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. Changes in the noncontrolling interest for the consolidated VIE for each period are presented in the accompanying consolidated statements of equity.

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. In addition, Jack Lasersohn, a member of the Company’s board of directors (Board), was also a member of the Cercacor board of directors until April 2, 2015. 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.

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 noninvasive measurements, including carbon monoxide, methemoglobin, fractional arterial oxygen saturation and hemoglobin. 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 in fiscal 2015 related to these five additional non-vital sign measurements, the Company and Cercacor terminated these licenses during fiscal 2015 and Cercacor agreed to refund the amounts previously paid by the Company for these licenses. 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. 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 multiparameter 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 multiparameter 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 $6.7 million, $5.5 million and $5.4 million for the fiscal years ended January 2, 2016, January 3, 2015 and December 28, 2013, 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 Board 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 from April 2009 through June 2010, the original anticipated completion date of this product development effort. Subsequent to July 2010, Cercacor continued to assist the Company with product development efforts and charged the Company accordingly. Beginning in 2012, the Board approved an increase in the percentage of Cercacor’s total engineering and engineering-related payroll expenses funded by the Company from 50% to 60%. During the fiscal years ended January 3, 2015 and December 28, 2013, the expenses for these additional services, materials and supplies totaled $3.1 million and $4.1 million, respectively. This arrangement was discontinued by mutual agreement effective as of January 4, 2015.

During the year ended January 2, 2016, 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. In addition, 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 during the third quarter of fiscal 2015.

The Company has also entered into an administrative services agreement with Cercacor effective January 1, 2007 (G&A Services Agreement) that governs certain general and administrative services the Company provides to Cercacor. Amounts charged by the Company pursuant to this G&A Services Agreement amounted to $0.2 million for each of the fiscal years ended January 2, 2016, January 3, 2015 and December 28, 2013.

In January 2015, the Company entered into a consulting services agreement (Consulting Agreement) with Cercacor that governs certain engineering consulting and clinical studies support services that Cercacor may provide to the Company from time-to-time. Expenses incurred by the Company related to this Consulting Agreement were $0.3 million for the fiscal year ended January 2, 2016.

Effective 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 consolidation. All direct engineering and clinical studies support expenses 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 consolidated statements of operations. Similarly, all direct general and administrative expenses that have been incurred by the Company and charged to Cercacor are included as selling, general and administrative expense in the Company’s consolidated statements of operations. 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.

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 consolidating balance sheets as of January 2, 2016 and January 3, 2015, and statements of operations for the years ended January 2, 2016, January 3, 2015 and December 28, 2013 reflecting the Company, Cercacor and related eliminations (in thousands) are as follows.



	January 2, 2016												January 3, 2015
Consolidating Balance Sheets:	Masimo Corp			Cercacor			Cercacor Elim			Total			Masimo Corp			Cercacor			Cercacor Elim			Total
ASSETS
Cash and cash equivalents	$	131,554		$	763		$	—		$	132,317		$	133,509		$	944		$	—		$	134,453
Accounts receivable, net	80,937			23			—			80,960			71,017			—			—			71,017
Inventories	62,038			—			—			62,038			69,718			—			—			69,718
Prepaid income taxes	2,342			62			—			2,404			324			93			—			417
Other current assets	21,230			1,277			(1,084		)	21,423			21,446			203			(178		)	21,471
Deferred cost of goods sold	66,844			—			—			66,844			67,485			—			—			67,485
Property and equipment, net	131,877			589			—			132,466			100,730			1,222			—			101,952
Intangible assets, net	29,045			2,858			(4,347		)	27,556			29,564			4,738			(6,531		)	27,771
Goodwill	20,394			—			—			20,394			20,979			—			—			20,979
Deferred income taxes	44,320			—			—			44,320			42,258			—			—			42,258
Other assets	11,013			—			—			11,013			7,450			2,021			(1,986		)	7,485
Total assets	$	601,594		$	5,572		$	(5,431	)	$	601,735		$	564,480		$	9,221		$	(8,695	)	$	565,006
LIABILITIES
Accounts payable	$	25,798		$	67		$	—		$	25,865		$	38,003		$	42		$	—		$	38,045
Accrued compensation	37,715			700			—			38,415			32,985			615			—			33,600
Accrued liabilities	45,142			164			(1,084		)	44,222			24,492			227			(178		)	24,541
Income taxes payable	2,565			212			—			2,777			6,350			212			—			6,562
Deferred revenue	21,280			376			(376		)	21,280			21,067			500			(500		)	21,067
Current portion of capital lease obligations	74			—			—			74			79			—			—			79
Deferred revenue	298			3,406			(3,406		)	298			453			6,031			(6,031		)	453
Long term debt	185,071			—			—			185,071			125,145			—			—			125,145
Other liabilities	7,964			57			—			8,021			9,634			125			(1,986		)	7,773
EQUITY
Common stock	50			14			(14		)	50			52			11			(11		)	52
Treasury stock	(340,873		)	(100		)	100			(340,873		)	(185,906		)	(100		)	100			(185,906		)
Additional paid-in capital	332,417			842			(842		)	332,417			288,686			491			(491		)	288,686
Accumulated other comprehensive loss	(4,739		)	—			—			(4,739		)	(2,093		)	—			—			(2,093		)
Retained earnings (deficit)	288,832			(166		)	(106		)	288,560			205,533			1,067			(1,340		)	205,260
Total Masimo Corporation stockholders’ equity	275,687			590			(862		)	275,415			306,272			1,469			(1,742		)	305,999
Noncontrolling interest	—			—			297			297			—			—			1,742			1,742
Total equity	275,687			590			(565		)	275,712			306,272			1,469			—			307,741
Total liabilities and equity	$	601,594		$	5,572		$	(5,431	)	$	601,735		$	564,480		$	9,221		$	(8,695	)	$	565,006