MEDSTONE INTERNATIONAL INC/, DEF 14C, 1996-02-09

MEDSTONE INTERNATIONAL INC/
DEF 14C, 1996-02-09
ELECTROMEDICAL & ELECTROTHERAPEUTIC APPARATUS

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SCHEDULE 14C INFORMATION

INFORMATION STATEMENT PURSUANT TO SECTION 14(C)
OF THE SECURITIES EXCHANGE ACT OF 1934 (AMENDMENT NO. )

Check the appropriate box:

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<S> <C>
/ / Preliminary Information Statement / / Confidential, for Use of the Commission
Only (as permitted by Rule 14c-5(d)(2))
/X/ Definitive Information Statement
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MEDSTONE INTERNATIONAL, INC.
- --------------------------------------------------------------------------------
(Name of Registrant As Specified in Charter)

Payment of Filing Fee (Check the appropriate box):

/ / $125 per Exchange Act Rules 0-11(c)(1)(ii), or 14c-5(g).

/X/ Fee computed on table below per Exchange Act Rules 14c-5(g) and 0-11.

(1) Title of each class of securities to which transaction applies:

Common Stock

(2) Aggregate number of securities to which transaction applies:

5,800,000

(3) Per unit price or other underlying value of transaction computed
pursuant to Exchange Act Rule 0-11 (Set forth the amount on which the
filing fee is calculated and state how it was determined):

Pro Forma Book Value of the Endocare Common Stock to be distributed was
$0.18 per share as of November 14, 1995

(4) Proposed maximum aggregate value of transaction:

$1,177,715

(5) Total fee paid:

$361.00

/X/ Fee paid previously with preliminary materials

/ / Check box if any part of the fee is offset as provided by Exchange Act Rule
0-11(a)(2) and identify the filing for which the offsetting fee was paid
previously. Identify the previous filing by registration statement number,
or the Form or Schedule and the date of its filing.

(1) Amount Previously Paid:

(2) Form, Schedule or Registration Statement No.:

(3) Filing Party:

(4) Date Filed:
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[MEDSTONE LETTERHEAD]

February 6, 1996

To the Stockholders of Medstone International, Inc.:

The Board of Directors of Medstone International, Inc. ("Medstone") has
approved a distribution of the outstanding shares of Common Stock of its wholly
owned subsidiary, Endocare, Inc. ("Endocare"), to holders of Medstone's Common
Stock. Each stockholder of Medstone will receive with this letter one share of
Endocare Common Stock for every one share of Medstone Common Stock held on
December 29, 1995. No stockholder vote is required or sought in connection with
the distribution. The enclosed Information Statement explains the distribution
of Endocare shares and related transactions and contains important financial and
other information about Endocare, its organization, business, management and
other matters. Please read the Information Statement carefully and keep it for
future reference.

The Board of Directors of Medstone believes the distribution of Common
Stock of Endocare is in the best interests of Medstone and its stockholders.
Following the distribution, management of each Company plans to concentrate its
attention and resources on their respective core businesses without regard to
the corporate objectives, policies and investment standards of the other. For
example, Endocare will focus on a distinct business -- developing, manufacturing
and marketing surgical devices to treat urological disorders -- while Medstone
will increase its focus on expanding the sales and service of its lithotripsy
products worldwide. Following the Distribution, Endocare will also continue to
provide research and development services to Medstone upon request.
Sincerely,

David V. Radlinski
Chairman and Chief Executive Officer
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[ENDOCARE LETTERHEAD]

February 6, 1996

To the Stockholders of Medstone International, Inc.:

The enclosed Information Statement contains important financial and other
information about Endocare, Inc. ("Endocare"), the corporation of which you will
become a stockholder if you owned shares of Medstone International, Inc. Common
Stock on December 29, 1995. Endocare develops, manufactures and markets devices
to treat urological diseases. We want to welcome you as an investor and invite
you to learn more about our Company.

We at Endocare are excited about the future of our Company and the impact
our products can have on urological disease treatment. We look forward to a long
relationship with each of you.
Sincerely,

Paul W. Mikus
Chairman and Chief Executive Officer
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INFORMATION STATEMENT

ENDOCARE, INC.
(A WHOLLY-OWNED SUBSIDIARY OF MEDSTONE INTERNATIONAL, INC.)

MEDSTONE INTERNATIONAL, INC.'S
DISTRIBUTION OF 5,516,528 SHARES OF
ENDOCARE, INC. COMMON STOCK
(PAR VALUE $.001 PER SHARE)

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

This Information Statement is being furnished in connection with the
distribution (the "Distribution") by Medstone International, Inc. ("Medstone")
to its stockholders of substantially all of the shares of Common Stock of its
wholly owned subsidiary, Endocare, Inc. ("Endocare" or the "Company").

It is expected that the Distribution will be made on or about February 6,
1996, to holders of record of the Common Stock of Medstone, $.004 par value per
share (the "Medstone Common Stock"), on December 29, 1995, on the basis of one
share of the Common Stock of Endocare, $.001 par value per share (the "Endocare
Common Stock"), for every one share of Medstone Common Stock held. The
Distribution will result in substantially all of the outstanding shares of
Endocare Common Stock being distributed to holders of Medstone Common Stock on a
pro rata basis.

No consideration will be required to be paid by Medstone stockholders for
the shares of Endocare Common Stock to be received by them in the Distribution,
nor will they be required to exchange shares of Medstone Common Stock to receive
Endocare Common Stock.

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

NO STOCKHOLDER APPROVAL OF THE DISTRIBUTION IS REQUIRED OR
SOUGHT. WE ARE NOT ASKING YOU FOR A PROXY AND YOU
ARE REQUESTED NOT TO SEND US A PROXY.

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

THE DATE OF THIS INFORMATION STATEMENT IS FEBRUARY 6, 1996
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TABLE OF CONTENTS

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PAGE
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Summary............................................................................... 3
The Company........................................................................... 5
The Distribution...................................................................... 5
Relationship Between Medstone and the Company After the Distribution.................. 9
Risk Factors.......................................................................... 11
Capitalization........................................................................ 17
Dividend Policy....................................................................... 17
Selected Financial Data............................................................... 18
Management's Discussion and Analysis of Financial Condition and Results of
Operations.......................................................................... 19
Business.............................................................................. 21
Management............................................................................ 26
Executive Compensation................................................................ 27
Security Ownership of Principal Stockholders and Management........................... 31
Description of Capital Stock.......................................................... 32
Anti-Takeover Effects of the Company's Certificate and Bylaws......................... 33
Liability and Indemnification of Officers and Directors............................... 35
Independent Accountants............................................................... 36
Additional Information................................................................ 36
Index to Financial Statements......................................................... 37
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SUMMARY

This Summary is qualified in its entirety by the more detailed information
appearing elsewhere in this Information Statement. Capitalized terms used but
not defined in this Summary are defined elsewhere in this Information Statement.

THE DISTRIBUTION

Distributing Company....... Medstone International, Inc. a Delaware corporation
("Medstone"), develops and markets lithotripsy
products.

Distributed Company........ Endocare, Inc., a Delaware corporation ("Endocare"
or the "Company"), develops, manufactures and
markets devices to treat urological diseases. See
"Business."

Distribution Ratio......... One share of Endocare Common Stock, par value $.001
per share, for every one share of Medstone Common
Stock.

Shares to be Distributed... A total of 5,516,528 shares of Endocare Common
Stock will be distributed to Medstone stockholders.

Record Date................ December 29, 1995 (close of business).

Distribution Date.......... On or about February 6, 1996.

Certain Tax Consequences... In general, it is anticipated that Medstone,
Endocare and the Medstone stockholders should not
recognize any taxable gain or income solely as a
result of the Distribution. As a condition of the
Distribution, Medstone will receive a tax opinion
from Wilson Sonsini Goodrich & Rosati, P.C. Palo
Alto, California, to the effect that the Company
may reasonably report the Distribution of Endocare
Common Stock to Medstone stockholders as a tax-free
distribution for federal income tax purposes. The
tax opinion will be subject to certain
qualifications and assumptions, the accuracy of
which are critical to the Distribution qualifying
as a taxfree distribution. See "The
Distribution -- Certain Federal Income Tax
Consequences of the Distribution."

Trading Market and
Symbol..................... The Company does not expect to qualify for listing
of its Common Stock on the Nasdaq Small Cap Market
upon completion of the Distribution. Trading, if
any, in the Company's Common Stock will be
conducted in the over-the-counter market on an
electronic bulletin board or in what are commonly
referred to as the "pink sheets." See "Risk
Factors -- Absence of Public Market; Possible
Illiquidity of Trading Market and Possible
Volatility of Stock Price."

Distribution Agent......... U.S. Stock Transfer Corporation, Glendale,
California, ("U.S. Stock Transfer") will act as the
Distribution Agent. The Distribution Agent will
mail share certificates beginning on or about the
Distribution Date.

Dividends.................. The Endocare Board of Directors anticipates that
the Company will retain any earnings and will not
pay dividends to its stockholders in the
foreseeable future. See "Dividend Policy."

Principal Office of the
Company.................. 18 Technology Drive, Suite 134, Irvine, California
92718, telephone: (714) 450-1410.

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Transfer Agent and
Registrar for Common
Stock.................... U.S. Stock Transfer will act as Endocare's Transfer
Agent and Registrar for the Endocare Common Stock.

Reasons for the
Distribution............... The Board of Directors of Medstone believes that
the Distribution is in the best interests of
Medstone and its stockholders for a number of
reasons. Among these are: (a) focusing the
management of each Company on the core business of
each Company without regard to the corporate
objectives and policies of the other Company, (b)
offering incentives more attractive and appropriate
for the motivation and retention of key employees
by each (c) improving the near term earnings of
Medstone, and (d) improving the likelihood that
each of Endocare and Medstone may have greater
access to capital than would otherwise be the case.

Relationship with Medstone
after the Distribution..... Medstone will own 100,000 shares of Endocare Common
Stock after the Distribution. Prior to the
Distribution, the Company and Medstone will enter
into a Distribution Agreement, pursuant to which
both parties agree to indemnify and hold the other
harmless from any liability for claims resulting
from any material breach of the representations and
warranties made by the indemnifying party in
connection with the Distribution. Additionally,
Medstone will make a capital contribution of cash
in the amount of $500,000 and the net assets
comprising the Company's business. See "The
Distribution" and "Relationship Between Medstone
and the Company After the Distribution."

Risk Factors............... Stockholders should carefully consider certain
factors described under "Risk Factors."

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THE COMPANY

Endocare develops, manufacturers and markets devices to treat urological
diseases. Endocare began as a department and was later formed as a division of
Medstone International, Inc. ("Medstone") to continue the research and
development efforts of Medstone in the treatment of urological disorders and to
focus on new product development. In addition to enhancing Medstone's existing
lithotripsy products, the research and development conducted by Endocare has
produced several products outside of Medstone's core business of lithotripsy.
The Company's products include its Prolase(R) side firing laser catheter and
electrosurgical devices designed to treat urological tissue and its CryoCare(TM)
System, which is currently in clinical trials. The common theme for all Endocare
product development is innovative design, minimally invasive and
outpatient-oriented procedures, and cost effective solutions for the
marketplace. The Company's goal is to continue to find better surgical solutions
for better patient care in the area of urologic disease. Following the
Distribution, the Company will also continue to perform research and development
for Medstone.

Endocare is a Delaware corporation incorporated in May 1994 with its
principal executive offices located at 18 Technology Drive, Suite 134, Irvine,
California 92718. Its telephone number is (714) 450-1410.

THE DISTRIBUTION

REASONS FOR DISTRIBUTION

The Board of Directors of Medstone has determined by unanimous vote that it
is in the best interests of Medstone, Endocare and the Medstone stockholders to
undertake the Distribution. The Distribution is designed to separate Medstone
and Endocare which have evolved into separate businesses with distinct missions
and financial, investment and operating characteristics so that each can adopt
strategies and pursue objectives appropriate to its specific business. Medstone
has a mature product line and must meet different regulatory standards than
Endocare, which is relying on new products meeting different regulatory
standards to sustain its revenue growth. The Distribution will permit the
management of each Company to concentrate its attention and resources on the
challenges faced by their respective core businesses without regard to the
corporate objectives, policies and investment standards of the other. In
particular, the Distribution is expected to improve the future earnings
prospects of Medstone by eliminating the research and development expenses
expected to be incurred by Endocare. Endocare should have better access to
capital markets to finance its growth and the commercialization of new products.
Separating the companies should also allow for increased executive focus for
both Medstone and Endocare and more effective incentive programs for key
employees of each Company. Separating Endocare from Medstone is also expected to
improve Endocare's ability to market its products through standard distribution
channels, some of which have been unavailable because of Endocare's relationship
to Medstone. Finally, the Board of Medstone believes the Distribution will
permit investors, customers, regulatory agencies and other constituencies to
evaluate the respective businesses of Medstone and Endocare more effectively.

MANNER OF EFFECTING DISTRIBUTION

The general terms and conditions relating to the Distribution are set forth
in a Distribution Agreement entered into between Medstone and Endocare prior to
the Distribution. Each stockholder of Medstone will receive one share of
Endocare Common Stock for every one share of Medstone Common Stock held on the
Record Date. Upon completion of the Distribution, there will be 5,616,528 shares
of Endocare Common Stock outstanding, as there were 5, 516,528 shares of
Medstone Common Stock outstanding on the Record Date. All of these shares will
be immediately eligible for sale in the public market without restriction under
the Securities Act of 1933, as amended (the "Securities Act"), except that any
shares owned by affiliates of Endocare may generally only be sold in compliance
with the applicable provisions of Rule 144. On the Distribution Date, there will
also be outstanding options to purchase 960,000 shares of Endocare Common Stock.
See "Capitalization."

The Distribution will be made on the Distribution Date to stockholders of
record of Medstone at the close of business on the Record Date. On the
Distribution Date, Medstone will deliver 5,516,528 outstanding shares

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of Endocare Common Stock to the Distribution Agent, for distribution to Medstone
stockholders as of the Record Date. The Distribution Agent will mail, beginning
promptly thereafter, certificates representing Endocare Common Stock to these
Medstone stockholders. Medstone stockholders will not be required to pay for
shares of the Endocare Common Stock received in the Distribution or to surrender
or exchange shares of Medstone Common Stock to receive shares of Endocare Common
Stock. No vote of Medstone stockholders is required or sought in connection with
the Distribution, and Medstone stockholders have no appraisal rights in
connection with the Distribution. Medstone will account for the Distribution as
a dividend.

DISTRIBUTION AGREEMENT

The general terms and conditions of the Distribution are set forth in the
Distribution Agreement to be entered into between Medstone and the Company prior
to the Distribution. In addition to providing for the transfer of Endocare's
capital equipment and other assets related to the research and development of
urological products, the Distribution Agreement and related agreements provide
for the investment in Endocare by Medstone of $500,000 as a capital contribution
to provide funding, and the transfer of certain patents and products currently
being marketed that were previously developed by the Endocare research and
development effort.

CERTAIN FEDERAL INCOME TAX CONSEQUENCES OF THE DISTRIBUTION

The following discussion sets forth a summary of the material federal
income tax consequences under the Internal Revenue Code of 1986, as amended (the
"Code"), to holders of Medstone Common Stock with respect to the receipt of the
Endocare Common Stock pursuant to the Distribution. The discussion may not
address all federal income tax consequences that may be relevant to particular
Medstone stockholders, e.g., foreign persons, dealers in securities and persons
who received Medstone Common Stock in compensatory transactions. In addition,
the discussion does not address any state, local or foreign tax considerations
relative to the Distribution. ACCORDINGLY, ALL HOLDERS ARE URGED TO CONSULT
THEIR OWN TAX ADVISORS.

Medstone has not requested a ruling from the Internal Revenue Service (the
"Service") with respect to the federal income tax consequences of the
Distribution. However, as a condition of the consummation of the Distribution,
Medstone will receive an opinion of Wilson Sonsini Goodrich & Rosati, P.C.
("Special Tax Counsel") that: (i) for federal income tax purposes, there is a
reasonable basis for treating the Distribution as a transaction qualifying under
Section 355 of the Code; and (ii) this discussion insofar as it relates to the
statements of law or legal conclusions is correct in all material respects.

In rendering the tax opinion, Special Tax Counsel will rely upon certain
representations and covenants made by Medstone, certain of its stockholders and
the Company, including the following: (a) following the Distribution, the
holders of Medstone common stock must maintain a substantial continuing
ownership interest in the Endocare capital stock they receive in the
Distribution; and (b) the Company must continue its historic research business
including the provision of research and development services on behalf of
Medstone. The tax opinion will be explicitly conditioned upon the accuracy of
such representations and covenants and upon certain assumptions critical to the
Distribution qualifying as a tax-free spinoff under Section 355 of the Code. The
tax opinion does not bind the Service nor does it preclude the Service from
adopting a contrary position from that taken in the tax opinion. In the event
the representations or assumptions are not accurate or the covenants are
breached, then Medstone and the Company will be unable to rely on the tax
opinion. Assuming the Distribution qualifies as a tax-free spinoff under Section
355, the following tax consequences will result:

(1) No gain or loss will be recognized by or includable in the income
of a holder of Medstone Common Stock solely as a result of the receipt of
Endocare Common Stock pursuant to the Distribution;

(2) No gain or loss will be recognized by Medstone or the Company
solely as a result of the Distribution;

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(3) The tax basis of Medstone Common Stock held by a Medstone
stockholder immediately before the Distribution will be apportioned between
such Medstone Common Stock and the Endocare Common Stock received by such
stockholder in the Distribution based upon the relative fair market value
of such Medstone Common Stock and Endocare Common Stock on the Distribution
Date (for purposes of the apportionment the Company has determined that the
value of the Endocare Common Stock as of the Distribution Date is $0.18 per
share); and

(4) Assuming that Medstone Common Stock held by a Medstone stockholder
is held as a capital asset, the holding period for the Endocare Common
Stock received in the Distribution will include the period during which
such Medstone Common Stock was held.

Notwithstanding the opinion of counsel referred to above the application of
Section 355 of the Code to the Distribution is complex and may be subject to
differing interpretation. In particular, the Service may challenge the tax-free
status of the Distribution on the grounds that it lacks an adequate "business
purpose" or that the active business requirement of Section 355(b) of the Code
(which requires the continuation after the Distribution of a business conducted
for at least five years prior to the Distribution) is not satisfied.
Accordingly, there can be no assurance that the Service will not successfully
assert that the Distribution is a taxable event.

If the Distribution does not qualify as a tax-free spinoff under Section
355 of the Code, then: (i) Medstone would recognize capital gain equal to the
difference between the fair market value of the Endocare Common Stock on the
Distribution Date and Medstone's tax basis in such stock (based on the
anticipated low value of the Endocare stock Medstone believes any such gain
should not be material); (ii) each stockholder receiving shares of Endocare
Common Stock in the Distribution may be treated as having received a
distribution equal to the value of the Endocare Common Stock received which
would be taxable as ordinary income to the extent of Medstone's current and
accumulated earnings and profits; (iii) the holding period for determining
capital gain treatment of the Endocare Common Stock received in the Distribution
would commence on the Distribution Date; and (iv) each stockholder would have a
tax basis in the shares of Endocare Common Stock received in the Distribution
equal to the fair market value of such shares. Corporate stockholders may be
eligible for a dividends-received deduction (subject to certain limitations)
with respect to the portion of the Distribution constituting a dividend, and may
be subject to the Code's extraordinary dividend provisions which, if applicable,
would require a reduction in such holder's tax basis in his or her Medstone
stock to the extent of such deduction.

The foregoing is a summary of material federal income tax considerations of
the Distribution under current law. Each stockholder should consult his or her
tax advisor as to the particular consequences of the Distribution to such
stockholder, in light of his or her personal circumstances, including the
application of state, local and foreign tax laws.

TRADING OF ENDOCARE COMMON STOCK

A "when issued" trading market in the Endocare Common Stock is expected to
develop prior to the Distribution Date. A "when issued" trading market occurs
when trading in shares begins prior to the time stock certificates are actually
available or issued.

Prior to the Distribution, there has not been any established public
trading market for the Endocare Common Stock. It is anticipated that certain
investment banking firms may make a market in the Endocare Common Stock
following the Distribution. Any such market making activity may be discontinued
at any time, without notice. There can be no assurance that an active trading
market in the Endocare Common Stock will develop, or, at what prices the
Endocare Common Stock will trade.

The Company does not expect to qualify for listing of its Common Stock on
the Nasdaq Small Cap Market upon completion of the Distribution. Trading, if
any, in the Company's Common Stock will be conducted in the over-the-counter
market on an electronic bulletin board or in what are commonly referred to as
the "pink sheets." See "Risk Factors -- Absence of Public Market; Possible
Illiquidity of Trading Market and Possible Volatility of Stock Price." Based on
the number of holders of Medstone Common Stock as of

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December 29, 1995, the Company is expected to have approximately 394
stockholders of record at the Distribution Date (including shares held in street
name).

OTHER CONSEQUENCES OF THE DISTRIBUTION

1995 STOCK OPTION PLAN

Endocare has adopted a 1995 Stock Option Plan (the "1995 Stock Plan") under
which employees, directors and consultants of the Company, its parent and any
subsidiaries are eligible to receive stock option grants and stock purchase
rights. In 1995, options to purchase up to 960,000 shares of the Company's
Common Stock were granted to certain officers and consultants of the Company
under the 1995 Stock Plan. See "Executive Compensation -- Stock Plan."

1995 DIRECTOR OPTION PLAN

Endocare has adopted a 1995 Director Option Plan under which outside
directors receive automatic grants of stock options. See
"Management -- Compensation of Directors."

QUESTIONS RELATING TO THE DISTRIBUTION

Questions relating to the Distribution or ownership of Common Stock of the
Company should be directed to the Chief Executive Officer, Endocare, Inc., 18
Technology Drive, Suite 134, Irvine, California, 92718, telephone (714)
450-1410.

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RELATIONSHIP BETWEEN MEDSTONE AND THE COMPANY AFTER THE DISTRIBUTION

The business of Endocare has historically been operated as a division of
Medstone. Endocare, Inc. was incorporated in 1994. The Company has relied upon
Medstone for financial support. The Company has also relied on Medstone for
assistance with personnel management and financial administration. Upon
completion of the Distribution, the Company will operate independently from
Medstone. Endocare will continue to provide research and development and other
services to Medstone for fair market value fees pursuant to the Intercompany
Agreements (as defined below).

INTERCOMPANY AGREEMENTS

Prior to the Distribution, Endocare and Medstone entered into a Research
and Development Services Agreement, Distribution Agreement, Administrative
Services Agreement and Contribution Agreement (collectively, "the Intercompany
Agreements"). The following are summaries of the principal provisions of such
agreements. These summaries are qualified in their entirety by reference to the
full text of such agreements, which have been filed as exhibits to the
Registration Statement of which this Information Statement is a part.

RESEARCH AND DEVELOPMENT AGREEMENT.

Following the Distribution certain research and development personnel of
Endocare will continue to perform research and development services for
Medstone. Under a Research and Development Services Agreement, Endocare will
bill Medstone on an hourly basis for any research and development services
performed.

DISTRIBUTION AGREEMENT

Under the Distribution Agreement, immediately following the Distribution,
nearly all of the Endocare Common Stock will be owned by stockholders of
Medstone and shares in the two companies will trade independently.

The Distribution Agreement also provides that each party agrees to
indemnify and hold the other harmless from certain liabilities, including claims
resulting from any breach of representations and warranties made by the
indemnifying party in connection with the Distribution.

The Distribution Agreement provides that Endocare has the right to hire
certain individuals approved by Medstone who are or have been employees of
Medstone. Medstone will have no further responsibility or liability with respect
to the employment relationship of such employees upon the effectiveness of the
Distribution, other than with respect to the final settlement or obligations
with respect to such employees under existing Medstone incentive and benefit
plans.

The Distribution Agreement provides that in connection with the transfer of
assets and the assumption of liabilities relating to the separation of the
businesses of Endocare and Medstone, Endocare and Medstone shall execute or
cause to be executed various conveyancing and assumption instruments in such
forms as the parties to the Distribution Agreement shall agree.

Pursuant to the Distribution Agreement, Medstone agrees to obtain all
consents, permits and authorizations necessary to transfer and to transfer to
Endocare any assets associated with the Endocare business which have not been
transferred by the Distribution Date. In addition, Medstone is to obtain
consents, permits and authorizations necessary to permit Endocare to assume any
liabilities associated with the Endocare business which have not been assumed by
Endocare by the Distribution Date.

The Distribution Agreement sets forth the respective obligations of
Medstone and Endocare with respect to liabilities for taxes and tax returns and
other tax related filings. In general, Medstone will be responsible for tax
filings of Endocare and paying those taxes (other than taxes accrued on its
financial statements) attributable to any taxable period (or that portion of any
taxable period) ending on or before the Distribution Date. Endocare shall be
responsible for filing its tax returns and paying its taxes attributable to
periods (or

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portions of any taxable periods) commencing on or after the date immediately
following the Distribution Date. In addition, the Distribution Agreement
requires Medstone and Endocare to cooperate in preparing those filings which
cover overlapping taxable periods that include the Distribution Date.

ADMINISTRATIVE SERVICES AGREEMENT

Under the Administrative Services Agreement, Medstone will provide certain
accounting, benefits and payroll services to Endocare and, under this agreement,
Medstone may also provide to Endocare the use of certain facilities. In
consideration for such services and use of such facilities, Endocare shall pay
to Medstone an hourly fee of $50. Pursuant to the terms of the Administrative
Services Agreement, Endocare and Medstone may contract employee services from
each other for a period not to exceed two years following the Distribution Date.

CONTRIBUTION AGREEMENT

Under the Contribution Agreement, Medstone will transfer to Endocare
certain Medstone property, including certain intellectual property and other
rights, used in connection with Endocare's business, and will make a cash
contribution of $500,000 to Endocare.

OTHER ARRANGEMENTS

The Board of Directors of Endocare consists of Paul W. Mikus, Kevin
Marinelli and Peter Bernardoni. Each member of the Endocare Board of Directors
serves until the next Annual Meeting of Endocare stockholders, at which time all
directors are subject to reelection.

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RISK FACTORS

The following risk factors should be considered carefully, in addition to
the other information contained in the Information Statement, in evaluating
Endocare and its business prospects.

LIMITED OPERATING HISTORY; HISTORY OF LOSSES; REPORT OF INDEPENDENT AUDITORS

The Company has a limited history of operations. Since its inception, the
Company has engaged primarily in research and development, and the Company has
minimal experience in manufacturing, marketing and selling its products in
commercial quantities. Additionally, the Company has incurred annual operating
losses since its inception, and expects to continue to incur operating losses as
new products will require substantial development, clinical, regulatory,
manufacturing and other expenditures. There can be no assurance that Endocare
will successfully develop or commercialize its current or future products, that
the Company will achieve significant revenues from sales, or that the Company
will achieve or sustain profitability in the future. Moreover, the Company's
independent auditors have issued their report containing an explanatory
paragraph which expresses substantial doubt regarding the Company's ability to
continue as a going concern based on certain existing conditions. In particular,
the realization of the Company's assets is dependent upon future events, the
outcome of which is indeterminable. Additionally, successful completion of the
Company's development program and its transition, ultimately, to attaining
profitable operations is dependent upon obtaining additional financing adequate
to fulfill its research and development activities, and achieving a level of
revenues adequate to support the Company's cost structure.

DECLINING SALES OF EXISTING PRODUCTS; UNCERTAIN MARKET ACCEPTANCE OF NEW
PRODUCTS

Sales of several existing Endocare products, including Prolase and Diolase,
have declined and are expected to continue to decline over the next two years
and beyond. Endocare's other products are either in varying stages of
development or are in the very early stage of market acceptance. There can be no
assurance that the Company's products will prove to be safe and effective in
clinical trials under applicable regulatory guidelines, and clinical trials may
identify significant technical or other obstacles that must be overcome prior to
obtaining necessary regulatory or reimbursement approvals. Even if a product
overcomes these obstacles, the Company's products will not be used unless they
present an attractive alternative to other treatments and that the clinical
benefits to the patient and cost savings achieved through use of the Company's
products outweigh the cost of such products. The Company believes that
recommendations and endorsements of physicians, patients and health care payors
will be essential for market acceptance of its products, and there can be no
assurance that any such recommendations or endorsements will be obtained. There
can be no assurance that the Company's products will gain any significant degree
of market acceptance among physicians, patients and health care payors. Failure
of the Company's products to achieve significant market acceptance would have a
material adverse effect on the Company's business, financial condition and
results of operations.

PRIOR RELIANCE ON MEDSTONE; NEED FOR ADDITIONAL FINANCING

The Company has operated as a division or wholly owned subsidiary of
Medstone since it commenced operations and has relied upon Medstone for
financial support and for assistance with personnel management and financial
administration. In connection with the Distribution, Medstone will make a
capital contribution to the Company of $500,000 cash and the net assets
comprising the Company's business. Upon completion of the Distribution, the
Company will no longer be able to rely on Medstone and will need to obtain
independent sources of financing and successfully replace administrative
capability previously provided by Medstone. Additionally, the Company will face
various costs associated with being a reporting company under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), including increased legal
and accounting fees. The Company's future liquidity and capital requirements
will depend upon numerous factors, including the progress of the Company's
clinical trials, actions relating to regulatory and reimbursement matters, the
cost and timing of expansion of marketing, sales, manufacturing and product
development activities, the extent to which the Company's products gain market
acceptance, and competitive developments. The Company believes that additional
financing may be required as early as 1996, and may seek such

11
<PAGE> 15

financing through public or private debt or equity offerings or from corporate
partners who may acquire a significant equity interest in Endocare. Future
equity financings may result in dilution to the holders of the Company's Common
Stock. Endocare's ability to obtain such financing will depend on its results of
operations, financial condition and business prospects, as well as market
conditions. The existence of the Intercompany Agreements may also have a
material adverse effect on the Company's ability to obtain financing. There can
be no assurance that any financing will be available on acceptable terms, either
from public or private sources, and there can be no assurance that the Company
will successfully operate independently of Medstone.

EFFECT OF INDUSTRY COMPETITION; INABILITY OF COMPANY TO COMPETE IN INDUSTRY

Endocare competes in an established field of surgical device manufacturers,
and the competition in this field is intense. Many of the Company's competitors
are significantly larger than the Company and have greater financial, technical,
research, marketing, sales, distribution and other resources than the Company.
Additionally, the Company believes there will be intense price competition for
products developed in the Company's market. There can be no assurance that the
Company's competitors will not succeed in developing or marketing technologies
and products that are more effective or commercially attractive than any that
are being developed or marketed by the Company, or that such competitors will
not succeed in obtaining regulatory approval, introducing or commercializing any
such products prior to the Company. Such developments could have a material
adverse effect on the Company's business, financial condition and results of
operations. Further, there can be no assurance that, even if the Company is able
to successfully compete, that it would do so in a profitable manner.

RAPID TECHNOLOGICAL AND INDUSTRY CHANGE

The medical device industry generally, and the urological disease treatment
market in particular, are characterized by rapid technological change, changing
customer needs, and frequent new product introductions. The Company's future
success will depend upon its ability to develop and introduce new products that
address the increasingly sophisticated needs of its customers. There can be no
assurance that the Company will be successful in developing and marketing new
products that achieve market acceptance or that the Company will not experience
difficulties that could delay or prevent the successful development,
introduction and marketing of new products. Further, there can be no assurance
that the Company's competitors will not succeed in developing or marketing
technologies and products, including drug-based treatments, that are more
effective or commercially attractive than any that are being developed by the
Company, or that such competitors will not succeed in obtaining regulatory
approval for introducing or commercializing any such products prior to the
Company. There can be no assurance that the Company's products will not be
rendered obsolete as a result of future innovations. Moreover, there can be no
assurance that the Company will correctly anticipate trends of technology that
the market prefers or that, even if it correctly anticipates such trends, that
it will achieve market acceptance of its products and meet market demand for its
products in a timely fashion.

LIMITED SALES AND MARKETING EXPERIENCE

The Company has only limited experience marketing and selling its products,
and does not have experience marketing and selling its products in commercial
quantities. The Company believes that to become and remain competitive, it will
need to develop third party distribution channels and/or create a substantial
direct sales force with technical expertise. Establishing marketing and sales
capabilities sufficient to support sales in commercial quantities will require
significant resources, and there can be no assurance that the Company will be
able to recruit and retain direct sales personnel, or that the Company will
succeed in establishing and maintaining any third party distribution channels,
or that the Company's future sales and marketing efforts will succeed at all.

LIMITED MANUFACTURING EXPERIENCE

12
<PAGE> 16

than one vendor. However, certain components and processes are currently
available from or performed by a single vendor. The ability of third party
manufacturing sources to deliver components or finished goods will affect the
Company's ability to commercialize its products, and the Company's dependence on
third party sources may adversely effect the Company's profit margins. Further,
the qualification of additional or replacement vendors for certain components or
services could be a lengthy process. Any supply interruption from a single
source vendor would have a material adverse effect on the Company's ability to
manufacture its products until a new source of supply was qualified and, as a
result, could have a material adverse effect on the Company's business,
financial condition and results of operations. In particular, in August 1995,
one of the Company's sole source vendors delayed its delivery of components to
the Company, and thereby caused the Company to delay the introduction of one of
its products.

Additionally, the Company's success will depend in part upon its ability to
manufacture its products in compliance with the FDA's Good Manufacturing
Practices ("GMP") regulations and other regulatory requirements, in sufficient
quantities and on a timely basis, while maintaining product quality and
acceptable manufacturing costs. Failure to increase production volumes in a
timely or cost effective manner or to maintain compliance with GMP or other
regulatory requirements could have a material adverse effect on the Company's
business, financial condition and results of operations. In particular, the
Company's recent relocation will require certification of its new facility as a
GMP facility. Any failure to obtain or delay in obtaining such certification
would have a material adverse effect on the Company's ability to manufacture its
products. Such a failure would have a material adverse effect on the Company's
business, financial condition and results of operations.

Further, the Company has limited experience in producing its products in
commercial quantities. Manufacturers often encounter difficulties in scaling up
production of new products, including problems involving production yields,
quality control and assurance, component supply and shortages of qualified
personnel. The Company's failure to overcome these manufacturing problems could
materially adversely affect the Company's business, financial condition and
results of operations.

DEPENDENCE UPON KEY PERSONNEL

The Company's future success depends to a significant degree upon the
continued service of key technical and senior management personnel, none of whom
is bound by an employment agreement or covered by an insurance policy of which
the Company is the beneficiary. The Company's future success also depends on its
continuing ability to attract, retain and motivate highly qualified technical,
managerial and sales personnel. Competition for such personnel is intense, and
there can be no assurance that the Company will be able to retain its existing
employees or attract, retain and motivate highly qualified personnel in the
future. If the Company is unable to hire the necessary personnel, its ability to
develop, market, manufacture and sell the Company's products could be impaired.
Such impairment could have a material adverse effect upon the Company's
business, financial condition and results of operations.

STRICT GOVERNMENT REGULATION; DIFFICULT AND LENGTHY REGULATORY APPROVAL PROCESS

Governmental regulations in the United States and other countries are a
significant factor affecting the research and development, manufacture and
marketing of the Company's products. In the United States, the U.S. Food and
Drug Administration ("FDA") has broad authority under the Federal Food, Drug and
Cosmetic Act and the Public Health Service Act to regulate the distribution,
manufacture and sale of medical devices. Foreign sales of drugs and medical
devices are subject to foreign governmental regulation and restrictions which
vary from country to country.

13
<PAGE> 17

subsequent to approving the use of lasers as in the Company's Prolase products,
deemed such use "experimental" for a particular procedure, which dramatically
decreased sales of the Company's Prolase products. There can be no assurance
that any such position by the FDA, or change of position by the FDA, would not
adversely impact the Company's business, financial condition or results of
operations. See "Business -- Government Regulation."

Regulatory approvals, if granted, may include significant limitations on
the indicated uses for which the Company's products may be marketed. In
addition, to obtain such approvals, the FDA and foreign regulatory authorities
may impose numerous other requirements on the Company. FDA enforcement policy
strictly prohibits the marketing of approved medical devices for unapproved
uses. In addition, product approvals can be withdrawn for failure to comply with
regulatory standards or the occurrence of unforseen problems following initial
marketing. There can be no assurance that the Company will be able to obtain
regulatory approvals for its products on a timely basis or at all, and delays in
receipt of or failure to receive such approvals, the loss of previously obtained
approvals, or failure to comply with existing or future regulatory requirements
would have a material adverse effect on the Company's business, financial
condition and results of operations.

UNCERTAINTY RELATING TO THIRD PARTY REIMBURSEMENT

In the United States, health care providers, such as hospitals and
physicians, that purchased medical devices such as the Company's products,
generally rely on third party payors, principally federal Medicare, state
Medicaid and private health insurance plans, to reimburse all or part of the
cost of medical procedures involving the Company's products. Reimbursement for
such procedures using devices that have received FDA approval has generally been
available in the United States. The Company anticipates that in a prospective
payment system, such as the DRG system utilized by Medicare, and in many managed
care systems used by private health care payors, the cost of the Company's
products will be incorporated into the overall cost of the procedure and that
there will be no separate, additional reimbursement for the Company's products.
The Company anticipates that hospital administrators and physicians will justify
the additional cost of the Company's products by the attendant cost savings and
clinical benefits derived from the use of the Company's products.

Separate reimbursement for the Company's products is not expected to be
available in the United States and there can be no assurance that reimbursement
for the Company's products will be available in international markets under
either governmental or private reimbursement systems. Furthermore, the Company
could be adversely affected by changes in reimbursement policies of governmental
or private health care payors, particularly to the extent any such changes
affect reimbursement for procedures in which the Company's products are used.
Failure by physicians, hospitals and other users of the Company's products to
obtain sufficient reimbursement from health care payors for procedures involving
the Company's products, or adverse changes in governmental and private third
party payors' policies toward reimbursement for such procedures, could have a
material adverse effect on the Company's business, financial condition and
results of operations.

PRODUCT LIABILITY AND RECALL RISKS; LIMITED INSURANCE COVERAGE

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

14
<PAGE> 18

UNCERTAINTY RELATED TO HEALTH CARE REFORM

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

INSUFFICIENT PROPRIETARY INFORMATION PROTECTIONS; RISK OF INFRINGEMENT OF
OTHERS' RIGHTS

Endocare's success will depend in part on its ability to secure and protect
intellectual property rights relating to its technology. While Endocare believes
that the protection of patents or licenses is important to its business, it also
relies on trade secrets, know-how and continuing technological innovation to
maintain its competitive position. No assurance can be given that Endocare's
patent applications will be approved, that Endocare will develop any additional
proprietary products that are patentable and/or that any issued patents will
provide Endocare with a competitive edge or will not be challenged by any third
parties.

The Company seeks to preserve the confidentiality of its technology by
entering into confidentiality agreements with its employees, consultants,
customers, and key vendors and by other means. No assurance can be given,
however, that these measures will prevent the unauthorized disclosure or use of
such technology.

No assurance can be given that Endocare's processes or products will not
infringe patents or proprietary rights of others or that any license required
would be made available under any such patents or proprietary rights, on terms
acceptable to Endocare or at all. From time to time, the Company has received
correspondence alleging infringement of proprietary rights of third parties. No
assurance can be given that any relevant claims of third parties would not be
upheld as valid and enforceable, and therefore that the Company could be
prevented from practicing the subject matter claimed or would be required to
obtain licenses from the owners of any such proprietary rights to avoid
infringement.

UNCERTAINTY OF TAX CONSEQUENCES

As a condition to the completion of the Distribution, Medstone and the
Company will receive an opinion from Wilson Sonsini Goodrich & Rosati, P.C.,
special tax counsel, to the effect that Medstone and the Company have a
reasonable basis for the position that the Distribution will qualify as a
tax-free spinoff under Section 355 of the Internal Revenue Code. This tax
opinion is offered in reliance on a number of assumptions, covenants and
representations made by Medstone, the Company and certain Medstone stockholders,
including the following: (a) following the Distribution, the holders of Medstone
common stock must maintain a substantial continuing ownership interest in the
Endocare capital stock they receive in the Distribution; and (b) the Company
must continue its historic research business including the provision of research
and development services on behalf of Medstone. These assumptions,
representations and covenants are critical to the Distribution qualifying as a
tax-free spinoff under Section 355 of the Internal Revenue Code. If any of the
representations or covenants are breached or any of the assumptions are
incorrect, then the factual foundation of the tax opinion would be flawed and it
may not be relied upon.

Further, as reflected in the tax opinion, the applicability of Section 355
to the Distribution is complex and may be subject to differing interpretations.
In particular, the Service may challenge the tax-free status of the Distribution
on the grounds that it lacks an adequate "business purpose" or that the active
business requirement of Section 355(b) of the Code (which requires the
continuation after the Distribution of a business conducted for at least five
years prior to the Distribution) is not satisfied. Accordingly, even if the
representations and the covenants are not breached, there can be no assurance
that the Internal Revenue Service will not successfully challenge the
applicability of Section 355 to the Distribution, or assert that the
Distribution fails the requirements of Section 355 on the basis of facts either
existing at the time of the Distribution or which may arise after the
Distribution Date.

15
<PAGE> 19

Neither Medstone nor the Company has undertaken any obligation to refrain
from any act that may be inconsistent with the Distribution qualifying as a
tax-free distribution under Section 355 or to indemnify each other or Medstone
stockholders for any tax liability (including interest or penalties) arising out
of an act causing the Distribution to fail to so qualify. See "Certain Federal
Income Tax Consequences of the Distribution."

ABSENCE OF PUBLIC MARKET; POSSIBLE ILLIQUIDITY OF TRADING MARKET; POSSIBLE
VOLATILITY OF STOCK PRICE

There has been no previous trading market for Endocare Common Stock and
there can be no assurance that a public market for the Common Stock will develop
or be sustained after the Distribution. The Company does not expect to qualify
for listing of its Common Stock on the Nasdaq Small Cap Market upon completion
of the Distribution. Trading, if any, in the Company's Common Stock will be
conducted in the over-the-counter market on an electronic bulletin board or in
what are commonly referred to as the "pink sheets." Such trading may cause the
Common Stock to be significantly less liquid than Common Stock or other
securities listed on the Nasdaq National Market or the Nasdaq Small Cap Market.
Moreover, if the Company should continue to experience losses from operations,
it may be unable to achieve the standards for quotation on the Nasdaq Small Cap
Market. As a result, an investor would find it more difficult to dispose of, or
to obtain accurate quotations as to the price of, the Company's securities. In
addition, the Company's securities may be subjected to so-called "penny stock"
rules that impose additional sales practice and market making requirements on
broker-dealers who sell and/or make a market in such securities. This could
affect the ability or willingness of broker-dealers to sell and/or make a market
in the Company's securities and the ability of holders of the Company's
securities to sell their securities in the secondary market.

There can be no assurance regarding the price at which the Endocare Common
Stock will trade before or after the Distribution Date. The market prices for
securities of emerging companies have historically been highly volatile. Future
announcements concerning Endocare or its competitors, including the Company's
operating results, technological innovations or new commercial products,
government regulations, developments concerning proprietary rights, litigation
or public concern as to safety of Endocare's products, as well as investor
perception of the Company and industry and general economic and market
conditions, may have a significant impact on the market price of Endocare's
Common Stock. In addition, the stock market is subject to price and volume
fluctuations that affect the market prices for companies in general and small
capitalization, high technology companies in particular, and are often unrelated
to their operating performance.

ANTI-TAKEOVER EFFECT OF CERTAIN CHARTER AND BYLAW PROVISIONS; POSSIBLE NEGATIVE
EFFECT ON STOCK PRICE

Certain provisions of the Company's Certificate of Incorporation and the
Bylaws may have the effect of making it more difficult for a third party to
acquire, or of discouraging a third party from attempting to acquire, control of
the Company. Such provisions could limit the price that certain investors might
be willing to pay in the future for shares of the Company's Common Stock. For
example, certain of these provisions allow the Company to issue Preferred Stock
without any vote or further action by the stockholders, eliminate the ability of
stockholders to act by written consent without a meeting and eliminate
cumulative voting in the election of directors. These provisions may make it
more difficult for stockholders to take certain corporate actions and may have
the effect of delaying or preventing a change in control of the Company.

16
<PAGE> 20

CAPITALIZATION

The following table sets forth the capitalization of the Endocare division
of Medstone, Endocare's predecessor, at September 30, 1995, the principal
financial adjustments that will result from the Distribution and the proforma
capitalization of Endocare after giving effect to the Distribution. Endocare has
historically operated as a division of Medstone. The Distribution will result in
the receipt by record holders of Medstone Common Stock of 5,516,528 shares of
Endocare's outstanding Common Stock. Additionally, Medstone will transfer to
Endocare the capital equipment and other assets related to the research and
development of urological products previously used by the Endocare division of
Medstone, and will invest $500,000 in cash in Endocare. The proforma information
may not reflect the capitalization of Endocare had Endocare been a stand-alone
Company as of September 30, 1995. This data should be read in conjunction with
the historical and proforma financial statements and the related notes thereto
included elsewhere herein.

<TABLE>
<CAPTION>
ACTUAL ADJUSTMENTS(1) PROFORMA
----------- -------------- ----------
<S> <C> <C> <C>
Division/Stockholders' equity (deficit):
Advances from Medstone............................ $ 2,579,912 $ (2,579,912) $ --
Preferred stock, $.001 par value, 1,000,000 shares
authorized; none issued or outstanding......... -- -- --
Common Stock, $.001 par value, 20,000,000 shares
authorized; no shares issued and outstanding at
September 30, 1995, 5,616,528 outstanding
proforma(2).................................... -- 5,617 5,617
Additional paid-in capital........................ -- 1,240,745 1,240,745
Accumulated deficit............................... (1,833,550) 1,833,550 --
----------- ----------- ----------
Total division/stockholders' equity
(deficit).................................... 746,362 500,000 1,246,362
----------- ----------- ----------
Total capitalization...................... $ 746,362 $ 500,000 $1,246,362
=========== =========== ==========
</TABLE>

- ---------------
(1) This proforma adjustment, which assumes that the Distribution occurred as of
September 30, 1995, reflects the forgiveness of intercompany debt resulting
from the funding of operations between Medstone and Endocare and the initial
capitalization of Endocare in the amount of $1,246,362, consisting of
Medstone's contribution of $500,000 cash and $746,362 of other assets at
September 30, 1995.

(2) The Company has granted options to purchase 960,000 shares of Endocare
Common Stock pursuant to its 1995 Stock Plan. The Company has an additional
640,000 shares reserved for issuance under its various stock plans. See
"Executive Compensation -- Stock Plan" and "Management -- Compensation of
Directors."

DIVIDEND POLICY

The Company presently intends to retain earnings for use in its business
and does not anticipate paying cash dividends in the foreseeable future.

17
<PAGE> 21

SELECTED FINANCIAL DATA

The following selected financial data of the Endocare division of Medstone,
Endocare's predecessor, reflects Endocare's historical operation as a division
of Medstone and should be read in conjunction with the Company's historical
financial statements and proforma financial information and respective notes
thereto included elsewhere in this Information Statement and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
following this section. The financial data as of December 31, 1993 and 1994, and
for each of the years in the three-year period ended December 31, 1994 have been
derived from the audited financial statements of the Company, included elsewhere
herein. The financial data for all other periods and dates have been derived
from unaudited financial statements of the Company. In the opinion of
management, such unaudited financial statements reflect all adjustments
(consisting only of normal recurring adjustments) necessary for a fair
presentation. Such information at and for the nine month period ended September
30, 1995 should not be taken as indicative of the future results of operations
or the future financial position of the Company as a stand-alone entity after
the Distribution.

The Distribution will result in the receipt by record holders of Medstone
Common Stock of 5,516,528 shares of Endocare's outstanding Common Stock.
Additionally, Medstone will transfer to Endocare the capital equipment and other
assets related to the research and development of urological products previously
used by the Endocare division of Medstone, and will invest $500,000 in cash in
Endocare.

<TABLE>
<CAPTION>
NINE MONTHS
YEARS ENDED DECEMBER 31, ENDED SEPTEMBER 30,
-------------------------------------------- ------------------------
1990 1991 1992 1993 1994 1994 1995
------ ---- ------ ------ ------ ------ -------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
Net product sales............... $ -- $ -- $ -- $2,697 $2,283 $1,878 $ 749
Research revenues............... 1,483 678 581 480 379 329 215
------- ---- ------ ------ ------ ------ ------
Total revenues.......... 1,483 678 581 3,177 2,662 2,207 964
Costs and expenses:
Cost of sales................... -- -- 8 630 638 546 260
Research and development........ 1,483 678 1,163 1,061 911 770 619
Selling, general and
administrative............... -- -- 84 2,000 1,376 1,143 467
------- ---- ------ ------ ------ ------ ------
Total costs and
expenses.............. 1,483 678 1,255 3,691 2,925 2,459 1,346
------- ---- ------ ------ ------ ------ ------
Loss from operations.............. -- -- (674) (514) (263) (252) (382)
Income tax expense................ -- -- -- -- -- -- --
------- ---- ------ ------ ------ ------ ------
Net loss.......................... $ -- $ -- $ (674) $ (514) $ (263) $ (252) $ (382)
======= ==== ====== ====== ====== ====== ======
Proforma net loss per share(1).... $ -- $(0.05) $ (.07)
====== ======
Proforma weighted average shares
outstanding(1)(2)............... 5,617 5,617
</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------------------------- SEPTEMBER 30,
1990 1991 1992 1993 1994 1995
------ ---- ------ ------ ------ -------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital................... $ -- $ -- $ 35 $ 236 $ 295 $ 295
Total assets...................... -- -- 133 1,041 972 799
Total division equity............. -- -- 118 867 864 746
</TABLE>

- ---------------
(1) Proforma net loss per share and proforma weighted average shares outstanding
have been computed based on the assumption that 5,616,528 shares of the
Endocare Common Stock were issued and outstanding during the nine months
ended September 30, 1995 and the year ended December 31, 1994. The 5,616,528
shares represent the number of shares to be issued and outstanding after the
Distribution.

18
<PAGE> 22

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Endocare Division of Medstone International, Inc. is primarily engaged in
the development, manufacture and marketing of devices to treat urological
disease. The Company also performs research and development services. The
Company has historically operated as a division of Medstone. The Company has no
independent operating history of its own and, to date, has not generated a
profit. Revenues to date have come from two primary sources: sales of research
services to Medstone and sales of laser catheters. Sales of the Company's laser
catheters in the first nine months of 1995 fell substantially from sales in
prior years, and the Company does not expect laser catheter sales to be a
significant contributor to its future revenues. Accordingly, there can be no
assurance that the Company will be able to generate sufficient revenue and cash
flow to maintain its operations beyond the $500,000 cash infusion from Medstone.
The Company must introduce new products that achieve sufficient market
acceptance in order to increase its revenue stream. The Company has entered into
an agreement with Medstone whereby the Company will continue to provide research
services after the date of the Distribution, although revenues attributable to
such services are expected to be less than those received in prior years.

RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, certain
financial data as a percentage of total revenues.

<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED DECEMBER ENDED
31, SEPTEMBER 30,
---------------------- -------------
1992 1993 1994 1994 1995
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Revenues:
Net product sales.............................. --% 85% 86% 85% 78%
Research revenues.............................. 100 15 14 15 22
---- --- --- --- ---
Total revenues......................... 100 100 100 100 100
Costs and expenses:
Cost of sales.................................. 1 20 24 25 27
Research and development....................... 200 33 34 35 64
Selling, general and administrative............ 14 63 52 51 49
---- --- --- --- ---
Total costs and expenses............... 215 116 110 111 140
---- --- --- --- ---
Net loss before income taxes..................... (115) (16 ) (10 ) (11 ) (40 )
Income tax expense............................... -- -- -- -- --
---- --- --- --- ---
Net loss......................................... (115)% (16 )% (10 )% (11 )% (40 )%
==== === === === ===
</TABLE>

NINE MONTHS ENDED SEPTEMBER 30, 1995 COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 1994

Revenues in the nine months ended September 30, 1995 decreased by
$1,224,000, or 55%, from the comparable period of the prior year due to a marked
decrease in the volume of laser catheters shipped during 1995. Competition from
lower cost products incorporating new technology caused a 52% reduction in unit
volume and also resulted in a decline in average selling prices. Research
billings also declined by $113,812 or 35%, as Medstone continued to refine its
approach to research.

Cost of sales decreased to $260,154 in the first nine months ended
September 30, 1995 compared to $545,841 for the first nine months of 1994, or a
52% reduction. This decrease is due to the lower unit volume of the Prolase II
product, and a reduced overhead base as the Company adjusted headcounts to
reflect a lower

19
<PAGE> 23

production level. As a percentage of net sales, cost of sales increased from 29%
in the 1994 period to 35% in the 1995 period due to lower unit prices and
volume.

Research and development costs declined by $149,989 or 19%, in the nine
months ended September 30, 1995 compared to the same period in 1994 due to the
decrease in the Company's research effort at Medstone's request as the Company
increased its efforts in developing new urological products for future
introduction.

Sales and marketing costs decreased by $501,537, or 69%, as the Company
recognized lower commission expenses due to both lower unit volume and a higher
percentage of direct, non-commissionable sales. General and administrative
expenses for the first nine months of 1995 decreased by $174,647 or 42%,
compared to the first nine months of 1994 as the Company reduced its expenses to
levels expected to fit with expected revenue levels.

YEAR ENDED DECEMBER 31, 1994 COMPARED TO YEAR ENDED DECEMBER 31, 1993

Revenues in 1994 decreased by $515,011 or 16%, from 1993. Product sales
decreased by $414,618, or 15%, due to increased competition in the marketplace
causing downward unit price pressure.

Cost of sales remained essentially unchanged from year to year, but
increased from 23% of net sales in 1993 to 28% of net sales in 1994. The change
in cost of sales as a percentage of net sales was due to the decrease in net
sales mentioned above, as overall costs were substantially the same in each year
due to the overhead structure built to manufacture a higher number of units than
were produced in 1994. The Company reduced its overhead structure in the second
half of 1994 to lower costs to produce the Company's products.

The decrease in research and development costs of $149,697, or 14%,
resulted from the reduction in efforts of the research team as the Company was
directed to refine the efforts on improvements for Medstone products.

Sales and marketing expenses decreased by $554,327, or 40%, in 1994
compared to the same period in the prior year due to the 1993 introduction of
the Prolase II laser catheter and the associated expenses of advertising,
product brochures and direct mailings. Commission expenses also declined due to
the lower net sales. General and administrative expenses decreased by $70,530,
or 12%, in 1994 compared to the same period in the prior year due to reductions
in consulting expenses for regulatory issues.

The operating loss in 1994 declined by 49% compared to 1993 due to the
reduced expense levels for all operating expenses as the Company refined its
sales and management efforts to best reflect the Company's operations.

LIQUIDITY AND CAPITAL RESOURCES

All the Company's operations have been financed to date by Medstone through
research revenues and intercompany advances. At September 30, 1995 the Company
had an accumulated deficit of $1,833,550 since its inception and has never been
profitable. In connection with the Distribution, Medstone will make a cash
contribution of $500,000 to the Company. Upon completion of the Distribution,
the Company will no longer be able to rely on Medstone and will need to obtain
independent sources of financing. The Company's future liquidity and capital
requirements will depend upon numerous factors, including the progress of the
Company's clinical trials, actions relating to regulatory and reimbursement
matters, the cost and timing of expansion of its marketing, sales, manufacturing
and product development activities, the extent to which the Company's products
gain market acceptance, and competitive developments. The Company believes that
additional financing may be required as early as 1996, and may seek such
financing through public or private debt or equity offerings or from corporate
partners who may acquire a significant equity interest in Endocare. Future
equity financings may result in dilution to the holders of the Company's Common
Stock. Endocare's ability to obtain such financing will depend on its results of
operations, financial condition and business prospects, as well as market
conditions. The existence of the Intercompany Agreements may also have a
material adverse effect on the Company's ability to obtain financing. There can
be no assurance that any financing will be available on acceptable terms, either
from public or private sources, and there can be no assurance that the Company
will successfully operate independently of Medstone.

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BUSINESS

MARKET BACKGROUND

DISEASES

Nearly half of the disorders treated by urologists are categorized as
prostate disease. The two most prevalent prostate diseases are an enlarged
prostate and prostate cancer. Enlargement of the prostate, commonly called
benign prostatic hyperplasia ("BPH") is a non-cancerous enlargement of the
innermost part of the prostate. BPH frequently results in a gradual squeezing of
the urethra, which runs through the prostate, resulting in symptoms of
obstructed outflow of urine from the bladder. A majority of males will
eventually suffer from enlargement of the prostate, an affliction that
progresses with age. Worldwide estimates of men displaying symptoms of BPH
approach 19 million, according to American Health Consultants, with 2.3 million
of these cases classified as severe.

Prostate cancer is a malignant tumor that begins most often in the outer
part of the prostate and, like other cancers, can be spread beyond the prostate
to other parts of the body. Prostate cancer is the most common cancer in men. In
the United States it is estimated that more than 200,000 men will be diagnosed
with prostate cancer in 1995, making it more prevalent than breast cancer in
women. With prompt treatment, the long-term outlook for men with localized,
early stage prostate cancer is favorable.

TREATMENTS

Treatments for BPH include surgical procedures such as transurethral
resection of the prostate ("TURP") and visual laser ablation of the prostate
("VLAP"), alternative therapies and drug therapy. The most common surgical
procedure, TURP, involves the removal of the prostate's innermost core in order
to reduce pressure on the urethra that is being pinched by the enlarged
surrounding prostate. TURP is performed by introducing an electrosurgical
cutting loop through the urethra and chipping out tissue until the obstruction
has been removed. VLAP and other alternative surgical procedures have been
developed in an attempt to find a less invasive procedure to relieve BPH. Common
to all these alternative procedures is the desire for a therapy that removes the
obstruction as effectively as a cutting loop but with substantially less
bleeding and on an outpatient, minimally invasive basis. Approximately one
million surgical procedures are performed worldwide each year to treat BPH,
approximately 400,000 in the United States.

Primary treatments for prostate cancer include radical prostatectomy, the
complete removal of the prostate, and hormonal therapy. Removal of the prostate
involves a major surgical procedure which has associated risks of morbidity and
long recovery time. In addition, post-operative problems include incontinence
and impotence. Hormonal therapies include drugs to prevent the release or
counter the action of male hormones or surgical removal of the testicles that
produce the male hormone. An alternative procedure to treat prostate cancer that
is in early stages of clinical trials involves cryosurgical destruction of the
prostate. In this procedure, cryogenic probes are placed through small access
ports to freeze the cancerous tissue. Early clinical trials suggest that
cryosurgical procedures can reduce the risks and post-operative problems
associated with radical surgery.

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<PAGE> 25

PRODUCTS

Endocare has developed and is continuing to develop a family of surgical
tools designed to treat diseases of the prostate. The first product introduced
by Endocare to the marketplace was its Prolase Side Firing Laser Catheter. The
Prolase I and Prolase II, first and second generation laser catheters, enable
urologists to treat tissue in a manner that involves substantially less bleeding
than traditional TURP surgical procedures. The Company has also introduced its
DioLase system, a 60 watt diode laser system used with the Prolase laser
catheter.

The Company has recently introduced two new devices for electrosurgical
procedures. The VaporBar(TM), a vaporizing roller bar, is used to remove large
volumes of tissue, and the UroLoop(TM) is an electrosurgical cutting loop that
resects and cauterizes tissue simultaneously. Each of these devices is designed
to be an improvement on current TURP procedures by substantially reducing the
bleeding associated with traditional TURP procedures, as such bleeding leads to
many of the complications associated with TURP.

Endocare's CryoCare system was introduced in early 1995 and is under
clinical investigation as a less invasive treatment for prostate cancer. Using
cryogenic probes positioned in the area intended for treatment from outside the
body using ultrasound guidance, the Cryocare system is designed to enable
destruction and removal of tumors through rapid freezing.

The Company has received 510(k) approval to market each of its principal
products. However, the Company is currently engaged in clinical trials with
respect to its ElectroLase(TM), an integrated laser and electrosurgery device
which enables the urologist to make use of both laser and electrosurgery tools
without changing the surgical device, and CryoCare products in order to obtain
additional information from clinicians regarding the use of the products. See
"Risk Factors -- Declining Sales of Existing Products; Uncertain Market
Acceptance of New Products."

SALES AND MARKETING

The Company sells its products domestically and internationally primarily
through distributors managed by two employees. In the United States, the
Company's products are sold through a network of stocking distributors and one
sales representative. The Company also markets its products in foreign countries
through independent distributors. International sales represented approximately
16% and 38% of the Company's revenues in 1994 and the first nine months of 1995,
respectively. Two of the Company's distributors, one in Korea and one in the
U.S., accounted for 13% and 16%, respectively, of the Company's revenues during
the first nine months of 1995. No customer accounted for more than 10% of the
Company's total revenue in 1994.

The Company's distributor agreements typically provide the distributor with
exclusive selling rights as to certain products in a particular territory, and
are terminable by either party on 180 days notice. Each party bears its own
expenses in performing under the agreement.

The Company's ability to distribute its products depends substantially on
the capabilities of its distributors. There can be no assurance that the Company
will be able to maintain or expand its relationships with its distributors or to
replace a distributor in the event any such relationship were terminated. In the
event that the Company's relationships with any of its distributors were
terminated and the Company were unable to replace the distribution capability,
the Company's ability to distribute its products would be materially adversely
affected, which would have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, in such event, the
Company's current sales and marketing personnel and financial resources would
not be sufficient to enable the Company to establish its own distribution
capability to market and sell its products.

RESEARCH AND DEVELOPMENT

The Company's research and development activities are performed internally
by its five person research and development staff. Current research and
development efforts are focusing on expanding the product lines to complement
the Company's existing products to treat urological diseases.

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<PAGE> 26

Research and development expenses for fiscal 1993 and 1994 and for the nine
months ended September 30, 1995 were $1,061,000, $911,000 and $619,000,
respectively.

MANUFACTURING

The Company uses a combination of internal manufacturing capacity and third
party manufacturers in its manufacturing efforts. Most of the Company's
purchased components and processes are available from more than one vendor.
However, certain components and processes are currently available from or
performed by a single vendor. The ability of third party manufacturing sources
to deliver components or finished goods will affect the Company's ability to
commercialize its products, and the Company's dependence on third party sources
may adversely affect the Company's profit margins. Further, although the Company
is in the process of identifying alternative vendors, the qualification of
additional or replacement vendors for certain components or services could be a
lengthy process. Any supply interruption from a single source vendor would have
a material adverse effect on the Company's ability to manufacture its products
until a new source of supply was qualified and, as a result, could have a
material adverse effect on the Company's business, financial condition and
results of operations. In particular, in August 1995, one of the Company's sole
source vendors delayed its delivery of components to the Company and thereby
caused the Company to delay the introduction of one of its products.

Additionally, the Company's success will depend in part upon its ability to
manufacture its products in compliance with the FDA's Good Manufacturing
Practices ("GMP") regulations and other regulatory requirements, in sufficient
quantities and on a timely basis, while maintaining product quality and
acceptable manufacturing costs. Failure to increase production volumes in a
timely or cost effective manner or to maintain compliance with GMP or other
regulatory requirements could have a material adverse effect on the Company's
business, financial condition and results of operations. In particular, the
Company's recent relocation will require certification of its new facility as a
GMP facility. Although application has been made for such certification, any
failure to obtain or delay in obtaining such certification would have a material
adverse effect on the Company's ability to manufacture its products. Such a
failure would have a material adverse effect on the Company's business,
financial condition and results of operations. Endocare has also obtained from
the California Department of Health Services a license to manufacture medical
devices and is subject to periodic inspections and other regulation by that
agency.

GOVERNMENT REGULATION

Governmental regulations in the United States and other countries are a
significant factor affecting the research and development, manufacture and
marketing of the Company's products. In the United States, the FDA has broad
authority under the Federal Food, Drug and Cosmetic Act and the Public Health
Service Act to regulate the distribution, manufacture and sale of drugs,
including biologics, and medical devices. Foreign sales of drugs and medical
devices are subject to foreign governmental regulation and restrictions which
vary from country to country.

Medical devices intended for human use in the United States are classified
into three categories, depending upon the degree of regulatory control to which
they will be subject. Such devices are classified by regulation into either
class I (general controls), class II (performance standards) or class III
(pre-market approval) depending upon the level of regulatory control required to
provide reasonable assurance of the safety and effectiveness of the device. Good
Manufacturing Practices, labeling, maintenance of records and filings with the
FDA continue to be applicable.

A subset of medical devices categorized as class I or II devices that were
commercially distributed before March 28, 1976 or are substantially equivalent
to a device that was in commercial distribution before that date

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<PAGE> 27

may be marketed after the acceptance of the pre-market notification under a
510(k) exemption. The 510(k) section of the Federal Food, Drug and Cosmetic Act
allows an exemption from the requirement of pre-market notification. Generally,
devices that have an existing history or track record are included in this
category.

The process of obtaining FDA and other required regulatory approvals is
lengthy and expensive. There can be no assurance that Endocare will be able to
obtain necessary approvals for clinical testing or for manufacturing or
marketing of its products. Failure to comply with applicable regulatory
approvals can, among other things, result in fines, suspensions of regulatory
approvals, product recalls, operating restrictions and criminal prosecution. In
addition, governmental regulation may be established which could prevent, delay,
modify or rescind regulatory approval of Endocare's products. For example, in
January 1993, the FDA, subsequent to approving the use of lasers as in the
Company's Prolase products, deemed such use "experimental" for a particular
procedure, which dramatically decreased sales of the Company's Prolase products.
Although such designation was later rescinded by the FDA, there can be no
assurance that any such position by the FDA, or change of position by the FDA,
would not adversely impact the Company's business, financial condition or
results of operations.

COMPETITION

Currently, the Company markets products in the following categories:
side-firing laser fibers, high power diode lasers, electrosurgical disposables
and cryosurgical systems. Significant competitors include Bard and ACMI/Circon.

Many of the Company's competitors discussed above are significantly larger
than the Company and have greater financial, technical, research, marketing,
sales, distribution and other resources than the Company. Additionally, the
Company believes there will be intense price competition for products developed
in the Company's market. There can be no assurance that the Company's
competitors will not succeed in developing or marketing technologies and
products that are more effective or commercially attractive than any that are
being developed or marketed by the Company, or that such competitors will not
succeed in obtaining regulatory approval, introducing or commercializing any
such products prior to the Company. Such developments could have a material
adverse effect on the Company's business, financial condition and results of
operations. Further, there can be no assurance that, even if the Company is able
successfully compete, that it would do so in a profitable manner.

INTELLECTUAL PROPERTY

The Company's policy is to secure and protect intellectual property rights
relating to its technology. While Endocare believes that the protection of
patents and licenses is important to its business, it also relies on trade
secrets, know-how and continuing technological innovation to maintain its
competitive position. The Company has received patents for the Prolase line of
side-firing laser fibers. Certain patents or copyrights for some of the new
products described under "Products" have been filed or are in the process of
being filed.

The Company seeks to preserve the confidentiality of its technology by
entering into confidentiality agreements with its employees, consultants,
customers and key vendors and by other means. No assurance can be given,
however, that these measures will prevent the unauthorized disclosure or use of
such technology.

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<PAGE> 28

No assurance can be given that Endocare's processes or products will not
infringe patents or proprietary rights of others or that any license required
would be made available under any such patents or proprietary rights, on terms
acceptable to Endocare or at all. From time to time, the Company has received
correspondence alleging infringement of proprietary rights of third parties.
Although the Company believes such correspondence is common in its industry, no
assurance can be given that any relevant claims of third parties would not be
upheld as valid and enforceable, and therefore that the Company could be
prevented from practicing the subject matter claimed or would be required to
obtain licenses from the owners of any such proprietary rights to avoid
infringement.

FACILITIES

The Company currently occupies 3,400 square feet of office, manufacturing,
engineering, warehouse space, and research and development laboratories in
Irvine, California. The property is leased from the Irvine Company, Irvine,
California for a term of twelve months.

EMPLOYEES

As of August 1, 1995, Endocare had a total of 11 employees, (9 full-time, 2
part time). Of the 11 employees, 5 are engaged directly in research and
development activities, 3 are engaged in manufacturing, 2 are engaged in sales
and marketing and 1 is employed in general and administrative positions.

Although Endocare conducts most of its research and development using its
own employees, the Company has funded, and plans to continue to fund, research
using consultants. Consultants provide services under written agreements and are
paid based on the amount of time spent on Company matters. Under their
consulting agreements, Endocare's consultants are required to disclose and
assign to the Company any ideas, discoveries and inventions developed by them in
the course of providing consulting services.

LEGAL PROCEEDINGS

The Company is not a party to any material litigation.

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<PAGE> 29

MANAGEMENT

DIRECTORS AND OFFICERS

The directors and executive officers of the Company are:

<TABLE>
<CAPTION>
NAME AGE POSITION
- ------------------------ --- -----------------------------------------------------------------------
<S> <C> <C>
Paul W. Mikus........... 30 President, Chief Executive Officer, Chief Financial Officer, Treasurer
and Chairman of the Board
Jacqueline Hibbs........ 38 Vice President, Sales and Marketing
Ralph Brady............. 38 Vice President, Product Development
Kevin Marinelli......... 31 Director
Peter Bernardoni........ 36 Director
</TABLE>

Mr. Mikus was employed by Medstone in various positions from 1989 through
September 1994, serving most recently as Manager of Engineering Development.
From September 1994 through June 1995, he served as director of the sales and
marketing organization for Prosurg Inc. Mr. Mikus rejoined Medstone in June 1995
as President of its Endocare division. Mr. Mikus has a B.S. Degree in Electrical
Engineering.

Ms. Hibbs has been with Medstone for the past six years. As Manager of
Marketing for the past four years, Ms. Hibbs has been responsible for all
marketing related aspects of Medstone's business. She joined Endocare in August
1995. Ms. Hibbs has a Bachelor's Degree in Business and Marketing.

Mr. Brady has been with Medstone for the past seven years. He has held
various positions during that time, most recently as design engineer. Mr. Brady
joined Endocare in August 1995. Mr. Brady has over ten years of experience in
medical device design.

Mr. Marinelli is the Chief Financial Officer of BKM, a privately-held
office furnishings and services Company. Mr. Marinelli is a Certified Management
Accountant. He has a Bachelor's Degree in Accountancy.

Mr. Bernardoni is a Partner of Technology Funding. Mr. Bernardoni joined
Technology Funding as an Investment Officer in 1988, was elected a Vice
President in 1992 and a Partner in 1994. He has served as a director of several
private and one public Company, PolyMedica. He currently serves on the boards of
Urogen, Circadian, Reflection Technologies, Adesso Specialty Services, and
Portable Energy Products. Mr. Bernardoni has a B.S.M.E. from Santa Clara
University and an M.S.M.E. from Stanford University.

MEDICAL ADVISORY BOARD

Dr. William Moseley is a practicing urologist in San Diego, California, and
Chief of Staff at Harbor View Medical Center. Dr. Moseley has been a principle
investigator in new prostate therapy devices. Dr. Moseley will be actively
involved in the early stage development of all Endocare research projects.

COMPENSATION OF DIRECTORS

Directors are elected annually. The Company does not compensate its
directors for their services as such. However, directors are reimbursed for
their out of pocket expenses in attending Board meetings and each of the
Company's non-employee directors participates in the 1995 Director Option Plan.

ENDOCARE, INC. 1995 DIRECTOR OPTION PLAN

GENERAL

The 1995 Director Option Plan (the "Director Plan") was adopted by the
Board in October 1995 and approved by the stockholders in November 1995, to
provide automatic, nondiscretionary grants of options to non-employee directors
("Outside Directors") of the Company. A total of 100,000 shares of Common Stock
has been reserved for issuance under the Director Plan.

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<PAGE> 30

The Director Plan provides that each Outside Director is automatically
granted an option to purchase 10,000 shares of Endocare Common Stock upon his or
her initial election or appointment as an Outside Director. Subsequently, each
Outside Director who has served for at least six months will be granted an
additional option to purchase 5,000 shares of Endocare Common Stock on January 1
of each year so long as he or she remains an Outside Director.

The Board may amend the Director Plan at any time, or may terminate it
without approval of the stockholders. However, no such action by the Board may
unilaterally alter or impair any option previously granted under the Director
Plan without the consent of the optionee. Unless terminated sooner by the Board,
the Director Plan will terminate in October 2005.

The exercise price of options granted to Outside Directors must be the fair
market value of Endocare Common Stock on the date of grant. Options granted to
Outside Directors have ten-year terms, subject to an Outside Director's
continued service as a director. Options granted to the Outside Directors vest
over four years at the rate of twenty-five percent per year.

ADJUSTMENT UPON CHANGES IN CAPITALIZATION

In the event any change is made in the Company's capitalization, such as a
stock split or stock dividend, which results in a greater or lesser number of
shares of Endocare Common Stock, appropriate adjustment will be made in the
option price and in the number of shares subject to the options. In the event of
the proposed dissolution or liquidation of the Company, to the extent that an
option has not been previously exercised, it will terminate immediately prior to
the consummation of such proposed action. In the event of the merger or sale of
substantially all of the assets of the Company, all outstanding options will
become fully vested unless the Board determines otherwise.

COMMITTEES OF THE BOARD OF DIRECTORS

The Board of Directors has a Compensation Committee and an Audit Committee,
in each case comprised of Messrs. Marinelli and Bernardoni, the non-employee
directors of Endocare. The Compensation Committee is authorized to determine the
compensation for the executive officers and administration and review the
Company's incentive and director compensation plans. The Compensation Committee
was formed in November 1995. The Audit Committee is authorized to meet with the
independent auditors of the Company to review the annual audit and reports of
various regulatory agencies, among other things. The Audit Committee was formed
in November 1995. There is no nominating committee or any other committee
performing the duties of a nominating committee.

EXECUTIVE COMPENSATION

The Company's Chief Executive Officer, Paul Mikus, will be compensated
$80,000 annually for fiscal 1996, although to date he has not received any
salary from Endocare. He will not receive any other compensation other than
500,000 shares subject to options granted in November 1995. He did not receive
an Endocare option grant, and did not exercise any Endocare options, during the
fiscal year ended December 31, 1994. None of the Company's other executive
officers has an annual salary over $100,000.

STOCK PLAN

ENDOCARE, INC. 1995 STOCK PLAN

GENERAL

The 1995 Stock Plan authorizes the Board of Directors (the "Board"), or one
or more committees which the Board may appoint from among its members (the
"Committee"), to grant options and rights to purchase Common Stock. Options
granted under the 1995 Stock Plan may be either "incentive stock options" as
defined in Section 422 of the Internal Revenue Code of 1986, as amended (the
"Code"), or nonstatutory stock options, as determined by the Board or the
Committee. A total of 1,500,000 shares of Common Stock has been reserved for
issuance under the 1995 Stock Plan.

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<PAGE> 31

As of the Distribution Date, options to purchase a total of 960,000 shares
of the Company's Common Stock have been granted under the 1995 Stock Plan,
including options to purchase 500,000, 100,000 and 100,000 shares granted to
Paul Mikus, Jacqueline Hibbs and Ralph Brady, respectively.

PURPOSE

The general purpose of the 1995 Stock Plan is to attract and retain the
best available personnel for positions of substantial responsibility, to provide
additional incentive to employees, consultants and directors and to promote the
success of the Company's business.

ADMINISTRATION

The 1995 Stock Plan may be administered by the Board or the Committee.
Subject to the other provisions of the 1995 Stock Plan, the Board has the
authority to: (i) interpret the plan and apply its provisions; (ii) prescribe,
amend or rescind rules and regulations relating to the plan; (iii) select the
persons to whom options and rights are to be granted; (iv) determine the number
of shares to be made subject to each option and right; (v) determine whether and
to what extent options and rights are to be granted; (vi) prescribe the terms
and conditions of each option and right (including the exercise price, whether
an option will be classified as an incentive stock option or a nonstatutory
option and the provisions of the stock option or stock purchase agreement to be
entered into between the Company and the grantee); (vii) amend any outstanding
option or right subject to applicable legal restrictions; (viii) authorize any
person to execute, on behalf of the Company, any instrument required to effect
the grant of an option or right; and (ix) take any other actions deemed
necessary or advisable for the administration of the 1995 Stock Plan. All
decisions, interpretations and other actions of the Committee shall be final and
binding on all holders of options or rights and on all persons deriving their
rights therefrom.

ELIGIBILITY

The 1995 Stock Plan provides that options and rights may be granted to the
Company's employees and consultants. Incentive stock options may be granted only
to employees. Any optionee who owns more than 10% of the combined voting power
of all classes of outstanding stock of the Company (a "10% Stockholder") is not
eligible for the grant of an incentive stock option unless the exercise price of
the option is at least 110% of the fair market value of the Common Stock on the
date of grant.

TERMS AND CONDITIONS OF OPTIONS

Each option granted under the 1995 Stock Plan is evidenced by a written
stock option agreement between the optionee and the Company and is subject to
the following terms and conditions:

(a) Exercise Price. The Board or the Committee determines the
exercise price of options to purchase shares of Common Stock at the time
the options are granted. However, excluding options issued to persons who,
at the time of grant, own stock representing 10% of the voting power of all
classes of stock of the Company ("10% Shareholders"), the exercise price
under an incentive stock option must not be less than 100% of the fair
market value of the Common Stock on the date the option is granted, and the
exercise price under a nonstatutory option must not be less than 85% of the
fair market value of the Common Stock on the date the option is granted. If
the Common Stock is listed on any established stock exchange or a Small Cap
Market system, the fair market value shall be the closing sale price for
such stock (or the closing bid if no sales were reported) on the date the
option is granted. If the Common Stock is traded on the over-the-counter
market, the fair market value shall be the mean of the high bid and high
asked prices on the date the option is granted.

(b) Form of Consideration. The means of payment for shares issued
upon exercise of an option is specified in each option agreement and
generally may be made by cash, check, a full-recourse promissory note,
other shares of Common Stock of the Company owned by the optionee, delivery
of an exercise notice together with irrevocable instructions to a broker to
deliver the exercise price to the Company from sale or loan proceeds, or by
a combination thereof.

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<PAGE> 32

(c) Exercise of the Option. Each stock option agreement will specify
the term of the option and the date when the option is to become
exercisable. However, in no event shall an option granted under the 1995
Stock Plan be exercised more than 10 years after the date of grant.
Moreover, in the case of an incentive stock option granted to a 10%
Shareholder, the term of the option shall be for no more than five years
from the date of grant.

(d) Termination of Employment. If an optionee's employment terminates
for any reason (other than death or permanent disability), then all options
held by such optionee under the 1995 Stock Plan expire upon the earlier of
(i) such period of time as is set forth in his or her option agreement (but
not to exceed ninety days after the termination of his or her employment in
the event of an incentive stock option) or (ii) the expiration date of the
option. The optionee may exercise all or part of his or her option at any
time before such expiration to the extent that such option was exercisable
at the time of termination of employment.

(e) Permanent Disability. If an employee is unable to continue
employment with the Company as a result of permanent and total disability
(as defined in the Code), then all options held by such optionee under the
1995 Stock Plan shall expire upon the earlier of (i) 12 months after the
date of termination of the optionee's employment or (ii) the expiration
date of the option. The optionee may exercise all or part of his or her
option at any time before such expiration to the extent that such option
was exercisable at the time of termination of employment.

(f) Death. If an optionee dies while employed by the Company, his or
her option shall expire upon the earlier of (i) 12 months after the
optionee's death or (ii) the expiration date of the option. The executor or
other legal representative or the optionee may exercise all or part of the
optionee's option at any time before such expiration to the extent that
such option was exercisable at the time of death.

(g) Termination of Options. Each stock option agreement will specify
the term of the option and the date when all or any installment of the
option is to become exercisable. Notwithstanding the foregoing, however,
the term of any incentive stock option shall not exceed 10 years from the
date of grant. No options may be exercised by any person after the
expiration of its term.

(h) Nontransferability of Options. During an optionee's lifetime, his
or her option(s) shall be exercisable only by the optionee and shall not be
transferable other than by will or laws of descent and distribution.

(i) Value Limitation. If the aggregate fair market value of all
shares of Common Stock subject to an optionee's incentive stock option
which are exercisable for the first time during any calendar year exceeds
$100,000, the excess options shall be treated as nonstatutory options.

(j) Other Provisions. The stock option agreement may contain such
terms, provisions and conditions not inconsistent with the 1995 Stock Plan
as may be determined by the Board or Committee.

STOCK PURCHASE RIGHTS

The 1995 Stock Plan permits the Company to grant rights to purchase Common
Stock either alone or in tandem with other awards granted under the 1995 Stock
Plan and/or cash awards made outside of the 1995 Stock Plan. The offer of a
right must be accepted within six months of its grant by the execution of a
restricted stock purchase agreement between the Company and the offeree and the
payment of the purchase price of the shares. Unless the Board or Committee
determines otherwise, the restricted stock purchase agreement shall grant the
Company a repurchase option exercisable upon termination of the purchaser's
employment or consulting relationship with the Company. The purchase price for
any shares repurchased by the Company shall be the original price paid by the
purchaser. The repurchase option shall lapse at such rate as the Board or
Committee may determine.

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<PAGE> 33

ADJUSTMENT UPON CHANGES IN CAPITALIZATION, CORPORATE TRANSACTIONS

In the event that the stock of the Company is changed by reason of any
stock split, reverse stock split, stock dividend, recapitalization or other
change in the capital structure of the Company, appropriate proportional
adjustments shall be made in the number and class of shares of stock subject to
the 1995 Stock Plan, the number and class of shares of stock subject to any
option or right outstanding under the 1995 Stock Plan, and the exercise price of
any such outstanding option or right. Any such adjustment shall be made upon
approval of the Board and, if required, the stockholders of the Company, whose
determination shall be conclusive. Notwithstanding the above, in connection with
any merger, consolidation, acquisition of assets or like occurrence involving
the Company, all outstanding options and rights shall be automatically
accelerated. In the event of a Change in Control of the Company (as such term is
defined in the 1995 Stock Plan, and which includes a merger or a sale of all or
substantially all of the Company's assets), if the Board so determines in its
discretion, outstanding options and rights shall have their exercisability fully
accelerated and/or the option and stock purchase right holders may be paid in
cash the excess of the change in control price over the option or right exercise
price.

AMENDMENT, SUSPENSIONS AND TERMINATION OF THE 1995 STOCK PLAN

The Board may amend, suspend or terminate the 1995 Stock Plan at any time;
provided, however, that stockholder approval is required for any amendment to
the extent necessary to comply with Rule 16b-3 promulgated under the Securities
Exchange Act of 1934 ("Rule 16b-3") or Section 422 of the Code, or any similar
rule or statute. In any event, the 1995 Stock Plan will terminate automatically
in 2005.

FEDERAL TAX INFORMATION

Options granted under the 1995 Stock Plan may be either "incentive stock
options," as defined in Section 422 of the Code, or nonstatutory options.

An optionee who is granted an incentive stock option will not recognize
taxable income either at the time the option is granted or upon its exercise,
although the exercise may subject the optionee to the alternative minimum tax.
Upon the sale or exchange of the shares more than two years after grant of the
option and one year after exercising the option, any gain or loss will be
treated as long-term capital gain or loss. If these holding periods are not
satisfied, the optionee will recognize ordinary income at the time of sale or
exchange equal to the difference between the exercise price and the lower of (i)
the fair market value of the shares at the date of the option exercise or (ii)
the sale price of the shares. A different rule for measuring ordinary income
upon such a premature disposition may apply if the optionee is also an officer,
director, or 10% Shareholder of the Company. The Company will be entitled to a
deduction in the same amount as the ordinary income recognized by the optionee.
Any gain or loss recognized on such a premature disposition of the shares in
excess of the amount treated as ordinary income will be characterized as
long-term or short-term capital gain or loss, depending on the holding period.

All other options which do not qualify as incentive stock options are
referred to as nonstatutory options. An optionee will not recognize any taxable
income at the time he is granted a nonstatutory option. However, upon its
exercise, the optionee will recognize taxable income generally measured as the
excess of the then fair market value of the shares purchased over the purchase
price. Any taxable income recognized in connection with an option exercise by an
optionee who is also an employee of the Company will be subject to tax
withholding by the Company. Upon resale of such shares by the optionee, any
difference between the sales price and the optionee's purchase price, to the
extent not recognized as taxable income as described above, will be treated as
long-term or short-term capital gain or loss, depending on the holding period.

The Company will be entitled to a tax deduction in the same amount as the
ordinary income recognized by the optionee with respect to shares acquired upon
exercise of a nonstatutory option.

THE FOREGOING IS A SUMMARY OF THE MATERIAL EFFECTS OF FEDERAL INCOME
TAXATION UPON THE OPTIONEE AND THE COMPANY IN CONNECTION WITH THE 1995 STOCK
PLAN. IT DOES NOT PURPORT TO BE COMPLETE AND REFERENCE SHOULD BE MADE TO THE
APPLICABLE PROVISIONS OF THE CODE. IN ADDITION, THIS SUMMARY DOES NOT DISCUSS
THE TAX CONSEQUENCES OF THE OPTIONEE'S DEATH OR THE INCOME TAX LAWS OF ANY
MUNICIPALITY, STATE OR FOREIGN COUNTRY IN WHICH AN OPTIONEE MAY RESIDE.

30
<PAGE> 34

SECURITY OWNERSHIP OF PRINCIPAL STOCKHOLDERS AND MANAGEMENT

The following table sets forth information with respect to the beneficial
ownership of Endocare Common Stock to be owned immediately following the
Distribution by (i) the holders of more than 5% of the Endocare Common Stock,
(ii) each director of the Company, (iii) the chief executive officer and (iv)
all directors and executive officers of the Company as a group.

<TABLE>
<CAPTION>
SHARES OF ENDOCARE
COMMON STOCK OWNED OR
TO BE RECEIVED
---------------------
NAME OF PERSON OR IDENTITY OF GROUP NUMBER(1) PERCENT
----------------------------------------------------------------- --------- -------
<S> <C> <C>
Errol Payne...................................................... 459,059 8.2%
100 Columbia, Suite 100
Aliso Viejo, CA 92656
Hathaway & Associates, Ltd....................................... 375,000 6.7%
119 Rowayton Avenue
Rowayton, CT 06853
Peter Bernardoni................................................. 211,351(2) 3.8%
2000 Alameda de las Pulgas
San Mateo, CA 94402
Paul Mikus....................................................... -- --
18 Technology Drive
Irvine, CA 92718
All executive officers and directors
as a group (5 persons)......................................... 211,351 3.8%
</TABLE>

- ---------------
(1) All such shares were held of record with sole voting and investment power,
subject to applicable community property laws, by the named individual
and/or by his wife, except as indicated in the following footnote.

(2) Includes 211, 351 shares held by Technology Funding Partners I. Technology
Funding, Inc. and Technology Funding Ltd. (together "Technology Funding"),
of which Peter Bernardoni is an officer or general partner, are the managing
general partners of Technology Funding Partners I. Technology Funding and
Mr. Bernardoni are entitled to exercise voting and investment power with
respect to all shares owned by Technology Funding Partners I and therefore
are deemed to be beneficial owner of such shares.

31
<PAGE> 35

DESCRIPTION OF CAPITAL STOCK

AUTHORIZED SHARES

Under the Company's Certificate of Incorporation ("Certificate" or
"Certificate of Incorporation"), the authorized capital stock of the Company
consists of 20,000,000 shares of Endocare Common Stock, par value $.001 per
share, and 1,000,000 shares of preferred stock, $.001 par value per share (the
"Endocare Preferred Stock"). Immediately prior to the Distribution, Medstone
owns all outstanding shares of Endocare Common Stock and there are outstanding
options to purchase up to 960,000 shares of Endocare Common Stock. No shares of
Endocare Preferred Stock have been issued. Immediately after the Distribution,
based on the number of shares of Medstone Common Stock outstanding as of
December 29, 1995 (with a distribution ratio of one share of Endocare Common
Stock for every one share of Medstone Common Stock), 5,616,528 shares of
Endocare Common Stock and no shares of the Endocare Preferred Stock will be
issued and outstanding. Medstone will own 100,000 shares of Common Stock after
the Distribution.

COMMON STOCK

Holders of Endocare Common Stock are entitled to one vote for each share on
all matters voted on by stockholders. The first annual meeting of stockholders
is expected to be held during 1996.

All shares of Endocare Common Stock to be distributed will be fully paid
and nonassessable. Holders of Endocare Common Stock do not have any
subscription, redemption or conversion privileges. Subject to the preferences or
other rights of any Endocare Preferred Stock that may be issued from time to
time, holders of Common Stock are entitled to participate ratably in dividends
on the Endocare Common Stock as are declared by the Board of Directors. Holders
of Endocare Common Stock are entitled to share ratably in all assets available
for distribution to stockholders in the event of liquidation or dissolution of
the Company, subject to distribution of the preferential amount, if any, to be
distributed to holders of Endocare Preferred Stock.

PREFERRED STOCK

The Company's Certificate of Incorporation authorizes the Board, without
any vote or action by the holders of Endocare Common Stock, to issue Endocare
Preferred Stock from time to time in one or more series. The Board is authorized
to determine the number of shares and designation of any series of Endocare
Preferred Stock and the dividend rights, dividend rate, conversion rights and
terms, voting rights (full or limited, if any), redemption rights and terms,
liquidation preferences and sinking fund terms of any series of Endocare
Preferred Stock. Issuances of Endocare Preferred Stock would be subject to the
applicable rules of the NASD or other organizations on whose systems the stock
of the Company may then be quoted or listed. Depending upon the terms of
Endocare Preferred Stock established by the Board, any or all series of Endocare
Preferred Stock could have preference over the Endocare Common Stock with
respect to dividends and other distributions and upon liquidation of the
Company. Issuance of any such shares with voting powers, or issuance of
additional shares of Endocare Common Stock, would dilute the voting power of the
outstanding Endocare Common Stock.

NO PREEMPTIVE RIGHTS

No holder of any capital stock of the Company has any preemptive right to
subscribe for or purchase any securities of any class or kind of the Company.

LISTING AND TRADING OF ENDOCARE COMMON STOCK

No current public trading market exists for Endocare Common Stock, although
a "when issued" market may develop prior to the Distribution Date. The Company
does not expect to qualify for listing of its Common Stock on the Nasdaq Small
Cap Market upon completion of the Distribution Trading, if any, in the Company's
Common Stock will be conducted in the over-the-counter market on an electronic
bulletin board or in what are commonly referred to as the "pink sheets." See
"Risk Factors -- Absence of Public Market; Possible Illiquidity of Trading
Market and Possible Volatility of Stock Price." The extent of the market for the

32
<PAGE> 36

Endocare Common Stock and the prices at which Endocare Common Stock may trade
prior to or after the Distribution cannot be predicted. See "Risk
Factors -- Absence of Public Market; Possible Illiquidity of Trading Market;
Possible Volatility of Stock Price." Stockholders should refer any questions
concerning trading in either Endocare Common Stock or Medstone Common Stock to
their brokers.

Shares of Endocare Common Stock distributed to stockholders of Medstone
will be freely transferable, except for shares received by persons who may be
deemed to be "affiliates" of the Company under the Securities Act. Persons who
may be deemed to be affiliates of the Company after the Distribution generally
include individuals or entities that control, are controlled by or are under
common control with the Company. Affiliates of the Company may sell their
Endocare Common Stock only pursuant to an effective registration statement under
the Securities Act or an exemption from the registration requirements of the
Securities Act.

Promptly following the Distribution Date, the Company intends to file a
registration statement under the Securities Act to register the offer and sale
of an aggregate of approximately 1,600,000 (including 960,000 shares subject to
outstanding options as of the Distribution Date) shares of Endocare Common Stock
under the 1995 Stock Plan and Director Plan. See "Executive
Compensation -- Stock Plan" and "Management -- Compensation of Directors."

TRANSFER AGENT AND REGISTRAR

U.S. Stock Transfer, Glendale, California, will be the transfer agent and
registrar for the Endocare Common Stock immediately following the Distribution.

ANTI-TAKEOVER EFFECTS OF THE COMPANY'S CERTIFICATE AND BYLAWS

The Company's Certificate of Incorporation and Bylaws are designed to
discourage certain types of transactions that may involve an actual or
threatened change of control of the Company and to encourage any person who
might seek to acquire control of the Company to negotiate with the Company's
Board of Directors. The Company believes that generally the interests of the
Company's stockholders would be served best if any change in control results
from negotiations with its Board of the proposed terms, such as the price to be
paid, the form of consideration and the anticipated tax effects of the
transaction.

The provisions described herein are designed to reduce the vulnerability of
the Company to an unsolicited proposal for a takeover of the Company that does
not contemplate the acquisition of all its outstanding shares of capital stock
at an adequate price or is otherwise unfair to its stockholders or an
unsolicited proposal for the restructuring or sale of all or part of the
Company. The Company believes that, as a general rule, such proposals would not
be in the best interests of the Company and its stockholders. However, to the
extent that these provisions do not discourage takeover attempts, they could
make it more difficult to accomplish transactions that are opposed by the
incumbent Board and could deprive stockholders of opportunities to realize
temporary takeover premiums for their shares or other advantages that large
accumulations of stock would provide.

The description below is a summary of material terms and is qualified in
its entirety by reference to the Company's Certificate of Incorporation and
Bylaws filed as exhibits to the Company's Registration Statement on Form 10-SB
of which this Information Statement is a part.

NUMBER OF DIRECTORS; REMOVAL; VACANCIES

The Company's Bylaws provide that the number of directors shall not be less
than three nor more than seven. The exact number of directors is set in
accordance with the Bylaws by resolution from time to time of a majority of the
entire Board. Interim vacancies on the Board or vacancies created by an increase
in the number of directors, may be filled by a majority of the directors then in
office.

33
<PAGE> 37

STOCKHOLDER ACTION

The Company's Certificate of Incorporation requires all stockholder action
to be taken at an annual or special meeting of stockholders and prohibits
stockholder action by written consent. The Bylaws of the Company also provide
that special meetings of stockholders can be called by the Chairman or the
President and the Board of Directors by majority vote.

The provisions prohibiting stockholder action by consent resolution and
limiting the ability of minority stockholders to call a special meeting may have
the effect of delaying consideration of a stockholder proposal until the next
annual meeting of the stockholders unless a special meeting is called for such
purpose.

Any call for a special meeting must specify the matters to be acted upon at
the meeting. Stockholders are not permitted to submit additional matters or
proposals for consideration of any special meeting.

STOCKHOLDER PROPOSALS

The Company's Bylaws establish an advance notice procedure for nominations
(other than by or at the direction of the Board) of candidates for election as
directors at, and for proposals to be brought before, an annual meeting of
stockholders of the Company. Subject to any applicable requirements, only such
nominations may be considered and such business may be conducted at an annual
meeting as has been brought before the meeting by or at the direction of the
Board or by a stockholder who has given to the Secretary of the Company timely
written notice, in proper form, of the same.

To be timely, notice of nominations or other business to be brought before
an annual meeting must be received by the Secretary of the Company not less than
60 days nor more than 90 days prior to the anniversary of the preceding year's
annual meeting or, if the date of the annual meeting is advanced by more than 30
days or delayed by more than 60 days from such anniversary date, such notice
must be received not earlier than 90 days prior to such annual meeting and not
later than the close of business on the later of: (i) the 60th day prior to the
annual meeting or (ii) the 10th day following the day on which public
announcement of the date of the meeting is first made.

Each notice must set forth (i) the name and address, as it appears on the
books of the Company, of the stockholder who intends to make the nomination or
proposal and of any beneficial owner on whose behalf the nomination or proposal
is made and (ii) the class and number of shares of the Company that are owned
beneficially and of record by such stockholder and beneficial owner. In
addition, in the case of a stockholder proposal, the notice shall set forth a
brief description of the business desired to be brought before the meeting, the
reasons for conducting such business at the meeting and any material interest of
such stockholder or beneficial owner in that proposed business.

In the case of a nomination of any person for election as a director, the
notice must set forth (i) all information regarding the nominee proposed by the
stockholder that would be required to be included in a proxy statement filed
pursuant to the proxy statement as a candidate for election and to serve as a
director of the Company if elected.

This provision is designed to facilitate planning for the conduct of the
Company's annual meeting of stockholders and to provide time for proposals to be
evaluated fully. It may have the effect of precluding a nomination or the
conduct of business at a particular meeting if the proper procedures are not
followed and may deter a potential acquiror from conducting a solicitation of
proxies to elect its own slate of directors of otherwise attempting to obtain
control of the Company, even if the conduct of such solicitation or such attempt
might be beneficial to the Company and its stockholders.

PREFERRED STOCK AND ADDITIONAL COMMON STOCK

Under the Company's Certificate of Incorporation, the Board has authority
to provide by resolution for issuance of shares of one or more series of
Endocare Preferred Stock. The Board is authorized to fix by resolution the terms
and conditions of each series. See "Description of Capital Stock -- Preferred
Stock." The Board also may issue additional shares of authorized but unissued
shares of Endocare Common Stock.

34
<PAGE> 38

The Company believes that the availability of Endocare Preferred Stock will
provide the Company with increased flexibility to facilitate possible future
financings and acquisitions and will allow the Company to better meet other
corporate needs that might arise. The authorized shares of Endocare Preferred
Stock, as well as authorized but unissued shares of Endocare Common Stock, will
be available for issuance without the expense and delay of stockholder action,
unless stockholder action is required by applicable law or the rules of the NASD
or other stock exchange or organization on which any class of stock of the
Company may then be quoted or listed.

These provisions give the Board of Directors the power to approve the
issuance of a series of Endocare Preferred Stock, or additional Endocare Common
Stock, with terms that could either impede or facilitate the completion of a
merger, tender offer or other takeover attempt. For example, the issuance of new
shares might impede a business combination if the terms of those shares include
series voting rights that would enable a holder to block business combinations,
or the issuance of new shares might facilitate a business combination if those
shares have general voting rights sufficient to cause an applicable percentage
vote required to be satisfied. The Board of Directors of the Company will make
any determination regarding issuance of additional shares based on its judgment
as to the best interest of its stockholders, customers, employees or other
constituencies.

CONTROL SHARE ACQUISITION STATUTE

The Company is subject to Section 203 of the Delaware General Corporation
Law ("Section 203"). Section 203 prohibits a publicly held Delaware corporation
from engaging in a "business combination" with an "interested stockholder" for a
period of three years after the date of the transaction in which the person
became an interested stockholder, unless (i) prior to such date, the board of
directors of the corporation approves either the business combination or the
transaction which resulted in the stockholder becoming an interested
stockholder, (ii) upon consummation of the transaction which resulted in the
stockholder becoming an interested stockholder, the interested stockholder owns
at least 85% of the outstanding voting stock excluding certain shares held by
employee director and employee stock plans, or (iii) on or after the
consummation date, the business combination is approved by the board of
directors and by the affirmative vote of at least 66 2/3% of the outstanding
voting stock that is not owned by the interested stockholder. For purposes of
Section 203, a "business combination" includes, among other things, a merger,
asset sale or other transaction resulting in a financial benefit to the
interested stockholder, and an "interested stockholder" is generally a person
who, together with affiliates and associates, owns (or within three years,
owned) 15% or more of the corporation's voting stock.

LIABILITY AND INDEMNIFICATION OF OFFICERS AND DIRECTORS

ELIMINATION OF LIABILITY IN CERTAIN CIRCUMSTANCES

Section 145(a) of the Delaware General Corporation Law (the "DGCL")
provides in relevant part that "a corporation shall have power to indemnify any
person who was or is a party or is threatened to be made a party to any
threatened, pending or completed action, suit or proceeding, whether civil,
criminal, administrative or investigative (other than an action by or in the
right of the corporation) by reason of the fact that he is or was a director,
officer, employee or agent of the corporation, partnership, joint venture, trust
or other enterprise, against expenses (including attorneys' fees), judgments,
fines and amounts paid in settlement actually and reasonably incurred by him in
connection with such action, suit or proceeding if he acted in good faith and in
a manner he reasonably believed to be in or not opposed to the best interests of
the corporation, and, with respect to any criminal action or proceeding, had no
reasonable cause to believe his conduct was unlawful." With respect to
derivative actions, Section 145(b) of the DGCL provides in relevant part that
"[a] corporation shall have power to indemnify any person who was or is a party
or is threatened to be made a party to any threatened, pending or completed
action or suit by or in the right of the corporation to procure a judgment in
its favor . . . [by reason of his service in one of the capacities specified in
the preceding sentence] against expenses (including attorneys' fees) actually
and reasonably incurred by him in connection with the defense or settlement of
such action or suit if he acted in good faith and in a manner he reasonably
believed to

35
<PAGE> 39

be in or not opposed to the best interests of the corporation and except that no
indemnification shall be made in respect of any claim, issue or matter as to
which such person shall have been adjudged to be liable to the corporation
unless and only to the extent that the Court of Chancery or the court in which
such action or suit was bought shall determine upon application that, despite
the adjudication of liability but in view of all the circumstances of the case,
such person is fairly and reasonably entitled to indemnity for such expenses
which the Court of Chancery or such other court shall deem proper."

The Company's Certificate of Incorporation provides that to the fullest
extent permitted by the DGCL, no director of the Company shall be personally
liable to the Company or its stockholders for monetary damages for breach of
fiduciary duty as a director. The Certificate of Incorporation also provides
that no amendment or repeal of such provision shall apply to or have any effect
on the right to indemnification permitted thereunder with respect to claims
arising from acts or omissions occurring in whole or in part before the
effective date of such amendment or repeal whether asserted before or after such
amendment or repeal.

The Company's Bylaws provide that the Company shall indemnify to the full
extent authorized by law each of its directors and officers against expenses
incurred in connection with any proceeding arising by reason of the fact that
such person is or was an agent of the corporation.

The Company has entered into indemnification agreements with its directors
and certain of its officers.

INDEPENDENT ACCOUNTANTS

The Board of Directors of the Company has selected Ernst & Young LLP to
audit the Company's financial statements for the year ending December 31, 1995.
Ernst & Young LLP has served as independent accountants of Medstone and the
Company throughout the periods covered by the financial statements included in
this Information Statement.

ADDITIONAL INFORMATION

The Company has filed with the Securities and Exchange Commission (the
"Commission") a Registration Statement on Form 10-SB under the Securities Act of
1934, as amended (the "1934 Act"), with respect to the Endocare Common Stock
being received by stockholders of Medstone in the Distribution. This Information
Statement does not contain all of the information set forth in the Form 10-SB
Registration Statement and the exhibits thereto, to which reference is hereby
made. Statements made in this Information Statement as to the contents of any
contract, agreement and other documents referred to herein are not necessarily
complete. With respect to each such contract, agreement or other documents filed
as an exhibit to the Registration Statement, reference is made to such exhibit
for a more complete description of the matter involved, and each such statement
shall be deemed qualified in its entirety by such reference. The Registration
Statement and the exhibits thereto filed by the Company with the Commission may
be inspected at the public reference facilities of the Commission.

The Company intends to furnish holders of Endocare Common Stock with annual
reports containing consolidated financial statements audited by an independent
public accounting firm and quarterly reports for the first three quarters of
each fiscal year containing unaudited financial statements.

36
<PAGE> 40

INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
ENDOCARE, INC. PAGE
----
<S> <C>
Historical Financial Statements
Endocare, Inc.
Report of Independent Auditors................................................... F-1
Balance Sheet as of September 30, 1995........................................... F-2
Note to Balance Sheet............................................................ F-3
Endocare, Division of Medstone International, Inc.
Report of Independent Auditors................................................... F-4
Balance Sheets as of September 30, 1995 (unaudited) and December 31, 1994 and
1993............................................................................ F-5
Statements of Operations for the nine months ended September 30, 1995 and 1994
(unaudited) and the years ended December 31, 1994, 1993 and 1992................ F-6
Statements of Cash Flow for the nine months ended September 30, 1995 and 1994
(unaudited) and the years ended December 31, 1994, 1993 and 1992................ F-7
Notes to Financial Statements.................................................... F-8
Schedule II -- Valuation and Qualifying Accounts................................. F-12
Unaudited Proforma Financial Information.............................................. F-13
CYTOCARE, INC.
Consolidated Financial Statements
Report of Independent Auditors................................................... F-17
Consolidated Balance Sheets at December 31, 1994 and 1993........................ F-18
Consolidated Statements of Income for the years ended December 31, 1994, 1993 and
1992............................................................................ F-19
Consolidated Statements of Stockholders' Equity for the years ended December 31,
1994, 1993 and 1992............................................................. F-20
Consolidated Statements of Cash Flows for the years ended December 31, 1994, 1993
and 1992........................................................................ F-21
Notes to Consolidated Financial Statements....................................... F-22
Schedule II -- Valuation and Qualifying Accounts................................. F-29
MEDSTONE INTERNATIONAL, INC.
Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets
September 30, 1995 (Unaudited) and December 31, 1994........................... F-30
Condensed Consolidated Statements of Operations (Unaudited)
Three and Nine Months Ended September 30, 1995 and 1994........................ F-31
Condensed Consolidated Statement of Stockholders' Equity (Unaudited)
Nine Months Ended September 30, 1995........................................... F-32
Condensed Consolidated Statements of Cash Flows (Unaudited)
Nine Months Ended September 30, 1995 and 1994.................................. F-33
Notes to Unaudited Condensed Consolidated Financial Statements................... F-34
Unaudited Proforma Financial Information.............................................. F-36
</TABLE>

37
<PAGE> 41

REPORT OF INDEPENDENT AUDITORS

Board of Directors
Medstone International, Inc.

We have audited the accompanying balance sheet of Endocare, Inc. as of September
30, 1995. This balance sheet is the responsibility of the Company's management.
Our responsibility is to express an opinion on this balance sheet based on our
audit.

We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the balance sheet is 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
audit provides a reasonable basis for our opinion.

In our opinion, the balance sheet referred to above presents fairly, in all
material respects, the financial position of Endocare, Inc. at September 30,
1995, in conformity with generally accepted accounting principles.

ERNST & YOUNG LLP

Orange County, California
December 15, 1995

F-1
<PAGE> 42

ENDOCARE, INC.

BALANCE SHEET
SEPTEMBER 30, 1995

<TABLE>
<S> <C>
ASSETS
Total Assets...................................................................... $ --
========
LIABILITIES AND STOCKHOLDERS' EQUITY
Total Liabilities................................................................. $ --
Stockholders Equity:
Preferred Stock, $.001 par value, 1,000,000 shares authorized, none issued or
outstanding..................................................................... --
Common Stock, $.001 par value 20,000,000 shares authorized, none issued or
outstanding..................................................................... --
Additional paid-in capital........................................................ --
--------
Total stockholders' equity........................................................ --
--------
Total liabilities and stockholders' equity........................................ $ --
========
</TABLE>

See accompanying notes to the Endocare, Inc. balance sheet

F-2
<PAGE> 43

ENDOCARE, INC.

NOTE TO BALANCE SHEET
SEPTEMBER 30, 1995

1. ORGANIZATION AND PRESENTATION

Endocare, Inc. was incorporated in Delaware as a wholly-owned subsidiary of
Medstone International, Inc. As of September 30, 1995, no shares of stock of
Endocare have been issued. Based on information elsewhere in the information
statement, 5,616,528 shares of common stock will be issued.

F-3
<PAGE> 44

REPORT OF INDEPENDENT AUDITORS

Board of Directors
Medstone International, Inc.

We have audited the accompanying balance sheets of Endocare, Division of
Medstone International, Inc. as of December 31, 1994 and 1993, and the related
statements of operations and cash flows for each of the three years in the
period ended December 31, 1994. Our audits also included the financial statement
schedule listed in the accompanying index. These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Endocare, Division of Medstone
International, Inc. at December 31, 1994 and 1993, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1994, in conformity with generally accepted accounting principles.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

The accompanying financial statements have been prepared assuming that Endocare,
Division of Medstone International, Inc. will continue as a going concern. As
discussed in Note 2, the realization of the Company's assets is dependent upon
future events, the outcome of which is indeterminable. Additionally, successful
completion of the Company's development program and its transition, ultimately,
to attaining profitable operations is dependent upon obtaining additional
financing adequate to fulfill its research and development activities, and
achieving a level of revenues adequate to support the Company's cost structure.
Accordingly, these conditions raise substantial doubt about the Company's
ability to continue as a going concern. The financial statements do not include
any adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from the possible inability of Endocare, Division of Medstone
International, Inc. to continue as a going concern.

ERNST & YOUNG LLP

Orange County, California
August 31, 1995

F-4
<PAGE> 45

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------
1994 1993
SEPTEMBER ----------- -----------
30,
1995
------------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and equivalents.............................. $ -- $ -- $ --
Accounts receivable, less allowance for doubtful
accounts of $97,106, $97,106 and $98,600 at
September 30, 1995 and December 31, 1994 and
1993, respectively............................. 79,025 189,781 303,505
Inventories....................................... 257,098 197,693 86,518
Prepaid expenses and other current assets......... 11,470 15,900 19,700
----------- ----------- -----------
Total current assets........................... 347,593 403,374 409,723
Property and equipment
Equipment........................................... 714,955 700,015 614,818
Furniture and fixtures............................ 36,173 97,188 98,888
Leasehold improvements............................ -- -- 31,108
----------- ----------- -----------
751,128 797,203 744,814
Less accumulated depreciation and amortization.... (323,857) (238,148) (123,547)
----------- ----------- -----------
Net property and equipment..................... 427,271 559,055 621,267
Other assets, net................................... 24,328 10,000 10,000
----------- ----------- -----------
$ 799,192 $ 972,429 $ 1,040,990
=========== =========== ===========
LIABILITIES AND DIVISION EQUITY
Current Liabilities:
Accounts payable.................................. $ 37,911 $ 4,968 $ 45,000
Accrued expenses.................................. -- 122 13,624
Accrued payroll expenses.......................... 13,291 101,775 106,716
Deferred revenue.................................. 1,628 1,628 1,628
Customer deposits................................. -- -- 7,000
----------- ----------- -----------
Total current liabilities...................... 52,830 108,493 173,968
Commitments
Division equity:
Advances from Medstone............................ 2,579,912 2,315,250 2,055,396
Accumulated (deficit)............................. (1,833,550) (1,451,314) (1,188,374)
----------- ----------- -----------
Total division equity.......................... 746,362 863,936 867,022
----------- ----------- -----------
$ 799,192 $ 972,429 $ 1,040,990
=========== =========== ===========
</TABLE>

See accompanying notes

F-5
<PAGE> 46

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
NINE MONTHS FOR THE YEAR ENDED DECEMBER 31,
ENDED --------------------------------------
SEPTEMBER 30, 1994 1993 1992
1994 ---------- ---------- ----------
NINE MONTHS -------------
ENDED
SEPTEMBER 30, (UNAUDITED)
1995
-------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Revenues:
Net product sales............ $ 749,192 $ 1,877,705 $2,282,819 $2,697,437 $ --
Research revenues............ 215,290 329,102 379,309 479,702 581,320
--------- --------- --------- --------- ---------
Total revenues............ 964,482 2,206,807 2,662,128 3,177,139 581,320
Costs and expenses:
Cost of sales................ 260,154 545,841 638,294 630,144 8,571
Research and development..... 619,508 769,497 910,929 1,060,626 1,163,082
Selling...................... 223,793 725,330 845,276 1,399,603 50,845
General and administrative... 243,264 417,911 530,569 601,099 32,863
--------- --------- --------- --------- ---------
Total costs and
expenses................ 1,346,719 2,458,579 2,925,068 3,691,472 1,255,361
--------- --------- --------- --------- ---------
Loss before income taxes....... (382,237) (251,772) (262,940) (514,333) (674,041)
Income taxes................... -- -- -- -- --
--------- --------- --------- --------- ---------
Net loss....................... $ (382,237) $ (251,772) $ (262,940) $ (514,333) $ (674,041)
========= ========= ========= ========= =========
</TABLE>

See accompanying notes

F-6
<PAGE> 47

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
NINE MONTHS FOR THE YEAR ENDED DECEMBER 31,
ENDED ----------------------------------
SEPTEMBER 30, 1994 1993 1992
1994 --------- ---------- ---------
NINE MONTHS -------------
ENDED
SEPTEMBER 30, (UNAUDITED)
1995
-------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Cash flows from operating
activities:
Net loss.......................... $(382,237) $(251,772) $(262,940) $ (514,333) $(674,041)
Adjustments to reconcile net loss
to net cash provided by (used
in) operating activities:
Depreciation................... 125,005 105,557 156,065 120,269 3,279
Provision for doubtful
accounts..................... -- -- -- 100,000 --
Changes in operating assets and
liabilities:
Accounts receivable.......... 110,756 26,020 113,724 (403,505) --
Inventories.................. (59,405) (120,520) (111,175) (71,499) (15,019)
Prepaid expenses and other... 4,430 13,188 3,800 15,189 (34,889)
Accounts payable............. 32,943 (901) (40,032) 40,000 5,000
Accrued expenses............. (122) (11,984) (13,502) 13,624 --
Accrued payroll expenses..... (88,484) 78 (4,941) 96,424 10,292
Deferred revenue............. -- -- -- 1,628 --
Customer deposits............ -- (7,000) (7,000) 7,000 --
Other, net................... (14,328) -- -- -- (10,000)
--------- --------- --------- --------- ---------
Net cash provided by (used in)
operating activities......... (271,442) (247,334) (166,001) (595,203) (715,378)
Cash flows from investing
activities:
Purchases of property and
equipment...................... (19,814) (114,712) (125,601) (667,988) (76,827)
Disposals of property and
equipment...................... 26,594 31,748 31,748 -- --
--------- --------- --------- --------- ---------
Net cash provided by (used in)
investing activities......... 6,780 (82,964) (93,853) (667,988) (76,827)
--------- --------- --------- --------- ---------
Cash flows from financing
activities:
Net advances from Medstone........ 264,662 330,298 259,854 1,263,191 792,205
--------- --------- --------- --------- ---------
Net increase/(decrease) in cash and
equivalents....................... 0 0 0 0 0
Cash and equivalents, beginning of
year.............................. 0 0 0 0 0
--------- --------- --------- --------- ---------
Cash and equivalents, end of year... $ 0 $ 0 $ 0 $ 0 $ 0
========= ========= ========= ========= =========
</TABLE>

See accompanying notes

F-7
<PAGE> 48

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

NOTES TO FINANCIAL STATEMENTS

1. ORGANIZATION AND OPERATIONS OF THE COMPANY

Endocare, Division of Medstone International, Inc. (the "Company") operates
as a research and development division of Medstone International, Inc.
("Medstone"). Endocare, Inc. was incorporated in Delaware as a wholly-owned
subsidiary of Medstone in May 1994. In connection with the Distribution,
Medstone will contribute $500,000 cash and the net assets of the Company to
Endocare, Inc. Medstone will subsequently distribute a stock dividend of one
share of Endocare, Inc. Common Stock for each share of Medstone Common Stock
outstanding.

The Company designs, manufactures, and markets the ProLase product line,
laser catheters used to treat urologic obstructions, and the DioLase, a diode
laser used in conjunction with the ProLase laser catheters. It also markets a
cytoscope used in the urologic treatment process.

2. BASIS OF PRESENTATION AND CONTINUED EXISTENCE

From January 1, 1990 through September 30, 1995, the Company has incurred
losses of $1,833,550. Recovery of the Company's assets is dependent upon future
events, the outcome of which is indeterminable. Additionally, successful
completion of the Company's development program and its transition, ultimately,
to attaining profitable operations is dependent upon obtaining additional
financing adequate to fulfill its research and development activities, and
achieving a level of revenues adequate to support the Company's cost structure.
There can be no assurance that the Company will be successful in these areas.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Cash and equivalents

The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents.

Concentrations of credit risk

The Company sells its products primarily to hospitals worldwide. Credit is
extended based on an evaluation of the customer's financial condition and
collateral generally is not required.

Inventories

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

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1994 1993
-------- -------
SEPTEMBER 30,
1995
-------------
(UNAUDITED)
-------------
<S> <C> <C> <C>
Raw materials..................................... $ 149,675 $107,462 $42,732
Work in process................................... 44,038 56,260 37,913
Finished goods.................................... 63,385 33,971 5,873
-------- -------- -------
$ 257,098 $197,693 $86,518
======== ======== =======
</TABLE>

F-8
<PAGE> 49

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

Property and equipment

Property and equipment are carried at cost. Depreciation and amortization
are computed on the straight-line method over the following estimated useful
lives:

<TABLE>
<S> <C>
Equipment...................................... 5 years
Furniture and fixtures......................... 5 years
Leasehold improvements......................... Life of lease
</TABLE>

Revenue Recognition

Sales are recognized upon the shipment of the product. Research revenues
are recognized as earned and billed.

4. INCOME TAXES

Income taxes have been allocated to the Company on a "separate return
basis" whereby such amounts are determined as if the Company were a separate
taxable entity. Because the Company has incurred operating losses since
inception it has given no benefit to its net deferred tax assets since their
realization is not assured. Accordingly, no provision or benefit for income
taxes has been provided in any year.

The Company's provision (benefit) for taxes based on income differs from
the amount obtained by applying the federal statutory tax rate to pretax income
(loss) primarily because of the Company's inability to benefit its net operating
losses and the establishment of a valuation allowance against its net deferred
tax assets.

The Company is in a net deferred tax asset position. Temporary differences
that give rise to a significant portion of the Company's deferred tax assets
consist of bad debt reserves, inventory reserves and other accruals with no
current tax benefit. The Company has established a valuation allowance to fully
offset its deferred tax assets in accordance with Statement of Financial
Accounting Standards -- 109, "Accounting for Income Taxes." The Company's net
operating losses and research and development credits have been included in the
consolidated tax returns of Medstone and have been fully utilized. As a result,
the Company has no net operating losses or research and development credits to
offset future taxable income.

5. EMPLOYEE BENEFIT PLAN

The Company has no separate benefit plan, but all eligible employees
participate in the defined contribution profit sharing 401(k) plan of Medstone.
The plan provides for the deferral of up to 15% of an employee's qualifying
compensation under Section 401(k) of the Internal Revenue Code. Contributions by
the Company may be made to the plan at the discretion of the Board of Directors.
No such contributions were made to the plan during the nine months ended
September 30, 1995 or the years ended December 31, 1994, 1993 and 1992.

6. RELATED PARTY TRANSACTIONS

Expense allocated to Medstone by Endocare consist of sales and marketing
personnel or engineering personnel who are sharing time between Endocare and
Medstone, (i.e. sales calls where Endocare sales representatives sell Endocare
products and also distribute Medstone sales literature.)

The Company has been operating as a division of Medstone since its
inception. The Company's operations have been located within the Medstone
facility, and have been allocated a rental charge based on square footage
occupied.

F-9
<PAGE> 50

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

The Company and Medstone share the services of certain employees. Employee
costs, including salary, payroll taxes and group insurance are allocated to the
Company or Medstone based on an equivalent percentage of time spent on the
Company's projects versus total time worked.

Research revenues recorded by Endocare represent costs of research efforts
performed on behalf of Medstone and billed to Medstone by Endocare.

Expenses other than those related to facilities and employees are allocated
to the Company based on actual usage or expense as consumed in the performance
of the Company's projects.

Advances from Medstone have no specific terms or conditions and represent
amounts incurred by Medstone on behalf of the operations of the Company. Cash
collected from the Company revenue stream was deposited into the Medstone bank
account and represented reductions of the advance from Medstone.

Management believes the allocations discussed above have been made on a
reasonable basis and are representative of the expenses the Company would have
incurred on a stand alone basis.

The following table summarizes the nature of the transactions reflected in
the Advances from Medstone:

<TABLE>
<CAPTION>
ADVANCES
FROM MEDSTONE
-------------
<S> <C>
Balance at December 31, 1991.............................................. $ 0
Cash collected from Endocare net product sales................................. 0
Research revenues recorded by Endocare for services performed on behalf of
Medstone..................................................................... (581,320)
Cash expended by Medstone on behalf of Endocare................................ 1,328,678
Expenses allocated to Endocare by Medstone..................................... 44,847
Expenses allocated to Medstone by Endocare..................................... 0
-------------
Balance at December 31, 1992.............................................. 792,205
Cash collected from Endocare net product sales................................. (2,295,332)
Research revenues recorded by Endocare for services performed on behalf of
Medstone..................................................................... (479,702)
Cash expended by Medstone on behalf of Endocare................................ 3,851,868
Expenses allocated to Endocare by Medstone..................................... 395,092
Expenses allocated to Medstone by Endocare..................................... (208,735)
-------------
Balance at December 31, 1993.............................................. 2,055,396
Cash collected from Endocare net product sales................................. (2,398,037)
Research revenues recorded by Endocare for services performed on behalf of
Medstone..................................................................... (379,309)
Cash expended by Medstone on behalf of Endocare................................ 2,773,226
Expenses allocated to Endocare by Medstone..................................... 399,290
Expenses allocated to Medstone by Endocare..................................... (135,316)
-------------
Balance at December 31, 1994.............................................. 2,315,250
Cash collected from Endocare net product sales................................. (859,948)
Research revenues recorded by Endocare for services performed on behalf of
Medstone..................................................................... (215,290)
Cash expended by Medstone on behalf of Endocare................................ 1,073,907
Expenses allocated to Endocare by Medstone..................................... 265,993
Expenses allocated to Medstone by Endocare..................................... 0
-------------
Balance at September 30, 1995 (unaudited)................................. $ 2,579,912
===========
</TABLE>

F-10
<PAGE> 51

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

Expenses allocated to Endocare by Medstone consist of facility rent,
utilities, property insurance, property taxes, facility maintenance, telephone,
office supplies and group health insurance. These expenses are purchased for the
related companies in total, and are then allocated based on square footage
occupied, headcount or some other pre-determined, fixed basis.

7. MAJOR CUSTOMERS

During the nine months ended September 30, 1995, two customers accounted
for over 10% of the Company's revenues. One, a Korean distributor, accounted for
13% of total revenues and the other, a domestic distributor, accounted for 16%
of total revenues. The Company derived 38% of its total revenues from foreign
customers during the nine months ended September 30, 1995, with 20% going to
Asia, 11% to the Middle East, and 7% to Europe. During the year ended December
31, 1994, no single customer accounted for 10% or more of the total revenue and
the Company derived 16% of its total revenues from export sales to foreign
customers with 7% going to Asia, 5% going to Europe, and 2% going to the Middle
East. During the year ended December 31, 1993, no single customer accounted for
10% or more of the total revenue and the Company derived 12% of its total
revenues from export sales to foreign customers.

F-11
<PAGE> 52

ENDOCARE, DIVISION OF MEDSTONE INTERNATIONAL, INC.

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
ADDITIONS
-------------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE OF
BEGINNING COSTS AND OTHER END
DESCRIPTION OF YEAR EXPENSES ACCOUNTS DEDUCTIONS OF YEAR
- ------------------------------------ ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C>
FOR THE YEAR ENDED
DECEMBER 31, 1994:
Allowance for doubtful accounts..... $ 98,600 $ -- $ -- $1,494(a) $ 97,106
======= ======== ======== ======== =======
FOR THE YEAR ENDED
DECEMBER 31, 1993:
Allowance for doubtful accounts..... $ -- $100,000 $ -- $1,400(a) $ 98,600
======= ======== ======== ======== =======
</TABLE>

- ---------------
(a) Write off of bad debts.

F-12
<PAGE> 53

ENDOCARE, INC.

PROFORMA FINANCIAL INFORMATION

The proforma information presented is theoretical in nature and not
necessarily indicative of the financial position of Endocare, Inc. had it been a
stand-alone Company for the periods presented. The proforma balance sheet
reflects the effects of the Distribution Agreement between Endocare and
Medstone. The Distribution Agreement with Medstone calls for the contribution to
capital of Endocare, Inc. of $500,000 cash and the net assets of Endocare,
Division of Medstone International, Inc. The proforma financial information
reflects the principal adjustments that will result from the Distribution as if
it had occurred as of September 30, 1995 for the balance sheet. The Company
expects expenses that have been allocated from Medstone to be replaced by
comparable outside expenses or to be continued under the Administrative Services
Agreement, consequently proforma statement of operations data are the same as
the historical data.

See accompanying notes to the proforma financial statements

F-13
<PAGE> 54

ENDOCARE, INC.

PROFORMA BALANCE SHEET
(UNAUDITED)

<TABLE>
<CAPTION>
DIVISION
HISTORICAL PROFORMA
SEPTEMBER 30, PROFORMA SEPTEMBER 30,
1995 ADJUSTMENT 1995
------------- ----------- -------------
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and equivalents............................. $ -- $ 500,000(1) $ 500,000
Accounts receivable, less allowance for doubtful
accounts of $97,106 at September 30, 1995..... 79,025 79,025
Inventories...................................... 257,098 257,098
Prepaid expenses and other current assets........ 11,470 -- 11,470
----------- ---------- ------------
Total current assets.......................... 347,593 500,000 847,593
Property and equipment
Equipment........................................ 714,955 714,955
Furniture and fixtures........................... 36,173 36,173
----------- ---------- ------------
751,128 751,128
Less accumulated depreciation and amortization... (323,857) (323,857)
----------- ---------- ------------
Net property and equipment.................... 427,271 427,271
Other assets, net.................................. 24,328 24,328
----------- ---------- ------------
$ 799,192 $ 500,000 $ 1,299,192
=========== ========== ============
LIABILITIES AND DIVISION/STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable................................. $ 37,911 $ $ 37,911
Accrued expenses................................. -- --
Accrued payroll expenses......................... 13,291 13,291
Deferred revenue................................. 1,628 1,628
----------- ---------- ------------
Total current liabilities..................... 52,830 -- 52,830
Division/Stockholders' equity:
Advances from Medstone........................... 2,579,912 (2,579,912)(1) --
Preferred Stock -- $.001 par value, 1,000,000
shares authorized, none issued or
outstanding................................... -- -- --
Common Stock -- $.001 par value, 20,000,000
shares authorized, none issued at September
30, 1995; 5,616,528 issued proforma........... -- 5,617(1) 5,617
Additional paid-in capital....................... -- 1,240,745(1) 1,240,745
Accumulated (deficit)............................ (1,833,550) 1,833,550(1) --
----------- ---------- ------------
Total division/stockholders' equity........... 746,362 500,000 1,246,362
----------- ---------- ------------
$ 799,192 $ 500,000 $ 1,299,192
=========== ========== ============
</TABLE>

See accompanying notes to the proforma financial statements

F-14
<PAGE> 55

ENDOCARE, INC.

PROFORMA STATEMENTS OF OPERATIONS
(UNAUDITED)

<TABLE>
<CAPTION>
PROFORMA
NINE MONTHS
ENDED FOR THE YEAR ENDED
SEPTEMBER 30, DECEMBER 31,
1995 1994
------------- ------------------
<S> <C> <C>
Revenues:
Net product sales........................................... $ 749,192 $2,282,819
Research Revenues........................................... 215,290 379,309
---------- ----------
Total revenues...................................... 964,482 2,662,128
Costs and expenses:
Cost of sales............................................... 260,154 638,294
Research and development.................................... 619,508 910,929
Selling..................................................... 223,793 845,276
General and administrative.................................. 243,264 530,569
---------- ----------
Total costs and expenses............................ 1,346,719 2,925,068
---------- ----------
Loss before income taxes...................................... (382,237) (262,940)
Benefit from income taxes..................................... -- --
---------- ----------
Net loss...................................................... $ (382,237) $ (262,940)
========== ==========
Proforma net loss per share(2)................................ $ (.07) $ (.05)
========== ==========
</TABLE>

See accompanying notes to the proforma financial statements

F-15
<PAGE> 56

ENDOCARE, INC.

NOTES TO PROFORMA FINANCIAL STATEMENTS
(UNAUDITED)

1. CONTRIBUTIONS AND CAPITALIZATION

This proforma adjustment, which assumes that the Distribution occurred as
of September 30, 1995, reflects the forgiveness of intercompany debt resulting
from the funding of operations between Medstone and Endocare and the initial
capitalization of Endocare in the amount of $1,246,362; consisting of Medstone's
contribution of $500,000 cash and $746,362 of other assets at September 30,
1995.

2. PROFORMA NET LOSS PER SHARE

Proforma net loss per share is based on 5,616,528 shares representing the
number of shares to be issued and outstanding after the Distribution assuming
they were issued as of January 1, 1994.

F-16
<PAGE> 57

REPORT OF INDEPENDENT AUDITORS

The Board of Directors
Cytocare, Inc.

We have audited the accompanying consolidated balance sheets of Cytocare, Inc.
as of December 31, 1994 and 1993, and the related consolidated statements of
income, stockholders' equity, and cash flows for each of the three years in the
period ended December 31, 1994. Our audits also included the financial statement
schedule listed in the accompanying index. These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Cytocare, Inc. at
December 31, 1994 and 1993, and the consolidated results of its operations and
its cash flows for each of the three years in the period ended December 31,
1994, in conformity with generally accepted accounting principles. Also, in our
opinion, the related financial statement schedule, when considered in relation
to the basic financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.

As discussed in the first paragraph of Note 8 to the financial statements, the
Company is a defendant in a class action lawsuit. Management of the Company
believes that the allegations are without merit and intends to continue to
vigorously defend against this action. The ultimate outcome of the litigation
cannot presently be determined. Accordingly, no provisions for any liability
that may result, if any, has been made in the financial statements.

ERNST & YOUNG LLP

Orange County, California
February 15, 1995

F-17
<PAGE> 58

CYTOCARE, INC.

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------
1994 1993
----------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents............................................ $ 1,261,596 $ 2,410,363
Short-term investments.......................................... 13,148,586 9,151,679
Accounts receivable, less allowance for doubtful accounts of
$257,000 and $168,000 in 1994 and 1993, respectively......... 1,825,150 1,617,477
Inventories..................................................... 1,607,090 1,620,078
Deferred tax assets............................................. 1,005,000 --
Prepaid expenses and other current assets....................... 394,595 541,852
----------- -----------
Total Current Assets.................................... 19,242,017 15,341,449
Property and equipment:
Lithotripters................................................... 3,775,120 2,285,232
Equipment....................................................... 1,681,765 1,596,316
Furniture and fixtures.......................................... 1,176,072 1,176,153
Leasehold improvements.......................................... 89,764 364,799
----------- -----------
6,722,721 5,422,500
Less accumulated depreciation and amortization.................. (3,727,123) (3,186,888)
----------- -----------
Net property and equipment.............................. 2,995,598 2,235,612
Other assets, net................................................. 22,500 132,061
----------- -----------
$22,260,115 $17,709,122
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable................................................ $ 521,496 $ 657,727
Accrued expenses................................................ 368,942 458,701
Accrued income taxes............................................ 601,776 828,738
Accrued payroll expenses........................................ 408,884 306,932
Deferred revenue................................................ 642,551 502,421
Customer deposits............................................... 40,000 180,750
----------- -----------
Total current liabilities............................... 2,583,649 2,935,269
Deferred tax liabilities.......................................... 225,000 --
Commitments and contingencies (Notes 3 and 8)
Stockholders' equity:
Common stock -- $.004 par value, 20,000,000 shares authorized,
4,944,603 and 4,871,268 shares issued and outstanding at
December 31, 1994 and 1993, respectively..................... 19,778 19,485
Additional paid-in capital...................................... 17,675,642 17,336,245
Unrealized loss on short-term investments....................... (46,279) --
Accumulated earnings (deficit).................................. 1,802,325 (2,581,877)
----------- -----------
Total stockholders' equity.............................. 19,451,466 14,773,853
----------- -----------
$22,260,115 $17,709,122
=========== ===========
</TABLE>

See accompanying notes

F-18
<PAGE> 59

CYTOCARE, INC.

CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31
-------------------------------------------
1994 1993 1992
----------- ----------- -----------
<S> <C> <C> <C>
Revenues:
Net equipment sales............................... $ 3,125,495 $ 2,316,805 $ 5,406,821
Procedures and maintenance fees and laser
catheters...................................... 12,537,264 10,874,799 7,529,432
Interest and dividend income...................... 642,058 481,319 631,378
----------- ----------- -----------
Total revenues............................ 16,304,817 13,672,923 13,567,631
Costs and expenses:
Cost of equipment sales........................... 1,139,805 1,657,488 2,722,074
Costs related to procedure and maintenance fees
and laser catheters............................ 4,863,595 3,848,715 3,271,865
Research and development.......................... 1,076,033 2,333,421 2,192,756
Selling........................................... 2,551,088 2,673,794 1,619,194
General and administrative........................ 2,105,324 2,226,293 1,582,592
Other expenses.................................... 34,770 337,977 868,151
----------- ----------- -----------
Total costs and expenses.................. 11,770,615 13,077,688 12,256,632
----------- ----------- -----------
Income before provision for income taxes............ 4,534,202 595,235 1,310,999
Provision for income taxes.......................... 150,000 65,000 142,000
----------- ----------- -----------
Net income.......................................... $ 4,384,202 $ 530,235 $ 1,168,999
=========== =========== ===========
Earnings per share:
Primary earnings per share........................ $ .82 $ .10 $ .22
=========== =========== ===========
Fully diluted earnings per share.................. $ .81 $ .10 $ .21
=========== =========== ===========
Number of shares used in the computation of earnings
per share:
Primary........................................... 5,350,404 5,398,257 5,222,568
=========== =========== ===========
Fully diluted..................................... 5,427,685 5,398,257 5,461,230
=========== =========== ===========
</TABLE>

See accompanying notes

F-19
<PAGE> 60

CYTOCARE, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
COMMON STOCK
------------------- ADDITIONAL ACCUMULATED UNREALIZED LOSS
NUMBER OF PAID-IN EARNINGS ON SHORT-TERM
SHARES AMOUNT CAPITAL (DEFICIT) INVESTMENTS TOTAL
--------- ------- ----------- ----------- --------------- -----------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1991.................. 4,763,263 $19,053 $17,114,320 $(4,281,111) $ -- $12,852,262
Common stock options
exercised............. 58,397 234 88,887 -- -- 89,121
Net income.............. -- -- -- 1,168,999 -- 1,168,999
--------- ------- ----------- ---------- -------- -----------
Balance at December 31,
1992.................. 4,821,660 19,287 17,203,207 (3,112,112) -- 14,110,382
Common stock options
exercised............. 49,608 198 133,038 -- -- 133,236
Net income.............. -- -- -- 530,235 -- 530,235
--------- ------- ----------- ---------- -------- -----------
Balance at December 31,
1993.................. 4,871,268 19,485 17,336,245 (2,581,877) -- 14,773,853
Common stock options
exercised............. 73,335 293 139,397 -- -- 139,690
Income tax benefit from
stock options......... -- -- 200,000 -- -- 200,000
Unrealized loss on
short-term
investments........... -- -- -- -- (46,279) (46,279)
Net income.............. -- -- -- 4,384,202 -- 4,384,202
--------- ------- ----------- ---------- -------- -----------
Balance at December 31,
1994.................. 4,944,603 $19,778 $17,675,642 $ 1,802,325 $ (46,279) $19,451,466
========= ======= =========== ========== ======== ===========
</TABLE>

See accompanying notes

F-20
<PAGE> 61

CYTOCARE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------
1994 1993 1992
------------ ---------- ----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income......................................... $ 4,384,202 $ 530,235 $1,168,999
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization................... 914,021 1,078,130 911,207
Provision for doubtful accounts................. 140,000 272,900 97,269
Provision for related party loan................ 34,849 183,551 257,817
Unrealized losses on short-term investments..... -- 228,316 113,014
Changes in operating assets and liabilities:
Accounts receivable........................... (336,390) (538,325) (765,064)
Inventories................................... (616,946) (407,889) 38,146
Deferred taxes................................ (780,000) -- --
Prepaid expenses and other.................... 147,257 (214,824) (34,216)
Accounts payable.............................. (136,231) (94,561) 369,157
Accrued expenses.............................. (89,759) (853,817) 442,294
Accrued income taxes.......................... (26,962) 23,588 104,999
Accrued payroll expenses...................... 101,952 (69,131) 18,511
Deferred revenue.............................. 140,130 147,810 (299,341)
Customer deposits............................. (140,750) 74,623 (1,293,873)
Other, net.................................... 28,203 (51,131) (30,223)
---------- ---------- ----------
Net cash provided by operating
activities............................... 3,763,576 309,475 1,098,696
---------- ---------- ----------
Cash flows from investing activities:
Purchases of investments available for sale........ (23,165,800) -- (2,996,009)
Proceeds from sales of investments available for
sale............................................ 19,122,614 -- --
Related party loan................................. (39,774) (112,500) (257,817)
Purchases of property and equipment................ (1,009,218) (998,261) (877,529)
Disposals of property and equipment................ 40,145 451,614 268,310
---------- ---------- ----------
Net cash used in investing activities...... (5,052,033) (659,147) (3,863,045)
---------- ---------- ----------
Cash flows from financing activities -- proceeds from
issuance of common stock........................... 139,690 133,236 89,121
---------- ---------- ----------
Net decrease in cash and equivalents................. (1,148,767) (216,436) (2,675,228)
Cash and equivalents at beginning of year............ 2,410,363 2,626,799 5,302,027
---------- ---------- ----------
Cash and equivalents at end of year.................. $ 1,261,596 $2,410,363 $2,626,799
========== ========== ==========
Supplemental cash flow disclosures:
Cash paid during the year for:
Interest........................................ $ -- $ -- $ --
Income taxes.................................... $ 956,962 $ 68,268 $ 37,001
Supplemental schedule of noncash investing and
financing activities:
Tax benefit of employee stock options.............. $ 200,000 $ -- $ --
</TABLE>

See accompanying notes

F-21
<PAGE> 62

CYTOCARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1994

1. ORGANIZATION AND OPERATIONS OF THE COMPANY

Cytocare, Inc. (formerly Medstone International, Inc. prior to renaming and
reorganization of the Company in January 1991) was incorporated in Delaware in
October 1984. The Company's wholly-owned subsidiary Medstone International, Inc.
("Medstone") designs, manufactures and markets the Medstone STS(TM) Shockwave
Therapy System (the "System") for the noninvasive disintegration of kidney
stones in human patients. In addition to sales of the System, Medstone generates
recurring revenue from procedure fees and fee for service arrangements for use
of the System and from repairs and maintenance of the Systems.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation

The consolidated financial statements include the accounts of the Company,
Medstone International, Inc. and Medstone Sales Corporation, a foreign sales
corporation.

Reclassifications

Certain prior period balances have been reclassified to conform with the
December 31, 1994 presentation.

Statement of cash flows

The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents.

The Company had net non-cash transfers of inventory into fixed assets of
$630,000, $168,000 and $468,000 for the years ended December 31, 1994, 1993 and
1992, respectively.

Short-term Investments

Effective January 1, 1994, the Company adopted the provisions of Statement
of Financial Accounting Standards No. 115, "Accounting for Certain Investments
in Debt and Equity Securities." The adoption did not have a significant impact
on the Company's consolidated financial statements. Management determines the
appropriate classification of such securities at the time of purchase and
reevaluates such classification as of each balance sheet date. Based on its
intent, the Company's investments are classified as available-for-sale and are
carried at fair value, with unrealized gains and losses, net of tax, reported as
a separate component of stockholders' equity. The investments are adjusted for
amortization of premiums and discounts to maturity and such amortization is
included in interest income. Realized gains and losses and declines in value
judged to be other than temporary are determined based on the specific
identification method and are reported in the consolidated statements of
operations.

The Company invests primarily in U.S. government securities, and corporate
obligations. As of December 31, 1994 and December 31, 1993, investments are
summarized as follows:

<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED FAIR
COST GAINS LOSS VALUE
----------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
1994
U.S. Treasury Bills.............. $13,194,865 $ -- $ 46,279 $13,148,586
1993
Mutual Funds..................... 9,493,009 -- 341,330 9,151,679
</TABLE>

Gross realized gains and losses were $0 and $331,817, respectively in 1994.

F-22
<PAGE> 63

CYTOCARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The amortized cost and estimated fair value of investments at December 31,
1994 by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because the issuer of the securities may have the
right to repurchase such securities.

<TABLE>
<CAPTION>
COST FAIR VALUE
----------- -----------
<S> <C> <C>
Due in one year or less........................... $13,194,865 $13,148,586
</TABLE>

Concentrations of credit risk

Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash equivalents,
marketable securities and accounts receivable. The Company's marketable
securities consist primarily of U.S. Treasury Bills.

The Company sells its products primarily to hospitals worldwide. Credit is
extended based on the evaluation of the customer's financial condition and
collateral generally is not required. The Company's ten largest customers
accounted for approximately 47% of accounts receivable on December 31, 1994.

Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market
and consist of the following:

<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------
1994 1993
---------- ----------
<S> <C> <C>
Raw Materials....................................... $1,194,369 $1,149,785
Work in process..................................... 181,416 67,951
Finished goods...................................... 231,305 402,342
---------- ----------
$1,607,090 $1,620,078
========== ==========
</TABLE>

Property and equipment

Property and equipment are carried at cost. Depreciation and amortization
are computed on the straight-line method over the following estimated useful
lives:

<TABLE>
<S> <C>
Lithotripters.................................. 5 years
Equipment...................................... 5 years
Furniture and fixtures......................... 5 years
Leasehold improvements......................... Life of lease
</TABLE>

Revenue recognition

Revenues are recognized in accordance with the underlying contractual terms
of each sale. Typically, revenue recognition requires the transfer of title upon
shipment, customer acceptance, receipt of specified down payments and
performance of all significant contractual obligations. All foreign sales
contracts are negotiated with payment terms in U.S. dollars so the Company has
no exposure to foreign currency price fluctuations.

Service and maintenance contract revenues are deferred and amortized over
the terms of the related contracts.

The results for the year ended December 31, 1992 include two systems
shipped in November 1990 to a foreign customer in the amount of $1.4 million.
This revenue, with related costs of $324,000, was recognized in December 1992
upon resolution of a dispute with a distributor.

F-23
<PAGE> 64

CYTOCARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Per share information

Per share information is presented in the accompanying consolidated
statements of income based upon the weighted average number of common and common
equivalent shares outstanding. Common equivalent shares result from the assumed
exercise of outstanding dilutive securities when applying the treasury stock
method. Fully diluted per share information is not presented for periods in
which the effect is antidilutive.

3. COMMITMENTS

In March 1994, the Company took occupancy of new office, manufacturing,
engineering, warehouse space, and research and development laboratories under an
operating lease with an initial term of two years. The monthly lease rate is
$12,500. Upon expiration of the initial two-year term, the Company has the
option to extend the lease in one year segments through March 1999 for modest
price increases. The future minimum lease payments under the initial
noncancelable term of the lease are as follows:

<TABLE>
<CAPTION>
MINIMUM RENTAL
--------------
<S> <C>
1995.......................................... $151,000
1996.......................................... 25,000
</TABLE>

Total net rent expense under all operating leases for the years ended
December 31, 1994, 1993 and 1992 was $237,000, $495,000, and $328,000,
respectively.

4. INCOME TAXES

The provision for income taxes consists of the following:

<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
1994 1993 1992
------------ ------------ ------------
<S> <C> <C> <C>
Current:
Federal..................................... $1,256,000 $ 84,000 $ 56,000
State....................................... 45,000 15,000 86,000
Utilization of tax credits.................. (373,000) (34,000) --
---------- -------- --------
Total Current....................... 928,000 65,000 142,000
---------- -------- --------
Deferred:
Federal..................................... (484,000) -- --
State....................................... (294,000) -- --
---------- -------- --------
Total Deferred...................... (778,000) -- --
---------- -------- --------
Provision for income taxes.................... $ 150,000 $ 65,000 $142,000
========== ======== ========
</TABLE>

F-24
<PAGE> 65

CYTOCARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following is a reconciliation of the provision for income taxes at the
federal statutory rate compared to the Company's effective tax rate:

<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
1994 1993 1992
------------ ------------ ------------
<S> <C> <C> <C>
Income tax at the statutory rate.............. $1,542,000 $ 202,000 $446,000
State income taxes (net of federal benefit)... (164,000) 36,000 57,000
Change in valuation allowance................. (775,000) -- --
Losses with current tax benefit............... -- (121,000) (376,000)
Tax credits with current benefit.............. (373,000) (34,000) --
Accruals with tax benefit..................... -- (29,000) --
Other......................................... (80,000) 11,000 15,000
---------- -------- --------
Provision for income taxes.................... $ 150,000 $ 65,000 $142,000
========== ======== ========
</TABLE>

The tax effect of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities are as follows:

<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31,
1994 1993
------------ ------------
<S> <C> <C>
Deferred Taxes:
Accruals and reserves not currently deductible for tax..... $ 888,000 $ 921,000
Net operating loss carryforward............................ 58,000 233,000
Credit for increasing research activities.................. 50,000 244,000
Depreciation............................................... -- 38,000
Other credits.............................................. 9,000 37,000
---------- ----------
Total gross deferred tax assets.......................... 1,005,000 1,473,000
Less valuation allowance................................. -- 1,473,000
---------- ----------
Net deferred assets...................................... 1,005,000 --
---------- ----------
Depreciation............................................... 225,000 --
---------- ----------
Total gross deferred tax liabilities..................... 225,000 --
---------- ----------
Net deferred tax assets and liabilities.................... $ 780,000 $ --
========== ==========
</TABLE>

At December 31, 1994, the Company has a California net operating loss
carryforward of approximately $950,000 and a California research and development
credit carryforward of approximately $50,000. These net operating losses and
credits expire in 1997 through 2008. As a result of continued profitability, the
Company recognized all of its deferred tax assets in the current year as
management believes it is more likely than not that such deferred tax assets
will be realized.

The Tax Reform Act of 1986 contains provisions which could substantially
limit the availability of the net operating loss carryforward as well as the
research and development credit carryforward if there is a greater than 50%
change of ownership during a three-year period. As of December 31, 1994, the
Company has experienced less than a 5% ownership change.

5. STOCK OPTIONS

In 1987, the Company adopted the 1987 Stock Option Plan (1987 Plan) under
which options could be granted to key employees or directors of the Company by a
committee appointed by the Company's Board of Directors (the Committee) to
purchase up to 476,323 shares of the Company's common stock. The exercise

F-25
<PAGE> 66

CYTOCARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

prices for options granted under the 1987 Plan were equal to the fair market
value of the common stock on the date of grant. During 1988 and 1989, the
Committee granted options which generally become exercisable with respect to
1/60th of the issuable shares of each elapsed month during the five-year period
commencing with dates determined by the Committee. All options granted in 1988
and 1989 terminate one year after the end of the five-year period. In June 1989,
the Company terminated the 1987 Plan as to the granting of additional options.
In April 1994, the termination date of the remaining 76,250 options exercisable
under the 1987 Plan was extended for an additional year from the previously
extended termination date.

In June 1989, the Company's stockholders approved the 1989 Stock Incentive
Plan (1989 Plan) which provides for the granting of a variety of stock-related
securities, including shares of common stock, stock options and stock
appreciation rights to employees and other selected individuals. In May 1991,
the Company's stockholders amended the 1989 Plan to increase the number of
shares issuable to 1,593,783 and eliminated the provision for an automatic
increase in the number of shares issuable on January 1 of each year by one
percent of the then outstanding shares. As of December 31, 1994, 753,698 options
for shares of common stock had been granted and are outstanding under the 1989
plan.

In June 1989, the Company's stockholders also approved the Nonemployee
Director Stock Option Plan. This plan provides for the issuance of up to 50,000
shares of the Company' common stock upon exercise of options granted thereunder.
As of December 31, 1994, 10,000 options for shares of common stock had been
granted under this plan.

Stock option activity under the Company's plans is summarized as follows:

<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
NUMBER OF OPTIONS 1994 1993 1992
- ------------------------------------------------ ------------ ------------ ------------
<S> <C> <C> <C>
Outstanding, beginning of year.................. 946,251 997,079 769,293
Granted......................................... 43,000 119,834 318,250
Exercised....................................... (73,335) (49,608) (58,397)
Cancelled....................................... (75,968) (121,054) (32,067)
----------- ---------- - -------- ---
Outstanding, end of year........................ 839,948 946,251 997,079
=========== =========== ===========
</TABLE>

<TABLE>
<CAPTION>
OPTION PRICE PER SHARE
- ------------------------------------------------
<S> <C> <C> <C>
Granted......................................... $ 5.47 $5.00 - $5.50 $2.37 - $4.88
Exercised....................................... $1.31 - $5.00 $1.31 - $5.00 $1.31 - $1.50
Outstanding, end of year........................ $1.31 - $5.50 $1.31 - $5.50 $1.31 - $5.00
</TABLE>

At December 31, 1994, 1993 and 1992, the number of unoptioned shares
reserved and available for issuance under the plans was 880,085, 776,782 and
674,367, respectively. Outstanding options for 677,539 shares were exercisable
at December 31, 1994.

Effective March 2, 1990, the Company changed the exercise price of all
outstanding options granted with exercise prices exceeding the closing market
value of the stock on that date. Accordingly, the exercise price of these
options was reduced to $5.00 per share.

6. EMPLOYEE BENEFIT PLAN

In January 1990, the Company established a defined contribution profit
sharing 401(k) plan for all eligible employees. The plan provides for the
deferral of up to 15% of an employee's qualifying compensation under Section
401(k) of the Internal Revenue Code. Contributions by the Company may be made to
the plan at the discretion of the Board of Directors. No such contributions were
made to the plan during the years ended December 31, 1994, 1993 and 1992.

F-26
<PAGE> 67

CYTOCARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

7. MAJOR CUSTOMERS AND FOREIGN SALES

During the year ended December 31, 1994, one foreign customer accounted for
10% of total revenue of the Company and the Company derived 13% of its total
revenues from sales to foreign customers. During the year ended December 31,
1993, no single customer accounted for 10% or more of the total revenue and the
Company derived 8% of its total revenues from sales to foreign customers. During
the year ended December 31, 1992, the Company recorded revenues from two
customers, one domestic and one foreign, each greater than 10% of the total
revenue and derived 25% of its total revenue from sales to foreign customers.

8. CONTINGENCIES

The Company is a defendant in two related class action lawsuits filed by
two shareholders of the Company alleging that adverse material information was
not disclosed at the time of the initial public offering and in subsequent
periods. On May 4, 1992, the district court granted summary judgment in one of
the actions in favor of the Company on all claims. On July 9, 1992, the district
court granted the Company's motion to dismiss the second action. In October
1994, the Company received the opinion of the Ninth Circuit of Appeals affirming
in part and reversing in part the United States District Court's decision
granting summary judgment in favor of the Company and several officers. The
complaints allege principally that adverse material information was not
disclosed at the time of the initial public offering in June 1988. The Company
intends to proceed to trial on any remaining matters. The ultimate outcome of
the litigation cannot presently be determined. Accordingly, no provision for any
liability that may result, if any, has been made in the financial statements.

From time to time, the Company is subject to legal actions and claims for
personal injuries or property damage related to patients who use its products.
The Company has obtained a liability insurance policy providing coverage for
product liability and other claims. Management does not believe that the
resolution of any current proceedings will have a material financial impact on
the Company.

9. RELATED PARTY TRANSACTIONS

During 1991, the Company was a party to the formation of Cardiac Science,
Inc., for which the Company purchased 5,353,031 shares of common stock, for a
cash payment of $.0016 per share. This purchase represented 77.3% of the
outstanding stock. As of July 8, 1991, the Company distributed a dividend to its
shareholders of record on that date, one share of Cardiac Science, Inc. stock
for each share of Cytocare stock held. The Company retained 629,768 shares of
common stock of Cardiac Science, Inc.

In June 1991, the Company agreed to loan Cardiac Science, Inc. up to
$220,000 to provide working capital pursuant to the terms of a revolving note
agreement. The unpaid principal amount of the loan, together with interest
accrued thereon at the rate of 10% per annum, was due and payable to Cytocare in
December 1991. Cytocare then agreed to extend this note and to loan additional
amounts to Cardiac Science, Inc. As of April 30, 1992, the Company had loaned
Cardiac Science, Inc. approximately $310,000. In April 1992, the Company agreed
to extend its initial loan to Cardiac Science, Inc. and to loan Cardiac Science,
Inc. an additional $200,000. These loans bore interest as a rate of 8% per
annum, payable quarterly, are secured by Cardiac Science's assets and were to
mature on the earlier of April 1, 1995 or the closing of the initial public
offering of Cardiac Science, Inc. common stock.

In September 1994, Cardiac Science completed a private placement offering,
and in conjunction with that offering, the Company exercised warrants to
purchase 2,720,000 shares of Cardiac Science Common Stock at $.15 per share. The
proceeds of $408,000 were used to pay down a portion of the loans described
above. The due date for the remaining principal balance of $102,000 has been
extended to April 1, 1996. The expiration date for the remaining warrants was
changed to March 31, 1996. In addition, the Company was issued 1,800,000 shares
of Cardiac Science Common Stock and a ten year warrant to purchase 1,000,000

F-27
<PAGE> 68

CYTOCARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

shares at $.001 per share in full payment of unsecured obligations of
approximately $176,000. At December 31, 1994, $104,335, which includes accrued
interest, has been loaned to Cardiac Science. A reserve of $104,335 has been
provided for non-payment of the loan.

As of December 31, 1994, the Company held warrants to purchase 680,000
shares of Cardiac Science's common stock at $.15 per share which expire March
31, 1996 and warrants to purchase 1,000,000 shares at $.001 per share, which
expire September 10, 2004.

Separately, the Company advanced amounts to Cardiac Science for some
operational expenses including (but not limited to) accounting services and
health insurance. These amounts were to be repaid by Cardiac Science on a
month-to-month basis. As of December 31, 1994, $8,947 had been advanced to
Cardiac Science. A reserve of $4,023 has been provided for non-payment of the
advances.

Effective March 15, 1994, all Cardiac Science business is conducted at a
location completely independent of Cytocare. This will insure that Cardiac
Science cannot be perceived as lacking autonomy over its own business and
technical operations.

F-28
<PAGE> 69

CYTOCARE, INC.

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
ADDITIONS
-----------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END
DESCRIPTION OF YEAR EXPENSES ACCOUNTS DEDUCTIONS OF YEAR
- --------------------------------------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C>
FOR THE YEAR ENDED DECEMBER 31, 1994:
Allowance for doubtful accounts........ $ 168,390 $140,000 $ -- $ 50,972 $ 257,418
======== ======== ======== ========= ========
Allowance for inventory obsolescence... $ 668,111 $ -- $ -- $ 2,562(a) $ 665,549
======== ======== ======== ========= ========
Allowance for related party loan....... $ 693,072 $ 34,849 $ -- $ 619,564(c) $ 108,357
======== ======== ======== ========= ========
Allowance for investment in related
party................................ $ 23,436 $ -- $ -- $ (619,564)(c) $ 643,000
======== ======== ======== ========= ========
FOR THE YEAR ENDED DECEMBER 31, 1993:
Allowance for doubtful accounts........ $ 746,368 $272,900 $ -- $ 850,878(b) $ 168,390
======== ======== ======== ========= ========
Allowance for inventory obsolescence... $ 678,123 $ -- $ -- $ 10,012(a) $ 668,111
======== ======== ======== ========= ========
Allowance for related party loan....... $ 509,521 $183,551 $ -- $ -- $ 693,072
======== ======== ======== ========= ========
FOR THE YEAR ENDED DECEMBER 31, 1992:
Allowance for doubtful accounts........ $ 949,992 $ 97,269 $ -- $ 300,893(b) $ 746,368
======== ======== ======== ========= ========
Allowance for inventory obsolescence... $ 742,670 $ -- $ -- $ 64,547(a) $ 678,123
======== ======== ======== ========= ========
Allowance for related party loan....... $ 251,704 $257,817 $ -- $ -- $ 509,521
======== ======== ======== ========= ========
</TABLE>

- ---------------
(a) Write-off of inventory.
(b) Write-off of bad debt including $642,000 for one significant customer.
(c) Reserve transferred from loan provision to investment provision due to
restructuring.

F-29
<PAGE> 70

MEDSTONE INTERNATIONAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,
1994
SEPTEMBER 30, ------------
1995
-------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents............................................ $ 2,417,258 $ 1,261,596
Short term investments.......................................... 14,423,706 13,148,586
Accounts receivable, less allowance for doubtful accounts of
$265,000 and $257,000 at September 30, 1995 and December 31,
1994, respectively........................................... 2,557,614 1,825,150
Inventories..................................................... 1,857,297 1,607,090
Deferred tax assets............................................. 1,005,000 1,005,000
Prepaid expenses and other current assets....................... 503,303 394,595
----------- -----------
Total currents assets................................... 22,764,178 19,242,017
Property and equipment, at cost................................... 5,936,075 6,722,721
Less accumulated depreciation and amortization.................. (2,904,235) (3,727,123)
----------- -----------
Net property and equipment.............................. 3,031,840 2,995,598
Other assets, net................................................. 153,573 22,500
----------- -----------
$ 25,949,591 $ 22,260,115
=========== ===========
</TABLE>

LIABILITIES AND STOCKHOLDERS' EQUITY

<TABLE>
<S> <C> <C>
Current liabilities:
Accounts payable................................................ $ 748,486 $ 521,496
Accrued expenses................................................ 280,455 368,942
Accrued income taxes............................................ 686,886 601,776
Accrued payroll expenses........................................ 306,583 408,884
Deferred revenue................................................ 612,025 642,551
Customer deposits............................................... -- 40,000
------------- ------------
Total current liabilities............................... 2,634,435 2,583,649
Deferred tax liabilities.......................................... 225,000 225,000
Commitments and contingencies
Stockholders' equity:
Common stock -- $.004 par value, 20,000,000 shares authorized,
5,226,003 and 4,944,603 shares issued and outstanding at
September 30, 1995 and December 31, 1994, respectively....... 20,904 19,778
Additional paid-in capital...................................... 18,046,530 17,675,642
Unrealized gain/(loss) on short-term investments................ -- (46,279)
Accumulated earnings............................................ 5,022,722 1,802,325
------------- ------------
23,090,156 19,451,466
------------- ------------
Total stockholders' equity................................... $ 25,949,591 $ 22,260,115
========== ==========
</TABLE>

See accompanying notes.

F-30
<PAGE> 71

MEDSTONE INTERNATIONAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- ---------------------------
1995 1994 1995 1994
---------- ---------- ----------- -----------
<S> <C> <C> <C> <C>
Revenues:
Net equipment sales................... $1,596,315 $ 265,000 $ 3,988,980 $ 2,551,095
Procedures and maintenance fees and
laser catheters.................... 3,430,836 3,551,319 9,642,894 9,325,049
Interest income....................... 256,567 183,506 733,338 443,269
----------- ----------- ------------ ------------
Total revenues................ 5,283,718 3,999,825 14,365,212 12,319,413
Costs and expenses:
Cost of equipment sales............... 686,011 97,368 1,727,487 1,063,060
Costs related to procedures and
maintenance fees................... 1,554,206 1,417,955 4,149,079 3,492,832
Research and development.............. 186,233 241,146 675,761 913,630
Selling............................... 531,326 611,692 1,501,042 2,104,656
General and administrative............ 413,249 472,477 1,296,257 1,617,753
Other expense (income)................ 50,584 10,906 64,189 31,408
----------- ----------- ------------ ------------
Total costs and expenses...... 3,421,609 2,851,544 9,413,815 9,223,339
----------- ----------- ------------ ------------
Income before provision for income
taxes................................. 1,862,109 1,148,281 4,951,397 3,096,074
Provision for (benefit from) income
taxes................................. 651,000 (331,000) 1,731,000 0
----------- ----------- ------------ ------------
Net income.............................. $1,211,109 $1,479,281 $ 3,220,397 $ 3,096,074
=========== =========== ============ ============
Earnings per share:
Primary............................... $ .22 $ .28 $ .58 $ .58
=========== =========== ============ ============
Fully diluted......................... $ .21 $ .27 $ .56 $ .57
=========== =========== ============ ============
Number of shares used in the computation
of income per share:
Primary............................... 5,590,330 5,336,111 5,538,913 5,329,987
=========== =========== ============ ============
Fully diluted......................... 5,649,209 5,395,963 5,704,439 5,384,628
=========== =========== ============ ============
</TABLE>

See accompanying notes.

F-31
<PAGE> 72

MEDSTONE INTERNATIONAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 1995
(UNAUDITED)

<TABLE>
<CAPTION>
COMMON STOCK
------------------- ADDITIONAL UNREALIZED LOSS
NUMBER OF PAID-IN ACCUMULATED ON SHORT-TERM
SHARES AMOUNT CAPITAL EARNINGS INVESTMENTS TOTAL
--------- ------- ----------- ----------- --------------- -----------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1994..... 4,944,603 $19,778 $17,675,642 $1,802,325 $ (46,279) $19,451,466
Common Stock option exercised.... 281,400 1,126 370,888 -- -- 372,014
Change in unrealized loss on
short-term investments......... -- -- -- -- 46,279 46,279
Net income....................... -- -- -- 3,220,397 -- 3,220,397
--------- ------- ----------- ---------- --------- -----------
Balance at September 30, 1995.... 5,226,003 $20,904 $18,046,530 $5,022,722 $ 0 $23,090,156
========= ======= =========== ========== ========= ===========
</TABLE>

See accompanying notes.

F-32
<PAGE> 73

MEDSTONE INTERNATIONAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 1995 AND 1994
(UNAUDITED)

<TABLE>
<CAPTION>
1995 1994
------------ ------------
<S> <C> <C>
Cash flows from operating activities:
Net income.................................................... $ 3,220,397 $ 3,096,074
Adjustments to reconcile net income to net cash
provided (used) by operating activities:
Depreciation and amortization.............................. 702,251 661,953
Provision for doubtful accounts............................ -- 140,000
Provision for related party loan........................... 1,315 28,492
Unrealized losses (gains) on short-term investments........ -- (9,513)
Changes in assets and liabilities:
Accounts receivable...................................... (728,699) (506,459)
Inventories.............................................. (663,889) (620,360)
Deferred tax assets...................................... -- (1,100,000)
Prepaid expenses and other current assets................ (108,708) 198,585
Accounts payable and accrued expenses.................... 36,202 81,461
Accrued income taxes..................................... 85,110 440,346
Deferred revenue......................................... (30,526) 212,205
Customer deposits........................................ (40,000) (180,750)
Other, net............................................... (131,073) 34,561
------------ ------------
Net cash provided by operating activities..................... 2,342,380 2,476,595
------------ ------------
Cash flows from investing activities:
Purchase of marketable securities............................. (15,471,271) (20,330,573)
Sale of marketable securities................................. 14,234,899 17,157,412
Related party loan............................................ 2,450 (28,492)
Purchase of property and equipment............................ (1,001,035) (795,954)
Disposal of property and equipment............................ 676,225 37,571
------------ ------------
Net cash used in investing activities......................... (1,558,732) (3,960,036)
------------ ------------
Cash flows from financing activities:
Proceeds from issuance of common stock........................ 372,014 116,059
------------ ------------
Net increase (decrease) in cash and cash equivalents............ 1,155,662 (1,367,382)
Cash and cash equivalents at beginning of period................ 1,261,596 2,410,363
------------ ------------
Cash and cash equivalents at end of period...................... $ 2,417,258 $ 1,042,981
============ ============
Supplemental cash flow disclosures:
Cash paid during the period for:
Income taxes............................................... $ 1,645,890 $ 659,654
Interest................................................... $ 0 $ 0
</TABLE>

See accompanying notes.

F-33
<PAGE> 74

MEDSTONE INTERNATIONAL, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1995

A. ORGANIZATION AND OPERATIONS OF THE COMPANY

Medstone International, Inc., formerly known as Cytocare, Inc. prior to its
renaming in September 1995 (the "Company" or "Medstone"), a Delaware corporation
formed in October 1984, develops, manufactures and markets medical devices and
therapeutics to treat urological diseases. Medstone manufactures, markets and
maintains lithotripters, and is expanding its Fee-for-Service Program that
supplies lithotripsy equipment to providers on a per procedure basis. Endocare,
the Company's endourology subsidiary, manufactures equipment and devices to
treat urologic soft tissue diseases. A majority of the Company's consolidated
revenues come from Medstone's lithotripsy business.

The Company, as a manufacturer of capital medical devices, has been
vertically integrating by offering its medical devices directly to providers on
a fee-per-procedure basis. Medstone currently offers mobile lithotripsy services
using mobile systems in the Western United States on a fee-per-procedure basis.
Medstone intends to expand efforts to grow this medical service side of its
business.

The Company continues efforts to separate its operating business units and
revenue streams into independent operations. Management hopes that such a
restructuring will benefit stockholders by bringing about operational advantages
as well as more discriminating and favorable valuations of Medstone's units.

B. BASIS OF PRESENTATION

In the opinion of the Company's management, the accompanying unaudited
condensed consolidated financial statements include all adjustments (which
consist only of normal recurring adjustments) necessary for a fair presentation
of its consolidated financial position at September 30, 1995 and consolidated
results of operations and cash flows for the periods presented. Certain prior
period balances have been reclassified to conform with current period
presentation. Although the Company believes that the disclosures in these
financial statements are adequate to make the information presented not
misleading, certain information and disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted and should be read in conjunction with the
Company's audited financial statements included in the Company's 1994 Annual
Report on Form 10-K filed with the Securities and Exchange Commission on March
28, 1995. Results of operations for the nine months ended September 30, 1995 are
not necessarily indicative of results to be expected for the full year.

C. PER SHARE INFORMATION

Per share information is presented in the accompanying consolidated
statements of operations based upon the weighted average number of common and
common equivalent shares outstanding. Common equivalent shares result from the
assumed exercise of outstanding dilutive securities when applying the treasury
stock method. Fully diluted per share information is not presented for periods
in which the effect is antidilutive.

D. INVENTORIES

At September 30, 1995 and December 31, 1994, inventories consisted of the
following:

<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1995 1994
------------- ------------
<S> <C> <C>
Raw materials...................................................... $ 1,311,406 $1,194,369
Work in process.................................................... 88,226 181,416
Finished goods..................................................... 457,665 231,305
---------- ----------
$ 1,857,297 $1,607,090
========== ==========
</TABLE>

F-34
<PAGE> 75

MEDSTONE INTERNATIONAL, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS -- (CONTINUED)

E. INCOME TAXES

The Company adopted Financial Accounting Standards Board Statement No. 109
in 1991. The effect of the adoption was to permit the Company to reduce its
income tax expense by the utilization of the net operating loss carryforward
rather than treating the realization of the net operating loss carryforward as
an extraordinary credit.

F. SHORT-TERM INVESTMENTS

The Company adopted Financial Accounting Standards Board Statement No. 115
as of January 1, 1994. The effect of the adoption is that the Company classifies
its entire investment portfolio as available-for-sale. Accordingly, unrealized
holding gains and losses on short-term investments will be carried as a separate
component of stockholder's equity.

G. CONTINGENCIES

The Company is a defendant in two related class action lawsuits filed on
behalf of two stockholders of the Company alleging that adverse material
information was not disclosed at the time of the initial public offering and in
subsequent periods. On May 4, 1992, the district court granted summary judgment
in one of the actions in favor of the Company on all claims. On July 9, 1992,
the district court granted the Company's motion to dismiss the second action.
Plaintiffs in both cases filed an appeal to the Ninth Circuit Court. In October
1994, the Company received the opinion of the Ninth Circuit Court of Appeals
affirming in part and reversing in part the United States District Court's
decision granting summary judgment in favor of the Company and several officers.
The complaints allege principally that adverse material information was not
disclosed at the time of the initial public offering in June 1988. In April
1995, the Company filed a Supreme Court brief, and in October 1995, the Company
was informed that the Supreme Court declined to hear the case, returning the
case to the district court for scheduling of the trial, for which the Company
intends to proceed. The ultimate outcome of this litigation cannot presently be
determined. Accordingly, no provision for any liability that may result, if any,
has been made in the financial statements.

F-35
<PAGE> 76

MEDSTONE INTERNATIONAL, INC.

PROFORMA FINANCIAL INFORMATION

Medstone International, Inc. (the "Company"), a Delaware corporation formed
in October 1984, develops, manufactures and markets medical devices and
therapeutics to treat urological diseases.

The Company is distributing to its shareholders, as a dividend, its
operations in the endourology area, which manufactures equipment and devices to
treat urologic soft tissue diseases and the operations of the biology division.

The endourology operation, known as Endocare, currently contributes to the
Company's revenues and expenses and the proforma adjustments reflect the removal
of the Endocare operations for the nine months ended September 30, 1995 and year
ended December 31, 1994. The adjustments to the balance sheet at September 30,
1995 reflect the removal of assets, liabilities and the dividend distribution
attributable to the Endocare operations.

The dividend distribution of Endocare will be composed of two separate
transactions. In connection with the distribution, Medstone will contribute
$500,000 and the net assets of the Endocare operation. Those operating assets
are composed of the following: accounts receivable, inventories, and fixed
assets. Medstone will then distribute a stock dividend of one share of Endocare
for each outstanding share of Medstone as of the record date of the
distribution.

Also reflected in the adjustments in the distribution to its stockholders
by the Company, of the operations of the biological division. The biological
division, which will be known as Urogen Corp. is the Company's research effort
in the areas of therapeutic, diagnostic and prognostic applications in urologic
oncology. Currently, there are no revenues attributable to this operation, and
adjustments to the statements of operations for the nine months ended September
30, 1995 and the year ended December 31, 1994 reflect removal of the Urogen
operations. The adjustments to the balance sheet at September 30, 1995 reflect
the removal of assets and the dividend distribution attributable to the Urogen
operations.

The dividend distribution of Urogen will be composed of two separate
transactions. In connection with the distribution, Medstone will contribute
$500,000 and the net assets of the Urogen operations. The operating assets are
composed of the fixed assets of the biological research group and the
proprietary prostatic murine antibodies. Medstone will then distribute a stock
dividend of one share of Urogen for each outstanding share of Medstone as of the
record date of the distribution.

The remaining activities of Medstone International, Inc., after
distribution, represent the Company's lithotripsy business. The operations
include the manufacture, sales and service of the Company's Medstone STS
lithotripter. The Company also provides fee-for-service lithotripsy to hospitals
with its mobile lithotripters on a per procedure basis and equipment maintenance
for customer owned equipment.

Per share information presented in the accompanying statements of
operations is based upon the weighted average number of common and common
equivalent shares outstanding. Common equivalent shares result from the assumed
exercise of outstanding dilutive securities when applying the treasury stock
method. Fully diluted per share information is not presented for periods in
which the effect is antidilutive.

F-36
<PAGE> 77

MEDSTONE INTERNATIONAL, INC.

PROFORMA BALANCE SHEET
(UNAUDITED)

<TABLE>
<CAPTION>
SEPTEMBER 30,
SEPTEMBER 30, PROFORMA 1995
1995 ADJUSTMENTS PROFORMA
------------- ----------- -------------
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and equivalents.............................. $ 2,417,258 $(1,000,000)(1) $ 1,417,258
Short-term investments............................ 14,423,706 -- 14,423,706
Accounts receivable............................... 2,557,614 (79,025)(2) 2,478,589
Inventories....................................... 1,857,297 (257,098)(3) 1,600,199
Deferred tax assets............................... 1,005,000 -- 1,005,000
Prepaid expenses and other current assets......... 503,303 (11,470) 491,833
----------- ----------- -----------
Total current assets...................... 22,764,178 (1,347,593) 21,416,585
Property and equipment:
Lithotripters..................................... 3,028,849 -- 3,028,849
Equipment......................................... 1,285,035 (916,991)(4) 368,044
Furniture and fixtures............................ 1,532,427 (198,872)(4) 1,333,555
Leasehold improvements............................ 89,764 -- 89,764
----------- ----------- -----------
5,936,075 (1,115,863) 4,820,212
Less accumulated depreciation and amortization.... (2,904,235) 543,533(4) (2,360,702)
----------- ----------- -----------
Net property and equipment................ 3,031,840 (572,330) 2,459,510
Other assets, net................................... 153,573 (24,327) 129,246
----------- ----------- -----------
$ 25,949,591 $(1,944,250) $ 24,005,341
=========== =========== ===========
</TABLE>

LIABILITIES AND STOCKHOLDERS' EQUITY

<TABLE>
<S> <C> <C> <C>
Current liabilities:
Accounts payable.................................. $ 748,486 $ (37,911) $ 710,575
Accrued expenses.................................. 280,455 -- 280,455
Accrued income taxes.............................. 686,886 -- 686,886
Accrued payroll expenses.......................... 306,583 (13,292) 293,291
Deferred revenue.................................. 612,025 (1,628) 610,397
------------- ----------- -------------
Total current liabilities................. 2,634,435 (52,831) 2,581,604
Deferred tax liabilities............................ 225,000 -- 225,000
Commitments and contingencies
Stockholders' equity:
Common Stock -- $.004 par value, 20,000,000 shares
authorized, 5,226,003 shares issued and
outstanding at September 30, 1995.............. 20,904 -- 20,904
Additional paid-in capital........................ 18,046,530 -- 18,046,530
Accumulated earnings.............................. 5,022,722 (1,891,419)(5) 3,131,303
------------- ----------- -------------
Total stockholders' equity................ 23,090,156 (1,891,419) 21,198,737
------------- ----------- -------------
$ 25,949,591 $(1,944,250) $ 24,005,341
========== ========== ==========
</TABLE>

See accompanying notes

F-37
<PAGE> 78

MEDSTONE, INC.

PROFORMA STATEMENTS OF INCOME

<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30, 1995 YEAR ENDED DECEMBER 31, 1994
------------------------------------------- -------------------------------------------
AS REPORTED ADJUSTMENTS PROFORMA AS REPORTED ADJUSTMENTS PROFORMA
----------- ----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Revenues:
Net equipment sales............ $ 3,988,980 $ -- $ 3,988,980 $3,125,495 $ -- $ 3,125,495
Procedures and maintenance fees
and laser catheters.......... 9,642,894 (749,192 )(6) 8,893,702 12,537,264 (2,282,819 )(6) 10,254,445
Interest and dividend income... 733,338 -- 733,338 642,058 -- 642,058
----------- ----------- ----------- ----------- ----------- -----------
Total revenues................... 14,365,212 (749,192 ) 13,616,020 16,304,817 (2,282,819 ) 14,021,998
Cost and expenses:
Cost of equipment sales........ 1,727,487 -- 1,727,487 1,139,805 -- 1,139,805
Costs related to procedure and
maintenance fees and laser
catheters.................... 4,149,079 (260,154 )(7) 3,888,925 4,863,595 (638,294 )(7) 4,225,301
Research and development....... 675,761 (460,471 )(8) 215,290 1,076,033 (696,724 )(8) 379,309
Selling........................ 1,501,042 (223,793 )(9) 1,277,249 2,551,088 (845,276 )(9) 1,705,812
General and administrative..... 1,296,257 (243,264 )(10) 1,052,993 2,105,324 (763,503 )(10) 1,341,821
Other expense.................. 64,189 -- 64,189 34,770 -- 34,770
----------- ----------- ----------- ----------- ----------- -----------
Total costs and expenses..... 9,413,815 (1,187,682 ) 8,226,133 11,770,615 (2,943,796 ) 8,826,818
----------- ----------- ----------- ----------- ----------- -----------
Income from continuing operations
before provision for income
taxes.......................... 4,951,397 438,490 5,389,887 4,534,202 660,977 5,195,179
Provision for income taxes....... 1,731,000 153,000 (11) 1,884,000 150,000 20,000 (11) 170,000
----------- ----------- ----------- ----------- ----------- -----------
Income from continuing
operations..................... 3,220,397 285,490 3,505,887 4,384,202 640,977 5,025,179
----------- ----------- ----------- ----------- ----------- -----------
Loss from discontinued
operations..................... -- (285,490 )(11) (285,490) -- (640,977 )(11) (640,977)
----------- ----------- ----------- ----------- ----------- -----------
Net income....................... $ 3,220,397 $ -- $ 3,220,397 $4,384,202 $ -- $ 4,384,202
=========== =========== =========== =========== =========== ===========
Earnings per share:
Primary earnings per share..... $ .58 $ .58 $ .82 $ .82
=========== =========== =========== ===========
Fully diluted earnings per
share.......................... $ .56 $ .56 $ .81 $ .81
=========== =========== =========== ===========
Number of shares used in the
computation of earnings per
share:
Primary........................ 5,538,913 5,538,913 5,350,404 5,350,404
=========== =========== =========== ===========
Fully diluted.................. 5,704,439 5,704,439 5,427,685 5,427,685
=========== =========== =========== ===========
</TABLE>

See accompanying notes

F-38
<PAGE> 79

MEDSTONE INTERNATIONAL, INC.

NOTES TO PROFORMA FINANCIAL STATEMENTS

The proforma adjustments reflect, as one set of adjustments, the activities
attributable to both Endocare, Inc. and Urogen Corp. and the initial
capitalization of both entities.

PROFORMA BALANCE SHEET ADJUSTMENTS:

(1) Cash

This adjustment has been made to reflect the two cash contributions of
$500,000 each, to Endocare and to Urogen.

(2) Accounts Receivable

This adjustment has been made to reflect the distribution to Endocare of
the gross receivables of $176,131 attributable to the Endocare operations.
Offsetting this gross receivable is an allowance for doubtful accounts of
$97,106 that is also attributable to the Endocare operations.

(3) Inventories

This adjustment has been made to reflect the distribution to Endocare of
the inventories of the Endocare operations.

(4) Property and equipment

This adjustment has been made to reflect the contribution of the fixed
assets of the two operations and their respective accumulated depreciation.
Listed below is the breakdown of the assets contributed to each operation.

<TABLE>
<CAPTION>
ENDOCARE UROGEN TOTAL
-------- -------- --------
<S> <C> <C> <C>
Equipment at cost.................................. $714,955 $202,036 $916,991
Furniture and fixtures at cost..................... 36,173 162,699 198,872
Accumulated depreciation........................... (323,857) (219,676) (543,533)
-------- -------- --------
Property and equipment, net........................ $427,271 $145,059 $572,330
======== ======== ========
</TABLE>

(5) Accumulated earnings

This adjustment has been made to reflect the dividend distributions of the
two stock dividends, composed of cash distributed $1,000,000 and net assets of
$891,419.

PROFORMA INCOME STATEMENT ADJUSTMENTS:

(6) Laser catheter revenues

This adjustment has been made to remove the Endocare revenues.

(7) Cost of sales

This adjustment has been made to remove the Endocare product costs.

(8) Research and development

This adjustment has been made to remove the Endocare and Urogen research
and development expenditures.

F-39
<PAGE> 80

MEDSTONE INTERNATIONAL, INC.

NOTES TO PROFORMA FINANCIAL STATEMENTS -- (CONTINUED)

(9) Selling

This adjustment has been made to remove the Endocare selling expenses.

(10) General and administrative

This adjustment has been made to remove the Endocare and Urogen
administration expenses.

(11) Provision for taxes and loss from discontinued operations

This adjustment is to record the tax effect of the losses of Endocare and
Urogen at the effective consolidated tax rate in effect for the periods
presented and to reflect the distribution of the Endocare and Urogen operations
as discontinued operations (net of taxes). The discontinued operations
presentation is provided solely for investor consideration and such presentation
will not be provided in Medstone's post-spin-off financial statements.

F-40