Edgar Filing: SONOSITE INC

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549

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FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the year fiscal year ended December 31, 2001

[_] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

for the transition period from to

Commission file number 0-23791

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SONOSITE, INC.
(Exact name of registrant as specified in its charter)

Washington 91-1405022
(State or other (I.R.S. Employer
jurisdiction Identification Number)
of incorporation or
organization)

21919 30th Drive SE
Bothell, WA 98021-3904
(425) 951-1200
(Address and telephone number of registrant's principal executive offices)

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

Name of exchange on which
Title of each class registered
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None Not applicable

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

Common stock, $0.01 par value

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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 [X] No [_]

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

The aggregate market value of the voting stock held by nonaffiliates of the
registrant, based on the closing sale price of the registrant's Common Stock on
February 21, 2002, as reported on the Nasdaq National Market, was $182,518,917.

As of February 21, 2002, there were 11,372,178 shares of the registrant's
Common Stock outstanding.

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SONOSITE, INC.
ANNUAL REPORT ON FORM 10-K

CONTENTS

Page No.
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PART I............................................................................................ 1
Item 1. Business......................................................................... 1
Important Factors That May Affect Our Business, Our Results of Operations and Our
Stock Price.................................................................... 8
Item 2. Properties....................................................................... 19
Item 3. Legal Proceedings................................................................ 19
Item 4. Submission of Matters to a Vote of Security Holders.............................. 19
PART II........................................................................................... 20
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters............ 20
Item 6. Selected Financial Data.......................................................... 21
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations..................................................................... 22
Item 7A. Quantitative and Qualitative Disclosures about Market Risk....................... 28
Item 8. Financial Statements and Supplementary Data...................................... 29
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure..................................................................... 51
PART III.......................................................................................... 52
Item 10. Directors and Executive Officers of the Registrant............................... 52
Item 11. Executive Compensation........................................................... 56
Item 12. Security Ownership of Certain Beneficial Owners and Management................... 58
Item 13. Certain Relationships and Related Transactions................................... 59
PART IV........................................................................................... 61
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K................. 61

Trademarks

SonoSite(R) is the registered trademark of SonoSite, Inc. The stylized
SonoSite logo, SonoHeart ELITE(TM), SonoSite 180PLUS(TM), SiteStand(TM),
SiteLink(TM), S.I.T.E.(TM), OnSite(TM) and SonoKnowledge(TM) are trademarks of
SonoSite, Inc. All other brand names, trademarks or service marks referred to
in this report are the property of their owners.

PART I

Our disclosure and analysis in this report and in our 2001 Annual Report to
shareholders, of which this report is a part, contain forward-looking
statements. Forward-looking statements provide our current expectations or
forecasts of future events. Forward-looking statements include statements about
our plans, objectives, expectations and intentions and other statements that
are not historical facts. Words such as "believe," "anticipate," "expect" and
"intend" may identify forward-looking statements, but the absence of these
words does not necessarily mean that a statement is not forward-looking.
Forward-looking statements are subject to known and unknown risks and
uncertainties, and are based on potentially inaccurate assumptions that could
cause actual results to differ materially from those expected or implied by the
forward-looking statements. You should not unduly rely on these forward-looking
statements, which speak only as of the date of this report.

We undertake no obligation to publicly update any forward-looking
statements, whether as a result of new information, future events or otherwise.
You are advised, however, to consult any further disclosures we make on related
subjects in our future Quarterly Reports on Form 10-Q, Current Reports on Form
8-K and Annual Reports on Form 10-K. Also note that we provide a cautionary
discussion of risks, uncertainties and possibly inaccurate assumptions relevant
to our business under the caption "Important Factors That May Affect Our
Business, Our Results of Operations and Our Stock Price" in this report. These
are risks that we think could cause our actual results to differ materially
from those anticipated in our forward-looking statements or from our expected
or historical results.

ITEM 1. BUSINESS

Overview

We are a leading provider of high performance, highly miniaturized,
hand-carried, all-digital ultrasound imaging devices for use in a variety of
clinical applications and settings. Our proprietary technologies have enabled
us to design hand-carried diagnostic ultrasound devices that combine
all-digital, high resolution imaging with advanced features and capabilities
traditionally found on cart-based ultrasound systems. We believe that the
portability, high quality and cost effectiveness of our products are expanding
existing markets and will create new markets for ultrasound imaging by:

. bringing ultrasound out of the imaging center to the patient's bedside or
the physician's examining table; and

. enabling physicians to conduct an "imaging physical" by incorporating
ultrasound imaging into routine physical examinations.

The size and complexity of traditional ultrasound systems typically compel
physicians to refer patients to a highly trained sonographer employed by an
imaging center, such as a hospital's radiology department. By providing
ultrasound at the primary point of care, our hand-carried, easy-to-use devices
can eliminate delays associated with the referral process and enable physicians
to use ultrasound more frequently and in a wider variety of clinical settings.
This increased accessibility creates the potential for enhanced patient care
through earlier diagnosis of diseases and conditions.

We currently focus on six key market segments: radiology, obstetrics and
gynecology, emergency medicine, surgery, cardiology and vascular medicine. Our
current products include the SonoSite 180PLUS, for general ultrasound imaging,
and the SonoHeart ELITE, specifically configured for cardiovascular
applications. These products are used together with any of our five
interchangeable handheld components, or transducers, that are designed for
specific clinical applications.

We were formerly the handheld ultrasound device division of ATL Ultrasound,
Inc., or ATL. On April 6, 1998, we were spun off as an independent,
publicly-owned Washington corporation to further the development and
commercialization of high performance, highly miniaturized, hand-carried,
all-digital ultrasound imaging

devices. ATL retained no ownership in us following the spin-off. Under an
agreement with ATL, we hold a five- year exclusive license to use any ATL
ultrasound technology existing at the time of the spin-off, or created by ATL
during the three years following the spin-off, in ultrasound devices weighing
15 pounds or less. On April 6, 2003, this license becomes nonexclusive and,
except for ATL patented technology or registered software, will extend to use
in ultrasound devices weighing more than 15 pounds. We sold our first products
in September 1999 and have sold a total of over 6,000 units to date. For the
year ended December 31, 2001, we had revenue of $45.7 million.

Industry Background

Ultrasound emerged as a safe and noninvasive method to provide real-time,
dynamic images for medical, soft-tissue imaging purposes in the late 1950s.
Ultrasound uses low power, high frequency sound waves to provide noninvasive,
real-time images of the body's soft tissue, organs and blood flow. Ultrasound
can be cost effective by eliminating the need for more invasive and expensive
procedures and allowing for earlier diagnosis of diseases and conditions. To
generate an ultrasound image, a clinician places the transducer on the skin or
in a body cavity near the targeted area. Tissues and bodily fluids reflect the
sound waves emitted by the transducer, which also receives these reflections.
Based on these reflections, the ultrasound device's beamformer measures and
organizes the sound waves and produces an image for visual examination, using
digital or analog signal processing or a combination of the two. Digital signal
processing technology, such as that used by our products, allows an ultrasound
device to process greater amounts of information. Accordingly, digital
ultrasound devices produce higher resolution images than analog and hybrid
analog/digital ultrasound machines.

Standard ultrasound imaging produces a two-dimensional image that physicians
use to diagnose and monitor disease states and conditions by analyzing the
relative shading of tissues or organs. This is known as grayscale imaging or
two dimensional imaging. Colorization technology expands standard ultrasound
imaging by enabling physicians to generate an image showing the direction and
extent of the relative velocity of blood flow through the body, including the
chambers and valves of the heart.

Initially, ultrasound was used to assess the general shape, size and
structure of internal soft tissues and organs. As ultrasound technology
evolved, leading to improved image quality, ultrasound imaging has expanded to
radiology, obstetrics and gynecology, cardiology, emergency medicine, surgery
and vascular medicine. In recent years, technological advances have greatly
improved the image quality of ultrasound systems and substantially increased
their diagnostic utility, encouraging growth in ultrasound procedure volume.
Prior to our products' availability, however, high quality images could be
produced only by highly trained sonographers using traditional cart-based
ultrasound imaging devices weighing up to 300 pounds and costing in excess of
$100,000.

According to Klein Biomedical Consultants, Inc., the worldwide market for
ultrasound imaging devices was approximately $3.1 billion in the year 2000. We
believe that our products compete in market segments representing approximately
22% of this market. In addition, we believe that the expansion of this market
to new users and new applications, enabled by the capabilities of our
hand-carried ultrasound devices, will lead to substantial additional demand for
our products.

Our Strategy

Our goal is to lead in the design, development and commercialization of high
performance, highly miniaturized, hand-carried, all-digital ultrasound imaging
devices. Our strategy to reach that goal consists of the following key elements:

. Maximize productivity of our U.S. sales force. We currently employ 51
direct sales representatives in the United States. We also employ several
clinical application specialists who, by assuming responsibility

for product installation and training, have enabled our sales
representatives to improve their efficiency. To further enhance the
productivity of our sales force, we intend to:

. increase our investment in training, educating and mentoring our sales
force;

. expand our clinical application specialist staff;

. initiate team selling for key corporate accounts; and

. organize our sales force by clinical markets and geographic regions.

. Raise market awareness of the SonoSite platform and brand name. We
believe the opportunity exists to build the SonoSite name into a global
brand synonymous with high performance, highly miniaturized, hand-carried,
all-digital ultrasound imaging. Although we have sold over 6,000 units to
date, our products are relative newcomers to the ultrasound market, the
first having been introduced in September 1999. To raise market awareness
of our brand and our technology, we intend to:

. increase our marketing efforts to traditional users of ultrasound;

. market to potential new users by promoting innovative uses and clinical
applications of ultrasound;

. increase our direct advertising to physicians and internists; and

. promote education and participate in trade shows.

. Maintain product and technology leadership. We believe our products
represent the most advanced technology in high performance, highly
miniaturized, hand-carried, all-digital ultrasound devices. We are
committed to maintaining this technological advantage by continuing to
enhance our existing products and to create new ones. We employ over 50
people in research and development dedicated to creating the next
generation of SonoSite products. We plan to introduce a new product line
in the second half of 2002 that we believe has the potential to
significantly expand our user base.

. Increase our direct sales force in key European markets. We have
transitioned from a third-party distribution model to a direct sales force
in key European markets. We recently launched direct sales operations in
the United Kingdom, France and Germany and will soon expand to Spain. We
now have 12 direct sales representatives in Europe, and we intend to
significantly expand this team over the next 24 months.

. Expand into new ultrasound markets. We believe that the portability, high
quality and cost effectiveness of our products will result in the creation
of new markets for us. We are bringing ultrasound out of the imaging
center directly to the patient at the primary point of care, such as the
emergency room, the physician's office and other nontraditional ultrasound
settings. We anticipate the development of an "imaging physical" -- the
use of ultrasound imaging in routine physical examinations. We believe
that these new users and new applications of ultrasound offer us a
significant potential for growth.

Our Products

We offer two types of hand-carried ultrasound imaging devices. These two
ultrasound devices each consist of an integrated color display, control panel,
including navigational trackball, and alphanumeric keyboard. Both devices are
built on the same hardware platform, which provides internal storage for over
100 images, clinical analysis packages, measurement tools and direct personal
computer connectivity. These devices can be powered through a standard electric
outlet or by a rechargeable lithium ion battery, which will operate the device
between two and four hours, depending upon the type of use and age of the
battery. Our ultrasound imaging devices weigh less than six pounds with a
single transducer attached and measure 13.3 inches long, 7.6 inches wide and
2.4 inches thick. Our two hand-carried ultrasound imaging devices are the
following:

. SonoSite 180PLUS. We announced the introduction of the SonoSite 180PLUS
in April 2001 and sold our first unit of this product shortly thereafter.
The SonoSite 180PLUS is a hand-carried ultrasound device for general
diagnostic imaging and offers the following major features:

. two dimensional, or B-mode, imaging, allowing real-time two-dimensional
visualization of anatomic structures within the body;

. M-mode imaging, providing a display of motion versus time. M-mode is
particularly useful for evaluation of fast-moving structures, such as
valves within the heart;

. pulsed wave, or PW, Doppler technology. PW Doppler imaging is used to
provide a quantitative assessment of the velocity of blood flow. The
name of the technology refers to the Doppler effect, which is an
apparent change in the frequency of the reflected ultrasound wave due to
the relative motion between the reflector and transducer;

. color power Doppler and directional color power Doppler, allowing
two-dimensional visualization of blood flow patterns;

. tissue harmonic imaging, or THI, a signal processing technique providing
enhanced image quality by using high frequency information to enhance
image resolution; and

. basic echocardiogram, or ECG, capability. When visualizing the heart, it
is often useful to visualize basic relationships between cardiac motion
and cardiac electrical activity. ECG provides this capability.

. SonoHeart ELITE. On February 4, 2002, we announced the introduction of
the SonoHeart ELITE, the latest improvement on our existing platform for
cardiology imaging. The SonoHeart ELITE is a hand-carried ultrasound
device intended for use by cardiologists and other healthcare providers in
the cardiology market. The SonoHeart ELITE has all the product features of
the SonoSite 180PLUS, as well as the following:

. continuous wave, or CW, Doppler technology, providing a quantitative
assessment of blood flow moving at speeds higher than PW Doppler is
capable of assessing.

We offer five types of transducers. Each of our transducers may be used with
either of our ultrasound imaging devices. This interchangeability allows our
customers to purchase a single hand-carried ultrasound device that can be used
in a variety of clinical applications.

. Transducers. Our five transducers are designed for use in the following
clinical applications:

. general abdominal and obstetrics imaging;

. intracavitary and gynecological ultrasound imaging;

. neonatal, vascular and pediatric imaging;

. cardiac, thoracic and abdominal imaging, and trauma assessment; and

. breast, musculoskeletal, vascular, interventional and small-parts
imaging.

We also offer the following related accessories and educational programs:

. Accessories. We sell the SiteStand mobile docking station and the
SiteLink imaging software, both of which enable communication between our
products and third-party output devices, such as printers, storage devices
and networks. We also offer a high resolution, 15-inch flat panel monitor
that may be physically connected with our SiteStand to increase the image
size and allow easy consultation among healthcare providers.

. Specialized training and education. We developed the SonoSite Institute
for Training and Education, or S.I.T.E., an initiative that seeks to
enable physicians and other healthcare providers who currently do not use
ultrasound imaging to become competent in the general use of ultrasound
and the fundamental operation of our products. Through S.I.T.E., we offer
an internal program, OnSite, as well as programs developed by third-party,
accredited education providers. We offer our customers education vouchers
that may be purchased for use with any of these educational programs. In
addition, with the help of well-known ultrasound clinicians, we produced
SonoKnowledge, an educational package of ultrasound training materials,
product operation training and accredited continuing medical education.

Sales and Marketing

Initially, we sold and marketed our products through third-party medical
product distributors worldwide. Currently, we have moved to a direct sales
model in the United States, the United Kingdom, France and Germany, and
anticipate expanding our direct sales efforts to other key European markets,
including Spain. We rely on third-party distributors in those markets where we
do not have a direct sales staff.

In February 2000, we initiated our direct sales operation in the United
States. In 2001, we significantly expanded the size of our U.S. direct sales
efforts by increasing the number of sales representatives from 26 to 51. We
expect to expand our U.S. team within the next 12 months with the addition of
clinical application specialists, who will provide product demonstration and
installation support to our sales representatives. In addition, we intend to
focus our sales representatives on specific clinical markets in addition to
geographic regions. We believe that these efforts will increase the
productivity of our direct sales representatives.

In the United States, we have complemented our direct sales efforts by
entering into group purchasing agreements with major healthcare group
purchasing organizations, or GPOs. Typically, a GPO negotiates with medical
device suppliers, such as us, on behalf of the GPO's member healthcare
facilities, providing such members with uniform pricing and terms and
conditions. In exchange, the GPO identifies us as a preferred supplier for its
members. Member facilities participating in the GPO's purchasing program can
consist of hospitals, medical group practices, nursing homes, surgery centers,
managed care organizations, long term care facilities, clinics and integrated
delivery networks. Currently, we have GPO supply agreements with AmeriNet,
Inc., Kaiser Permanente, Novation, LLC, Premier, Inc. and Broadlane, Inc.

Elsewhere outside the United States, we continue to sell to other potential
markets through third-party foreign distributors, such as Olympus Promarketing
Inc. in Japan. Additionally, in the United Kingdom we have a supply agreement
with the Purchasing and Supply Agency of the National Health Service, or NHS,
which contracts on a national basis for products and services purchased by the
NHS.

We derived approximately $23.8 million, or 52%, of our sales revenue from
domestic sales in 2001. This compares to approximately $15.2 million, or 47%,
and approximately $4.3 million, or 42%, in 2000 and 1999.

We derived approximately $21.9 million, or 48%, of our sales revenue from
foreign sales in 2001. This compares to approximately $16.9 million, or 53%,
and approximately $5.9 million, or 58%, in 2000 and 1999. Japan accounted for
approximately $7.8 million, or 17%, of our revenue in 2001. This compares to
approximately $8.3 million, or 26%, and approximately $0.1 million, or 1%, in
2000 and 1999. We attribute revenue to a foreign country based on the location
to which we ship our products.

Our revenues from international sales may be adversely affected by a number
of risks, including competition, currency rate fluctuations, reduced protection
for intellectual property rights, longer receivables collection periods, the
cost or difficulty in localizing products for foreign markets, and the cost or
difficulty of compliance with export laws, including license requirements,
trade restrictions and tariff increases.

Patents and Intellectual Property Rights

We rely on a combination of patent, copyright, trademark and trade secret
laws and other agreements with employees and third parties to establish and
protect our proprietary rights. We require our officers, employees and
consultants to enter into standard agreements containing provisions requiring
confidentiality of proprietary information and assignment to us of all
inventions made during the course of their employment. We also seek to enter
into nondisclosure agreements with our commercial counterparties and limit
access to, and distribution of, our proprietary information.

We are committed to developing and protecting our intellectual property and,
where appropriate, file patent applications to protect our technology. We own
five U.S. patents relating to various aspects of our products,

including the weight of digital beamformers, beamforming capabilities, digital
conversion circuitry, transceiver circuitry and circuit integration. Subject to
our paying maintenance fees, these patents will remain in force for a number of
years. We currently have four patent applications for which notices of
allowance have been granted, and 10 other patent applications pending.

We license certain ultrasound technology from our former parent, ATL, under
a Technology Transfer and License Agreement executed at the time of our
spin-off as a public company. Under that agreement, we have a five-year
exclusive license to use any ATL ultrasound technology existing at the time of
the spin-off, or created by ATL during the three years following the spin-off,
in ultrasound devices weighing 15 pounds or less. After five years, this
license becomes nonexclusive and, except for ATL patented technology or
registered software, will extend to use in ultrasound devices weighing more
than 15 pounds. As part of this arrangement, we cross-license certain of our
technology to ATL for use in ultrasound devices weighing more than 15 pounds.

We hold a number of registered and unregistered trademarks, service names
and domain names that are used in our business. Generally, federally registered
trademarks offer protection for renewable terms of 10 years so long as the mark
continues to be used in commerce.

On July 24, 2001, Neutrino Development Corporation filed a complaint against
us, which alleged that our sale and manufacture of our hand-carried ultrasound
devices infringed upon a patent held by Neutrino. We responded to the claim,
asserting alternative defenses of noninfringement and patent invalidity. In
addition, we filed a counterclaim seeking a declaratory judgment of
noninfringement and invalidity regarding Neutrino's patent. We also defeated
Neutrino's request for a preliminary injunction preventing us from
manufacturing and selling our products pending the ultimate disposition of the
litigation. On February 20, 2002, in what is known as a "Markman" hearing, the
parties presented their arguments regarding the proper construction of
Neutrino's patent claims. The court has not yet ruled on the issues presented
in that hearing. We continue to vigorously defend ourselves against this claim
and we are confident of a positive outcome. Nevertheless, we have been forced
to incur substantial expenses in defense of this claim, and we expect to incur
additional substantial litigation expenses until the claim is resolved.

Competition

We currently face competition from companies that manufacture cart-based and
portable ultrasound devices. The dominant competitors in this industry are GE
Medical Systems, a unit of General Electric Company, Siemens AG and Philips
Medical Systems, a unit of Koninklijke Philips Electronics, N.V. that recently
purchased two other competitors, Agilent Healthcare Solutions Group and ATL,
our former parent company. In addition, as the market for hand-carried, high
performance ultrasound devices develops, we expect competition to increase as
potential and existing competitors enter the hand-carried market or modify
their existing products to more closely approximate the combined portability,
quality, performance and cost of our products. Our current competitors in the
hand-carried market include GE Medical Systems, Agilent/Philips Medical
Systems, Biosound Easaote, Inc., Medison America Inc., a subsidiary of Medison
Company, Ltd., and Terason, a division of TeraTech Corporation. Other potential
entrants to the hand-carried market include Novasonics, Inc.

Research and Development and Technology

We currently employ over 50 individuals dedicated to the technical support
and enhancement of our products and development of new generations of products.
Since our spin-off from ATL, we have invested a cumulative total of $46.4
million in research and development.

For the twelve months ended December 31, 2001, 2000 and 1999, expenses
attributable to research and development for our business totaled $12.7
million, $11.8 million and $14.5 million. We believe our products represent the
most advanced technology in high performance, highly miniaturized,
hand-carried, all-digital ultrasound imaging devices. We believe our technology
gives us a competitive advantage, and we are committed

to maintaining this advantage by continuing to enhance our existing products
and create new ones. Accordingly, we intend to maintain our research and
development expenses at levels we believe necessary to maintain this
competitive advantage.

Manufacturing

Prior to the fourth quarter of 2000, we had outsourced the manufacture of
our products to ATL. In the fourth quarter of 2000, we transitioned product
manufacturing to our own facility in Bothell under the control of our
employees. In order to make this transition, we built a series of manufacturing
lines and developed our own manufacturing processes and procedures.

Government Regulation

The manufacture and sale of our products are subject to extensive regulation
by numerous governmental authorities, principally the U.S. Food and Drug
Administration, or FDA, as well as several other state and foreign agencies.
The FDA requires that all medical devices introduced to the market be preceded
either by premarket notification clearance under Section 510(k) of the Federal
Food, Drug & Cosmetic Act, or an approved premarket approval application, or
PMA. By granting 510(k) clearance, the FDA indicates agreement with an
applicant's determination that the product for which clearance has been sought
is substantially equivalent to medical devices that were on the market prior to
1976 or have subsequently received clearance. A premarket approval indicates
that the FDA has determined the company must submit clinical trial data and
manufacturing quality assurance information to prove it is safe and effective
for its labeled indications. The process of obtaining 510(k) clearance
typically takes approximately two to three months, while a premarket approval
process typically takes more than a year. We received 510(k) clearance for the
SonoSite 180 system with 10 clinical applications in March 1999 and 510(k)
clearance for the SonoHeart system in December 1999. We increased the clinical
applications to 14 with the 510(k) clearance received in November 2000. We
believe that our future generation hand-carried ultrasound devices will also
require only 510(k) clearance. Also, in August 2001 the FDA classified as a
class II field action a May 2000 software upgrade we issued to correct an error
in an algorithm contained in one of our products. We are currently appealing
the FDA's classification. If our appeal of this classification is unsuccessful,
we will be required to take additional steps to ensure that all affected
purchasers receive the upgrade. If required to take action, we do not believe
the associated costs will be significant.

Our products and our product components are also subject to various domestic
and foreign manufacturing standards and electrical safety and emission
standards, such as those of Underwriters Laboratories and the ISO 9001
standards, described below. We and our suppliers are subject to FDA regulations
governing registration of manufacturing facilities and compliance with the
FDA's Quality System Regulations, or QSR. The FDA performs periodic unannounced
on-site inspections to determine compliance with such regulations. The FDA
inspected our manufacturing facility in August 2001. In addition, the British
Standards Institution performed a management systems assessment of our
manufacturing processes in May 2000, February 2001 and June 2001. These
inspections resulted in our submitting and implementing corrective action
responses, and we believe those responses have been accepted by those agencies.
We believe that we are currently in compliance with applicable QSR.

Our regulatory compliance programs encompass verification of our compliance
with international standards for medical device design, manufacture,
installation, and servicing, known as ISO 9001 standards. On

September 13, 1999, we received Conformite Europeene, or CE, Marking approval,
signifying European Certification to the international quality system standards
and to the European Medical Device Directive, which encompass ISO 9001
standards. The Certification allows us to distribute the SonoSite 180 and
SonoHeart devices to the 19 countries of the European Union and the European
Free Trade Association. The FDA harmonized in June 1998 its QSR for the United
States with ISO 9001 and EN 46001 standards.

Service and Warranty

Our typical warranty period is one year and is included with the original
purchase of our ultrasound imaging devices. However, the customer can purchase
a service contract from us to extend the original warranty period or enhance
its coverage. All returned products are diagnosed for cause of failure and for
possible design improvements to incorporate in future products.

Employees

As of December 31, 2001, we had approximately 250 full-time employees, of
which approximately 21% were engaged in research and product development, 30%
in manufacturing, 40% in sales and marketing activities and the remaining 9% in
administrative capacities, including executive, finance, human resources,
regulatory and information services and technology. Of these, approximately 240
are U.S. employees. There has never been a work stoppage and no employees are
covered by collective bargaining agreements. We believe our employee relations
are good.

Important Factors That May Affect Our Business, Our Results of Operations and
Our Stock Price

If our products do not gain market acceptance, we will fail to generate
sufficient revenue to maintain our business.

The market for hand-carried, high performance ultrasound devices is new and
largely undeveloped. Our products represent a new technological alternative to
traditional ultrasound examinations. We seek to sell our products to current
users of ultrasound, as well as to physicians and other healthcare providers
who do not currently use ultrasound, and our success will depend on the
acceptance of our products by the medical community, patients and third-party
payors as medically useful, safe and cost-effective. Competing hand-carried or
traditional cart-based ultrasound devices may be more cost-effective than our
products. Physicians and other healthcare providers may adopt our products at a
slow rate, if at all. If the market fails to accept our products, we will be
unable to generate sufficient sales revenue to maintain our business.

If we are unable to compete effectively, we will fail to generate sufficient
revenue to maintain our business.

. greater financial and infrastructure resources;

. larger research and development staffs;

. greater experience in product manufacturing, marketing and distribution;

. greater brand name recognition; and

. long-standing relationships with many of our potential customers.

These manufacturers of cart-based and portable ultrasound devices could use
their greater resources to increase and withstand competition through various
means, including price and payment terms, product quality,

market penetration, employee compensation, hospital systems integration and
complementary services such as warranty protection, maintenance and product
training. Existing product supply relationships between these companies and our
potential customers could discourage widespread adoption of our products due to
brand loyalty or preferred customer discounts. Competition from these companies
could result in higher turnover of our employees. If we are unable to respond
to competitive pressures from the cart-based and portable ultrasound markets,
we could experience delayed or reduced market acceptance of our products,
higher expenses and lower sales revenue.

In addition, as the market for hand-carried, high performance ultrasound
devices develops, we expect competition to increase as potential and existing
competitors enter the hand-carried market or modify their existing products to
more closely approximate the combined portability, quality, performance and
cost or our products. Our current competitors in the hand-carried market
include GE Medical Systems, Agilent/Philips Medical Systems, Biosound Easaote,
Inc., Medison America Inc., a subsidiary of Medison Company, Ltd., and Terason,
a division of TeraTech Corporation. Other potential entrants to the
hand-carried market include Novasonics, Inc. These competitors may develop
highly portable or hand-carried ultrasound devices that offer the same or
greater reliability and quality, perform greater or more useful functions, or
are more cost-effective than our products. If we are unable to compete
effectively with new entrants to the hand-carried, high performance ultrasound
market, we will be unable to generate sufficient sales revenue to maintain our
business.

If our competitors develop and market medical imaging devices that render our
products obsolete or noncompetitive, we will be unable to compete.

The life cycles of our products are difficult to estimate. Our products
could become obsolete or unmarketable if:

. our competitors introduce ultrasound devices that are superior to ours;

. other products using new technologies emerge; or

. industry standards exceed our products' capabilities.

If we fail to enhance our existing products or develop and market new
products, our products will become obsolete and we will be unable to compete.

Our single technological platform renders us less able to withstand adverse
changes in the market.

Although we market our products for use in a variety of clinical
applications and settings, we have only a single technological platform upon
which all our ultrasound devices are based. Any attempt to design a new
platform for ultrasound imaging will require substantial amounts of time and
money, and may not be successful. If our platform becomes obsolete,
unmarketable or unaccepted by the market for any reason, and we are unable or
slow to develop a new platform to replace it, we will be unable to generate
sufficient sales revenue to maintain our business.

If traditional providers of ultrasound examinations discourage potential new
users from adopting our products, we could experience limited demand for our
products.

In traditional ultrasound practice, physicians and other healthcare
providers typically refer patients to centralized locations where radiologists
and other specialized personnel provide ultrasound examinations. Although our
products are currently used by radiologists, our products also enable the
delivery of ultrasound examinations at the primary point of care by the
examining physician or healthcare provider. Radiologists and other ultrasound
specialists have a professional and financial interest in maintaining
traditional ultrasound practice. If these traditional providers of ultrasound
examinations discourage other healthcare providers from adopting our products,
we could experience limited demand for our products.

If the training and education necessary to conduct ultrasound examinations
discourage new users from adopting our products, we could experience limited
demand for our products.

We seek to sell our products to customers already experienced in ultrasound
procedures, as well as to physicians and other healthcare providers who do not
currently use ultrasound imaging devices or administer ultrasound examinations.
Any new users of ultrasound will require training and education to properly
administer ultrasound examinations. If these potential customers are unable or
unwilling to be trained due to cost, time constraints, unavailability of
courses or other reasons, we could experience limited demand for our products.

If our suppliers, including our single-source suppliers, fail to supply us with
the components that we need to manufacture our products on a timely basis, we
could experience production delays, cost increases and lost sales.

We depend on suppliers, including some single-source suppliers, to provide
highly specialized parts, such as custom-designed integrated circuits, cable
assemblies and transducer components. We also depend on single-source suppliers
to provide other components, such as image displays, batteries, capacitors and
cables. We do not maintain significant inventories of components, and may
experience an interruption of supply if a supplier is unable or unwilling to
meet our time, quantity and quality requirements. There are relatively few
alternative sources of supply for some of these components. An increase in
demand for some parts by other companies could also interrupt our supply of
components. We have in the past experienced supply problems in timeliness and
quality, but to date these problems have not resulted in lost sales or lower
demand. Nevertheless, if we experience an interruption of supply or are
required to switch suppliers, the manufacture and delivery of our products
could be interrupted, our manufacturing costs could substantially increase and
we could lose substantial amounts of product sales.

If we or our suppliers fail to comply with regulations governing our
manufacturing practices, we could experience production delays, cost increases
and lost sales.

The FDA requires us and our key suppliers to demonstrate and maintain
compliance with the FDA's Quality System Regulation, or QSR, which covers the
methods and documentation of the design, testing, production, control, quality
assurance, labelling, packaging and shipping of our products. The FDA enforces
the QSR through periodic, unannounced inspections. We or any of our key
component suppliers may fail to comply with regulatory requirements. Failure to
take corrective action in response to a QSR inspection could force a shut-down
of our manufacturing operations and a recall of, or field action relating to,
our products. Such failure may prevent us from meeting production schedules,
minimizing manufacturing costs, maintaining quality requirements or completing
product sales.

For example, the FDA inspected our manufacturing facility in August 2001. In
addition, the British Standards Institution performed a management systems
assessment of our manufacturing processes in May 2000, February 2001 and June
2001. These inspections resulted in observations to which we submitted
responses, and we believe these responses have been accepted by those agencies.
Also, in August 2001 the FDA classified as a class II field action a May 2000
software upgrade we issued to correct an error in an algorithm contained in one
of our products. If our appeal of this classification is unsuccessful, we will
be required to take additional steps to ensure that all affected purchasers
receive the upgrade. If required to take action, we do not believe the
associated costs will be significant. Although to date these actions by
regulatory bodies have not required us to incur substantial costs or delay
product shipments, we expect to experience further inspections and incur
additional costs as a result of government regulation.

Our limited manufacturing experience and the complexity of our products may
impair our ability to respond effectively to manufacturing problems, manage our
inventory and avoid excessive warranty costs.

order to make this transition, we built a series of manufacturing lines and
developed our own manufacturing processes and procedures. We have limited
experience in managing manufacturing problems and risks, such as line
shutdowns, product procurement issues, regulatory compliance, rework, quality
system issues or yield issues. We manufacture our products and determine
product mix based on forecasts of sales in future periods. Incorrect forecasts
and long order lead-times could lead to shortages or surpluses of product
inventory. If we experience any manufacturing problems, we may experience
delays in the shipment of our products. Our failure to effectively manage our
manufacturing process may prevent us from meeting production schedules,
minimizing manufacturing costs, maintaining quality requirements or completing
product sales.

In addition, our products are intricate and technically complex. As a
result, deficiencies in our design and manufacturing process may result in
significant warranty exposure. Our products generally carry a one-year warranty
against defects in materials and workmanship. We will be responsible for all
claims, actions, damages, liens, liabilities and costs for all product field
actions, returns and defects attributable to manufacturing. Although we have
established accruals for the liability associated with product warranties, any
unforeseen warranty exposure could increase our expenses and impair our
operating results.

Our reliance on a single manufacturing facility may impair our ability to
respond to natural disasters or other unforeseen catastrophic events.

Our sole manufacturing facility is located in a single building in Bothell,
Washington. Despite precautions taken by us, a natural disaster such as an
earthquake or other unanticipated catastrophic events at this building could
significantly impair our ability to manufacture our products and operate our
business. Our facility and certain manufacturing equipment would be difficult
to replace and could require substantial replacement lead-time. Such
catastrophic events may also destroy any inventory of product or components.
While we carry insurance for natural disasters and business interruption, the
occurrence of such event could result in losses that exceed the amount of our
insurance coverage, which would impair our financial results.

If our products do not perform as expected, we could experience lost revenue,
delayed or reduced market acceptance of our products, increased costs and
reputational damage.

Our success depends on the market's confidence that we can provide reliable,
high quality medical devices. Our customers are particularly sensitive to
product defects and errors because of the use of our products in clinical
medical practice. Our reputation and the public image of our products may be
impaired for any of the following reasons:

. failure of products to perform as expected;

. a perception that our products are difficult to use; and

. litigation concerning the performance of our products or our technology.

Even after any underlying problems are resolved, any manufacturing defects
or performance errors in our products could result in lost revenue, delay in
market acceptance, damage to our reputation, increased service and warranty
costs and claims against us.

We have a history of losses, we expect future losses and we may never be
profitable.

We have incurred net losses in each quarter since we commenced operations.
As of December 31, 2001, we had an accumulated deficit of approximately $77.9
million. We expect to incur additional losses over the next several quarters,
and these losses may increase if we cannot increase or sustain our revenue. Our
revenue from product sales has been insufficient to cover our expenses, and we
expect that our operating expenses will substantially increase in the
foreseeable future as we expand our sales and marketing infrastructure, our
manufacturing capability and possibly our product development activities. Our
expansion efforts, to be

successful, may require more funding than we currently anticipate. Accordingly,
we will need to generate significant additional sales revenue in the future
before we will be able to achieve and maintain profitability. If we cannot
generate such revenue, we may never be profitable. Even if we do become
profitable, we may be unable to sustain or increase future profitability on a
quarterly or annual basis. If we fail to do so, the market price for our common
stock will likely fall.

A failure to manage our growth could impair our ability to achieve our business
objectives.

We have experienced rapid growth since our inception as a stand-alone
company. Our sales revenue increased from $10.2 million in 1999 to $32.0
million in 2000 and $45.7 million in 2001. During 2001, we increased the number
of our sales representatives in the United States from 26 to 51, introduced two
new products to the market and began expanding our operations in Europe. We
expect continued significant growth in all areas of operations as we continue
to develop, manufacture, market and sell our products. Our growth could strain
our existing management, operational and financial resources. In order to
manage our growth effectively, we will need to expand our manufacturing and
quality assurance staff, our sales staff and our manufacturing capabilities. In
addition, we will need to improve the productivity and efficiency of our
existing operational, financial and management resources and information
systems. We may be unable to hire and retain the personnel necessary to operate
and expand our business. We also may be unable to increase the productivity and
efficiency of our existing resources. If we fail to timely improve or augment
our existing resources in response to our growth, we may be unable to
effectively manage our business and achieve our objectives.

Our strategy of expanding and maintaining our domestic sales force may fail to
generate a substantial increase in sales.

We began direct sales of our products in the United States in February 2000
with a sales force comprised of sonographers with little direct sales
experience. Since then, we have nearly doubled the size of our direct sales
force in the United States by supplementing our sonographers with trained
professional sales people. We expect to continue expanding our domestic sales
force to add clinical application specialists, including cardiology product
specialists, in an effort to improve our sales efficiency and reach new
markets. This expansion will require extensive training efforts, substantial
management attention and a substantial increase in sales and marketing
expenses. Despite our expenditures and efforts, we may not successfully expand
our market penetration or generate a substantial increase in sales.

Our limited financial resources may impair our ability to market our products
effectively and may limit our product sales.

Marketing is critical to generate awareness of our products and promote the
new uses of ultrasound that our products enable. Our marketing efforts must
overcome the marketing efforts of our competitors, as well as the resistance
that may be shown by both existing and new ultrasound users. We have incurred
and will continue to incur significant expenditures for a range of marketing
efforts, including attendance at trade shows, direct mail solicitations and
print advertising. If our limited financial resources impair our marketing
budget, we may be unable to generate sufficient brand awareness to positively
impact product sales. This lack of brand awareness may result in delayed or
reduced market acceptance of our products and may limit our product sales.

If our operating results fluctuate and fall below expectations of securities
analysts and investors, our stock price may fall and you may lose some or all
of your investment.

Our operating results have fluctuated in the past, and we expect these
fluctuations to continue in the foreseeable future. Many factors affecting our
quarterly operating results are outside our control, including:

. product and price competition;

. global economic conditions;

. performance of our third-party distributors;

. year-end customer budget constraints and other customer buying patterns;
and

. changes in component cost and availability.

Other factors are difficult to control, including:

. demand for our products;

. estimating appropriate manufacturing levels for forecasted sales;

. inventory management and obsolescence;

. performance of our direct sales and distribution channels;

. development of new and enhanced products;

. product introductions and commercializations; and

. timing and magnitude of our expenses.

A negative fluctuation of our operating results could run contrary to the
expectations of securities analysts or investors, which may reduce the market
price of our stock and cause a loss of some or all of your investment.

Our creation, maintenance and expansion of direct sales and distribution
operations in Europe will burden our resources and may fail to generate a
substantial increase in sales.

We have historically relied on third-party distributors to sell our products
in Europe. We recently commenced operations in the United Kingdom, Germany and
France to sell our products directly in each of those countries. We expect to
expand our European direct sales operations in the future. Establishing,
maintaining and expanding these operations will require us to:

. substantially increase our costs of operations;

. temporarily divert existing management resources;

. establish an efficient and self-reliant local infrastructure;

. attract, hire and train qualified local sales and administrative personnel;

. comply with additional local regulatory requirements; and

. expand our information, financial, distribution and control systems to
manage expanded global operations.

Our movement into Europe will require substantial financial and management
resources. The costs of this expansion are unpredictable, difficult to control
and may exceed budgeted amounts. Despite our expenditures and efforts, we may
not generate a substantial increase in European sales revenue, which would
impair our operating results.

Our foreign sales revenue is subject to currency fluctuation and other risks
associated with doing business outside the United States.

The percentage of our sales revenue originating outside the United States
equaled 48% in 2001 and 53% in 2000. Of this foreign sales revenue,
approximately 35% originated in Japan in 2001 and 49% in 2000. Our revenue from
international sales may be adversely affected by any of the following risks:

. currency rate fluctuations;

. reduced protection for intellectual property rights;

. longer receivables collection periods and greater difficulty in
receivables collection;

. localizing products for foreign markets; and

. compliance with export laws, including license requirements, trade
restrictions and tariff increases.

As of December 31, 2001, 58% of our outstanding accounts receivable balance
was from international customers. Our distributor in Japan was indebted to us
for approximately $4.3 million, representing 28% of our outstanding accounts
receivable balance. In addition, approximately 4% of our outstanding
receivables was from a single customer in Argentina who was indebted to us for
$626,000. We regularly review our receivable position in foreign countries for
any indication that collection may be at risk. For example, due to current
economic events in Argentina, including the decision to allow the Argentine
peso to float against the U.S. dollar, we recorded an additional allowance of
$188,000 on an account in Argentina during the fourth quarter, and we may be
required to write off some or all of our Argentine receivables.

Our foreign distributors may be unwilling or unable to devote sufficient
resources to market and sell our products, which could delay or reduce market
acceptance and sales of our products outside the United States.

We currently depend on foreign distributors to help promote market
acceptance and demand for our products in countries in which we do not have a
direct sales force. For example, sales to our distributor in Japan, Olympus,
represented 17% of our revenue in 2001. Foreign distributors that are in the
business of distributing other medical products may not devote the resources
and support required within these countries to generate awareness of our
products and grow or maintain product sales. If these distributors are
unwilling or unable to market and sell our products, we could experience
delayed or reduced market acceptance and sales of our products outside the
United States.

The loss of any principal member of our management team or scientific staff, on
whom we rely heavily, could impair our ability to compete.

Our success depends heavily on our ability to retain the services of the
principal members of our management and scientific staff. Competition among
medical device companies for qualified employees is intense. We may fail to
retain these key employees, and we may fail to attract qualified replacements
if they do leave. We do not maintain key-person insurance on any of our
employees. We do not have employment agreements with any of our employees. The
loss of any of our key employees could significantly delay or prevent the
achievement of our scientific or business objectives.

If we are unable to protect and enforce our intellectual property rights, we
may be unable to compete effectively.

Much of our value arises out of our proprietary technology and intellectual
property for the design, manufacture and use of hand-carried ultrasound imaging
devices. Our success and ability to compete effectively depend on our ability
to protect our proprietary information. We rely on patent, copyright, trade
secret and trademark laws to protect our proprietary technology and limit the
ability of others to compete with us using the same or similar technology.

We currently hold five patents relating to the weight of digital
beamformers, beamforming capabilities, digital conversion circuitry,
transceiver circuitry and circuit integration. Additionally, we have a license
from our former parent, ATL, to use certain ATL technology and ATL
technological developments in our hand-carried products. This license is
exclusive through April 5, 2003, and nonexclusive after that date. We also
enter into confidentiality or license agreements with our employees,
consultants and corporate partners, and generally control access to, and the
distribution of, our product designs, documentation and other proprietary
information, as well as the designs, documentation and other information that
we license from others.

Our efforts afford only limited protection and may not adequately protect
our rights to the extent necessary to sustain any competitive advantage we may
have. Despite our efforts to protect our intellectual property, we may
experience:

. unauthorized use of our technology by competitors;

. independent development of the same or similar technology by a competitor,
coupled with a lack of enforceable patents on our part;

. failure of our pending patent applications to result in issued patents;

. successful interference actions to our patents or successful oppositions
to our patents and patent applications;

. unauthorized disclosure or use of our proprietary information by former
employees or affiliates; and

. failure by our commercial partners to comply with their obligations to
share technology or use our technology in a limited manner.

Policing unauthorized use of our intellectual property will be difficult and
may be cost-prohibitive. We may fail to prevent misappropriation of our
technology, particularly in countries where the laws may not protect our
proprietary rights to the same extent as the laws of the United States. If we
cannot prevent other companies from using our proprietary technology or if our
patents are found invalid or otherwise unenforceable, we may be unable to
compete effectively against other manufacturers of ultrasound devices, which
could decrease our market share.

If we are involved in intellectual property claims and litigation, the
proceedings may divert our resources and subject us to significant liability
for damages, substantial litigation expense and the loss of our proprietary
rights.

In order to protect or enforce our patent rights, we may initiate patent
litigation. In addition, others may initiate patent litigation against us. We
may become subject to interference proceedings conducted in patent and
trademark offices to determine the priority of inventions. There are numerous
issued and pending patents in the medical device field. The validity and
breadth of medical technology patents may involve complex legal and factual
questions for which important legal principles may remain unresolved. In
addition, because patent applications can take many years to result in issued
patents and are maintained in confidence by the U.S. Patent and Trademark
Office while pending, there may be currently pending applications of which we
are unaware, which may later result in issued patents that our products may
infringe. There could also be existing patents of which we are not aware that
one or more of our products may infringe. Litigation may be necessary to:

. assert or defend against claims of infringement;

. enforce our issued and licensed patents;

. protect our trade secrets or know-how; or

. determine the enforceability, scope and validity of the proprietary rights
of others.

We may become involved in the defense and prosecution, if necessary, of
intellectual property suits, patent interferences, opposition proceedings and
other administrative proceedings. For example, on July 24, 2001, Neutrino
Development Corporation filed a complaint against us, which alleged that our
sale and manufacture of our hand-carried ultrasound devices infringed upon a
patent held by Neutrino. We responded to the claim, asserting alternative
defenses of noninfringement and patent invalidity. In addition, we filed a
counterclaim seeking a declaratory judgment of noninfringement and invalidity
regarding Neutrino's patent. We also defeated Neutrino's request for a
preliminary injunction preventing us from manufacturing and selling our
products for the duration of the litigation. On February 20, 2002, in what is
known as a "Markman" hearing, the parties presented their arguments regarding
the proper construction of Neutrino's patent claims. The court has not yet
ruled on the

issues presented in that hearing, and may issue a ruling at any time. Although
we continue to vigorously defend ourselves against this claim, this litigation
may result in an adverse judgment against us. We have been forced to incur
substantial expenses in defense of this claim, and we expect to incur
additional substantial litigation expenses until the claim is resolved.

Our involvement in intellectual property claims and litigation could:

. divert existing management, scientific and financial resources;

. subject us to significant liabilities;

. allow our competitors to market competitive products without obtaining a
license from us;

. cause product shipment delays and lost sales;

. require us to enter into royalty or licensing agreements, which may not be
available on terms acceptable to us, if at all; or

. force us to discontinue selling or modify our products or to develop new
products.

If healthcare reimbursement practices or reform restricts coverage available to
our customers for the use of our products, we may experience limited market
acceptance of our products.

Market acceptance of our products depends in part on the extent to which our
customers will receive reimbursement for our products from governmental
authorities, private health insurers and other third-party payors. The
continuing efforts of governmental, private health insurers and other
third-party payors to contain or reduce the costs of healthcare through various
means may limit market acceptance of our products. Increasing efforts by
governmental and third-party payors, such as Medicare, private insurance plans
and managed care organizations, to contain or reduce healthcare costs may
affect our ability to market our current products, commercialize our potential
products and become profitable. Reimbursement coverage, if available, may not
be adequate to enable us to achieve market acceptance of our products. In
addition, we believe that third-party payors will attempt to reduce healthcare
costs by limiting both coverage and level of reimbursement for new products
cleared by the FDA or comparable foreign agencies. Our products enable new
kinds of medical procedures involving novel ultrasound applications. The
efforts of government and third-party payors to contain or reduce the cost of
healthcare could restrict physicians' and other healthcare providers'
willingness to select our products and implement new ultrasound procedures,
which could delay or reduce market acceptance of our products.

Additionally, there has been and will continue to be a number of federal and
state proposals to implement government controls on pricing. The existence and
adoption of these proposals could affect our ability to successfully market our
current products and commercialize new products.

Compliance with governmental regulation of our business could be costly and
time-consuming, and could prevent us from introducing new products in a timely
manner.

Our products, our manufacturing activities and the manufacturing activities
of our third-party medical device manufacturers are subject to extensive
regulation by a number of governmental agencies, including the FDA and
comparable international agencies. Our third-party manufacturers and we are or
will be required to:

. obtain prior clearance or approval from these agencies before we can
market and sell our products;

. undergo rigorous inspections by domestic and international agencies; and

. satisfy content requirements for all of our sales and promotional
materials.

Compliance with the regulations of these agencies, including the
Environmental Protection Agency and the Occupational Safety and Health
Administration, may require us to incur substantial costs and may delay or
prevent the introduction of new or improved products. We may be subject to
fines, sanctions, including the temporary or permanent suspension of
operations, product field actions, criminal prosecution and marketing

restrictions, if we fail to comply with the laws and regulations pertaining to
our business. Our third-party medical device manufacturers may also be subject
to the same sanctions and, as a result, may fail to supply us with components
required to manufacture our products.

Product liability and other claims and product field actions could increase our
costs, delay or reduce our sales and damage our reputation, which could
significantly impair our financial condition.

The sale and support of our products entail the risk of product liability,
malpractice or warranty claims, including those based on claims that the use or
failure of one of our products resulted in a misdiagnosis or harm to a patient.
Although to date we have not been involved in any medical malpractice or
product liability litigation, we may incur significant liability if such
litigation were to occur. We may also face adverse publicity resulting from a
product field action or a liability claim against us. Although we currently
maintain liability insurance, any product liability we incur may exceed our
insurance coverage. Liability insurance is expensive and may cease to be
available on acceptable terms, if at all. A product liability or other claim or
product field action not covered by our insurance or exceeding our coverage
could significantly impair our financial condition. In addition, a product
field action or a liability claim against us could significantly harm our
reputation and make it more difficult to obtain the funding and commercial
relationships necessary to maintain our business.

If our stock price continues to be volatile, your shares may decline in value.

The market price for our common stock, as well as for securities of emerging
growth companies generally, has been volatile in the past and is likely to
continue to be volatile. You may be unable to resell your shares at or above
the price you paid due to a number of factors, many of which are beyond our
control, including:

. the difference between quarterly operating results and those expected by
investors or securities analysts;

. changes in earnings estimates by analysts;

. the loss of significant orders;

. announcements of technological innovations or new products by our
competitors;

. changes in the structure of healthcare financing and payment systems;

. general conditions in the medical industry or global economy;

. a lack of liquidity in the market for our stock; and

. significant sales of our common stock by one or more of our shareholders.

Our future capital-raising activities could involve the issuance of equity
securities, which would dilute your investment and could result in a decline in
the trading price of our common stock.

To meet our long-term funding requirements, we may sell securities in the
public or private equity markets if and when conditions are favorable, even if
we do not have an immediate need for additional capital at that time.
Furthermore, we may enter into financing transactions at prices that represent
a substantial discount to market price. Raising funds through the issuance of
equity securities will dilute the ownership of our existing shareholders. A
negative reaction by investors and securities analysts to any sale of our
equity securities could result in a decline in the trading price of our common
stock.

If we incur tax liability in connection with our spin-off from ATL, we would be
required to pay a potentially significant expense, which would diminish our
financial resources.

Our spin-off was treated by ATL as a tax-free spin-off under Section 355 of
the Internal Revenue Code of 1986. If, however, ATL were to recognize taxable
gain from the spin-off, the Internal Revenue Service could impose that
liability on any member of the ATL consolidated group as constituted prior to
the spin-off, including us. ATL agreed to cover 85% of any such liability,
unless the tax is imposed due to our actions solely or by ATL

solely, in which case, we have agreed with ATL that the party who is solely at
fault shall bear all of the tax liability. ATL may refuse to indemnify us or
may argue that it did not cause the tax liability to be imposed. In such event,
we may incur a significant expense for all or a portion of taxes related to the
spin-off.

If our expenses exceed our revenue and we fail to obtain timely additional
financing, we could experience delays or reductions in our product development
and sales efforts, which would impair our operating results.

To date, our revenue has been insufficient to cover the expenses of our
operations. Our future revenue may continue to be insufficient to support the
expenses of our operations and the expansion of our business. We may therefore
need additional equity or debt capital to finance our operations as we develop
our products and expand our sales. To date, our capital requirements have been
met primarily by the sale of equity, sales revenue and contributions by ATL in
connection with our spin-off. ATL has no further obligations to provide us with
funding, and we do not expect any future funding from this source. Therefore,
if we require additional financing, we would need to explore other sources of
financing, including public equity or debt offerings, private placements of
equity or debt and collaborative or other arrangements with corporate partners.
Financing may be unavailable when needed or may be unavailable on acceptable
terms. If we fail to obtain financing, we may be required to delay, reduce or
eliminate some or all of our research and development and sales and marketing
efforts, and our business could fail.

The concentrated ownership of our common stock could delay or prevent a change
of control, which could cause a decline in the market price of our common stock.

As of December 31, 2001, our executive officers, directors and affiliated
entities together beneficially owned approximately 5% of the outstanding shares
of our common stock. Four other shareholders owned in the aggregate
approximately 42.0% of the outstanding shares of our common stock. Among these
shareholders, the State of Wisconsin Investment Board, or SWIB, owned
approximately 17.2% of the outstanding shares of our common stock and WM
Advisors owned approximately 11.6%. As a result, these shareholders or any
other concentrated owner may be able to exert significant influence over all
matters requiring shareholder approval, including the election of directors,
matters relating to the attraction and retention of employees, and approval of
significant corporate transactions that could include certain matters relating
to future financing arrangements and unsolicited tender offers. This
concentration of ownership may delay, deter or prevent a third party from
acquiring control over us at a premium over the then-current market price of
our common stock, which could result in a decrease in our stock price.

Our restated articles of incorporation, our bylaws, Washington law and some of
our agreements contain provisions that could discourage a takeover and prevent
shareholders from receiving a premium for their shares.

There are provisions in our restated articles of incorporation, our bylaws
and Washington law that make it more difficult for a third party to obtain
control of us, even if doing so would be beneficial to our shareholders.
Additionally, our acquisition may be made more difficult or expensive by the
following:

. change of control provisions in our license agreement with ATL, which
require us to pay ATL:

. $150 million if, prior to April 6, 2003, any single person or entity
obtains, directly or indirectly, voting control of a majority of our
common stock or the power to elect our entire board of directors; or

. $75 million if, at any time between April 6, 2003 and April 6, 2006, any
single person or entity engaged in the medical diagnostic imaging
business, other than through the sale or manufacture of our products,
obtains, directly or indirectly, voting control of a majority of our
common stock or the power to elect our entire board of directors;

. our shareholder rights agreement, which is sometimes called a "poison
pill"; and

. acceleration provisions in benefit plans and change-in-control agreements
with our employees.

ITEM 2. PROPERTIES

Our principal offices are located in Bothell, Washington, where we lease
approximately 65,000 square feet. The facility includes approximately 30,000
square feet of office space, 25,000 square feet of manufacturing space and
10,000 square feet used for other things, such as warehousing, reception and
meeting rooms. The lease runs through 2007. We believe that these facilities
will be adequate to meet our needs for the foreseeable future. Additionally, we
or our subsidiaries lease smaller office facilities at each subsidiary location.

ITEM 3. LEGAL PROCEEDINGS

On July 24, 2001, Neutrino Development Corporation filed a complaint against
us in U.S. District Court, Southern District of Texas, Houston Division,
alleging infringement of U.S. Patent 6,221,021 as a result of our use, sale and
manufacture of the SonoSite 180, SonoSite 180PLUS, SonoHeart and SonoHeart PLUS
devices. The complaint asserts claims for preliminary and permanent injunctive
relief enjoining all alleged acts of infringement, compensatory and enhanced
damages, attorney's fees and costs, and pre- and post-judgment interest. On
August 14, 2001, we filed an answer asserting alternative defenses of
noninfringement and patent invalidity, and included a counterclaim seeking a
declaratory judgment of noninfringement and invalidity regarding Neutrino's
patent. On October 4, 2001, the court denied a request by Neutrino for
preliminary injunctive relief to prevent us from manufacturing and selling our
products pending the ultimate disposition of the litigation. On February 20,
2002, in what is known as a "Markman" hearing, the parties presented their
arguments regarding the proper construction of Neutrino's patent claims. The
court has not yet ruled on the issues presented in that hearing. We believe we
have good and sufficient defenses to the claims of patent infringement asserted
against us by Neutrino and we are vigorously defending ourselves in this matter.

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

No matters were submitted to a vote of our shareholders during the fourth
quarter of the year ended December 31, 2001.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is traded on the Nasdaq National Market under the symbol
SONO. As of February 20, there were 3,664 holders of record of the common
stock. This figure does not include the number of shareholders whose shares are
held of record by a broker or clearing agency, but does include each such
brokerage house or clearing agency as a single holder of record.

The high and low sales prices for our common stock for each quarter are
listed below. These prices reflect interdealer prices, without retail mark-up,
mark-down or commission, and may not necessarily represent actual transactions.

Year High Low
---- ------ ------

2001
Fourth quarter $27.50 $17.99
Third quarter. $27.85 $14.65
Second quarter $20.00 $10.50
First quarter. $17.38 $ 8.38
2000
Fourth quarter $21.06 $12.00
Third quarter. $35.13 $17.00
Second quarter $35.13 $18.63
First quarter. $37.25 $21.88

We have not declared or paid cash dividends on our common stock. We
currently intend to retain all earnings, if any, for future growth and,
therefore, do not intend to pay cash dividends on our common stock in the
foreseeable future.

ITEM 6. SELECTED FINANCIAL DATA

The selected financial data should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Financial Statements and Notes thereto included elsewhere in this Form 10-K.

For the Years Ended December 31,
-----------------------------------------------
2001 2000 1999 1998 1997
-------- -------- -------- -------- -------

(in thousands, except per share data)

Statement of Operations Data
Sales revenues............................................ $ 45,695 $ 32,037 $ 10,185 $ -- $ --
Cost of sales revenue..................................... 21,861 18,649 6,498 -- --
-------- -------- -------- -------- -------
Gross margin on sales revenue............................. 23,834 13,388 3,687 -- --
Grant revenue............................................. -- -- 125 973 2,948
Operating expenses:
Research and development................................. 12,715 11,835 14,533 9,474 7,064
Sales and marketing...................................... 22,312 17,371 9,767 3,120 1,268
General and administrative............................... 5,198 4,647 2,637 1,904 610
-------- -------- -------- -------- -------
Total operating expenses.................................. 40,225 33,853 26,937 14,498 8,942
Other income (loss):
Interest income.......................................... 1,123 2,478 1,600 541 --
Interest expense......................................... (175) (155) (117) (41) --
Equity in (losses) earnings of affiliates................ (675) (830) 30 -- --
Other loss............................................... (291) -- -- -- --
-------- -------- -------- -------- -------
Total other income (loss)................................. (18) 1,493 1,513 500 --
-------- -------- -------- -------- -------
Net loss.................................................. $(16,409) $(18,972) $(21,612) $(13,025) $(5,994)
======== ======== ======== ======== =======
Basic and diluted net loss per share (1).................. $ (1.59) $ (2.01) $ (3.08) $ (2.72) $ (1.28)

Weighted average common and potential common shares
used in computing basic and diluted net loss per share (1) 10,300 9,418 7,025 4,796 4,684

As of December 31,
------------------------------------
2001 2000 1999 1998 1997
------- ------- ------- ------- ----

(in thousands)

Balance Sheet Data
Cash and cash equivalents.................. $33,116 $11,067 $33,252 $ 7,526 --
Working capital (deficiency)............... 49,326 40,534 54,923 16,934 (170)
Total assets............................... 63,178 58,024 69,726 23,290 410
Long-term obligations, less current portion 185 316 135 481 --
Total shareholders' equity................. 55,683 47,808 63,709 19,833 240

--------
(1) Net loss per share amounts are computed on the basis described in Note 2 of
Notes to the Consolidated Financial Statements for periods subsequent to
the April 6, 1998 Distribution Date. For the periods prior to the
Distribution Date, weighted average shares outstanding represent ATL
weighted average shares as adjusted for the exchange ratio established on
the Distribution Date of one of our shares for every three shares of ATL.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Overview

We design, manufacture and sell high performance, highly miniaturized,
hand-carried, all-digital ultrasound imaging devices and related products for
use in a variety of clinical applications and settings. Our current products
include the SonoSite 180PLUS and the SonoHeart ELITE ultrasound devices and
related accessories and educational programs. Our devices employ five
interchangeable transducers attached to the device by a cable. These
transducers, each designed for a different medical use, send out and receive
ultrasound waves.

Initially, we sold our products through third-party medical product
distributors worldwide. In February 2000, we began a direct sales operation in
the United States. As of December 31, 2001, we had 51 direct sales
representatives in the United States. To support these direct sales efforts, we
have entered into group purchasing agreements with major healthcare group
purchasing organizations that identify us as a preferred supplier for major
hospital and clinic networks throughout the United States. We recently expanded
our direct sales efforts into foreign markets by establishing three wholly
owned subsidiaries, SonoSite, Ltd. in the United Kingdom, SonoSite France SARL
in France and SonoSite GmbH in Germany. In those countries where we do not have
a direct sales force, we continue to sell our products through third-party
medical product distributors, such as Olympus in Japan.

Until the sale of our first product in September 1999, we were a product
development company with significant expenditures for research and development.
We currently employ over 50 product development personnel. Since our spin-off
from ATL, we have incurred expenditures of $46.4 million for research and
development. We continue to introduce new technology through ongoing investment
in research and development. Research and development expenses for the year
2001 were $12.7 million.

Since operations began, we have incurred losses. As of December 31, 2001, we
had an accumulated deficit of $77.9 million. Since the sale of our first
product in September 1999, sales revenues have totaled $87.9 million. Our gross
margin on our sales revenue has never exceeded our expenses and therefore we
continue to incur losses. We have funded our operations with our revenues, a
contribution of $30.0 million from ATL in connection with the spin-off and net
proceeds of $87.9 million through the issuance of shares of our common stock in
public and private equity financings. In addition, we have received
approximately $4.7 million from the exercise of stock options.

We expect to continue to incur operating losses unless and until our product
sales generate sufficient revenue to fund our continuing operations. We may be
unable to generate sufficient revenue to fund our operations in future periods.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States of America. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, we evaluate our
estimates, including those related to product returns, bad debts, inventories,
investments, warranty obligations, service contracts, contingencies and
litigation. We base our estimates on historical experience and on various other
assumptions that we believe are reasonable under the circumstances. The results
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.

We believe the following critical accounting policies require our more
significant judgments and estimates used in the preparation of our consolidated
financial statements:

Revenue recognition. We recognize sales revenue when a product is shipped
under an agreement with a customer, risk of loss and title have passed to the
customer and collection of any resulting receivable is reasonably assured. For
service contracts, revenue is recognized over the term of the contract. Sales
discounts are recorded as a reduction in revenue.

In connection with sales to certain specific international customers, we
sometimes conclude that full collection of the related accounts receivable is
not reasonably assured due to extended payment terms or the financial condition
of our customer and consequently we do not recognize revenue or cost of
revenues at the time of title transfer. Additionally, in cases of nonstandard
delivery and acceptance criteria, we will not recognize revenue at shipment,
but rather wait until we determine such criteria have been satisfied.

Valuation of inventories. Inventories are stated at the lower of standard
cost, which approximates actual cost on a first-in, first-out method, or
market. Included in our inventories balance are demonstration products used by
our sales representatives and marketing department and items that have been
shipped to customers for which revenue recognition requirements have not been
met. Cost adjustments are recorded for obsolete material, earlier generation
products and used product held either as saleable inventory or as demonstration
product.

We make judgements regarding the carrying value of our inventory based on
current market conditions. Market conditions may change depending upon
competitive product introductions, consumer demand and reimbursement criteria
in the medical community. If market conditions change or if the introduction of
new products by us impacts the market for our previously released products we
may be required to write-down the cost of our inventory.

Results of Operations

Revenue

Sales revenue increased to $45.7 million in 2001, compared to $32.0 million
in 2000 and $10.2 million in 1999. The increase in 2001 as compared with 2000
was primarily due to an increase in unit sales and an increase in the average
selling price on a per system basis. In the United States, we increased the
number of direct sales representatives to 51 at the end of 2001, compared to 26
at the end of 2000. The average selling price per system increased due to an
increase in the number of transducers and accessories sold with each system and
an increase in the percentage of direct sales compared with distributor sales.

The increase in sales revenue in 2000 compared to 1999 was primarily due to
2000 being the first full year of product sales, as compared to four months of
product sales in 1999. Our product shipments in 1999 and first quarter of 2000
were primarily to meet initial worldwide distributor demand. In the second
quarter of 2000, we released the SonoSite 180 system along with a new
transducer, which resulted in additional sales to distributors in the second
quarter. As the initial orders from distributors decreased, sales revenue
decreased during the third and fourth quarters of 2000 and consisted primarily
of direct sales in the United States and reorders from our distributors upon
sell-through to end customers.

The following represents sales revenue by region:

For the Year Ended December 31,
-------------------------------
2001 2000 1999
------- ------ -------

United States:
Direct sales.................................... 49% 25% --
Distributor sales............................... 3% 22% 42%
---- ---- ----
Total U.S. sales................................... 52% 47% 42%
Japan.............................................. 17% 26% 1%
Europe, Africa and the Middle East................. 20% 12% 27%
Canada, South and Latin America, Asia (a) and other 11% 15% 30%
---- ---- ----
Total sales revenue................................ 100% 100% 100%
==== ==== ====

--------
(a) Asia includes China, India, Korea, Singapore and Taiwan.

Total U.S. sales increased to 52% of total revenue in 2001, compared to 47%
in 2000 and 42% in 1999 due to our new product introductions and increased
selling efforts. Within the United States, direct sales increased to 49% of the
total revenue in 2001 compared to 25% in 2000 and none in 1999 due to the
increase in direct sales representatives. With our transition to a direct sales
force, distributor sales in the United States decreased to 3% of total revenue
in 2001 compared to 22% in 2000 and 42% in 1999.

Sales revenue from Japan decreased to 17% in 2001 from 26% in 2000 due to a
higher relative increase in sales in the United States, Europe, Africa and the
Middle East. The increase of sales revenue in Japan to 26% in 2000 from 1% in
1999 was due to limited selling in Japan in 1999.

Sales revenue from Europe, Africa and the Middle East increased to 20% of
total revenue in 2001 from 12% in 2000 due to an increase in direct sales in
the United Kingdom and a large multi-system sale in the first quarter of 2001.
The decrease to 12% of total revenue from 27% in 1999 was due to a higher
relative increase in sales in the United States and Japan.

Sales revenue from Canada, South and Latin America and Asia (excluding
Japan) decreased to 11% of total revenue in 2001 from 15% in 2000 and 30% in
1999 due to a higher relative increase in sales in the United States, Europe
and Japan.

We anticipate that sales revenue will increase in 2002 compared to prior
years due to continued expansion of our direct selling efforts in the United
States and Europe, introduction of new products and product features, and the
overall expansion of market awareness and acceptance of our products. However,
increased competition may impact the extent of the increase in our anticipated
growth in sales revenue. We currently face competition from larger companies
having greater financial and other resources that manufacture cart-based and
portable ultrasound devices. Some of these competitors are introducing highly
portable and hand-carried ultrasound products. Additionally, regulatory
approval of our new products in Japan may experience delays, which could impact
our anticipated sales revenue.

Gross margin

Gross margin increased to 52% in 2001, compared to 42% in 2000 and 36% in
1999. The increase in gross margin in 2001 was primarily due to a combination
of increased selling prices and manufacturing efficiencies. The increased
selling prices resulted from an increase in the number of transducers and
accessories sold with each system and an increase in the percentage of direct
sales compared with distributor sales. Costs as a percentage of sales decreased
in 2001 because costs on a per unit basis decreased as our production volumes
increased. Cost of sales in 2000 was higher than in 1999 due to a schedule
reduction fee paid to ATL, our contract manufacturer, when we brought
manufacturing in-house in the fourth quarter. Bringing manufacturing in-house
has resulted in an overall reduction in our per unit costs of manufacturing.

The increase in gross margin in 2000 from 1999 is primarily due to the low
sales level in 1999, which resulted in higher costs per unit due to the
application of manufacturing overhead expenses over less volume. We believe our
2001 gross margin better represents the relationship of manufacturing costs to
sales going forward. We expect gross margins in 2002 to be similar to the gross
margin achieved at the end of 2001. Nevertheless, lower prices due to increased
competition from existing and new competitors in the highly portable ultrasound
device market would lower our gross margin. Included in our inventories are
demonstration products, refurbished products and products held by our
customers, which are valued by us at amounts expected to result in a normal
margin upon sale. If market conditions change or the introduction of new
products by us impacts the market for our previously released products, we may
be required to write-down the cost of our inventory resulting in a negative
impact on gross margins. Additionally, we rely on our sales forecasts to
determine production volume. To the extent we overestimate our sales forecasts,
we may produce excess inventory, which may result in an increase in our costs
of goods sold and a decrease in our gross margin.

Operating expenses

Research and development expenses were $12.7 million in 2001, compared to
$11.8 million in 2000 and $14.5 million in 1999. Research and development
expenses increased in 2001 primarily due to increased activities surrounding
the final design, verification and validation of the PLUS platforms and related
transducers

and continued engineering design and development of new products, including the
new ELITE system and its features, which were announced in February 2002.

The decrease in 2000 research and development expenses compared to 1999 was
primarily due to a reduction in design, verification, validation and prototype
costs due to the completion and introduction of our initial product in 1999.

We anticipate that research and development expenses will decrease in 2002
as compared to 2001 primarily due to a reduction in the product development
costs associated with new products that are completed and introduced in 2002.
However, should our competitors develop products with features that equal or
exceed the features that exist in our products, we may incur higher than
anticipated research and development costs in order to accelerate existing
programs and compete more effectively.

Sales and marketing expenses increased to $22.3 million in 2001, compared to
$17.4 million in 2000 and $9.8 million in 1999. The increase in 2001 was
primarily due to an increase in direct selling expenses in the United States
and Europe. U.S. direct selling expenses increased by $3.2 million to $10.3
million, compared to $7.1 million in 2000. This increase was primarily due to
costs associated with the increase in the number of sales representatives and
sales management. Our expansion into Europe resulted in additional expenses in
2001 due to the addition of our direct selling operation. Offsetting these
increases was a decrease in marketing expenses due to market research expenses
incurred at the end of 2000 that were not incurred in 2001.

The increase in 2000 sales and marketing expenses compared to 1999 was
primarily due to our initial product release in September 1999 and subsequent
product releases, resulting in increased marketing and selling costs to support
both our product sales and market awareness.

We anticipate that sales and marketing expenses will continue to increase in
2002 in the United States and Europe as we continue to expand our direct
selling efforts in these markets. In the United States, we plan to add clinical
applications specialists to provide demonstration and installation support to
our sales representatives. In Europe, selling and marketing expenses will
increase due to our expected expansion of direct selling activities in Germany,
France and Spain.

General and administrative expenses were $5.2 million in 2001, compared to
$4.6 million in 2000 and $2.6 million in 1999. The increase in general and
administrative expenses in 2001 compared to 2000 related primarily to legal
expenses incurred to defend our intellectual property rights.

The increase in general and administrative expenses in 2000 compared to 1999
primarily related to the costs of moving into larger facilities in June 2000,
an increase in our allowance for doubtful accounts and our addition of
personnel to support the rapid growth in the direct selling area.

We anticipate that general and administrative expenses will increase in 2002
to support our continued growth in sales and distribution and our international
expansion as well as the continued defense of our intellectual property rights.
It is possible that we may incur additional unanticipated legal expenses as we
continue to defend our patent rights in the existing patent litigation or any
potential new litigation.

Other income (loss)

For other income and loss, we reported a loss of $18,000 in 2001, compared
to income of $1.5 million in 2000 and 1999. The decrease in 2001 compared to
2000 was primarily due to decreased interest income of $1.4 million as a result
of our decreased average investment balance and lower interest rates. The
increase in equity investment losses was the result of losses from our joint
venture in China.

Other income of $1.5 million in 2000 was level with 1999. The increase in
interest income between 2000 and 1999 of approximately $878,000 was due to our
higher average investment balance resulting from equity proceeds, excluding the
exercise of stock options, of $76.7 million received in 1999. The increase in
equity

investment losses was primarily the result of losses from our joint venture in
China and an affiliate that managed our direct sales force. At the end of 2000,
we decided to discontinue contracting for our direct sales representatives and
terminated this relationship and wrote off our investment in the affiliate.

Liquidity and Capital Resources

Our cash and cash equivalents balance increased to $33.1 million at the end
of 2001, compared to $11.1 million at the end of 2000 and $33.3 million at the
end of 1999. Cash and cash equivalents were primarily invested in money market
accounts in 2001. Cash, cash equivalents and short-term investment securities
at year-end was $33.1 million for 2001, compared to $29.3 million for 2000 and
$49.8 million for 1999. The increase in 2001 was primarily due to net proceeds
of $23.1 million received from a private placement sale of common stock in
August. The decrease in 2000 was primarily due to cash used in operations to
fund inventory and our net loss.

Operating activities used cash of $17.8 million in 2001, compared to $22.2
million in 2000 and $28.1 million in 1999. The 2001 decrease in cash used in
operations as compared with 2000 was primarily due to a reduction in
inventories, which related to our consumption of raw material that we obtained
from ATL as part of the transfer of the manufacturing operations in-house, a
reduction in our net loss and an increase in deferred liabilities resulting
from extended service contracts. These items were partially offset by increases
in accounts receivable due to significant sales volume in December 2001 as
compared to the prior year and a reduction in accounts payable primarily
related to payments to ATL for the raw material inventory noted above. The
decrease in cash used in 2000 as compared to 1999 was primarily due to a
reduction in accounts receivable and a reduction in our net loss, both of which
are partially offset by increased inventory levels.

Investing activities provided cash of $15.9 million in 2001, compared to
cash used of $2.5 million in 2000 and $22.6 million in 1999. The cash provided
in 2001 was primarily due to maturities of investment securities and was
partially offset by the purchases of investment securities and property and
equipment. Cash provided was used to fund our operations. The decrease in cash
used in 2000 was primarily due to decreases in purchases of investment
securities compared to 1999 as a result of decreased financing activities.

We anticipate using cash to invest in high quality investment instruments in
2002, the extent of which will be dependent upon the interest rate environment
during the year and the timing of cash flows from our operations during the
year.

Financing activities provided cash of $24.0 million in 2001, compared to
$2.5 million in 2000 and $76.4 million in 1999. In August 2001, we received net
proceeds of $23.1 million through the sale of 1,666,667 shares of our common
stock. In November 1999, we raised net proceeds of $29.3 million through the
sale of 1,250,000 shares of our common stock. In April 1999, we raised net
proceeds of $35.4 million through the sale of 2,990,000 shares of our common
stock. Additionally, in 1999, we received $12.0 million in contributed capital
from ATL. There were no private or public sales of common stock by us in 2000
other than the exercise of employee stock options.

We anticipate that cash used in operations will decrease in 2002 compared to
2001 primarily due to anticipated decreases in our net loss. This decrease will
be dependent upon our ability to successfully sell our products, collect our
receivables, control our inventories and manage our expenses.

We believe that our existing cash and cash generated from operations will be
sufficient to fund our operations and capital expenditure requirements for at
least the next year. Nevertheless, we may experience an increased need for
additional cash due to:

. any adverse impact to our revenues or gross margins as a result of
increased competition;

. any delay or inability to collect accounts receivable timely as a result
of continued or deteriorating global economic conditions;

. a need to significantly increase our sales and marketing and research and
development expenditures as a result of increased competition or new
market opportunities; and
. a need to significantly increase our sales and marketing expenditures as a
result of our introduction of new products.

Additionally, we have the following contractual obligations and commitments
as of December 31, 2001:

Operating Leases Capital Leases Total
---------------- -------------- -----
(in thousands)

2002....... $ 970 $159 $1,129
2003....... 1,012 159 1,171
2004....... 1,053 40 1,093
2005....... 1,084 -- 1,084
2006....... 1,114 -- 1,114
Thereafter 557 -- 557
------ --- ------
$5,790 $358 $6,148
====== ==== ======

Other commitments

As part of our agreements with our suppliers, suppliers may procure
resources and material expected to be used for the manufacture of our product
in accordance with our production schedule provided to them. In the event these
items are not used in the quantities submitted as part of the production
schedule or material becomes obsolete as a result of production timing,
material changes or design changes, we may be responsible for compensating our
suppliers for these procurements.

As part of obtaining our lease for our current facility, we were required to
deposit approximately $334,000, representing restricted cash with our bank,
which is included in other long-term assets. Additionally, we are required to
maintain a cash balance as security for, and in the same dollar amount as,
letters of credit we were required to open for the benefit of one of our
suppliers. At the end of 2001, the balance of this account was approximately
$243,000 and it is included in other long-term assets.

New Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (FASB), issued
statement of Financial Accounting Standard No. 141, "Business Combinations,"
and Statement No. 142, "Goodwill and Other Intangible Assets." Statement No.
141 requires that all business combinations be accounted for under a single
method--the purchase method. Use of the pooling-of-interest method is no longer
permitted. Statement 141 requires that the purchase method be used for business
combinations initiated after June 30, 2001. Statement 142 requires that
goodwill no longer be amortized to earnings, but instead be reviewed for
impairment. The amortization of goodwill ceases upon adoption of the statement,
which was adopted by us on January 1, 2002. The adoption of this statement is
not expected to have an impact on our financial statements.

In July 2001, the FASB issued Statement No. 143, "Accounting for Asset
Retirement Obligations." Statement No. 143 requires that the fair value of an
asset retirement obligation be recorded as a liability in the period in which
it is incurred. The associated asset retirement costs must be capitalized as
part of the carrying amount of the long-lived asset. The statement will be
effective for fiscal years beginning after June 15, 2002. The adoption of this
statement is not expected to have an impact on our financial statements.

Statement No. 121 and provides a single method of accounting for long-lived
assets to be disposed of. We are required and plan to adopt the provisions of
Statement No. 144 for the fiscal year beginning January 1, 2002. The adoption
of this statement for long-lived assets held for use is not expected to have a
material impact on our financial statements. The provisions of the statement
for assets held for sale or other disposal generally are required to be applied
prospectively after the adoption date to newly initiated disposal activities.
Therefore, we cannot determine the potential future effects that the adoption
of this statement for assets held for sale or other disposal will have on our
financial statements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest rate risk

Our exposure to market risk, as it relates to changes in interest rates, is
not considered to be significant due to the short-term nature of our
investments currently. Nearly all funds are held in money market accounts. If
we were to invest these funds, our investment policy requires us to invest in
high quality, short-term instruments with companies rated A or better by
Moody's or Standard and Poor's or commercial paper rated A-1 or P-1 or better.

As of December 31, 2001, we held $33.1 million in cash and cash equivalents
and had no investments in debt securities. As of December 31, 2000, we held
$11.1 million in cash and cash equivalents and $18.2 million in short-term debt
securities.

Foreign currency risk

Except for sales transacted by our wholly owned subsidiaries in the United
Kingdom, France and, beginning in 2002, Germany, and our joint venture in
China, we transact all our sales in U.S. dollars (USDs); therefore, the
obligations of our international customers are in USDs. Our exposure to risk
from fluctuations in foreign currencies relates primarily to the strengthening
of the USD against the local currency of our international customers, which may
impact our ability to collect amounts owed by our international customers.

As of December 31, 2001, 58% of our outstanding accounts receivable balance
was from international customers. Our distributor in Japan was indebted to us
for approximately $4.3 million, representing 28% of our outstanding accounts
receivable balance. We regularly review our receivable position in foreign
countries for any indication that collection may be at risk. A single customer
in Argentina was indebted to us for $626,000 at December 31, 2001, for which an
additional allowance of $188,000 was recorded in the fourth quarter of 2001 as
a result of economic conditions in Argentina. In addition, we utilize letters
of credit where they are warranted in order to mitigate our collection risk.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

SONOSITE, INC.

INDEX TO FINANCIAL STATEMENTS

Page
----

Independent Auditors' Report................................................... 30
Consolidated Balance Sheets.................................................... 31
Consolidated Statements of Operations.......................................... 32
Consolidated Statements of Cash Flows.......................................... 33
Consolidated Statements of Shareholders' Equity and Comprehensive Income (Loss) 34
Notes to the Consolidated Financial Statements................................. 35

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Shareholders,
SonoSite, Inc.

We have audited the accompanying consolidated balance sheets of SonoSite,
Inc. and subsidiaries as of December 31, 2001 and 2000, and the related
consolidated statements of operations, cash flows and shareholders' equity and
comprehensive loss for each of the years in the three-year period ended
December 31, 2001. In connection with our audits of the consolidated financial
statements, we also have audited the financial statement schedule listed in
Item 14(a). These consolidated financial statements and the financial statement
schedule are the responsibility of SonoSite, Inc.'s management. Our
responsibility is to express an opinion on these consolidated financial
statements and the financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SonoSite,
Inc. and subsidiaries as of December 31, 2001 and 2000, and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2001, in conformity with accounting principles
generally accepted in the United States of America. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.

KPMG LLP

Seattle, Washington
February 14, 2002

SONOSITE, INC.

CONSOLIDATED BALANCE SHEETS

As of December 31,
------------------
2001 2000
-------- --------

(in thousands,
except share data)
ASSETS
Current Assets
Cash and cash equivalents.................................................. $ 33,116 $ 11,067
Short-term investment securities........................................... -- 18,218
Accounts receivable, less allowance for doubtful accounts of $932 and $723. 14,003 7,303
Inventories................................................................ 8,299 12,325
Prepaid expenses and other assets.......................................... 1,017 1,400
-------- --------
Total current assets.......................................................... 56,435 50,313
Property and equipment, net................................................... 5,685 5,980
Receivable from affiliate..................................................... 188 880
Other assets.................................................................. 870 851
-------- --------
Total assets.................................................................. $ 63,178 $ 58,024
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Accounts payable........................................................... $ 1,914 $ 5,561
Accrued expenses........................................................... 3,816 3,684
Current portion of long-term obligations................................... 131 253
Deferred revenue........................................................... 1,248 281
-------- --------
Total current liabilities..................................................... 7,109 9,779
Deferred rent................................................................. 201 121
Long-term obligations, less current portion................................... 185 316
-------- --------
Total liabilities............................................................. 7,495 10,216
-------- --------

Commitments and contingencies

Shareholders' Equity
Preferred stock, $1.00 par value...........................................
Authorized shares--6,000,000...........................................
Issued and outstanding shares--none.................................... -- --
Common stock, $0.01 par value
Shares authorized--50,000,000..........................................
Issued and outstanding shares--
As of December 31, 2001--11,363,231.................................
As of December 31, 2000--9,551,596.................................. 114 96
Additional paid-in capital............................................. 133,470 109,195
Accumulated deficit.................................................... (77,901) (61,492)
Accumulated other comprehensive income................................. -- 9
-------- --------
Total shareholders' equity.................................................... 55,683 47,808
-------- --------
Total liabilities and shareholders' equity.................................... $ 63,178 $ 58,024
======== ========

See accompanying notes to the consolidated financial statements

SONOSITE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except loss per share)

For the Years Ended December 31,
-------------------------------
2001 2000 1999
-------- -------- --------

Sales revenue........................................................ $ 45,695 $ 32,037 $ 10,185
Cost of sales revenue................................................ 21,861 18,649 6,498
-------- -------- --------
Gross margin on sales revenue........................................ 23,834 13,388 3,687

Grant revenue........................................................ -- -- 125

Operating expenses:
Research and development.......................................... 12,715 11,835 14,533
Sales and marketing............................................... 22,312 17,371 9,767
General and administrative........................................ 5,198 4,647 2,637
-------- -------- --------
Total operating expenses............................................. 40,225 33,853 26,937

Other income (loss):
Interest income................................................... 1,123 2,478 1,600
Interest expense.................................................. (175) (155) (117)
Equity in (losses) earnings of affiliates......................... (675) (830) 30
Other loss........................................................ (291) -- --
-------- -------- --------
Total other income (loss)............................................ (18) 1,493 1,513
-------- -------- --------
Net loss............................................................. $(16,409) $(18,972) $(21,612)
======== ======== ========
Basic and diluted net loss per share................................. $ (1.59) $ (2.01) $ (3.08)
======== ======== ========
Weighted average common and potential common shares used in computing
basic and diluted net loss per share............................... 10,300 9,418 7,025
======== ======== ========

See accompanying notes to the consolidated financial statements

SONOSITE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

For the Years Ended December 31,
-------------------------------
2001 2000 1999
-------- -------- --------

Operating activities:
Net loss....................................................................... $(16,409) $(18,972) $(21,612)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization............................................... 2,276 2,192 1,390
Loss on disposition of plant and equipment.................................. -- 84 --
Loss on investments......................................................... 240 -- --
Equity in losses (earnings) of affiliates................................... 675 830 (30)
Amortization of premiums (discounts) on investment securities............... -- 26 (69)
Amortization of deferred stock compensation................................. -- 29 197
Changes in operating assets and liabilities:
Accounts receivable......................................................... (6,700) 553 (7,857)
Inventories................................................................. 4,026 (10,399) (2,326)
Receivable from affiliate................................................... 129 (480) (400)
Prepaid expenses and other assets........................................... 383 (223) (872)
Accounts payable............................................................ (3,647) 2,842 1,936
Accrued expenses............................................................ 132 1,200 1,360
Deferred liabilities........................................................ 1,047 110 213
-------- -------- --------
Net cash used in operating activities.......................................... (17,848) (22,208) (28,070)
Investing activities:
Purchase of investment securities........................................... (2,624) (49,919) (64,844)
Proceeds from maturities of investment securities........................... 20,593 51,490 45,095
Investment in affiliate..................................................... -- (500) --
Purchase of property and equipment.......................................... (1,981) (2,892) (2,856)
Increase in other assets.................................................... (131) (657) (1)
-------- -------- --------
Net cash provided by (used in) investing activities............................ 15,857 (2,478) (22,606)
Financing activities:
Proceeds from sale of common shares......................................... 23,147 -- 64,734
Exercise of stock options................................................... 1,146 2,972 617
Contributions from ATL...................................................... -- -- 12,000
New borrowings.............................................................. -- 300 --
Repayment of long-term obligations.......................................... (253) (771) (347)
Decrease in bank overdraft.................................................. -- -- (602)
-------- -------- --------
Net cash provided by financing activities...................................... 24,040 2,501 76,402
Net change in cash............................................................. 22,049 (22,185) 25,726
Cash and cash equivalents at beginning of period............................... 11,067 33,252 7,526
-------- -------- --------
Cash and cash equivalents at end of period..................................... $ 33,116 $ 11,067 $ 33,252
======== ======== ========
Supplemental disclosure of cash flow information:
Cash paid for interest...................................................... $ 175 $ 155 $ 116
======== ======== ========
Supplemental disclosure of non-cash investing and financing activities:
Investment in affiliate made through inventory shipments.................... $ -- $ -- $ 400
======== ======== ========
Equipment acquired through long-term obligations............................ -- $ 519 $ --
======== ======== ========

See accompanying notes to the consolidated statements

SONOSITE, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(in thousands, except shares)

Additional Deferred
paid-in stock Accumulated
Shares Amount capital compensation deficit
---------- ------ ---------- ------------ -----------

Balance at December 31, 1998.................................... 4,872,193 $ 49 $ 40,784 $ (91) $(20,908)

Net loss........................................................ -- -- -- -- (21,612)
Net unrealized loss on investment securities.................... -- -- -- -- --

Comprehensive loss..............................................
Sales of common shares, net of issuance costs of $5,386......... 4,240,000 42 64,692 -- --
Issuance of options/warrants to nonemployees.................... -- -- 174 (174) --
Exercise of stock options....................................... 98,418 1 616 -- --
Cancellation of restricted stock................................ (978) -- -- -- --
Amortization of deferred stock compensation..................... -- -- -- 197 --
Cancellation of stock options to nonemployees................... -- -- (39) 39 --
---------- ---- -------- ----- --------
Balance at December 31, 1999.................................... 9,209,633 92 106,227 (29) (42,520)

Net loss........................................................ -- -- -- -- (18,972)
Net unrealized gain on investment securities.................... -- -- -- -- --

Comprehensive loss..............................................
Exercise of warrants............................................ 8,877 -- -- -- --
Exercise of stock options....................................... 334,126 4 2,968 -- --
Cancellation of restricted stock................................ (1,040) -- -- -- --
Amortization of deferred stock compensation..................... -- -- -- 29 --
---------- ---- -------- ----- --------
Balance at December 31, 2000.................................... 9,551,596 96 109,195 -- (61,492)

Net loss........................................................ -- -- -- -- (16,409)
Net unrealized loss on investment securities.................... -- -- -- -- --
Less reclassification adjustment for losses included in net loss -- -- -- -- --

Comprehensive loss..............................................
Sales of common shares, net of issuance costs of $1,853......... 1,666,667 17 23,130 -- --
Exercise of stock options....................................... 145,009 1 1,145 -- --
Cancellation of restricted stock................................ (41) -- -- -- --
---------- ---- -------- ----- --------
Balance at December 31, 2001.................................... 11,363,231 $114 $133,470 $ -- $(77,901)
========== ==== ======== ===== ========

Accumulated
other Total
comprehensive shareholders'
income (loss) equity
------------- -------------

Balance at December 31, 1998.................................... $ -- $ 19,834

Net loss........................................................ -- (21,612)
Net unrealized loss on investment securities.................... (60) (60)
--------
Comprehensive loss.............................................. (21,672)
Sales of common shares, net of issuance costs of $5,386......... -- 64,734
Issuance of options/warrants to nonemployees.................... -- --
Exercise of stock options....................................... -- 617
Cancellation of restricted stock................................ -- --
Amortization of deferred stock compensation..................... -- 197
Cancellation of stock options to nonemployees................... -- --
----- --------
Balance at December 31, 1999.................................... (60) 63,710

Net loss........................................................ -- (18,972)
Net unrealized gain on investment securities.................... 69 69
--------
Comprehensive loss.............................................. (18,903)
Exercise of warrants............................................ -- --
Exercise of stock options....................................... -- 2,972
Cancellation of restricted stock................................ -- --
Amortization of deferred stock compensation..................... -- 29
----- --------
Balance at December 31, 2000.................................... 9 47,808

Net loss........................................................ -- (16,409)
Net unrealized loss on investment securities.................... (249) (249)
Less reclassification adjustment for losses included in net loss 240 240
--------
Comprehensive loss.............................................. (16,418)
Sales of common shares, net of issuance costs of $1,853......... -- 23,147
Exercise of stock options....................................... -- 1,146
Cancellation of restricted stock................................ -- --
----- --------
Balance at December 31, 2001.................................... $ -- $ 55,683
===== ========

See accompanying notes to the consolidated financial statements

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Business Overview

SonoSite commenced operations as a division of ATL Ultrasound, Inc., or ATL.
We were formed to develop the design and specifications for a highly portable
ultrasound device and other highly portable ultrasound products for diagnostic
imaging in a multitude of clinical and field settings. On April 6, 1998 (the
"Distribution Date"), we became an independent, publicly-owned company through
a distribution of one new share of our stock for every three shares of ATL
stock held as of that date. ATL retained no ownership in SonoSite following the
spin-off.

We finalized the development and began commercialization of our first
products in 1999, recognizing our initial product sales revenue in September
1999. Continuing to develop and enhance our products in 2000, we introduced the
SonoHeart system for cardiology and the high frequency SonoSite180 system. In
April 2001, we announced the release of our SonoSite 180PLUS and SonoHeart PLUS
systems, both of which include advanced imaging capabilities.

Initially, we sold our products primarily through medical product
distributors worldwide. In February 2000, we established a contract direct
sales force focused exclusively on selling our products within the United
States. In the first quarter of 2001, we elected to convert our contract
selling force to direct employees and to expand the number of direct sales
people domestically.

Internationally, we address other large potential markets through our
relationship with Olympus in Japan, our joint venture in China and dedicated
distributors in other traditionally large ultrasound markets. During 2001, we
established wholly owned subsidiaries, SonoSite, Ltd., in the United Kingdom,
and SonoSite France SARL in France. Subsequent to December 31, 2001, we
established a third wholly owned subsidiary, SonoSite GmbH in Germany. Each
subsidiary is chartered to develop direct selling operations within their
assigned territories.

2. Summary of Significant Accounting Policies

Basis of presentation

The consolidated financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America. The
condensed consolidated financial statements include the accounts of SonoSite,
Inc., and our wholly owned subsidiaries. All significant intercompany accounts
and transactions have been eliminated in consolidation. In preparing the
financial statements, management must make estimates and make assumptions that
affect 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 revenues and expenses during the reporting period. Actual results
could differ from those estimates.

Reclassification of prior period balances

Certain amounts reported in previous periods have been reclassified to
conform to current period presentation.

Financial instruments

Cash and cash equivalents

Cash and cash equivalents consist of money market accounts with major U.S.
banks and highly liquid debt instruments with original or remaining maturities
at purchase of three months or less.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Investment securities

Investment securities consist of high grade corporate debt. While our intent
is to hold our securities until maturity, we classify all securities as
available-for-sale, as the sale of such securities may be required prior to
maturity to implement management strategies. These securities are carried at
fair value, with the unrealized gains and losses reported as a component of
other comprehensive loss until realized. Realized gains and losses from the
sale of available-for-sale securities, if any, are determined on a specific
identification basis.

A decline in market value of any available-for-sale security below cost that
is determined to be other than temporary results in a revaluation of its
carrying amount to fair value. The impairment is charged to earnings and a new
cost basis for the security is established. Premiums and discounts are
amortized or accreted over the life of the related security as an adjustment to
yield using the effective interest method. Interest income is recognized when
earned.

Accounts receivable

In the ordinary course of business, we grant credit to a broad customer
base. Of the accounts receivable balance at December 31, 2001, 58% and 42% were
receivable from international and domestic parties, prior to any allowance for
doubtful accounts, of which approximately $283,000 was included in other
long-term assets. The same percentages as of December 31 2000 were 51% and 49%
prior to any allowance for doubtful accounts, of which approximately $345,000
was included in other long-term assets.

The following table presents individual customers whose outstanding
receivable balance as a percentage of total trade receivables and/or revenue as
a percentage of total sales revenue exceeded 10% as of December 31:

Accounts
Receivable Sales Revenue
--------- -------------
2001 2000 2001 2000 1999
---- ---- ---- ---- ----

Japanese distributor. 28% 17% 26%
Brazilian distributor 11%
U.S. distributor..... 14% 22%
U.S. distributor..... 15%
Italian distributor.. 10%
-- -- -- -- --
Totals............... 28% 11% 17% 40% 47%
== == == == ==

We maintain allowances for doubtful accounts for estimated losses resulting
from the inability of our customers to make required payments. If the financial
condition of our customers were to deteriorate, resulting in an impairment of
their ability to make payments, additional allowances may be required.

Fair value of financial instruments

The carrying value of our financial instruments, including cash and cash
equivalents, accounts receivable, certain long-term other assets and debt,
approximates fair value. Cash and cash equivalents and accounts receivable
approximate fair value due to their short-term nature. Long-term other assets
and debt approximate fair value as interest rates on these notes approximate
market.

Inventories

Inventories are stated at the lower of standard cost, which approximates
actual cost on a first-in, first-out method, or market. Included in our
inventories balance are demonstration products used by our sales

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

representatives and marketing department, and items that have been shipped to
customers for which revenue recognition requirements have not been met
including products whose title and custody have passed to the customer.
Adjustments to cost are recorded for obsolete material, earlier generation
products and used product held either as saleable inventory or as demonstration
product if necessary to reduce their carrying values to amounts which will
result in approximately normal profit margins upon sale. Inventory items for
which title has passed to customers are evaluated for recoverability based on
the same process we use to evaluate collection of accounts receivable. If
market conditions are less favorable than those projected by management,
additional downward inventory cost adjustments may be required.

Property and equipment

Property and equipment are stated at historical cost, less accumulated
depreciation and amortization. Maintenance and repair costs are expensed as
incurred, with additions and improvements to property and equipment capitalized.

Depreciation and amortization are calculated using the straight-line method
over estimated useful lives as follows:

Asset Estimated Useful Lives
----- ----------------------
Equipment, other than
computer 5-7 years
Software 3 years
Computer equipment 3-5 years
Furniture and fixtures 5 years
Leasehold improvements Lesser of estimated
useful life or expected
remaininglease term

The carrying value of long-lived assets is evaluated for impairment when
events or changes in circumstances occur, which may indicate the carrying
amount of the asset may not be recoverable. We evaluate the carrying value of
the assets by comparing the estimated future cash flows generated from the use
of the asset and its eventual disposition with the assets' reported net book
value.

Investment in and receivable from affiliates

When we have investments in companies where we have the ability to exercise
influence over operating and financial policies, these investments are
accounted for under the equity method. Accordingly, our share in the net income
or loss in these investees is included in other income or loss.

We have a 40% ownership in a joint venture in China. Because our share of
losses exceeded our initial investment balance, we have since recorded losses
as a reduction to our receivable from this affiliate. Future adverse changes in
market conditions or poor operating results of the underlying investee could
result in losses or an inability to recover the carrying value of the
receivable from affiliate, thereby possibly requiring an impairment charge in
the future.

Concentration of credit and supply risk

Financial instruments that potentially subject us to concentrations of
credit risk consist principally of cash equivalents, investments and accounts
receivable.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

We depend on some single-source suppliers to provide highly specialized
parts and other components. We do not intend to maintain significant
inventories of components, and may experience an interruption of supply if a
supplier is unable or unwilling to meet our time, quantity and quality
requirements. There are relatively few alternative sources of supply for some
of these items. An increase in demand for some parts by other companies in our
industry could also interrupt our supply of components.

Revenue recognition

Sales revenue

We recognize sales revenue when a product is shipped under an agreement with
a customer, risk of loss and title have passed to the customer and collection
of any resulting receivable is reasonably assured. For service contracts,
revenue is recognized over the term of the contract. Sales discounts are
recorded as a reduction of revenue. Deferred revenue primarily represents
unearned revenue from service contracts made under agreements with customers.
Our typical warranty period is one year and is included with the original
purchase of our ultrasound imaging devices. However, the customer can purchase
a service contract from us to extend the original warranty period or enhance
its coverage. We accrue charges for related product warranty expenses based
upon estimated costs to repair or replace products sold. These expenses to date
have not been significant.

Grant Revenue

Grant revenue consists of monies received under a United States Government
Defense Advanced Research Projects Administrative (DARPA) grant. Grant revenue
was recognized consistent with the terms of the DARPA grant and was generally
tied to the achievement of technological milestones.

Research and development

Research and development costs are expensed as incurred.

Advertising costs

We expense costs for advertising and promotional activities as incurred.
Advertising and promotional expenses for the years ended December 31, 2001,
2000 and 1999 were $4.3 million, $4.2 million and $3.8 million.

Income taxes

Deferred income taxes are provided based on the estimated future tax effects
of temporary differences between financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards arising subsequent to the Distribution Date.

Deferred tax assets and liabilities are measured using enacted tax rates
that are expected to apply to taxable income in the years in which those
temporary differences and carryforwards are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date. A
valuation allowance is established when necessary to reduce deferred tax assets
to the amount, if any, expected to be realized. Under certain provisions of the
Internal Revenue Code of 1986, as amended, the availability of our net
operating loss and tax credit carryforwards may be subject to limitation if it
should be determined that there has been a change in ownership of more than
50%. Such determination could limit the utilization of net operating loss and
tax credit carryforwards.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Stock-based compensation

We apply the principles of APB Opinion No. 25 (APB 25), "Accounting for
Stock Issued to Employees" and related interpretations when measuring
compensation costs for our employee stock option plans. Pro forma net loss and
net loss per share are presented as if compensation costs had been determined
in accordance with Statement of Financial Accounting Standard No. 123 (SFAS
123), "Accounting for Stock-Based Compensation."

Net loss per share

Basic and diluted net loss per share was computed by dividing the net loss
by the weighted average common shares outstanding exclusive of unvested
restricted shares.

As more fully described in Note 7, we have an Adjustment Plan, which
includes options granted in connection with the spin-off distribution occurring
on April 6, 1998. As part of this distribution, existing ATL option holders
received one of our options for every six ATL options held. Outstanding options
to purchase our shares, our unvested restricted shares issued by ATL and
options issued by us were not included in the computations of diluted net loss
per share because to do so would be antidilutive. As of December 31, 2001, our
outstanding options and unvested restricted shares issued by ATL through the
Distribution Date totaled 115,537 and 459 and outstanding options we issued
totaled 2,505,651. As of December 31, 2000, our outstanding options and
unvested restricted shares issued by ATL through the Distribution Date totaled
146,320 and 2,185 and outstanding options we issued totaled 2,153,926. As of
December 31, 1999, our outstanding options and unvested restricted shares
issued by ATL through the Distribution Date totaled 206,983 and 14,013 and
outstanding options we issued totaled 1,905,652.

The following is a reconciliation of the numerator and denominator of the
basic loss per share calculations (in thousands, except loss per share):

2001 2000 1999
------------------------ ----------------------- -----------------------
Loss Shares LPS Loss Shares LPS Loss Shares LPS
-------- ------ ------ -------- ------ ------ -------- ------ ------

Weighted average shares outstanding....... 10,301 9,426 7,044
Weighted average unvested restricted stock (1) (8) (19)
------ ----- -----
Basic and diluted loss per share.......... $(16,409) 10,300 $(1.59) $(18,972) 9,418 $(2.01) $(21,612) 7,025 $(3.08)
======== ====== ====== ======== ===== ====== ======== ===== ======

Foreign Currency Translation

The functional currencies of our international subsidiaries are the local
currency of the country in which the subsidiary is located. Assets and
liabilities denominated in foreign currencies are translated at the exchange
rate on the balance sheet date. Net sales, costs and expenses of international
operations are translated at average rates of exchange prevailing during the
period. Translation adjustments resulting from this process were immaterial in
all periods presented. Realized and unrealized gains and losses on currency
transactions were immaterial in all periods presented.

New Accounting Pronouncements

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

method be used for business combinations initiated after June 30, 2001.
Statement 142 requires that goodwill no longer be amortized to earnings, but
instead be reviewed for impairment. The amortization of goodwill ceases upon
adoption of the statement, which will be adopted by us on January 1, 2002. The
adoption of this statement is not expected to have an impact on our financial
statements.

In July, 2001, the FASB issued Statement No. 143, "Accounting for Asset
Retirement Obligations." Statement No. 143 requires that the fair value of an
asset retirement obligation be recorded as a liability in the period in which
it is incurred. The associated asset retirement costs must be capitalized as
part of the carrying amount of the long-lived asset. The statement will be
effective for fiscal years beginning after June 15, 2002. The adoption of this
statement is not expected to have an impact on our financial statements.

In August 2001, the FASB issued Statement No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," which supersedes Statement No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of." Statement No. 144 retains many of the fundamental
provisions of Statement No. 121 and provides a single method of accounting for
long-lived assets to be disposed of. We are required and plan to adopt the
provisions of Statement No. 144 for the fiscal year beginning January 1, 2002.
The adoption of this statement for long-lived assets held for use is not
expected to have a material impact on our financial statements. The provisions
of the statement for assets held for sale or other disposal generally are
required to be applied prospectively after the adoption date to newly initiated
disposal activities. Therefore, we cannot determine the potential future
effects that the adoption of this statement for assets held for sale or other
disposal will have on our financial statements.

3. Arrangements with ATL

We entered into several agreements with ATL effective as of the Distribution
Date. These agreements were negotiated between our chief executive officer and
the chief executive officer of ATL. Both parties considered the terms of these
agreements competitive with the cost of obtaining such rights and services in
arm's-length negotiations with third parties. The following is a summary of the
significant agreements:

OEM Supply Agreement

During 1999 and the first half of 2000, ATL produced many of our products,
including our systems and most of our transducers. During the fourth quarter of
2000, we completed the transitioning of our manufacturing operations from ATL
to our own facility. This included transferring equipment, personnel and
inventory. As a result, ATL no longer manufactures products for us. We do not
expect any further payments to be made to ATL as a result of this contract.

Technology Transfer and License Agreement

We entered into a technology transfer and license agreement with ATL. Under
this agreement, we took ownership of certain ultrasound technology developed as
part of the DARPA grant and also patent rights, which had been established or
were being pursued for that technology.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

devices weighing more than 15 pounds. On April 6, 2003, this cross-license
becomes nonexclusive and, except for the patented technology and registered
software of each party, extends to all ultrasound devices regardless of weight.

Our license from ATL bears a royalty equivalent to a percentage of the net
sales of ultrasound products under fifteen pounds that use ATL technology. If
prior to April 6, 2003, any single person or entity obtains, directly or
indirectly, voting control of a majority of our common stock or the power to
elect our entire board of directors, we will be required to pay $150 million to
ATL. If at any time between April 6, 2003 and April 6, 2006, any single person
or entity engaged in the medical diagnostic imaging business, other than
through the sale or manufacture of our products, obtains, directly or
indirectly, voting control of a majority of our common stock or the power to
elect our entire board of directors, we will be required to pay $75 million to
ATL. For the years ended December 31, 2001, 2000 and 1999, we incurred a
royalty expense to ATL of $1.3 million, $908,000 and $297,000, which is
included in cost of sales revenue.

After this five-year period, each party's ongoing obligation with respect to
the technology of the other will be to respect the patent and copyright rights
of the other, although we will retain a license to use the previously licensed
ATL technology in hand-carried systems and ATL will retain a license to use our
previously licensed technology in full-size ultrasound systems.

4. Cash, cash equivalents and investment securities

The following table summarizes our cash, cash equivalents and investment
securities at fair value (in thousands):

As of December 31,
------------------
2001 2000
------- -------

Cash............................................. $ 2,305 $ 5,054
Cash equivalents:
Money market accounts........................... 30,811 3,026
Commercial paper................................ -- 2,987
------- -------
Total cash and cash equivalents.................. $33,116 $11,067
======= =======
Investment securities:
Short-term corporate bonds (due within one year) $ -- $18,218
======= =======

The amortized cost, gross unrealized holding gains and losses and fair value
of investment securities classified as available-for-sale securities as of
December 31, 2000 were as follows (in thousands):

Gross unrealized Gross unrealized Gross unrealized Fair
Amortized cost holding gains holding losses value
---------------- ---------------- ---------------- -------

Corporate bonds $18,209 $47 $38 $18,218

Securities sold prior to maturity resulted in minimal realized gains or
losses. Interest income, net of management fees, from securities for the years
ended December 31, 2001, 2000 and 1999 was $0.9 million, $2.1 million and $1.1
million.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

5. Financial statement detail as of and for the year ended December 31,

Inventories consisted of the following (in thousands):

2001 2000
------ -------

Raw material..................................... $3,915 $ 4,257
Finished goods................................... 4,384 8,068
------ -------
Total inventories................................ $8,299 $12,325
====== =======

At December 31, 2001, finished goods includes approximately $758 of
inventory whose title had passed to the customer and for which revenue has not
yet been recognized.

Property and equipment consisted of the following (in thousands):

2001 2000
------- -------

Equipment, other than computer................... $ 4,293 $ 3,710
Software......................................... 3,000 2,413
Computer equipment............................... 2,539 2,003
Furniture and fixtures........................... 1,077 1,001
Leasehold improvements........................... 899 700
------- -------
11,808 9,827
Less accumulated depreciation and amortization... (6,123) (3,847)
------- -------
Total property and equipment..................... $ 5,685 $ 5,980
======= =======

Assets acquired under capital leases, included above (in thousands):

2001 2000
----- ------

Software......................................... $ 147 $ 880
Computer equipment............................... 372 372
Equipment, other than computer................... -- 68
----- ------
519 1,320
Less accumulated amortization.................... (203) (777)
----- ------
Total assets under capital lease................. $ 316 $ 543
===== ======

Accrued expenses consisted of the following (in thousands):

2001 2000
------ ------

Payroll and related.............................. $1,853 $1,573
Outside services................................. 909 1,272
Warranty accrual................................. 281 326
Royalties due.................................... 424 186
Other............................................ 349 327
------ ------
Total accrued expenses........................... $3,816 $3,684
====== ======

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

6. Investments in and receivables from affiliates

In 1999, we made an initial capital contribution of $400,000 in the form of
inventory into SonoSite China Limited (SonoSite China) for a 40% ownership
interest. We account for this investment under the equity method of accounting.
Receivables from affiliate represents the outstanding amount owed to us by
SonoSite China for purchases of inventory less our equity losses in earnings of
SonoSite China that exceed our initial capital contribution. SonoSite China has
a net deficiency in equity. From the date the deficiency occurred, we have
recorded 100% of the losses in SonoSite China and will continue to do so until
our net investment balance is zero. As of December 31, 2001, our net investment
balance in SonoSite China was $188,000.

For the years ended December 31, 2001, 2000 and 1999, we recognized sales
revenue to SonoSite China in the amount of $303,000, $298,000 and $772,000.

During 2000, we invested $500,000 for a 19.9% common stock investment in a
company from which we were also contracting for direct sales services. We used
the equity method of accounting for this investment. In the fourth quarter of
2000, we decided to terminate our business relationship with this affiliate
when we decided to discontinue the direct sales contract and hire the
contractors as employees in early 2001. We then accelerated our amortization of
excess acquisition cost of $475,000 to fully amortize the remaining balance in
the fourth quarter of 2000 when we made this decision. We paid $1.0 million in
2001 for contract direct sales service expenses and fees to transfer their
direct sales representative to us. We paid them $3.4 million in 2000 for
contract direct sales services. We maintain the 19.9% ownership in the entity,
but have no net investment balance in the affiliate as the losses exceeded our
initial cash contribution.

7. Shareholders' equity

Stock option plans

As of December 31, 2001, we had the following stock compensation plans: the
1998 Nonofficer Employee Stock Option Plan ("1998 NOE Plan"), the 1998 Option,
Stock Appreciation Right, Restricted Stock, Stock Grant and Performance Unit
Plan ("1998 Plan"), the Nonemployee Director Stock Option Plan ("Director
Plan"), the Management Incentive Compensation Plan ("MIC Plan"), and the
Adjustment Plan. Additionally, in 2000, we granted 95,000 options outside of
these plans to corporate officers, which are included within the information
presented herein and contain similar provisions to our 1998 Plan. We account
for stock options under provisions of APB 25 and therefore, to the extent the
fair value of the underlying stock is equal to or less than the exercise price
on the measurement date, no compensation expense is recognized for employee
stock option grants.

If we accounted for the costs relating to all option grants under the
provisions of SFAS 123, our net loss and net loss per share would have been the
following pro forma amounts (in thousands, except per share data):

2001 2000 1999
-------- -------- --------

Net loss:
As reported....................... $(16,409) $(18,972) $(21,612)
Pro forma......................... $(23,549) $(24,601) $(26,962)
Basic and diluted net loss per share:
As reported....................... $ (1.59) $ (2.01) $ (3.08)
Pro forma......................... $ (2.29) $ (2.61) $ (3.84)

Pro forma compensation expense is recognized for the fair value of each
option estimated on the date of grant using the Black-Scholes multiple option
pricing model. The following assumptions were used for option

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

grants in 2001, 2000 and 1999: expected volatility 63%, 63% and 61%; risk-free
interest rates 4.5%, 4.9% and 6.4%; expected terms of 6.5, 6.5, and 5.0 years;
and zero dividend yield.

Under the 1998 NOE Plan, 1998 Plan, MIC Plan and option grants outside our
stock option plans, as of December 31, 2001, 2,760,313 total shares of common
stock were authorized primarily for issuance upon exercise of stock options at
prices equal to the fair market value of our common shares at the date of
grant. As of December 31, 2001, 369,662 shares were available for grant under
these stock option plans. In most cases, stock options are exercisable at 25%
each year over a four-year vesting period and have a ten-year term from the
grant date. However, provisions for 377,000 options granted in 1999 allowed for
potential early vesting to occur upon the achievement of certain financial
targets in 1999 and 2000. In 1999, these financial targets were met and, as a
result, 188,500 options vested effective February 2000. These targets were not
met in 2000 and therefore the unvested portion, 188,500 options, vest four
years from their date of grant.

Under the Director Plan, as of December 31, 2001, 115,000 shares of common
stock were authorized for issuance of stock options at prices equal to the fair
market value of our common shares at the date of grant. At December 31, 2001,
there were no shares available for grant under this Plan. Stock options are
exercisable and vest in full one year following their grant date provided the
optionee has continued to serve as our director. Each option expires on the
earlier of ten years from the grant date or 90 days following the termination
of a director's service as our director.

We also have an Adjustment Plan, which includes options granted in
connection with the dividend distribution occurring on April 6, 1998. As part
of this distribution, existing ATL option holders received one of our options
for every six ATL options held. There was no change to the intrinsic value of
the option grant, ratio of exercise price to market value, vesting provisions
or option period as a result of the distribution. As of December 31, 2001,
115,537 shares of common stock were authorized primarily for issuance upon
exercise of stock options at prices equal to the fair market value of our
common shares at the date of grant.

Prior to the Distribution Date, we had no stock option plans specifically
identified as our plans. All stock options granted through that date were part
of ATL option plans.

Also as part of the distribution, restricted shares totaling 459 and 2,185,
as determined using the exchange ratio of one of our restricted shares for
every three ATL restricted shares, were outstanding as of December 31, 2001 and
2000.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Summary of stock option activity

The following table presents summary stock option activity for the years
ended December 31 (shares presented in thousands):

2001 2000 1999
--------------- --------------- ---------------
Weighted Weighted Weighted
average average average
exercise exercise exercise
Shares price Shares price Shares price
------ -------- ------ -------- ------ --------

Outstanding, beginning of year....................... 2,300 $13.50 2,113 $10.04 1,548 $ 6.95
Non-Adjustment Plan grants........................... 725 $16.10 778 $20.86 759 $15.86
Exercised............................................ (145) $ 7.70 (334) $ 9.45 (98) $ 6.27
Cancelled............................................ (259) $13.91 (257) $12.65 (96) $10.25
----- ------ ----- ------ ----- ------
Outstanding, end of year............................. 2,621 $14.49 2,300 $13.50 2,113 $10.04
===== ====== ===== ====== ===== ======
Exercisable, end of year............................. 1,026 $11.78 760 $ 9.00 501 $ 6.38
===== ====== ===== ====== ===== ======
Weighted average fair value of options granted during
the period......................................... $11.45 $15.04 $10.73
====== ====== ======

The following is a summary of stock options outstanding (shares presented in
thousands):

Options outstanding Options exercisable
-------------------------------- --------------------
Weighted
average Weighted Weighted
remaining average average
Number Contractual exercise Number exercise
Range of exercise prices outstanding life price exercisable price
------------------------ ----------- ----------- -------- ----------- --------

$ 1.64 - $ 6.94..... 755 6.01 $ 6.63 584 $ 6.56
$ 6.97 - $12.88..... 539 8.08 $11.98 156 $11.07
$12.97 - $14.57..... 477 8.98 $14.40 23 $13.96
$14.96 - $23.96..... 448 8.52 $17.89 117 $16.24
$24.27 - $34.97..... 402 8.43 $28.97 146 $29.57
----- ---- ------ ----- ------
2,621 7.77 $14.49 1,026 $11.78
===== ==== ====== ===== ======

Stock purchase rights

On April 6, 1998, we and First Chicago Trust Company of New York ("First
Chicago") entered into a Rights Agreement. The Rights Agreement was
subsequently amended on October 24, 2001 to reflect that EquiServe Trust
Company, N.A. had succeeded First Chicago as the rights agent. The Rights
Agreement has certain anti-takeover provisions, which will cause substantial
dilution to a person or group that attempts to acquire us; however, it will not
interfere with any merger or other business combination approved by our board
of directors.

Under the terms of the Rights Agreement, holders of our common stock also
hold rights exercisable in certain circumstances discussed below. Holders of
these rights may purchase 1/100th of a share of our Series A Participating
Cumulative Preferred Stock, par value of $1.00, at a price equal to four times
the average high and low sales prices of our common stock quoted on the Nasdaq
National Market for each of the 10 trading days commencing on the sixth trading
day following April 6, 1998. Circumstances under which these rights are

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

exercisable involve acquisition or knowledge of expected acquisition or tender
of 15% or more of our outstanding common stock. In addition, the board of
directors may redeem all, but not part, of the rights outstanding for
consideration in cash or common stock at a price equal to $0.01 per right.

Separate certificates for rights will not be distributed. Our common stock
certificates serve as evidence of the rights. Prior to exercise of the rights
and in accordance with the terms of the Rights Agreement, the rights have no
voting or dividend value. If the rights are not exercised prior to April 5,
2008, they expire, with no consideration for the expiration being provided to
the holder of the right.

In connection with the sale of common stock described below under
"Financing," the Rights Agreement was amended on August 8, 2001. The amendment
provided an exemption to one of the acquirers of the common stock from the 15%
ownership threshold described above, provided that the acquirer is the
beneficial owner of less than 20% of our common stock.

Warrants

In 1999, we issued 15,000 warrants to nonemployee consultants in connection
with marketing work performed. These warrants had exercise prices of $11.44 and
vested one year from their date of grant. During 2000, all these warrants were
exercised through a cashless exercise, which resulted in the issuance of
8,877 shares of common stock. As of December 31, 2001, no warrants were
outstanding.

8. Financing

In August 2001, we sold 1,666,667 shares of common stock at a price of
$15.00 per share to selected institutional and other accredited investors. Net
proceeds from this private placement were $23.1 million. In November 1999, we
raised net proceeds of $29.3 million through the sale of 1,250,000 shares of
our common stock. In April 1999, we raised net proceeds of $35.4 million
through the sale of 2,990,000 shares of our common stock. Additionally, in
1999, we received $12.0 million in contributed capital from ATL.

9. Income taxes

For income tax purposes, our results through the Distribution Date were
included in the consolidated federal income tax return of ATL and, accordingly,
the net operating loss generated prior to the Distribution Date will not be
available to us for use in periods subsequent to the Distribution Date. During
the period from the Distribution Date through December 31, 2001, we accumulated
a net operating loss carryforward of approximately $68.0 million and research
and experimentation tax credit carryforwards of approximately $1.9 million.
This carryforward begins expiring in 2018 and will be fully expired in 2021.
Approximately $5.0 million of the net operating loss carryforward results from
stock option deductions which, when and if realized, would result in a credit
to shareholders' equity.

Because we incurred losses since inception, a valuation allowance entirely
offsetting deferred tax assets has been established, thereby eliminating any
deferred tax benefit. The increase in the valuation allowance of $6.9 million
in 2001, $7.7 million in 2000, and $8.1 million in 1999 is primarily the result
of increasing net operating loss carryforwards.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

The tax effects of temporary differences and carryforwards that give rise to
significant portions of deferred tax assets and deferred tax liabilities at
December 31 are as follows (in thousands):

2001 2000
-------- --------

Deferred tax assets:
Domestic net operating loss carryforwards....... $ 23,052 $ 17,961
International net operating loss carryforwards.. 165 --
Research and experimentation tax credit
carryforwards.................................. 1,921 844
Allowances and accruals not recognized for tax
purposes....................................... 620 376
Other........................................... 539 420
-------- --------
Gross deferred tax assets......................... 26,297 19,601
Valuation allowance............................... (26,297) (19,414)
-------- --------
-- 187
Deferred tax liabilities:
Depreciation.................................... -- (187)
-------- --------
Net deferred tax assets........................... $ -- $ --
======== ========

10. Employee Benefit Plan

401(k) Retirement Savings Plan

All our employees in the United States are eligible to participate in our
401(k) Plan. Terms of the 401(k) Plan permit an employee to contribute up to a
maximum of 16% of an employee's annual compensation on a post-tax or pretax
basis, up to the maximum permissible by the Internal Revenue Service (IRS)
during any plan year. Contributions exceeding the IRS limitation may be made
only on a post-tax basis. We match each employee's contribution in increments
equivalent to 100% for the first 3% and 50% for the second 3% of the employee's
contribution percentage. In 2001, 2000 and 1999, we contributed $540,000,
$369,000 and $207,000 in matching contributions to the 401(k) Plan in
accordance with the plan's terms. Employees immediately vest in the
contributions the employee makes. Vesting in our contribution on behalf of the
employee occurs at equal increments at the end of each year of the first five
years of an employee's service with us.

11. Commitments and contingencies

Operating leases

We currently lease office and manufacturing space under operating leases. As
of December 31, 2001, future minimum lease payments are as follows (in
thousands):

2002............................................. $ 970
2003............................................. 1,012
2004............................................. 1,053
2005............................................. 1,084
2006............................................. 1,114
Thereafter....................................... 557
------
$5,790
======

Rent expense for the years ended December 31, 2001, 2000, and 1999 was $1.0
million, $730,000 and $329,000.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Capital lease obligations

We entered into certain long-term obligations to finance the purchase of
capital equipment as part of our normal business operations. Original terms of
the obligations range from 18 to 48 months and have imputed interest rates
ranging between 10% and 15%. Obligations are secured by underlying assets. The
following is a summary of the capital lease obligations and the related future
minimum payments as of December 31, 2001 (in thousands):

2002............................................... $ 159
2003............................................... 159
2004............................................... 40
-----
Total lease payments............................... 358
Less amount representing interest.................. (42)
-----
Present value of net minimum capital lease payments 316
Less current portion............................... (131)
-----
Long-term obligations, excluding current portion... $ 185
=====

Other commitments

As part of obtaining our lease for our current facility, we were required to
deposit approximately $334,000, representing restricted cash with our bank,
which is included in other long-term assets. Additionally, we are required to
maintain a cash balance as security for letters of credit we were required to
open for the benefit of one of our suppliers. At the end of 2001, the balance
of this account was approximately $243,000 and is included in other long-term
assets.

We entered into several corporate purchasing agreements, including AmeriNet
Inc., Kaiser Permanente, Novation LLC, Broadlane, Inc. and Premier Inc. These
agreements include clauses for administration fees, service agreements,
favorable pricing, preferential availability and notification periods. We
recorded expenses related to these agreements of approximately $236,000 in
2001, $22,000 in 2000 and none in 1999.

Contingencies

We have obtained approval from the United States Food and Drug
Administration (FDA) to sell and distribute our product domestically. However,
we cannot assure you that the FDA will approve future product submissions by
us. Additionally, international sales and distribution are dependent upon our
obtaining approval of certain foreign regulatory agencies. We have obtained
approval from many of these agencies; however, we cannot assure you that we
will obtain approval from other foreign regulatory agencies from which we seek
approval in the future, on a timely basis, or if at all.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

PLUS devices. The complaint asserts claims for preliminary and permanent
injunctive relief enjoining all alleged acts of infringement, compensatory and
enhanced damages, attorney's fees and costs, and pre- and post-judgment
interest. On August 14, 2001, we filed an answer asserting alternative defenses
of non-infringement and patent invalidity, and including a counterclaim seeking
a declaratory judgment of non-infringement and invalidity regarding Neutrino's
patent. On October 4, 2001, the court denied a request by Neutrino for
preliminary injunctive relief to prevent us from manufacturing and selling our
products pending the ultimate disposition of the litigation. On February 20,
2002, in what is known as a "Markman" hearing, the parties will present their
arguments regarding the proper construction of Neutrino's patent claims. We
believe we have good and sufficient defenses to the claims of patent
infringement asserted against us by Neutrino and we are vigorously defending
ourselves in this matter.

12. Segment reporting

We currently have one operating segment. We market our products in the
United States and internationally through our direct sales force and our
indirect distribution channels. Our chief operating decision maker evaluates
resource allocation decisions and our performance based upon revenue recorded
in geographic regions and does not receive financial information about expense
allocation on a disaggregated basis. Geographic regions are determined by the
shipping destination. Sales revenues by geographic location and segregated
between distributor and direct sales in the United States for the years ended
December 31 are as follows (in thousands):

2001 2000 1999
------- ------- -------

United States direct sales....................... $22,220 $ 8,044 $ --
United States distributor........................ 1,604 7,130 4,254
------- ------- -------
Total United States.............................. 23,824 15,174 4,254
Japan............................................ 7,768 8,307 131
Other Asia (a)................................... 2,079 2,094 2,140
Europe, Africa and the Middle East............... 9,088 3,767 2,730
Canada, South and Latin America.................. 2,936 2,242 718
Other areas...................................... -- 453 212
------- ------- -------
Total sales revenue.............................. $45,695 $32,037 $10,185
------- ------- -------

--------
(a) Other Asia includes China, India, Korea, Singapore and Taiwan.

13. Subsequent Event

On February 13, 2002, our board of directors authorized the filing of a
registration statement with the SEC as part of our plan to raise additional
capital.

SONOSITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

14. Quarterly results--unaudited

For the three months ended,
-----------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
(in thousands, except per share amounts)

2001:
Sales revenue............................................ $ 8,163 $10,283 $11,911 $15,338
Cost of sales revenue.................................... 4,866 5,325 5,167 6,503
------- ------- ------- -------
Gross margin............................................. 3,297 4,958 6,744 8,835
Operating expenses....................................... 10,217 9,711 9,377 10,920
Other income (loss)...................................... 195 (280) 369 (302)
------- ------- ------- -------
Net loss................................................. $(6,725) $(5,033) $(2,264) $(2,387)
======= ======= ======= =======
Basic and diluted net loss per share..................... $ (0.70) $ (0.52) $ (0.21) $ (0.21)
======= ======= ======= =======
Shares used in computation of basic and diluted net loss
per share.............................................. 9,567 9,623 10,629 11,358
======= ======= ======= =======
2000:
Sales revenue............................................ $ 7,985 $ 9,034 $ 8,311 $ 6,707
Cost of sales revenue.................................... 4,623 4,974 4,674 4,378
------- ------- ------- -------
Gross margin............................................. 3,362 4,060 3,637 2,329
Operating expenses....................................... 7,215 7,545 8,711 10,382
Other income (loss)...................................... 609 568 494 (178)
------- ------- ------- -------
Net loss................................................. $(3,244) $(2,917) $(4,580) $(8,231)
======= ======= ======= =======
Basic and diluted net loss per share..................... $ (0.35) $ (0.31) $ (0.49) $ (0.86)
======= ======= ======= =======
Shares used in computation of basic and diluted net loss
per share.............................................. 9,225 9,284 9,426 9,519
======= ======= ======= =======

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors

The following table sets forth the name and age of each director, the
positions and offices held by the nominee with us and the period during which
he has served.

Director
Name Age Positions and Offices with SonoSite Since
---- --- ----------------------------------- --------

Kirby L. Cramer.................................. 65 Chairman of the Board of Directors 1998
Kevin M. Goodwin................................. 44 President, Chief Executive Officer and Director 1998
Edward V. Fritzky................................ 51 Director 1998
Steven R. Goldstein, M.D......................... 51 Director 1998
Ernest Mario, Ph.D............................... 64 Director 1999
William G. Parzybok, Jr.......................... 59 Director 1998
Jeffrey Pfeffer, Ph.D............................ 55 Director 1998
Dennis A. Sarti, M.D............................. 59 Director 1998
Richard S. Schneider, Ph.D....................... 61 Director 2001
Jacques Souquet, Ph.D............................ 54 Director 1998

Kirby L. Cramer has served as our Chairman of the board of directors since
April 1998. Since 1991, Mr. Cramer has served as Chairman Emeritus of Hazelton
Laboratories Corporation, a contract biological and chemical research
laboratory, which was acquired by Corning Inc. in 1987. Since 1993, he also has
served as Chairman of Northwestern Trust Company, a wealth management company.
From 1968 to 1987, Mr. Cramer served as Chief Executive Officer of Hazelton
Laboratories Corporation. In addition to the above, Mr. Cramer is a member of
the boards of directors of Immunex Corporation, a biotechnology company, DJ
Orthopedics Corporation, an orthopedic device company, Life Sciences Research,
Inc., a contract clinical testing laboratory, The Commerce Bank of Washington,
N.A., Landec Corporation, a material science company, and Array Biopharma, a
biopharmaceutical company. Mr. Cramer holds a B.A. degree from Northwestern
University and a M.B.A. degree from the University of Washington and is a
graduate of the Harvard Business School's Advanced Management Program.

Kevin M. Goodwin has served as our President, Chief Executive Officer and a
director since April 1998. From February 1997 to April 1998, Mr. Goodwin served
as Vice President and General Manager of ATL Ultrasound, Inc.'s handheld
systems business group. From August 1991 to February 1997, Mr. Goodwin served
as Vice President and General Manager of ATL Ultrasound's businesses in Asia,
the Pacific and Latin America. From 1987 to August 1991, Mr. Goodwin served in
a variety of sales positions at ATL Ultrasound. From 1980 to 1987, Mr. Goodwin
served in various management positions with American Hospital Supply, Picker
International, and Baxter Healthcare Corporation, all medical equipment and
supply distributors. Mr. Goodwin holds a B.A. degree from Monmouth College,
with an emphasis on hospital management, and attended the Executive Program at
the Stanford Graduate School of Business.

Edward V. Fritzky has served as a director of SonoSite since April 1998. Mr.
Fritzky has served as Chairman of the board and Chief Executive Officer of
Immunex Corporation, a biotechnology company, since January 1994. From 1992 to
1994, he served as President of Lederle Laboratories, a division of American
Cyanamid Company, a pharmaceutical and chemical company. Mr. Fritzky was Vice
President of Lederle Laboratories from 1989 to 1992. Prior to joining Lederle
Laboratories, he was an executive at Searle Pharmaceuticals, Inc., a subsidiary
of the Monsanto Company, a pharmaceutical and chemical company. During his
tenure at Searle, Mr. Fritzky was Vice President, Marketing for the United
States and later President and General Manager of Searle Canada, Inc., a joint
venture with Lorex Pharmaceuticals. Mr. Fritzky also serves on

the board of directors of Geron Corporation, a biopharmaceutical company. Mr.
Fritzky holds a B.A. degree from Duquesne University and is a graduate of the
Advanced Executive Program at the J.L. Kellogg Graduate School of Management at
Northwestern University.

Steven R. Goldstein, M.D. has served as a director of SonoSite since April
1998. Since 1995, he has served as Professor of Obstetrics and Gynecology at
New York University School of Medicine. Since July 1980, Dr. Goldstein has held
various positions as a doctor of Obstetrics and Gynecology at New York
University Medical Center, serving as Director of Gynecological Ultrasound
since 1994, and as Co-Director of Bone Densitometry for the Department of
Obstetrics and Gynecology since 1997. Dr. Goldstein holds an M.D. degree from
New York University School of Medicine and completed his residency in
Obstetrics and Gynecology at New York University-affiliated hospitals in 1980.

Ernest Mario, Ph.D. has served as a director of SonoSite since December
1999. Dr. Mario serves as Chairman and Chief Executive Officer of Apothogen,
Inc., a pharmaceutical company. Prior to joining Apothogen in 2002, Dr. Mario
served as Chairman of the board and Chief Executive Officer of ALZA
Corporation, a manufacturer of therapeutic drug delivery systems. Prior to
joining ALZA, Dr. Mario served as Chief Executive of Glaxo Holdings plc, a
pharmaceutical corporation, from May 1989 to March 1993, and as Deputy Chairman
from January 1992 to March 1993. Prior to that time, Dr. Mario served as
Chairman and Chief Executive Officer of Glaxo, Inc., a subsidiary of Glaxo
Holdings, from 1988 to 1989 and as President and Chief Operating Officer of
Glaxo, Inc. from 1986 to 1988. Dr. Mario is also a director of Catalytica
Energy Systems, Inc., a biotechnology company, Orchid Biosciences, Inc., a
biotechnology company, COR Therapeutics, Inc., a cardio-therapeutics company,
and Pharmaceutical Product Development, Inc., a pharmaceutical product company.
Dr. Mario holds a B.S. from Rutgers University and M.S. and Ph.D. degrees in
physical sciences from the University of Rhode Island. He is an adjunct
professor of pharmacy at the University of Rhode Island, and holds honorary
doctorates from the University of Rhode Island and Rutgers University.

William G. Parzybok, Jr. has served as a director of SonoSite since May
1998. From February 1991 to July 1998, Mr. Parzybok was Chairman of the board
and Chief Executive Officer of Fluke Corporation, a manufacturer of electronic
test and measurement instruments. From 1988 to 1991, he served as Vice
President and General Manager of various groups of Hewlett-Packard Company, a
computer hardware and instrument manufacturer. Mr. Parzybok is a director of
Penford Corporation, a specialty chemical company, and WRQ, Inc., a software
company. Mr. Parzybok holds B.S. and M.S. degrees from Colorado State
University.

Jeffrey Pfeffer, Ph.D. has served as a director of SonoSite since April
1998. He is the Thomas D. Dee II Professor of Organizational Behavior at the
Graduate School of Business at Stanford University, where he has been a faculty
member since 1979. He also served on the faculty at the University of Illinois
and the University of California at Berkeley and served as the Thomas Henry
Carroll-Ford Foundation Visiting Professor of Business Administration at
Harvard Business School. Dr. Pfeffer is a member of the boards of directors of
Portola Packaging, Inc., a plastic closure manufacturer, Actify, Inc., a
three-dimensional software company, Audible Magic Corporation, an internet
software company, and Unicru, Inc., an application service provider of hiring
management systems. Dr. Pfeffer holds B.S. and M.S. degrees from Carnegie
Mellon University and a Ph.D. from Stanford University.

Dennis A. Sarti, M.D. has served as a director of SonoSite since July 1998.
Since December 2001, Dr. Sarti, a radiologist, has served as Medical Director
of Beverly Radiology Medical Group. From October 1993 to November 2000, Dr.
Sarti served as Chairman of the Department of Medical Imaging at St. John's
Health Center in Santa Monica, California. Since April 1994, he has also served
as director of the Technology Steering Committee for St. John's Health Center.
From July 1978 to July 1986, Dr. Sarti served as the Director of Diagnostic
Ultrasound at the UCLA School of Medicine. Dr. Sarti holds a B.S. degree from
St. Vincent's College and an M.D. degree from the University of Pittsburgh
School of Medicine.

Richard S. Schneider, Ph.D. has served as director of SonoSite since April
2001. From October 1990 until his retirement in June 1999, Dr. Schneider was
general partner of Domain Associates in Princeton, New Jersey, a venture
capital management firm focused on life sciences. From April 1986 to July 1990,
he served as Vice

President of 3i Ventures Corporation, a venture capital company. From June 1983
to December 1989, he served as President of Biomedical Consulting Associates, a
biomedical products consulting company. From 1967 to June 1983, he was Vice
President and founder of Syva Corporation, a diagnostics company that was part
of Syntex Corporation, a pharmaceutical company. Dr. Schneider is a member of
the boards of directors of Landec Corporation, a material science company,
Selective Genetics Inc., a gene therapy company, and MitoKor, a mitochondrial
sciences company. Dr. Schneider holds a B.S. degree in chemistry from the
University of California, Berkeley and a Ph.D. degree in organic chemistry from
the University of Wisconsin. Dr. Schneider also completed post-doctoral studies
at the Massachusetts Institute of Technology and attended the Stanford Graduate
School of Business.

Jacques Souquet, Ph.D. has served as a director of SonoSite since April
1998. Dr. Souquet has served as Chief Technology Officer of Philips Medical
Systems since January 2001. From June 1993 to December 2000, Dr. Souquet served
as Chief Technology Officer and Senior Vice President for Product Generation at
ATL Ultrasound, which was acquired by Philips Medical Systems in September
1998. From March 1989 to June 1993, Dr. Souquet served as Director of Strategic
Marketing and Product Planning and Vice President for Product Generation of ATL
Ultrasound. He joined ATL Ultrasound in August 1981 as a principal scientist in
the cardiology division. Dr. Souquet received a High Engineering Degree from
Ecole Superieure d'Electricite of Paris, France, a Ph.D. degree from Orsay
University of France in the field of optical memory, and a second Ph.D. degree
from Stanford University in the field of new acoustic imaging techniques for
medical ultrasound applications and nondestructive testing.

Director Compensation

Directors who are employees of SonoSite do not receive any fee for their
services as directors. Directors who are not employees of SonoSite are paid an
annual retainer of $16,000 plus $1,000 for each sequence of board of directors
and committee meetings attended. Any nonemployee director serving as Chairman
of the board is paid an additional $75,000 per year. We also reimburse
directors for reasonable expenses they incur in attending meetings of the board.

Directors are eligible to receive options to purchase shares of our common
stock under our Nonemployee Director Stock Option Plan and our 1998 Option,
Stock Appreciation Right, Restricted Stock, Stock Grant and Performance Unit
Plan, or 1998 Plan. Under these plans, we established a program under which
each nonemployee director automatically receives an option to purchase 10,000
shares of our common stock on the date of his or her initial election or
appointment as director. Each nonemployee director thereafter receives an
option to purchase 5,000 shares of our common stock immediately following the
next year's annual meeting of shareholders and each annual meeting of
shareholders thereafter for as long as the director serves on our board. In
lieu of these grants, a nonemployee director elected as Chairman of our board
will receive, upon his or her initial election to this position, an option to
purchase 25,000 shares of our common stock. The Chairman will thereafter
automatically receive an option to purchase 10,000 shares of our common stock
immediately following the next year's annual meeting of shareholders and each
annual meeting of shareholders thereafter. All options have an exercise price
equal to the fair market value of the common stock on the date of grant.
Options vest in full and become exercisable 12 months after the date of grant,
assuming a director's continued service on our board during this time. Options
expire on the tenth anniversary of the date of grant, subject to earlier
termination if a director ceases to be a director. Immediately prior to a
merger, consolidation, liquidation or similar reorganization of SonoSite, an
option granted under these plans may be exercised in whole or in part,
regardless of whether the vesting schedule for the options has been satisfied.

Executive Officers

Our executive officers and their ages as of December 31, 2001, are as
follows:

Officer
Name Age Positions Since
---- --- --------- -------

Kevin M. Goodwin................................. 44 President, Chief Executive Officer and Director 1998
Bradley G. Garrett............................... 51 Chief Customer Fulfillment Officer 2000
Jens U. Quistgaard, Ph.D......................... 38 Chief Product and Marketing Officer 1998
Michael J. Schuh................................. 41 Vice President - Finance, Chief Financial Officer and Secretary 2000

Kevin M. Goodwin biographical summary included under "Directors."

Bradley G. Garrett has served as our Chief Customer Fulfillment Officer
since October 2001. From April 2000 to September 2001, Mr. Garrett served as
our Vice President - Operations. From February 1998 to April 2000 Mr. Garrett
served as Vice President of Operations for Laughlin-Wilt Group, a contract
manufacturer of printed circuit assemblies and electronic products. From August
1995 to December 1997, Mr. Garrett served as Vice President of Operations for
Advanced Input Devices, a manufacturer of custom keyboards and input devices.
From 1988 to 1995, Mr. Garrett served as Director of Systems Operations for ATL
Ultrasound. Mr. Garrett holds B.A. and M.B.A. degrees from the University of
Oregon.

Jens U. Quistgaard, Ph.D. has served as our Chief Product and Marketing
Officer since October 2000. From April 2000 to October 2000, Dr. Quistgaard
served as our Vice President - Product Development, and from April 1998 to
April 2000, he served as our Vice President - Product Development and
Operations. From February 1997 to April 1998, Dr. Quistgaard served as
Executive Director of ATL Ultrasound's handheld systems business group. From
July 1995 to January 1997, Dr. Quistgaard served as Chief of the senior
technology staff of ATL Ultrasound. He joined ATL Ultrasound in 1990, as a
senior engineer. Dr. Quistgaard holds a B.S. degree in mathematics and
computational sciences from Stanford University and M.S. and Ph.D. degrees in
electrical engineering from the University of Washington.

Michael J. Schuh has served as our Vice President - Finance, Chief Financial
Officer and Secretary since July 2000. From December 1999 to June 2000, Mr.
Schuh served as the Chief Operating Officer and Chief Financial Officer of
Capital Associates, a leasing company. From June 1986 to November 1999, Mr.
Schuh worked in various positions at Leasetec Corporation, a high technology
leasing company, serving as Vice President-Finance from July 1997 to November
1999, Director of Strategic Planning and Acquisitions from January 1995 to July
1997, European Finance Director from June 1991 to January 1995 and Corporate
Controller from June 1986 to June 1991. From August 1982 to June 1986, Mr.
Schuh worked at Deloitte Haskins & Sells, an accounting firm. Mr. Schuh holds a
B.A. degree in accounting from the University of Wisconsin.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
our officers, directors and persons who beneficially own more than 10% of a
registered class of our equity securities to file reports of ownership and
changes in ownership with the Securities and Exchange Commission. Officers,
directors and greater than 10% shareholders are required by Commission
regulation to furnish us with copies of all Section 16(a) forms they file.

Based solely on our review of the copies of such forms received by us, or
written representations from certain reporting persons that no forms were
required for those persons, we believe that during the 2001 fiscal year, all
filing requirements applicable to our officers, directors and greater than 10%
beneficial owners were complied with.

ITEM 11. EXECUTIVE COMPENSATION

Compensation Summary

The following table sets forth information regarding compensation paid to
our chief executive officer and our four other most highly compensated
executive officers for the last three years.

Long-Term
Awards
------------

Annual Compensation Common Stock All Other
--------------------- Underlying Compensation
Name and Principal Position Year Salary Bonus Options (#) (1)
--------------------------- ---- -------- ------- ------------ ------------

Kevin M. Goodwin.............................. 2001 $275,000 $ -- 100,000 $ 8,201
President and Chief Executive Officer 2000 279,900 -- 9,398
1999 225,000 -- 30,000 8,941
Jens U. Quistgaard............................ 2001 203,846 -- 30,000 7,301
Chief Product and Marketing Officer 2000 194,807 15,000 7,302
1999 162,308 -- 20,000 6,816
Bradley G. Garrett (2)........................ 2001 178,077 -- 10,000 1,151
Chief Customer Fulfillment Officer 2000 119,300 34,275 80,000 3,680
Michael J. Schuh (3).......................... 2001 170,769 30,000 3,532
Vice President -- Finance, Chief Financial
Officer and Secretary 2000 68,653 20,000 60,000 120,378

--------
(1) Unless otherwise indicated, All Other Compensation consists of
employer-matching contributions made to the SonoSite 401(k) Retirement
Savings Plan and group term life premiums paid by SonoSite.
(2) 2000 salary for Mr. Garrett represents compensation received from April 17,
2000, through December 31, 2000. All Other Compensation for 2000 represents
$1,523 in closing costs on the sale of Mr. Garrett's home and $2,157 for
employer-matching 401(k) contributions and group term life insurance
premiums paid by SonoSite.
(3) 2000 salary for Mr. Schuh represents compensation received from July 24,
2000 through December 31, 2000. All Other Compensation for 2000 represents
$70,372 for a relocation allowance, including the net closing costs on the
sale of Mr. Schuh's house, $46,274 for the tax gross-up, and $3,732 for
employer-matching 401(k) contributions and group term life premiums paid by
SonoSite.

Option Grants in 2001

The following table sets forth information regarding stock options granted
to our named executive officers during the year ended December 31, 2001.

Percent of Potential Realizable Value
Number of Total at Assumed Annual Rates
Securities Options of Stock Price
Underlying Granted to Appreciation for Option
Options Employees Exercise Term (3)
Granted in 2001 Price Per --------------------------
Name (#) (%) (1) Share (2) Expiration Date 5% 10%
---- ---------- ---------- --------- ---------------- -------- ----------

Kevin M. Goodwin................................. 100,000 13.79 $14.570 April 24, 2011 $916,299 $2,322,083
Jens U. Quistgaard............................... 30,000 4.14 14.570 April 24, 2011 274,890 696,625
Michael J. Schuh................................. 20,000 2.76 15.250 February 8, 2011 191,813 486,091
10,000 1.38 14.570 April 24, 2011 91,630 232,208
Bradley G. Garrett............................... 10,000 1.38 14.570 April 24, 2011 91,630 232,208

--------
(1) Based on a total of 724,950 options granted to employees during 2001.
(2) The exercise price per share is the average of the high and low sales
prices of our common stock as reported on the date of the grant by the
Nasdaq National Market.
(3) The assumed rates of appreciation are prescribed by the Securities and
Exchange Commission for illustrative purposes only and are not intended to
forecast or predict future stock prices.

Option Exercises and Year-End Values

The following table sets forth information regarding the net value realized
on the exercise of options during 2001 and the value of outstanding options at
December 31, 2001 by our named executive officers.

Number of Securities
Underlying Unexercised Value of Unexercised
Options (#) In-the-Money Options ($) (2)
Shares Acquired Value ------------------------- ----------------------------
Name on Exercise (#) Realized ($) (1) Exercisable Unexercisable Exercisable Unexercisable
---- --------------- ---------------- ----------- ------------- ----------- -------------

Kevin M. Goodwin............. -- $-- 127,500 152,500 $2,262,971 $1,968,534

Jens U. Quistgaard........... -- -- 77,637 72,500 1,348,376 978,469

Bradley G. Garrett........... -- -- 20,000 70,000 64,075 303,425

Michael J. Schuh............. -- -- 15,000 75,000 -- 320,000

--------
(1) The value realized upon exercise of an option is the difference between the
fair market value of the shares received upon exercise, valued on the
exercise date, and the exercise price paid.
(2) The value of the unexercised options is calculated based on the closing
price of our common stock as reported on the Nasdaq National Market on
December 31, 2001, which was $25.69 per share.

Compensation Committee Interlocks and Insider Participation

None of our executive officers serves as a member of the compensation
committee or board of directors of any entity that has an executive officer
serving as a member of our compensation committee or board of directors.

Change-in-Control Arrangements

Change-in-Control Agreements. We have entered into change-in-control
agreements with Messrs. Garrett, Goodwin and Schuh and Dr. Quistgaard. These
agreements, which are substantially similar to each other, provide that, in the
event of a change in control of SonoSite, the executive will receive an annual
base salary that is no less than the annual base salary in effect immediately
before the change in control and an annual bonus equal to at least the average
of the three annual bonuses paid to the executive in the three years prior to
the change in control. The agreements also provide that the executive will be
entitled to continue participating in our employee benefits plans and welfare
benefits plans or programs. The agreements also provide that we must make
severance payments equal to two times the sum of the executive's annual base
salary. We must also make an additional payment equal to the executive's bonus
for the fiscal year ended immediately prior to the change in control or, if no
bonus was paid in the prior year, an additional payment of 10% of base salary.
The agreements also provide for payments to the executive if the executive
suffers a disability while employed by us and provides for payments to the
executive's estate if the executive dies while employed by us.

1998 Plan. Under the 1998 Plan (and under our Management Incentive
Compensation Plan, which incorporates the terms of the 1998 Plan with respect
to stock options), upon a change in control each outstanding option and stock
appreciation right will automatically become exercisable in full for the total
remaining number of shares covered by the option or stock appreciation right.
In addition, during the 90-day period following a change in control, an
optionee may choose to receive cash equal to the difference between the
exercise price of the option and the fair market value of a share of common
stock of SonoSite as determined pursuant to the 1998 Plan (except for optionees
with related stock appreciation rights and, in the case of a director, any
director who received an option without related stock appreciation rights and
during the six-month period prior to the change in control), in lieu of
exercising the option and paying the option price. Also under the 1998 Plan,
all restrictions on shares of restricted stock will lapse upon a change in
control, and performance units will be paid (unless the optionee has previously
had his or her benefits deferred by the compensation committee in which case
this payment is also deferred) pro rata to the date of a change in control, and
all amounts otherwise deferred by SonoSite and any employee in connection with
performance units will be distributed.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table summarizes information regarding the beneficial
ownership of our outstanding common stock as of December 31, 2001, for:

. each person or group that we know owns more than 5% of the common stock;

. each of our directors;

. each of our named executive officers; and

. all of our directors and executive officers as a group.

Beneficial ownership is determined in accordance with rules of the
Securities and Exchange Commission and includes shares over which the indicated
beneficial owner exercises voting or investment power. Shares of common stock
subject to options currently exercisable or exercisable within 60 days are
deemed outstanding for computing the percentage ownership of the person holding
the options but are not deemed outstanding for computing the percentage
ownership of any other person. Except as otherwise indicated, we believe the
beneficial owners of the common stock listed below, based on information
furnished by them, have sole voting and investment power with respect to the
number of shares listed opposite their names. As of December 31, 2001,
11,363,231 shares of common stock were issued and outstanding. The following
officers and directors can be reached at our principal offices.

Number of Percent of
Shares Shares
Beneficially Beneficially
Name and Address of Beneficial Owner Owned Owned
------------------------------------ ------------ ------------

State of Wisconsin Investment Board (1)............... 1,955,477 17.21%
121 East Wilson Street
Madison, WI 53702
WM Advisors (1)....................................... 1,318,468 11.60
1201 Third Avenue, Suite 1400
Seattle, WA 98101
ICM Asset Management (1).............................. 866,061 7.62
601 West Main Avenue, Suite 600
Spokane, WA 99201
Capital Guardian Trust Company (1).................... 630,200 5.55
11100 Santa Monica Blvd.
Los Angeles, CA 90025
Kevin M. Goodwin (2).................................. 157,184 1.38
Kirby L. Cramer (3)................................... 89,632 *
Jens U. Quistgaard, Ph.D. (4)......................... 79,137 *
Dennis A. Sarti, M.D. (5)............................. 50,000 *
Jacques Souquet, Ph.D. (6)............................ 43,387 *
Jeffrey Pfeffer, Ph.D. (7)............................ 27,800 *
William G. Parzybok, Jr. (8).......................... 27,000 *
Michael J. Schuh (9).................................. 23,000 *
Edward V. Fritzky (8)................................. 21,000 *
Bradley G. Garrett (8)................................ 20,000 *
Ernest Mario, Ph.D. (10).............................. 20,000 *
Steven R. Goldstein, M.D. (11)........................ 10,000 *
Richard S. Schneider, Ph.D............................ -- --
All directors and executive officers as a group
(13 people) (12).................................... 568,140 5.00

--------
* Less than one percent.
(1) Based on publicly available information as of December 31, 2001.

(2) Includes 127,500 shares subject to options exercisable within 60 days of
December 31, 2001 and 10,602 shares held in an individual retirement
account.
(3) Includes 45,000 shares subject to options exercisable within 60 days of
December 31, 2001 and 2,000 shares held by Mr. Cramer's spouse.
(4) Includes 77,637 shares subject to options exercisable within 60 days of
December 31, 2001 and 1,500 shares held in an Individual Retirement
Account.
(5) Includes 20,000 shares subject to options exercisable within 60 days of
December 31, 2001 and 25,000 shares over which Dr. Sarti and his spouse
share voting power and are held in the Sarti Family Trust.
(6) Includes 27,664 shares subject to options exercisable within 60 days of
December 31, 2001.
(7) Includes 20,000 shares subject to options exercisable within 60 days of
December 31, 2001 and 7,800 shares over which Dr. Pfeffer and his spouse
share voting and dispositive power.
(8) Includes 20,000 shares subject to options exercisable within 60 days of
December 31, 2001.
(9) Includes 20,000 shares subject to options exercisable within 60 days of
December 31, 2001 and 1,000 shares held in an Individual Retirement
Account.
(10) Includes 15,000 shares subject to options exercisable within 60 days of
December 31, 2001 and 5,000 shares held by Dr. Mario's spouse.
(11) Includes 10,000 shares subject to options exercisable within 60 days of
December 31, 2001.
(12) Includes 422,801 shares subject to options exercisable within 60 days of
December 31, 2001.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Relationship with ATL Ultrasound. One of our directors, Jacques Souquet, is
currently an executive officer of Philips Medical Systems, which acquired all
of the outstanding shares of ATL in 1998. In connection with our spin-off from
ATL, we entered into the following agreements with ATL that govern our
relationship and provide for the allocation of certain liabilities and
obligations arising from periods prior to the spin-off:

Technology Transfer and License Agreement. We entered into a technology
transfer and license agreement with ATL. Under this agreement, we took
ownership of certain ultrasound technology developed as part of the DARPA grant
and also patent rights, which had been established or were being pursued for
that technology.

As part of this agreement, we also entered into a cross-license whereby we
have the exclusive right to use technology existing on the Distribution Date or
developed by ATL during the three-year period following the Distribution Date
in ultrasound devices weighing 15 pounds or less, and ATL has the exclusive
right to use our technology existing on the Distribution Date or developed by
us during the same three-year period in ultrasound devices weighing more than
15 pounds. On April 6, 2003, this license becomes nonexclusive and, except for
the patented technology and registered software of each party, extends to all
ultrasound devices regardless of weight.

Our license from ATL bears a royalty equivalent to a percentage of the net
sales of ultrasound products under fifteen pounds that use ATL technology. If
prior to Aril 6, 2003, any single person or entity obtains, directly or
indirectly, voting control of a majority of our common stock or the power to
elect our entire board of directors, we will be required to pay $150 million to
ATL. If at any time between April 6, 2003 and April 6, 2006, any single person
or entity engaged in the medical diagnostic imaging business, other than
through the sale or manufacture of our products, obtains, directly or
indirectly, voting control of a majority of our common stock or the power to
elect our entire board of directors, we will be required to pay $75 million to
ATL.

OEM Supply Agreement. We entered into an OEM Supply Agreement with ATL
Ultrasound under which we have the option to have handheld ultrasound products
and subassemblies manufactured exclusively for us by ATL Ultrasound in
accordance with our specifications for a period up to five years from April 6,
1998. During

1999 and the first half of 2000, ATL produced many of our products, including
our systems and most of our transducers. During the fourth quarter of 2000, we
completed the transition of our manufacturing operations from ATL to our own
facility. This included transferring equipment, personnel and inventory. As a
result, ATL no longer manufactures product for us. We do not expect any further
payments to be made to ATL as a result of this contract.

Change-in-Control Agreements with our Executive Officers. We have entered
into change-in-control agreements with Messrs. Garrett, Goodwin and Schuh and
Dr. Quistgaard, our executive officers. See "Executive
Compensation--Change-in-Control Arrangements." We believe that the transactions
described above were made on terms no less favorable to us than could have been
obtained from unaffiliated third parties. Any future transactions between us
and our officers, directors, principal shareholders and their affiliates will
be subject to approval by a majority of our board of directors, including a
majority of our independent and disinterested directors, and will be on terms
that we believe are no less favorable to us than would be available from
independent third parties.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) Documents filed as part of this report:

(1) Financial Statements--See "Index to Financial Statements" under Item
8 of this Report.
(2) Financial Statement Schedule.

Schedule II

Valuation and Qualifying Accounts

Additions
charged to
Balance at general and
beginning administrative Balance at
of year expense Deductions end of year
---------- -------------- ---------- -----------
(in thousands)

Year ended December 31, 2001:
Allowance for doubtful accounts.................. $723 $384 $175 $932

Year ended December 31, 2000:
Allowance for doubtful accounts.................. $ 96 $631 $ 4 $723

Year ended December 31, 1999:
Allowance for doubtful accounts.................. $ -- $ 96 $ -- $ 96

(3) Exhibits.

Exhibit No. Description
----------- -----------

3.1(A) Restated Articles of Incorporation of the registrant

3.3(E) Bylaws of the registrant

4.1(A) Rights Agreement between First Chicago Trust Company and the registrant, dated April 6, 1998

4.2(E) Amendment to Rights Agreement, dated August 8, 2001

4.3 Amendment to Rights Agreement, dated October 24, 2001

10.1(E) 1998 Option, Stock Appreciation Right, Restricted Stock, Stock Grant and Performance Unit Plan,
as amended and restated

10.2(A) Terms of Stock Option Grant Program for Nonemployee Directors under the SonoSite, Inc. 1998
Option, Stock Appreciation Right, Restricted Stock, Stock Grant and Performance Unit Plan

10.3(E) 1998 Nonofficer Employee Stock Option Plan, as amended and restated

10.4(E) Nonemployee Director Stock Option Plan, as amended and restated

10.5(C) Management Incentive Compensation Plan

10.6(B) Adjustment Plan

10.7(A) Form of Senior Management Employment Agreement between the registrant and each of
Kevin M. Goodwin, Jens U. Quistgaard, Ph.D., Michael J. Schuh and Bradley G. Garrett

10.8(A) Technology Transfer and License Agreement between ATL Ultrasound, Inc. and the registrant,
effective as of April 6, 1998, as amended

10.9 Third Amendment to Technology Transfer and License Agreement between ATL Ultrasound, Inc.
and the registrant, dated as of March 10, 2000

10.10(D) Lease Agreement between Riggs & Company, a division of Riggs Bank N.A., and registrant, dated
December 28, 1999

10.11(D) Distribution Agreement between Olympus Optical Co. Ltd. and the registrant, dated August 1,
1999

10.12 Assignment of Distribution Agreement by and among Olympus Optical Co., Ltd., Olympus
Promarketing, Inc. and the registrant, dated October 5, 2001

23.1 Consent of KPMG LLP, independent auditors

24.1 Power of attorney (contained on signature page)

--------
(A) Incorporated by reference to the designated exhibit included in the
Company's Registration Statement on Form S-1 (Registration No. 333-71457).
(B) Incorporated by reference to the designated exhibit included in the
Company's report on Form 10 (SEC File No. 000-23791).
(C) Incorporated by reference to the designated exhibit included in the
Company's report on Form 10-K for the year ended December 31, 1998 (SEC
File No. 000-23791).
(D) Incorporated by reference to the designated exhibit included in the
Company's report on Form 10-K for the year ended December 31, 1999 (SEC
File No. 000-23791).
(E) Incorporated by reference to the designated exhibit included in the
Company's report on Form 10-Q for the quarter ended September 30, 2001 (SEC
File No. 000-23791).

(b) Reports on Form 8-K:

No reports on Form 8-K were filed during the quarter ended December 31, 2001.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

SONOSITE, INC.

By: /S/ MICHAEL J. SCHUH
-----------------------------
Michael J. Schuh
Vice President-Finance, Chief
Financial
Officer, Secretary and
Treasurer

Date: February 22, 2002

POWER OF ATTORNEY

Each person whose individual signature appears below hereby authorizes and
appoints Kevin M. Goodwin and Michael J. Schuh, and each of them, with full
power of substitution and resubstitution and full power to act without the
other, as his or her true and lawful attorney-in-fact and agent to act in his
or her name, place and stead and to execute in the name and on behalf of each
person, individually and in each capacity stated below, and to file, any and
all amendments to this report, and to file the same, with all exhibits thereto,
and other documents in connection therewith, with the Securities and Exchange
Commission, granting unto said attorneys-in-fact and agents, and each of them,
full power and authority to do and perform each and every act and thing,
ratifying and confirming all that said attorneys-in-fact and agents or any of
them or their or his or her substitute or substitutes may lawfully do or cause
to be done by virtue thereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the Company
and in the capacities indicated below on the 22nd day of February 2002.

/S/ KIRBY L. CRAMER Chairman of the Board
------------------------------
Kirby L. Cramer

/S/ KEVIN M. GOODWIN President, Chief Executive
------------------------------ Officer and Director
Kevin M. Goodwin (Principal Executive
Officer)

/S/ MICHAEL J. SCHUH Vice President-Finance, Chief
------------------------------ Financial Officer,
Michael J. Schuh Secretary and Treasurer
(Principal Financial and
Accounting Officer)

/S/ EDWARD V. FRITZKY Director
------------------------------
Edward V. Fritzky

/S/ STEVEN R. GOLDSTEIN, M.D. Director
------------------------------
Steven R. Goldstein, M.D.

/S/ ERNEST MARIO, PH.D. Director
------------------------------
Ernest Mario, Ph.D.

/S/ WILLIAM G. PARZYBOK, JR. Director
------------------------------
William G. Parzybok, Jr.

/S/ JEFFREY PFEFFER, PH.D. Director
------------------------------
Jeffrey Pfeffer, Ph.D.

/S/ DENNIS A. SARTI, M.D. Director
-----------------------------
Dennis A. Sarti, M.D.

/S/ RICHARD S. SCHNEIDER, Director
PH.D.
-----------------------------
Richard S. Schneider, Ph.D.

/S/ JACQUES SOUQUET, PH.D. Director
-----------------------------
Jacques Souquet, Ph.D.

INDEX TO EXHIBITS

Exhibit No. Description
----------- -----------

3.1(A) Restated Articles of Incorporation of the registrant

3.3(E) Bylaws of the registrant

4.1(A) Rights Agreement between First Chicago Trust Company and the registrant, dated April 6, 1998

4.2(E) Amendment to Rights Agreement, dated August 8, 2001

4.3 Amendment to Rights Agreement, dated October 24, 2001

10.1(E) 1998 Option, Stock Appreciation Right, Restricted Stock, Stock Grant and Performance Unit Plan,
as amended and restated

10.2(A) Terms of Stock Option Grant Program for Nonemployee Directors under the SonoSite, Inc. 1998
Option, Stock Appreciation Right, Restricted Stock, Stock Grant and Performance Unit Plan

10.3(E) 1998 Nonofficer Employee Stock Option Plan, as amended and restated

10.4(E) Nonemployee Director Stock Option Plan, as amended and restated

10.5(C) Management Incentive Compensation Plan

10.6(B) Adjustment Plan

10.7(A) Form of Senior Management Employment Agreement between the registrant and each of
Kevin M. Goodwin, Jens U. Quistgaard, Ph.D., Michael J. Schuh and Bradley G. Garrett

10.8(A) Technology Transfer and License Agreement between ATL Ultrasound, Inc. and the registrant,
effective as of April 6, 1998, as amended

10.9 Third Amendment to Technology Transfer and License Agreement between ATL Ultrasound, Inc.
and the registrant, dated as of March 10, 2000

10.10(D) Lease Agreement between Riggs & Company, a division of Riggs Bank N.A., and registrant, dated
December 28, 1999

10.11(D) Distribution Agreement between Olympus Optical Co. Ltd. and the registrant, dated August 1,
1999

10.12 Assignment of Distribution Agreement by and among Olympus Optical Co., Ltd., Olympus
Promarketing, Inc. and the registrant, dated October 5, 2001

23.1 Consent of KPMG LLP, independent auditors

24.1 Power of attorney (contained on signature page)