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CORRESP
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filename1.htm

    seccommentresponse_101707.htm

    10/18/07

    Securities
      and Exchange Commission

      100
        F
        Street, NE

      Washington,
        D.C. 20549

      Attn:
        Brian R. Cascio, Accounting Branch Chief, Division of Corporation
        Finance

      RE:           Response
        to SEC Comment Letter dated 09/27/07

      Dear
        Mr.
        Cascio,

      We
        received a letter from you dated September 27, 2007 with review comments
        on our
        Form 10-K for the fiscal year ended December 31, 2006 and Form 10-Q for the
        quarter ended June 30, 2007 (File No. 0-32501).

      We
        are
        pleased to provide the following response to your comments.

      SEC
        Comment #1:

      Form
        10-K for the fiscal year ended 12/31/2006 – Variable Interest Entity, page
        46

      We
        note
        your disclosure that Olympus is protected from absorbing all expected losses
        in
        the Joint Venture and may not be an “at risk” holder.  Please tell us
        how you concluded that Olympus and not Cytori is the primary
        beneficiary.

      Company
        response to SEC comment #1:

      As
        noted
        in our disclosure, significant judgment was involved in determining the primary
        beneficiary of the Joint Venture (or “JV”).  We determined Olympus to
        be the primary beneficiary based on analysis performed in accordance with
        FIN
        46R.  Paragraph 17 of FIN 46R states if two or more related parties
        together hold an aggregate variable interest in a Variable Interest Entity
        (“VIE”) that would, if held by a single party, identify that party as the
        primary beneficiary, then the primary beneficiary is the party most closely
        associated with the VIE.  Paragraph 17 requires an analysis of all
        relevant facts and circumstances in determining who is most closely associated
        with the VIE, including the following considerations:

      A)
        The
        existence of a principal-agency relationship between parties within the related
        party group.

      Although
        Olympus and Cytori (as 50/50 owners) are both exposed to the economic
        variability of the Joint Venture, a de facto agency relationship exists between
        Olympus and the JV due to provisions contained within the Shareholders’
Agreement that provide that Olympus controls the JV Board, with three out
        of
        five Board members including Chairman.  All significant decisions are
        made by the Board, and although certain specified activities of the JV require
        the consent of both shareholders, under the current ownership structure Cytori
        does not have any participatory rights that would overcome the presumption
        of
        control by Olympus.

          1

      B)
        The
        relationship and significance of the activities of the VIE to the various
        parties within the related party group.

      The
        Joint
        Venture was formed to develop and manufacture future generation medical devices
        based on our Celution™ System.  Cytori contributed intellectual
        property (“IP”) to the JV that will be used to develop the
        device.  While the primary development activities are currently the
        responsibility of Olympus, Cytori will contribute ongoing research efforts
        and
        assistance in the coordination of the quality systems in conjunction with
        Cytori’s regulatory efforts.  Since Olympus is currently the primary
        developer and effectively controls the JV (which includes the intellectual
        property contributed by Cytori), we have concluded that the principal activities
        of the JV are more closely associated with Olympus than Cytori.

      C)
        A
        party’s exposure to the expected losses of the VIE.

      Although
        both Olympus and Cytori are exposed to the economic variability of the Joint
        Venture (as noted in “A.” above), Olympus also holds a put option that could
        require Cytori to repurchase its interests in the Joint Venture.  This
        possibility is contingent upon certain specific insolvency or change of control
        events at Cytori.  The put option does create a possibility that
        Olympus could be protected from absorbing expected losses in the Joint
        Venture.  However, it was our judgment that this somewhat remote
        possibility did not outweigh the additional factors under consideration,
        namely
        the activities of the JV and Olympus’ majority control of the Board of
        Directors.

      D)
        The
        design of the VIE.

      The
        Joint
        Venture is set up with each shareholder owning a 50% interest.  Cytori
        contributed IP to the JV in exchange for its 50% ownership, while Olympus
        contributed $30,000,000.  The Common Stock Purchase Agreement entered
        into in mid-2005 granted Olympus a 7% (as of 9/30/05) equity stake in Cytori,
        but the proceeds received by Cytori of $11,000,000 exceeded the fair value
        of
        the equity received by Olympus.  This premium was paid (at least in
        part) as a direct incentive by Olympus for Cytori to grant Olympus an interest
        in the JV.  Also, as noted above, in paragraph A, Olympus controls the
        JV Board, with three out of five Board members including the
        Chairman.

      Based
        on
        the above analysis, we believe that Olympus is the party which has activities
        most closely associated with those of the JV and should therefore be considered
        the primary beneficiary and consolidate the entity.

          2

      SEC
        Comment #2:

      Financial
        Statements – Note 2. Revenue Recognition, page 61

      Please
        tell us and disclose in future filings your basis for recognizing revenues
        under
        research and development arrangements and why these would not be recorded
        as a
        reduction to research and development expenses.  We note the
        disclosure on page 61 that you are reimbursed for “qualifying expenditures”
under some of these arrangements.

      Company
        response to SEC comment #2:

      Reimbursement
        for “qualifying expenditures” relates to grant funding from our arrangement with
        the National Institute of Health (“NIH”).  Revenues derived from
        reimbursement of direct out-of-pocket expenses for research costs associated
        with grants are recorded in compliance with EITF Issue 99-19, Reporting
        Revenue Gross as a Principal Versus Net as an Agent, and EITF
        Issue 01-14, Income Statement Characterization of Reimbursements
        Received for “Out-of-Pocket” Expenses Incurred.  According to the
        criteria established by these EITF Issues, in transactions where we have
        the
        discretion to choose suppliers, bear credit risk and perform part of the
        services required in the transaction, we record revenue for the gross amount
        of
        the reimbursement.  The costs associated with these reimbursements are
        reflected as a component of research and development expense in the consolidated
        statements of operations.  We also note that the government obtains
        substantial rights under the arrangement, in the same manner (but perhaps
        not to
        the same extent) as a commercial customer that similarly contracts with Cytori
        to perform research activities.  Accordingly, the NIH grant
        arrangement should be treated like other customer contracts and recognized
        inflows should be classified as revenues in the income
        statement.  Additionally, similar research and development efforts
        would have taken place with or without NIH funding as they are key component
        of
        the entity’s ongoing or central operations.  Thus inflows generated by
        such activities are recognized as revenue in accordance with SFAS No. 6 as
        discussed below.

      Statement
        of Financial Accounting Concepts No. 6 defines revenues as “inflows or other
        enhancements of assets of an entity or settlements of its liabilities (or
        a
        combination of both) from delivering or producing goods, rendering services,
        or
        other activities that constitute the entity's ongoing major or central
        operations”.  Research arrangements we have with commercial
        enterprises such as Olympus and Senko are considered a key component of our
        central and ongoing operations.  Accordingly, the inflows from such
        arrangements are presented as revenues in our income statement.

      Revised
        Future Disclosure:

      Revenues
        derived from reimbursement of direct out-of-pocket expenses for research
        costs
        associated with grants are recorded in compliance with EITF Issue No.
        99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent,
        and EITF Issue No. 01-14, Income Statement Characterization of
        Reimbursements Received for “Out-of-Pocket” Expenses Incurred.  In
        accordance with the criteria established by these EITF Issues, the Company
        records grant revenue for the gross amount of the reimbursement.  The costs
        associated with these reimbursements are reflected as a component of research
        and development expense in the consolidated statements of
        operations.

      Additionally,
        research arrangements we have with commercial enterprises such as Olympus
        and
        Senko are considered a key component of our central and ongoing
        operations.  Accordingly, the inflows from such arrangements are
        presented as revenues in the consolidated statements of operations.

          3

      SEC
        Comment #3:

      Note
        4. Transaction with Olympus Corporation, page 67

      Please
        tell us and disclose in future filings the basis for your accounting treatment
        of the proceeds received from the common stock purchase agreement with
        Olympus.  Clarify why you recorded the difference between the proceeds
        received and the fair values of your common stock and option liability as
        deferred revenue.  Clarify the specific revenue arrangement or
        activity that this relates to, how the amount of deferred revenue related
        to
        this activity was determined and how it will be recognized.  Clarify
        why the difference should not have been recorded to additional paid-in
        capital.

      Company
        response to SEC comment #3:

      The
        difference between the proceeds received and the fair values of the common
        stock
        and option liability was recorded as deferred revenue, since conceptually,
        at
        least some of the excess proceeds represent a prepayment for future
        contributions and obligations of Cytori for the benefit of the Joint Venture,
        rather than solely as an equity investment in Cytori.  These
        contributions include 1) the granting of an exclusive, perpetual license
        to
        Cytori’s device related Adipose Stem Cell intellectual property to the JV, and
        2) Cytori’s performance of research and development activities related to
        Adipose Stem Cell device technology that will benefit the JV.  Cytori
        will also perform work relative to the development and commercialization
        of the
        specific Devices that the JV is developing, in addition to certain regulatory
        efforts under the development agreement.

      According
        to EITF 00-21 and SFAS 133, separate contracts should be combined and evaluated
        as a single arrangement when they are negotiated in tandem.  The
        Common Stock Purchase Agreement specifically contemplated and identified
        the
        Joint Venture arrangement, subsequently entered into by Olympus and Cytori,
        as
        its “Purpose”.  Accordingly, we believe that it is most accurate that these
        be linked for accounting purposes.  Therefore, in light of the direct
        linkage between the Common Stock Purchase Agreement and the JV arrangement,
        and
        the premium paid above the market price of the shares, we have concluded
        that it
        is reasonable to presume that the $11,000,000 proceeds paid by Olympus
        contemplate more than a simple equity investment in Cytori.

      As
        a
        result, the common stock and additional paid-in capital balances resulting
        from
        the Olympus transactions have been valued based on Cytori’s closing market price
        for its listed shares on the last trading day prior to the time that the
        Common
        Stock Purchase Agreement was signed.  Also note that the fact that
        Cytori’s common stock was relatively thinly traded has no bearing on the
        accounting described above.  Management believes that SFAS 123R (the
        closest analogous accounting guidance) suggests that the best measure of
        fair
        value is quoted market prices, even if a company’s stock is thinly
        traded.

          4

      As
        noted
        above and in our footnote disclosure, the deferred revenue component of the
        $11,000,000 was calculated as the remaining proceeds after deducting the
        fair
        value of the option liability and the market value of the common
        stock.  The recognition of this deferred amount is based on a
        proportional performance methodology.  Cytori will recognize revenues
        from the license/development accounting unit using a proportional performance
        methodology, resulting in the de-recognition of amounts recorded as deferred
        revenues as Cytori completes various milestones underlying the development
        services.

      The
        relative values assigned to each milestone involved substantial judgment.
        The
        assignment process was based on discussions with persons responsible for
        the
        various aspects of the development process as well as the relative cost of
        completing each milestone.  Cytori acknowledges that the SEC believes
        that recognizing revenues based on costs incurred is not appropriate for
        most
        contractual arrangements (i.e., other than for long-term construction
        contracts).  However, we are not, in fact, recognizing revenues as
        costs are incurred, but instead recognizing revenues once substantive milestones
        (i.e., output measures) are achieved.

      Revised
        Future Disclosure:

      The
        difference between the proceeds received and the fair values of the common
        stock
        and option liability was recorded as deferred revenue, since conceptually,
        the
        excess proceeds represent a prepayment for future contributions and obligations
        of Cytori for the benefit of the Joint Venture (or “JV”), rather than additional
        equity investment in Cytori.

      The
        recognition of this deferred amount will require the achievement of service
        related milestones, under a proportional performance methodology.  If
        and as such revenues are recognized, deferred revenue will be
        decreased.

      SEC
        Comment #4:

      Note
        4. Transaction with Olympus Corporation, page 67

      We
        note
        the disclosure on pages 36, 45 and 68 of the use of an independent valuation
        firm.  While management may elect to take full responsibility for
        these valuations, if you choose to continue to refer to the expert in any