A tumor found by a prostate biopsy is usually assigned a grade by a pathologist. The most common prostate cancer grading system is called the Gleason grading system. A Gleason score, which ranges from 2 to 10, usually is used to estimate the tumor’s growth rate. Typically, the lower the score, the slower the cancer grows. Most localized cancers of the prostate gland are associated with an intermediate score ranging from Gleason scores 4 through 6.

Staging is the process of determining how far the cancer has spread. The treatment and recovery outlook depend on the stage of the cancer. The TNM system is the staging process used most often. The TNM system describes the extent of the primary tumor (T stage), whether the cancer has spread to nearby lymph nodes (N stage), and the absence or presence of distant metastasis (M stage). The TNM descriptions can be grouped together with stages labeled 0 through IV (0-4). The higher the number, the further the cancer has spread. The following table summarizes the various stages of prostate cancer.

Stages		Characteristics of Prostate Cancer
T1 or T2		Localized in the prostate
T3 or T4		Locally advanced
N+ or M+		Spread to pelvic lymph nodes (N+) or distant organs (M+)

 

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Treatment Options and Protocol

 

In addition to brachytherapy, localized prostate cancer is commonly treated with radical prostatectomy (RP) and external beam radiation therapy (EBRT). Recently, intensity modulated radiation therapy (IMRT) has seen increased application, particularly in combination with brachytherapy for cancers that have begun to spread beyond the prostate. Other treatments include cryosurgery, hormone therapy, watchful waiting, and finasteride, a drug commonly prescribed to treat benign enlargement of the prostate and male baldness. Some of these therapies may be combined in special cases to address a specific cancer stage or patient need. When the cancerous tissue is not completely eliminated, the cancer typically returns to the primary site, often with metastases to other areas.

Radical Prostatectomy. Historically the most common treatment option for prostate cancer, radical prostatectomy is an invasive surgical procedure in which the entire prostate gland is removed. RP is performed under general anesthesia and typically involves a hospital stay of several days for patient observation and recovery. This procedure is often associated with relatively high rates of impotence and incontinence. For instance, a study published in the Journal of the American Medical Association in January 2000 reported that approximately 60% of men who had received RP reported erectile dysfunction as a result of surgery. The same report found that approximately 40% of the patients studied reported at least occasional incontinence. New bilateral nerve-sparing techniques are currently being used more frequently in order to address these side effects, but these techniques require a high degree of surgical skill. RP is typically more expensive than other common treatment modalities.

External Beam Radiation Therapy. EBRT allows patients to receive treatment on an outpatient basis and at a lower cost than RP. EBRT involves directing a beam of radiation from outside the body at the prostate gland in order to destroy cancerous tissue. The course of treatment usually takes seven to eight weeks to deliver the total dose of radiation prescribed to kill the tumor. Studies have shown, however, that the ten-year disease free survival rates with treatment through EBRT are less than the disease free survival rates after RP or brachytherapy treatment. In addition, because the radiation beam travels through the body to reach the prostate, normal tissue lying in the path of the radiation beam is also damaged. Other side effects are associated with EBRT. For instance, rectal wall damage caused by the radiation beam is a noted negative side effect. Data suggests that between 30% and 40% of the patients who undergo EBRT suffer problems with erectile dysfunction after treatment.

 

Intensity Modulated Radiation Therapy. IMRT is a newer, more advanced form of EBRT in which sophisticated computer control is used to aim the beam at the target volume from multiple different angles and to vary the intensity of the beam. Thus, damage to normal tissue and critical structures is minimized by distributing the unwanted radiation over a larger geometric area. The course of treatment is similar to EBRT and requires daily doses over a period of seven to eight weeks to deliver the total dose of radiation prescribed to kill the tumor. IMRT is relatively new and thus not widely available for use as a treatment modality. As a result fewer clinical data regarding treatment effectiveness and the incidence of side effects are available. One advantage of IMRT, and to some extent EBRT, is the ability to treat cancers that have begun to spread from the tumor site. An increasingly popular therapy for patients with more advanced prostate cancer is a combination of IMRT with seed implant brachytherapy.

Cryosurgery. Cryosurgery, a procedure in which tissue is frozen to destroy tumors, is another treatment option for prostate cancer. Currently, this procedure is less widely used, although promising treatment outcomes have been reported. Cryosurgery typically requires a one to two day hospital stay and is associated with higher rates of impotence and other side effects than seed implant brachytherapy.

Other Treatments. Other treatments include hormone therapy and chemotherapy, which may be used to reduce the size of cancerous tumors. However, these treatments are not intended to ultimately cure a patient of prostate cancer. Instead, such treatment choices are made by physicians in an attempt to extend patients’ lives if the cancer has reached an advanced stage or as ancillary treatment methods used in conjunction with other treatment modalities. Common side effects of hormone therapy are impotence, decreased libido and breast enlargement. Common side effects of chemotherapy are nausea, hair loss and fatigue.

 

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“Watchful waiting” or “active surveillance”, while not a treatment, is recommended by some physicians in extreme circumstances based on the severity and growth rate of the disease, as well as the age and life expectancy of the patient. Physicians and patients who choose watchful waiting are frequently seeking to avoid the negative side effects associated with RP or other treatment modalities. Through careful monitoring of PSA levels and close examination for advancing symptoms of prostate cancer, physicians may choose active treatments at a later date.

Treatment Protocol. Prostate cancer patients electing seed therapy first undergo an ultrasound test or CT scan, which generates a two-dimensional image of the prostate. With the assistance of a computer program, a three-dimensional treatment plan is created that calculates the number and placement of the seeds required for the best possible distribution of radiation to the prostate. Once the implant model has been constructed, the procedure is scheduled and the seeds are ordered. The number of seeds implanted normally ranges from 85 to 135, with the number of seeds varying with the size of the prostate. The procedure is usually performed under local anesthesia in an outpatient setting. The seeds are implanted using needles inserted into the prostate. When all seeds have been inserted, seed placement is verified through an ultrasound image, CT scan, fluoroscope or MRI. An experienced practitioner typically performs the procedure in approximately 45 minutes, with the patient normally returning home the same day. Most patients are able to return to their normal activities within one or two days following the procedure.

Origin of Brachytherapy seeds

One of the first reports in the medical literature regarding brachytherapy seeds that deliver “soft x-ray” radiation directly to tumors by permanent implantation appeared in 1965, authored by Donald C. Lawrence and Dr. Ulrich K. Henschke. Don Lawrence later developed and patented the titanium-encapsulated I-125 brachytherapy seed. His company, Lawrence Soft Ray Inc., provided the world’s supply of seeds from 1967 to 1978 until the 3M Corporation purchased the technology. Eventually 3M sold the business to Amersham PLC, which spun off this business to its division ONCURA, today the market leader in Iodine-125 seeds. All commercially available seeds trace their origin to Mr. Lawrence’s invention. Don Lawrence was a founder of IsoRay, LLC, the first predecessor company to IsoRay.

Brachytherapy has been used as a treatment for prostate cancer for more than 30 years. Formerly, seeds containing the radioactive isotope Iodine-125 were implanted in prostate tumors through open surgery. However, this technique fell into disfavor because the seeds were often haphazardly arranged resulting in radiation not reaching all of the targeted cancerous tissue. Compounding this was the fact that often an unintended radiation dose was delivered to healthy surrounding tissues, particularly the urethra and rectum. Originally, brachytherapy earned an unfavorable reputation because the early adopters did not have the imaging technologies needed for accurate placement of the seeds. This resulted in poor tumor control and greater damage to surrounding healthy tissue. Since the introduction of the ultrasound-guided, transperineal implantation technique in the late 1980s, brachytherapy has become a treatment that not only provides excellent therapeutic value but is very convenient and economical for the patient. The benefits of the advancements in imaging, computer dose planning, and the actual implant procedure have been validated by the improved clinical results achieved using modern brachytherapy techniques.

The introduction of Palladium-103 in the mid-1980s represented a major technology advancement in brachytherapy and played a significant role in the dramatic increase in the number of brachytherapy procedures performed. Within a relatively short period of time, ¹⁰³Pd captured 40% of the growing brachytherapy market.

Cesium-131 represents the first major advancement in brachytherapy technology in over 18 years with attributes that management believes could make it the long term “seed of choice” for internal radiation procedures. Management believes that the ¹³¹Cs seed has specific clinical advantages for treating cancer over ¹²⁵I and ¹⁰³Pd.

There is a large and growing potential market for the Company’s products. Several significant clinical and market factors are contributing to the increasing popularity of the brachytherapy procedure. In Europe brachytherapy is growing in excess of 25% per year and it is expected that market growth in the U.S. will also increase dramatically. In 1996 only 4% of prostate cancer cases were treated with brachytherapy, or about 8,000 procedures. In 2005, it was estimated that over 60,000 brachytherapy procedures were performed for prostate cancer. Brachytherapy as a treatment is now more common than radical prostatectomy and has become the treatment of choice for early-stage prostate cancer. Considerable attention is now being given to high risk and faster growing prostate cancers as well. Brachytherapy has significant advantages over competing treatments including lower cost, better survival data, fewer side effects, a faster recovery time and the convenience of a single outpatient procedure that generally lasts 45 minutes (Merrick, et al., Techniques in Urology, Vol. 7, 2001; Potters, et al., Journal of Urology, May 2005; Sharkey, et al., Current Urology Reports, 2002).  

 

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Clinical Results

Long term survival data are now available for brachytherapy with ¹⁰³Pd and ¹²⁵I, which support the efficacy of brachytherapy. Clinical data indicate that brachytherapy offers success rates for early-stage prostate cancer treatment that are equal to or better than those of RP or EBRT. While clinical studies of brachytherapy to date have focused on results from brachytherapy with Pd-103 and I-125, management believes that this data will be relevant for brachytherapy with Cs-131, and Cs-131 may offer improved clinical outcomes over Pd-103 and I-125, given its shorter half-life and higher energy.

Improved patient outcomes. A number of published studies on the use of ¹⁰³Pd and ¹²⁵I brachytherapy in the treatment of early-stage prostate cancer have been very positive (we have not obtained consent to cite the studies listed below).

 

·

In September 2006 a 5 year prospective study to assess the impact of interstitial brachytherapy on the quality of life of patients with localized prostate cancer was published. The results of the present study confirm that the impact of interstitial brachytherapy on the patients’ quality of life is low despite its transient negative effects on some function, and extend existing knowledge concerning quality of life after interstitial brachytherapy. International Journal of Radiation Oncology; Volume 66; 1;31-37.

·

A twelve-year clinical study published in the 2004 Supplement of the International Journal of Radiation Oncology, Biology and Physics, reported relative survival rate of 84% for low risk cancer patients, 78% for intermediate risk cancer patients and 68% for high risk cancer patients. The study was conducted by Dr. Lou Potters, et al. of the New York Prostate Institute and included 1,504 patients treated with brachytherapy between 1992 and 2000.

·

A study published in the January 2004 issue of the International Journal of Radiation Oncology, Biology and Physics, reported that brachytherapy, radical prostatectomy, high-dose external beam radiation therapy and combined therapies produced similar cure rates. The study was conducted by Dr. Patrick Kupelian, Dr. Louis Potters, et al. and included 2,991 patients with Stage T1 or T2 prostate cancer. Of these patients, 35% of patients underwent surgery, 16% received low-dose EBRT, 10% received high-dose EBRT, 7% received combination therapy and 32% received brachytherapy. After five years, the biochemical relapse-free survival rate was 83% for brachytherapy, 81% for radical prostatectomy, 81% for high-dose EBRT, 77% for combination therapy and 51% for low-dose EBRT.

·

A nine-year clinical study published in the March 2000 issue of the International Journal of Radiation Oncology, Biology and Physics, reported that 83.5% of patients treated with Pd-103 seeds were cancer-free at nine years. The study was conducted by Dr. John Blasko of the Seattle Prostate Institute and included 230 patients with clinical stage T1 and T2 prostate cancer. Only 3% experienced cancer recurrence in the prostate.

·

Results from a 10-year study conducted by Dr. Datolli and Dr. Wallner published in the International Journal of Radiation Oncology, Biology and Physics in September 2002, were presented at the October 2002 American Society for Therapeutic Radiology and Oncology (ASTRO) conference confirming the effectiveness of the Pd-103 seed in patients with aggressive cancer who previously were considered poor candidates for brachytherapy. The 10-year study was comprised of 175 patients with Stage T2-T3 prostate cancer treated from 1991 through 1995. Of these patients, 79 percent remained completely free of cancer without the use of hormonal therapy or chemotherapy.

·

A study by the Northwest Prostate Institute in Seattle, Washington reported 79% disease-free survival at 12 years for brachytherapy in combination with external beam radiation (Ragde, et al., Cancer, July 2000). The chance of cure from brachytherapy is nearly 50% higher than for other therapies for men with large cancers (PSA 10-20) and over twice as high as other therapies for men with the largest cancers (PSA 20+) (K. Wallner, Prostate Cancer: A Non-Surgical Perspective, Smart Medicine Press, 2000).

 

Reduced Incidence of Side Effects. Sexual potency and urinary incontinence are two major concerns men face when choosing among various forms of treatment for prostate cancer. Because the IsoRay ¹³¹Cs seed delivers a highly concentrated and confined dose of radiation directly to the prostate, healthy surrounding tissues and organs typically experience less radiation exposure. Management believes, and initial results appear to support, that this should result in lower incidence of side effects and complications than may be incurred with other conventional therapies, and when side effects do occur, they should resolve more rapidly than those experienced with I-125 and Pd-103 isotopes.

 

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Favorable Market Factors

 

Lower Treatment Cost. The total one-time cost of brachytherapy ranges from $10,000 to $17,000 per procedure. This is less than the cost of a radical prostatectomy or RP, which ranges from $17,000 to $20,000, excluding treatment for side effects and post-operative complications. Brachytherapy cost is comparable to the cost of EBRT (external beam radiation), which is approximately $14,000 to $35,000 for a seven to nine week course of treatment.

 

Favorable Demographics. Prostate cancer incidence and mortality increase with age. Prostate cancer is found most often in men who are over the age of 50. The National Cancer Institute has reported that the incidence of prostate cancer increases dramatically in men over the age of 55. Currently, one out of every six men is at lifetime risk of developing prostate cancer. More than seven out of ten men diagnosed with prostate cancer are over the age of 65. At the age of 70, the chance of having prostate cancer is 12 times greater than at age 50. According to the American Cancer Society, prostate cancer incidence rates increased between 1988 and 1992 due to earlier diagnosis in men who otherwise had no sign of symptoms. Early screening has fostered a decline in the prostate cancer death rate since 1990.

The number of prostate cancer cases in the U.S. is expected to increase due to the expanding population of men over the age of 55. The U.S. Census Bureau estimates this segment of the population will increase from 25.9 million men in 2000 to 32 million men by 2008 - a 24% increase. Extrapolating that data, management believes that the U.S. will provide over 180,000 candidates annually for prostate brachytherapy by 2008.

 

Increased PSA Screening. Early PSA screening and testing leads to early diagnosis. The American Cancer Society recommends that men without symptoms or risk factors and who have a life expectancy of at least ten years, should begin regular annual medical exams at the age of 50, and believes that health care providers should offer as part of the exam the prostate-specific antigen blood test. The PSA blood test determines the amount of prostate specific antigen present in the blood. PSA is found in a protein secreted by the prostate, and elevated levels of PSA can be associated with either prostatitis (a noncancerous inflammatory condition) or a proliferation of cancer cells in the prostate. Industry studies have shown that the PSA test can detect prostate cancer up to five years earlier than the digital rectal exam. Ultrasound tests and biopsies are typically performed on patients with elevated PSA readings to confirm the existence of cancer.

 

Our Strategy

 

The key elements of IsoRay’s strategy include:

·

Continue to introduce the IsoRay 131Cs seed into the U.S. brachytherapy market. Utilizing a direct sales organization and selected channel partners, IsoRay intends to capture a leadership position by expanding overall use of the brachytherapy procedure for prostate cancer, capturing much of the incremental market growth and taking market share from existing competitors.

·

Create a state-of-the-art manufacturing process. IsoRay has constructed a state-of-the-art manufacturing facility in Richland, Washington in its leased facility, to implement our proprietary manufacturing process which is designed to improve profit margins and provide adequate manufacturing capacity to support future growth and ensure quality control. If Initiative 297 presents a strategic roadblock to the Company, or if attractive financing alternatives are available in another state, IsoRay will construct a permanent manufacturing facility in another state. Working with leading scientists, IsoRay intends to design and create a proprietary separation process to manufacture enriched barium, a key source material for 131Cs, to ensure adequate supply and greater manufacturing efficiencies.

·

Introduce Cesium-131 therapies for other cancers. IsoRay intends to partner with other companies to develop the appropriate delivery technology and therapeutic delivery systems for treatment of other solid tumors such as breast, lung, liver, pancreas, neck, and brain cancer. IsoRay’s management believes that the first major opportunities may be for the use of Cesium-131 in adjunct therapy for the treatment of residual lung and breast cancers.

·

Support clinical research and sustained product development. The Company plans to structure and support clinical studies on the therapeutic benefits of Cs-131 for the treatment of solid tumors and other patient benefits. We are and will continue to support clinical studies with several leading radiation oncologists to clinically document patient outcomes, provide support for our product claims and compare the performance of our seeds to competing seeds. IsoRay plans to sustain long-term growth by implementing research and development programs with leading medical institutions in the U.S. to identify and develop other applications for IsoRay’s core radioisotope technology.

 

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Management believes there is a large and growing addressable market for IsoRay’s products. Several factors appear to contribute to the increasing popularity of the brachytherapy procedure. Long-term survival data are now available for brachytherapy (other than with respect to treatment from Cs-131 seeds). Brachytherapy has become the treatment of choice for not only early-stage prostate cancer but is now being considered for treatment of fast growing, aggressive tumors. For the treatment of prostate cancer, seed brachytherapy is now more common than surgery (radical prostatectomy). Seed brachytherapy has significant advantages over competing treatments including lower cost, better survival data, fewer side effects, a faster recovery time and the convenience of an outpatient procedure that generally lasts 45 minutes. Over 60,000 procedures were forecasted to occur in the U.S. in 2005. At the October 1, 2006 Cs-131 seed price of $59, this represents a potential $350 million market for seeds that is forecast to grow substantially by 2009 according to a recent market survey performed by Frost & Sullivan, a nationally recognized market research firm. IsoRay’s management believes that the ¹³¹Cs seed will add incremental growth to the existing brachytherapy seed market as physicians who are currently reluctant to recommend brachytherapy for their prostate patients due, in part, to side effects caused by longer-lived isotopes, become comfortable with the shorter half-life of ¹³¹Cs, and the anticipated reduction of side effects.

 

Products

IsoRay markets the Cesium-131 seed and intends to market other radioactive isotopes in the future. Additionally, it will attempt to create a market, primarily in clinical trials, for the liquid Cs-131 isotope, which is created in the production of IsoRay’s ¹³¹Cs seed.

Cs-131 Seed Product Description and Use in Cancer Treatment

Brachytherapy seeds are small devices that deliver therapeutic radiation directly to tumors. Each seed contains a radioisotope sealed within a welded titanium capsule. In prostate cancer procedures, approximately 85 to 135 seeds are permanently implanted in a 45-minute outpatient procedure. The isotope decays over time, and the seeds become inert. The seeds may be used as a primary treatment or in conjunction with other treatment modalities such as external beam radiation therapy, chemotherapy, or as treatment for residual disease after excision of primary tumors.

Significant advantages of brachytherapy over competing treatments include: fewer side effects (the likelihood of impotence and incontinence is reduced when seeds are used to treat prostate cancer); short, convenient outpatient procedure (typically 45 minutes); faster recovery time (days vs. weeks); lower cost than other treatment modalities; higher cure rates for solid tumors; less pain; and overall considerably better quality of life. The primary disadvantage of brachytherapy is subjecting the human body to radiation and the side effects of radiation. Physician errors in seed placement and the number of seeds implanted may also result in the failure to eradicate the cancer or in negative side effects from over-radiation of certain tissues in the body.

A diagram of the IsoRay seed appears in Figure 1. The seed contains an x-ray opaque marker surrounded by a ceramic substrate to which the isotope is chemically attached. The seed core is placed in a titanium tube and precision laser welded to form a hermetically sealed source of therapeutic radiation suitable for permanent implantation. The x-ray marker allows the physician to accurately determine seed placement within the tumor.

 

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Figure 1: Cross section of ¹³¹Cs seed

Competitive Advantages of Cs-131

 

Management believes that ¹³¹Cs has specific clinical advantages for treating cancer over I-125 and Pd-103, the other isotopes currently used in brachytherapy seeds. The table below highlights the key differences of the three seeds. The Company believes that the short half-life, high-energy characteristics of ¹³¹Cs will increase industry growth and facilitate meaningful penetration into the treatment of other forms of cancer such as breast cancer.

Brachytherapy Isotope Comparison

		Cesium-131		Palladium-103		Iodine-125
Half Life		9.7 Days		17.5 days		60 days
Avg. Energy		30.4 KeV+		21 KeV+		28.5 KeV+
Dose Delivery		90% in 33 days		90% in 58 days		90% in 204 days
Total Dose		115 Gy		125 Gy		145 Gy
Anisotropy Factor*		.969		.877 (TheraSeed® 2000)		.930 (OncoSeed® 6711)

 

^*Degree of symmetry of therapeutic dose, a factor of 1.00 indicates symmetry.  

⁺KeV = kiloelectron volt, a standard unit of measurement for electrical energy.

 

Shorter half-life. The Company believes that Cesium-131’s shorter half-life of 9.7 days will prove to have greater biological effectiveness, will mitigate the negative effects of long radiation periods on healthy tissue and will reduce the duration of any side effects. A shorter half-life produces more intense therapeutic radiation over a shorter period of time and may reduce the potential for cancer cell survival and tumor recurrence. Radiobiological studies indicate that shorter-lived isotopes are more effective against faster growing tumors (Dicker, et. al., Semin. Urol. Onc. 18:2, May 2000). Other researchers conclude that “half-lives in the approximate range 4-17 days are likely to be significantly better for a wide range of tumor types for which the radiobiologic characteristics may not be precisely known in advance.” (Armpilia CI, et. al., Int. J. Rad. Oncol. Biol. Phys. 55:2, February 2003).

 

Higher energy. The Cs-131 isotope average decay energy of 30.4 KeV (versus 21 KeV for Pd-103 and 28.5 KeV for I-125) generates a therapeutic radiation field that extends beyond the current dosimetry reference point of 1 cm. Pd-103 seeds emit radiation that does not penetrate as far in tissue (up to 40% lower than Cs-131). To compensate for this more Pd-103 seeds are required to attain the equivalent dose as if Cs-131 seeds were used. This increase in the number of seeds implanted increases the time and cost required to perform Pd-103-based procedures. The lower energy from ¹⁰³Pd seeds may also result in greater non-uniformity of the implant dose as dose rates near the surface of each seed must be higher to compensate for lower doses at greater distances from each seed. The high energy of Cs-131 can result in radiation toxicity if the dosage is not properly calculated by the implanting physician and staff but the higher energy of Cs-131 does make the isotope more “forgiving” for treatment planning purposes.

 

Reduced side effects. Because the IsoRay ¹³¹Cs seed device delivers a highly concentrated and confined dose of radiation directly to the prostate, healthy surrounding tissues and organs are exposed to less radiation than with other treatments. Management believes this should result in fewer and less severe side effects and complications than may be incurred with other conventional therapies.

 

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Figure 2: Cs-131 seed Autoradiograph

Shape of radiation field. The shape of the radiation field generated by a ¹³¹Cs seed is more uniform than most brachytherapy seed designs, and this uniformity may result in better radiation dose coverage and improved therapeutic effectiveness. Figure 2 shows an autoradiograph (film exposed by radiation from the seed itself) of an IsoRay seed, which shows this uniformity of the radiation field that is expected to result in better radiation dose coverage. IsoRay has conducted extensive computer modeling and testing of the seed design. The IsoRay seed has passed all Nuclear Regulatory Commission (“NRC”) requirements for sealed radioactive sources. Dose uniformity was tested and the results compared well to those predicted by industry standard computer modeling techniques. In the third quarter of 2002, seeds were sent to the National Institute for Standards and Technology for calibration, and have undergone dosimetry testing according to American Association of Physicists in Medicine (“AAPM”) protocols. The results of these tests were compiled in IsoRay’s 510(k) submission to the FDA and were subsequently published in the June 2004 issue of Medical Physics. The results of these tests showed superior dose characteristics relative to the leading I-125 and Pd-103 seeds.

 

Reduced costs. The characteristics of ¹³¹Cs seeds described above may result in the use of 10%-30% less seeds per procedure, compared to other isotopes, thereby reducing the total physical radiation dose to the patient and reducing the costs of the procedure for the third-party payers and the patient.

Yttrium 90

Since formation of the Company, management had intended to introduce a second product, Yttrium 90, sometime in 2006. However, management now intends to focus all of its efforts on manufacturing and marketing Cs-131 as it now believes that Yttrium 90 will require the acquisition of additional capital beyond the needs of support for Cs-131 and distract management from its core business at a time when it believes it can gain valuable market share for Cs-131.

 

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Cs-131 Manufacturing Process

Cs-131 is a radioactive isotope that can be produced by the neutron bombardment of Barium-130. When Ba-130 is put into a nuclear reactor it becomes Ba-131, the radioactive material that is the parent isotope of Cs-131. The overall process includes the following:

 

·

Isotope Generation. The radioactive isotope Cs-131 is normally produced by placing a quantity of stable non-radioactive barium (ideally pure Ba-130) into the neutron flux of a nuclear reactor. The irradiation process converts a small fraction of this material into a radioactive form of barium (Ba-131). The Ba-131 decays by electron capture to the radioactive isotope of interest (Cs-131). Due to the short half-life of both the Ba-131 and Cs-131 isotopes, potential suppliers must be capable of removing irradiated materials from the reactor core on a routine basis for subsequent processing to produce ultra-pure Cs-131. The Company has identified more than five reactors facilities in the U.S., Europe and the former Soviet Union that are capable of meeting these requirements. As of November 10, 2006, IsoRay had agreements in place with three suppliers of irradiated Ba-131 or Cs-131. The Company’s agreement with Russia’s Institute of Nuclear Materials (which commenced as of August 25, 2005 and ends August 25, 2012) allows the Company to purchase irradiated Ba-131 for $300.00 per Curie of the isotope. The projected value of the agreement over its term is $30,000,000 with $300,000 worth of isotope projected to be delivered in the first full year of production, although neither of these amounts are obligations to purchase any given quantity of the isotopes in a particular time period. Through September 30, 2006, the Company had paid approximately $202,000 to the Institute of Nuclear Materials. On October 6, 2006, Medical entered into a Contract with FSUE “SSE - Research Institute of Atomic Reactors (“RIAR”) in Russia. The Contract provides for delivery to Medical of purified Cs-131 isotope, which is used by Medical to produce its proprietary Cs-131 brachytherapy seed used in the treatment of prostate cancer. The total value of the Contract over its term, which expires on May 1, 2014, is $6,300,000. Delivery of the isotope is scheduled to commence in January 2007 and continue through December 2013, upon submission of written orders by Medical forty-five days in advance of the planned date of delivery. Medical also entered into an Agreement for Exclusive Rights to Buy on October 6, 2006 with RIAR. This Agreement gives Medical the exclusive right to purchase the Cs-131 isotope produced by RIAR for a period of seven years, or through October 6, 2013. In addition, the Company is engaged in the development of a barium enrichment device that, if successful, should reduce the cost of producing Cs-131 while maintaining the purity and consistency required in the end product.

·

Isotope Separation and Purification. Upon irradiation of the barium feedstock, the Ba-131 begins decaying to Cs-131. At pre-determined intervals the Cs-131 produced is separated from the barium feedstock and purified using a proprietary radiochemical separations process (patent applied for). Due to the high-energy decay of Ba-131, this process is performed under stringent radiological controls in a highly shielded isolator or “hot cell” using remote manipulators. After separating Cs-131 from the energetic Ba-131, subsequent seed processing may be performed in locally shielded fume hoods or glove boxes. If enriched barium feedstock is used, the residual barium remaining after subsequent Cs-131 separation cycles (“milkings”) will be recycled back to the reactor facility for re-irradiation. This material will be recycled as many times as economically feasible, which should make the process more cost effective. As an alternative to performing the Cs-131 separation in our own facilities, IsoRay may enter into agreements with other entities to supply “raw” Cs-131 by performing the initial barium/cesium separation at their facilities, followed by final purification at IsoRay’s facility.

·

Internal Seed Core Technology. The purified Cs-131 isotope is incorporated into an internal assembly that contains a binder, spacer and a gold X-ray marker. This internal core assembly is subsequently inserted into a titanium case. The dimensional tolerance for each material is extremely important. Several carrier materials and placement methods have been evaluated, and through a process of elimination, we have developed favored materials and methods during our laboratory testing. The equipment necessary to produce the internal core includes accurate cutting and gauging devices, isotope incorporation vessels, reaction condition stabilization and monitoring systems, and tools for placing the core into the titanium tubing prior to seed welding.

·

Seed Welding. Following production of the internal core and placement into the titanium capsule, each seed is laser welded to produce a sealed radioactive source and biocompatible medical device. This manufacturing technology requires: accurate placement of seed components with respect to the welding head, accurate control of welding parameters to ensure uniform temperature and depth control of the weld, quality control assessment of the weld integrity, and removal of the finished product for downstream processing or rejection of unacceptable materials to waste. Inspection systems are capable of identifying and classifying these variations for quality control and to ensure low scrap rates. Finally, the rapid placement and removal of components from the welding zone affects overall product throughput.

·

Quality Control. We have established procedures and controls to meet all FDA and ISO 9001:2000 Quality Standards. Product quality and reliability will be secured by utilizing multiple sources of irradiation services, feedstock material, and other seed manufacturing components. An intensive production line preventive maintenance and spare parts program will be implemented. Also, an ongoing training program will be established for customer service to ensure that all regulatory requirements for the FDA, DOT and applicable nuclear radiation and health authorities are fulfilled.

 

The Company has implemented a just-in-time production process that is keenly responsive to customer input and orders to ensure that individual customers receive a higher level of customer service from us than from existing seed suppliers who have the luxury of longer lead times due to longer half-life products. Time from order confirmation to completion of product manufacture can be reduced to several working days, including receipt of irradiated barium (from a supplier’s reactor), separation of Cs-131 (at our facilities), isotope labeling of the core, and loading of cores into pre-welded titanium “cans” for final welding, testing, quality assurance and shipping.

 

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It is up to each physician to determine the dosage necessary for implants and acceptable dosages vary among physicians. Many of the physicians who order our seeds order more seeds than necessary but wish to assure themselves that they have a sufficient amount. Upon receipt of an order, the Company either delivers the seeds from its facility directly to the physician using Federal Express or sends the order to an independent preloading service which delivers the seeds preloaded into needles just prior to implant. If the implant is postponed or rescheduled, the short half-life of the seeds makes them unsuitable for use and therefore they must be re-ordered. In recent months the Company has experienced losses of viable seeds that have increased the Company’s monthly expenditures. The Company is seeking to implement methods to better forecast demand for seeds and reduce unused inventory.

 

Automated Manufacturing Process

IsoRay has held discussions with leading designers and manufacturers of automated seed manufacturing equipment that have manufactured, installed and deployed automated production lines in Europe and the United States. In addition, IsoRay engaged in preliminary discussions with another seed manufacturer regarding obtaining an existing automated seed production line. Based on technical evaluations and on site reviews of both options, IsoRay elected to automate its current manufacturing process in phases. Current production rates with IsoRay’s semi automated seed welding equipment exceed those attainable with fully automated lines. Phased implementation of automation is expected to be less costly than fully automated production lines and will benefit IsoRay by reducing labor costs and helping to ensure consistent manufacturing quality.

 

Manufacturing Facility

 

The initial production of the IsoRay Cs-131 brachytherapy seed commenced at PNNL in 2004. IsoRay signed a lease agreement and completed construction (tenant improvements) of an interim production facility in Richland, Washington that received final regulatory approval on October 6, 2005 and began radioactive production operations shortly thereafter. This lease agreement expires on September 30, 2007 and the Company is currently negotiating an extension of the lease to allow continued operations in this facility. The Company is actively considering several alternative sites for its future production facilities. The Company is also considering another state as a location for a future facility, either as the Company’s sole manufacturing facility or as a secondary production facility. No agreements have been reached for any possible facilities outside of Washington.

Isotope Testing in Idaho

On December 14, 2005, IsoRay and Idaho’s Advanced Test Reactor (“ATR”) entered into a collaboration and partnership agreement for the design, analysis and fabrication of a capsule containing barium carbonate, to be irradiated at the ATR and then shipped to IsoRay for processing and analysis of the ¹³¹Cs product.  As an adjunct to this testing, IsoRay and the Pocatello Development Authority entered into an Economic Development Agreement, dated December 14, 2005, under which the Pocatello Development Authority provided IsoRay with $200,000 (subject to repayment under certain conditions) to use toward the cost of testing at the ATR.  During July 2006, several capsules were irradiated and shipped to IsoRay’s PIRL facility for analysis.  The results of the analyses indicate the capsule performed as designed and that a planned capsule shuttle system will provide adequate conditions for ¹³¹Cs production that will enhance IsoRay’s overall production capacity.

Repackaging Services

Most brachytherapy manufacturers offer their seed product to the end user packaged in four principal configurations provided in a sterile or non-sterile package depending on the customer’s preference. These include:

·	Loose seeds

·	Pre-loaded needles (loaded with 3 to 5 seeds and spacers)

·	Strands of seeds (consists of seeds and spacers in a biocompatible “shrink wrap”)

·	Pre-loaded Mick cartridges (fits the Mick applicator - seed manufacturers usually load and sterilize Mick cartridges in their own manufacturing facilities)

 

No single package configuration dominates the market at this point. Market share estimates, based on internal management studies of the market, for each of the four packaging types are: loose seeds (negligible amount), Mick cartridges (20%), pre-loaded needles (30%) and strands (50%). Market trends indicate significant movement toward the stranded configuration, as there are some clinical data suggesting less potential for post-implant seed migration when a stranded configuration is used.

 

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The role of the preloading service is to package, assay and certify the contents of the final product configuration shipped to the customer. A commonly used method of providing this service is through independent radiopharmacies such as Anazao Healthcare and Advanced Care Medical Inc. Manufacturers send loose seeds along with the physician's instructions to the radiopharmacy who, in turn, loads needles and/or strands the seeds according to the doctor's instructions. These pharmacies then sterilize the product and certify the final packaging prior to shipping directly to the end user.

 

IsoRay has held discussions with the major independent radiopharmacies and determined the additional time required for delivery of loose seeds to an off-site radiopharmacy for subsequent assay, preloading and sterilization creates additional loss of our isotope due to decay and is prohibitive on a long-term basis. However, to increase sales in the near-term we are using these services until our own custom preloading operation comes fully on-line in 2006. On March 1, 2006, the Company entered into a Service Agreement with Advanced Care Medical, Inc. for preloading services. The term of the Service Agreement is one year, with automatic one year extensions unless terminated, and prices vary from $6-18 per seed depending on how the seeds are packaged. In late March 2006, the Company’s stranding service became operational but stranding activity was suspended pending FDA 510(k) clearance of preloaded seed configurations as devices rather than convenience kits for seeds. The 510(k) filing for the stranding activity was submitted to the FDA in August 2006 and the Company expects to receive clearance in the second quarter of fiscal 2007. 

 

The Company currently loads Mick cartridges in our own facility which in recent months accounted for more than 65% of total seed orders. The Company has retained a consultant to assist with implementation of the custom preloading service and expects to begin offering its seed in all four of the commonly used packaging configurations to the rest of its customer base within forty-five to sixty days, pending FDA 510(k) clearance of selected preloaded seed configurations. Providing this service in-house will reduce the current cycle time for any given customer order by three to four days by eliminating the need to ship loose seeds to a third-party provider. This reduction in cycle time will eliminate approximately 25% loss in isotope activity due to radioactive decay. The cost of priority overnight shipment of each order of seeds to a third-party provider is also eliminated. However, we will continue to utilize the independent radiopharmacies in the future both as a backup to our own preloading operation and to handle periodic increases in demand.

 

Independent radiopharmacies usually provide the final packaging of the product delivered to the end user. This eliminates the opportunity for reinforcing the "branding" of our seed product. By providing its own repackaging service, the Company preserves the product branding opportunity and eliminates any concerns related to the handling of its product by a third party prior to delivery to the end user.

 

Providing different packaging configurations adds significant value to the product while providing an additional revenue stream and incremental margins to the Company through the pricing premiums that can be charged. The end users of these packaging options are willing to pay a premium because of the savings they realize by eliminating the need for loose seed handling and loading capabilities on site, eliminating the need for additional staffing to load and sterilize seeds and needles, and eliminating the expense of additional assaying of the seeds.  

 

Management estimates the cost of establishing the custom preloading service in its new, leased facility to be approximately $250,000, most of which has already been spent on capital equipment. The custom preloading area has been created in the facility and the necessary equipment has been delivered and installed. Operating procedures are in place, staff members have been trained, and process validation activities have been completed. Technicians have been added to the staff to handle the seed loading and stranding operations. As the Company is not currently performing the stranding function pending FDA 510(k) clearance, these staff members are currently being utilized in our seed production process. PNNL will continue to provide independent third-party assay of the seeds for the foreseeable future. Our customer service staff will provide assistance with shipping, documentation and tracking of all orders from the repackaging service to the end user.

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Barium Enrichment Device

Barium-130 is the original source material for Cs-131. When Ba-130 is put into a nuclear reactor it becomes Ba-131, the radioactive material that is the parent isotope of Cs-131. Barium metal found in nature contains only 0.1% of Ba-130 with six other isotopes making up the other 99.9%. As part of its manufacturing process the Company intends to develop a barium enrichment device that should create “enriched barium” with a higher concentration of the Ba-130 isotope than is found in naturally occurring barium. In addition to creating a higher purity Ba-130, which translates into higher purity Cs-131, a successfully completed barium enrichment device would result in higher yields of Cs-131. The Company has identified sources of enriched barium, including in the former Soviet Union, that we are using until the barium enrichment device is developed.

Marketing and Sales

Marketing Strategy

The Company intends to position Cs-131 as the isotope of choice for prostate brachytherapy. Based on preliminary clinical studies, management believes there is no apparent clinical reason to use other isotopes when Cesium-131 is available. The advantages associated with a higher energy and shorter half-life isotope are generally accepted within the clinical community and the Company intends to help educate potential patients about the clinical benefits a patient would experience from the use of Cs-131 for their brachytherapy seed treatment. The potential negative effects of the prolonged radiation times associated with the long half-life of Iodine-125 make this isotope less attractive than Cesium-131.

We target competing isotopes as our principal competition rather than the various manufacturers and distributors of these isotopes. In this way, the choice of brachytherapy isotopes will be less dependent on the name and distribution strengths of the various iodine and palladium manufacturers and distributors and more dependent on the therapeutic benefits of Cs-131. The Company focuses the purchasing decision on the advantages and functionality of the Cs-131 isotope while seeking to educate the cancer patient about these clinical benefits.

The professional and patient market segments each play a role in the ultimate choice of cancer treatment and the specific isotope chosen for seed brachytherapy treatment. The Company is tailoring its marketing message to each audience. IsoRay has retained an advertising agency in the Seattle area to assist with its marketing communication program. The agency is coordinating the creation and distribution of all advertising material and work with the print and visual media.

We are seeking to promote the advantages of Cs-131’s unique combination of high energy and short half-life within the clinical market. Because we believe there is no apparent clinical reason to choose other isotopes over cesium, we have and will continue to target those high volume users of other isotopes as our implant sites. We also emphasize the prolonged radiation times and the high doses of radiation given to the patient by the iodine isotope and the possible negative effects of this prolonged radiation to the adjacent healthy tissues. We believe that this is an important marketing message because clinicians generally agree the radiation given by Iodine has little or no clinical benefit after 120 to 150 days, but Iodine continues to give off non-therapeutic radiation for approximately 600 days.

 

To promote our products to the clinical and professional audience, we are using a combination of marketing messages to appear in print and visual media. Past and planned marketing activities include: attendance at the major brachytherapy-related clinical conferences to exhibit our products and provide marketing information for annual meetings, conferences and other forums of the various professional societies; print advertising in brachytherapy clinical journals; and promoting clinical presentations by experts in the field at major conferences.

In today’s U.S. health care market patients are more informed and involved in the management of their health and any treatments required. Many physicians relate incidents of their patients coming for consultations armed with articles researched on the Internet and other sources describing new treatments and medications. In many cases, these patients are demanding a certain therapy or drug and the physicians are complying when medically appropriate.

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Because of this market factor, we also promote our products directly to the general population. The audience targeted will be the prostate cancer patient, his spouse, family and care givers. The marketing message to this segment of the market emphasizes the specific advantages of Cs-131, including fewer side effects, less total radiation, and shorter period of radiation. The Company is targeting this market through its website, located at www.isoray.com, advertising in magazines read by prostate cancer patients and their care givers, and through patient advocacy efforts.

Another key element of our strategy is to validate and support all product claims with well-designed and executed clinical studies that support the efficacy and positive patient outcomes of our Cs-131 seed. We intend to sponsor physician-directed studies that will compare the performance of our seeds to Pd-103 and I-125 seeds. During the remainder of 2006 and into 2007, IsoRay plans to continue its collaboration with leading physicians to develop clinical data on the efficacy of Cs-131 seeds. Noted contributors from the medical physics community will be consulted regarding the benefits of brachytherapy using shorter half-life, improved dosimetry, and higher decay energy seeds. Articles will be submitted to professional journals such as Medical Physics and the International Journal of Radiation Oncology, Biology, and Physics.

Sales and Distribution

According to a recent industry survey, approximately 2,000 hospitals and free standing clinics are currently offering radiation oncology services in the United States. Not all of these facilities offer seed brachytherapy services. These institutions are staffed with radiation oncologists and medical physicists who provide expertise in radiation therapy treatments and serve as consultants for urologists and prostate cancer patients. We target the radiation oncologists and the medical physicists as well as urologists as key clinical decision makers in the type of radiation therapy offered to prostate cancer patients.

IsoRay has a direct sales organization to introduce Cs-131 to radiation oncologists and medical physicists. During 2006, IsoRay expanded its sales force to nine experienced individuals and management intends to hire one more sales person by December 31, 2006. By hiring experienced and successful brachytherapy sales people, the Company reduces the risk of delay in penetrating the market due to a lack of knowledge of the industry or unfamiliarity with the key members of the brachytherapy community.

The initial response to our new isotope from prominent radiation oncologists, medical physicists and urologists in the US has been very positive. As of September 1, 2006, the Company had supplied the ¹³¹Cs seed to 36 well-known implant centers strategically located throughout the U.S.

The Company will expand its U.S. sales force as it expands the customer base. If the Company implements its plans to expand outside the U.S. market, it plans to use established distributors in the key markets in these other countries. This strategy should reduce the time and expense required to identify, train and penetrate the key implant centers and establish relationships with the key opinion leaders in these markets. Using established distributors also should reduce the time spent acquiring the proper radiation handling licenses and other regulatory requirements of these markets.

Pricing

Payment for IsoRay products comes from third-party payers including Medicare/Medicaid and private insurance groups. These payers reimburse the hospitals and clinics via well-established payment procedures. On October 31, 2003, as a result of IsoRay’s predecessor’s filing for an Additional Device Category, CMS (Centers for Medicare and Medicaid Services) approved a HCPCS/CPT code (2633) for Cs-131 brachytherapy seeds. Reimbursement amounts are periodically reviewed and revised. Medicare is the most significant U.S. payer for prostate brachytherapy services, and is the payer in approximately 70% of all U.S. prostate brachytherapy cases. CMS reviews and adjusts outpatient reimbursement on a periodic and ad hoc basis, but no changes are expected for 2006. As of October 1, 2006, the price for our loose seeds was $59 per seed.

Prostate brachytherapy is typically performed in a hospital outpatient setting, and as such, is covered by the CMS Outpatient Prospective Payment System. Currently in 2006, Medicare is reimbursing hospital’s out patient departments, Ambulatory Surgery Centers, and approved physician office settings based on patient specific invoices sent from the manufacturer to the provider. The provider then sends the invoice to Medicare for reimbursement based on Medicare’s reimbursement methodology for that place of service. Other insurance companies typically have followed CMS’ Outpatient Prospective Payment Systems in determining their reimbursement policies. When charges for the seeds are correctly submitted in the appropriate format to CMS, 100% of the total cost of the seeds is reimbursed to the hospital or clinic by CMS.

 

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Other Information

 

Customers

Customers representing ten percent or more of total Company sales for the twelve months ended June 30, 2006 include:

	Community Hospital of Los Gatos	Los Gatos, CA	20.1% of revenue
	Chicago Prostate Cancer Center	Westmont, IL	18.7% of revenue
	Mills Peninsula Health Center	San Mateo, CA	10.4% of revenue

The loss of any of these significant customers would have a temporary adverse effect on the Company’s revenues, which would continue until the Company located new customers to replace them.

 

Proprietary Rights

 

The Company relies on a combination of patent, copyright and trademark laws, trade secrets, software security measures, license agreements and nondisclosure agreements to protect its proprietary rights. Some of the Company’s proprietary information may not be patentable.

 

The Company intends to vigorously defend its proprietary technologies, trademarks, and trade secrets. Members of management, employees, and certain equity holders have previously signed non-disclosure, non-compete agreements, and future employees, consultants, advisors, with whom the Company engages, and who are privy to this information, will be required to do the same. A patent for the Cesium separation and purification process was granted on May 23, 2000 by the U.S. Patent and Trademark Office (USPTO) under Patent Number 6,066,302, with an expiration date of May 23, 2020. The process was developed by Lane Bray, a shareholder of the Company, and has been assigned exclusively to IsoRay. IsoRay’s predecessor also filed for patent protection in four European countries under the Patent Cooperation Treaty. Those patents have been assigned to IsoRay.

Our management believes that certain aspects of the IsoRay seed design and construction techniques are patentable innovations. These innovations have been documented in IsoRay laboratory records, and a patent application was filed with the USPTO on November 12, 2003. Certain methodologies regarding isotope production, separation, and seed manufacture are retained as trade secrets and are embodied in IsoRay’s procedures and documentation. In June and July of 2004, three patent applications were filed relating to methods of deriving Cs-131 developed by IsoRay employees. The Company is currently working on developing and patenting additional methods of deriving Cs-131 and other isotopes.

There are specific conditions attached to the assignment of the Cs-131 patent from Lane Bray. In particular, the associated Royalty Agreement provides for 1% of gross profit payment from seed sales (gross seed sales price minus direct production cost) to Lane Bray and 1% of gross profit from any use of the Cs-131 process patent for non-seed products. If IsoRay reassigns the Royalty Agreement to another company, these royalties increase to 2%. The Royalty Agreement has an anti-shelving clause which requires IsoRay to return the patent if IsoRay permanently abandons sales of products using the invention.

Effective August 1, 1998, Pacific Management Associates Corporation (PMAC) transferred its entire right, title and interest in an exclusive license agreement with Donald Lawrence to IsoRay, LLC (a predecessor company) in exchange for a membership interest. The license agreement was transferred to IsoRay through a series of mergers and the reverse acquisition.

 

The terms of the license agreement require the payment of a royalty based on the Net Factory Sales Price, as defined in the agreement, of licensed product sales. Because the licensor’s patent application was ultimately abandoned, only a 1% “know-how” royalty based on Net Factory Sales Price, as defined, remains applicable. To date, there have been no product sales incorporating the licensed technology and there is no royalty due pursuant to the terms of the agreement. Management believes that because this technology is not presently being used and believes it will not be used in the future that no royalties will be paid under this agreement.

 

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Research And Development

 

From inception (December 17, 2001) through June 30, 2006, IsoRay and its predecessor companies incurred more than $2.25 million in costs related to research and development activities. The Company expects to continue to have employees working on activities that will be classified as research or development for the foreseeable future.

 

Government Regulation

 

The Company's present and future intended activities in the development, manufacture and sale of cancer therapy products are subject to extensive laws, regulations, regulatory approvals and guidelines. Within the United States, the Company's therapeutic radiological devices must comply with the U.S. Federal Food, Drug and Cosmetic Act, which is enforced by the FDA. The Company is also required to adhere to applicable FDA regulations for Good Manufacturing Practices, including extensive record keeping and periodic inspections of manufacturing facilities. IsoRay's predecessor obtained FDA 510(k) clearance in March 2003 to market the IsoRay ¹³¹Cs seed for the treatment of localized solid tumors.

Specifically, in the United States, the FDA regulates, among other things, new product clearances and approvals to establish the safety and efficacy of these products. We are also subject to other federal and state laws and regulations, including the Occupational Safety and Health Act and the Environmental Protection Act.

The Federal Food, Drug, and Cosmetic Act and other federal statutes and regulations govern or influence the research, testing, manufacture, safety, labeling, storage, record keeping, approval, distribution, use, reporting, advertising and promotion of such products. Noncompliance with applicable requirements can result in civil penalties, recall, injunction or seizure of products, refusal of the government to approve or clear product approval applications, disqualification from sponsoring, or conducting clinical investigations, prevent us from entering into government supply contracts, withdrawal of previously approved applications and criminal prosecution.

 

Approval of new medical devices is a lengthy procedure and can take a number of years and the expenditure of significant resources. There is a shorter FDA review and clearance process, the premarket notification process, or the 510(k) process, whereby a company can market certain medical devices that can be shown to be substantially equivalent to other legally marketed devices. We have been able to achieve market clearance for our ¹³¹Cs seed using the 510(k) process.

 

In the United States, medical devices are classified into three different categories over which FDA applies increasing levels of regulation: Class I, Class II and Class III. Most Class I devices are exempt from premarket notification (510(k)); most Class II devices require premarket notification (510(k)) and most Class III devices require premarket approval. Our ¹³¹Cs seed is a Class II device and has received 510(k) clearance.

 

As a registered medical device manufacturer with the FDA, we are subject to inspection to ensure compliance with their current Good Manufacturing Practices, or cGMP. These regulations require that we and any of our contract manufacturers design, manufacture and service products and maintain documents in a prescribed manner with respect to manufacturing, testing, distribution, storage, design control and service activities. Modifications or enhancements that could significantly affect the safety or effectiveness of a device or that constitute a major change to the intended use of the device require a new 510(k) notice for any product modification. We may be prohibited from marketing the modified product until the 510(k) notice is cleared by the FDA.

The Medical Device Reporting regulation requires that we provide information to the FDA on deaths or serious injuries alleged to be associated with the use of our devices, as well as product malfunctions that are likely to cause or contribute to death or serious injury if the malfunction were to recur. Labeling and promotional activities are regulated by the FDA and, in some circumstances, by the Federal Trade Commission.

 

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As a medical device manufacturer, we are also subject to laws and regulations administered by governmental entities at the federal, state and local levels. For example, our facility is licensed as a medical product manufacturing facility in the State of Washington and is subject to periodic state regulatory inspections. Our customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us.

 

In the United States, as a manufacturer of medical devices and devices utilizing radioactive byproduct material, we are subject to extensive regulation by not only federal governmental authorities, such as the FDA, but also by state and local governmental authorities, such as the Washington State Department of Health, to ensure such devices are safe and effective. In Washington State, the Department of Health, by agreement with the federal Nuclear Regulatory Commission ("NRC"), regulates the possession, use, and disposal of radioactive byproduct material as well as the manufacture of radioactive sealed sources to ensure compliance with state and federal laws and regulations. Our ¹³¹Cs brachytherapy seeds constitute both medical devices and radioactive sealed sources and are subject to these regulations. Because Cesium is a new radioactive isotope, centers which sell our ¹³¹Cs seeds must each amend their radioactive licenses and re-file these amended licenses with each state in which they operate and this approval process may take between four months to one year.

 

Moreover, our use, management and disposal of certain radioactive substances and wastes are subject to regulation by several federal and state agencies depending on the nature of the substance or waste material. We believe that we are in compliance with all federal and state regulations for this purpose.

 

Washington voters approved Initiative 297 in late 2004, which may impose additional restrictions on sites at which mixed radioactive and hazardous wastes are generated and stored, including PNNL, as it prohibits additional mixed radioactive and hazardous waste from being brought to sites, such as PNNL, until the existing on-site waste conforms to all state and federal environment laws. In June 2006, a U.S. District Court judge ruled that Initiative 297 was unconstitutional in its entirety. However, the state of Washington has indicated that it would appeal the decision. If this decision is overturned and Initiative 297 is enforced it could impact our ability to manufacture our seeds, whether at PNNL or elsewhere in the State of Washington.

 

Seasonality

 

The Company is now aware of a seasonal influence on its business. During the months of July and August, physicians take vacations and defer seed implantation surgeries causing a momentary decline in revenue which management believes is ultimately realized later.

 

Employees

 

As of November 1, 2006, IsoRay employed 57 full-time individuals and one part-time individual. The Company's future success will depend, in part, on its ability to attract, retain, and motivate highly qualified technical and management personnel. From time to time, the Company may employ independent consultants or contractors to support its research and development, marketing, sales and support and administrative organizations. None of the Company's employees are represented by any collective bargaining unit. IsoRay estimates that successful implementation of its growth plan would result in up to 60 additional employees by the end of calendar year 2007.

Competition

The Company competes in a market characterized by technological innovation, extensive research efforts and significant competition. In general, the IsoRay seed competes with conventional methods of treating localized cancer, including, but not limited to, radical prostatectomy and external beam radiation therapy which includes intensity modulated radiation therapy, as well as competing permanent brachytherapy devices. RP has historically represented the most common medical treatment for early-stage, localized prostate cancer. EBRT is also a well-established method of treatment and is widely accepted for patients who represent a poor surgical risk or whose prostate cancer has advanced beyond the stage for which surgical treatment is indicated. Management believes that if general conversion from these treatment options (or other established or conventional procedures) to the IsoRay seed does occur, such conversion will likely be the result of a combination of equivalent or better efficacy, reduced incidence of side effects and complications, lower cost, quality of life issues and pressure by health care providers and patients.

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History has shown the advantage of being the first to market a new brachytherapy product. For example, Oncura currently claims nearly 30% of the market with the original I-125 seed. Theragenics Corp., which introduced the original Pd-103 seed, is second with a nearly 30% market share. The Company believes it may obtain a similar and significant advantage by being the first to introduce a Cs-131 seed.

The Company’s patented Cs-131 separation process is likely to provide us a sustainable competitive advantage in this area. Production of Cs-131 also requires specialized facilities (hot cells) that represent high cost and long lead time if not readily available. In addition, a competitor would need to develop a method for isotope attachment and seed assembly, would need to conduct testing to meet NRC and FDA requirements, and would need to obtain regulatory approvals before marketing a competing device.

Several companies have obtained regulatory approval to produce and distribute Palladium-103 and Iodine-125 seeds, which compete directly with our seed. Six of those companies represent nearly 100% of annual brachytherapy seed sales worldwide: CR Bard, Inc., Oncura (part of Galil), Theragenics Corp., North American Scientific, Inc., Mentor Corp., and Best Medical International, Inc. The top three - CR Bard, Inc., Oncura and Theragenics - currently garner over 80% of annual sales.

Although there is no assurance that the Company’s Cs-131 seed will retain its favorable reimbursement amount when periodically reviewed and revised, presently the Cs-131 seed has a higher reimbursement rate than either the Palladium-103 or Iodine-125 seeds.

 

It is possible that three or four of the current I-125 or Pd-103 seed manufacturers (e.g., Oncura, Theragenics, North American Scientific, etc.) are capable of producing and marketing a Cs-131 seed, but none have reported efforts to do so. Best Medical obtained a seed core patent in 1992 that named 10 different isotopes, including Cs-131, for use in their seeds. Best Medical received FDA 510(k) clearance to market a Cs-131 seed on June 6, 1993 but has failed to produce any products for sale.

Additional Growth Opportunities

The Cs-131 isotope has the performance characteristics to be a technological platform for sustained long-term growth. The most immediate opportunities are introducing Cs-131 to Canada, Europe and other international markets, introducing Cs-131-based therapies for other forms of solid tumors focusing first on breast tumors, and through the marketing of other radioactive isotopes. These growth initiatives are in the early stages of planning and appear to be significant incremental opportunities.

The Company plans to introduce Cs-131 initially into Europe and later into other international markets through partnerships and strategic alliances with channel partners for manufacturing and distribution. Another advantage of the Cs-131 isotope is its potential applicability to other cancers and other diseases. Cs-131 has FDA clearance to be used for treatments for a broad spectrum of cancers including breast, brain, lung, and liver cancer, and the Company believes that a major opportunity exists as an adjunct therapy for the treatment of breast cancer. Preliminary discussions have begun with prominent physicians regarding the use of Cs-131-based therapies for the treatment of lung, pancreatic and brain cancer. There is the opportunity to develop and market other radioactive isotopes to the US market, and to market the Cs-131 isotope itself, separate from its use in our seeds. The Company is also in the preliminary stages of exploring alternate methods of delivering our isotopes to various organs of the body, as it may be advantageous to use delivery methods other than a titanium-encapsulated seed to deliver radiation to certain organs.

 

 

Subsequent to June 2005, the Company’s executive offices are located at 350 Hills Street, Suite 106, Richland, WA 99354, (509) 375-1202, where IsoRay currently leases approximately 3,765 square feet of office and laboratory space for $5,144 per month from Energy Northwest. The lease expires December 31, 2006, but is renewable. The Company is not affiliated with its lessor. Additional office space will be needed as employees are hired, and is currently available at this location. The Company believes that its current facilities will be adequate until the end of fiscal year 2007, but it will need additional facilities at that time. In the future, due to business growth, the Company may elect to combine administrative services and production in one building which the Company may lease or build depending on market conditions.

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We have entered into a lease, which commenced as of regulatory licensing approval on October 6, 2005, for a facility located in Richland, Washington that management believes will provide adequate space to manufacture the Cs-131 product for the prostate cancer markets until late 2007, with a maximum manufacturing capacity of approximately 60,000 seeds per month and total square footage of 4,400 feet. The lease is for a term of twelve months following regulatory licensing approval, with a twelve-month extension option. Payment for the initial lease term was the issuance of 24,007 shares of IsoRay, Inc. common stock. The lease may be extended on a month-to-month basis by mutual agreement of the parties. The lessor is Pacific EcoSolutions Incorporated (PEcoS), and the Company is not affiliated with this lessor. Equipment installed at this facility includes a hot cell, a glove box, three fume-hoods, laser welders and laser welding tooling, which complete the laser sealing of the seeds; sophisticated testing equipment that allows us to test materials used at several stages of the production process and assay the completed seeds prior to shipment; and sterilizing and packaging systems that allow the seeds to be pre-loaded into delivery systems according to customer specifications. We believe we will need to add to the capital production equipment installed at this facility within the next six to twelve months to meet increasing demand for our product, and have adequate room at the facility to install equipment that would approximately double the production capacity up to 60,000 seeds per month (approximately 600 patient treatments).

 

The Company’s management believes that all facilities occupied by the Company are adequate for present requirements, and that the Company’s current equipment is in good condition and is suitable for the operations involved.

 

LEGAL PROCEEDINGS

 

We are not a party to any pending legal proceeding. Management is not aware of any threatened litigation, claims or assessments.

 

Set forth below is certain information regarding our directors and executive officers, each of whom took office in July 2005, except for Mr. Babcock and Mr. Smith, who took office on March 31, 2006. Our Board of Directors is comprised of five directors. There are no family relationships between any of our directors or executive officers. Each of our directors is elected to serve until our next annual meeting of our shareholders and until his successor is elected and qualified or until such director's earlier death, removal or termination. Our Board of Directors appoints our officers, and their terms of office are at the discretion of the Board of Directors, except to the extent governed by an employment contract.

 

Name		Age		Position Held
Roger Girard		63		Chairman, President, CEO
Jonathan Hunt		39		Chief Financial Officer - Treasurer
David Swanberg		50		Executive Vice President - Operations and Corporate Secretary, Director
Robert Kauffman		65		Director
Thomas LaVoy		46		Director
Stephen Boatwright		43		Director
Dwight Babcock		58		Director
Albert Smith		62		Director

Roger Girard - In addition to serving as President, Chairman and CEO for the Company, Mr. Girard is also the CEO, President and Chairman of the Board of IsoRay Medical, Inc., and has served in these positions since the formation of IsoRay Medical, Inc. Mr. Girard was CEO and Chairman of IsoRay’s predecessor company from August of 2003 until October 1, 2004. Mr. Girard has been actively involved in the management and the development of the management team at IsoRay, and his experienced leadership has helped drive IsoRay’s development to date. From June 1998 until August of 2003, Mr. Girard served as President of Strategic Financial Services, a business consulting company based in Seattle, Washington designed to help wealthy individuals and companies with strategic planning and financial strategy. Strategic Financial Services previously provided its services to a medical device company. Mr. Girard served as its sole employee. Mr. Girard also served as the managing partner for the Northwest office of Capital Consortium, another business consulting company based in Seattle, during this time. Capital Consortium employed four people and analyzed business market potential for start-ups and early stage companies. Mr. Girard has knowledge, experience and connections to private, institutional and public sources of capital and is experienced in managing and designing capital structures for business organizations as well as organizing and managing the manufacturing process, distribution, sales, and marketing, based on his 35 years of experience.

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Jonathan Hunt - Mr. Hunt has over 10 years of finance and accounting experience, including financial reporting, SEC knowledge, and operational analysis. Before joining IsoRay earlier this year, he was employed by Hypercom Corporation, a global provider of electronic payment solutions and manufacturer of credit card terminals, serving as its Assistant Corporate Controller from 2005 to 2006. His finance background also includes serving as both a Manager and Director of Financial Reporting and a Director of Operational Planning and Analysis for Circle K Corporation and its affiliates from 2000 to 2005 and working for PricewaterhouseCoopers LLP from 1992 to 1999 where his last position held was Business Assurance Manager. Mr. Hunt holds Masters of Accountancy and Bachelor of Science degrees from Brigham Young University and is a Certified Public Accountant.

 

David Swanberg - Mr. Swanberg has more than 22 years experience in engineering and materials science, nuclear waste and chemical processing, aerospace materials and processes, and environmental technology development and environmental compliance. Beginning in November 1995 and until January 2004, Mr. Swanberg was employed full time as Sr. Chemical/Environmental Engineer for Science Applications International Corporation working on a variety of projects including nuclear waste research and development. Mr. Swanberg joined IsoRay’s predecessor company in March of 1999 on a part-time basis and has held management positions in the IsoRay companies since 2000. Mr. Swanberg began full-time employment with IsoRay in February 2004. He has been instrumental in development of IsoRay’s initial product, the Cs-131 brachytherapy seed, including interfaces with technical, regulatory, and quality assurance requirements. With IsoRay and its predecessor companies, he has managed the development and production of radioactive seeds to support testing to meet NRC and FDA requirements, provided technical guidance for characterization of the IsoRay seed to meet AAPM Task Group 43 protocols, and coordinated production and testing of non-radioactive seeds to conform to ISO standards for brachytherapy devices. He is President of the Nuclear Medicine Research Council. He holds an MS in Chemical Engineering, is a licensed Chemical Engineer, and a certified Level II Radiation Worker.

 

Robert Kauffman - Mr. Kauffman has served as Chief Executive Officer and Chairman of the Board of Alanco Technologies, Inc. (NASDAQ: ALAN), an Arizona-based information technology company, since July 1, 1998. Mr. Kauffman was formerly President and Chief Executive Officer of NASDAQ-listed Photocomm, Inc., from 1988 until 1997 (since renamed Kyocera Solar, Inc.). Photocomm was the nation’s largest publicly owned manufacturer and marketer of wireless solar electric power systems with annual revenues in excess of $35 million. Prior to Photocomm, Mr. Kauffman was a senior executive of the Atlantic Richfield Company (ARCO) whose varied responsibilities included Senior Vice President of ARCO Solar, Inc., President of ARCO Plastics Company and Vice President of ARCO Chemical Company. Mr. Kauffman earned an M.B.A. in Finance at the Wharton School of the University of Pennsylvania, and holds a B.S. in Chemical Engineering from Lafayette College, Easton, Pennsylvania.

 

Thomas LaVoy - Mr. LaVoy has served as Chief Financial Officer of SuperShuttle International, Inc., since July 1997 and as Secretary since March 1998. SuperShuttle is one of the largest providers of shuttle services in major cities throughout the West and Southwest regions of the United States. He has also served as a director of Alanco Technologies, Inc. (NASDAQ: ALAN) since 1998. From September 1987 to February 1997, Mr. Lavoy served as Chief Financial Officer of NASDAQ-listed Photocomm, Inc. Mr. Lavoy was a Certified Public Accountant with the firm of KPMG Peat Marwick from 1980 to 1983. Mr. Lavoy has a Bachelor of Science degree in Accounting from St. Cloud University, Minnesota, and is a Certified Public Accountant.

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Stephen Boatwright - Mr. Boatwright has been a member of Keller Rohrback, PLC in Phoenix, Arizona since January 2005. From 1997 through January 2005, Mr. Boatwright was a partner at Gammage & Burnham, PLC, also in Phoenix, Arizona. Throughout his career, he has provided legal counsel to both private and public companies in many diverse industries. In recent years, Mr. Boatwright’s legal practice has focused on representing technology, biotechnology, life science and medical device companies for their securities, corporate and intellectual property licensing needs. Mr. Boatwright earned both a J.D. and an M.B.A. from the University of Texas at Austin, and holds a B.A. in Philosophy from Wheaton College.

Dwight Babcock - Mr. Babcock has served as Chairman and Chief Executive Officer of Apex Data Systems, Inc. an information technology company, since 1975. Apex Data Systems automates the administration and claims adjudication needs of insurance companies both nationally and internationally. Mr. Babcock was formerly President and CEO of Babcock Insurance Corporation (BIC) from 1974 until 1985. BIC was a nationally recognized Third Party Administrator operating within 35 states. Mr. Babcock has knowledge and experience in the equity arena and has participated in various activities within the venture capital, private and institutional capital markets. Mr. Babcock studied marketing and economics at the University of Arizona where he currently serves on the University of Arizona Astronomy Board.

Albert Smith - Mr. Smith was the co-founder of and served as Vice Chairman of CSI Leasing, Inc., a private computer leasing company from 1972 until March 2005. He founded Extreme Video, LLC a private video conferencing company in Scottsdale, Arizona in December 2005 where he presently serves as CEO and President. Mr. Smith presently serves as a director for Center for Arizona Policy (Scottsdale) and Doulos Ministries (Denver). Mr. Smith has extensive experience in marketing and sales having managed a national sales force of over fifty people while at CSI Leasing, Inc. Mr. Smith has a BS in Business Administration from Ferris State College.

 

Significant Employees

 

Certain significant employees of our subsidiary, IsoRay Medical, Inc., and their respective ages as of the date of this Prospectus are set forth in the table below. Also provided is a brief description of the experience of each significant employee during the past five years.

 

Name		Age		Position Held
Lori Woods		44		Vice President
Lane Bray		78		Chemist
Garrett Brown		43		Chief Technology Officer
Oleg Egorov		36		Director of Radiochemical Development
Lisa Mayfield		37		Director of Operations
Fredric Swindler		59		VP, Regulatory Affairs and Quality Assurance

 

Lori Woods - Ms. Woods joined the Company in July 2006 and has over 20 years experience in medical device technology and healthcare services. Ms. Woods served as the CEO of Pro-Qura, a medical services company focusing on brachytherapy quality assurance and education, from 2002 until joining the Company. During her tenure at Pro-Qura, Ms. Woods developed its business strategy, expanded its business portfolio in quality assurance beyond prostate brachytherapy into other areas of cancer, and increased funding by 50%. Prior to this, she served as the Vice President of Sales at ATI Medical in 2002, Vice President of Sales - West and Vice President of Marketing and Business Development for Imagyn Medical Technologies from 2000 to 2002, Director of Business Development for Seattle Prostate Institute from 1998 to 2000, and Regional Vice President and Regional Manager of Interdent from 1994 to 1998. Ms. Woods holds a Bachelor of Science degree in Business Administration - Marketing from Loma Linda University.

Lane Bray - Mr. Bray is known nationally and internationally as a technical expert in separations, recovery, and purification of isotopes and is a noted authority in the use of cesium and strontium ion exchange for Department of Energy’s West Valley and Hanford nuclear waste cleanup efforts. In 2000, Mr. Bray received the ’Radiation Science and Technology’ award from the American Nuclear Society. Mr. Bray has authored or co-authored over 110 research publications, 12 articles for 9 technical books, and holds 24 U.S. and foreign patents. Mr. Bray patented the USDOE/PNNL process for purifying medical grade Yttrium-90 that was successfully commercialized in 1999. Mr. Bray also recently invented and patented the proprietary isotope separation and purification process that is assigned to IsoRay. Mr. Bray was elected ’Tri-Citian of the Year’ in 1988, nominated for ’Engineer of the Year’ by the American Nuclear Society in 1995, and was elected ’Chemist of the Year for 1997’ by the American Chemical Society, Eastern Washington Section. Mr. Bray retired from the Pacific Northwest National Laboratory in 1998. Since retiring in 1998, Mr. Bray worked part time for PNNL on special projects until devoting all of his efforts to IsoRay in 2004. Mr. Bray has been a Washington State Legislator, a Richland City Councilman, and a Mayor of Richland. Mr. Bray has a B.A. in Chemistry from Lake Forest College.

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Garrett Brown - Dr. Brown was Manager of Radiochemistry - Hot Cell Operations for International Isotopes, Inc., a major radiopharmaceutical and medical device startup company, from January 1998 until May 1999 and was instrumental in bringing a new brachytherapy seed implant device to commercialization. Dr. Brown’s responsibilities included hands-on radiological work in fume hoods, glove boxes and remote manipulator hot cells, process definition, research, development, installation, optimization, waste minimization, procedure documentation, facility design and training. Dr. Brown also served as the technical interface to executive management for business development, shipping/receiving, QA/QC, facilities and marketing/sales. Prior to that, Dr. Brown, as a Senior Research Scientist at the Pacific Northwest National Laboratory, was responsible for the weekly production of multi-Curie quantities of medical grade Y-90, and research programs to develop high tech sorbents for separation of Cs-137, Sr-90 and Tc-99 from high-level radioactive wastes stored at the Hanford Nuclear Reservation. From May 1999 to the present, Dr. Brown has been a technical consultant with GNB Technical Consultants. Dr. Brown has co-authored numerous technical publications in the field. Dr. Brown has a Ph.D. in Analytical Chemistry and BS in Chemistry, cum laude. He has served as IsoRay’s Chief Technical Officer since May of 2000. In March 2004, Dr. Brown was certified as a Radiological Safety Officer.

Oleg Egorov - Dr. Egorov is recognized nationally and internationally for his work in radiochemistry, radioanalytical chemistry, analytical chemistry and instrumentation. Prior to joining IsoRay in December of 2005 as Director of Radiochemical Development, Dr. Egorov worked from May 1998 as a Senior Research Scientist at the Pacific Northwest National Laboratory (PNNL). Prior to that time, he served the Environmental Molecular Sciences Laboratory at PNNL as a Graduate Research Fellow, from August 1994 to May 1998, and as a Graduate Research Assistant to the University of Washington’s Center for Process Analytical Chemistry from September 1992 to August 1993. Former positions included a tenure as a Research Engineer at the Department of Radiochemistry at the Moscow State University, Moscow, Russia between September 1998 to August 1992, and Field Chemist at the Institute of Volcanology, at the Russian Academy of Science at Petropavlovsk-Kamchatsky, Russia, during the summers of 1989 and 1990 concurrent to studies that lead to his acquisition of Master of Science in Radiochemistry from the Moscow State University. During his tenure at PNNL, Dr. Egorov had led world-class basic and applied R&D programs directed at new chemistries and instrumentation for automated production of short-lived medical isotopes for the treatment of cancer, automated process monitoring, radionuclide sensors for groundwater monitoring, and laboratory automation. Dr. Egorov pioneered the application of flow-based techniques for automating radiochemical analyses of nuclear wastes, renewable surface sensing and separations, and equilibration-based radionuclide sensing. He has authored/co-authored numerous peer-reviewed publications in these areas, including several book chapters. Dr. Egorov holds four U.S./international patents, three of which have been licensed to industry. Dr. Egorov was a recipient of numerous outstanding performance and key contributor awards. In 2003, Dr. Egorov was nominated for the American Chemical Society Arthur F. Findeis Award for Achievements by a Young Analytical Scientist. In 2004, Dr. Egorov was a recipient of a Federal Laboratory Consortium Award for Excellence in Technology Transfer for “Alpha Particle Immunotherapy for Treating Leukemia and Solid-Tumor Metastases”. Dr. Egorov holds a M.S. in Radiochemistry from Moscow State University, Moscow, Russia; a M.S. in Environmental and Analytical Chemistry and a Ph.D. in Analytical Chemistry from the University of Washington.

Lisa Mayfield - Lisa Mayfield has over ten years of commercial healthcare sales, marketing and business development experience. Between December 1993 and August 2004, Ms. Mayfield has held senior management positions in the pharmaceutical and medical device and diagnostics sectors of Johnson & Johnson as well as at J&J Corporate. During her time at J&J and prior to joining IsoRay in December 2005, Ms. Mayfield was responsible for implementing positive business results in over 11 different therapeutic markets. After leaving J&J and prior to joining IsoRay, Ms. Mayfield worked as a consultant to various healthcare companies in the radioisotope and oncology markets. As a result of her exposures, Ms. Mayfield has built a wealth of knowledge about the healthcare marketplace as a whole and complements this knowledge with a comprehensive understanding of internal operations. Ms. Mayfield has been responsible for best practices for product development, branding, forecasting, regulatory compliance, reimbursement and strategic planning. During her time at IsoRay, Ms. Mayfield has been able to successfully implement new policies and procedures that facilitate growth as well as provide top level guidance over strategic business operations. Ms. Mayfield is acting Director of Operations at IsoRay. Ms. Mayfield holds a Bachelors of Science in Economics from the University of Washington.

 

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Fredric Swindler – Mr. Swindler joined the Company in October 2006 and has over 30 years experience in manufacturing and regulatory compliance. Mr. Swindler served as VP, Quality Assurance and Regulatory Affairs for Medisystems Corporation, a manufacturer and distributor of medical devices, from 1994 until joining the Company. During his tenure at Medisystems Corporation, Mr. Swindler developed a quality system to accommodate vertically integrated manufacturing, developed regulatory strategies, policies and procedures, and submitted nine pre-market notifications [510(k)] to the FDA. Prior to this, Mr. Swindler held various positions with Marquest Medical Products from 1989 to 1994, Sherwood Medical Products from 1978 to 1989, Oak Park Pharmacaceuticals in 1978, and Mead Johnson & Company from 1969 to 1978. Mr. Swindler holds a Bachelor of Science degree in Biomedical Engineering from Rose Hulman Institute of Technology and a Masters of Business Administration from the University of Evansville.

 

Executive Compensation

 

The following summary compensation table sets forth information concerning compensation for services rendered in all capacities during our past three fiscal years awarded to, earned by or paid to each of the following executive officers (the “Executive Officers”). None of the Company’s executive officers, other than those listed below, received compensation in fiscal year 2006 in excess of $100,000.

 

		Annual Compensation									Long-Term Compensation Awards
Name and Principal Position		Fiscal Year(1)			Salary			Bonus			Restricted Stock Awards			Securities Underlying Options			All Other Compensation
Roger Girard, Chief Executive Officer(5)			2006		$	199,231			—			—			—			—
			2005		$	113,958			—			—			—			—
			2004		$	71,031			—		$	9,900			513,840			—
Thomas Scallen, Former Chief Executive Officer(2)			2006			—			—			—			—			—
			2005			—			—			—			—		$	50,000	(3)
			2004			—			—		$	7,871	(4)		—			—
David Swanberg, Executive Vice President - Operations			2006		$	120,000		$	25,000			—			150,000			—
			2005		$	54,746			—			—			—			—
			2004		$	32,515			—			—			—			—
Barry Griffiths, Former Western Area Director			2006		$	124,800		$	55,000			—			—			—
			2005		$	79,241		$	52,500			—			252,708			—
			2004		$	15,000			—			—			—			—
Curtis Ellis, Midwest Area Director			2006		$	168,115		$	39,125			—			84,236			—
			2005			—			—			—			—			—
			2004			—			—			—			—			—

 

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(1)

Fiscal year 2006 consisted of the period from July 1, 2005 to June 30, 2006; fiscal year 2005 consisted of the period from October 1, 2004 through June 30, 2005; and, fiscal year 2004 consisted of the year ended September 30, 2004.

 

(2)

Mr. Scallen served as our Chief Executive Officer during the listed fiscal years and until his resignation effective July 28, 2005.

 

(3)

Represents a $50,000 cash payment in June 2005 to Mr. Scallen in settlement of all accrued but unpaid compensation.

 

(4)

Represents the issuance of 787,100 shares of restricted common stock as compensation associated with the conversion of the outstanding notes payable and accrued interest payable. This transaction was valued at approximately $7,781, which was equal to the “fair value” of the Company’s common stock on the conversion date. The Company relied upon Section 4(2) of the Securities Act of 1933, as amended, for an exemption from registration for this issuance.

 

(5)

Mr. Girard did not begin serving as our CEO until July 28, 2005, but he has served as CEO of our subsidiary and its predecessor company since August 2003. The compensation listed was paid to Mr. Girard by IsoRay or its predecessor company.

 

Option/SAR Grants in Last Fiscal Year

 

The following table sets forth information concerning grants of stock options to the Executive Officers during the fiscal year ended June 30, 2006.

Name		Number of Securities Underlying Options			Percent of total options Granted to Employees in Fiscal Year			Exercise Price ($/Share)			Expiration Date
David Swanberg			150,000			23.45	%	$	1.00			8/18/2015
Curtis Ellis			84,236			13.17	%	$	4.15			8/01/2015

Aggregated Option Exercises in Last Fiscal Year and Fiscal Year End Option Values

 

The following table sets forth the number of shares covered by unexercised stock options held by the Executive Officers as of June 30, 2006, and the value of “in-the-money” stock options, which represents the positive spread between the exercise price of a stock option or warrant and the market price of the shares subject to such option or warrant as of June 30, 2006.

		Number of Shares Acquired			Value			Number of Securities Underlying Unexercised Options at Fiscal Year-End						Value of Unexercised In-the-Money Options at Fiscal Year-End
Name		on Exercise			Realized			Exercisable			Unexercisable			Exercisable			Unexercisable
Roger Girard			0		$	0			513,840			0		$	1,186,970		$	N/A
David Swanberg			0		$	0			150,000			0		$	375,000		$	N/A
Barry Griffiths			0		$	0			84,236			168,472		$	194,585		$	389,170
Curtis Ellis			0		$	0			0			84,236		$	N/A		$	N/A

 

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Employment Agreements 

The Company entered into an employment agreement with Roger Girard, its Chief Executive Officer, effective October 6, 2005 (the “Girard Agreement”). The term of the Girard Agreement is through October 6, 2009, and will automatically extend for an additional one year term on each anniversary date unless the term is modified or terminated in accordance with the terms of the Girard Agreement at least ninety days prior to a given anniversary date. The Girard Agreement provides for a base salary of $300,000 which was effective July 1, 2006. Mr. Girard is also entitled to participate in any benefit plans provided to key executives of the Company, and to a bonus at the discretion of the Board of Directors.

The Company has not entered into employment agreements with any other officers as of the date of this filing.

Director Compensation

Since July 28, 2005, we have paid our directors who are not employees of the Company a director’s fee of $1,000 per meeting attended, plus expenses. We also granted each non-employee director immediately exercisable options to purchase 100,000 shares of our common stock during the fiscal year ended June 30, 2006. Robert Kauffman, Thomas LaVoy and Stephen Boatwright each received 100,000 options at an exercise price of $2.00 per share. Dwight Babcock and Al Smith each received 100,000 options, 50,000 of which are exercisable at $6.30 per share and 50,000 of which are exercisable at $3.80 per share.

 

The Company’s directors did not receive any cash compensation during the nine months ended June 30, 2005 or the year ended September 30, 2004.

 

INDEMNIFICATION OF DIRECTORS AND OFFICERS

 

The Company’s Articles of Incorporation provide to directors and officers indemnification to the full extent provided by law, and provide that, to the extent permitted by Minnesota law, a director will not be personally liable for monetary damages to the Company or its shareholders for breach of his or her fiduciary duty as a director, except for liability for certain actions that may not be limited under Minnesota law. On July 1, 2006, the Company entered into Indemnification Agreements with each of its directors and executive officers, and the Company intends to enter into substantially identical agreements with any officers and directors who take office in the future. The purpose of the Indemnification Agreements is to provide all officers and directors with indemnification to the fullest extent permitted under the Minnesota Business Corporations Act.

 

Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons pursuant to the foregoing provisions, or otherwise, in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable.

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SECURITIES OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The following tables set forth certain information regarding the beneficial ownership of the Company’s common stock and preferred stock as of November 10, 2006 for (a) each person known by the Company to be a beneficial owner of five percent or more of the outstanding common or preferred stock of the Company, (b) each executive officer, director and nominee for director of the Company, and (c) directors and executive officers of the Company as a group. As of November 10, 2006, the Company had 15,853,852 shares of common stock and 91,298 shares of preferred stock outstanding.

 

Name and Address of Beneficial Owner (1)		Amount of Common Shares Owned			Derivative Securities Exercisable or Convertible Within 60 Days of November 10, 2006			Total Common Shares Beneficially Owned			Percent of Common Shares Owned(2)
Roger Girard, Chief Executive Officer, President and Chairman			368,532			513,840			882,372			5.39	%
Jonathan Hunt, Chief Financial Officer			—			—			—			—	%
Michael Dunlop, Former Chief Financial Officer			138,050			145,000			283,050			1.77	%
David Swanberg, Executive Vice President and Director(3)			324,327			156,667			480,994			3.01	%
Robert Kauffman, Director			43,802			150,000			193,802			1.21	%
Thomas LaVoy, Director			8,423			150,000			158,423			0.99	%
Stephen Boatwright, Director(4)			—			234,236			234,236			1.46	%
Dwight Babcock, Director(5)			42,403			150,000			192,403			1.20	%
Albert Smith, Director			108,947			150,000			258,947			1.62	%
Thomas K. Scallen, Former Chief Executive Officer(6)			50,000			—			50,000			0.32	%
MicroCapital Fund LP and MicroCapital Fund Ltd(7)			1,200,000			1,200,000			2,400,000			14.07	%
All Officers and Directors as a group (8 persons)			896,434			1,504,743			2,401,177			13.83	%

 

(1)

Except as otherwise noted, the address for each of these individuals is c/o IsoRay, Inc., 350 Hills St., Suite 106, Richland, Washington 99354.

 

(2)

Percentage ownership is based on 15,853,852 shares of Common Stock outstanding on November 10, 2006. Shares of Common Stock subject to stock options, warrants or convertible debentures which are currently exercisable/convertible or will become exercisable/convertible within 60 days after November 10, 2006 are deemed outstanding for computing the percentage ownership of the person or group holding such options, but are not deemed outstanding for computing the percentage ownership of any other person or group.

 

(3)

Mr. Swanberg’s options include 6,667 owned by his spouse.

 

(4)

Mr. Boatwright’s options include 84,236 options held by an entity controlled by Mr. Boatwright.

 

(5)

Mr. Babcock’s common shares include 2,695 shares owned by his spouse.

 

(6)

Mr. Scallen’s address is 4701 IDS Center, Minneapolis, MN 55302.

 

(7)

MicroCapital Fund LP and MicroCapital Fund Ltd’s address is 1285 Avenue of the Americas, New York, NY 10019.

Preferred Stock Share Ownership as of November 10, 2006

 

Name and Address of Beneficial Owner		Amount of Preferred Shares Owned			Options or Warrants Exercisable Within 60 Days of November 10, 2006			Total Preferred Shares Beneficially Owned			Percent of Preferred Shares Owned(1)
Aissata Sidibe(2)			20,000			—			20,000			21.91	%
Daniel MacKay(3)			18,015			—			18,015			19.73	%
John Arvid Forsman(4)			14,218			—			14,218			15.57	%
William and Karen Thompson Trust(5)			14,218			—			14,218			15.57	%
Jamie Granger(6)			10,529			—			10,529			11.53	%
Hostetler Living Trust(7)			9,479			—			9,479			10.38	%

 

48

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(1)

Percentage ownership is based on 91,298 shares of Preferred Stock outstanding on November 10, 2006. Shares of Preferred Stock subject to stock options or warrants which are currently exercisable or will become exercisable within 60 days after November 10, 2006 are deemed outstanding for computing the percentage ownership of the person or group holding such options, but are not deemed outstanding for computing the percentage ownership of any other person or group.

 

(2)

The address of Ms. Sidibe is 229 Lasiandra Ct, Richland, WA 99352.

 

(3)

The address of Mr. MacKay is 41 NW Sierra Drive, Camas, WA 98607.

 

(4)

The address of Mr. Forsman is 659 Alden Lane, Livermore, CA 94550.

 

(5)

The address of the William and Karen Thompson Trust is 285 Dondero Way, San Jose, CA 95119.

 

(6)

The address of Jamie Granger is 53709 South Nine Canyon Road, Kennewick, WA 99337.

 

(7)

The address of the Hostetler Living Trust is 9257 NE 175th Street, Bothell, WA 98011.

No officers or directors beneficially own shares of Preferred Stock.

 

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 

 

Mr. Stephen Boatwright, a Company director, has been actively involved in providing various legal services to the Company, IsoRay Medical, Inc. and IsoRay Medical, Inc.’s predecessors through the law firms of Gammage and Burnham and Keller Rohrback, PLC. From September 2004 until January 2005, Gammage and Burnham received approximately $141,000 as payment for legal services performed for IsoRay Medical, Inc. and its predecessors. From February 2005 though June 30, 2005, IsoRay Medical, Inc. paid Keller Rohrback, PLC approximately $144,000 for legal services. During the fiscal year ended June 30, 2006, the Company paid Keller Rohrback, PLC approximately $390,000 for legal services. In addition, the Company had accrued at June 30, 2006 approximately $77,000 in legal fees to be paid. In exchange for consulting services including providing advice to IsoRay Medical, Inc. as to the structure of organization and compensation arrangements with employees and also in connection with developing various policies and procedures, Quatsch Ventures, LLC, an entity controlled by Mr. Boatwright, received options to purchase 84,236 shares of our common stock in 2004.

IsoRay Medical, Inc.’s patent rights to its Cesium-131 process were acquired from Lane Bray, a shareholder of the Company, and are subject to a 1% royalty on gross profits and certain contractual restrictions. Pursuant to the royalty agreement, the Company must also pay a royalty of 2% of Gross Sales, as defined, for any sub-assignments of the aforesaid patented process to any third parties. The royalty agreement will remain in force until the expiration of the patents on the assigned technology, unless earlier terminated in accordance with the terms of the underlying agreement. To date, there have been no product sales incorporating the technology and there is no royalty due pursuant to the terms of the agreement.

On January 16, 2005, in addition to certain other shareholders, the following officers and directors of the Company were awarded shares of common stock for guaranteeing a loan with the Benton Franklin Economic Development District (“BFEDD”) in the amount of $230,000, which was funded in December 2004, and a line of credit with Columbia River Bank in the amount of $395,000: Michael Dunlop guaranteed $15,000 of the BFEDD loan and $30,000 of the Columbia River Bank line of credit, for which he received 12,888 post-merger shares; Roger Girard guaranteed $20,000 of the BFEDD loan, for which he received 5,728 post-merger shares; John Hrobsky guaranteed $15,000 of the Columbia River Bank line of credit, for which he received 4,296 post merger shares; and David Swanberg guaranteed $30,000 of the Columbia River Bank line of credit, for which he received 8,592 post-merger shares. During fiscal year 2006, certain original guarantors, including John Hrobsky, declined to continue guaranteeing the loans and forfeited the shares which had been granted to them. Due to this the following officers agreed to increase the amount of their guarantees as follows: Michael Dunlop guaranteed an additional $5,000 of the Columbia River Bank line of credit, for which he received an additional 1,432 common shares; and Roger Girard guaranteed an additional $105,000 of the Columbia River Bank line of credit, for which he received an additional 30,072 common shares.

49

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On May 27, 2005, the Company, Century Park Transitory Subsidiary, Inc., a Delaware corporation, Thomas Scallen and Anthony Silverman (shareholders of the Company), and IsoRay Medical, Inc., a Delaware corporation, entered into a Merger Agreement. Pursuant to the Merger Agreement, Century Park Transitory Subsidiary, Inc. was merged with and into IsoRay Medical, Inc. and IsoRay Medical, Inc. became a wholly-owned subsidiary of the Company. The Merger Agreement was subject to the satisfaction of certain conditions, including the granting of certain “piggy-back” and demand registration rights to the purchasers of certain convertible debentures of IsoRay Medical, Inc., Anthony Silverman and certain other affiliates of the Company; the agreements of the officers and directors of IsoRay Medical, Inc. to lock-up the shares of common stock of the Company they received in the merger for a period of one year from the closing of the merger; the agreements of Thomas Scallen and Anthony Silverman to escrow certain shares of common stock of the Company; and the receipt by IsoRay Medical, Inc. from Anthony Silverman or his associates of one million dollars as the purchase price of certain securities of IsoRay Medical, Inc. before the closing. These conditions were satisfied prior to the closing of the merger, which occurred on July 28, 2005.

The Board voted on July 28, 2005 to compensate each of the independent Directors $1,000 per meeting for their attendance at the Board meetings. On July 28, 2005, the Company’s Board of Directors granted 100,000 options to purchase common stock to each of its three independent Directors: Thomas Lavoy, Stephen Boatwright, and Robert Kauffman. On March 31, 2006 and June 30, 2006, the Company’s Board of Directors granted a total of 100,000 options to purchase common stock to its new independent Directors: Albert Smith and Dwight Babcock. Directors who are also serving as management of the Company were not granted stock options for Director service, and will not be paid for attendance at Board meetings.

During 2005, IsoRay Medical, Inc. paid or accrued $5,600 for accounting services performed by a company owned by a member of the Board of Directors of IsoRay Medical, Inc.

Effective July 12, 1999, Lane Bray, a Member of IsoRay, LLC (and also a shareholder of IsoRay, Inc.), assigned his right, title and interest in an invention (including the U.S. patent application therefore and any associated patent rights) to IsoRay, LLC in exchange for a royalty equal to 1% of the Gross Profit, as defined, from the sale of “seeds” incorporating the technology. IsoRay, LLC also agreed to pay all remaining costs associated with obtaining the patent. In January 2000, IsoRay, LLC applied for the patent, which was subsequently granted effective May 23, 2000. The patent and associated royalty obligation were transferred to IsoRay, Inc. (WA domiciled) effective May 1, 2002 in connection with a tax-free reorganization whereby IsoRay LLC ceased operations, and assigned all assets and liabilities to IsoRay, Inc. (WA domiciled).

IsoRay Inc. assigned this patent to IsoRay Products LLC, who assigned the patent to IsoRay Medical, Inc. who, pursuant to the royalty agreement must also pay a royalty of 2% of Gross Sales, as defined, for any sub-assignments of the aforesaid patented process to any third parties. The royalty agreement will remain in force until the expiration of the patents on the assigned technology, unless earlier terminated in accordance with the terms of the underlying agreement. To date, there have been no product sales incorporating the technology and there is no royalty due pursuant to the terms of the agreement.

Patent and Know-How Royalty License Agreement

Effective August 1, 1998, Pacific Management Associates Corporation (PMAC) transferred its entire right, title and interest in an exclusive license agreement with Donald Lawrence to IsoRay, LLC (a predecessor company) in exchange for a membership interest. The terms of the license agreement require the payment of a royalty based on the Net Factory Sales Price, as defined in the agreement, of licensed product sales. Because the licensor’s patent application was ultimately abandoned, only a 1% “know-how” royalty based on Net Factory Sales Price, as defined, remains applicable. To date, there have been no product sales incorporating the licensed technology and there is no royalty due pursuant to the terms of the agreement. The Company believes that because this technology is not presently being used and believes it will not be used in the future that no royalties will be paid under this agreement.

50

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SELLING SHAREHOLDERS

 

The following table details the name of each selling shareholder (including, for entity shareholders, the name of the natural person controlling the selling shareholder in parentheses), the number of shares owned by that selling shareholder, and the number of shares that may be offered by each selling shareholder for resale under this prospectus.  The selling shareholders may sell up to 9,064,890 shares of our common stock from time to time in one or more offerings under this prospectus, of which 4,830,940 are shares of common stock currently held by the selling shareholders, and 4,233,950 are shares of common stock issuable upon the exercise of warrants held by the selling shareholders. Because each selling shareholder may offer all, some or none of the shares it holds, and because, based upon information provided to us, there are currently no agreements, arrangements, or understandings with respect to the sale of any of the shares, no definitive estimate as to the number of shares that will be held by each selling shareholder after the offering can be provided. The following table has been prepared on the assumption that all shares offered under this prospectus will be sold to parties unaffiliated with the selling shareholders. Except as indicated below, no selling shareholder nor any of their affiliates have held a position or office, or had any other material relationship, with us.

 

We are registering the shares listed below pursuant to contractual registration obligations. We entered into a Registration Rights Agreement dated August 9, 2006 with certain shareholders and warrant holders, which provided for registration rights. We also entered into three Registration Rights Agreements, dated February 1, 2006, October 17, 2005 and June 30, 2005, pursuant to which certain shareholders were granted demand and piggyback registration rights.

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Name		Beneficial Ownership Before the Offering (1)			Percentage of Common Stock Owned Before Offering			Shares of Common Stock Included in Prospectus			Shares of Common Stock Issuable Upon Conversion of Warrants Included in Prospectus (2)			Exercise Price of Warrant Included in Prospectus			Grant Date of Warrant Included in Prospectus			Term of Warrant Included in Prospectus			Total Shares of Common Stock Included in Prospectus			Beneficial Ownership After the Offering (3)			Percentage of Common Stock Owned After Offering (3)
5901 PROPERTIES LLC			13,334			*			6,667			6,667		$	6.50			2/14/2006			2/14/2008			13,334			-			*
ALAN E WALTAR & ANNA E WALTAR TTEE ALAN E WALTAR & ANNA E WALTAR TR UA DTD 7.3.98			57,982			*			8,000			8,000		$	6.00			1/19/2006			1/19/2008			16,000			11,982			*
ALAN L TALESNICK			10,000			*			10,000			-												10,000			-			*
ALLAN J KASEN & RONA L KASEN JTWROS			20,000			*			10,000			10,000		$	6.00			1/24/2006			1/24/2008			20,000			-			*
AMENDED & RESTATED D & A KIRSCHEN FAMILY TRUST DTD 11/23/99			35,000			*			35,000			-												35,000			-			*
ANTHONY SILVERMAN (7)			534,528			3.32	%		666			-			-			-			-			666			533,862			3.31	%
ANTHONY SILVERMAN IRA ROLLOVER			150,000			*			12,500			12,500		$	6.00			10/28/2005			10/28/2007			25,000			125,000			*
BARRY BLUESTEIN & MARIAN BLUESTEIN COMMUNITY PROPERTY			10,000			*			5,000			5,000		$	6.00			1/12/2006			1/12/2008			10,000			-			*
BARRY S PEARLMAN TTEE HUSBANDS TR UA BARRY S & CATHERINE D PEARLMAN INT TR DTD 2/22/93 AMD 11/5/99			20,922			*			10,461			10,461		$	6.00 to $6.50			1/30/2006 - 2/10/2006			1/30/2008 - 2/10/2008			20,922			-			*
BAVISPE LIMITED PARTNERSHIP			114,235			*			50,000			50,000		$	6.00			12/31/2005			12/31/2007			100,000			14,235			*
BERNARD B HERICKHOFF & LINDA A HERICKHOFF JTWROS			10,000			*			5,000			5,000		$	6.50			2/10/2006			2/10/2008			10,000			-			*
BMO NESBITT BURNS IN TR FOR DELTA ONE NORTHER RIVERS FUND LP			6,000			*			3,000			3,000		$	6.50			2/10/2006			2/10/2008			6,000			-			*
BMO NESBITT BURNS IN TR FOR DELTA ONE RSP NORTHERN RIVERS FUND			3,500			*			1,750			1,750		$	6.50			2/10/2006			2/10/2008			3,500			-			*
BMO NESBITT BURNS IN TR FOR NORTHERN RIVERS INNOVATION FUND LP			90,500			*			45,250			45,250		$	6.50			2/10/2006			2/10/2008			90,500			-			*
BRANDT E BUNTING & COLLEEN M BUNTING JT TEN			10,000			*			10,000			-												10,000			-			*
BRENDAN BRIAN HENNESSY			10,000			*			5,000			5,000		$	6.00			1/20/2006			1/20/2008			10,000			-			*
BRIAN L RAHN & BETH L RAHN COMMUNITY PROPERTY			10,000			*			10,000			-												10,000			-			*
BRUCE D BERGLIN & DONEDA E BERGLIN COMMUNITY PROPERTY			10,000			*			5,000			5,000		$	6.00			1/12/2006			1/12/2008			10,000			-			*

 

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BRUCE HAFFNER & LISA HAFFNER JTWROS			15,000			*			7,500			7,500		$	6.00			12/2/2005			12/2/2007			15,000			-			*
BRYAN W WATERS			37,500			*			18,750			18,750		$	6.00			12/31/2005			12/31/2007			37,500			-			*
C DENNIS NAU			70,586			*			35,293			35,293		$	6.00 to $6.50			1/30/2006 - 2/10/2006			1/30/2008 - 2/10/2008			70,586			-			*
CARL D MACPHERSON III & MARCIA K MACPHERSON REV LIV TRUST DTD 3.15.93			10,000			*			10,000			-												10,000			-			*
CARR-HUML INVESTORS LLC			20,000			*			10,000			10,000		$	6.00			1/12/2006			1/12/2008			20,000			-			*
CHAD J SHIMEK			12,500			*			6,250			6,250		$	6.00			1/28/2006			1/28/2008			12,500			-			*
CHAP TRAN & RUJIWAN TRAN JTWROS			12,500			*			6,250			6,250		$	6.00			1/17/2006			1/17/2008			12,500			-			*
CHARLES B WHEELER			40,000			*			20,000			20,000		$	6.00			1/9/2006			1/9/2008			40,000			-			*
CHARLES LE SUEUR			62,500			*			31,250			31,250		$	6.00			12/31/2005			12/31/2007			62,500			-			*
CHARLES SCHWAB & COMPANY CF VISTA MORTAGE SERVICES INC 401K FBO JAMES SCANNELL			14,500			*			7,250			7,250		$	6.00			12/31/2005			12/31/2007			14,500			-			*
CHRIS C ROWLAND			10,475			*			5,000			-												5,000			5,475			*
CHRISTOPHER R WALTON			12,500			*			6,250			6,250		$	6.00			12/21/2005			12/21/2007			12,500			-			*
CONSTANCE A CURRAN			80,000			*			40,000			40,000		$	3.00			8/17/2006			8/17/2011			80,000			-			*
COSTANTINO A LANZA			10,000			*			5,000			5,000		$	6.00			12/21/2005			12/21/2007			10,000			-			*
DALE SCHMITZ			10,000			*			10,000			-												10,000			-			*
DALLAS C ANDERSON & LOUISE C ANDERSON TEN COM			20,000			*			10,000			10,000		$	6.00			12/6/2005 - 1/12/2006			12/6/2007 - 1/12/2008			20,000			-			*
DAMON ZUMWALT			50,000			*			25,000			25,000		$	6.00			1/25/2006			1/25/2008			50,000			-			*
DANIEL BOCK TTEE PREMIER IDEAS INCORPORATED DEFINED BENEFITS PENSION PLAN DTD 12/27/1995			12,500			*			6,250			6,250		$	6.00			1/24/2006			1/24/2008			12,500			-			*
DAVID E CORNFORTH			20,000			*			20,000			-												20,000			-			*
DAVID L RALPH & JOSHUA D RALPH & BRITTNY C R RALPH JTWROS			15,000			*			7,500			7,500		$	6.00			1/13/2006			1/13/2008			15,000			-			*
DAVID P PARUPSKY			16,628			*			8,314			8,314		$	6.00 to $6.50			12/21/2005 - 2/14/2006			12/21/2007 - 2/14/2008			16,628			-			*
DAVID R ELLIS			10,000			*			5,000			5,000		$	6.00			1/19/2006			1/19/2008			10,000			-			*
DAVID VERE MASON			60,000			*			30,000			30,000		$	3.00 to $6.00			12/31/2005 - 8/17/2006			12/31/2007 - 8/17/2011			60,000			-			*
DIANNE R RUSSELL			5,000			*			2,500			2,500		$	6.00			11/9/2005			11/9/2007			5,000			-			*
DOMINICK & DOMINICK LLC (5)			206,300			1.28	%		-			206,300		$	3.00			8/9/2006			8/9/2011			206,300			-			*
DONALD B SCHREIFELS			180,943			1.14	%		70,000			70,000		$	3.00 to $6.00			12/12/2005 - 8/17/2006			12/12/2007 - 8/17/2011			140,000			40,943			*
DONALD D MONTGOMERY			10,000			*			5,000			5,000		$	6.00			1/24/2006			1/24/2008			10,000			-			*
DOROTHY J OSTEN			10,000			*			5,000			5,000		$	6.00			1/25/2006			1/25/2008			10,000			-			*

 

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DOSS & COMPANY			60,000			*			30,000			30,000		$	3.00			8/17/2006			8/17/2011			60,000			-			*
DOUGLAS L HILDRETH & RUTH M HILDRETH JTWROS			30,000			*			25,000			5,000		$	6.00			12/21/2005			12/21/2007			30,000			-			*
DUANE FERGUSON & BARBARA J FERGUSON COMMUNITY PROPERTY			47,500			*			23,750			23,750		$	6.00			12/9/2005 - 12/12/2005			12/9/2007 - 12/12/2007			47,500			-			*
DWIGHT W BABCOCK (4)			52,208			*			12,500			12,500		$	6.00			12/31/2005			12/31/2007			25,000			27,208			*
E MARK FISHMAN LIVING TR DTD 5/11/99			18,738			*			9,369			9,369		$	6.00 to $6.50			1/30/2006 - 2/10/2006			1/30/2008 - 2/10/2008			18,738			-			*
EDWARD W DAVIS			10,000			*			10,000			-												10,000			-			*
EFTHIMIOS CHRISTOPHER ANASTASSATOS			14,819			*			5,000			5,000		$	6.00			1/17/2006			1/17/2008			10,000			4,819			*
ELMER A HANSEN TTEE ELMER A HANSEN TRUST DTD 10.1.87			10,000			*			10,000			-												10,000			-			*
ERNESTO ZARAGOZA			10,000			*			5,000			5,000		$	6.00			1/9/2006			1/9/2008			10,000			-			*
EUGENE A HARCSAR			20,000			*			10,000			10,000		$	3.00			8/17/2006			8/17/2011			20,000			-			*
EUGENE A RAYMOND & MARILY K RAYMOND JTTEN			10,000			*			5,000			5,000		$	6.00			1/23/2006			1/23/2008			10,000			-			*
FIIRST DISCOUNT BROKERAGE (5)			3,373			*			-			3,373		$	6.00 to $6.50			2/13/2006 - 2/28/2006			2/13/2008 - 2/28/2008			3,373			-			*
FIRST CLEARING CORPORATION CF J PETER KLINE ROLLOVER IRA			10,000			*			5,000			5,000		$	6.00			12/30/2005			12/30/2007			10,000			-			*
FRANCIS J CALCAGNO & SUSAN CALCAGNO JT TEN			20,000			*			10,000			10,000		$	3.00			8/17/2006			8/17/2011			20,000			-			*
GARY A HEDSTROM			12,527			*			5,000			5,000		$	6.00			11/23/2005			11/23/2007			10,000			2,527			*
GARY A PRAGLIN & SYNTHIA PRAGLIN AS COMMUNITY PROPERTY			10,000			*			5,000			5,000		$	6.00			1/17/2006			1/17/2008			10,000			-			*
GENE P CLASEN			10,000			*			5,000			5,000		$	6.00			1/24/2006			1/24/2008			10,000			-			*
GERALD MILLMAN			60,000			*			30,000			30,000		$	3.00			8/17/2006			8/17/2011			60,000			-			*
GREG BERGLUND			35,769			*			20,000			-												20,000			15,769			*
H TERRY MONROE			10,000			*			10,000			-												10,000			-			*
H&P FAMILY PARTNERSHIP LLC			10,000			*			5,000			5,000		$	6.00			1/27/2006			1/27/2008			10,000			-			*
HAMPTON SECURITIES (5)			1,500			*			-			1,500		$	6.00			2/13/2006			2/13/2008			1,500			-			*
HARLYN R GRIFFITHS			50,000			*			25,000			25,000		$	6.00			12/2/2005			12/2/2007			50,000			-			*
HARLYN R GRIFFITHS			25,000			*			12,500			12,500		$	6.00			1/24/2006			1/24/2008			25,000			-			*
HAROLD J WALZ & RITA M WALZ JTWROS			10,000			*			5,000			5,000		$	6.00			2/10/2006			2/10/2008			10,000			-			*
HEATHER VANBENTHEM			25,000			*			12,500			12,500		$	6.00			12/31/2005			12/31/2007			25,000			-			*
HERBERT ALEXANDER COOK JR & STEPHANIE COOK JTTEN			20,000			*			10,000			10,000		$	6.00			1/20/2006			1/20/2008			20,000			-			*
HERMAN O HAENERT & JUDITH A HAENERT JTWROS			10,000			*			5,000			5,000		$	6.00			12/31/2005			12/31/2007			10,000			-			*

 

54

---

 

HIEN TON			15,000			*			7,500			7,500		$	6.00			1/17/2006			1/17/2008			15,000			-			*
HOA DUONG UNG			12,500			*			6,250			6,250		$	6.00			1/12/2006			1/12/2008			12,500			-			*
HORIZON CAPITAL FUND			40,000			*			20,000			20,000		$	3.00			8/17/2006			8/17/2011			40,000			-			*
IGOR OYSTACHER			12,500			*			6,250			6,250		$	6.00			12/31/2005			12/31/2007			12,500			-			*
IRA J GAINES			28,760			*			10,000			10,000		$	6.00			12/21/2005			12/21/2007			20,000			8,760			*
J DAPRAY MUIR			5,000			*			2,500			2,500		$	6.50			2/10/2006			2/10/2008			5,000			-			*
J RICHARD HUNT & SHIRLEY M HUNT JTTEN			10,000			*			5,000			5,000		$	6.00			1/24/2006			1/24/2008			10,000			-			*
J SMYTHE RICH			103,694			*			51,847			51,847		$	6.00 to $6.50			1/30/2006 - 2/7/2006			1/30/2008 - 2/7/2008			103,694			-			*
JACOB WILLIAM SCHWARTZ			15,950			*			2,500			2,500		$	6.00			12/31/2005			12/31/2007			5,000			10,950			*
JAM FAMILY TRUST			10,000			*			5,000			5,000		$	6.00			1/9/2006			1/9/2008			10,000			-			*
JAMES D HARTMAN			10,000			*			10,000			-												10,000			-			*
JAMES F SPELLMIRE & KATHLEEN T SPELLMIRE JTWROS			10,000			*			5,000			5,000		$	6.00			12/6/2005			12/6/2007			10,000			-			*
JAMES J MINDER & SUSAN A DAVIS TTEES JAMES J MINDER & SUSAN A DAVIS FAM TR DTD 5/27/98			25,950			*			7,500			7,500		$	6.00			1/25/2006			1/25/2008			15,000			10,950			*
JAMES L CHUBB & KAREN A CHUBB JTWROS			20,000			*			10,000			10,000		$	6.00			1/6/2006			1/6/2008			20,000			-			*
JAMES N SPELLMAN			20,000			*			10,000			10,000		$	6.00			12/27/2005			12/27/2007			20,000			-			*
JAMES S SCHMITZ			10,000			*			10,000			-												10,000			-			*
JAMIE G GRANGER & LANGDON K HOLTON JR AS COMMUNITY PROPERTY			10,000			*			5,000			5,000		$	6.00			1/17/2006			1/17/2008			10,000			-			*
JDH CAPITAL LLC			10,000			*			5,000			5,000		$	6.00			1/27/2006			1/27/2008			10,000			-			*
JEFF SILVERMAN (6)			1,800			*			-			1,800		$	6.00			2/13/2006			2/13/2008			1,800			-			*
JEREMY JAMES KOLLMANN & KRISTIE THERESA KOLLMANN COMMUNITY PROPERTY			10,000			*			5,000			5,000		$	6.50			2/10/2006			2/10/2008			10,000			-			*
JERRY L RUSSELL			25,000			*			12,500			12,500		$	6.00			12/31/2005 -1/12/2006			12/31/2007 - 1/12/2008			25,000			-			*
JILL E FACTOR & ARNOLD FACTOR TEES FBO JILLE FACTOR REV TR DTD 12/10/202			20,000			*			10,000			10,000		$	6.00			1/24/2006			1/24/2008			20,000			-			*
JOHN BOESEL (6)			4,037			*			-			4,037		$	6.00 to $6.50			2/13/2006 - 2/28/2006			2/13/2008 - 2/28/2008			4,037			-			*
JOHN E BRENNAN			160,000			1.00	%		80,000			80,000		$	3.00			8/17/2006			8/17/2011			160,000			-			*
JOHN E VAN LEEUWEN & CHRISTINE VAN LEEUWEN JTWROS			15,000			*			15,000			-												15,000			-			*

 

55

---

 

JOHN FREDERICK DOSS			40,000			*			20,000			20,000		$	3.00			8/17/2006			8/17/2011			40,000			-			*
JOHN IANNICCA			5,000			*			2,500			2,500		$	6.00			12/21/2005			12/21/2007			5,000			-			*
JOHN K ANGIOLETTI			20,000			*			10,000			10,000		$	6.00			12/31/2005			12/31/2007			20,000			-			*
JOHN R DOSS			160,000			1.00	%		80,000			80,000		$	3.00			8/17/2006			8/17/2011			160,000			-			*
JOHN S HOCKING ROTH IRA			10,000			*			5,000			5,000		$	6.00			1/20/2006			1/20/2008			10,000			-			*
JOHN W MATHEWS			20,000			*			10,000			10,000		$	6.00			12/2/2005			12/2/2007			20,000			-			*
JOHN W SIDDALL			104,753			*			50,000			-												50,000			54,753			*
JON A WINTERTON			20,000			*			10,000			10,000		$	6.00			1/24/2006			1/24/2008			20,000			-			*
JON FABRI			43,423			*			17,500			17,500		$	6.00			11/19/2005 - 1/23/2006			11/19/2007 - 1/23/2008			35,000			8,423			*
JULIE SINGLETON			50,000			*			25,000			25,000		$	6.00			12/31/2005			12/31/2007			50,000			-			*
JULY PARTNERS LLP			35,000			*			17,500			17,500		$	6.00			12/31/2005			12/31/2007			35,000			-			*
K EVAN FRIEDMAN			40,000			*			20,000			20,000		$	3.00			8/17/2006			8/17/2011			40,000			-			*
KAREN M LARSEN & RICHARD C LARSEN JTWROS			25,000			*			25,000			-												25,000			-			*
KATSINAM PARTNERS LP			102,376			*			37,500			37,500		$	6.00			12/6/2005 - 12/31/2005			12/6/2007 - 12/31/2007			75,000			27,376			*
KAY S SILVERMAN REV TR			25,000			*			12,500			12,500		$	6.00			11/8/2005			11/8/2007			25,000			-			*
KEN K V NGO			12,500			*			6,250			6,250		$	6.00			1/12/2006			1/12/2008			12,500			-			*
KENNETH R MILLER & MARY B MILLER JTWROS			20,000			*			10,000			10,000		$	6.00			11/9/2005 - 12/29/2005			11/9/2007 - 12/29/2007			20,000			-			*
KENNETH S BERTRAM & JOYCE L BERTRAM JTWROS			20,000			*			15,000			5,000		$	6.00			11/17/2005			11/17/2007			20,000			-			*
KERI SEGNA LIVINGSTON & JAMES P LIVINGSTON JTTEN			10,000			*			5,000			5,000		$	6.00			1/20/2006			1/20/2008			10,000			-			*
KEVIN F ENGELS			18,423			*			5,000			5,000		$	6.00			11/10/2005			11/10/2007			10,000			8,423			*
KEVIN FREEMAN			22,440			*			10,000			-		$	6.00									10,000			12,440			*
LANCE E KELLER			10,000			*			5,000			5,000		$	6.00			12/21/2005			12/21/2007			10,000			-			*
LAWRENCE R ROTHSTEIN			74,096			*			25,000			25,000		$	6.00			1/13/2006			1/13/2008			50,000			24,096			*
LAWRENCE SUCHAROW			11,112			*			5,556			5,556		$	6.50			2/10/2006			2/10/2008			11,112			-			*
LEE EUSTACE			10,000			*			5,000			5,000		$	6.00			12/27/2005			12/27/2007			10,000			-			*
LINDA J WATKINS			10,000			*			10,000			-												10,000			-			*
LOREN COHEN			26,426			*			5,000			5,000		$	6.00			1/17/2006			1/17/2008			10,000			16,426			*
LYNETTE F MOSS			46,937			*			20,000			-												20,000			26,937			*
MARGARET SCHRAMM			12,500			*			6,250			6,250		$	6.00			12/31/2005			12/31/2007			12,500			-			*

 

56

---

 

MARK B ABELSON & JANET W ABELSON 1991 REV TR			100,000			*			100,000			-												100,000			-			*
MARK J MATSOCK			88,450			*			38,750			38,750		$	6.00			12/2/2005 - 12/31/2005			12/2/2007 - 12/31/2007			77,500			10,950			*
MARY JANE A ERKENS			20,000			*			15,000			5,000		$	6.50			2/10/2006			2/10/2008			20,000			-			*
MERCEDES GROUP LIMITED PARTNERSHIP			8,888			*			4,444			4,444		$	6.50			2/10/2006			2/10/2008			8,888			-			*
MEYERS ASSOCIATES (5)			33,153			*			-			33,153		$	6.00 to $6.50			2/13/2006 - 2/28/2006			2/13/2008 - 2/28/2008			33,153			-			*
MICHAEL A MEYERS			80,000			*			40,000			40,000		$	3.00			8/17/2006			8/17/2011			80,000			-			*
MICHAEL DASWICK & KIMBERLY DASWICK JT TEN			10,000			*			10,000			-												10,000			-			*
MICHAEL DASWICK & KIMBERLY DASWICK JTWROS			52,943			*			10,000			-												10,000			42,943			*
FCC CUST FBO MICHAEL HULS ROTH IRA			33,333			*			333			-			-			-			-			333			33,000			*
MICHAEL R OHLHAUSEN			50,000			*			25,000			25,000		$	6.00			1/27/2006			1/27/2008			50,000			-			*
MICHAEL W WIVIOTT AND MARCIA A WIVIOTT AS COMMUNITY PROPERTY			5,000			*			2,500			2,500		$	6.00			1/27/2006			1/27/2008			5,000			-			*
MICROCAPITAL FUND LP			1,600,000			9.61	%		800,000			800,000		$	3.00			8/17/2006			8/17/2011			1,600,000			-			*
MICROCAPITAL FUND LTD			800,000			4.92	%		400,000			400,000		$	3.00			8/17/2006			8/17/2011			800,000			-			*
MOOSA EBRAHIMIAN			20,000			*			10,000			10,000		$	3.00			8/17/2006			8/17/2011			20,000			-			*
MOUNTAINVIEW OPPORTUNISTIC GROWTH FUND LP			80,000			*			40,000			40,000		$	3.00			8/17/2006			8/17/2011			80,000			-			*
MOUNTAINVIEW OPPORTUNITISTIC GROWTH FUND LP			74,096			*			25,000			25,000		$	6.00			1/19/2006			1/19/2008			50,000			24,096			*
NBCN CLEARING INC IN TRUST FOR ROBERT G WATT ACCOUNT 4H3193-F			10,000			*			5,000			5,000		$	6.00			1/25/2006			1/25/2008			10,000			-			*
NBCN CLEARING INC ITF PATRICIA WAKEFIELD AC 4H-1040-A			10,000			*			10,000			-												10,000			-			*
NBCN CLEARING INC ITF WARREN WAKEFIELD AC 4H-0894-E			10,000			*			10,000			-												10,000			-			*
NEIL KONIETZKO			198,423			1.25	%		120,000			70,000		$	6.00			10/28/2005 - 1/20/2006			10/28/2007 - 1/20/2008			190,000			8,423			*
NORBERT F HANSEN			10,000			*			5,000			5,000		$	6.00			1/25/2006			1/25/2008			10,000			-			*
NORMAN H WINER 1995 IRRV TRUST			12,500			*			6,250			6,250		$	6.00			1/6/2006			1/6/2008			12,500			-			*
NORMAN WINER			200,000			1.25	%		100,000			100,000		$	6.00			11/3/2005			11/2/2007			200,000			-			*
OCUTUS INC			20,000			*			10,000			10,000		$	6.00			1/19/2006			1/19/2008			20,000			-			*
PAT LAMBERT (6)			71,854			*			333			40,521		$	6.00 to $6.50			2/13/2006 - 2/28/2006			2/13/2008 - 2/28/2008			40,854			31,000			*
PATRICK N BERTRAM & BRIAN E BERTRAM JTWROS			10,000			*			5,000			5,000		$	6.50			2/10/2006			2/10/2008			10,000			-			*

 

57

---

 

PATRICK S WILLIAMS			25,000			*			12,500			12,500		$	6.00			12/21/2005			12/21/2007			25,000			-			*
PAUL A ACKER & MICHELE ACKER-HOCEVAR TEN COM			10,000			*			5,000			5,000		$	6.00			1/12/2006			1/12/2008			10,000			-			*
PAUL IANNICCA			24,436			*			12,218			12,218		$	6.00			12/15/2005 - 12/31/2005			12/15/2007 - 12/31/2007			24,436			-			*
PAULA W SONSALLA & KEVIN W SONSALLA JTWROS			5,000			*			2,500			2,500		$	6.00			1/12/2006			1/12/2008			5,000			-			*
PLEIADES INVESTMENT PARTNERS R LP			170,400			1.07	%		85,200			85,200		$	3.00			8/17/2006			8/17/2011			170,400			-			*
POTOMAC CAPITAL INTERNATIONAL LTD			149,600			*			74,800			74,800		$	3.00			8/17/2006			8/17/2011			149,600			-			*
POTOMAC CAPITAL PARTNERS LP			240,000			1.50	%		120,000			120,000		$	3.00			8/17/2006			8/17/2011			240,000			-			*
R WILLIAM ROOT JR			176,158			1.11	%		50,000			50,000		$	6.00			12/9/2005 - 1/4/2006			12/8/2007 - 1/4/2008			100,000			76,158			*
RALPH E SCHMITZ & KATHY A SCHMITZ JTWROS			10,000			*			10,000			-												10,000			-			*
RALPH K SCHATZMAIR			46,057			*			12,500			12,500		$	6.00			12/31/2005			12/31/2007			25,000			21,057			*
RICHARD KELLY (6)			2,813			*			-			2,813		$	6.00 to $6.50			2/13/2006 - 2/28/2006			2/13/2008 - 2/28/2008			2,813			-			*
RICHARD M ROOZEN & JAYNIE S ROOZEN COMMUNITY PROPERTY			10,000			*			5,000			5,000		$	6.00			1/12/2006			1/12/2008			10,000			-			*
RICHARD W HASKEL			20,000			*			10,000			10,000		$	3.00			8/17/2006			8/17/2011			20,000			-			*
ROBERT BATES & LISA BATES COMMUNITY PROPERTY			10,000			*			5,000			5,000		$	6.00			1/12/2006			1/12/2008			10,000			-			*
ROBERT E FURNEY LIVING TRUST			55,000			*			32,500			22,500		$	6.00			12/31/2005 - 1/19/2006			12/31/2007 - 1/19/2008			55,000			-			*
ROBERT J KLICK & JOSEPH R KLICK JTWROS			10,000			*			5,000			5,000		$	6.00			1/13/2006			1/13/2008			10,000			-			*
ROBERT J SCHMITZ & ERIN J SCHMITZ JT TEN			10,000			*			5,000			5,000		$	6.00			12/21/2005			12/21/2007			10,000			-			*
ROBERT JASON SIMMONS			15,000			*			15,000			-												15,000			-			*
ROBERT L PARRISH			11,014			*			10,000			-												10,000			1,014			*
ROBERT S FORMAN & ROBYN M FORMAN JT TEN			10,000			*			5,000			5,000		$	6.00			12/21/2005			12/21/2007			10,000			-			*
RONALD A LEDERKRAMER & DONNA E BAKER JTWROS			35,000			*			20,500			14,500		$	6.00			1/17/2006			1/17/2008			35,000			-			*
RONALD ALAN WEINSTEIN & CATHY LYNN WEINSTEIN AS COMMUNITY PROPERTY			64,765			*			12,500			-												12,500			52,265			*
RONALD ALAN WEINSTEIN & CATHY LYNN WEINSTEIN JT TEN			17,500			*			17,500			-												17,500			-			*
RONALD ALAN WEINSTEIN 2004 LIVING TRUST			41,979			*			35,000			-												35,000			6,979			*
ROSEMARY HODNETT			16,000			*			8,000			8,000		$	3.00			8/17/2006			8/17/2011			16,000			-			*
ROSS C PEARLMAN TTEE HUSBANDS TR UA ROSS C & ALLYSON D PEARLMAN INTERVIVOS TR DTD 4/7/93			9,368			*			4,684			4,684		$	6.00 to $6.50			1/30/2006 - 2/10/2006			1/30/2008 - 2/10/2008			9,368			-			*
ROYAL TRUST CO OF CANADA IN TRUST FOR ACCOUNT 110748003			50,000			*			25,000			25,000		$	6.00			1/18/2006			1/18/2008			50,000			-			*

 

58

---

 

RYAN F BARRADAS			10,000			*			5,000			5,000		$	6.00			12/21/2005			12/21/2007			10,000			-			*
S & J VEAL INC			12,500			*			6,250			6,250		$	6.00			12/31/2005			12/31/2007			12,500			-			*
SHAWN G ROOT AND SHALONA G ROOT JTWROS			10,000			*			5,000			5,000		$	6.00			1/27/2006			1/27/2008			10,000			-			*
SHERMAN FAMILY TRUST			10,000			*			10,000			-		$	6.00									10,000			-			*
SHERRI CLARKSON			20,000			*			10,000			10,000		$	6.00			10/31/2005			10/31/2007			20,000			-			*
SHERRY A CLASEN & GENE P CLASEN JTTEN			50,000			*			25,000			25,000		$	6.00			1/24/2006			1/24/2008			50,000			-			*
SMILIS LLC			19,218			*			5,000			-		$	6.00									5,000			14,218			*
SOURCE CAPITAL (5)			850			*			-			850		$	6.00			2/13/2006			2/13/2008			850			-			*
STANLEY SCHLOZ			33,333			*			333			-			-			-			-			333			30,000			*
STANTON F WEISSENBORN			80,000			*			40,000			40,000		$	3.00			8/17/2006			8/17/2011			80,000			-			*
STEALTH INVESTMENTS INC			44,876			*			8,750			8,750		$	6.00			12/31/2005			12/31/2007			17,500			27,376			*
STELLA TRUST DTD 4.10.03			15,000			*			7,500			7,500		$	6.00			12/21/2005			12/21/2007			15,000			-			*
STEPHEN G MARECK			30,000			*			30,000			-												30,000			-			*
STEPHEN T. MEADOW			33,333			*			33,333			-			-			-			-			33,333			-			*
STEPPING STONES PARTNERS LP ATTN: DANIEL HICKEY			80,000			*			40,000			40,000		$	3.00			8/17/2006			8/17/2011			80,000			-			*
STERLING TRUST COMPANY CUSTODIAN FBO TIMOTHY TURNBULL			5,000			*			2,500			2,500		$	6.50			2/9/2006			2/9/2008			5,000			-			*
STERNE AGEE & LEACH INC CF DAVID J SWANBERG ROLLOVER IRA (4)			31,000			*			25,500			5,500		$	6.00			10/28/2005			10/28/2007			31,000			-			*
STERNE AGEE & LEACH INC CF DAVID O'FALLON IRA			10,000			*			5,000			5,000		$	6.00			12/14/2005			12/14/2007			10,000			-			*
STERNE AGEE & LEACH INC CF PAUL E RUECKER IRA			10,000			*			5,000			5,000		$	6.00			12/31/2005			12/31/2007			10,000			-			*
STERNE AGEE & LEACH INC CF ROBERT RYAN IRA			15,000			*			7,500			7,500		$	6.00			12/31/2005			12/31/2007			15,000			-			*
STERNE AGEE & LEACH INC CF RON H WEST IRA			10,000			*			5,000			5,000		$	6.00			11/17/2005			11/17/2007			10,000			-			*
STEVEN A BOLAN			15,000			*			7,500			7,500		$	6.00			1/20/2006			1/20/2008			15,000			-			*
STEWART INVESTMENTS INC			70,000			*			70,000			-												70,000			-			*
SUZANN J OTT AND DENNIS L OTT JT TEN			38,046			*			2,500			-												2,500			35,546			*
SUZANN J OTT AND DENNIS L OTT JTWROS			2,500			*			2,500			-												2,500			-			*
SWANSON LIVING TRUST			20,000			*			10,000			10,000		$	6.00			1/24/2006			1/24/2008			20,000			-			*

 

59

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TERRY L MYHRE & KATHRYN M MYHRE JTTEN			50,000			*			25,000			25,000		$	6.00			1/20/2006			1/20/2008			50,000			-			*
TEZAK INVESTMENT CORPORATION			10,000			*			5,000			5,000		$	6.00			12/21/2005			12/20/2007			10,000			-			*
THAINE J FISCHER			10,000			*			5,000			5,000		$	6.00			12/31/2005			12/31/2007			10,000			-			*
THE ALAN GESS LIVING TRUST			15,000			*			7,500			7,500		$	6.00 to $6.50			1/23/2006 - 2/10/2006			1/23/2008 - 2/10/2008			15,000			-			*
THE BERTRAM FAMILY TRUST			20,000			*			10,000			10,000		$	6.00			11/9/2005 - 1/12/2006			11/9/2007 - 1/12/2008			20,000			-			*
THE BERTRAM FAMILY TRUST DTD 3/10/05			10,000			*			5,000			5,000		$	6.50			2/10/2006			2/10/2008			10,000			-			*
THE KELLY REVOCABLE TRUST			14,211			*			5,000			5,000		$	6.00			11/9/2005			11/9/2007			10,000			4,211			*
THE ROBERT E SHARPLES & MADELINE SHARPLES FAMILY TR			10,000			*			5,000			5,000		$	6.50			2/10/2006			2/10/2008			10,000			-			*
THE SMART FAMILY TRUST			15,450			*			2,500			2,500		$	6.00			1/17/2006			1/17/2008			5,000			10,450			*
THOMAS E CONNER III			33,698			*			10,000			-												10,000			23,698			*
THOMAS J QUINLAN			20,000			*			10,000			10,000		$	3.00			8/17/2006			8/17/2011			20,000			-			*
THOMAS AND SHEILA SMITH			31,718			*			2,173			-			-			-			-			2,173			29,545			*
THOMAS S SMITH & SHEILA T SMITH JT TEN			12,500			*			10,000			2,500		$	6.00			1/20/2006			1/20/2008			12,500			-			*
TKJ PROPERTIES LLC			10,000			*			10,000			-												10,000			-			*
TTR PROPERTIES LLC			100,000			*			50,000			50,000		$	6.00			12/31/2005			12/31/2007			100,000			-			*
VERE KARSDALE MASON			10,000			*			5,000			5,000		$	6.00			12/31/2005			12/31/2007			10,000			-			*
VERN L COX & FRANCES L COX COMMUNITY PROPERTY			10,000			*			10,000			-		$	6.00									10,000			-			*
VIERECK FAMILY TRUST DTD 6.28.02			10,000			*			5,000			5,000		$	6.00			12/31/2005			12/31/2007			10,000			-			*
VINCE PALASOTA			25,000			*			12,500			12,500		$	6.00			12/31/2005 - 1/12/2006			12/31/2007 - 1/12/2008			25,000			-			*
VINCENT A MANGUS			10,000			*			5,000			5,000		$	6.00			1/23/2006			1/23/2008			10,000			-			*
WAYNE T CLASEN			60,000			*			30,000			30,000		$	6.00			1/24/2006			1/24/2008			60,000			-			*
WEINSTEIN INTER-VIVOS TRUST AGREEMENT			60,000			*			30,000			30,000		$	6.00			12/31/2005 - 1/17/2006			12/31/2007 - 1/17/2008			60,000			-			*
WILLIAM A SCHREIFELS			30,000			*			20,000			10,000		$	6.00			10/21/2005			10/21/2007			30,000			-			*
WILLIAM G MULDOON & JANET L MULDOON TEN COM			114,412			*			25,000			25,000		$	6.00			12/31/2005			12/31/2007			50,000			64,412			*
WILLIAM HOBBINS FORESTER			12,500			*			6,250			6,250		$	6.00			12/31/2005			12/31/2007			12,500			-			*
WILLIAM J NCOPEY			5,000			*			5,000			-		$	6.00									5,000			-			*
WILLIAM J NOONEY			5,000			*			5,000			-		$	6.00									5,000			-			*
WILLIAM R BELL			10,000			*			5,000			5,000		$	6.00			1/23/2006			1/23/2008			10,000			-			*
ZACHARY DUTTON & JACQUELINE B DUTTON COMMUNITY PROPERTY			15,000			*			7,500			7,500		$	6.00			10/28/2005 - 1/17/2006			10/28/2007 - 1/17/2008			15,000			-			*

 

* Less than one percent

 

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¹ The number and percentage of shares beneficially owned is determined in accordance with Rule 13d-3 of the Securities Exchange Act of 1934, as amended, and the information is not necessarily indicative of beneficial ownership for any other purpose. Under such rule, beneficial ownership includes any shares as to which the selling shareholder has sole or shared voting power or investment power and also any shares that the selling shareholder has the right to acquire within 60 days.

² This column includes all shares of common stock issuable upon exercise of warrants held by the named selling shareholder.

³ Assumes that all securities registered will be sold.

⁴ These selling shareholders are our executive officers and directors.

⁵ These selling shareholders are broker/dealers.

⁶ These selling shareholders are affiliates of broker/dealers.

⁷ 50,000 of these shares are held in escrow.

 

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PLAN OF DISTRIBUTION

 

The selling stockholders may use any one or more of the following methods when disposing of shares or interests therein:

 

- ordinary brokerage transactions and transactions in which the broker-dealer solicits purchasers;

 

- block trades in which the broker-dealer will attempt to sell the shares as agent, but may position and resell a portion of the block as principal to facilitate the transaction;

 

- purchases by a broker-dealer as principal and resale by the broker-dealer for its account;

 

- an exchange distribution in accordance with the rules of the applicable exchange;

 

- privately negotiated transactions;

 

- short sales effected after the date the registration statement of which this Prospectus is a part is declared effective by the SEC;

 

- through the writing or settlement of options or other hedging transactions, whether through an options exchange or otherwise;

 

- broker-dealers may agree with the selling stockholders to sell a specified number of such shares at a stipulated price per share; and

 

- a combination of any such methods of sale.

 

The selling stockholders may, from time to time, pledge or grant a security interest in some or all of the shares of common stock owned by them and, if they default in the performance of their secured obligations, the pledges or secured parties may offer and sell the shares of common stock, from time to time, under this prospectus, or under an amendment to this prospectus under Rule 424(b)(3) or other applicable provision of the Securities Act amending the list of selling stockholders to include the pledge, transferee or other successors in interest as selling stockholders under this prospectus. The selling stockholders also may transfer the shares of common stock in other circumstances, in which case the transferees, pledges or other successors in interest will be the selling beneficial owners for purposes of this prospectus.

 

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In connection with the sale of our common stock or interests therein, the selling stockholders may enter into hedging transactions with broker-dealers or other financial institutions, which may in turn engage in short sales of the common stock in the course of hedging the positions they assume. The selling stockholders may also sell shares of our common stock short and deliver these securities to close out their short positions, or loan or pledge the common stock to broker-dealers that in turn may sell these securities. The selling stockholders may also enter into option or other transactions with broker-dealers or other financial institutions or the creation of one or more derivative securities which require the delivery to such broker-dealer or other financial institution of shares offered by this prospectus, which shares such broker-dealer or other financial institution may resell pursuant to this prospectus (as supplemented or amended to reflect such transaction).

 

The aggregate proceeds to the selling stockholders from the sale of the common stock offered by them will be the purchase price of the common stock less discounts or commissions, if any. Each of the selling stockholders reserves the right to accept and, together with their agents from time to time, to reject, in whole or in part, any proposed purchase of common stock to be made directly or through agents. We will not receive any of the proceeds from this offering. Upon any exercise of the warrants by payment of cash, however, we will receive the exercise price of the warrants.

 

The selling stockholders also may resell all or a portion of the shares in open market transactions in reliance upon Rule 144 under the Securities Act, provided that they meet the criteria and conform to the requirements of that rule.

 

The selling stockholders and any underwriters, broker-dealers or agents that participate in the sale of the common stock or interests therein may be “underwriters” within the meaning of Section 2(11) of the Securities Act. Any discounts, commissions, concessions or profit they earn on any resale of the shares may be underwriting discounts and commissions under the Securities Act. Selling stockholders who are “underwriters” within the meaning of Section 2(11) of the Securities Act will be subject to the prospectus delivery requirements of the Securities Act.

 

To the extent required, the shares of our common stock to be sold, the names of the selling stockholders, the respective purchase prices and public offering prices, the names of any agent, dealer or underwriter, any applicable commissions or discounts with respect to a particular offer will be set forth in an accompanying prospectus supplement or, if appropriate, a post-effective amendment to the registration statement that includes this prospectus.

 

In order to comply with the securities laws of some states, if applicable, the common stock may be sold in these jurisdictions only through registered or licensed brokers or dealers. In addition, in some states the common stock may not be sold unless it has been registered or qualified for sale or an exemption from registration or qualification requirements is available and is complied with.

 

We have advised the selling stockholders that the anti-manipulation rules of Regulation M under the Exchange Act may apply to sales of shares in the market and to the activities of the selling stockholders and their affiliates. In addition, to the extent applicable we will make copies of this prospectus (as it may be supplemented or amended from time to time) available to the selling stockholders for the purpose of satisfying the prospectus delivery requirements of the Securities Act. The selling stockholders may indemnify any broker-dealer that participates in transactions involving the sale of the shares against certain liabilities, including liabilities arising under the Securities Act.

 

We have agreed to indemnify the selling stockholders against liabilities, including liabilities under the Securities Act and state securities laws, relating to the registration of the shares offered by this prospectus.

 

We have agreed with the selling stockholders to keep the registration statement of which this prospectus constitutes a part effective until the earlier of (1) such time as all of the shares covered by this prospectus have been disposed of pursuant to and in accordance with the registration statement or (2) the date on which the shares may be sold pursuant to Rule 144(k) of the Securities Act.

 

DESCRIPTION OF SECURITIES

 

The Company’s Articles of Incorporation provide that the Company has the authority to issue 200 million shares of capital stock, which are currently divided into two classes as follows: 194 million shares of common stock, par value of $0.001 per share; and 6 million shares of preferred stock, also with a par value of $0.001 per share. As of November 10, 2006, the Company had 15,853,852 shares of common stock and 91,298 shares of Series B preferred stock outstanding. The Company also had options to purchase 3,436,176 shares of common stock, warrants to purchase 4,772,068 shares of common stock, warrants to purchase 173,292 shares of preferred stock, and $455,000 in principal amount of convertible debentures (convertible into common stock at $4.15 per share) outstanding on that date.

 

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The Common Stock

 

Voting. Holders of the common stock are entitled to one vote per share on all matters to be voted on by the Company’s shareholders. The Company’s bylaws provide that a majority of the outstanding shares of the corporation entitled to vote constitute a quorum at a meeting of the shareholders.

 

Dividends. The Company’s Board of Directors, in its sole discretion, may declare and pay dividends on the common stock, payable in cash or other consideration, out of funds legally available, if all dividends due on the preferred stock have been declared and paid. The Company has not paid any cash dividends on its common stock and does not plan to pay any cash dividends on its common stock for the foreseeable future.

 

Liquidation, Subdivision, or Combination. In the event of any liquidation, dissolution or winding up of the Company or upon the distribution of its assets, all assets and funds remaining after payment in full of the Company’s debts and liabilities, and after the payment to holders of any then outstanding preferred stock of the full preferential amounts to which they were entitled, would be divided and distributed among holders of the common stock.

 

Anti-Takeover Effects Of Provisions Of The Articles Of Incorporation. The authorized but unissued shares of our common and preferred stock are available for future issuance without our shareholders’ approval. These additional shares may be utilized for a variety of corporate purposes including but not limited to future public or direct offerings to raise additional capital, corporate acquisitions and employee incentive plans. The issuance of such shares may also be used to deter a potential takeover of IsoRay that may otherwise be beneficial to shareholders by diluting the shares held by a potential suitor or issuing shares to a shareholder that will vote in accordance with IsoRay’s Board of Directors’ desires. A takeover may be beneficial to shareholders because, among other reasons, a potential suitor may offer shareholders a premium for their shares of stock compared to the then-existing market price.

 

The Preferred Stock

 

The Company’s preferred stock is divided into two series - Series A and Series B - designated as follows:

 

·

1,000,000 shares of Series A are authorized and 5,000,000 shares of Series B are authorized. As of November 10, 2006 there were no shares of Series A issued and outstanding; there were 91,298 Series B preferred shares issued and outstanding. The Company has no plans to issue any Series A shares for the foreseeable future.

 

·

The Series A shares are entitled to a 10% dividend annually on the stated value per share ($1.20) of the Series A, while the Series B shares are entitled to a cumulative 15% dividend annually on the stated value per share ($1.20) of the Series B. Such dividends will be declared and paid at the discretion of the Board to the extent funds are legally available for the payment of dividends.

 

·

Both series of preferred shares vote equally with the common stock, with each share of preferred having the number of votes equal to the voting power of one share of common stock, except that the vote or written consent of a majority of the outstanding preferred shares is required for any changes to the Company’s Articles of Incorporation, Bylaws or Certificate of Designation or for any bankruptcy, insolvency, dissolution or liquidation of the company.

 

·

Shares of either series of preferred stock may be converted at the option of the holder into shares of common stock at a rate of one share of common stock for each share of preferred stock being converted, subject to adjustment for stock splits, stock combinations, reorganization, merger, consolidation, reclassification, exchange or substitution.

 

64

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·

Both series of preferred stock are subject to automatic conversion into common stock upon the closing of a firmly underwritten public offering pursuant to an effective registration statement under the Act, covering the offer and sale of common stock in which the gross proceeds to the Company are at least $4 million.

 

·

The Board of Directors has approved the cancellation of the Series A Preferred Stock, given that there are no Series A shares issued, and this cancellation will occur in the near future. The Board of Directors has no plans at this time to issue additional series of preferred stock.

 

Warrants

 

We are registering 4,233,950 shares of common stock underlying warrants as part of this Prospectus. Certain of these warrants entitle the holder to purchase one share of Common Stock at any time until expiration (varying from October 2007 to February 2008) for $6.00 or $6.50. The total number of shares of common stock issuable upon conversion of these warrants is 1,964,650 shares. The number of shares and price at which these warrants are exercisable is subject to adjustment in certain events, such as mergers, reorganizations or stock splits, to prevent dilution. At any time after the closing bid price for the common stock on the NASDAQ (or, if the Common Stock is not then traded on the NASDAQ, then on the principal exchange on which the Common Stock is traded) has equaled or exceeded $9.00 per share for any consecutive two month period, upon 30 days’ written notice, the Company may redeem any unexercised outstanding warrants for $0.01 per warrant. Holders of these warrants will have the right to exercise the warrants after such notification and through the redemption date of the warrants. These warrants have no price protection features. 

The Company also has an additional 2,269,300 warrants outstanding that are included in this Registration Statement. These warrants entitle the holder to purchase one share of common stock at any time until their expiration on August 17, 2011 for $3.00. The number of shares and price at which these warrants are exercisable is subject to adjustment in certain events, such as mergers, reorganizations or stock splits, to prevent dilution. At any time after the closing bid price for the common stock on the NASDAQ (or, if the Common Stock is not then traded on the NASDAQ, then on the principal exchange on which the Common Stock is traded) has equaled or exceeded $4.50 per share for any consecutive two month period, upon 30 days’ written notice, the Company may redeem any unexercised outstanding warrants for $0.01 per warrant. Holders of these warrants will have the right to exercise the warrants after such notification and through the redemption date of the warrants. These warrants have no price protection features.

 

 

Keller Rohrback, PLC, Phoenix, Arizona will issue an opinion with respect to the validity of the shares of common stock being offered hereby. In exchange for consulting services, Quatsch Ventures, LLC, an entity controlled by Stephen Boatwright, one of the Company’s directors, received options to purchase 84,236 shares of our common stock in 2004. Mr. Boatwright is a member of Keller Rohrback, PLC, which provides legal services to the Company and IsoRay Medical. During IsoRay’s fiscal year ended June 30, 2006, IsoRay paid Keller Rohrback, PLC approximately $390,000 for legal services.

 

EXPERTS

 

Our audited financial statements for the fiscal years ended June 30, 2006 and June 30, 2005 have been audited by DeCoria, Maichel & Teague, P.S., independent registered public accountants.  The report of this registered public accounting firm, which appears elsewhere herein, includes an explanatory paragraph as to our ability to continue as a going concern.  Our financial statements are included in reliance upon this report and upon the authority of such firm as an expert in auditing and accounting.

 

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CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING

AND FINANCIAL DISCLOSURE

 

The Company’s Board of Directors engaged DeCoria, Maichel & Teague, P.S., the independent auditor for the Company’s wholly-owned subsidiary, to be its new independent auditor effective November 15, 2005, which was also the effective date of S.W. Hatfield, CPA’s dismissal as the Company’s certifying accountant by the Board.

 

Except for an expression of doubt about our ability to continue as a going concern, S.W. Hatfield’s audit reports on the Company’s financial statements as of June 30, 2005 and September 30, 2004 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.

 

During the two fiscal years ended June 30, 2005 and September 30, 2004, and through November 15, 2005 there were no disagreements with S.W. Hatfield on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedures, which disagreements, if not resolved to the satisfaction of S.W. Hatfield would have caused it to make a reference to the subject matter of the disagreements in connection with its report; and there were no reportable events as described in Item 304(a)(1)(iv)(B) of Regulation S-B promulgated by the Securities and Exchange Commission (the “SEC”) pursuant to the Securities Exchange Act of 1934, as amended.

 

During the Company’s two most recent fiscal years and through November 15, 2005, the Company did not consult DeCoria, Maichel & Teague with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company’s financial statements, or any other matters or reportable events listed in Item 304(a)(2) of Regulation S-B. However, IsoRay Medical, the Company’s wholly-owned subsidiary, has consulted with DeCoria, Maichel & Teague, its independent auditor, during these time periods solely in connection with IsoRay Medical’s financial statements.

 

FURTHER INFORMATION

 

We are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, and file reports, proxy statements and other information with the Securities and Exchange Commission.  These reports, proxy statements and other information may be inspected and copied at the public reference facilities maintained by the Securities and Exchange Commission at 100 F Street, N.E., Room 1580, Washington, D.C. 20549 and at the Securities and Exchange Commission’s regional offices.  You can obtain copies of these materials from the Public Reference Section of the Securities and Exchange Commission upon payment of fees prescribed by the Securities and Exchange Commission.  You may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330.  The Securities and Exchange Commission’s Web site contains reports, proxy and information statements and other information regarding registrants that file electronically with the Securities and Exchange Commission.  The address of that site is www.sec.gov.

Index to Financial Statements

		Page
Unaudited Financial Statements:
	Consolidated Balance Sheets as of September 30, 2006 and June 30, 2006	F-2
	Consolidated Statements of Operations for the three months ended
	September 30, 2006 and 2005	F-3
	Consolidated Statements of Cash Flows for the three months ended
	September 30, 2006 and 2005	F-4
	Notes to Consolidated Financial Statements	F-5
Report of Independent Registered Public Accounting Firm		F-11
Financial Statements:
	Consolidated Balance Sheets as of June 30, 2006 and 2005	F-12
	Consolidated Statements of Operations for the years ended
	June 30, 2006 and 2005	F-13
	Consolidated Statements of Stockholders’ Equity (Deficit) for the years
	ended June 30, 2006 and 2005	F-14
	Consolidated Statements of Cash Flows for the years ended June 30,
	2006 and 2005	F-15
	Notes to Consolidated Financial Statements	F-16

F-1

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IsoRay, Inc. and Subsidiary

Consolidated Balance Sheets

 

		September 30,
		2006			June 30,
		(Unaudited)			2006
ASSETS
Current assets:
Cash and cash equivalents		$	5,160,557		$	2,207,452
Accounts receivable, net of allowance for doubtful accounts
of $63,237 and $85,183, respectively			652,255			596,447
Inventory			217,788			161,381
Prepaid expenses			193,771			161,546
Total current assets			6,224,371			3,126,826
Fixed assets, net of accumulated depreciation			1,608,257			1,642,293
Deferred financing costs, net of accumulated amortization			252,501			274,358
Licenses, net of accumulated amortization			268,419			273,475
Other assets, net of accumulated amortization			347,383			338,987
Total assets		$	8,700,931		$	5,655,939
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses		$	654,062		$	584,296
Accrued payroll and related taxes			706,827			614,645
Accrued interest payable			13,699			11,986
Notes payable, due within one year			46,031			51,351
Capital lease obligations, due within one year			190,266			183,554
Convertible debentures payable, due within one year			455,000			455,000
Total current liabilities			2,065,885			1,900,832
Notes payable, due after one year			569,608			581,557
Capital lease obligations, due after one year			162,642			220,415
Asset retirement obligation			68,953			67,425
Total liabilities			2,867,088			2,770,229
Shareholders' equity:
Preferred stock, $.001 par value; 6,000,000 shares authorized:
Series A: 1,000,000 shares allocated; no shares issued and outstanding			-			-
Series B: 5,000,000 shares allocated; 91,298 and 144,759 shares issued and
outstanding			91			145
Common stock, $.001 par value; 194,000,000 and 100,000,000 shares authorized;
15,853,852 and 15,157,901 shares issued and outstanding			15,854			15,158
Subscriptions receivable			-			(6,122,007	)
Additional paid-in capital			22,291,594			22,538,675
Accumulated deficit			(16,473,696	)		(13,546,261	)
Total shareholders' equity			5,833,843			2,885,710
Total liabilities and shareholders' equity		$	8,700,931		$	5,655,939

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

 

F-2

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IsoRay, Inc. and Subsidiary

Consolidated Statements of Operations

Three Months Ended September 30, 2006 and 2005 (Unaudited)

		Three months ended September 30,
		2006			2005
Product sales		$	1,025,444		$	210,915
Cost of product sales			1,288,145			720,166
Gross loss			(262,701	)		(509,251	)
Operating expenses:
Research and development			245,598			25,782
Sales and marketing expenses			672,930			315,039
General and administrative expenses			1,733,132			960,949
Total operating expenses			2,651,660			1,301,770
Operating loss			(2,914,361	)		(1,811,021	)
Non-operating income (expense):
Interest income			40,183			6,959
Financing expense			(53,257	)		(155,628	)
Non-operating income (expense), net			(13,074	)		(148,669	)
Net loss		$	(2,927,435	)	$	(1,959,690	)
Basic loss per share		$	(0.19	)	$	(0.22	)
Shares used in computing net loss per share:
Basic			15,300,747			8,830,965

 

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

 

F-3

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IsoRay, Inc. and Subsidiary

Consolidated Statements of Cash Flows

Three Months Ended September 30, 2006 and 2005 (Unaudited)

		Three months ended September 30,
		2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss		$	(2,927,435	)	$	(1,959,690	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization of fixed assets			89,426			45,961
Amortization of deferred financing costs and other assets			39,773			55,592
Accretion of asset retirement obligation			1,528			-
Noncash share-based compensation			781,443			-
Merger consulting fees paid by issuance of common stock			-			330,000
Changes in operating assets and liabilities:
Accounts receivable, net			(55,808	)		(86,056	)
Inventory			(56,407	)		(38,226	)
Prepaid expenses			(32,225	)		(61,458	)
Accounts payable and accrued expenses			69,766			(248,232	)
Accrued payroll and related taxes			92,182			90,177
Accrued interest payable			1,713			52,493
Net cash used by operating activities			(1,996,044	)		(1,819,439	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of fixed assets			(55,390	)		(253,833	)
Additions to licenses and other assets			(21,256	)		(54,458	)
Net cash used by investing activities			(76,646	)		(308,291	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sales of convertible debentures payable			-			550,000
Principal payments on notes payable			(17,269	)		(19,436	)
Principal payments on capital lease obligations			(51,061	)		(4,408	)
Proceeds from cash sales of common shares pursuant to private placement, net of offering costs			4,702,931			-
Proceeds from cash sales of preferred stock, pursuant to exercise of warrants			8,709			-
Proceeds from cash sales of common stock, pursuant to exercise of warrants			-			56,937
Proceeds from cash sales of common stock, pursuant to exercise of options			382,485			70,548
Net cash provided by financing activities			5,025,795			653,641
Net increase in cash and cash equivalents			2,953,105			(1,474,089	)
Cash and cash equivalents, beginning of period			2,207,452			1,685,731
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	5,160,557		$	211,642

 

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

 

F-4

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IsoRay, Inc.

Notes to the Unaudited Consolidated Financial Statements

For the three-month periods ended September 30, 2006 and 2005

 

1. Basis of Presentation

The accompanying consolidated financial statements are those of IsoRay, Inc., and its wholly-owned subsidiary (“IsoRay” or the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation.

The accompanying interim consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, consistent in all material respects with those applied in the Company’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2006, except for the July 1, 2006 adoption of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”) — See Note 2. The financial information is unaudited but reflects all adjustments, consisting only of normal recurring accruals, which are, in the opinion of the Company’s management, necessary for a fair statement of the results for the interim periods presented. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-QSB should be read in conjunction with the Company’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2006.

2. Share-Based Compensation

Prior to July 1, 2006, the Company accounted for share-based employee compensation, including stock options, using the method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations (“APB 25”). Under APB 25, if stock options are granted at market price then no compensation cost is recognized, and a disclosure is made regarding the pro forma effect on net earnings assuming compensation cost had been recognized in accordance with Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). During December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123R, Share-Based Payment, which requires companies to measure and recognize compensation expense for all share-based payments at fair value. SFAS 123R eliminates the ability to account for share-based compensation transactions using APB 25, and generally requires that such transactions be accounted for using prescribed fair-value-based methods. SFAS 123R permits public companies to adopt its requirements using one of two methods: (a) a “modified prospective” method in which compensation costs are recognized beginning with the effective date based on the requirements of SFAS 123R for all share-based payments granted or modified after the effective date, and based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date or (b) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits companies to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either for all periods presented or prior interim periods of the year of adoption. Effective July 1, 2006, the Company adopted SFAS 123R using the modified prospective method. No share-based employee compensation cost was reflected in the statement of operations prior to the adoption of SFAS 123R. Results for prior periods have not been restated.

 

F-5

---

The following table presents the share-based compensation expense recognized in accordance with SFAS 123R during the three months ended September 30, 2006 and in accordance with APB 25 during the three months ended September 30, 2005:

		Three months ended September 30,
		2006			2005
Cost of product sales		$	50,833		$	—
Research and development			11,835			—
Sales and marketing			46,781			—
General and administrative			671,994			—
Total share-based compensation		$	781,443		$	—

The adoption of SFAS 123R reduced income before income tax expense and net income for the three months ended September 30, 2006 by $781,443. Basic loss per common share for the three months ended September 30, 2006 would have been $0.14 if the Company had not adopted SFAS 123R, compared to reported basic loss per common share of $0.19. The total value of the stock options awards is expensed ratably over the service period of the employees receiving the awards. As of September 30, 2006, total unrecognized compensation cost related to stock-based options and awards was $944,407 and the related weighted-average period over which it is expected to be recognized is approximately 1.23 years.

The Company currently provides stock-based compensation under three equity incentive plans approved by the Board of Directors: the Amended and Restated 2005 Employee Stock Option Plan, the Amended and Restated 2005 Stock Option Plan, and the 2006 Director Stock Option Plan. Stock option awards granted from these plans are granted at the fair market value on the date of grant, and vest over a period determined at the time the options are granted, generally ranging from zero to three years, and generally have a maximum term of ten years. For stock options with graded vesting terms, the Company recognizes compensation cost on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in substance, multiple awards.

A summary of stock option activity within the Company’s share-based compensation plans and charges for the three months ended September 30, 2006 is as follows:

		Shares			Price (a)			Life (b)			Value (c)
Outstanding at June 30, 2006			3,129,692		$	2.05
Granted (d)			627,900			3.15
Exercised			(321,416	)		1.19
Outstanding at September 30, 2006			3,436,176		$	2.33			9.04		$	3,667,141
Expected to vest at
September 30, 2006			3,380,949		$	2.32			9.04		$	3,629,538
Vested and exercisable at
September 30, 2006			2,789,770		$	2.04			8.98		$	3,510,462

(a)    Weighted average price per share.

 

(b)  Weighted average remaining contractual life.

 

(c)  Aggregate intrinsic value.

 

(d)

All options granted had exercise prices equal to the ending market price of the Company’s common stock on the grant date.

The aggregate intrinsic value of options exercised during the three months ended September 30, 2006 was $702,763.

 

F-6

---

The weighted average fair value of stock option awards granted and the key assumptions used in the Black-Scholes valuation model to calculate the fair value are as follows for the three months ended September 30, 2006 and 2005:

		Three months ended September 30,
		2006			2005
Weighted average fair value of options granted		$	2.10		$	0.68
Key assumptions used in determining fair value:
Weighted average risk-free interest rate			4.90	%		4.60	%
Expected life of the option (in years)			5.51			8.50
Expected stock price volatility			75.00	%		30.00	%
Expected dividend yield			0.00	%		0.00	%

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The risk-free interest rate is based on the U.S. treasury security rate in effect as of the date of grant. The expected lives of options and the volatility are based on historical data of the Company.

The following table illustrates the effect on net loss and net loss per common share for the three months ended September 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to all outstanding stock option awards for periods presented prior to the Company’s adoption of SFAS 123R:

 

		Three months ended September 30, 2005
Net loss, as reported		$	1,959,690
Stock-based compensation expense determined
Under fair value methods for all stock options			156,000
Proforma net loss		$	2,115,690
Net loss per share:
Basic, as reported		$	0.22
Basic, pro forma		$	0.24

 

 

3. Loss per Share

The Company accounts for its income (loss) per common share according to SFAS No. 128, Earnings Per Share. Under the provisions of SFAS No. 128, primary and fully diluted earnings per share are replaced with basic and diluted earnings per share. Basic earnings per share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding, and does not include the impact of any potentially dilutive common stock equivalents. Common stock equivalents, including warrants to purchase the Company's common stock and common stock issuable upon the conversion of notes payable, are excluded from the calculations when their effect is antidilutive. Basic weighted average shares outstanding for the year ended June 30, 2005 have been adjusted to reflect the exchange ratio contained in the merger transaction dated July 28, 2005. At June 30, 2006 and 2005, the calculation of diluted weighted average shares does not include preferred stock, options, or warrants that are potentially convertible into common stock as those would be antidilutive due to the Company’s net loss position.

 

F-7

---

Securities that could be dilutive in the future as of September 30, 2006 and 2005 are as follows:

		September 30,
		2006			2005
Preferred stock			91,928			1,260,732
Preferred stock warrants			173,292			224,300
Common stock warrants			4,768,563			354,627
Common stock options			3,436,176			2,310,046
Convertible debentures			109,639			997,078
Total potential dilutive securities			8,579,598			5,146,783

 

4. Risks and Uncertainties

The Company’s financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of liabilities and commitments in the normal course of business. However, our large operating losses and accumulated deficit, among other things, raise substantial doubt about our ability to continue as a going concern. Management plans to raise additional financing (including the sale of additional equity or borrowings) and grow the revenues of our core product while continually analyzing other market opportunities. However, no assurance can be given that such financing will be completed on terms acceptable to the Company or that the Company will be able to meet its revenue targets. If the Company is unable to obtain additional financing and grow revenues, we may have to curtail our business or cease operations. The financial statements do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

5. Return of Subscription Receivable Shares

The Company had previously entered into Purchase Agreements with Mercatus & Partners, Limited, a United Kingdom private limited company (“Mercatus”) in December 2005 that permitted Mercatus to purchase 1,748,146 shares of common stock subject to the receipt of funding. As no funding had been received, on May 18, 2006, the Company requested the return of the share certificates. After significant delay and the Company’s attainment of a court order, the share certificates were returned. On August 8, 2006, the share certificates were cancelled and the Purchase Agreements were terminated. The Company then reversed the subscription receivable and the related entry to additional paid-in capital.

6. August 2006 Stock Purchase Agreement

On August 17, 2006, the Company sold certain shares of its common stock and warrants to purchase common stock pursuant to a Common Stock and Warrant Purchase Agreement (the "Purchase Agreement") dated August 9, 2006. The securities were issued to 25 accredited investors pursuant to the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. MicroCapital, LLC acted as the lead investor for the transaction. Net proceeds of $4.7 million was received by the Company in exchange for the issuance of 2,063,000 shares of common stock and warrants to purchase 2,063,000 shares of common stock. In addition, brokers assisting the Company with the capital raise were issued warrants to purchase 206,300 shares of common stock on identical terms as the warrants issued to investors. If all warrants were exercised, the Company would receive $6,808,500.

 

F-8

---

Pursuant to the Purchase Agreement, the purchase price per share of the Company’s common stock was $2.50, and the accompanying warrants were issued with an exercise price of $3.00 per share. The warrants and the Purchase Agreement contain anti-dilution provisions, including one providing that, if the Company issues stock or rights to acquire stock at a price less than $2.00 (excluding certain issuances such as options to employees, directors and certain consultants and shares issued in connection with licensing or leasing transactions), the Company is required to issue to each investor additional shares equal to 25% of what such investor purchased in the original transaction. The warrants are exercisable by the holder (subject to anti-dilution and adjustment provisions) for a period of five years from the date of issuance. The warrants are callable by the Company for 45 days after a period of 60 trading days in which the price of the underlying stock exceeds $4.50 per share for 30 of the 60 days, and only if a registration statement covering the underlying shares is effective.

In connection with the Purchase Agreement, the Company also entered into a Registration Rights Agreement whereby the Company has agreed to file a registration statement to cover the re-sale of the shares of common stock sold and issuable upon exercise of the warrants. Under the Registration Rights Agreement, the Company has agreed to file the registration statement within 60 days of the closing, cure any defect causing the registration statement to fail to be effective within 10 business days, and cause suspension periods for the registration statement to not exceed 60 days in any 360 day period. If the Company fails to comply with these provisions, the Company will be required to pay as liquidated damages an amount equal to 2% of the aggregate purchase price paid by the investors for each 30 day period during which the failure continues, not to exceed 10% of the aggregate purchase price. A Form SB-2 Registration Statement to register these shares was filed with the SEC on October 16, 2006 and amended on October 19, 2006 and is currently pending SEC review.

7. Settlement Agreements with Former Executives

In September 2006, the Company entered into a settlement agreement with a former executive. As part of the settlement the Company agreed to pay the former executive $100,000 in September 2006 and $215,000 in January 2007.

Also in September 2006, the Company reached a preliminary settlement agreement, subject to approval of the Board of Directors, with its former Chief Financial Officer. The preliminary settlement calls for payments totaling $288,000, with the timing of these payments under negotiation.

8. Subsequent Event

Supply Contract

On October 6, 2006, IsoRay Medical, Inc., the wholly owned subsidiary of the Registrant, entered into a Contract with FSUE "SSE - Research Institute of Atomic Reactors" ("RIAR") in Russia. The Contract provides for delivery to IsoRay Medical of purified Cs-131 isotope, which is used by IsoRay Medical to produce its proprietary Cs-131 brachytherapy seed used in the treatment of prostate cancer. The total value of the Contract over its term, which expires on May 1, 2014, is $6,300,000. Delivery of the isotope is scheduled to commence in January 2007 and continue through December 2013, upon submission of written orders by IsoRay Medical forty-five days in advance of the planned date of delivery.

 

F-9

---

IsoRay Medical also entered into an Agreement for Exclusive Right to Buy on October 6, 2006 with RIAR. This Agreement gives IsoRay Medical the exclusive right to purchase the Cs-131 isotope produced by RIAR for a period of seven years, or through October 6, 2013.

 

F-10

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Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

IsoRay, Inc.

Richland, Washington

We have audited the accompanying consolidated balance sheets of IsoRay, Inc. and Subsidiary (“the Company”) (see Note 1) as of June 30, 2006 and 2005, and the related consolidated statements of operations, changes in shareholders’ equity (deficit) and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion the financial statements referred to above present fairly, in all material respects, the consolidated financial position of IsoRay, Inc. and Subsidiary as of June 30, 2006 and 2005, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the financial statements, certain conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 3. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

 

/s/ DeCoria, Maichel & Teague, P.S.

Spokane, Washington

September 26, 2006

F-11

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IsoRay, Inc. and Subsidiary

Consolidated Balance Sheets

		June 30,
		2006			2005
ASSETS
Current assets:
Cash and cash equivalents		$	2,207,452		$	1,653,144
Accounts receivable, net of allowance for doubtful accounts
of $85,183 and $17,075, respectively			596,447			49,969
Inventory			161,381			81,926
Prepaid expenses			161,546			181,266
Total current assets			3,126,826			1,966,305
Fixed assets, net of accumulated depreciation			1,642,293			842,323
Deferred financing costs, net of accumulated amortization			274,358			548,837
Licenses, net of accumulated amortization			273,475			18,656
Other assets, net of accumulated amortization			338,987			226,263
Total assets		$	5,655,939		$	3,602,384
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable and accrued expenses		$	584,296		$	695,588
Accrued payroll and related taxes			614,645			157,924
Accrued interest payable			11,986			41,325
Notes payable, due within one year			51,351			43,116
Capital lease obligations, due within one year			183,554			9,604
Convertible debentures payable, due within one year			455,000			-
Total current liabilities			1,900,832			947,557
Notes payable, due after one year			581,557			562,224
Capital lease obligations, due after one year			220,415			19,584
Convertible debentures payable, due after one year			-			3,587,875
Asset retirement obligation			67,425			-
Total liabilities			2,770,229			5,117,240
Shareholders' equity (deficit):
Preferred stock, $.001 par value; 6,000,000 shares authorized:
Series A: 1,000,000 shares allocated; no shares issued and outstanding			-			-
Series B: 5,000,000 shares allocated; 144,759 and 1,338,167 shares issued and
outstanding			145			1,338
Common stock, $.001 par value; 194,000,000 and 100,000,000 shares authorized;
15,157,901 and 6,163,623 shares issued and outstanding			15,158			6,164
Subscriptions receivable			(6,122,007	)		-
Additional paid-in capital			22,538,675			3,805,773
Accumulated deficit			(13,546,261	)		(5,328,131	)
Total shareholders' equity (deficit)			2,885,710			(1,514,856	)
Total liabilities and shareholders' equity (deficit)		$	5,655,939		$	3,602,384

 

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

 

F-12

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IsoRay, Inc. and Subsidiary

Consolidated Statements of Operations

 

		Year ended June 30,
		2006			2005
Product sales		$	1,994,306		$	201,731
Cost of product sales			3,815,122			1,474,251
Gross loss			(1,820,816	)		(1,272,520	)
Operating expenses:
Research and development			450,425			137,532
Sales and marketing expenses			1,420,500			701,822
General and administrative expenses			3,503,522			1,871,325
Total operating expenses			5,374,447			2,710,679
Operating loss			(7,195,263	)		(3,983,199	)
Non-operating income (expense):
Interest income			51,744			2,394
Financing expense			(689,100	)		(167,493	)
Loss on disposal of fixed assets			-			(120,890	)
Debt conversion expense (Note 11)			(385,511	)		-
Non-operating income (expense), net			(1,022,867	)		(285,989	)
Net loss		$	(8,218,130	)	$	(4,269,188	)
Basic loss per share		$	(0.68	)	$	(0.78	)
Shares used in computing net loss per share:
Basic			12,051,964			5,470,046

 

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

 

F-13

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IsoRay, Inc. and Subsidiary

Consolidated Statements of Changes in Shareholders’ Equity (Deficit)

		IsoRay, Inc. (MN) (1)																		IsoRay Medical, Inc.
		Series B Preferred Stock						Common Stock						IsoRay, Inc. (WA) Common Stock  (2)						Series B Preferred Stock						Common Stock
		Shares			Amount			Shares			Amount			Shares			Amount			Shares			Amount			Shares			Amount			Subscriptions Receivable			Additional Paid-in Capital			Accumulated Deficit			Total
Balances at June 30, 2004			-		$	-			-		$	-			2,767,700		$	2,768			-		$	-			8,424		$	8		$	-		$	1,369,910		$	(1,058,943	)	$	313,743
Issuance of IsoRay, Inc. (WA) common shares pursuant to exercise of options															71,580			71																		71,509						71,580
Issuance of IsoRay, Inc. (WA) common shares as compensation															57,025			57																		56,968						57,025
Issuance of IsoRay Products LLC member shares for cash, net of offering costs																																				303,743						303,743
Merger of IsoRay, Inc (WA) and IsoRay Products LLC into IsoRay Medical, Inc.															(2,896,305	)		(2,896	)		1,249,832			1,249			5,195,205			5,196						(3,549	)					-
Reversal of dividends accrued by IsoRay Products LLC																																				91,765						91,765
Issuance of IsoRay Medical, Inc. common shares for cash pursuant to private
placement, net of offering costs																											644,828			645						1,355,933						1,356,578
Issuance of IsoRay Medical, Inc. common shares pursuant to exercise of warrants
granted in connection with private placement																											109,296			109						64,766						64,875
Issuance of IsoRay Medical, Inc. common shares as inducement for guarantee of debt																											177,856			178						348,203						348,381
Issuance of IsoRay Medical, Inc. common shares as partial payment for laser
welding stations																											25,526			26						49,974						50,000
Issuance of Series B preferred shares pursuant to exercise of warrants																					90,823			91												96,651						96,742
Exchange of Series B preferred shares for IsoRay Medical, Inc. common shares																					(2,488	)		(2	)		2,488			2						-						-
Payments to common shareholders in lieu of issuing fractional shares																																				(100	)					(100	)
Net loss																																							(4,269,188	)		(4,269,188	)
Balances at June 30, 2005			-			-			-			-			-			-			1,338,167			1,338			6,163,623			6,164			-			3,805,773			(5,328,131	)		(1,514,856	)
Merger of IsoRay, Inc. (formerly Century Park Pictures Corporation) and
IsoRay Medical, Inc., net of fractional shares paid in cash (see Note 1)			1,338,132			1,338			6,163,518			6,164									(1,338,167	)		(1,338	)		(6,163,623	)		(6,164	)											-
Common stock held by shareholders of Century Park Picture Corporation
after the reverse acquisition									2,498,534			2,499																								8,733						11,232
Issuance of common shares as payment for merger consulting services									168,472			169																								329,831						330,000
Payments to shareholders in lieu of issuing fractional shares																																				(734	)					(734	)
Issuance of preferred stock pursuant to exercise of warrants			8,708			8																														6,977						6,985
Issuance of preferred stock pursuant to exercise of warrants paid by surrending
a partial note payable			44,788			45																														48,268						48,313
Issuance of common stock pursuant to exercise of warrants									84,147			84																								49,866						49,950
Issuance of common stock pursuant to exercise of options									101,284			101																								119,476						119,577
Conversion of preferred stock to common stock			(1,246,869	)		(1,246	)		1,246,869			1,246																														-
Exchange of convertible debentures payable to common stock									911,271			911																								3,681,964						3,682,875
Issuance of warrants pursuant to short-term inducement to convert debentures																																				385,511						385,511
Issuance of warrants as inducement for note payable from shareholder (see Note 9)																																				60,000						60,000
Issuance of common stock pursuant to the October 2005 private
placement, net of offering costs									1,500,000			1,500																								5,406,626						5,408,126
Issuance of common stock pursuant to the February 2006 private
placement, net of offering costs									268,889			269																								1,107,955						1,108,224
Issuance of common stock to Mercatus subject to a subscription
receivable agreement									1,748,146			1,748																					(6,122,007	)		6,120,259						-
Issuance of common stock for payment of invoices									39,007			39																								184,996						185,035
Issuance of common stock pursuant to the June 2006 warrant
exercise solicitation, net of offering costs									427,764			428																								1,223,174						1,223,602
Net loss																																							(8,218,130	)		(8,218,130	)
Balances at June 30, 2006			144,759		$	145			15,157,901		$	15,158			-		$	-			-		$	-			-		$	-		$	(6,122,007	)	$	22,538,675		$	(13,546,261	)	$	2,885,710

 

1. IsoRay, Inc (MN) is the current registrant (formerly Century Park Pictures Corporation) and a Minnesota corporation.

2. IsoRay, Inc. (WA) is a former Washington corporation which was merged into IsoRay Medical, Inc. in fiscal year 2005.

 

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

 

F-14

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IsoRay, Inc. and Subsidiary

Consolidated Statements of Cash Flows

		Year ended June 30,
		2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss		$	(8,218,130	)	$	(4,269,188	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization of fixed assets			271,060			140,099
Amortization of deferred financing costs and other assets			384,266			82,358
Accretion of asset retirement obligation			4,385			-
Loss on disposal of fixed assets			-			120,890
Merger consulting fees paid by issuance of common stock			330,000			-
Consulting and repair fees paid by issuance of common stock			39,750			57,025
Rent expense paid by issuance of common stock			90,026			-
Debt conversion expense (Note 11)			385,511			-
Changes in operating assets and liabilities:
Accounts receivable, net			(546,478	)		(49,969	)
Inventory			(79,455	)		(62,200	)
Prepaid expenses			41,252			(104,133	)
Accounts payable and accrued expenses			(132,646	)		566,567
Accrued payroll and related taxes			456,721			99,914
Accrued interest payable			(29,339	)		33,090
Net cash used by operating activities			(7,003,077	)		(3,385,547	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of fixed assets			(474,795	)		(724,029	)
Additions to licenses and other assets			(395,201	)		(431,438	)
Cash acquired in reverse acquisition (Note 1)			32,587			-
Net cash used by investing activities			(837,409	)		(1,155,467	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of notes payable, net of financing costs			646,542			315,000
Proceeds from sales of convertible debentures payable			550,000			3,587,875
Principal payments on notes payable			(592,790	)		(23,653	)
Principal payments on capital lease obligations			(124,688	)		(2,914	)
Proceeds from cash sales of common shares pursuant to private placement, net of offering costs			6,516,350			1,847,511
Proceeds from cash sales of preferred stock, pursuant to exercise of warrants			6,985			-
Proceeds from cash sales of common stock, pursuant to exercise of warrants			49,950			-
Proceeds from cash sales of common stock, pursuant to exercise of options			119,577			-
Proceeds from cash sales of common stock, pursuant to June 2006 warrant exercises			1,223,602			-
Payments to common shareholders in lieu of issuing fractional shares			(734	)		(100	)
Net cash provided by financing activities			8,394,794			5,723,719
Net increase in cash and cash equivalents			554,308			1,182,705
Cash and cash equivalents, beginning of period			1,653,144			470,439
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	2,207,452		$	1,653,144
Supplemental disclosures of cash flow information:
Cash paid for interest		$	361,832		$	57,657
Non-cash investing and financing activities:
Exchange of convertible debentures payable for shares of common stock		$	3,682,875		$	-
Fixed assets acquired by capital lease obligations			507,947			32,102
Increase in PP&E related to asset retirement obligation			63,040
Issuance of common shares as partial payment for production equipment			25,248			50,000
Issuance of common shares as partial payment of notes payable			48,313			-
Liabilities acquired in acquisition			21,355			-
Prepaid rent paid by issuance of common stock			120,036			-
Issuance of warrants as an inducement for a note payable			60,000			-
Issuance of preferred shares for debt reduction			-			46,007
Issuance of common shares as compensation for guarantee of debt			-			348,381
Reversal of dividends payable to IsoRay Products LLC members			-			(91,765	)

 

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

 

F-15

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IsoRay, Inc.

Notes to Consolidated Financial Statements

For the years ended June 30, 2006 and 2005

1. Organization

Historical Organization

Century Park Pictures Corporation (“Century”) was organized under Minnesota law in 1983. Century is a public company subject to the periodic reporting requirements of the Securities Exchange Act of 1934.

 

Century had no operations since its fiscal year ended September 30, 1999 through June 30, 2005.

Merger Transaction

On May 27, 2005, IsoRay Medical, Inc. (“Medical”) entered into a merger agreement with Century to merge with Century’s newly-formed, wholly-owned subsidiary.

On July 28, 2005, the merger transaction closed. As a result of the merger, Medical became a wholly-owned subsidiary of Century, which concurrently changed its name to IsoRay, Inc. (“IsoRay” or “the Company”).

IsoRay issued shares of its common and preferred stock to the holders of common and preferred stock of Medical at a rate of 0.842362 share of IsoRay’s stock for each share of Medical’s stock. Options and warrants to purchase common and preferred stock of Medical were also converted at the same rate into options and warrants to purchase common and preferred stock of IsoRay, Inc. On a fully-diluted basis, Medical’s shareholders owned approximately 82% of IsoRay’s outstanding securities.

Management believes the transaction was structured to qualify as a non-taxable reorganization under Section 368(a)(1)(A) of the Internal Revenue Code of 1986, as amended.

Financial Presentation

Medical, a Delaware corporation, was incorporated effective June 15, 2004 to develop, manufacture and sell isotope-based medical products and devices for the treatment of cancer and other diseases. Medical is headquartered in Richland, Washington.

Medical was formed for the purpose of combining the operations of IsoRay, Inc. (a former Washington corporation) (“IsoRay (WA)”) and its subsidiary, IsoRay Products LLC, two companies that shared common ownership and management with Medical. Medical’s management initiated a merger transaction effective October 1, 2004, in order to accomplish the combining of operations.

Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, requires that following a merger the accounting acquirer’s financial statements should be used for historical comparisons. Although the legal acquirer was Century, for accounting purposes Medical was the acquirer and as such Medical’s historical financial statements are shown for comparative purposes. Also for accounting purposes, the merger was accounted for as though it happened on July 1, 2005.

As part of the reverse merger, Medical acquired cash of $32,587 and accounts payable of $21,355.

 

F-16

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2. Summary of Significant Accounting Policies

Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary (collectively the “Company”). All significant intercompany accounts and transactions have been eliminated.

Basis of Presentation

During the fourth quarter of fiscal year 2005, Medical’s management determined that Medical had emerged from the development stage, inasmuch as its planned principal operations had commenced. Prior to that time, Medical’s activities had consisted primarily of conducting research and development and soliciting equity and debt financing. Accordingly, the Company’s financial statements are no longer presented as those of a development stage enterprise as they were in prior periods, as prescribed by Statement of Financial Accounting Standards (SFAS) No. 7, Accounting and Reporting by Development Stage Enterprises.

Cash Equivalents

The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents.

Accounts Receivable

Accounts receivable are stated at the amount that management of the Company expects to collect from outstanding balances. Management provides for probable uncollectible amounts through an allowance for doubtful accounts. Additions to the allowance for doubtful accounts are based on management’s judgment, considering historical write-offs, collections and current credit conditions. Balances which remain outstanding after management has used reasonable collection efforts are written off through a charge to the allowance for doubtful accounts and a credit to the applicable accounts receivable. Payments received subsequent to the time that an account is written off are considered bad debt recoveries.

Inventory

Inventory is reported at the lower of cost or market, determined using the weighted average method, or net realizable value.

Fixed Assets

Fixed assets are carried at the lower of cost or net realizable value. Production equipment with a cost of $2,500 or greater, and other fixed assets with a cost of $1,000 or greater are capitalized. Major betterments that extend the useful lives of assets are also capitalized. Normal maintenance and repairs are charged to expense as incurred. When assets are sold or otherwise disposed of, the cost and accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in operations.

Depreciation is computed using the straight-line method over the following estimated useful lives:

 

Production equipment	7 years
Office equipment	5 years
Furniture and fixtures	5 years

                                

F-17

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Leasehold improvements and capital lease assets are amortized over the shorter of the life of the lease or the estimated life of the asset.

The Company has adopted the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The provisions of SFAS No. 144 require that an impairment loss be recognized when the estimated future cash flows (undiscounted and without interest) expected to result from the use of an asset are less than the carrying amount of the asset. Measurement of an impairment loss is based on the estimated fair value of the asset if the asset is expected to be held and used.

Management of the Company periodically reviews the net carrying value of all of its equipment on an asset by asset basis. These reviews consider the net realizable value of each asset, as measured in accordance with the preceding paragraph, to determine whether an impairment in value has occurred, and the need for any asset impairment write-down.

Although management has made its best estimate of the factors that affect the carrying value based on current conditions, it is reasonably possible that changes could occur which could adversely affect management's estimate of net cash flows expected to be generated from its assets, and necessitate asset impairment write-downs.

Deferred Financing Costs

Financing costs related to the acquisition of debt are deferred and amortized over the term of the related debt using the effective interest method. Deferred financing costs include the fair value of shares issued to certain shareholders for their guarantee of certain Company debt (see Notes 8 and 9). Amortization of deferred financing costs, totaling $296,608 and $76,746 for the years ended June 30, 2006 and 2005, respectively, is included in financing expense on the statements of operations.

Licenses

Amortization of licenses is computed using the straight-line method over the estimated economic useful lives of the assets. In fiscal year 2006, the Company entered into an agreement with IBt, SA, a Belgian company (“IBt”) to use IBt’s proprietary “Ink Jet” production process and paid to IBt $275,000. The IBt license is being amortized over the 15 year term of the license. Amortization of licenses was $20,530 and $2,674 for the years ended June 30, 2006 and 2005, respectively.

The Company periodically reviews the carrying values of licenses in accordance with SFAS No. 144 and any impairments are recognized when the expected future operating cash flows to be derived from such assets are less than their carrying value.

Based on the licenses recorded at June 30, 2006, and assuming no subsequent impairment of the underlying assets, the annual amortization expense for each fiscal year ended June 30th, is expected to be as follows: $20,224 for 2007, $20,224 for 2008, $20,224 for 2009, $18,600 for 2010, and $18,333 for 2010.

Other Assets

Other assets, which include deferred charges and patents, are stated at cost, less accumulated amortization. Amortization of patents is computed using the straight-line method over the estimated economic useful lives of the assets. The Company periodically reviews the carrying values of patents in accordance with SFAS No. 144 and any impairments are recognized when the expected future operating cash flows to be derived from such assets are less than their carrying value.

 

F-18

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Based on the patents and other intangible assets recorded in other assets at June 30, 2006, and assuming no subsequent impairment of the underlying assets, the annual amortization expense for each fiscal year ended June 30th, is expected to be as follows: $10,790 for 2007, $4,826 for 2008, $1,843 for 2009, $1,843 for 2010, and $1,843 for 2010.

Asset Retirement Obligation

SFAS No. 143, Asset Retirement Obligations, establishes standards for the recognition, measurement and disclosure of legal obligations associated with the costs to retire long-lived assets. Accordingly, under SFAS No. 143, the fair value of the future retirement costs of the Company’s leased assets are recorded as a liability on a discounted basis when it is incurred and an equivalent amount is capitalized to property and equipment. The initial recorded obligation, which has been discounted using the Company’s credit-adjusted risk free-rate, will be reviewed periodically to reflect the passage of time and changes in the estimated future costs underlying the obligation. The Company amortizes the initial amount capitalized to property and equipment and recognizes accretion expense in connection with the discounted liability over the estimated remaining useful life of the leased assets.

During the years ended June 30, 2006 and 2005, the asset retirement obligation changed as follows:

		2006
Beginning balance		$	-
New obligations			63,040
Accretion of discount			4,385
Ending balance		$	67,425

Financial Instruments

The Company discloses the fair value of financial instruments, both assets and liabilities, recognized and not recognized in the balance sheet, for which it is practicable to estimate the fair value. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than a forced liquidation sale.

The carrying amounts of financial instruments, including cash and cash equivalents; accounts receivable; accounts payable; notes payable; capital lease obligations; and convertible debentures payable, approximated their fair values at June 30, 2006 and 2005.

Revenue Recognition

The Company applies the provisions of SEC Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. SAB No. 104, which supersedes SAB No. 101, Revenue Recognition in Financial Statements, provides guidance on the recognition, presentation and disclosure of revenue in financial statements. SAB No. 104 outlines the basic criteria that must be met to recognize revenue and provides guidance for the disclosure of revenue recognition policies. The Company recognizes revenue related to product sales when (i) persuasive evidence of an arrangement exists, (ii) shipment has occurred, (iii) the fee is fixed or determinable, and (iv) collectibility is reasonably assured.

 

F-19

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Revenue for the fiscal years ended June 30, 2006 and 2005 was derived solely from sales of the ¹³¹Cs brachytherapy seed, which is used in the treatment of cancer. The Company recognizes revenue once an order has been received and shipped to the customer. Prepayments, if any, received from customers prior to the time that products are shipped are recorded as deferred revenue. In these cases, when the related products are shipped, the amount recorded as deferred revenue is recognized as revenue. The Company accrues for sales returns and other allowances at the time of shipment.

Stock-Based Compensation

SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, requires companies to recognize stock-based expense based on the estimated fair value of employee stock options. Alternatively, SFAS No. 123 allows companies to retain the current approach set forth in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), provided that expanded footnote disclosure is presented. The Company has not adopted the fair value method of accounting for stock-based compensation under SFAS No. 123, but provides the pro forma disclosure required when appropriate (see Note 12).

Research and Development Costs

Research and development costs, including salaries, research materials, administrative expenses and contractor fees, are charged to operations as incurred. The cost of equipment used in research and development activities which has alternative uses is capitalized as part of fixed assets and not treated as an expense in the period acquired. Depreciation of capitalized equipment used to perform research and development is classified as research and development expense in the year computed.

Advertising and Marketing Costs

Advertising and marketing costs are expensed as incurred except for the cost of tradeshows which are deferred until the tradeshow occurs.

Shipping and Handling Costs

Shipping and handling costs are expensed as incurred and included in cost of product sales.

Legal Contingencies

In the ordinary course of business, the Company is involved in legal proceedings involving contractual and employment relationships, product liability claims, patent rights, and a variety of other matters. The Company records contingent liabilities resulting from asserted and unasserted claims against it, when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. The Company discloses contingent liabilities when there is a reasonable possibility that the ultimate loss will exceed the recorded liability. Estimating probable losses requires analysis of multiple factors, in some cases including judgments about the potential actions of third-party claimants and courts. Therefore, actual losses in any future period are inherently uncertain. Currently, the Company does not believe any probable legal proceedings or claims will have a material impact on its financial position or results of operations. However, if actual or estimated probable future losses exceed the Company’s recorded liability for such claims, it would record additional charges as other expense during the period in which the actual loss or change in estimate occurred.

 

F-20

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Income Taxes

Income taxes are accounted for under the liability method. Under this method, the Company provides deferred income taxes for temporary differences that will result in taxable or deductible amounts in future years based on the reporting of certain costs in different periods for financial statement and income tax purposes. This method also requires the recognition of future tax benefits such as net operating loss carryforwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period that includes the enactment of the change.

Income (Loss) Per Common Share

The Company accounts for its income (loss) per common share according to SFAS No. 128, Earnings Per Share. Under the provisions of SFAS No. 128, primary and fully diluted earnings per share are replaced with basic and diluted earnings per share. Basic earnings per share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding, and does not include the impact of any potentially dilutive common stock equivalents. Common stock equivalents, including warrants to purchase the Company's common stock and common stock issuable upon the conversion of notes payable, are excluded from the calculations when their effect is antidilutive. Basic weighted average shares outstanding for the year ended June 30, 2005 have been adjusted to reflect the exchange ratio contained in the merger transaction dated July 28, 2005 (see Note 1). At June 30, 2006 and 2005, the calculation of diluted weighted average shares does not include preferred stock, options, or warrants that are potentially convertible into common stock as those would be antidilutive due to the Company’s net loss position.

Securities that could be dilutive in the future as of June 30, 2006 and 2005 are as follows:

		2006			2005
Preferred stock			144,759			1,338,167
Preferred stock warrants			179,512			233,008
Common stock warrants			2,502,769			136,158
Common stock options			3,129,692			2,237,802
Convertible debentures			109,639			864,548
Total potential dilutive securities			6,066,371			4,809,683

Use of Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management of the Company to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Accordingly, actual results could differ from those estimates and affect the amounts reported in the financial statements.

Reclassification Entries

Certain reclassifications, primarily the separate disclosure of deferred financing costs and licenses, have been made to the 2005 financial statements to conform to the presentation in the 2006 financial statements.

 

F-21

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3. Risks and Uncertainties 

The Company’s financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of liabilities and commitments in the normal course of business. However, our large operating losses and accumulated deficit, among other things, raise substantial doubt about our ability to continue as a going concern. Management plans to raise additional financing (including the sale of additional equity or borrowings) and grow the revenues of our core product while continually analyzing other market opportunities. However, no assurance can be given that such financing will be completed on terms acceptable to the Company or that the Company will be able to meet its revenue targets. If the Company is unable to obtain additional financing and grow revenues, we may have to curtail our business or cease operations. The financial statements do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

4. Inventory

Inventory consists of the following at June 30, 2006 and 2005:

		2006			2005
Raw materials		$	61,531		$	27,659
Work in process			67,906			54,267
Finished goods			31,944			–
		$	161,381		$	81,926

The cost of materials and production costs contained in inventory that are not useable due to the passage of time, and resulting loss of bio-effectiveness, are written off to cost of product sales at the time it is determined that the product is not useable. It is not possible to determine what portion of cost of product sales is represented by “spoilage.”

5. Prepaid Expenses

Prepaid expenses consist of the following at June 30, 2006 and 2005:

		2006			2005
Prepaid contract work		$	7,913		$	65,328
Prepaid insurance			21,340			15,853
Prepaid rent			30,009			–
Other prepaid expenses			102,284			100,085
		$	161,546		$	181,266

 

6. Fixed Assets

Fixed assets consist of the following at June 30, 2006 and 2005:

		2006			2005
Production equipment		$	590,908		$	399,448
Office equipment			70,060			31,028
Furniture and fixtures			100,653			7,736
Leasehold improvements			652,404			138,692
Capital lease assets (a)			599,738			34,049
Construction in progress			34,254			366,034
			2,048,017			976,987
Less accumulated depreciation			(405,724	)		(134,664	)
		$	1,642,293		$	842,323

 

F-22

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(a) June 30, 2006 balance includes asset retirement addition of $63,040.

Depreciation and amortization expense related to fixed assets totaled $271,060 and $140,099 for 2006 and 2005, respectively. Accumulated amortization of capital lease assets totaled $55,644 at June 30, 2006.

7. Other Assets

Other assets, net of accumulated amortization, consist of the following at June 30, 2006 and 2005:

		2006			2005
Deferred charges		$	318,885		$	204,649
Patents and trademarks, net of accumulated amortization of $13,831 and $12,318			20,102			21,614
		$	338,987		$	226,263

Deferred charges consist of prepaid legal fees for patents which have not yet been obtained, and prepayments and deposits on fixed assets and contracts. Amortization of patents and trademarks was $1,513 and $2,938 for the years ended June 30, 2006 and 2005, respectively.

8. Bank Line of Credit

The Company has a $375,000 revolving line of credit with Columbia River Bank that expires on March 1, 2007. Amounts outstanding under the line bear interest at the bank’s reference rate (Wall Street Journal Prime Rate, which was 8.25% at June 30, 2006) plus 2.0%. The line of credit is collateralized by all accounts receivable and inventory, and is personally guaranteed by certain shareholders up to $375,000 (see Note 12). The Company had no borrowings under the line of credit at June 30, 2006.

9. Notes Payable

Notes payable consist of the following at June 30, 2006 and 2005:

		2006			2005
Tri-City Industrial Development Council
(TRIDEC) note payable (a)		$	10,000		$	20,000
Benton-Franklin Economic Development
District (BFEDD) note payable (b)			204,237			222,693
Columbia River Bank note payable (c)			–			43,654
Convertible notes payable (d)			–			318,993
Hanford Area Economic Investment Fund
Committee (HAEIFC) note payable (e)			418,671			–
			632,908			605,340
Less amounts due within one year			(51,351	)		(43,116	)
Amounts due after one year		$	581,557		$	562,224

 

F-23

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(a)

This is a non-interest bearing note, due in annual installments of $10,000, maturing August 2006. The note payable to TRIDEC bears no interest, but has not been discounted because the note was exchanged solely for cash.

(b)

The note payable to BFEDD, which is collateralized by substantially all of the Company’s assets, and guaranteed by certain shareholders, was executed pursuant to a Development Loan Agreement. The note contains certain restrictive covenants relating to: working capital; levels of long-term debt to equity; incurrence of additional indebtedness; payment of compensation to officers and directors; and payment of dividends. The note is payable in monthly installments including interest at 8.0% per annum with a final balloon payment due in October 2009. At June 30, 2006, the Company was not in compliance with certain of the covenants. The Company has obtained a waiver from BFEDD, relating to these covenants, through June 30, 2007.

(c)

During fiscal year 2006, the Company repaid the note payable to Columbia River Bank from cash on hand.

(d)

The merger agreement between Medical, IsoRay (WA), and IsoRay Products LLC (see Note 1) provided the former note holders of IsoRay Products LLC with the option of exchanging their notes for IsoRay Medical, Inc. Series A preferred shares, or receiving IsoRay Medical, Inc. notes payable with substantially the same terms and conditions as their IsoRay Products LLC notes. None of the IsoRay Products LLC note holders elected to receive IsoRay Medical, Inc. Series A preferred shares. Accordingly, all the note holders (i.e., investors) were issued convertible notes. Note holders can convert principal and accrued interest on their outstanding balances into Series B preferred shares by exercising the warrants that were issued to them in connection with the merger (see Note 1). The notes accrued interest at 10%, which was paid quarterly, and were scheduled to mature in 2006 and 2007. All of the notes were converted into preferred shares or repaid during 2006.

(e)

In June 2006, the Company entered into a note payable with HAEIFC, which is collateralized by receivables, inventory, equipment, and certain life insurance policies. The total note payable facility is for $1.4 million and is to be used to purchase production equipment. In June 2006, the Company requested an initial disbursement of approximately $400,000. The note contains certain restrictive covenants relating to: financial ratios; payment of compensation to officers and directors; and payment of dividends. The note accrues interest at 9% and is payable in monthly installments with the final installment due in July 2016.

On October 14, 2005, the Company borrowed $250,000 under a short-term note payable from a shareholder who was later appointed to the Board of Directors in April 2006. The note, which bore interest at the rate of 10.0%, was paid in full on its due date of December 1, 2005. In connection with the loan, the Company granted a warrant to purchase 12,500 shares of common stock at an aggregate total exercise price of $10. The Company recorded financing expenses of $60,000 related to the issuance of these warrants.

Principal maturities on notes payable are due as follows:

Year ending June 30,
2007		$	51,351
2008			49,072
2009			53,593
2010			179,068
2011			38,204
Thereafter			261,620
		$	632,908

F-24

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10. Capital Lease Obligations

The Company leases certain equipment under long-term agreements that represent capital leases. Future minimum lease payments under capital lease obligations are as follows:

Year ending June 30,
2007		$	232,336
2008			215,057
2009			27,627
2010			–
2011			–
Thereafter			–
Total future minimum lease payments			475,020
Less amounts representing interest			(71,051	)
Present value of net minimum lease payments			403,969
Less amounts due in one year			(183,554	)
Amounts due after one year		$	220,415

 

11. Convertible Debentures Payable

Through June 30, 2005, the Company had sold $3,587,875 of convertible debentures pursuant to the January 31, 2005 Offering (see Note 12). In July 2005, the Company sold an additional $550,000 of these convertible debentures. The debentures, which bear interest at 8% and mature two years from the date of issuance (through June 2007), can be converted into shares of the Company’s common stock at a rate of $4.15 per share plus, at the discretion of the Company, either a cash payment for accrued interest, or that number of common shares equal to the amount of unpaid accrued interest at $4.15 per share.

After the debentures had been outstanding for six months, the Company could, at its option, prepay them, in whole or in part, by paying the principal and interest accrued through the date of the prepayment. If only a portion of the debenture is prepaid, a new debenture with substantially the same terms and conditions will be issued to the debenture holder for the remaining principal balance.

On December 13, 2005, the Board of Directors announced a short-term conversion inducement to current holders of the convertible debentures, originally issued in conjunction with the January 31, 2005 Private Placement Offering. Holders were permitted two conversion options: 1) convert under the original terms of the debenture to the Company’s common stock at a $4.15 conversion price, and register the newly issued shares in the Form SB-2 Registration Statement filed with the SEC on November 10, 2005, or 2) convert under terms essentially identical to those offered to purchasers of Units in the Offering of October 17, 2005 - a $4.00 conversion price and one callable warrant to purchase one share of the Company's common stock at an exercise price of $6.00 per share for each share issued upon conversion (waiving registration rights for approximately one year). As of June 30, 2006, holders of $3,682,875 of debentures had converted to common stock of the Company, responding to the inducement of the second exercise method described above. As of June 30, 2006, the Company had issued 911,271 shares of common stock (including approximately 23,840 incremental shares not previously available to holders of debentures under the original conversion terms), and 659,469 warrants to purchase shares of common, exercisable at $6.00 per share. As of June 30, 2006, the Company recognized $385,511 in non-cash short-term inducement expense, in accordance with SFAS No. 84.

 

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12. Shareholders’ Equity (Deficit)

The authorized capital structure of the Company consists of $.001 par value preferred stock and $.001 par value common stock.

Preferred Stock

The Company's Certificate of Incorporation authorizes 6,000,000 shares of $0.001 par value preferred stock available for issuance with such rights and preferences, including liquidation, dividend, conversion and voting rights, as described below.

Series A

Series A preferred shares are entitled to a 10% dividend annually on the stated par value per share. These shares are convertible into shares of common stock at the rate of one share of common stock for each share of Series A preferred stock, and are subject to automatic conversion into common stock upon the closing of an underwritten public offering pursuant to an effective registration statement under the Securities Act of 1933 covering the offer and sale of common stock in which the gross proceeds to the Company are at least $4 million. Series A preferred shareholders have voting rights equal to the voting rights of common stock, except that the vote or written consent of a majority of the outstanding preferred shares is required for any changes to the Company’s Certificate of Incorporation, Bylaws or Certificate of Designation, or for any bankruptcy, insolvency, dissolution or liquidation of the Company. Upon liquidation of the Company, the Company’s assets are first distributed ratably to the Series A preferred shareholders. At June 30, 2006, there were no Series A preferred shares outstanding.

Series B

Series B preferred shares are entitled to a cumulative 15% dividend annually on the stated par value per share. These shares are convertible into shares of common stock at the rate of one share of common stock for each share of Series B preferred stock, and are subject to automatic conversion into common stock upon the closing of an underwritten public offering pursuant to an effective registration statement under the Securities Act of 1933 covering the offer and sale of common stock in which the gross proceeds to the Company are at least $4 million. Series B preferred shareholders have voting rights equal to the voting rights of common stock, except that the vote or written consent of a majority of the outstanding preferred shares is required for any changes to the Company’s Certificate of Incorporation, Bylaws or Certificate of Designation, or for any bankruptcy, insolvency, dissolution or liquidation of the Company. Upon liquidation of the Company, the Company’s assets are first distributed ratably to the Series A preferred shareholders, then to the Series B preferred shareholders. At June 30, 2006, there were 144,759 Series B preferred shares outstanding and cumulative dividends in arrears were $39,356.

 

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In addition to the shares of common stock and Series B preferred stock issued pursuant to the merger transaction (see Note 1), the Company had the following transactions that affected shareholders’ equity (deficit) during the years ended June 30, 2006 and 2005.

IsoRay, Inc. June 2006 Warrant Exercise Solicitation

In June 2006, the Board of Directors approved a limited one-time discount of the exercise price of outstanding warrants (with exercise prices over $3.00) to $3.00 per share of common stock if the warrants were exercised on or before June 30, 2006.  The warrants were primarily held by investors who purchased them as part of the Company’s October 2005 and February 2006 private placement offerings. The Company issued 427,764 common shares and raised $1,223,602, net of offering costs, through this warrant exercise solicitation.

IsoRay, Inc. February 2006 Private Placement

On February 1, 2006 the Company commenced an offering of Investment Units (“Units”) for sale, pursuant to a Private Placement Offering (the “February 2006 Offering”), which management believes was exempt from registration under the Securities Act of 1933 ("the Act") pursuant to Section 4(2) of the Act and Rule 506 of Regulation D. The February 2006 Offering consisted of a maximum of 89 Units, each Unit consisting of 5,000 shares of common stock and a warrant to purchase 5,000 shares of common stock at an exercise price of $6.50 per share. The Units were sold for $22,500 per Unit. The Company closed this offering on February 24, 2006. Approximately $1.1 million, net of offering costs, was raised under the February 2006 Offering.

IsoRay, Inc. Subscriptions Receivable

On December 7, 2005, the Company entered into a SICAV ONE Securities Purchase Agreement and a SICAV TWO Securities Purchase Agreement (collectively, the "Purchase Agreements") with Mercatus & Partners, Limited, a United Kingdom private limited company ("Mercatus"). The Purchase Agreements permitted Mercatus to purchase 1,748,146 shares of the Company's common stock at a purchase price of $3.502 per share subject to receipt of funding. As no funding had been received, on May 18, 2006, the Company requested immediate return of the certificates representing all shares of common stock to which Mercatus had previously subscribed in accordance with the terms of the Purchase Agreements. The Purchase Agreements call for return of certificates within ten days if funding is not received within two days of receipt of the notice. After significant delay and the Company's attainment of a court order, the share certificates were returned. On August 8, 2006, the share certificates were cancelled and the Purchase Agreements were terminated (see Note 17).

IsoRay, Inc. October 2005 Private Placement

On January 30, 2006 the Company closed an offering of Units for sale, pursuant to a Private Placement Offering (“the October 2005 Offering”) of October 17, 2005, which management believes was exempt from registration under the Securities Act of 1933 ("the Act") pursuant to Section 4(2) of the Act and Rule 506 of Regulation D. The October 2005 Offering consisted of a maximum of 200 Units, each Unit consisting of 5,000 shares of common stock and a warrant to purchase 5,000 shares of common stock at an exercise price of $6.00 per share. This maximum was increased, pursuant to the terms of the October 2005 Offering, at the sole discretion of the Company, to a maximum of 300 Units. The Units were sold for $20,000 per Unit. Approximately $5.4 million, net of offering costs, was raised under the October 2005 Offering.

 

F-27

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IsoRay Medical, Inc. January 2005 Private Placement

In January 2005, Medical commenced an offering (“the January 2005 Offering”) of up to $2,000,000 of 8% convertible debentures (see Note 11) to accredited investors in a private placement, which management believes was exempt from registration under the Securities Act of 1933 ("the Act") pursuant to Section 4(2) of the Act and Rule 506 of Regulation D. On May 27, 2005, Medical amended and restated the January 2005 Offering to increase the maximum amount of the offering to $4,150,000.

Through June 30, 2005, Medical sold debentures totaling $3,587,875. In connection with the sales of these debentures, Medical paid commissions totaling $216,783 and legal expenses totaling $56,470, which amounts have been recorded as deferred financing costs.

In July 2005, Medical sold an additional $550,000 of debentures pursuant to this offering. The sale of these additional debentures was not subject to payment of commissions.

In 2006, $3,682,875 of the debentures were converted to common stock pursuant to a short-term conversion inducement (see Note 11).

IsoRay Medical, Inc. October 2004 Private Placement

In October 2004, Medical commenced an offering (“the October 2004 Offering”) of up to $2,000,000 of securities to accredited investors in a private placement, which management believes was exempt from registration under the Securities Act of 1933 ("the Act") pursuant to Section 4(2) of the Act and Rule 506 of Regulation D. The October 2004 Offering consisted of up to 100 Investment Units, each unit consisting of 10,000 shares of Medical’s common stock and a callable warrant to purchase 3,000 shares of common stock at an exercise price of $.50 per share, for $20,000 per Investment Unit. Simultaneous with the October 2004 Offering, the officers and directors of Medical had the right to independently sell similar Investment Units pursuant to a separate private placement memorandum on substantially the same terms and conditions as the October 2004 Offering.

During the year ended June 30, 2005, Medical sold 76.55 Investment Units, representing 765,500 common shares and callable warrants for the purchase of 229,650 common shares, for cash totaling $1,531,000. In connection with the sales of the Investment Units, Medical paid commissions and expense allowances totaling $119,980 to broker-dealers, and legal expenses totaling $54,442 to attorneys, which amounts have been recorded as reductions of additional paid-in capital.

In connection with the October 2004 Offering, Medical granted the selling broker-dealers warrants to purchase 4.23 Investment Units at $20,000 per Investment Unit. These Investment Units, which expire on March 25, 2007, represent 42,300 IsoRay Medical, Inc. common shares and 12,690 warrants to purchase common shares at $.50 per share.

Issuance of Common Stock for Guarantee of Debt

During fiscal year 2005, Medical issued 211,140 shares of its common stock to certain shareholders as an inducement for their guarantee of the Columbia River Bank line of credit (see Note 8) and the note payable to Benton-Franklin Economic Development District (see Note 9). The transactions were recorded at the fair value of the shares, estimated to be $348,381, since management considered this amount to be more readily determinable than the value of the guarantees. The guarantees were recorded as deferred financing costs (see Note 2).

 

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Issuance of Common Stock in Payment of Consulting Services

During 2006, the Company issued 173,472 shares of its common stock in full satisfaction of consulting services including 168,472 shares that were issued as payment for merger consulting services (see Note 1). The shares were valued using the market price of the stock on the date of issue.

Issuance of Common Stock in Partial Payment of Equipment Purchase

During 2006, the Company issued 10,000 shares of its common stock and paid $962 of cash in full satisfaction for the purchase of production equipment and repairs and maintenance invoices totaling $40,962. The shares were valued using the market price of the stock on the date of issue.

During 2005, Medical issued 30,303 shares of its common stock and paid $40,000 of cash in full satisfaction of the $90,000 purchase price of three laser welding stations. The transaction was recorded at the purchase price of the laser welding stations, since management considered this amount to be more readily determinable than the fair value of the shares.

Cash Payments for Fractional Shares

During 2006, the Company paid a combined total of $734 to the former common and preferred shareholders of Medical and Century for fractional shares that resulted from the merger that was effective July 28, 2005 (see Note 1).

During 2005, Medical paid a combined total of $100 to the former common shareholders of IsoRay, Inc. (WA) and the former Class A, B and C members of IsoRay Products LLC for fractional shares that resulted from the merger that was effective October 1, 2004 (see Note 1).

 

Warrants to Purchase Series B Preferred Stock

 

Pursuant to a private placement of debt units during 2003 and 2004, IsoRay Products LLC issued $365,000 of notes payable to investors (see Note 9) and granted warrants for the purchase of 227,750 of its Class A member shares. In connection with the merger transaction of IsoRay (WA) and IsoRay Products LLC into IsoRay Medical, Inc. (see Note 1), Medical exchanged the IsoRay Products LLC warrants for warrants to purchase 384,440 IsoRay Medical, Inc. Series B preferred shares. The warrants activity is summarized as follows:

		2006 (a)						2005 (a)
		Warrants			Price (b)			Warrants			Price (b)
Beginning balance outstanding			233,008		$	0.84			323,830		$	0.91
Exercised			(53,496	)		1.03			(90,822	)		1.07
Ending balance outstanding			179,512		$	0.79			233,008		$	0.84

 

(a)

2005 share and price data and 2006 beginning balances have been adjusted to reflect the 0.842362 conversion ratio (see Note 1).

 

(b)

Weighted average price per share.

 

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The following table summarizes additional information about the Company’s preferred warrants outstanding as of June 30, 2006:

 

Number of Warrants		Price			Expiration Date
56,876		$	0.70			October 30, 2006
28,438			0.70			January 31, 2007
31,102			1.06			February 28, 2007
6,220			1.40			February 28, 2007
56,876			0.70			March 30, 2007
179,512

 

Warrants to Purchase Common Stock

In connection with the February 2006 Offering, the October 2005 Offering, the October 2004 Offering, and at other times the Company has issued warrants for the purchase of common stock. The warrants activity is summarized as follows:

		2006 (a)						2005 (a)
		Warrants			Price (b)			Warrants			Price (b)
Beginning balance outstanding			136,158		$	1.20			-		$	-
Warrants issued			2,878,522			5.85			245,454			0.93
Exercised			(511,911	)		2.49			(109,296	)		0.59
Ending balance outstanding			2,502,769		$	5.73			136,158		$	1.20

 

(a)

2005 share and price data and 2006 beginning balances have been adjusted to reflect the 0.842362 conversion ratio (see Note 1).

 

(b)

Weighted average price per share.

The following table summarizes additional information about the Company’s common warrants outstanding as of June 30, 2006:

Number of Warrants		Range of Exercise Prices			Expiration Date
19,500		$	6.00			January 2007
2,488		$	1.06			February 2007
46,419		$	0.59 to $2.37			March 2007
277,616		$	4.15			July 2007
12,500		$	0.0008			October 2007
53,000		$	6.00			October 2007
162,500		$	6.00			November 2007
935,382		$	5.75 to $6.00			December 2007
680,750		$	6.00			January 2008
281,923		$	6,00 to $6,50			February 2008
5,691		$	4.15			March 2008
25,000		$	2.00			July 2015
2,502,769

 

F-30

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Common Stock Option Plans

 

On July 28, 2005, the Company adopted the Amended and Restated 2005 Stock Option Plan (the "Option Plan") and the Amended and Restated 2005 Employee Stock Option Plan (the "Employee Plan"), pursuant to which it may grant equity awards to eligible persons. The Option Plan allows the Board of Directors to grant options to purchase up to 1,800,000 shares of common stock to directors, officers, key employees and service providers of the Company, and the Employee Plan allows the Board of Directors to grant options to purchase up to 2,000,000 shares of common stock to officers and key employees of the Company. These options can be granted with various vesting schedules and have a maximum term of 10 years.

 

These plans replaced the IsoRay Medical, Inc. 2004 Stock Option Plan (“the 2004 Plan”) and the IsoRay Medical, Inc. 2004 Employee Stock Option Plan (“the 2004 Employee Plan”). The stated purpose of the plans was to provide an incentive-based form of compensation to directors, officers, key employees and service providers of Medical and encourage such persons to invest in shares of Medical’s common stock, thereby acquiring a proprietary interest in the success of Medical.

 

Replacement options were issued from the Option Plan and the Employee Plan to replace those options previously granted under the 2004 Plan and the 2004 Employee Plan. The replacement options are included in the totals show below for options granted and outstanding pursuant to the Option Plan and the Employee Plan.

 

Stock-Based Compensation

As described in Note 2, the Company currently accounts for stock-based compensation in accordance with SFAS No. 123. As permitted by SFAS No. 123, management currently accounts for share-based payments to employees using APB 25's intrinsic value method, and provides expanded footnote disclosure when necessary.

In December 2004, the Financial Accounting Standards Board issued SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS No. 123(R)"), which is a revision of SFAS No. 123. SFAS No. 123(R) also supersedes APB 25, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach prescribed by SFAS No. 123. SFAS No. 123(R) requires that all share-based payments to employees, including grants of employee stock options, be recognized in the income statement based on their fair values. Pro forma disclosure will no longer be permitted. SFAS No. 123(R) is effective at the beginning of the first fiscal year beginning after December 15, 2005. The Company plans to adopt SFAS 123(R) on July 1, 2006 on a prospective basis. Upon adoption, all future employee stock option grants plus the balance of the non-vested grants awarded prior to July 1, 2006, will be expensed over the stock option vesting period based on the fair value at the date the options are granted. The Company estimates that the impact of adoption will be an additional expense of $189,430 for employee stock options granted prior to June 30, 2006.

 

F-31

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A summary of the Company’s stock option activity and related information for the years ended June 30, 2006 and 2005 is as follows:

 

		2006 (a)						2005 (a)
		Shares			Price (b)			Shares			Price (b)
Beginning balance outstanding			2,237,802		$	1.31			383,430		$	1.19
Granted (c)			1,189,722			3.23			1,962,703			1.33
Cancelled			(196,548	)		1.19			-			-
Exercised			(101,284	)		1.18			(108,331	)		1.19
Ending balance outstanding			3,129,692		$	2.05			2,237,802		$	1.31
Exercisable at end of year			2,649,576		$	1.79

 

(a)

2005 share and price data and 2006 beginning balances have been adjusted to reflect the 0.842362 conversion ratio (see Note 1).

 

(b)

Weighted average price per share.

 

(c)

All options granted had exercise prices equal to the ending market price of the Company’s common stock on the grant date.

The following table summarizes additional information about the Company’s stock options outstanding as of June 30, 2006:

 

		Options Outstanding									Options Exercisable
Range of Exercise Prices		Shares			Price (a)			Life (b)			Shares			Price (a)
$1.00 to $1.19			1,886,179		$	1.16			8.97 yrs			1,717,707		$	1.16
$1.96 to $2.00			653,791			1.98			9.09 yrs			653,791			1.98
$3.80 to $4.15			318,472			3.99			9.49 yrs			128,078			3.88
$5.50 to $6.55			271,250			6.15			9.64 yrs			150,000			6.38
Total options			3,129,692									2,649,576

 

(a)

Weighted average exercise price.

 

(b)

Weighted average remaining contractual life.

The pro forma net loss presented below for the years ended June 30, 2006 and 2005 was determined as if the Company had accounted for these options under the fair value method of SFAS No. 123. The fair value of these options was estimated at the date of grant using the Black-Scholes method set forth in SFAS No. 123(R).

		2006			2005
Net loss as reported		$	8,158,130		$	4,269,188
SFAS No. 123 stock option expense			1,167,086			771,365
Pro forma net loss		$	9,325,216		$	5,040,553
Net loss per share:
Basic, as reported		$	0.68		$	0.78
Basic, pro forma			0.77			0.92
Diluted, as reported			0.68			0.78
Diluted, pro forma			0.77			0.92

 

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The following assumptions were used in calculating the fair value of the options:

 

		2006			2005
Weighted average risk-free interest rate			4.67	%		3.50	%
Expected life of the option (in years)			7.31			10.00
Expected price volatility			31.24	%		30.00	%
Expected dividend yield			0.00	%		0.00	%

 

If the Company had fully accounted for its employee stock options in accordance with the provisions of SFAS No. 123, compensation expense would have been $1,167,086 and $771,365 greater than the amounts recorded for the years ended June 30, 2006 and 2005, respectively.

 

13. Income Taxes

The Company recorded no income tax provision or benefit for the years ended June 30, 2006 and 2005.

At June 30, 2006, the Company had a net deferred tax asset of approximately $3,820,000, arising principally from net operating loss carryforwards. The deferred tax asset was calculated based on the currently enacted 34% statutory income tax rate. Since management of the Company cannot determine if it is more likely than not that the Company will realize the benefit of its net deferred tax asset, a valuation allowance equal to the full amount of the net deferred tax asset at June 30, 2006 has been established.

At June 30, 2006, the Company had tax basis net operating loss carryforwards of approximately $11,000,000 available to offset future regular taxable income. These net operating loss carryforwards expire through 2026.

IsoRay Products LLC was a limited liability company prior to the merger with Medical. In lieu of current federal income taxes arising at the company level, the individual members were taxed on their proportionate share of the company’s taxable income. Accordingly, there are no net operating loss carryforwards related to this entity.

14. Related Party Transactions

In addition to transactions described in Note 12, the Company had the following transactions with related parties:

The Company received various legal services from two law firms in which one of the firm’s partners is a member of the Company’s Board of Directors. The total amounts paid in 2006 and 2005 to the law firms was $390,000 and $285,000, respectively. The 2006 expenses include approximately $77,000 accrued in accounts payable as of June 30, 2006.

During fiscal year 2006, the Company paid $60,000 to a shareholder for strategic business and financial consulting.

During 2005, Medical paid or accrued $5,600 for accounting services performed by a company owned by a member of Medical’s Board of Directors.

 

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15. Commitments and Contingencies

Royalty Agreement for Invention and Patent Application

A shareholder of the Company previously assigned his rights, title and interest in an invention to IsoRay Products LLC in exchange for a royalty equal to 1% of the Gross Profit, as defined, from the sale of “seeds” incorporating the technology. The patent and associated royalty obligations were transferred to the Company in connection with the merger transactions (see Note 1).

The Company must also pay a royalty of 2% of Gross Sales, as defined, for any sub-assignments of the aforesaid patented process to any third parties. The royalty agreement will remain in force until the expiration of the patents on the assigned technology, unless earlier terminated in accordance with the terms of the underlying agreement. To date, there have been no product sales incorporating the technology and there is no royalty due pursuant to the terms of the agreement.

Patent and Know-How Royalty License Agreement

IsoRay Products LLC was the holder of an exclusive license to use certain “know-how.” This license was transferred to Medical and subsequently to the Company in connection with the merger transactions (see Note 1). The terms of the original license agreement required the payment of a royalty based on the Net Factory Sales Price, as defined in the agreement, of licensed product sales. Because the licensor’s patent application was ultimately abandoned, only a 1% “know-how” royalty based on Net Factory Sales Price, as defined, remains applicable. To date, there have been no product sales incorporating the licensed technology and there is no royalty due pursuant to the terms of the agreement. Management does not believe that it will ever incorporate this technology in its products and therefore that no royalty payment will be due.

Battelle Memorial Institute Production Agreement

In April 2004, IsoRay Products LLC entered into an agreement with Battelle Memorial Institute, Pacific Northwest Division (Battelle), the operator of the Pacific Northwest National Laboratory, for certain production-related services and facilities. This agreement was assumed by Medical and subsequently by the Company following the merger transactions (see Note 1). In accordance with the terms of the agreement, the Company is required to make advance payments, which are then applied against billings by Battelle as services are provided. During the years ended June 30, 2006 and 2005, the Company incurred $868,650 and $574,225, respectively, of costs for production-related services and facilities provided by Battelle. At June 30, 2006, prepaid expenses include $7,913 related to this agreement. The agreement, which expires December 31, 2007, may be terminated at any time by either party, upon giving a 60-day written notice to the other party.

Operating Lease Agreements

The Company leases office and laboratory space and production and office equipment under noncancelable operating leases. The lease agreements require monthly lease payments and expire on various dates through June 2011. Future minimum lease payments under operating leases are as follows:

Year ending June 30,
2007		$	45,443
2008			13,369
2009			9,747
2010			9,604
2011			9,175
Thereafter			–
		$	87,338

 

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In February 2005, the Company entered into a lease agreement for a portion of a building in which it established production facilities. The lease term commenced on regulatory licensing approval, which was obtained in October 2005, and terminates one year from the commencement date of the lease. The annual rental was paid using 24,007 shares of the Company’s common stock. Rent expense of $90,026 has been recognized in the year ended June 30, 2006 relating to this facility.

Rental expense (including rent paid with common stock) amounted to $155,838 and $28,641 for the years ended June 30, 2006 and 2005, respectively.

License Agreement with IBt

In February 2006, the Company signed a license agreement with International Brachytherapy s.a. (“IBt”) covering North America and providing the Company with access to IBt’s Ink Jet production process and its proprietary polymer seed technology for use in brachytherapy procedures using Cesium-131. The Company paid license fees of $275,000 during 2006 and another payment of $225,000 was to be made in August 2006 pursuant to the license agreement. Royalty payments based on net sales revenue incorporating the technology are also required, with minimum quarterly royalties ranging from $100,000 to $200,000 and minimum annual royalties ranging from $400,000 to $800,000 over the term of the agreement.

As of the date of this report, the August 2006 payment has not been made as the Company has been in continued negotiations with IBt concerning the amount and timing of future royalty payments due to the low market acceptance of the polymer seed technology.

16. Concentrations of Credit and Other Risks

Financial Instruments

The Company’s financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable.

The Company’s cash and cash equivalents are maintained with high-quality financial institutions. The accounts are guaranteed by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. At June 30, 2006, uninsured cash balances totaled $1,726,445.

The Company’s accounts receivable result from credit sales to customers. The Company had three customers whose sales were greater than 10% for each of the years ended June 30, 2006 and 2005. These customers represented 49.15% and 70.93% of the Company’s total revenues for the years ended June 30, 2006 and 2005, respectively. Those same customers accounted for 47.9% and 77.5% of the Company’s net accounts receivable balance at June 30, 2006 and 2005, respectively.

Sales to the Company’s largest customer totaled 20.6% and 30.6% of total revenues in 2006 and 2005, respectively.

The loss of any of these significant customers would have a temporary adverse effect on the Company’s revenues, which would continue until the Company located new customers to replace them.

 

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The Company routinely assesses the financial strength of its customers and provides an allowance for doubtful accounts as necessary.

Inventories

Most components used in the Company’s product are purchased from outside sources. Certain components are purchased from single suppliers. The failure of any such supplier to meet its commitment on schedule could have a material adverse effect on the Company’s business, operating results and financial condition. If a sole-source supplier were to go out of business or otherwise become unable to meet its supply commitments, the process of locating and qualifying alternate sources could require up to several months, during which time the Company’s production could be delayed. Such delays could have a material adverse effect on the Company’s business, operating results and financial condition.

17. Subsequent Events

The following events and transactions have occurred subsequent to June 30, 2006:

Return of Subscription Receivable Shares

The Company had previously entered into Purchase Agreements with Mercatus in December 2005 that permitted Mercatus to purchase 1,748,146 shares of common stock subject to the receipt of funding (see Note 12). As no funding had been received, on May 18, 2006, the Company requested the return of the share certificates. After significant delay and the Company’s attainment of a court order, the share certificates were returned. On August 8, 2006, the share certificates were cancelled and the Purchase Agreements were terminated.

August 2006 Stock Purchase Agreement

On August 17, 2006, the Company sold certain shares of its common stock and warrants to purchase common stock pursuant to a Common Stock and Warrant Purchase Agreement (the "Purchase Agreement") dated August 9, 2006. The securities were issued to 25 accredited investors pursuant to the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. MicroCapital, LLC acted as the lead investor for the transaction. A total of $5,158,000 in cash proceeds (less 6% commissions to registered broker-dealers and other legal costs) was received by the Company in exchange for the issuance of 2,063,200 shares of common stock and warrants to purchase 2,063,200 shares of common stock. In addition, brokers assisting the Company with the capital raise were issued warrants to purchase 206,300 shares of common stock on identical terms as the warrants issued to investors. If all warrants were exercised, the Company would receive $6,808,500.

Pursuant to the Purchase Agreement, the purchase price per share of the Company’s common stock was $2.50, and the accompanying warrants were issued with an exercise price of $3.00 per share. The warrants and the Purchase Agreement contain anti-dilution provisions, including one providing that, if the Company issues stock or rights to acquire stock at a price less than $2.00 (excluding certain issuances such as options to employees, directors and certain consultants and shares issued in connection with licensing or leasing transactions), the Company is required to issue to each investor additional shares equal to 25% of what such investor purchased in the original transaction. The warrants are exercisable by the holder (subject to anti-dilution and adjustment provisions) for a period of five years from the date of issuance. The warrants are callable by the Company for 45 days after a period of 60 trading days in which the price of the underlying stock exceeds $4.50 per share for 30 of the 60 days, and only if a registration statement covering the underlying shares is effective.

 

F-36

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In connection with the Purchase Agreement, the Company also entered into a Registration Rights Agreement whereby the Company has agreed to file a registration statement to cover the re-sale of the shares of common stock sold and issuable upon exercise of the warrants. Under the Registration Rights Agreement, the Company has agreed to file the registration statement within 60 days of the closing, cure any defect causing the registration statement to fail to be effective within 10 business days, and cause suspension periods for the registration statement to not exceed 60 days in any 360 day period. If the Company fails to comply with these provisions, the Company will be required to pay as liquidated damages an amount equal to 2% of the aggregate purchase price paid by the investors for each 30 day period during which the failure continues, not to exceed 10% of the aggregate purchase price.

Settlement Agreements with Former Executives

In September 2006, the Company entered into a settlement agreement with a former executive. As part of the settlement the Company agreed to pay the former executive $100,000 in September 2006 and $215,000 in January 2007. As the former executive’s employment with the Company ended in March 2006, the full amount of both payments was accrued as of June 30, 2006 in accrued payroll.

Also in September 2006, the Company reached a preliminary settlement agreement with its former Chief Financial Officer. The preliminary settlement calls for payments totaling $288,000 through September 2007. As the former Chief Financial Officer’s employment ended in September 2006, no accrual was made as of June 30, 2006.

 

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Part II

 

INFORMATION NOT REQUIRED IN THE PROSPECTUS

 

Item 24. Indemnification of Directors and Officers  

The Company's Articles of Incorporation provide to directors and officers indemnification to the full extent provided by law, and provide that, to the extent permitted by Minnesota law, a director will not be personally liable for monetary damages to the Company or its shareholders for breach of his or her fiduciary duty as a director, except for liability for certain actions that may not be limited under Minnesota law. On July 1, 2006, the Company entered into Indemnification Agreements with each of its directors and executive officers, and the Company intends to enter into substantially identical agreements with any officers and directors who take office in the future. The purpose of the Indemnification Agreements is to provide all officers and directors with indemnification to the fullest extent permitted under the Minnesota Business Corporations Act.

Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons pursuant to the foregoing provisions, or otherwise, in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable.

 

Item 25. Other Expenses of Issuance and Distribution

Securities and Exchange Commission registration fee		$	2,995
Transfer agent fees		$	2,000
Accounting fees and expenses		$	5,000
Legal fees and expenses		$	40,000
Blue sky fees and expenses		$	5,000
Total		$	54,995

 

All amounts are estimates, other than the Commission's registration fee. We are paying all expenses of the offering listed above. No portion of these expenses will be borne by the selling shareholders. The selling shareholders, however, will pay any other expenses incurred in selling their common stock, including any brokerage commissions or costs of sale.

 

Item 26. Recent Sales of Unregistered Securities  

 

During the past three years the following sales of unregistered securities were completed by the Registrant:

 

·

On August 17, 2006, the Registrant sold certain shares of its common stock and warrants to purchase common stock pursuant to a Common Stock and Warrant Purchase Agreement (the "Purchase Agreement") dated. The securities were issued to 25 accredited investors pursuant to the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. MicroCapital, LLC acted as the lead investor for the transaction. A total of $5,158,000 in cash proceeds (less 6% commissions to registered broker-dealers) was received by the Registrant in exchange for the issuance of 2,063,200 shares of common stock and warrants to purchase 2,063,200 shares of common stock. In addition, brokers assisting the Registrant with the capital raise were issued warrants to purchase 206,300 shares of common stock on identical terms as the warrants issued to investors. If all warrants were exercised, the Registrant would receive $6,808,500.

 

II-1

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·

On January 2, 2006 the Registrant issued 5,000 shares of common stock in exchange for consulting services by Rockberry LLC pursuant to the exemption from registration provided by Section 4(2) of the Securities Act.

 

·

In February 2006, the Registrant sold 268,899 shares of common stock, and issued an equal number of warrants to purchase common stock, for cash proceeds of $1,210,000. These sales were effected pursuant to the exemption from registration provided by Regulation D promulgated under the Securities Act of 1933, as amended (the “Securities Act”), and Section 4(2) of the Securities Act. None of these shares or warrants are included in this registration statement. In connection with this sale, 12,889 warrants were issued as compensation to certain NASD registered broker-dealers. None of these warrants or shares of common stock which would be issued pursuant to the exercise of these warrants are included in this registration.

 

·

Between October 17, 2005 and January 31, 2006, the Registrant sold 1,500,000 shares of common stock, and issued an equal number of warrants to purchase common stock, for cash proceeds of $6,000,000 (less commissions of ten percent (10%) on securities placed by broker/dealers). This common stock was sold as part of a unit offering including one share of common stock and a callable warrant to purchase one share of common stock at $6.00 per share with a two-year term. These sales were effected pursuant to the exemption from registration provided by Regulation D promulgated under the Securities Act, and Section 4(2) of the Securities Act. None of the shares or warrants are included in this registration statement. In connection with this sale, 92,159 warrants were issued as compensation to certain NASD registered broker-dealers. None of these warrants are included in this registration.

·

On December 7, 2005, the Company entered into a SICAV ONE Securities Purchase Agreement and a SICAV TWO Securities Purchase Agreement (collectively, the “Purchase Agreements”) with Mercatus & Partners, Limited, a United Kingdom private limited company (“Mercatus”). The Purchase Agreements permitted Mercatus to purchase 1,778,146 shares of the Company’s common stock at a purchase price of $3.502 per share, or an aggregate payment of $6,227,067, subject to receipt of funding. This sale was effected pursuant to the exemption from registration provided by Regulation D promulgated under the Securities Act, and Section 4(2) of the Securities Act. On May 18, 2006, the Company requested that the certificates representing these shares be returned immediately. On August 8, 2006, the share certificates were cancelled and the Purchase Agreements were terminated.

·

On November 18, 2005, the Registrant issued 10,000 shares of common stock to Intellegration LLC in exchange for $40,000 of capital production equipment, consulting services, and repair and maintenance services on production equipment used in the PIRL facilities pursuant to the exemption from registration provided by Section 4(2) of the Securities Act. None of these shares is included in this registration.

·

On October 6, 2005, the Registrant issued 24,007 shares of common stock to Nuvotec USA, Inc. as payment for one year’s lease of the PIRL facilities pursuant to the exemption from registration provided by Section 4(2) of the Securities Act. None of these shares is included in this registration.

·

On July 28, 2005, pursuant to the Merger, the Registrant issued 6,401,081 shares of its common stock, 1,338,167 shares of its Series B preferred stock, options to purchase 2,069,337 shares of its common stock, warrants to purchase 344,792 shares of its common stock, and warrants to purchase 233,014 shares of its preferred stock. These securities were issued by the Registrant in reliance upon an exemption from registration under Section 4(2) and Regulation D of the Securities Act of 1933, as amended.

·

In April 2005, the Registrant sold an aggregate of approximately 83,334 shares for cash proceeds of $85,000. These shares were sold to three purchasers - Andrew Ecclestone (48,999 shares), Gary Boster (29,399 shares) and Philip and Stephanie Rogers (4,934 shares) - in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. All of these shares are included in this registration.

II-2

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·

On December 3, 2003, the Registrant issued 26,236 shares of restricted common to Thomas Scallen, its former CEO, as compensation valued at $7,871, in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. All of these shares are included in this registration.

 

·

On December 3, 2003, the Registrant issued 289,193 shares of restricted common stock to Mark Rosenberg in redemption of two notes payable of approximately $36,758, pursuant to the conversion terms of the two notes and in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. None of these shares are included in this registration.

 

Additionally, during the past three years the following sales of unregistered securities were completed by IsoRay Medical, Inc. and predecessor IsoRay companies as noted:

 

IsoRay Medical, Inc.

 

·

Between January 31, 2005 and July 10, 2005, IsoRay Medical, Inc. sold approximately $4,137,875 in principal amount of 8% convertible debentures (less commissions of ten percent (10%) on securities placed by broker/dealers), in reliance on the exemption from registration provided by Rule 506 of Regulation D of the Securities Act, that subsequent to the merger between the Registrant and IsoRay Medical, Inc. were convertible into 995,882 shares of common stock of the Registrant. On December 13, 2005, the Board of Directors of the Registrant announced a short-term conversion inducement to current holders of these convertible debentures. Holders were permitted two conversion options: 1) convert under the original terms of the debenture to the Company’s common stock at a $4.15 conversion price, and include the newly issued shares in this registration statement, or 2) convert under terms essentially identical to those offered to purchasers of Units in the Registrant’s offering of October 17, 2005: a $4.00 conversion price and one callable warrant to purchase one share of the Company's common stock at an exercise price of $6.00 per share for each share issued upon conversion (waiving registration rights for approximately one year). As of May 5, 2006, holders of $3,682,875 of debentures had converted to common stock of the Registrant. As of that date, the Registrant had issued 911,276 shares of common stock, and 659,469 warrants to purchase shares of common stock, exercisable at $6.00 per share, leaving $455,000 in principal amount of debentures unconverted. Of the 911,276 shares of common stock issued pursuant to conversion of the debentures, 251,800 shares are included in this registration.

 

·

On March 31, 2005, IsoRay Medical, Inc. issued, in reliance on the exemption from registration provided by Section 4(2) of the Securities Act, 30,303 shares of its common stock and paid $40,000 of cash to Intellegration LLC in full satisfaction of the $90,000 purchase price of three laser welding stations. Pursuant to the merger with the Registrant, these 30,303 shares were converted into 25,526 shares of the Registrant’s common stock, of which all 25,526 are included in this registration.

 

·

In January, 2005, IsoRay Medical, Inc. issued, in reliance on the exemption from registration provided by Section 4(2) of the Securities Act, 211,140 shares of its common stock under §83(b) (subject to a substantial risk of forfeiture) to certain shareholders as an inducement for their guarantee of the Columbia River Bank line of credit and the note payable to Benton-Franklin Economic Development District. The transactions were recorded at the fair value of the shares, estimated to be $348,381. Pursuant to the merger with the Registrant, these 211,140 shares were converted into 177,854 shares of the Registrant’s common stock, of which none are included in this registration.

II-3

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·

Between October 15, 2004 and January 21, 2005, IsoRay Medical, Inc. sold 765,500 shares of common stock and issued 229,650 warrants to purchase shares of common stock for $.50 per share, for a total of $1,531,000 to accredited individual investors, (less commissions of ten percent (10%) on securities placed by broker/dealers), in reliance on Rule 506 of Regulation D of the Securities Act. All 229,650 warrants were subsequently exercised prior to the completion of the merger on July 28, 2005. Pursuant to the merger, all 995,150 shares of IsoRay Medical, Inc. were converted into 838,230 shares of the Registrant. All of these shares are included in this registration.

·

In connection with the October 15, 2004 private placement, IsoRay Medical, Inc. granted, in reliance on the exemption from registration provided by Section 4(2) of the Securities Act, the selling broker-dealers warrants to purchase 4.23 units at $20,000 per unit. These units represented 42,300 shares of IsoRay Medical, Inc. common stock and warrants to purchase 12,690 common shares at $.50 per share. These units were converted into 35,631 shares of the Registrant’s common stock and warrants to purchase 10,689 shares of the Registrant’s common stock at $.59 per share. A total of 46,320 shares of common stock representing the number of shares which would be issued pursuant to exercising the warrants in these units are include in this registration.

·

In June 2004, IsoRay Medical, Inc. issued 10,000 of its common shares to Mr. Girard primarily for services rendered and for $100 cash pursuant to Section 4(2) of the Securities Act. The Company recorded $9,900 of compensation expense in connection with the issuance of these shares. During the merger with the Registrant, these 10,000 shares were converted into 8,423 shares of the Registrant’s common stock, of which 1,684 are included in this registration.

 

IsoRay Products LLC

 

·

Between October 15, 2003, and September 30, 2004, in reliance on the exemption from registration provided by Section 4(2) of the Securities Act and Rule 506 of Regulation D of the Securities Act, in a three-phase private equity offering prior to the October 1, 2004 business combination of IsoRay, Inc., IsoRay Products LLC, and IsoRay Medical, Inc., IsoRay Products LLC sold 879,014 Class A shares, 241,500 Class C shares, and issued 127,750 warrants to debt unit investors, to purchase Class A or Class C shares at exercise prices ranging from $1.00 to $2.00 for a total of $1,541,417, less offering costs.

 

Class A Shares. The Class A shareholders were entitled to a 15% annual, cumulative dividend payable quarterly. In connection with the business combination, the 879,014 IsoRay Products LLC Class A shares were converted into approximately 1,483,723 IsoRay Medical, Inc. Series B preferred shares. Subsequent to the merger with the Registrant, these 1,483,723 IsoRay Medical, Inc. Series B preferred shares were converted into approximately 1,249,809 shares of the Registrant’s Series B preferred stock. Subsequent to the merger with the Registrant, most Series B preferred shareholders converted their preferred stock into common stock, and as of May 5, of the initial 1,249,809 shares of the Registrant’s Series B preferred stock issued, only 181,248 shares of Series B preferred stock remain issued and outstanding; the balance having been exchanged for shares of the Registrant’s common stock. Approximately 36,252 shares of common stock to be received upon conversion of the preferred stock are included in this registration.

            Class B and Class C Shares. The IsoRay Products LLC Class B and Class C shareholders were not entitled to a dividend as were the IsoRay Products LLC Class A shareholders. Class B Shareholders, in the aggregate, were the holders 2,896,305 shares of common stock of the parent company, IsoRay, Inc. (WA domiciled). In connection with the business combination, these 2,896,305 IsoRay, Inc. (WA domiciled) shares of common stock, 100,000 shares of additional Class B shares of IsoRay Products LLC issued to Roger Girard and 241,500 IsoRay Products LLC Class C shares were converted into 6,167,470 replacement IsoRay Medical, Inc. shares of common stock. Subsequent to the merger with the Registrant, these 6,167,470 IsoRay Medical, Inc. common shares were converted into approximately 5,195,180 shares of the Registrant’s common stock. Approximately 1,023,401 of these shares are included in this registration.

II-4

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Debt Units. 

·

Each debt unit consisted of a $5,000 secured note payable and two warrants. The notes payable were secured by the Company's patents, patents pending and current patent applications, accrued interest at 10%, payable quarterly, and matured three years from their issue date. Each warrant entitled the holder to purchase 875 IsoRay Products LLC Class A shares. One of the warrants was exercisable through July 1, 2005, and the second warrant is exercisable through February 28, 2007. The warrant exercise prices ranged from $1.00 to $2.00 per share, depending on the IsoRay Products LLC Class A share price at the time of the debt unit sale.

In connection with the business combination between IsoRay Medical, Inc., IsoRay, Inc. and IsoRay Products LLC, the note holders were issued IsoRay Medical, Inc. notes payable with substantially the same terms and conditions as their IsoRay Products LLC notes, and the IsoRay Products LLC warrants were exchanged for warrants to purchase 215,640 IsoRay Medical, Inc. Series B Preferred shares. Subsequent to the merger with the Registrant, these warrants to purchase 215,640 IsoRay Medical, Inc. Series B Preferred shares were exchanged for approximately 181,647 warrants to purchase Series B Preferred shares of the Registrant. As of May 5, 2006, only 34,836 of the 181,647 warrants remained unexercised, of which 6,967 underlying shares are included in this registration. The entire $365,000 outstanding secured notes payable, received in the IsoRay Products LLC private placement, have now been repaid, and the balance of 146,811 warrants which have been exercised for Series B Preferred shares have been exchanged for an equal number of shares of common stock, of which 20%, or approximately 29,362 shares are included in this registration.

·

In connection with the private placement of October 15, 2003, IsoRay Products LLC granted warrants for the purchase of 100,000 of its Class A member shares to Pinnacle International Holdings, LLC, a financial services company, pursuant to Section 4(2) of the Securities Act. These warrants were exercisable at $1.00 per share. Subsequent to the business combination of the IsoRay companies, these warrants were exchanged for 168,799 warrants to purchase IsoRay Medical, Inc. shares of Series B Preferred stock at $.59 per share. Pursuant to the merger with the registrant, these 168,799 warrants were exchanged for warrants to purchase 142,190 shares of the Registrant’s common stock at $.70 per share. Of these 142,190 warrants, 24,438 of the underlying shares of common stock are included in this registration.

·

In September 2003, Roger Girard, President of IsoRay, Inc., was issued 100,000 IsoRay Products LLC Class B shares primarily for services rendered and in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. IsoRay Products LLC recorded $50,000 of compensation expense in connection with the issuance of these shares. Subsequent to the business combination among IsoRay companies, these shares were exchanged for 168,798 shares of IsoRay Medical, Inc., which were subsequently exchanged in connection with the merger with the Registrant for 142,189 shares of the Registrant’s common stock, of which 28,437 are included in this registration statement.

 

IsoRay, Inc. (WA domicile)

 

·

During March 2004, IsoRay, Inc. issued 80,000 shares of its common stock in full satisfaction of the $80,000 purchase price of a prototype laser welding station and in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. Subsequent to the business combination among IsoRay companies, these 80,000 shares were exchanged for 154,431 shares of IsoRay Medical, Inc. common stock, which were subsequently exchanged for 130,088 shares of common stock of the Registrant pursuant to the Merger. Of those 130,088 shares of common stock, 26,018 are included in this registration.

·

As of December 2003 IsoRay, Inc. sold 80,000 shares of its common stock for $80,000 cash and in reliance on the exemption from registration provided by Section 4(2) of the Securities Act. These 80,000 shares of IsoRay, Inc. common stock were exchanged for 154,431 shares of common stock of IsoRay Medical, Inc. This shareholder sold 92,800 shares of common stock of IsoRay Medical, Inc. at the time of the merger. The remaining 61,631 shares of IsoRay Medical, Inc. common stock held by this investor were exchanged for 51,915 shares of common stock of the Registrant at the time of the Merger, of which 10,382 are included in this registration.

II-5

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Other than investors (this term excludes those who received shares for services) who purchased Class A or C shares, certain employee investors in IsoRay, Inc., and purchasers of debt units, all of the investors were accredited. Regardless of status, all investors signed subscription agreements acknowledging their accredited or non-accredited status and received a private placement memorandum explaining the business of the Company and the related risks. None of the offerings were underwritten or conducted by underwriters but were all conducted on a best efforts basis.

 

Item 27. Exhibits.  

 

(except as otherwise indicated, all exhibits were previously filed)

 

Exhibit #		Description
2.1		Merger Agreement dated as of May 27, 2005, by and among Century Park Pictures Corporation, Century Park Transitory Subsidiary, Inc., certain shareholders and IsoRay Medical, Inc., incorporated by reference to the Form 8-K filed on August 3, 2005.
2.2		Certificate of Merger, filed with the Delaware Secretary of State on July 28, 2005, incorporated by reference to the Form 8-K filed on August 3, 2005.
3.1		Articles of Incorporation and By-Laws are incorporated by reference to the Exhibits to the Registrant's Registration Statement of September 15, 1983.
3.2		Certificate of Designation of Rights, Preferences and Privileges of Series A and B Convertible Preferred Stock, filed with the Minnesota Secretary of State on June 29, 2005, incorporated by reference to the Form 8-K filed on August 3, 2005.
3.3		Restated and Amended Articles of Incorporation, incorporated by reference to the Form 10-KSB filed on October 11, 2005.
4.2		Form of Lock-Up Agreement for Certain IsoRay Medical, Inc. Shareholders, incorporated by reference to the Form 8-K filed on August 3, 2005.
4.3		Form of Lock-Up Agreement for Anthony Silverman, incorporated by reference to the Form 8-K filed on August 3, 2005.
4.4		Form of Registration Rights Agreement among IsoRay Medical, Inc., Century Park Pictures Corporation and the other signatories thereto, incorporated by reference to the Form 8-K filed on August 3, 2005.
4.5		Form of Escrow Agreement among Century Park Pictures Corporation, IsoRay Medical, Inc. and Anthony Silverman, incorporated by reference to the Form 8-K filed on August 3, 2005.
4.6		Form of Escrow Agreement among Century Park Pictures Corporation, IsoRay Medical, Inc. and Thomas Scallen, incorporated by reference to the Form 8-K filed on August 3, 2005.

 

II-6

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4.7		Amended and Restated 2005 Stock Option Plan, incorporated by reference to the Form S-8 filed on August 19, 2005.
4.8		Amended and Restated 2005 Employee Stock Option Plan, incorporated by reference to the Form S-8 filed on August 19, 2005.
4.9		Form of Registration Right Agreement among IsoRay Medical, Inc., Meyers Associates, L.P. and the other signatories thereto, dated October 15, 2004, incorporated by reference to the Form SB-2 filed on November 10, 2005.
4.10		Form of Registration Rights Agreement among IsoRay, Inc., Meyers Associates, L.P. and the other signatories thereto, dated February 1, 2006, incorporated by reference to the Form SB-2/A1 filed on March 24, 2006.
4.11		Form of IsoRay, Inc. Common Stock Purchase Warrant, incorporated by reference to the Form SB-2/A1 filed on March 24, 2006.
4.12		2006 Director Stock Option Plan, incorporated by reference to the Form S-8 filed on August 18, 2006.
4.13		Form of Registration Rights Agreement among IsoRay, Inc. and the other signatories thereto, dated August 9, 2006, incorporated by reference to the Form 8-K filed on August 18, 2006.
4.14		Form of IsoRay, Inc. Common Stock Purchase Warrant, dated August 9, 2006, incorporated by reference to the Form 8-K filed on August 18, 2006.
4.15		Form of Registration Rights Agreement among IsoRay, Inc., Meyers Associates, L.P. and the other signatories thereto, dated October 17, 2005, incorporated by reference to the Form SB-2 filed on October 16, 2006.
5.1		Opinion of Keller Rohrback, P.L.C., filed herewith.
10.2		Universal License Agreement, dated November 26, 1997 between Donald C. Lawrence and William J. Stokes of Pacific Management Associates Corporation, incorporated by reference to the Form SB-2 filed on November 10, 2005.
10.3		Royalty Agreement of Invention and Patent Application, dated July 12, 1999 between Lane A. Bray and IsoRay LLC, incorporated by reference to the Form SB-2 filed on November 10, 2005.
10.4		Tri-City Industrial Development Council Promissory Note, dated July 22, 2002, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.5		Section 510(k) Clearance from the Food and Drug Administration to market Lawrence CSERION Model CS-1, dated March 28, 2003, incorporated by reference to the Form SB-2 filed on November 10, 2005.
10.6		Battelle Project No. 45836 dated June 20, 2003, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.7		Applied Process Engineering Laboratory Apel Tenant Lease Agreement, dated April 23, 2001 between Energy Northwest and IsoRay, LLC, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.

 

II-7

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10.8		Work for Others Agreement No. 45658, R2, dated April 27, 2004 between Battelle Memorial Institute, Pacific Northwest Division and IsoRay Products LLC, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.9		Development Loan Agreement for $230,000, dated September 15, 2004 between Benton-Franklin Economic Development District and IsoRay Medical, Inc., incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.10		Registry of Radioactive Sealed Sources and Devices Safety Evaluation of Sealed Source, dated September 17, 2004, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.11		CRADA PNNL/245, "Y-90 Process Testing for IsoRay", dated December 22, 2004 between Pacific Northwest National Laboratory and IsoRay Medical Inc., including Amendment No. 1, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.12		Intentionally Omitted
10.13		Amendment 1 to Agreement 45658, dated February 23, 2005 between Battelle Memorial Institute Pacific Northwest Division and IsoRay Medical, Inc., incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.14		Equipment Lease Agreement dated April 14, 2005 between IsoRay Medical, Inc. and Nationwide Funding, LLC, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.15		Lease Agreement, Rev. 2, dated November 1, 2005 between Pacific EcoSolutions, Inc. and IsoRay Medical, Inc., incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.16		Master Lease Agreement Number 5209, dated May 7, 2005 between VenCore Solutions LLC and IsoRay Medical, Inc., incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.17		Contract #840/08624332/04031 dated August 25, 2005 between IsoRay, Inc. and the Federal State Unitary Enterprise << Institute of Nuclear Materials >>, Russia, incorporated by reference to the Form SB-2 filed on November 10, 2005.
10.18		State of Washington Radioactive Materials License dated October 6, 2005, incorporated by reference to the Form SB-2 filed on November 10, 2005.
10.19		Express Pricing Agreement Number 219889, dated October 5, 2005 between FedEx and IsoRay Medical, Inc., incorporated by reference to the Form 10-QSB filed on November 21, 2005.
10.20		Girard Employment Agreement, dated October 6, 2005 between Roger E. Girard and IsoRay, Inc., incorporated by reference to the Form 10-QSB filed on November 21, 2005.
10.21		Contract Modification Quality Class G, dated October 25, 2005 to Contract Number X40224 between Energy Northwest and IsoRay, Inc., incorporated by reference to the Form 10-QSB filed on November 21, 2005.
10.22		Agreement dated August 9, 2005 between the Curators of the University of Missouri and IsoRay Medical, Inc., incorporated by reference to the Form SB-2/A2 filed on April 27, 2006 (confidential treatment requested).
10.23		SICAV ONE Securities Purchase Agreement, dated December 7, 2005, by and between IsoRay, Inc. and Mercatus & Partners, Ltd., incorporated by reference to the Form 8-K filed on December 12, 2005.

 

II-8

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10.24		SICAV TWO Securities Purchase Agreement, dated December 7, 2005, by and between IsoRay, Inc. and Mercatus & Partners, Ltd., incorporated by reference to the Form 8-K filed on December 12, 2005.
10.25		Economic Development Agreement, dated December 14, 2005, by and between IsoRay, Inc. and the Pocatello Development Authority, incorporated by reference to the Form 8-K filed on December 20, 2005.
10.26		License Agreement, dated February 2, 2006, by and between IsoRay Medical, Inc. and IBt SA, incorporated by reference to the Form 8-K filed on March 24, 2006 (confidential treatment requested).
10.27		Benton Franklin Economic Development District Loan Covenant Waiver Letter, dated as of March 31, 2005, incorporated by reference to the Form SB-2/A3 filed on May 12, 2006.
10.28		Service Agreement between IsoRay, Inc. and Advanced Care Medical, Inc., dated March 1, 2006, incorporated by reference to the Form SB-2/A2 filed on April 27, 2006.
10.29		Business Loan Agreement between IsoRay Medical, Inc. and Columbia River Bank, dated March 1, 2006, incorporated by reference to the Form SB-2/A4 filed on May 26, 2006.
10.30		Letter from HAEIFC to IsoRay Medical, Inc. dated April 26, 2006, incorporated by reference to the Form SB-2/A5 filed on June 6, 2006.
10.31		Loan Agreement, dated June 15, 2006, by and between IsoRay Medical, Inc. and the Hanford Area Economic Investment Fund Committee, incorporated by reference to the Form 8-K filed on June 21, 2006.
10.32		Commercial Security Agreement, dated June 15, 2006, by and between IsoRay Medical, Inc. and the Hanford Area Economic Investment Fund Committee, incorporated by reference to the Form 8-K filed on June 21, 2006.
10.33		Common Stock and Warrant Purchase Agreement among IsoRay, Inc. and the other signatories thereto, dated August 9, 2006, incorporated by reference to the Form 8-K filed on August 18, 2006.
10.34		Benton Franklin Economic Development District Loan Covenant Waiver Letter, dated September 26, 2006, incorporated by reference to the Form 10-KSB filed on September 28, 2006.
10.35		Form of Officer and Director Indemnification Agreement, incorporated by reference to the Form SB-2 Post Effective Amendment No. 2 filed on October 13, 2006.

 

10.36		Contract No. 840/20553876/11806-32, dated October 6, 2006, by and between IsoRay Medical, Inc. and FSUE “SSC-Research Institute of Atomic Reactors,” incorporated by reference to the Form 8-K filed on November 6, 2006 (confidential treatment requested for redacted portions)
10.37		Agreement for Exclusive Right to Buy, dated October 6, 2006, by and between IsoRay Medical, Inc. and FSUE “SSC-Research Institute of Atomic Reactors,” incorporated by reference to the Form 8-K filed on November 6, 2006 (confidential treatment requested for redacted portions)

 

16.1

Letter from S.W. Hatfield, CPA to the SEC dated December 13, 2005, incorporated by reference to the Form 8-K filed on December 14, 2005.

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21.1		Subsidiaries of the Registrant, incorporated by reference to the Form 10-KSB filed on October 11, 2005.
23.1		Consent of Keller Rohrback, P.L.C. (included in Exhibit 5.1)

 

23.2

Consent of DeCoria, Maichel & Teague, P.S., filed herewith.

 

Item 28.  Undertakings.  

 

The undersigned Registrant hereby undertakes:

 

1. To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement to:

 

(a)  include any prospectus required by Section 10(a)(3) of the Securities Act of 1933;

 

(b)  reflect in the prospectus any facts or events which, individually or, together, represent a fundamental change in the information in the registration statement. Notwithstanding the forgoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in the volume and price represent no more than a 20% change in the maximum aggregate offering price set forth in the "Calculation of Registration Fee" table in the effective registration statement; and

 

(c) include any additional or changed material information on the plan of distribution.

 

2.  For determining liability under the Securities Act, to treat each such post-effective amendment as a new registration statement of the securities offered, and the offering of such securities at that time to be the initial bona fide offering.

 

3.  To file a post-effective amendment to remove from registration any of the securities that remain unsold at the end of the offering.

 

4. For determining liability of the undersigned small business issuer under the Securities Act to any purchaser in the initial distribution of the securities, that in a primary offering of securities of the undersigned small business issuer pursuant to this registration statement, regardless of the underwriting method used to sell the securities to the purchaser, if the securities are offered or sold to such purchaser by means of any of the following communications, the undersigned small business issuer will be a seller to the purchaser and will be considered to offer or sell such securities to such purchaser:

 

i.

Any preliminary prospectus or prospectus of the undersigned small business issuer relating to the offering required to be filed pursuant to Rule 424;

 

ii.

Any free writing prospectus relating to the offering prepared by or on behalf of the undersigned small business issuer or used or referred to by the undersigned small business issuer;

 

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iii.

The portion of any other free writing prospectus relating to the offering containing material information about the undersigned small business issuer or its securities provided by or on behalf of the undersigned small business issuer; and

 

iv.

Any other communication that is an offer in the offering made by the undersigned small business issuer to the purchaser.