PACIFIC BIOMETRICS INC, 10KSB, 1997-09-29

PACIFIC BIOMETRICS INC
10KSB, 1997-09-29
COMMERCIAL PHYSICAL & BIOLOGICAL RESEARCH

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U.S. Securities and Exchange Commission
Washington, D.C. 20549

FORM 10-KSB

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended June 30, 1997 Commission File Number 0-21537
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PACIFIC BIOMETRICS, INC.
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(Exact name of small business issuer specified in its charter)

Delaware 93-1211114
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(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)

1370 Reynolds Avenue, Suite 119, Irvine, CA 92614
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(Address of principal executive offices)

714-263-993
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(Issuer's telephone number)

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value per share Redeemable Common Stock
Purchase Warrants

Indicate by check mark whether the registrant (1) filed all reports required to
be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
(or 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 the 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 registrants knowledge, in definitive proxy of information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. [ ]

The issuer's revenues for the year ended June 30, 1997 were $2,788,570.

As of September 25, 1997 there were 3,705,522 outstanding shares of common
stock, par value $0.01 per share. The aggregate market value of the voting
stock of the registrant held by non-affiliates of the registrant on September
25, 1997 based on the average bid and asked price on such date was $9,383,806.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of Form 10-KSB is incorporated herein by
reference to the registrant's definitive Proxy Statement relating to its 1997
Annual Meeting of Stockholders which will be filed with the Commission within
120 days after the end of the registrants fiscal year.

Traditional Small Business Disclosure Format: Yes ( ) No ( X )

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PACIFIC BIOMETRICS, INC.

INDEX TO FORM 10-KSB

PART 1 Page
----

ITEM 1 - BUSINESS........................................................ 3

ITEM 2 - PROPERTIES...................................................... 14

ITEM 3 - LEGAL PROCEEDINGS............................................... 14

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............. 14

PART II

ITEM 5 - MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS......................................................... 15

ITEM 6 - MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND PLAN OF OPERATION.................... 15

ITEM 7 - FINANCIAL STATEMENTS............................................ 19

ITEM 8 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURES............................ 19

PART III

ITEM 9 - DIRECTORS AND OFFICERS OF THE REGISTRANT........................ 20

ITEM 10 - EXECUTIVE COMPENSATION.......................................... 20

ITEM 11 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT................................................. 20

ITEM 12 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................. 20

ITEM 13 - EXHIBITS AND REPORTS ON FORM 8-K................................ 20

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PART I

ITEM 1 - BUSINESS

GENERAL

Pacific Biometrics, Inc. ("PBI-Delaware" or the "Company") was incorporated
in Delaware in May 1996. PBI-Delaware was formed in connection with the
acquisition of BioQuant, Inc. ("BioQuant"), a Michigan corporation, and Pacific
Biometrics, Inc. ("PBI"or "PBI-WA"), a Washington corporation. On June 28,
1996, the Company completed the mergers whereby BioQuant and PBI-WA became
wholly-owned subsidiaries of the Company in separate stock-for-stock exchange
transactions.

In 1993, BioQuant acquired a license to utilize skin patch technology for use
in the field of osteoporosis. In 1995, BioQuant acquired rights to antibodies
specific to biochemical markers of bone loss for use with the skin patch
technology. The Company has focused its efforts on developing a product,
Osteopatch-TM-, that the Company believes will become a useful indicator of bone
loss leading to osteoporosis.

The Company's BioQuant subsidiary was founded in 1985 and conducted extensive
research and development, mostly funded by government grants, relating to
various immunoassays. In 1989, BioQuant patented a device known as the
SalivaSac-Registered Trademark- that facilitates the collection of saliva
without contamination from enzymes, food particles, mucopolysaccharides, blood,
and other particulate matter.

The Company's PBI-WA subsidiary was founded in 1989 and operates a specialty
reference laboratory based in Seattle, WA. In January 1995, PBI-WA merged with
one of its former clients, Merchant House Scientific, Inc. This merger enabled
PBI-WA to offer its first disposable product to the laboratory testing market,
SPINPRO-Registered Trademark-, a sample preparation device which simplifies and
improves the methods for performing certain kinds of tests in the laboratory
setting.

The synergies among PBI-WA and BioQuant, through the technical expertise and
research capabilities of their respective personnel, have expedited current
development of the Osteopatch-TM- product and the development of
SalivaSac-Registered Trademark- diagnostic applications. Additionally, the
Company anticipates that its laboratory facilities will be positioned to capture
a significant portion of the analysis revenues which will be associated with the
Osteopatch-TM- product.

CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. Except for historical
matters, the matters discussed in this Form 10-KSB are forward-looking
statements that involve risks and uncertainties. The following sections contain
forward-looking statements of management's beliefs based on, among other things,
assumptions made by, and information currently available to management,
including management's own knowledge and assessment of the Company's industry,
competition and current regulatory environment. Such forward-looking statements
involve risks and uncertainties that could cause actual results to differ
materially.

BUSINESS OVERVIEW

The Company is a development stage company engaged in the research and
commercialization of non-invasive diagnostic products for the detection and
management of chronic disease. In addition, the Company operates a premier
reference laboratory for measurement of disease risk factors such as cholesterol
for coronary heart disease.

The Company's core technologies relate to the concept of using human sweat or
saliva as the diagnostic medium. Many diagnostic analytes found in blood are
also found in sweat and saliva. The traditional diagnostic fluids for the past
100 years have been blood and urine. This has been the case partly due to the
lack of sample collection and processing technology that could make other fluids
such as sweat and saliva viable diagnostic options. One of the

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distinguishing features of the Company as compared to other development stage
companies is its level of diversification. Besides having more than one product
and technology, the Company also has a successful clinical trial reference lab.

The Company's focus is to (i) finalize development and commercialize the
Osteopatch-TM-; (ii) expand its specialty reference laboratory business; and
(iii) evaluate the feasibility of non-invasive glucose testing using
SalivaSac-Registered Trademark-.

OSTEOPOROSIS. The human body and its major organs are supported and
protected by a matrix of connective tissues. Major connective tissue systems in
the body include bone, cartilage, tendons and skin. The body's principal
connective tissue systems are bone and cartilage. Major diseases and disorders
affecting bone and cartilage include osteoporosis, Paget's disease, cancers that
metastasize to bone, osteoarthritis and other disorders. Many of these diseases
and disorders can be disabling, can affect the quality of life, and can
eventually lead to death.

Bone is a dynamic tissue that is continually regenerated and remodeled. This
process consists of bone formation and resorption (loss) and is necessary to
maintain skeletal integrity. Between 10 percent and 20 percent of the adult
skeleton is replaced each year by the remodeling process. From childhood to
early adulthood, bone formation exceeds resorption, causing bone mass to
increase. After reaching peak bone mass between the ages of thirty and forty,
bone resorption begins to exceed formation, and both men and women experience a
slow, age-related phase of bone loss, lasting for the rest of their lives. Many
women also experience an accelerated phase of bone loss for several years
following menopause, primarily due to the cessation of estrogen production.

Bone resorption occurs when cells called "osteoclasts" excavate small pits
throughout the bone. This process is followed by bone formation, in which cells
called "osteoblasts" produce and deposit bone collagen to fill the pits
excavated by the osteoclasts. Remodeling takes place continuously throughout
the skeleton, at multiple locations and in different phases at the same time.
The osteoclastic and osteoblastic processes produce fragments of collagen and
other proteins, which are released into the bloodstream and eventually appear in
other bodily fluids, including urine and perspiration.

In general, the bone resorption and formation processes are tightly coupled
and balanced. When this process becomes unbalanced or exaggerated, bone disease
occurs. Additionally, certain drugs or medications can have an adverse side
effect of increasing bone loss.

Osteoporosis is a disease characterized by low bone mass and a deterioration
of the structural integrity of bone, which significantly increases the risks of
bone fractures, primarily of the spine, hip, wrist and pelvis, and of back pain
and spinal deformity. There are three basic forms of osteoporosis: (i)
postmenopausal osteoporosis; (ii) age-associated osteoporosis, affecting men and
women over the age of seventy; and (iii) idiopathic osteoporosis, affecting
premenopausal women and middle-aged men and of unknown cause. In addition,
there is a related condition known as secondary osteoporosis, in which bone loss
results from an identifiable agent or disease, such as certain gastrointestinal
diseases or the use of steroids to treat autoimmune diseases.

By far the most common form of osteoporosis is postmenopausal osteoporosis,
which accounts for approximately 80 percent of the individuals who suffer from
osteoporosis. Postmenopausal osteoporosis typically begins to affect women
within fifteen to twenty years after menopause as a result of an accelerated
rate of bone resorption related to an estrogen deficiency caused by menopause.

Osteoporosis is widespread and represents a major health care problem. An
estimated 28 million Americans and more than 75 million people worldwide suffer
from osteoporosis. In the U.S. alone, approximately 1.5 million hip and other
bone fractures occur each year as a result of osteoporosis. Many of the elderly
women and men who incur these fractures are confined to wheelchairs or have to
enter nursing homes as a result and may also suffer additional complications.

According to the National Osteoporosis Foundation, forty percent of all women
in the U.S. will have at least one fracture by the age of seventy. Expenditures
related to osteoporosis currently exceed $14 billion annually in the U.S. and
$10 billion in Europe with such costs expected to triple by the year 2020
resulting from the expected increase

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in the aged population. The Company believes that delaying the onset of severe
osteoporosis could reduce the incidence of fractures and thereby result in
treatment cost savings and improved quality of life.

THERAPEUTIC OPTIONS. Treatment exists to prevent continued bone loss, but as
yet there is no effective treatment to restore bone mass in individuals with
advanced osteoporosis.

Estrogen replacement therapy, calcium supplementation and exercise are used
to prevent or at least forestall continued bone loss. In the U.S., estrogen
replacement therapy is the treatment of choice for women with postmenopausal
osteoporosis. Recent studies suggest that estrogen replacement therapy is
required for a minimum of seven years following menopause (and possibly for
life) in order to provide protection against osteoporosis.

Estrogen replacement therapy has a number of potential side effects,
including increased risk of endometrial cancer, possibly increased risks of
breast and other cancers, and increased risks of gallbladder disease. As a
result, approximately 70 percent of American women taking estrogen (which is
prescribed for a number of purposes, including the treatment of menopausal
symptoms and the prevention of cardiovascular disease) stop doing so after the
first year of use. In addition, recent studies have suggested that the standard
dosage is inadequate to stop bone loss in approximately 15 percent of the women
using estrogen replacement therapy.

The effective use of estrogen replacement therapy is hampered because there
is no effective means of monitoring the rate of bone loss at relatively short
intervals in order (i) to enable patients to decide whether the efficacy of
treatment outweighs the risks of its side effects and (ii) to determine the
approximately 15 percent of the women using estrogen replacement therapy for
whom the standard dosage is inadequate and serves only to expose them to the
side effects of therapy without its benefits.

A number of pharmaceutical companies worldwide are currently developing other
drugs for the treatment of osteoporosis. Most of these new drugs are designed
to stop bone resorption, although some effort is directed toward agents that
will stimulate bone growth. Many of these drugs are in various stages of pre-
clinical and clinical trials in the U.S., Europe and Japan, and some of them are
expected to become commercially available in the next two years. For example,
Merck & Co., Inc. ("Merck") received U.S. Food and Drug Administration ("FDA")
approval in October 1995 for their new bisphosphonate drug, Fosamax-Registered
Trademark-. The bisphosphonates act to stop bone resorption and are expected to
increase the need for diagnostic testing in order to identify those patients who
are losing bone rapidly, and to verify that the dose prescribed is adequate to
stop bone loss in a particular patient. Eli Lilly & Co. and Procter & Gamble
also have new drugs in Phase III clinical trials.

DIAGNOSIS. Osteoporosis is a "silent" disease in which rapid bone loss
occurs years, and even decades, before clinical symptoms appear. Diagnosis of
osteoporosis frequently occurs only at the time of a bone fracture.

At present, bone densitometry involving quantitative computed tomography (in
the case of the vertebrae) and dual-energy absorptiometry (in the case of the
spine and hip), is used to measure the amount of bone loss in order to diagnose
osteoporosis or to assess the risks of osteoporosis. Bone densitometry has a
considerable limitation, however, because it does not permit a convenient
measurement of the rate of bone loss. In order to evaluate the rate of bone
loss, bone densitometry requires a baseline measurement and successive
measurements over a period of one to two years in order to determine the changes
in bone mass of a patient with actively progressing osteoporosis. These
patients experience an average rate of bone loss of 2 to 4 percent per year.
Measurements must be spread over an even longer period in order to measure rates
of bone loss less than 2 to 4 percent annually.

Because of the long period of time required to measure the rate of bone loss,
the Company believes current bone densitometry techniques are not suitable for
general screening of women in the early stages of menopause or for monitoring
the efficacy of treatments for osteoporosis. More recently, biochemical markers
have been identified that are reliable indicators of the rate of bone loss.

In a diagnostic context, a biochemical marker is a chemical produced by the
body whose presence is highly specific to a particular disease or condition.
During the last five years, there has been considerable research devoted to
developing a biochemical marker for bone resorption sufficiently sensitive to
permit rates of resorption to be

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determined.

Most research attention has been directed to four biochemical markers:
Pyridinoline ("Pyd"), Deoxypyridinoline ("Dpd"), N-telopeptide and C-
telopeptide. All of these markers identify the presence of bone collagen
fragments in body fluids. Collagen is the major protein component of bone.
Collagen cross-links provide structural stability and insolubility to collagen
and are released when collagen breaks down during bone resorption.

All the markers appear highly specific to bone loss, although there is debate
in the scientific community on the specificity of each marker. All the markers
have been studied extensively in urine. These studies have shown that (i) the
markers are released into the blood stream (and ultimately into urine, as the
kidneys extract them as a waste) only when mature bone breaks down and not when
new bone is formed, (ii) markers are not metabolized further once released into
the blood stream and thus directly reflect bone resorption and (iii) marker
levels are not affected by diet (e.g. foods containing collagen).

In addition to biochemical markers for resorption, markers have been
discovered for bone formation. These include certain molecules that are
released into the blood as a result of osteoblastic activity, such as alkaline
phosphatase and osteocalcin.

Research suggests that urine tests may not provide the most accurate
information concerning resorption, particularly because urine test results
reflect only a "snapshot" of the patient's bone marker levels which may be
affected by many external variables such as exercise, hormone levels and
medications. Studies have indicated that urine tests to detect signs of
resorption are subject to variations in excess of 30 percent, much too high to
be considered a predictor of risk of osteoporosis. Such variability limits the
utility of urine tests to measuring the effectiveness of resorption-blocking
drugs during treatment only after osteoporosis has been conclusively diagnosed
by other means. This high variability rate could be avoided by using multiple
urine samplings over a twenty-four hour period, but at high cost and
inconvenience to the patient. To date, no effective blood serum test for bone
markers is commercially available, although several are under development. The
Company believes that the Osteopatch-TM- provides a solution to the wide
variations experienced in urine sampling, resulting in a more accurate
measurement of bone loss, which in turn will improve the ability to detect
subtle changes in bone resorption, and, when compared to control group
standards, identify individuals who are losing bone rapidly and are subject to
increased risk of fracture due to osteoporosis.

THE COMPANY'S OSTEOPATCH-TM-

The Company holds exclusive worldwide rights to the use of a transdermal
perspiration collection device, the Osteopatch-TM-, for measuring bone loss that
may assist in the detection of osteoporosis. Eleven patents have been issued to
the inventors of this device, one patent has been granted to the Company and
four additional patents are pending. The Osteopatch-TM- is designed for
extended wear (e.g. several days) and is particularly useful in capturing
biochemical markers via continuous collection from perspiration over an extended
time period. The Company will be measuring markers of bone resorption (loss)
from perspiration as an early indicator of bone loss. Since bone metabolism is
known to vary during the day and from day-to-day, the Company believes the
Osteopatch-TM- will enable the Company to reduce this variation and thereby be
able to distinguish a disease state of bone loss from normal biological
variations due to physical exertion, fluctuating hormone levels and other
factors. Along with the patented collection device, the Company has exclusive
rights to patented antibodies that are specific to known biochemical markers of
bone loss. The Company is developing a proprietary, highly sensitive
immunoassay that can measure the bone loss markers in human perspiration.

The Company has under development a skin patch test to measure both Pyd and
Dpd in perspiration as a screening, monitoring and early diagnostic test for
osteoporosis. Pyd and Dpd are well known biochemical markers of bone resorption
that have been characterized by numerous clinical studies and publications from
around the world. These markers have been reported in the scientific literature
to be highly specific to the breakdown of bone collagen and sensitive to
diseases and therapies affecting bone metabolism and in one recent study,
predictive of osteoporosis associated fractures. The Company has exclusive
rights, relating to bone resorption in human perspiration, to use patented
antibodies for these markers owned by Metra BioSystems, Inc. ("Metra"), a
developer and marketer of bone loss urine tests. The Company expects to
introduce its Osteopatch-TM- test in the U.S. and possibly abroad in 1998,

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following completion of its immunoassay and clinical trials, which introduction
is subject to approval or clearance by the FDA.

The skin patch test is expected to provide patient convenience, ease of
laboratory collection and processing, and superior accuracy. The Company
believes that the "ease of use" of the Osteopatch-TM- will make it attractive to
the "point of care" testing market. Point of care testing occurs in the
physician's office, outpatient sites and in the patient's home. The Company
believes that the point of care testing marketplace will grow substantially over
the next several years.

It is the Company's strategy to develop alliances and distribution agreements
with organizations that either currently market to the point of care testing
marketplace or are positioning themselves for this marketplace, including
pharmaceutical companies, diagnostic distributors, and consumer health related
entities. The Company has had numerous discussions with many entities and
intends to establish strategic relationships after it has filed its 510(k)
application with the FDA.

The Company has also received inquiries from distributors outside the U.S.
and will continue to explore the international marketplace for its products. On
August 12, 1997, the Company announced an agreement with Segix Italia for a
market and technical evaluation of the OsteopatchTM diagnostic system for the
Italian market. At the end of this evaluation agreement, Segix Italia, S.p.A.
("Segix") has an option for an exclusive long term supply and distribution
agreement, for the Italian market.

On August 25, 1997, the Company announced that it had successfully completed
pilot clinical studies with its OsteopatchTM non-invasive skin patch for
potential use in the management of osteoporotic disease. With the successful
completion of its pilot studies, the Company has recruited medical centers
across the U.S. for its main Clinical Utility Study. The results of the study
will be used to support the Company's 510(k) notification application with the
FDA. A combined total of over 300 subjects may be evaluated, and this study is
estimated to take three to four months. Based on discussions with the FDA, the
Company believes the Osteopatch will be reviewed under the Class II medical
devices category and will require a 510(k) notification application. This FDA
review is expected to take up to 6 months to complete. There can be no
assurance that the Company's 510(k) notification application will be accepted or
that the review process will be completed in a timely manner, either of which
events could have a material adverse effect on the Company.

The Company believes that the education of physicians, patients, and insurers
about the long term benefits of early diagnosis and treatment of bone disorders
is important to the success of the Company's products. As managed care becomes
increasingly more prevalent in the U.S., emphasis on disease prevention should
increase along with the demand for early and cost-effective diagnostic tests.
This emphasis on preventive health care along with the availability of advanced
drug therapies for osteoporosis from pharmaceutical companies will continue to
increase the need for cost-effective diagnostic devices that detect osteoporosis
and monitor the effectiveness of drug therapies.

LABORATORY OPERATIONS

The Company has a fully equipped 6,000 square feet laboratory in Seattle,
Washington that supports clinical trials and product development in the
diagnostics and pharmaceutical industries. This facility provides full service
laboratory analysis, development of reference methods, protocol development,
data management and consulting services to a large number of clients. The
Company is planning to relocate the Seattle laboratory to a 14,800 square feet
facility that is currently being renovated. The move is scheduled for the
second quarter of fiscal 1998.

The Company's laboratory has supported numerous Phase I through IV
pharmaceutical clinical trials as well as diagnostic product clinical trials.
The Company's expertise in lipid analysis includes in-house Centers for Disease
Control ("CDC") reference methodologies for total cholesterol, LDL cholesterol,
HDL cholesterol and triglycerides. Research and routine methodologies include
quantitation of lipids and lipoproteins by different techniques such as
fractionation by ultracentrifugation, electrophoresis, chemical precipitation
and various immuno assays. The Company's scientists have been extensively
involved at the national level in developing guidelines for lipid measurements
and method improvement. Many of the current standard lipid methods have been
developed at the

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Company, including the current CDC Designated Comparison Method for HDL
cholesterol.

In the emerging field of osteoporosis laboratory assessments, the Company has
developed a complete test menu for bone metabolism, including the serum markers
of bone formation, the urinary markers of bone resorption, and several related
tests involving measurement of hormones and other substances.

The key services that the Company provides to the diagnostics industry are
conducting laboratory analysis including contract research to assist in product
development, providing reference materials to assess quality of products in
research and development and manufacturing stages, providing proficiency testing
and standardization services, supporting diagnostic clinical trials as a central
specialty laboratory and clinical trial manager, and consulting for regulatory,
strategic, and technical issues related to successful product development.

In both the pharmaceutical and diagnostic market segments, the Company's
central laboratory services are highly regarded for the training and skills of
its scientists and support personnel, the techniques used for laboratory
testing, the quality control measures employed and the Company's ability to
manage complex data efficiently and creatively for its clients.

In addition to expansion of the Company's reference laboratory services, the
Company also expects that its laboratory operations will increase concurrently
with the introduction of the Osteopatch-TM- and that its revenues will increase
proportionately with market acceptance of the Osteopatch-TM-, since the
perspiration collected from the Osteopatch-TM- must be analyzed in a laboratory
setting. It is expected that the Company's laboratory in Seattle, Washington
will conduct a significant portion of the analysis related to the Osteopatch-TM-
product. The reputation of the laboratory for quality, the consistency of doing
all testing from a single laboratory and the inherent advantages of the
Osteopatch-TM- technology are all expected to contribute to physician acceptance
of test results in this emerging new field. Strategically, since the Company
will supply its own assay to use with the Osteopatch-TM-, the Company will have
characteristics of both a diagnostic test kit manufacturer and a clinical
laboratory. This will be an unique combination in the osteoporosis field that
will enable the Company to compete effectively against both clinical
laboratories and diagnostic manufacturers since the Company should benefit from
higher profit margins by providing both services.

SALIVASAC-REGISTERED TRADEMARK-

Saliva is a useful body fluid for diagnostic purposes but is difficult to
handle in the laboratory because it contains mucopolysaccharides, particulate
matter, blood contamination, enzymes and other large molecules. These
substances tend to complicate the processing of saliva, which must be frozen or
centrifuged, and often interfere with sensitive assays used to measure analytes
of medical interest. The Company has a patented saliva collection and
processing device called the SalivaSac-Registered Trademark-. The
SalivaSac-Registered Trademark- is a small device consisting of a semipermeable
outer membrane and containing a small quantity of a substance such as salt or
sugar that acts as an osmotic driver. When the device is placed in the mouth it
rapidly fills with saliva that is filtered as it passes through the
semipermeable membrane. The resulting fluid is clear, easy to use, and does not
contain interfering substances. Based on preliminary studies conducted by the
Company and others, this product has numerous potential applications including
therapeutic drug monitoring, detection of drugs of abuse, measurement of
hormones and analytes of infectious disease.

The Company is also researching applications of this technology for diabetes.
One application, supported by a National Institute of Health ("NIH") Small
Business Innovative Research ("SBIR") grant involves the measurement of saliva
glucose as a non-invasive substitute for blood glucose. While previous attempts
by others to correlate saliva glucose with blood glucose have been unsuccessful,
the Company has had encouraging preliminary results using the
SalivaSac-Registered Trademark- device as it appears to exclude substances that
interfere with accurate glucose measurements. The Company is proceeding with
research on saliva glucose and has an application pending for a Phase II NIH
SBIR grant.

In addition to developing applications for the SalivaSac-Registered
Trademark-, the Company will seek to license the SalivaSac-Registered Trademark-
to others for applications in markets that the Company does not intend to serve
itself. The Company does not believe that any products developed using
SalivaSac-Registered Trademark- will be available for regulatory approval or
test marketing prior to the end of fiscal 1998.

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In July 1997, the Company signed a letter of intent outlining research
collaboration terms with a small privately held company, which has strip assay
technology to support the continued development of a non-invasive glucose test.
Subject to definitive documentation and final negotiation of terms the Company
will have exclusive use of their technology for diabetes testing in saliva.

In September 1997, the Company was awarded a $98,000 SBIR grant to research
non-invasive tests for cholesterol in saliva.

SPINPRO-REGISTERED TRADEMARK-

The Company has licensed a patented technology that simplifies the
preparation of serum samples for tests requiring a separation step prior to
obtaining an analytical result. This technology incorporates the functions of
precise sample measurement, sample separation and reagent dispensing in a
specially designed, multiple chamber sample tube. This low cost, disposable
device enables the accurate and controlled processing of complex tests requiring
a pretreatment step by relatively unskilled laboratory personnel. The Company
has named this new technology "SPINPRO-Registered Trademark-" and has registered
the name as a Company trademark.

The Company has introduced its first SPINPRO-Registered Trademark- product to
the market in the form of a device that facilitates the testing of HDL
cholesterol. A test that previously required tedious off-line preparation in
most laboratories is now greatly facilitated by using the Company's
SPINPRO-Registered Trademark- technology. Since the introduction of this
product alternate advanced technology has been used by competitors to develop
other methods of testing HDL cholesterol thereby increasing competition.

This device is distributed by Sigma Diagnostics ("Sigma"), a large
distributor of diagnostic reagents and products to laboratories in the U.S. and
several European countries. In order to maintain its exclusive distribution
rights, Sigma must purchase the following minimum quantities in the first three
years of the contract: 1.25 million units, 2.75 million units and 4.00 million
units, respectively. Sigma has not purchased units in these quantities but the
Company at this time has not elected to notify Sigma of loss of exclusivity.

The Company was required to make a minimum royalty payment in June 1996 under
the SPINPRO-Registered Trademark- license agreement in order to maintain
exclusivity of the technology. The Company elected not to make such payment and
believes that the loss of exclusivity, of which the Company has not yet been
notified, will not have a material adverse effect on the business or prospects
of the Company.

Production of SPINPRO-Registered Trademark- units is currently suspended as
a result of the termination of a manufacturing agreement with the Company's
prior supplier of the SPINPRO-Registered Trademark- product (see Management's
Discussion and Analysis of Financial Condition and Results of Operations (" MD&
A")). The expected relocation of SPINPRO-Registered Trademark- manufacturing may
further disrupt production while new manufacturing and supply arrangements are
negotiated, however, such disruptions are not anticipated to have a material
effect on the Company's operations or financial condition, since
SPINPRO-Registered Trademark- revenues have not been material to date. The
Company is investigating other applications of its SPINPRO-Registered Trademark-
technology, alternate methods of distribution and joint venture opportunities.

OTHER PRODUCTS

In September 1997, the Company announced that it had signed a letter of
intent with Sudormed, Inc. ("Sudormed") and Sudor Partners, the licensors of the
skin patch for applications of measuring bone loss markers in sweat which is the
basis for the Company's Osteopatch-TM- system. The letter of intent provides
for the acquisition by the Company of an exclusive world-wide license to all
applications for use of the skin patch technology except for those relating to
alcohol and drugs of abuse which have been previously licensed to another
company. The parties have until December 31, 1997 to enter into a definitive
agreement and complete due diligence. If the acquisition of this license is
consummated, the Company intends to examine the potential for the sweat patch
technology in areas such as cardiovascular disease, cancer and pediatrics.

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<PAGE>

BUSINESS STRATEGY

The Company's strategy is to focus on the development of cost-effective,
convenient diagnostic tests and improved laboratory techniques that support the
objectives of early diagnosis, prevention and therapeutic monitoring. Critical
to this strategy is focusing the development of new products in certain disease
areas. The Company, therefore, will strive to be a leader in testing relating
to common, chronic diseases of an aging population, which ensures a large and
growing population for the next two to three decades. Additionally, the Company
anticipates that it will build on its leadership reputation in laboratory
testing and methods in the fields of coronary heart disease and osteoporosis by
aggressively seeking new clinical trial support business from developers of new
therapeutics and diagnostics in these fields, and continue to maintain
leadership in these areas through the support of methods standardization and
proficiency testing. Over time, if feasible, the Company anticipates that it
will build similar capabilities and expertise in diabetes and arthritis testing
and therapeutic monitoring by seeking a role in clinical trials of new products
and technology developed by others.

The Company plans to establish the Osteopatch-TM- as a leading collection and
diagnostic device for risk assessment and management of therapy for osteoporosis
and to develop applications for the SalivaSac-Registered Trademark- to aid in
the treatment of diabetes and other ailments. This strategy includes educating
physicians and other healthcare professionals, forming strategic marketing and
distribution alliances with established market leaders to establish and then
expand market share for the Osteopatch-TM-, maintaining a strong proprietary
position for its products and technology, expanding laboratory operations and
continuing research and development of its products and technologies.

MATERIAL CONTRACTS

The Company has the exclusive rights to certain patents, which it believes
substantially covers the Osteopatch-TM- technology as it relates to osteoporosis
applications. Pursuant to the terms of the Company's license agreement with
Sudor Partners, the Company is required to pay royalties to Sudor Partners. The
Company is required to make minimum royalty payments in the amount of $15,000
each calendar quarter. The license terminates automatically if the Company
should fail to make a royalty payment on the date due. The license is also
terminable in the event (i) of a failure to perform any conditions of the
license agreement, (ii) the Company becomes insolvent or institutes bankruptcy
proceedings, (iii) the Company's assets are seized or attached, (iv) of a
failure to make timely royalty payments and (v) of termination of the supply
agreement discussed below. Upon termination, Sudor Partners acquires title to
any improvements to the patented technology and to any registrations or
approvals of governmental agencies, such as the FDA, relating to products that
incorporate the patented technology. The Company is currently in compliance
with all obligations under the license agreement.

The supply agreement between the Company and Sudormed, an affiliate of Sudor
Partners, provides that Sudormed will manufacture the Osteopatch-TM- for the
Company. Sudormed currently subcontracts manufacture of the patch technology to
The 3M Company. In the event certain specified minimum purchases are not met by
the Company, the license agreement will become non-exclusive. The Company is
required to purchase a minimum of 100,000 Osteopatch-TM- units prior to March
31, 1998. The required minimum purchase amount increases each year through
March 31, 2001, when 2,000,000 units must be purchased. Sudor Partners has the
right to change the price for units in the event that its direct costs of
manufacturing the units changes.

Excluding Japan, the Company is the exclusive worldwide licensee of
antipyridinium crosslinks antibody technology, which is used in the quantitative
measurement of pyridinium crosslinks in all body fluids, from Metra for use in
sweat. The license will convert to a nonexclusive license upon the earlier of
(i) seven years from the first commercial sale of products incorporating the
licensed technology, or (ii) February 15, 2005. The Company is required to pay
a royalty per patient report. The license is terminable (A) upon a material
breach of the license agreement, (B) upon dissolution or liquidation of the
Company, or (C) the Company's failure to invest either (i) $100,000 annually in
the research and development of the licensed technology prior to its submission
for FDA approval or (ii) $40,000 annually in the research and development of the
licensed technology subsequent to its submission for FDA approval. Under the
license agreement, Metra receives a royalty-free, non-exclusive license to use
improvements made by the Company to the Metra anti-body technology. The Company
is currently in compliance with its obligations under this license agreement.

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<PAGE>

The Company had contracted with an outside supplier to manufacture its
SPINPRO-Registered Trademark- HDL product. The Company is obligated under the
manufacturing agreement to reimburse the supplier for certain costs incurred to
produce the product, such as molds and equipment. In January 1997, the Company
received formal notification of termination, effective April 6, 1997, of its
agreement related to the manufacture of the Company's SPINPRO-Registered
Trademark- product. In April 1997, the Company acquired the molds, production
equipment and inventory from the prior manufacturer, as required by the
manufacturing agreement, for approximately $364,000 (see MD & A).

The Company has entered into an agreement with Sigma whereby Sigma has the
exclusive right to distribute the SPINPRO-Registered Trademark- HDL device in
the U.S. and certain European countries and (except for Physician Sales and
Service) throughout the rest of the world on a non-exclusive basis. The
agreement, set to expire October 26, 1998, is automatically renewable for
successive one year terms unless either party otherwise notifies the other of
its intention to terminate. The agreement is terminable in the event (i) of a
failure to observe any material term of the agreement, (ii) either party becomes
insolvent or (iii) if either party is ordered or resolves to windup or liquidate
its business. The Company is currently in compliance with all obligations under
this Agreement.

LICENSED PATENTS AND PROPRIETARY RIGHTS

The Company's success will depend in part on its ability to obtain patent
protection for its products both in the U.S. and other countries. The patent
positions of biotechnology and pharmaceutical firms are generally uncertain and
involve complex legal and factual questions. No consistent policy has emerged
regarding the breadth of claims allowed in biotechnology patents. While the
Company's licensor is currently prosecuting its patent applications, the Company
does not know whether any application will result in the issuance of a patent
or, if any patent is issued, whether claims ultimately allowed thereunder will
provide significant proprietary protection or will be invalidated.

The commercial success of the Company will also depend in part on not
infringing patents or proprietary rights of others, and not breaching licenses
granted to the Company. The Company may be required to obtain licenses to
third-party technology necessary to conduct the Company's business. Any failure
by the Company to license, at a reasonable cost, any technology required to
commercialize its technologies or products would have an adverse impact on the
Company.

Litigation, which could result in substantial cost to the Company, may also
be necessary to enforce any patents issued to the Company's licensor or to
determine the scope and validity of other parties' proprietary rights. If the
outcome of any such litigation is adverse to the Company, the Company's business
could be adversely affected. To determine the priority of inventions, the
Company may have to participate in interference proceedings declared by the U.S.
Patent Office or similar proceedings in foreign patent offices, which could
result in substantial cost to the Company and may result in an adverse decision
as to the priority of the inventions licensed to the Company. The Company
believes there will continue to be significant litigation in the industry
regarding patent and other intellectual property rights.

The Company also relies upon unpatented trade secrets. Others may
independently develop substantially equivalent proprietary information and
techniques, or otherwise gain access to the Company's trade secrets or disclose
such technology. The Company requires its employees and consultants to execute
a confidentiality agreement upon the commencement of an employment or consulting
relationship with the Company. The agreement provides that all confidential
information developed by or made known to an individual during the course of the
employment or consulting relationship generally must be kept confidential. In
the case of employees, the agreement provides that all inventions conceived by
the individual while employed by the Company are the Company's exclusive
property. These agreements may not provide meaningful protection for the
Company's trade secrets in the event of unauthorized use or disclosure of such
information.

GOVERNMENT REGULATION

The development, testing, manufacturing and marketing of the Company's
products are regulated in the U.S. by the FDA. The testing for, preparation of,
and subsequent FDA review of required applications is expensive, lengthy and

11
<PAGE>

uncertain. Moreover, regulatory approval, if granted, can include significant
limitations on the indicated uses for which a product may be marketed. Failure
to comply with applicable regulations can result in fines, suspensions of
approvals, product seizures, injunctions, recalls, operating restrictions and
criminal prosecutions. Delays in receipt of or failure to receive clearances or
approvals for the products of the Company would adversely affect the marketing
of such products and the results of future operations.

Distribution of the Company's products outside the U.S. will also be subject
to regulation which varies from country to country. Japan requires the
submission of clinical data in a manner analogous to the requirements of the
FDA. France requires the submission of clinical data with local content. The
regulatory requirements in all countries, however, are subject to change. In
addition, the export by the Company of certain of its products that have not yet
been cleared for domestic, commercial distribution may be subject to export
restrictions imposed by U.S. regulatory agencies.

Diagnostic products marketed in the U.S. are required to obtain FDA
clearance. The Company intends to seek FDA clearance for the Osteopatch-TM- in
the form of a 510(k) "device" premarket notification procedure to demonstrate
"substantial equivalence" to a legally marketed product. Clinical test data
will be required to demonstrate substantial equivalence. The Company believes
that its 510(k) notification will be acted upon favorably and quickly, although
there can be no assurance that this will be the case. The Company's belief is
based on (i) the fact that the FDA has already cleared the skin patch as a
collection device and may be expected to clear the Osteopatch-TM- as a
collection device for Pyd and Dpd and (ii) the fact that the FDA has cleared
Metra's 510(k) submissions for its immunoassay test kits to measure Pyd and Dpd
levels in "first morning void" urine samples. If the Company is able to
demonstrate a correlation between Pyd and/or Dpd levels in perspiration and
measurable physiologic changes in patients, the Company believes that its
osteoporosis product can be shown to be substantially equivalent to medical
devices (i.e., diagnostic kits for measurement of Pyd and/or Dpd levels in
urine) which the FDA has already cleared for marketing and thus qualifies for
the 510(k) notification procedure. Furthermore, there can be no assurance that
the FDA will not request the development of additional data following the
original submission, causing the Company to incur further cost and delay. Nor
can there be any assurance that the FDA will not restrict the intended use of
the product as a condition for clearance. In addition, the Company's
promotional and educational activities regarding its diagnostic products must
comply with evolving FDA policies and regulations regarding acceptable product
promotion practices.

If the FDA concludes that a device is not substantially equivalent to another
legally marketed device, submission of a pre-market approval ("PMA") application
will be required. If the FDA indicates that a PMA is required for the products
of the Company, the application will require the results of clinical studies and
manufacturing information, and likely review by a panel of experts outside of
the FDA. Clinical studies would need to be conducted in accordance with FDA
requirements. The failure to comply would result in the FDA's refusal to accept
the data or the imposition of regulatory sanctions. FDA review of a PMA can
take significantly longer than that for a 510(k) notification. Further, if a
company wishes to propose modifications to a product subsequent to FDA approval
under a PMA application, including changes in indications or other significant
modifications to labeling, or modifications to the manufacturing process, or if
a company wishes to change its manufacturing facility, a PMA supplement must
first be submitted to the FDA for its review and approval.

The FDA also requires the Company to manufacture its products in compliance
with current Good Manufacturing Practices ("GMP") regulations which govern the
procedures, controls and documentation used in manufacturing the Company's
products. The FDA ensures GMP compliance through periodic facility inspections.
Accordingly, the manufacturer of the components of the Company's products must
comply with these requirements.

The Company's laboratory business is subject to federal regulation by the
Department of Health and Human Services ("HHS") and the FDA. Under the Clinical
Laboratory Improvements Amendments of 1988 and regulations promulgated
thereunder, the Company's laboratory must maintain a certificate of compliance
with the regulatory requirements applicable to the types of clinical testing
performed by the laboratory. These regulatory requirements govern the
laboratory's test methods, quality control procedures and proficiency, and may
be enforced through inspections and proficiency testing by HHS or its designee.
Under the FDA's Good Laboratory Practices regulations, the Company's laboratory
must comply with regulations promulgated by the FDA that govern testing
procedures and quality control procedures relating to non-clinical testing
performed in support of applications for research or marketing

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<PAGE>

permits regulated by the FDA. These regulations may be enforced through
inspections by the FDA. The Company believes it is in substantial compliance
with all government requirements it is subject to.

COMPETITION

The Company expects to experience intense competition from companies
developing biochemical markers with clinical applications for bone resorption.
The Company anticipates that it will face intense competition in attempting to
establish market share. There can be no assurance that the competitive
positions of these competitors or of other companies will not be enhanced
significantly through collaborative arrangements with large pharmaceutical
companies, other companies or academic institutions. The Company's competitors
may succeed in developing, obtaining patent protection for, receiving FDA and
other regulatory approvals for, or commercializing products more rapidly than
the Company. If the Company is successful in commercializing its products, it
will be required to compete, with respect to manufacturing efficiency and
marketing capabilities, in areas that it has limited expertise. The Company
also competes in acquiring products or technology from universities.
Furthermore, rapid technological development could result in actual or proposed
technologies, products or processes of the Company becoming obsolete prior to
successful commercialization.

Certain diseases and disorders targeted by the Company's products can be
diagnosed and monitored using existing imaging technologies, such as dual-energy
X-ray absorptiometry ("DEXA") and new ultrasound technologies are under
development. The Company believes that current imaging systems serve a
different function than products that test for biochemical markers, since the
Company's products can identify a patient's rate of bone loss, while DEXA
measures a patient's existing bone mineral density at a specific moment in time.
In addition, these bone mineral density techniques are relatively expensive and
availability can be limited, especially in rural areas. Two of the leading
companies in this field are Lunar Corporation and Hologic, Inc.

Other companies that measure bone loss through bone markers include Metra and
Ostex, which have allied themselves with larger diagnostic and pharmaceutical
companies. These companies and their strategic alliances have greater
financial, marketing, and other resources than the Company. The Company's
products will have to compete based on technological superiority, usefulness in
commercial versus clinical environments, ease of patient use, accuracy of
results and price. There can be no assurance that the Company will be able to
effectively compete based on the foregoing factors.

MAJOR CUSTOMERS

Each contract for laboratory services is negotiated separately with the
pharmaceutical manufacturer or research organization and is usually limited to a
specific project with limited duration. The cancellation of any contracts with
existing customers or the failure to replace such contracts upon expiration or
termination could have a material adverse effect on the Company's laboratory
operations. One customer individually accounted for approximately 35.9 percent
of the Company's total sales in fiscal 1997 and another customer individually
accounted for approximately 29.5 percent of the Company's total sales in fiscal
1996. Sales to the Company's five largest customers represented approximately
76.8 percent and 63.0 percent of total sales in fiscal 1997 and fiscal 1996,
respectively. As the Company's laboratory operations grow, the Company expects
that its dependence on any one or group of customers will diminish.

EMPLOYEES

As of June 30, 1997, the Company employed thirty-one persons, including
twenty-seven full time and four part time.

RESEARCH AND DEVELOPMENT EXPENDITURES

Research and development expenditures were $1.1 million for the year ended
June 30, 1997 and $0.5 million for the year ended June 30, 1996. Research and
development expenditures for the period from inception have been $2.4

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<PAGE>

million. In addition, $6.4 million of expense was recorded in 1996 for the
value of purchased in-process research and development related to the merger
with BioQuant.

ITEM 2 - PROPERTIES

The Company's executive offices are located at 1370 Reynolds Avenue, Irvine,
California and its laboratory facilities are located at both the Irvine,
California location and in Seattle, Washington. The Company leases
approximately 3,570 square feet of office and laboratory space in Irvine,
California pursuant to a one year lease, at an annual rental of $32,130, which
expires on September 30, 1997. The Company also leases approximately 7,500
square feet of office space that includes approximately 6,000 square feet of
laboratory space in Seattle, Washington pursuant to a five year lease at an
annual rental of $121,093, which expires on September 30, 1997. The Company is
arranging to stay in its Irvine facility on a month to month basis and is
currently seeking alternate facilities which will be adequate for its expected
levels of operations.

The Company has leased a new facility in Seattle which has approximately
14,800 square feet pursuant to a ten year lease at an average annual rental of
$238,000, which expires on September 30, 2007. The facility, currently being
renovated, will be ready for occupancy in the second quarter of fiscal 1998. A
security deposit of $100,000 has been placed in an interest bearing account in
the Company's name, with interest earned accruing to the Company. This amount
has been classified as restricted cash on the accompanying consolidated balance
sheet.

ITEM 3 - LEGAL PROCEEDINGS

The Company is not a party to any material legal proceedings. However, the
former manufacturer of SPINPRO-Registered Trademark- has demanded arbitration in
connection with alleged breaches of the contract relating to the manufacture
of SPINPRO-Registered Trademark-. The Company does not believe that the
claims have any merit and believes that the ultimate outcome of this
proceeding will not have a material impact on the Company.

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

No matters were submitted to a vote of security holders during the fourth
quarter ended June 30, 1997.

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<PAGE>

PART II

ITEM 5 - MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS

The Common Stock of the Company began trading in October 1996 (subsequent to
the initial public offering) on the Nasdaq Small Cap Market under the symbol
"PBMI" and under "PBMIW" for the Warrants. Prior to the offering in October
1996, no established public trading market existed. The following table sets
forth the high and low sales prices for the Common Stock and the Warrants for
the fiscal periods indicated as reported by Nasdaq. The quotations shown
represent inter-dealer prices without adjustment for retail markups, markdowns
or commissions and may not necessarily reflect actual transactions.

COMMON STOCK WARRANTS
------------ --------
HIGH LOW HIGH LOW
---- --- ---- ---
Second Quarter ended 12/31/96 5 1/2 2 7/8 3/8 1/8
Third Quarter ended 3/31/97 4 3/8 1 7/8 7/16 1/8
Fourth Quarter ended 6/30/97 2 7/8 1 1/2 3/8 5/32

The per share closing sales price of the Common Stock was 3 5/8 and the
closing sales price of the Warrants was 9/16 as reported by Nasdaq on September
25, 1997. As of September 25, 1997 the Company had in excess of 800 beneficial
holders and 131 record holders of the Common Stock and had in excess of 600
beneficial holders and 5 record holders of the Warrants. At this time the
Company does not pay a dividend and does not plan to in the immediate future.

ITEM 6 - MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The following discussion and analysis should be read in conjunction with the
consolidated financial statements and notes in this Form 10-KSB.

OVERVIEW

On June 28, 1996, the Company completed the mergers whereby BioQuant and PBI-
WA became wholly-owned subsidiaries of the Company in stock-for-stock exchanges.
The merger with BioQuant was treated as a purchase by PBI-WA for accounting
purposes in accordance with generally accepted accounting principles ("GAAP").
As a result of this transaction, the Company's results of operations for the
year ended June 30, 1996, as reported in the financial statements included
elsewhere in this annual report, include only the operations of PBI-WA. The
Company's results of operations for the year ended June 30, 1997 include both
wholly-owned subsidiaries, PBI-WA and BioQuant.

In January 1995, Pacific Biometrics, Inc., a Washington corporation ("Old
PBI") and Merchant House Scientific, Inc. ("MHS") were merged into PBI/MHS
Consolidation Corporation, a Washington corporation ("PBI/MHS"), which was
treated as a purchase of old PBI by MHS for accounting purposes in accordance
with GAAP. As a result of that transaction, the Company's results of operations
for the year ended June 30, 1995, as reported in the inception-to-date
information, include only five months of the results of operations of Old PBI
whereas fiscal 1996 results include a full year of the merged entities.

As a result of the mergers described above, the Company operates a reference
laboratory that services the pharmaceutical and medical diagnostics industries,
produces a disposable HDL cholesterol testing device and is currently developing
the Osteopatch-TM- diagnostic product. The Company is also conducting research
relating to the feasibility of developing products utilizing
SalivaSac-Registered Trademark-.

To date, the Company's revenues have consisted primarily of fees charged by
the laboratory for services provided to customers, a nominal amount of sales
from the SPINPRO-Registered Trademark- HDL cholesterol testing device, and U.S.
Government grants awarded to the Company under the NIH SBIR programs to support
research activities.

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<PAGE>

Expenses consist, and are expected to continue to consist, primarily of
operating expenses necessary to conduct the commercial laboratory operation,
research and development costs for products under development, administration
expenses and payment of license and royalty fees to acquire and maintain the
Company's intellectual property rights.

As of June 30, 1997, the Company had an accumulated deficit of $11,734,611
which included a one-time charge of $6,373,884 for the value of purchased
research and development expenses relating to the Company's merger with BioQuant
and a one-time charge of $428,368 relating to a prior merger involving PBI-WA in
1995.

RESULTS OF OPERATIONS:

The following table compares the periods ending June 30, 1997 and June 30,
1996 as shown in the attached financial statements and shows the same periods
and on a proforma basis with 1996 BioQuant results for informative purposes:

- -------------------------------------------------
Rounded to Actuals Proforma
the Nearest w/o 96 with 96
Thousand Dollars from BioQuant BioQuant
Financials Results Results
- -------------------------------------------------

Revenues:
- -------------------------------------------------
Ending 6/30/97 $ 2,789 $ 2,789 The growth in revenues
- ------------------------------------------------- resulted from an increase
Ending 6/30/96 $ 1,657 $ 1,662 in the number and size of the
- ------------------------------------------------- laboratory's clinical trial
Dollar variance $ 1,132 $1,127 contracts.
- -------------------------------------------------
Percent variance 68% 68%
- -------------------------------------------------

Laboratory expenses and cost of sales:
- -------------------------------------------------
Ending 6/30/97 $ 1,711 $ 1,711 Costs increased less than the
- ------------------------------------------------- increase in revenue due to
Ending 6/30/96 $ 1,364 $1,364 improved economics of scale,
- ------------------------------------------------- investment in labor saving
Dollar variance $ 347 $ 347 technology and a higher mix of
- ------------------------------------------------- specialty services.
Percent variance 25% 25%
- -------------------------------------------------

Diagnostic research and product development:
- -------------------------------------------------
Ending 6/30/97 $ 1,087 $ 1,087 The 133% increase is primarily
- ------------------------------------------------- due to the inclusion of
Ending 6/30/96 $ 467 $ 976 BioQuant's Osteopatch-TM- and
- ------------------------------------------------- SalivaSac-Registered
Dollar variance $ 620 $ 111 Trademark- development costs
- ------------------------------------------------- which are not included in
Percent variance 133% 11% the prior year financials.
- -------------------------------------------------

General and administrative expenses:
- -------------------------------------------------
Ending 6/30/97 $ 1,575 $ 1,575 The 51% increase is primarily
- ------------------------------------------------- attributable to the inclusion
Ending 6/30/96 $ 1,041 $ 1,377 of 1997 BioQuant expenses
- ------------------------------------------------- which are not contained in the
Dollar variance $ 534 $ 198 prior year financials and
- ------------------------------------------------- additional costs of being a
Percent variance 51% 14% publicly-held company.
- -------------------------------------------------

Total other income (expense):
- -------------------------------------------------
Ending 6/30/97 $ 107 $ 107 The 296% increase is due
- ------------------------------------------------- to interest income earned from
Ending 6/30/96 $ 27 $ 118 IPO proceeds and BioQuant
- ------------------------------------------------- grant income not contained in
Dollar variance $ 80 $ (11) prior year financials.
- -------------------------------------------------
Percent variance 296% (9%)
- -------------------------------------------------

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LIQUIDITY AND CAPITAL RESOURCES

The Registration Statement pertaining to the initial public offering ("IPO")
of the Company was declared effective by the Securities and Exchange Commission
on October 29, 1996. Gross proceeds from the public offering were $8,075,000.
The Company is using the net proceeds from the offering (approximately $6.3
million) for product development activities relating to the Osteopatch-TM-, for
funding the growth of its central reference laboratory operations, and also used
approximately $1.2 million to repay debt (see notes to Financial Statements) and
for working capital.

Prior to the IPO, the Company financed its operations through a combination
of equity, bank debt, advances from related parties, and two bridge loans which
were made immediately prior to the IPO. In June 1996, the Company completed its
First Bridge Loan financing of $250,000. This loan bore interest at the rate of
14% and was paid in full with funds from the Company's Second Bridge Loan
financing. The Company issued 50,000 warrants in connection with this
financing. In July 1996, the Company completed additional financing in the form
of a Second Bridge Loan of $1,000,000. This loan bore interest at 14% was paid
in full with funds from the Company's IPO. The Company issued 250,000 warrants
in connection with this financing.

Successful future operations depend primarily upon the Company's ability to
complete development of the Osteopatch-TM- product, obtain FDA clearance, and
achieve successful product commercialization. Although the number of people at
risk of osteoporosis is large in both the United States and worldwide, there can
be no assurance that the Company will be able to meet its objective to develop
and commercialize a cost effective osteoporosis related diagnostic product. The
risks facing the Company include the ability to obtain regulatory approval which
is dependent upon such factors as the results of clinical trials, the discretion
of regulatory officials, and potential changes in regulations, all of which may
be beyond the control of the Company. In addition, successful commercialization
of any product will be dependent upon market acceptance, competition,
technological change, and dependence on collaborators for research, development
and marketing assistance.

The Company's future operations also depend on its ability to grow a
profitable reference laboratory operation. Although the Company has increased
laboratory revenues, is currently operating the laboratory at a profit and has
established cardiovascular and osteoporosis expertise, there can be no
assurances that the Company will be able to continue such growth or maintain
profitability on contracts for laboratory services. In addition, contracts are
entered into for a specified period (usually less than a year) but can be
canceled at any time. Accordingly, the laboratory operation is dependent on a
few large contracts and the Company's ability to replace such contracts upon
expiration or termination, of which there can be no assurance.

In January 1997, the Company received formal notification of termination,
effective April 6, 1997, of its agreement related to the manufacture of the
Company's SPINPRO-Registered Trademark- product. The Company has established a
$100,000 reserve as of December 31, 1996 for the costs that it expected to incur
in relation to the relocation of SPINPRO-Registered Trademark- manufacturing
operations, equipment and personnel. As of June 30, 1997, the Company has a
reserve of $83,000 related to SPINPRO-Registered Trademark-.

In April 1997, the Company acquired the SPINPRO-Registered Trademark- molds,
production equipment and inventory from the prior manufacturer, as required by
the manufacturing agreement, for approximately $364,000. This transaction was
financed in part by approximately $325,000 from a capital equipment leasing
facility entered into with Transamerica Business Credit Corporation, an
institutional lender (the "Facility").

The Facility provides credit for equipment purchases up to $1,500,000 with
$725,000 of immediately available funds and an additional $775,000 for equipment
purchases once the Company has met certain objectives. The Company received
gross proceeds of $376,808 under the Facility as of June 30, 1997 which was used
to purchase the SPINPRO-Registered Trademark- molds and equipment plus other
laboratory equipment. In July 1997, Transamerica increased the portion of the
$1,500,000 facility that is immediately available to $1,000,000 from $725,000.

17
<PAGE>

the option to exercise an exclusive long term supply and distribution agreement
with PBI for the Italian market. If Segix exercises its option to execute the
supply and distribution agreement it will give the Company access to the Italian
market through Segix's 70 person direct sales force.

In September 1997, the Company announced that it had signed a letter of
intent with Sudormed, Inc. and Sudor Partners which would provide to the Company
an exclusive world-wide license to all applications (except for those relating
to alcohol and drugs of abuse) of the skin patch technology. Subject to due
diligence and execution of definitive agreements by December 31, 1997, the
Company will pay Sudor Partners $2.8 million over a fifteen month period, which
includes a lump-sum payment of $1.6 million due December 31, 1998. The
definitive agreement will also provide more favorable terms for the Company
regarding the price, royalty and minimum purchases related to the existing
Osteopatch-TM- supply agreement with Sudormed.

In July 1997, the Company signed a letter of intent outlining research
collaboration terms with a small privately held company which has strip assay
technology to support the continued development of a non-invasive glucose test.
Subject to definitive documentation and final negotiation of terms the Company
will have exclusive use of their technology for diabetes testing in saliva.

In September 1997, the Company was awarded a $98,000 SBIR grant to research
non-invasive tests for cholesterol in saliva.

The Company assumed SPINPRO-Registered Trademark- manufacturing with no
disruption in production by renting production space for $3,000 per month on a
month to month basis from the former manufacturer. On June 15, 1997 after
utilizing certain key inventory components purchased from the former
manufacturer and making shipments to customers to meet their requirements, the
Company suspended production at the former manufacturer's location and placed
all SPINPRO-Registered Trademark- equipment and inventory in storage to await
potential relocation to a new facility. Relocation of SPINPRO-Registered
Trademark- manufacturing may further disrupt production while new manufacturing
and supply arrangements are negotiated, however, such disruptions are not
anticipated to have a material effect on the Company's operations or financial
condition, since SPINPRO-Registered Trademark- revenues have not been material
to date, and may not be material in the future.

The Company expects to continue to incur significant operating losses for at
least two years due to anticipated increases in research and development
activities associated with the Osteopatch-TM- product, establishment of a
marketing program for the reference laboratory and general and administrative
expenses.

The Company anticipates, based on currently proposed plans and assumptions
relating to its operations, that the net proceeds of the IPO, together with
projected revenues from operations, and debt arrangements will be sufficient to
satisfy its contemplated cash requirements for the 1998 fiscal year. The
Company is actively working to raise additional funds through equity or debt
arrangements to cover longer term requirements.

The adequacy of the Company's available cash equivalents and revenue from
operations to sustain current and anticipated levels of operations are subject
to a number of variables including maintaining and increasing existing
laboratory revenues and profitability, performance of products in clinical
trials, the level and timing of research and development costs necessary to
obtain FDA clearance of products under development, the costs and timing
associated with commercial production and marketing of such products, the
execution of definitive agreements with key partners, intensified competition,
third party reimbursement, and technology obsolescence prior to successful
commercialization.

While management does not currently anticipate an issue related to funding,
if adequate funds are not available through increased revenues or existing cash
flows, the Company may have to seek alternate sources of financing, which may
include debt or equity or a combination of both. However there can be no
assurance that such external sources of funding will be available on terms
favorable to the Company, in which event, the Company may be required to delay,
scale back or eliminate one or more of its research and development programs,
including but not limited to the development of the Osteopatch-TM-, or to obtain
funds through entering into arrangements with collaborative partners or others
that may require the Company to relinquish rights to certain of its technologies
or potential products that the

18
<PAGE>

Company would not otherwise relinquish, or require substantial dilution or
changes in shareholder rights in order to raise additional funds.

STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS NOT YET ADOPTED

In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings Per Share". SFAS No. 128 requires companies to adopt
its provisions for fiscal years beginning after December 15, 1997, including
interim periods, and requires restatement of all prior period earnings per share
("EPS") data presented. Earlier application is not permitted. SFAS No. 128
specifies the computation, presentation and disclosure requirements for EPS.
The implementation of SFAS No. 128 is not expected to have a material effected
on the EPS data presented by the Company.

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income".
SFAS No. 130, which is effective for fiscal years beginning after December 15,
1997 and requires restatement of earlier periods presented, establishes
standards for the reporting and display of comprehensive income and its
components in a full set of general purpose financial statements. Comprehensive
income is defined as the change in equity of a business enterprise during a
period from transactions and other events and circumstances from nonowner
sources. The implementation of SFAS No. 130 is not expected to have a material
effect on the Company's results of operations.

In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information". SFAS No. 131, which is effective for
fiscal years beginning after December 15, 1997 and requires restatements of
earlier periods presented, established standards for the way that a public
enterprise reports information about key revenue-producing segments in the
annual financials statements and selected information in interim financial
reports. It also establishes standards for related disclosures about products
and services, geographic areas and major customers. The implementation of SFAS
No. 131 is not expected to have a material effect on the Company's current
reporting.

ITEM 7 - FINANCIAL STATEMENTS

The required financial statements appear at the end of this report, and are
incorporated herein by reference. See index to consolidated financial
statements at page F-1.

ITEM 8 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURES

None.

19
<PAGE>

PART III

ITEM 9 - DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

Incorporated by reference to the Company's Proxy Statement for Annual Meeting
of Stockholders to be filed with the Securities and Exchange Commission within
120 days after the close of the fiscal year ended June 30, 1997.

ITEM 10 - EXECUTIVE COMPENSATION

ITEM 11 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

ITEM 12 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

ITEM 13 - EXHIBITS, LIST AND REPORTS ON FORM 8-K

(a) Exhibits are listed on the Index to Exhibits at the end of this report.
The exhibits required by Item 601 of Regulation S-B are listed on such
Index in response to this Item and are incorporated herein by reference.

(b) No reports on Form 8-K were filed during the last quarter of the period
covered by this report.

20
<PAGE>

PACIFIC BIOMETRICS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Page
----
Report of Independent Accountants.................................. F - 2
Consolidated Balance Sheet as of June 30, 1997..................... F - 3
Consolidated Statements of Operations for the years ended
June 30, 1997 and 1996, and for the period from inception
(December 1992) to June 30, 1997................................. F - 4

Consolidated Statements of Cash Flows for the years ended
June 30, 1997 and 1996, and for the period from inception
(December 1992) to June 30, 1997................................. F - 5

Consolidated Statements of Stockholders' Equity for the
period from inception (December 1992) to June 30, 1997........... F - 7

Notes to Consolidated Financial Statements......................... F - 8

F-1
<PAGE>

REPORT OF INDEPENDENT ACCOUNTANTS

The Board of Directors
Pacific Biometrics, Inc.
Irvine, California

We have audited the accompanying consolidated balance sheet of Pacific
Biometrics, Inc. (a company in the development stage) as of June 30, 1997, and
the related consolidated statements of operations and cash flows for the years
ended June 30, 1997 and 1996, and for the period from inception (December 1992)
to June 30, 1997, and the consolidated statement of stockholders' equity for the
period from inception (December 1992) to June 30, 1997. These consolidated
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 consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Pacific
Biometrics, Inc. as of June 30, 1997, and the consolidated results of its
operations and its cash flows for the years ended June 30, 1997 and 1996, and
for the period from inception (December 1992) to June 30, 1997, in conformity
with generally accepted accounting principles.

COOPERS & LYBRAND L.L.P.

Newport Beach, California
September 26, 1997

F-2
<PAGE>

PACIFIC BIOMETRICS, INC.
(a company in the development stage)
CONSOLIDATED BALANCE SHEET
June 30, 1997

ASSETS
Current assets:
Cash and cash equivalents $2,916,695
Short term investments, net of unamortized
discount of $26,890 973,110
Accounts receivable, net of allowance for doubtful
accounts of $31,280 469,315
Inventory 25,789
Prepaid expenses 166,186
-------------
Total current assets 4,551,095
Property and equipment, net 667,483
Other assets:
Technology license 101,562
Prepaid financing costs 12,000
Restricted cash 100,000
Deposits and other 8,679
-------------
Total assets $5,440,819
-------------
-------------

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Notes payable to related parties $ 252,413
Accounts payable 192,396
Accrued payroll related and other liabilities 358,963
Advances from customers 118,434
Capital lease obligations 217,434
-------------
Total current liabilities 1,139,640
-------------

Capital lease obligations - long term portion 229,982
-------------

Commitments and contingencies (Note 12)

Stockholders' equity:
Preferred stock, $0.01 par value, 5,000,000 shares
authorized, no shares issued and outstanding
Common stock, $0.01 par value, 30,000,000 shares
authorized, 3,705,522 shares issued and outstanding 37,055
Additional paid-in capital 15,768,753
Deficit accumulated during the development stage (11,734,611)
-------------
Total stockholders' equity 4,071,197
-------------
Total liabilities and stockholders' equity $5,440,819
-------------
-------------

The accompanying notes are an integral part of these
consolidated financial statements.

F-3
<PAGE>

PACIFIC BIOMETRICS, INC.
(A COMPANY IN THE DEVELOPMENT STAGE)
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED JUNE 30, 1997 AND 1996, AND FOR THE PERIOD
FROM INCEPTION (DECEMBER 1992) TO JUNE 30, 1997

For the Period
from Inception
(December 1992)
to June 30,
1997 1996 1997
---- ---- --------
<S> <C> <C> <C>
Laboratory testing revenues and
consulting fees $ 2,788,570 $ 1,657,280 $ 5,012,682
-------------- -------------- --------------

Operating expenses:
Laboratory and cost of goods sold 1,710,808 1,363,624 3,575,486
Research and product development 1,086,596 467,074 2,413,528
General and administrative 1,575,266 1,041,023 3,974,123
Manufacturing relocation expense 100,000 100,000
Purchased in-process research and
product development 6,373,884 6,373,884
Amortization of goodwill 428,368
-------------- -------------- --------------
Total operating expenses 4,472,670 9,245,605 16,865,389
-------------- -------------- --------------
Operating loss (1,684,100) (7,588,325) (11,852,707)
-------------- -------------- --------------
Other income (expense):
Interest expense (145,835) (39,852) (211,849)
Interest income 147,940 5,588 153,528
Grant and other income 104,766 61,726 176,417
-------------- -------------- --------------
106,871 27,462 118,096
-------------- -------------- --------------
Net loss $ (1,577,229) $ (7,560,863) $(11,734,611)
-------------- -------------- --------------
-------------- -------------- --------------

Net loss per share $ (.51) $ (5.89) $ (9.58)
-------------- -------------- --------------
-------------- -------------- --------------
Number of shares used in per share
calculation 3,081,516 1,284,285 1,224,791
-------------- -------------- --------------
-------------- -------------- --------------
</TABLE>

The accompanying notes are an integral part of these
consolidated financial statements.

F-4
<PAGE>

PACIFIC BIOMETRICS, INC.
(A COMPANY IN THE DEVELOPMENT STAGE)
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED JUNE 30, 1997 AND 1996, AND FOR THE PERIOD
FROM INCEPTION (DECEMBER 1992) TO JUNE 30, 1997

For the Period
from Inception
(December 1992)
1997 1996 to June 30, 1997
---- ---- ----------------
<S> <C> <C> <C>
Cash flows from operating activities:
Cash received from customers $ 2,401,838 $ 1,686,710 $ 4,606,925
Cash paid to suppliers and employees (4,314,726) (2,443,706) (8,686,661)
Grants, interest and other income received 252,706 67,315 329,946
Interest paid (145,835) (39,853) (211,850)
-------------- -------------- --------------
Cash used by operations (1,806,017) (729,534) (3,961,640)
-------------- -------------- --------------

Cash flows from investing activities:
Cash acquired in connection with mergers 31,200 221,698
Purchases of technology licenses (100,000)
Advances to BioQuant prior to acquisition,
net (145,000) (145,000)
Capital expenditures (136,897) (18,592) (198,392)
Organization costs (5,000) (5,000)
Deposits and other 7,940 3,238
Purchase of short-term investments (973,110) (973,110)
-------------- -------------- --------------
Cash used by investing activities (1,102,067) (137,392) (1,196,566)
-------------- -------------- --------------

Cash flows from financing activities:
Common stock sold for cash 8,085,005 360,000 9,548,905
Cost of equity issuances (1,790,290) (1,790,290)
Common stock option exercise proceeds 26,503 26,503
Proceeds (repayments) with related parties (146,198) 464,461 713,765
Proceeds (repayment) of First Bridge Loan (250,000) 250,000
Repayment of bank borrowings (175,967) (62,105) (246,616)
Proceeds from Second Bridge Loan 1,000,000 1,000,000
Repayment of Second Bridge Loan (1,000,000) (1,000,000)
Prepaid financing costs 18,000 (30,000) (12,000)
Transfer to restricted cash (100,000) (100,000)
Payments on capital lease obligations (35,172) (18,534) (65,366)
-------------- -------------- --------------
Cash provided by financing activities 5,631,881 963,822 8,074,901
-------------- -------------- --------------

Increase in cash and cash equivalents 2,723,797 96,896 2,916,695
Cash and cash equivalents:
Beginning of period 192,898 96,002
-------------- -------------- --------------
End of period $ 2,916,695 $ 192,898 $ 2,916,695
-------------- -------------- --------------
-------------- -------------- --------------
</TABLE>

F-5
<PAGE>

For the Period
from Inception
(December 1992)
1997 1996 to June 30, 1997
---- ---- ----------------
<S> <C> <C> <C>
Reconciliation of Net Loss to Net Cash
Used by Operating Activities:
Net loss $ (1,577,229) $ (7,560,863) $ (11,734,611)
Purchased in-process research and
product development expense 6,373,884 6,373,884
Amortization of goodwill 428,368
Common stock issued for services 220,800 466,026 767,326
Reserve for relocation of manufacturing 100,000 100,000
Services provided for subscription
receivable 55,556
Depreciation and amortization 79,665 29,992 144,307
Amortization of technology license 62,500 11,111 162,500
Changes in operating accounts:
Accounts receivable (216,903) 22,789 (312,093)
Other receivables 31,200 (9,946) 37,751
Supplies (5,952) 15,063 719
Prepaid expenses (165,925) 14,308 (167,459)
Accounts payable and accrued
liabilities (164,344) (99,781) 240,780
Deferred compensation 22,496 34,996
Advances from customers (169,829) (14,613) (93,664)
----------------- ---------------- -------------------
Cash used by operations $ (1,806,017) $ (729,534) $ (3,961,640)
----------------- ---------------- -------------------
----------------- ---------------- -------------------
</TABLE>

The accompanying notes are an integral part of these
consolidated financial statements.

F-6
<PAGE>

PACIFIC BIOMETRICS, INC.
(A COMPANY IN THE DEVELOPMENT STAGE)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE PERIOD FROM INCEPTION (DECEMBER 1992) TO JUNE 30, 1997

Additional Development
Common Stock Subscription Paid-in Stage
Shares Amount Receivable Capital Deficit Total
------ ------ ---------- ------- ------- -----
<S> <C> <C> <C> <C> <C> <C>
Common stock issued for cash at
inception (December 1992) 511,862 $ 5,119 $ (245,000) $ 494,881 $ 255,000
Common stock issued for cash 46,920 469 603,431 603,900
Cash received in satisfaction of
subscription receivable 283,578 283,578
Common stock issued in connection with
purchase of technology license and services 62,561 569 (55,556) 54,987
Stockholder loans converted to equity 634,963 634,963
Services provided in satisfaction of
subscription receivable 16,978 16,978
Common stock issued for services
and loan guarantees 47,867 479 80,021 80,500
Common stock issued in connection with
acquisition of Pacific Biometrics, Inc.
(a Washington corporation) 189,061 1,891 143,109 145,000
Conversion from $0.01 to no par value
common stock 2,011,392 (2,011,392)
Net loss $ (2,596,519) (2,596,519)
--------- ----------- --------- ---------- ------------ -----------
Balance, june 30, 1995 858,271 2,019,919 (2,596,519) (576,600)
Common stock issued for cash 45,500 360,000 360,000
Common stock issued for services 135,080 466,026 466,026
Issuance of $0.01 par value common stock in
exchange for no par value common stock in
connection mergers (2,835,556) 2,835,556
Common stock issued in connection
with acquisition of BioQuant 700,364 7,003 5,919,997 5,927,000
Net loss (7,560,863) (7,560,863)
--------- ----------- --------- ---------- ------------ -----------
Balance, June 30, 1996 1,739,215 17,392 8,755,553 (10,157,382) (1,384,437)
Common stock issued for services 64,000 640 220,160 220,800
Stockholder loans converted to common stock 142,274 1,423 489,422 490,845
Common stock issued for cash 2,900 29 9,976 10,005
Initial Public Offering (IPO) 1,700,000 17,000 8,058,000 8,075,000
Underwriter commissions and IPO costs (1,790,290) (1,790,290)
Common stock issued for exercised options 57,133 571 25,932 26,503
Net loss (1,577,229) (1,577,229)
--------- ----------- --------- ---------- ------------ -----------
Balance, June 30, 1997 3,705,522 $ 37,055 $ 0 $ 15,768,753 ($11,734,611) $ 4,071,197
--------- ----------- -------- ------------ ------------ -----------
--------- ----------- -------- ------------ ------------ -----------
</TABLE>

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE
CONSOLIDATED FINANCIAL STATEMENTS.

F-7
<PAGE>

PACIFIC BIOMETRICS, INC.
(A COMPANY IN THE DEVELOPMENT STAGE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND BASIS OF PRESENTATION

Pacific Biometrics, Inc. ("PBI-Delaware" or the "Company") develops
diagnostic and laboratory products and provides laboratory services in the
fields of cardiovascular disease and osteoporosis laboratory testing. The
Company's strategy is to focus on the development of cost-effective, non-
invasive diagnostic tests and improved laboratory techniques in order to achieve
early diagnosis, prevention, and therapeutic monitoring. The Company was
incorporated in Delaware in May 1996. The Company conducts its business through
its wholly-owned subsidiaries, Pacific Biometrics, Inc., a Washington
corporation ("PBI-WA") and BioQuant, Inc., a Michigan corporation ("BioQuant").
On June 28, 1996, the Company completed the mergers (the "Mergers") whereby
BioQuant and PBI-WA became wholly-owned subsidiaries of the Company in separate
stock-for-stock exchange transactions.

Except for the revenues from the laboratory and from the sale of the
Company's cholesterol diagnostic product, all of the Company's potential
products are currently in research and development, and no revenues have been
generated to date. Consequently, the Company is a development stage enterprise.

The majority of the outstanding stock of PBI-Delaware, after the Mergers, was
owned by the former stockholders of PBI-WA and therefore the acquisition of PBI-
WA was accounted for as a reverse acquisition. The merger with BioQuant was
accounted for as a purchase transaction with PBI-WA as the acquirer of BioQuant.
Therefore, financial results of BioQuant prior to June 28, 1996 are not included
in the accompanying consolidated financial statements. All outstanding shares
of stock, options and warrants of PBI-WA and BioQuant were exchanged for similar
securities of PBI-Delaware.

In January 1995, Pacific Biometrics, Inc., a Washington corporation ("Old
PBI") and Merchant House Scientific, Inc. ("MHS") were merged into PBI/MHS
Consolidation Corporation, a Washington corporation ("PBI/MHS"), which
subsequently changed its name to Pacific Biometrics, Inc. The merger was
accounted for as a purchase transaction with MHS as the accounting acquirer of
Old PBI. Therefore, financial results of Old PBI prior to January 1995 are not
included in the consolidated financial statements. MHS was incorporated in
December 1992.

On June 28, 1996, PBI-Delaware acquired BioQuant. This acquisition was
accomplished through the issuance of three classes of common stock. All classes
of common stock held equal voting rights; however, two classes of common stock
were restricted as to their trading rights (the "restricted stock"). The right
to trade the restricted stock was dependent on the Company's ability to achieve
certain performance milestones. In July 1996, a majority of the Company's
stockholders voted to convert all of the outstanding classes of common stock to
a single class of common stock thereby eliminating any trading restrictions on
the stock. The accompanying consolidated financial statements reflect all the
outstanding common stock as a single class of stock as if the conversion had
occurred as of the earliest period presented. A summary of the allocation of
purchase price based on an independent appraisal is as follows:

Assets acquired:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,200
Supplies. . . . . . . . . . . . . . . . . . . . . . . . . 10,616
Property and equipment. . . . . . . . . . . . . . . . . . 18,197
Technology license. . . . . . . . . . . . . . . . . . . . 164,062
Other assets. . . . . . . . . . . . . . . . . . . . . . . 3,282
Purchased in-process research and product development . . 6,373,884
----------
Total assets acquired. . . . . . . . . . . . . . . . . . . . 6,601,241
Liabilities assumed. . . . . . . . . . . . . . . . . . . . . 674,241
----------
$5,927,000
----------
----------

F-8
<PAGE>

All material intercompany balances and transactions have been eliminated in
the accompanying consolidated financial statements.

The purchased in-process research and product development had met several
technical milestones during the development process, but at the date of
acquisition clinical trials had not yet commenced. Consequently, the purchased
in-process research and development had not yet reached technological
feasibility, as defined by generally accepted accounting principles. In
management's opinion, this technology had no alternative future use. Therefore,
the amount was charged to expense in accordance with generally accepted
accounting principles.

In connection with the BioQuant merger, options and warrants to purchase
BioQuant shares were converted to 491,535 options and 74,083 warrants to
purchase shares of common stock of the Company at prices ranging from $.13 to
$4.22 per share.

INITIAL PUBLIC OFFERING

On November 4, 1996, the Company completed an initial public offering ("the
IPO") of 1,700,000 "units" at $4.75 per unit. Each unit consisted of one share
of common stock and one redeemable warrant. The IPO generated $6,284,710 in
proceeds, net of underwriting commissions and other related expenses totaling
$1,790,290.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

CASH AND CASH EQUIVALENTS

Cash and cash equivalents consist of highly liquid investments with an
original maturity of three months or less when purchased. Cash and cash
equivalents are stated at cost, which approximates market value.

SHORT-TERM INVESTMENTS

At June 30, 1997, the Company's short-term investments consist of U.S.
Treasury securities with contractual maturities of less than twelve months, and
the carrying amount of these investments approximates market value. The Company
has classified all of its investments in marketable debt securities as held-to-
maturity, and accounted for these investments at amortized cost. Accordingly,
no adjustment for unrealized holding gains or losses has been reflected in the
accompanying financial statements.

INVENTORY

Inventory consists of items used to calibrate test equipment or verify
testing methods related to lipids, inventory related to saliva collection
devices and finished SPINPRO-Registered Trademark- units. These items are
recorded at the lower of estimated cost (weighted-average) or market.

RESTRICTED CASH

During 1997, in connection with the signing of a new facility lease in
Seattle, Washington, the Company is required to maintain $100,000 as a security
deposit, throughout the term of the lease. This amount has been recorded as
restricted cash on the accompanying consolidated balance sheet.

PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Depreciation and amortization
are provided using the straight-line method over the useful lives of the related
assets. Leasehold improvements are amortized over the terms of the respective
leases. The cost and related accumulated depreciation of property or equipment
sold or otherwise disposed of are removed from the accounts and the resulting
gains or losses are included in the statement of operations.

F-9
<PAGE>

LONG LIVED ASSETS

The Company adopted the provisions of SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of"
effective with its fiscal year ended June 30, 1997. SFAS No. 121 requires an
entity to review long-lived assets and certain identifiable intangibles whenever
events or changes in circumstances indicate the carrying amount of an asset may
not be recoverable. Impairment losses are recognized when the carrying amount
of the asset exceeds the estimated fair value of the asset. There was no impact
on the Company as a result of implementing SFAS No. 121.

TECHNOLOGY LICENSES

The Company has an exclusive worldwide license for the use of a transdermal
perspiration collection device for measuring bone loss. There is no license fee
related to this agreement. The Company also has a license for the use of the
SPINPRO-Registered Trademark- technology. The license fee of $100,000 related
to this agreement has been fully amortized.

The Company has licensed exclusive rights, related to bone resorption in
human perspiration, to use patented anti-pyridinium crosslinks antibody
technology (this is an exclusive worldwide license excluding Japan). Licensing
fees have been recorded at cost and are being amortized over the estimated
useful lives of the agreement of four years. The amount charged to expense in
connection with amortizing these licensing fees was $62,500 and $11,111 for the
years ended June 30, 1997 and 1996 respectively, and $162,500 for the period
from inception to date.

CUSTOMER ADVANCES

The Company receives advances from certain customers to perform consulting,
laboratory services, and clinical studies. These advances are deferred and
recognized as revenue in the period the related services are performed.

INCOME TAXES

Deferred tax assets and liabilities are recorded for differences between the
financial statement and tax bases of the assets and liabilities that will result
in taxable or deductible amounts in the future based on enacted tax laws and
rates applicable to the periods in which the differences are expected to affect
taxable income. Valuation allowances are established when necessary to reduce
deferred tax assets to the amount expected to be realized. Income tax expense
is recorded for the amount of income tax payable or refundable for the period
increased or decreased by the change in deferred tax assets and liabilities
during the period.

FINANCIAL INSTRUMENTS

The carrying amounts of cash and cash equivalents approximate fair value due
to the short-term maturities of these instruments. The carrying value of the
Company's debt approximates their estimated fair values because the rates of
interest on the debt approximate current interest rates for similar obligations
with like maturities.

STOCK-BASED COMPENSATION

The Company has adopted the disclosure-only provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation." SFAS 123 defines a fair value based
method of accounting for stock options granted to employees. Fair value of the
stock option is determined considering factors such as the exercise price, the
expected life of the option, the current price of the underlying stock and its
volatility, expected dividends on the stock, and the risk-free interest rate for
the expected term of the option. Under the fair value based method,
compensation cost is measured at the grant date based on the fair value of the
award and is recognized over the service period. Pro forma disclosures for
entities that elect to continue to measure compensation cost under the intrinsic
method provided by Accounting Principles Board Opinion No. 25 must include the
effects of all awards granted in fiscal years that begin after December 15,
1994.

F-10
<PAGE>

REVENUE RECOGNITION

The Company recognizes revenue in the period that the related services are
performed, or products are shipped. Currently, the Company is in the
development stage and derives revenues from laboratory services and sales of its
cholesterol diagnostic product.

STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS NOT YET ADOPTED

NET LOSS PER SHARE

Net loss per share is computed using the weighted-average number of common
stock and common stock equivalent shares outstanding during the periods. Common
equivalent shares from stock options and warrants are excluded from the
computation if their effect is antidilutive, except that pursuant to the
requirements of the Securities and Exchange Commission Staff Accounting Bulletin
No. 83, common equivalent shares relating to stock options and warrants (using
the treasury stock method and the anticipated offering price) issued subsequent
to September 5, 1995, have been included in the computation for all periods
presented prior to the Company's IPO.

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 disclosures of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenues and expenses during the reporting period.
Accordingly, actual results could differ from those estimates and assumptions.

RECLASSIFICATIONS

Certain reclassifications have been made to the consolidated statement of
operations for 1996 and for the period from inception to date in order to
conform to the 1997 presentation.

RISKS AND UNCERTAINTIES

The Company's products require approvals from the Food and Drug
Administration (FDA) and international

F-11
<PAGE>

regulatory agencies prior to commercialized sales. There can be no assurance
that the Company's products will receive any of the required approvals. If the
Company is denied such approvals or if such approvals are delayed, it would have
a material adverse effect on the Company.

3. CONCENTRATION OF CREDIT RISK

The Company has cash deposits at U.S. banks and financial institutions which
exceed federally-insured limits at June 30, 1997. The Company is exposed to
credit loss for amounts in excess of insured limits in the event of non-
performance by the institution; however, the Company does not anticipate non-
performance.

One customer individually accounted for approximately 35.9 percent of the
Company's total sales in fiscal 1997 and another customer individually
accounted for approximately 29.5 percent of the Company's total sales in fiscal
1996. Sales to the Company's five largest customers represented approximately
76.8 percent and 63.0 percent of total sales in fiscal 1997 and fiscal 1996,
respectively. The Company reviews a customer's credit history before extending
credit, and generally does not require collateral from customers. The Company
establishes allowances for doubtful accounts when management believes the
Company is exposed to credit risk.

The Company relies on two vendors to supply licensed technology necessary for
the Company's Osteopatch-TM- product. The Company has a contractual agreement
with the suppliers and management does not feel the concentration exposes the
Company to significant risk in the near term.

4. PROPERTY AND EQUIPMENT

Property and equipment consists of the following at June 30, 1997:

Laboratory equipment . . . . . . . . . . . . . . . . . . . . . . $ 147,297
Computer equipment . . . . . . . . . . . . . . . . . . . . . . . 114,223
Office furniture and equipment . . . . . . . . . . . . . . . . . 19,030
Leasehold improvements . . . . . . . . . . . . . . . . . . . . . 24,806
Equipment held under capital leases. . . . . . . . . . . . . . . 505,434
---------
Gross property and equipment . . . . . . . . . . . . . . . . . . 810,790
Less accumulated depreciation and amortization . . . . . . . . . (143,307)
---------
Net property and equipment . . . . . . . . . . . . . . . . . . . $ 667,483
---------
---------

5. CAPITAL LEASES

The Company leases laboratory and other equipment under capital lease
arrangements. The equipment related to the capital leases have an original cost
of $505,434 and accumulated amortization of $40,736 at June 30, 1997. The
obligations under capital leases have interest rates ranging from 8% to 9% and
mature at various dates through 2000. Annual future minimum lease payments for
years subsequent to June 30, 1997 are as follows:

1998 $ 241,751
1999 147,757
2000 107,904
-----------

Total minimum payments 497,412
Less amount representing interest (49,996)
-----------
Obligations under capital leases 447,416
Less current portion (217,434)
-----------
Long term portion $ 229,982
-----------
-----------

F-12
<PAGE>

6. FINANCING

FIRST BRIDGE LOAN

In June 1996, the Company completed its First Bridge Loan financing of
$250,000. This loan bore interest at the rate of 14% and was paid in full with
funds from the Company's Second Bridge Loan financing. The Company issued
50,000 warrants in connection with this financing (Note 11).

SECOND BRIDGE LOAN

In July 1996, the Company completed additional financing in the form of a
Second Bridge Loan of $1,000,000. This loan bore interest at 14% was paid in
full with funds from the Company's IPO. The Company issued 250,000 warrants in
connection with this financing (Note 11).

BANK FINANCING

The Company had a $200,000 line of credit with a bank which was converted to
a term loan in June 1996. The balance at the date of conversion was $159,445.
This loan bore interest at the bank's index rate plus 2.5% (10.75% at June 30,
1996), and was paid off in full with funds from the Company's IPO.

The Company had a loan from a bank with a balance outstanding of $16,522 at
June 30, 1996. This loan bore interest at the prime rate plus 1.4% (9.9% at
June 30, 1996). The loan was paid off in full with funds from the Company's IPO.

CAPITAL EQUIPMENT FINANCING

In April 1997 the Company entered into a capital equipment leasing facility
with Transamerica Business Credit Corporation, an institutional lender (the
"Facility"). The Facility provides credit for equipment purchases up to
$1,500,000 with $725,000 of immediately available funds and the remaining
$775,000 available once the Company has met certain objectives. The related
equipment serves as collateral for the debt. The Company has received gross
proceeds of $376,808 under the Facility as of June 30, 1997 which was used to
purchase production and laboratory equipment. The Company issued 51,429 warrants
in connection with this financing (Note 11). Subsequent to year end the
immediately available portion of the credit line was increased to $1,000,000 and
the Company received additional gross proceeds of approximately $114,000 for the
purchase of laboratory equipment.

STOCKHOLDER LOANS

At June 30, 1996, the Company owed certain stockholders $660,000. During
fiscal 1997, $460,000 of this debt was converted to equity (Note 9) and the
remaining $200,000 was refinanced in connection with the Second Bridge Loan.

7. RELATED PARTY TRANSACTIONS

The Company has entered into deferred compensation agreements with four of
its senior executives. The agreements provide that a specified portion of their
salaries be deferred until they elect to receive the deferred amount. At June
30, 1997, the Company's deferred compensation obligation was $65,413.
Compensation expense in connection with these agreements was $30,417 and $22,496
for the years ended June 30, 1997 and 1996, respectively, and $65,413 for the
period from inception to June 30, 1997. The liability for deferred compensation
of $65,413 was converted to a promissory note bearing annual interest at 7% and
is payable on demand. This obligation is included with notes payable to related
parties on the accompanying consolidated balance sheet.

In September 1993, the Company entered into a contract for management and
consulting services with a company owned by certain of the Company's
stockholders. The Company incurred $186,000 for management and consulting
services provided during the year ended June 30, 1996 and $300,098 for the
period from inception to June 30, 1997.

F-13
<PAGE>

The liability for management consulting services under this contract of $187,000
was converted to a promissory note bearing annual interest at 7% and is payable
on demand. This obligation is included with notes payable to related parties on
the accompanying consolidated balance sheet. The management contract was
terminated effective June 28, 1996.

The Company paid $28,172 and $27,661 to related parties for consulting
services provided during the years ended June 30, 1997 and 1996, respectively,
and $83,587 for the period from inception to June 30, 1997.

During fiscal 1997, the Company issued 64,000 shares of common stock valued
at $220,800 to Directors in exchange for services.

8. INCOME TAXES

At June 30, 1997, the Company had accumulated net operating loss
carryforwards for tax purposes of approximately $7.25 million which expire
through 2012. Losses accumulated through the date will be limited to use by the
respective company which generated the net operating losses. The utilization of
net operating losses may be limited under the provisions of Internal Revenue
Code Section 382 and similar state provisions.

The following is a reconciliation of income tax benefit to the amount based
on the U.S. statutory rate of 34%:

FOR THE PERIOD
FROM INCEPTION
YEARS ENDED JUNE 30, (DECEMBER 1992)
-------------------- TO JUNE 30,
1997 1996 1997
---- ---- ----
Income tax benefit based on
U.S. statutory rate. . . . . . $(536,257) $ (2,570,693) $(3,989,767)
Write-off of purchased
research and development . . . 2,167,121 2,167,121
Other. . . . . . . . . . . . . . 1,980 147,625
Losses which provide no
current tax benefit. . . . . . 534,277 403,572 1,675,021
---------- ---------- ---------
Income tax benefit . . . . . . $ 0 $ 0 $ 0
---------- ---------- ---------
---------- ---------- ---------

Significant components of the Company's deferred tax assets and liabilities
are as follows at June 30, 1997:

Deferred tax assets:
Allowance for bad debts. . . . . . . . . . . . . . $ 13,544
Accrued expenses . . . . . . . . . . . . . . . . . 45,892
Deferred compensation. . . . . . . . . . . . . . . 16,777
Other tax assets . . . . . . . . . . . . . . . . . 1,224
Tax loss carryforwards . . . . . . . . . . . . . . 2,751,977

Deferred tax liabilities:
Fixed asset/Intangible asset . . . . . . . . . . . (172,167)
--------------

Total net deferred tax asset . . . . . . . . . . . . . 2,657,247
Valuation allowance. . . . . . . . . . . . . . . . . . (2,657,247)
--------------
Net deferred tax assets. . . . . . . . . . . . . . . . $ 0
--------------
--------------

F-14
<PAGE>

The provision for income taxes was as follows:

FOR THE PERIOD
FROM INCEPTION
(DECEMBER 1992)
TO JUNE 30,
1997 1996 1997
---- ---- -----

Current provision. . . . . . . . $ 0 $ 0 $ 0
Deferred benefit . . . . . . . . (595,114) (403,572) (1,962,593)
Change in valuation allowance. . 595,114 403,572 1,962,593
------- ------- ---------
Provision for income taxes . . . $ 0 $ 0 $ 0
---------- ----------- -----------
---------- ----------- -----------

The Company has established a valuation allowance against its deferred tax
assets due to the uncertainty surrounding the realization of such assets.
Management periodically evaluates the recoverability of the deferred tax assets.
At such time as it is determined that it is more likely than not that the
deferred tax assets are realizable, the valuation allowance will be reduced.

9. SUPPLEMENTARY INFORMATION ON NONCASH TRANSACTIONS

EQUIPMENT PURCHASED UNDER CAPITAL LEASE

Year Equipment Value
---- ---------------
1996 $ 28,006
1997 $ 477,428
---------

From inception to June 30, 1997 $ 505,434
---------
---------

STOCKHOLDER LOANS CONVERTED TO EQUITY

During 1997, certain of the Company's stockholders converted their loans to
the Company for 142,274 shares of the Company's common stock, valued at $3.45
per share. The amount converted was $490,845, including accrued interest of
$30,845. For the period from inception to June 30, 1997, a total of $1,125,808
in stockholder loans have been converted to equity.

COMMON STOCK ISSUED FOR TECHNOLOGY LICENSE, SERVICES AND LOAN GUARANTEES

The Company has issued common stock for technology licenses, services and
loan guarantees as follows:

Year Issued Number of Shares Estimated Fair Value
- ----------- ---------------- --------------------
1994 62,561 $ 55,556
1995 47,867 $ 80,500
1996 135,080 $ 466,026
1997 64,000 $ 220,800
------- ---------
For the period from inception to
June 30, 1997 309,508 $ 822,882
------- ---------
------- ---------

COMMON STOCK ISSUED IN CONNECTION WITH ACQUISITIONS

In 1996, the Company acquired BioQuant through an exchange of common stock as
described in Note 1. The Company issued 700,364 shares of common stock to the
stockholders of BioQuant in connection with this acquisition.

F-15
<PAGE>

10. STOCK OPTION PLANS

1996 STOCK INCENTIVE PLAN

In July 1996, the Company adopted a Stock Incentive Plan (the "Plan") with
1,000,000 shares of common stock reserved for issuance under this Plan. Options
granted under this plan may be either incentive stock options within the meaning
of Section 422(b) of the Internal Revenue Code, or nonqualified options. The
Company may also award stock appreciation rights, restricted stock, performance
shares, loans or tax offset payments. The option price of each incentive stock
option granted shall not be less than the fair value of the underlying common
stock, and will expire no later than ten years following the date of grant.
With respect to nonqualified options, the exercise price and term will be
determined at the discretion of the Board. However, the exercise price will not
be less than 85% of the fair value of the underlying stock, and the term will
not exceed a period of ten years. The options generally vest over five years.

In connection with the BioQuant merger, all outstanding options to purchase
BioQuant shares became fully vested and were converted to 491,535 options to
purchase shares of the Company's common stock.

The Company will submit to a vote of the security holders a proposal to
increase the authorized shares for the Plan as described in the Company's Proxy
Statement for Annual Meeting of Stockholders to be filed with the Securities and
Exchange Commission within 120 days after the close of the fiscal year ended
June 30, 1997.

The following is a summary of the activity in the Plan for the period from
inception:

SHARES UNDER OPTIONS
--------------------
WEIGHTED AVERAGE
EXERCISE PRICE EXERCISE PRICE
PER SHARE PER SHARE SHARES
--------- --------- ------
<S> <C> <C> <C>
Conversion of BiOquant options $0.13 - $0.63 $0.27 491,535

Granted - - -
Exercised - - -
Terminated
------------- ---------- ---------

Options outstanding at June 30, 1996 $0.13 - $0.63 $0.27 491,535

Granted $2.38 - $5.00 $3.69 761,908
Exercised $0.13 - $0.63 $0.54 (57,133)
Terminated $ 4.75 $4.75 (5,000)
------------- ---------- ---------

Options outstanding at June 30, 1997 $0.13 - $5.00 $2.42 1,191,310
------------- ----- ---------
------------- ----- ---------
Options exercisable at June 30, 1997 $0.13 - $5.00 $1.13 570,310
------------- ----- ---------
------------- ----- ---------
</TABLE>

The weighted average contractual life remaining of options outstanding at June
30, 1997 is approximately 5 years.

F-16
<PAGE>

STOCK-BASED COMPENSATION

The Company has adopted the disclosure-only provisions of SFAS No. 123. Had
compensation cost been determined based on the fair value of stock options
granted in 1997 and 1996 in a manner consistent with the method promulgated by
SFAS No. 123, the Company's net loss and loss per share would have been
increased to the pro forma amounts below:

For the Years Ended June 30 For the Period from
--------------------------- Inception (December 1992)
1997 1996 to June 30, 1997
---- ---- ----------------
Net loss:
As reported $ (1,577,229) $ (7,560,863) $ (11,734,611)
Pro forma $ (2,318,067) $ (8,833,939) $ (13,748,525)
Loss per share:
As reported $ (0.51) $ (5.89) $ (9.58)
Pro forma $ (0.75) $ (6.88) $ (11.23)

The fair value of each option grant was estimated on the date of the grant
using the Black-Scholes option pricing model. The assumptions used for the
Black-Scholes computation for the years ended June 30, 1997 and 1996 are as
follows: the risk-free interest rate was the U.S. Treasury Bond rate for the
corresponding grant date of 6.64% in 1996 and ranging from 5.97% to 6.64% in
1997; the exercise price is equal to the fair market value of the underlying
stock at the grant date; the expected life of the option is the term to
expiration, ranging from 1-10 years; volatility is 93.5%; and the common stock
will pay no dividends.

11. STOCK PURCHASE WARRANTS:

In connection with the BioQuant merger, outstanding warrants to purchase
BioQuant shares were converted to 74,083 warrants to purchase shares of the
Company's common stock at a price of $4.22.

In connection with Bridge Loans completed by the Company during June and
July 1996, the Company issued 300,000 warrants. Each warrant entitles the
holder to purchase a share of the Company's common stock for $5.70 and are
exercisable until April 30, 1998. No discount was recorded for the value of
the warrants because the amount was not material.

In October 1996, as a part of the IPO, 1,700,000 redeemable warrants were
issued. Each warrant entitles the holder to purchase one share of common stock
at an exercise price of $12.00. The warrants expire on January 31, 1998. These
warrants are redeemable by the Company under certain conditions at a redemption
price of $.10 per warrant, beginning April 30, 1997. As of June 30, 1997, the
Company has not redeemed any of these warrants.

Also in conjunction with the IPO, the Company issued a warrant to the
underwriters to purchase 170,000 shares of common stock at an exercise price of
$5.70 per share, exercisable over a four-year period commencing October 30,
1997.

During 1997, the Company issued 51,429 warrants to an institutional lender in
conjunction with a capital equipment leasing facility (Note 6). Each warrant
entitles the holder to purchase one share of the Company's common stock at an
exercise price of $2.63. The warrants expire on March 13, 2004. No discount
was recorded for the value of the warrants because the amount was not
material.

12. COMMITMENTS AND CONTINGENCIES

OPERATING LEASES

The Company has entered into non-cancelable operating leases for office
facilities. Under these leases, the Company is responsible for its
proportionate share of real estate taxes, insurance and common area maintenance
costs. Rent expense on these lease agreements was $222,033 and $205,128 for the
years ended June 30, 1997 and 1996, respectively, and $560,454 for the period
from inception to June 30, 1997.

F-17

<PAGE>

Future minimum lease payments are as follows:

YEAR ENDED JUNE 30,
-------------------

1998 . . . . . . . . . $ 215,050
1999 . . . . . . . . . 234,600
2000 . . . . . . . . . 237,999
2001 . . . . . . . . . 241,398
2002 . . . . . . . . . 245,404
Thereafter . . . . . . 1,208,020
----------
$2,382,471
----------
----------

TECHNOLOGY AND MANUFACTURING AGREEMENTS

The Company has entered into a license agreement with respect to its
osteoporosis technology. This agreement provides for royalty payments to the
licensors based on gross profits as defined in the agreement, with minimum
royalty payments of $15,000 each quarter. As of June 30, 1997, the Company has
made all required royalty payments.

The Company has also entered into a supply agreement with an affiliate of
the owners of the technology which requires certain minimum purchases to retain
the exclusive use of the licensed technology. This agreement requires the
Company to purchase a minimum of 100,000 units by March 31, 1998. As of June
30, 1997, all minimum purchase requirements have been met.

EMPLOYMENT AND NONCOMPETITION AGREEMENTS

The Company has entered into employment and noncompetition agreements with
certain executives. These agreements specify that the executives may not engage
in any competitive activity for periods ranging from 9 months to 2 years
following termination. The agreements will provide for compensation of 9 months
salary, bonuses and benefits in the event of termination without cause.

SPINPRO-Registered Trademark-

During 1997, the Company received notification of the termination of its
manufacturing agreement with a third party related to the manufacture of the
SPINPRO-Registered Trademark- product. As a result of this termination, the
Company has reimbursed the third party for the value of molds and production
equipment through the form of a capital equipment leasing facility (Note 5). As
of June 30, 1997, the remaining inventory, molds and production equipment, have
been relocated to a storage facility.

The Company is currently evaluating its alternatives for continuing
production of the SPINPRO-Registered Trademark- product. The Company estimated
the total cost of the relocation to be $100,000, which has been charged to the
accompanying consolidated statement of operations. As of June 30, 1997, a
liability of approximately $83,000 remains in order to cover the remaining costs
of identifying a manufacturer, placing equipment and personnel, and resuming
production. This amount is included in accrued liabilities on the accompanying
consolidated balance sheet.

13. SUBSEQUENT EVENTS (UNAUDITED)

The capital equipment leasing facility entered into with Transamerica
Business Credit Corporation, an institutional lender (the "Facility"), provides
credit for equipment purchases of $1,500,000 with $725,000 of immediately
available funds and an additional $775,000 of additional credit for equipment
purchases, once the Company has met certain objectives, including an infusion of
additional equity capital. After June 30, 1997 the immediately available
portion of the credit line was increased to $1,000,000.

F-18
<PAGE>

In August 1997, the Company announced an agreement with Segix for a market
and technical evaluation of the Company's OsteopatchTM diagnostic system for the
Italian market. At the end of this evaluation agreement, Segix has the option
to exercise an exclusive long term supply and distribution agreement with PBI
for the Italian market. If Segix exercises its option to execute the supply and
distribution agreement it will give the Company access to the Italian market
through Segix's 70 person direct sales force.

On September 26, 1997 the Company received from the former manufacturer
of SPINPRO-Registered Trademark- (Note 12) a demand for arbitration in
connection with alleged breaches of the contract relating to the manufacture
of SPINPRO-Registered Trademark-. The Company does not believe that the
claims have any merit and believes that the ultimate outcome of this
proceeding will not have a material impact on the Company.

14. MANAGEMENT'S PLANS

The Company anticipates, based on currently proposed plans and assumptions
relating to its operations, that the Company's current cash and cash equivalents
and short-term investments, together with projected revenues from operations,
and debt arrangements will be sufficient to satisfy its contemplated cash
requirements for the 1998 fiscal year. The Company is actively working to raise
additional funds through equity or debt arrangements to cover longer term
requirements.

F-19
<PAGE>

SIGNATURES

In accordance with section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

DATED: September 26, 1997 Pacific Biometrics, Inc.

By /S/PAUL G. KANAN
-----------------------------
Paul G. Kanan, President and Chief
Executive Officer

In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and dates.

/S/PAUL G. KANAN President, Chief Executive DATED: September 26,1997
- ------------------------ Officer and Director
Paul G. Kanan (principal executive officer)

/S/PETER B. LUDLUM Vice President, Chief DATED: September 26,1997
- ------------------------ Financial Officer and
Peter B. Ludlum Accounting Officer
(principal financial officer)

/S/ELLEN A. RUDNICK Chairman of the Board DATED: September 26,1997
- ------------------------
Ellen A. Rudnick

/S/MARY L. CAMPBELL Director and Treasurer DATED: September 26,1997
- ------------------------
Mary L. Campbell

/S/TERRY M. GILES Director DATED: September 26,1997
- ------------------------
Terry M. Giles

/S/CRAIG M. GOLDSTONE Director DATED: September 26,1997
- ------------------------
Craig M. Goldstone

/S/DOUGLAS S. HARRINGTON Director and Secretary DATED: September 26,1997
- ------------------------
Douglas S. Harrington

<PAGE>

INDEX OF EXHIBITS

1.1 -- Revised Form of Underwriting Agreement.*
3.1 -- Certificate of Incorporation of the Registrant.*
3.2 -- Amended and Restated By-Laws of the Registrant.*
4.1 -- Specimen Stock Certificate.*
4.2 -- Specimen Warrant Certificate.*
4.3 -- Form of Warrant Agreement.*
4.4 -- Revised Form of Underwriter's Purchase Warrant.*
10.1 -- License Agreement, dated December 31, 1992, by and between Sudor
Partners and CEO Advisors, Inc.*
10.2 -- Amendment No. 1 To License Agreement, dated August 6, 1993 by and
between Sudor Partners and CEO Advisors, Inc.*
10.3 -- Supply Agreement, dated August 6, 1993, by and between Sudormed, Inc.
and CEO Advisors, Inc.*
10.4 -- Assignment of License and Supply Agreements--Consent, dated September
7, 1993, October 7, 1993 and October 11, 1993, by and between CEO
Advisors, Inc. and BioQuant, Inc.*
10.5 -- License Agreement, dated February 15, 1995, by and between Metra and
BioQuant.*, **
10.6 -- Development Agreement, dated October 4, 1995, by and between BioQuant
and Assay Designs.*
10.7 -- Agreement, dated October 26, 1995, by and between PBI-WA and Sigma
Diagnostics.*
10.8 -- Manufacturing Agreement, dated March 1, 1996, by and between Merchant
House Scientific and Irvine Scientific.*
10.9 -- Agreement and Plan of Merger, dated May 15, 1996, by and among
BioQuant, Inc., Pacific Biometrics Inc. and BioQuant-Acquisition,
Inc.*
10.10 -- Agreement and Plan of Merger, dated May 15, 1996, by and among Pacific
Biometrics, Inc. (Washington), Pacific Biometrics, Inc. (Delaware),
and PBI-Acquisition, Inc.*
10.11 -- Office Lease, dated January 15, 1990, by and between Bruce M. and Ann
Stever Blume and Pacific Biometrics, Inc.*
10.12 -- Amendment No. 1 to Lease Agreement, dated June 15, 1992, by and
between Blume 1100 Limited Partnership and Pacific Biometrics, Inc.*
10.13 -- Office Lease, dated August 13, 1992, by and between Blume 1100 Limited
Partnership and Drake Mortgage.*
10.14 -- Assignment of Lease, dated November 30, 1993, by and between Pacific
Biometrics, Inc. and Columbia First Service, Inc.*
10.15 -- Standard Form Lease, dated May 23, 1993, by and between Merchant House
Scientific and Harris Trust and Savings Bank.*
10.16 -- First Amendment to Lease, dated July 11, 1996, by and between Bank of
New York, as directed Trustee for Unisys Master Trust and
Registrant.*
10.17 -- Stock Incentive Plan.*
10.18 -- Employment Agreement, dated October 14, 1996, by and between
Registrant and Ellen A. Rudnick.*
10.19 -- Employment Agreement, dated October 14, 1996 by and between Registrant
and Paul G. Kanan.*
10.20 -- Employment Agreement, dated October 23, 1996 by and between Registrant
and G. Russell Warnick.*
10.21 -- Employment Agreement, dated October 22, 1996 by and between Registrant
and Elizabeth Teng Leary, Ph.D.*
10.22 -- Clinical Laboratory Agreement, dated March 8, 1995, by and between
Warner-Lambert Company and Registrant.*
10.23 -- Clinical Laboratory Agreement, dated March 7, 1996 by and between
Parke-Davis Pharmaceutical Research and Registrant.*
10.24 -- Clinical Laboratory Agreement, dated March 7, 1996, by and between
Parke-Davis Pharmaceutical Research and Registrant.*
10.25 -- Office Lease, dated April 23, 1997, by and between Tom Kane and Elsa
Kane and Pacific Biometrics, Inc.
21.1 -- Subsidiaries.*
25.1 -- Powers of Attorney appear on the signature page in Part II of the
Registration Statement filed on September 6, 1996.*
27.1 -- Financial Data Schedule.

<PAGE>

* Incorporated by reference to Exhibits of Registrant's Registration
Statement on Form SB-2, Registration No. 333-11551

** Portions of this document have been deleted pursuant to a request for
confidential treatment.

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
THIS HAS BEEN PREPARED FOR SUBMISSION TO YOUR ATTORNEY FOR REVIEW AND
APPROVAL PRIOR TO SIGNING
NO REPRESENTATION IS MADE BY LICENSEE AS TO ITS LEGAL SUFFICIENCY
OR TAX CONSEQUENCES
CBA TEXT DISCLAIMER: TEXT DELETED BY LICENSEE INDICATED BY STRIKE. NEW TEXT
INSERTED BY LICENSEE INDICATED BY SMALL CAPITAL LETTERS.

THIS LEASE AGREEMENT ("the Lease") is entered into this 23RD day of APRIL,
1997, between TOM KANE AND ELSA KANE ("Landlord"), and PACIFIC BIOMETRICS,
INC. ("Tenant"). Landlord and Tenant agree as follows:

1. LEASE SUMMARY.

a. LEASED PREMISES. The leased premises (the "Premises") consist of the
real property legally described on attached Exhibit A, and all
improvements thereon.

b. LEASE COMMENCEMENT DATE. The Lease shall commence on AUGUST 1, 1997,
or such earlier or later date as provided in Section 3 (the "Commencement
Date").

c. LEASE TERMINATION DATE. The Lease shall terminate at midnight on
JULY 31, 2007, or such earlier or later date as provided in Section 3
(the "Termination Date").

d. BASE RENT. The base monthly rent shall be (check one): / / $_____, or
/X/ according to the Rent Rider attached hereto. Rent shall be payable at
Landlord's address shown in Section 1(h) below, or such other place
designated in writing by Landlord.

e. PREPAID RENT. Upon execution of this Lease, Tenant shall deliver to
Landlord the sum of $19,550.05 as prepaid rent, to be applied to the Rent
due for the SECOND month(s) of the Lease.

f. SECURITY DEPOSIT. The amount of the security deposit is $100,000.00.

g. PERMITTED USE. The Premises shall be used only for GENERAL OFFICE AND
TESTING LABORATORY and for no other purpose without the prior written
consent of Landlord.

h. NOTICE AND PAYMENT ADDRESSES:

Landlord: 610 WEST HIGHLAND DRIVE, SEATTLE, WA 98119 Fax No.:_____

Tenant: 220 WEST HARRISON, SEATTLE, WA 98119 Fax No.:_____

i. LEASE COMMISSION. Landlord shall pay a commission to COLLIER'S
MACAULAY NICOLLS INTERNATIONAL ("Landlord's Broker") in the amount stated
in a separate listing agreement or, if there is no listing agreement,
then (check one)

/ / $_____/_____ % (complete only one) of the gross rent payable pursuant
to Section 1(d) or

/ / $_____ per square foot of the Premises. The commission shall be
earned upon occupancy of the Premises by Tenant, and paid one-half upon
execution of this Lease and one-half upon occupancy of the Premises by
Tenant. Landlord's Agent shall pay to _____ ("Tenant's Broker") the
amount stated in a separate agreement between them or, if there is no
agreement, $_____/_____ % (complete only one) of the commission paid to
Landlord's Agent, within five (5) days after receipt by Landlord's Agent.

2. PREMISES. Landlord leases to Tenant, and Tenant leases from Landlord the
Premises upon the terms specified in this Lease.

3. TERM.

a. COMMENCEMENT DATE. The Lease shall commence on the date specified in
Section 1(b), or on such earlier or later date as may be specified by
written notice delivered by Landlord to Tenant advising Tenant that the
Premises are ready for possession and specifying the Commencement Date,
which shall not be less than _____ (30 if not completed) days following
the date of such notice. If Tenant occupies the Premises before the
Commencement Date specified in Section 1(b), then the Commencement Date
shall be the date of occupancy. If Landlord acts diligently to make the
Premises available to Tenant, neither Landlord nor any agent or employee
of Landlord shall be liable for any damage or loss due to Landlord's
inability or failure to deliver possession of the Premises to Tenant as
provided in this Lease EXCEPT IF SUCH FAILURE RESULTS FROM LANDLORD'S
NEGLIGENCE. The Termination Date shall be modified upon any change in the
Commencement Date so that the length of the Lease term is not changed. If
Landlord does not deliver possession of the Premises to Tenant within THIRTY
(30) days (60 if not completed) after the date specified in Section 1(b),
Tenant may elect to cancel this Lease by giving written notice to Landlord
within 30 days after such time period ends. If Tenant gives such notice, the
Lease shall be canceled, all prepaid rent and security deposits shall be
refunded to tenant, and neither Landlord nor Tenant shall have any further
obligations to the other. The first "Lease Year" shall commence on the
Commencement Date and shall end on the date which is twelve (12) months
from the end of the month in which the Commencement Date occurs. Each
successive Lease Year during the initial term and any

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LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

extension terms shall be twelve (12) months, commencing on the first day
following the end of the preceding Lease Year, except that the last Lease
Year shall end on the Termination Date.

b. TENANT OBLIGATIONS. To the extent Tenant's tenant improvements are not
completed in time for the Tenant to occupy or take possession of the
Premises on the Commencement Date due to the failure of Tenant to fulfill
any of its obligations under this Lease, the Lease shall nevertheless
commence on the Commencement Date.

Except as specified elsewhere in this Lease, Landlord makes no
representations or warranties to Tenant regarding the Premises, including
the structural condition of the Premises and the condition of all
mechanical, electrical, and other systems on the Premises. Except for any
tenant improvements described on attached Exhibit B to be completed by
Landlord (defined therein as "Landlord's Work"), Tenant shall be
responsible for performing any work necessary to bring the Premises into
condition satisfactory to Tenant. By signing this Lease, Tenant
acknowledges that it has had adequate opportunity to investigate the
Premises, acknowledges responsiblity for making any corrections,
alterations and repairs to the Premises (other than the Landlord's Work),
and acknowledges that the time needed to complete any such items shall not
delay the Commencement Date.

Attached Exhibit B sets forth all Landlord's Work, if any, and all tenant
improvements to be completed by Tenant ("Tenant's Work"), which is to be
performed on the Premises. Responsibilities for design, payment and
performance of all such work shall be as set forth on attached Exhibit B.
If Tenant fails to notify Landlord of any defects in the Landlord's Work
within THIRTY (30) days of delivery of possession to Tenant, Tenant shall
be deemed to have accepted the Premises in their then condition. If Tenant
discovers any major defects in the Landlord's Work during this 30 day
period that would prevent Tenant from using the Premises for its intended
purpose, Tenant shall so notify Landlord in writing and the Commencement
Date shall be delayed until after Landlord has corrected the major defects
and Tenant has had five (5) days to inspect and approve the Premises after
Landlord's correction of such defects. The Commencement Date shall not be
delayed if Tenant's inspection reveals minor defects in the Landlord's
Work that will not prevent Tenant from using the Premises for their
intended purpose. Tenant shall prepare a punch list of all minor defects
and provide the punch list to Landlord. Landlord shall promptly correct
all punch list items.

4. RENT. Tenant shall pay Landlord without demand, deduction or offset, in
lawful money of the United States, the monthly rental stated in
Section 1(d) in advance on or before the first day of each month during
the Lease Term, and any other additional payments due to Landlord
(collectively the "Rent") when required under this Lease. Payments for
any partial month at the beginning or end of the Lease term shall be
prorated.

If any sums payable by Tenant to Landlord under this Lease are not
received by the TENTH (10TH) day of each month, Tenant shall pay Landlord
in addition to the amount due, for the cost of collecting and handling
such late payment, an amount equal to the greater of $100 or five percent
(5%) of the delinquent amount. In addition, all delinquent sums payable
by Tenant to Landlord and not paid within TEN (10) days of the due date
shall, at Landlord's option, bear interest at the rate of twelve percent
(12%) per annum, or the highest rate of interest allowable by law,
whichever is less. Interest on all delinquent amounts shall be calculated
from the original due date to the date of payment.

Landlord's acceptance of less than the full amount of any payment due
from Tenant shall not be deemed an accord and satisfaction or compromise
of such payment unless Landlord specifically consents in writing to
payment of such lesser sum as an accord and satisfaction or compromise of
the amount which Landlord claims.

5. SECURITY DEPOSIT. UPON EXECUTION OF THE LEASE, TENANT SHALL DEPOSIT INTO
AN INTEREST BEARING SECURITY DEPOSIT ACCOUNT AS SPECIFIED IN SECTION 1(F)
ABOVE. If Tenant breaches any covenant or condition of this Lease,
including but not limited to the payment of Rent, Landlord may apply all
or any part of the PRINCIPAL OF THE security deposit to the payment of
any sum in default and any damage suffered by Landlord as a result of
Tenant's breach. In such event, Tenant shall, within five (5) days after
written demand therefor by Landlord, deposit with Landlord the amount so
applied. Any payment to Landlord from the security deposit shall not be
construed as a payment of liquidated damages for any default. If Tenant
complies with all of the covenants and conditions of this Lease
throughout the SEVENTH (7TH) YEAR OF THIS Lease term, the security
deposit shall be repaid to Tenant with interest within 30 days.

6. USES. The Premises shall be used only for the use(s) specified in
Section 1(g) above (the "Permitted Use"), and for no other business or
purpose without the prior written consent of Landlord. No act shall be
done on or around the Premises that is unlawful or that will increase the
existing rate of insurance on the Premises. Tenant shall not commit or
allow to be committed any waste upon the Premises, or any public or
private nuisance.

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LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

7. COMPLIANCE WITH LAWS. Tenant shall not cause or permit the Premises to
be used in any way which violates any law, ordinance, or governmental
regulation or order. Landlord represents to Tenant that, to the best of
Landlord's knowledge, with the exception of any Tenant's Work, as of the
Commencement Date, the Premises comply with all applicable laws, rules,
regulations, or orders, including without limitation, the Americans With
Disabilities Act, if applicable, and Landlord shall be responsible to
promptly cure any noncompliance which existed on the Commencement Date.
Tenant shall be responsible for complying with all laws applicable to the
Premises as a result of Tenant's particular use, such as modifications
required by the Americans With Disabilities Act as a result of Tenant
opening the Premises to the public as a place of public accommodation. If
the enactment or enforcement of any law, ordinance, regulation or code
during the Lease term requires any changes to the Premises during the
Lease term, the Tenant shall perform all such changes at its expense if
the changes are required due to the nature of Tenant's activities at the
Premises, or to alterations that Tenant seeks to make to the Premises;
otherwise, Landlord shall perform all such changes at its expense.

8. UTILITIES. Landlord shall not be responsible for providing any utilities
to the Premises, but represents and warrants to Tenant that as of the
Commencement Date electricity, water, sewer, and telephone utilities are
available to the Premises. Tenant shall determine whether the
available capacity of such utilities will meet Tenant's needs. Tenant shall
install and connect, if necessary, and directly pay for all water, sewer,
gas, janitorial, electricity, garbage removal, heat, telephone, and other
utilities and services used by Tenant on the Premises during the Term, SO
LONG AS such services are billed directly to Tenant.

9. TAXES. Tenant shall pay all Taxes (defined below) applicable to the
Premises during the Lease term. All payments for Taxes shall be made at
least ten (10) days prior to their due date. Tenant shall promptly furnish
Landlord with satisfactory evidence that Taxes have been paid. If any Taxes
paid by Tenant cover any period of time before or after the expiration of
the Term, Tenant's share of those Taxes will be prorated to cover only the
period of time within the tax fiscal year during which this Lease was in
effect, and Landlord shall promptly reimburse Tenant to the extent required.
If Tenant fails to timely pay any Taxes, Landlord may pay them, and Tenant
shall repay such amount to Landlord with Tenant's next rent installment.

The term "Taxes" shall mean: (i) any form of real estate tax or
assessment imposed on the Premises by any authority, including any city,
state or federal government, or any improvement district, as against any
legal or equitable interest of Landlord or Tenant in the Premises or in the
real property of which the Premises are a part, or against rent paid for
leasing the Premises; and (ii) any form of personal property tax or
assessment imposed on any personal property, fixtures, furniture, tenant
improvements, equipment, inventory, or other items, and all replacements,
improvements, and additions to them, located on the Premises, whether owned
by Landlord or Tenant. "Taxes" shall exclude any net income tax imposed on
Landlord for income that Landlord receives under this Lease.

Tenant may contest the amount or validity, in whole or in part, of any
Taxes at its sole expense, only after paying such Taxes or posting such
security as Landlord may reasonably require in order to protect the Premises
against loss or forfeiture. Upon the termination of any such proceedings,
Tenant shall pay the amount of such Taxes or part of such Taxes as finally
determined, together with any costs, fees, interest penalties, or other
related liabilities. Landlord shall cooperate with Tenant in contesting any
Taxes, provided Landlord incurs no expense or liability in doing so.

10. ALTERATIONS. Tenant may make alterations, additions or improvements to
the Premises, including any Tenant's Work identified on attached Exhibit B
("Alterations"), with the prior written consent of Landlord WHICH CONSENT
WILL NOT BE UNREASONABLY WITHHELD OR DELAYED. The term "Alterations" shall
not include the installation of shelves, movable partitions, Tenant's
equipment, and trade fixtures which may be performed without damaging
existing improvements or the structural integrity of the Premises, and
Landlord's consent shall not be required for Tenant's installation of those
items. Tenant shall complete all Alterations at Tenant's expense in
compliance with all applicable laws and in accordance with plans and
specifications approved by Landlord, and using contractors approved by
Landlord. Landlord shall be deemed the owner of all Alterations except for
those which Landlord requires to be removed at the end of the Lease term.
Tenant shall remove all Alterations at the end of the Lease term unless
Landlord conditioned its consent upon Tenant leaving a specified
Alteration at the Premises, in which case Tenant shall not remove such
Alteration. Tenant shall immediately repair any damage to the Premises
caused by removal of Alterations.

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LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

11. REPAIRS AND MAINTENANCE. Tenant shall, at its sole expense, maintain the
Premises in good condition and promptly make all NON-STRUCTURAL repairs
and replacements, necessary to keep the Premises in safe operating
condition, but excluding the roof, foundation and exterior walls, which
Landlord shall maintain in good condition and repair at Landlord's
expense. Tenant shall not damage any demising wall or disturb the
structural integrity of the Premises and shall promptly repair any damage
or injury done to any such demising walls or structural elements caused
by Tenant or its employees, agents, contractors, or invitees.
Notwithstanding anything in this Section to the contrary, Tenant shall
not be responsible for any repairs to the Premises made necessary by the
acts of Landlord or its agents, employees, contractors or invitees
therein.

Upon expiration of the Lease term, whether by lapse of time or otherwise,
Tenant shall promptly and peacefully surrender the Premises, together
with all keys, to Landlord in as good condition as when received by
Tenant from Landlord or as thereafter improved, reasonable wear and tear
and insured casualty excepted.

12. ACCESS. After reasonable notice from Landlord (except in cases of
emergency, where no notice is required), Tenant shall permit Landlord and
its agents and employees to enter the Premises at all reasonable times
for the purposes of repair or inspection. This Section shall not impose
any repair or other obligation upon Landlord not expressly stated
elsewhere in this Lease. After reasonable notice to Tenant, Landlord
shall have the right to enter the Premises for the purpose of showing
the Premises to prospective purchasers or lenders at any time, and to
prospective tenants within 180 days prior to the expiration or sooner
termination of the Lease term.

NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS LEASE; LANDLORD
RECOGNIZES THE WORK TO BE PERFORMED BY TENANT IS CONFIDENTIAL AND
PROPRIETARY, AND LANDLORD WILL USE ITS BEST EFFORTS TO ENTER THE
PREMISES, OR ALLOW ITS AGENTS AND EMPLOYEES TO ENTER THE PREMISES,
ONLY WHEN ACCOMPANIED BY AN ESCORT PROVIDED BY TENANT. LANDLORD WILL
BE LIABLE TO TENANT FOR ANY DAMAGE RESULTING FROM LANDLORD'S
VIOLATION OF THIS SECTION 12.

13. SIGNAGE. Tenant shall obtain Landlord's written consent before
installing any signs upon the Premises WHICH CONSENT WILL NOT BE
UNREASONABLY WITHHELD OR DELAYED. Tenant shall install any approved
signage at Tenant's sole expense and in compliance with all applicable
laws. Tenant shall not damage or deface the Premises in installing or
removing signage and shall repair any injury or damage to the Premises
caused by such installation or removal.

14. DESTRUCTION OR CONDEMNATION.

a. DAMAGE AND REPAIR. If the Premises are partially damaged but not
rendered untenantable, by fire or other insured casualty, then
Landlord shall diligently restore the Premises and this Lease shall
not terminate. The Premises shall not be deemed untenantable if
less than twenty-five percent (25%) of the Premises are damaged.
If insurance proceeds are available to Landlord but are not
sufficient to pay the entire cost of restoring the Premises, then
Landlord may elect to terminate this Lease and keep the insurance
proceeds, by notifying Tenant within sixty (60) days of the date of
such casualty. LANDLORD WILL, HOWEVER, CARRY "FULL REPLACEMENT COST"
INSURANCE.

If the Premises are entirely destroyed, or partially damaged and rendered
TOTALLY untenantable, by fire or other casualty, Landlord may, at its
option: (a) terminate this Lease as provided herein, or (b) restore the
Premises to their previous condition. If, within 60 days after receipt by
Landlord from Tenant of written notice that Tenant REASONABLY deems the
Premises untenantable, Landlord fails to notify Tenant of its election to
restore the Premises, or if Landlord is unable to restore the Premises
within six (6) months of the date of the casualty event, then Tenant may
elect to terminate the Lease.

If Landlord restores the Premises under this Section 14(a), Landlord
shall proceed with reasonable diligence to complete the work, and the
base monthly rent shall be abated in the same proportion as the
untenantable portion of the Premises bears to the whole Premises,
provided that there shall be a rent abatement only if the damage or
destruction of the Premises did not result from, the neglect of Tenant,
or Tenant's officers, contractors, licensees, agents, servants,
employees, guests, OR invitees. Provided, Landlord complies with its
obligations under this Section, no damages, compensation or claim shall
be payable by Landlord for inconvenience, loss of business or annoyance
directly, incidentally or consequentially arising from any repair or
restoration of any portion of the Premises. Landlord will not carry
insurance of any kind for the protection of Tenant or any improvements
paid for by Tenant or as provided in Exhibit B or on Tenant's furniture
or on any fixtures, equipment, improvements or appurtenances of Tenant
under this Lease, and Landlord shall not be obligated to repair any
damage thereto or replace the same unless the damage is caused by
Landlord's negligence.

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LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

b. If the Premises are made untenantable by eminent domain, or conveyed
under a threat of condemnation, this Lease shall automatically terminate
as of the earlier of the date title vests in the condemning authority or
the condemning authority first has possession of the Premises and all
Rents and other payments shall be paid to that date. In case of taking of
a part of the Premises that does not render the Premises untenantable,
then this Lease shall continue in full force and effect and the base
monthly rental shall be equitably reduced based on the proportion by
which the floor area of any structures is reduced, such reduction in Rent
to be effective as of the earlier of the date the condemning authority
first has possession of such portion or title vests in the condemning
authority. Landlord shall be entitled to the entire award from the
condemning authority attributable to the value of the Premises and Tenant
shall make no claim for the value of its leasehold. Tenant shall be
permitted to make a separate claim against the condemning authority for
moving expenses or damages resulting from interruption in its business,
provided that in no event shall Tenant's claim reduce Landlord's award.

15. INSURANCE.

a. LIABILITY INSURANCE. During the Lease term, Tenant shall pay for and
maintain commercial general liability insurance with broad form property
damage and contractual liability endorsements. This policy shall name
Landlord as an additional insured, and shall insure Tenant's activities
and those of Tenant's employees, officers, contractors, licenses, agents,
servants, employees, guests, invitees or visitors with respect to the
Premises against loss, damage or liability for personal injury or death
or loss or damage to property with a combined single limit of not less
than $1,000,000, and a deductible of not more than $5,000. The insurance
will be noncontributory with any liability insurance carried by Landlord.

b. CASUALTY INSURANCE. During the Lease term, Tenant shall pay for and
maintain all-risk coverage casualty insurance for the Premises, in an
amount sufficient to prevent Landlord or Tenant from becoming a
co-insurer under the terms of the policy, and in an amount not less than
the replacement cost of the Premises, with a deductible of not more than
$5,000. The casualty insurance policy shall name Tenant as the insured
and Landlord and Landlord's lender(s) as additional insureds, with loss
payable to Landlord, Landlord's lender(s), and Tenant as their interests
may appear. In the event of a casualty loss on the Premises, Landlord may
apply insurance proceeds under the casualty insurance policy in the
manner described in Section 14(a).

c. MISCELLANEOUS. Insurance required under this Section shall be with
companies rated A-XV or better in Best's Insurance Guide, and which are
authorized to transact business in the State of Washington. No insurance
policy shall be canceled or reduced in coverage and each such policy
shall provide that it is not subject to cancellation or a reduction in
coverage except after thirty (30) days prior written notice to Landlord.
Tenant shall deliver to Landlord upon commencement of the Lease and from
time to time thereafter, copies or certificates of the insurance policies
required by this Section. In no event shall the limit of such policies
be considered as limiting the liability of Tenant under this Lease.

d. WAIVER OF SUBROGATION. Landlord and Tenant hereby release each other
and any other tenant, their agents or employees, from responsibility for,
and waive their entire claim of recovery for any loss or damage arising
from any cause covered by insurance required to be carried by each of
them. Each party shall provide notice to the insurance carrier or
carriers of this mutual waiver of subrogation, and shall cause its
respective insurance carriers to waive all rights of subrogation against
the other. This waiver shall not apply to the extent of the deductible
amounts to any such policies or to the extent of liabilities exceeding
the limits of such policies.

16. INDEMNIFICATION. Tenant shall defend, indemnify, and hold Landlord
harmless against all liabilities, damages, costs, and expenses, including
attorneys' fees, arising from any negligent or wrongful act or omission
of Tenant or Tenant's officers, contractors, licensees, agents, servants,
employees, guests, OR invitees on or around the Premises as a result of
any act, omission or negligence of Tenant, or Tenant's officers,
contractors, licensees, agents, servants, employees, guests, invitees, or
visitors, or arising from any breach of this Lease by Tenant. Tenant
shall use legal counsel acceptable to Landlord in defense of any action
within Tenant's defense obligation. Landlord shall defend, indemnify and
hold Tenant harmless against all liabilities, damages, costs, and
expenses, including attorneys' fees, arising from any negligent or
wrongful act or omission of Landlord or Landlord's officers, contractors,
licensees, agents, servants, employees, guests, invitees, or visitors on
or around the Premises or arising from any breach of this Lease by
Landlord. Landlord shall use legal counsel acceptable to Tenant in
defense of any action within Landlord's defense obligation.

17. ASSIGNMENT AND SUBLETTING. Tenant shall not assign, sublet, mortgage,
encumber or otherwise transfer any interest in this Lease (collectively
referred to as a "Transfer") or any part of the Premises, without first
obtaining Landlord's written consent which shall not be unreasonably
withheld or delayed. No Transfer shall relieve Tenant of

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LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

any liability under this Lease notwithstanding Landlord's consent to
such transfer. Consent to any Transfer shall not operate as a waiver of
the necessity for Landlord's consent to any subsequent Transfer.

If Tenant is a partnership, limited liability company, corporation, or
other entity, any transfer of this Lease by merger, consolidation,
redemption or liquidation, or any change(s) in the ownership of, or power
to vote, which singularly or collectively represents a majority of the
beneficial interest in Tenant, shall constitute a Transfer under this
Section.

As a condition to Landlord's approval, if given, any potential assignee
or sublessee otherwise approved by Landlord shall assume all obligations
of Tenant under this Lease and shall be jointly and severally liable with
Tenant and any guarantor, if required, for the Payment of Rent and
performance of all terms of this Lease. In connection with any Transfer,
Tenant shall provide Landlord with copies of all assignments, subleases
and assumption instruments.

NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS LEASE; IF TENANT IS A
PUBLICLY OWNED COMPANY, TRANSFERS OF STOCK IN TENANT IN ANY AMOUNT WILL
BE PERMITTED WITHOUT LANDLORD'S CONSENT.

18. LIENS. Tenant shall keep the Premises free from any liens created by or
through Tenant. Tenant shall indemnify and hold Landlord harmless from
liability from any such liens including, without limitation, liens
arising from any Alterations. If a lien is filed against the Premises by
any person claiming by, through or under Tenant, Tenant shall, upon
request of Landlord, at Tenant's expense, immediately furnish to Landlord
a bond in form and amount and issued by a surety satisfactory to
Landlord, indemnifying Landlord and the Premises against all liabilities,
costs and expenses, including attorneys' fees, which Landlord could
reasonably incur as a result of such lien(s).

19. DEFAULT. The following occurrences shall each be deemed an Event of
Default by Tenant.

a. FAILURE TO PAY. Tenant fails to pay any sum, including Rent, due under
this Lease following THREE (3) days written notice from Landlord of the
failure to pay.

c. INSOLVENCY. Tenant becomes insolvent, voluntarily or involuntarily
bankrupt, or a receiver, assignee or other liquidating officer is
appointed for Tenant's business, provided that in the event of any
involuntary bankruptcy or other insolvency proceeding, the existence of
such proceeding such constitute an Event of Default only if such
proceeding is not dismissed or vacated within 60 days after its
institution or commencement.

d. LEVY OR EXECUTION. Tenant's interest in this Lease or the Premises, or
any part thereof, is taken by execution or other process of law directed
against Tenant, or is taken upon or subjected to any attachment by any
creditor of Tenant, if such attachment is not discharged within 15 days
after being levied.

e. OTHER NON-MONETARY DEFAULTS. Tenant breaches any agreement, term or
covenant of this Lease other than one requiring the payment of money and
not otherwise enumerated in this Section, and the breach continues for a
period of 10 days after the notice by Landlord to Tenant of the breach.

G. NOTWITHSTANDING ANYTHING IN THE LEASE TO CONTRARY, IF ANY BREACH
OF THIS LEASE BY TENANT CANNOT REASONABLY BE CURED WITHIN THIRTY (30)
DAYS, SUCH BREACH WILL NOT BE AN EVENT OF DEFAULT UNDER THIS LEASE SO
LONG AS TENANT COMMENCES TO CURE THE BREACH WITHIN THE THIRTY (30) DAY
PERIOD AND DILIGENTLY PURSUES TO CURE THE BREACH WITHIN A REASONABLE
PERIOD OF TIME.

20. REMEDIES.

Landlord shall have the following remedies upon an Event of Default.
Landlord's rights and remedies under this Lease shall be cumulative, and
none shall exclude any other right or remedy allowed by law.

a. TERMINATION OF LEASE. Landlord may terminate Tenant's interest under
the Lease, but no act by Landlord other than written notice from Landlord
to Tenant of termination shall terminate this Lease. The Lease shall
terminate on the date specified in the notice of termination. Upon
termination of this Lease, Tenant will remain liable to Landlord for
damages in an amount equal to the rent and other sums that would have
been owing by Tenant under this Lease for the balance of the Lease term,
less the net proceeds, if any, of any reletting of the Premises by
Landlord subsequent to the termination, after deducting all Landlord's
Reletting Expenses (as defined below). Landlord shall be entitled to
either collect damages from Tenant monthly on the days on which rent or
other amounts would have been payable under the Lease, or alternatively,
Landlord may accelerate Tenant's obligations under the Lease and recover
from Tenant; (i) unpaid rent which had been earned at the time of
termination; (ii) the amount by which the unpaid rent which would

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LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

have been earned after termination until the time of award exceeds the amount
of rent loss that Tenant proves could reasonably have been avoided; (iii) the
amount by which the unpaid rent for the balance of the term of the Lease
after the time of award exceeds the amount of rent loss that Tenant proves
could reasonably be avoided (discounting such amount by the discount rate of
the Federal Reserve Bank of San Francisco at the time of the award, plus 1%);
and (iv) any other amount necessary to compensate Landlord for all the
detriment proximately caused by Tenant's failure to perform its obligations
under the Lease, or which in the ordinary course would be likely to result
from the Event of Default, including without limitation Reletting Expenses
described in Section 20b.

b. RE-ENTRY AND RELETTING. Landlord may continue this Lease in full force
and effect, and without demand or notice, re-enter and take possession of
the Premises or any part thereof, expel the Tenant from the Premises and
anyone claiming through or under the Tenant, and remove the personal property
of either. Landlord may relet the Premises, or any part of them, in
Landlord's or Tenant's name for the account of Tenant, for such period of
time and at such other terms and conditions, as Landlord, in its discretion
may determine. Landlord may collect and receive the rents for the Premises.
Re-entry or taking possession of the Premises by Landlord under this Section
shall not be construed as an election on Landlord's part to terminate this
Lease, unless a written notice of termination is given to Tenant. Landlord
reserves the right following any re-entry or reletting, or both, under this
Section to exercise its right to terminate the Lease. During the Event of
Default, Tenant will pay Landlord the rent and other sums which would be
payable under this Lease if repossession had not occurred, LESS the net
proceeds, if any, after reletting the Premises, after deducting Landlord's
Reletting Expenses. "Reletting Expenses" is defined to include all expenses
incurred by Landlord in connection with reletting the Premises, including
without limitation, all repossession costs, brokerage commissions, attorneys'
fees, remodeling and repair costs, costs for removing and storing Tenant's
property and equipment, and rent concessions granted by Landlord to any new
Tenant, prorated over the life of the new lease.

c. WAIVER OF REDEMPTION RIGHTS. Tenant, for itself, and on behalf of any
and all persons claiming through or under Tenant, including creditors of all
kinds, hereby waives and surrenders all rights and privileges which they may
have under any present or future law, to redeem the Premises or to have a
continuance of this Lease for the Lease term, as it may have been extended.

d. NONPAYMENT OF ADDITIONAL RENT. All costs which Tenant agrees to pay to
Landlord pursuant to this Lease shall in the event of nonpayment be treated
as if they were payments of Rent, and Landlord shall have all the rights
herein provided for in case of nonpayment of Rent.

e. FAILURE TO REMOVE PROPERTY. If Tenant fails to remove any of its
property from the Premises at Landlord's request following an uncured Event
of Default, Landlord may, at its option, remove and store the property at
Tenant's expense and risk. If Tenant does not pay the storage cost within
five (5) days of Landlord's request, Landlord may, at its option, have any or
all of such property sold at public or private sale (and Landlord may become
a purchaser at such sale), in such manner as Landlord deems proper, without
notice to Tenant. Landlord shall apply the proceeds of such sale: (i) to the
expense of such sale, including reasonable attorneys' fees actually incurred;
(ii) to the payment of the costs or charges for storing such property;
(iii) to the payment of any other sums of money which may then be or
thereafter become due Landlord from Tenant under any of the terms hereof; and
(iv) the balance, if any, to Tenant. Nothing in this Section shall limit
Landlord's right to sell Tenant's personal property as permitted by law to
foreclose Landlord's lien for unpaid rent.

F. LANDLORD DEFAULT. LANDLORD WILL BE IN DEFAULT UNDER THIS LEASE IF
LANDLORD FAILS TO PERFORM OR OBSERVE ANY OBLIGATION OF LANDLORD UNDER THIS
LEASE IF THE FAILURE IS NOT CURED WITHIN THIRTY (30) DAYS AFTER WRITTEN
NOTICE HAS BEEN GIVEN BY TENANT TO LANDLORD. IF THE DEFAULT CANNOT BE
REASONABLY BE CURED WITHIN THIRTY (30) DAYS, LANDLORD WILL NOT BE IN DEFAULT
IF LANDLORD COMMENCES TO CURE THE DEFAULT WITHIN THE THIRTY (30) DAY PERIOD
AND DILIGENTLY PURSUES TO CURE THE DEFAULT WITHIN A REASONABLE PERIOD OF
TIME. IF, HOWEVER, THE NATURE OF THE DEFAULT ADVERSELY IMPACTS TENANT'S
ABILITY TO CONDUCT THEIR BUSINESS, THEN CURE PERIOD SHOULD BE NO MORE THAN
FIVE (5) WORKING DAYS AFTER TENANT'S NOTICE. IF LANDLORD IS IN DEFAULT UNDER
THIS LEASE, TENANT MAY (A) CURE LANDLORD'S DEFAULT AND OFFSET RENT PAYMENTS
UNTIL TENANT HAS RECOVERED THE COST OF SUCH CURE OF (B) TERMINATE THIS LEASE,
IN WHICH CASE THIS LEASE SHALL BE OF NO FURTHER FORCE OR EFFECT AND NEITHER
PARTY SHALL HAVE ANY FURTHER OBLIGATION TO THE OTHER.

21. MORTGAGE SUBORDINATION AND ATTORNMENT. This Lease shall automatically be
subordinate to any mortgage or deed of trust created by Landlord which is
now existing or hereafter placed upon the Premises including any advances,
interest, modifications, renewals, replacements or extensions ("Landlord's
Mortgage"), provided the holder of any Landlord's Mortgage or any person(s)
acquiring the Premises at any sale or other proceeding under any such
Landlord's Mortgage shall elect to continue this Lease in full force and
effect. Tenant shall attorn to the holder of any Landlord's Mortgage or any
person(s) acquiring the Premises at any sale or other proceeding under any
Landlord's Mortgage provided such person(s) assume the obligations of
Landlord under this Lease. Tenant shall promptly and in

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

no event later than fifteen (15) days execute, acknowledge and deliver
documents which the holder of any Landlord's Mortgage may reasonably
require as further evidence of this subordination and attornment.
Notwithstanding the foregoing, Tenant's obligations under this Section
are conditioned on the holder of each of Landlord's Mortgage and each
person acquiring the Premises at any sale or other proceeding under any
such Landlord's Mortgage not disturbing Tenant's occupancy and other
rights under this Lease, so long as no uncured Event of Default exists.

22. NON-WAIVER. Landlord's waiver of any breach of any term contained in
this Lease shall not be deemed to be a waiver of the same term for
subsequent acts of Tenant. The acceptance by Landlord of Rent or other
amounts due by Tenant hereunder shall not be deemed to be a waiver of any
breach by Tenant preceding such acceptance.

23. HOLDOVER. If Tenant shall, without the written consent of Landlord,
hold over after the expiration or termination of the Term, such tenancy
shall be deemed to be on a month-to-month basis and may be terminated
according to Washington law. During such tenancy, Tenant agrees to pay to
Landlord 125% the rate of rental last payable under this Lease, unless
a different rate is agreed upon by Landlord. All other terms of the Lease
shall remain in effect.

24. NOTICES. All notices under this Lease shall be in writing and
effective (i) when delivered in person, (ii) three (3) days after being
sent by registered or certified mail to Landlord or Tenant, as the case
may be, at the Notice Addresses set forth in Section 1(h); or (iii) upon
confirmed transmission by facsimile to such persons at the facsimile
numbers set forth in Section 1(h) or such other addresses/facsimile
numbers as may from time to time be designated by such parties in writing.

25. COSTS AND ATTORNEYS' FEES. If Tenant or Landlord engage the services
of an attorney to collect monies due or to bring any action for any
relief against the other, declaratory or otherwise, arising out of this
Lease, including any suit by Landlord for the recovery of Rent or other
payments, or possession of the Premises, the losing party shall pay the
prevailing party a reasonable sum for attorneys' fees in such suit, at
trial and on appeal.

26. ESTOPPEL CERTIFICATES. Tenant shall, from time to time, upon written
request of Landlord, execute, acknowledge and deliver to Landlord or its
designee a written statement specifying the following, subject to any
modifications OR ADDITIONS necessary to make such statements true and
complete: (i) the date the Lease term commenced and the date it expires;
(ii) the amount of minimum monthly Rent and the date to which such Rent
has been paid; (iii) that this Lease is in full force and effect and has
not been assigned, modified, supplemented or amended in any way; (iv) that
this Lease represents the entire agreement between the parties; (v) that
all conditions under this Lease to be performed by Landlord have been
satisfied; (vi) that there are no existing claims, defenses or offsets
which the Tenant has against the enforcement of this Lease by Landlord;
(vii) that no Rent has been paid more than one month in advance; and
(viii) that no security has been deposited with Landlord (or, if so, the
amount thereof). Any such statement delivered pursuant to this Section may
be relied upon by a prospective purchaser of Landlord's interest or
assignee of any mortgage or new mortgagee of Landlord's interest in the
Premises. If Tenant shall fail to respond within ten (10) days of receipt
by Tenant of a written request by Landlord as herein provided, Tenant
shall be deemed to have given such certificate as above provided without
modification and shall be deemed to have admitted the accuracy of any
information supplied by Landlord to a prospective purchaser or mortgagee.

27. TRANSFER OF LANDLORD'S INTEREST. This Lease shall be assignable by
Landlord without the consent of Tenant. In the event of any transfer or
transfers of Landlord's interest in the Premises, other than a transfer
for security purposes only, upon the assumption of this Lease by the
transferee, Landlord shall be automatically relieved of obligations and
liabilities accruing from and after the date of such transfer, except
for any retained security deposit or prepaid rent, and Tenant shall
attorn to the transferee.

28. RIGHT TO PERFORM. If Tenant shall fail to timely pay any sum or
perform any other act on its part to be performed hereunder, Landlord may
make any such payment or perform any such other act on Tenant's part to
be made or performed as provided in this Lease. Tenant shall, on demand,
reimburse Landlord for its expenses incurred in making such payment or
performance. Landlord shall (in addition to any other right or remedy of
Landlord provided by law) have the same rights and remedies in the event
of the nonpayment of sums due under this Section as in the case of
default by Tenant in the payment of Rent.

29. HAZARDOUS MATERIAL. Landlord represents and warrants to Tenant that
to the best of Landlord's knowledge, there is no "Hazardous Material" (as
defined below) on, in, or under the Premises as of the Commencement Date
except as otherwise disclosed to Tenant in writing before the execution
of this Lease. LANDLORD DISCLOSES THAT THERE ARE CERTAIN AREAS OF THE
BUILDING WHICH CONTAIN ASBESTOS. - If there is any Hazardous Material on,
in, or under the Premises as of the Commencement Date which has been or
thereafter becomes unlawfully released through no fault of Tenant, then
Landlord shall indemnify, defend and hold Tenant harmless from any and
all claims, judgments, damages,

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

penalties, fines, costs, liabilities or losses including without
limitation sums paid in settlement of claims, attorneys' fees, consultant
fees and expert fees, incurred or suffered by Tenant either during or
after the Lease term as the result of such contamination.

Tenant shall not cause or permit any Hazardous Material to be brought
upon, kept, or used in or about, or disposed of on the Premises by
Tenant, its agents, employees, contractors or invitees, except in strict
compliance with all applicable federal, state and local laws,
regulations, codes and ordinances. If Tenant breaches the obligations
stated in the preceding sentence, then Tenant shall indemnify, defend and
hold Landlord harmless from any and all claims, judgments, damages,
penalties, fines, costs, liabilities or losses including, without
limitation, diminution in the value of the Premises, damages for the loss
or restriction on use of rentable or usable space or of any amenity of
the Premises, or elsewhere, damages arising from any adverse impact on
marketing of space at the Premises, and sums paid in settlement of claims,
attorneys' fees, consultant fees and expert fees incurred or suffered by
Landlord either during or after the Lease term. These indemnifications by
Landlord and Tenant include, without limitation, costs incurred in
connection with any investigation of site conditions or any clean-up,
remedial, removal or restoration work, whether or not required by any
federal, state or local governmental agency or political subdivision,
because of Hazardous Material present in the Premises, or in soil or
ground water on or under the Premises. Tenant shall immediately notify
Landlord of any inquiry, investigation or notice that Tenant may receive
from any third party regarding the actual or suspected presence of
Hazardous Material on the Premises.

Without limiting the foregoing, if the presence of any Hazardous Material
brought upon, kept or used in or about the Premises by Tenant, its
agents, employees, contractors or invitees, results in any unlawful
release of Hazardous Material on the Premises or any other property,
Tenant shall promptly take all actions, at its sole expense, as are
necessary to return the Premises or any other property, to the condition
existing prior to the release of any such Hazardous Material; provided
that Landlord's approval of such actions shall first be obtained, which
approval may be withheld at Landlord's sole discretion.

As used herein, the term "Hazardous Material" means any hazardous,
dangerous, toxic or harmful substance, material or waste including
biomedical waste which is or becomes regulated by any local governmental
authority, the State of Washington or the United States Government due to
its potential harm to the health, safety or welfare of humans or the
environment.

30. RIGHT OF ENTRY. Landlord and its agents, employees and contractors
shall have the right to enter the Premises at reasonable times for
inspection, to make repairs, alterations, and improvements, to show the
Premises to prospective purchasers and, within six (6) months prior to
the expiration of the Lease term, to show the Premises to prospective
tenants.

NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS LEASE; LANDLORD
RECOGNIZES THE WORK TO BE PERFORMED ON THE PREMISES BY TENANT IS
CONFIDENTIAL AND PROPRIETARY, AND LANDLORD WILL USE ITS BEST EFFORTS TO
ENTER THE PREMISES, OR ALLOW ITS AGENTS AND EMPLOYEES TO ENTER THE
PREMISES, ONLY WHEN ACCOMPANIED BY AN ESCORT PROVIDED BY TENANT. LANDLORD
WILL BE LIABLE TO TENANT FOR ANY DAMAGE RESULTING FROM LANDLORD'S
VIOLATION OF THIS SECTION 30.

31. QUIET ENJOYMENT. So long as Tenant pays the Rent and performs all of
its obligations in this Lease, Tenant's possession of the Premises will
not be disturbed by Landlord or anyone claiming by, through or under
Landlord, or by the holders of any Landlord's Mortgage or any successor
thereto.

32. GENERAL.

a. HEIRS AND ASSIGNS. This Lease shall apply to and be binding upon
Landlord and Tenant and their respective heirs, executors administrators,
successors and assigns.

b. BROKERS' FEES. Tenant represents and warrants to Landlord that it has not
engaged any broker, finder or other person who would be entitled to any
commission or fees for the negotiation, execution, or delivery of this
Lease other than as disclosed in Section 1(i) or elsewhere in this Lease.
Tenant shall indemnify and hold Landlord harmless against any loss, cost,
liability or expense incurred by Landlord as a result of any claim
asserted by any such broker, finder or other person on the basis of any
arrangements or agreements made or alleged to have been made by or on
behalf of Tenant. This subparagraph shall not apply to brokers with whom
Landlord has an express written brokerage agreement.

c. ENTIRE AGREEMENT. This Lease contains all of the covenants and
agreements between Landlord and Tenant relating to the Premises. No prior
agreements or understanding pertaining to the Lease shall be valid or of
any force or effect and the covenants and agreements of this Lease shall
not be altered, modified or added to except in writing signed by Landlord
and Tenant.

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

d. SEVERABILITY. Any provision of this Lease which shall prove to be
invalid, void or illegal shall in no way affect, impair or invalidate any
other provision of this Lease.

e. FORCE MAJEURE. Time periods for either party's performance under any
provisions of this Lease (excluding payment of Rent) shall be extended
for periods of time during which the party's performance is prevented due
to circumstances beyond such party's control, including without
limitation, fires, floods, earthquakes, lockouts, strikes, embargoes,
governmental regulations, acts of God, public enemy, war or other strife.

f. GOVERNING LAW. This Lease shall be governed by and construed in
accordance with the laws of the State of Washington.

g. MEMORANDUM OF LEASE. This Lease shall not be recorded. However,
Landlord and Tenant shall, at the other's request, execute and record a
memorandum of Lease in recordable form that identifies Landlord and
Tenant, the commencement and expiration dates of the Lease, and the legal
description of the Premises as set forth on attached Exhibit A.

h. SUBMISSION OF LEASE FORM NOT AN OFFER. One party's submission of this
Lease to the other for review shall not constitute an offer to lease the
Premises. This Lease shall not become effective and binding upon Landlord
and Tenant until it has been fully signed by both Landlord and Tenant.

i. AUTHORITY OF PARTIES. Any individual signing this Lease on behalf of
an entity represents and warrants to the other that such individual has
authority to do so and, upon such individual's execution, that this Lease
shall be binding upon and enforceable against the party on behalf of whom
such individual is signing.

33. EXHIBITS AND RIDERS. The following exhibits and riders are made a part of
this Lease:

Exhibit A - Legal Description
Exhibit B - Tenant Improvement Schedule

(Check the box for any of the following that will apply. Any riders
checked shall be effective only upon being initialed by the parties and
attached to the Lease. Capitalized terms used in the Riders have the
meanings given to them in the Lease.)

/X/ Rent Rider
/ / Retail Use Rider
/ / Arbitration Rider
/X/ Limitation on Landlord's Liability Rider
/ / Guaranty of Tenant's Lease Obligations Rider
/ / Option to Extend Rider

34. AGENCY DISCLOSURE. At the signing of this Agreement,

Landlord's Agent RICH MERMELSTEIN & TIM FOSTER OF COLLIERS INTERNATIONAL
----------------------------------------------------------
(insert names of Licensee and the Company name as licensed)

represented LANDLORD
-------------------------------------------------------------
(insert Landlord, Tenant, both Landlord and Tenant or
neither Landlord nor Tenant)

and Tenant's Broker (Licensee) PAUL SUZMAN OF BUSINESS SPACE RESOURCES
----------------------------------------
(insert names of Licensee and the Company
name as licensed)

represented TENANT
-------------------------------------------------------------
(insert Landlord, Tenant, both Landlord and Tenant or
neither Landlord nor Tenant)

If Tenant's Licensee and Landlord's Agent are different salespersons
affiliated with the same Broker, then both Buyer and Seller confirm their
consent to that Broker acting as a dual agent. If Tenant's Licensee and
Landlord's Agent are the same salesperson representing both parties,
then both Landlord and Tenant confirm their consent to that salesperson
and his/her Broker acting as dual agent. Landlord and Tenant confirm
receipt of the pamphlet entitled "The Law of Real Estate Agency."

35. BROKER PROVISIONS. Landlord shall pay to Landlord's Agent an additional
commission upon the exercise by Tenant of any option to extend the Term
according to any commission agreement or, in the absence of one,
according to Landlord's Agent's commission schedule in effect as of the
execution of this Lease. If Landlord's Agent is the procuring cause of
any other lease or sale entered into between Landlord and Tenant concerning
the Premises, Landlord shall pay a commission in the amount set forth in
Landlord's Agent's commission schedule in effect as of the execution of
this Lease. Landlord's successor shall be obligated to pay any unpaid
commissions upon any transfer of this Lease and any such transfer shall not
release the transferor from liability to pay such commissions. If Landlord's
Agent is required to employ an attorney to enforce or declare it rights
under this Section, the prevailing party in any such action shall be
entitled to recover its reasonable attorneys' fees, in an amount determined
by the court. Neither

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

Landlord's Agent nor Tenant's Licensee are receiving compensation from more
than one party to this transaction unless otherwise disclosed on an attached
addendum, in which case Landlord and Tenant consent to such compensation.

LANDLORD'S AGENT AND TENANT'S LICENSEE HAVE MADE NO REPRESENTATIONS OR
WARRANTIES CONCERNING THE PREMISES, THE MEANING OF THE TERMS AND CONDITIONS
OF THIS LEASE, LANDLORD'S OR TENANT'S FINANCIAL STANDING, ZONING, COMPLIANCE
OF THE PREMISES WITH APPLICABLE LAWS, SERVICE OR CAPACITY OF UTILITIES,
OPERATING EXPENSES, OR HAZARDOUS MATERIALS. LANDLORD AND TENANT ARE EACH
ADVISED TO SEEK INDEPENDENT LEGAL ADVICE ON THESE AND OTHER MATTERS ARISING
UNDER THIS LEASE.

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

IN WITNESS WHEREOF this Lease has been executed the date and year first above
written.

TOM KANE /s/ Thomas Kane PACIFIC BIOMETRICS, INC.
------------------------ ----------------
LANDLORD: TENANT:

ELSA KANE /s/ Elsa Kane /s/ Paul G. Kanan
------------------------ -----------------------------------------
LANDLORD: Tenant:

/s/ Paul G. Kanan
- --------------------------------- -----------------------------------------
By: By:

President & CEO
- --------------------------------- -----------------------------------------
Its: Its:

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

STATE OF WASHINGTON )
)ss.
COUNTY OF KING )
-------------------

I certify that I know or have satisfactory evidence that Elsie Kane is the
person who appeared before me and said person acknowledged that Elsie Kane
signed this instrument, on oath stated that Elsie Kane was authorized to
execute the instrument and acknowledged it as the landlord of said to be the
free and voluntary act of such party for the uses and purposes mentioned in
the instrument.

DATED: 5-12, 1997.

(Seal or stamp) /s/ Holly Ferguson
----------------------------------
Printed Name: Holly Ferguson
--------------------
NOTARY PUBLIC in and for the State
[Seal] of Washington, residing at Seattle
-------
My Commission expires: 2-27-98
------------

STATE OF WASHINGTON )
)ss.
COUNTY OF KING )
-------------------

I certify that I know or have satisfactory evidence that Thomas Kane is the
person who appeared before me and said person acknowledged that Thomas Kane
signed this instrument, on oath stated that Thomas Kane was authorized to
execute the instrument and acknowledged it as the landlord of said to be the
free and voluntary act of such party for the uses and purposes mentioned in
the instrument.

DATED: 5-12, 1997.

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)
(CONTINUED)

STATE OF WASHINGTON )
)ss.
COUNTY OF KING )
-------------------

I certify that I know or have satisfactory evidence that Paul Hanan is the
person who appeared before me and said person acknowledged that Paul Kanan
signed this instrument, on oath stated that Paul Kanan was authorized to
execute the instrument and acknowledged it as the President & CEO of CEO
Pacific Biometrics to be the free and voluntary act of such party for the
uses and purposes mentioned in the instrument.

DATED: May 14, 1997.

(Seal or stamp) /s/ Max Mayer
-------------------------------------
Printed Name: Max Mayer
-----------------------
NOTARY PUBLIC in and for the State
[Seal] of Washington, residing at Seafirst
----------
My Commission expires: Sept 27, 2000
---------------

STATE OF WASHINGTON )
)ss.
COUNTY OF )
-------------------

I certify that I know or have satisfactory evidence that ______________ is
the person who appeared before me and said person acknowledged that
______________ signed this instrument, on oath stated that
________________________________ was authorized to execute the instrument and
acknowledged it as the _______________________ of ____________________________
to be the free and voluntary act of such party for the uses and purposes
mentioned in the instrument.

DATED: __________, 19___.

(Seal or stamp)
-------------------------------------

Printed Name:
------------------------

NOTARY PUBLIC in and for the State
of Washington, residing at
----------
My Commission expires:
---------------

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)

EXHIBIT A
[LEGAL DESCRIPTION]

Lot 7, 8 and South Half of Lot 9, Block 12, of D.T. Denny's North Seattle
Addition to the City of Seattle as recorded in Volume 1 of Plats, Page 41,
King County, Washington.

<PAGE>

LEASE AGREEMENT
(SINGLE TENANT FOR ENTIRE PARCEL - TRIPLE NET)

EXHIBIT B
[TENANT IMPROVEMENT SCHEDULE]

BASED ON THE EMICK, HOWARD & SEIBERT, INC. SPACE PLAN DATED 2-26-97 THE TOTAL
IMPROVEMENT COST TO THE PROPERTY IS ESTIMATED AT $348,467.53. THE LANDLORD
SHALL BE RESPONSIBLE FOR $148,200.00 OF THIS COST AND THE TENANT SHALL BE
RESPONSIBLE FOR THE BALANCE; $200,267.53. TENANT'S PORTION IS TO BE
AMORTIZED AT AN INTEREST RATE OF 10% OVER SEVEN (7) YEARS AND IS REFLECTED IN
THE RENTAL RATE. THESE DOLLAR AMOUNTS ARE SUBJECT TO CHANGE BASED ON
CONSTRUCTION DRAWINGS WHICH EMICK, HOWARD & SEIBERT, INC. WILL BEGIN UPON
LEASE EXECUTION. TENANT SHALL BE RESPONSIBLE FOR ALL COSTS BEYOND
$348,467.53. PERMITTING AND CONSTRUCTION BASED ON THE FINAL CONSTRUCTION
DRAWINGS IS TO BEGIN IMMEDIATELY TO ENABLE AN AUGUST 1, 1997 OCCUPANCY.

<PAGE>

RENT RIDER

Landlord and Tenant should complete only those provisions below which apply.
Any provision below which is not completed shall not apply to the Lease.

1. BASE MONTHLY RENT SCHEDULE. Tenant shall pay Landlord base monthly rent
during the Lease Term according to the following schedule:

LEASE YEAR (STATED IN YEARS OR MONTHS) Base Monthly Rent Amount

Year 1 $19,550.05
Year 2 $19,550.05
Year 3 $19,858.80
Year 4 $20,167.55
Year 5 $20,476.30
Year 6 $20,785.05
Year 7 $21,093.80
Year 8 $18,525.00
Year 9 $19,019.00
Year 10 $19,513.00

/s/ TAK /s/ PYK
- ------------------------ ------------------------
Landlord's Initials Tenant's Initials

/s/ EK
- ------------------------
Landlord's Initials

- ------------------------
Landlord's Initials

<PAGE>

LIMITATION ON LANDLORD'S LIABILITY RIDER

Landlord and Tenant agree that Tenant's recourse against Landlord for any
obligations of Landlord under this Lease shall be limited to Tenant's
execution against Landlord's right, title and interest from time to time in
the Premises. Neither Landlord nor any of its partners, shareholders,
members, officers, directors, or other principals shall have any personal
liability to Tenant as the result of any breach or default by Landlord under
this Lease.

/s/ TAK /s/ PYK
- ------------------------ ------------------------
Landlord's Initials: Tenant's Initials:

/s/ EK
- ------------------------ ------------------------
Landlord's Initials: Tenant's Initials:

<PAGE>
<ARTICLE> 5

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JUN-30-1997
<PERIOD-START> JUL-01-1996
<PERIOD-END> JUN-30-1997
<CASH> 2,916,695
<SECURITIES> 973,110
<RECEIVABLES> 500,595
<ALLOWANCES> (31,280)
<INVENTORY> 25,789
<CURRENT-ASSETS> 4,551,095
<PP&E> 810,790
<DEPRECIATION> (143,307)
<TOTAL-ASSETS> 5,440,819
<CURRENT-LIABILITIES> 1,139,640
<BONDS> 0
0
0
<COMMON> 37,055
<OTHER-SE> 4,034,142
<TOTAL-LIABILITY-AND-EQUITY> 5,440,819
<SALES> 2,788,570
<TOTAL-REVENUES> 2,788,570
<CGS> 1,710,808
<TOTAL-COSTS> 1,710,808
<OTHER-EXPENSES> 2,761,862
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 145,835
<INCOME-PRETAX> (1,577,229)
<INCOME-TAX> 0
<INCOME-CONTINUING> (1,577,229)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,577,229
<EPS-PRIMARY> (0.51)
<EPS-DILUTED> (0.51)

</TABLE>