Variable Interest Entity (VIE)

The Company follows authoritative guidance for the consolidation of its VIE, which requires an enterprise to determine whether its variable interest gives it a controlling financial interest in a VIE. Determination about whether an enterprise should consolidate a VIE is required to be evaluated continuously as changes to existing relationships or future transactions may result in consolidating or deconsolidating the VIE.

Cercacor Laboratories, Inc. (Cercacor)

Cercacor is an independent entity spun off from the Company to its stockholders in 1998. Joe Kiani, the Company’s Chairman and Chief Executive Officer, is also the Chairman and Chief Executive Officer of Cercacor. The Company is a party to a Cross-Licensing Agreement with Cercacor, which was most recently amended and restated effective January 1, 2007 (the Cross-Licensing Agreement), that governs each party’s rights to certain intellectual property held by the two companies. In addition, the Company entered into a Services Agreement with Cercacor effective January 1, 2007, which governs the general and administrative services the Company provides to Cercacor.

Under the Cross-Licensing Agreement, the Company granted Cercacor an exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET^® owned by the Company, including all improvements on this technology, for the monitoring of non-vital signs measurements and to develop and sell devices incorporating Masimo SET^®for monitoring non-vital signs measurements in any product market in which a product is intended to be used by a patient or pharmacist rather than a professional medical caregiver. The Company refers to this market as the Cercacor Market. The Company also granted Cercacor a non-exclusive, perpetual and worldwide license, with sublicense rights, to use all Masimo SET^® for the measurement of vital signs in the Cercacor Market.

The Company exclusively licenses from Cercacor the right to make and distribute products in the professional medical caregiver markets, which the Company refers to as the Masimo Market, that utilize rainbow^® technology for certain non-invasive measurements, including carbon monoxide, methemoglobin, fractional arterial oxygen saturation and hemoglobin. The Company also has the option to obtain exclusive licenses to make and distribute products that utilize rainbow^® technology for the monitoring of other non-vital signs measurements, including blood glucose, in product markets where the product is intended to be used by a professional medical caregiver. During the year ended December 28, 2013, the Company exercised its right to license from Cercacor five additional non-vital sign measurements for $0.5 million each, or $2.5 million in the aggregate. As the result of new data related to these five additional non-vital sign measurements, the Company and Cercacor terminated these licenses during the three months ended October 3, 2015 and Cercacor agreed to refund the amounts previously paid by the Company for these licenses.

To date, the Company has developed and commercially released devices that measure carbon monoxide, methemoglobin and hemoglobin using licensed rainbow^® technology. The Company also markets certain other rainbow technologies, such as rainbow Acoustic Monitoring^™, the rights to which are owned by the Company and for which no licensing fee is paid to Cercacor.

The Company’s license to rainbow^® technology for these parameters in these markets is exclusive on the condition that the Company continues to pay Cercacor royalties on its products incorporating rainbow^® technology, subject to certain minimum aggregate royalty thresholds, and that the Company uses commercially reasonable efforts to develop or market products incorporating the licensed rainbow^® technology. The royalty rate is up to 10% of the rainbow^® royalty base, which includes handhelds, tabletop and multi-parameter devices. Handheld products incorporating rainbow^® technology will carry up to a 10% royalty rate. For other products, only the proportional amount attributable to that portion of the Company’s devices used to monitor non-vital signs measurements, rather than to monitor vital signs measurements, and sensors and accessories for measuring only non-vital signs parameters, will be included in the 10% rainbow^® royalty base. Effective January 2009, for multi-parameter devices, the rainbow^®royalty base includes the percentage of the revenue based on the number of rainbow^® enabled measurements. For hospital contracts where the Company places equipment and enters into a sensor contract, the Company pays a royalty to Cercacor on the total sensor contract revenues based on the ratio of rainbow^® enabled devices to total devices.

The current annual minimum aggregate royalty obligation under the license is $5.0 million. Actual aggregate royalty liabilities to Cercacor under the license were $1.7 million and $4.3 million for the three and nine months ended October 3, 2015, respectively, and $0.9 million and $4.0 million for the three and nine months ended September 27, 2014, respectively. In connection with a change in control of the Company, as defined in the Cross-Licensing Agreement, the minimum aggregate annual royalties for licensed rainbow^® measurements payable to Cercacor related to carbon monoxide, methemoglobin, fractional arterial oxygen saturation, hemoglobin and blood glucose will increase to $15.0 million, plus up to $2.0 million for other rainbow^® measurements.

In February 2009, in order to accelerate the product development of an improved hemoglobin spot-check measurement device, Pronto-7^®, the Company’s board of directors agreed to fund additional engineering expenses of Cercacor. Specifically, these expenses included third-party engineering materials and supplies expense as well as 50% of Cercacor’s total engineering and engineering-related payroll expenses. Beginning in 2012, the Company’s board of directors approved an increase in the percentage of Cercacor’s total engineering and engineering-related payroll expenses funded by the Company from 50% to 60%. This arrangement was discontinued by mutual agreement effective as of January 4, 2015. During the three and nine months ended September 27, 2014, the expenses for these additional services, materials and supplies totaled $0.8 million and $2.6 million, respectively. During the three months ended October 3, 2015, Cercacor completed a review of its fiscal 2014 cross-charges related to Pronto-7^®. Based on this review, it was determined that less than 60% of Cercacor’s total engineering and engineering-related payroll expenses were attributable to the development of Pronto-7^®, resulting in an overpayment by the Company of approximately $1.6 million. Both parties also reviewed and agreed to equally share approximately $1.4 million of previously incurred engineering-related payroll expenses associated with research for a new LED sensor technology. As a result, the parties mutually agreed that Cercacor would refund $0.9 million to the Company in the quarter ended October 3, 2015.

Effective as of July 6, 2015, the Company and Cercacor entered into a patent transfer and licensing agreement (the Patent Agreement) pursuant to which, among other things, the Company purchased certain patents from Cercacor (the Purchased Patents) for an aggregate purchase price of $2.4 million. Pursuant to the Patent Agreement, the Company granted Cercacor an irrevocable, non-exclusive, worldwide license with respect to the products and services covered by the Purchased Patents.

Pursuant to authoritative accounting guidance, Cercacor is consolidated within the Company’s financial statements for all periods presented. The Company is required to consolidate Cercacor since the Company is currently deemed to be the primary beneficiary of Cercacor’s activities. This determination is based primarily on the facts that the Company is Cercacor’s sole customer and Cercacor is currently financially dependent on the Company for funding. Accordingly, all intercompany royalties, option and license fees and other charges between the Company and Cercacor, as well as all intercompany payables and receivables, have been eliminated in the consolidation. Also, all direct engineering expenses that have been incurred by the Company and charged to Cercacor, or that have been incurred by Cercacor and charged to the Company, have not been eliminated and are included as research and development expense in the Company’s condensed consolidated statements of comprehensive income. Upon consolidation, $3.9 million and $6.5 million of deferred revenue related to technology licensed to the Company as of October 3, 2015 and January 3, 2015, respectively, were eliminated.

Assets of Cercacor can only be used to settle obligations of Cercacor and creditors of Cercacor have no recourse to the general credit of the Company. The condensed consolidated balance sheets include a noncontrolling interest in Cercacor of $1.0 million and $1.7 million as of October 3, 2015 and January 3, 2015, respectively, which represents the value of common stock, additional paid-in capital and retained earnings of Cercacor that are not available to the Company. In addition, the condensed consolidated balance sheets include, net of intercompany eliminations, total assets of $4.0 million and $7.2 million as of October 3, 2015 and January 3, 2015, respectively, related to Cercacor. Cercacor’s total assets as of October 3, 2015 included $2.9 million for intangible assets and $0.8 million for property and equipment. Cercacor’s total assets as of January 3, 2015 included $4.7 million for intangible assets and $1.2 million for property and equipment. The Company’s condensed consolidated balance sheets include total liabilities related to Cercacor, net of intercompany eliminations, of $0.9 million as of October 3, 2015 and $1.2 million as of January 3, 2015.

For the foreseeable future, the Company anticipates that it will continue to consolidate Cercacor pursuant to the current authoritative accounting guidance; however, in the event that Cercacor is no longer considered a VIE under such accounting guidance, the Company may discontinue consolidating the entity.

The changes in noncontrolling interest for Cercacor were as follows (in thousands):



	Nine Months Ended October 3, 2015
Noncontrolling interest, beginning of period	$	1,742
Increase in additional paid-in capital of noncontrolling interest	9
Net loss attributable to noncontrolling interest	2,752
Noncontrolling interest, end of period	$	(1,001	)