SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

CYTORI THERAPEUTICS, INC.

(Exact name of Registrant as Specified in Its Charter)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.    Large Accelerated Filer   o  Accelerated Filer  o  Non-Accelerated Filer  ý

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes   o    No  ý

As of April 30, 2006, there were 15,567,038 shares of the registrant’s common stock outstanding.

CYTORI THERAPEUTICS, INC.

INDEX

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PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Cytori Therapeutics, Inc.:

We have reviewed the accompanying consolidated condensed balance sheet of Cytori Therapeutics, Inc. and subsidiaries (the Company) as of March 31, 2006, the related consolidated condensed statements of operations and comprehensive loss and cash flows for the three-month periods ended March 31, 2006 and 2005.  These consolidated condensed financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the consolidated condensed financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Cytori Therapeutics, Inc. and subsidiaries as of December 31, 2005, and the related consolidated statements of operations and comprehensive loss, stockholders’ deficit, and cash flows for the year then ended (not presented herein); and in our report dated March 24, 2006, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying consolidated condensed balance sheet as of December 31, 2005, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

Note 1 of the Company’s audited financial statements as of December 31, 2005 and for the year then ended discloses that the Company derives a substantial portion of its revenues from a related party.  Our auditors’ report on those financial statements dated March 24, 2006, includes an explanatory paragraph referring to the matter in note 1 of those consolidated financial statements.

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CYTORI THERAPEUTICS, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

(unaudited)

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

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CYTORI THERAPEUTICS, INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(UNAUDITED)

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

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CYTORI THERAPEUTICS, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

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CYTORI THERAPEUTICS, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

MARCH 31, 2006

(UNAUDITED)

1.     Basis of Presentation

Our accompanying unaudited consolidated condensed financial statements as of March 31, 2006 and for the three months ended March 31, 2006 and 2005 have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for annual financial statements.  Our consolidated condensed balance sheet at December 31, 2005 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations of Cytori Therapeutics, Inc., and our subsidiaries, have been included.  Operating results for the three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.  For further information, refer to our consolidated financial statements for the year ended December 31, 2005 and footnotes thereto which were included in our Annual Report on Form 10-K, dated March 30, 2006.

Certain prior period amounts have been reclassified to conform to current period presentation.  Effective January 1, 2006 we have presented the expense related to our stock-based compensation programs in the same lines as we classify cash compensation paid to the recipient employees.  See note 4 below for further details.

2.     Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from these estimates.  Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the periods they are determined to be necessary.

Our most significant estimates and critical accounting policies involve revenue recognition, evaluating goodwill for impairment, accounting for product line dispositions, assessing how to report our investment in Olympus-Cytori, Inc., and determining the fair value of stock options and other equity-based compensation

3.     Segment Information

On July 11, 2005, we announced the reorganization of our business based on two distinct operating segments – (a) Regenerative cell technology and (b) MacroPore Biosurgery, which manufactures bioresorbable implants.  In the past, our resources were managed on a consolidated basis.  However, in an effort to better reflect our focus and significant progress in the development of regenerative therapies, we are now evaluating and therefore reporting our financial results in two segments.

Our regenerative cell technology segment is focused on the discovery and development of cell-based therapies for cardiovascular disease, spine and orthopedic conditions, gastrointestinal disorders and new approaches for aesthetic and reconstructive surgery using regenerative cells from adipose tissue, also known as fat tissue.  Our MacroPore Biosurgery unit manufactures and distributes the HYDROSORB™ family of FDA-cleared bioresorbable spine and orthopedic implants; it also develops Thin Film bioresorbable implants for sale in Japan through Senko Medical Trading Company (“Senko”), which has exclusive distribution rights to these products in Japan.

We measure the success of each operating segment based on operating results and, additionally, in the case of the regenerative cell technology segment, the achievement of key research objectives.  In arriving at our operating results for each segment, we use the same accounting policies as those used for our consolidated company and as described throughout this note.   However, segment operating results exclude allocations of company-wide general and administrative costs and changes in fair value of our option liabilities.

Prior year results presented below have been developed on the same basis as the current year figures.  For all periods presented, we did not have any intersegment transactions.

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The following tables provide information regarding the performance and assets of our operating segments:

4.     Stock Based Compensation

Accounting Policy

On January 1, 2006, we adopted the provisions of Financial Accounting Standards Board Statement No. 123R, “Share-Based Payment” (“SFAS 123R”) using the modified prospective transition method. SFAS 123R requires us to measure all share-based payment awards granted after January 1, 2006, including those with employees, at fair value. Under SFAS 123R, the fair value of stock options and other equity-based compensation must be recognized as expense in the statements of operations over the requisite service period of each award.

Beginning January 1, 2006, we have recognized compensation expense under SFAS 123R for the unvested portions of outstanding share-based awards previously granted under the Company’s (a) 2004 Equity Incentive Plan and (b) 1997 Stock Option and Stock Purchase Plan, over the periods these awards continue to vest.  This compensation expense is recognized based on the fair values and attribution methods that were previously disclosed in our prior period financial statements.

Prior to January 1, 2006, we applied the intrinsic value-based method of accounting for share-based payment transactions with our employees, as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations including Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation-An Interpretation of APB Opinion No. 25”. Under the intrinsic value method, compensation expense was recognized only if the current market price of the underlying stock exceeded the exercise price of the share-based payment award as of the measurement date (typically the date of grant). Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As permitted by SFAS 123 and by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”, we disclosed on a pro forma basis the net income and earnings per share that would have resulted had we adopted SFAS 123 for measurement purposes.

The fair values of the stock-options granted during the three months ended March 31, 2005 were estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

Had compensation expense been recognized for stock-based compensation plans in accordance with SFAS No. 123, we would have recorded the following net loss and net loss per share amounts for the three months ended March 31, 2005:

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Stock-Based Compensation Arrangements

During 2004, we adopted the 2004 Equity Incentive Plan (the “2004 Plan”), which provides our employees, directors and consultants the opportunity to purchase our common stock through non-qualified stock options, stock appreciation rights, restricted stock units, or restricted stock and cash awards. The 2004 Plan initially provides for issuance of 3,000,000 shares of our common stock, which number may be cumulatively increased (subject to Board discretion) on an annual basis beginning January 1, 2005, which annual increase shall not exceed 2% of our then outstanding stock.

During 1997, we adopted the 1997 Stock Option and Stock Purchase Plan (the “1997 Plan”), which provides for the direct award or sale of shares and for the grant of incentive stock options (“ISOs”) and non-statutory options to employees, directors or consultants. The 1997 Plan, as amended, provides for the issuance of up to 7,000,000 shares of our common stock. The exercise price of ISOs cannot be less than the fair market value of the underlying shares on the date of grant. ISOs can be granted only to employees. Option vesting is determined by the Board of Directors and is generally over a four-year period. Options expire no later than ten years from date of grant.

Generally, awards issued under the 2004 Plan or the 1997 Plan have a contractual term of 10 years.  Most awards contain one of the following two vesting provisions:

•      25% of a granted award will vest after one year of service, while an additional 1/48 of the award will vest at the end of each month thereafter for 36 months, or

•      1/48 of the award will vest at the end of each month over a four-year period.

In all instances, we determined that the requisite service period associated with awards granted under either the 2004 Plan or the 1997 Plan is four years.

A summary of activity for the options under the 1997 and 2004 plans for the three months ended March 31, 2006 is as follows:

In the first quarter of 2005, we granted 760,000 stock options.  The total intrinsic value of stock options exercised was $1,314,717 and $17,175 for the three months ended March 31, 2006 and 2005, respectively.

The fair value of each outstanding option award for the three months ended March 31, 2006 was estimated on the date of grant using the Black-Scholes-Merton option valuation model based on the following assumptions:

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The expected term assumption was estimated using the “simplified method”, as described in Staff Accounting Bulletin No. 107, Share-Based Payment.  This method estimates the expected term of an option based on the average of the vesting period and the contractual term of an option award.

The expected volatility assumption was based on the historical volatility of our common stock since the first day we became publicly traded (August 2000).

The weighted average risk-free interest rate represents interest rate for treasury constant maturities published by the Federal Reserve Board. If the term of available treasury constant maturity instruments is not equal the expected term of an employee option, we use the weighted average of the two Federal Reserve securities closest to the expected term of the employee option.

Dividend yield has been assumed to be zero as (a) we have never declared or paid any dividends and (b) do not currently anticipate paying any cash dividends on our outstanding shares of common stock in the foreseeable future.

The following summarizes the total employee compensation cost recognized in the accompanying financial statements:

As of March 31, 2006, the total compensation cost related to non-vested stock options not yet recognized for all plans presented is approximately $4,978,000. These costs are expected to be recognized over a weighted average period of 2 years.

In calculating the fair value of option awards granted after January 1, 2006, we, for the most part, used the same methodologies and assumptions employed prior to our adoption of SFAS 123R.  For instance, our estimate of expected volatility is based exclusively on our historical volatility, since we have granted options that vest purely based on the passage of time and otherwise meet the criteria to exclusively rely on historical volatility, as set out in Staff Accounting Bulletin No. 107, “Share-based Payment”.  We did, however, change our policy of attributing the cost of share-based payment awards granted after January 1, 2006 from the “graded vesting approach” to the “straight-line” method. We believe that this change more accurately reflects the manner in which our employees vest in an option award.

Cash received from stock option exercises for the three months ended March 31, 2006 was $506,000. No income tax benefits have been recorded related to these stock option exercises.  SFAS 123R prohibits recognition of tax benefits for exercised stock options until such benefits are realized.  As we presently have tax loss carryforwards from prior periods and expect to incur tax losses in 2006, we would not be able to benefit from the deduction for exercised stock options in the current reporting period.

To settle stock option awards that have been exercised, we will issue new shares of our common stock.  At March 31, 2006, we have an aggregate of 79,436,000 shares authorized and available to satisfy option exercises under our plans.

Cash used to settle equity instruments granted under share-based payment arrangements amounted to $0.

Non-Employee Stock Based Compensation

In the first quarter of 2006, we granted 2,500 shares of restricted common stock to a non-employee scientific advisor. Because the shares granted are not subject to additional future vesting or service requirements, the stock based compensation expense of approximately $18,000 recorded in the first quarter of 2006 constitutes the entire grant-date fair value of this award, and no future period charges will be recorded. The stock is restricted only in that it cannot be sold for a specified period of time. There are no vesting requirements. This scientific advisor will also be receiving cash consideration as services are performed. The fair value of the stock granted was $7.04 per share based on the market price of our common stock on the date of grant.  There were no discounts applied for the effects of the restriction, since the value of the restriction is considered to be de minimis.  The entire charge of $18,000 was reported as a component of research and development expenses.

5.     Short-term Investments

We invest excess cash in highly liquid debt instruments of financial institutions and corporations with strong credit ratings and in United States government obligations.  We have established guidelines relative to diversification and maturities that maintain

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safety and liquidity.  These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates.

We evaluate our investments in accordance with the provisions of Statement of Financial Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  Based on our intent, our investment policies and our ability to liquidate debt securities, we classify short-term investment securities within current assets.  Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as accumulated other comprehensive income (loss) within stockholders’ equity.  The amortized cost basis of debt securities is periodically adjusted for amortization of premiums and accretion of discounts to maturity.  Such amortization is included as a component of interest income or interest expense.  The amortized cost basis of securities sold is based on the specific identification method and all such realized gains and losses are recorded as a component within other income (expense).  Based on such evaluation, our management has determined that all investment securities (other than those classified as cash equivalents) are properly classified as available-for-sale.

We review the carrying values of our investments and write down such investments to estimated fair value by a charge to the statements of operations when the severity and duration of a decline in the value of an investment is considered to be other than temporary.  The cost of securities sold or purchased is recorded on the settlement date.

At March 31, 2006, the excess of carrying cost over the fair value of our short-term investments is immaterial.

6.     Inventories

Inventories include the cost of material, labor and overhead, and are stated at the lower of average cost, determined on the first-in, first-out (FIFO) method, or market.  We periodically evaluate our on-hand stock and make appropriate provisions for any stock deemed as excess or obsolete.

We expense excess manufacturing costs- that is, costs resulting from lower than “normal” production levels.  The provisions of SFAS No. 151, “Inventory Costs- an Amendment of ARB No. 43, Chapter 4,” were adopted during the first quarter of 2006 and have not had a significant effect on our financial statements.

No inventory provisions were recorded during the first quarter of 2006 or 2005.

7.     Long-Lived Assets

In accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” we assess certain of our long-lived assets, such as property and equipment and intangible assets other than goodwill, for potential impairment when there is a change in circumstances that indicates carrying values of assets may not be recoverable.  Such long-lived assets are deemed to be impaired when the undiscounted cash flows expected to be generated by the asset (or asset group) are less than the asset’s carrying amount.  Any required impairment loss would be measured as the amount by which the asset’s carrying value exceeds its fair value, and would be recorded as a reduction in the carrying value of the related asset and a charge to operating expense.  During the three months ended March 31, 2006 and 2005, we had no impairment losses associated with our long-lived assets.

8.     Revenue Recognition

Product Sales

We sell our (non-Thin-Film) MacroPore Biosurgery products to Medtronic, Inc. (“Medtronic”) under a Distribution Agreement dated January 5, 2000 and amended December 22, 2000 and October 8, 2002, as well as a Development and Supply Agreement dated January 5, 2000 and amended December 22, 2000 and September 30, 2002.  These revenues are classified as sales to related party in our statements of operations.

We recognize revenue on product sales to Medtronic only after both (a) the receipt of a purchase order from Medtronic and (b) shipment of ordered products to Medtronic, as title and risk of loss pass upon shipment.

On occasion, we will offer Medtronic extended payment terms.  We do not recognize revenues under these arrangements until the payment becomes due or is received, if that occurs earlier.  Moreover, we warrant that our products are free from manufacturing defects at the time of shipment.  We have recorded a reserve for the estimated costs we may incur under our warranty program (see note 9).

In May 2004, we sold most, but not all, of our intellectual property rights and tangible assets related to our Thin Film product line to MAST Biosurgery AG, a Swiss corporation (“MAST”) and a subsidiary of MAST.  The net proceeds received initially were recorded as deferred gain on sale of assets (see note 17).

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As part of the sale agreement, we agreed to act as a back-up supplier until MAST could integrate the acquired assets into their own manufacturing operations.  Specifically, the back-up supply agreement required us to sell products ordered by MAST at our manufacturing cost.  Accordingly, we recognized a portion of the deferred gain as revenues upon the sale of products to MAST under the back-up supply arrangements.  The amount of the deferred gain recognized as revenues was equal to the excess of (a) the fair value of products sold, based on historical selling prices of similar products, over (b) our manufacturing cost.

License/Distribution Fees

If separable under Emerging Issues Task Force Issue 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”), we recognize any upfront payments received from license/distribution agreements as revenues ratably over the period in which the customer benefits from the license/distribution agreement.

To date, we have not received any upfront license payments that are separable under EITF 00-21.  Accordingly, such license revenues have been combined with other elements, such as research and development activities, for purposes of revenue recognition.  For instance, we account for the license fees and milestone payments under the Distribution Agreement with Senko as a single unit of accounting.  Similarly, we have attributed the upfront fees received under the arrangements with Olympus Corporation (“Olympus”) (see note 16) to a combined unit of accounting comprising a license we granted to Olympus-Cytori, Inc. (the “Joint Venture”) as well as development services we agreed to perform for this entity.

Research and Development

We earn revenue for performing tasks under research and development agreements with both commercial enterprises, such as Olympus Corporation and Senko, and governmental agencies like the National Institutes of Health (“NIH”).  Revenue earned under development agreements is classified as either research grant or development revenues in our statements of operations, depending on the nature of the arrangement.  The costs associated with earning these revenues are typically recorded as research and development expense.

We received a total of $22,000,000 from Olympus and Olympus-Cytori, Inc. during 2005 in two separate but related transactions (see note 16).  Approximately $4,689,000 of this amount related to common stock that we issued, as well as two options we granted, to Olympus (see note 16 for further details).  Moreover, in 2006, we received $11,000,000 from the Joint Venture upon achieving the CE Mark on the Celution™ System.  Considering the $4,689,000 initially allocated to the two options, we recorded upfront fees totaling $28,311,000 as deferred revenues, related party.  In exchange for these proceeds, we agreed to (a) provide Olympus-Cytori, Inc. an exclusive and perpetual license to our therapeutic device technology, including the Celution™ System and certain related intellectual property, and (b) perform future development services related to commercializing the Celution™ System (see note 16).  As noted above, the license and development services are not separable under EITF 00-21.  Accordingly, we will recognize the $28,311,000 allocated to deferred revenues, related party, using a proportional performance methodology- that is, as we complete substantive milestones related to the development component of the combined accounting unit.  As of March 31, 2006, we have recognized $683,000 of the deferred revenues, related party as development revenues.   All related development costs are expensed as incurred and are included in research and development expense on the statement of operations.

In the third quarter of 2004, we entered into a Distribution Agreement with Senko.  Under this agreement, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  We have also earned or will be entitled to earn additional payments under the Distribution Agreement based on achieving the following defined research and development milestones:

•      In 2004, we received a nonrefundable payment of $1,250,000 from Senko after filing an initial regulatory application with the Japanese Ministry of Health, Labor and Welfare (“MHLW”) related to the Thin Film product line.  We initially recorded this payment as deferred revenues of $1,250,000.

•      Upon the achievement of commercialization (i.e., regulatory approval by the MHLW), we will be entitled to an additional nonrefundable payment of $250,000.

Of the amounts received and deferred, we recognized development revenues of $142,000 and $9,000 in the first quarter of 2006 and 2005, respectively, representing the fair value of the completed milestones relative to the fair value of the total efforts expected to be necessary to achieve regulatory approval by the MHLW.  As noted above, the license and the milestone components of the Senko Distribution Agreement are accounted for as a single unit of accounting.  This single element of $3,000,000 in fees includes $1,500,000 which is potentially refundable.  We have recognized, and will continue to recognize, the non-contingent fees allocated to this combined deliverable as we complete performance obligations under the Distribution Agreement with Senko.  We will not recognize the potentially refundable portion of the fees until the right of refund expires.  See note 18 for further details.

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Under our agreement with the NIH, we are reimbursed for “qualifying expenditures” related to research on adipose-derived cell therapy for myocardial infarction.  To receive funds under the grant arrangement, we are required to (i) demonstrate that we incurred “qualifying expenses,” as defined in the grant agreement between the NIH and us, (ii) maintain a system of controls, whereby we can accurately track and report all expenditures related solely to research on Adipose-Derived Cell Therapy for Myocardial Infarction, and (iii) file appropriate forms and follow appropriate protocols established by the NIH.  When we are reimbursed for costs incurred under grant arrangements with the NIH, we recognize revenues for the lesser of:

•      Qualifying costs incurred (and not previously recognized) to date, plus any allowable grant fees for which we are entitled to funding from the NIH; or,

•      The outputs generated to date versus the total outputs expected to be achieved under the research arrangement.

In the three months ended March 31, 2006 and 2005, we recognized NIH grant revenue of $4,000 and $23,000 and incurred qualifying costs of $4,000 and $22,000.

9.     Warranty

We provide a limited warranty under our agreements with our customers for products that fail to comply with product specifications.  We have recorded a reserve for estimated costs we may incur under our warranty program.

The following summarizes the movements in our warranty reserve, which is subcategorized under accounts payable and accrued expenses, at March 31, 2006 and 2005:

10.  Income Taxes

Income taxes are accounted for under the asset and liability method.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (loss) in the years in which those temporary differences are expected to be recovered or settled.  Due to our current loss position and expectations for the foreseeable future, a full valuation allowance was recognized against deferred tax assets.

11.  Loss Per Share

We compute loss per share based on the provisions of SFAS No. 128, “Earnings Per Share.”  Basic per share data is computed by dividing income or loss available to common stockholders by the weighted average number of common shares outstanding during the period.  Diluted per share data is computed by dividing net income or loss available to common stockholders by the weighted average number of common shares outstanding during the period increased to include, if dilutive, the number of additional common share equivalents that would have been outstanding if potential common shares had been issued using the treasury stock method.  Potential common shares were related entirely to outstanding but unexercised option awards and warrants for all periods presented.

We have excluded all potentially dilutive securities from the calculation of diluted loss per share attributable to common stockholders for the first quarter ended March 31, 2006 and 2005, as their inclusion would be antidilutive.  Potentially dilutive common shares excluded from the calculations of diluted loss per share were 5,932,251 and 782,545 for the first quarter of 2006 and 2005, respectively.

Additionally, potential common shares excluded from per share calculations due to exercise prices that exceeded average market values were 2,316,750 and 4,892,243 for the three months ended March 31, 2006 and 2005, respectively.  Potential common shares in 2006 include an option to purchase 2,200,000 shares related to the Olympus equity agreement (see note 16).

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12.  Commitments and Contingencies

We have contractual obligations to make payments on leases of office and manufacturing space as follows:

Rent expense for the three months ended March 31, 2006 and 2005 was $627,000 and $212,000, respectively.  Payments for our Callan Rd. location will commence in June 2006.

On May 24, 2005, we entered into a lease for 91,000 square feet of space located at 3020 and 3030 Callan Road, San Diego, California.  The majority of our operations are located in this facility.  The agreement bears rent at a rate of $1.15 per square foot, with annual increases of 3%.  The lease term is 57 months, commencing on October 1, 2005 and expiring on June 30, 2010.  In addition, we are committed to providing a minimum of $837,000 in agreed-upon leasehold improvements to the facility, which are not reflected in the table of contractual obligations shown above.  As of March 31, 2006, we have made $3,055,000 in improvements to the facility as a part of our facility retrofits.

We are subject to various claims and contingencies related to legal proceedings.  Due to their nature, such legal proceedings involve inherent uncertainties including, but not limited to, court rulings, negotiations between affected parties and governmental actions. Management assesses the probability of loss for such contingencies and accrues a liability and/or discloses the relevant circumstances, as appropriate. Management believes that any liability to us that may arise as a result of currently pending legal proceedings will not have a material adverse effect on our financial condition, liquidity, or results of operations as a whole.

Refer to note 17 for a discussion of our commitments and contingencies related to our arrangements with MAST and Senko.

Refer to note 16 for a discussion of our commitments and contingencies related to our transactions with Olympus, including (a) our obligation to the Joint Venture in future periods and (b) certain put and call rights embedded in the arrangements with Olympus.

Refer to note 13 for a discussion of our commitments and contingencies related to our interactions with the University of California.

13.  License Agreement

On October 16, 2001, StemSource, Inc. entered into an exclusive worldwide license agreement with the Regents of the University of California (“UC”), licensing all of UC’s rights to certain pending patent applications under prosecution by UC and (in part) by  the University of Pittsburgh (“U Pitt”), for the life of these patents, with the right of sublicense.  The exclusive license currently relates to an issued patent and various pending applications relating to Adipose Derived Stem Cells.  In November 2002, we acquired StemSource, and the license agreement was assigned to us.

The agreement calls for annual payments until such time as we begin commercial sales of any products utilizing the licensed technology.  Upon achieving commercial sales we will be required to pay variable royalties based on the net sales of products sold.  The royalties are further subject to minimum annual royalties increasing annually with a plateau in the fifth year.  In addition, we are obligated to pay certain milestone payments upon achieving any of the following: (a) the filing of an investigational new drug application, (b) applying for marketing approval, or (c) receiving marketing approval.  We may also be subject to a substantial change of control payment within sixty days of a change of control transaction.

Additionally, we are obligated to reimburse UC for patent prosecution costs on any patents pending including foreign applications.

Although our power as licensee to successfully use these rights to exclude competitors from the market is untested, we believe that the loss of all rights to this patent could significantly impact our development of the regenerative cell technology and/or commercialization of related products.

The University of Pittsburgh filed a lawsuit in the fourth quarter of 2004, naming all of the inventors who had not assigned their ownership interest in Patent 6,777,231 to U Pitt.  It was seeking a determination that its assignors, rather than the University of California’s assignors, are the true inventors of U.S. Patent No. 6,777,231.  This lawsuit could subject us to significant costs and,

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if U Pitt wins the lawsuit, our license rights to this patent could be nullified or rendered non-exclusive with respect to any third party that might license rights from U Pitt.  Accordingly, if U Pitt wins the lawsuit, our regenerative cell strategy could be significantly affected.

We are not named as a party to the lawsuit but our president, Marc Hedrick, is a named individual defendant because he is one of the inventors identified on the patent.  We are providing substantial financial and other assistance to the defense of the lawsuit.

In the three months ended March 31, 2006 and 2005, we expensed $505,000 and $152,000, respectively, related to this license.  These expenses have been classified as general and administrative expense in the accompanying consolidated financial statements.  We believe that the amount accrued as of March 31, 2006 is a reasonable estimate of our exposure for the probable expenses for litigation, prosecution, and other expenses related to the license agreement.

14.  Long-term Obligations

In 2003, we entered into an Amended Master Security Agreement to provide financing for new equipment purchases.

As of March 31, 2006, the future contractual principal payments, for the remainder of 2006 and subsequent years, on all of our outstanding promissory notes related to the Amended Master Security Agreement are as follows:

15.  Composition of Certain Financial Statement Captions

Inventories, net

As of March 31, 2006 and December 31, 2005, inventories, net, were comprised of the following:

Other Current Assets

As of March 31, 2006 and December 31, 2005, other current assets were comprised of the following:

Property and Equipment, net

As of March 31, 2006 and December 31, 2005, property and equipment, net, were comprised of the following:

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Accounts Payable and Accrued Expenses

As of March 31, 2006 and December 31, 2005, accounts payable and accrued expenses were comprised of the following:

16.  Transactions with Olympus Corporation

Initial Investment by Olympus Corporation in Cytori

In the second quarter of 2005, we entered into a Common Stock Purchase Agreement (the “Purchase Agreement”) with Olympus in which we received $11,000,000 in cash proceeds.

Under this agreement, we issued 1,100,000 newly issued shares of common stock to Olympus. We reflected the common stock issued to Olympus in our financial statements at the market value of our common stock at the time of the Purchase Agreement ($2.73 per share, or $3,003,000 in the aggregate).

In addition, we also granted Olympus an immediately exercisable option to acquire 2,200,000 shares of our common stock on or before December 31, 2006 at $10 per share.  We have accounted for this grant as a liability in accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” because from the date of grant through the expiration, we are required to deliver listed common stock to settle the option shares upon exercise.

At the time we entered into the Purchase Agreement, we estimated the fair value of the option liability to be $186,000 based on the following assumptions:

•      Contractual term of 1.67 years,

•      Risk-free interest rate of 3.46%, and

•      Estimated share-price volatility of 59.7%

As of March 31, 2006 and December 31, 2005, we re-estimated the fair value of the option liability to be $3,356,000 and $3,731,000, respectively, based on the following assumptions:

•      Contractual term of 9 months and 1 year,

•      Risk-free interest rate of 4.82% and 4.38%, and

•      Estimated share-price volatility of 61.7% and 65.1%, respectively.

The decrease in the fair value by $375,000 for the three months ended March 31, 2006 was recorded in the statements of operations as a component of change in fair value of option liabilities.

The $11,000,000 in total proceeds we received in the second quarter of 2005 exceeded the sum of (i) the market value of our stock as well as (ii) the fair value of the option at the time we entered into the share purchase agreement.  The $7,811,000 difference between the proceeds received and the fair values of our common stock and option liability is recorded as a component of deferred revenues, related party in the accompanying balance sheet.

As of March 31, 2006, Olympus holds approximately 7.1% of our issued and outstanding shares.  If Olympus had chosen to exercise its option on March 31, 2006 to purchase all 2,200,000 shares, it would have possessed 21.2% of our outstanding common stock as of March 31, 2006.  Additionally, Olympus has a right, which it has not yet exercised, to designate a director to

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serve on our Board of Directors.

Formation of the Olympus-Cytori Joint Venture

As discussed in note 8 above, on November 4, 2005, we entered into a joint venture and other related agreements (the “Joint Venture Agreements”) with Olympus.  The Joint Venture is owned equally by Olympus and us.

Under the Joint Venture Agreements:

•      Olympus paid $30,000,000 for its 50% interest in the Joint Venture.  Moreover, Olympus simultaneously entered into a License/Joint Development Agreement with the Joint Venture and us to develop a second generation commercial system and manufacturing capabilities.

•      We licensed our device technology, including the Celution™ System and certain related intellectual property, to the Joint Venture for use in future generation devices.  These devices will process and purify adult stem and regenerative cells residing in adipose (fat) tissue for various therapeutic clinical applications.  In exchange for this license, we received a 50% interest in the Joint Venture, as well as an initial $11,000,000 payment from the Joint Venture; the source of this payment was the $30,000,000 contributed to the Joint Venture by Olympus.  Moreover, upon receipt of a CE mark for the first generation Celution™ System in January 2006, we received an additional $11,000,000 development milestone payment from the Joint Venture.

As a result of the $30 million cash contribution to the Joint Venture by Olympus, we realized an immediate appreciation in the carrying value of our interests in the Joint Venture.  As a result, we reported accretion of interests in the Joint Venture of $3,829,000 as a credit directly to additional paid-in capital in the fourth quarter of 2005.  This accounting treatment is required by Securities and Exchange Commission Staff Accounting Bulletin No. 51, “Accounting for Sales of Stock by a Subsidiary,” which prohibits gains from equity transactions (in this case, the non-cash accretion of the interests held in an investment issuing additional shares to another shareholder) when such entity is a “newly-formed, non-operating entity” or a “research and development stage company.”

We have determined that the Joint Venture is a variable interest entity (“VIE”) pursuant to FASB Interpretation No. 46 (revised 2003), “Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51” (“FIN 46R”), but that Cytori is not the VIE’s primary beneficiary.  Accordingly, we have accounted for our interests in the Joint Venture using the equity method of accounting, since we can exert significant influence over the Joint Venture’s operations.  At March 31, 2006, the carrying value of our investment in the Joint Venture is $101,000. We are under no obligation to provide additional funding to the Joint Venture, but may choose to do so.  In the first quarter of 2006, we and Olympus each contributed $150,000 to the Joint Venture.

Put/Calls and Guarantees

The Shareholders’ Agreement between Cytori and Olympus provides that in certain specified circumstances of insolvency or if we experience a change in control, Olympus will have the rights to (i) repurchase our interests in the Joint Venture at the fair value of such interests or (ii) sell its own interests in the Joint Venture to Cytori at the higher of (a) $22,000,000 or (b) their fair value (the “Put”).

As of November 4, 2005, the fair value of the Put was determined to be $1,500,000.  At December 31, 2005 and March 31, 2006, the fair value of the Put was $1,600,000 and $1,500,000, respectively.  The Put value has been recorded in the caption Option liabilities in the balance sheet.  The change in the Put value was recorded in the statements of operations as a component of Change in fair value of option liabilities.

The valuations of the Put were completed by an independent valuation firm using an option pricing theory based simulation analysis (i.e., a Monte Carlo simulation).  The valuations are based on assumptions as of the valuation date with regard to the market value of Cytori and the estimated fair value of the Joint Venture, the expected correlation between the values of Cytori and the Joint Venture, the expected volatility of Cytori and the Joint Venture, the bankruptcy recovery rate for Cytori, the bankruptcy threshold for Cytori, the probability of a change of control event for Cytori, and the risk free rate.

The following assumptions were employed in estimating the value of the Put at March 31, 2006 (these assumptions were not materially different from those used in valuing the Put as of November 4, 2005 and December 31, 2005):

•      The expected volatilities of Cytori and the Joint Venture were assumed to be 63.2% and 69.1%, respectively,

•      The bankruptcy recovery rate for Cytori was assumed to be 21%,

•      The bankruptcy threshold for Cytori was assumed to be $10.78 million,

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•      The probability of a change of control event for Cytori was assumed to be 3.04%,

•      The expected correlation between fair values of Cytori and the Joint Venture in the future was assumed to be 99%, and

•      The risk free rate was assumed to be 4.86%.

The Put has no expiration date.  Accordingly, we will continue to recognize a liability for the Put and mark it to market each quarter until it is exercised or until the arrangements with Olympus are amended.

The Joint Venture has exclusive access to our technology for the development, manufacture, and supply of the devices (second generation and beyond) for all therapeutic applications.  Once a second generation Celution™ System is developed and approved by regulatory agencies, the Joint Venture may sell such systems exclusively to us at a formula-based transfer price; we have retained marketing rights to the second generation devices for all therapeutic applications of adipose stem and regenerative cells.

As part of the various agreements with Olympus, we will be required, following commercialization of the Celution™ System, to provide monthly forecasts to the Joint Venture specifying the quantities of each category of devices that we intend to purchase over a rolling six-month period.  Although we are not subject to any minimum purchase requirements, we are obliged to buy a minimum percentage of the products forecasted by us in such reports.  Since we can effectively control the number of devices we will agree to purchase and because no commercial devices have yet been developed to trigger the forecast requirement, we estimate that the fair value of this guarantee is de minimis as of March 31, 2006.

Exclusive right granted to Olympus

On February 22, 2006, we granted Olympus an exclusive right to negotiate a commercialization collaboration for the use of adipose stem and regenerative cells for a specific therapeutic area outside of cardiovascular disease.  In exchange for this right, we received $1,500,000 from Olympus, which is non-refundable but may be applied towards any definitive commercial collaboration in the future.  As part of this agreement, Olympus will conduct market research and pilot clinical studies in collaboration with us over a 12 to 18 month period for the therapeutic area.

The $1,500,000 was not received until after the first quarter of 2006; therefore, as of March 31, 2006, the $1,500,000 was recorded as receivable, related party, with an offsetting credit recorded to deferred revenues, related party.  The deferred revenues, related party will be recognized as revenue either (i) in connection with other consideration received as part of a definitive commercial collaboration in the future, or (ii) when the exclusive negotiation period expires.

Deferred revenues, related party

As of March 31, 2006, the deferred revenues, related party account primarily consists of the consideration we have received in exchange for future services that we have agreed to perform on behalf of Olympus and the Joint Venture.  These services include completing preclinical and clinical studies, product development and seeking regulatory approval for the treatment of various therapeutic conditions with adult stem and regenerative cells residing in adipose (fat) tissue.  These services also include providing an exclusive and perpetual license to our device technology, including the Celution™ System and certain related intellectual property.

Pursuant to Emerging Issues Task Force Issue 00-21, “Revenue Arrangements with Multiple Deliverables,” we have concluded that the license and development services must be accounted for as a single unit of accounting.  Refer to note 8 for a full description of our revenue recognition policy.

Condensed financial information for the Joint Venture

A summary of the unaudited condensed financial information for the Joint Venture as of March 31, 2006 and December 31, 2005 and for the three months ended March 31, 2006 and for the period from November 4, 2005 (inception) to March 31, 2006 is as follows:

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17.  Gain on Sale of Assets, Thin Film Product Line

In May 2004, we sold most, but not all, of our intellectual property rights and tangible assets related to our Thin Film product line to MAST (see note 18).  The carrying value of the assets transferred to MAST prior to disposition totaled $634,000, and was comprised of the following:

•      Finished goods inventory of $177,000,

•      Manufacturing and development equipment of $217,000, and

•      Goodwill of $240,000.

Under this agreement we were contractually entitled to the following additional consideration (none of this consideration has been recognized in the financial statements):

•      $200,000, payable only upon receipt of 510(k) clearance from the U.S. Food and Drug Administration (“FDA”) for a hernia wrap product (thin film combined product); and

•      $2,000,000 on or before the earlier of (i) May 31, 2005, known as the “Settlement Date,” or (ii) 15 days after the date upon which MAST has hired a Chief Executive Officer (“CEO”), provided the CEO held that position for at least four months and met other requirements specified in the sale agreement.  Note that clause (ii) effectively means that we would not have received payment of $2,000,000 before May 31, 2005 unless MAST had hired a CEO on or before January 31, 2005 (four months prior to the Settlement Date).  Moreover, in the event that MAST had not hired a CEO on or before January 31, 2005, MAST may have (at its sole option and subject to the requirements of the sale agreement) alternatively provided us with a 19% equity interest in the MAST business that is managing the Thin Film assets at May 31, 2005 in lieu of making the $2,000,000 payment.    Our contention was that MAST did in fact hire a CEO on or before January 31, 2005 and, thus, we were entitled to a $2,000,000 cash payment on or before May 31, 2005.

MAST did not make the payments specified above.  Therefore, on June 14, 2005, we initiated arbitration proceedings against MAST, asserting that MAST was in breach of the Asset Purchase Agreement by failing to pay the final $2,000,000 in purchase price (among other issues).  MAST responded asserting its own claims on or about June 23, 2005.  MAST’s claims included but were not limited to the following allegations: (i) we inadequately transferred know-how to MAST, (ii) we misrepresented the state of the distribution network, (iii) we provided inadequate product instructions to users, and (iv) we failed to adequately train various distributors.

In August 2005, the parties settled the arbitration proceedings and gave mutual releases of all claims, excepting those related to the territory of Japan, and agreed to contractual compromises, the most significant of which is our waiving of the obligation for MAST to either pay the final cash purchase installment of $2,000,000 or to deliver 19% of its shares.  Moreover, if MAST exercises its Purchase Right (see note 18) and Thin Film products are marketed in Japan, MAST would no longer be obliged to share certain gross profits and royalties with us.

In exchange, MAST agreed to supply - at no cost to us- all required product for any necessary clinical study for the territory of Japan and to cooperate in the planning of such study.  However, if MAST exercises its Purchase Right or if we enter into a supply agreement with MAST for the territory of Japan, we would be obliged to reimburse MAST for any Thin Film product supplied in connection with the Japanese study at a cost of $50 per sheet.

As a result of the arbitration settlement, we recognized the remaining deferred gain on sale of assets of $5,650,000, less $124,000 of related deferred costs, in the statement of operations in the third quarter of 2005.

18.  Thin Film Japan Distribution Agreement

In the third quarter of 2004, we entered into a Distribution Agreement with Senko.  Under this agreement, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  Specifically, the license covers Thin Film products with the following indications:

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•      Anti-adhesion,

•      Soft tissue support, and

•      Minimization of the attachment of soft tissues throughout the body.

The Distribution Agreement with Senko commences upon “commercialization”.  In simplest terms, commercialization occurs when one or more Thin Film product registrations are completed with the MHLW.

Following commercialization, the Distribution Agreement has a duration of five years and is renewable for an additional five years after reaching mutually agreed minimum purchase guarantees.

The Distribution Agreement also provides for us to supply certain products to Senko at fixed prices over the life of the agreement once we have received approval to market these products in Japan.  In addition to the product price, Senko will also be obligated to make royalty payments to us of 5% of the sales value of any products Senko sells to its customers during the first three years post-commercialization.

At the inception of this arrangement, we received a $1,500,000 license fee which was recorded as deferred revenues in 2004.  We have also received $1,250,000 in milestone payments from Senko. See “Revenue Recognition” under note 8 above for our policies with regard to the timing of when these amounts will be recognized as revenues.

As part of the Thin Film sales agreement (see note 17), we granted MAST a right to acquire our Thin Film-related interest in Japan (the “Purchase Right”) during the time period and according to the following terms:

•      From May 31, 2005 to May 31, 2007, the exercise price of the Purchase Right will be equal to the fair market value of the Japanese business, but in no event will be less than $3,000,000.

•      Moreover, between May 31, 2005 and May 31, 2007, MAST will have a right of first refusal to match the terms of any outside offer to buy our Japanese Thin Film business.

We have agreed to provide back-up supply of products to Senko subject to the terms of the Distribution Agreement in the event that (a) MAST exercises its Purchase Right and (b) MAST materially fails to deliver product to Senko.  In this circumstance, Senko would pay any amounts due for purchases of product, as well as make royalty payments directly to us.  We would be obliged to remit 5% of the gross margin to MAST on any products sold to Senko.  We believe that it is unlikely in practice that this contingency will materialize.  Accordingly, we estimate the fair value of this guarantee to be de minimis as of the end of the current reporting period.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains certain statements that may be deemed “forward-looking statements” within the meaning of United States securities laws.  All statements, other than statements of historical fact, that address activities, events or developments that we intend, expect, project, believe or anticipate will or may occur in the future are forward-looking statements.  Such statements are based upon certain assumptions and assessments made by our management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate.  The forward-looking statements included in this report are also subject to a number of material risks and uncertainties, including but not limited to the risks described under the “Risk Factors” section in Part II below.

We encourage you to read those descriptions carefully.  We caution you not to place undue reliance on the forward-looking statements contained in this report.  These statements, like all statements in this report, speak only as of the date of this report (unless an earlier date is indicated) and we undertake no obligation to update or revise the statements except as required by law.  Such forward-looking statements are not guarantees of future performance and actual results will likely differ, perhaps materially, from those suggested by such forward-looking statements.

Overview

Cytori Therapeutics, Inc. is a biotechnology company that specializes in the discovery and development of regenerative medicine therapies for cardiovascular disease, gastrointestinal disorders, spine and orthopedic repair, and aesthetic and reconstructive surgery. Our primary focus is to advance adipose-derived stem and regenerative cell therapies into and through clinical trials and commercialize these therapies with an innovative cell processing device called the Celution™ System. This system automates the complex procedure for extracting and concentrating a patient’s stem and regenerative cells from his/her own adipose tissue at the bedside in about an hour.

The commercial version of the Celution™ System will be manufactured and serviced through the Olympus-Cytori Joint Venture that we established in November 2005. We will be the sole customer of the Joint Venture and we currently own all distribution rights of the Celution™ System into hospitals and clinics for all potential therapeutic applications into hospitals and clinics.

During the first quarter of 2006, we began production of the first generation Celution™ System, which we independently developed and will use primarily to conduct human clinical studies on adipose stem and regenerative cells. By the end of the first quarter, we established the infrastructure and capacity to manufacture these systems and their related one-time use cartridges at a rate that enable us to supply clinical trial centers. While we are conducting these studies, the Olympus-Cytori Joint Venture will design and engineer the commercial version and make related preparations for scale-up manufacturing and servicing.

In January 2006, we received regulatory clearance on the clinical trial version of our Celution™ System in Europe (CE Mark). With this approval, we will initiate clinical studies to seek reimbursement and claims expansion so that we may market the device for specific therapeutic applications. During 2006, we expect to begin a clinical study using adipose stem and regenerative cells as a treatment for cardiovascular disease. In preparation for this study, and subsequent studies we expect to conduct in the U.S., we formed a cardiovascular clinical advisory board comprised of expert cardiologists as well as cardiac imaging specialists. This board will help guide our design and execution of these planned clinical studies.

Additionally, we will consider providing the Celution™ System to clinical researchers in Europe and Asia who have expressed interest in utilizing the device for clinical research in select therapeutic areas and who have been granted approval by their hospitals’ institutional review boards. This will broaden the medical community’s understanding of adipose stem and regenerative cells and help explore the specific therapeutic areas that may be addressed with this technology.

After the end of the first quarter, an investigator-initiated study was approved in Japan at Kyushu Central Hospital in Fukuoka, Japan to investigate the use of adipose stem and regenerative cells in breast reconstruction following a partial mastectomy. This application could serve as an alternative to a synthetic implant or a complicated surgical procedure. We are evaluating proposals from other researchers at this time in Europe and Japan to whom we expect to provide Celution™ Systems to select centers sometime this year.

During and after the end of the first quarter, we reported additional data on an important preclinical study evaluating the use of adipose stem and regenerative cells for treating heart attacks in a model that approximated a true clinical setting. The findings found that treatment with adipose stem and regenerative cells beneficially increased capillary density, thereby improving blood flow to the heart. In addition, we observed an increase in wall thickness and evidence that stem and regenerative cells may reduce the incidence of arrhythmias following a heart attack.

Additionally, after the end of the quarter, we reported results demonstrating that adipose-derived stem and regenerative cells

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improved heart function in chronic ischemia, a form of coronary artery disease, in a preclinical study.  The findings showed that adipose stem and regenerative cells resulted in improvement of key heart measurements compared to a control group including ejection fraction and wall thickness as well as a corresponding decrease in the amount of dead scar tissue.  These results will support the design of our cardiac clinical studies.

To broaden and accelerate our research and development efforts, we are seeking research collaborations and commercialization partnerships with pharmaceutical, medical device or biotechnology companies.

In the first quarter, we granted Olympus Corporation (“Olympus”) an exclusive option to negotiate the rights to distribute the Celution™ System and related one-time use cartridges for a therapeutic application outside of cardiovascular disease. In exchange for this right, we received $1,500,000 from Olympus subsequent to the end of the first quarter of 2006. As part of the deal, Olympus will conduct market research and pilot clinical studies in collaboration with us over a 12 to 18 month period. Also during the first quarter, we received an $11,000,000 milestone payment from the Joint Venture as a result of achieving the CE Mark on the Celution™ System.

At present, we derive the majority of our product revenues from our MacroPore Biosurgery unit, which develops and manufactures innovative bioresorbable surgical implants. Potential cash flows, if any, from MacroPore Biosurgery may be used to support our development of adipose stem and regenerative cell therapies.

MacroPore Biosurgery manufactures the HYDROSORB™ family of FDA-cleared bioresorbable spine and orthopedic implants, which are distributed worldwide exclusively through Medtronic, Inc. (“Medtronic”). The prospects for this business are uncertain and rest largely upon Medtronic’s efforts and intentions. Additionally, MacroPore Biosurgery is developing our Thin Film bioresorbable implants for sale in Japan exclusively through Senko Medical Trading Co. (“Senko”), which owns distribution rights exclusively for Japan. This product line is currently under regulatory review by the Japanese Ministry of Health, Labour and Welfare. Accordingly, there have not been any sales of Thin Film product to Senko.

The research and development of our adipose stem and regenerative cell therapies has been, and will continue to be, very costly. We anticipate expanding our research and development expenses to fund clinical trial costs, preclinical research, and general and administrative activities. As a result, we expect to continue incurring losses for the foreseeable future. Before we begin to realize appreciable product revenues from the Celution™ System, and ultimately achieve consistent profitability on a quarterly and annual basis, we believe we will first need to successfully conduct controlled, randomized clinical trials in specific therapeutic areas to demonstrate the benefits of using adipose stem and regenerative cells.

We believe our research and development expenses will continue to increase should we advance more products into and through clinical trials. We plan to fund this research and development predominantly from our existing cash reserves; potential issuances of our equity, including Olympus’ option to purchase up to 2.2 million shares of our common stock at $10.00 per share; potential cash flows from MacroPore Biosurgery product sales; and payments, if any, related to potential partnerships or product line divestitures that we are currently considering.

Since 2002, we have divested or partnered two product families from our MacroPore Biosurgery unit, resulting in over $30 million of cash inflow.  We are actively pursuing several potential transactions related to the remaining product families with this business unit and believe such transactions, if completed, will result in further cash inflow.

Transactions with Olympus

During 2005, we entered into a number of strategic and collaboration arrangements with Olympus.  In the second quarter of 2005, Olympus purchased 1,100,000 shares of our common stock.  In addition, we granted Olympus an option to purchase up to 2,200,000 additional shares of common stock at $10.00 per share; this option expires December 31, 2006.   Olympus was also given a right to nominate one of our Directors, but has not yet exercised this right.  We received $11,000,000 from Olympus upon signing this agreement.

On November 4, 2005, we formed a joint venture with Olympus called Olympus-Cytori, Inc. (“the Joint Venture”).  We received $11,000,000 in cash from the Joint Venture, the source of which was from Olympus’ initial investment in the entity.

The Joint Venture will develop and manufacture future generation devices (based on our existing Celution™ System) that will process and purify adult stem and regenerative cells residing in adipose tissue, also known as fat.  The Joint Venture alliance creates synergies between two companies that share the same vision for regenerative medicine.  Olympus, as a worldwide leader in the development of innovative medical products, will contribute its expertise in engineering, manufacturing and servicing of sophisticated devices. In parallel, Cytori will increase its focus on the development of therapeutic applications for adipose stem and regenerative cells for multiple large markets.  Together, this alignment enables the creation of a premier brand of devices for regenerative medicine to be sold by Cytori.

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As a result of the various arrangements with Olympus, we received $22,000,000 in cash during 2005.  We also received an additional $11,000,000 milestone payment in January 2006 after obtaining a CE Mark for the first generation Celution™ System.  We may possibly receive even more cash proceeds if Olympus decides to exercise its option to purchase 2,200,000 shares of Cytori common stock at an exercise price of $10.00 per share.

We plan to use the $33,000,000 in cash proceeds received to fund the development activities that are necessary to support the commercialization of future generation devices based on our Celution™ System.  These development activities include performing preclinical and clinical trials, seeking regulatory approval, and performing product development related to therapeutic applications for adipose stem and regenerative cells for multiple large markets.

The joint venture arrangement with Olympus provides Cytori with a source of revenue in near- and medium- term.  On March 31, 2006, we recorded $28,311,000 as deferred revenues, related party, a liability account, in the consolidated balance sheet.

This balance sheet account represents unearned payments for future services that we have agreed to perform on behalf of the Joint Venture.  As we complete our future service obligations, we will recognize income (using a proportional performance methodology) and reduce the deferred revenues, related party account.  Specifically, we expect to recognize the $28,311,000 as revenue from 2006 through 2009.  The exact timing of when amounts will be reported as development revenue will depend on internal factors (for instance, our ability to complete the service obligations we have agreed to perform) as well as external considerations, including obtaining the necessary regulatory approvals for various therapeutic applications related to the Celution™ System.   In the first quarter of 2006, we recognized $683,000 of the deferred revenues, related party as development revenues.

As part of the various agreements with Olympus, we will be required, following commercialization of the Celution™ System, to provide monthly forecasts to the Joint Venture specifying the quantities of each category of devices that we intend to purchase over a rolling six-month period.  Although we are not subject to any minimum purchase requirements, we are obliged to buy a minimum percentage of the products forecasted by us in such reports.  Since we can effectively control the number of devices we will agree to purchase and because no commercial devices have yet been developed to trigger the forecast requirement, we estimate that the fair value of this guarantee is de minimis as of March 31, 2006 and therefore no amounts related to this guarantee are reflected on the statement of financial position.

In certain specified circumstances of insolvency or if we experience a change in control, Olympus will have the rights to (i) repurchase our interests in the joint venture at the fair value of such interests or (ii) sell its own interests in the joint venture to Cytori at the higher of (a) $22,000,000 or (b) their fair value (the “Put”).   These put and call rights are contingent on events that are unlikely to occur.  Nonetheless, accepted valuation techniques suggest that the put right has a value of approximately $1,500,000 as of March 31, 2006.  This value has been recorded as a component of Option liabilities in our balance sheet.  Note that the put right is perpetual.  Accordingly, we will continue to recognize a liability for the Put and mark it to market each quarter until it is exercised or until the arrangements with Olympus are amended.

We determined that the Joint Venture is a variable interest entity (“VIE”) under FASB Interpretation No. 46 (revised 2003), “Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51” (“FIN 46R”), but that we are not the Joint Venture’s primary beneficiary.   Accordingly, we have accounted for our interests in the Joint Venture using the equity method of accounting, since we can exert significant influence over the Joint Venture’s operations.

On February 22, 2006, we granted Olympus an exclusive right to negotiate a commercialization collaboration for the use of adipose stem and regenerative cells for a specific therapeutic area outside of cardiovascular disease.  In exchange for this right, we will receive $1,500,000 from Olympus, which is non-refundable but may be applied towards any definitive commercial collaboration in the future.  As part of this agreement, Olympus will conduct market research and pilot clinical studies in collaboration with us over a 12 to 18 month period for the therapeutic area.    As of March 31, 2006, the $1,500,000 was recorded as receivable, related party, with an offsetting credit recorded to deferred revenues, related party.  The deferred revenues, related party will be recognized as revenue either (i) in connection with other consideration received as part of a definitive commercial collaboration in the future, or (ii) when the exclusive negotiation period expires.

Thin Film Japan Distribution Agreement

Even after consummation of the 2004 Thin Film asset sale to MAST, we retained all rights to Thin Film business in Japan (subject to a purchase option of MAST, as described later below), and we received back from MAST a license of all rights to Thin Film technologies in the:

•      Spinal field, exclusive at least until 2012, and

•      Field of regenerative medicine, non-exclusive on a perpetual basis.

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In the third quarter of 2004, we entered into a Distribution Agreement with Senko.  Under this agreement, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  Specifically, the license covers Thin Film products with the following indications:

•      Anti-adhesion,

•      Soft tissue support, and

•      Minimization of the attachment of soft tissues throughout the body.

The Distribution Agreement with Senko commences upon “commercialization.”  In simplest terms, commercialization occurs when one or more Thin Film product registrations are completed with the Japanese Ministry of Health, Labour and Welfare (“MHLW”).

Following commercialization, the Distribution Agreement has a duration of five years and is renewable for an additional five years after reaching mutually agreed minimum purchase guarantees.

We received a $1,500,000 upfront license fee from Senko.  We have recorded the $1,500,000 received as a component of deferred revenues in the accompanying balance sheet.  Half of the license fee is refundable if the parties agree commercialization is not achievable and a proportional amount is refundable if we terminate the arrangement, other than for material breach by Senko, before three years post-commercialization.

Under the Distribution Agreement, we will also be entitled to earn additional payments from Senko based on achieving defined milestones.  On September 28, 2004, we notified Senko of completion of the initial regulatory application to the MHLW for the Thin Film product.  As a result, we became entitled to a nonrefundable payment of $1,250,000, which we received in October 2004 and recorded as a component of deferred revenues.

We have recognized development revenues of $142,000 and $51,000, respectively, for the three months ended March 31, 2006 and 2005.  Refer to the Critical Accounting Policies and Significant Estimates section of this discussion for further details regarding our revenue recognition policies related to the Senko Distribution Agreement.

The previously described sale agreement granted MAST a “Purchase Right” to acquire, at any time before May 31, 2007, our Thin Film-related interests and rights for Japan.  If MAST chooses to exercise the Purchase Right between now and May 31, 2007, the exercise price of the Purchase Right will be equal to the fair market value of the Japanese business, but in no event will be less than $3,000,000.  Moreover, until May 31, 2007, MAST has a right of first refusal to match the terms of any outside offer to buy our Japanese Thin Film business.

If MAST exercises the Purchase Right, we both may become obligated to reimburse each other for certain costs we have respectively incurred or will incur related to product development and protection of intellectual property rights in Japan.

Stock Based Compensation

In January 2006, we adopted Financial Accounting Standards Board Statement No. 123R, Share-Based Payment (“SFAS 123R”).  SFAS 123R requires us to measure all share-based payment awards granted after, or that were unvested as of, January 1, 2006 at fair value.

We adopted SFAS 123R using the modified prospective method of transition. Accordingly, we have recognized employee stock-based compensation expense of $786,000 for the three months ended March 31, 2006, but reported no comparable charge for the three months ended March 31, 2005.  Specifically, we recorded compensation expense for:

•      Awards granted after January 1, 2006, and

•      The unvested portion of previously granted awards outstanding at the date of adoption.

Awards granted prior to our implementation of SFAS 123R were accounted for under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based employee compensation cost is reflected in net loss in the accompanying statement of operations for the three months ended March 31, 2005, as all options granted had exercise prices equal to the market value of the underlying common stock on the date of grant.

As of March 31, 2006, the total compensation cost related to non-vested stock options not yet recognized for all plans presented is approximately $4,978,000. These costs are expected to be recognized over a weighted average period of 2 years.

In calculating the fair value of option awards granted after January 1, 2006, we, for the most part, used the same methodologies and assumptions employed prior to our adoption of SFAS 123R.  For instance, our estimate of expected volatility is based exclusively

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on our historical volatility, since we have granted options that vest purely based on the passage of time and otherwise meet the criteria to exclusively rely on historical volatility, as set out in Staff Accounting Bulletin No. 107, “Share-Based Payment”.  We did, however, change our policy of attributing the cost of share-based payment awards granted after January 1, 2006 from the “graded vesting approach” to the “straight-line” method.  We believe that this change more accurately reflects the manner in which our employees vest in an option award.

Since the adoption of SFAS 123R, we have not in any way modified previously granted share-based payment awards, nor have we made any changes to the types of awards we have historically granted to our employees.

Results of Operations

Product revenues

Product revenues relate to our MacroPore Biosurgery segment and include revenues from our spine and orthopedic products.  The following table summarizes the components for the three months ended March 31, 2006 and 2005:

Spine and orthopedic product revenues represent sales of bioresorbable implants used in spine and orthopedic surgical procedures.  These revenues were primarily related to orders during the three months ended March 31, 2006 for our radiographically identifiable Spine System products, marketed under the name MYSTIQUE™, which Medtronic, our sole distributor of spine and orthopedic products, launched in the third quarter of 2005.  This product represents the latest design addition to our family of HYDROSORB™ products.  Revenues in the first quarter of 2005 were dominated by pre-launch stocking orders for our MYSTIQUE™ products.  Subsequent to product launch in the third quarter of 2005, Medtronic’s stocking requirements have been substantially met, and therefore production and sales have declined in the first quarter of 2006.

Note that Medtronic owns approximately 6.4% of our outstanding common stock as of March 31, 2006.

The future:  We sell our spine and orthopedic products exclusively to Medtronic at fixed selling prices that are subject to adjustment biannually (based on Medtronic’s selling prices to its customers).  Our revenue from this product line is dependent upon the market’s adoption of our technology, which is largely dependent upon Medtronic’s marketing efforts and pricing strategies.  To increase our revenues from spine and orthopedic products, we depend largely on Medtronic’s ability and commitment to build and expand HYDROSORB™ market share.  We currently anticipate additional orders for the MYSTIQUE™ portion of the HYDROSORB™ product line during the remainder of 2006.  We have, however, been disappointed in the past by Medtronic’s level of effort in marketing our products.  It is unlikely that we will see significant sales of the current non-MYSTIQUE™ products in the future, and our visibility of the size and timing of MYSTIQUE™ orders is limited.

We expect all product revenues to be attributable to Medtronic now that domestic Thin Film revenues have ceased, although this may change when commercialization of the Thin Film products in Japan occurs and we begin Thin Film shipments to Senko.

Cost of product revenues

Cost of product revenues relates to our MacroPore Biosurgery segment and includes material, manufacturing labor, overhead costs and an inventory provision.  The following table summarizes the components of our cost of revenues for the three months ended March 31, 2006 and 2005: