SPECIALTY LABORATORIES, 424B1, 2000-12-08

SPECIALTY LABORATORIES
424B1, 2000-12-08
MEDICAL LABORATORIES

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<PAGE>

P R O S P E C T U S

5,000,000 SHARES

[LOGO]

COMMON STOCK

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

This is Specialty Laboratories, Inc.'s initial public offering.
Specialty Laboratories, Inc. is selling all of the shares.

Currently, no public market exists for the shares. The shares have been
approved for listing on the New York Stock Exchange under the symbol "SP."

INVESTING IN THE COMMON STOCK INVOLVES RISKS WHICH ARE DESCRIBED IN THE
"RISK FACTORS" SECTION BEGINNING ON PAGE 6 OF THIS PROSPECTUS.

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<TABLE>
<CAPTION>
PER SHARE TOTAL
--------- -----
<S> <C> <C>
Public offering price...................................... $16.00 $80,000,000
Underwriting discount...................................... $1.12 $5,600,000
Proceeds, before expenses, to Specialty Laboratories....... $14.88 $74,400,000
</TABLE>

The underwriters may also purchase up to an additional 750,000 shares at
the public offering price, less the underwriting discount, within 30 days from
the date of this prospectus to cover overallotments.

Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if this
prospectus is truthful or complete. Any representation to the contrary is a
criminal offense.

The shares will be ready for delivery on or about December 13, 2000.

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

MERRILL LYNCH & CO.

UBS WARBURG LLC

U.S. BANCORP PIPER JAFFRAY
-----------

The date of this prospectus is December 7, 2000.

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INSIDE FRONT COVER

FRONT COVER GATE FOLD

Text (top): "Specialty Laboratories"
Graphic (top): Photo collage of researcher and laboratory samples.

Text: "Specialty Laboratories Diagnostic Information Helping Doctors Help
Patients-Registered Trademark-"
<PAGE>
GATEFOLD

INSIDE LEFT COVER

Text (top): "Specialty Laboratories"
Graphic (top): Photo collage of three laboratory workers working in a
laboratory.

Text: "Specialty Laboratories Process Automation"

INSIDE RIGHT COVER

Graphic (top): Photo collage of different stages of the laboratory process.

Text: "Specialty Laboratories Information Systems Helping Doctors Help
Patients-Registered Trademark-"
<PAGE>
TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
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<S> <C>
Prospectus Summary.......................................... 1
Risk Factors................................................ 6
Special Note Regarding Forward-Looking Statements........... 16
Use of Proceeds............................................. 17
Dividend Policy............................................. 17
Capitalization.............................................. 18
Dilution.................................................... 19
Selected Consolidated Financial Data........................ 20
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 24
Business.................................................... 33
Management.................................................. 55
Certain Transactions........................................ 67
Principal Shareholders...................................... 69
Description of Capital Stock................................ 71
Shares Eligible for Future Sale............................. 73
United States Federal Tax Considerations For Non-United
States Holders............................................ 75
Underwriting................................................ 78
Legal Matters............................................... 81
Experts..................................................... 81
Where You Can Find More Information......................... 81
Index to Financial Statements............................... F-1
</TABLE>

<PAGE>
PROSPECTUS SUMMARY

YOU SHOULD READ THE ENTIRE PROSPECTUS, INCLUDING THE SUMMARY, TOGETHER WITH
THE FINANCIAL DATA AND RELATED NOTES BEFORE MAKING AN INVESTMENT DECISION. THE
TERMS "SPECIALTY," "SPECIALTY LABORATORIES," "WE," "US" AND "OUR" AS USED IN
THIS PROSPECTUS REFER TO SPECIALTY LABORATORIES, INC. AND ITS SUBSIDIARIES AS A
COMBINED ENTITY, EXCEPT WHERE IT IS MADE CLEAR THAT SUCH TERM MEANS ONLY THE
PARENT COMPANY.

SPECIALTY LABORATORIES

OUR COMPANY

We are a leading research-based clinical laboratory focused predominantly on
developing and performing esoteric clinical laboratory tests, which we refer to
as assays. Esoteric assays are complex, comprehensive or unique tests used to
diagnose, evaluate and monitor patients. These assays are often performed on
sophisticated instruments by highly skilled personnel and are therefore offered
by a limited number of clinical laboratories. We believe we offer one of the
industry's most comprehensive menus of esoteric assays, many of which have been
developed through our internal research and development efforts.

Our primary customers are hospitals, independent clinical laboratories and
physicians. We educate physicians on the clinical value of our assays through
our information-oriented marketing campaigns. We strengthen our customer
relationships by offering all of our customers information technology solutions
that accelerate and automate assay ordering and results reporting. Approximately
85% of our transactions with our customers are conducted electronically, with
50% of these transactions occurring over the Internet.

Our development of 600 new or improved assays in the past five years has
enhanced our reputation as a prolific developer of first-to-market assays. In
particular, we have leveraged our expertise in gene-based diagnostics to produce
novel assays in many high growth segments of esoteric testing, including fields
of medicine such as infectious disease, gastroenterology, oncology and
cardiology. We market and sell many of our esoteric assays under trademarks such
as GenotypR-TM-, our assays for predicting resistance of the HIV virus to
medication, and ANAlyzer-Registered Trademark-, our assays used to help diagnose
complex autoimmune disorders. For the nine months ended September 30, 2000,
approximately 43% of our net revenue was derived from branded esoteric assays.

We have increased profitability from continuing operations, exclusive of
write-downs for unused facilities and stock-based compensation charges, in each
of the last seven quarters. This increase in operating profitability has
resulted from refocusing our sales and marketing efforts, investing in
information technology and aggressively improving our operating efficiency. For
the nine months ended September 30, 2000, we had net revenue of $113.7 million
and net income of $6.6 million.

According to Lab Industry Strategic Outlook 2000, published by Washington
G-2 Reports, the esoteric clinical laboratory testing market accounts for
approximately $2.0 billion in annual revenue. We believe that the size of the
esoteric assay market will increase as a result of trends such as the growing
incidence of chronic disease, scientific advances driving development of more
sophisticated and specialized clinical assays, increased attention to
cost-effective disease detection and prevention, and increased life expectancy.

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COMPETITIVE ADVANTAGES

We believe we are uniquely positioned in the esoteric assay market due to
the following competitive advantages:

- our comprehensive menu of over 3,500 esoteric assays, designed to meet the
specific needs of physician specialists;

- our research and development expertise in developing novel assays, such as
our GenotypR-TM- line of assays that predict HIV resistance;

- alignment of our interests with those of our hospital customers by
complementing, rather than competing with, their outreach laboratory
business;

- customer-focused information technology platforms that accelerate and
automate assay ordering and results reporting; and

- operating efficiency highlighted by a specimen management system that we
expect to reduce the potential for human error, increase productivity of
laboratory staff and improve turn-around time.

STRATEGY

We expect to grow our business by leveraging our reputation as a leading
provider of esoteric assays through implementation of the following strategies:

- continue introductions of first-to-market assays by leveraging our
internal research and development capabilities, and licensing technologies
from preferred strategic partners;

- educate the physician specialists responsible for ordering our assays
through information-oriented marketing campaigns;

- increase penetration of the hospital customer base, which represents our
largest growth opportunity;

- leverage proprietary information technology applications; and

- pursue complementary markets by expanding our menu of assays for broader
applications and targeting additional customer segments.

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We were incorporated in 1975 under the name Clinical Immunologies, Inc. We
changed our name in 1985 to Specialty Laboratories, Inc. Our headquarters are
located at 2211 Michigan Avenue, Santa Monica, California 90404 and our
telephone number is (310) 828-6543. Our web site address is
www.specialtylabs.com. The information on our web site is not a part of this
prospectus.

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Specialty Laboratories-Registered Trademark-,
DataPassport-Registered Trademark- and ANAlyzer-Registered Trademark- are
registered trademarks of Specialty Laboratories, Inc. DataPassportMD-TM-,
DataPassport Clinical Trials-TM-, DataPassport II-TM-, TARO-TM-, Outreach
Express-TM-, GenotypR-TM-, UltraQuant-TM-, "We help doctors help
patients-Registered Trademark-" and DPMD-TM- are trademarks of Specialty
Laboratories, Inc. All other trademarks and service marks used herein are the
property of their respective owners.

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THE OFFERING

<TABLE>
<S> <C>
Common stock offered by Specialty
Laboratories............................ 5,000,000 shares

Common stock outstanding after the
offering................................ 20,187,507 shares

Use of proceeds........................... We estimate that our net proceeds from this offering
will be approximately $72.6 million. We intend to use
these proceeds for:

- repayment of the $12.1 million outstanding under
our credit facilities;

- expansion of sales and marketing capabilities,
research and development and other general
corporate purposes, including working capital;
and

- potential acquisition of complementary
businesses, products or technologies.

See "Use of Proceeds" for more information concerning
our intended use of proceeds from this offering.

Risk factors.............................. See "Risk Factors" and other information included in
this prospectus for a discussion of factors you
should carefully consider before deciding to invest
in shares of our common stock.

New York Stock Exchange symbol............ SP
</TABLE>

The number of shares to be outstanding after the offering includes all
shares outstanding as of September 30, 2000, but excludes:

- 4,020,280 shares of common stock reserved for issuance under our 2000
Stock Incentive Plan, of which 1,871,971 shares are subject to outstanding
options as of September 30, 2000, at a weighted average exercise price of
$2.03 per share; and

- 330,000 shares of common stock reserved for issuance under our 2000
Employee Stock Purchase Plan.

Unless otherwise indicated, the information in this prospectus assumes that
the underwriters have not exercised their overallotment option and reflects a
2.2-for-1 stock split on October 30, 2000.

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SUMMARY CONSOLIDATED FINANCIAL DATA

The following table presents our summary consolidated financial data. You
should read the summary financial information set forth below in conjunction
with "Selected Consolidated Financial Data" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and our consolidated
financial statements and related notes appearing elsewhere in this prospectus.
As adjusted information has been presented to give effect to the sale of
5,000,000 shares of common stock in this offering at an initial public offering
price of $16.00 per share, after deducting the underwriting discounts and
estimated offering expenses, and repayment of all of our debt outstanding under
our credit facilities. See "Use of Proceeds" and "Capitalization."

<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
------------------------------ -------------------
1997 1998 1999 1999 2000
-------- -------- -------- -------- --------
(UNAUDITED)
(AMOUNTS IN THOUSANDS, EXCEPT PER
SHARE AND PERCENTAGE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net revenue........................................ $106,357 $113,843 $130,142 $96,676 $113,714
Costs and expenses:
Costs of services................................ 60,157 65,098 74,784 56,161 64,111
Selling, general and administrative (exclusive of
stock-based compensation charges).............. 39,813 42,084 46,903 34,769 36,258
Stock-based compensation charges (1)............. -- -- 2,818 2,693 706
Write-down of unused facilities (2).............. -- -- 2,209 2,209 369
-------- -------- -------- ------- --------
Total costs and expenses........................... 99,970 107,182 126,714 95,832 101,444
-------- -------- -------- ------- --------
Operating income................................... 6,387 6,661 3,428 844 12,270
Interest expense, net.............................. 883 1,159 1,639 1,139 1,016
-------- -------- -------- ------- --------
Income (loss) from continuing operations before
provision (benefit) for income taxes............. 5,504 5,502 1,789 (295) 11,254
Provision for income taxes......................... 2,506 2,273 930 77 4,644
-------- -------- -------- ------- --------
Income (loss) from continuing operations........... 2,998 3,229 859 (372) 6,610
Loss from discontinued operations (3).............. (936) (3,060) (2,001) (2,001) --
-------- -------- -------- ------- --------
Net income (loss).................................. $ 2,062 $ 169 $ (1,142) $(2,373) $ 6,610
======== ======== ======== ======= ========
Income (loss) per share (4):
Basic:
Continuing operations............................ $ 0.19 $ 0.21 $ 0.05 $ (0.02) $ 0.42
Discontinued operations.......................... (0.06) (0.20) (0.12) (0.13) --
-------- -------- -------- ------- --------
$ 0.13 $ 0.01 $ (0.07) $ (0.15) $ 0.42
======== ======== ======== ======= ========
Diluted:
Continuing operations............................ $ 0.19 $ 0.21 $ 0.05 $ (0.02) $ 0.38
Discontinued operations.......................... (0.06) (0.20) (0.12) (0.13) --
-------- -------- -------- ------- --------
$ 0.13 $ 0.01 $ (0.07) $ (0.15) $ 0.38
======== ======== ======== ======= ========
Weighted-average shares outstanding (4):
Basic............................................ 15,457 15,459 16,045 16,037 15,904
Diluted.......................................... 15,477 15,505 17,004 16,037 17,426
OTHER DATA:
Adjusted EBITDA (5)................................ $ 9,942 $ 10,844 $ 13,864 $ 9,664 $ 17,733
Adjusted EBITDA as a % of net revenue.............. 9.3% 9.5% 10.7% 10.0% 15.6%
Cash flow provided by continuing operating
activities....................................... $ 5,994 $ 7,353 $ 3,315 $ 2,873 $ 9,210
Cash flow used in investing activities............. (15,128) (5,158) (3,696) (2,825) (4,644)
Cash flow provided by (used in) financing
activities....................................... 11,047 2,942 (56) 534 (5,094)
</TABLE>

(CONTINUED ON FOLLOWING PAGE; FOOTNOTES APPEAR ON FOLLOWING PAGE)

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<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 2000
--------------------------
ACTUAL AS ADJUSTED
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(IN THOUSANDS, UNAUDITED)
<S> <C> <C>
BALANCE SHEET DATA:
Working capital............................................. $10,035 $ 76,033
Total assets................................................ 64,615 125,090
Long-term debt, including current portion................... 12,125 --
Total shareholders' equity.................................. 26,761 99,361
</TABLE>

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(1) We recorded stock-based compensation charges of $2.8 million for the year
ended December 31, 1999 in connection with the sale of our common stock to
management and the grant of stock options to management and directors in
1999. We recorded stock-based compensation charges of $0.7 million for the
nine months ended September 30, 2000 resulting from the amortization of
deferred stock-based compensation and variable stock-based compensation
charges on certain stock options.

(2) During the year ended December 31, 1999, management decided to abandon our
Memphis facility, resulting in a write-down of the unused facility totaling
$2.2 million, which included a reserve of $0.8 million for future net lease
costs. During the nine months ended September 30, 2000, a month-to-month
lease with a related party was terminated on a facility resulting in a
write-off of $0.4 million for the unamortized leasehold improvements related
to the facility.

(3) We discontinued all foreign operations in 1999. For details of the
components of discontinued operations, see Note 3 of the consolidated
financial statements contained elsewhere in this prospectus. Because these
operations were substantially shut down in 1999, we incurred no related
ongoing losses during the nine months ended September 30, 2000.

(4) All periods have been adjusted for a 2.2-for-1 stock split on October 30,
2000.

(5) Adjusted EBITDA is defined as EBITDA adjusted to exclude stock-based
compensation charges and write-down of unused facilities. EBITDA consists of
income (loss) from continuing operations before interest, income taxes,
depreciation and amortization. EBITDA and adjusted EBITDA should not be
considered as measures of financial performance under generally accepted
accounting principles (GAAP). Items excluded from EBITDA and adjusted EBITDA
are significant components in understanding and assessing financial
performance. We present EBITDA and adjusted EBITDA, which are non-GAAP
measures, to enhance the understanding of our operating results. EBITDA and
adjusted EBITDA should not be considered in isolation or as alternatives to
net income, cash flows generated by operations, investing or financing
activities, or other financial statement data presented in the consolidated
financial statements as indicators of financial performance or liquidity.
Because EBITDA and adjusted EBITDA are not measurements determined in
accordance with GAAP and are thus susceptible to varying calculations,
EBITDA and adjusted EBITDA as presented may not be comparable to other
similarly titled measures of other companies. For reconciliation of income
(loss) from continuing operations to adjusted EBITDA, see "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Overview."

5
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RISK FACTORS

ANY INVESTMENT IN SHARES OF OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK.
YOU SHOULD CONSIDER CAREFULLY THE FOLLOWING INFORMATION ABOUT THESE RISKS,
TOGETHER WITH ALL OF THE OTHER INFORMATION CONTAINED IN THIS PROSPECTUS BEFORE
YOU DECIDE TO BUY OUR COMMON STOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY
OCCUR, OUR BUSINESS, FINANCIAL CONDITION, RESULTS OF OPERATIONS AND FUTURE
GROWTH PROSPECTS COULD BE MATERIALLY ADVERSELY AFFECTED. ADDITIONAL RISKS AND
UNCERTAINTIES NOT PRESENTLY KNOWN TO US OR THAT WE CURRENTLY BELIEVE TO BE
IMMATERIAL ALSO MAY IMPAIR OUR BUSINESS. ANY ADVERSE EFFECT ON OUR BUSINESS,
FINANCIAL CONDITION OR RESULTS OF OPERATIONS COULD RESULT IN A DECLINE IN THE
TRADING PRICE OF OUR COMMON STOCK AND THE LOSS OF ALL OR PART OF YOUR
INVESTMENT.

RISKS RELATED TO OUR BUSINESS

IF ADVANCES IN TECHNOLOGY ALLOW OTHERS TO PERFORM ASSAYS SIMILAR TO OURS, THE
DEMAND FOR OUR ASSAYS MAY DECREASE.

The esoteric clinical laboratory industry is characterized by advancing
technology which may enable other clinical laboratories, hospitals, physicians
or other medical providers to perform assays with properties similar to ours in
a more efficient or cost-effective manner than is currently possible. Such
technological advances may be introduced by, not just our competitors, but by
any third party. For instance, a diagnostic manufacturing company may release an
instrument or technology that would make it cost-effective for our customers to
perform esoteric assays internally, rather than through us. If these or other
advances in technology result in a decreased demand for our assays, our assay
volume and net revenue would decline.

THE ESOTERIC CLINICAL LABORATORY INDUSTRY IS INTENSELY COMPETITIVE. IF WE ARE
UNABLE TO SUCCESSFULLY COMPETE, WE MAY LOSE MARKET SHARE.

The esoteric clinical laboratory industry is highly competitive. This
industry is dominated by several national independent laboratories, but includes
many smaller niche and regional independent laboratories as well. Our primary
competitors include:

- large commercial enterprises, such as Quest Diagnostics, or Quest, and
Laboratory Corporation of America, or LabCorp, that offer a wide test and
product menu on a national scale;

- smaller niche laboratories like Impath or Athena Diagnostics that focus on
a narrow segment of the esoteric market; and

- institutions such as Mayo Medical Laboratories, or Mayo, and Associated
Regional University Pathologists, or Associated, that are affiliated with
large medical centers or universities.

Large commercial enterprises, including Quest and LabCorp, have
substantially greater financial resources and may have larger research and
development programs and more sales and marketing channels than we do, enabling
them to potentially develop and market competing assays. These enterprises may
also be able to achieve greater economies of scale or establish contracts with
payor groups on more favorable terms. Smaller niche laboratories compete with us
based on their reputation for offering a narrow test menu. Academic and regional
institutions generally lack the advantages of the larger commercial laboratories
but still compete with us on a limited basis.

Any of our competitors may successfully develop and market assays that are
either superior to, or are introduced prior to, our assays. If we do not compete
effectively with other independent clinical laboratories, we may be unable to
maintain or grow our market share.

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THE PREMIUM PRICES THAT WE INITIALLY CHARGE FOR NEW ASSAYS MAY DROP IF OUR
COMPETITORS ARE ABLE TO DEVELOP AND MARKET COMPETING ASSAYS MORE QUICKLY THAN
THEY CURRENTLY DO.

Typically, we market new esoteric assays at premium prices for several years
before similar assays are developed as either standardized prepared kits for
broad application or as internally developed assays by competing laboratories.
The opportunity to sell our products at premium prices may be reduced or
eliminated if our competitors are able to develop and market competing assays
more quickly than they currently do.

For example, our net revenue from one assay for HIV Quantitation was:

- in 1997, $25 million, or 23.7% of total 1997 net revenue;

- in 1998, $19.7 million, or 17.3% of total 1998 net revenue; and

- in 1999, $17.3 million, or 13.3% of total 1999 net revenue.

This decreasing trend has been primarily due to competition from subsequently
introduced assays. If we are unable to develop newer assays which meet market
demand, our net revenue and profit margins may decrease.

SOME OF OUR CUSTOMERS ARE ALSO OUR PRIMARY COMPETITORS. IF THEY REDUCE OR
DISCONTINUE PURCHASING OUR ASSAYS FOR COMPETITIVE REASONS, IT WILL REDUCE OUR
NET REVENUE.

Some of our customers, such as Quest, LabCorp, Mayo and Associated, also
compete with us by providing esoteric testing services. They often refer to us
assays that they either cannot or elect not to perform themselves. For the nine
months ended September 30, 2000, sales to our competitors were $6.9 million or
6.0% of our net revenue. These parties may decide not to refer assays to us
because they wish to develop and market assays similar to ours. For example, in
July 1997, SmithKline Beecham Clinical Laboratories, or SmithKline Labs, began
to significantly limit the number of assays it referred to us. We believe that
SmithKline Labs terminated its relationship with us because it decided to offer
assays similar to ours. In 1996, SmithKline Labs comprised 21.7% of our net
revenue, whereas in 1999, after being acquired by Quest, SmithKline Labs
(excluding Quest accounts prior to the acquisition) only comprised 1.6% of our
net revenue. If other independent laboratories decide to reduce or discontinue
purchases of our assays for competitive reasons, it will reduce our net revenue.

IF WE ARE UNABLE TO DEVELOP AND SUCCESSFULLY MARKET NEW ASSAYS OR IMPROVE
EXISTING ASSAYS IN A TIMELY MANNER, OUR PROFIT MARGINS MAY DECLINE.

In order to maintain our margins and benefit from the premium prices that we
typically charge for our newly introduced esoteric assays, we must continually
develop new assays and improve our existing assays through licensing
arrangements with third parties and through the efforts of our R & D department.
There is no assurance, however, that we will be able to maintain our current
pace of developing and improving assays in the future. Even if we develop such
assays in a timely manner, our customers may not utilize these new assays. If we
fail to develop new technologies, release new or improved assays on a timely
basis, or if such assays do not obtain market acceptance, our profit margins may
decline.

IF WE FAIL TO ACQUIRE LICENSES FOR NEW OR IMPROVED ASSAY TECHNOLOGY PLATFORMS,
WE MAY NOT BE ABLE TO ACCELERATE ASSAY IMPROVEMENT AND DEVELOPMENT, WHICH COULD
HARM OUR ABILITY TO INCREASE OUR NET REVENUE.

Our ability to accelerate new assay development and improve existing
performance will depend, in part, on our ability to license new or improved
assay technology platforms on favorable terms. We may not be able to negotiate
acceptable licensing arrangements and we cannot be certain that such
arrangements will yield commercially successful assays. Further, even if we
enter into such

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arrangements with these third parties, their devotion of resources to these
efforts may not be within our control or influence. If we are unable to license
these technologies at competitive rates, our research and development costs may
increase. In addition, if we are unable to develop new or improved assays
through such research and development efforts, our assays may be outdated when
compared with our competition's assays, and our net revenue may decrease.

A SIGNIFICANT PORTION OF OUR NET REVENUE DEPENDS ON A SINGLE CUSTOMER, UNILAB
CORPORATION. IF OUR RELATIONSHIP WITH UNILAB IS TERMINATED OR NOT RENEWED, OUR
BUSINESS MAY SUFFER.

For the nine months ended September 30, 2000 and the year ended
December 31, 1999, we sold $11.0 million and $9.6 million in services to Unilab
Corporation accounts, which comprised 9.6% and 7.4% of our net revenue,
respectively. Although we have entered into an agreement with Unilab in which it
has agreed to refer to us, until the agreement expires in October 2002, at least
90% of the esoteric laboratory services it outsources each year or, in the event
of a change of control of Unilab or the purchase by Unilab of a licensed
clinical laboratory with a test menu materially broader than that of Unilab, at
least $800,000 of esoteric laboratory services per month, there is no assurance
that it will uphold this obligation. In addition, if Unilab does not renew this
agreement in October 2002, it will then no longer be under any obligation to
provide us with minimum assay referrals. If, for any reason, Unilab's purchase
of our services were to be materially reduced or if Unilab failed to renew its
contract with us in October 2002, it may decrease our net revenue.

WE RELY ON A FEW ASSAYS FOR A SIGNIFICANT PORTION OF OUR NET REVENUE. IF DEMAND
FOR THESE ASSAYS WERE TO WEAKEN FOR ANY REASON, OUR NET REVENUE WOULD DECREASE.

A significant portion of our net revenue is derived from 20 assays. Net
revenue from these 20 assays comprised 52.4% of our total net revenue for the
nine months ended September 30, 2000 and 53.4% for the year ended December 31,
1999. In addition, for each of past three years, over 10% of our net revenue has
been derived from one assay for HIV Quantitation. As a result, a significant
portion of our net revenue is concentrated among these assays, and in
particular, our HIV Quantitation assay. If competing assays are introduced by
competitors or demand for these assays otherwise decreases, our net revenue
would decrease.

IF GROUP PURCHASING ORGANIZATIONS DO NOT RENEW AND MAINTAIN OUR CONTRACTS, WE
MAY LOSE AN IMPORTANT MECHANISM BY WHICH TO FURTHER PENETRATE THE HOSPITAL
CUSTOMER BASE.

Many of our existing and potential hospital customers are part of group
purchasing organizations, which typically pool independent hospitals together to
negotiate for pricing and services, including prices for laboratory tests. These
group purchasing organizations provide incentives to their participating
hospitals to utilize clinical laboratories which have contracts with the group
purchasing organizations.

Our participation in group purchasing organizations constitutes one aspect
of our overall strategy to attract new hospital customers. We have contracts
with five group purchasing organizations: AmeriNet, Joint Purchasing
Organization, Managed Healthcare Associates, Novation (formerly known as VHA)
and Shared Services Healthcare. We are typically granted non-exclusive provider
status under these contracts. Our contract with Novation will expire in
February 2001, while the contracts with the other group purchasing organizations
will expire at times from 2001 to 2003.

For the nine months ended September 30, 2000, sales of our services to
hospitals which utilized the pricing structures under the Novation and AmeriNet
group purchasing organization contracts comprised $25.3 million or 22.2%, and
$5.6 million or 4.9% of our net revenues, respectively. Sales to hospitals
within the other three group purchasing organizations comprised less than 1% of
our net revenues for the same period. These group purchasing organizations offer
a substantial growth opportunity to gain additional revenue from existing
hospital customers. While we believe that over

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1,800 of our 2,100 hospital customers are affiliated with these five group
purchasing organizations, only approximately 400 of these customers qualify for
discounts under these contracts.

We cannot be certain that if our agreement with Novation, AmeriNet or any
other group purchasing organization is terminated or not renewed, that we will
be able to retain any of the accounts of the participating hospitals. If any
hospital customer affiliated with a group purchasing organization no longer uses
our services, it will reduce our net revenue. In addition, if we are unable to
attract new hospital customers because any group purchasing organization
contract is terminated, it may adversely affect our ability to grow our
business.

FAILURE IN OUR INFORMATION TECHNOLOGY SYSTEMS COULD SIGNIFICANTLY INCREASE
TURN-AROUND TIME, REDUCE OUR PRODUCTION CAPACITY, AND OTHERWISE DISRUPT OUR
OPERATIONS, WHICH MAY REDUCE OUR CUSTOMER BASE AND RESULT IN LOST NET REVENUE.

Our success depends, in part, on the continued and uninterrupted performance
of our information technology systems, including our
DataPassport-Registered Trademark- suite of products. Sustained or repeated
system failures that interrupt our ability to process assay orders, deliver
assay results or perform assays in a timely manner would reduce significantly
the attractiveness of our products to our customers. Our business, results of
operations and financial condition could be materially and adversely affected by
any damage or failure that interrupts or delays our operations.

Our computer systems are vulnerable to damage from a variety of sources,
including telecommunications failures, malicious human acts and natural
disasters. Moreover, despite network security measures, some of our servers are
potentially vulnerable to physical or electronic break-ins, computer viruses and
similar disruptive problems, in part because they are located at a third party
web hosting company, Exodus Communications, in El Segundo, California, and we
cannot control the maintenance and operation of the Exodus data centers. Despite
the precautions we have taken, unanticipated problems affecting our systems
could cause interruptions in our information technology systems.

We have insurance policies designed to cover losses arising from such
interruptions. Our policies include coverage for commercial general liability
with a limit of $10 million. However, these insurance policies may not
adequately compensate us for any losses that may occur due to any failures in
our systems.

IF WE LOSE OUR COMPETITIVE POSITION IN PROVIDING VALUABLE INFORMATION TECHNOLOGY
SOLUTIONS AS AN ANCILLARY SERVICE TO OUR CUSTOMERS, WE MAY NOT BE ABLE TO
MAINTAIN OR GROW OUR MARKET SHARE.

Over the past four years, we have made a substantial investment in our
information technology solutions, such as DataPassport-Registered Trademark- and
DataPassportMD-TM-, to facilitate electronic assay ordering and results
reporting as a value added service for our customers. Based on management's
experience in the industry and discussions with our customers, we believe that
our competitors have not yet implemented similar information technology tools.
We further believe that these solutions are one factor considered by our
customers when selecting a reference laboratory. In the future, our competitors
may offer similar or better information technology solutions to our existing and
potential customer base. If this occurs, we will lose this competitive
advantage, and as a result, may be unable to maintain or increase our market
share.

CLINICIANS OR PATIENTS USING OUR PRODUCTS OR SERVICES MAY SUE US AND OUR
INSURANCE MAY NOT SUFFICIENTLY COVER ALL CLAIMS BROUGHT AGAINST US, WHICH WILL
INCREASE OUR EXPENSES.

The development, marketing, sale and performance of healthcare services
exposes us to the risk of litigation, including medical malpractice. Damages
assessed in connection with, and the costs of defending, any legal action could
be substantial. We currently maintain insurance with coverage up to

9
<PAGE>
$20 million, either singly or in the aggregate, which we believe to be adequate
to cover our exposure in our current professional liability claims and
employee-related matters which were incurred in the ordinary course of business.
Although we believe that these claims may not have a material affect on us,
because we expect them to be covered by this insurance, we may be faced with
litigation claims which exceed our insurance coverage or are not covered under
our insurance policy. In addition, litigation could have a material adverse
effect on our business if it impacts our existing and potential customer
relationships, creates adverse public relations, diverts management resources
from the operation of the business or hampers our ability to perform assays or
otherwise conduct our business.

IF PROTECTION OF THE INTELLECTUAL PROPERTY UNDERLYING OUR TECHNOLOGY AND TRADE
SECRETS IS INADEQUATE, THEN THIRD PARTIES MAY BE ABLE TO USE OUR TECHNOLOGY OR
SIMILAR TECHNOLOGIES, THUS REDUCING OUR ABILITY TO COMPETE.

We currently rely on certain technologies for which we believe patents are
not economically feasible and therefore may be developed independently or copied
by our competitors. Furthermore, we rely on certain proprietary trade secrets
and know-how, which we have not patented. Although we have taken steps to
protect our unpatented trade secrets and know-how, principally through the use
of confidentiality agreements with our employees, there can be no assurance that
these agreements will not be breached, that we would have adequate remedies for
any breach, or that our trade secrets will not otherwise become known or be
independently developed or discovered by competitors. If our trade secrets
become known or are independently developed or discovered by competitors, it
could have a material adverse effect on our ability to compete.

OUR ASSAYS MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, WHICH MAY
CAUSE US TO ENGAGE IN COSTLY LITIGATION WHICH MAY CAUSE US TO PAY SUBSTANTIAL
DAMAGES AND PROHIBIT US FROM SELLING OUR ASSAYS.

Other companies or institutions engaged in assay development, including our
competitors, may obtain patents or other proprietary rights that would prevent,
limit or interfere with our ability to develop, perform or sell our assays. As a
result, we may be found to be, or accused of, infringing on the proprietary
rights of others. For example, in response to a patent infringement allegation
from Athena Diagnostics in 1997, we ceased performing an assay used to diagnose
late onset Alzheimer's disease. We have received letters from Chiron Corporation
and the National Institute of Health in February 1998 and April 2000,
respectively, claiming that some of our assays may violate their patents. The
assays which may be affected by these claims comprised approximately
$18.7 million of our net revenue for the nine months ended September 30, 2000.
While management believes that none of these claims will have a material adverse
effect on our business, there can be no assurance that there will be no adverse
consequences to us. As a result of these claims and any other infringement
related claims, we could incur substantial costs in defending any litigation,
and intellectual property litigation could force us to do one or more of the
following:

- cease developing, performing or selling products or services that
incorporate the challenged intellectual property;

- obtain and pay for licenses from the holder of the infringed intellectual
property right; or

- redesign or reengineer our assays.

Any efforts to reengineer our assays or any inability to sell our assays
could substantially increase our costs, force us to interrupt product sales,
delay new assay releases and ultimately, reduce our revenues.

10
<PAGE>
WE MAY ENCOUNTER PROBLEMS OR DELAYS IN OPERATING OR IMPLEMENTING OUR AUTOMATED
PROCESSING SYSTEMS, WHICH COULD DISRUPT OUR OPERATIONS, REQUIRE US TO DEVELOP
ALTERNATIVES AND INCREASE OUR COSTS.

In order to meet growth in demand for our esoteric assays, we will have to
process many more patient samples than we are currently processing. We have
implemented a high-speed specimen sorting system known as the Total Accessioning
Re-Organization System, or TARO-TM-. In addition, we plan to develop and
implement other automated systems to enhance our testing procedures, including
the implementation of a specimen splitting system. We will need to develop
sophisticated software to support these other automated procedures, analyze the
data generated by these tests and report the results. Further, as we attempt to
increase the number of patient samples we process, throughput or quality-control
problems may arise.

If we are unable to consistently process patient samples on a timely basis
because of delays or failures in our implementation of these automated systems,
or if we encounter problems with our established automated processes, we will be
required to develop alternate means to process our business which may increase
our costs.

WE MAY ACQUIRE OTHER BUSINESSES, PRODUCTS OR TECHNOLOGIES IN ORDER TO REMAIN
COMPETITIVE IN OUR MARKET AND OUR BUSINESS COULD BE ADVERSELY AFFECTED AS A
RESULT OF ANY OF THESE FUTURE ACQUISITIONS.

In order to remain competitive, we may find it necessary to acquire
additional businesses, products or technologies. At this time, we have no
specific understanding, commitments or agreements with respect to any
acquisitions. If we identify an appropriate acquisition candidate, we may not be
successful in negotiating acceptable terms of the acquisition, financing the
acquisition, or integrating the acquired business, products or technologies into
our existing business and operations. We have virtually no experience in
acquiring other businesses and integrating them into our operations. Further,
completing an acquisition and integrating an acquired business will
significantly divert management time and resources. If we consummate any
significant acquisitions using stock or other securities as consideration, your
equity in us could be significantly diluted. If we make any significant
acquisitions using cash consideration, we may be required to use a substantial
portion of our available cash, including the proceeds of this offering.
Acquisition financing may not be available on favorable terms, if at all. In
addition, we may be required to amortize significant amounts of goodwill and
other intangible assets in connection with future acquisitions, which would harm
our operating results.

OUR OPERATIONS AND FACILITIES ARE SUBJECT TO STRINGENT LAWS AND REGULATIONS AND
IF WE ARE UNABLE TO COMPLY, OUR BUSINESS MAY BE SIGNIFICANTLY HARMED.

As a provider of healthcare-related services, we are subject to extensive
and frequently changing federal, state and local laws and regulations governing
licensure, billing, financial relationships, referrals, conduct of operations,
purchases of existing businesses, cost-containment, direct employment of
licensed professionals by business corporations and other aspects of our
business relationships.

If we do not comply with existing or additional laws or regulations, or if
we incur penalties, it could increase our expenses, prevent us from increasing
net revenue, or hinder our ability to conduct our business. In addition, changes
in existing laws or regulations, or new laws or regulations, may delay or
prevent us from marketing our products or cause us to reduce our pricing.

FRAUD AND ABUSE

Of particular importance to our operations are federal and state laws
prohibiting fraudulent billing and providing for the recoupment of
non-fraudulent overpayments, as a large number of laboratories have been forced
by the federal and state governments, as well as by private payors, to enter
into substantial settlements under these laws. Government investigations of
clinical laboratories have been ongoing for a number of years and are expected
to continue in the future. While written "corporate compliance" programs to
actively monitor compliance with fraud laws and other regulatory

11
<PAGE>
requirements are recommended by the Department of Health and Human Services'
Office of the Inspector General and are common in the clinical laboratory
industry, we are only in the process of implementing such a program.

FEDERAL AND STATE CLINICAL LABORATORY LICENSING

The operations of our clinical laboratory are subject to a stringent level
of regulation under the Clinical Laboratory Improvement Amendments. For
certification under the Clinical Laboratory Improvement Amendments, laboratories
such as us must meet various requirements, including requirements relating to
quality assurance, quality control and personnel standards. Our laboratory is
also subject to strict regulation by California, New York and various other
states. We are accredited by the College of American Pathologists, and therefore
are subject to their requirements and evaluation. Our failure to comply with
Clinical Laboratory Improvement Amendments, state or other applicable
requirements could result in various penalties, including loss of licensure,
certification or accreditation. Such penalties could result in our being unable
to continue performing laboratory testing. Compliance with such standards is
verified by periodic inspections and requires participation in proficiency
testing programs. No assurances can be given that our facilities will pass all
future inspections conducted to ensure compliance with federal or any other
applicable licensure or certification laws. Substantial expenditures are
required on an ongoing basis to ensure that we comply with existing regulations
and to bring us into compliance with newly instituted regulations.

FOOD & DRUG ADMINISTRATION

Neither the FDA nor any other governmental agency currently fully regulates
the new assays we internally develop. Although the FDA previously asserted that
its jurisdiction extends to tests generated in a clinical laboratory, it has
allowed these tests to be run and the results commercialized without FDA
premarket approval. However, we cannot predict the extent of future FDA
regulation and there can be no assurance that the FDA will not consider testing
conducted at a clinical laboratory to require premarketing clearance. Hence, we
might be subject in the future to greater regulation, or different regulations,
that could have a material effect on our finances and operations.

ANTI-KICKBACK REGULATIONS

Existing federal laws governing Medicare and Medicaid and other similar
state laws impose a variety of broadly described restrictions on financial
relationships among healthcare providers, including clinical laboratories. These
laws include federal anti-kickback laws which prohibit clinical laboratories
from, among other things, making payments or furnishing other benefits intended
to induce the referral of patients for tests billed to Medicare, Medicaid or
certain other federally funded programs. In addition, they also include
self-referral prohibitions which prevent us from accepting referrals from
physicians who have non-exempt ownership or compensation relationships with us
as well as anti-markup and direct billing rules that may apply to our
relationships with our customers. Sanctions for violations of these laws may
include exclusion from participation in Medicare, Medicaid and other federal
healthcare programs, and criminal and civil fines and penalties.

FEE-SPLITTING

The laws of many states prohibit physicians from sharing professional fees
with non-physicians and prohibit non-physician entities, such as us, from
practicing medicine and from employing physicians to practice medicine. If we do
not comply with existing or additional regulations, or if we incur penalties, it
could increase our expenses, prevent us from increasing net revenue, or hinder
our ability to conduct our business. In addition, changes in existing
regulations or new regulations may delay or prevent us from marketing our
products or cause us to reduce our pricing.

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<PAGE>
IF WE DO NOT COMPLY WITH LAWS AND REGULATIONS GOVERNING THE CONFIDENTIALITY OF
MEDICAL INFORMATION, IT WILL ADVERSELY AFFECT OUR ABILITY TO DO BUSINESS OVER
THE INTERNET.

The confidentiality of patient medical information is subject to substantial
regulation by the state and federal governments. State and federal laws and
regulations govern both the disclosure and the use of confidential patient
medical information. Most states have laws that govern the use and disclosure of
patient medical information and the right to privacy. Similarly, many federal
laws also may apply to protect such information, including the Electronic
Communications Privacy Act of 1986 and federal laws relating to confidentiality
of mental health records and substance abuse treatment.

Legislation governing the dissemination and use of medical information is
continually being proposed at both the state and federal levels. For example,
the Health Insurance Portability and Accountability Act of 1996 requires the
U.S. Secretary of Health and Human Services to develop regulations to protect
the security and privacy of individually identifiable health information that is
electronically transmitted or received. In November 1999, the U.S. Secretary of
Health and Human Services published proposed regulations under the Health
Insurance Portability and Accountability Act of 1996 that would protect the
security and privacy of individually identifiable health information that is
transmitted or received over the Internet. When these regulations become final,
they will likely require that holders or users of electronically transmitted
patient health information implement measures to maintain the security and
privacy of such information. Ultimately, this and other legislation may even
affect the dissemination of medical information that is not individually
identifiable. Physicians and other persons providing patient information to us
are also required to comply with these laws and regulations. If a patient's
privacy is violated, or if we are found to have violated any state or federal
statute or regulation with regard to the confidentiality, dissemination or use
of patient medical information, we could be liable for damages, or for civil or
criminal fines or penalties.

The commercialization of our Internet products including Outreach
Express-TM-, DataPassportMD-TM-, and DataPassport Clinical Trials-TM- is
strictly governed by state and federal laws and regulations, including the new
regulations under the Health Insurance Portability and Accountability Act of
1996. We have implemented encryption technology to protect patient medical
information, however, use of encryption technology does not guarantee the
privacy and security of confidential information. We believe that we are in
material compliance with all applicable state and federal laws and regulations
governing the confidentiality, dissemination and use of medical record
information. However, differing interpretations of existing laws and
regulations, or the adoption of new laws and regulations, could reduce or
eliminate our ability to obtain or use patient information which, in turn, could
limit our ability to use our information technology products for electronically
transmitting patient data.

OUR NET REVENUE WILL BE DIMINISHED IF PAYORS DO NOT AUTHORIZE REIMBURSEMENT FOR
OUR SERVICES.

There has been and will continue to be significant efforts by both federal
and state agencies to reduce costs in government healthcare programs and
otherwise implement government control of healthcare costs. In addition,
increasing emphasis on managed care in the United States may continue to put
pressure on the pricing of healthcare services. Uncertainty exists as to the
reimbursement status of new assays. Third party payors, including state payors
and Medicare, are challenging the prices charged for medical products and
services. Government and other third party payors increasingly are limiting both
coverage and the level of reimbursement for our services. Third party insurance
coverage may not be available to patients for any of our existing assays or
assays we discover and develop. Third party payors accounted for approximately
7.4% of our net revenue in 1999 and 7.9% of our net revenue for the nine months
ended September 30, 2000. However, a substantial portion of the testing for
which we bill our hospital and laboratory clients is ultimately paid by third
party payors and we do not know the percentage of our net revenue that is
indirectly derived from these payors. Any pricing pressure exerted by these
third party payors on our customers may, in turn, be exerted by our

13
<PAGE>
customers on us. If government and other third party payors do not provide
adequate coverage and reimbursement for our assays, our net revenue may decline.

IF A CATASTROPHE WERE TO STRIKE OUR CLINICAL LABORATORY FACILITY, WE WOULD BE
UNABLE TO PROCESS OUR CUSTOMERS' SAMPLES FOR A SUBSTANTIAL AMOUNT OF TIME AND WE
WOULD BE UNABLE TO OPERATE OUR BUSINESS COMPETITIVELY.

Our clinical and processing facility may be affected by catastrophes such as
earthquakes or sustained interruptions in electrical service. Earthquakes are of
particular significance to us because all of our clinical laboratory facilities
are located in Santa Monica, California, an earthquake-prone area. In the event
our existing clinical laboratory facility or equipment is affected by man-made
or natural disasters, we would be unable to process our customers' samples in a
timely manner and unable to operate our business in a commercially competitive
manner. To address these risks, we have in place formal recovery plans for all
interruptions of service. This includes identification of alternate laboratory
testing facilities and complete disaster recovery protocols. We also carry
earthquake insurance with coverage amount of up to $10 million and have
outsourced part of our data storage and processing equipment to a facility
designed to withstand most earthquakes. Despite these precautions, there is no
assurance that we could recover quickly from a serious earthquake or other
disaster.

RISKS RELATED TO THIS OFFERING

OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE AND THIS COULD CAUSE OUR STOCK
PRICE TO FLUCTUATE OR DECLINE.

Our quarterly operating results have varied significantly in the past and
may vary significantly in the future. If our quarterly net revenue and operating
results fall below the expectations of securities analysts and investors, the
market price of our common stock could fall substantially. Operating results
vary depending on a number of factors, many of which are outside our control,
including:

- demand for our assays and ancillary services;

- loss of a significant customer or group purchasing organization contract;

- new assay introductions by competitors;

- changes in our pricing policies or those of our competitors;

- the hiring and retention of key personnel;

- changes in healthcare laws and regulations; and

- costs related to acquisitions of technologies or businesses.

We plan to expand our sales and marketing, research and development and
general and administrative efforts, which will lead to an increase in expenses.
If our net revenue does not increase along with these expenses, our business,
operating results and financial condition could be materially harmed and
operating results in a given quarter could be worse than expected.

For a more detailed description of our quarterly results, please see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

THE PRICE OF OUR COMMON STOCK MAY BE LOWER THAN THE PRICE YOU PAY IN THIS
OFFERING.

Prior to this offering, there has been no public market for our common
stock. After this offering, an active trading market in our stock might not
develop or continue to exist. If you purchase shares of our common stock in this
offering, you will pay a price that was not established in a competitive market.
Rather, you will pay a price that we negotiated with the representatives of the
underwriters. The price of our common stock that will prevail in the market
after the offering may be lower than the price you pay.

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<PAGE>
OUR STOCK PRICE IS LIKELY TO BE VOLATILE AND COULD DROP UNEXPECTEDLY.

Following this offering, the price at which our common stock will trade is
likely to be volatile. The stock market has from time to time experienced
significant price and volume fluctuations that have affected the market prices
of securities, particularly securities of clinical laboratory, biotechnology and
other healthcare service companies. As a result, you may experience a material
decline in the market price of our common stock, regardless of our operating
performance. In the past, following periods of volatility in the market price of
a particular company's securities, securities class action litigation has often
been brought against that company. We may become involved in this type of
litigation in the future. Litigation of this type is often expensive and diverts
management's attention and resources.

WE ARE CONTROLLED BY A SINGLE EXISTING SHAREHOLDER, WHOSE INTERESTS MAY DIFFER
FROM YOUR INTERESTS.

Our principal shareholder is Specialty Family Limited Partnership, whose
sole general managing partner is our Chairman and Chief Executive Officer,
Dr. James B. Peter. Specialty Family Limited Partnership, together with
Dr. Peter, currently beneficially own approximately 94% of the outstanding
shares of our common stock and after the offering will beneficially own
approximately 71% of the outstanding shares of our common stock. Accordingly,
the Specialty Family Limited Partnership along with Dr. Peter will have
significant influence in determining the outcome of any corporate transaction or
other matter submitted to the shareholders for approval, including election of
directors, mergers, consolidations and the sale of all or substantially all of
our assets. Our principal shareholder will also have the power to prevent or
cause a change in control. The interests of this shareholder may differ from
your interests. In addition, this concentration of ownership may delay, prevent,
or deter a change in control and could deprive you of an opportunity to receive
a premium for your common stock as part of a sale of our business.

SHARES ELIGIBLE FOR PUBLIC SALE AFTER THIS OFFERING COULD ADVERSELY AFFECT OUR
STOCK PRICE.

The market price of our common stock could drop due to sales of a large
number of shares of our common stock in the market after this offering or the
perception that such sales could occur. These sales could also make it more
difficult for us to sell equity securities in the future at a time and at a
price that we deem appropriate.

ANTI-TAKEOVER PROVISIONS IN OUR CHARTER DOCUMENTS COULD PREVENT OR DELAY A
CHANGE IN CONTROL AND, AS A RESULT, NEGATIVELY IMPACT OUR SHAREHOLDERS.

We have taken a number of actions that could have the effect of discouraging
a takeover attempt. For example, provisions of our amended and restated articles
of incorporation and amended and restated bylaws could make it more difficult
for a third party to acquire us, even if doing so would be beneficial to our
shareholders. These provisions also could limit the price that certain investors
might be willing to pay in the future for shares of our common stock.

These provisions include:

- limitations on who may call special meetings of shareholders;

- advance notice requirements for nominations for election to the board of
directors or for proposing matters that can be acted upon by shareholders
at shareholder meetings; and

- the ability of our board of directors to issue preferred stock, without
shareholder approval.

YOU WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION.

The initial public offering price of our common stock is substantially
higher than the book value per share of the outstanding common stock. As a
result, you will incur immediate and substantial dilution. In the past, we
issued options to acquire common stock at prices significantly below the initial
public offering price. To the extent these outstanding options are ultimately
exercised, there will be further dilution to investors.

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<PAGE>
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
THIS PROSPECTUS INCLUDES FORWARD-LOOKING STATEMENTS WHICH COULD DIFFER FROM
ACTUAL FUTURE RESULTS.

Some of the matters discussed in this prospectus include forward-looking
statements. Statements that are predictive in nature, that depend upon or refer
to future events or conditions or that include words such as "expects,"
"anticipates," "intends," "plans," "believes," "estimates," "thinks" and similar
expressions are forward-looking statements. These statements involve known and
unknown risks, uncertainties and other factors which may cause our actual
results and performance to be materially different from any future results or
performance expressed or implied by these forward-looking statements. These
factors include the following:

- competition;

- technological advances relating to clinical laboratory testing;

- our ability to develop or license new, marketable assays;

- demographic changes;

- existing governmental regulations and changes in, or the failure to comply
with, governmental regulations;

- legislative proposals for healthcare reform;

- our ability to hire and retain qualified personnel;

- liability and other claims asserted against us;

- changes in Medicare, Medicaid and other third party payor payment levels;

- changes in generally accepted accounting principles;

- the availability and terms of capital to fund acquisitions or replacement
facilities; and

- our ability to successfully acquire and integrate additional technologies
or businesses.

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<PAGE>
USE OF PROCEEDS

We estimate that the net proceeds we will receive from the sale of the
shares of common stock offered by us will be $72.6 million, after deducting the
underwriting discount and estimated offering expenses. If the underwriters'
overallotment option is exercised in full, we estimate that the net proceeds
will be $83.8 million.

We intend to use our net proceeds for the repayment of all of the debt
outstanding under our credit facilities, expansion of sales and marketing
capabilities, research and development and other general corporate purposes,
including working capital. We also may use a portion of our net proceeds to
acquire complementary businesses, products or technologies. We have no specific
understandings, commitments or agreements with respect to any acquisitions. The
amounts that we actually expend for working capital purposes will vary
significantly depending on a number of factors, including revenue growth, if
any, the amount of cash we generate from operations and the progress of our test
development efforts. We will retain broad discretion in allocating the net
proceeds of this offering.

As of September 30, 2000, the outstanding debt under our credit facilities
totaled $12.1 million, consisting of $10.1 million under our term loan
facilities and $2.0 million under our revolving line of credit. Portions of the
term loan mature on March 31, 2002, January 1, 2004 and February 1, 2004 and the
revolving line of credit expires on September 3, 2002. As of September 30, 2000,
the weighted average interest rate under these borrowings was 9.02%.

Pending any use, the net proceeds of this offering will be invested in
short-term, interest-bearing securities.

DIVIDEND POLICY

We have not declared or paid any cash dividends on our capital stock since
1992. We currently intend to retain future earnings, if any, to provide funds to
finance the expansion of our business. In addition, in connection with a loan
and security agreement, we are restricted from paying dividends in cash. As a
result, we do not anticipate paying any cash dividends in the foreseeable
future.

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<PAGE>
CAPITALIZATION

The following table sets forth our capitalization as of September 30, 2000:

- on an actual basis; and

- as adjusted to give effect to the sale of 5,000,000 shares of our common
stock at an initial public offering price of $16.00 per share, after
deducting the estimated underwriting discount and estimated expenses of
this offering and repayment of all of our debt under our credit
facilities. Please see "Use of Proceeds."

You should read this information in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations," our
consolidated financial statements and the related notes appearing elsewhere in
this prospectus.

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 2000
--------------------------
ACTUAL AS ADJUSTED
--------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Long-term debt, including current portion.............. $12,125 $ --
Shareholders' equity:
Common stock, no par value per share, 100,000,000
shares authorized, 15,187,507 shares issued and
outstanding--actual, 20,187,507 shares issued and
outstanding--as adjusted........................... 6,905 79,505
Preferred stock, no par value per share, 10,000,000
shares authorized, no shares issued and
outstanding--actual, no shares issued and
outstanding--as adjusted........................... -- --
Retained earnings.................................... 22,040 22,040
Deferred stock-based compensation.................... (2,184) (2,184)
------- -------
Total shareholders' equity......................... 26,761 99,361
------- -------
Total capitalization............................... $38,886 $99,361
======= =======
</TABLE>

This information excludes:

- 330,000 shares of common stock reserved for issuance under our 2000
Employee Stock Purchase Plan.

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<PAGE>
DILUTION

Our net tangible book value as of September 30, 2000 was approximately
$26.8 million, or $1.76 per share of common stock. Net tangible book value per
share represents the amount of our total tangible assets less total liabilities,
divided by the number of shares of common stock outstanding. After giving effect
to the issuance and sale of 5,000,000 shares of common stock offered by us at an
initial public offering price of $16.00 per share and after deducting the
underwriting discount and estimated offering expenses payable by us, our pro
forma net tangible book value as of September 30, 2000 would have been
$99.4 million, or $4.92 per share. This represents an immediate increase in net
tangible book value of $3.16 per share to existing shareholders and an immediate
dilution of $11.08 per share to new investors purchasing shares in this
offering. The following table illustrates this per share dilution:

<TABLE>
<S> <C> <C>
Initial public offering price per share.................... $ 16.00
Net tangible book value per share at September 30,
2000................................................... $ 1.76
Increase in net tangible book value per share
attributable to new investors.......................... 3.16
-----------------------
Pro forma net tangible book value per share after
offering................................................. 4.92
-----------------------
Dilution per share to new investors........................ $ 11.08
=======================
</TABLE>

If the underwriters' overallotment option is exercised in full, the pro
forma net tangible book value per share after the offering would be $5.28 per
share, the increase in net tangible book value per share to existing
shareholders would be $3.52 per share and the dilution in net tangible book
value to new investors would be $10.72 per share.

The following table summarizes, as of September 30, 2000, the differences
between the total consideration paid and the average price per share paid by
existing shareholders and by new investors purchasing shares of common stock in
this offering.

<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION
--------------------- ---------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- -------- ----------- -------- -------------
<S> <C> <C> <C> <C> <C>
Existing shareholders.................... 15,187,507 75.2% $ 609,137 0.8% $ 0.04
New investors............................ 5,000,000 24.8 80,000,000 99.2 16.00
---------- ----- ----------- -----
Total.................................. 20,187,507 100.0% $80,609,137 100.0%
========== ===== =========== =====
</TABLE>

This information excludes:

- 330,000 shares of common stock reserved for issuance under our 2000
Employee Stock Purchase Plan.

To the extent that any of these options are exercised, there will be further
dilution to new investors.

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<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA

The statement of operations data set forth below for the years ended
December 31, 1997, 1998 and 1999 and the balance sheet data at December 31, 1998
and 1999 are derived from our financial statements that have been audited by
Ernst & Young LLP, which are included elsewhere in this prospectus, and are
qualified by reference to those financial statements. The statement of
operations data set forth below for the years ended April 30, 1995 and 1996 and
the balance sheet data as of April 30, 1995 and 1996 and as of December 31, 1997
are derived from our financial statements that have been audited, but are not
included in this prospectus, to which reclassifications have been made to
conform to the presentation of costs and expenses, continuing operations,
discontinued operations and net assets of discontinued foreign operations for
the other periods presented. The statement of operations data for the eight
months ended December 31, 1996 and the balance sheet data at December 31, 1996
are derived from financial statements that are unaudited and are not included in
this prospectus. The data for the nine months ended September 30, 1999 and 2000
and at September 30, 2000 are derived from unaudited financial statements
included elsewhere in this prospectus. We have prepared the unaudited
information on the same basis as the audited financial statements and have
included all adjustments, consisting only of normal recurring adjustments, that
we consider necessary for a fair presentation of our financial position at such
date and our operating results for these periods. You should read the selected
financial information set forth below in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
our consolidated financial statements and related notes appearing elsewhere in
this prospectus.

20
<PAGE>

<TABLE>
<CAPTION>
YEARS ENDED EIGHT MONTHS NINE MONTHS ENDED
APRIL 30, ENDED YEARS ENDED DECEMBER 31, SEPTEMBER 30,
------------------- DECEMBER 31, ------------------------------ -------------------
1995 1996 1996 1997 1998 1999 1999 2000
-------- -------- ------------- -------- -------- -------- -------- --------
(UNAUDITED) (UNAUDITED)
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net revenue................... $39,008 $55,710 $54,010 $106,357 $113,843 $130,142 $96,676 $113,714
Costs and expenses:
Costs of services........... 18,257 26,698 26,006 60,157 65,098 74,784 56,161 64,111
Selling, general and
administrative (exclusive
of stock-based
compensation charges)..... 15,859 22,580 17,826 39,813 42,084 46,903 34,769 36,258
Stock-based compensation
charges (1)............... -- -- -- -- -- 2,818 2,693 706
Write-down of unused
facilities (2)............ -- 429 -- -- -- 2,209 2,209 369
------- ------- ------- -------- -------- -------- ------- --------
Total costs and expenses...... 34,116 49,707 43,832 99,970 107,182 126,714 95,832 101,444
------- ------- ------- -------- -------- -------- ------- --------
Operating income.............. 4,892 6,003 10,178 6,387 6,661 3,428 844 12,270
Interest expense, net......... 234 318 160 883 1,159 1,639 1,139 1,016
------- ------- ------- -------- -------- -------- ------- --------
Income (loss) from continuing
operations before income
taxes....................... 4,658 5,685 10,018 5,504 5,502 1,789 (295) 11,254
Provision for income taxes.... 714 2,058 3,910 2,506 2,273 930 77 4,644
------- ------- ------- -------- -------- -------- ------- --------
Income (loss) from continuing
operations.................. 3,944 3,627 6,108 2,998 3,229 859 (372) 6,610
Loss from discontinued
operations (3).............. (561) (895) (1,080) (936) (3,060) (2,001) (2,001) --
------- ------- ------- -------- -------- -------- ------- --------
Net income (loss)............. $ 3,383 $ 2,732 $ 5,028 $ 2,062 $ 169 $ (1,142) $(2,373) $ 6,610
======= ======= ======= ======== ======== ======== ======= ========
Income (loss) per share (4):
Basic:
Continuing operations....... $ 0.26 $ 0.23 $ 0.39 $ 0.19 $ 0.21 $ 0.05 $ (0.02) $ 0.42
Discontinued operations..... (0.05) (0.06) (0.07) (0.06) (0.20) (0.12) (0.13) --
------- ------- ------- -------- -------- -------- ------- --------
$ 0.21 $ 0.17 $ 0.32 $ 0.13 $ 0.01 $ (0.07) $ (0.15) $ 0.42
======= ======= ======= ======== ======== ======== ======= ========
Diluted:
Continuing operations....... $ 0.26 $ 0.23 $ 0.39 $ 0.19 $ 0.21 $ 0.05 $ (0.02) $ 0.38
Discontinued operations..... (0.05) (0.06) (0.07) (0.06) (0.20) (0.12) (0.13) --
------- ------- ------- -------- -------- -------- ------- --------
$ 0.21 $ 0.17 $ 0.32 $ 0.13 $ 0.01 $ (0.07) $ (0.15) $ 0.38
======= ======= ======= ======== ======== ======== ======= ========
Weighted average shares
outstanding (4):
Basic....................... 15,400 15,476 15,493 15,457 15,459 16,045 16,037 15,904
Diluted..................... 15,400 15,489 15,514 15,477 15,505 17,004 16,037 17,426
</TABLE>

(CONTINUED ON FOLLOWING PAGE; FOOTNOTES APPEAR ON FOLLOWING PAGE)

21
<PAGE>

<TABLE>
<CAPTION>
AS OF APRIL 30, AS OF DECEMBER 31, AS OF
------------------- -------------------------------------------- SEPTEMBER 30,
1995 1996 1996 1997 1998 1999 2000
-------- -------- ----------- -------- -------- -------- --------------
(UNAUDITED) (UNAUDITED)
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital.................. $ 2,939 $ 3,852 $ 5,272 $ 2,899 $ 2,035 $ 3,616 $10,035
Total assets..................... 15,998 22,066 30,839 48,229 55,998 59,859 64,615
Long-term debt, including current
portion........................ 2,939 3,378 3,714 14,761 17,703 18,382 12,125
Total shareholders' equity....... 8,478 11,360 15,250 17,135 16,953 18,281 26,761
</TABLE>

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

(2) During the year ended April 30, 1996, a proposed expansion to a new facility
was abandoned, resulting in a write-down of the unused facility totaling
$0.4 million. During the year ended December 31, 1999, management decided to
abandon our Memphis facility, resulting in a write-down of the unused
facility totaling $2.2 million, which included a reserve of $0.8 million for
future net lease costs. During the nine months ended September 30, 2000, a
month-to-month lease with a related party was terminated on a facility
resulting in a write-off of $0.4 million for the unamortized leasehold
improvements related to the facility.

(3) We discontinued all foreign operations in 1999. For details of the
components of discontinued operations, see note 3 of the consolidated
financial statements contained elsewhere in this prospectus. Because these
operations were substantially shut down in 1999, we incurred no related
ongoing losses during the nine months ended September 30, 2000.

(4) All periods have been adjusted for a 2.2-for-1 stock split on October 30,
2000.

22
<PAGE>

EBITDA should not be considered in isolation or as alternatives to net
income, cash flows generated by operations, investing or financing
activities, or other financial statement data presented in the consolidated
financial statements as indicators of financial performance or liquidity.
Because EBITDA and adjusted EBITDA are not measurements determined in
accordance with GAAP and are thus susceptible to varying calculations,
EBITDA and adjusted EBITDA as presented may not be comparable to other
similarly titled measures of other companies. For reconciliation of Income
(loss) from continuing operations to adjusted EBITDA, see "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Overview."

23
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THE FOLLOWING DISCUSSION OF OUR FINANCIAL CONDITION AND RESULTS OF
OPERATIONS SHOULD BE READ IN CONJUNCTION WITH OUR SELECTED CONSOLIDATED
FINANCIAL DATA AND THE CONSOLIDATED FINANCIAL STATEMENTS AND RELATED NOTES
INCLUDED ELSEWHERE IN THIS PROSPECTUS. THIS SECTION INCLUDES FORWARD-LOOKING
INFORMATION THAT INVOLVES RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS COULD
DIFFER MATERIALLY FROM THOSE ANTICIPATED BY FORWARD-LOOKING INFORMATION DUE TO
FACTORS DISCUSSED UNDER "RISK FACTORS," "SPECIAL NOTE REGARDING FORWARD LOOKING
STATEMENTS," "BUSINESS" AND ELSEWHERE IN THIS PROSPECTUS.

FOR PURPOSES OF THE FOLLOWING DISCUSSION, ADJUSTED EBITDA IS DEFINED AS
EBITDA ADJUSTED TO EXCLUDE STOCK-BASED COMPENSATION CHARGES AND THE WRITE-DOWN
OF UNUSED FACILITIES. FOR A COMPLETE DEFINITION OF EBITDA, PLEASE SEE
FOOTNOTE 5 UNDER "SELECTED CONSOLIDATED FINANCIAL DATA."

OVERVIEW

We are a leading research-based clinical laboratory predominantly focused on
developing and performing esoteric clinical laboratory tests, which we refer to
as assays. We offer one of the industry's most comprehensive menus comprised of
more than 3,500 clinical esoteric assays, many of which have been developed
through our internal research and development efforts. Esoteric assays are
complex, comprehensive or unique tests used to diagnose, evaluate and monitor
patients. These assays are often performed on sophisticated instruments by
highly skilled personnel and are therefore offered by a limited number of
clinical laboratories.

We have grown rapidly in recent years. For the three years ended
December 31, 1999, our net revenue and adjusted EBITDA grew at compound annual
growth rates of 10.6% and 18.1%, respectively. As illustrated in the following
table, we have increased our adjusted EBITDA in each of the last seven
consecutive quarters. This growth has resulted from expansion of our sales and
marketing forces, our investments in information technology, our aggressive
efforts to improve operating efficiency and economies of scale. We do not
believe, however, that this past performance is necessarily indicative of future
financial results. See "Risk Factors" and "Special Note Regarding
Forward-Looking Statements" for a discussion of some of the risks and
uncertainties which may cause our actual results and performance to be
materially different from our past performance.

<TABLE>
<CAPTION>
THREE MONTHS ENDED
------------------------------------------------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30,
1999 1999 1999 1999 2000 2000 2000
--------- -------- ------------- ------------ --------- -------- -------------
(AMOUNTS IN THOUSANDS EXCEPT PERCENTAGE DATA, UNAUDITED)
<S> <C> <C> <C> <C> <C> <C> <C>
Net revenue.......... $30,592 $32,575 $33,509 $33,466 $35,607 $38,557 $39,550

Adjusted EBITDA...... 2,551 3,211 3,902 4,200 4,875 6,043 6,815
Adjusted EBITDA as a
% of net revenue... 8.3% 9.9% 11.6% 12.5% 13.7% 15.7% 17.2%
</TABLE>

We believe that our typical esoteric assay is priced at approximately twice
that of a routine test. Our assays also have higher costs than routine tests due
to the necessity of specialized laboratory instruments and highly skilled
laboratory personnel. If we are successful in obtaining or renewing large
customer or group purchasing organization contracts, our average price per assay
may slightly decrease, as these contracts typically incorporate volume
discounts.

Since 1997, we have made significant investments in our business to expand
sales and marketing capabilities and develop information technology and process
automation. As part of our strategy to increase our penetration of the hospital
market, we have grown our sales force to 60 persons at September 30, 2000 from
33 at December 31, 1997. We have spent approximately $6.0 million since

24
<PAGE>
1998 to develop our customer-focused information technology suite of products.
Since 1998, we have invested approximately $1.0 million in process automation,
which we expect will increase our assay capacity and throughput, and reduce our
cost of services.

R & D spending has averaged $2.3 million per year since 1997. In 1999, we
refocused our R & D efforts on the efficient introduction of new assays with
significant potential for growth and higher average selling prices, many of
these in molecular diagnostics. Gene-based diagnostic assays represented nearly
40% of our net revenue for the nine months ended September 30, 2000. We have
also increased our efforts to license technologies developed by third parties
that complement our internal R & D objectives. To continue growing our business,
we intend to use a portion of the proceeds from this offering to increase our
overall level of R & D spending, including an accelerated pursuit of licensing
arrangements.

Prior to 1997, our revenues were heavily dependent on national clinical
laboratories. In 1997, we refocused our sales and marketing efforts to increase
our penetration of the hospital market. One of our primary strategies has been
to align ourselves with hospitals by not competing with them for the routine
tests that represent a valuable source of revenue. As a result, the proportion
of our net revenue from hospitals has increased. Net revenue from hospital
customers as a percentage of total net revenue increased to over 50% in the
first nine months of 2000 from 32.5% for the year ended December 31, 1997.

Since 1997, we have achieved consistent net revenue growth despite the
substantial reduction of business from a significant independent laboratory
customer, SmithKline Beecham Clinical Laboratories, or SmithKline Labs.
SmithKline Labs withdrew approximately $10.0 million of annualized net revenue
in July 1997, and an additional $13.0 million of annualized net revenue in
July 1998.

REVENUE RECOGNITION

The vast majority of our net revenue is derived from the performance of
esoteric assays for hospitals, independent laboratories, physicians and other
medical providers. Although we typically bill our customers directly for these
services, in some cases we bill various third party payors, such as private
insurance, Medicare, Medicaid or individual patients. We recognize revenue at
the time the assay result is reported to our customer.

EXPENSE RECOGNITION

Expenses are recognized as incurred and are generally classified between
cost of services and selling, general and administrative expenses. Components of
cost of services include salaries and employee benefits, research and
development costs, supplies and reagents, courier costs, depreciation of
laboratory equipment and leasehold improvements. Selling, general and
administrative expenses include salaries and employee benefits, sales and
marketing, insurance and bad debt expense.

STOCK-BASED COMPENSATION CHARGES

Stock-based compensation charges represent the difference between the
exercise price of options granted, or the price of stock sold to employees and
directors, and the deemed fair value of our common stock on the date of grant or
sale in accordance with Accounting Principles Board Opinion No. 25 and its
related interpretations. In the case of options, we recognize this compensation
charge over the vesting periods of the options using an accelerated amortization
methodology in accordance with Financial Accounting Standards Board
Interpretation No. 28. For purposes of the period-to-period comparisons included
in "Results of Operations," selling, general and administration expenses exclude
these stock-based compensation charges, which are reflected as a separate line
item.

25
<PAGE>
We have recorded deferred stock-based compensation related to unvested stock
options granted to employees and directors. Based on the number of outstanding
options granted as of September 30, 2000, we expect to amortize approximately
$2.2 million of deferred stock-based compensation in future periods. We expect
to amortize this deferred stock-based compensation approximately as follows:
$0.4 million during the remainder of 2000, $1.1 million during 2001,
$0.4 million during 2002, $0.2 million during 2003 and $20,000 during 2004. We
anticipate that the exercise price of stock options granted after the offering
will be at the reported market price of our common stock, and therefore no
deferred stock-based compensation will result from these grants.

DISCONTINUED OPERATIONS

In fiscal year 1995, we began operating internationally by providing routine
laboratory services and kit manufacturing to create revenue growth. In
August 1999, we implemented a plan to discontinue all of our foreign operations,
due to continued losses incurred with these foreign operations. We have no
further obligations nor any plans to fund any additional losses of these foreign
operations. For details of the components of discontinued operations, see
Note 3 of the consolidated financial statements contained elsewhere in this
prospectus. Since these operations were substantially shut down in 1999, we
incurred no related ongoing losses during the nine months ended September 30,
2000.

ADJUSTED EBITDA

Adjusted EBITDA is defined as EBITDA adjusted to exclude stock-based
compensation charges and write-down of unused facilities. EBITDA consists of
income (loss) from continuing operations before interest, income taxes,
depreciation and amortization. Items excluded from EBITDA and adjusted EBITDA
are significant components in understanding and assessing financial performance.
We present EBITDA and adjusted EBITDA, which are non-GAAP measures, to enhance
the understanding of cash flows generated by operations, investing or financing
activities, or other financial statement data presented in the consolidated
financial statements as indicators of financial performance or liquidity.

The following table reconciles income (loss) from continuing operations to
adjusted EBITDA.

<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED EIGHT MONTHS ENDED
APRIL 30, ENDED YEARS ENDED DECEMBER 31, SEPTEMBER 30,
------------------- DECEMBER 31, ------------------------------ -------------------
1995 1996 1996 1997 1998 1999 1999 2000
-------- -------- ------------- -------- -------- -------- -------- --------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
RECONCILIATION OF INCOME (LOSS) FROM CONTINUING OPERATIONS TO ADJUSTED EBITDA:
Income (loss) from continuing
operations................... $3,944 $3,627 $ 6,108 $2,998 $ 3,229 $ 859 $ (372) $ 6,610
Interest expense, net........ 234 318 160 883 1,159 1,639 1,139 1,016
Provision for income taxes... 714 2,058 3,910 2,506 2,273 930 77 4,644
Depreciation expense......... 885 1,371 1,206 3,555 4,183 5,409 3,918 4,388
Stock-based compensation
charges.................... -- -- -- -- -- 2,818 2,693 706
Write-down of unused
facilities................. -- 429 -- -- -- 2,209 2,209 369
------ ------ ------- ------ ------- ------- ------ -------
Adjusted EBITDA................ $5,777 $7,803 $11,384 $9,942 $10,844 $13,864 $9,664 $17,733
====== ====== ======= ====== ======= ======= ====== =======
</TABLE>

RESULTS OF OPERATIONS

The following table sets forth the percentage of net revenue represented by
certain items in our consolidated statements of operations.

26
<PAGE>

<TABLE>
<CAPTION>
NINE MONTHS
YEARS ENDED ENDED
DECEMBER 31, SEPTEMBER 30,
------------------------------ -------------------
1997 1998 1999 1999 2000
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Net revenue.............................................. 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of services......................................... 56.6 57.2 57.5 58.1 56.4
Selling, general and administrative expenses (exclusive
of stock-based compensation charges)................... 37.4 37.0 36.0 36.0 31.9
Operating income......................................... 6.0 5.9 2.6 0.9 10.8
Income (loss) from continuing operations before income
taxes.................................................. 5.2 4.8 1.4 (0.3) 9.9
Income (loss) from continuing operations................. 2.8 2.8 0.7 (0.4) 5.8
Loss from discontinued operations........................ (0.9) (2.7) (1.5) (2.1) --
Net income (loss)........................................ 1.9 0.1 (0.9) (2.5) 5.8
</TABLE>

NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED WITH NINE MONTHS ENDED
SEPTEMBER 30, 1999

NET REVENUE

Net revenue increased $17.0 million, or 17.6%, to $113.7 million for the
nine months ended September 30, 2000 from $96.7 million for the comparable prior
year period. Approximately $12.8 million of the increase is attributed to
additional net revenue generated from focusing our sales force on hospital
customers, and approximately $5.5 million of the increase is attributed
primarily to additional net revenue from sales to independent laboratories,
including Unilab. Partially offsetting these increases, net revenue from sales
to physicians and other medical providers decreased by approximately
$1.3 million primarily due to concentrated efforts to eliminate unprofitable
physician accounts.

COST OF SERVICES

Cost of services increased $7.9 million, or 14.2%, to $64.1 million for the
nine months ended September 30, 2000 from $56.2 million for the comparable prior
year period. This increase is directly attributed to the increase in assay
volume during the same period. As a percentage of net revenue, cost of services
decreased to 56.4% for the nine months ended September 30, 2000 from 58.1% for
the comparable prior year period. The decrease reflects the economies of scale
realized by processing significantly higher assay volume and efficiencies
provided by the ongoing automation of our laboratory operations.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (EXCLUSIVE OF STOCK-BASED
COMPENSATION CHARGES)

Selling, general and administrative expenses increased $1.5 million, or
4.3%, to $36.3 million for the nine months ended September 30, 2000 from
$34.8 million for the comparable prior year period. This increase is due to the
growth of our operations. Selling expense for the nine months ended
September 30, 2000 and September 30, 1999 was $8.7 million and $8.2 million,
respectively. This increase resulted primarily from the continued expansion of
our sales force. As a percentage of net revenue, selling, general and
administrative expenses decreased to 31.9% for the nine months ended
September 30, 2000 from 36.0% for the comparable prior year period. The decrease
reflects the economies of scale associated with processing significantly higher
assay volume. As a percentage of net revenue, bad debt expense increased to 3.7%
for the nine months ended September 30, 2000 from 3.2% for the comparable prior
year period. This increase resulted from the increase in net revenue from third
party payors.

27
<PAGE>
STOCK-BASED COMPENSATION CHARGES

Stock-based compensation charges decreased by $2.0 million to $0.7 million
for the nine months ended September 30, 2000 from $2.7 million for the
comparable prior year period. The charge in the nine months ended September 30,
1999 included $0.3 million related to a sale of stock to management and
$2.4 million related to stock options granted in February 1999. For the nine
months ended September 30, 2000, variable stock-based compensation charges of
$134,000 were recorded related to certain stock options for the period from
July 1, 2000 through their dates of exercise in September 2000.

WRITE-DOWN OF UNUSED FACILITIES

Prior to SmithKline Labs substantially reducing its level of business with
us, we had committed to lease and improve a building in Memphis, Tennessee,
primarily to process assays for certain large independent laboratory customers.
Subsequently, management decided in the second quarter of 1999 not to use the
Memphis facility, resulting in a write-down of the facility totaling
$2.2 million, which included a reserve of $0.8 million for future net lease
costs. For more information concerning this write-down, see Note 4 of the
interim consolidated financial statements appearing elsewhere in this
prospectus.

We terminated a facility lease in Santa Monica, California with Santa Monica
Properties, a company owned by our Chairman and Chief Executive Officer,
Dr. James Peter, effective September 1, 2000. A write-down of approximately
$0.4 million for the unamortized leasehold improvements to this facility was
recorded in the third quarter of 2000.

INTEREST EXPENSE, NET

Net interest expense decreased $0.1 million, or 10.8%, to $1.0 million for
the nine months ended September 30, 2000 from $1.1 million for the comparable
prior year period. The decrease is due primarily to the reduction of our bank
borrowings as a result of favorable cash flows from improved earnings.

PROVISION FOR INCOME TAXES

Provision for income taxes was $4.6 million for the nine months ended
September 30, 2000 as compared to $0.1 million for the comparable prior year
period. We had an effective income tax rate for continuing operations of 41.3%
for the nine months ended September 30, 2000. Though the comparable prior year
had a loss from continuing operations before income taxes, the provision rate
was affected by expenses incurred in connection with our sale of stock to
members of management in that period which were not deductible for income tax
purposes. Since we incurred a loss from continuing operations before income
taxes in this period, these non-deductible expenses effectively lowered our tax
rate.

LOSS FROM DISCONTINUED OPERATIONS

Loss from discontinued operations was $2.0 million for the nine months ended
September 30, 1999. We discontinued all of our foreign operations in 1999 and
have no further obligations nor plans to fund any additional losses of these
foreign operations. For details of the components of the loss from discontinued
operations in the nine months ended September 30, 1999, see note 3 of the
interim consolidated financial statements.

ADJUSTED EBITDA

Adjusted EBITDA increased by $8.0 million, or 83.5%, to $17.7 million for
the nine months ended September 30, 2000 from $9.7 million for the comparable
prior year period. As a percentage of net

28
<PAGE>
revenue, adjusted EBITDA increased to 15.6% for the nine months ended
September 30, 2000 from 10.0% for the comparable prior year period. These
results reflect economies of scale associated with processing significantly
higher assay volume and efficiencies provided by ongoing automation of assays.

NET INCOME (LOSS)

Net income increased by $9.0 million to $6.6 million for the nine month
period ended September 30, 2000 from a net loss of $2.4 million for the
comparable prior year period. The increase is due primarily to increased
operating income resulting from higher assay volume and efficiencies provided by
ongoing automation of assays. The comparable 1999 period also contained charges
in excess of current year charges of $2.0 million for stock-based compensation,
$1.8 million for a write-down of unused facilities and $2.0 million for
discontinued operations.

YEAR ENDED DECEMBER 31, 1999 COMPARED WITH YEAR ENDED DECEMBER 31, 1998

NET REVENUE

Net revenue increased $16.3 million, or 14.3%, to $130.1 million for the
year ended December 31, 1999 from $113.8 million for the prior year. During
1999, net revenue from hospitals increased by $16.9 million due to focusing our
sales force on hospital customers. Net revenue from physicians and other medical
providers also increased by $3.8 million for the same period as we benefited in
1999 from a trial sales program utilizing a significant number of part-time
sales persons focused on the physician market to supplement our full-time sales
force in the prior year. These increases were partially offset by a
$4.4 million decline in net revenue from other independent laboratories due
mainly to SmithKline Labs substantially reducing its business with us in the
third quarter of 1998. This business represented 6.3% of our net revenue in 1998
as compared to 1.6% in 1999.

COST OF SERVICES

Cost of services increased $9.7 million, or 14.9%, to $74.8 million for the
year ended December 31, 1999 from $65.1 million for the prior year. This
increase is attributable to the increase in assay volume. As a percentage of net
revenue, cost of services increased slightly to 57.5% for the year ended
December 31, 1999 from 57.2% for the prior year.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (EXCLUSIVE OF STOCK-BASED
COMPENSATION CHARGES)

Selling, general and administrative expenses increased $4.8 million, or
11.5%, to $46.9 million for the year ended December 31, 1999 from $42.1 million
for the prior year. The increase is attributable to the growth of our
operations. As a percentage of net revenue, selling, general and administrative
expenses decreased to 36.0% for the year ended December 31, 1999 from 37.0% for
the prior year. The decrease reflects the economies of scale associated with
processing significantly higher assay volume. As a percentage of net revenue,
bad debt expense remained constant at 3.3% for both years ended December 31,
1999 and 1998.

STOCK-BASED COMPENSATION CHARGES

In connection with the sale of our common stock to management and the grant
of stock options to management and directors in 1999, we recorded stock-based
compensation charges of approximately $2.8 million for the year ended
December 31, 1999. No stock-based compensation charges were recorded in 1998.

WRITE-DOWN OF UNUSED FACILITIES

In connection with the decision in the second quarter of 1999 not to use the
Memphis facility, we recorded a write-down totaling $2.2 million for the year
ended December 31, 1999. For more

29
<PAGE>
information concerning this write-down, see Note 4 of the consolidated financial
statements appearing elsewhere in this prospectus.

INTEREST EXPENSE, NET

Net interest expense increased to $1.6 million for the year ended
December 31, 1999 from $1.2 million for the prior year, representing an increase
of $0.4 million, or 41.5%. This increase is due primarily to increased
borrowings under our bank loan agreements for capital expenditures and working
capital needs to support our growth.

PROVISION FOR INCOME TAXES

We provided for income taxes in the amount of $0.9 million for the period
ended December 31, 1999 as compared to $2.3 million for the prior year. We had
an effective income tax rate for continuing operations of 52.0% for the year
ended December 31, 1999 compared to a rate of 41.3% for the prior year. The
higher tax rate in 1999 is due primarily to expenses incurred in connection with
our sale of stock to members of management in 1999 which were not deductible for
income tax purposes.

LOSS FROM DISCONTINUED OPERATIONS

Loss from discontinued operations decreased $1.1 million to $2.0 million for
the year ended December 31, 1999 from $3.1 million for the prior year. We
discontinued all of our foreign operations in 1999. For details of the
components of the loss from discontinued operations in 1999 and 1998, see
Note 3 of the consolidated financial statements contained elsewhere in this
prospectus.

ADJUSTED EBITDA

Adjusted EBITDA increased by $3.0 million, or 27.8%, to $13.9 million for
the year ended December 31, 1999 from $10.8 million for the prior year. As a
percentage of net revenue, adjusted EBITDA increased to 10.7% for the year ended
December 31, 1999 from 9.5% for the prior year. These results reflect economies
of scale associated with processing significantly higher assay volume and
efficiencies provided by ongoing automation of assays.

NET INCOME (LOSS)

Net income decreased by $1.3 million to a net loss of $1.1 million for the
year ended December 31, 1999 from net income of $0.2 million for the prior year.
The decrease during 1999 was due primarily to the write-down of the Memphis
facility of $2.2 million and the recording of stock-based compensation charges
of approximately $2.8 million, offset in part by improved operating income
(before charges for stock-based compensation and write-down of unused
facilities) of $1.8 million and a reduced loss of $1.1 million from discontinued
operations.

YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31, 1997

NET REVENUE

Net revenue increased $7.5 million, or 7.0%, to $113.8 million for the year
ended December 31, 1998 from $106.4 million for the prior year. During 1998, net
revenue from hospitals increased by $9.3 million due to focusing our sales force
on hospital customers. Net revenue from physicians and other medical providers
also increased by $5.2 million for the same period as a result of our 1998 trial
sales program utilizing a significant number of part-time sales persons focused
on the physician market to supplement our full-time sales force. These increases
were offset by a $6.8 million decline in net revenue from other independent
laboratories due mainly to SmithKline Labs substantially reducing its business
with us in the third quarter of 1998. SmithKline Labs represented 16.5% of our
net revenue in 1997 as compared to 6.3% in 1998.

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<PAGE>
COST OF SERVICES

Cost of services increased $4.9 million, or 8.2%, to $65.1 million for the
year ended December 31, 1998 from $60.2 million for the prior year. The increase
in cost of services is attributable to an increase in assay volume during the
same period. As a percentage of net revenue, cost of services increased to 57.2%
for the year ended December 31, 1998 from 56.6% for the prior year. The increase
is attributed mainly to overcapacity related to SmithKline Labs substantially
reducing its business with us in the third quarter of 1998.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (EXCLUSIVE OF STOCK-BASED
COMPENSATION CHARGES)

Selling, general and administrative expenses increased $2.3 million, or
5.7%, to $42.1 million for the year ended December 31, 1998 from $39.8 million
for the prior year. The increase in selling, general and administrative expenses
is attributed to expanding the national sales force to replace the business lost
from SmithKline Labs. As a percentage of net revenue, selling, general and
administrative expenses decreased to 37.0% for the year ended December 31, 1998
from 37.4% for the prior year. As a percentage of net revenue, bad debt expense
increased to 3.3% for the year ended December 31, 1998 from 2.7% for the prior
year. This increase resulted from increase in revenues from third party payors.

INTEREST EXPENSE, NET

Net interest expense increased $0.3 million, or 31.1%, to $1.2 million for
the year ended December 31, 1998 from $0.9 million for the prior year. This
increase is due primarily to increased borrowings under our bank loan agreements
for capital expenditures and working capital needs to support our growth.

PROVISION FOR INCOME TAXES

Our provision for income taxes was $2.3 million for the year ended
December 31, 1998 as compared to $2.5 million for the prior year. We had an
effective income tax rate on continuing operations of 41.3% for the year ended
December 31, 1998 compared to a rate of 45.5% for the prior year.

LOSS FROM DISCONTINUED OPERATIONS

The loss from discontinued operations increased $2.1 million to $3.1 million
for the year ended December 31, 1998 from $0.9 million for the prior year. We
discontinued all of our foreign operations in 1999. For details of the
components of the loss from discontinued operations in 1998 and 1997, see
Note 3 of the consolidated financial statements contained elsewhere in this
prospectus.

ADJUSTED EBITDA

Adjusted EBITDA increased by $0.9 million, or 9.1%, to $10.8 million for the
year ended December 31, 1998 from $9.9 million for the prior year. As a
percentage of net revenue, adjusted EBITDA increased to 9.5% for the year ended
December 31, 1998 from 9.3% for the prior year. These results reflect economies
of scale associated with processing significantly higher assay volume and
efficiencies provided by ongoing automation of assays.

NET INCOME (LOSS)

Net income decreased by $1.9 million to $0.2 million for the period ended
December 31, 1998 from $2.1 million for the prior year. The decrease is due
mainly to an increase in the loss from discontinued operations of $2.1 million
from the prior year.

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<PAGE>
LIQUIDITY AND CAPITAL RESOURCES

Our liquidity requirements have historically consisted of sales and
marketing expenses, research and development expenses, capital expenditures,
working capital, debt service and corporate expenses. We have typically funded
these requirements and the growth of our business through net cash provided by
continuing operating activities and borrowings under our bank credit facilities.
We currently maintain a $15.0 million line of credit and have a commitment
letter to expand our line of credit to $30.0 million upon completion of this
offering, subject to negotiation of definitive agreements. As of September 30,
2000, we had total debt of $12.1 million outstanding, consisting of
$10.1 million under our term loan facilities and $2.0 million under our
revolving line of credit. As of September 30, 2000, the weighted average
interest rate under these borrowings was 9.02%.

Net cash provided by continuing operating activities was $9.2 million and
$2.9 million for the nine months ended September 30, 2000 and 1999,
respectively. The $6.3 million improvement in 2000 was primarily due to our
improved operating performance. Net cash used in investing activities was
$4.6 million and $2.8 million for the nine months ended September 30, 2000 and
1999, respectively. The primary use of funds were capital expenditures to
support our growth. Net cash used in financing activities was $5.1 million for
the nine months ended September 30, 2000. The primary use of funds were payments
made on our bank line of credit. During the same period in 1999, net cash
provided by financing activities was $0.5 million.

We generated net cash provided by continuing operating activities of
$3.3 million for the year ended December 31, 1999. We used $3.7 million of net
cash in investing activities and $0.1 million in financing activities during the
same period. As of September 30, 2000, we had cash totaling $0.2 million and
working capital of $10.0 million.

Allowance for doubtful accounts as a percentage of gross receivables has
increased from 7.5% as of December 31, 1998 to 9.7% as of September 30, 2000.
The 2.2% increase is due primarily to the increased net revenues from third
party billings, which generally have a higher bad debt experience. The third
party billings increased from 12.4% of net revenue for the year ended
December 31, 1998 to 17.1% of net revenue for the nine months ended
September 30, 2000. We do not believe this trend of increasing third party
billings will continue in the future.

Allowance for doubtful accounts as a percent of gross receivables decreased
from 13.0% as of December 31, 1999 to 9.7% as of September 30, 2000, due
primarily to the timing of the write off of fully reserved accounts receivable.

We expect that the proceeds from this offering, together with our funds from
operations, existing funds and an expanded credit facility will be sufficient to
fund our operations and meet our capital requirements for the next 12 months.

INFLATION

Inflation was not a material factor in either revenue or operating expenses
during the past three fiscal years and the nine months ended September 30, 1999
and 2000.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," which
establishes accounting and reporting standards for derivative instruments and
hedging activities. SFAS 133 requires that an entity recognize all derivatives
as either assets or liabilities in the statement of financial position and
measure those instruments at fair value. This statement was amended by SFAS 137
which defers the effective date to all fiscal quarters of fiscal years beginning
after June 15, 2000. SFAS 133 is effective for our first quarter in the fiscal
year ending December 31, 2001 and is not expected to have a material effect on
our financial position or results of operations.

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BUSINESS

OVERVIEW

We are a leading research-based clinical laboratory predominantly focused on
developing and performing esoteric clinical laboratory tests, which we refer to
as assays. We believe we offer one of the industry's most comprehensive menus,
comprised of more than 3,500 esoteric assays, many of which have been developed
through our internal research and development efforts. Esoteric assays are
complex, comprehensive or unique tests used to diagnose, evaluate and monitor
patients. These assays are often performed on sophisticated instruments by
highly skilled personnel and are therefore offered by a limited number of
clinical laboratories. For the nine months ended September 30, 2000, we had net
revenue of $113.7 million and net income of $6.6 million.

Our primary customers are hospitals, independent clinical laboratories and
physicians. We have aligned our interests with those of hospitals, our fastest
growing client segment, by not competing in the routine test market that
provides them with a valuable source of revenue. We educate physicians on the
clinical value of our assays through our information-oriented marketing
campaigns. Our technical, experienced sales force concentrates on the hospitals
and independent laboratories that serve as distribution channels for physician
assay orders. We use our advanced information technology solutions to accelerate
and automate electronic assay ordering and results reporting with these
customers.

We believe we have achieved our reputation as a prolific developer of
first-to-market assays by developing 600 new or improved esoteric assays in the
past five years. In particular, we have leveraged our expertise in gene-based
diagnostics to produce novel assays in many high growth segments of esoteric
testing, including fields of medicine such as infectious disease,
gastroenterology, oncology and cardiology. We intend to continue directing our
research and development, or R & D, efforts towards new assay development with
specific focus on emerging diagnostic fields, such as the study of proteins,
including chromosomes, also known as genomics. We believe that branding our
assays reinforces our competitive advantage established by our expertise in
developing and introducing first-to-market assays. We expect that these
strategies, combined with our competitive strengths, will continue to position
us as a leader in the esoteric segment of the clinical laboratory industry.

CLINICAL LABORATORY INDUSTRY

Clinical laboratory testing is critical to the delivery of quality
healthcare to patients. According to Lab Industry Strategic Outlook 2000,
published by Washington G-2 Reports, the entire U.S. clinical laboratory
industry had revenues exceeding $30 billion in 1999. Laboratory tests are used
generally by physicians to assist in the detection, diagnosis, evaluation,
monitoring and treatment of diseases and other medical conditions through the
measurement and analysis of chemical and cellular components in blood, other
bodily fluids and tissues. Clinical laboratory tests are frequently ordered as
part of physician office visits and hospital admissions. According to Washington
G-2 Reports, approximately 94% percent of all clinical laboratory tests ordered
are considered routine and can be performed by most clinical laboratories.
Esoteric assays generally require more sophisticated instruments and highly
skilled personnel, and are typically outsourced to independent clinical
laboratories that specialize in such assays.

The clinical laboratory industry consists primarily of hospital-based
laboratories, independent clinical laboratories and physician office
laboratories. Washington G-2 Reports estimates that approximately 63% of U.S.
clinical testing revenues in 1999 were attributable to hospital-based
laboratories, approximately 26% were attributable to independent clinical
laboratories and approximately 11% were attributable to physician office
laboratories and other medical providers.

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ROUTINE SEGMENT OF CLINICAL LABORATORY INDUSTRY

Routine tests are ordered by physicians and may be performed by clinical
laboratories through the use of standardized prepared kits manufactured by
diagnostic companies. Routine tests include procedures in the areas of blood
chemistry, hematology, urine chemistry, bacteriology, tissue pathology and
cytology. Commonly ordered individual tests include red and white blood cell
counts, Pap smears, blood cholesterol level tests, urinalyses and pregnancy
tests. Because routine tests often employ mass-produced commercial kits, which
can be performed with limited training, they are usually more competitively
priced than esoteric assays. We do not compete in the routine segment of the
clinical laboratory industry.

ESOTERIC SEGMENT OF CLINICAL LABORATORY INDUSTRY

Washington G-2 Reports estimates that $2.0 billion of the clinical
laboratory industry's revenues are derived from esoteric assays. Esoteric assays
are typically ordered when a physician requires additional information to
complete a diagnosis, establish a prognosis or to choose and monitor a
therapeutic regimen. Esoteric assays include procedures in the areas of
molecular diagnostics, protein chemistry, cellular immunology and advanced
microbiology. Commonly ordered esoteric assays include viral and bacterial
detection assays, drug therapy monitoring assays, autoimmune panels and complex
cancer evaluations. In contrast to routine tests, esoteric assays generally
require sophisticated instruments and materials and highly skilled personnel to
perform and analyze results. Consequently, esoteric assays are generally priced
substantially higher than routine tests. Because it is not cost-effective for
most hospitals, independent laboratories or physician office laboratories to
develop and perform a broad menu of esoteric assays, these assays are generally
outsourced to independent clinical laboratories that specialize in performing
these complex assays.

We believe the size of the esoteric clinical laboratory market will increase
due to the following trends:

- growing incidence of many chronic diseases, and acute and chronic
infections, driving the development of new assays for early detection and
management;

- ongoing advances in the fields of chemistry, pharmacology and genomics
facilitating the development of more specialized and sophisticated assays;

- increased physician and patient awareness of the benefits of specialized
assays in the early detection and management of diseases;

- increased focus on the use of assays in determining an effective and
economical therapeutic regimen; and

- increased life expectancy and the general aging of the population.

OUR COMPETITIVE ADVANTAGES

COMPREHENSIVE MENU OF ESOTERIC ASSAYS

We currently offer a comprehensive menu of more than 3,500 esoteric assays,
which we believe is greater than any other clinical laboratory in the United
States. The breadth of our assay menu distinguishes us from large independent
laboratories which typically offer only a select number of esoteric assays and
smaller niche laboratories focused on specific clinical areas. Our comprehensive
menu allows our customers to rely on us for substantially all of their esoteric
testing needs.

Many of our assays were developed through our R & D efforts and are unique
and proprietary to us. We have historically leveraged our expertise in molecular
diagnostics and applied it to high growth segments of the esoteric testing
industry including fields of medicine such as infectious disease,

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gastroenterology, oncology and cardiology. We believe that we have developed one
of the most extensive menus of assays in these attractive growth areas.

We market and sell many of our esoteric assays under trademarks such as
GenotypR-TM-, our assays for predicting resistance to HIV, and
ANAlyzer-Registered Trademark-, our assays used to help diagnose complex
autoimmune disorders. For the nine months ended September 30, 2000,
approximately 43% of our net revenue was derived from branded esoteric assays.
We believe these branding efforts have contributed to increased market share and
premium pricing as physician specialists often continue to rely on our products,
even after the introduction of a similar assay by a competitor.

RESEARCH AND DEVELOPMENT EXPERTISE

We focus our R & D efforts on introducing novel assays, improving existing
technologies and enhancing our reputation as an industry leader in new assay
development. We have developed and introduced over 600 new or improved esoteric
assays over the past five years. Our ability to bring a new esoteric assay to
market within approximately three months provides us with a distinct advantage
over our competitors. As an example, in 1988, we believe we were the first
commercial laboratory to capitalize on the use of polymerase chain reaction
technology, or PCR, by introducing and making PCR tests for HIV widely
available. In emergency situations, we endeavor to develop new assays within a
shorter period of time. For example, in 1999, within two weeks of learning about
the outbreak of West Nile Fever in the New York metropolitan area, we developed
a breakthrough detection assay and worked with the Centers for Disease Control
and Prevention to notify physicians that this assay was available to monitor the
spread of the virus causing the outbreak.

INTERESTS ALIGNED WITH OUR HOSPITAL CUSTOMERS

Our predominant focus on the esoteric segment of the clinical laboratory
industry allows us to align our interests with those of our hospital customers.
Many hospital-based laboratories attempt to increase revenue by marketing and
performing routine tests for physicians, commonly known as laboratory
"outreach." Hospitals compete with national independent clinical laboratories
for these routine tests. We believe that hospitals are more inclined to refer
their esoteric testing to independent clinical laboratories which do not compete
with them for routine tests.

We enhance our hospital customers' outreach capabilities by marketing our
comprehensive menu of esoteric assays as a complement to their routine testing.
We also emphasize our laboratory outreach advisory services that help hospitals
market their outreach laboratories to their physician community. These advisory
services include information technology tools that will help connect hospital
laboratories to physician offices. This connectivity improves communications and
logistics between the hospital laboratories and their physician clients. We
potentially benefit by receiving more esoteric assay referrals from these
hospitals as they may receive more routine and esoteric laboratory referrals
from their physicians. Ultimately, we believe this strategy enhances our access
to esoteric assays that might otherwise be referred to our competitors.

CUSTOMER-FOCUSED INFORMATION TECHNOLOGY PLATFORMS

Our ability to offer all of our customers information technology that
accelerates and automates assay ordering and results reporting is a distinct
competitive advantage. We believe that many of our competitors still manage a
large portion of their order and results transactions manually. In 1998,
approximately 40% of our transactions were transmitted electronically,
principally through direct computer to computer links with a small number of our
largest customers. At that time, we began a customer-focused information
technology initiative to efficiently utilize the Internet. This project reduced
the implementation time and cost of providing electronic links to large and
small customers alike. This led to substantial cost savings, fewer data entry
errors, improved ease of assay ordering and

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<PAGE>
shorter turn-around time for results reporting. Today, approximately 85% of our
transactions with our customers are conducted electronically, with 50% of these
transactions occurring over the Internet. Furthermore, we believe that our
customer-focused information technology offerings include a number of features
that cannot be easily duplicated.

OPERATING EFFICIENCY AND FLEXIBILITY

We continually evaluate our operations for process improvement opportunities
and have made substantial investments in advanced process automation projects.
In July 2000, we began implementing an automated specimen management system
known as TARO-TM-. This high speed sorting system reduces the potential for
human error, increases the productivity of laboratory staff and shortens
turn-around time within the laboratory. We are currently developing an ancillary
system to TARO-TM- that is designed for high-throughput, precise division of
specimens, a process commonly known as aliquotting. This system is scheduled to
be operational in late 2001.

Our research orientation affords us the flexibility to choose between
standardized prepared kits, other available testing technologies, and our own
internally developed methodologies depending on cost, quality and market
preference. This flexibility provides operating efficiencies which many other
clinical laboratories must forgo due to their dependency on platforms designed
for specific commercial kits.

OUR STRATEGY

Our fundamental objective is to grow our business by leveraging our
reputation as a leading provider of esoteric clinical laboratory testing
services. We focus our information-oriented marketing campaigns on educating
physician specialists that may order our assays. We concentrate our direct
selling efforts on the hospitals and independent laboratories that serve as
distribution channels for physician assay orders. Key components of our strategy
include the following:

CONTINUE INTRODUCTIONS OF FIRST-TO-MARKET ASSAYS

We intend to focus our R & D efforts on developing and introducing novel,
first-to-market assays that meet the emerging needs of the medical community. We
expect to accomplish this by continually evaluating assays and related
technologies that result in enhanced clinical utility, shorter turn-around time
or better assay performance. We believe this strategy will help sustain our
higher average selling prices and offer the greatest prospects for long-term
revenue and profit growth. We believe that the selective application of the
following strategies gives us the flexibility to pursue market opportunities in
a rapid and cost-effective manner and will enable us to improve assay
development:

- LEVERAGE OUR INTERNAL R & D CAPABILITIES. We have historically relied on
our internal R & D program to generate new and improved assays to address
emerging opportunities. Since 1995, we have spent approximately
$11 million on R & D with a recent emphasis on those areas that complement
our competitive strengths and offer potential for long-term growth. We
intend to utilize our comprehensive menu and R & D expertise to address
attractive growth areas such as infectious disease, gastroenterology,
oncology and cardiology and to exploit our expertise in molecular
diagnostics, including advances in genetics, genomics and
pharmacogenetics, or the genetically determined response to drugs. For the
nine months ended September 30, 2000, molecular diagnostic assays
represented over 40% of our net revenue.

- LICENSE TECHNOLOGIES FROM PREFERRED STRATEGIC PARTNERS. We recently began
complementing our R & D efforts through the licensing of technologies from
biotechnology, diagnostic and life science companies. We actively pursue
new technology platforms that we can combine with our expertise to develop
new assays and improve our existing menu. In return, our partners may
leverage our expertise to find new markets for their technologies. We have
recently established

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strategic partnerships with companies such as Sequenom, Third Wave
Technologies and Epoch Biosciences to advance our efforts in assay
development and performance.

EDUCATE PHYSICIAN SPECIALISTS ABOUT OUR ASSAYS

We intend to continue educating physician specialists on the clinical value
of our assays through research publications, print advertisement, direct mail
and the Internet. These targeted marketing tools are designed to be effective
while minimizing the need for direct physician contact by our sales
representatives. We actively pursue publication of our scientific research in
peer-reviewed journals and have had nearly 800 such articles published. We have
printed and continually update ten widely-used, proprietary reference manuals on
the "use and interpretation" of our assays, focusing on medical specialties such
as infectious disease, gastroenterology, oncology and cardiology. We present our
research at scientific meetings and exhibit at over 50 national and regional
conferences throughout the year. Our web site is another vehicle for educating
physicians about our assays and contains our entire menu, on-line technical
materials and links to other medical sites that support the role of esoteric
assays in effective diagnosis and treatment of diseases.

INCREASE PENETRATION IN THE HOSPITAL CUSTOMER BASE

We believe that the hospital sector represents our largest growth
opportunity. We are currently the primary reference laboratory to only 300 of
our 2,100 hospital customers, which is an increase from 67 primary hospital
customers in 1996. We intend to pursue the following strategies to add new
hospital customers and become the primary reference laboratory to more of our
existing hospital customers:

- expand our hospital sales force;

- leverage our comprehensive menu of esoteric assays, enabling hospitals to
utilize us for a significant portion of their reference testing;

- emphasize our non-compete position and highlight our outreach services
that enable hospital laboratories to better market to physicians;

- promote our extensive information technology solutions tailored to meet
the electronic interface needs of individual hospitals and hospital
networks; and

- utilize our participation in group purchasing organization contracts to
increase the volume of referred assays from member hospitals.

LEVERAGE PROPRIETARY INFORMATION TECHNOLOGY APPLICATIONS

We develop our information technology products to accelerate and automate
assay ordering and results reporting. We intend to leverage our proprietary
network-based applications to strengthen our relationships with existing
customers and attract new ones. Specifically, these products address customers'
preference for interface solutions that can be installed quickly, are easy to
use, and help increase their productivity. As an example, our web-based
DataPassportMD-TM- product, currently linked to over 1,200 customers, can be
operational at a customer's site within 24 hours. We have utilized
DataPassportMD-TM- since 1998 to electronically interface with our customers and
provide easy access to a wide variety of assay information. We plan to further
differentiate ourselves through additional enhancements and upgrades to this
product. We are also in the process of developing new applications that will
enable multiple hospitals to share clinical laboratory order and result
information between facilities. This capability is important to large hospital
networks trying to reduce costs by consolidating laboratory services. In
addition, we are exploring the advantages of integrating externally developed
applications for better access to assay-related content, such as wireless
notification of laboratory results to personal digital assistants.

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PURSUE COMPLEMENTARY MARKETS

We believe our key competitive strengths, including our comprehensive assay
menu, R & D expertise, technical sales and marketing organization, existing
customer relationships and advanced information technology capabilities,
position us to pursue opportunities in complementary markets by expanding our
menu of assays for broader application and pursuing additional customer
segments. For example, in order to better market to children's hospitals, we
have expanded our pediatric assay menu and added relevant age-related reference
ranges. To compete with niche oncology laboratories, we are developing and
adding assays that assist pathologists in diagnosing complex cancer cases. To
grow our clinical trials business, we intend to continue developing assays and
data management tools to the specifications of pharmaceutical and biotechnology
companies for their use in clinical trials.

PRODUCTS AND SERVICES

We perform all of our testing services at our laboratory facility in Santa
Monica, California. We do not have patient service centers and therefore do not
obtain specimens directly from patients. Typically, our customers collect a
patient's specimen and forward it directly to our laboratory facility. Our
laboratory facility accepts specimens 24 hours a day, seven days a week, 365
days a year. Most specimens are analyzed and the results are reported within 48
hours of receipt.

We currently offer a comprehensive menu of more than 3,500 esoteric assays,
which we believe is greater than any other laboratory in the United States. The
breadth of our assay menu distinguishes us from large independent laboratories
that typically offer only a select number of esoteric assays and smaller niche
laboratories focused on specific clinical areas. Our comprehensive menu allows
our customers to rely on us for substantially all of their esoteric testing
needs. Esoteric assays are typically ordered when a physician requires
additional information to complete a diagnosis, establish a prognosis, or to
choose and monitor a therapeutic regimen. For the nine months ended
September 30, 2000, our net revenue was primarily derived from assays within the
following recognized medical specialty areas:

EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC

<TABLE>
<CAPTION>
CARDIO/COAG 8%
<S> <C>
Endocrinology 8%
Gastroenterology 23%
Infectious Disease 37%
Nephrology 1%
Neurology 3%
Oncology 11%
Rheumatology 9%
</TABLE>

Many of our assays were designed by our R & D team and are unique and
proprietary to us. We have historically leveraged our expertise in molecular
diagnostics and applied it to high growth segments of the esoteric testing
industry including fields of medicine such as infectious disease,
gastroenterology, oncology and cardiology. Molecular diagnostic assays comprised
nearly 40% of our net revenue for the nine months ended September 30, 2000.
Broadly speaking, molecular diagnostics includes all test procedures
incorporating or identifying DNA- or RNA-based targets. This includes assays
detecting the presence of a gene for a given disorder such as cystic fibrosis
and assays examining DNA to help predict a patient's response to different
drugs, such as HIV resistance assays. These

38
<PAGE>
assays can also detect viruses by identifying their unique genetic profile. We
believe that we have developed one of the most extensive menus of molecular
diagnostics assays. As a result of this expertise, we intend to develop novel,
first-to-market assays and capture additional revenues by capitalizing on recent
advances in the accumulated knowledge of the human genome.

Our assays for Hepatitis B and C and cardiovascular disease illustrate our
ongoing application of advanced diagnostic techniques to diseases affecting a
large or growing segment of the population. Hepatitis B and C together affect
approximately five million Americans, including three million with active
infections. In this market, we offer 42 assays using molecular diagnostics and
other techniques to help physician specialists diagnose and monitor therapy
effectiveness. In the cardiovascular disease market, we offer over 40 assays
designed to help physicians identify high risk individuals. These assays help
identify genetic mutations and infectious, metabolic and autoimmune markers all
associated with increased cardiovascular risk.

We market and sell many of our assays under trademarked names such as
GenotypR-TM-, our assays for predicting resistance to HIV, and
ANAlyzer-Registered Trademark-, our assays used to diagnose complex autoimmune
disorders. For the nine months ended September 30, 2000, approximately 43% of
our net revenue was derived from branded assays. We believe these branding
efforts have contributed to increased market share and premium pricing as
physician specialists often continue to rely on our products, even after the
introduction of a similar assay by a competitor.

As a courtesy to our customers, we also offer approximately 300 routine
tests, in addition to our 3,500 esoteric assays. These routine tests represented
less than 1% of our net revenue in 1999.

While we offer over 3,500 esoteric assays, 20 of our esoteric assays
currently account for a substantial portion of our net revenue. These assays, on
a net revenue basis, accounted for 52.4% of our net revenue for the nine months
ended September 30, 2000, and 53.4% for the year ended December 31, 1999. In
addition, a single assay accounted for more than 10% of our net revenue for the
nine months ended September 30, 2000 and the years ended December 31, 1997, 1998
and 1999. See "Risk Factors."

MARKETING AND SALES

MARKETING AND SALES ORGANIZATION

Our marketing and sales organization consists of a staff of 14 marketing
professionals and 60 technical representatives and sales managers. Our sales
representatives average over ten years of selling experience, including seven
years in clinical laboratory or diagnostic testing sales. Over 40% of our sales
force are licensed medical technologists. Sales representatives principally
focus on large accounts including hospitals or independent laboratories
throughout the United States, with a small percentage of their time spent
selling directly to physician specialists. We continually educate our sales
representatives on the technical and clinical merits of our products. We use
traditional sales meetings, technical on-line sales training and in-the-field
training to ensure our sales representatives are properly informed about all
areas of our product lines and selling processes.

MARKETING STRATEGY

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<PAGE>
research at scientific meetings and exhibit at over 50 national and regional
conferences throughout the year. Our web site is another vehicle for educating
physicians about our assays and contains our entire directory of services,
on-line technical materials and links to other medical sites that support the
role of esoteric assays in effective diagnosis and treatment of diseases.

SALES STRATEGY

We concentrate our selling efforts on the management teams of hospitals and
other independent laboratories that serve as distribution channels for physician
assay orders. These management teams typically include laboratory managers,
pathologists, finance and information technology personnel. To a lesser extent,
we also call directly on physician specialists who create the demand for our
assays.

Increasing revenue from smaller existing accounts is an important strategy
due to the large number of hospitals with whom we are already doing business.
Our marketing department provides our sales representatives with a comprehensive
database containing pertinent information on hospital information technology
systems, key contacts and existing competition. Sales representatives are
trained to find new market opportunities and provide solutions to address unmet
customer needs which may include outreach support, information technology
products, assay information and general servicing.

We also facilitate hospital sales through affiliations with group purchasing
organizations. Although hospitals participating in group purchasing
organizations are not obligated to use the group purchasing organization
contracted laboratory for their reference testing, a group purchasing
organization contract may provide us with access to additional hospital
business. For further discussion of our group purchasing organization
relationships, see "Customers--Hospitals" below.

CUSTOMERS

Our customers include hospitals, independent laboratories, physician
specialists and other medical providers. The following table provides
percentages of our net revenue by class of customer:

<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED DECEMBER 31, ENDED SEPTEMBER 30,
------------------------------------ ----------------------
1997 1998 1999 1999 2000
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Hospitals...................................... 32.5% 38.5% 46.7% 46.6% 50.9%
Independent Laboratories....................... 55.4% 45.7% 36.5% 36.4% 35.9%
Physician Specialists and Others............... 12.1% 15.8% 16.8% 17.0% 13.2%
------- ------- ------- ------- -------
Total...................................... 100.0% 100.0% 100.0% 100.0% 100.0%
======= ======= ======= ======= =======
</TABLE>

HOSPITALS

Hospitals, our fastest growing customer segment, accounted for approximately
51% of our net revenue for the nine months ended September 30, 2000. Of the
estimated 5,000 hospitals to which we target our services, approximately 2,100
are currently our customers. We are a primary provider of esoteric reference
laboratory testing services for approximately 300 of these hospital customers.

Many of our hospital customers are part of group purchasing organizations
which typically pool independent hospitals together to negotiate for pricing and
services, including prices for laboratory tests. Generally, hospitals
participating in group purchasing organizations are not obligated to use the
group purchasing organization contracted laboratory for their reference testing
and many hospitals are

40
<PAGE>
affiliated with multiple group purchasing organizations. We are currently under
contract with the following voluntary group purchasing organizations:

<TABLE>
<CAPTION>
ESTIMATED
NUMBER OF CONTRACT
GROUP PURCHASING ORGANIZATION MEMBER HOSPITALS EXPIRATION DATE
----------------------------- ---------------- ---------------
<S> <C> <C>
AmeriNet........................................ 2,000 August 2001

Joint Purchasing Corporation.................... 400 December 2001

Managed Healthcare Associates................... 300 May 2003

Novation (formerly known as VHA)................ 800 February 2001

Shared Services Healthcare...................... 550 June 2003
</TABLE>

The other material terms of these agreements are as follows: the agreements
with group purchasing organizations each provide for discounted fee structures
for our assays including capped price increases. Some of these contracts provide
additional discounts for certain assays. Most of these contracts also provide
that we pay an administrative fee to the group purchasing organization.

INDEPENDENT LABORATORIES

For the nine months ended September 30, 2000, regional independent
laboratories represented 19% of our net revenue and national independent
laboratories represented 17% of our net revenue. Together, we service over 1,300
accounts in the independent laboratory segment. Regional independent
laboratories typically receive test requests directly from physicians. Regional
laboratories will perform the routine tests and outsource the esoteric assays to
an esoteric national laboratory like us. Although other national independent
laboratories perform some esoteric testing, they may outsource to us any
esoteric assays they are unable to perform and also honor requests from
physician specialists who specify that we perform particular assays.

In October 1999, we entered into an agreement with Unilab pursuant to which
it has agreed to refer to us, until the agreement expires in October 2002, at
least 90% of the esoteric laboratory services it outsources each year or, in the
event of a change of control of Unilab or the purchase by Unilab of a licensed
clinical laboratory with a test menu materially broader than that of Unilab, at
least $800,000 of esoteric laboratory services per month. For the nine months
ended September 30, 2000, we sold $11.0 million in services to Unilab. This
agreement can only be terminated for cause and will automatically renew for
successive renewal terms of one year each unless terminated by either party.

PHYSICIAN SPECIALISTS AND OTHERS

For the nine months ended September 30, 2000, physician specialists
comprised approximately 11.5% of our net revenue and represented over 3,200
accounts. Currently, there are more than 200,000 physician specialists in the
U.S., of which approximately 120,000 fall directly into our targeted medical
specialties. Although they account for a small percentage of direct net revenue,
physician specialists can influence the clinical acceptance of an assay, and can
specifically influence laboratory choice by specifying that a particular
specimen be sent to us or by ordering a particular assay that is unique to or
branded by us.

The majority of our remaining net revenue is derived from clinical trials.
Our clinical trials business focuses primarily on pharmaceutical and
biotechnology companies trying to develop new drugs. Testing services for the
clinical trials market comprise approximately 2% of our net revenue for the nine
months ended September 30, 2000. We currently have contracts with 18 companies
conducting clinical trials. We believe that many companies choose us for their
clinical trials because of our experience in developing new assays and offering
the necessary tools to manage the resulting data.

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<PAGE>
PAYORS, BILLING & REIMBURSEMENT

We typically bill our customers, such as hospitals or other independent
laboratories, directly. In some instances, we bill the individual patient
directly or third party payors such as Medicare, Medicaid or private insurance.
The following table illustrates our payor mix as a percent of net revenue since
1997:

<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
------------------------------------ NINE MONTHS ENDED
1997 1998 1999 SEPTEMBER 30, 2000
-------- -------- -------- -------------------
<S> <C> <C> <C> <C>
Customer............................. 89.4% 87.6% 84.3% 82.9%
Patient.............................. 5.1% 5.6% 8.3% 9.2%
Medicare............................. 3.2% 3.2% 3.5% 4.2%
Medicaid............................. 1.0% 1.6% 2.0% 1.5%
Other Insurance...................... 1.3% 2.0% 1.9% 2.2%
----- ----- ----- -----
Total............................ 100.0% 100.0% 100.0% 100.0%
===== ===== ===== =====
</TABLE>

All of our billing and payment functions are executed through our
centralized computerized billing system. Our web-based DataPassportMD-TM-
product provides accurate billing information for Medicare, Medicaid and other
insurance reimbursements at the time of assay ordering. This results in benefits
such as reduced bad debt expense and lower days sales outstanding.

INFORMATION TECHNOLOGY

We have invested significant resources into information technology that
accelerates and automates test ordering and results reporting with our
customers. Our proprietary information technology products, collectively branded
as DataPassport-Registered Trademark-, are designed to take advantage of new
Internet-based technologies. Although some customers only require a simple
electronic transfer of orders and results, others are seeking solutions to help
them connect disparate systems or connect physician practices associated with
laboratory outreach programs. Compared to other currently available information
technology applications designed to have similar functionality, we believe all
of our information technology products have the advantages of faster system
implementation, greater ease of use and lower customer costs. We have also
invested resources designed to provide patient confidentiality and compliance
with all governmental regulations regarding data security.

In 1998, approximately 40% of our transactions were transmitted
electronically, principally through direct computer to computer links with a
small number of our largest customers. At that time, we began a customer-focused
information technology initiative to effectively utilize the Internet and
provide electronic connectivity to large and small customers alike. Today, 85%
of the transaction volume with our customers is transmitted electronically, with
over 50% of these orders placed over the Internet.

Our current offering of information technology products include
DataPassport-Registered Trademark- client interface module and
DataPassportMD-TM-. We are in the process of developing Outreach Express-TM- and
DataPassportII-TM- each of which are described in detail below. We believe that
our evolving suite of information technology products will continue to lead to
greater customer loyalty, a reduction of data entry errors, acceleration of test
ordering and results reporting, and substantial cost savings. The security
features on our information technology products are intended to protect the
confidentiality of patient information in accordance with state and federal law.

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<PAGE>
DATAPASSPORT-REGISTERED TRADEMARK- CLIENT INTERFACE MODULE

Because of the volume of assays ordered, our larger accounts require a
direct connection between us and their Laboratory Information System, also known
as LIS, to streamline the assay ordering and results reporting process.
Traditional methods of connecting directly with a customer's LIS system are
generally cumbersome and require a significant amount of time to implement
because such links are dependent on the involvement of a third party LIS vendor
to assist in software programming. Our DataPassport-Registered Trademark- client
interface module greatly decreases this implementation lag time and bypasses the
need for the LIS vendor by emulating the hospital's LIS data format.
Consequently, our client interface module may be operative within six to eight
weeks, as compared with six months or more for traditional computer to computer
links. The client interface module also provides additional features not
available with traditional computer to computer links, such as assay and
physician utilization reports, and a flexible architecture that can accommodate
future expansion and require fewer internal customer resources.

DATAPASSPORTMD-TM-

We believe this product is the most widely used web-based laboratory order
entry and resulting system in hospitals today. Currently, more than 1,200 of our
customers are using DataPassportMD-TM-. One of the key benefits of
DataPassportMD-TM- is that it permits electronic order entry and results
reporting for our smaller volume customers, and can be used alone or as part of
a flexible architecture. DataPassportMD-TM- does not require any specialized
hardware at the user site, making implementation almost immediate. We have added
unique features to enhance the order entry and results reporting screens,
including on-line access to our proprietary "use and interpretation of tests"
books, graphical reporting features and extensive report generation tools for
monitoring test or customer usage. We believe this product is user friendly,
requiring only simple training for system users and on-site data maintenance.

OUTREACH EXPRESS-TM-

We anticipate that our hospital and independent laboratory customers wishing
to grow their testing business will use Outreach Express-TM-. This product is
intended to allow these customers to connect with physicians directly over the
Internet. Outreach Express-TM- uses the functionality of DataPassportMD-TM- and
will be hosted through our servers. The advantages to these customers are that
no specialized hardware needs to be purchased and the entire information
technology product may be supported outside their laboratory. We are designing
Outreach Express-TM- to enable physicians to access assay results from hospitals
and independent laboratories electronically and thus, more quickly than
receiving such information manually. We believe that Outreach Express-TM- will
provide these customers with a competitive advantage in their respective market.
By aiding these customers in their outreach efforts, we believe that they will
continue to utilize our services. We currently have Outreach Express-TM- in
testing at eight pilot sites.

DATAPASSPORTII-TM-

We are currently developing DataPassportII-TM-, a product intended to
emphasize outreach network opportunities for our hospital customers. These
opportunities apply to multiple hospitals in a network who elect to share
clinical laboratory order and result information between facilities.
DataPassportII-TM- is being positioned as an advancement to the capabilities of
DataPassport-Registered Trademark- client interface module and a complementary
product to DataPassportMD-TM-. DataPassportII-TM- is expected to optimize the
technology used to interface with hospitals. This product is designed to be
especially useful in hospitals where LIS systems are difficult to interface or
hospitals that have different LIS systems.

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<PAGE>
PROCESS AUTOMATION

We are implementing an automation system known as the Total Accessioning
Re-Organization system, or TARO-TM-, for our pre- and post-analytical specimen
management. This high speed automated sorting system reduces the potential for
human error, increases the productivity of laboratory staff and decreases
overall turn-around time within the laboratory. Specifically, TARO-TM- automates
specimen sorting to the appropriate assay batch, enhances specimen tracking
applications and reduces manual set up procedures at the analytical workbench.

We are currently developing an ancillary system to TARO-TM- that is designed
for high-throughput, precise aliquotting. This automated system is expected to
substantially reduce the traditional manual process of dividing specimens into
smaller components when multiple tests are requested on a single patient. Like
TARO-TM-, this system is expected to deliver higher quality service levels to
our customers while at the same time reducing our operating costs.

We utilize information technology applications extensively in conjunction
with automated specimen management systems at the analytical site within the
laboratory. Other projects are under development as we continue to refine our
processes to improve accuracy and productivity.

RESEARCH AND DEVELOPMENT

We focus our R & D efforts on accelerating new assay development, evaluating
alternatives to costly diagnostics, improving existing assay performance and
commercializing existing technologies developed by our strategic partners. We
have 32 employees in the R & D department, 18 of whom hold an M.D. or Ph.D.
degree. All of our R & D efforts have been company-sponsored. No R & D efforts
have been sponsored by our customers. We have spent $1.5 million on research and
development during the nine months ended September 30, 2000, and $2.3 million,
$2.4 million and $2.2 million in research development for the years ended
December 31, 1999, December 31, 1998 and December 31, 1997, respectively.
Through our efforts, we have introduced over 600 new or improved esoteric assays
in the past five years. Our R & D efforts enable us to grow revenues, increase
market share and command premium pricing for many of our assays.

Our process of creating a new assay begins with input from many sources,
including, our scientific team, our marketing department, scientific symposiums,
customers and scientific journals. A team composed of representatives from
R & D, marketing and operations evaluates the potential for a proposed assay,
examining issues from disease prevalence to production costs. Once an assay is
approved by this team, our R & D staff initiates development and validation of
that assay. Currently, our average time to internally develop and market a new
esoteric assay is three months.

To advance our internal development efforts of new technology applications,
we seek strategic partners whose technology can be applied to a variety of
disease conditions and produce advantages related to accuracy, performance,
speed of testing or cost reduction. Our adoption of the Sequenom MALDI-TOF-TM-
system is an example of such an enabling platform. We expect turn-around time to
be dramatically reduced by eliminating procedures typical with conventional DNA
testing and we also expect lower costs by decreasing reagent use. This system
has applications in many medical areas, including infectious diseases, bacterial
identification and genomics.

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<PAGE>
STRATEGIC PARTNERSHIPS AND LICENSING ARRANGEMENTS

We actively pursue strategic partnerships that provide us with technologies
or intellectual property that help facilitate accelerated assay development and
commercialization. In addition, such agreements may provide us with the
opportunity to collect royalties from third parties for sublicensing these
technologies to others. Five important technologies that we have licensed
through strategic relationships include:

- Roche's PCR technology which is the technology platform for many of our
gene-based assays;

- Sequenom's MALDI-TOF-TM- technology which allows us to significantly
accelerate the analytical time for our DNA assays;

- Epoch Biosciences' technology which improves performance of assay systems
for molecular analysis that is used to locate and identify genes
associated with cancer;

- Third Wave Technologies' novel DNA detection and quantitation system; and

- Gen Probe's patented RNA gene to be used as a screen for identifying
bacterial infections.

ROCHE AGREEMENT

In 1992, we entered into an agreement with Roche Molecular Systems under
which we license polymerase chain reaction, or PCR, technology which is the
foundation for many of our gene-based diagnostic assays. In 1999, this PCR
technology was augmented by an additional license arrangement with Roche. Our
licenses to use Roche's technology are not exclusive and Roche may grant similar
rights to other parties. In exchange for these licenses, we have agreed to pay
Roche royalties on our sale of assays incoporating the Roche technology. Both
license agreements will terminate at the expiration of the last of the PCR
technology patents which expire in 2004.

SEQUENOM AGREEMENT

In June 2000, we purchased from Sequenom a high speed machine capable of
detecting and characterizing pieces of DNA. In connection with this purchase, we
pay Sequenom development fees to develop assays for us which we will utilize
with the machine to facilitate genotyping of certain infections. In addition to
the development fees, Specialty will pay royalties to Sequenom based on revenues
generated from our sale of any new assays developed utilizing Sequenom's
technology. For any newly developed assay for which we desire exclusive rights,
a licensing agreement can be negotiated with Sequenom.

EPOCH BIOSCIENCES AGREEMENT

In May 2000, we entered into a strategic partnership with Epoch Biosciences
to collaborate our research and development effort to identify and commercialize
new assays to detect human leukemias. In addition to fixed fees we pay to Epoch
upon the identification of successful assay probes, Specialty will pay royalties
to Epoch based on revenues generated from our sale of new assays developed
utilizing Epoch's technology. If the collaboration is successful in developing
new assays, we will have the exclusive right to commercialize these assays for a
period of one year. This agreement will continue until the expiration of any
patent rights licensed from Epoch, unless earlier terminated by mutual agreement
or otherwise.

45
<PAGE>
THIRD WAVE AGREEMENT

In April 2000, we entered into a strategic relationship with Third Wave
Technologies in order to utilize and incorporate Third Wave's DNA detection and
quantification system in our assay menu. Our collaborative relationship will
continue until terminated by either party with prior notice. There are no fees
or royalties associated with this agreement.

GEN-PROBE AGREEMENT

In March 2000, we entered into an agreement with Gen-Probe under which we
license technology to facilitate our development of new assays and improve
existing assays which identify bacterial infections. Our license to use
Gen-Probe's technology is not exclusive and Gen-Probe may grant similar rights
to other parties. In exchange for the Gen-Probe technology, we have agreed to
pay Gen-Probe royalties on our sale of assays which incorporate the technology.
We have granted Gen-Probe a non-exclusive license to any improvements we make
upon the Gen-Probe technology. The agreement will expire in March 2002 and can
be renewed for one year, on the same terms, with the mutual consent of the
parties.

PROPRIETARY RIGHTS

We protect the proprietary methodologies for assays developed by our R & D
group as our trade secrets. All of our employees and consultants sign a
proprietary information and inventions agreement upon hiring. To date, we have
experienced no known material theft of trade secrets. We have copyrighted the
proprietary software developed for products such as
DataPassport-Registered Trademark-, DataPassportMD-TM-, Outreach Express-TM- and
TARO-TM-. We also have obtained copyright registrations, as appropriate, for our
published books and clinical information which we provide either electronically
or in print to requesting clinicians. Many of our assays are branded products
and we have registered these trademarks accordingly. We also have registered our
slogans used in our clinical information and other advertising materials.

On April 5, 2000, we received a letter from the National Institutes of
Health, the NIH, advising us that it believes that two of our assays, HIV-1
GenotypR-TM- and HIV GenotypR-PLUS-TM-, infringe its U.S. Patent 5,252,477. The
patent is generally directed to the human HIV protease amino acid and DNA
sequences and methods for synthesis and purification.

We received a letter from Chiron Corporation in or about February 1998
claiming that some of our Hepatitis C, or HCV, assays may be covered by its U.S.
Patent 5,714,596. As of June 23, 2000, we entered into an agreement to purchase
the majority of our HCV assays from Bayer Corporation, which has represented
that it has a license for U.S. Patent 5,714,596.

Neither NIH nor Chiron has filed suit against us. We intend to defend any
such suit that may arise vigorously and to assert all available defenses to
allegations of patent infringement that would be available to us. We do not
believe the outcome of either of these matters is likely to have a material
adverse effect on our business, financial condition or results of operations.

COMPETITION

The esoteric clinical laboratory business is highly competitive and is
dominated by several national laboratories, as well as many smaller niche and
regional organizations. Our primary competitors include large independent
laboratories, such as Quest and LabCorp, that offer a wide test and product menu
on a national scale. These large national independent laboratories have
significantly greater financial, sales and logistical resources than we do and
may be able to achieve greater economies of scale, or establish contracts with
payor groups on more favorable terms than we can. We also compete with smaller
niche laboratories, like Impath or Athena Diagnostics, that occupy a narrow
segment of the

46
<PAGE>
esoteric market by offering a very specific assay menu. Finally, institutions
such as Mayo Medical Laboratories and Associated Regional University
Pathologists that are affiliated with large medical centers or universities
generally lack the advantages of the larger commercial laboratories but instead
compete with us on the limited basis of offering a perceived higher quality.

We believe that healthcare providers consider the following factors, among
others, in selecting an esoteric clinical laboratory:

- accuracy, timeliness and consistency in reporting assay results;

- number and types of assays performed by the laboratory;

- ability to develop new and useful assays;

- service capability and quality;

- ability to transfer assay results electronically;

- reputation in the medical community;

- pricing of assay services; and

- reputation as a source of clinically useful, assay-related information.

We believe that we compete favorably with our principal competitors for
esoteric testing services in these areas. However, we cannot assure you that we
will maintain our competitive position in the future.

QUALITY ASSURANCE

We maintain a comprehensive quality assurance system that monitors
performance throughout the laboratory to ensure accuracy and precision in
specimen handling and daily laboratory clinical testing. We also have written
protocols based upon nationally standardized guidelines to guide our test
performance and results interpretation, and to monitor and evaluate our problem
solving procedures. We believe that we have obtained all appropriate approvals
and licenses for providing clinical laboratory testing services. We participate
in numerous quality and proficiency testing programs, including the proficiency
programs administered by the College of American Pathologists and the Centers
for Disease Control and Prevention, along with other independent state, national
and international programs. Participation in the Laboratory Accreditation
Program requires periodic self-evaluation, which is monitored by the College of
American Pathologists. Routine monitoring of control results and blind specimen
submissions provides information necessary to identify and resolve potential
problems.

All laboratory testing and associated processes are described in written
standard operating procedures and procedures which follow the format of the
National Committee on Clinical Laboratory Standard's clinical laboratory
procedure manual. Included therein are instructions for routine monitoring of
quality control data, the frequency with which tests are to be run, the
tolerance limits and the corrective action which is to be taken when tolerance
limits are exceeded.

GOVERNMENT REGULATION

ANTIFRAUD LAWS/OVERPAYMENTS

Numerous federal and state laws provide for penalties in connection with
improper billing practices involving healthcare services. Remedies under these
laws include imprisonment, monetary penalties, damages and asset forfeitures.
Monetary penalties may reach $10,000 for each test improperly billed. These laws
include, among others, the federal False Claims Act, which prohibits the
submission of fraudulent claims in connection with Medicare, Medicaid and
certain other governmental programs. In

47
<PAGE>
addition to direct suits by the federal government, the False Claims Act
authorizes private parties to bring suit on behalf of the government against
providers and entitles such a person to a portion of any final recovery. In
addition, the Social Security Act provides for civil monetary penalties and
recovery of treble damages for services which are fraudulently billed to the
Medicare program or a Medicaid program. Providers convicted of any criminal
offense relating to Medicare or Medicaid covered services or of certain felonies
in connection with other private or governmental healthcare programs are subject
to mandatory exclusion from the Medicare and Medicaid programs. In addition, the
Health Care Financing Administration may exclude from the Medicare and Medicaid
programs any provider convicted under any state or federal law of certain
offenses relating to fraud, or who has been subjected to a civil monetary
penalty under the above described provisions of the Social Security Act. The
Health Care Financing Administration also may suspend Medicare payments to any
provider it believes has engaged in fraudulent billing practices. Remedies
generally similar to those described above are also available to state Medicaid
programs.

The federal government has investigated and continues to investigate the
billing practices of numerous large and small clinical laboratories. Such
investigations and related litigation have involved a broad range of issues,
including the practices of laboratories of grouping tests into panels for
billing and ordering purposes, the marketing of tests to physicians, billing for
hematology tests and indices, billing for tests not performed, double billing,
billing for tests which are not medically necessary, improper coding, and
numerous other potentially improper practices. These investigations have
resulted in all of the largest national independent laboratory companies, as
well as many regional and local laboratories, having entered into settlement
agreements in amounts that in several instances have exceeded $100 million.
While most fraud enforcement activity has involved the Medicare and Medicaid
programs, lawsuits by private insurance companies based upon fraud theories are
also common. To our knowledge, we are not subject to any investigations or
lawsuits alleging fraudulent billing practices. However, there can be no
assurance that our activities will not be challenged under the fraud laws in the
future.

Independent of fraud allegations, Medicare and Medicaid programs and private
payors may retroactively determine that certain payments for services must be
repaid due to a failure to satisfy applicable payor requirements. Significant
delays in or recoupments of payments could have a material adverse effect on our
revenues. In this regard, the Health Care Financing Administration recently
asserted that certain tests performed by us were not adequately documented, were
not properly coded for billing purposes, or were not medically necessary, and
that it overpaid us for services by $1.1 million based upon an audit period from
September 1997 through March 1999. The repayment was made out of existing
reserves and did not negatively impact net income. Although we have repaid this
amount, we are vigorously appealing this overpayment claim. However, there can
be no assurance that other issues will not be pursued by the Health Care
Financing Administration or that these same issues will not be pursued by the
Health Care Financing Administration with respect to other time periods.

LABORATORY/PHYSICIAN/HOSPITAL RELATIONSHIPS

"SELF-REFERRAL" LEGISLATION. We are subject to "self-referral" prohibitions
under federal Medicare law, commonly known as the Stark Law and to similar
restrictions of California law, the Physician Ownership and Referral Act, which
apply to referrals by California physicians. When taken together, these
restrictions generally prohibit us from billing the patient or any governmental
or private payor for any test when the physician ordering the test, or any
relative of such physician, has an investment interest in, or compensation
arrangement with us.

Both the Physician Ownership and Referral Act and the Stark Law contain an
exception for referrals made by physicians who hold investment interests in a
publicly traded company that has shareholders' equity of $75 million at the end
of its most recent fiscal year, and satisfies certain other requirements.
California's self-referral restrictions applicable to referrals of workers'
compensation

48
<PAGE>
testing also contain a similar exception, except that total gross assets at the
end of its most recent fiscal year has to be at least $100 million. Until such
time as we qualify for these exemptions, we will attempt to identify and to
notify physicians who are prohibited from making referrals to us, and will
install in our billing procedures a system to prevent billing for any referrals
that may come to us from such physicians. However, because many shareholders
hold stock in the name of their stock brokerage firm, it may not be possible for
us to fully comply with the self-referral requirements prior to our qualifying
for the public company exemptions. In addition, we will need to monitor our
compensation relationships with physicians under the self-referral laws even
after qualifying for the public company exemptions. For example, our provision
of information technology support to physician customers must be carefully
structured in order to comply with the self-referral laws. Laboratories which
violate the Stark Law must refund any amounts collected in connection with
prohibited referrals and are also subject to monetary penalties of $15,000 for
each test improperly billed for and exclusion from the Medicare and Medicaid
programs. In addition, billings for services where the referral was prohibited
may be actionable under false claims statutes. Substantial penalties may also be
imposed in the event of Physician Ownership and Referral Act violations.
Although we believe that we are in compliance in all material respects with the
Physician Ownership and Referral Act and the Stark Law, there can be no
assurance that we will not be found to be in violation of these laws in the
future. In addition, other states have self-referral restrictions with which we
may have to comply that may differ from those imposed by federal and California
law.

ANTIKICKBACK LAWS. The Medicare/Medicaid antikickback statute prohibits
laboratories from paying remuneration as inducement for referrals of patients or
specimens for testing paid for by the Medicare or Medicaid programs. Based upon
a federal court decision specifically considering physician ownership of
laboratories and an antikickback safe harbor regulation applicable to
investments in certain publicly traded companies, we believe that a challenge to
physician investments in our company is unlikely.

A number of business practices in the clinical laboratory industry have been
criticized by Medicare's Office of Inspector General, including the provision of
phlebotomy staff to clients who perform clerical or other functions for the
client which are not directly and solely related to the collection or processing
of laboratory specimens, the provision of computers or fax machines to clients
which are not used exclusively in connection with performance of the
laboratory's work, the lease of space in a physician's office for rent which
exceeds the fair rental value of such space, certain acquisition agreements
where the sellers may make referrals to the buyer after the sale and other
compensation relationships between laboratories and entities from which they
receive referrals, or to which they make referrals, if such relationships are
intended to induce referrals. In addition, Medicare's Office of Inspector
General has indicated that discounts given by laboratories to clients with
respect to their private pay patients and/or HMO patients must not be intended
to induce referrals of Medicare or Medicaid patients by the client to the
laboratory. Our business practices are governed by the antikickback laws,
including our negotiated discounted pricing arrangements, our participation in
group purchasing organizations and provision of information technology to our
customers. Because, in most instances, we bill our customers for both their
Medicare and non-Medicare testing at a uniform price, we believe the Medicare's
Office of Inspector General concerns regarding discounts will not apply to us.
Moreover, statutory exceptions and "safe harbor" regulations are available to
protect certain discounts offered to customers and certain payments we make to
group purchasing organizations.

Some states, including California, also prohibit payments from being given
to physicians, hospitals or others by clinical laboratories as compensation or
inducement for referrals of patients or test specimens, regardless of the source
of payment for such testing. In addition, laboratories offering pricing to their
customers that is more favorable than that offered directly to patients may be
deemed to pay prohibited kickbacks under state laws. However, we believe that a
kickback will not result under California law if the laboratory's customer
passes all of such discount to its patients in the form of lower testing
charges. Because we expect our California customers to comply with the "pass
through"

49
<PAGE>
requirements applicable to them, we do not believe that any favorable pricing we
offer to California physicians or hospitals violates California's antikickback
laws. However, markups by our non-California customers who are not bound by
anti-markup restrictions may implicate California's antikickback laws.

Any action taken against us under the Medicare/Medicaid antikickback statute
could result in criminal penalties being imposed pursuant to the U.S. Sentencing
Guidelines, civil monetary penalties of $50,000 per violation plus treble
damages, and exclusion from Medicare and Medicaid participation. Laboratories
that violate the California antikickback laws or similar antikickback,
anti-markup, or direct billing laws of other states may be subject to loss of
licensure and substantial fines.

While we believe that we are in compliance with the antikickback statutes,
there can be no assurance that our relationships with physicians, hospitals and
other customers will not be subject to investigation or a successful challenge
under such laws. If imposed for any reason, sanctions under the antikickback
laws could have a material adverse effect on our business.

CERTIFICATION AND LICENSES

We are required to maintain various federal and state licenses,
certifications and permits necessary to conduct our business. Our laboratory is
certified pursuant to the Clinical Laboratory Improvement Amendments, which
subject virtually all clinical laboratories to national standards for assuring
quality of laboratory performance. Licensure is also required and maintained for
our laboratory under the laws of the State of California. We are licensed in
states which require us to be licensed in order for us to perform services for
their residents, including Florida, Maryland, New York, Pennsylvania and Rhode
Island. Our laboratory facilities are also certified by the College of American
Pathologists.

The above programs establish standards for the day-to-day operation of a
clinical laboratory, including the training and skills required of personnel and
quality control. In addition, federal and state laws mandate proficiency
testing, which involves testing of specimens that have been specifically
prepared for the laboratory. If a laboratory is out of compliance with the
Clinical Laboratory Improvements Amendments or other applicable requirements,
the Health Care Financing Administration or the California Department of Health
Services may assess substantial civil money penalties, restrict the tests which
the laboratory may perform, impose specific corrective action plans, suspend the
laboratory's approval to receive Medicare payments, and/or suspend, revoke or
limit the laboratory's Clinical Laboratory Improvements Amendments certificate
or state license. If a laboratory's Clinical Laboratory Improvements Amendments
certificate or state license is suspended or revoked, its ability to perform
further testing terminates.

In June 1999, the Health Care Financing Administration asserted that we were
out of compliance with Clinical Laboratory Improvements Amendments regulations
pertaining to specific quality assurance functions, imposed certain fines in
connection therewith, and indicated that the next level of sanction, if we did
not come into compliance, would be revocation of our Clinical Laboratory
Improvements Amendments certificate. After the Health Care Financing
Administration's resurvey in June 2000, we were able to satisfy the Health Care
Financing Administration that we were in compliance with the applicable
requirements. While we have appealed the fine imposed by the Health Care
Financing Administration, which totaled $116,000, there can no assurance that we
will be successful in such appeal. We believe we are presently in compliance
with all certification and licensure requirements.

COMPLIANCE

We have reviewed the pertinent regulations of the Clinical Laboratory
Improvements Amendments and related rulings and policy guidelines and we believe
that our business practices adhere to the stated requirements. We will continue
to monitor legislation and implement the practices therein, but there can be no
guarantee that we will pass all future inspections or otherwise be found to be
in compliance with these and other regulations in the future.

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The Department of Health and Human Services' Office of the Inspector General
has in recent years suggested adoption of a written compliance plan to promote
standards of ethics and business practice that will prevent fraudulent conduct.
We are in the process of adopting such a compliance plan and have recently
appointed a full-time compliance director to assist us with our regulatory
compliance.

"CORPORATE PRACTICE" OF MEDICINE

California law, as well as the laws of many other states, prohibit
physicians from sharing professional fees with non-physicians such as
laboratories, and prohibit non-physicians from practicing medicine, including
pathology, and from employing pathologists or other physicians. California law
provides that the practice of medicine without a license is a misdemeanor, and a
violation of the laws governing the practice of medicine could be a basis for
assessment of fines and penalties, imposition of a cease and desist order, and
the suspension or revocation of a California laboratory license. State and
federal law also prohibit us from being compensated for referrals we make to our
pathologists. We have previously employed pathologists, and are in the process
of restructuring our relationships with pathologists in a manner which we
believe does not violate any prohibition against the "corporate practice" of
medicine or otherwise violate state or federal law. We do not believe that any
violations which we may have committed in the past are likely to result in
sanctions that would have a material adverse effect on our business, financial
condition or results of operations.

INCREASED REGULATION OF GENETIC TESTING

The federal Food and Drug Administration, or the FDA, regulates the
manufacture of medical devices, including laboratory testing equipment,
diagnostic kits and certain reagents. While the FDA believes that it has
authority to regulate tests developed by laboratories for their own use, the
FDA, to date, has allowed the development of such tests to proceed under the
regulations under the Clinical Laboratory Improvements Amendments governing a
laboratory's development of its own assays. The FDA has also subjected the
commercialization of certain immunohistochemical stains, tumor markers and
analyte specific reagents to limited regulation, and requires us to make certain
disclosures in connection with their use. The federal Centers for Disease
Control and Prevention, or CDC, has published notice of its intent to revise the
regulations under the Clinical Laboratory Improvements Amendments to
specifically recognize and regulate a genetic testing specialty. In addition,
the Department of Health and Human Services' Secretary's Advisory Committee on
Genetic Testing advises the Department of Health and Human Services as to
various issues raised by the development and use of genetic testing. The
Secretary's Advisory Committee on Genetic Testing has published and requested
comments on its preliminary recommendations for increased participation on the
part of the FDA and increased regulation of genetic testing under Clinical
Laboratory Improvements Amendments. As a result of the activities of the FDA,
the CDC and the Secretary's Advisory Committee on Genetic Testing, it is
possible that our existing and future assays may be subject to a regulatory
approval similar to the pre-marketing approval process which the FDA applies to
drugs and medical devices, or may be subject to other increased regulatory
standards, which could have a negative effect on our business.

OTHER REGULATIONS

Pursuant to the Occupational Safety and Health Act, known as OSHA,
laboratories must provide a safe workplace to their employees, and OSHA has
issued rules to protect workers from blood-borne pathogens and other hazards
that are commonly found in laboratories. We are also subject to licensing and
regulation under federal, state and local laws relating to the handling and
disposal of medical specimens, hazardous waste and radioactive materials. We are
also subject to regulations of the Department of Transportation, the Public
Health Service's Centers for Disease Control & Prevention and the Postal Service
which apply to the surface and air transportation of laboratory specimens.
Although we believe that we are currently in compliance in all material respects
with the above laws,

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failure to comply could subject us to denial of the right to conduct business,
fines, criminal penalties and other enforcement actions.

CHANGES IN LABORATORY REIMBURSEMENT

HEALTH CARE REFORM

A number of proposals aimed at increasing healthcare insurance coverage or
reducing healthcare costs have been considered in recent years which, if
enacted, would have affected major reforms of the healthcare system. Such
proposals include: increased enrollment of Medicare beneficiaries in managed
care systems, increased availability of health insurance to individuals and to
small businesses, requirements that all businesses offer health insurance
coverage to their employees, the provision of tax credits for purchase of health
insurance, the formation of regional "health alliances" to act as healthcare
purchasing agents and the creation of a government health insurance plan that
would cover all citizens. We cannot predict whether any of these or other
proposals will be adopted at the state or federal levels, or what effect, if
any, such proposals would have on our business.

REDUCTIONS TO MEDICARE OR MEDICAID FEE SCHEDULES

For testing performed other than for hospitals, nursing facilities and other
laboratories, laboratories are required to bill Medicare and Medicaid directly,
and generally must accept reimbursement from these programs as payment in full
for services performed for Medicare and Medicaid patients. Such direct billings
by us to Medicare accounted for approximately 3.5% of our net revenue in 1999
and 4.2% of our net revenue this year to date. Medicaid net revenue was 2.0% of
our total net revenue in 1999 and represents 1.5% of our net revenue for the
nine months ended September 30, 2000. However, a substantial portion of the
testing for which we bill our hospital and independent laboratory customers is
for Medicare and Medicaid patients, and we do not know the percentages of our
net revenue that are indirectly derived from these programs. Any pricing
pressure exerted by these programs on our customers may cause them to reduce
their payments to us.

Congress has established maximum fee schedules for clinical laboratory
testing performed for Medicare beneficiaries, excluding hospital and nursing
facility inpatients. Payment for in-patient laboratory services is included in
the prospective payment rates paid to the patient's facility. State Medicaid
programs are prohibited from paying more for testing than the Medicare fee
schedule amounts and, in most instances, they pay significantly less. When
initially established, the Medicare fee schedules were set at 60% of prevailing
local charges. Maximum reimbursement rates for clinical laboratory testing have
subsequently been substantially reduced, and it should be expected that such fee
schedules will be further reduced in the future. For example, a ceiling on
Medicare and Medicaid payments to laboratories commonly referred to as the
"national cap" amount has been reduced numerous times in recent years. Most
recently, Congress reduced the national cap to 74% of the national median of
local fee schedules and eliminated consumer price index increases to the
national cap and local fee schedules through the year 2002. Medicare
reimbursement has also been reduced from time-to-time by an effective rate of
between 1% and 2% pursuant to Gramm-Rudman-Hollings sequestration. In addition,
from time-to-time proposals have been made that beneficiary cost sharing again
be applied to laboratory testing paid for by Medicare. The costs of billing and
collecting co-payment amounts and associated bad debt could reduce the revenue
actually realized by laboratories.

MEDICARE REIMBURSEMENT FOR TECHNICAL COMPONENT OF HOSPITAL PATHOLOGY
SERVICES. In the past, independent laboratories have been permitted to bill for
the technical component of certain pathology services which are performed for
Medicare hospital patients. The Health Care Financing Administration has
promulgated regulations to end such separate billing as of January 1, 2001. Any
such services we perform after such date will have to be billed to the patient's
hospital. Hospitals will receive no additional reimbursement from Medicare for
such services provided to inpatients, and

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reimbursement for these services under the new outpatient prospective payment
system generally may be lower than it was previously. Such changes therefore may
result in a reduction in the payments we receive from hospitals for these
services.

ELIMINATION OF DUAL CHARGE STRUCTURE. Proposals have been made to restrict
"dual charge" billing practices under which laboratories charge higher fees to
Medicare and Medicaid than are charged to physicians, hospitals, laboratories
and other purchasers who are in a position to negotiate favorable rates. Thus,
it has been proposed that existing authority for the Department of Health and
Human Services to exclude from Medicare and Medicaid program participation any
providers that charge amounts to the Medicare program that are "substantially in
excess" of their "usual charges" be used to respond to laboratory pricing
practices. Similarly, the Health Care Financing Administration is permitted to
adjust statutorily prescribed fees for some medical services, including clinical
laboratory services, if the fees are grossly excessive and therefore not
inherently reasonable. The Health Care Financing Administration has issued an
interim final rule setting forth criteria to be used in determining whether the
otherwise statutorily prescribed fees should be reduced which includes
consideration of whether such fees are grossly higher or lower than the payment
made for the services by other purchasers in the same locality. Fees payable by
Medicare for clinical laboratory services may be reduced as a result of the
application of the above rules or by similar restrictions which may be applied
in the future.

In addition, the California Medi-Cal program is required by California
regulations to pay no more for testing than the amount which a laboratory
charges pursuant to any fee schedule it applies generally to its physician or
hospital customers. While the extent to which this rule applies to our discounts
which are negotiated on a case-by-case basis is unclear, it is possible that a
recoupment action could be bought against us based upon discounts which we give
to certain customers of ours.

CONTRACTS FOR LABORATORY SERVICES. Proposals have been made to require
competitive bidding procurement of Medicare laboratory testing services. The
Health Care Financing Administration is required to complete five Medicare
bidding demonstrations involving various types of medical services by 2002, and
the Health Care Financing Administration is expected to include a clinical
laboratory demonstration project in a metropolitan statistical area. Similarly,
California legislation requires the implementation of a program of negotiated
laboratory service contracting for the Medi-Cal program. In addition, a large
portion of the Medi-Cal program has been converted into a managed care system,
resulting in negotiated laboratory service contracts between laboratories and
other providers of healthcare services. Increased enrollment of Medicare or
Medicaid beneficiaries in HMOs or negotiated contracting arrangements may also
result in a larger portion of our business being subject to negotiated contracts
with payors.

To obtain competively bid contracts to perform services, it might be
necessary for us to agree to substantial reductions in our payments from the
Medicare and Medi-Cal programs. Such contracts may be exclusive and laboratories
which do not hold such contracts may be denied access to the Medicare/ Medi-Cal
testing market and could have difficulty obtaining private patient testing from
physicians participating in the contracting or managed care program.

"BUNDLING" OF MEDICARE SERVICES. Proposals have been made to reimburse
clinical laboratory testing services as part of a larger "bundle" of healthcare
services. Under one proposal, physicians would be reimbursed an additional
amount for each office visit they had with a Medicare beneficiary and would be
responsible for paying for any required laboratory services out of this sum.
This or other "bundling" proposals, if enacted, could have an adverse effect on
our operations.

NONGOVERNMENTAL EFFORTS. Managed care arrangements may become increasingly
prevalent in the clinical laboratory services market. For example, HMOs,
insurance companies and self-insured employers may provide laboratory services
directly or contract with laboratories at favorable fee-for-

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service or capitated rates and require their enrollees to obtain service only
from such contracted laboratories. To the extent that we or our customers are
unable to obtain contracts to provide such testing services or must discount
prices to obtain such contracts, our revenues and profit margins could be
adversely affected.

REQUIREMENTS OF DIAGNOSIS CODES

Certain tests are only reimbursable by Medicare when the laboratory submits
an appropriate diagnosis code which it has obtained from the ordering physician.
To the extent that the requirements for such diagnosis codes are expanded to
additional tests or are adopted by Medicaid or private insurance programs, or we
are unable to obtain required codes from physicians, our reimbursement could be
adversely affected.

FACILITIES

Our primary facility is located in Santa Monica, California and is comprised
of four separate buildings totaling 85,357 square feet. Three of our building
leases expire in 2003 and one building lease expires in 2004. Additionally,
three of our leases have options for five additional years upon expiration of
the current leases. Our production, research and administrative functions occupy
these buildings. Annual rent for these four buildings is approximately $1.6
million plus applicable property taxes, maintenance costs and utilities.

We also operate one stand-alone triage collection and processing center in
Worcester, Massachusetts to serve Boston area customers. This facility contains
1,578 square feet and is leased at approximately $34,700 per year on a
month-to-month basis. We also occupy a smaller 210 square foot administrative
facility at the same address.

EMPLOYEES

As of September 30, 2000, we employed 798 individuals. Thirty-two are
engaged in research and development, 175 in administration and clerical
functions, 91 in sales and marketing, 54 in information technology and 446 in
our clinical laboratory and related operations. None of our employees are
represented by labor unions, and we believe our employee relations are good.

LEGAL PROCEEDINGS

Specialty Laboratories Asia Pte. Ltd., a Singapore corporation, or SLA, is
60% owned by our wholly-owned subsidiary, Specialty Laboratories International
Ltd., a British Virgin Islands corporation. SLA was headquartered in Singapore
but in early 1999, SLA ceased all operations and is currently insolvent. A
former employee of SLA has obtained a judgment for $350,000 against SLA and a
default judgment of approximately $1.95 million in a wrongful termination action
against SLA filed by him in Singapore. The former employee has filed an action
against SLA in California to attempt to collect on the Singapore judgment and
has obtained a default judgment of $2.5 million against SLA in California. The
former employee has served discovery upon Specialty and certain directors and
officers, has sought to compel these officers and directors to provide this
discovery, and has requested sanctions in connection with these requests. Our
management believes that any claim against us or our directors and officers in
connection with these judgments, if made, would be without merit, and we would
vigorously defend any such action.

We are involved in various claims and legal actions arising in the ordinary
course of business. These matters include, without limitation, professional
liability, employee-related matters, inquiries from governmental agencies and
Medicare or Medicaid carriers requesting comment on allegations of billing
irregularities that are brought to their attention through billing audits or
third parties. We believe, based upon the advice of counsel and consideration of
all facts available at this time, that the ultimate disposition of these matters
will not have a material adverse effect on our business, financial condition or
results of operations.

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MANAGEMENT

DIRECTORS AND EXECUTIVE OFFICERS

Our executive officers and directors and their ages as of September 30, 2000
and the positions held by them are set forth below:

<TABLE>
<CAPTION>
NAME AGE POSITION(S)
---- -------- -----------
<S> <C> <C>
James B. Peter, M.D., Ph.D................ 67 Chairman of the Board and Chief Executive
Officer
Paul F. Beyer............................. 41 President, Chief Operating Officer and
Director
Frank J. Spina............................ 46 Chief Financial Officer
Shoji Maruyama, D.M.Sc.................... 59 Senior Vice President
Dan R. Angress............................ 43 Vice President, Marketing
Bart E. Thielen........................... 35 Vice President, Finance and Treasurer
John W. Littleton......................... 40 Vice President, Sales
Thomas E. England, Ph.D................... 50 Vice President, Laboratory Operations
Donald K. Gordon.......................... 41 Chief Information Officer
Deborah A. Estes.......................... 44 Director and Secretary
Richard E. Belluzzo....................... 46 Director
Douglas S. Harrington, M.D................ 47 Director
Thomas R. Testman......................... 64 Director
William J. Nydam.......................... 50 Director
</TABLE>

JAMES B. PETER, M.D., PH.D. is our founder, controlling shareholder and has
served as the Chairman of the Board of Directors since our inception in 1975 and
our Chief Executive Officer since July 1995. Dr. Peter is the father of Deborah
A. Estes, our Secretary and one of our directors. Dr. Peter received a B.S. in
Biology from Creighton University, an M.D. from St. Louis University and a Ph.D.
from the University of Minnesota. He is the author of over 400 publications in
science and medicine.

PAUL F. BEYER has served as President and Chief Operating Officer since
January 1996 and as a Director since October 1996. Prior to joining Specialty,
Mr. Beyer served in several capacities at the Mayo Clinic from 1984 until 1995,
including the Chief Executive Officer of Medical Laboratory Network, a clinical
laboratory owned by Mayo, from 1990 to 1995. Mr. Beyer received a B.S. in
Management from Niagara University and an M.B.A. from Rensselaer Polytechnic
Institute.

FRANK J. SPINA has served as Chief Financial Officer since October 2000.
From October 1999 to October 2000, Mr. Spina served as Chief Financial Officer
of MedicaLogic/Medscape, Inc., a healthcare and information technology company.
From October 1997 to October 1999, Mr. Spina served as Chief Financial Officer
of 3D Systems Corporation, an information technology company. Prior to October
1997, Mr. Spina served as Vice President and Controller at Qualcomm
Incorporated. Mr. Spina received a B.A. in Political Science and a B.A. in
Accounting from Baldwin-Wallace College.

SHOJI MARUYAMA, D.M.SC. has served as Senior Vice President since
September 1998. Prior to joining Specialty, Dr. Maruyama worked in several
capacities at BML, Inc., a Japanese clinical laboratory. From 1987 to 1998,
Dr. Maruyama served as Managing Director of BML and from 1982 to 1987, he served
as a director overseeing laboratory process management. Dr. Maruyama received a
B.S. in Engineering from Toyama University and a D.M.Sc. from Juntendo
University in Japan.

DAN R. ANGRESS has served as Vice President, Marketing since April 1997.
From June 1995 to April 1997, Mr. Angress served as Director, Marketing. Prior
to joining Specialty, Mr. Angress served in several marketing capacities,
including Vice President of Marketing at Oncogenetics, now owned by

55
<PAGE>
Impath, and Marketing Manager at Nichols Institute, now owned by Quest
Diagnostics. Mr. Angress received a B.S. in Biology from the University of
California, Irvine and an M.B.A. from Willamette University.

BART E. THIELEN has served as Vice President, Finance and Treasurer since
July 1996. From July 1995 to July 1996, Mr. Thielen served as our Controller.
Prior to joining Specialty, Mr. Thielen served in several financial capacities
at Quest Diagnostics. Mr. Thielen received a B.A. in Accounting from Aurora
University.

JOHN W. LITTLETON has served as Vice President, Sales since March 1997.
Prior to joining Specialty, Mr. Littleton served in several capacities including
Vice President of Sales and Marketing at Quest Diagnostics from January 1989 to
February 1997. Mr. Littleton received a B.A. in Political Science from Seton
Hall University.

THOMAS E. ENGLAND, PH.D. has served as Vice President, Laboratory Operations
since June 1998. From April 1997 to June 1998, Dr. England served as our Vice
President, Clinical Trials. Prior to joining Specialty, Dr. England served in
several capacities at MDS Inc., a life sciences company, including General
Manager, Clinical Trials from 1994 to April 1997 and Laboratory Director from
1980 to 1994. Dr. England received a B.S. in Biochemistry from Bishop's
University in Canada, a Ph.D. in Biochemistry from McMaster University and a
Post-Doctorate diploma in Clinical Biochemistry from the University of Toronto.

DONALD K. GORDON has served as Chief Information Officer since
September 2000. From January 1997 to August 2000, Mr. Gordon served as Chief
Information Officer of Unimed Management Company. From March 1993 to
January 1997, Mr. Gordon served as Director of Systems at Health Plans
Incorporated. Mr. Gordon received a B.S. in Mechanical Engineering from
Northeastern University.

DEBORAH A. ESTES has served as a Director and as Secretary since 1990. From
1994 to the present, Ms. Estes has been actively involved in managing the
financial affairs of the Peter family. Ms. Estes is the daughter of our
controlling shareholder, Chairman and Chief Executive Officer, Dr. James B.
Peter. Ms. Estes received a B.S. in Business Administration from Creighton
University.

RICHARD E. BELLUZZO has served as a Director since October 1996. Since
September 1999, Mr. Belluzzo has served as Group Vice President of Microsoft
Corporation. From January 1998 to September 1999, Mr. Belluzzo served as Chief
Executive Officer of Silicon Graphics, Inc. From 1975 until January 1998,
Mr. Belluzzo served in several senior capacities for Hewlett-Packard Corp.
Mr. Belluzzo serves on the Board of Directors of Imation, Inc., a public company
that develops, manufactures and markets products and services for color
management, imaging and data storage applications. Mr. Belluzzo received a B.S.
in Finance from Golden Gate University.

DOUGLAS S. HARRINGTON, M.D. has served as a Director since October 1996.
Since December 1996, Dr. Harrington has served as Chief Executive Officer of
ChromaVision Medical Systems, Inc., a public medical diagnostics company, and
Chairman of the Board since May 2000. Dr. Harrington served as Chairman and
President of Strategic Business Solutions, Inc., a biotechnology company, and as
a principal in Douglas S. Harrington and Associates, a strategic consulting
firm, from February 1995 to December 1996. From January 1992 to January 1995,
Dr. Harrington served as President of Nichols Institute Reference Laboratories,
which is now part of Quest Diagnostics. Dr. Harrington also serves on the Board
of Directors of several public and private companies including ChromaVision
Medical Systems, Inc. and Merge Technologies, Inc., a public company that
provides clinical information systems and integration solutions for healthcare
organizations. Dr. Harrington received a B.A. in Molecular Biology and an M.D.
from the University of Colorado.

THOMAS R. TESTMAN has served as a Director since October 1996. Since 1992,
Mr. Testman has served on the Board of Directors of several public and private
healthcare companies including

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Minimed, Inc., a public company that designs, manufactures and sells
microinfusion systems and glucose monitoring systems for the management of
diabetes, and ChromaVision Medical Systems, Inc. From 1962 to 1992, Mr. Testman
served in several capacities with Ernst & Young LLP including his last position
as Managing Partner. Mr. Testman received a B.A. in Business from Pacific Union
College and an M.B.A. from Trinity University.

WILLIAM J. NYDAM has served as a Director since August 1999. Since
September 1999, Mr. Nydam has served as Senior Vice President of Science
Applications International Corp., an information technology firm. From
January 1986 to September 1999, Mr. Nydam served in various capacities at
Premier, Inc., a healthcare company, including his last position as Executive
Vice President. Mr. Nydam also serves on the Board of Directors of several
private companies. Mr. Nydam received a B.S. in Accounting and an M.B.A. from
the University of California at Berkeley.

BOARD OF DIRECTORS AND COMMITTEES

Our Board of Directors currently consists of seven members each serving for
a term of one year. At each annual meeting of the shareholders, directors will
be elected by the holders of common stock.

The audit committee reports to the Board of Directors regarding the
appointment of our independent public accountants, the scope and results of our
annual audits, compliance with our accounting and financial policies and
management's procedures and policies relative to the adequacy of our internal
accounting controls. The audit committee consists of Messrs. Belluzzo, Nydam and
Testman.

The compensation committee reviews and makes recommendations to the Board of
Directors regarding our compensation and performance policies and all forms of
compensation to be provided to our executive officers and directors. In
addition, the compensation committee reviews bonus and stock compensation
arrangements for all of our other employees. The current members of the
compensation committee are Dr. Harrington and Messrs. Belluzzo, Nydam and
Testman.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

No interlocking relationships exist between our Board of Directors or our
compensation committee and the Board of Directors or compensation committee of
any other company, nor has any such interlocking relationship existed in the
past.

DIRECTOR COMPENSATION

We do not provide cash or equity compensation to employee directors for
serving on our Board of Directors or for attendance of committee meetings of the
Board of Directors. Non-employee directors receive a retainer of $2,500 per
quarter and $1,500 for each Board of Directors meeting attended. Future
non-employee directors will, upon their initial election or appointment to the
Board of Directors, receive an automatic option grant to purchase 22,000 shares
of common stock that will vest over a four-year period from the grant date.
Current members of the Board of Directors were granted options to purchase
48,125 shares of common stock in 1999 for prior service. Members of the Board of
Directors will receive annual option grants of 5,500 shares of common stock
vesting over a four-year period, which are to be granted on April 1st of every
year and will have an exercise price equal to the fair market value of our
common stock at date of grant.

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EXECUTIVE COMPENSATION

The following table sets forth the total compensation paid or accrued for
the year ended December 31, 1999 to our Chief Executive Officer and our four
other most highly compensated executive officers, referred to as the "named
executive officers."

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
ANNUAL COMPENSATION
---------------------------------------- SECURITIES
OTHER ANNUAL UNDERLYING
NAME AND PRINCIPAL POSITION(S) SALARY ($) BONUS ($) COMPENSATION($) OPTIONS(#)
------------------------------ ---------- --------- --------------- ----------
<S> <C> <C> <C> <C>
James B. Peter ................................. 604,981 300,000 -- --
Chairman and Chief Executive Officer
Paul F. Beyer .................................. 289,000 406,568 6,897(1) 531,641
President and Chief Operating Officer
John W. Littleton .............................. 241,000 159,661 6,452(2) 265,800
Vice President, Sales
Bart E. Thielen ................................ 139,257 185,846 8,070(3) 186,061
Vice President, Finance and Treasurer
Thomas E. England .............................. 169,326 73,738 9,800(4) 186,061
Vice President, Laboratory Operations
</TABLE>

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

(1) Consists of $1,904 for automobile lease and $4,993 in 401(k) matching
contributions paid by us.

(2) Consists of $1,452 for automobile lease and $5,000 in 401(k) matching
contributions paid by us.

(3) Consists of $3,070 for automobile lease and $5,000 in 401(k) matching
contributions paid by us.

(4) Consists of $4,800 for automobile lease and $5,000 in 401(k) matching
contributions paid by us.

EMPLOYMENT AGREEMENTS

In September 2000, we entered into employment agreements with Dr. James B.
Peter, Mr. Paul F. Beyer, Mr. John W. Littleton, Mr. Bart E. Thielen and
Dr. Thomas E. England. In October 2000, we also entered into an employment
agreement with Frank J. Spina.

PETER AND BEYER AGREEMENTS

Dr. James B. Peter, our Chairman of the Board and Chief Executive Officer,
and Paul F. Beyer, our President and Chief Operating Officer, each have
contracts which provide for annual base salaries of $600,000 and $286,000,
respectively. If the officer is terminated other than for cause or if he resigns
for good reason during the first five years of the contract, each agreement
provides that we will continue to pay his base salary for a two year period and
his bonus for a one year period.

Dr. Peter additionally receives customary health and related benefits,
supplemental insurance products, including life insurance at a cost of up to an
additional $50,000 per annum, a leased vehicle with operating expenses,
initiation fees and dues at up to three clubs, and a bonus of approximately 47%
of the value of these benefits to reimburse him for the out-of-pocket tax costs
with respect to these benefits. Mr. Beyer additionally receives customary health
and related benefits, supplemental insurance products, including life insurance
at a cost of up to an additional $15,000 per annum, and a leased vehicle.

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OTHER EXECUTIVE OFFICER AGREEMENTS

In September 2000, we also entered into employment agreements with
Messrs. Littleton and Thielen and Dr. England and in October 2000 we entered
into an employment agreement with Frank J. Spina, each of which may be
terminated at any time. The salary and maximum potential bonuses for each is as
follows:

<TABLE>
<CAPTION>
BASE SALARY MAXIMUM BONUS (PERCENT OF BASE)
----------- -------------------------------
<S> <C> <C>
Littleton............................. $248,268 60%
Spina................................. 220,000 60%
Thielen............................... 148,000 60%
England............................... 175,053 40%
</TABLE>

Additionally, these agreements provide for severance benefits in the amount
of twelve months continued base pay and vesting of options if the officer is
terminated other than for cause during the first three years of the contract.
Each of these officers also receives customary health and related benefits. Mr.
Spina's employment agreement provides for the grant of options to purchase
110,000 shares at the initial public offering price.

OPTION GRANTS IN LAST FISCAL YEAR

The following table sets forth grants of stock options for the year ended
December 31, 1999 to our named executive officers. We did not grant any stock
appreciation rights to our named executive officers and directors during the
fiscal year ended December 31, 1999. The potential realizable value is
calculated based on the term of the option at its time of grant. It is
calculated assuming that the fair market value of common stock on the date of
grant appreciates at the indicated annual rate compounded annually for the
entire term of the option and that the option is exercised and sold on the last
day of its term for the appreciated stock price. These numbers are calculated
based on the requirements of the Securities and Exchange Commission and do not
reflect our estimate of future stock price growth. The percentage of total
options granted to employees in the last fiscal year is based on options to
purchase an aggregate of 1,839,068 shares of common stock granted during the
fiscal year to our employees and directors.

<TABLE>
<CAPTION>
PERCENT OF POTENTIAL REALIZABLE
TOTAL VALUE AT ASSUMED RATES
NUMBER OF OPTIONS OF STOCK PRICE
SECURITIES GRANTED TO APPRECIATION FOR
UNDERLYING EMPLOYEES OPTION TERM
OPTIONS IN FISCAL EXERCISE PRICE EXPIRATION ----------------------
NAME GRANTS (#) YEAR (%) PER SHARE ($) DATE 5%($) 10%($)
---- ---------- ---------- -------------- ---------- --------- -----------
<S> <C> <C> <C> <C> <C> <C>
James B. Peter..................... -- -- -- -- -- --
Paul F. Beyer...................... 531,641 28.9% $1.21 04/01/09 $405,775 $1,028,313
John W. Littleton.................. 265,800 14.5 1.21 04/01/09 202,871 514,116
Bart E. Thielen.................... 186,061 10.1 1.21 04/01/09 142,011 359,883
Thomas E. England.................. 186,061 10.1 1.21 04/01/09 142,011 359,883
</TABLE>

FISCAL YEAR-END OPTION VALUES

The following table sets forth the number and value of exercisable and
unexercisable options held by our named executive officers at fiscal year ended
December 31, 1999. There was no public trading market for our common stock as of
December 31, 1999. Accordingly, the value of unexercised options has been
calculated by subtracting the exercise price from the fair market value of $4.88
per share on December 31, 1999, estimated by management for financial reporting
purposes, multiplied by the number of shares underlying the option. None of our
named executive officers exercised options in 1999.

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AGGREGATE OPTION EXERCISES IN 1999

<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
OPTIONS AT IN-THE-MONEY OPTIONS AT
FISCAL YEAR-END(#) FISCAL YEAR-END
--------------------------- ---------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
James B. Peter..................... -- -- -- --
Paul F. Beyer...................... 531,641 -- $1,950,156 --
John W. Littleton.................. 199,351 66,449 731,255 $243,746
Bart E. Thielen.................... 186,061 -- 682,504 --
Thomas E. England.................. 93,031 93,030 341,252 341,252
</TABLE>

2000 STOCK INCENTIVE PLAN

INTRODUCTION. Our 2000 Stock Incentive Plan is intended to serve as the
successor equity incentive program to our 1999 Stock Option/Stock Issuance Plan.
Our 2000 plan was adopted by our Board of Directors and approved by our
shareholders on September 5, 2000. Our 2000 plan will become effective on the
date the underwriting agreement for this offering is signed. At that time, all
outstanding options under the predecessor 1999 plan will be transferred to our
2000 plan, and no further option grants will be made under the 1999 plan. The
transferred options will continue to be governed by their existing terms, unless
our compensation committee elects to extend one or more features of our 2000
plan to those options. Except as otherwise noted below, the transferred options
have substantially the same terms as will be in effect for grants made under the
discretionary option grant program of our 2000 plan.

SHARE RESERVE. 4,020,280 shares of common stock have been authorized for
issuance under our 2000 plan. Such share reserve consists of the number of
shares we estimate will be carried over from our 1999 plan, including the shares
subject to outstanding options thereunder, plus an additional increase of
approximately 880,000 shares. The number of shares of common stock reserved for
issuance under our 2000 plan will automatically increase on the first trading
day in January each calendar year, beginning in calendar year 2001, by an amount
equal to 3% of the total number of shares of common stock outstanding on the
last trading day in December of the preceding calendar year, but in no event
will any such annual increase exceed 1,100,000 shares. In addition, no
participant in our 2000 plan may be granted stock options, separately
exercisable stock appreciation rights and direct stock issuances for more than
1,100,000 shares of common stock per calendar year.

EQUITY INCENTIVE PROGRAMS. Our 2000 plan is divided into five separate
components:

- the discretionary option grant program, under which eligible individuals
in our employ or service may be granted options to purchase shares of
common stock at an exercise price not less than 100% of the fair market
value of those shares on the grant date;

- the stock issuance program, under which such individuals may be issued
shares of common stock directly, through the purchase of such shares at a
price not less than 100% of their fair market value at the time of
issuance or as a bonus tied to the attainment of performance milestones or
the completion of a specified period of service;

- the salary investment option grant program, under which our executive
officers and other highly compensated employees may be given the
opportunity to apply a portion of their base salary to the acquisition of
special below-market stock option grants;

- the automatic option grant program, under which option grants will
automatically be made at periodic intervals to our non-employee directors
to purchase shares of common stock at an exercise price equal to 100% of
the fair market value of those shares on the grant date; and

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- the director fee option grant program, under which our non-employee
directors may be given the opportunity to apply a portion of the annual
retainer fee otherwise payable to them in cash each year to the
acquisition of special below-market option grants.

ELIGIBILITY. The individuals eligible to participate in our 2000 plan
include our officers and other employees, our non-employee board members and any
consultants we hire.

ADMINISTRATION. The discretionary option grant program and the stock
issuance program will be administered by the compensation committee. This
committee will determine which eligible individuals are to receive option grants
or stock issuances under those programs, the time or times when such option
grants or stock issuances are to be made, the number of shares subject to each
such grant or issuance, the status of any granted option as either an incentive
stock option or a non-statutory stock option under the federal tax laws, the
vesting schedule to be in effect for the option grant or stock issuance and the
maximum term for which any granted option is to remain outstanding. The
compensation committee will also have the exclusive authority to select the
executive officers and other highly compensated employees who may participate in
the salary investment option grant program in the event that program is
activated for one or more calendar years.

PLAN FEATURES. Our 2000 plan will include the following features:

- the exercise price for the shares of common stock subject to option grants
made under our 2000 plan may be paid in cash or in shares of common stock
valued at fair market value on the exercise date. The option may also be
exercised through a same-day sale program without any cash outlay by the
optionee. In addition, the plan administrator may provide financial
assistance to one or more optionees in the exercise of their outstanding
options or the purchase of their unvested shares by allowing such
individuals to deliver a full-recourse, interest-bearing promissory note
in payment of the exercise price and any associated withholding taxes
incurred in connection with such exercise or purchase;

- the compensation committee will have the authority to cancel outstanding
options with the consent of the option holder under the discretionary
option grant program, including options transferred from the 1999 plan, in
return for the grant of new options for the same or a different number of
option shares with an exercise price per share based upon the fair market
value of our common stock on the new grant date;

- stock appreciation rights are authorized for issuance under the
discretionary option grant program. Such rights will provide the holders
with the election to surrender their outstanding options for an
appreciation distribution from us equal to the fair market value of the
vested shares of common stock subject to the surrendered option, less the
aggregate exercise price payable for those shares. Such appreciation
distribution may be made in cash or in shares of common stock. None of the
outstanding options under our 1999 plan contain any stock appreciation
rights;

- the 2000 plan will include the following change in control provisions
which may result in the accelerated vesting of outstanding option grants
and stock issuances:

- in the event that we are acquired by merger or asset sale, each
outstanding option under the discretionary option grant program which
is not to be assumed by the successor corporation will automatically
accelerate in full, and all unvested shares under the discretionary
option grant and stock issuance programs will immediately vest, except
to the extent our repurchase rights with respect to those shares are to
be assigned to the successor corporation;

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- the compensation committee will have complete discretion to structure
one or more options under the discretionary option grant program so
those options will vest as to all the option shares in the event those
options are assumed in the acquisition but the optionee's service with
us or the acquiring entity is subsequently terminated. The vesting of
outstanding shares under the stock issuance program may be accelerated
upon similar terms and conditions;

- the compensation committee will also have the authority to grant
options which will immediately vest in the event we are acquired,
whether or not those options are assumed by the successor corporation;

- the compensation committee may grant options and structure repurchase
rights so that the shares subject to those options or repurchase rights
will vest in connection with a successful tender offer for more than
50% of our outstanding voting stock or a change in the majority of our
Board of Directors through one or more contested elections for Board of
Director membership. Such accelerated vesting may occur either at the
time of such transaction or upon the subsequent termination of the
individual's service; and

- the options currently outstanding under our 1999 plan will immediately
vest in the event we are acquired by merger or sale of substantially
all our assets, unless those options are assumed by the acquiring
entity or our repurchase rights with respect to any unvested shares
subject to those options are assigned to such entity. However, a number
of those options may also contain a special acceleration provision
pursuant to which the shares subject to those options will immediately
vest upon an involuntary termination of the optionee's employment
within 18 months following an acquisition in which the repurchase
rights with respect to those shares are assigned to the acquiring
entity.

SALARY INVESTMENT OPTION GRANT PROGRAM. In the event the compensation
committee elects to activate the salary investment option grant program for one
or more calendar years, each of our executive officers and other highly
compensated employees selected for participation may elect, prior to the start
of the calendar year, to reduce his or her base salary for that calendar year by
a specified dollar amount not less than $10,000 nor more than $50,000. Each
selected individual who files such a timely election will automatically be
granted, on the first trading day in January of the calendar year for which his
or her salary reduction is to be in effect, an option to purchase that number of
shares of common stock determined by dividing the salary reduction amount by
two-thirds of the fair market value per share of our common stock on the grant
date. The option will be exercisable at a price per share equal to one-third of
the fair market value of the option shares on the grant date. As a result, the
option will be structured so that the fair market value of the option shares on
the grant date less the exercise price payable for those shares will be equal to
the amount by which the optionee's salary is reduced under the program. The
option will become exercisable in a series of 12 equal monthly installments over
the calendar year for which the salary reduction is to be in effect.

AUTOMATIC OPTION GRANT PROGRAM. Under the automatic option grant program,
each individual who first becomes a non-employee director at any time after the
completion of this offering will automatically receive an option grant for
22,000 shares on the date such individual joins the Board of Directors, provided
such individual has not been in our prior employ. In addition, on April 1st of
each year after the completion of this offering, each non-employee director who
is to continue to serve as a non-employee director, including each of our
current non-employee/directors, will automatically be granted an option to
purchase 5,500 shares of common stock, provided such individual has served on
our board for at least six months.

Each automatic grant will have an exercise price per share equal to the fair
market value per share of our common stock on the grant date and will have a
term of 10 years, subject to earlier termination following the optionee's
cessation of service on the Board of Directors. The option will be immediately
exercisable for all of the option shares; however, we may repurchase, at the
exercise price paid per

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<PAGE>
share, any shares purchased under the option which are not vested at the time of
the optionee's cessation of service on the Board of Directors. The shares
subject to each initial 22,000-share automatic option grant will vest in a
series of four successive annual installments upon the optionee's completion of
each year of service on the Board of Directors over the four-year period
measured from the grant date. The shares subject to each annual 5,500-share
automatic option grant will vest upon the optionee's completion of one year of
service on the Board of Directors measured from the grant date. However, the
shares will immediately vest in full upon certain changes in control or
ownership or upon the optionee's death or disability while a director.

DIRECTOR FEE OPTION GRANT PROGRAM. Should the director fee option grant
program be activated in the future, each non-employee director will have the
opportunity to apply all or a portion of any cash retainer fee for the year to
the acquisition of a below-market option grant. The option grant will
automatically be made on the first trading day in January in the year for which
the retainer fee would otherwise be payable in cash. The option will have an
exercise price per share equal to one-third of the fair market value of the
option shares on the grant date, and the number of shares subject to the option
will be determined by dividing the amount of the retainer fee applied to the
program by two-thirds of the fair market value per share of our common stock on
the grant date. As a result, the option will be structured so that the fair
market value of the option shares on the grant date less the exercise price
payable for those shares will be equal to the portion of the retainer fee
applied to that option. The option will become exercisable in a series of 12
equal monthly installments over the calendar year for which the fee election is
to be in effect. However, the option will become immediately exercisable for all
the option shares upon the optionee's death or disability while serving as a
board member.

Our 2000 plan will also have the following features:

- outstanding options under the salary investment, automatic option and
director fee option grant programs will immediately vest if we are
acquired by a merger or asset sale or if there is a successful tender
offer for more than 50% of our outstanding voting stock or a change in
the majority of our board through one or more contested elections;

- limited stock appreciation rights will automatically be included as
part of each grant made under the salary investment option grant
program and the automatic and director fee option grant programs, and
these rights may also be granted to one or more officers as part of
their option grants under the discretionary option grant program.
Options with this feature may be surrendered to us upon the successful
completion of a hostile tender offer for more than 50% of our
outstanding voting stock. In return for the surrendered option, the
optionee will be entitled to a cash distribution from us in an amount
per surrendered option share based upon the highest price per share of
our common stock paid in that tender offer; and

- the Board of Directors may amend or modify the 2000 plan at any time,
subject to any required shareholder approval. The 2000 plan will
terminate no later than August 15, 2010.

EMPLOYEE STOCK PURCHASE PLAN

INTRODUCTION. Our Employee Stock Purchase Plan was adopted by the Board of
Directors and approved by the shareholders on September 5, 2000. The plan will
become effective immediately upon the signing of the underwriting agreement for
this offering. The plan is designed to allow our eligible employees and the
eligible employees our participating subsidiaries to purchase shares of common
stock, at semi-annual intervals, with their accumulated payroll deductions.

SHARE RESERVE. 330,000 shares of our common stock will initially be
reserved for issuance. The reserve will automatically increase on the first
trading day in January each calendar year, beginning in

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calendar year 2001, by an amount equal to 1% of the total number of outstanding
shares of our common stock on the last trading day in December in the prior
calendar year. In no event will any such annual increase exceed 550,000 shares.

OFFERING PERIODS. The plan will have a series of successive overlapping
offering periods, with a new offering period beginning on the first business day
of May and November each year. Each offering period will have a duration of
24 months, unless otherwise determined by the compensation committee. However,
the initial offering period may have a duration in excess of 24 months and will
start on the date the underwriting agreement for this offering is signed and
will end on the last business day in October 2002. The next offering period will
start on the first business day in May 2001 and will end on the last business
day of April 2003.

ELIGIBLE EMPLOYEES. Individuals scheduled to work more than 20 hours per
week for more than 6 calendar months per year may join an offering period on the
start date of that period. However, employees may participate in only one
offering period at a time.

PAYROLL DEDUCTIONS. A participant may contribute up to 15% of his or her
cash earnings through payroll deductions, and the accumulated deductions will be
applied to the purchase of shares on each semi-annual purchase date. The
purchase price per share will be equal to 85% of the fair market value per share
on the start date of the offering period in which the participant is enrolled
or, if lower, 85% of the fair market value per share on the semi-annual purchase
date. Semi-annual purchase dates will occur on the last business day of April
and October each year. However, a participant may not purchase more than 440
shares on any purchase date, and not more than 82,500 shares may be purchased in
total by all participants on any purchase date. Our compensation committee will
have the authority to change these limitations for any subsequent offering
period.

RESET FEATURE. If the fair market value per share of our common stock on
any purchase date is less than the fair market value per share on the start date
of the two-year offering period, then that offering period will automatically
terminate, and a new two-year offering period will begin on the next business
day. All participants in the terminated offering will be transferred to the new
offering period.

CHANGE IN CONTROL. Should we be acquired by merger or sale of substantially
all of our assets or more than fifty percent of our voting securities, then all
outstanding purchase rights will automatically be exercised immediately prior to
the effective date of the acquisition. The purchase price in effect for each
participant will be equal to 85% of the market value per share on the start date
of the offering period in which the participant is enrolled at the time the
acquisition occurs or, if lower, 85% of the fair market value per share
immediately prior to the acquisition.

PLAN PROVISIONS. The following provisions will also be in effect under the
plan:

- the plan will terminate no later than the last business day of
October 2010; and

- the Board of Directors may at any time amend, suspend or discontinue
the plan. However, certain amendments may require shareholder approval.

401(k) RETIREMENT PLAN

We adopted a defined contribution 401(k) plan effective January 1991. The
plan generally covers all employees on our payroll who are at least 21 years of
age. Employees become eligible to participate in the plan after they have worked
for at least six months, commencing on the date of hire. The plan provides for
voluntary employee contributions of up to 15% of their annual pre-tax
compensation, subject to the maximum limit allowed by the Internal Revenue
Service guidelines, which is currently $10,500 annually. We may make matching
contributions to each participating employee based on his or her voluntary
contributions to the plan. Our matching contribution currently is 50% of the
first 6% of pay contributed to the plan. Participants are immediately vested in
their voluntary contributions plus

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actual earnings. Our matching contributions to the plan are subject to vesting
at the rate of 20% per year beginning after the employee's second year of
employment with us. The plan is intended to qualify under Section 401 of the
Internal Revenue Code so that contributions by employees or by us to the plan,
and income earned on the plan contributions, are not taxable to employees until
withdrawn from the plan, so that contributions by us, if any, will be deductible
by us when made. The trustee under the plan, at the discretion of each
participant, invests the employee contributions to the plan in selected
investment options. For the year ended December 31, 1999, we made matching
contributions of approximately $515,000 to the plan. The plan permits us to make
discretionary profit-sharing contributions each year. We made no profit-sharing
contributions to the plan in 1999.

We also adopted a nonqualified Deferred Compensation Plan effective
June 1997. The Deferred Compensation Plan covers a select group of management or
highly compensated employees. Under the program, employee-designated deferrals
of up to 100% of salary, commissions and bonus are withheld by us. An amount
equal to the withholding is invested at the direction of the employee, in a
portfolio of phantom investments selected from the available investments under
the program, which are tracked by an administrator. With a portion of the
withholding, we purchase life insurance policies on each of the participating
executives with us named as beneficiary of the policies. Deferred compensation,
including gains and losses on phantom investments, amounted to $1,813,000 at
December 31, 1999.

INDEMNIFICATION OF DIRECTORS AND OFFICERS

Our amended and restated articles of incorporation limit the personal
liability of our directors for monetary damages to the fullest extent permitted
by the California General Corporation Law. Under California law, a director's
liability to a company or its shareholders may not be limited:

- for acts or omissions that involve intentional misconduct or a knowing and
culpable violation of law;

- for acts or omissions that a director believes to be contrary to the best
interests of the company or its shareholders or that involve the absence
of good faith on the part of the director;

- for any transaction from which a director derived an improper personal
benefit;

- for acts or omissions that show a reckless disregard for the director's
duty to the company or its shareholders in circumstances in which the
director was aware, or should have been aware, in the ordinary course of
performing the director's duties, of a risk of serious injury to the
company or its shareholders;

- for acts or omissions that constitute an unexcused pattern of inattention
that amounts to an abdication of the director's duty to the company or its
shareholders;

- under Section 310 of the California General Corporation Law concerning
contracts or transactions between the company and a director; or

- under Section 316 of the California General Corporation Law concerning
directors' liability for improper dividends, loans and guarantees.

In addition, under California law a director's liability to a company or its
shareholders may not be limited for any act or omission (i) occurring prior to
the date when its amended and restated articles of incorporation becomes
effective or (ii) as an officer, notwithstanding that the officer is also a
director or that his or her actions, if negligent or improper, have been
ratified by the directors.

The limitation of liability does not affect the availability of injunctions
and other equitable remedies available to our shareholders for any violation by
a director of the director's fiduciary duty to us or our shareholders.

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Our amended and restated articles of incorporation also include an
authorization for us to indemnify our "agents," as defined in Section 317 of the
California General Corporation Law, through bylaw provisions, by agreement with
the agents, vote of our shareholders or disinterested directors, or otherwise,
to the fullest extent permitted by law. Under this provision, our amended and
restated bylaws provide for indemnification of our directors, officers and
employees. In addition, we may, at our discretion, provide indemnification to
persons whom we are not obligated to indemnify. The amended and restated bylaws
also allow us to enter into indemnification agreements with individual
directors, officers, employees and other agents.

We have entered into indemnification agreements with each of our officers
and directors. These agreements contain provisions that may require us, among
other things, to indemnify these officers and directors against liabilities that
may arise because of their status or service as officers or directors, except
for liabilities arising from willful misconduct of a culpable nature, advance
their expenses incurred as a result of any proceeding against them as to which
they could be indemnified, and obtain officers' and directors' liability
insurance if it is maintained for other officers and directors. These agreements
do not require us to indemnify our directors and officers in situations where:

- the remuneration rendered against our officer or director is determined by
final judgment or other final adjudication that such remuneration was in
violation of law;

- a judgment is rendered against the director or officer for an accounting
of profits made from the purchase or sale of our securities under the
provisions of Section 16(b) of the Securities Exchange Act of 1934, as
amended, or similar provisions of any federal, state or local statutory
laws;

- the officer's or director's conduct is adjudged to have been knowingly
fraudulent or deliberately dishonest, or constitutes willful misconduct;
or

- a court determines that indemnification under the circumstances is not
lawful.

Before the completion of this offering, we intend to obtain directors' and
officers' liability insurance.

At present, we are not aware of any pending or threatened litigation or
proceeding involving a director, officer, employee or agent in which
indemnification would be materially required or permitted. We are not aware of
any threatened litigation or proceeding that might result in a material claim
for indemnification. We believe that our charter provisions and indemnification
agreements are necessary to attract and retain qualified persons as directors
and officers.

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CERTAIN TRANSACTIONS

Other than the transactions described below, for the last three years, there
has not been, nor is there currently proposed, any transaction or series of
similar transactions to which we were or will be a party:

- in which the amount involved exceeded or will exceed $60,000, and

- in which any director, executive officer, holder of more than 5% of our
common stock or any member of their immediate family had or will have a
direct or indirect material interest.

All future transactions between us and any director or executive officer
will be subject to approval by a majority of the disinterested members of our
Board of Directors.

SALE OF COMMON STOCK

During February 1999, we sold 129,351 shares of our common stock to Paul F.
Beyer for $1.21 per share.

INDEBTEDNESS

In November 1996, we loaned $150,000 to the Peter Family Revocable Trust.
The trustees of the Peter Family Revocable Trust are James B. Peter and Joan C.
Peter. The beneficiaries of such trust are James B. Peter and Joan C. Peter. The
debt was repaid in March 2000.

On February 16, 1999, we loaned $700,000 to the Peter Family Revocable Trust
pursuant to a promissory note. The promissory note accrued interest at a rate of
9% per annum. The promissory note was paid in full on March 1, 2000.

SPECIALITY FAMILY LIMITED PARTNERSHIP

We purchased 2% of the limited partnership interest in Specialty Family
Limited Partnership on August 26, 1999 from the Estate of Carl J. Peter, III for
an aggregate purchase price of $310,700. This brought our ownership interest in
the Specialty Family Limited Partnership up to 7.712%. The administrator of the
Estate of Carl J. Peter, III is Deborah A. Estes, a member of our Board of
Directors and a shareholder. In addition, the Specialty Family Limited
Partnership is our largest shareholder.

As a result of our ownership interest in the Specialty Family Limited
Partnership, we were a party to the Specialty Family Limited Partnership
Agreement, dated September 1, 1995, as amended. The sole managing general
partner of Specialty Family Limited Partnership is our Chairman and Chief
Executive Officer, Dr. James B. Peter, as trustee of the Peter Family Revocable
Trust. In addition, the general partners are Deborah A. Estes, one of our
directors, and Joan C. Peter, as trustee for the Peter Family Revocable Trust.
The limited partners consist of children or grandchildren of James B. Peter or
trusts of the children or grandchildren of James B. Peter. The term of the
partnership is until December 31, 2085. No limited partner may transfer its
partnership interest without the prior written consent of both general partners
and those limited partners holding more than two-thirds in interest.

On August 15, 2000, the Specialty Family Limited Partnership redeemed our
entire interest in the partnership in exchange for 1,136,749 shares of our
common stock. We have cancelled all 1,136,749 shares of our common stock we
received from the partnership.

LEASES

We have leased four properties, a 12,863 square foot facility and three
single family dwellings, within the last three years from James B. Peter or
Santa Monica Properties of which Dr. James B. Peter is both a direct and
indirect owner. We do not currently occupy any of these properties. We have,
however, subleased a portion of each of these properties to other parties.

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12,863 SQUARE FEET. The 12,863 square foot facility was initially owned by
James B. Peter and Joan C. Peter. The lease was later assigned by the Peters to
Santa Monica Properties. From 1997 through September 1, 2000, when the lease
terminated, we leased the property for $17,000 per month. During our tenancy, we
subleased a portion of the property to unrelated parties. Our last sublease was
with the Regents of the University of California who leased a portion of the
property for $12,400 per month.

SINGLE FAMILY DWELLINGS. From 1986 through the third quarter of 1998, we
rented a single family dwelling from James B. Peter. From 1997 through the third
quarter of 1998 when the lease was terminated, we paid $1,700 per month in rent.
During our tenancy, we subleased the property to some of our employees. In our
last sublease, the rent to be paid to us totaled $1,700 per month.

We rented another single family dwelling from Santa Monica Properties. We
terminated the lease at the end of 1997. In 1997, we paid $1,700 per month in
rent. During our tenancy, we subleased the facility to various people. However,
in the last several years of our lease, the property remained vacant.

From 1990 through 1997, we rented a third single family dwelling from Santa
Monica Properties. In 1997, we paid an aggregate of $19,800 in rent. During our
tenancy, we subleased the facility to some of our employees. In our last
sublease, the rent to be paid to us totaled $850 per month.

We have made leasehold improvements to each of these properties. We made
leasehold improvements in the amount of approximately $25,864 in 1999,
approximately $116,000 in 1998 and approximately $335,117 in 1997. We do not
expect to make further improvements in the future.

SUBSIDIARY AGREEMENT

We also entered into a Stock Purchase Agreement and Plan of Reorganization
with several shareholders of Specialty Laboratories International Ltd., or SLIL,
on December 30, 1998. Pursuant to this agreement, the holders of 50% of the
outstanding and issued stock of SLIL exchanged shares held by them for an
aggregate of 382,800 of our shares. Each of the exchanging shareholders were
trusts of children or grandchildren of James B. Peter, including the Deborah A.
Estes Third Generation Trust.

We entered into a license agreement effective June 1, 1995 with Specialty
Laboratories Asia Limited, which changed its name to Specialty Laboratories
International Ltd., or SLIL. SLIL is wholly-owned by us. Under the license
agreement, we licensed to SLIL certain technology, intellectual property, trade
secrets and products relating to clinical reference laboratory testing,
biotechnology research and diagnostic, prognostic and monitoring testing
services. The license is a non-transferable exclusive right and license in
perpetuity to use and sublicense the licensed property in connection with the
establishment and operation of clinical reference testing laboratories in
certain Asian countries. The aggregate license fee to be paid by SLIL is
$100,000. Currently, SLIL is no longer an operating entity. However, SLIL has
granted a sublicense to Specialty Laboratories Asia Pte. Ltd., a Singapore
corporation, or SLA. SLA has ceased operations and is currently insolvent.
Therefore, our ability to regain the licensed property is limited until the
termination of the sublicense is authorized by Singapore bankruptcy courts.

We currently have five subsidiaries. Each of our five subsidiaries have
ceased operations and are in the process of being dissolved.

ANNUITY

We purchased and fully funded an annuity for Mel Agopian, a Senior Vice
President of Operations who retired on December 31, 1999. This annuity
originally totaled approximately $546,000 and provides a payment stream of
$10,000 per month over 60 months beginning February 1, 2000.

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<PAGE>
PRINCIPAL SHAREHOLDERS

The following table sets forth information with respect to beneficial
ownership of our common stock as of September 30, 2000 and as adjusted to
reflect the sale of common stock offered by us in this offering for:

- each person known by us to beneficially own more than 5% of our common
stock;

- each executive officer named in the Summary Compensation Table;

- each of our directors; and

- all of our executive officers and directors as a group.

Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and includes voting or investment power with
respect to the securities. Unless otherwise indicated, the address for those
listed below is c/o Specialty Laboratories, Inc., 2211 Michigan Avenue, Santa
Monica, California 90404. Except as indicated by footnote, and subject to
applicable community property laws, the persons named in the table have sole
voting and investment power with respect to all shares of common stock shown as
beneficially owned by them. The number of shares of common stock outstanding
used in calculating the percentage for each listed person includes the shares of
common stock underlying options held by such persons that are exercisable within
60 days of September 30, 2000, but excludes shares of common stock underlying
options held by any other person. Percentage of beneficial ownership is based on
15,187,507 shares of common stock outstanding as of September 30, 2000 and
20,187,507 shares of common stock outstanding after completion of this offering.

<TABLE>
<CAPTION>
PERCENTAGE OF SHARES
BENEFICIALLY OWNED
NUMBER OF SHARES ---------------------
BENEFICIALLY OWNED PRIOR TO AFTER THE
NAME OF BENEFICIAL OWNER PRIOR TO OFFERING OFFERING OFFERING
------------------------ ------------------ --------- ---------
<S> <C> <C> <C>
James B. Peter (1)........................................ 14,263,251 93.9% 70.7%
Specialty Family Limited Partnership (2).................. 13,603,251 89.6% 67.4%
Paul F. Beyer (3)......................................... 660,992 4.2% 3.2%
John W. Littleton (4)..................................... 290,521 1.9% 1.4%
Bart E. Thielen (5)....................................... 231,334 1.5% 1.1%
Thomas E. England (6)..................................... 197,494 1.3% *
Deborah A. Estes (7)...................................... 127,600 * *
Richard R. Belluzzo....................................... 48,125 * *
Douglas S. Harrington..................................... 48,125 * *
William J. Nydam (8)...................................... 48,125 * *
Thomas R. Testman......................................... 48,125 * *
All directors and executive officers as a group (14
persons) (9)............................................ 16,168,925 97.5% 74.9%
</TABLE>

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

* Represents less than 1%.

(1) Consists of 13,603,251 shares held by Specialty Family Limited Partnership
and 660,000 shares held by the Peter Family Revocable Trust. James B. Peter
is a trustee and beneficiary of the Peter Family Revocable Trust. As
trustee of the Peter Family Revocable Trust, Dr. Peter is also the sole
general managing partner of the Specialty Family Limited Partnership.

(2) Reflects shares owned by Specialty Family Limited Partnership. James B.
Peter, as the trustee of the Peter Family Revocable Trust, is the sole
managing general partner and Joan C. Peter, as trustee of the Peter Family
Revocable Trust, and Deborah A. Estes are the general partners.

(3) Includes 531,641 shares subject to options exercisable within 60 days of
September 30, 2000.

(4) Includes 265,800 shares subject to options exercisable within 60 days of
September 30, 2000.

(5) Includes 186,061 shares subject to options exercisable within 60 days of
September 30, 2000.

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<PAGE>
(6) Includes 186,061 shares subject to options exercisable within 60 days of
September 30, 2000.

(7) Consists of 63,800 shares held by The Deborah A. Estes Third Generation
Trust and 63,800 shares held by The James B. Peter, Jr. Third Generation
Trust.

(8) Includes 32,243 shares subject to options exercisable within 60 days of
September 30, 2000.

(9) Includes 1,398,866 shares subject to options exercisable within 60 days of
September 30, 2000.

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<PAGE>
DESCRIPTION OF CAPITAL STOCK

Our amended and restated articles of incorporation, which will become
effective upon the consummation of this offering, authorizes the issuance of up
to 100,000,000 shares of common stock, no par value, and up to
10,000,000 shares of preferred stock, no par value, the rights and preferences
of which may be established from time to time by our Board of Directors. As of
September 30, 2000, 15,187,507 shares of common stock and no shares of preferred
stock were outstanding. As of September 30, 2000, we had 20 shareholders.

COMMON STOCK

Under our articles of incorporation, holders of our common stock are
entitled to one vote for each share held of record on all matters submitted to a
vote of the shareholders, including the election of directors. They do not have
cumulative voting rights. Subject to preferences that may be applicable to any
then-outstanding preferred stock, holders of our common stock are entitled to
receive ratably dividends, if any, as may be declared by the Board of Directors
out of legally available funds. In case of a liquidation, dissolution or
winding-up of Specialty, the holders of common stock will be entitled to share
ratably in the net assets legally available for distribution to shareholders
after payment of all of our liabilities and any preferred stock then
outstanding. Holders of common stock have no preemptive or conversion rights or
other subscription rights. There are no redemption or sinking fund provisions
applicable to the common stock. The rights, preferences and privileges of
holders of the common stock are subject to the rights of the holders of the
shares of any series of preferred stock that we may designate and issue in the
future.

PREFERRED STOCK

Our Board of Directors has the authority, without further action by the
shareholders, to issue from time to time shares of preferred stock in one or
more series. The Board of Directors may fix the number of shares, designations,
preferences, powers and other special rights of the preferred stock. The
preferences, powers, rights and restrictions of different series of preferred
stock may differ. The issuance of preferred stock could decrease the amount of
earnings and assets available for distribution to holders of common stock or
adversely affect the rights and powers, including voting rights, of the holders
of common stock. The issuance may also have the effect of delaying, deferring or
preventing a change in control of Specialty. After the closing of this offering,
we will not have any preferred stock outstanding and have no plans to issue any
preferred stock.

ANTI-TAKEOVER PROVISIONS

Our articles of incorporation and bylaws contain provisions that could have
the effect of discouraging potential acquisition proposals or making a tender
offer or delaying or preventing a change in control of Specialty, including
changes a shareholder might consider favorable. In particular, our articles of
incorporation and bylaws, as applicable, among other things, will:

- provide that special meetings of shareholders can be called by the
chairman of the board of directors, the president, the board of directors
or by a majority of the shareholders. In addition, the business permitted
to be conducted at any special meeting of shareholders is limited to the
business brought before the meeting by the board of directors, the
chairman of the board of directors, the president or any such shareholder;

- provide for an advance notice procedure with regard to the nomination,
other than by or at the direction of the board of directors, of candidates
for election as directors and with regard to business to be brought before
a meeting of shareholders; and

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<PAGE>
- allow us to issue up to 10,000,000 shares of preferred stock with rights
senior to those of the common stock and that otherwise could adversely
affect the rights and powers, including voting rights, of the holders of
common stock. In certain circumstances, this issuance could have the
effect of decreasing the market price of the common stock, as well as
having the anti-takeover effects discussed above.

These provisions are intended to enhance the likelihood of continuity and
stability in the composition of our board of directors and in the policies
formulated by them, and to discourage certain types of transactions that may
involve an actual or threatened change in control of Specialty. These provisions
are designed to reduce our vulnerability to an unsolicited acquisition proposal
and to discourage certain tactics that may be used in proxy fights. We believe
that the benefits of increased protection of our potential ability to negotiate
with the proponent of an unfriendly or unsolicited proposal to acquire or
restructure Specialty outweigh the disadvantages of discouraging such proposals
because, among other things, negotiation of such proposals could result in an
improvement of their terms. However, these provisions could have the effect of
discouraging others from making tender offers for our shares that could result
from actual or rumored takeover attempts. These provisions also may have the
effect of preventing changes in our management.

In addition, since after the offering approximately 71% of our outstanding
capital stock is expected to be held by the Specialty Family Limited Partnership
and the Peter Family Revocable Trust, both of which are controlled by Dr. James
B. Peter, an unfriendly takeover attempt is unlikely.

TRANSFER AGENT AND REGISTRAR

The Transfer Agent and Registrar for the common stock is Registrar and
Transfer Company.

LISTING

We expect the common stock to be approved for listing on the New York Stock
Exchange under the symbol "SP."

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<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE

Prior to this offering, there has not been a public market for our common
stock. Future sales of substantial amounts of our common stock in the public
market could adversely affect prevailing market prices of our common stock and
our ability to raise equity capital in the future.

Upon completion of this offering, we will have outstanding an aggregate of
20,187,507 shares of our common stock, assuming no exercise of the underwriters'
overallotment option and no exercise of outstanding options after September 30,
2000. Of these shares, all of the shares sold in this offering will be freely
tradable without restriction or further registration under the Securities Act,
unless such shares are purchased by "affiliates" as that term is defined in
Rule 144 under the Securities Act. The remaining 15,187,507 shares of common
stock held by existing shareholders are "restricted securities" as that term is
defined in Rule 144 under the Securities Act. Restricted securities may be sold
in the public market only if registered or if they qualify for an exemption from
registration under Rule 144 or 701 under the Securities Act, which rules are
summarized below.

All of our executive officers and directors and all existing shareholders
have entered into lock-up agreements providing that, subject to limited
exceptions, they will not sell, directly or indirectly, any common stock without
the prior consent of Merrill Lynch, Pierce, Fenner & Smith Incorporated for a
period of 180 days from the date of this prospectus.

Subject to the provisions of Rules 144, 144(k) and 701, all of these
restricted securities will be eligible for sale in the public market beginning
180 days after the date of this prospectus upon expiration of the lock-up
agreements described above.

In general, under Rule 144 as currently in effect, beginning 90 days after
the date of this prospectus, a person who has beneficially owned shares of our
common stock for at least one year would be entitled to sell within any
three-month period a number of shares that does not exceed the greater of:

- 1% of the number of shares of common stock then outstanding, which will
equal approximately 201,875 shares immediately after this offering; or

- the average weekly trading volume of the common stock on the New York
Stock Exchange during the four calendar weeks preceding the filing of a
notice on Form 144 with respect to such sale.

Sales under Rule 144 are also subject to certain manner of sale provisions
and notice requirements and to the availability of current public information
about us.

Under Rule 144(k), a person who is not one of our affiliates at any time
during the three months preceding a sale, and who has beneficially owned the
shares proposed to be sold for at least two years, including the holding period
of any prior owner other than an affiliate, is entitled to sell such shares
without complying with the manner of sale, public information, volume limitation
or notice provisions of Rule 144. Therefore, unless otherwise restricted,
"144(k) shares" may be sold immediately upon the completion of this offering.

In general, under Rule 701 of the Securities Act as currently in effect,
each of our employees, consultants or advisors who purchase shares from us in
connection with a compensatory stock plan or other written agreement is eligible
to resell such shares 90 days after the effective date of this offering in
reliance on Rule 144, but without compliance with certain restrictions,
including the holding period, contained in Rule 144.

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<PAGE>
STOCK OPTIONS

Immediately after this offering, we intend to file a registration statement
on Form S-8 under the Securities Act covering 4,350,280 shares of common stock
reserved for issuance under our 2000 Stock Incentive Plan and 2000 employee
stock purchase plan. As of September 30, 2000, options to purchase 1,871,971
shares of common stock were issued and outstanding.

Upon the expiration of the lock-up agreements described above, at least
1,679,258 shares of common stock will be subject to vested options, based on
options outstanding as of September 30, 2000. Such registration statement is
expected to be filed and effective as soon as practicable after the effective
date of this offering. Accordingly, shares registered under such registration
statement will, subject to vesting provisions and Rule 144 volume limitations
applicable to our affiliates, be available for sale in the open market
immediately after the 180-day lock-up agreements expire.

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<PAGE>
UNITED STATES FEDERAL TAX CONSIDERATIONS FOR NON-UNITED STATES HOLDERS

The following is a general discussion of the material United States federal
income and estate tax consequences of the ownership and disposition of our
common stock by a non-U.S. holder. As used in this discussion, the term
"non-U.S. holder" means a beneficial owner of our common stock that is not, for
U.S. federal income tax purposes:

- an individual who is a citizen or resident of the United States;

- a corporation or partnership created or organized in or under the laws of
the United States or any political subdivision of the United States, other
than a partnership treated as foreign under U.S. Treasury regulations;

- an estate whose income is includible in gross income for U.S. federal
income tax purposes regardless of its source; or

- a trust, in general, if a U.S. court is able to exercise primary
supervision over the administration of the trust and one or more U.S.
persons have authority to control all substantial decisions of the trust.

An individual may be treated as a resident of the United States in any
calendar year of U.S. federal income tax purposes, instead of a nonresident, by,
among other ways, being present in the United States on at least 31 days in that
calendar year and for an aggregate of at least 183 days during current calendar
year and the two immediately preceding calendar years. For purposes of this
calculation, you would count all of the days present in the current year,
one-third of the days present in the immediately preceding year and one-sixth of
the days present in the second preceding year. Residents are taxed for U.S.
federal income purposes as if they were U.S. citizens.

This discussion does not consider any state, local or non-U.S. tax
consequences. In addition, this discussion does not consider all aspects of U.S.
federal income and estate taxation that may be or become relevant in light of
your particular circumstances, such as by a partnership or other pass-through
entity:

- U.S. state and local or non-U.S. tax consequences;

- specific facts and circumstances that may be relevant to a particular
non-U.S. holder's tax position, including, if the non-U.S. holder is a
partnership that the U.S. tax consequences of holding and disposing of our
common stock may be affected by certain determinations made at the partner
level;

- the tax consequences for the shareholders, partners or beneficiaries of a
non-U.S. holder;

- special tax result that may apply to particular non-U.S. holders, such as
financial institutions, insurance companies, tax-exempt organizations,
U.S. expatriates, broker-dealers, and traders in securities; or

- special tax rules that may apply to a non-U.S. holder that holds our
common stock as part of a "straddle" "hedge," "conversion transaction,"
"synthetic security" or other integrated investment.

The following discussion is based on provisions of the U.S. Internal Revenue
Code of 1986, as amended, applicable U.S. Treasury regulations and
administrative and judicial interpretations, all as in effect on the date of
this prospectus, and all of which are subject to change, retroactively or
prospectively. The following summary assumes that a non-U.S. holder holds our
common stock as a capital asset. EACH NON-U.S. HOLDER SHOULD CONSULT A TAX
ADVISOR REGARDING THE U.S. FEDERAL, STATE, LOCAL, AND NON-U.S. INCOME AND OTHER
TAX CONSEQUENCES OF ACQUIRING, HOLDING, AND DISPOSING OF SHARES OF OUR COMMON
STOCK.

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<PAGE>
DIVIDENDS

We do not anticipate paying cash dividends on our common stock in the
foreseeable future. See "Dividend Policy." In the event that we pay dividends on
our common stock, we will have to withhold a U.S. federal withholding tax at a
rate of 30%, or a lower rate if provided by an applicable income tax treaty,
from the gross amount of the dividends paid to a non-U.S. holder.

In addition, a "branch profits tax" may be imposed at a 30% rate, or a lower
rate specified in an applicable income tax treaty, on dividends received by a
foreign corporation that are effectively connected with the conduct of a trade
or business in the United States.

Dividends that are effectively connected with a non-U.S. holder's conduct of
a trade or business in the United States or, if provided in an applicable income
tax treaty, dividends that are attributable to a permanent establishment in the
United States, are not subject to the U.S. withholding tax, but are instead
taxed in the manner applicable to U.S. persons. In that case, we will not have
to withhold U.S. federal withholding tax if the non-U.S. holder complies with
applicable certification and disclosure requirements.

Non-U.S. holders should consult their tax advisors regarding their
entitlement to benefits under any income tax treaty and the manner of claiming
the benefits of the treaty. A non-U.S. holder that is eligible for a reduced
rate of U.S. federal withholding tax under an income tax treaty may obtain a
refund or credit of any excess amounts withheld by filing an appropriate claim
for a refund with the U.S. Internal Revenue Service.

GAIN ON DISPOSAL OF COMMON STOCK

A non-U.S. holder generally will not be taxed on gain recognized on a
disposition of our common stock unless:

- you are an individual who holds our common stock as a capital asset, you
are present in the United States during more than 182 days in the taxable
year of the disposition and you meet certain other conditions (though any
such person will generally be treated as a resident of the U.S.);

- the gain is effectively connected with the non-U.S. holder's conduct of a
trade or business in the United States or, in some instances if an income
tax treaty applies, is attributable to a permanent establishment
maintained by the non-U.S. holder in the United States;

- we are or have been a "U.S. real property holding corporation" for U.S.
federal income tax purposes at any time during the shorter of the five
year period ending on the date of disposition or the period that the
non-U.S. holder held our common stock. We have determined that we are not,
and we believe we will not become, a U.S. real property holding company.

Gains of individual non-U.S. holders subject to U.S. tax only because the
holder was present in the U.S. for more than 182 days during the year of
disposition (net of losses from sales or exchanges of capital assets incurred
during the year) are taxed at a flat rate of 30%. Other taxable gains are taxed
in the same manner in which U.S. federal income tax is imposed on citizens or
residents of the U.S. In addition, if any gain is taxable because we are or were
a United States real property holding corporation, the buyer of our shares will
be required to withhold a tax equal to 10% of the amount realized on the sale.

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<PAGE>
FEDERAL ESTATE TAX

Common stock owned or treated as owned by an individual who is a non-U.S.
holder at the time of death will be included in the individual's gross estate
for U.S. federal estate tax purposes, unless an applicable estate tax or other
treaty provides otherwise and, therefore, may be subject to U.S. federal estate
tax.

INFORMATION REPORTING AND BACKUP WITHHOLDING TAX

We must report annually to the U.S. Internal Revenue Service and to each
non-U.S. holder the amount of dividends paid to that holder and the tax withheld
from those dividends. Copies of the information returns reporting those
dividends and withholding may also be made available to the tax authorities in
the county in which the non-U.S. holder is a resident under the provisions of an
applicable income tax treaty or agreement.

Under some circumstances, U.S. Treasury regulations require additional
information reporting and backup withholding at a rate of 31% on some payments
on common stock. Under currently applicable law, non-U.S. holders generally will
be exempt from these additional information reporting requirements and form
backup withholding on dividends paid prior to 2001 if we either were required to
withhold a U.S. federal withholding tax from those dividends or we paid those
dividends to an address outside the United States. After 2000, however, the
gross amount of dividends paid to a non-U.S. holder that fails to certify its
non-U.S. holder status in accordance with applicable U.S. Treasury regulations
generally will be subject to backup withholding at a rate of 31%.

The payment of the proceeds of the disposition of common stock by a non-U.S.
holder to or through the U.S. office of a broker or a non-U.S. office of a U.S.
broker generally will be reported to the U.S. Internal Revenue Service and be
subject to backup withholding at a rate of 31% unless the non-U.S. holder either
certifies its status as a non-U.S. holder under penalties of perjury or
otherwise establishes an exemption. The payment of the proceeds of the
disposition of common stock by a non-U.S. holder to or through a non-U.S. office
of a non-U.S. broker will not be subject to backup withholding or reported to
the U.S. Internal Revenue Service unless the non-U.S. broker has certain
enumerated connections with the United States. In general, the payment of
proceeds form the disposition of common stock by or through a non-U.S. office of
a broker that is a U.S. person or has certain enumerated connections with the
United States will be reported to the U.S. Internal Revenue Service and, after
2000, may be subject to backup withholding at a rate of 31%, unless the broker
receives a statement from the non-U.S. holder, signed under penalty of perjury,
certifying its non-U.S. status or the broker has documentary evidence in its
files that the holder is a non-U.S. holder and the broker has no actual
knowledge to the contrary.

Non-U.S. holders should consult their own tax advisors regarding the
application of the information reporting and backup withholding rules to them,
including changes to these rules that will become effective after 2000.

Any amounts withheld under the backup withholding rules from a payment to a
non-U.S. holder will be refunded, or credited against the holder's U.S. federal
income tax liability, if any, provided that the required information is
furnished to the U.S. Internal Revenue Service.

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UNDERWRITING

Subject to the terms and conditions set forth in a purchase agreement among
us, we have agreed to sell to the underwriters, and each of the underwriters
severally and not jointly has agreed to purchase the number of shares listed
opposite its name below.

<TABLE>
<CAPTION>
NUMBER
UNDERWRITERS OF SHARES
<S> <C>
Merrill Lynch, Pierce, Fenner & Smith
Incorporated...................................... 1,666,667
UBS Warburg LLC............................................. 1,666,667
U.S. Bancorp Piper Jaffray Inc.............................. 1,666,666
---------
Total............................................. 5,000,000
=========
</TABLE>

The underwriters have agreed to purchase all of the shares being sold
pursuant to the purchase agreement if any of these shares are purchased. If an
underwriter defaults, the purchase agreement provides that the commitments of
the nondefaulting underwriters may be increased or the purchase agreement may be
terminated.

We have agreed to indemnify the underwriters against some liabilities,
including liabilities under the Securities Act, or to contribute to payments the
underwriters may be required to make in respect of those liabilities.

The underwriters are offering the shares, subject to prior sale, when, as
and if issued to and accepted by them, subject to approval of certain legal
matters by their counsel, including the validity of the shares, and other
conditions contained in the purchase agreement, such as the receipt by the
underwriters of officer's certificates and legal opinions. The underwriters
reserve the right to withdraw, cancel or modify offers to the public and to
reject orders in whole or in part.

COMMISSIONS AND DISCOUNTS

The underwriters propose initially to offer the shares to the public at the
initial public offering price on the cover page of this prospectus and to
dealers at such price less a concession not in excess of $.67 per share. The
underwriters may allow, and such dealers may reallow, a discount not in excess
of $.10 per share to other dealers. After the initial public offering, the
public offering price, concession and discount may be changed.

The following table shows the public offering price, underwriting discount
and proceeds before expenses to us. This information is presented assuming
either no exercise or full exercise by the underwriters of their overallotment
option.

<TABLE>
<CAPTION>
PER SHARE WITHOUT OPTION WITH OPTION
--------- -------------- -----------
<S> <C> <C> <C>
Public offering price............................ $16.00 $80,000,000 $92,000,000
Underwriting discount............................ $1.12 $5,600,000 $6,440,000
Proceeds, before expenses, to Specialty.......... $14.88 $74,400,000 $85,560,000
</TABLE>

The expenses of the offering, exclusive of the underwriting discount, are
estimated at $1,800,000 and are payable by us.

OVERALLOTMENT OPTION

We have granted an option to the underwriters to purchase up to 750,000
additional shares at the initial public offering price, less the underwriting
discount. The underwriters may exercise this option for 30 days from the date of
this prospectus solely to cover any overallotments. If the underwriters exercise
this option, each underwriter will be obligated, subject to conditions contained
in the purchase

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<PAGE>

agreement, to purchase a number of additional shares proportionate to such
underwriter's initial amount reflected in the above table.

RESERVED SHARES

At our request, the underwriters have reserved for sale, at the initial
public offering price, up to 450,000 shares offered by this prospectus for sale
to some of our directors, officers, employees, business associates and related
persons. If these persons purchase reserved shares, this will reduce the number
of shares available for sale to the general public. Any reserved shares that are
not orally confirmed for purchase within one day of the pricing of this offering
will be offered by the underwriters to the general public on the same terms as
the other shares offered by this prospectus.

NO SALES OF SIMILAR SECURITIES

We and our executive officers and directors and all existing shareholders
have agreed, with exceptions, not to sell or transfer any common stock for
180 days after the date of this prospectus without first obtaining the written
consent of Merrill Lynch. Specifically, we and these other individuals have
agreed not to directly or indirectly:

- offer, pledge, sell or contract to sell any of our common stock;

- sell any option or contract to purchase any of our common stock;

- purchase any option or contract to sell any of our common stock;

- grant any option, right or warrant for the sale of any of our common
stock;

- lend or otherwise dispose of or transfer any of our common stock;

- request or demand that we file a registration statement related to our
common stock; or

- enter into any swap or other agreement that transfers, in whole or in
part, the economic consequence of ownership of any of our common stock
whether any such swap or transaction is to be settled by delivery of
shares or other securities, in cash or otherwise.

This lockup provision applies to common stock and to securities convertible
into or exchangeable or exercisable for or repayable with common stock. It also
applies to our common stock owned now or acquired later by the person executing
the agreement or for which the person executing the agreement later acquires the
power of disposition.

NEW YORK STOCK EXCHANGE LISTING

We expect the shares to be approved for listing on the New York Stock
Exchange, subject to notice of issuance, under the symbol "SP." In order to meet
the requirements for listing on that exchange, the U.S. underwriters and the
international managers have undertaken to sell a minimum number of shares to a
minimum number of beneficial owners as required by that exchange.

Before this offering, there has been no public market for our common stock.
The initial public offering price was determined through negotiations between us
and the underwriters. In addition to prevailing market conditions, the factors
considered in determining the initial public offering price are:

- the valuation multiples of publicly traded companies that the underwriters
believe to be comparable to us;

- our financial information;

- the history of, and the prospects for, us and the industry in which we
compete;

- an assessment of our management, its past and present operations and the
prospects for, and timing of, our future revenues;

- the present state of our development;

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- the percentage interest of us being sold as compared to our valuation; and

- the above factors in relation to market values and various valuation
measures of other companies engaged in activities similar to ours.

An active trading market for our shares of common stock may not develop. It
is also possible that after the offering shares of our common stock will not
trade in the public market at or above the initial public offering price.

The underwriters do not expect to sell more than 5% of the shares in the
aggregate to accounts over which they exercise discretionary authority.

PRICE STABILIZATION, SHORT POSITIONS AND PENALTY BIDS

Until the distribution of the shares is completed, SEC rules may limit the
underwriters from bidding for or purchasing our common stock. However, the
underwriters may engage in transactions that stabilize the price of the common
stock, such as bids or purchases that peg, fix or maintain that price.

The underwriters may purchase and sell our common stock in the open market.
These transactions may include short sales, stabilizing transactions and
purchases to cover positions created by short sales. Short sales involve the
sale by the underwriters of a greater number of shares than they are required to
purchase in the offering. "Covered" short sales are sales made in an amount not
greater that the underwriters' option to purchase additional shares from the
issuer in the offering. The underwriters may close out any covered short
position by either exercising their option to purchase additional shares or
purchasing shares in the open market. In determining the source of shares to
close out the covered short position, the underwriters will consider, among
other things, the price of shares available for purchase in the open market as
compared to the price at which they may purchase shares through the
overallotment option. "Naked" short sales are any sales in excess of such
option. The underwriters must close out any naked short position by purchasing
shares in the open market. A naked short position is more likely to be created
if the underwriters are concerned that there may be downward pressure on the
price of the common shares in the open market after pricing that could adversely
affect investors who purchase in the offering. Stabilizing transactions consist
of various bids for or purchases of common shares made by the underwriters in
the open market prior to the completion of the offering.

The underwriters may also impose a penalty bid. This occurs when a
particular underwriter repays to the underwriters a portion of the underwriting
discount received by it because the underwriters have repurchased shares sold by
or for the account of such underwriter in stabilizing or short covering
transactions.

Similar to other purchase transactions, the underwriters' purchases to cover
the syndicate short sales may have the effect of raising or maintaining the
market price of our common stock or preventing or retarding a decline in the
market price of the common shares. As a result, the price of our common stock
may be higher than the price that might otherwise exist in the open market.

Neither we nor any of the underwriters makes any representation or
prediction as to the direction or magnitude of any effect that the transactions
described above may have on the price of the common stock. In addition, neither
we nor any of the underwriters make any representation that the underwriters
will engage in these transactions or that these transactions, once commenced,
will not be discontinued without notice.

ELECTRONIC PROSPECTUS

Merrill Lynch will be facilitating Internet distribution for the offering to
some of its Internet subscription customers. Merrill Lynch intends to allocate a
limited number of shares for sale to its online brokerage customers. An
electronic prospectus is available on the website maintained by Merrill

80
<PAGE>
Lynch. Other than the prospectus in electronic format, the information on the
Merrill Lynch website relating to the offering is not a part of this prospectus.

LEGAL MATTERS

The validity of the common stock offered hereby will be passed upon for
Specialty by Brobeck, Phleger & Harrison LLP, Los Angeles, California. Certain
legal matters will be passed upon for the underwriters by Debevoise & Plimpton,
New York, New York.

EXPERTS

The consolidated financial statements of Specialty at December 31, 1998 and
December 31, 1999, and for each of the three years in the period ended
December 31, 1999 appearing in this prospectus and Registration Statement have
been audited by Ernst & Young LLP, independent auditors, as set forth in their
report thereon appearing elsewhere herein, and are included in reliance upon
such report given on the authority of such firm as experts in accounting and
auditing.

WHERE YOU CAN FIND MORE INFORMATION

We have filed with the Securities and Exchange Commission a registration
statement on Form S-1 (including exhibits and schedules thereto) under the
Securities Act with respect to the common stock to be sold in this offering.
This prospectus, which constitutes a part of the registration statement, does
not contain all of the information set forth in the registration statement or
the exhibits and schedules which are part of the registration statement. For
further information with respect to Specialty and the common stock, reference is
made to the registration statement and the exhibits and schedules thereto.
Statements contained in this prospectus as to the contents of any contract,
agreement or other document referred to are not necessarily complete, and in
each case reference is made to the copy of such contract, agreement or other
document filed as an exhibit to the registration statement for a more complete
description of the matter involved, and each such statement is qualified in its
entirety by such reference.

You may read and copy all or any portion of the registration statement or
any reports, statements or other information in our files in the Commission's
public reference room at Room 1024, Judiciary Plaza, 450 Fifth Street, N.W.,
Washington, D.C., 20549 and at the regional offices of the Commission located at
Seven World Trade Center, 13th Floor, New York, New York 10048 and 500 West
Madison Street, Suite 1400, Chicago, Illinois 60661. You can request copies of
these documents upon payment of a duplicating fee, by writing to the Commission.
Please call the Commission at 1-800-SEC-0330 for further information on the
operation of the public reference rooms. Our Commission filings, including the
registration statement, will also be available to you on the Commission's
Internet site (http://www.sec.gov).

We intend to furnish to our shareholders annual reports containing financial
statements audited by our independent auditors and to make available to our
shareholders quarterly reports containing unaudited financial data for the first
three quarters of each fiscal year.

81
<PAGE>
------------------------

You should rely only on the information contained in this prospectus. We
have not, and the underwriters have not, authorized any other person to provide
you with different information. If anyone provides you with different or
inconsistent information, you should not rely on it. We are not, and the
underwriters are not, making an offer to sell these securities in any
jurisdiction where the offer or sale is not permitted. You should assume that
the information appearing in this prospectus is accurate as of the date on the
front cover of this prospectus only. Our business, financial condition,
operating results and prospects may have changed since that date.

82
<PAGE>
SPECIALTY LABORATORIES, INC.

INDEX TO FINANCIAL STATEMENTS

CONTENTS

<TABLE>
<S> <C>
Audited Financial Statements:

Report of Ernst & Young LLP, Independent Auditors......... F-2

Consolidated Balance Sheets at December 31, 1998 and
1999.................................................... F-3

Consolidated Statements of Operations for the Years Ended
December 31, 1997, 1998 and 1999........................ F-4

Consolidated Statements of Shareholders' Equity for the
Years Ended December 31, 1997, 1998 and 1999............ F-5

Consolidated Statements of Cash Flows for the Years Ended
December 31, 1997, 1998 and 1999........................ F-6

Notes to Consolidated Financial Statements................ F-7

Unaudited Condensed Financial Statements:

Consolidated Balance Sheet at September 30, 2000.......... F-22

Consolidated Statements of Operations for the Nine Months
Ended September 30, 1999 and 2000....................... F-23

Consolidated Statement of Shareholders' Equity for the
Nine Months Ended September 30, 2000.................... F-24

Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 1999 and 2000....................... F-25

Notes to Interim Consolidated Financial Statements........ F-26
</TABLE>

F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Board of Directors
Specialty Laboratories, Inc.

We have audited the accompanying consolidated balance sheets of Specialty
Laboratories, Inc. as of December 31, 1998 and 1999, and the related
consolidated statements of operations, shareholders' equity and cash flows for
the three years in the period ended December 31, 1999. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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
Specialty Laboratories, Inc. as of December 31, 1998 and 1999, and the
consolidated results of its operations and its cash flows for the three years in
the period ended December 31, 1999 in conformity with accounting principles
generally accepted in the United States.

/s/ ERNST & YOUNG LLP

Woodland Hills, California
April 21, 2000, except for the
October 30, 2000 stock split described
in Note 1 as to which the date is
October 30, 2000

F-2
<PAGE>
SPECIALTY LABORATORIES, INC.

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------
1998 1999
----------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash...................................................... $ 869,141 $ 717,297
Accounts receivable, less allowance for doubtful accounts
of $1,806,559 in 1998 and $4,016,938 in 1999............ 22,139,739 26,774,755
Deferred income taxes..................................... 1,891,354 2,680,354
Inventory................................................. 1,348,615 1,798,929
Prepaid expenses and other assets......................... 1,260,565 1,276,014
----------- -----------
Total current assets........................................ 27,509,414 33,247,349

Property and equipment, net................................. 23,481,682 20,271,587
Net assets of discontinued foreign operations............... 1,898,394 --
Deferred income taxes....................................... 2,021,601 3,735,601
Other assets................................................ 1,087,256 2,604,648
----------- -----------
$55,998,347 $59,859,185
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 9,814,033 $10,118,571
Accrued liabilities....................................... 9,366,202 9,065,874
Income taxes payable...................................... 1,206,112 1,298,629
Current portion of long-term debt......................... 5,088,446 9,148,222
----------- -----------
Total current liabilities................................... 25,474,793 29,631,296

Long-term debt, net of current portion...................... 12,614,417 9,233,977

Other long-term liabilities................................. 956,035 2,712,576

Commitments and contingencies

Shareholders' equity:
Common stock, no par value:
Authorized shares--100,000,000
Issued and outstanding shares--15,839,560 in 1998 and
16,066,681
in 1999............................................... 607,291 4,055,050
Retained earnings......................................... 16,882,890 15,430,365
Deferred stock-based compensation......................... -- (354,079)
Loan to shareholder....................................... (150,000) (850,000)
Accumulated other comprehensive loss...................... (387,079) --
----------- -----------
Total shareholders' equity.................................. 16,953,102 18,281,336
----------- -----------
$55,998,347 $59,859,185
=========== ===========
</TABLE>

SEE ACCOMPANYING NOTES.

F-3
<PAGE>
SPECIALTY LABORATORIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------
1997 1998 1999
------------ ------------ ------------
<S> <C> <C> <C>
Net revenue........................................ $106,357,480 $113,842,487 $130,142,532

Costs and expenses:
Cost of services................................. 60,157,431 65,097,739 74,783,817
Selling, general and administrative (exclusive of
stock-based compensation charges).............. 39,812,658 42,083,817 46,903,375
Stock-based compensation charges................. -- -- 2,818,039
Write-down of unused facility.................... -- -- 2,208,981
------------ ------------ ------------
Total costs and expenses........................... 99,970,089 107,181,556 126,714,212
------------ ------------ ------------
Operating income................................... 6,387,391 6,660,931 3,428,320

Interest income.................................... -- -- (52,762)
Interest expense................................... 883,824 1,158,636 1,691,935
------------ ------------ ------------
Income from continuing operations before
income taxes..................................... 5,503,567 5,502,295 1,789,147

Provision for income taxes......................... 2,506,000 2,273,000 930,000
------------ ------------ ------------
Income from continuing operations.................. 2,997,567 3,229,295 859,147
Loss from discontinued operations, net of income
tax benefits..................................... (935,699) (3,060,401) (2,000,972)
------------ ------------ ------------
Net income (loss).................................. $ 2,061,868 $ 168,894 $ (1,141,825)
============ ============ ============
Income (loss) per share--basic:
Continuing operations............................ $ .19 $ .21 $ .05
Discontinued operations.......................... (.06) (.20) (.12)
------------ ------------ ------------
Net income (loss).................................. $ .13 $ .01 $ (.07)
============ ============ ============
Income (loss) per share--diluted:
Continuing operations............................ $ .19 $ .21 $ .05
Discontinued operations.......................... (.06) (.20) (.12)
------------ ------------ ------------
Net income (loss).................................. $ .13 $ .01 $ (.07)
============ ============ ============
</TABLE>

SEE ACCOMPANYING NOTES.

F-4
<PAGE>
SPECIALTY LABORATORIES, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
ACCUMULATED
COMMON STOCK DEFERRED OTHER
----------------------- RETAINED STOCK-BASED LOAN TO COMPREHENSIVE
SHARES AMOUNT EARNINGS COMPENSATION SHAREHOLDER INCOME (LOSS) TOTAL
---------- ---------- ----------- ------------ ----------- ------------- -----------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1997....... 15,456,760 $ 605,551 $14,794,298 $ -- $(150,000) $ -- $15,249,849
Comprehensive income (loss):
Foreign currency translation
adjustment................. -- -- -- -- -- (176,770) (176,770)
Net income................... -- -- 2,061,868 -- -- -- 2,061,868
-----------
Total comprehensive income..... 1,885,098
---------- ---------- ----------- ----------- --------- --------- -----------
Balance, January 1, 1998....... 15,456,760 605,551 16,856,166 -- (150,000) (176,770) 17,134,947
Shares issued for acquisition
of interest in affiliate... 382,800 1,740 (142,170) -- -- -- (140,430)
Comprehensive income (loss):
Foreign currency translation
adjustment................. -- -- -- -- -- (210,309) (210,309)
Net income................... -- -- 168,894 -- -- -- 168,894
-----------
Total comprehensive loss....... (41,415)
---------- ---------- ----------- ----------- --------- --------- -----------
Balance, December 31, 1998..... 15,839,560 607,291 16,882,890 -- (150,000) (387,079) 16,953,102
Proceeds from sale of shares
to employees, plus related
compensation charge of
$341,814................... 227,121 617,455 -- -- -- -- 617,455
Compensation charge related
to stock options vested at
date of grant.............. -- 1,750,776 -- -- -- -- 1,750,776
Deferred compensation related
to stock option grants..... -- 1,079,528 -- (1,079,528) -- -- --
Amortization of deferred
compensation............... -- -- -- 725,449 -- -- 725,449
Purchase of 2% interest in
Specialty Family Limited
Partnership................ -- -- (310,700) -- -- -- (310,700)
Loan to shareholder.......... -- -- -- -- (700,000) -- (700,000)
Comprehensive income (loss):
Foreign currency translation
adjustment................. -- -- -- -- -- 387,079 387,079
Net loss..................... -- -- (1,141,825) -- -- -- (1,141,825)
-----------
Total comprehensive loss....... (754,746)
---------- ---------- ----------- ----------- --------- --------- -----------
Balance, December 31, 1999..... 16,066,681 $4,055,050 $15,430,365 $ (354,079) $(850,000) $ -- $18,281,336
========== ========== =========== =========== ========= ========= ===========
</TABLE>

SEE ACCOMPANYING NOTES.

F-5
<PAGE>
SPECIALTY LABORATORIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------
1997 1998 1999
------------ ----------- -----------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Income from continuing operations..................... $ 2,997,567 $ 3,229,295 $ 859,147
Adjustments to reconcile income from continuing
operations to net cash provided by continuing
operating activities:
Depreciation........................................ 3,554,545 4,183,355 5,408,763
Deferred income taxes............................... (800,000) (1,898,000) (2,503,000)
Stock-based compensation charges.................... -- -- 2,818,039
Write-down of unused facility....................... -- -- 2,208,981
Loss on disposals of property and equipment......... -- 1,197 29,396
Changes in assets and liabilities:
Accounts receivable, net.......................... (3,711,764) (2,615,367) (4,635,016)
Inventory, prepaid expenses and other assets...... (943,923) (557,241) (1,983,156)
Accounts payable.................................. 1,730,928 224,417 437,757
Accrued liabilities............................... 2,243,554 4,203,083 (934,549)
Income taxes payable.............................. 392,990 155,797 92,517
Other long-term liabilities....................... 530,034 426,001 1,516,541
------------ ----------- -----------
Net cash provided by continuing operating
activities.......................................... 5,993,931 7,352,537 3,315,420

INVESTING ACTIVITIES
Purchases of property and equipment................... (15,128,120) (5,173,965) (3,711,842)
Proceeds from sales of property and equipment......... -- 15,700 15,800
------------ ----------- -----------
Net cash used in investing activities................. (15,128,120) (5,158,265) (3,696,042)

FINANCING ACTIVITIES
Net change in revolving bank line of credit........... 6,746,804 (821,240) 2,314,919
Borrowings under bank term loans...................... 5,000,000 4,813,508 --
Repayment of bank term loans.......................... (700,000) (1,050,000) (1,635,583)
Loan to shareholder................................... -- -- (700,000)
Purchase of interest in Specialty Family Limited
Partnership......................................... -- -- (310,700)
Sale of common stock to employees..................... -- -- 275,642
------------ ----------- -----------
Net cash provided by (used in) financing activities... 11,046,804 2,942,268 (55,722)

DISCONTINUED OPERATING ACTIVITIES
Net investment in (return from) foreign affiliates.... (1,443,551) (4,736,463) 284,500
------------ ----------- -----------
Net cash provided by (used in) discontinued operating
activities.......................................... (1,443,551) (4,736,463) 284,500
------------ ----------- -----------
Net increase (decrease) in cash....................... 469,064 400,077 (151,844)
Cash at beginning of year............................. -- 469,064 869,141
------------ ----------- -----------
Cash at end of year................................... $ 469,064 $ 869,141 $ 717,297
============ =========== ===========
Supplemental disclosures of cash flow information:
Cash paid for:
Interest.......................................... $ 883,000 $ 1,435,000 $ 1,448,000
============ =========== ===========
Income taxes...................................... $ 3,160,000 $ 2,524,000 $ 2,044,000
============ =========== ===========
</TABLE>

SEE ACCOMPANYING NOTES.

F-6
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 1999

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS

Specialty Laboratories, Inc. (the Company) provides esoteric reference
laboratory testing services to hospitals, independent laboratories, and
physicians throughout the United States. The Company's continuing operations are
in one reportable segment, the domestic clinical laboratory industry.

DISCONTINUED OPERATIONS

In August 1999, management of the Company began implementing a plan for the
discontinuance of all of the Company's foreign operations which were located in
Southeastern Asia, India and Egypt. This plan contemplated the sale or
abandonment of each foreign location in which the Company had operations or
interests. See Note 3 of Notes to Consolidated Financial Statements for
additional information on discontinued operations.

COMMON STOCK SPLITS

On February 5, 1999, the Company's Board of Directors authorized a 100-for-1
split in the form of a stock dividend of the shares of its common stock and
authorized the amendment of the Company's Articles of Incorporation to increase
the authorized number of shares of common stock to 10,000,000 in connection with
this stock split.

On October 30, 2000, the Company's Board of Directors further amended the
Company's Articles of Incorporation to effect a 2.2-for-1 stock split and to
increase the authorized number of shares of common stock to 100,000,000. All per
share and common share amounts presented in these consolidated financial
statements have been adjusted to reflect this stock split.

PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION

The consolidated financial statements include the accounts of Specialty
Laboratories, Inc. and its subsidiary, Specialty Laboratories
International, Ltd. (SLIL) (100% owned). All intercompany transactions have been
eliminated in consolidation.

In 1998, the Company obtained 100% ownership of SLIL by exchanging
382,800 shares of the Company's common stock for the remaining 50% stock of
SLIL. The former 50% owner of SLIL is an affiliate of the majority owners of the
Company. Prior to the transaction, SLIL's financial statements were consolidated
with the Company's because of the commonality of the majority ownership of the
Company and of the 50% of SLIL not owned by the Company.

FOREIGN CURRENCY TRANSLATION

Balance sheet accounts of the discontinued foreign operations are translated
at the current exchange rate as of the end of the year. Income statement
accounts are translated at average currency exchange rates. The Company's
portion of the resulting translation adjustment is recorded as a component of
accumulated other comprehensive income (loss) in shareholders' equity.

F-7
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INVENTORY

Inventory consists primarily of laboratory supplies and is stated at the
lower of the average cost or market.

ACCOUNTS RECEIVABLE AND NET REVENUE

Accounts receivable and net revenue are recorded net of contractual
allowances. The allowance for doubtful accounts represents an estimate of future
credit losses.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost. Depreciation and amortization are
computed using the straight-line method over the estimated useful lives of the
respective assets as follows:

<TABLE>
<S> <C>
Information technology equipment and 3 - 5 years
systems............................
Professional equipment............... 5 - 10 years
Office furniture and equipment....... 5 - 10 years
The lesser of life of asset or lease
Leasehold improvements............... term
</TABLE>

The Company capitalizes purchased software, which is ready for service, and
software development costs incurred on significant projects in accordance with
the provisions of AICPA Statement of Position 98-1, "Accounting for Software
Costs." Qualifying internal and external costs, consisting primarily of system
acquisition and third-party system development costs, incurred during the
application development stage are capitalized and are amortized as described
above.

REVENUE RECOGNITION

The Company recognizes revenue as services are rendered upon completion of
the testing process for a specific customer order for which the Company has no
future performance obligations to the customer, the customer is obligated to pay
and the fees are non-refundable. The Company's revenue recognition policies are
in compliance with the Securities and Exchange Commission Staff Accounting
Bulletin No. 101.

Services are provided to certain patients covered by various third party
payor programs including Medicare and Medicaid. Billings for services under
third party payor programs are included in net revenue net of allowances for
differences between the amounts billed and estimated receipts under such
programs. Adjustments to the estimated payment amounts based on final settlement
with the third party payor programs are recorded upon settlement. In 1997, 1998
and 1999, 4.2%, 4.8% and 5.5%, respectively, of net revenue was from Medicare or
Medicaid programs.

RESEARCH AND DEVELOPMENT EXPENDITURES

Research and development expenditures are expensed as incurred. The amounts
charged to research and development expense were $2,222,000, $2,392,000 and
$2,332,000 in 1997, 1998 and 1999, respectively.

F-8
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CONCENTRATIONS OF CREDIT RISK

The Company's concentration of credit risk with respect to accounts
receivable is limited due to the large number of payors comprising its patient
base which are spread across the United States. In addition, the Company
maintains allowances for potential credit losses and such losses have been
within management's expectations. The Company routinely assesses the financial
strength of its customers and generally does not require collateral.

One customer accounted for 16.5% of net revenue in 1997. No customer
accounted for over 10% of net revenue in 1998 or 1999. The Company's largest
customer accounted for 7.4% of net revenues for the year ended December 31, 1999
and comprised 2.5% of net accounts receivable at December 31, 1999.

ESTIMATES AND ASSUMPTIONS

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities, and the
reported amounts of revenues and expenses for the year then ended. The Company
routinely estimates amounts to be recovered from third party payors. Actual
results could differ from those estimates.

STOCK-BASED COMPENSATION

As permitted by Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" (SFAS No. 123), the Company accounts
for stock options granted to its employees and outside directors using the
intrinsic value method. The Company's stock option grants in 1999 were granted
with exercise prices below the fair value of the Company's common stock as
estimated by the Company's management for financial reporting purposes. For
stock option grants which were vested at date of grant, the difference between
the exercise prices and such estimated fair values was expensed to stock-based
compensation charges as of the date of grant. For stock options not vested at
date of grant, the Company has recorded deferred stock-based compensation for
the difference between exercise prices and estimated fair values which is being
amortized to expense on an accelerated basis using the graded vesting method
over the stock options' vesting periods in accordance with Financial Accounting
Standards Board (FASB) Interpretation No. 28.

For sales of the Company's common stock to employees at a price below such
estimated fair value, the difference between the sales price and such estimated
fair value was expensed to stock-based compensation charges as of the date of
the sales.

All outstanding stock options granted by the Company prior to 1999 were
canceled in 1999 and were concurrently replaced with newly granted stock
options. The exercise price for certain of the newly granted options was lower
than the exercise price of the canceled options. These "repriced" options will
be accounted for as "variable" options effective July 1, 2000 until exercised in
accordance with FASB Interpretation No. 44.

F-9
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INCOME TAXES

The Company utilizes the liability method of accounting for income taxes as
set forth in Statement of Financial Accounting Standards No. 109, "Accounting
for Income Taxes." Under this method, deferred income taxes are determined based
on the difference between the financial statement and tax basis of assets and
liabilities using current tax rates and regulations.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company's financial instruments consist mainly of cash, accounts
receivable, accounts payable and its bank credit facility.

The fair value of substantially all financial instruments of the Company
approximates their carrying values in the aggregate due to the short-term nature
of these instruments. The interest rates on borrowings under the Company's bank
credit facilities are adjusted periodically to market rates.

The Company has not used any derivatives or other foreign currency hedging
instruments and, accordingly, believes that Statement of Financial Accounting
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities," will have no effect on the Company's financial statements.

EARNINGS PER SHARE

Basic and diluted earnings per share information was calculated based on the
following weighted average shares:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------
1997 1998 1999
---------- ---------- ----------
<S> <C> <C> <C>
Basic--weighted average shares........... 15,456,760 15,458,856 16,044,529
Dilutive effect of outstanding stock
options................................ 21,023 46,299 959,796
---------- ---------- ----------
Diluted--weighted average shares......... 15,477,783 15,505,155 17,004,325
========== ========== ==========
</TABLE>

In accordance with Statement of Financial Accounting Standards No. 128,
"Earnings per Share," the diluted weighted average number of shares for 1999 was
used for computing income from continuing operations, loss from discontinued
operations and net loss per share even though the effect of including dilutive
stock options was anti-dilutive to the loss per share amounts.

F-10
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

2. PROPERTY AND EQUIPMENT

Property and equipment consists of the following:

<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------
1998 1999
------------ ------------
<S> <C> <C>
Information technology equipment and systems..... $ 17,196,309 $ 19,784,519
Professional equipment........................... 7,588,245 7,798,733
Office furniture and equipment................... 3,836,347 3,923,495
Leasehold improvements........................... 7,966,605 8,114,524
Memphis facility leasehold improvements.......... 1,334,761 --
Construction in progress......................... 133,934 217,113
------------ ------------
38,056,201 39,838,384
Less accumulated depreciation and amortization... (14,574,519) (19,566,797)
------------ ------------
$ 23,481,682 $ 20,271,587
============ ============
</TABLE>

3. DISCONTINUED FOREIGN OPERATIONS

In fiscal year 1995, the Company started operating internationally by
providing routine laboratory services and kit manufacturing as an avenue to
create revenue growth. In August 1999, the Company implemented a plan to
discontinue all of its foreign operations, due to continued losses incurred with
these foreign operations.

SLIL owns 60% of Specialty Laboratories Asia Private, Ltd. (SLA) which, in
turn, owns 50% of Specialty Ranbaxy, Ltd. (SRL) and 50% of Specialty Medical
Laboratories Sdn. Bhd. (SML). Prior to the discontinuance of its foreign
operations, the Company accounted for SLA's investments in SRL and SML on the
equity method. During the year ended December 31, 1998, the Company wrote down
the carrying value of its investments in, and advances to, SRL and SML to zero.
Subsequently in the year ended December 31, 1999, management began implementing
a plan to close down the operations of SLA and to dispose of its interests in
SRL and SML. As of December 31, 1999, SLA was insolvent. Since the Company has
no further obligations nor any plans to fund any additional losses of SLA, SRL
or SML, the Company has not recorded any additional losses beyond those
previously recorded. On July 14, 2000, provisional liquidators of SLA were
appointed by an Order of Court in Singapore (unaudited). See Note 12 of Notes to
Consolidated Financial Statements for a description of litigation involving SLA.

In August 1999, the Company began to shut down its Egyptian operations. The
net assets of the Egyptian operations were written down to zero, as no net
proceeds were anticipated to be received from their disposal. The Company had
ceased all operations in Egypt prior to December 31, 1999.

The foreign operations each served customers in their local markets by
providing routine medical laboratory and health screening services to physicians
and corporations, and differed from the Company's continuing operations, which
provides esoteric testing primarily to hospitals and routine laboratories. The
operations in Singapore and Malaysia also manufactured routine testing kits for
sale to third parties in Asia. Because these business activities differ
significantly and were managed separately from the Company's esoteric medical
laboratory services, the foreign operations collectively

F-11
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

3. DISCONTINUED FOREIGN OPERATIONS (CONTINUED)
would qualify as a separate business segment of the Company. These foreign
operations have been classified in the accompanying consolidated financial
statements as a discontinued operation and their assets and liabilities have
been aggregated as net assets of discontinued operations in the accompanying
balance sheets.

Condensed results of operations for the Company's discontinued foreign
operations are as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------------
1997 1998 1999
----------- ----------- -----------
<S> <C> <C> <C>
Net revenue............................ $ 1,404,463 $ 1,051,426 $ 643,282
Operating costs and expenses........... 1,946,373 3,718,479 2,158,099
----------- ----------- -----------
(541,910) (2,667,053) (1,514,817)
Equity in losses of investees.......... (2,495,250) (1,666,621) --
Write-off of uncollectible advances to
investees............................ -- (616,483) --
Disposal of property and equipment..... -- -- (1,984,429)
Minority interests..................... 2,101,461 1,056,756 174,274
----------- ----------- -----------
Loss before income tax benefits........ (935,699) (3,893,401) (3,324,972)
Income tax benefits.................... -- 833,000 1,324,000
----------- ----------- -----------
Loss from discontinued operations...... $ (935,699) $(3,060,401) $(2,000,972)
=========== =========== ===========
</TABLE>

4. WRITE-DOWN OF UNUSED FACILITY

In 1997, the Company leased a building in Memphis, Tennessee for a potential
geographical expansion of its operations. Subsequently in June 1999, the
Company's management decided not to move into the Memphis facility and to make
it available for sublease to a third party. As a result, the costs of leasehold
improvements related to the facility of $1,334,761 and the Company's estimate of
its additional net lease costs for the facility, which amounted to $874,220,
were recognized as a loss in 1999. The accrual of estimated future lease costs
was computed by calculating the present value of the remaining lease payments,
offset by the present value of estimated future sublease income assuming a
sub-lease start date of November 2002, using a discount rate of 7%. During the
remainder of 1999, $133,396 was charged against the liability, which had a
balance of $740,824 at December 31, 1999. The Company's accrual of estimated
lease costs is subject to change based on future events. Any future adjustments
to the accrual will be classified as a write-down of unused facility costs in
the Company's consolidated statement of operations. The facility had not been
subleased as of December 31, 1999.

F-12
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

5. ACCRUED AND OTHER LONG-TERM LIABILITIES

Accrued liabilities consist of the following:

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------
1998 1999
----------- -----------
<S> <C> <C>
Employee compensation related...................... $ 5,229,942 $ 5,901,538
Royalties.......................................... 4,136,260 3,164,336
----------- -----------
$ 9,366,202 $ 9,065,874
=========== ===========
</TABLE>

The Company has various royalty agreements for technology licensed from
third parties which require that royalty fees be paid based upon a percentage of
net revenue derived from assays using the licensed technology. Royalty payments
are generally made on a semi-annual basis.

Other long-term liabilities consist of the following:

<TABLE>
<CAPTION>
DECEMBER 31,
---------------------
1998 1999
-------- ----------
<S> <C> <C>
Deferred compensation................................. $956,035 $1,768,001
Annuity payments due to former employee............... -- 545,502
Non-current portion of accrued rent for unused
facility............................................ -- 399,074
-------- ----------
$956,035 $2,712,576
======== ==========
</TABLE>

6. LONG-TERM DEBT

Long-term debt consists of the following:

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------
1998 1999
----------- -----------
<S> <C> <C>
Revolving line of credit........................... $ 9,639,355 $11,954,275
Term loan payable to bank, payable in monthly
installments of $83,333 plus interest (8.06% rate
at December 31, 1999) through March 2002......... 3,250,000 2,416,667
Term loan payable to bank, payable in monthly
installments of $80,225 plus interest (8.32%
weighted average rate at December 31, 1999)
through February 2004............................ 4,813,508 4,011,257
----------- -----------
17,702,863 18,382,199
Less current portion............................... (5,088,446) (9,148,222)
----------- -----------
$12,614,417 $ 9,233,977
=========== ===========
</TABLE>

F-13
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

6. LONG-TERM DEBT (CONTINUED)
loan agreement, and all outstanding borrowings under the revolving line of
credit, which may be prepaid at any time without penalty, are payable on
September 3, 2002.

An initial term loan is payable over a five-year period with monthly
payments of principal of $83,333 plus interest, with a maturity date of
March 31, 2002. A subsequent term loan is payable over a five-year period with
monthly payments of principal of $80,225 plus interest, with a maturity date of
February 1, 2004. A third term loan was made in February 2000 in the amount of
$6,186,491, which was used to reduce outstanding borrowings under the revolving
line of credit, and is payable with monthly payments of principal of $128,885
plus interest, with a maturity date of January 1, 2004.

All borrowings under the bank loan agreement, including the revolving line
of credit and term loans, bear interest at LIBOR plus a defined rate. At each
interest rate reset date, the Company selects the period, ranging from one month
to one year, for which the new rate will be effective.

Borrowings under the revolving line of credit and term loan facilities are
cross collateralized by substantially all of the Company's assets. The bank loan
agreement contains certain restrictive covenants, including maintenance of
certain levels of financial ratios.

Portions of the revolving line of credit carried the following interest
rates:

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------------------------
1998 1999
--------------------- ----------------------
RATE AMOUNT RATE AMOUNT
-------- ---------- -------- -----------
<S> <C> <C> <C> <C>
The reference rate...................... 7.23% $4,639,355 8.50% $ 1,554,275
LIBOR plus 2.2%......................... 7.74% 5,000,000 8.30% 5,000,000
LIBOR plus 2.2%......................... -- -- 7.81% 5,400,000
---------- -----------
$9,639,355 $11,954,275
========== ===========
</TABLE>

Future principal payments of long-term debt as of December 31, 1999 are as
follows:

<TABLE>
<CAPTION>
YEAR AMOUNT
---- -----------
<S> <C>
2000........................................................ $ 9,148,222
2001........................................................ 3,509,325
2002........................................................ 2,925,993
2003........................................................ 2,509,325
Thereafter.................................................. 289,334
-----------
$18,382,199
===========
</TABLE>

Amounts payable in year 2000 are comprised of the principal payments due in
year 2000 on the three term loans plus the portion of the revolving line of
credit not refinanced by the third term loan in February 2000.

Interest expense for 1997, 1998 and 1999 was $883,824, $1,158,636 and
$1,691,935, respectively.

F-14
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

7. 401(k) PROFIT SHARING PLAN

The Company maintains a defined contribution 401(k) profit sharing plan (the
401(k) Plan) covering all employees after minimum eligibility requirements have
been met.

In accordance with the 401(k) Plan, eligible employees may contribute up to
15% of their salaries to the 401(k) Plan. The Company will match the employee's
contribution at 50 cents per dollar up to 6% of the employee's salary. Matching
contributions by the Company to the 401(k) Plan amounted to $468,000, $549,000
and $515,000 in 1997, 1998 and 1999, respectively. Profit sharing contributions
to the 401(k) Plan are discretionary and no discretionary contributions were
made during 1997, 1998 or 1999.

8. DEFERRED COMPENSATION PROGRAM

The Company has a non-qualified deferred compensation program (the Program)
for certain executives. Under the Program, employee-designated deferrals of
salary are withheld by the Company. An amount equal to the withholding is
"invested" at the direction of the employee, in a portfolio of phantom
investments selected from the available investments under the Program, which are
tracked by an administrator. With a portion of the withholding, the Company
purchases life insurance policies on each of the participating executives with
the Company named as beneficiary of the policies.

Deferred compensation, including gains and losses on phantom investments,
amounted to $956,000 and $1,813,000 at December 31, 1998 and 1999, respectively,
and is classified in other long-term liabilities. The cash surrender value of
the life insurance policies, which amounted to $792,000 and $1,428,000 at
December 31, 1998 and 1999, respectively, is recorded in other non-current
assets.

9. SHAREHOLDERS' EQUITY

OWNERSHIP OF COMMON STOCK

Approximately 91.7% of the Company's common shares are owned by the
Specialty Family Limited Partnership (Partnership) and 4.1% are owned by the
Peter Family Revocable Trust (Trust). The Company's Chairman and Chief Executive
Officer is the sole managing general partner of the Partnership and a trustee of
the Trust. The Partnership's major asset is its ownership of the Company's
common stock. In 1999, the Company purchased a 2% interest in the Partnership,
in addition to a 5.9% interest acquired in prior years. The cost of the
purchases, amounting to $310,700 in 1999 and $873,000 in prior years, has been
accounted for as a reduction in retained earnings due to the Partnership's
underlying ownership of the Company's common stock.

STOCK OPTION PLANS

During 1999, the Company's Board of Directors approved the 1999 Stock
Option/Stock Issuance Plan (the 1999 Plan) as a comprehensive equity incentive
program and granted 1,839,068 options to acquire shares of the Company's common
stock to certain employees and the outside directors of the Company. Outstanding
stock options previously granted were effectively cancelled and replaced with
new options under the 1999 Plan. The options granted have an exercise price of
$1.21 or $1.23 per share and 1,108,171 of such options were vested as of their
date of grant. The balance of the options granted vest 25% upon the first
anniversary of an employee's employment (33% for the outside directors upon the
first anniversary of service as a director) and thereafter ratably in equal
monthly

F-15
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

9. SHAREHOLDERS' EQUITY (CONTINUED)
installments for the next 36 months (the next 24 months for outside directors).
The options have a term of ten years from the date of grant.

As of December 31, 1999, the Company has reserved 3,140,280 shares of common
stock for future issuances of stock options.

Changes in options outstanding for the periods indicated were as follows:

<TABLE>
<CAPTION>
WEIGHTED
NUMBER OF AVERAGE RANGE OF
OPTIONS EXERCISE PRICE EXERCISE PRICES
--------- -------------- ---------------
<S> <C> <C> <C>
Outstanding at January 1, 1997,
December 31, 1997 and 1998........... 147,400 $1.56 $1.23 - $1.76
Options cancelled and replaced......... (147,400) $1.56 $1.23 - $1.76
Options granted........................ 1,839,068 $1.21 $1.21 - $1.23
--------- ----- -------------
Outstanding at December 31, 1999....... 1,839,068 $1.21 $1.21 - $1.23
========= ===== =============
Options exercisable at December 31,
1997................................. 53,020 $1.57 $1.23 - $1.76
Options exercisable at December 31,
1998................................. 94,380 $1.62 $1.23 - $1.76
Options exercisable at December 31,
1999................................. 1,437,834 $1.21 $1.21 - $1.23
</TABLE>

There were no options granted in 1997 or 1998 and none were exercised,
forfeited or expired during 1997, 1998 or 1999. The weighted-average remaining
contractual life of outstanding options was 7.35 and 9.26 years at December 31,
1998 and 1999, respectively.

Pro forma net income and earnings per share, as required to be disclosed by
SFAS No. 123, determined as if the Company had accounted for its stock options
under the fair-value method of that Statement, is as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------
1997 1998 1999
---------- ---------- --------
<S> <C> <C> <C>
Income from continuing operations:
As reported.............................. $2,997,567 $3,229,295 $859,147
Pro forma................................ 2,985,567 3,217,295 337,882

Basic income from continuing operations per
share:
As reported.............................. $ .19 $ .21 $ .05
Pro forma................................ .19 .21 .02
Diluted income from continuing operations
per share:
As reported.............................. $ .19 $ .21 $ .05
Pro forma................................ .19 .21 .02
</TABLE>

These pro forma amounts may not be representative of future disclosures
since the estimated fair value of stock options would be amortized to expense
over the vesting period, and additional options may be granted in future years.

F-16
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

9. SHAREHOLDERS' EQUITY (CONTINUED)
The fair value for the options granted in 1999 ($2.03 per option) was
estimated at the date of grant using a Black-Scholes option pricing model with
the following weighted-average assumptions:

<S> <C>
Risk-free interest rates.................................... 6%
Dividend yields............................................. 0%
Weighted-average expected life of option.................... 5 years
Expected volatility based upon peer companies............... .55
</TABLE>

STOCK-BASED COMPENSATION

In connection with the sales of common stock to certain employees and the
granting of stock options to certain employees and the Company's outside
directors on February 5, 1999, the amount of related compensation to be
recognized was determined by the Company to be the difference between the stock
purchase or option exercise price and the fair value of the Company's common
stock at that date as estimated by the Company's management for financial
reporting purposes. For the common stock sales and the stock options which were
vested as of their date of grant, the related compensation was expensed in full
as of February 5, 1999. For the stock options which were not vested as of their
date of grant, the related compensation was recorded as deferred stock
compensation which is classified as a reduction of shareholders' equity and is
being amortized to expense over the vesting periods of the related stock
options.

Stock-based compensation charges for the year ended December 31, 1999 are
comprised of the following components:

<S> <C>
Charged to expense on transaction date:
Stock options vested at date of grant..................... $1,750,776
Common stock sold to certain employees.................... 341,814
Amortization of deferred stock compensation................. 725,449
----------
$2,818,039
==========
</TABLE>

INFORMATION RELATED TO PERIODS AFTER DECEMBER 31, 1999 (UNAUDITED)

The Company estimates that amortization of deferred stock-based
compensation, based upon stock options granted and forfeited during the nine
months ended September 30, 2000 in addition to stock options outstanding at
December 31, 1999, will be approximately as follows:

<TABLE>
<CAPTION>
YEAR ENDING
-----------
<S> <C>
2000...................................................... $1,010,000
2001...................................................... 1,100,000
2002...................................................... 440,000
2003...................................................... 180,000
2004...................................................... 20,000
</TABLE>

F-17
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

9. SHAREHOLDERS' EQUITY (CONTINUED)

The future amount of amortization of deferred stock-based compensation could
be affected by future forfeitures of stock options. All outstanding stock
options granted by the Company prior to 1999 were cancelled in 1999 and were
concurrently replaced with newly granted stock options. The exercise price for
certain of the newly granted options was lower than the exercise price of the
cancelled options. These "repriced" options were accounted for as "variable"
options effective July 1, 2000 until exercised in September 2000 in accordance
with FASB Interpretation No. 44. The "variable" stock-based compensation charge
for these options was $134,353 from July 1, 2000 through their dates of exercise
in September 2000.

10. INCOME TAXES

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial statement
purposes and the amounts used for income tax purposes.

Significant components of the Company's deferred tax assets and liabilities
are as follows:

<TABLE>
<CAPTION>
DECEMBER 31
-----------------------
1998 1999
---------- ----------
<S> <C> <C>
Deferred tax assets:
Allowances for doubtful accounts and contractual
allowances....................................... $ 916,713 $1,568,895
State income taxes................................. 205,020 281,180
Depreciation expense............................... 401,267 700,862
Foreign losses..................................... 835,498 391,368
Stock-based compensation charges................... -- 986,788
Vacation accrual................................... 312,220 332,437
Other compensation accruals........................ 1,242,237 1,327,470
Write-down of unused facility...................... -- 826,955
---------- ----------
Net deferred tax assets.............................. $3,912,955 $6,415,955
========== ==========
</TABLE>

There is no valuation allowance for deferred tax assets as of December 31, 1998
and 1999. The Company believes that it is probable that the results of future
operations will generate sufficient taxable income to realize the remaining
deferred tax assets.

F-18
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

10. INCOME TAXES (CONTINUED)
The components of the provision (benefit) for income taxes are as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
-------------------------------------
1997 1998 1999
---------- ---------- -----------
<S> <C> <C> <C>
Continuing operations:
Current:
Federal.............................................. $2,631,000 $2,663,000 $ 2,569,000
State................................................ 675,000 672,000 864,000
---------- ---------- -----------
3,306,000 3,335,000 3,433,000
Deferred:
Federal.............................................. (686,000) (799,000) (1,848,000)
State................................................ (114,000) (263,000) (655,000)
---------- ---------- -----------
(800,000) (1,062,000) (2,503,000)
---------- ---------- -----------
Total continuing......................................... 2,506,000 2,273,000 930,000
Discontinued operations:
Current:
Federal.............................................. -- 124,000 (1,030,000)
State................................................ -- (121,000) (294,000)
---------- ---------- -----------
-- 3,000 (1,324,000)
Deferred:
Federal.............................................. -- (771,000) --
State................................................ -- (65,000) --
---------- ---------- -----------
-- (836,000) --
---------- ---------- -----------
Total discontinued operations............................ -- (833,000) (1,324,000)
---------- ---------- -----------
$2,506,000 $1,440,000 $ (394,000)
========== ========== ===========
</TABLE>

A reconciliation of the federal statutory rate to the Company's effective
tax rate for continuing operations is as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
------------------------------------
1997 1998 1999
-------- -------- --------
<S> <C> <C> <C>
Tax provision at statutory rate......................... 34.0% 34.0% 34.0%
State and local taxes, net of federal benefit........... 6.7 6.1 7.2
Non-deductible expenses................................. 4.8 1.0 10.4
Other................................................... -- .2 .4
---- ---- ----
Effective tax rate...................................... 45.5% 41.3% 52.0%
==== ==== ====
</TABLE>

F-19
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

11. RELATED PARTY TRANSACTIONS

During 1996, the Company loaned the Trust $150,000 without interest. During
1999, the Company loaned the Trust an additional $700,000 which bore interest at
a rate of 9% which was paid monthly. Both loans were repaid in March 2000.
During the year ended December 31, 1999, interest income of $52,762 was accrued
and paid on this loan.

See Note 12 for a description of leases with a related party.

12. COMMITMENTS AND CONTINGENCIES

The Company leases certain facilities and equipment under capital and
operating leases. Certain leases contain renewal and purchase options. Rental
expense was approximately $2,936,000, $1,997,000 and $2,280,000 for 1997, 1998
and 1999, respectively.

The Company leases on a month-to-month basis a facility and parking lot from
Santa Monica Properties Partnership (SMPP) which is owned by various
shareholders of the Company. The Company also leased three single family
dwellings from SMPP during portions of 1997 and 1998 for the purpose of
providing relocation assistance for new employees. Total payments to SMPP were
$263,000, $219,000 and $205,000 for 1997, 1998 and 1999, respectively, and are
included in the amounts of rent expense shown above.

Future minimum lease payments under noncancelable operating leases with
initial terms of one year or more are as follows:

<TABLE>
<CAPTION>
MEMPHIS
PROPERTY ALL OTHERS TOTAL
---------- ---------- -----------
<S> <C> <C> <C>
Year ending:
2000.................................. $ 262,440 $2,374,278 $ 2,636,718
2001.................................. 262,440 2,016,690 2,279,130
2002.................................. 262,440 2,031,987 2,294,427
2003.................................. 262,440 1,444,568 1,707,008
2004 and thereafter................... 984,150 154,454 1,138,604
---------- ---------- -----------
Total minimum lease payments.......... $2,033,910 $8,021,977 $10,055,887
========== ========== ===========
</TABLE>

CONTINGENCIES

A former employee of SLA has obtained a judgment for $350,000 against SLA
and a default judgment of approximately $1.95 million in a wrongful termination
action against SLA filed in Singapore. The former employee has filed an action
against SLA in California to attempt to collect on the Singapore judgment and
has obtained a default judgment of $2.5 million against SLA in California. The
former employee has also served discovery upon the Company and certain of its
directors and officers, has sought to compel these officers and directors to
provide this discovery and has requested sanctions in connection with their
request. No overt allegations of any material liability have been made against
the Company. The Company's management believes that any claim against the
Company or its directors and officers in connection with these judgments, if
made, would be without merit and the Company would vigorously defend any such
action.

F-20
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

DECEMBER 31, 1999

12. COMMITMENTS AND CONTINGENCIES (CONTINUED)
The Company is from time to time subject to claims arising in the ordinary
course of business. These claims have included assertions that the Company's
assays infringe existing patents; however, none of the claimants have filed
litigation against the Company. The Company intends to defend vigorously any
such litigation that may arise and to assert all available defenses to
allegations of patent infringement that would be available to the Company. In
the opinion of management, the ultimate resolution of such proceedings will not
have a material adverse effect on the consolidated financial position,
operations or cash flows of the Company.

13. EVENTS SUBSEQUENT TO DECEMBER 31, 1999 (UNAUDITED)

In June 1999, the Health Care Financing Administration asserted that the
Company was out of compliance with Clinical Laboratory Improvement Amendments
regulations pertaining to specific quality assurance functions, imposed certain
fines in connection therewith, and indicated that the next level of sanction, if
the Company did not come into compliance, could be revocation of their Clinical
Laboratory Improvement Amendments certificate. After the Health Care Financing
Administration's resurvey in June 2000, management indicated the Company was
able to satisfy the Health Care Financing Administration that the Company was in
compliance with the applicable requirements. While the Company has appealed the
fine imposed by the Health Care Financing Administration, which totaled $116,000
and was accrued by the Company in June 2000, there can be no assurance that the
Company will be successful in such appeal. Management believes the Company is
presently in compliance with all certification and licensure requirements.

On August 15, 2000, the Partnership redeemed the Company's interest in the
Partnership in exchange for 1,136,749 shares of the Company's common stock,
which were then cancelled by the Company.

On September 5, 2000, the Company's Board of Directors adopted and the
shareholders approved the 2000 Stock Incentive Plan (2000 Plan). The 2000 Plan
will become effective on the date the underwriting agreement for the Offering is
signed. 4,020,280 shares of the Company's common stock have been authorized for
issuance under the 2000 Plan, including shares currently reserved under the
1999 Plan.

The Company filed a Registration Statement with the Securities and Exchange
Commission on September 12, 2000 for an initial public offering for the sale of
5,750,000 shares of its common stock (including 750,000 shares issuable upon
exercise of the Underwriters' overallotment option).

In September and October 2000, the Company entered into employment
agreements with six employees. The agreements with two of the employees, which
provide in the aggregate for annual base salaries of $886,000, provide that if
the employee is terminated other than for cause or if he resigns for good reason
during the first five years of his contract, the Company will pay his base
salary for a two year period and his bonus for a one year period subsequent to
such severance. The agreements with the four other employees, which provide in
the aggregate for annual base salaries of approximately $800,000, provide that
if the employee is terminated for other than cause during the first three years
of his contract, the Company will pay his salary for a one year period
subsequent to such severance. If any of the six employees is terminated for
cause, no further payments are due to them under the contracts.

On October 30, 2000, the Company's Board of Directors amended the Company's
Articles of Incorporation to authorize 10,000,000 shares of no par value
preferred stock. No shares of preferred stock have been issued.

F-21
<PAGE>
SUPPLEMENTAL INFORMATION

SPECIALTY LABORATORIES, INC.

CONSOLIDATED BALANCE SHEET (UNAUDITED)

SEPTEMBER 30, 2000

<TABLE>
<S> <C>
ASSETS
Current assets:
Cash...................................................... $ 189,191
Accounts receivable, less allowances for doubtful accounts
of $3,492,210........................................... 32,668,161
Deferred income taxes..................................... 2,792,854
Inventory................................................. 1,251,435
Prepaid expenses and other assets......................... 991,770
-----------
Total current assets........................................ 37,893,411

Property and equipment, net................................. 20,135,349
Deferred income taxes....................................... 3,848,101
Other assets................................................ 2,738,019
-----------
$64,614,880
===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $10,240,656
Accrued liabilities....................................... 8,192,776
Income taxes payable...................................... 3,902,539
Current portion of long-term debt......................... 5,522,725
-----------
Total current liabilities................................... 27,858,696

Long-term debt, net of current portion...................... 6,601,982

Other long-term liabilities................................. 3,392,885

Commitments and contingencies

Shareholders' equity:
Common stock, no par value:
Authorized shares--100,000,000
Issued and outstanding shares--15,187,507............... 6,905,333
Retained earnings......................................... 22,040,397
Deferred stock-based compensation......................... (2,184,413)
-----------
Total shareholders' equity.................................. 26,761,317
-----------
$64,614,880
===========
</TABLE>

SEE ACCOMPANYING NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS.

F-22
<PAGE>
SPECIALTY LABORATORIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------------
1999 2000
----------- ------------
<S> <C> <C>
Net revenue................................................. $96,675,660 $113,713,886

Costs and expenses:
Cost of services.......................................... 56,161,322 64,110,497
Selling, general and administrative (exclusive of
stock-based compensation charges)....................... 34,768,828 36,257,832
Stock-based compensation charges.......................... 2,692,677 706,454
Write-down of unused facilities........................... 2,208,981 369,494
----------- ------------
Total costs and expenses.................................... 95,831,808 101,444,277
----------- ------------
Operating income............................................ 843,852 12,269,609

Interest income............................................. (37,001) (14,625)
Interest expense............................................ 1,175,683 1,030,202
----------- ------------
Income (loss) from continuing operations before income
taxes..................................................... (294,830) 11,254,032

Provision for income taxes.................................. 77,000 4,644,000
----------- ------------

Income (loss) from continuing operations.................... (371,830) 6,610,032
Loss from discontinued operations, net of income tax
benefits of $1,324,000 in 1999............................ (2,000,972) --
----------- ------------
Net income (loss)........................................... $(2,372,802) $ 6,610,032
=========== ============

Income (loss) per common share--basic:
Continuing operations..................................... $ (.02) $ .42
Discontinued operations................................... (.13) --
----------- ------------
Net income (loss)........................................... $ (.15) $ .42
=========== ============

Income (loss) per common share--diluted:
Continuing operations..................................... $ (.02) $ .38
Discontinued operations................................... (.13) --
----------- ------------
Net income (loss)........................................... $ (.15) $ .38
=========== ============
</TABLE>

SEE ACCOMPANYING NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS.

F-23
<PAGE>
SPECIALTY LABORATORIES, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 2000

<TABLE>
<CAPTION>
COMMON STOCK DEFERRED STOCK-
----------------------- RETAINED BASED LOAN TO
SHARES AMOUNT EARNINGS COMPENSATION SHAREHOLDER TOTAL
---------- ---------- ----------- --------------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Balance, January 1, 2000... 16,066,681 $4,055,050 $15,430,365 $ (354,079) $(850,000) $18,281,336
Deferred compensation
related to stock option
grants, net of
forfeitures.............. -- 2,402,435 -- (2,402,435) -- --
Amortization of deferred
compensation............. -- -- -- 572,101 -- 572,101
Proceeds from exercise of
stock options............ 257,575 313,495 -- -- -- 313,495
Variable stock-based
compensation charges for
certain stock options.... -- 134,353 -- -- -- 134,353
Repayment of loan to
shareholder.............. -- -- -- -- 850,000 850,000
Shares received and
cancelled upon redemption
of interest in Specialty
Family Limited
Partnership.............. (1,136,749) -- -- -- -- --
Net income................. -- -- 6,610,032 -- -- 6,610,032
---------- ---------- ----------- ----------- --------- -----------
Balance, September 30,
2000..................... 15,187,507 $6,905,333 $22,040,397 $(2,184,413) $ -- $26,761,317
========== ========== =========== =========== ========= ===========
</TABLE>

SEE ACCOMPANYING NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS.

F-24
<PAGE>
SPECIALTY LABORATORIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 2000

<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
1999 2000
----------- -----------
<S> <C> <C>
OPERATING ACTIVITIES
Income (loss) from continuing operations.................... $ (371,830) $ 6,610,032
Adjustments to reconcile income (loss) from continuing
operations to net cash provided by continuing operating
activities:
Depreciation.............................................. 3,918,161 4,387,886
Deferred income taxes..................................... (2,305,000) (225,000)
Loss on disposals of property and equipment............... 24,078 23,041
Write-down of unused facilities........................... 2,208,981 369,494
Stock-based compensation charges.......................... 2,692,677 706,454
Changes in assets and liabilities:
Accounts receivable, net................................ (3,810,601) (5,893,406)
Inventory, prepaid expenses and other assets............ 460,772 698,365
Accounts payable........................................ 1,159,773 122,083
Accrued liabilities..................................... (399,598) (873,097)
Income taxes payable.................................... (972,101) 2,603,911
Other long-term liabilities............................. 268,129 680,309
----------- -----------
Net cash provided by continuing operating activities........ 2,873,441 9,210,072

INVESTING ACTIVITIES
Purchases of property and equipment......................... (2,825,204) (4,644,183)
----------- -----------
Net cash used in investing activities....................... (2,825,204) (4,644,183)

FINANCING ACTIVITIES
Net change in revolving bank line of credit................. 2,463,563 (9,940,874)
Borrowings under bank term loans............................ -- 6,186,491
Repayment of bank term loans................................ (1,194,909) (2,503,108)
Repayment (borrowings) of loan to shareholder............... (700,000) 850,000
Purchase of interest in Specialty Family Limited
Partnership............................................... (310,700) --
Sale of common stock to employees........................... 275,642 --
Proceeds from exercise of stock options..................... -- 313,495
----------- -----------
Net cash provided by (used in) financing activities......... 533,596 (5,093,996)

DISCONTINUED OPERATING ACTIVITIES
Net investment in foreign affiliates........................ (51,319) --
----------- -----------
Net cash used in discontinued operating activities.......... (51,319) --
----------- -----------
Net increase (decrease) in cash............................. 530,514 (528,107)
Cash at beginning of period................................. 869,141 717,298
----------- -----------
Cash at end of period....................................... $ 1,399,655 $ 189,191
=========== ===========

Supplemental disclosures of cash flow information:
Cash paid for:
Interest................................................ $ 1,070,000 $ 1,039,000
=========== ===========
Income taxes............................................ $ 2,044,000 $ 2,442,000
=========== ===========
</TABLE>

SEE ACCOMPANYING NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS.

F-25
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

SEPTEMBER 30, 2000

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS

Specialty Laboratories, Inc. (the Company) provides esoteric reference
laboratory testing services to hospitals, independent laboratories and
physicians throughout the United States. The Company's continuing operations are
in one reportable segment, the domestic clinical laboratory industry.

INTERIM FINANCIAL INFORMATION

The financial information as of September 30, 2000 and for the nine months
ended September 30, 1999 and 2000 is unaudited and includes all adjustments,
consisting only of normal recurring adjustments, that the Company's management
considers necessary for a fair presentation of the Company's operating results
and cash flows for such periods. Results for the nine month period ended
September 30, 2000 are not necessarily indicative of results to be expected for
the full year ending December 31, 2000 or any future period.

DISCONTINUED OPERATIONS

In August 1999, management of the Company began implementing a plan for the
discontinuance of all of the Company's foreign operations which were located in
Southeastern Asia, India and Egypt. This plan contemplated the sale or
abandonment of each foreign location in which the Company had operations or
interests. See Note 3 of Notes to Interim Consolidated Financial Statements for
additional information on discontinued operations.

STOCK SPLIT

On October 30, 2000, the Company's Board of Directors amended the Company's
Articles of Incorporation to effect a 2.2-for-1 stock split and to increase the
authorized number of common shares to 100,000,000. All per share and common
share amounts presented in the condensed consolidated financial statements have
been adjusted to reflect this stock split.

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company's
wholly-owned subsidiary. All intercompany transactions have been eliminated in
consolidation.

MAJOR CUSTOMERS

No customer accounted for over 10% of net revenue for the nine months ended
September 30, 1999 or September 30, 2000. The Company's largest customer
accounted for 9.6% of net revenues for the nine months ended September 30, 2000
and comprised 2.2% of net accounts receivable at September 30, 2000.

RESEARCH AND DEVELOPMENT EXPENDITURES

Research and development expenditures are expensed as incurred. The amounts
charged to research and development expense were $1,811,000 and $1,474,000 for
the nine months ended September 30, 1999 and 2000, respectively.

F-26
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
COMPREHENSIVE INCOME

For the nine months ended September 30, 1999, comprehensive net loss was
comprised of the following:

<S> <C>
Net loss.................................................... $(2,372,802)
Foreign currency translation adjustment..................... 387,079
-----------
Comprehensive net loss...................................... $(1,985,723)
===========
</TABLE>

There were no items of other comprehensive income (loss) for the nine months
ended September 30, 2000.

ESTIMATES AND ASSUMPTIONS

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities, and the
reported amounts of revenues and expenses for the year then ended. The Company
routinely estimates amounts to be recovered from third-party payors. Actual
results could differ from those estimates.

STOCK-BASED COMPENSATION

As permitted by Statement of Financial Accounting Standard No. 123,
"Accounting for Stock-Based Compensation" (SFAS No. 123), the Company accounts
for stock options granted to its employees and outside directors using the
intrinsic value method. The Company's stock options have generally been granted
with exercise prices below the fair value of the Company's common stock as
estimated by the Company's management for financial reporting purposes. For
stock option grants which were vested at date of grant, the difference between
the exercise prices and such estimated fair values was expensed to stock-based
compensation charges as of the date of grant. For stock options not vested at
date of grant, the Company has recorded deferred stock-based compensation for
the difference between their exercise prices and such estimated fair values
which is being amortized to expense on an accelerated basis using the graded
vesting method over the stock options' vesting periods in accordance with
Financial Accounting Standards Board (FASB) Interpretation No. 28.

All outstanding stock options granted by the Company prior to 1999 were
canceled in 1999 and were concurrently replaced with newly granted stock
options. The exercise price for certain of the newly granted options was lower
than the exercise price of the canceled options. These "repriced" options were
accounted for as "variable" options effective July 1, 2000 until their exercise
during September 2000 in accordance with FASB Interpretation No. 44.

F-27
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income by the weighted
average number of common shares outstanding. Dilutive earnings per share is
computed by dividing net income by the weighted average number of common shares
outstanding plus potentially dilutive shares for the portion of the year they
were outstanding. Potentially dilutive common shares result solely from
outstanding stock options. Because of the losses for the nine months ended
September 30, 1999, the effects of outstanding stock options were excluded from
the dilutive per share calculations as their inclusion would be anti-dilutive.

Basic and diluted earnings per share information was calculated based on the
following weighted average shares:

<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
1999 2000
---------- ----------
<S> <C> <C>
Basic--weighted average shares....................... 16,037,238 15,904,042
Dilutive effect of outstanding stock options......... -- 1,522,430
---------- ----------
Diluted--weighted average shares..................... 16,037,238 17,426,472
========== ==========
</TABLE>

2. PROPERTY AND EQUIPMENT

Property and equipment consists of the following at September 30, 2000:

<TABLE>
<S> <C>
Information technology equipment and systems................ $ 22,166,357
Professional equipment...................................... 8,696,938
Office furniture and equipment.............................. 3,995,629
Leasehold improvements...................................... 7,737,650
Construction in progress.................................... 1,325,700
------------
43,922,273
Less accumulated depreciation and amortization.............. (23,786,925)
------------
$ 20,135,349
============
</TABLE>

3. DISCONTINUED FOREIGN OPERATIONS

A wholly-owned subsidiary of the Company owns 60% of Specialty Laboratories
Asia Private, Ltd. (SLA) which, in turn, owns 50% of Specialty Ranbaxy, Ltd.
(SRL) and 50% of Specialty Medical Laboratories Sdn. Bhd. (SML). In the year
ended December 31, 1999, management began implementing a plan to close down the
operations of SLA and to dispose of its interests in SRL and

F-28
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

3. DISCONTINUED FOREIGN OPERATIONS (CONTINUED)
SML. As of December 31, 1999, SLA was insolvent. Since the Company has no
further obligations nor any plans to fund any additional losses of SLA, SRL or
SML, the Company has not recorded any additional losses beyond those previously
recorded. On July 14, 2000, provisional liquidators of SLA were appointed by an
Order of Court in Singapore. See Note 9 of Notes to Interim Consolidated
Financial Statements for a description of litigation involving SLA.

In August 1999, the Company began to shut down its Egyptian operations. The
net assets of the Egyptian operations were written down to zero, as no net
proceeds were anticipated to be received from their disposal. The Company ceased
all operations in Egypt prior to December 31, 1999.

The foreign operations each served customers in their local markets by
providing routine medical laboratory and health screening services to physicians
and corporations, respectively and differs from the Company's continuing
operations, which provides esoteric testing primarily to hospitals and routine
laboratories. The operations in Singapore and Malaysia also manufactured routine
testing kits for sale to third-parties in Asia. Because these business
activities differ significantly and were managed separately from the Company's
esoteric medical laboratory services, the foreign operations collectively would
qualify as a separate business segment of the Company.

There was no income or loss from discontinued operations during the nine
months ended September 30, 2000.

4. WRITE-DOWN OF UNUSED FACILITIES

In 1997, the Company leased a building in Memphis, Tennessee for a potential
geographical expansion of its operations. Subsequently in 1999, the Company's
management decided not to move into the Memphis facility and to make it
available for sublease to a third party. As a result, the cost of the leasehold
improvements related to the facility of $1,334,761 and the Company's estimate of
its additional net lease costs for the facility, which amounted to $874,220,
were recognized as a loss as of June 30, 1999. The accrual of estimated future
lease costs was computed by calculating the present value of the remaining lease
payments, offset by the present value of estimated future sublease income
assuming a sub-lease start date of November 2002, using a discount rate of 7%.
During the nine months ended September 30, 2000, $214,644 was charged against
the liability which had a balance of $526,180 at September 30, 2000. The
Company's accrual of estimated lease costs is subject to change based on future
events. Any future adjustments to the accrual will be classified as a write-down
of unused facility costs in the Company's consolidated statement of operations.
The facility had not been subleased as of September 30, 2000.

Beginning in 1997, the Company leased on a month-to-month basis a property
from a partnership in which the Company's Chairman of the Board and Chief
Executive Officer is both a direct and indirect owner. The Company utilized a
portion of the property and subleased the remainder of the property. As a result
of the Company's proposed initial public offering, the lease between the Company
and the partnership was terminated on September 1, 2000 on which date the
Company had a balance of $369,494 in unamortized leasehold improvements for this
property. Accordingly, a loss was recognized for this amount as of September 1,
2000.

F-29
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

5. LONG-TERM DEBT

Long-term debt consists of the following at September 30, 2000:

<TABLE>
<S> <C>
Revolving line of credit.................................... $ 2,013,400
Term loan payable to bank, payable in monthly installments
of $83,333 plus interest at 9.50% through March 2002...... 1,666,667
Term loan payable to bank, payable in monthly installments
of $80,225 plus interest at 8.65%-9.50% through February
2004...................................................... 3,289,230
Term loan payable to bank, payable in monthly installments
of $128,885 plus interest at 8.65%-9.50% through January
2004...................................................... 5,155,410
-----------
12,124,707
Less current portion........................................ (5,522,725)
-----------
$ 6,601,982
===========
</TABLE>

The Company has a bank loan agreement which provides for a revolving line of
credit in addition to term loans. The Company's revolving line of credit
provides for borrowings of up to $15,000,000, subject to a borrowing base
limitation of 75% of eligible accounts receivable as defined in the related loan
agreement, and all outstanding borrowings under the revolving line of credit,
which may be prepaid at any time without penalty are payable on September 3,
2002.

An initial term loan is payable over a five-year period with monthly
payments of principal of $83,333 plus interest, with a maturity date of
March 31, 2002. A second term loan is payable over a five-year period with
monthly payments of principal of $80,225 plus interest, with a maturity date of
February 1, 2004. A third term loan was made in February, 2000 and is payable
with monthly payments of principal of $128,885 plus interest, with a maturity
date of January 1, 2004.

All borrowings under the bank loan agreement, including the revolving line
of credit and term loans, bear interest at LIBOR plus a defined rate. At each
interest rate reset date, the Company elects to lock in the new rate for a
certain specified period ranging from one month to one year.

Borrowings under the revolving line of credit and term loan facilities are
cross collateralized by substantially all of the Company's assets. The agreement
contains certain restrictive covenants, including maintenance of certain levels
of financial ratios.

The current portion of long-term debt at September 30, 2000 is comprised of
the principal payments due on or before September 30, 2001 on the three term
loans plus the balance of the outstanding borrowings under the revolving line of
credit.

F-30
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

6. OTHER LONG-TERM LIABILITIES

Other long-term liabilities at September 30, 2000 consist of the following:

<S> <C>
Deferred compensation.................................... $1,927,421
Annuity payments due to former employee.................. 478,684
Non-current installment of software acquisition costs.... 600,000
Non-current portion of accrued rent for unused
facility............................................... 293,191
Other.................................................... 93,588
----------
$3,392,885
==========
</TABLE>

7. SHAREHOLDERS' EQUITY

PREFERRED STOCK

COMMON STOCK

On August 15, 2000, the Specialty Family Limited Partnership ("Partnership")
redeemed the Company's interest in the Partnership in exchange for 1,136,749
shares of the Company's common stock, which were then cancelled by the Company.
Other than the cancellation of the outstanding shares, no other accounting was
required for this transaction.

STOCK OPTIONS

As of January 1, 2000, the Company granted to certain employees of the
Company 132,000 options to acquire shares of the Company's common stock at an
exercise price of $1.56 per share. As of July 1, 2000, the Company granted to
certain employees of the Company 255,200 options to acquire shares of the
Company's common stock at an exercise price of $7.00 per share. The options
granted vest 25% upon the first anniversary of an employee's employment and
thereafter ratably in equal monthly installments for the next 36 months. The
options have a term of 10 years from date of grant. The difference between the
option exercise price and the fair value of the Company's common stock as
estimated by the Company's management for financial reporting purposes as of the
dates of grant was recorded as deferred stock-based compensation and is being
amortized to expense over the vesting periods of the related stock options on an
accelerated basis using the graded vesting method.

F-31
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

7. SHAREHOLDERS' EQUITY (CONTINUED)
Stock-based compensation charges are comprised of the following components:

<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------
1999 2000
---------- --------
<S> <C> <C>
Charged to expense on transaction date:
Stock options vested at date of grant............... $1,750,776 $ --
Common stock sold to certain employees.............. 341,814 --
Amortization of deferred stock-based compensation..... 600,087 572,101
Variable stock-based compensation charges for certain
stock options....................................... -- 134,353
---------- --------
$2,692,677 $706,454
========== ========
</TABLE>

On September 5, 2000, the Company's Board of Directors adopted and the
shareholders approved the 2000 Stock Incentive Plan (2000 Plan). The 2000 Plan
will become effective on the date the underwriting agreement for the offering is
signed. 4,020,280 shares of the Company's common stock have been authorized for
issuance under the 2000 Plan, including shares currently reserved under the
1999 Plan.

F-32
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

8. INCOME TAXES

The components of the provision (benefit) for income taxes are as follows:

<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------
1999 2000
----------- ----------
<S> <C> <C>
Continuing operations:
Current:
Federal......................................... $ 1,783,000 $3,797,000
State........................................... 599,000 1,072,000
----------- ----------
2,382,000 4,869,000

Deferred:
Federal......................................... (1,702,000) (175,000)
State........................................... (603,000) (50,000)
----------- ----------
(2,305,000) (225,000)
----------- ----------
Total continuing.................................... 77,000 4,644,000

Discontinued operations:
Current:
Federal......................................... (1,030,000) --
State........................................... (294,000) --
----------- ----------
(1,324,000) --

Deferred:
Federal......................................... -- --
State........................................... -- --
----------- ----------
-- --
----------- ----------
Total discontinued operations....................... (1,324,000) --
----------- ----------
$(1,247,000) $4,644,000
=========== ==========
</TABLE>

9. RELATED PARTY TRANSACTION

In March 2000, a loan of $850,000 to the Peter Family Revocable Trust was
repaid in full.

10. CONTINGENCIES AND COMMITMENTS

CONTINGENCIES

A former employee of SLA has obtained a judgment of $350,000 against SLA and
a default judgment of approximately $1.95 million in a wrongful termination
action against SLA filed in Singapore. The former employee has filed an action
against SLA in California to attempt to collect on the Singapore judgment and
has obtained a default judgment of $2.5 million against SLA in California. The
former employee has also served discovery upon the Company and certain of its
directors and officers, has sought to compel these officers and directors to
provide this discovery and has requested

F-33
<PAGE>
SPECIALTY LABORATORIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)

SEPTEMBER 30, 2000

10. CONTINGENCIES AND COMMITMENTS (CONTINUED)
sanctions in connection with these requests. No overt allegations of any
material liability have been made against the Company. The Company's management
believes that any claim against the Company or its directors and officers in
connection with these judgments, if made, would be without merit and the Company
would vigorously defend any such action.

The Company is from time to time subject to claims arising in the ordinary
course of business. These claims have included assertions that the Company's
assays infringe existing patents; however, none of the claimants have filed
litigation against the Company. The Company intends to defend vigorously any
such litigation that may arise and to assert all available defenses to
allegations of patent infringement that would be available to the Company. In
the opinion of management, the ultimate resolution of such proceeding will not
have a material adverse effect on the consolidated financial position,
operations or cash flows of the Company.

COMMITMENTS

In September and October 2000, the Company entered into employment
agreements with six employees. The agreements with two of the employees, which
provide in the aggregate for annual base salaries of $886,000, provide that if
the employee is terminated other than for cause or if he resigns for good reason
during the first five years of his contract, the Company will pay his base
salary for a two year period and his bonus for a one year period subsequent to
his severance. The agreements with the four other employees, which provide in
the aggregate for annual base salaries of approximately $800,000, provide that
if the employee is terminated for other than cause during the first three years
of his contract, the Company will pay his salary for a one year period
subsequent to his severance. If any of the six employees is terminated for
cause, no further payments are due to them under the contracts.

11. PROPOSED INITIAL PUBLIC OFFERING

F-34
<PAGE>
INSIDE BACK COVER

Text (top): "Specialty Laboratories"

Graphic (top): Photo collage of laboratory worker performing research, reference
manuals and laboratory samples.

Text: "Specialty Laboratories Research and Development Helping Doctors Help
Patients-Registered Trademark-"
<PAGE>
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------

Through and including January 1, 2001 (the 25th day after the date of this
prospectus), all dealers effecting transactions in these securities, whether or
not participating in this offering, may be required to deliver a prospectus.
This is in addition to the dealers' obligation to deliver a prospectus when
acting as underwriters and with respect to their unsold allotments or
subscriptions.

5,000,000 SHARES

[LOGO]

COMMON STOCK

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P R O S P E C T U S
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MERRILL LYNCH & CO.
UBS WARBURG LLC
U.S. BANCORP PIPER JAFFRAY

DECEMBER 7, 2000

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