PHYSIOMETRIX INC, 10-K, 1999-03-31

PHYSIOMETRIX INC
10-K, 1999-03-31
ELECTROMEDICAL & ELECTROTHERAPEUTIC APPARATUS

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K

(MARK ONE)

/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.

FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998.
OR

/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934.

FOR THE TRANSITION PERIOD FROM ______________ TO ______________.

COMMISSION FILE NUMBER: 000-27956
------------------------
PHYSIOMETRIX, INC.

(Exact name of registrant as specified in its charter)

DELAWARE 77-0248588
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)

FIVE BILLERICA PARK, 01862
101 Billerica Ave., N. Billerica, MA (Zip code)
(Address of principal executive offices)

Registrant's telephone number, including area code: (978) 670-2422

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value
(Title of class)
------------------------

Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /

Indicate by check mark if disclosures of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.

The aggregate value of voting stock held by non-affiliates of the Registrant
was approximately $4,508,364 as of January 31, 1999, based upon the average of
the high and low prices of the Registrant's Common Stock reported for such date
on the Nasdaq National Market. Shares of Common Stock held by each executive
officer and director and by each person who owns 5% or more of the outstanding
Common Stock have been excluded in that such persons may be deemed to be
affiliates. The determination of affiliate status is not necessarily a
conclusive determination for other purposes. As of January 31, 1999, the
Registrant had outstanding 5,707,366 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Certain information is incorporated into Part III of this report by
reference to the Proxy Statement for the Registrant's 1999 annual meeting of
stockholders to be filed with the Securities and Exchange Commission pursuant to
Regulation 14A not later than 120 days after the end of the fiscal year covered
by this Form 10-K.

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PHYSIOMETRIX, INC.
INDEX

<TABLE>
<CAPTION>
PAGE
NUMBER
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<S> <C>
PART I.................................................................................................. 3

Item 1. BUSINESS................................................................................ 3
Item 2. PROPERTIES.............................................................................. 20
Item 3. LEGAL PROCEEDINGS....................................................................... 20
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..................................... 20

PART II................................................................................................. 21

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS........................................................... 21
Item 6. SELECTED FINANCIAL DATA................................................................. 22
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS................................................... 23
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA............................................. 26
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE................................................... 26

PART III................................................................................................ 27

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT..................................... 27
Item 11. EXECUTIVE COMPENSATION................................................................. 27
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT............................................................................ 27
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS......................................... 27

PART IV................................................................................................. 28

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K........................................................................... 28
</TABLE>

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PART I

ITEM 1.

INTRODUCTION

Physiometrix designs, develops, manufactures and markets noninvasive,
advanced medical products incorporating proprietary materials, electronics
technology and software for use in neurological monitoring applications during
surgical and diagnostic procedures. The Company sells its products to hospitals,
clinics and physicians' offices domestically and internationally. The Company's
current principal product focus is its electronic neurology monitoring products
consisting of the Patient State Analyzer, an innovative system for monitoring
brain activity during anesthesia, which is currently in clinical trials. The
Company's initial products, which were commercially introduced in 1994, are its
innovative e - Net headpiece and disposable HydroDot biosensors, which are
based upon the Company's proprietary HydroGel technology, and its custom
electronics. These products are packaged as the HydroDot NeuroMonitoring System,
which was developed and is sold for brain monitoring applications, such as
clinical electroencephalograph ("EEG") procedures. The system is marketed and
sold as a safer, lower cost alternative to current EEG data collection
technology. The system connects and interfaces to the standard input on all
conventional EEG instruments currently in use worldwide, yet offers reduced
patient setup time, more reliable data readings, and enhanced patient comfort
and safety.

PATIENT STATE ANALYZER. The Patient State Analyzer is being developed by
the Company to provide a simplified, user friendly analysis of patient brain
activity during surgical procedures involving general anesthesia. Currently,
such monitoring is used only in a small percentage of all such procedures,
primarily during high risk interventions such as cardiology and neurology
surgeries. At present, brain monitoring can only be accomplished through
traditional EEG techniques involving lengthy setups and the use of flammable
materials and cumbersome equipment. Traditional EEG devices also require a
neurologist to interpret their data output. As a result, anesthesiologists are
reluctant to use EEG monitoring during other surgical procedures, despite the
potential benefits offered by brain monitoring such as improved patient safety,
shorter patient recovery times, and lower overall costs per procedure. The
Patient State Analyzer will incorporate the Company's HydroDot NeuroMonitoring
System, the NeuroLink, and the Equinox EEG technology. In addition, the Company
is developing the final component of the Patient State Analyzer, a proprietary
software module which will process EEG data and provide an easy to read signal
to anesthesiologists regarding patient's brain activity.

The Company believes that monitoring patients' brain activity during surgery
with the Patient State Analyzer will improve patient safety and lower costs per
surgical procedure by better controlling the amount of anesthesia administered
during surgeries. This will reduce the amount of postoperative recovery time
required, and eliminate the requirement of a neurologist or specialized
technologists to interpret EEG results during surgery. The Company believes that
these benefits create the opportunity for the Patient State Analyzer to become
the standard of care during all surgical interventions using general anesthesia.
The Company plans to resubmit a 510(k) clearance application to the FDA for the
Patient State Analyzer in late 1999, and is working with clinical investigators
at several institutions, including Harvard Medical School, in the development of
the system.

The Company will not be able to market the Patient State Analyzer or other
potential products in the United States unless and until it obtains clearance or
approval from the FDA and there can be no assurance that the Company will obtain
FDA clearance for such products on a timely basis, if at all.

This Report on Form 10-K contains certain forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. Actual events or results may differ materially
from those projected in the forward-looking statements as a result of the
factors described herein and in the documents incorporated herein by reference.
Such forward-looking statements include, but are not limited to, statements
concerning (i) business strategy; (ii) products under

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development; (iii) other products; (iv) marketing and distribution; (v) research
and development; (vi) manufacturing; (vii) competition; (viii) government
regulation; (ix) third-party reimbursement; (x) operating and capital
requirements and (xi) clinical trials

The table below summarizes the products currently offered by the Company,
the products under development by the Company, the markets served by these
products and their present development and/or commercialization status:

<TABLE>
<CAPTION>
PRODUCT DESCRIPTION DEVELOPMENT/COMMERCIALIZATION STATUS
- ------------------------------------ ------------------------------------ ------------------------------------
<S> <C> <C>
Patient State Analyzer Intraoperative EEG monitoring system Under development
(incorporates proprietary software
under development, OR e-Net and
NeuroLink electronics)
HydroDot NeuroMonitoring System EEG headpiece Commercial sales
- - e-Net EEG headpiece for children Commercial sales
- - Small e-Net - OR e-Net EEG headpiece for operating room Commercial sales Commercial sales
applications (designed for use with
Patient State Analyzer)
- - HydroDot biosensors Disposable biosensors for use with
e-Nets
HydroSpot biosensors Disposable biosensors attached to Commercial sales
lead wires
</TABLE>

INDUSTRY OVERVIEW

EEG MARKET

An EEG procedure measures neurophysiological activity by measuring the
intensity and pattern of electrical signals generated by the brain. Undulations
in the recorded electrical signals are called brain waves, and the entire record
of electrical rhythms and other electrical activity (ongoing background signals
and event related transients) of the brain is an EEG. EEGs are widely used to
assist in the diagnosis of epilepsy, brain tumors, physiological disorders and
other brain abnormalities. Because the electrical waves produced by an injured
or abnormal brain will differ in predictable ways from waves produced by a
normal brain, an EEG exam should disclose and help diagnose brain abnormalities
and injuries.

Although EEG based brain monitoring has been performed for over 70 years, it
is only recently that medical professionals have begun to recognize the benefits
of EEGs as a broad based diagnostic tool. This should be contrasted with the
field of cardiac monitoring in which medical professionals have long been aware
of the benefits of such monitoring, and have integrated electrocardiogram
("ECG") procedures into both preventive and diagnostic health care. As a result,
medical device and instrument companies have concentrated on, and provided
improved technology for, the cardiac monitoring market. However, EEG technology
has remained virtually unchanged since its inception.

There are approximately 48 million surgical interventions performed annually
worldwide under general anesthesia, representing a neuromonitoring market
opportunity estimated in excess of $1 billion. The Company is developing the
Patient State Analyzer to address this market. Currently, anesthesiologists
measure heart, breathing rates, as well as other physiological changes, to
monitor the effect of anesthesia on patients. However, the brain, the organ
which anesthetic drugs affect the earliest, is generally not directly monitored.
Nevertheless, in several types of surgical procedures, including high risk
cardiology and vascular surgical procedures, brain monitoring is recognized by
clinicians as particularly important. Routine monitoring of brain functions
during surgery can result in earlier detection of abnormalities that,

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if left undetected, could result in serious surgical and post surgical
complications. Such monitoring can also potentially reduce costs and
postoperative recovery times by enabling a reduction in the amount of anesthesia
used during the surgical procedure, which would enable patients to emerge from
the effects of the anesthesia and be ambulatory more quickly following the
procedure. Today, such monitoring can only be accomplished through the use of
conventional EEG procedures, which require the use of collodion, a flammable,
toxic gel material, for attachment of electrodes as well as cumbersome EEG
equipment in the close confines of the operating room environment. In addition,
anesthesiologists are typically not familiar with conventionally produced EEG
test results, and a neurologist must therefore be on hand to interpret EEG test
information. The Company believes that the availability of a low cost, easy to
use monitoring device such as the Patient State Analyzer could substantially
increase brain monitoring during surgical procedures involving general
anesthesia.

CURRENT EEG PROCEDURE

Currently, to perform a typical EEG exam, the technician must measure, mark,
clean and abrade 20 spots on the scalp. After these procedures are completed, 20
disc shaped electrodes are placed on the points identified on the scalp.
Collodion is typically used during this process. Abrasion of the skin is
necessary in order to provide a sufficiently low impedance signal (typically
less than 5,000 ohms) to the EEG monitor. Electrodes can be misplaced, resulting
in inaccurate readings, and can fall off, necessitating that the technician
restart the recording. At the end of the procedure, cleanup of the collodion
used to affix the electrodes to the scalp requires the use of toxic solvents and
is both time consuming and unpleasant for the patient. In addition, incomplete
sterilization of the cup electrodes can result in increased risk of infection
for the patient. These difficulties in patient setup and cleanup also contribute
to reduced operating efficiencies in the EEG laboratory. The current method for
performing EEGs also suffers from several functional deficiencies, including
difficulty in achieving effective electrical contact between the patient and the
device, the possibility of electrode movement or displacement during the EEG
examination, creation of salt bridges, or unwanted electrical circuits between
electrodes, that result in a high level of EEG signal interference. The
consequences of these deficiencies include poor signal quality making diagnoses
questionable, a need to administer repeat tests and signal format that is not
conducive to advanced diagnostic analytical techniques. The Company believes
that these deficiencies have limited the growth of EEG monitoring.

A traditional EEG procedure takes an average of about 60 minutes, of which
about 30 minutes is made up of actual recording time. The traditional EEG is
extremely sensitive to patient movement, sweating, electrical interference and
muscle tension; any of these may make a tracing uninterpretable. For most of the
actual recording, the patient will lie calmly with their eyes closed. Additional
studies which most laboratories routinely perform include recording during
hyperventilation and photic simulation with a repetitive flash. For many
tracings, subjects are encouraged to fall asleep, if they can. Some laboratories
induce sleep with oral chloral hydrate.

In response to the inherent inadequacies of traditional methods for
performing EEGS, one manufacturer has introduced a device, which it calls
ElectroCap. This product uses an enclosed "bathing cap" type format, in which
the electrodes are encased in a headpiece that is much like a rubber bathing
cap. The Company believes the ElectroCap suffers from several disadvantages,
including the requirement for many different sized caps for different head
sizes, difficulty in placing electrodes because the technician cannot see the
electrode positioning due to the cap, and the closed design of the cap which is
uncomfortably hot and confining for the patient. In addition, to improve signal
quality, the patient's scalp must be aggressively abraded with a blunt needle
which is a painful, awkward and potentially infectious procedure.

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THE PHYSIOMETRIX SOLUTION

The Company believes that the availability of a low-cost, easy to use
monitoring device such as the Patient State Analyzer, could substantially
increase brain monitoring during surgery and has the potential to become the
standard of care in brain monitoring during administration of general
anesthesia.

The Physiometrix HydroDot NeuroMonitoring System has been developed to
address and seek to overcome the deficiencies of current methods of performing
EEGS. The HydroDot System incorporates innovative product features that improve
clinical efficacy, patient comfort and allow the EEG laboratory to perform EEG
procedures more efficiently. Physiometrix' E - Net is a proprietary, flexible,
open net matrix that fits over the patient's head and uses disposable, soft
hydrogel biosensors that are inserted into the matrix at predetermined locations
that correspond to points on the scalp where conventional cup electrodes would
otherwise be affixed manually. In effect, the E - Net serves as a template to
automatically position the HydroDot biosensors for the EEG procedure. The
E - Net fits a majority of adult head sizes. The elasticity of the E - Net
ensures accurate placement of the HydroDot biosensors and the maintenance of
proportionality between electrodes. The Company also sells a smaller version of
the E - Net which, together with the adult sized E - Net, enables over 95%
of head sizes to be accommodated. The proprietary hydrogel electrode material is
adhesive, but does not leave a residue. In contrast to conventional EEG methods,
time consuming and often painful scalp preparation is not required to achieve a
low impedance signal. The hair is simply parted and the HydroDot biosensors are
pressed into the sockets on the E - Net. For testing environments in which
there is the potential for hostile electrical interference, the E - Net can
connect to an adjacent analog to digital interface module that digitizes the
electrode signal, transmits the digital data via a fiber optic link to the
instrument location, where it is converted back into an analog form acceptable
to the EEG input electronics. This data transmission procedure virtually
eliminates ambient noise that is present in most EEGs (especially electronic
noise in the intensive care unit, operating room and emergency room) as a result
of the "antennae" effect from using wire leads to transmit electrical data, and
can be used with any EEG instrument.

The E - Net reduces average EEG setup times by approximately 75 percent (6
to 8 minutes versus 30 minutes), in addition to providing a high quality and
accurate signal. The HydroDot NeuroMonitoring System offers the following
advantages over traditional modalities:

- Electrode positioning is fast, easy, accurate and reproducible; time
consuming measurements are avoided.

- Patient preparation time is greatly reduced and the use of toxic,
flammable substances is avoided.

- Patient comfort is enhanced because patients can move around untethered;
the open E - Net structure provides ventilation and the patient is not
encumbered by a large number of wires.

- Adhesive qualities of the hydrogel provide excellent skin contact without
slippage, eliminate salt bridges and prevent electrodes from falling off
the scalp.

- Biosensors ensure reproducible signal quality and minimize collection of
electrical interference from the environment.

- Risk of infection is reduced through the use of disposable biosensors and
reduced need for scalp abrasion.

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BUSINESS STRATEGY

The Company's objective is to become the leader in the design, development
and commercialization of brain monitoring technology. Key elements of the
Company's strategy include the following:

- DESIGN AND DEVELOP INNOVATIVE, PROPRIETARY PRODUCTS FOR THE NEUROLOGY AND
SURGICAL MARKET. Physiometrix plans to capitalize on the growing
recognition among medical professionals of easy to use and reliable method
of brain monitoring. The Company intends to remain focused on the
development and marketing of products for surgery including products that
are designed to expand the use of neurological monitoring. The Company has
substantial design and development expertise in the neurological
monitoring field and will seek to position itself at the forefront of
innovation in this industry.

- DIVERSIFY PRODUCT OFFERINGS TO INCREASE MARKET PENETRATION.The Company
seeks to offer a range of products, including hardware and disposable
products designed to encourage broader use of EEG monitoring. The Company
believes that it will be able to significantly expand its penetration of
the neurology and surgery markets with the introduction of the Patient
State Analyzer.

- BROADEN MARKETING CHANNELS. The Company will seek to implement a broad
based marketing strategy, using distributors in the United States and
internationally. The Company will need to select a distribution partner to
market the Patient State Analyzer to anesthesiologists, hospital
administrators, and, to a lesser extent, managed care centers.

- OUTSOURCE MANUFACTURING TO CONTROL COSTS. The Company will seek to
outsource many manufacturing processes to qualified contract manufacturers
to control costs, maintain quality and reduce capital investment, while
retaining control over key proprietary processes for certain components of
its products.

PRODUCTS AND TECHNOLOGY
Discussed below is a description of the HydroDot Neuromonitoring system. The
Company intends to either license this technology to another company or
transition out of the business by end of June 1999. The PSA is currently in
clinical trials and will not provide revenue to the Company in 1999.

E - NET. The E - Net is an open handed headpiece designed to position
and hold the HydroDot disposable biosensors symmetrically against the scalp
during an EEG study. The E - Net is manufactured from a proprietary elastic
material and positions 20 biosensors according to the internationally recognized
10-20 System on head sizes varying from 48 to 62 centimeters in circumference.
The 10-20 System is a standard, universal methodology for marking and measuring
the patient's scalp for electrode placement in EEG procedures.

The E - Net is held in place by adjustable straps, one at the back of the
neck and the other around the chin. These strap positions minimize interaction
between head motion and electrode position. The open handed design of the
E - Net allows access to the scalp for parting the hair and for placing
additional biosensors on the patient. The expandable, shielded wire leads on the
outside of the E - Net are combined into a single connector that interfaces to
the straight cable. The E - Net is reusable with an expected lifetime of up to
200 applications. The elastic material is shielded by a fabric sheath and the
wires are covered in a protective jacket and ultrasonically welded to the
biosensor sockets. The disposable biosensors snap out of the E - Net after it
is removed and the entire E - Net may be sterilized in disinfectant solution.
Its key competitive features are elastic proportionality, increased patient
comfort, standardized placement of biosensors, elimination of measurements, open
handed design, integrated wiring, and durability. The E - Net is currently
sold separately for $250.00 or as a starter kit with a half case of HydroDot
biosensors (enough for approximately 10 EEG procedures) and a straight cable for
connection to EEG machines for $495.00.

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Small E - Net. Because the HydroDot NeuroMonitoring System is much less
traumatic to patients than traditional EEG procedures, it is much easier to use
on children. Physiometrix' small E - Net, introduced in March 1995, enables
technicians to use the HydroDot NeuroMonitoring System on children.

OR E - NET. The Company has developed the OR E - Net, which is
specially designed so that it can be used during surgical procedures in which
blood flow to the brain could be compromised. Typically, hospitals have had to
rely on collodion as an adhesive for their operating room procedures to secure
the metal cup electrodes. Many institutions have banned collodion from operating
room use because it is highly flammable. As a result, the Company believes that
the HydroDot NeuroMonitoring System can potentially replace many products
currently available for such uses.

HYDRODOT DISPOSABLE BIOSENSORS. The HydroDot biosensors are disposable and
are used in lieu of conventional cup electrodes to acquire EEG signals from a
patient. The biosensors are packaged in ready-to-use sealed trays of 24 sensors.
Minimal skin preparation and no collodion is required when the sensors are
inserted into the sockets on the E - Net. When the E - Net is removed after
completion of an EEG examination, the sensors leave no residue on the scalp. The
HydroDot biosensors provide high signal quality through the incorporation of a
silver/silver chloride reference and an adhesive proprietary hydrogel material
that conforms to the scalp. Because the HydroDot biosensors are disposable, they
can be used on patients with contagious diseases and discarded, thereby reducing
the risk of spreading infectious disease. Their key competitive features are
ease of use, reduced risk of infection, cleanliness, improved signal quality and
increased safety. The HydroDot biosensors are sold in 20-tray cases for $180.00.

HYDROSPOT. The Company has developed the HydroSpot biosensor for those
technicians who want the benefits of the HydroDot biosensors, but do not wish to
use the E - Net because they prefer a procedure setup similar to that used
with conventional cup electrodes. The HydroSpot is a hydrogelled disposable
biosensor attached to a reusable lead wire and will be offered as an alternative
to the conventional cup electrodes typically employed in EEG procedures. In
addition to routine EEG procedures, the HydroSpot has potential application for
long term EEG monitoring and several other applications including evoked
potentials and nerve conduction velocity studies which are often used in
evaluation of carpal tunnel syndrome patients.

PRODUCTS UNDER DEVELOPMENT

PATIENT STATE ANALYZER. Physiometrix is developing the Patient State
Analyzer ("PSA") for brain monitoring in the operating room. The PSA is expected
to utilize a single use Disposable Appliance to record EEG for continuous
analysis by the PSA. The PSA is being designed to extract data known to be
sensitive to the functional level of each region of the brain, the adequacy of
blood supply and the interaction of each region with neighboring regions on the
opposite side of the brain. Based on such measurements, statistical procedures
will be used to deliver an analysis of the data into a measurement called a
"self-norm," to provide a base for monitoring the effects of anesthesia.

The PSA will record "self-norms" both prior to and immediately after the
administration of anesthesia. During intraoperative procedures, the PSA will
constantly monitor data and its relationship to those two endpoints and alert
the anesthesiologist as to changes in the patient's state of consciousness. The
PSA will provide the anesthesiologist with a readout regarding the patient's
ideal anesthetized state. Normal neurological function for the patient will be
determined by recording a brief EEG immediately prior to anesthesia and a
subsequent brief EEG as soon as the patient has reached an optimal anesthetized
state.

The PSA will consist of portions of the Company's Equinox EEG hardware with
a single use version of the E.Net in place of the standard E - Net and an 8
channel preamplifier input. Software will include testing electrode impedance,
amplifier calibration, EEG collection, quantitative analysis after artifact
removal (brain wave abnormalities resulting from external stimulation, eye
blinking or muscle movement),

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display and storage. The capability to construct group norms for a particular
procedure will be provided, so the user can build criteria for the typical
patient.

The Company expects that the PSA will be developed in two phases. The first
phase will include the development and implementation of proprietary software
for displaying changes in the patient's level of consciousness. The development
system platform will consist of a standard personal computer and a NeuroLink
fiber optic interface card. The second phase will consist of trials seeking to
validate the effectiveness and safety of the PSA during operating conditions
using six different anesthetic agents. Each agent will be evaluated in 20 cases.
The software is planned for development in a modular fashion. The Company
expects that it will include a data acquisition module, signal processing
module, artifact removal module, signal analysis module, a data storage module
and a user interface module. By developing a system software specification
defining the use of software modules, development time and cost for new
Physiometrix products is expected to be reduced.

The Patient State Analyzer represents a new approach for brain monitoring
during surgery. Market acceptance of this product will be dependent upon, among
other things, the willingness of physicians, EEG technicians and others to adopt
use of these products. Market acceptance will also be dependent upon the
Company's ability to convince potential users of this product of its cost and
efficacy advantages.

The Patient State Analyzer is currently in clinical trials in the United
States. The Company intends to resubmit a 510(k) clearance application to the
FDA for the Patient State Analyzer in late 1999 and is working with leading
neurologists and anesthesiologists at several institutions, including Harvard
Medical School, in the development of the system.

MARKETING AND DISTRIBUTION

The Company intends, in connection with the planned commercial introduction
of the Patient State Analyzer, to select a distribution partner with substantial
experience and capabilities in sales of capital equipment to hospitals,
anesthesiologists and other potential users of such systems. The Company
currently does not intend to increase significantly its sales force to market
the Patient State Analyzer.

RESEARCH AND DEVELOPMENT

Physiometrix research and development activities are performed by the
Company's internal research and development staff, whose activities are
augmented by the use of outside consultants for particular projects and areas of
specialization. The Company has retained consultants for hardware and software
design and clinical evaluation and development of the Patient State Analyzer.
The Company's future research and development efforts are expected to be focused
on completion of development of the Patient State Analyzer.

Research and development expenses for the years ended December 31, 1996,
1997 and 1998 were $1,189,336, $2,500,601 and $4,108,451 respectively, none of
which was customer funded.

MANUFACTURING

The Company manufactures its products at its facilities in North Billerica,
Massachusetts. Production occurs in approximately 5,000 square feet of space
utilizing standard production equipment for most processes and proprietary
equipment for several specialized operations. The Company's production area
includes a segregated area where temperature can be controlled and maintained
for the production of the HydroDot biosensors. The Company intends to increase
outsourcing of manufacturing to contract manufacturers for certain components in
order to reduce cost and capital requirements and improve quality, while
retaining control over certain proprietary manufacturing processes.

The Company manufactures its products in conformance with FDA's GMPs, and
intends to comply with ISO 9001 standards when required in order to continue to
produce products for sale in Europe. Any

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failure by the Company to remain in compliance with the GMPs or comply with ISO
9001 standards could have a material adverse effect on the Company's business,
financial condition and results of operation.

The Company purchases components from various suppliers and relies on single
sources for several parts. To date, the Company has not experienced any
significant adverse effects resulting from shortages of components. Delays
associated with any future part shortages, particularly as the Company scales up
its manufacturing activities, would have a material adverse effect on the
Company's business, financial condition and results of operations.

The Company currently manufactures its HydroDot NeuroMonitoring Systems and
NeuroLink in limited quantities. The Company does not have experience in
manufacturing its products in commercial quantities. Manufacturers often
encounter difficulties in scaling up production of products, including problems
involving production yields, quality control and assurance, component supply and
lack of qualified personnel. Difficulties encountered by the Company in scaling
up manufacturing could have a material adverse effect on its business, financial
condition and results of operations.

COMPETITION

The Company believes that the primary competitive factors in the market for
neurological monitoring devices are the ability to provide products that can
improve clinical efficacy, reduce patient setup time, and contribute to
improvement of laboratory operating efficiencies. The Company believes that the
innovations it has developed in the field of neurology monitoring can
potentially afford it a competitive advantage. There is currently one other
Company who has a commercial product similar to the Patient State Analyzer.

PATENTS AND PROPRIETARY RIGHTS

The Company's policy is to protect its proprietary position by, among other
methods, filing United States and foreign patent applications to protect
technology, inventions and improvements that are important to its business. The
Company has nine issued United States patents and four United States patent
applications pending in the areas of biosensor material compositions, electrode
configurations, diagnostic systems and system-to-instrument data links.

The patent positions of medical device companies, including those of the
Company, are uncertain and involve complex and evolving legal and factual
questions. The coverage sought in a patent application either can be denied or
significantly reduced before or after the patent is issued. Consequently, there
can be no assurance that any patent applications will result in the issuance of
patents, or that the Company's issued or any future patents will provide
significant protection or commercial advantage or will not be circumvented by
others. Since patent applications are secret until patents are issued in the
United States or corresponding applications are published in international
countries, and since publication of discoveries in the scientific or patent
literature often lags behind actual discoveries, the Company cannot be certain
that it was the first to make the inventions covered by each of its pending
patent applications or that it was the first to file patent applications for
such inventions. There can be no assurance that patents held by or licensed to
the Company or any patents that may be issued as a result of the Company's
pending or future patent applications will be of commercial benefit, afford the
Company adequate protection from competing products or technologies or will not
be challenged by competitors or others or declared invalid. Also, there can be
no assurance that the Company will have the financial resources to defend its
patents from infringement or claims of invalidity.

In the event a third party has also filed a patent application relating to
an invention claimed in a Company patent application, the Company may be
required to participate in an interference proceeding declared by the United
States Patent and Trademark Office ("US PTO") to determine priority of
invention, which could result in substantial uncertainties and costs to the
Company, even if the eventual outcome is favorable to the Company. There can be
no assurance that any patents issued to the Company would be held valid by a
court of competent jurisdiction.

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The Company relies upon trade secret protection for certain unpatented
aspects of other proprietary technology. There is no assurance that others will
not independently develop or otherwise acquire substantially equivalent
proprietary information or techniques, others will not otherwise gain access to
the Company's proprietary technology or disclose such technology, or the Company
can meaningfully protect its trade secrets.

The Company typically requires its employees and consultants to execute
appropriate confidentiality and proprietary information agreements upon the
commencement of employment or consulting relationship with the Company. These
agreements generally provide that all confidential information developed or made
known to the individual by the Company during the course of the individual's
relationship with the Company, is to be kept confidential and not disclosed to
third parties, except in specific circumstances. The agreements generally
provide that all inventions conceived by the individual in the course of
rendering services to the Company shall be the exclusive property of the
Company; however, certain of the Company's agreements with consultants, who
typically are employed on a full time basis by academic institutions or
hospitals, do not contain assignment of invention provisions. There can be no
assurance, however, that these agreements will provide meaningful protection or
adequate remedies for the Company in the event of unauthorized use, transfer or
disclosure of such information or inventions.

GOVERNMENT REGULATION

UNITED STATES

The Company's HydroDot NeuroMonitoring System (including its family of
E - Nets, and HydroDot biosensors, HydroSpot, Patient State Analyzer and other
potential products are and will be regulated in the United States as medical
devices by the FDA under the Federal Food, Drug, and Cosmetic Act ("FDC Act")
and require premarket clearance or approval by the FDA prior to
commercialization. In addition, certain material changes or modifications to
medical devices also are subject to FDA review and clearance or approval.
Pursuant to the FDC Act, the FDA regulates the research, testing, manufacture,
safety, labeling, storage, record keeping, advertising, distribution and
production of medical devices in the United States. Noncompliance with
applicable requirements can result in warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or premarket
approval for devices, and criminal prosecution. Medical devices are classified
into one of three classes, Class I, II or III, on the basis of the controls
deemed by FDA to be necessary to reasonably ensure their safety and
effectiveness. Class I devices are subject to general controls (E.G., labeling,
premarket notification and adherence to Good Manufacturing Practices ("GMP").
Class II devices are subject to general controls and to special controls (E.G.,
performance standards, postmarket surveillance, patient registries, and FDA
guidelines). Generally, Class III devices are those which must receive premarket
approval by the FDA to ensure their safety and effectiveness (E.G., life
sustaining, life supporting and implantable devices, or new devices which have
not been found substantially equivalent to legally marketed devices), and
require clinical testing to ensure safety and effectiveness and FDA approval
prior to marketing and distribution. FDA also has the authority to require
clinical testing of Class I and Class II devices. A premarket approval ("PMA")
application must be filed if the proposed device is not substantially equivalent
to a legally marketed predicate device or if it is a Class II device for which
FDA has called for such applications.

If human clinical trials of a device are required and if the device presents
a "significant risk," the manufacturer or the distributor of the device is
required to file an investigational device exemption ("IDE") application prior
to commencing human clinical trials. The IDE application must be supported by
data, typically including the results of animal and, possibly, mechanical
testing. If the IDE application is approved by FDA, human clinical trials may
begin at a specific number of investigational sites with a maximum number of
patients, as approved by the agency. Sponsors of clinical trials are permitted
to sell those devices distributed in the course of the study provided such costs
do not exceed recovery of the costs

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of manufacture, research, development and handling. The clinical trials must be
conducted under the auspices of an independent institutional review board
("IRB") established pursuant to FDA regulations.

Generally, before a new device can be introduced into the market in the
United States, the manufacturer or distributor must obtain FDA clearance of a
510(k) notification or approval of a PMA application. If a medical device
manufacturer or distributor can establish that a device is "substantially
equivalent" to a legally marketed Class I or Class II device, or to a Class II
device for which FDA has not called for PMAs, the manufacturer or distributor
may seek clearance from FDA to market the device by filing a 510(K)
notification. The 510(k) notification may need to be supported by appropriate
data establishing the claim of substantial equivalence to the satisfaction of
FDA. FDA recently has been requiring a more rigorous demonstration of
substantial equivalence.

Following submission of the 510(k) notification, the manufacturer or
distributor may not place the device into commercial distribution until an order
is issued by FDA. No law or regulation specifies the time limit by which FDA
must respond to a 510(k) notification. At this time, FDA typically responds to
the submission of a 510(k) notification within 150 to 200 days. An FDA order may
declare that the device is substantially equivalent to another legally marketed
device and allow the proposed device to be marketed in the United States. FDA,
however, may determine that the proposed device is not substantially equivalent
or require further information, including clinical data, to make a determination
regarding substantial equivalence. Such determination or request for additional
information could delay market introduction of the products that are the subject
of the 510(k) notification.

If a manufacturer or distributor of medical devices cannot establish that a
proposed device is substantially equivalent to a legally marketed device, the
manufacturer or distributor must seek premarket approval of the proposed device
through submission of a PMA application. A PMA application must be supported by
extensive data, including preclinical and clinical trial data, as well as
extensive literature to prove the safety and effectiveness of the device.
Following receipt of a PMA application, if FDA determines that the application
is sufficiently complete to permit a substantive review, FDA will "file" the
application. Under the FDC Act, FDA has 180 days to review a PMA application,
although the review of such an application more often occurs over a protracted
time period, and generally takes approximately two years or more from the date
of filing to complete.

The PMA application approval process can be expensive, uncertain and
lengthy. A number of devices for which premarket approval has been sought have
never been approved for marketing. The review time is often significantly
extended by FDA, which may require more information or clarification of
information already provided in the submission. During the review period, an
advisory committee likely will be convened to review and evaluate the
application and provide recommendations to FDA as to whether the device should
be approved. In addition, FDA will inspect the manufacturing facility to ensure
compliance with FDA's GMP requirements prior to approval of an application. If
granted, the approval of the PMA application may include significant limitations
on the indicated uses for which a product may be marketed.

The Company received clearance of 510(k) premarket notification from the FDA
to market the HydroDot NeuroMonitoring System, HydroSpot and Equinox EEG System
for EEG monitoring and the EP System for certain external defibrillation
applications and RF return during electrosurgical procedures where a combination
of defibrillation and RF return indications is required. The Company believes
that the Patient State Analyzer and other potential products currently under
development will be subject to FDA clearance by 510(k) notification, however,
the FDA may require the Company to submit a PMA application for such products.
There can be no assurance that the Company will be able to obtain necessary
510(k) clearance or PMA application approval to market the Patient State
Analyzer or any other products, on a timely basis, if at all, and delays in
receipt or failure to receive such 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 the
Company's business, financial condition and results of operations.

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The Company is also required to register as a medical device manufacturer
with the FDA and state agencies and to list its products with the FDA. As such,
the Company will be inspected by both FDA and state agencies for compliance with
the FDA's GMP and other applicable regulations. These regulations require that
the Company manufacture its products and maintain its documents in a prescribed
manner with respect to manufacturing, testing and control activities. Further,
the Company is required to comply with various FDA requirements for design,
safety, advertising and labeling.

The Company is required to provide information to the FDA on death or
serious injuries alleged to have been associated with the use of its medical
devices, as well as product malfunctions that would likely cause or contribute
to death or serious injury if the malfunction were to recur. In addition, the
FDA prohibits an approved device from being marketed for unapproved
applications. If the FDA believes that a company is not in compliance with the
law, it can institute proceedings to detain or seize products, issue a recall,
enjoin future violations and assess civil and criminal penalties against the
company, its officers and its employees. Failure to comply with the regulatory
requirements could have a material adverse effect on the Company's business,
financial condition and results of operations.

The advertising of most FDA regulated products is subject to both FDA and
Federal Trade Commission jurisdiction. The Company also is subject to regulation
by the Occupational Safety and Health Administration and by other governmental
entities.

Regulations regarding the manufacture and sale of the Company's products are
subject to change. The Company cannot predict what impact, if any, such changes
might have on its business, financial condition or results of operations.

INTERNATIONAL

International sales of the Company's products are subject to the regulatory
agency product registration requirements of each country. The regulatory review
process varies from country to country. The Company has relied on its
international distributors to obtain necessary foreign regulatory approvals for
sales of its products overseas. The Company also intends to seek any necessary
additional regulatory approvals in certain European countries and in Japan in
connection with future marketing and sales efforts in these countries. The
Company anticipates that it will rely on OEM partners and distributors for
assistance in obtaining any future international regulatory approvals. There can
be no assurance, however, that the Company will secure additional international
OEM partners or distributors or that international regulatory approvals, if
sought, will be obtained on a timely basis or at all.

In connection with future sales in the European market, the Company
anticipates that it will implement policies and procedures which will allow the
Company's manufacturing and quality assurance processes to receive ISO 9001
certification. ISO 9001 standards for quality operations have been developed to
ensure that companies know, on a worldwide basis, the standards of quality to
which they will be held. The European Union has promulgated rules which require
that medical products receive by mid 1998 the CE mark, an international symbol
of quality and compliance with applicable European medical device directives.
Failure to receive CE mark certification will prohibit the Company from selling
its products in Europe. There can be no assurance that the Company will be
successful in meeting certification requirements. ISO 9001 certification is one
of the CE mark certification requirements.

THIRD PARTY REIMBURSEMENT

In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices such as the Company's 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 therapeutic and diagnostic catheterization procedures. Reimbursement for
neurophysiological monitoring procedures performed using devices that have
received FDA clearance or approval has generally been available in the United
States. The Company anticipates that in a capitated payment system, such as the
DRG system

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utilized by Medicare and many managed care systems used by private health care
payors, the cost of the Company's products will be incorporated into the overall
cost of the procedure and that there will be no separate, additional
reimbursement for the Company's products.

Internationally, future market acceptance of the Company's products may 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. The main types of health
care payment systems in international markets are government sponsored health
care and private insurance. There can, however, be no assurance that
reimbursement for procedures performed using the Company's products will be
available in international markets under either governmental or private
reimbursement systems.

The Company could be adversely affected by changes in reimbursement policies
of governmental or private health care payors, particularly to the extent any
such changes affect reimbursement for procedures in which the Company's products
are used. Failure by physicians, hospitals and other users of the Company's
products to obtain sufficient reimbursement from health care payors for
procedures in which the Company's 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 the Company's business,
financial condition and results of operations.

PRODUCT LIABILITY AND INSURANCE

The Company's business involves the risk of product liability claims. The
Company has not experienced any product liability claims to date. Although the
Company maintains product liability insurance with coverage limits of $2 million
per occurrence and an annual aggregate maximum of $3 million, there can be no
assurance that product liability claims will not exceed such insurance coverage
limits, which could have a material adverse effect on the Company, or that such
insurance will be available on commercially reasonable terms or at all.

EMPLOYEES

As of December 31, 1998, the Company had 36 full time employees. Of these
employees, 16 were engaged in research and development activities, 6 in
manufacturing and manufacturing engineering, 6 in quality assurance and
regulatory affairs, 3 in sales and marketing and 5 in general and administrative
functions. No employees are covered by collective bargaining agreements, and the
Company believes it maintains good relations with its employees. In addition,
with its focus on the development of the PSA and transition from E - Net and
HydroDot products, the Company reduced its workforce to 18 employees on January
31, 1999. See Note 1 to Financial Statements.

ADDITIONAL RISK FACTORS

DEPENDENCE UPON HYDRODOT NEUROMONITORING SYSTEM AND FUTURE PRODUCTS. The
Company received 510(k) premarket notification clearance from the FDA in October
1993 to market the HydroDot NeuroMonitoring System. The HydroDot NeuroMonitoring
System is currently the Company's principal commercial product and is expected
to account for most of the Company's revenue through 1999. However, the Company
anticipates revenues related to the product to decrease significantly in
connection with the Company's focus on the Development of PSA. The Company
commercially introduced the HydroDot NeuroMonitoring System in August 1994.
There can be no assurance that the Company will be able to manufacture these
products in commercial quantities at acceptable costs, or that it will be able
to market such systems successfully. Increases in international sales of these
products will require the Company to obtain foreign regulatory approvals and
secure "OEM" partners or establish foreign distribution capability. If these
products are not commercially successful, the Company's business, financial
condition and results of operations would be materially adversely affected.

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The Company is developing the Patient State Analyzer, which will require
further development and regulatory approvals before it can be marketed in the
United States or internationally. There can be no assurance that the Company's
development efforts will be successful or that the Patient State Analyzer or any
other product developed by the Company will be safe or effective, capable of
being manufactured in commercial quantities at acceptable costs, approved by
regulatory authorities or successfully marketed. If the Patient State Analyzer
is not successfully commercialized, the Company's business, financial condition
and results of operations would be materially adversely affected.

UNCERTAINTY OF MARKET ACCEPTANCE. The Company's HydroDot NeuroMonitoring
System represents a novel method to monitor neurophysiological activity. The
Patient State Analyzer is being designed primarily to monitor the effects of
anesthesia on a patient during medical procedures by analyzing such patient's
neurophysiological activity and alerting the anesthesiologist of changes in this
activity. There can be no assurance that these products or any other products
developed by the Company will gain any significant degree of market acceptance
among physicians, patients and health care payors, even if the necessary
international and United States regulatory approvals are obtained and
distribution channels are established. The Company believes that recommendations
and endorsements by physicians will be essential for market acceptance of the
HydroDot NeuroMonitoring System and Patient State Analyzer and other products
developed by the Company, and there can be no assurance that any such
recommendations or endorsements will be obtained. Physicians will not use the
Company's products unless they determine, based on clinical data and other
factors, that these products are an attractive alternative to other means of
monitoring neurophysiological activity and that the clinical benefits to the
patient and cost savings achieved through use of these products outweigh the
cost of switching to such products from other commercially available
alternatives. In addition, clinical experience with the HydroDot
NeuroMonitoring System indicates that the system may be less effective with, or
may not be suitable for use with, patients with long or thick hair. This may
adversely affect market acceptance of the HydroDot system. Acceptance among
physicians will depend upon the Company's ability to train neurologists,
anesthesiologists and other potential users of the Company's products and the
willingness of such users to learn new patient monitoring methods. Market
acceptance will also be dependent upon acceptance of the Company's products by
hospital administrators and will require the Company to provide evidence to such
administrators of the cost effectiveness and clinical utility of the Company's
products. Failure of the Company's products to achieve significant market
acceptance would have a material adverse effect on the Company's business,
financial condition and results of operations.

LIMITED OPERATING HISTORY AND COMMERCIAL SCALEUP RISK. The Company has a
limited history of operations. Since its inception in January 1990, the Company
has been primarily engaged in research and development of neurophysiological
monitoring products. The Company has sold a small number of units of the
HydroDot NeuroMonitoring System and it has generated only limited revenues from
commercial sales and does not have experience in manufacturing, marketing or
selling its products in quantities necessary for achieving profitability.
Whether the Company can successfully manage the transition to a larger scale
commercial enterprise will depend upon the successful development of its
manufacturing capability, the development of its marketing and distribution
network, obtaining foreign regulatory approvals for the HydroDot NeuroMonitoring
System, and Patient State Analyzer and other potential products and
strengthening its financial and management systems, procedures and controls.
With respect to the Company's proposed Patient State Analyzer System, the
Company will need to develop a sales and marketing effort targeted towards
anesthesiologists, rather than neurologists to whom the Company has previously
marketed its products. Failure to make such a transition successfully would have
a material adverse effect on the Company's business, financial condition and
results of operations. In addition, there can be no assurance that the Company
will achieve significant revenues from either domestic or international sales or
achieve or sustain profitability in the future.

HISTORY OF LOSSES AND EXPECTATION OF FUTURE LOSSES; FLUCTUATIONS IN
OPERATING RESULTS. The Company has experienced significant operating losses
since inception and, as of December 31, 1998 had an accumulated

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deficit of approximately $25.9 million. The development and commercialization of
the Company's current products and other new products, if any, will require
substantial development, clinical, regulatory and other expenditures. The
Company expects its operating losses to continue for at least the next few years
as it continues to expend substantial resources to expand marketing and sales
activities, scale up manufacturing capabilities, increase research and
development and support regulatory and reimbursement approvals. Results of
operations may fluctuate significantly from quarter to quarter and will depend
upon numerous factors, including actions relating to regulatory and
reimbursement matters, the extent to which the Company's products gain market
acceptance, introduction of alternative means for neurophysiological monitoring
and competition.

LIMITED MANUFACTURING, MARKETING AND SALES EXPERIENCE. The Company has only
limited experience in manufacturing the HydroDot NeuroMonitoring System and has
not yet manufactured it in commercial quantities. As a result, the Company has
no experience manufacturing its products in volumes necessary for the Company to
achieve significant commercial sales, and there can be no assurance that
reliable, high volume manufacturing can be achieved at a commercially reasonable
cost. If the Company encounters any manufacturing difficulties, including
problems involving product yields, quality control and assurance, supplies of
components or shortages of qualified personnel, it could have a material adverse
effect on its business, financial condition and results of operations.

The Company has only sold a small number of its HydroDot NeuroMonitoring
Systems in the United States since it obtained 510(k) clearance in October 1993
and does not have experience marketing and selling such products in commercial
quantities. The Company markets and sells its HydroDot NeuroMonitoring System
and intends to market and sell its Patient State Analyzer and other potential
products in the United States through distribution partners, and there can be no
assurance that such distribution partners will effectively market and sell the
Company's products.

Through its distributors, the Company has obtained the regulatory approvals,
if any, required to market and sell its products in certain foreign markets.
However, regulatory requirements vary by region, and compliance with such
regulations may be costly and time consuming. There can be no assurance that the
Company will obtain the necessary regulatory approvals or successfully sell its
products in any additional foreign markets. Additionally, international revenues
are subject to a number of risks, including generally greater difficulties in
accounts receivables collections, financial instability of distributors, failure
of distributors to promote effectively products, longer payment cycles, exposure
to foreign currency fluctuations, and political and economic instability.

If the Company secures the necessary regulatory approvals to sell the
Patient State Analyzer or any other potential products in the United States or
in foreign markets, the Company would have to establish a separate marketing and
sales capability for those products. This would require significant effort and
expense and would be subject to all the risks attendant to establishing a
marketing and sales capability for its current products, including its HydroDot
NeuroMonitoring System. Failure by the Company to successfully market its
products domestically or internationally would have a material adverse effect on
the Company's business, financial condition and results of operations.

RISKS OF INTERNATIONAL SALES. A number of risks are inherent in
international operations and transactions, and the Company will be subject to
such risks to the extent it engages in international sales. International sales
and operations may be limited or disrupted by the imposition of government
controls, changes in regulatory requirements or interpretations thereof, export
license requirements, political instability, trade restrictions, changes in
tariffs, financial instability of distributors, collectibility of receivables,
differences in purchasing systems for medical products, and difficulties in
staffing, coordinating and managing international operations. Additionally, the
Company's business, financial condition and results of operations may be
adversely affected by fluctuations in international currency exchange rates as
well as constraints on the Company's ability to maintain or increase prices.
There can be no assurance that the Company will be able to commercialize
successfully its current or future products in any international market.

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GOVERNMENT REGULATION. The manufacture and sale of medical devices,
including the HydroDot NeuroMonitoring System, Patient State Analyzer and other
potential products, are subject to extensive regulation by numerous governmental
authorities in the United States, principally the FDA and corresponding state
agencies, and in other countries. In the United States, the Company's products
are regulated as medical devices and are subject to the FDA's premarket
clearance or approval requirements. The process of obtaining FDA and other
required regulatory approvals is lengthy, expensive and uncertain, frequently
requiring from one to several years from the date of FDA submission if premarket
approval is obtained at all.

Regulatory approvals, if granted, may include significant limitations on the
indicated uses for which the product may be marketed. In addition, to obtain
such approvals, the FDA and certain foreign regulatory authorities impose
numerous other requirements with which medical device manufacturers must comply.
FDA enforcement policy strictly prohibits the marketing of approved medical
devices for unapproved uses. In addition, product approvals could be withdrawn
for failure to comply with regulatory standards or the occurrence of unforeseen
problems following the initial marketing. The Company will be required to adhere
to applicable FDA regulations regarding GMP and similar regulations in other
countries, which include testing, control and documentation requirements.
Ongoing compliance with GMP and other applicable regulatory requirements will be
monitored through periodic inspections by federal and state agencies and by
comparable agencies in other countries. Failure to comply with applicable
regulatory requirements, including marketing products for unapproved uses, could
result in, among other things, warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, refusal of the government to grant premarket clearance or premarket
approval for devices, withdrawal of approvals and criminal prosecution. Changes
in existing regulations or adoption of new governmental regulations or policies
could prevent or delay regulatory approval of the Company's products. Certain
material changes to medical devices also are subject to FDA review and clearance
or approval.

Sales of medical devices outside of the United States are subject to
international regulatory requirements that vary from country to country. The
time required to obtain approval for sale internationally may be longer or
shorter than that required for FDA approval, and the requirements may differ. In
Europe, the Company will be required to obtain the certifications necessary to
enable the "CE" mark to be affixed to the Company's products in order to sell
products commercially in member countries of the European Union. The Company has
not obtained these certifications, and there can be no assurance it will be able
to do so in a timely manner. Many other countries in which the Company intends
to operate either do not currently regulate medical devices or have minimal
registration requirements; however, these countries may develop more extensive
regulations in the future that could affect the Company's ability to market its
products. In addition, significant costs and requests for additional information
may be encountered by the Company in its efforts to obtain regulatory approvals.
Any such events could substantially delay or preclude the Company from marketing
its products in the United States or internationally.

There can be no assurance that the Company will be able to obtain the
certifications necessary for affixation of the CE mark on the Company's products
or other necessary regulatory approvals or clearances on a timely basis or at
all, and delays in receipt of or failure to receive such approvals or
clearances, the loss of previously obtained approvals, or failure to comply with
existing or future regulatory requirements would have a material adverse effect
on the Company's business, financial condition and results of operations.

INTENSE COMPETITION, TECHNOLOGICAL ADVANCES AND RISK OF
OBSOLESCENCE. Competition in the market for neurophysiological monitoring
devices is intense and could increase. The Company believes its principal
competition will come from existing providers of EEG equipment and electrodes.
Most of the Company's competitors have significantly greater financial,
technical, research, marketing, sales, distribution and other resources than the
Company, as well as greater name recognition. There can be no assurance that the
Company's competitors will not succeed in developing or marketing technologies
and products that are

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more effective or commercially attractive than any that are being developed or
marketed by the Company, or that such competitors will not succeed in obtaining
regulatory approval, introducing or commercializing any such products prior to
the Company. Such developments could have a material adverse effect on the
Company's business, financial condition and results of operations.

RELIANCE ON PATENTS AND PROTECTION OF PROPRIETARY TECHNOLOGY. The Company's
ability to compete effectively will depend in part on its ability to develop and
maintain proprietary aspects of its technology. There can be no assurance that
the Company's issued patents or any patents that may be issued as a result of
the Company's United States or international patent applications will offer any
degree of protection. There can be no assurance that any patents that may be
issued to the Company or any of the Company's patent applications will not be
challenged, invalidated or circumvented in the future. In addition, there can be
no assurance that competitors, many of which 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 the Company's
ability to make, use or sell its products either in the United States or in
international markets.

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. There can be no assurance that the Company will not in
the future become subject to patent infringement claims and litigation or
interference proceedings declared by the USPTO to determine the priority of
inventions. The defense and prosecution of intellectual property suits, USPTO
interference proceedings and related legal and administrative proceedings are
both costly and time consuming. Litigation may be necessary to enforce patents
issued to the Company, to protect trade secrets or knowhow owned by the Company
or to determine the enforceability, scope and validity of the proprietary rights
of others.

Any litigation or interference proceedings will result in substantial
expense to the Company and significant diversion of effort by the Company's
technical and management personnel. An adverse determination in litigation or
interference proceedings to which the Company may become a party could subject
the Company to significant liabilities to third parties or require the Company
to seek licenses from third parties. Costs associated with licensing or similar
arrangements that may be involved in statement of intellectual property
disputes, including patent disputes, may be substantial and could include
ongoing royalties. Furthermore, there can be no assurance that necessary
licenses would be available to the Company on satisfactory terms if at all.
Adverse determinations in a judicial or administrative proceeding or failure to
obtain necessary licenses could prevent the Company from manufacturing and
selling its products, which would have a material adverse effect on the
Company's business, financial condition and results of operations.

In addition to patents, the Company relies on trade secrets and proprietary
know how, which it seeks to protect, in part, through appropriate
confidentiality and proprietary information agreements. These agreements
generally provide that all confidential information developed or made known to
the individual by the Company during the course of the individual's relationship
with the Company, is to be kept confidential and not disclosed to third parties,
except in specific circumstances. The agreements generally provide that all
inventions conceived by the individual in the course of rendering services to
the Company shall be the exclusive property of the Company; however, certain of
the Company's agreements with consultants, who typically are employed on a full
time basis by academic institutions or hospitals, do not contain assignment of
invention provisions. There can be no assurance that proprietary information or
confidentiality agreements with employees, consultants and others will not be
breached, that the Company would have adequate remedies for any breach, or that
the Company's trade secrets will not otherwise become known to or independently
developed by competitors.

UNCERTAINTY RELATING TO THIRD PARTY REIMBURSEMENT. In the United States,
health care providers, such as hospitals and physicians, that purchase medical
devices such as the Company's products, generally rely on

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Third Party payors, principally federal Medicare, state Medicaid and private
health insurance plans, to reimburse all or part of the cost of therapeutic and
diagnostic procedures. Reimbursement for neurophysiological monitoring
procedures performed using devices that have received FDA clearance or approval
has generally been available in the United States. The Company anticipates that
in a capitated payment system, such as the DRG system utilized by Medicare and
many managed care systems used by private health care payors, the cost of the
Company's products will be incorporated into the overall cost of the procedure
and that there will be no separate, additional reimbursement for the Company's
products.

PRODUCT LIABILITY AND RECALL RISK, LIMITED INSURANCE COVERAGE. The
manufacture and sale of medical products entail significant risk of product
liability claims or product recalls. There can be no assurance that the
Company's existing or future insurance coverage limits are or would be adequate
to protect the Company from any liabilities it might incur in connection with
the sale of its products. In addition, the Company may require increased product
liability coverage as its products are commercialized. Such insurance is
expensive and in the future may not be available on acceptable terms, if at all.
A successful product liability claim or series of claims brought against the
Company in excess of its insurance coverage, or a recall of the Company's
products, could have a material adverse effect on the Company's business,
financial condition and results of operations.

DEPENDENCE UPON KEY SUPPLIERS. Physiometrix purchases components used in
its products from various suppliers and relies on single sources for several
components. To date, the Company has not experienced significant component
shortages. Delays associated with any future component shortages could have a
material adverse effect on the Company's business, financial condition and
results of operations, particularly as the Company scales up its manufacturing
activities in support of international commercial sales and United States
commercial sales.

DEPENDENCE UPON KEY PERSONNEL AND MEDICAL ADVISORS. The Company is
dependent upon a number of key management and technical personnel. The loss of
the services of one or more key employees would have a material adverse effect
on the Company. The Company has no employment agreements with any of its key
personnel. The Company's success will also depend on its ability to attract and
retain additional highly qualified management and technical personnel. The
Company faces intense competition for qualified personnel, many of whom are
often subject to competing employment offers, and there can be no assurance that
the Company will be able to attract and retain such personnel. Furthermore, the
Company relies on the services of several medical and scientific consultants,
all of whom are employed on a full time basis by hospitals or academic or
research institutions. Such consultants are therefore not available to devote
their full time or attention to the Company's affairs.

19
<PAGE>
UNCERTAINTY RELATING TO NEW PRODUCT DEVELOPMENT. The Company's strategy
involves the design and development of new products. Products under development
include the Patient State Analyzer. The Company's future revenues, and any
future profitability of the Company, will depend upon the successful completion
of development of and commercial introduction of this product. The product
development process is time consuming and costly, and there can be no assurance
that product development will be successfully completed, that necessary
regulatory approvals or clearances will be granted by the FDA on a timely basis,
or at all, or that any new products developed and introduced by the Company will
achieve market acceptance. Failure by the Company to develop, obtain necessary
regulatory clearances or approvals for, or successfully market, new products,
including in particular the Patient State Analyzer, would have a material
adverse effect on the Company's business, financial condition and results of
operations.

UNCERTAINTY RELATED TO HEALTH CARE REFORM. Political, economic and
regulatory influences are subjecting the health care industry in the United
States to fundamental change. Although Congress has failed to pass comprehensive
health care reform legislation to date, the Company anticipates that Congress,
state legislatures and the private sector will continue to review and assess
alternative health care delivery and payment systems. Potential approaches that
have been considered include mandated basic health care benefits, controls on
health care spending through limitations on the growth of private health
insurance premiums and Medicare and Medicaid spending, the creation of large
insurance purchasing groups, price controls and other fundamental changes to the
health care delivery system. Legislative debate is expected to continue in the
future, and market forces are expected to demand reduced costs. The Company
cannot predict what impact the adoption of any federal or state health care
reform measures, future private sector reform or market forces may have on its
business.

POSSIBLE VOLATILITY OF STOCK PRICE. The stock market has from time to time
experienced significant price and volume fluctuations that are unrelated to the
operating performance of particular companies. These broad market fluctuations
may adversely affect the market price of the Company's Common Stock. In
addition, the market price of the Company's Common Stock is likely to be highly
volatile. Factors such as fluctuations in the Company's operating results,
announcements of technological innovations or new products by the Company or its
competitors, FDA and international regulatory actions, actions with respect to
reimbursement matters, developments with respect to patents or proprietary
rights, public concern as to the safety of products developed by the Company or
others, changes in health care policy in the United States and internationally,
changes in stock market analysts' recommendations regarding the Company, other
medical device companies or the medical device industry generally or general
market conditions may have a significant effect on the market price of the
Common Stock. In addition, it is possible that in a future fiscal quarter, the
Company's results of operations will fail to meet the expectations of stock
market analysts and investors and, in such event, the market price of the
Company's Common Stock would be materially and adversely affected.

20
<PAGE>
ITEM 2. PROPERTIES

The Company leases an approximately 12,000 square foot facility in North
Billerica, Massachusetts. This facility includes manufacturing, laboratory and
office space. The facility is leased through December 14, 1999. The Company
believes these facilities will be adequate to meet its current and reasonably
anticipated future requirements.

ITEM 3. LEGAL PROCEEDINGS

The Company is not party to any legal proceedings.

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

The Company's Common Stock is traded on the Nasdaq National Market (PHYX).
The number of record holders of the Company's Common Stock at January 31, 1999
was 86. The Company has not paid any dividends since its inception and does not
intend to pay any dividends in the foreseeable future.

The Company completed an initial public offering of 2,000,000 shares of
Common Stock in April 1996. Prior to the initial public offering, the Company's
Common Stock was not publicly traded.

Quarterly high and low stock prices are as follows:

<TABLE>
<CAPTION>
QUARTER ENDED HIGH LOW
- ----------------------------------------------------------------------------------------------------- ------- -------
<S> <C> <C>
March 31, 1998....................................................................................... $ 2 1/4 $ 1 1/16
June 30, 1998........................................................................................ $ 2 1/8 $ 1 1/16
September 30, 1998................................................................................... $ 3 13/16 $ 1
December 31, 1998.................................................................................... $ 1 5/8 $ 7/16
</TABLE>

<TABLE>
<CAPTION>
QUARTER ENDED HIGH LOW
- ----------------------------------------------------------------------------------------------------- ------- -------
<S> <C> <C>
March 31, 1997....................................................................................... $ 4 3/8 $ 3 1/4
June 30, 1997........................................................................................ $ 4 1/4 $ 2 5/8
September 30, 1997................................................................................... $ 3 3/8 $ 2 3/8
December 31, 1997.................................................................................... $ 3 $ 2
</TABLE>

21
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------
<S> <C> <C> <C> <C> <C>
1994 1995 1996 1997 1998
------------- ------------- ------------- ------------- -------------
STATEMENTS OF OPERATIONS DATA:
Revenues.............................. $ 72,677 $ 321,835 $ 413,698 $ 1,006,381 $ 596,535
Costs and expenses:
Cost of goods sold.................. 622,765 1,164,268 1,189,510 1,925,316 2,151,889
Research and development............ 741,068 392,413 1,189,336 2,500,601 4,108,451
Selling, general and
administrative.................... 1,756,515 1,575,481 1,652,596 2,739,423 1,935,941
Equipment writeoff.................... -- -- -- -- 337,648
------------- ------------- ------------- ------------- -------------
3,120,348 3,132,162 4,031,442 7,165,340 8,533,929
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
Operating loss........................ (3,047,671) (2,810,327) (3,617,744) (6,158,959) (7,937,394)
Interest income....................... 61,712 75,465 683,461 788,878 406,677
Interest expense...................... (56,551) (36,876) (90,090) (23,016) --
------------- ------------- ------------- ------------- -------------
Net loss.............................. $ (3,042,510) $ (2,771,738) $ (3,024,373) $ (5,393,097) $ (7,530,717)
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
Net Loss per common share (Pro Forma
in 1995)............................ $ (.83) $ (.80) $ (.96) $ (1.33)
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
Shares used in computing net loss per
common share (Pro Forma in 1995).... 3,338,974 3,766,494 5,615,360 5,678,644
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------
<S> <C> <C> <C> <C> <C>
1994 1995 1996 1997 1998
------------ ----------- ------------- ------------- -------------
BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments........................... $ 3,019,483 $ 432,126 $ 18,146,248 $ 11,588,286 $ 4,589,585
Working capital (deficit)............... 2,662,202 (214,710) 16,990,259 11,555,124 4,454,151
Total assets............................ 3,575,565 1,048,000 19,151,982 13,376,170 5,201,374
Notes payable to stockholders, net of
current portion....................... 176,420 82,089 -- -- --
Accumulated deficit..................... (7,204,976) (9,976,714) (13,001,087) (18,394,184) (25,924,901)
Total stockholders' equity.............. 2,814,877 46,944 17,575,615 12,310,052 4,851,264
</TABLE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion of the financial condition and results of
operations of Physiometrix, Inc. should be read in conjunction with the
Financial Statements and related Notes thereto included elsewhere in this Form
10-K. This Report on Form 10-K contains certain forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. Actual events or results may differ
materially from those projected in the forward-looking statements as a result of
the factors described herein and in the documents incorporated herein by
reference. Such forward-looking statements include, but are not limited to,
statements concerning (i) business strategy; (ii) products under development;
(iii) other products; (iv) marketing and distribution; (v) research and
development; (vi) manufacturing; (vii) competition; (viii) government regulation
especially as it relates to

22
<PAGE>
FDA approvals; (ix) third-party reimbursement, (x) operating and capital
requirements and (xi) clinical trials.

OVERVIEW

Since its inception in January 1990, Physiometrix has been engaged primarily
in the design and development and more recently the manufacture and sale of
noninvasive, advanced medical products. The Company's products which incorporate
proprietary materials and electronics technology are used in neurological
monitoring applications. The Company's initial products are its e - Net
headpiece and disposable HydroDot biosensors and custom electronics, which are
packaged as the HydroDot NeuroMonitoring System. The Company also has two
additional neurological monitoring products, the Equinox EEG System which was
commercially introduced in February 1997 and discontinued in June 1998 and the
Patient State Analyzer (PSA), which is currently in clinical trials. The Company
believes that the Patient State Analyzer will be subject to FDA 510(k) clearance
notification. However, the FDA may require the Company to submit a premarket
approval ("PMA") application for this product. There can be no assurance that
the Company will be able to obtain necessary 510(k) clearance or PMA application
approval to market the Patient State Analyzer or any other products on a timely
basis, if at all.

Physiometrix has a limited history of operations and has experienced
significant operating losses since its inception. As of December 31, 1998, the
Company had an accumulated deficit of approximately $25.9 million. The HydroDot
NeuroMonitoring System is currently the Company's principal commercial product
and is expected to account for most of the Company's revenue through 1999. The
Company anticipates that its operating results will fluctuate on a quarterly
basis for the foreseeable future due to several factors, including actions
relating to regulatory and reimbursement matters, the extent to which the
Company's products gain market acceptance, introduction of alternative means for
neurophysiological monitoring and competition. Results of operations will also
be affected by the progress of clinical trials and in house development
activities, and the extent to which the Company establishes distribution
channels for its products domestically and internationally. There can be no
assurance the Company will achieve significant commercial revenues or
profitability.

RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 1998 AND 1997

REVENUES

Revenues decreased 41% to $597,000 for the year ended December 31, 1998 from
$1,006,000 for the year ended December 31, 1997. This decrease is primarily the
result of a lower level of sales of the Company's Equinox EEG System, which was
discontinued in the second quarter of 1998 due to slow demand in the market and
increased competition.

COST OF GOODS SOLD

Cost of goods sold increased 12% to $2,152,000 for the year ended December
31, 1998 from $1,925,000 for the year ended December 31, 1997. This increase was
primarily due to inventory writedowns of $354,000 related to discontinuance of
the Company's Equinox product line and $236,000 related to the net realizable
value of the remaining HydroDot Nueromonitoring inventory. The Company intends
to either license the technology to another company or transition out of the
business by end of June 1999.

GROSS MARGIN

The negative gross profit margin results from fixed headcount and overhead
in the quality assurance and manufacturing groups, as well as, charges related
to the discontinuance of the Equinox product line. The gross margin produced by
the e - Net/HydroDot business has not provided enough sales volume to

23
<PAGE>
cover these fixed expenses. Gross margin related to the HydroDot Nueromonitoring
business in 1998 was consistent with gross margin produced in 1997 in percentage
terms. Pricing of the product did not change in 1998 and material costs of
inventory were comparable to 1997. The Company wrote off the HydroDot
Nueromonitoring inventory to reflect its nominal net realizable value. The
Company intends to either license the technology to another company or
transition out of the business by the end of June 1999.

RESEARCH AND DEVELOPMENT EXPENSES

Research and development expenses consisting principally of salaries,
consulting fees, pilot production units and clinical trial expenses increased
64% to $4,108,000 for the year ended December 31, 1998 from $2,501,000 for the
year ended December 31, 1997. This increase is primarily the result of ongoing
development and clinical evaluation for the Patient State Analyzer including the
assembly of units for the upcoming clinical study. The Company expects the
clinical study to cost approximately $1.1 million, of which approximately
$150,000 of costs have been incurred. The Company expects that the study will be
concluded in the third quarter of 1999. Several areas within the Patient State
Analyzer require testing including hardware to be used in clinical trials, final
versions of software for clinical trials and the electrode set which feeds EEG
data to the device. The Company has no assurance that the testing which will be
undertaken will demonstrate that the device functions adequately to successfully
complete the clinical trials. The Company expects research and development
expenses to decrease significantly in 1999 compared to 1998.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses decreased 29% to $1,936,000 for
the year ended December 31, 1998 from $2,739,000 for the year ended December 31,
1997. This decrease is primarily due to discontinuation of the Equinox product
line which resulted in a reduction of the Company's outside sales force and
related expenses.

WRITEDOWN OF ASSETS

The Company recorded a $338,000 charge in the year ended December 31, 1998
related to long lived assets no longer utilized by the Company in connection
with the discontinuance of the Equinox product line and the net realizable value
of the HydroDot Nueromonitoring equipment. This will result in lower
depreciation expense in 1999 and forward.

INTEREST INCOME AND EXPENSE:

Interest income decreased $382,000 to $407,000 for the year ended December
31, 1998 from $789,000 for the year ended December 31, 1997. This was the result
of a lower average cash balance in 1998 versus 1997. Interest expense decreased
$23,016 to zero for the year ended December 31, 1998, due to the repayment of a
note payable during 1997.

The Company has experienced operating losses since inception and therefore
has not paid any federal income taxes since its inception. The Company accounts
for income taxes under Statement of Financial Accounting Standards No. 109 ("FAS
No. 109"). Realization of deferred tax assets is dependent on future earnings,
if any, the timing and amount of which are uncertain. Accordingly, valuation
allowances, in amounts equal to the net deferred tax assets as of December 31,
1998 and 1997, have been established in each period to reflect these
uncertainties.

At December 31, 1998, the Company had federal net operating loss
carryforwards of $18,300,000 and federal and state tax credit carryforwards of
$409,000, that will expire in varying amounts through 2018, if not utilized.
Utilization of net operating loss and tax credit carryforwards will be subject
to substantial annual limitations provided by the Internal Revenue Code of 1986,
as amended. The annual limitation may result in the expiration of net operating
loss and tax credit carryforwards before full utilization.

24
<PAGE>
YEARS ENDED DECEMBER 31, 1997 AND 1996

Revenues were $1,006,000 in 1997, a $593,000 increase over 1996. This was
primarily the result of increased Equinox sales, which was introduced in early
1997.

Cost of goods sold were $1,925,000 in 1997, an increase of $736,000 over
1996. This is due to increased sales and overhead costs associated with the
increased levels of manufacturing.

Research and development expenses were $2,501,000 in 1997, a $1,311,000
increase from 1996. This is primarily due to the increased personnel and
consulting costs for the development of the Company's Equinox and Patient State
Analyzer (PSA) including clinical trial costs for the PSA.

Selling, general and administrative expenses were $2,739,000 in 1997, an
increase of $1,087,000 over 1996. This was primarily the result of increased
sales and marketing expenses associated with the Equinox product introduction.

Interest income was $789,000 in 1997, an increase of $105,000 over 1996.
This was the result of investing the cash proceeds from the Company's initial
public offering.

Interest expense was $23,000 in 1997, a $67,000 decrease from 1996, due to
the Company paying off $541,000 in borrowings under a revolving credit facility.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 1998, the Company's cash, cash equivalents and short-term
investments were $4,590,000 as compared to $11,588,000 at December 31, 1997.

The Company's operating activities used cash of $6,900,000 in the year ended
December 31, 1998 as compared to $5,634,000 in the year ended December 31, 1997.
The $1,266,000 increase in net cash used in 1998 compared to 1997 was primarily
the result of the increased net loss of the Company.

The Company's financing activities provided cash of $51,000 in the year
ended December 31, 1998 as compared to the use of $549,000 in the year ended
December 31, 1997. The 1997 financing activities included a repayment of the
line of credit of $541,000.

Net cash provided by investing activities in the year ended December 31,
1998 was $2,335,000, as compared with $14,959,000 provided in the year ended
December 31, 1997. The decrease was due to reduced short term investing activity
as the Company attempts to keep its funds liquid to fund operating expenses.

The Company's principal source of liquidity at December 31, 1998 consists of
cash and cash equivalents in the amount of $4,590,000. The Company believes it
has the necessary cash and cash equivalents on hand at December 31, 1998 to fund
its operations and execute its operating plan through May 2000. The Company has
already taken the necessary actions in the first quarter of 1999, to manage its
cash consistent with its operating plan by reducing its workforce to 18
employees and eliminating specifically identified incremental costs including
outside consultants.

The Company believes that the success of the PSA is the most critical
component to the Company's ability to continue as a going concern. The Company's
plan for 1999 is to conduct the final clinical study of the PSA, which is
expected to cost approximately $1 million. The Company has engaged a reputable
third party administrator to oversee the clinical study process in 1999 for a
fee of approximately $400,000. The Company has also engaged a group of six
hospitals to perform the clinical study for an estimated $400,000. The remaining
costs will be incurred through the use of outside consultants. The Company does
not believe the cost of the clinical trials will exceed $1 million. The Company
is in the process of identifying qualified strategic partners to serve as the
contract manufacturer and as the worldwide distributors of the product. The
Company expects to incur $1.6 million of salary and benefit costs for the 18
remaining

25
<PAGE>
employees in 1999 and $690,000 in overhead costs. The Company does not expect
any additional costs in 1999.

Once the Company completes a successful clinical study, secures regulatory
approval and has determined its strategic partners, the Company will require
additional equity funding to engage the contract manufacturer for the production
of the PSA. The Company believes it has sufficient cash to operate through May
2000, which allows management the necessary time to complete these critical
activities. In addition a current investor in the Company has indicated its
intention to financially support the Company through 1999.

In the unlikely event the clinical study is not successful and regulatory
approval is denied, the Company would consider further refinement or development
of the technology or a new technology altogether. Under these circumstances, the
Company would continue to pursue completion of clinical trials, securing
regulatory approval and launching a product based on the technology of the PSA.

Although management and the current investors of the Company do not have any
intention of liquidating the business the Company would consider a sale of the
technology, if in 2000, its cash constraints will not allow it to execute its
plan.

The Company is aware of one other company with similar products to the PSA.
The Company does not believe it will be at a significant disadvantage in
marketing its products against this company.

YEAR 2000 CONSIDERATIONS

The Company has reviewed its computer systems for Year 2000 compliance and
tested whether the systems will conform to Year 2000 requirements. The Company
has brought its internal financial systems into compliance and has determined
that the Patient State Analyzer is Year 2000 compliant. There are no current
products for sale that the Company will continue into Year 2000. The total cost
of this effort did not exceed $50,000 and was completed in November 1998. The
Company is capitalizing the hardware and software components and expensing all
other costs of this effort. The Company does not have exposure due to third
party compliance issues. The Company believes it will incur no additional
expenses related to Year 2000 issues. There are no contingency plans in place as
there is not an identified issue requiring action at this time, but the Company
will continually evaluate issues which may arise that would present a
significant risk to the Company and implement contingency plans if required.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The Report of Independent Auditors, Financial Statements and Notes to
Financial Statements begin on page F-1.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

Not applicable.

26
<PAGE>
PART III

Certain information required by Part III is omitted from this Report on Form
10-K in that the Registrant will file a definitive proxy statement within 120
days after the end of its fiscal year pursuant to Regulation 14A with respect to
the 1999 Annual Meeting of Stockholders (the "Proxy Statement") to be held June
1, 1999 and certain information included therein is incorporated herein by
reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item relating to directors is incorporated
by reference to the information under the caption "PROPOSAL NO. 1 ELECTION OF
DIRECTORS" in the Proxy Statement.

The executive officers of the Registrant, who are elected by the board of
directors, are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
- ----------------------------------------------------- --- -----------------------------------------------------
<S> <C> <C>
John A. Williams 51 President, Chief Executive Officer and Director
Daniel W. Muehl 36 Vice President of Finance & Administration and Chief
Financial Officer
</TABLE>

JOHN A. WILLIAMS joined the Company in December 1993 and has served as a
member of the Board of Directors and as the Company's President and Chief
Executive Officer. Prior to that time, Mr. Williams served as President of Bruel
and Kjaer Medical, a medical device company, from 1990 to 1993. Mr. Williams was
Vice President of Sales and Marketing at Medtronic/AMI, a medical device
company, from 1988 to 1990 and Vice President of Sales and Marketing, Worldwide
at Merrimack Laboratories from 1983 to 1987.

DANIEL W. MUEHL joined the Company in February 1998 as Vice President of
Finance & Administration and Chief Financial Officer. Previously, Mr. Muehl was
Chief Operating Officer and Chief Financial Officer at Number Nine Visual
Technology from 1995 to 1998 and served in various finance positions at
Powersoft Corporation and Medical Care America from 1991 to 1995. Mr. Muehl is a
Certified Public Accountant and served his public accountancy with Ernst & Young
LLP and Laventhol and Horwath from 1985 to 1991.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item is incorporated by reference to the
information under the caption "Executive Compensation" in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this item is incorporated by reference to the
information under the caption "Record Date and Stock Ownership" in the Proxy
Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is incorporated by reference to the
information under the caption "Certain Transactions" in the Proxy Statement.

27
<PAGE>
PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(A) 1. FINANCIAL STATEMENTS

The following Financial Statements of Physiometrix, Inc. and Report of Ernst
& Young LLP, Independent Auditors are in this Form 10-K.

<TABLE>
<CAPTION>
PAGE
-----------
<S> <C>
Report of Independent Auditors........................................................................ F1
Balance Sheets at December 31, 1997 and 1998.......................................................... F2
Statements of Operations for the Years Ended December 31, 1996, 1997 and 1998......................... F3
Statements of Cash Flows for the Years Ended December 31, 1996, 1997 and 1998......................... F4
Statements of Stockholders' Equity for the Years Ended December 31, 1996, 1997 and 1998............... F5
Notes to Financial Statements......................................................................... F6
</TABLE>

2. FINANCIAL STATEMENT SCHEDULES

All schedules are omitted because they are not applicable or the required
information is shown in the Financial Statements or the notes thereto.

3. EXHIBITS

Refer to (c) below.

(B) REPORTS ON FORM 8-K

The Company was not required to and did not file any reports on Form 8-K
during the year ended December 31, 1998.

28
<PAGE>
(C) EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
- --------- ------------------------------------------------------------------------------------------------------
<C> <S>
3.1(1) Restated Certificate of Incorporation of the Company.

3.2(1) Bylaws of the Company, as amended.

4.1(1) Specimen Common Stock Certificate.

4.2(1) Form of Warrant Agreement between the Company and Crutterdon Roth Incorporated, with form of Warrant
attached

10.1(1) Form of Indemnification Agreement between the Company and each of its directors and officers.

10.2(1) 1991 Incentive Stock Plan and Form of Stock Option Agreement thereunder.

10.3(2) 1996 Director Option Plan.

10.4(2) 1996 Employee Stock Purchase Plan and forms of agreements thereunder.

10.5(1) Lease dated October 11, 1994 between the Company and Yvon Cormier, Trustee of YCEE Investment Trust,
for a facility located at Five Billerica Park, 101 Billerica Avenue, North Billerica, Massachusetts
01862.

10.6(1) Restated Shareholder Rights Agreement dated June 24, 1994 between the Company and certain holders of
the Company's securities.

23.1 Consent of Ernst & Young LLP, Independent Auditors.

24.1 Power of Attorney. Reference is made to page F-12

27.1 Financial Data Schedule-1998 Year-End
</TABLE>

- ------------------------

(1) Filed as an Exhibit to the Company's Registration Statement on Form S-1
(File No. 33302138) and incorporated herein by reference.

(2) Filed as an Exhibit to the Company's Registration Statement on Form S-8
(File No. 33316525) and incorporated herein by reference.

29
<PAGE>
REPORT OF INDEPENDENT AUDITORS

THE BOARD OF DIRECTORS AND STOCKHOLDERS
PHYSIOMETRIX, INC.

We have audited the accompanying balance sheets of Physiometrix, Inc. as of
December 31, 1997 and 1998, and the related statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1998. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Physiometrix, Inc. at
December 31, 1997 and 1998, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles.

/s/
ERNST & YOUNG LLP

Boston, Massachusetts
February 4, 1999

F-1
<PAGE>
PHYSIOMETRIX, INC.

BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31
----------------------------
<S> <C> <C>
1997 1998
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents.......................................................... $ 9,104,147 $ 4,589,585
Short-term investments............................................................. 2,484,139 --
Accounts receivable, net of allowance of $25,000 in 1997 and $5,000 in 1998 for
doubtful accounts................................................................ 311,194 87,400
Inventories, net................................................................... 640,131 --
Prepaid expenses................................................................... 81,631 127,276
------------- -------------
Total current assets........................................................... 12,621,242 4,804,261

Equipment, net..................................................................... 662,410 306,795
Due from officer................................................................... 84,000 84,000
Other assets....................................................................... 8,518 6,318
------------- -------------
Total assets....................................................................... $ 13,376,170 $ 5,201,374
------------- -------------
------------- -------------

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable................................................................... $ 621,353 $ 107,447
Accrued expenses................................................................... 444,765 242,663
------------- -------------
Total current liabilities...................................................... 1,066,118 350,110

Commitments and contingencies
Stockholders' equity...............................................................
Preferred stock: $.001 par value; 10,000,000 shares authorized:
Common stock: $.001 par value, 50,000,000 shares authorized; 5,640,825 shares in
1997 and 5,707,366 shares in 1998 issued and outstanding....................... 5,641 5,707
Additional paid-in capital......................................................... 30,698,595 30,770,458
Accumulated deficit................................................................ (18,394,184) (25,924,901)
------------- -------------

Total stockholders' equity......................................................... 12,310,052 4,851,264
------------- -------------

Total liabilities and stockholders' equity......................................... $ 13,376,170 $ 5,201,374
------------- -------------
------------- -------------
</TABLE>

See accompanying notes

F-2
<PAGE>
PHYSIOMETRIX, INC.

STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------
<S> <C> <C> <C>
1996 1997 1998
------------- ------------- -------------
Revenues............................................................. $ 413,698 $ 1,006,381 $ 596,535

Costs and expenses:
Cost of goods sold................................................. 1,189,510 1,925,316 2,151,889
Research and development........................................... 1,189,336 2,500,601 4,108,451
Selling, general and administrative................................ 1,652,596 2,739,423 1,935,941
Equipment writeoffs................................................ -- -- 337,648
------------- ------------- -------------

4,031,442 7,165,340 8,533,929
------------- ------------- -------------
Operating loss....................................................... (3,617,744) (6,158,959) (7,937,394)
Interest income...................................................... 683,461 788,878 406,677
Interest expense..................................................... (90,090) (23,016) --
------------- ------------- -------------

Net loss............................................................. $ (3,024,373) $ (5,393,097) $ (7,530,717)
------------- ------------- -------------
------------- ------------- -------------

Basic net loss per common share...................................... $ (.80) $ (.96) $ (1.33)
------------- ------------- -------------
------------- ------------- -------------

Shares used in computing basic net loss per common share............. 3,766,494 5,615,360 5,678,644
------------- ------------- -------------
------------- ------------- -------------
</TABLE>

See accompanying notes

F-3
<PAGE>
PHYSIOMETRIX, INC.

STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------
<S> <C> <C> <C>
1996 1997 1998
-------------- -------------- --------------
OPERATING ACTIVITIES:
Net loss......................................................... $ (3,024,373) $ (5,393,097) $ (7,530,717)

Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization.................................. 114,640 205,456 166,824
Stock compensation............................................. -- 53,000 21,300
Equipment writeoffs............................................ 325 -- 337,648
Changes in operating assets and liabilities:
Accounts receivable.......................................... 52,716 (272,998) 223,794
Inventories.................................................. (107,927) (360,342) 640,131
Prepaid expenses and other assets............................ (60,236) 20,762 (43,445)
Accounts payable and accrued expenses........................ 443,844 113,321 (716,008)
-------------- -------------- --------------
Net cash used in operating activities............................ (2,581,011) (5,633,898) (6,900,473)

INVESTING ACTIVITIES:
Purchase of equipment............................................ (334,178) (375,028) (148,857)
Proceeds from sale of equipment.................................. 800 -- --
Purchase of available-for-sale securities........................ (150,684,912) (127,696,952) (103,269,408)
Proceeds from maturity of available-for-sale securities.......... 132,866,995 143,030,730 105,753,547
-------------- -------------- --------------
Net cash provided by (used in) investing activities.............. (18,151,295) 14,958,750 2,335,282

FINANCING ACTIVITIES:
Proceeds from (payments on) demand note.......................... 541,334 (541,334) --
Proceeds from notes payable to stockholders...................... 380,428 --
Principal payments on notes payable to stockholders.............. (100,895) (82,236) --
Proceeds from issuance of common stock........................... 19,807,644 74,534 50,629
-------------- -------------- --------------
Net cash provided by (used in) financing activities.............. 20,628,511 (549,036) 50,629
-------------- -------------- --------------

Net increase (decrease) in cash and cash equivalents............. (103,795) 8,775,816 (4,514,562)
Cash and cash equivalents at beginning of year................... 432,126 328,331 9,104,147
-------------- -------------- --------------
Cash and cash equivalents at end of year......................... $ 328,331 $ 9,104,147 $ 4,589,585
-------------- -------------- --------------
-------------- -------------- --------------
</TABLE>

See accompanying notes

F-4
<PAGE>
PHYSIOMETRIX, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
PREFERRED STOCK COMMON STOCK TOTAL
---------------------- ----------------------- ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT PAID-IN-CAPITAL DEFICIT EQUITY
---------- ---------- ---------- ----------- -------------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31,
1995....................... 4,027,662 $ 4,028 134,154 $ 134 $ 10,019,496 $(9,976,714) $ 46,944
Issuance of common stock
pursuant to initial
public offering, net of
issuance costs of
$671,160............... 2,000,000 2,000 19,776,841 19,778,841
Conversion of preferred
stock to common stock
pursuant to initial
public offering........ (4,027,662) (4,028) 3,222,130 3,222 806
Conversion of bridge loan
financing to common
stock pursuant to
initial public
offering............... 62,672 63 689,337 689,400
Deferred compensation
related to stock
options granted........ 56,000 56,000
Issuance of common stock
upon exercise of
options................ 161,368 161 28,157 28,318
Issuance of warrants..... 485 485
Net loss................. (3,024,373) (3,024,373)
---------- ---------- ---------- ----------- -------------- ------------ ------------
BALANCE AT DECEMBER 31,
1996....................... 5,580,324 5,580 30,571,122 (13,001,087) 17,575,615
Issuance of common stock
upon exercise of
options................ 35,861 36 10,088 10,124
Issuance of common stock
under Employee Stock
Purchase Plan.......... 24,640 25 64,385 64,410
Stock compensation....... 53,000 53,000
Net loss................. (5,393,097) (5,393,097)
---------- ---------- ---------- ----------- -------------- ------------ ------------
BALANCE AT DECEMBER 31,
1997....................... 5,640,825 5,641 30,698,595 (18,394,184) 12,310,052
Issuance of common stock
upon exercise of
options................ 29,871 30 18,525 18,555
Issuance of common stock
under Employee Stock
Purchase Plan.......... 36,670 36 32,038 32,074
Stock compensation....... 21,300 21,300
Net loss................. (7,530,717) (7,530,717)
---------- ---------- ---------- ----------- -------------- ------------ ------------
BALANCE AT DECEMBER 31,
1998....................... $ $5,707,366 $ 5,707 $ 30,770,458 ($25,924,901) $4,851,264
---------- ---------- ---------- ----------- -------------- ------------ ------------
---------- ---------- ---------- ----------- -------------- ------------ ------------
</TABLE>

See accompanying notes

F-5
<PAGE>
PHYSIOMETRIX, INC.

NOTES TO FINANCIAL STATEMENTS

1. COMPANY DESCRIPTION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

THE COMPANY

Physiometrix, Inc. (the "Company") is engaged in the development,
manufacturing and marketing of medical devices for use in neurodiagnostic
monitoring in health care. The ultimate success of the Company is dependent upon
the regulatory approval and marketing of its products and its ability to secure
adequate financing until the Company is operating profitably. During 1998, the
Company decided to discontinue the sale of products ancillary to the Company's
core technology to devote all of its resources to the introduction of the
Patient State Analyzer (PSA).

LIQUIDITY

The Company believes that the success of the PSA is the most critical
component to the Company's ability to continue as a going concern. The Company's
plan for 1999 is to conduct the final clinical study of the PSA, which is
expected to cost approximately $1 million. The Company has engaged a reputable
third party administrator to oversee the clinical study process in 1999 for a
fee of approximately $400,000. The Company has also engaged a group of six
hospitals to perform the clinical study for an estimated $400,000. The remaining
costs will be incurred through the use of outside consultants. The Company
does not believe the cost of the clinical trials will exceed $1 million. The
Company is in the process of identifying qualified strategic partners to serve
as the contract manufacturer and as the worldwide distributors of the product.
The Company expects to incur $1.6 million of salary and benefit costs for the 18
remaining employees in 1999 and $690,000 in overhead costs. The Company does not
expect any additional costs in 1999.

Once the Company completes a successful clinical study, secured regulatory
approval and has determined its strategic partners, the Company will require
additional equity funding to engage the contract manufacturer for the PSA. The
Company believes it has sufficient cash to operate through May 2000, which
allows management the necessary time to complete these critical activities. In
addition, one of the Company's current investors has indicated its intention to
financially support the Company through 1999.

The Company is aware of one other company with similar products to the PSA.
The Company does not believe it will be at a significant disadvantage in
marketing its products against this company.

F-6
<PAGE>
PHYSIOMETRIX, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

1. COMPANY DESCRIPTION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
USE OF ESTIMATES

The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

Cash equivalents consist principally of United States Treasury bills and
certificates of deposit with maturities of three months or less at the date of
purchase. In addition, the Company had certain investments in commercial paper,
U.S. government agencies and debt securities, which did not meet the definition
of cash equivalents and have been classified as short-term investments. These
securities are considered available-for-sale securities. The estimated fair
value is equal to the cost of the securities and due to the nature of the
securities, there are no unrealized gains or losses at the balance sheet dates.

CONCENTRATIONS OF CREDIT RISK

The Company places its cash investments in high quality short-term,
interest-bearing investment grade securities including U.S. Treasury securities
and high grade corporate notes. By policy, the Company limits the amount of
credit exposure in any one financial instrument or institution. One customer
accounted for 38% and 34% of accounts receivable at December 31, 1998 and 1997
respectively, and 12% of 1998 revenues and 10% of 1997 revenues.

INVENTORIES

Inventories are stated at the lower of cost (first-in, first-out) or market.

EQUIPMENT

Equipment is recorded at cost and is depreciated using the straight line
method over its estimated useful life of five years.

REVENUE RECOGNITION

The Company recognizes revenue for product sales upon shipment, net of
allowances for discounts and estimated returns which are also provided for at
the time of shipment

STOCK--BASED COMPENSATION

The Company has elected to follow Accounting Principles Board Opinion No. 25
("APB 25"), "Accounting for Stock Issued to Employees" and related
interpretations in accounting for its stock-based compensation plans, rather
than the alternative fair value accounting method provided for under Statement
of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for
Stock-Based Compensation," as this alternative requires the use of option
valuation models that were not developed for use in valuing employee stock
options. Under APB 25, where the exercise price of options granted under these
plans equals the market price of the underlying stock on the date of grant, no
compensation expense is required.

F-7
<PAGE>
PHYSIOMETRIX, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

1. COMPANY DESCRIPTION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
NET LOSS PER COMMON SHARE

Basic net loss per share represents net loss divided by weighted average
shares outstanding. Diluted earnings per share is not presented as the Company
has generated net losses in 1996, 1997 and 1998.

ACCOUNTING PRONOUNCEMENTS

The Company adopted SFAS No. 130, "Reporting Comprehensive Income," and SFAS
No. 131, "Disclosures About Segments of an Enterprise and Related Information"
in 1998. The new accounting standards have no impact on the Company's financial
statements.

In June 1998, SFAS No. 133, "Accounting For Derivative Instruments and
Hedging Activities" was issued which is effective for fiscal year 2000. The
Company believes that the adoption of this statement will not have a material
impact on the Company's financial statements.

2. INVENTORIES

Inventories consisted of raw materials of $405,446, work in progress of
$67,391 and finished goods of $167,294 at December 31, 1997. Due to the
anticipated discontinuance of the HydroDot Nueromonitoring System, a product
ancillary to the company's technology, the company has disposed of or fully
reserved for related inventory.

3. EQUIPMENT

Equipment consists of the following at December 31:

<TABLE>
<CAPTION>
1997 1998
---------- ----------
<S> <C> <C>
Computer equipment................................................... $ 602,726 $ 339,768
Machinery and equipment.............................................. 549,879 245,849
---------- ----------
1,152,605 585,617
Accumulated depreciation............................................. (490,195) (278,822)
---------- ----------
$ 662,410 $ 306,795
---------- ----------
---------- ----------
</TABLE>

4. ACCRUED EXPENSES

Accrued expenses consist of the following at December 31:

<TABLE>
<CAPTION>
1997 1998
---------- ----------
<S> <C> <C>
Payroll............................................................... $ 169,056 $ 110,487
Professional fees..................................................... 141,425 121,737
Other................................................................. 134,284 10,439
---------- ----------
$ 444,765 $ 242,663
---------- ----------
---------- ----------
</TABLE>

F-8
<PAGE>
PHYSIOMETRIX, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

5. LEASES

The Company leases its administrative and manufacturing facility under a
non-cancelable operating lease which expires in December 1999. Future minimum
operating lease payments as of December 31, 1998 are as follows:

<TABLE>
<S> <C>
1999.............................................................. $ 140,371
2000.............................................................. 9,135
---------
Total minimum lease payments...................................... $ 149,506
---------
---------
</TABLE>

Total rent expense was approximately $96,000 in 1996, $115,000 in 1997 and
$144,000 in 1998.

6. STOCKHOLDERS' EQUITY

The Company is authorized to issue 10,000,000 shares of preferred stock,
$.001 par value, in one or more series, each of such series to have such rights
and preferences, including voting rights, dividends rights, conversion rights,
redemption privileges and liquidation preferences, as shall be determined by the
Board of Directors.

The Company has issued warrants to purchase 100,000, 6,000 and 52,227 shares
of common stock at $13.20, $11.00 and $6.60 per share respectively, expiring in
2001. At December 31, 1998, 1,449,919 shares of common stock have been reserved
for issuance upon exercise of common stock warrants and stock options.

7. EMPLOYEE BENEFIT PLANS

STOCK OPTION PLANS

The Company's 1991 Incentive Stock Plan (the Plan) provides for the issuance
of incentive and nonstatutory common stock options to employees, officers and
consultants. The Plan provides for the granting of up to 1,500,000 options to
purchase shares of the Company's common stock. Except for nonstatutory options,
the exercise price of the options granted under the Plan may not be less than
100% of the fair market value of the common stock subject to the option on the
date of grant as determined by the Board of Directors. Generally, options
granted under the Plan vest over a four-year period and expire ten years from
the date of grant.

The Company's 1996 Director Option Plan (The Director Plan) provides that
each nonemployee director who becomes a director will be granted a nonstatutory
option to purchase 15,000 shares of common stock at its then fair market value.
Annually thereafter, each nonemployee director will be granted a nonstatutory
option to purchase 5,000 shares of common stock as its then fair market value.
All options will vest ratably over four years and expire ten years after date of
grant. A total of 110,000 shares of common stock are available for grant under
the Director Plan.

F-9
<PAGE>
PHYSIOMETRIX, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

7. EMPLOYEE BENEFIT PLANS (CONTINUED)
A summary of option activity for the two plans is as follows:

<TABLE>
<CAPTION>
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
1996 PRICE 1997 PRICE 1998 PRICE
------------- ------------- ------------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning of year......... 748,228 $ .30 685,681 $ 1.03 847,561 $ 1.51
Granted.................................. 109,400 4.59 246,100 2.78 592,650 1.21
Canceled................................. (10,597) .33 (48,359) 1.97 (464,424) 2.47
Exercised................................ (161,350) .11 (35,861) .28 (29,871) .62
------------- ------------- -----------
Outstanding at end of year............... 685,681 $ 1.03 847,561 $ 1.51 945,916 $ .87
------------- ------------- ------------- ----- ----------- -----
------------- ------------- ------------- ----- ----------- -----
Price Range at end of year............... $ .04-$6.25 $ .04-$6.25 $ .04-$4.00
------------- ------------- -----------
------------- ------------- -----------
Exercisable at end of year............... 327,493 $ .55 513,668 $ 1.03 574,199 $ .76
------------- ------------- ------------- ----- ----------- -----
------------- ------------- ------------- ----- ----------- -----
Available for grant at end of year....... 671,743 474,002 345,776
------------- ------------- -----------
------------- ------------- -----------
</TABLE>

The following table presents weighted average price and life information
about significant option groups outstanding at December 31, 1998:

<TABLE>
<CAPTION>
EXERCISE OPTIONS OPTIONS
PRICE OUTSTANDING EXERCISABLE
- ----------- ----------- -----------
<S> <C> <C>
$.04-$.63... 434,766 405,729
$.75-$4.00.. 511,150 168,470
----------- -----------
945,916 574,199
----------- -----------
----------- -----------
</TABLE>

The weighted average contractual life of options outstanding at December 31,
1997 and 1998 was 8.2, 7.9 years and 7.5 years, respectively. The weighted
average fair value of options granted in 1996, 1997 and 1998 was $2.93, $2.38
and $1.13.

Pro forma information regarding net loss and net loss per share was computed
in accordance with Statement 123, and has been determined as if the Company has
accounted for its employee stock options granted subsequent to December 31, 1994
under the fair value method of that Statement. The fair value for these options
was estimated at the date of grant using a Black-Scholes option pricing model
with the following weighted-average assumptions for 1996, 1997 and 1998
respectively, risk-free interest rate of 6.42%, 5.91% and 4.92%, dividend yield
of 0%, volatility factor of the expected market price of the Company's common
stock of 66%, 118% and 151% and a weighted-average expected life of the option
of 5.5 years. The Company has also included the compensation related to its
Employee Stock Purchase Plan in 1996, 1997 and 1998 under FAS 123 in the pro
forma net loss presented below. For purposes of Pro Forma disclosures, the
estimated fair value of the options is amortized over the options' vesting
period.

F-10
<PAGE>
PHYSIOMETRIX, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

7. EMPLOYEE BENEFIT PLANS (CONTINUED)
The Company has determined that the pro forma net loss per share as computed
under Statement 123 is as follows:

<TABLE>
<CAPTION>
1996 1997 1998
------------- ------------- -------------
<S> <C> <C> <C>
Net loss
As reported.................................... $ (3,024,373) $ (5,393,097) $ (7,530,717)
Pro forma...................................... $ (3,065,572) $ (5,604,513) $ (7,781,080)
Basic net loss per share
As reported.................................... $ (.80) $ (.96) $ (1.33)
Pro forma...................................... $ (.81) $ (1.00) $ (1.37)
</TABLE>

EMPLOYEE STOCK PURCHASE PLAN

Under the 1996 Employee Stock Purchase Plan ("the Purchase Plan") eligible
employees may purchase common stock at a price per share equal to 85% of the
lower of the fair market value of the common stock at the beginning of the
offering period or end of each six month purchase period. Participation in the
offering is limited to 20% of the employees compensation or $25,000 in any
purchase period. The first offering commenced on December 1, 1996 and the
Purchase Plan will terminate April 2006. A total of 150,000 shares of Common
Stock has been reserved for issuance under the Purchase Plan. A total of 24,640
and 36,670 shares of Common Stock were purchased in 1997 and 1998, respectively.

401(K) SAVINGS PLAN

The 401(k) Savings Plan ("Savings Plan") allows all employees that have
attained the age of 21 to make annual, tax-deferred contributions of up to 15%
of their eligible compensation. Annually, the Company may make discretionary
matching contributions based upon a percentage of the employees' contributions.
The Company made no such contributions to the Savings Plan in 1996, 1997 or
1998.

8. INCOME TAXES

Since the Company has incurred only losses since inception, and due to the
degree of uncertainty related to the use of the loss carryforwards, the Company
has fully reserved this benefit. At December 31, 1998, the Company had tax net
operating loss carryforwards of approximately $18.3 million available to offset
federal taxable income. The Company also has research and development tax credit
carryforwards of approximately $409,000 available to offset federal and state
income taxes. Both carryforwards expire in varying amounts through 2018. The
Company also had approximately $17.0 million in net operating loss carryforwards
to offset state taxable income. This carryforward expires in varying amounts
through 2003. In accordance with Section 382 of the Internal Revenue Code, the
use of the above carryforwards will be subject to annual limitations based upon
ownership changes of the Company's stock which have occurred.

F-11
<PAGE>
PHYSIOMETRIX, INC.

NOTES TO FINANCIAL STATEMENTS (CONTINUED)

8. INCOME TAXES (CONTINUED)
Significant components of the Company's deferred income taxes are as follows
as of December 31:

<TABLE>
<CAPTION>
1997 1998
------------- -------------
<S> <C> <C>
Net operating loss carryforwards................................ $ 5,004,000 $ 7,261,000
Research and development costs.................................. 1,831,000 2,510,000
Research and development tax credits............................ 284,000 409,000
Other........................................................... 134,000 4,000
------------- -------------
7,253,000 10,184,000
Valuation allowance............................................. (7,253,000) (10,184,000)
------------- -------------
Net deferred tax asset.......................................... $ -- $ --
------------- -------------
------------- -------------
</TABLE>

The valuation allowance increased by $2,931,000 in 1998 due primarily to the
unbenefitted net operating loss incurred in 1998. The tax net operating loss
carryforward differs from the accumulated deficit principally due to temporary
differences in the recognition of certain revenue and expense items for
financial and tax reporting purposes, consisting primarily of research and
development costs.

9. RELATED PARTY TRANSACTIONS

Certain of the Company's legal services, principally related to patent
matters, are provided by a firm which is affiliated with a director/shareholder.
Payments to this company amounted to approximately $51,000, $23,900 and zero in
1996, 1997 and 1998, respectively.

The Company has a loan outstanding to an officer in the amount of $84,000 at
December 31, 1998 which is due in installments periodically from 1999 to 2002.
The loan accrued interest at the applicable federal rate (6.31% at December 31,
1998).

F-12
<PAGE>
SIGNATURES

Pursuant to the requirements of the Securities Act, the Registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

PHYSIOMETRIX, INC.

BY: /S/ JOHN A. WILLIAMS
------------------------------------------
John A. Williams
PRESIDENT AND CHIEF EXECUTIVE OFFICER

KNOW ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints John A. Williams and Daniel W. Muehl,
jointly and severally, his or her attorneys in fact, and each with the power of
substitution, for him or her in any and all capacities, to sign any amendments
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said attorneys in
fact, or his or her substitute or substitutes, may do or cause to be done by
virtue thereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated.

SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------
President, Chief Executive
/s/ JOHN A. WILLIAMS Officer
- ------------------------------ and Director March 31, 1999
John A. Williams (Principal Executive
Officer)
Vice President and Chief
/s/ DANIEL W. MUEHL Financial Officer
- ------------------------------ (Principal Financial and March 31, 1999
Daniel W. Muehl Accounting Officer)
/s/ THOMAS BARUCH Director
- ------------------------------ March 31, 1999
Thomas Baruch
/s/ JAMES E. NICHOLSON Director
- ------------------------------ March 31, 1999
James E. Nicholson
/s/ THOMAS J. TOY Director
- ------------------------------ March 31, 1999
Thomas J. Toy
<PAGE>
EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
- --------- -----------------------------------------------------------------------------------------------------
<C> <S>

3.1(1) Restated Certificate of Incorporation of the Company.

3.2(1) Bylaws of the Company, as amended.

4.1(1) Specimen Common Stock Certificate.

4.2(1) Form of Warrant Agreement between the Company and Crutterdon Roth Incorporated, with form of Warrant
attached

10.1(1) Form of Indemnification Agreement between the Company and each of its directors and officers.

10.2(1) 1991 Incentive Stock Plan and Form of Stock Option Agreement thereunder.

10.3(2) 1996 Director Option Plan.

10.4(2) 1996 Employee Stock Purchase Plan and forms of agreements thereunder.

10.6(1) Restated Shareholder Rights Agreement dated June 24, 1994 between the Company and certain holders of
the Company's securities.

23.1 Consent of Ernst & Young LLP, Independent Auditors.

24.1 Power of Attorney. Reference is made to page F-12

27.1 Financial Data Schedule-1998 Year-End
</TABLE>

(1) Filed as an Exhibit to the Company's Registration Statement on Form S-1
(File No. 33302138) and incorporated herein by reference.

(2) Filed as an Exhibit to the Company's Registration Statement on Form S-8
(File No. 33316525) and incorporated herein by reference.

<PAGE>

EXHIBIT 23.1

Consent of Ernst & Young LLP, Independent Auditors

We consent to the incorporation by reference in the Registration Statement
(Form S-8 No. 33-16525) pertaining to the Physiometrix, Inc. 1991 Stock Plan,
1996 Director Option Plan, and 1996 Employee Stock Purchase Plan of our
report dated February 4, 1999, with respect to the financial statements of
Physiometrix, Inc. included in the Annual Report (Form 10-K) for the year
ended December 31, 1998.

/s/
ERNST & YOUNG LLP

Boston, Massachusetts
March 31, 1999

<PAGE>
<ARTICLE> 5

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 4,589,585
<SECURITIES> 0
<RECEIVABLES> 87,400
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 4,804,261
<PP&E> 585,617
<DEPRECIATION> (278,822)
<TOTAL-ASSETS> 5,201,374
<CURRENT-LIABILITIES> 350,110
<BONDS> 0
0
0
<COMMON> 5,707
<OTHER-SE> 4,845,557
<TOTAL-LIABILITY-AND-EQUITY> 5,201,374
<SALES> 0
<TOTAL-REVENUES> 596,535
<CGS> 2,151,889
<TOTAL-COSTS> 8,533,929
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 0
<INCOME-TAX> 0
<INCOME-CONTINUING> (7,937,394)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
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