The following discussion should be read in conjunction with VirtualScopics' consolidated balance sheet, and related consolidated statements of operations, consolidated changes in stockholders' equity and cash flow for the years ended December 31, 2008 and 2007, included elsewhere in this report. This discussion contains forward-looking statements, the accuracy of which involves risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons including, but not limited to, those discussed in "Risk Factors" and elsewhere in this report. We disclaim any obligation to update information contained in any forward-looking statements.

Overview

VirtualScopics, Inc. is a leading provider of imaging solutions to accelerate drug and medical device development. We have developed a robust software platform for analysis and modeling of both structural and functional medical images. In combination with our industry-leading experience and expertise in advanced imaging biomarker measurement, this platform provides a uniquely clear window into the biological activity of drugs and devices in clinical trial patients, allowing our customers to make better decisions faster.

In July 2000, VirtualScopics was formed after being spun out of the University of Rochester. In June 2002, we purchased the underlying technology and patents created by VirtualScopics' founders from the University of Rochester. We own all rights to the patents underlying its technology. Since our inception, our principal activities have consisted of:

· research and development;

· providing imaging related services within the pharmaceutical industry;

· business development of customer and strategic relationships; and

· raising capital.

Revenue over the past seven years has been derived primarily from image processing services in connection with pharmaceutical drug trials. For these services, we have been concentrating in the areas of oncology and osteoarthritis. We have also derived a small portion of revenue from consulting services, and pharmaceutical drug trials in the neurology and cardiovascular areas. We expect that the concentration of our revenue will continue in these services and in those areas in 2009. Revenues are recognized as the MRI and CT images that we process are quantified and delivered to our customers and/or the services are performed.

Once we enter into a new contract for participation in a drug trial, there are several factors that can effect whether we will realize the full benefits under the contract, and the time over which we will realize that revenue. Customers may not continue our services due to performance reasons with their compounds in development. Furthermore, the contracts may contemplate performance over multiple years. Therefore, revenue may not be realized in the fiscal year in which the contract is signed. Recognition of revenue under the contract may also be affected by the timing of patient recruitment and image site identification and training.

Results of Operations

Results of Operations for Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Revenue

We had revenues of $7,131,000 for the year ended December 31, 2008 compared to $5,647,000 for the year ended December 31, 2007, representing a 26% increase. The increase in revenues is directly related to the growing demand for our services in the industry. We continue to see growing demand for our Oncology analysis services as well as demand within the medical device industry. During 2008 we performed work for 33 customers, representing 90 different projects, in connection with their pharmaceutical drug trials primarily in the fields of oncology and musculoskeletal diseases (osteoarthritis and rheumatoid arthritis) along with various other projects. As of December 31, 2008, we had active projects with 12 of the leading 15 pharmaceutical companies in the world. The majority of the pharmaceutical projects for which we have performed work to date are in pre-clinical, Phase I or Phase II studies. In 2009, we expect that a majority of our work on pharmaceutical trial projects will continue to be focused in Phase II and III. During 2008, we generated approximately $5.0 million in revenues for our customers in Phase I, II, and III, this compares to approximately $3.3 million in 2007, a 52% increase.

Gross Profit

We had a gross profit of $3,099,000 for the year ended December 31, 2008 compared to $1,967,000 for the comparable period in 2007. Our gross profit improved year over year due to the greater amount of work performed on later stage clinical trials, efficiencies made within our operations, and the reduction in work force at the end of 2007. Later stage trials (Phase II/III) typically have more analysis due to the patient population of the study, as a result, we tend to have greater economies of scale because of the repetitive nature of the work we perform. We believe we can continue to generate near 50% gross margins as we scale the business and therefore, we do not anticipate significant additional investments to be made within our operational infrastructure in 2009.

Research and Development

Research and development costs decreased in 2008 by $499,000, or 35%, to $941,000, when compared to 2007. The decrease was largely attributed to the reduction in employees with our research and development area. During 2007, we began seeing heightened demand for our services in later stage clinical trials and less heavily on research projects as our technology and services became more widely used in the industry and less early stage/proof of concept work was necessary. As a larger percentage of our projects were in later stage clinical trials (as opposed to research/pre-clinical studies) less time was required of the research group to work on customer projects. Additionally, we determined at that time that additional internal funding of research projects was not necessary. As a result, at the end of 2007, we realigned our research group to better reflect the market demand for our services. As of December 31, 2008, there were nine employees in our research and development group, this includes the algorithm and software development groups. Our research and development efforts are centered around improving the functionality of our existing algorithms and software platform as well as the refinement of our algorithms to new therapeutic areas.

Sales and Marketing

Sales and marketing costs increased in 2008 by $471,000, to $1,220,000, when compared to 2007. The increase was a result of marketing efforts during the first half of 2008. Due to the changing nature of our business and the customers we target, we re-branded our marketing materials in order to have a consistent and representative reflection of the services we provide and the value it generates for our customers. Our previous marketing efforts were centered around the technology as opposed to the benefits for our customers. As of the date of this report, there are four individuals in our sales and marketing department.

General and Administrative

General and administrative expenses for the year ended December 31, 2008 were $3,158,000, a decrease of $596,000 or 16%, when compared to 2007. The decrease is mainly due to the $380,000 decrease in stock compensation expense due to the timing and valuation of the vesting of outstanding stock options. Also contributing to the decrease in general and administrative costs was a reduction in our spending on public and investor relations during 2008 compared to 2007. In 2007, the Company raised $4.35 million in a convertible series B offering which led to higher costs incurred on investor outreach. Legal costs were also lower in 2008 as a result of settling of a legal matter with a former executive in early 2007.

Depreciation and Amortization

Depreciation and amortization charges decreased for the year ended December 31, 2008 by $20,000 or 4%, to $466,000, when compared to 2007. This decrease is attributed to slight declines in the amortization and depreciation of patents and computer equipment. The amortization and depreciation schedules are based on the timing and life of the patent costs and equipment. We continue to invest in our patent portfolio and computer systems, however, do not anticipate significant expenditures necessary in either area to support our current business.

Interest (Expense)/Income, net

Interest income for the year ended December 31, 2008 was $74,000, representing interest derived on the Company's operating and savings accounts, compared to interest income of $154,000 in 2007. The decrease in interest income was due to lower rates of return earned on our investment accounts. Other expense for the years ended December 31, 2008 and 2007 was $16,000 and $13,000, respectively. This decrease in interest expense was due to quarterly payments on loans from certain VirtualScopics stockholders. The loans were fully paid as of December 31, 2007.

Net Loss

Our net loss for the year ended December 31, 2008 was $2,629,000 compared to a net loss of $4,321,000 for the year ended December 31, 2007. The decrease in our net loss over the prior period was related to higher revenues, better gross margin and reduced spending in research and development, as planned and outlined above.

In accordance with EITF 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios" and EITF 00-27, "Application of Issue No. 98-5 to Certain Convertible Instruments," the series B convertible preferred stock was considered to have an embedded beneficial conversion feature because the conversion price was less than the fair value of the Company's common stock at the issuance date. This beneficial conversion feature is calculated after the warrants have been valued with proceeds allocated on a relative value basis. The series B convertible preferred stock was fully convertible beginning on November 23, 2007 and the value of the beneficial conversion feature was recorded as a deemed dividend. As a result, the net loss attributable to common stockholders for the year ended December 31, 2007 was $5,801,980, including series B preferred stock deemed dividend of $1,381,361. No similar beneficial conversion feature was recorded in 2008.

Liquidity and Capital Resources

Our working capital as of December 31, 2008 and 2007 was approximately $2,923,000 and $4,239,000, respectively. The decrease in working capital was a result of the $4.35 million private placement of newly issued series B preferred stock that occurred September 2007, thereby increasing the cash position at the end of 2007. The private placement resulted in net proceeds to the company of approximately $3.9 million. A portion of the capital was spent in 2008 on sales and marketing efforts as well as supporting some of the development efforts.

On September 17, 2007, as mentioned above, we completed a private placement of 4,350 shares of series B convertible preferred stock, par value $0.001 per share, and warrants to purchase the Company's common stock, par value $0.001 per share, for an aggregate purchase price of $4,350,000. At the time of the closing, we were required to restrict cash equal to ten percent of the stated value of the series B convertible preferred stock that are outstanding, or $435,000, for the payment of dividends plus $200,000 for the payment of investor relation services over the next two years. As of December 31, 2007, the Company had $498,799 in cash restricted for dividend payments and investor relations services. As of December 31, 2008, the restricted balance has been fully spent and no further restrictions of our cash on hand exist.

Net cash used in operating activities totaled $846,000 in 2008 compared to $2,814,000 in 2007. This significant decrease in the amount of cash used on operating activities was primarily the result of the increase in our revenues and reduction in expenses in 2008 as compared to 2007. Also impacting the change from prior year was the timing of our receivables, accounts payable and accrued expenses and advance billings from customers, which is reflected in deferred revenue. As we perform the services to our customers, revenue is recognized and offset against deferred revenue.

We invested $127,000 in the purchase of equipment and the acquisition of patents in 2008, compared to $343,000 for the investment of these items in 2007. This decrease largely represents a decrease in furniture and leasehold improvement costs in 2008 due to a relocation of facilities in 2007 which created higher than average costs. We anticipate that our IT related costs will increase in 2009 as we continue to experience greater demand from our customers. During 2008, we incurred $100,000 in patent costs associated with filing costs for intellectual property, as compared to $138,000 in 2007.

Net cash provided by our financing activities in 2008 was $161,000, compared to net cash provided by our financing activities of $3,211,000 in 2007. This decrease was due to the private placement of our series B convertible preferred stock issued in September 2007, as described above.

We currently expect that existing cash and cash equivalents will be sufficient to fund our existing operations for the next 12 months. If in the next 12 months our plans or assumptions change or prove to be inaccurate, we may be required to seek additional capital through public or private debt or equity financings. If we need to raise additional funds, we may not be able to do so on terms favorable to us, or at all. If we cannot raise sufficient funds on acceptable terms, we may have to curtail our level of expenditures and our rate of expansion.

Off Balance Sheet Arrangements

We have no off-balance sheet arrangements, other than the consulting agreements and operating leases (as described in "Contractual Obligations" below) that have or are reasonably likely to have a current or future effect that is material to investors on our financial condition, revenues or expenses, results of operations, liquidity, capital resources or capital expenditures.

Contractual Obligations

The following table summarizes our contractual obligations at December 31, 2008 which we expect to have an effect on our liquidity and cash flow in future periods. (See Item 2: Description of Property for a full description of our lease obligations which includes a portion of the lease to be paid in our common stock.)

                            Payments Due by Period

                                   Less than

                      Total          1 Year       1-4 Years

Operating Leases   $ 1,146,956     $  309,674     $  837,282

The Company entered into a Services and Co-Marketing Agreement dated March 1, 2004, in which it agreed to pay Chondrometrics GmbH, a German limited liability company, fees equal to approximately 7% of the gross revenues it derived from certain services each year throughout the term of the agreement. The Company was obligated to make minimum payments to Chondrometrics for the first three years of the agreement. Payments made to Chondrometrics in 2008 and 2007 amounted to $15,000 and $37,000, respectively. There was no minimum payment required in 2008. The agreement terminated on December 31, 2008.

Critical Accounting Policies

Our management's discussion and analysis of our financial condition and results of operations is based on our 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 assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the revenues and expenses during the reporting periods. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are more fully described in Note 2 to our financial statements appearing elsewhere in this report. The following accounting policies are important in fully understanding and evaluating our reported financial results.

Patents

Costs incurred to acquire and file for patents, including legal costs, are capitalized as long-lived assets and amortized on a straight-line basis over the lower of the estimated useful life or legal life of the patent, which is 20 years.

Impairment of Long-Lived Assets

The Company adopted SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets." Long-lived assets held for use are subject to an impairment assessment if the carrying value is no longer recoverable based upon the undiscounted cash flows of the assets. The amount of the impairment is the difference between the carrying amount and the fair value of the asset. Management does not believe that there is any impairment of long-lived assets at December 31, 2008.

Revenue Recognition

The Company applies the revenue recognition principles set forth under the Securities and Exchange Commission Staff Accounting Bulletin No. 104, "Revenue Recognition," with respect to its revenues from image analysis, consulting and project/data management services, and recognizes revenue when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when an agreement exists, services and products are provided to the customer, prices are fixed or determinable, and collectibility is reasonably assured. Revenues are reduced for estimated discounts and other allowances, if any.

The Company provides advanced medical image analysis on a per image basis, and recognizes revenue when the image analysis is completed and delivered to the customer. Revenue related to project, data and site management services is recognized as the services are rendered and in accordance with the terms of the contract. Consulting revenue is recognized once the services are rendered and typically charged as an hourly rate.

Occasionally, the Company provides software development services to its customers, which may require significant development, modification, and customization. Software development revenue is billed on a fixed price basis and recognized upon delivery of the software and acceptance by the customer on a completed contract basis in accordance with the American Institute of Certified Public Accountants Statement of Position 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." The Company does not sell software licenses, upgrades or enhancements, or post-contract customer services.

Reimbursements received for out-of-pocket expenses incurred are reported as revenue in the financial statements in accordance with Emerging Issues Task Force No. 01-14, "Income Statement Characterization of Reimbursements received for 'Out-of-Pocket' Expenses Incurred."

Research and Development

Research and development expenses consist of costs incurred to further our research and development activities and include salaries and related employee benefits, consultants and research-related overhead expenses. Research and development costs are expensed as incurred.

Stock-Based Compensation

On January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123R, "Share-Based Payment," using the modified prospective method. Consequently, for the year ended December 31, 2008, the Company's results of operations reflect compensation expense for new stock options granted and vested under its stock incentive plans during the fiscal year 2008 and the unvested portion of previous stock option grants which vested during the fiscal year 2008.

The Company accounts for its stock-based payments to non-employees under the guidance of Emerging Issues Task Force ("EITF") 96-18, "Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring or in Connection with Selling Goods or Services," which states that the transaction should be valued based on the fair value of the services provided or the fair value of the equity received, whichever is more reliably measurable.

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board ("FASB") issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115" ("SFAS No. 159"). This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is expected to expand the use of fair value measurement, which is consistent with the Board's long-term measurement objectives for accounting for financial instruments. SFAS No. 159 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of SFAS No. 157. SFAS No. 159 did not have an impact on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141R, "Business Combinations" ("SFAS No. 141R"), which replaces SFAS No. 141, "Business Combinations." SFAS No. 141R establishes principles and requirements for determining how an enterprise recognizes and measures the fair value of certain assets and liabilities acquired in a business combination, including noncontrolling interests, contingent consideration, and certain acquired contingencies. SFAS No. 141R also requires acquisition-related transaction expenses and restructuring costs be expensed as incurred rather than capitalized as a component of the business combination. SFAS No. 141R will be applicable prospectively to business combinations for which the acquisition date is on or after January 1, 2009. SFAS No. 141R would have an impact on accounting for any businesses acquired after the effective date of this pronouncement.

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements-An Amendment of ARB No. 51" ("SFAS No. 160"). SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary (previously referred to as minority interests). SFAS No. 160 also requires that a retained noncontrolling interest upon the deconsolidation of a subsidiary be initially measured at its fair value. Upon effectiveness of SFAS No. 160, the Company would be required to report any noncontrolling interests as a separate component of consolidated stockholders' equity. The Company would also be required to present any net income allocable to noncontrolling interests and net income attributable to the stockholders of the Company separately in its consolidated statements of operations. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after January 1, 2009. SFAS No. 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. All other requirements of SFAS No. 160 shall be applied prospectively. SFAS No. 160 would have an impact on the presentation and disclosure of the noncontrolling interests of any non wholly-owned businesses acquired in the future.

In March 2008, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 161, "Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133" ("SFAS No. 161"). SFAS No. 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance and cash flows. The guidance in SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. This Statement encourages, but does not require, comparative disclosures for earlier periods at initial adoption. Management has concluded that the implementation of SFAS No. 161 will have no impact on the Company's consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position SFAS 142-3, Determination of the Useful Life of Intangible Assets ("FSP SFAS 142-3"). FSP SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. The objective of this FSP is to improve the consistency between the useful life of a recognized intangible asset under Statement 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R, Business Combinations, and other U.S. GAAP principles. FSP SFAS 142-3 is effective for fiscal years beginning after December 15, 2008. The adoption of FSP SFAS 142-3 is effective January 1, 2009 and is not expected to have a material impact on the Company's consolidated financial statements.

In June 2008, the FASB ratified Emerging Issue Task Force ("EITF") 07-5, "Determining Whether an Instrument (or an Embedded Feature) is Indexed to an Entity's Own Stock" ("EITF 07-5"). EITF 07-5 provides framework for determining whether an instrument is indexed to an entity's own stock. EITF 07-5 is effective for fiscal years beginning after December 15, 2008. The implementation of EITF 07-5 is not expected to have a material effect on the Company's consolidated financial statements.

In October 2008, The FASB issued FSP 157-3 "Determining Fair Value of a Financial Asset in a Market That is Not Active" (FSP 157-3). FSP 157-3 classified the application of SFAS No. 157 in an inactive market. It demonstrated how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The implementation of FSP 157-3 did not have a material effect on the Company's consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157"). This Statement defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS No. . . .