under the heading "Government Regulation" in the section entitled "Business."

ArthroCare Strategy

Our objective is to use our patented Coblation technology to design, develop, manufacture and sell innovative, clinically superior surgical devices for the arthroscopic surgical treatment of joint injuries and for the surgical treatment of other soft-tissue conditions throughout the body. The key elements of our strategy include:

• EXPANDING OUR PRODUCT OFFERING TO ADDRESS A LARGER NUMBER OF ARTHROSCOPIC PROCEDURES. We are continuously expanding our portfolio of products in arthroscopy by enhancing our existing products to serve the needs of physicians. For example, we have increased our penetration of arthroscopy procedures in the knee through the addition of disposable devices with suction capability.

• EXPANDING INTO ADDITIONAL SURGICAL MARKETS. Our systems are being used to perform many types of arthroscopic surgeries and also have been cleared for use in certain types of cosmetic, ENT, spinal and general surgery procedures. We have CE marked our neurological products for sale in Europe. We are planning to introduce these products in the United States once FDA marketing clearance is received. We are developing our Coblation technology for use in myocardial revascularization, a cardiology procedure, with our partner, Boston Scientific Corporation.

• EXPANDING INTERNATIONAL PRESENCE. We have established an extensive distributor network, supported by our regional managers, in selected international markets. We have signed agreements with several marketing partners to assist with regulatory requirements and to market and distribute our products internationally.

• STRUCTURING FLEXIBLE STRATEGIES TO COMMERCIALIZE OUR COBLATION TECHNOLOGY. We have chosen to adopt a customized distribution strategy to optimize our commercialization efforts in each of our target markets. In arthroscopy, spinal and ENT surgery, we utilize distributor relationships supported by focused regional managers and a small direct sales force. In cosmetic surgery, we have chosen to partner with a leading cosmetic surgery company, Inamed Corporation. We have chosen to partner with Boston Scientific Corporation to further develop and to commercialize our technology in the myocardial revascularization application of the cardiology market.

COBLATION TECHNOLOGY

Our products are based on our patented soft-tissue surgical controlled ablation technology, which we call Coblation. Coblation technology involves an innovative use of radio frequency energy characterized by precision, accuracy, ease of use and the capability of performing at temperatures lower than current traditional electrosurgical tools.

Traditional electrosurgical tools rely upon heat to burn away targeted tissue, which often results in thermal damage to tissue surrounding the surgical area. Additionally, the lack of tactile feedback with these devices makes it difficult for surgeons to control the depth of tissue penetration. Coblation technology employs a lower temperature process that minimizes the risk of thermal burn of tissue while increasing the surgeon's control and precision.

Coblation technology uses an electrically conductive fluid in the gap between the electrode and tissue. When electrical current is applied to this fluid, it creates a charged layer of particles. As the layer of charged particles comes into contact with the targeted tissue, the molecular bonds within the cells of the targeted tissue are broken. This process causes the cells to disintegrate molecule by molecule, so that tissue is volumetrically removed. Because this effect is confined to the surface layer of the targeted tissue, minimal damage occurs to surrounding tissue, potentially resulting in reduced pain and faster recovery for the patient. An additional advantage is that Coblation can be performed in a continuous mode, resulting in efficient tissue ablation thereby reducing the overall procedure time as compared to conventional methods. In addition to achieving more precise tissue ablation or shrinkage and less damage to surrounding tissue, surgical devices based on Coblation technology can achieve sealing of bleeding vessels near the surgical site.

We commercially introduced our soft-tissue surgery system in December 1995 and by the year ended January 1, 2000, we had reported 49 months of sales. Since the arthroscopic soft-tissue surgery system accounts for most of our product sales, we are highly dependent on its sales. Our spinal surgery, neuro surgery, cosmetic surgery, and ENT surgery products have only recently become available, and to date, we have sold only a small number of units. We cannot assure you that we will be able to continue to manufacture arthroscopy products in commercial quantities at acceptable costs, or that we will be able to continue to market such products successfully.

To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians' education with respect to Coblation technology and continue working on new product development efforts specifically for knee applications. Furthermore, in order to maintain and increase current market penetration we must be aggressive in increasing our installed base of controllers to generate increased disposable device revenue. To date, we have placed our controller units at substantial discounts in order to stimulate demand for our disposable devices.

We believe that surgeons will not use our products unless they determine, based on experience, clinical data and other factors, that these systems are an attractive alternative to conventional means of tissue ablation. There are only a few independently published clinical reports and limited long- term clinical follow-up to support the marketing efforts for our Arthroscopic System. We believe that continued recommendations and endorsements by influential arthroscopic surgeons are essential for market acceptance of our Arthroscopic System. If our Coblation technology does not continue to receive endorsement by influential surgeons or our long-term data does not support our current claims of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.

THE ARTHROSCOPY MARKET

In 1999, approximately 2.9 million arthroscopic procedures were performed in the United States. Due to patient demand for less invasive procedures, we believe the number of arthroscopic procedures is growing. In addition, a greater emphasis on physical fitness and an aging population is increasing the incidence of joint injuries. Joints are susceptible to injuries from blows, falls or twisting, as well as from natural deterioration and stiffening associated with aging.

Historically, joint injuries have been treated using open surgery involving large incisions, a hospital stay and a prolonged recovery period. In contrast, arthroscopic surgery, which was introduced in the early 1980's, is performed through several small incisions called portals and can be performed on an outpatient basis. We believe that arthroscopic surgery has gained wide market acceptance because it offers shorter hospital stays and reduced recovery time, resulting in reduced costs and improved medical outcomes.

To perform arthroscopic surgery, a surgeon uses a tool to visualize the site and other tools to perform the surgery. The tool used to visualize the site, called an arthroscope, is a small fiber-optic viewing instrument made up of a small lens, a light source and a video camera, which allows the surgeon to view the surgical procedure on a video monitor. During the arthroscopic procedure, an irrigant such as saline is flushed through the joint to permit clear visualization through the arthroscope and to create the space within the joint for the surgical procedure. The surgeon inserts the arthroscope into the joint through a portal measuring approximately six millimeters, or 1/4 of an inch, in length. Other portals are used for the insertion of surgical instruments to perform the surgery and to facilitate the flow of irrigants. With small incision sites and direct access to most areas of the joint, a surgeon can diagnose and correct an array of joint problems such as cartilage tears, ligament tears and removal of loose and degenerative tissue.

The advantages of arthroscopic surgery over open surgery are often significant. Due to the smaller incisions and reduced surgical trauma, the patient might experience several benefits including reduced pain; treatment on an outpatient basis; reduced or eliminated hospitalization times; immediate joint mobility and less muscle atrophy; less surrounding tissue damage; lower rate of complications; and generally quicker rehabilitation. In addition, treatment on an outpatient basis and reduced operating time can significantly lower hospital costs.

Knee

The knee is the most commonly injured joint. In 1999, knee injuries accounted for approximately 1.5 million arthroscopic procedures in the United States. Damage to a meniscus, a pad of cartilage that helps cushion the knee joint, is a common form of knee injury. A meniscus can be torn by a twist of the leg when the knee is flexed, displaced either inward toward the center of the shin bone or outward beyond the surface of the thighbone, or worn down by normal aging. The knee is also susceptible to partial or complete tears of the ligaments and degeneration of the cartilage on the underside of the kneecap. In addition, the cartilage covering the bony surfaces of the knee can become rough or tear loose from the bone as a result of age or injury, causing pain and interfering with smooth joint movement.

Shoulder

The shoulder joint, because of its range of motion, is susceptible to a number of injuries. In 1999, approximately 670,000 arthroscopic procedures in the shoulder were performed in the United States. We believe that shoulder arthroscopy is the fastest-growing portion of the arthroscopy market. With repetitive motion and lifting of the arm, such as that which occurs during a tennis serve, a bone formation of the upper arm may pinch one of the shoulder muscles and cause persistent pain, known as a rotator cuff injury. Strengthening exercises and physiotherapy can treat this condition; however, many rotator cuff injuries require surgical intervention. We believe that a significant percentage of the population is born with a susceptibility to rotator cuff injuries.

Elbow, Ankle, Wrist and Hip

The elbow, ankle, wrist and hip joints are also susceptible to certain stress-related injuries and deterioration due to aging. In 1998, approximately 200,000 arthroscopic procedures were performed in the elbow, ankle, wrist and hip in the United States. We believe that the current number of surgical procedures in the elbow, ankle, wrist and hip is relatively small due to the limitations of conventional arthroscopic surgical equipment.

CONVENTIONAL TREATMENT METHODOLOGIES: THE PROBLEM

Most arthroscopic procedures require the surgeon to probe, cut, sculpt and shape tissue and seal bleeding vessels to achieve satisfactory results. Surgeons frequently use a combination of instruments when performing an arthroscopic procedure because each instrument is designed to perform a specific function. Use of an assortment of tools requires the surgeon to insert and remove each of the tools from the portals several times during the same procedure.

Surgical procedures can employ one or more of four groups of surgical instruments: (1) power or motorized instruments, such as cartilage and bone shavers; (2) mechanical instruments, such as basket punches, graspers and scissors; (3) electrosurgical systems; or (4) laser systems.

Power instruments are generally used to smooth tissue and cartilage defects on the surface of the bones of the joint. The damaged tissue is removed from the joint using suction through a tube surrounding the shaft of the tool, which can become obstructed by bits of tissue and bone. Power shavers have rotating cutters inside a tube and are available in a number of tip angles or sizes for the precise shaving of tissue. Mechanical tools must be resharpened at regular intervals and sterilized after each procedure.

Conventional electrosurgical systems are used to seal blood vessels, which is necessary to minimize bleeding and maximize the arthroscopic surgeon's visibility of the procedure through the arthroscope. Conventional electrosurgical systems contain two electrodes: the electrode tip held by the surgeon and a dispersive pad that rests under the patient's body. The metal electrode tip of the instrument, which resembles a pencil point, is placed on or near the bleeding vessel to be sealed. A generator connected to the electrode delivers high-frequency voltage that arcs between the electrode and the target tissue, sealing blood vessels in its vicinity. After arcing, the current travels through the remaining tissue of the patient's body, through the skin to the dispersive electrode pad, before being directed back to the generator.

Laser systems are used to remove tissue while sealing bleeding vessels. Because laser systems are not tactile tools, the surgeon cannot feel how much tissue is being ablated. The surgeon must be extensively trained to precisely position the laser to control the depth of tissue penetration to minimize unintended tissue damage. In addition, the temperature of the laser instrument is high and, as a result, can cause damage to surrounding tissue and vascular areas. We believe that laser tools have not received wide acceptance because of high capital cost and significant ongoing maintenance and operating expenses, lack of tactile feedback for the surgeon, required training and certification, and the concern about damage that may be caused by the significant heat generated by these devices.

THE ARTHROCARE ARTHROSCOPIC SYSTEM: A SOLUTION

Our Arthroscopic System is a radio frequency surgical device intended to perform tissue ablation, sculpting or shrinkage as well as sealing bleeding vessels. Our Arthroscopic System is comprised of an assortment of disposable bipolar multi-electrode and single electrode devices, a connecting cable, foot pedal or switch and a radio frequency controller. We sell our Arthroscopic System for use in all six major joints: knee, shoulder, elbow, ankle, wrist and hip. Many types of tissue, including cartilage and ligaments, can be ablated using our Arthroscopic System.

Our controller delivers radio frequency energy to the disposable device. Surgeons can use the disposable device to ablate, sculpt or shrink tissue or seal bleeding vessels. The surgeon can control the mode of operation and power setting with the foot pedal or keys on the front panel of the controller.

Accordingly, a surgeon using the Arthroscopic System does not need to remove and insert a variety of instruments to perform different tasks as is required when using conventional arthroscopic instruments. Our disposable devices are approved for sale in tip sizes ranging from 1.5 mm to 4.5 mm, and in tip angles ranging from zero to 90 degrees. We currently sell 25 models for arthroscopy in various tip sizes, angles and shapes, enabling the surgeon to ablate different volumes of tissue and to reach treatment sites not readily accessible by existing mechanical instruments and motorized cutting tools. In addition, some of our disposable devices provide suction capability.

We commercially introduced the Arthroscopic System in December 1995. The list price of the controller, including the cable, is approximately $7,500. The disposable devices have list prices ranging from approximately $115 to $195, and typically one disposable device is used per procedure. We are marketing and selling our Arthroscopic System in the United States through a network of independent orthopedic distributors and a small direct sales force. We have ramped up our manufacturing capabilities, and from 1998 to 1999, have almost doubled our disposable volumes while maintaining yields.

The Spinal Surgery Market

We believe spinal surgery has an estimated 1999 market size of more than $1 billion and is the most rapidly growing segment of orthopedic surgery, increasing in excess of 25 percent annually. Chronic back pain afflicts approximately nine million people in the U.S. and is the number one cause of healthcare expenditures. Chronic back pain is estimated to cost the nation more than $50 billion per year in direct and indirect medical expenses. Approximately one-half of those afflicted suffer from disabling pain; chronic back pain is the most common reason for disability for persons under age 50 and is the second leading cause of workers' absenteeism. The major causes of persistent, often disabling, back pain are disruption of a portion of the disc, chronic inflammation of the disc, also known as herniation, or relative instability of the vertebral bodies surrounding a given disc, such as the instability that often occurs due to a degenerative disease. Intervertebral discs mainly function to cushion and tether the vertebrae, providing flexibility and stability to the patient's spine. As discs degenerate, they lose their water content and height, bringing the adjoining vertebrae closer together. This results in a weakening of the shock absorption properties of the disc and a narrowing of the nerve openings in the sides of the spine which may pinch these nerves. This disc degeneration can eventually cause back and leg pain.

Often, inflammation from disc herniation can be treated successfully by non-surgical means, such as rest, therapeutic exercise, or through the use of anti-inflammatory medications. In some cases, the disc tissue is irreparably damaged, thereby necessitating a discectomy, the removal of a portion of the disc or the entire disc to eliminate the source of inflammation and pressure. In more severe cases, the adjacent vertebral bodies must be stabilized following excision of the disc material to avoid recurrence of the disabling back pain. One approach to stabilizing the vertebrae, termed spinal fusion, is to insert an interbody graft or implant into the space vacated by the degenerative disc. In this procedure, a small amount of bone may be grafted from other portions of the body, such as the hip, and packed into the implants. This allows the bone to grow through and around the implant, fusing the vertebral bodies and alleviating the pain.

Another surgical treatment for degenerative disc disease, termed laminectomy, involves cutting away the lamina, the bony plate that connects the bony ridges of the spine, known as pedicles. This allows the nerve tissue to shift position to release pressure.

Until recently, spinal discectomy, laminectomy and fusion procedures resulted in major operations and traumatic dissection of muscle and bone removal or bone fusion. The open surgical procedures are invasive and typically require a team of surgeons due to the length and complexity of the procedure. Recovery time is also lengthy. To overcome the disadvantages of traditional traumatic spinal surgery, minimally-invasive spinal surgery was developed. In minimally-invasive spinal procedures, the spinal canal is not penetrated and therefore bleeding with ensuing scarring is minimized or completely avoided. In addition, the risk of instability from ligament and bone removal is generally lower in minimally-invasive procedures than with open discectomy. Further, less trauma during surgery often results in rapid rehabilitation and fast recovery.

We believe that approximately 1.9 million spine procedures are performed annually worldwide. We also believe that spinal surgery is the most rapidly growing segment of orthopedic surgery.

Conventional Treatment Methodologies for Treatment of Spine Diseases and Disorders

Techniques for the treatment of spinal diseases or disorders include laser and mechanical techniques. These procedures can be "open" or minimally invasive depending on the complexity, and generally require the surgeon to form a passage or operating corridor from the external surface of the patient to the spinal disc(s) for passage of surgical instruments and implants. Typically, the formation of this operating corridor requires the removal of soft tissue, muscle or other types of tissue. This tissue is usually removed with mechanical or powered instruments, such as, graspers, cutters and drills. Multiple mechanical and powered instruments must be used and are time-intensive. In addition, these instruments sever blood vessels within this tissue, often causing profuse bleeding that obstructs the surgeon's view of the target site.

Once the operating corridor is established, the nerve root is retracted and a portion or all of the disc is removed with mechanical or powered instruments. These instruments are typically slow and tedious, and can require up to 40 minutes to remove a single disc. In addition, these instruments, particularly powered instruments, are not extremely precise, and it is often difficult during the procedure to differentiate between the target disc tissue and other structures within the spine, such as bone, cartilage, ligaments, nerves and surrounding tissue. Thus, the surgeon must be extremely careful to minimize damage to the cartilage and bone within the spine, and to avoid damaging nerves.

Both lasers and monopolar radio frequency devices have been used in spinal surgery. We believe both have significant drawbacks. Lasers are expensive and tedious to use. Another disadvantage with lasers is the difficulty in judging the depth of tissue ablation. Because healthy tissue, bones, ligaments and nerves often lie within close proximity of the spinal disc, it is essential to maintain a minimum depth of tissue penetration. Monopolar radio frequency devices increase the risk of unwanted electrical stimulation to portions of the patient's body by utilizing electric current that disperses into the patient's body.

The ArthroCare Spinal Surgery System

In September 1999, we announced our expansion into the spinal surgery market. Our Spinal Surgery System is CE marked. We have received 510(k) clearance for use of the system in spinal surgery procedures in the United. Our spinal surgery products, based on our Coblation technology, include multi-functional disposable devices optimized for spinal surgery. The disposable products are compatible with the controller that is used for arthroscopic and ENT surgery procedures.

Our controller is used to deliver radio frequency energy to the disposable devices. The disposable devices are intended for single use and utilize multiple or single electrodes to ablate tissue and seal bleeding vessels. In some cases, our disposable devices may also include one or more tubes for the delivery of electrically conductive fluid to the target site and/or for suction capability. The incorporation of ablation, suction and fluid management into a single disposable device potentially reduces operating time and expense. Although we have had limited clinical experience with these products in spinal surgery procedures, we believe physician and patient benefits experienced in arthroscopic surgery, such as more rapid recovery time, reduced thermal injury to tissue and reduced post-operative pain when compared to existing techniques, could also apply to spinal surgery procedures.

Our disposable devices consist of the ACCESS^TM SpineWand^TM, Reflex^TM and the DisCoblator^TM. The ACCESS SpineWand is a bipolar electrosurgical device designed for controlled ablation of soft tissue. We believe that the ACCESS SpineWand will be an effective tool for creating precise incisions through connective tissue to provide access to the disc in discectomy, laminectomy and fusion procedures. In addition, we believe that the ACCESS SpineWand may be effectively used to remove soft tissue from bones in preparation for fusion procedures.

The DisCoblator is a bipolar electrosurgical device designed for aggressive removal of large tissue volumes. The DisCoblator includes fluid delivery and suction capabilities and incorporates an active screen electrode design to inhibit clogging. We have marketed the DisCoblator to volumetrically remove a portion or all of the disc during discectomy and fusion procedures. Although there has been limited clinical experience with this product, we believe that the DisCoblator is capable of removing a disc in less time than mechanical instruments, such as graspers or cutters.

The ArthroCare Neuro Surgery Market

Approximately 250,000 surgical procedures are performed in the brain each year, and more than 110,000 metastatic brain tumors are diagnosed annually in the United States. According to the American Cancer Society, brain tumors are the second fastest growing cause of cancer death among people over age 65 and are one of the most common types of cancer found in children. In addition, brain trauma affects another 1.5 million people each year in the United States.

Conventional Treatment Methodologies for Treatment of Neurological Diseases

Surgery, radiation, and chemotherapy are the three most common treatments used individually or in combination, for brain tumors. While, surgery is the preferred method of treatment it is not always practical given difficult or impossible access to the tumor. Coblation therapy can allow minimally invasive access to the tumor and allow the physician to quickly remove solid tissue with minimal thermal injury through its process of molecular disassociation.

The ArthroCare Neuro Surgery System

In February 2000, we announced that we were expanding our marketing efforts for our spinal surgery system to specifically address selected applications in neuro surgery. Our Spinal Surgery System is CE marked in Europe and we will utilize this system for use in neuro surgery. We have received 510(k) clearance for use of the system in spinal surgery procedures in the United States and are awaiting clearance for neuro surgery applications. Our spinal and neuro surgery products, based on our Coblation technology, include multi-functional disposable devices optimized for spinal and neuro surgery. The disposable products are compatible with the controller that is used for arthroscopic and ENT surgery procedures.

Our controller is used to deliver radio frequency energy to the disposable devices. The disposable devices are intended for single use and utilize multiple or single electrodes to ablate tissue and seal bleeding vessels. In some cases, our disposable devices may also include one or more tubes for the delivery of electrically conductive fluid to the target site and/or for suction capability. The incorporation of ablation, suction and fluid management into a single disposable device potentially reduces operating time and expense. Although we have had limited clinical experience with these products in neuro surgery procedures, we believe physician and patient benefits experienced in arthroscopic surgery, such as more rapid recovery time, reduced thermal injury to tissue and reduced post-operative pain when compared to existing techniques, could also apply to neuro surgery procedures.

The Ear, Nose and Throat (ENT) Market

We believe that in 1998, approximately 1.4 million ENT procedures were performed worldwide. Surgical procedures are commonly used to treat ear, nose and throat disorders, including obstructive sleep apnea, snoring and other obstructions of the sinus and nasal passages. For example, surgical approaches for the treatment of obstructive sleep apnea include the removal of excess tissue from the upper airway or moving the lower jaw forward to widen the patient's airway. These procedures are performed by highly specialized surgeons, are expensive, are extremely painful for the patient and involve lengthy recovery periods. Non-invasive treatment approaches include continuous positive airway pressure, or CPAP, which requires the patient to wear a nasal mask connected to an airflow generator that forces air through the nasal passages during sleep.

Conventional treatment methodologies for ENT surgical procedures have been performed by lasers, endoscopes and microsurgical tools. We believe our Coblation technology can be used in numerous types of ENT procedures.

The ArthroCare ENT Surgery System

Our ENT Surgery System uses the same technology as the Arthroscopic System, which ablates tissue through a more precise and significantly cooler process than that of traditional electrosurgery devices. Our controller is used to deliver radio frequency energy to the disposable devices. The disposable devices are intended for single use and utilize multiple or single electrodes to ablate tissue while sealing bleeding vessels. In some cases, our disposable devices may also include one or more tubes for the delivery of electrically conductive fluid to the target site and/or for suction capability. The incorporation of ablation, suction and fluid management into a single disposable device potentially reduces operative time and expense. Although we have had limited clinical experience with these products in ENT surgery procedures, we believe physician and patient benefits experienced in arthroscopic surgery, such as more rapid recovery time, reduced thermal injury to tissue and reduced post-operative pain when compared to existing techniques, could apply to ENT surgery procedures.

Our ENT Surgery System is CE marked, and we have received 510(k) clearances for use of the system in general head, neck and oral surgical procedures, minimally-invasive sinus surgery, and the treatment of snoring in the United States. We have been marketing the ENT surgery products through a network of distributors and regional sales managers in the United States and internationally since February 1999.

The Cosmetic Surgery Market

The cosmetic surgery market is primarily comprised of procedures for skin resurfacing to rejuvenate, remove or reduce wrinkles of the skin, remove scarring or lesions and perform traditional techniques such as face lifts or brow lifts. Of the approximately 1.6 million cosmetic surgery procedures performed annually worldwide, approximately 325,000 were laser resurfacing procedures performed in the United States to reduce the wrinkled appearance of skin.

Conventional Treatment Methodologies for Cosmetic Surgery

Conventional methods of skin resurfacing include chemical peels, dermabrasions and laser resurfacing. In chemical peels, an acid-based chemical solution is used to improve the texture of the skin by removing its damaged outer layers. In dermabrasion, surgical scraping is used to remove the skin's top layers. Chemical peels and dermabrasions have minimal effect on wrinkles, and can cause scarring and pigmentary changes. Lasers are often used to achieve wrinkle reduction and removal. The conventional continuous wave carbon dioxide, or CO₂ laser has been used successfully to resurface skin. However, the excessive heat diffusion into surrounding skin during the use of this laser results in unwanted cell death and unacceptable rates of scarring and impaired wound healing. The new generation of pulsed lasers has proven to be an effective method for the treatment of surface imperfections and irregularities, including wrinkles, pigmented spots, and acne scars. These lasers permit precise ablation of tissue with minimal accumulation and dispersion of heat resulting in minimal thermal damage and char.

The ArthroCare Cosmetic Surgery System

Our Cosmetic Surgery System utilizes the same technology as the Arthroscopic System, which removes tissue through a more precise and significantly cooler process than traditional electro surgery systems or dermatologic lasers. Our Cosmetic Surgery System is a radio frequency, electro surgical device for use in skin resurfacing and other dermatologic and cosmetic procedures. Our Cosmetic Surgery System incorporates a disposable bipolar device, a connecting resterilizable handpiece with cable and a radio frequency controller. This controller design differs from the controllers used in arthroscopy, ENT surgery and spinal surgery. The controller delivers radio frequency energy to the multi-electrode or single electrode disposable device. Clinical trials indicate that our Cosmetic Surgery System may enable the physician to reduce wrinkles, rhytids and furrows.

Our Cosmetic Surgery System is CE marked for skin resurfacing procedures, and we have received 510(k) clearance for use of the system in general dermatologic procedures as well as skin resurfacing for the purpose of wrinkle reduction in the United States.

We have entered into an worldwide distribution agreement with Inamed Corporation to license, market and distribute our Coblation-based products for cosmetic surgical procedures, typically performed by cosmetic surgeons, dematologists and facial plastic surgeons, including some ENT physicians. The Cosmetic Surgery System is being distributed under the Refinity™ and Coblation® brand names in the U.S. by McGhan, a worldwide leader in the cosmetic and plastic surgery product markets and an Inamed company. Internationally, the Cosmetic Surgery System is being distributed under the Coblation® Plasma Surgery System name by Collagen Aesthetics an Inamed Corporation.

ArthroCare's Cardiology Program

We have established a program to explore the application of our Coblation technology in various areas within cardiology. One of our programs is in myocardial revascularization, a newly-introduced procedure for treatment of heart disease. Lasers have been recently introduced for use in myocardial revascularization. However, we believe that the high capital cost associated with lasers may impede the widespread adoption of this technology.

We believe that Coblation technology could be used to perform myocardial revascularization. We have an agreement with Boston Scientific Corporation under which they will further develop, seek regulatory approvals for and market our Coblation technology for use in this application.

Benefits of Our Coblation Technology

Our patented Coblation technology, delivered in the form of multi-electrode and single electrode, bipolar disposable devices, offers a number of benefits that we believe may provide advantages over competing surgical methods and devices. The principal benefits include:

• EASE OF USE. Our Coblation-based soft-tissue surgery systems perform many of the functions of mechanical tools, power tools and electrosurgery instruments, allowing the surgeon to use a single instrument. The lightweight device is simple to use and complements the surgeon's existing tactile skills without the need for extensive training.

• PRECISION. In contrast to conventional tools, our Coblation-based soft tissue surgery systems permit surgeons to perform more precise tissue ablation and sculpting. We believe this may result in more rapid patient rehabilitation.

• BENEFITS TO PATIENTS. Coblation technology operates at cooler temperatures than traditional electrosurgical tools. This can lead to significant benefits for patients treated with Coblation-based disposable devices due to the minimal amount of thermal injury to surrounding tissue. As a result, we believe that patients are likely to experience less trauma and pain following surgery and may recover more quickly.

• ABLATION AND SEALING OF BLEEDING VESSELS. Our Coblation- based soft-tissue surgery systems allow for the efficient sealing of bleeding vessels without changing tools.

• COST REDUCTION. Our Coblation soft-tissue surgery systems eliminate the need to introduce multiple instruments to remove and sculpt tissue and seal bleeding vessels. We believe this may reduce operating time and thereby produce cost savings for health care providers.

DEPENDENCE UPON COLLABORATIVE ARRANGEMENTS

Inamed Corporation. In early 1999, we entered into a license and distribution agreement with Inamed Corporation (through its' acquisition of Collagen Aesthetics, Incorporated), under this agreement, Inamed acquired exclusive, worldwide marketing rights for our cosmetic surgery products. We perform product development, manufacturing, and clinical and regulatory functions for our Cosmetic Surgery System.

Boston Scientific Corporation. In February 1998, we entered into a license and distribution agreement under which Boston Scientific Corporation will help to develop, obtain regulatory approval for and market products based on our Coblation technology for myocardial revascularization procedures. Under the agreement, Boston Scientific Corporation acquired exclusive licensing rights to our intellectual property in this field. Boston Scientific Corporation will pay licensing fees to us upon achievement of designated clinical and regulatory milestones, and royalties on sales of resulting products. Boston Scientific Corporation will perform clinical and regulatory functions, product development and sales and marketing. We will also focus on product development and will manufacture devices for Boston Scientific Corporation.

RESEARCH AND DEVELOPMENT

We have focused our research and development efforts in two areas. First, in response to physician feedback, we are continually working on enhancements to designs of our products to provide greater versatility in existing features and functions. In addition, we continue to design new disposable devices that incorporate added functionalities. Second, we are exploring new applications of our Coblation technology in other soft-tissue surgical markets. We have undertaken preliminary studies and development for the use of our technology in several fields.

MANUFACTURING

Our disposable devices and controllers are currently manufactured in our 10,000 square foot manufacturing facility in Sunnyvale, California. Our products are manufactured from several components, some of which are supplied to us by third parties.

Most of the components we use in the manufacture of our products are available from more than one supplier. For some components, however, there are relatively few alternate sources of supply and the establishment of additional or replacement suppliers for such components may not be accomplished quickly. With respect to a few components, we rely upon single source suppliers. For example, one single source supplier provides us with a component used in substantially all of our disposable devices. In addition, we use a single subcontractor to sterilize our disposable devices. If the services of this subcontractor were interrupted, we cannot be sure that we would be able to identify and qualify an alternate sterilizer prior to the occurrence of any disruption in our manufacturing process. We do not believe any such disruption is likely since this subcontractor has several facilities from which it is able to provide sterilization services to us. We are dependent upon these third parties for the manufacture of our products, and our profit margins and our ability to develop and deliver such products on a timely basis may be adversely affected by the lack of alternative sources of supply. See "Risk Factors-We Have Limited Manufacturing Experience" for a description of the potential disruption in supply of our products and risks to our operations resulting from our reliance upon single source suppliers.

Manufacture of the controllers was brought in-house in late 1997 for purposes of maintaining process control, ensuring adequate supply, and leveraging fixed costs. We manufacture three different controller models for which the manufacturing process is substantially the same.

We currently manufacture 40 different versions of our disposable devices. Due to the various attributes of our disposable devices, which include, among other functions, fluid management and suction, the manufacturing process is varied. In order to improve yields, we have recently converted from batch processing of our disposable devices to a continuous manufacturing process.

We have established quality assurance systems in conformance with the FDA's Quality System Regulation, or QSR. Our facility has received ISO 9001/EN46001 certification and is in conformance with the Medical Device Directive, or MDD, for sale of products in Europe.

MARKETING AND SALES

We estimate that of the 18,500 orthopedic surgeons in the United States, approximately 80% perform arthroscopy and approximately 40% consider arthroscopy to be their major practice area. We have shipped more than 6,800 controller units and approximately 630,000 disposable devices as of January 1, 2000 for a variety of indications. We use a combination of distributors supported by regional sales managers, a small direct sales force and corporate partners to sell our products both domestically and internationally.

We are marketing and selling our arthroscopic, spinal surgery and ENT surgery products in the United States through a network of independent distributors supported by regional sales managers and a small direct sales force. We have more than 35 distributors representing more than 350 field sales representatives in the United States. Inamed Corporation is the worldwide distributor for our Cosmetic Surgery System.

We are marketing and selling our neuro surgery products internationally and will market in the United States after receipt of 510(k) clearance from the FDA. In order to facilitate the introduction of this new product line we will leverage our existing distribution system for spinal surgery.

We have established distribution capability in certain countries by means of exclusive and non-exclusive distribution agreements with corporations, including with Arthrex for the distribution of our arthroscopy products in Europe, South Africa, South and Central America and Russia; Kobayashi Pharmaceutical for the distribution of our arthroscopy, spinal surgery and ENT surgery products in Japan; and Smith & Nephew, Inc. for the distribution of our arthroscopy and ENT surgery products in New Zealand and Australia. We have also established distribution capability through relationships with distributors in Korea, Taiwan, Canada, Mexico, the Caribbean, the Middle East and Northern Africa.

We believe the use of our products is generally intuitive to surgeons and does not require extensive training. We frequently conduct training seminars and demonstrations at regional training centers and trade shows. Our partners also conduct training activities in their areas of responsibility.

At hospitals and surgical centers where several procedures can be performed simultaneously, the procurement of multiple controllers is required. We have offered our controllers at substantial discounts in the past and may be required to continue to offer such discounts to generate demand for our disposable devices. In addition, motorized and mechanical instruments, lasers and electro surgery systems currently used by hospitals, surgical centers and private physicians have become widely accepted. If physicians do not determine that our soft-tissue surgery systems are an attractive alternative to conventional means, our business would be materially adversely affected.

PATENTS AND PROPRIETARY RIGHTS

Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology. We own 20 issued U.S. patents and 16 issued international patents. In addition, we have more than 70 pending U.S. patent applications and over 100 international patent applications corresponding to over 20 of the U.S. filings. The initial U.S. patent is currently set to expire in 2008, three issued patents are currently expected to expire between 2008 and 2012 and the other 16 U.S. patents are expected to expire between 2014 and 2016. We believe that the issued patents are directed at, among other things, both the core technology used in our soft- tissue surgery systems, including both multi-electrode and single electrode configurations of our disposable devices, as well as the use of Coblation technology in specific surgical procedures.

The issued patents are directed at, among other things, the following:

• systems and methods for applying radio frequency energy to tissue in the presence of electrically conductive fluid such as isotonic saline;

• disposable devices having an electrode array and a system designed to supply current independently to individual electrodes; and

• systems and methods for employing radio frequency energy in urology, gynecology, ENT, cosmetic surgery, skin resurfacing and cardiac procedures.

The pending patent applications include coverage for the fundamental tissue ablation and cutting technology as well as methods and apparatus for specific procedures.

We cannot assure you that the patents we have obtained, or any patents that we may obtain as a result of our U.S. or international patent applications, will provide any competitive advantages for our products or that they will not be successfully challenged, invalidated or circumvented in the future. In addition, we cannot assure you that competitors, many of whom have substantial resources and have made substantial investments in competing technologies, will not seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the United States or in international markets.

A number of other companies and universities and research institutions have filed patent applications or have issued patents relating to monopolar and/or bipolar electrosurgical methods and apparatus. In addition, we have become aware of, and may become aware of in the future, patent applications and issued patents that relate to our products and/or the surgical applications and issued patents and, in some cases, have obtained internal and/or external opinions of counsel regarding the relevance of certain issued patents to our products. We do not believe that our products currently infringe any valid and enforceable claims of the issued patents that we have reviewed. However, if third-party patents or patent applications contain claims infringed by our technology and such claims are ultimately determined to be valid, we cannot assure you that we would be able to obtain licenses to those patents at a reasonable cost, if at all, or be able to develop or obtain alternative technology. The inability to do either would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. We cannot assure you that we will not have to defend ourselves in court against allegations of infringement of third-party patents.

In addition to patents, we rely on trade secrets and proprietary know-how, which we seek to protect, in part, through confidentiality and proprietary information agreements. We require our key employees and consultants to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information developed or made known to the individual by us during the course of the individual's relationship with us, is to be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. We cannot assure you that employees will not breach the agreements, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known to or be independently developed by competitors.

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark Office, or USPTO, to determine the priority of inventions. On February 13, 1998 we filed a lawsuit against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging among other things, infringement of several of our patents. The lawsuit has been settled. The defense and prosecution of this lawsuit and intellectual property suits generally, USPTO interference proceedings and related legal and administrative proceedings are both costly and time-consuming. We believe that the lawsuit was necessary, and if others violate our proprietary rights, further litigation may be necessary to enforce our patents, to protect trade secrets or know-how owned by us or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceedings will be costly and cause significant diversion of effort by our technical and management personnel. An adverse determination, other litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease using such technology. Although patent and intellectual property disputes in the medical device area have often been settled through licensing or similar arrangements, costs associated with such arrangements may be substantial and could include ongoing royalties. Furthermore, we cannot be sure that we could obtain necessary licenses on satisfactory terms, if at all. Adverse determinations in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling our products, which would have a material adverse effect on our business, financial condition, results of operations, and future growth prospects.

COMPETITION

We believe that the principal competitive factors in the soft-tissue surgery markets include:

• acceptance by leading physicians;

• improved patient outcomes;

• superior product quality;

• the publication of peer-reviewed clinical studies;

• product innovation;

• sales and marketing capability; and

• strong intellectual property.

Arthroscopy

We compete directly with the providers of tissue removal systems including conventional electrosurgical systems, manual instruments, power shavers and laser systems, in arthroscopic procedures. Smith & Nephew Endoscopy, which owns Acufex Microsurgical, Inc. and Dyonics, Inc.; Conmed Corporation, including its Linvatec unit; Medtronic, Inc., which owns Sofamor Danek; and Stryker Corp. each have large shares of the market for manual instruments, power shavers and arthroscopes.

Johnson & Johnson, including Mitek, a division of its Ethicon, Inc. unit, is marketing a bipolar electrosurgical system developed by Gyrus Medical Ltd., a company based in the United Kingdom. The bipolar electrosurgical system marketed by Mitek competes directly with our tissue ablation and shrinkage technology in arthroscopy. In addition, the Linvatec unit of Conmed Corporation is marketing a monopolar electrosurgical tool for tissue ablation in arthroscopy. Oratec Interventions Inc. manufactures and sells a monopolar tissue shrinkage system that competes directly with our arthroscopic products. The tissue shrinkage market represents a small portion of the overall market in arthroscopy for our products.

We believe that the Arthroscopic System, comprising the controller unit and disposable devices, presents a competitive pricing structure compared to alternative tools being used in arthroscopic procedures. While our disposable devices perform many functions in one tool, most competitive disposable devices only perform a single function. In such cases, multiple disposable or reusable devices would be required. Laser systems have a significantly higher capital cost than our controller and require significant ongoing maintenance and operating expenses. We are also aware of additional competitors that may commercialize products using technology similar to ours.

Spinal and Neuro Surgery

We believe that Coblation technology will compete effectively against conventional tissue removal technology used in spinal and neurosurgery procedures, such as mechanical instruments, monopolar electrosurgical instruments, ultrasonic and powered instruments. Mechanical instruments for tissue removal in the spine are manufactured and sold by a large number of small, diverse, specialty companies, and the substantial bulk of monopolar electrosurgical instruments are manufactured by Valleylab and Linvatec. We may indirectly compete with large companies in the spine fusion market, such as Medtronic Sofamor Danek, Sulzer Spine-Tech, Surgical Dynamics and DePuy Acromed. In addition, we are aware of several small companies offering alternative treatments for back pain that may indirectly compete with our products. For example, Oratec Interventions manufactures and sells a catheter that uses resistive heating to reduce chronic low back pain caused by degenerative disc disease and Radionics manufactures and sells monopolar electrosurgical instruments for creating RF lesions to denervate tissue in the spine. In neurosurgery, we will directly compete with a variety of tissue removal systems designed for removing brain and cranial-based tumors, such as the CUSAÔ , an ultrasonic tissue aspiration system manufactured by Valleylab.

Ear, Nose and Throat Surgery

There are large companies, such as Smith & Nephew, Inc., Stryker Corp., Medtronic, Incorporated, which owns Xomed Surgical Products, Inc., and Conmed Corporation, which have shares of the market for manual and powered instruments for minimally-invasive sinus surgery. In addition, we face competition from laser companies, such as ESC Medical Systems Ltd., which develops and markets lasers for various ENT surgery applications. We expect that competition from these and other well-established competitors will increase as will competition from smaller medical device companies, such as Somnus Medical Technologies, Inc., Elmed Inc. and Ellman International, Inc. Somnus Medical Technologies, Inc. manufactures and sells medical devices that utilize radio frequency energy for the treatment of upper airway disorders, such as snoring and obstructive sleep apnea. Elmed Inc. and Ellman International, Inc. both manufacture and sell a variety of medical devices that use conventional radio frequency energy for tissue removal, cutting and/or coagulation for the treatment of snoring and other ENT surgery procedures.

Cosmetic Surgery

The cosmetic surgery industry includes a number of large and well established companies that provide devices for rejuvenating skin, hair removal, scar removal, the treatment of vascular and pigmented lesions and other applications, including companies that manufacture and sell dermabrasion equipment or chemical peels, and companies that manufacture and sell lasers. In skin resurfacing, we will compete with much larger companies that manufacture lasers for medical use, such as Coherent Medical Group and ESC Medical Systems Ltd directly. ESC recently merged with Laser Industries, Ltd. The combined company develops and markets lasers for a broad range of cosmetic applications including the non-invasive treatment of varicose veins and other benign vascular lesions, hair removal, skin rejuvenation and others. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and cosmetic surgery.

We cannot assure you that we can effectively convince surgeons and physicians to adopt our Coblation technology in the face of competition. In addition, we cannot be sure that these or other companies will not succeed in developing technologies and products that are more effective than ours or that would render our technology or products obsolete or uncompetitive. Many of these competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than us. We have received 510(k) clearances to market tissue ablation products to treat disorders in other surgical fields that we may enter. These fields are intensely competitive and we cannot assure you that these potential products would be successfully marketed.

Third-Party Reimbursement

In the United States, health care providers, such as hospitals and physicians, that purchase medical devices, such as our products, generally rely on third-party payors, principally federal Medicare, state Medicaid and private health insurance plans, to reimburse all or part of the cost of the procedure in which the medical device is being used. Reimbursement for arthroscopic, ENT surgery and spinal surgery procedures performed using devices that have received FDA approval has generally been available in the United States. Generally, cosmetic procedures are not reimbursed. In addition, some health care providers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures.

Government Regulation

United States

Our products are considered medical devices and are subject to extensive regulation in the United States. We must obtain premarket clearance or approval by the FDA for each of our products and indications before they can be commercialized. FDA regulations are wide ranging and govern, among other things:

• product design and development;

• product testing;

• product labeling;

• product storage;

• premarket clearance or approval;

• advertising and promotion; and

• product sales and distribution.

Noncompliance with applicable regulatory requirements can result in enforcement action, which may include:

• warning letters;

• fines, injunctions and civil penalties against us;

• recall or seizure of our products;

• operating restrictions, partial suspension or total shutdown of our production;

• refusing our requests for premarket clearance or approval of new products;

• withdrawing product approvals already granted; and

• criminal prosecution.

Unless an exemption applies, generally, before we can introduce a new medical device into the United States market, we must obtain FDA clearance of a 510(k) premarket notification or approval of a premarket approval application, or PMA application. If we can establish that our device is "substantially equivalent" to a "predicate device," i.e., a legally marketed Class I or Class II device or a preamendment Class III device (i.e., one that was in commercial distribution before May 28, 1976) for which the FDA has not called for PMAs, we may seek clearance from the FDA to market the device by submitting a 510(k) premarket notification. The 510(k) premarket notification will need to be supported by appropriate data, including, in some cases, clinical data, establishing the claim of substantial equivalence to the satisfaction of the FDA.

We have received 510(k) clearance to market our Arthroscopic System for surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. We have received clearance to market our Spinal Surgery System in the United States. In addition, we have received 510(k) clearance to market our Cosmetic Surgery System in general dermatology and for skin resurfacing for the purpose of wrinkle reduction. We have received 510(k) clearance to market the ENT Surgery System in general head and neck surgical procedures, as well as snoring, minimally-invasive sinus surgery and tonsillectomies. We cannot assure you that we will be able to obtain necessary clearances or approvals to market any other products, or existing products for new intended uses, on a timely basis, if at all. Delays in receipt or failure to receive clearances or approvals, the loss of previously received clearances or approvals, or failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in the intended use of the device, requires a new 510(k) clearance. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any such decision. If the FDA disagrees with a manufacturer's decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to submit a premarket notification requesting 510(k) clearance. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance is obtained. We have modified some of our marketed devices, but have determined that, in our view, new 510(k) clearances are not required. No assurance can be given that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any modification, the FDA also may require us to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.

If we cannot establish that a proposed device is substantially equivalent to a legally marketed device, we must seek premarket approval through submission of a PMA application. A PMA application must be supported by extensive data, including, in many instances, preclinical and clinical trial data, as well as extensive literature to prove the safety and effectiveness of the device. If necessary, we will file a PMA application for approval to sell our potential products. The PMA process can be expensive, uncertain and lengthy. We cannot assure you that we will be able to obtain PMA approvals on a timely basis, if at all, and delays in receipt or failure to receive approvals, could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We are also required to demonstrate and maintain compliance with the Quality System Regulation, or QSR. The QSR incorporates the requirements of Good Manufacturing Practice and relates to product design, testing, and manufacturing quality assurance, as well as the maintenance of records and documentation. The FDA enforces the QSR through inspections. We cannot assure you that we or our key component suppliers are or will continue to be in compliance, will not encounter any manufacturing difficulties, or that we or any of our subcontractors or key component suppliers will be able to maintain compliance with regulatory requirements. Failure to do so will have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We may not promote or advertise our products for uses not within the scope of our clearances or approvals or make unsupported safety and effectiveness claims. These determinations can be subjective. We cannot assure you that the FDA would agree that all of our promotional claims are permissible or that the FDA will not require us to revise our promotional claims or take enforcement action against us based upon our labeling and promotional materials.

International

International sales of our products are subject to strict regulatory requirements. The regulatory review process varies from country to country. We have obtained regulatory clearance to market the Arthroscopic System in Europe, Japan, Australia, Taiwan, Korea, Canada and Mexico, to market our cosmetic surgery products in Europe and Canada and to market our ENT surgery products and our spinal and neuro surgery products in Europe, but we have not obtained any other international regulatory approvals in other international markets. We cannot assure you that we will obtain such clearances and approvals on a timely basis, or at all.

For European distribution, we have received ISO 9001/EN46001 certification and the EC Certificate pursuant to the European Union Medical Device Directive 93/42/EEC, allowing us to CE mark our products after assembling appropriate documentation. ISO 9001/EN46001 certification standards for quality operations have been developed to ensure that companies know the standards of quality on a worldwide basis. Failure to maintain the CE Mark will preclude us from selling our products in Europe. We cannot assure you that we will be successful in maintaining certification requirements.

Product Liability Risk and Insurance Coverage

The development, manufacture and sale of medical products entail significant risk of product liability claims. Our current product liability insurance coverage limits are $10,000,000 per occurrence and $10,000,000 in the aggregate. We cannot assure you that such coverage limits are adequate to protect us from any liabilities we might incur in connection with the development, manufacture and sale of our products. In addition, we may require increased product liability coverage as products are successfully commercialized in additional applications. Product liability insurance is expensive and in the future may not be available to us on acceptable terms, if at all. We have not received any product liability claims to date. However, a successful product liability claim or series of claims brought against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition, results of operations and prospects.

Employees

As of January 1, 2000, we had 239 employees of whom 145 people were engaged in manufacturing activities, 24 people were engaged in research and development activities, 33 people were engaged in sales and marketing activities, 18 people were engaged in regulatory affairs and quality assurance and 19 people were engaged in administration and accounting. No employees are covered by collective bargaining agreements, and we believe we maintain good relations with our employees.

We are dependent upon a number of key management and technical personnel. The loss of the services of one or more key employees or consultants could have a material adverse effect on us. Our success will also depend on our ability to attract and retain additional highly qualified management and technical personnel. We face intense competition for qualified personnel, many of whom often receive competing employment offers. We cannot assure you that we will be able to attract and retain such personnel. Furthermore, our scientific advisory board members are all otherwise employed on a full-time basis. As a result, the scientific advisory board members are not available to devote their full time or attention to our affairs.

Facilities

We lease approximately 32,000 square feet in two neighboring buildings in Sunnyvale, California for administrative offices, general and administrative purposes, manufacturing facilities and warehousing space. Our two leases for these facilities will expire in February 2002. We believe that our existing facilities are adequate for our immediate needs through 2000.

ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS

We Are Dependent Upon Our Arthroscopic System

We commercially introduced our Arthroscopic System in December 1995. Since our Arthroscopic System accounts for 90% of our product sales, we are highly dependent on its sales. Our spinal surgery, cosmetic surgery, and ENT surgery products have only recently become available, and to date, we have sold only a small number of units. We cannot assure you that we will be able to continue to manufacture arthroscopy products in commercial quantities at acceptable costs, or that we will be able to continue to market such products successfully.

To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians' education with respect to Coblation technology and continue working on new product development efforts specifically for knee applications. Furthermore, in order to maintain and increase current market penetration we must be aggressive in increasing our installed base of controllers to generate increased disposable device revenue. To date, we have placed our arthroscopic controllers at substantial discounts in order to stimulate demand for our disposable devices.

We believe that surgeons will not use our products unless they determine, based on experience, clinical data and other factors, that these systems are an attractive alternative to conventional means of tissue ablation. There are only a few independently published clinical reports and limited long- term clinical follow-up to support the marketing efforts for our Arthroscopic System. We believe that continued recommendations and endorsements by influential arthroscopic surgeons are essential for market acceptance of our Arthroscopic System. If our Coblation technology does not continue to receive endorsement by influential surgeons or our long-term data does not support our current claims of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.

Commercial Success of Our Non-Arthroscopic Products Is Uncertain

We have developed several new applications for our Coblation technology in spinal and neuro surgery, cosmetic surgery and ENT surgery. Additionally we have established a program to explore the application of our Coblation technology in various areas within cardiology. Our products for these non-arthroscopic indications are in various stages of commercialization and development, and we may be required to undertake time-consuming and costly commercialization, development and additional regulatory approval activities. We are awaiting 510(k) clearance in the United States to market our Spinal Surgery System specifically for use in neuro surgery. If we do not receive this or future clearances we will be unable to market this and future products for specific indications and our business, financial condition, results of operations and future growth prospects could be materially adversely affected. We cannot assure you that product development will ever be successfully completed, that regulatory clearances or approvals, if applied for, will be granted by the FDA or foreign regulatory authorities on a timely basis, if at all, or that the products will ever achieve commercial acceptance.

We may have to make a significant investment in additional preclinical and clinical testing, regulatory, physician training and sales and marketing activities to further develop and commercialize the spinal surgery, neuro surgery, cosmetic surgery, ENT surgery and cardiology product lines. Although we believe that these products offer certain advantages, we cannot assure you that these advantages will be realized, or if realized, that these products will result in any meaningful benefits to physicians or patients.

Development and commercialization of our current and future non-arthroscopic products are subject to the risks of failure inherent in the development of new medical devices. These risks include the following:

• that such products will not be easy to use, will require extensive training or will not be cost-effective;

• that we will experience delays in testing or marketing;

• that such testing or marketing will result in unplanned expenditures or in expenditures above those anticipated by us;

• that our products will not be proven safe or effective;

• that third parties will develop and market superior or equivalent products;

• that such products will fail to receive necessary regulatory clearances or approvals;

• that such products will be difficult or uneconomical to manufacture on commercial scale; and

• that proprietary rights of third parties will preclude us and our collaborative partners from marketing such products.

In addition, the success of our non-arthroscopic products will depend on their adoption as alternatives to conventional means of tissue ablation. Clinical experience and follow-up data for our non-arthroscopic indications are limited, and we have sold only a small number of units to date. We believe that recommendations and endorsement of influential physicians are essential for market acceptance of our products.

For information regarding the status of our regulatory approvals for our products, see the information under the heading "Government Regulation" in the section entitled "Business."

We Have Limited Marketing and Sales Experience

We currently have limited experience in marketing and selling our products. To the extent that we have established or will enter into distribution arrangements for the sale of our products, we are and will be dependent upon the efforts of third parties. We are marketing and selling our arthroscopic surgery, spinal surgery and ENT surgery product lines in the United States through a network of independent distributors supported by regional sales managers and a small direct sales force. These distributors sell arthroscopy, spinal surgery and ENT surgery devices for a number of other manufacturers. In addition, we are marketing and selling our neuro surgery products internationally and will market in the United States after the receipt of 510(k) clearance. We plan to utilize existing spinal surgery distributors, for the commercialization of these products both domestically and internationally. We cannot assure you that these distributors will commit the necessary resources to effectively market and sell our arthroscopic surgery, spinal surgery, neuro surgery or ENT surgery product lines, or that they will be successful in selling our products.

We have recently established a marketing presence in various countries and we cannot assure you that these newly established operations will be successful. In order to successfully market our products internationally, we will need to address many issues with which we have little or no experience, including the securing of necessary regulatory approvals in international markets and the potential reuse of our disposable devices by our customers. Even if we are able to successfully deal with these issues, we cannot assure you that we will be able to establish successful distribution capabilities internationally or receive favorable pricing for our products. In addition, we may face currency exchange risks as part of our international expansion. To the extent our marketing and sales efforts are unsuccessful, our business, financial condition, results of operations and future growth prospects may be materially adversely affected.

We Have Limited Manufacturing Experience

To be successful, we must manufacture our products in commercial quantities in compliance with regulatory requirements at acceptable costs. At the present time, we have limited manufacturing experience. Our manufacturing operations consist of an in-house assembly operation for the manufacture of disposable devices and controllers. We currently produce 40 models of disposable devices utilizing different functionalities, including suction and fluid management. As we increase the number of product designs for our disposable devices, the complexity of our manufacturing processes will increase. We manufacture three different controller models. Although the manufacturing processes for the controllers designed to date are substantially the same, we cannot be certain that we will be able to continue to manufacture these controllers without additional expense and capabilities. We could also encounter difficulties in manufacturing our current or future products which could reduce yields, result in supply disruptions and adversely affect our gross margins. If we have delays in manufacturing, we will not have adequate finished inventory to meet our needs. If our quality assurance programs do not continue to meet the demands of the complexity and capacity of the products we manufacture, we may experience product returns.

We Are Dependent on Key Suppliers

We depend on several sole source suppliers for some of our product components, including one component that we include in substantially all of our disposable devices. If the supply of materials from a sole source supplier were interrupted, replacement or alternative sources might not be readily obtainable due to the regulatory requirements applicable to our manufacturing operations. In addition, a new or supplemental filing with applicable regulatory authorities may require clearance prior to our marketing a product containing new material. This clearance process may take a substantial period of time and we cannot assure you that we would be able to obtain the necessary regulatory approval for the new material to be used in our products on a timely basis, if at all. This could create supply disruptions that would materially adversely affect our business, financial condition, results of operations and future growth prospects.

In addition, we use a single subcontractor to sterilize the disposable devices. We cannot assure you that we can identify and qualify an alternate sterilizer. Our inability to secure an alternative sterilizer, if required, would limit our ability to manufacture disposable devices and could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We Face Intense Competition

The markets for our current and potential products are intensely competitive. These markets include arthroscopy, spinal surgery, neuro surgery, ENT surgery, cosmetic surgery, and cardiology. We cannot assure you that other companies will not succeed in developing technologies and products that are more effective than ours or that would render our technology or products obsolete or uncompetitive in these markets.

In arthroscopy, we compete against companies such as Johnson & Johnson, Smith & Nephew, Inc., Conmed Corporation, Stryker Corp. and Oratec Interventions, Inc. which market products to remove or shrink tissue. Specifically, Johnson & Johnson is currently marketing worldwide a bipolar electrosurgical system for tissue ablation. We are also aware of additional competitors that may commercialize products using technology similar to ours. In spinal surgery, we compete against companies which market products to remove tissue and treat spinal disorders. In ENT surgery, we compete against companies that offer manual instruments, such as Smith & Nephew, Inc., Stryker Corp., Conmed Corporation, and Xomed Surgical Products, Inc., which was recently acquired by Medtronic, Inc. In addition, we compete with companies that develop and market lasers for various ENT surgery applications, including ESC Medical Systems Ltd. Smaller companies, including Somnus Medical Technologies Inc., Elmed Inc. and Ellman International, Inc. also sell medical devices for the treatment of various ENT disorders including snoring and obstructive sleep apnea. In cosmetic surgery, we compete against companies such as Coherent Medical Group, and ESC Medical Systems Ltd. which market lasers for use in this field. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and cosmetic surgery. In cardiology, we may compete with companies which use lasers to treat cardiovascular disease. Other approaches to alleviating cardiovascular disease, including drugs or other surgical approaches, may also be competitive.

Many of our competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. Some of these companies offer broad product lines that they may offer as a single package and frequently offer significant discounts as a competitive tactic. For example, in order to compete successfully, we anticipate that we may have to continue to offer substantial discounts on our controllers in order to increase demand for our disposable devices, and that this competition could have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Furthermore, some of our competitors utilize purchasing contracts that link discounts on the purchase of one product to purchases of other products in their broad product lines. Many of the hospitals in the United States have purchasing contracts with our competitors. Accordingly, customers may be dissuaded from purchasing our products rather than the products of these competitors to the extent the purchase would cause them to lose discounts on products.

We Face Uncertainty Over Reimbursement

Failure by physicians, hospitals and other users of our products to obtain sufficient reimbursement from health care payors for procedures in which our products are used or adverse changes in governmental and private third-party payors' policies toward reimbursement for such procedures would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Reimbursement for arthroscopic, spinal surgery and ENT surgery procedures performed using devices that have received FDA approval has generally been available in the United States. Typically, cosmetic surgery procedures are not reimbursed.

We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payors. In addition, some health care providers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures. We anticipate that in a prospective payment system, such as the diagnosis related group system utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our products will be incorporated into the overall cost of the procedure and that there will be no separate, additional reimbursement for our products. We anticipate that hospital administrators and physicians will justify the use of our products by the apparent cost savings and clinical benefits that we believe will be derived from the use of our products. However, we cannot assure you that this will be the case.

If we obtain the necessary international regulatory approvals, market acceptance of our products in international markets would be dependent, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government- sponsored health care and private insurance. We intend to seek international reimbursement approvals, although we cannot assure you that any such approvals will be obtained in a timely manner, if at all.

Our Business Depends on Attracting and Retaining Collaborators and Licensors

In order to successfully develop and commercialize certain products, we may enter into collaborative or licensing arrangements with medical device companies and other entities to fund and complete our research and development activities, pre-clinical and clinical testing, manufacturing, regulatory approval activities and to achieve successful commercialization of future products. We have signed an exclusive, worldwide distribution agreement with Inamed Corporation (Collagen Aesthetics, Inc.) for our cosmetic surgery products. We have also entered into a license agreement under which Boston Scientific Corporation will help develop, obtain regulatory approval for and market products based on our Coblation technology for myocardial revascularization procedures. See the information under the heading "Collaborative Arrangements" in the section entitled "Business" for a discussion of these arrangements.

Our participation in collaborative and licensing arrangements with third parties subjects us to a number of risks. Collaborative partners typically have significant discretion in electing whether to pursue any of the planned activities. We cannot control the amount and timing of resources our collaborative partners may devote to our products, and we cannot assure you that our partners will perform their obligations as expected. Business combinations or significant changes in a corporate partner's business strategy may adversely affect that partner's ability to meet its obligations under the arrangements. If a collaborative partner were to terminate or breach its agreement with us, or otherwise fail to complete its obligations in a timely manner, our business, financial condition, results of operations and prospects would be materially adversely affected. To the extent that we are not able to establish further collaborative arrangements or that any or all of our existing collaborative arrangements are terminated, we would be required to seek new collaborative arrangements or to undertake commercialization at our own expense, which could significantly increase our capital requirements, place additional strain on our human resource requirements and limit the number of products which we would be able to develop and commercialize. In addition, we cannot assure you that our existing and future collaborative partners will not pursue alternative technologies or develop alternative products either on their own or in collaboration with others, including our competitors.

We cannot assure you that disputes will not arise in the future with respect to the ownership of rights to any technology or products developed with any collaborative partner. Lengthy negotiations with potential new collaborative partners or disagreements between established collaborative partners and us could lead to delays in or termination of the research, development or commercialization of certain products or result in litigation or arbitration that would be time consuming and expensive. Failure by any collaborative partner to commercialize successfully any product to which it has obtained rights from us, or the decision by a collaborative partner to pursue alternative technologies or commercialize or develop alternative products, either on its own or in collaboration with others, could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

Our Operating Results Will Fluctuate

We have experienced significant operating losses since inception and, as of January 1, 2000, we had an accumulated deficit of $21.9 million. Results of operations may fluctuate significantly from quarter to quarter due to many factors, including the following:

• the introduction of new product lines;

• increased penetration in existing applications;

• product returns;

• achievement of research and development milestones;

• the amount and timing of receipt and recognition of license fees;

• manufacturing or supply disruptions;

• timing of expenditures;

• absence of a backlog of orders;

• receipt of necessary regulatory approvals;

• the level of market acceptance for our products;

• timing of the receipt of orders and product shipments; and

• promotional programs for our products.

We cannot assure you that future quarterly fluctuations will not adversely affect our business, financial condition, results of operations or future growth prospects. Our revenues and profitability will be critically dependent on whether or not we can successfully continue to market our Coblation-based technology product lines. We cannot assure you that we will maintain or increase our revenues or level of profitability.

We May Be Unable to Effectively Protect Our Intellectual Property

Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology. We believe that our issued patents are directed at, among other things, the core technology used in our soft-tissue surgery systems, including both multi- electrode and single electrode configurations of our disposable devices, as well as the use of Coblation technology in specific surgical procedures.

We cannot assure you that the patents we have obtained, or any patents we may obtain as a result of our pending U.S. or international patent applications, will provide any competitive advantages for our products. We also cannot assure you that those patents will not be successfully challenged, invalidated or circumvented in the future. In addition, we cannot assure you that competitors, many of which have substantial resources and have made substantial investments in competing technologies, have not already applied for or obtained, or will not seek to apply for and obtain, patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the United States or in international markets. Patent applications are maintained in secrecy for a period after filing. We may not be aware of all of the patents and patent applications potentially adverse to our interests.

A number of medical device and other companies and universities and research institutions have filed patent applications or have issued patents relating to monopolar and/or bipolar electrosurgical methods and apparatus. We have received, and we may receive in the future, notifications of potential conflicts of existing patents, pending patent applications and challenges to the validity of existing patents. In addition, we have become aware of, and may become aware of in the future, patent applications and issued patents that relate to our products and/or the surgical applications and issued patents and, in some cases, have obtained internal and/or external opinions of counsel regarding the relevance of certain issued patents to our products. We do not believe that our products currently infringe any valid and enforceable claims of the issued patents that we have reviewed. However, if third-party patents or patent applications contain claims infringed by our technology and such claims are ultimately determined to be valid, we may not be able to obtain licenses to those patents at a reasonable cost, if at all, or be able to develop or obtain alternative technology. Our inability to do either would have a material adverse effect on our business, financial condition, results of operations and prospects. We cannot assure you that we will not have to defend ourselves in court against allegations of infringement of third-party patents, or that such defense would be successful.

In addition to patents, we rely on trade secrets and proprietary know-how, which we seek to protect, in part, through confidentiality and proprietary information agreements. We require our key employees and consultants to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information, developed or made known to the individual during the course of the individual's relationship with us, is to be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. We cannot assure you that employees will not breach such agreements, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known to or be independently developed by competitors.

We May Become Subject to Patent Litigation

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark Office, the USPTO, to determine the priority of inventions. On February 13, 1998, we filed a lawsuit against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging, among other things, infringement of several of our patents. The parties subsequently settled this lawsuit. Under the terms of the settlement, Ethicon, Inc. has licensed our U.S. patents for current products in the arthroscopy and gynecology markets. The settlement agreement also established a procedure for resolution of certain potential intellectual property disputes in these two markets without litigation. Under this procedure, the licenses granted in the Ethicon settlement have been extended to Australia and Canada in February 2000.

Defending and prosecuting intellectual property suits, USPTO interference proceedings and related legal and administrative proceedings are costly and time-consuming. Further litigation may be necessary to enforce our patents, to protect our trade secrets or know-how or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceedings will be costly and will result in significant diversion of effort by technical and management personnel. An adverse determination in any of the litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require us to license disputed rights from third parties or require us to cease using such technology, which would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Patent and intellectual property disputes in the medical device area have often been settled through licensing or similar arrangements, and could include ongoing royalties. We cannot assure you that we can obtain the necessary licenses on satisfactory terms, if at all.

The Market Price of Our Stock May Be Highly Volatile

During this fiscal year our common stock has traded between a range of $13.50 and $79.00 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including:

• quarterly fluctuations in results of our operations;

• our ability to successfully commercialize our products;

• ncements regarding results of regulatory approval filings, clinical studies or other testing, technological innovations or new commercial products by us or our competitors;

• developments concerning government regulations, proprietary rights or public concern as to the safety of technology;

• the execution of new collaborative agreements and material changes in our relationships with our business partners;

• market reaction to acquisitions and trends in sales, marketing, and research and development;

• changes in earnings estimates by analysts;

• sales of common stock by existing stockholders; and

• economic and political conditions.

The market price for our common stock may also be affected by our ability to meet analysts' expectations. Any failure to meet such expectations, even slightly, could have an adverse effect on the market price of our common stock. In addition, the stock market is subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against the company. If similar litigation were instituted against us, it could result in substantial costs and a diversion of our management's attention and resources, which could have an adverse effect on our business, results of operations and financial condition. See Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.

Delaware Law, Provisions in Our Charter and Our Stockholder Rights Plan Could Make the Acquisition of Our Company By Another Company More Difficult

Our stockholder rights plan and certain provisions of our certificate of incorporation and bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of our company. This could limit the price that certain investors might be willing to pay in the future for shares of our common stock. Some provisions of our certificate of incorporation and bylaws allow us to issue preferred stock without any vote or further action by the stockholders, to eliminate the right of stockholders to act by written consent without a meeting, to specify procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings, and to eliminate cumulative voting in the election of directors. Some provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. Our stockholder rights plan, the possible issuance of preferred stock, the procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of ArthroCare, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock.

We Must Obtain Governmental Clearances Or Approvals Before We Can Sell Our Products; We Must Continue To Comply With Applicable Laws and Regulations.

United States

Our products are considered medical devices and are subject to extensive regulation in the United States. We must obtain premarket clearance or approval by the FDA for each of our products and indications before they can be commercialized. FDA regulations are wide ranging and govern, among other things:

• product design and development;

• product testing;

• product labeling;

• product storage;

• premarket clearance or approval;

• advertising and promotion; and

• product sales and distribution.

Noncompliance with applicable regulatory requirements can result in enforcement action, which may include:

• warning letters;

• fines, injunctions and civil penalties against us;

• recall or seizure of our products;

• ating restrictions, partial suspension or total shutdown of our production;

• refusing our requests for premarket clearance or approval of new products;

• withdrawing product approvals already granted; and

• criminal prosecution.

Unless an exemption applies, generally, before we can introduce a new medical device into the United States market, we must obtain FDA clearance of a 510(k) premarket notification or approval of a premarket approval application, or PMA application. If we can establish that our device is "substantially equivalent" to a "predicate device," i.e., a legally marketed Class I or Class II device or a preamendment Class III device (i.e., one that was in commercial distribution before May 28, 1976) for which the FDA has not called for PMAs, we may seek clearance from the FDA to market the device by submitting a 510(k) premarket notification. The 510(k) premarket notification will need to be supported by appropriate data, including, in some cases, clinical data, establishing the claim of substantial equivalence to the satisfaction of the FDA.

We have received 510(k) clearance to market our Arthroscopic System for surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. We have received 510(k) clearance in the United States to market our Spinal Surgery System. In addition, we have received 510(k) clearance to market our Cosmetic Surgery System in general dermatology procedures and for skin resurfacing for the purpose of wrinkle reduction. We have received 510(k) clearance to market the ENT Surgery System in general head and neck surgical procedures as well as snoring, minimally-invasive sinus surgery and tonsillectomies. We cannot assure you that we will be able to obtain necessary clearances or approvals to market any other products, or existing products for new intended uses, on a timely basis, if at all. Delays in receipt or failure to receive clearances or approvals, the loss of previously received clearances or approvals, or failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in the intended use of the device, requires a new 510(k) clearance. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any such decision. If the FDA disagrees with a manufacturer's decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to submit a premarket notification requesting 510(k) clearance. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance is obtained. We have modified some of our marketed devices, but have determined that, in our view, new 510(k) clearances are not required. No assurance can be given that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any modification, the FDA also may require us to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.

If we cannot establish that a proposed device is substantially equivalent to a legally marketed device, we must seek premarket approval through submission of a PMA application. A PMA application must be supported by extensive data, including, in many instances, preclinical and clinical trial data, as well as extensive literature to prove the safety and effectiveness of the device. If necessary, we will file a PMA application for approval to sell our potential products. The PMA process can be expensive, uncertain and lengthy. We cannot assure you that we will be able to obtain PMA approvals on a timely basis, if at all, and delays in receipt or failure to receive approvals, could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We are also required to demonstrate and maintain compliance with the Quality System Regulation, or QSR. The QSR incorporates the requirements of Good Manufacturing Practice and relates to product design, testing, and manufacturing quality assurance, as well as the maintenance of records and documentation. The FDA enforces the QSR through inspections. We cannot assure you that we or our key component suppliers are or will continue to be in compliance, will not encounter any manufacturing difficulties, or that we or any of our subcontractors or key component suppliers will be able to maintain compliance with regulatory requirements. Failure to do so will have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We may not promote or advertise our products for uses not within the scope of our clearances or approvals or make unsupported safety and effectiveness claims. These determinations can be subjective. We cannot assure you that the FDA would agree that all of our promotional claims are permissible or that the FDA will not require us to revise our promotional claims or take enforcement action against us based upon our labeling and promotional materials.

International

International sales of our products are subject to strict regulatory requirements. The regulatory review process varies from country to country. We have obtained regulatory clearance to market the Arthroscopic System in Europe, Japan, Australia, Taiwan, Korea, Canada and Mexico, to market our cosmetic surgery products in Europe and Canada and to market our ENT surgery products and our spinal and neuro surgery products in Europe, but we have not obtained any other international regulatory approvals in other international markets. We cannot assure you that we will obtain such clearances and approvals on a timely basis, or at all.

For European distribution, we have received ISO 9001/EN46001 certification and the EC Certificate pursuant to the European Union Medical Device Directive 93/42/EEC, allowing us to CE mark our products after assembling appropriate documentation. ISO 9001/EN46001 certification standards for quality operations have been developed to ensure that companies know the standards of quality on a worldwide basis. Failure to maintain the CE Mark will preclude us from selling our products in Europe. We cannot assure you that we will be successful in maintaining certification requirements.

ITEM 2. PROPERTIES

The company leases approximately 32,000 square feet in two neighboring buildings in Sunnyvale, California, which comprise the company's administrative offices and manufacturing and warehousing space. The company's two leases for these facilities extend through February 2002. The company believes that its existing facilities will be sufficient for its operational purposes through 2000.

ITEM 3. LEGAL PROCEEDINGS

We are currently involved in ongoing litigation. In June 1998, we announced that we had entered into an exclusive worldwide marketing and distribution agreement with Xomed Surgical Products for our products in the ENT surgery market. On February 4, 1999, Xomed Surgical Products of Jacksonville, Florida filed a complaint against the Company in the Fourth Judicial Circuit, Duval County Florida, alleging breach of contract by the Company. In the complaint, Xomed has demanded a full refund of the amounts paid for certain products bought by Xomed from the Company, and for a portion of an exclusive license fee paid by Xomed pursuant to an exclusive license and distribution agreement between Xomed and the Company (see the description of this contract referenced elsewhere in this 10-K). This license and distribution agreement was terminated by the Company on February 5, 1999. The Company believes that the suit is without merit, and filed a Motion to Dismiss on February 24, 1999.

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

Not applicable

PART II

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

Our common stock trades publicly on The Nasdaq Stock Market under the symbol ARTC. The following table sets forth for the periods indicated, the quarterly high and low closing sales prices of the common stock on The Nasdaq Stock Market.

                                Three Month Period Ended
           -------------------------------------------------------------------
1999        April 3, 1999     July 3, 1999   October 2, 1999  January 1, 2000
-----      ---------------- ---------------- ---------------- ----------------
High...            $20.500          $22.063          $58.875          $76.625
Low....             13.500           15.500           24.313           41.375



                                Three Month Period Ended
           -------------------------------------------------------------------
1998        April 4, 1998     July 4, 1998   October 3, 1998  January 2, 1999
-----      ---------------- ---------------- ---------------- ----------------
High...            $15.375          $18.625          $22.250          $21.750
Low....             10.375           13.750           12.000           11.250

                                                             Year Ended
                                  ----------------------------------------------------------------
                                   January 1,   January 2,   January 3,  December 28, December 31,
                                      2000         1999         1998         1996         1995
                                  ------------ ------------ ------------ ------------ ------------
                                                (in thousands, except per share data)


Statements of Operations Data:
   Product sales..................    $44,219      $24,624      $12,796       $6,022         $218
   License fees and royalties.....      4,505        3,292       --           --           --
   Total revenue..................     48,724       27,916       12,796        6,022          218
   Gross profit...................     29,891       15,548        4,301          780         (229)
   Operating expenses.............     25,242       18,625       13,401        9,989        6,940
   Net income (loss)..............      5,543       (2,141)      (7,688)      (7,705)      (6,950)
   Basic  net income (loss)
    per share.....................      $0.59       ($0.24)      ($0.87)      ($0.97)      ($1.82)
   Diluted  net income (loss)
    per share.....................      $0.54       ($0.24)      ($0.87)      ($0.97)      ($1.82)


                                   January 1,   January 2,   January 3,  December 28, December 31,
                                      2000         1999         1998         1996         1995
                                  ------------ ------------ ------------ ------------ ------------
                                                           (in thousands)
Balance Sheet Data:
   Cash, cash equivalents
   and available-for-sale
   securities (including
   long-term portion).............    $79,607       $8,058      $19,872      $29,281       $4,774
   Working capital................     85,118       16,973       20,342       23,468        5,119
   Total assets...................    110,039       27,760       26,675       33,297        7,800
   Total stockholders' equity(1)..    102,883       22,305       23,546       30,782        6,325

                                                         Year Ended
                                            -------------------------------------
                                            January 1,   January 2,   January 3,
                                               2000         1999         1998
                                            -----------  -----------  -----------
                                                       (in thousands)
Revenue:
      Product sales........................    $44,219      $24,624      $12,796
      License fees and royalties...........      4,505        3,292           --
                                            -----------  -----------  -----------
      Total revenue........................     48,724       27,916       12,796
Cost of product sales......................     18,833       12,368        8,495
                                            -----------  -----------  -----------
      Gross profit.........................     29,891       15,548        4,301

Operating expenses:
      Research and development.............      4,929        4,355        4,026
      Sales and marketing..................     15,493       10,495        6,263
      General and administrative...........      4,820        3,775        3,112
                                            -----------  -----------  -----------
      Total operating expenses.............     25,242       18,625       13,401
                                            -----------  -----------  -----------
             Income (loss) from operations.      4,649       (3,077)      (9,100)
Interest income and other, net.............      1,125          937        1,413
                                            -----------  -----------  -----------
Income (loss) before income tax provision..      5,774       (2,140)      (7,687)
Income tax provision.......................        231            1            1
                                            -----------  -----------  -----------
             Net income (loss).............     $5,543      ($2,141)     ($7,688)
                                            ===========  ===========  ===========

                                                        January 1,   January 2,
                                                           2000         1999
                                                        -----------  -----------
                            ASSETS
Current assets:
      Cash and cash equivalents........................    $47,875       $2,826
      Available-for-sale securities....................     22,582        5,232
      Accounts receivable, net of allowances
            of $683 in 1999 and $469 in 1998...........     13,917        5,972
      Inventories......................................      6,960        7,069
      Prepaid expenses and other current assets........        719        1,038
                                                        -----------  -----------
            Total current assets.......................     92,053       22,137
Available-for-sale securities...........................     9,150           --
Property and equipment, net............................      7,366        4,560
Related party receivables..............................      1,205          723
Other assets...........................................        265          340
                                                        -----------  -----------
      Total assets.....................................   $110,039      $27,760
                                                        ===========  ===========

         LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
      Accounts payable.................................     $2,930       $1,797
      Accrued liabilities..............................      1,234        1,734
      Accrued compensation.............................      2,689        1,056
      Deferred revenue.................................         22          517
      Capital lease obligation, current portion........         60           60
                                                        -----------  -----------
            Total current liabilities..................      6,935        5,164
Capital lease obligation, less current portion.........         87          151
Deferred rent..........................................        134          140
                                                        -----------  -----------
            Total liabilities..........................      7,156        5,455
                                                        -----------  -----------
Commitments (Note 5)

Preferred stock, par value $0.001:
      Authorized: 5,000 shares;
      Issued and outstanding: none                             --           --
Common stock, par value $0.001:
      Authorized: 20,000 shares;
      Issued and outstanding: 10,691 shares in 1999
      and 8,973 shares in 1998.........................         11            9
Additional paid-in capital.............................    125,200       49,901
Notes receivable from stockholders.....................       (273)         (51)
Deferred compensation..................................        --           (68)
Accumulated other comprehensive loss...................       (151)         (39)
Accumulated deficit....................................    (21,904)     (27,447)
                                                        -----------  -----------
Total stockholders' equity.............................    102,883       22,305
                                                        -----------  -----------
            Total liabilities and stockholders' equity.   $110,039      $27,760
                                                        ===========  ===========

                                                         Year Ended
                                            -------------------------------------
                                            January 1,   January 2,   January 3,
                                               2000         1999         1998
                                            -----------  -----------  -----------
Revenues:
      Product sales........................    $44,219      $24,624      $12,796
      License fees and royalties...........      4,505        3,292           --
                                            -----------  -----------  -----------
      Total revenues.......................     48,724       27,916       12,796
Cost of product sales......................     18,833       12,368        8,495
                                            -----------  -----------  -----------
      Gross profit.........................     29,891       15,548        4,301
                                            -----------  -----------  -----------
Operating expenses:
      Research and development.............      4,929        4,355        4,026
      Sales and marketing..................     15,493       10,495        6,263
      General and administrative...........      4,820        3,775        3,112
                                            -----------  -----------  -----------
      Total operating expenses.............     25,242       18,625       13,401
                                            -----------  -----------  -----------
             Income (loss) from operations.      4,649       (3,077)      (9,100)
Interest income and other, net.............      1,125          937        1,413
                                            -----------  -----------  -----------
Income (loss) before income tax provision..      5,774       (2,140)      (7,687)
Income tax provision.......................       (231)          (1)          (1)
                                            -----------  -----------  -----------
             Net income (loss).............     $5,543      ($2,141)     ($7,688)
                                            ===========  ===========  ===========

Basic net income (loss) per common share...      $0.59       ($0.24)      ($0.87)
                                            ===========  ===========  ===========

Diluted net income (loss) per common share.      $0.54       ($0.24)      ($0.87)
                                            ===========  ===========  ===========

Shares used in computing basic net
 income (loss) per common share............      9,460        8,926        8,813
                                            ===========  ===========  ===========

Shares used in computing diluted net
 income (loss) per common share............     10,237        8,926        8,813
                                            ===========  ===========  ===========

                                                                              Accumu-
                                                          Notes                lated
                                                         Receiv-               Other
                                                          able                Compre-                           Compre-
                           Common Stock     Additional    from     Deferred   hensive   Accumu-      Total      hensive
                        -------------------   Paid-in    Stock-    Compen-    Income/    lated    Stockholders' Income/
                          Shares    Amount    Capital    holders    sation     Loss     Deficit      Equity      Loss
                        ----------- ------- ----------- --------- ---------- --------- ---------- ------------ ---------
December 28, 1996......  8,778,344      $9     $48,862      $(92)     $(388)       $9   $(17,618)     $30,782
Issuance of common
  stock through:
  Exercise of
   options.............     74,287      --         201       --         --        --         --           201
  Employee stock
   purchase plan.......     16,865      --          90       --         --        --         --            90
Amortization of
 deferred compensation.       --        --        --         --         160       --         --           160
Change in unrealized
 gain on
 available-for-sale
 securities............       --        --        --         --         --          1        --             1         1
Net loss...............       --        --        --         --         --        --      (7,688)      (7,688)   (7,688)
                        ----------- ------- ----------- --------- ---------- --------- ---------- ------------ ---------
January 3, 1998........  8,869,496       9      49,153       (92)      (228)       10    (25,306)      23,546   ($7,687)
                                                                                                               =========
Issuance of common
  stock through:
  Exercise of
   options.............     89,927      --         586       --         --        --         --           586
  Employee stock
   purchase plan.......     13,545      --         162       --         --        --         --           162
Amortization of
 deferred compensation.       --        --        --         --         160       --         --           160
Repayment of notes
 receivable from
 stockholder...........       --        --        --          41        --        --         --            41
Change in unrealized
 gain on
 available-for-sale
 securities............       --        --        --         --         --        (10)       --           (10)      (10)
Currency translation
 adjustment............       --        --        --         --         --        (39)       --           (39)      (39)
Net loss...............       --        --        --         --         --        --      (2,141)      (2,141)   (2,141)
                        ----------- ------- ----------- --------- ---------- --------- ---------- ------------ ---------
January 2, 1999........  8,972,968       9      49,901       (51)       (68)      (39)   (27,447)      22,305   ($2,190)
                                                                                                               =========
Issuance of common
  stock through:
  Secondary offering
   at $56 per share
   net of issuance
    costs of $5,165....  1,368,500       2      71,469       --         --        --         --        71,471
  Exercise of
   options.............    335,610      --       3,626      (273)       --        --         --         3,353
  Employee stock
   purchase plan.......     13,907      --         204       --         --        --         --           204
Amortization of
 deferred compensation.       --        --        --         --          68       --         --            68
Repayment of notes
 receivable from
 stockholder...........       --        --        --          51        --        --         --            51
Change in unrealized
 gain on
 available-for-sale
 securities............       --        --        --         --         --        (33)       --           (33)      (33)
Currency translation
 adjustment............       --        --        --         --         --        (79)       --           (79)      (79)
Net income.............       --        --        --         --         --        --       5,543        5,543     5,543
                        ----------- ------- ----------- --------- ---------- --------- ---------- ------------ ---------
January 1, 2000........ 10,690,985     $11    $125,200     ($273)    $  --      ($151)  ($21,904)    $102,883    $5,431
                        =========== ======= =========== ========= ========== ========= ========== ============ =========

                                                  For the Years Ended
                                         --------------------------------------
                                          January 1,   January 2,   January 3,
                                             2000         1999         1998
                                         ------------ ------------ ------------
Cash flows from operating activities:
  Net income (loss).....................      $5,543      ($2,141)     ($7,688)
  Adjustments to reconcile net income
    (loss) to net cash provided by
    (used in) operating activities:
    Depreciation and amortization.......       2,415          958          615
    Provision for doubtful accounts
      receivable and product returns....         214         (125)         276
    Forgiveness of notes receivable.....         --           --            11
    Provision for excess and
      obsolete inventory................         740          (26)         249
    Loss/(gain) on disposal of
      property and equipment............          74           (4)          19
    Non cash stock deferred
      compensation......................          68          160          160
    Deferred rent.......................          (6)         (17)         --
  Changes in operating assets and
    liabilities:
    Accounts receivable.................      (8,159)      (3,624)      (1,248)
    Inventory...........................        (631)      (5,024)      (1,509)
    Prepaid expenses and other
      current assets....................         319         (838)         (55)
    Accounts payable....................       1,133          829          (87)
    Accrued liabilities.................       1,133          803          742
    Deferred revenue....................        (495)         517          --
    Other assets........................          75         (273)           6
                                         ------------ ------------ ------------
    Net cash provided by (used in)
      operating activities..............       2,423       (8,805)      (8,509)
                                         ------------ ------------ ------------
Cash flows from investing activities:
  Purchases of property and equipment...      (5,295)      (3,893)        (562)
  Purchases of available-for-sale
    securities..........................     (29,084)     (28,059)     (20,656)
  Sales or maturities of
    available-for-sale securities.......       2,551       34,511       26,895
                                         ------------ ------------ ------------
    Net cash provided by (used in)
      investing activities..............     (31,828)       2,559        5,677
                                         ------------ ------------ ------------
Cash flows from financing activities:
  Issuance of notes receivable to
   related parties......................        (848)         --          (686)
  Repayment of capital leases...........         (64)         (14)         (41)
  Repayment of notes receivable from
   related parties......................          93          148           97
  Repayment of notes receivable from
   stockholder..........................          51           41          --
  Proceeds from issuance of common
    stock and preferred stock,
    net of issuance costs...............      71,675          162           90
  Proceeds from exercise of options
    to purchase common stock............       3,626          586          201
                                         ------------ ------------ ------------
    Net cash provided by (used in)
      financing activities..............      74,533          923         (339)
                                         ------------ ------------ ------------
Effect of exchange rate on changes
  in cash...............................         (79)         (39)         --
                                         ------------ ------------ ------------
Net increase (decrease) in cash
  and cash equivalents..................      45,049       (5,362)      (3,171)
Cash and cash equivalents,
  beginning of year.....................       2,826        8,188       11,359
                                         ------------ ------------ ------------
Cash and cash equivalents, end of year..     $47,875       $2,826       $8,188
                                         ============ ============ ============

                                                         Year Ended
                                            -------------------------------------
                                            January 1,   January 2,   January 3,
                                               2000         1999         1998
                                            -----------  -----------  -----------
Basic:
  Net income (loss).........................    $5,543      ($2,141)     ($7,687)
                                            ===========  ===========  ===========
  Weighted average common shares
     outstanding............................     9,460        8,926        8,813
                                            ===========  ===========  ===========

  Net income (loss) per share...............     $0.59       ($0.24)      ($0.87)
                                            ===========  ===========  ===========

Diluted:
  Net income (loss).........................    $5,543      ($2,141)     ($7,687)
                                            ===========  ===========  ===========
  Weighted average common shares
     outstanding............................     9,460        8,926        8,813
  Options to purchase common stock..........       678           --           --
  Warrants..................................        99           --           --
                                            -----------  -----------  -----------
  Total weighted common stock and
   common stock equivalents.................    10,237        8,926        8,813
                                            ===========  ===========  ===========

  Net income (loss) per share...............     $0.54       ($0.24)      ($0.87)
                                            ===========  ===========  ===========

Antidilutive securities:
  Options to purchase common stock..........        --        1,464        1,055
  Warrants..................................        --           80           --
                                            -----------  -----------  -----------
                                                    --        1,544        1,055
                                            ===========  ===========  ===========

                                        Gross      Gross                Fair
                            Amortized Unrealized Unrealized  Accrued   Market
                              Cost      Gains      Losses   Interest    Value
                            --------- ---------- ---------- --------- ---------
Maturity date less than
1 year:
  Commerical Paper.........  $17,119         $4      $  --     $  --   $17,123
  Corporate notes and
   bonds...................    5,389         --         (1)       32     5,420


Maturity date greater
than 1 year:
  Corporate notes and
   bonds...................    6,206         --        (25)       38     6,219
  U.S. government notes
    and bonds..............    2,970         --        (16)       16     2,970
                            --------- ---------- ---------- --------- ---------
Total......................  $31,684         $4       ($42)      $86   $31,732
                            ========= ========== ========== ========= =========

                                                      January 1,   January 2,
                                                         2000         1999
                                                     ------------ ------------
                                                           (in thousands)
Inventories:
   Raw materials...................................       $2,870       $3,127
   Work-in-process.................................        1,280        1,852
   Finished goods..................................        2,810        2,090
                                                     ------------ ------------
                                                          $6,960       $7,069
                                                     ============ ============

Prepaid expenses and other current assets:
   Prepaid insurance...............................         $132         $212
   Prepaid rent....................................           15          --
   Other...........................................          572          826
                                                     ------------ ------------
                                                            $719       $1,038
                                                     ============ ============

Property and equipment:
   Machinery and equipment.........................       $1,621       $1,672
   Tooling and molds...............................          603          343
   Computer equipment..............................        1,833        1,397
   Controller placements...........................        6,955        2,637
   Furniture and fixtures..........................          342          332
   Leasehold improvements..........................          403          271
                                                     ------------ ------------
                                                          11,757        6,652
   Less accumulated depreciation and amortization..       (4,391)      (2,092)
                                                     ------------ ------------
                                                          $7,366       $4,560
                                                     ============ ============

Equipment acquired under capital leases
  included in property and equipment above:
     Machinery and equipment.......................         $109         $109
     Computer equipment............................          217          217
     Less accumulated depreciation.................         (170)         (99)
                                                     ------------ ------------
                                                            $156         $227
                                                     ============ ============

Accrued liabilities:
   Accrued professional fees.......................          $30         $150
   Accrued warranty................................          174          302
   Other...........................................        1,030        1,282
                                                     ------------ ------------
                                                          $1,234       $1,734
                                                     ============ ============

      2000.........................................          $74
      2001.........................................           74
      2002.........................................           13

      2000.........................................         $631
      2001.........................................          645
      2002.........................................          110

(in thousands)
                                                  For the Years Ended
                                         --------------------------------------
                                          January 1,   January 2,   January 3,
                                             2000         1999         1998
                                         ------------ ------------ ------------
Non-cash financing and investing
activities:
 Additions to property and equipment
 acquired under capital lease...........      $  --          $217       $  --

Cash paid during the period for:
      Interest..........................          23            1            5
      Income Taxes......................          93            1            1

                                                  Outstanding Options
                                                 ----------------------
                                       Shares                 Weighted
                                     Available     Number     Average
                                        for          of       Exercise
                                       Grant       Shares      Price
                                     ----------  ----------  ----------
BALANCES, DECEMBER 28, 1996........    861,442     544,098       $6.32
Options granted....................   (723,300)    723,300       $8.43
Options exercised..................        --      (74,166)      $2.71
Options canceled...................    162,203    (162,203)      $5.43
                                     ----------  ----------
BALANCES, JANUARY 3, 1998..........    300,345   1,031,029       $8.20
Additional shares authorized.......    750,000          --
Options granted....................   (601,950)    601,950      $15.17
Options exercised..................        --      (89,927)      $6.52
Options canceled...................    111,650    (111,650)      $8.89
                                     ----------  ----------
BALANCES, JANUARY 2, 1999..........    560,045   1,431,402      $11.18
Options granted....................   (388,450)    388,450      $20.11
Options exercised..................        --     (297,025)      $8.47
Options canceled...................     86,005     (86,005)     $14.04
                                     ----------  ----------
BALANCES, JANUARY 1, 2000..........    257,600   1,436,822      $13.80
                                     ==========  ==========

                                                  For the Years Ended
                                         --------------------------------------
                                          January 1,   January 2,   January 3,
                                             2000         1999         1998
                                         ------------ ------------ ------------
                                           (in thousands, except per share data)
Net income (loss) -- as reported........      $5,543      ($2,141)     ($7,688)
Net income (loss) -- pro forma..........      $2,768      ($3,650)     ($8,466)

Net income (loss) per common share
  as reported...........................       $0.59       ($0.24)      ($0.87)

Net income (loss) per common share
  pro forma.............................       $0.29       ($0.41)      ($0.96)

Net income (loss) per diluted share
  as reported...........................       $0.54       ($0.24)      ($0.87)

Net income (loss) per diluted share
  pro forma.............................       $0.27       ($0.41)      ($0.96)

    Risk-free interest rate............  4.98% - 7.13%
    Expected life......................       4 years
    Expected dividends.................           ---
    Expected volatility................            52%

                           Options Outstanding            Options Exercisable
                    ----------------------------------- ----------------------
                                  Weighted-
                                   Average    Weighted-              Weighted-
                                  Remaining    Average                Average
    Range of           Number    Contractual  Exercise     Number    Exercise
   Exercise Prices  Outstanding  Life (years)   Price   Exercisable    Price
------------------- ------------ ------------ --------- ------------ ---------
$0.0010  to  $7.37      147,740         5.65     $4.03      100,000     $3.95
  $8.25                 294,100         7.48     $8.25      180,474     $8.25
  $9.00  to $11.23      235,286         7.56    $10.59      122,744    $10.38
 $11.50  to $13.75       70,827         7.93    $12.47       31,113    $12.42
 $14.00                 180,191         9.16    $14.00       32,931    $14.00
 $14.88  to $17.25      140,230         8.41    $15.40       46,805    $15.27
 $17.63                 176,583         8.61    $17.63       51,204    $17.63
 $17.88                 129,865         8.44    $19.09       57,345    $20.51
 $34.75                 236,740         9.66    $34.75       19,385    $34.75
 $42.81                 123,000         9.94    $42.81          402    $42.81
                    ------------                        ------------
                      1,734,562         8.26    $17.45      642,403    $12.41
                    ============                        ============

                                                     January 1,   January 2,
                                                        2000         1999
                                                    ------------ ------------
Deferred tax assets:
   Net operating loss carryforwards................      $9,901       $6,726
   Capitalized research and development costs......         862        1,067
   Capitalized start-up costs......................         156          323
   Research and development credit.................       1,424        1,120
   Allowances and reserves.........................         942        2,093
                                                    ------------ ------------
Deferred tax assets................................      13,285       11,329

Less: valuation allowance and other................     (13,285)     (11,329)
                                                    ------------ ------------

   Net deferred tax assets.........................      $  --        $  --
                                                    ============ ============

                                              Additions
                                 Balance at   Charged to               Balance
                                  Beginning    Cost and                at end
                                   of Year     Expenses   Deductions   of Year
                                 ----------- ------------ ----------- ---------
Year ended January 1, 2000
 Deducted from asset accounts:
  Allowance for doubtful
   accounts and product returns..      $469         $214       $ --       $683
  Allowance for excess and
   obsolete inventory............       323          740         --      1,063

Year ended January 2, 1999
 Deducted from asset accounts:
  Allowance for doubtful
   accounts and product returns..      $594       $ --         ($125)     $469
  Allowance for excess and
   obsolete inventory............       349         --          ($26)     $323

Year ended January 3, 1998
 Deducted from asset accounts:
  Allowance for doubtful
   accounts and product returns..      $318         $276       $ --       $594
  Allowance for excess and
   obsolete inventory............       100          249         --        349