SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

ANNUAL REPORT

VENTANA MEDICAL SYSTEMS, INC.

Registrant’s telephone number, including area code: (520) 887-2155

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

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001 par value

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

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

      The aggregate value of voting stock held by non-affiliates of the Registrant was approximately $225,268,299 based upon the average of the high and low prices of the Registrant’s Common Stock reported for such date on the Nasdaq National Market. Shares of Common Stock have been excluded in that such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes. As of December 31, 1999, the Registrant had outstanding 13,593,640 shares of Common Stock.

Not applicable

PART I

Item 1.  DESCRIPTION OF BUSINESS

      This report on Form 10-K may contain projections, estimates and other forward-looking statements that involve a number of risks and uncertainties. For a discussion of factors which may affect the outcome projected in such statements, see “Cautionary Factors That May Affect Future Results,” beginning on page 14. While this outlook represents our current judgement on the future direction of our business, such risks could cause actual results to differ materially from our future performance listed below. We undertake no obligation to release publicly the results of any revisions to these forward-looking statements to reflect events and circumstances arising after the date of this report on Form 10-K.

      For our current and historical financial positions, see “Selected Financial Data,” beginning on page 25.

Summary of Our Business

      Unless the context requires otherwise, all references to “we,” “our” or “us” refer to Ventana Medical Systems, Inc., a corporation originally incorporated in the state of Delaware in 1991, and its five subsidiaries:

      •  Ventana Medical Systems, S.A.

      •  Ventana Medical Systems GmbH

      •  Ventana Medical Systems Japan K.K.

      •  BioTek Solutions, Inc.

      •  BioTechnology Tools, Inc.

      We develop, manufacture and market instruments and consumables that are used to automate diagnostic and drug discovery procedures in clinical histology laboratories and drug discovery laboratories worldwide. Our instrument-reagent systems are designed to prepare and stain patient tissue or cells mounted on a microscope slide for examination by a pathologist. The consumable products we market that are required to operate our instruments include reagents slides and other accessories. Our systems are designed to provide users with high-quality and consistent results, high throughput and significant labor savings. Our clinical products are used by histology labs, which are labs that focus on the analysis of human tissue, to assist anatomical pathologists in the diagnosis of cancer and infectious diseases. Our research products are used by research labs at large pharmaceutical, biotechnology and genomics companies and medical research centers to assist in the discovery of new drugs. Our instruments have been placed in forty of the top fifty U.S. cancer centers, which are recognized as leaders in cancer research and treatment as reported in the July 1999 issue of U.S. News and World Reports, including Johns Hopkins Hospital, the Mayo Clinic, Memorial Sloan-Kettering Cancer Center and M.D. Anderson Medical Center.

      According to the National Cancer Institute, cancer is the second leading cause of death in the United States. Currently 8.4 million people in the U.S. have a history of invasive cancer. Mortality rates are improved by early detection and the selection of appropriate therapies. Histology tests performed on our instruments are used by pathologists and oncologists to assist in diagnosis of cancer and to select an appropriate therapy. Based upon our modeling of the market, we estimate that histology labs worldwide could potentially purchase in excess of $1.3 billion in instruments and consumables on an annual basis. In addition, the pharmaceutical, biotechnology and the genomic companies who are analyzing the human genome to accelerate new drug discovery also benefit from automation of analysis of genes and human cell structure.

Industry Overview

      We target our instrument-reagent systems at two markets: the histology lab and the drug discovery lab. We currently derive the majority of our revenues and profits from the sale of instrument systems and

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  Histology

      Based upon a sampling of hospitals, we estimate that there are about 7,000 histology labs worldwide. Of this total we estimate about 3,500 are in North America, 2,500 in Europe and 1,000 in Japan and the remainder of the world. Most histology labs are hospital based; however, a small number of regional reference labs are found in North America and Japan.

      Histology is the study of the microscopic structure of tissues. In an histology lab, an anatomical pathologist attempts to identify the causes and consequences of disease in a specific part of the body. An anatomical pathologist uses tools ranging from the naked eye to powerful microscopes and even molecular analysis of cell proteins and genes. This is done by examining tissue samples obtained during surgery or through biopsy procedures to identify structural and other changes in cells, tissues and organs. Anatomical pathology examinations are among the most reliable ways to establish a diagnosis or, if not a diagnosis, definitive information on the type of disease suffered by the patient.

      All patient samples entering the histology lab move through seven basic processing steps or work cells:

	•	Accessioning — Tissue is entered into the hospital information system for medical records and billing purposes.
	•	Grossing — Following accessioning, the gross patient tissue specimen is examined by a pathologist. Several tissue samples are then cut from the gross specimen for further examination and placed in small plastic cassettes.
	•	Tissue Processing — Cassettes from gross specimens are generated throughout the day and placed at the end of the day in an instrument called a tissue processor for overnight batch processing. Tissue processors preserve the tissue by setting it in a fixative, usually formalin, and infusing the tissue with paraffin so it can be more readily sectioned or cut. An alternative to using a fixative is to freeze tissue and handle it in a frozen state although, we estimate that less than 5% of patient specimens entering histology labs are frozen.
	•	Embedding — The first activity that usually occurs in a histology laboratory each morning is to remove the processed tissue from each cassette and embed it in a paraffin block. This work is performed manually and is undertaken to produce a specimen of uniform size that can be cut on a microtome.
	•	Sectioning — Each tissue block is next transferred to the sectioning area of the lab where very thin sections are cut on a microtome or ultramicrotome, depending on the test to be performed, and mounted on a microscope slide. The number of slides that are cut from each block varies according to the case and is usually determined by the pathologist who is performing the gross analysis.
	•	Hemotoxlyn and Eosin, or H&E, Staining — Each microscope slide is then stained with two basic stains, Hemotoxlyn and Eosin, that help the pathologist identify each cell’s nucleus, cytoplasm and membrane.
	•	Microscopic Examination — Finally, each H&E stained slide is examined by a pathologist using a microscope to determine if the tissue or cells are healthy or diseased. In particular, the pathologist is looking for the presence of microorganisms that could indicate an infectious disease or deformed cells that could indicate the presence of cancer. In cases where an H&E stained slide appears to have abnormalities, the pathologist performing the initial examination of a patient specimen will request that the slide undergo additional testing. We estimate this happens in approximately 15% of cases.

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      Additional tests which may be requested by the pathologist include immunohistochemistry, special stains or in situ hybridization tests. These tests are significantly more complex than the H&E stains and may require special reagents.

	•	Immunohistochemistry, or IHC, stains are used primarily by pathologists to assist in the diagnosis of cancer and by oncologists to determine different treatment options. Pathologists use IHC stains to test for the presence or overexpression of the proteins involved in cancer.
	•	Special stains are used primarily to assist in the diagnosis of infectious diseases, although they can also be used to assist in cancer diagnosis. Special stains are chemical dye stains that localize to microorganisms located in tissue and to specific tissue types.
	•	In situ hybridization, or ISH, stains can be used to assist in the diagnosis of infectious diseases or genetic mutations that are usually associated with the presence of cancer.

      We do not currently participate in all histology lab work cells. We currently offer products that are used in tissue processing, sectioning, IHC staining, special stains and ISH staining.

      Tissue Processing. In developed nations, all histology labs have at least one automated tissue processor instrument and most labs have two or more. In less developed countries, tissue processing is still performed manually in most labs. We estimate that the worldwide installed base of tissue processing instruments is greater than 10,000 and, based upon our field experience, we estimate annual shipments to be between 1,000 and 1,500 instruments. The size of the annual shipment market is driven primarily by replacements, although some shipments reflect growth driven by an increase in surgical procedures. Tissue processors consume a substantial quantity of reagents (fixatives, alcohol, xylene, paraffin), however we do not participate in this reagent market.

      Microtomes. Microtomes are used to cut thin sections of tissue following embedding. Ultramicrotomes cut tissue and other samples for use in electron microscope and other sophisticated analytic devices. They cut much thinner sections than traditional microtomes. Every histology lab utilizes several microtomes. Only sophisticated labs, usually located in medical teaching institutions, have access to ultramicrotomes.

      IHC Staining. We estimate that there are in excess of 20 million slides stained with IHC annually on a worldwide basis. The majority of these slides are stained in the approximately 7,000 hospital-based histology labs. However, in North America and Japan some hospitals send their IHC slides to regional reference labs for staining rather than performing the work themselves. Based upon our growth, we estimate that the number of IHC slides processed by labs in the U.S. on an annual basis is growing at about 6%-8% rate due to:

      •  increasing acceptance of the value of the technology by pathologists and oncologists;

	•	the increasing incidence of cancer as the population ages;
	•	the emergence of new stains that may influence therapy choices; and
	•	the shifting of the market from manual to automated IHC slide processing.

      We estimate that in excess of 50% of the IHC slides processed in North America, and in excess of 25% of the IHC slides processed in Europe, are stained in automated instruments. Most of the rest of the world is using manual staining, which we believe represents a substantial growth opportunity as a portion of these users are converted to automated systems.

      IHC instruments require reagents and accessories to operate. We supply a full line of these consumables for use with our instruments. Our experience in the industry suggests that we are the worldwide market leader in supplying automated IHC staining systems.

      Special Stains. We estimate that the special stains market is larger than the IHC market in terms of slides processed on a worldwide basis. There is an opportunity to place instruments with virtually every hospital-based histology lab as special stains slides are rarely sent to reference labs. Currently, nearly all

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      ISH Staining. The clinical market for ISH staining is currently very small due to the difficulty of performing ISH stains manually and the small number of stains accepted for clinical use. We expect automation to grow the clinical market. Currently, the principal clinical tests are used to detect infectious diseases, primarily viruses, in tissue. However, ISH tests for genetic mutations may eventually become important clinical tests. The only ISH genetic mutation test performed in the histology lab today is the test for Her-2/neu gene over-amplification in cancerous breast tissue. This is currently a small market as most laboratories prefer to measure Her-2/neu status using an IHC stain.

  Pharmaceutical Research

      The pharmaceutical research market consists of over 2,000 labs worldwide. The labs are located in large pharmaceutical companies, smaller biopharmaceutical companies and medical research centers. In these labs, research is being conducted to determine the causes of disease and the discovery of drugs to treat disease. Genomics, or the study of genes and their function, is seeking to accelerate the drug discovery process by understanding the molecular mechanisms of disease. The genomics revolution is providing pharmaceutical researchers with a dramatic increase in the number of potential drug targets, such as a specific protein involved in a disease process, against which to conduct screens of compound collections, or compound libraries. In addition, pharmaceutical researchers are vastly expanding the size of compound libraries they use to screen against new drug targets. As a result, researchers require new lab technologies capable of screening increasingly large compound libraries against an increasing number of drug targets in a cost-effective, automated and rapid manner.

      Genomics is the analysis of nucleic acids, which are the fundamental regulatory molecules of life. Nucleic acids take two forms, DNA or RNA. These molecules contain and convey the instructions that govern all cellular activities, including protein manufacture and cell reproduction. DNA and RNA consist of linear strands of nucleotide bases, the specific sequences of which constitute the genetic information in the cell. The unique genetic blueprint for all living organisms is encoded in the DNA. The entire DNA content of an organism is known as its genome, which is organized into functional units called genes. Any defect or mutation in the sequence of nucleotide bases in the DNA or RNA can disrupt cell or protein function and lead to disease.

      Genomics has created opportunities to fundamentally alter the field of human medicine through the discovery and development of novel drugs and an improved ability to diagnose and manage disease. Interest in understanding the relationships between genes and disease has generated a worldwide effort to identify and sequence the genes of many organisms, including the approximately three billion nucleotide pairs and the estimated 100,000 genes within the human genome. Once researchers identify the genes and their nucleotide sequences, we anticipate that an understanding of the specific function of each of these genes and the role that different genes play in disease will require many years of additional research.

Business Strategy

      Our objectives are to expand our worldwide leadership position in histology lab automation and to penetrate the drug discovery market with technology perfected for the histology market. Our strategy is to:

      Provide high-quality, innovative and flexible automation systems for tissue analysis. Our position as a leader in the histology lab automation market has been built on innovative automated instrument-reagent systems. Our systems have been designed as broad enabling platforms that permit customers to easily expand their test menu. These automated systems allow for superior patient care by providing anatomical pathologists with higher quality, more consistent and more timely staining than through manual methods. Further, labs benefit by increasing output and reducing labor costs through automation and walk-away convenience.

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      Provide high throughput, value-added testing systems for various genomics applications. We intend to pursue the same broad strategies in the pharmaceutical research market as we are pursuing in the histology market. We also intend to consider developing relationships with other organizations with complementary skills or technologies, which should allow us to quickly acquire capabilities we need in a rapidly changing market.

      Maximize placement of our automated systems in histology and drug discovery laboratories both domestically and worldwide. Rapidly automating manual work cells permits us to strengthen our competitive position by establishing a large base of instruments that current or future market entrants must overcome. We estimate that our worldwide installed base of IHC and special stains instruments is significantly larger than the combined installed bases of instruments of all of our current competitors. We believe that the size and quality of our direct sales coverage will permit us to maximize instrument placements and maximize revenue stream per placement.

      Ensure a steady stream of consumables sales for use in these instruments. Each IHC, special stain and ISH instrument placed typically provides us with a recurring revenue stream through the sale of reagents and other consumable supplies. Our strategy is to increase this revenue stream by converting all existing manual tests performed by the customer to full automation and by selling the customer all the required reagents for the automated tests. We intend to expand our menu of automated tests over time, which should increase the consumable revenue we receive from each instrument placement, as typically our systems are closed systems which can only be operated with consumables produced by us.

      Continue ongoing technological development and improvement of our instruments and reagents. We design all of our own products, unlike most of our competitors, who rely on outside design firms to create their instruments. We are developing new instruments and enhancing existing instruments and developing reagants for our installed base of instruments as well as for new products. Both our engineering and reagent research and development organizations work closely with their manufacturing counterparts on all new products to ensure they can be produced cost effectively. We protect our designs with an aggressive intellectual property strategy.

History of the Company

      We were incorporated in California in 1985 by a pathologist practicing at the University of Arizona Medical Center who was interested in automating IHC staining. In 1993 we were reincorported in Delaware. In 1989 we procured venture capital funding and launched our first instrument-reagent system in 1991. We have launched multiple new systems since then, some of which were developed internally and some of which were acquired.

Our Products

      We market five product lines: tissue processors, microtomes, IHC staining instruments, special stains instruments and ISH staining instruments. Some of these instruments use consumables such as slides,

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Product Offerings

  Tissue Processors

      We entered the tissue processing work cell when we acquired BioTechnology Tools. BioTechnology Tools designed, manufactured and marketed through distributors a tissue processor known as the PTP-1530 which we have subsequently modified and now market as the Renaissance.

      Our Renaissance tissue processor is a batch instrument that can accommodate up to 350 specimens at a time. This completely enclosed system can be configured as a floor or bench top unit. It has easy-to-use software with flexible programmability and a pulse magnetic stirrer that significantly improves the quality of prepared tissue. The Renaissance quality control system allows the customer to monitor the quality of the reagents being used, and to extend the life of their reagents using a paraffin cleaning system. We do not market a complementary line of consumables with the Renaissance.

  Microtomes

      We also entered the sectioning work cell through the acquisition of BioTechnology Tools. BioTechnology Tools designed, manufactured and sold through distributors two product lines of sectioning equipment. Our first product line, the Series 100 Microtome, is designed to section tissue in the histology lab and is our lead product.

      Our second product line, ultramicrotomes, is marketed under the BioTechnology Tools RMC trade name. Ultramicrotomes cut much thinner specimens than the histology product line and are used to prepare specimens for examination under an electron microscope or other sophisticated analytic device. Our ultramicrotomes are used for clinical analysis of patient tissue, medical research and by the electronics and automotive industry for incoming quality inspection of raw materials.

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      We are a small competitor in the histology microtome market. Microtomes consume a large number of specialty blades; however, we do not participate in the specialty blade market.

  Staining Systems and Associated Reagents

      The principal benefits of automated cellular and tissue analysis using our integrated systems as compared with manual methods are:

	•	improved reliability, reproducibility and consistency of test results;
	•	faster turnaround time for test results;
	•	increased test throughput for the testing;
	•	reduced dependence on skilled technicians;
	•	ability to obtain maximum clinical information from minimally-sized biopsies;
	•	ability to document processing protocols (patient priority instruments);
	•	enhanced cellular differentiation through multiple staining on a single slide; and
	•	standardization of slide preparation among institutions.

      In addition to these critical clinical and operational advantages, we have determined that our automated approach has cost advantages as well.

      IHC Staining. Our first product launch in 1991 was an instrument-reagent system to automate IHC staining. Prior to the introduction of this system, all IHC staining was performed manually or using low-level automation. In early 1996, we acquired our principal competitor in the IHC market, BioTek Solutions, Inc. We now enjoy a leading market share position in automated IHC staining worldwide.

      We currently market two IHC instrument systems with a full line of complementary reagents and accessories. Our line of IHC products includes batch-processing systems targeted to large hospital clinical labs and reference and research labs and patient priority systems targeted to hospital clinical labs. Although our existing batch processing systems are “open,” providing the customer with the ability to purchase reagents from either us or other sources, the majority of our United States customers with batch processing systems regularly purchase reagents from us. Our patient priority systems are “closed” in that customers must purchase detection chemistries from us in order to operate the instruments.

      Our line of TechMate batch processing instruments is designed for large volume testing using a single antibody on multiple patient biopsies and research applications in which long incubation times and unique detection chemistries are required. Our batch processing instruments employ capillary action to perform IHC tests. Patient biopsies are placed on capillary gap slides, which maintain a space of predetermined width between adjacent slides when loaded into TechMate systems. Reagents are loaded into disposable reagent trays and programmable software directs the instrument to apply the reagents in the proper sequence. The instrument immerses the bottoms of the slides in the reagents as programmed and the reagents are drawn up the slide and over the tissue specimen by capillary action. After each reagent application and incubation, the instrument removes the reagent from the specimen by placing the slides onto disposable blotting pads. In North America, we directly manufacture and market reagents for use in our TechMate systems.

      The TechMate 500, has a 120-slide capacity, which is applicable to both large and moderately-sized reference labs and large research labs. The TechMate 250, which has a 40-slide capacity, is targeted primarily for the European and other international markets. We distribute this product through a collaborative marketing relationship with another company. The products are manufactured on a contract basis by a third party and we receive a royalty on the sale.

      The NexES system provides an automated approach for applying primary antibodies and detection chemistries. The NexES system is barcode driven and is designed for multiple tests on a single patient

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      The NexES is based upon a modular design and an external personal computer operating under a Windows 98 environment for software control. Each module holds up to 20 slides in the reaction chamber and 25 reagents on its reagent carousel. The modular design of the NexES and external personal computer permits the linkage of up to eight NexES IHC or special stains modules together, creating the capacity to process up to 160 slides. The NexES therefore offers users a significant degree of flexibility as users can purchase from one to eight modules depending upon their test volume requirements.

      Reagent products are composed of primary antibodies and detection chemistries, each of which is required for an IHC test. Customers that have patient priority systems must use our detection chemistries on all tests. They have the option of purchasing primary antibodies from us or other sources. Customers who have our batch processing systems have the option of purchasing both antibodies and detection chemistries from us or other sources. Users of a majority of our United States installed batch processing systems regularly purchase reagents from the us.

      We sell a line of over 215 primary antibodies used to detect antigens in combination with detection chemistry kits on our instruments. We market all of the antibodies used to perform the IHC tests that currently account for more than 90% of total IHC test volume.

      We estimate that detection chemistries typically account for approximately 60% of the total expenditures for reagents required to perform IHC tests using our instruments. We produce a line of detection chemistries for use on both patient priority and batch processing systems which provide the user with standardized reagents, thereby giving the user convenient and rapid results. The detection chemistries have been developed by us using proprietary formulations which, when combined with our primary antibodies and other reagents, optimize the results of tests performed on our instruments. These kits generate the visual signal in an IHC reaction at the site where a primary antibody is bound to a specific antigen or molecule in the cell or tissue. The patient priority system utilizes detection kits which include (i) a DAB Kit which generates a brown color; (ii) an AEC Kit which generates a deep red color; (iii) an Alkaline Phosphatase Red Kit which generates a bright red color; and (iv) an Alkaline Phosphatase Blue Kit which generates a deep blue color. We currently sell DAB and Alkaline Phosphatase Red for use with our batch processing instruments. The detection kits are designed to perform tests on a wide variety of specimens, so a lab can, for example, perform tests on tissue preserved in paraffin and on frozen tissue simultaneously. Our detection chemistries have been formulated to provide long term stability for reproducibility and ease of use as well as a high signal to noise ratio for optimal sensitivity.

      We offer a line of consumable ancillary products that are necessary for processing slides on our instruments. These include buffers for optimizing the IHC reaction and counterstains for staining cell nuclei, which are used with both patient priority and batch processing instruments. The buffers ensure good morphology, low backgrounds and high signals. The counterstains provide additional convenience for the customer by eliminating the need for additional processing of the slides after staining on the instrument. For use with patient priority instruments, we also supply a proprietary liquid coverslip used to inhibit evaporation during processing in the instrument, fixatives for maintaining the morphology of cells or tissues, enzymes for unmasking antigens and slide barcodes for use in identifying the slide and its specific IHC reaction steps. For use with batch processing instruments, we also provide disposable reagent trays which are used to hold the reagents during IHC reactions, capillary gap slides and wicking pads used for reagent removal between applications.

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      Special Stains. In late 1998, we launched our second instrument-reagent system which handles special stains testing. It was the first automated special stains system offered to histology labs. We believe that we have established ourselves as the clear market leader in this product segment. We supply both an automated instrument for special staining and all the reagents needed to operate the instrument. Two competitors have entered the automated special staining market since we launched our system.

      The special stains module can be operated by the same control computer that operates our NexES IHC modules. Any combination of up to eight special stains and IHC modules may be operated by a single control computer. This flexibility enables customers to design a combination special stains/ IHC system that meets the specific needs of their lab. It also provides future flexibility for handling lab growth.

      The special stains module uses a different approach for dispensing reagents than the IHC system. The special stains aspiration and dispense system permits us to use a low cost container for our reagents.

      We currently market eleven different special stains kits that we estimate account for about 85% of all types of special stains performed in histology labs. We plan to expand this test menu in the future so that our special stain system can meet more than of 95% of most laboratories special staining needs. All of our special stain kits were developed using proprietary protocols.

      ISH Staining. We entered the ISH staining market with the launch of our GenII system in 1995. The GenII was primarily sold into the drug discovery market although some instruments were placed in histology labs for clinical use. We have not aggressively marketed the GenII in recent years due to high field support requirements and low consumption of reagents and accessories.

      We launched our second ISH staining system in December 1999 called the Discovery. The Discovery system can function as a high throughput processor of DNA and RNA microarrays. It can also be used as a high throughput processor of tissue arrays used to validate gene drug leads. We anticipate that this system will primarily be sold to companies involved in pharmaceutical research but also intend to market to histology labs for clinical use.

      The Discovery staining system consists of a staining module and a full line of complementary reagents and accessories. The “front-end” of the system is open, permitting researchers to use their own molecular probes in searching for genetic mutations. The “back-end” of the system consisting of detection chemistry that attaches to the molecular probe and permits the researcher to visualize the target, is closed and must be purchased from us. The only exception to this is where the detection chemistry is mounted on the target probe. This is the case when a flourescent in situ hybridization, or FISH, stain is performed.

      The Discovery instrument can currently only perform ISH stains tests. A future software release will permit the Discovery to perform both ISH and IHC stains tests. This dual staining capability will permit researchers to stain tissue for both genetic mutations and for the proteins produced by those mutations.

      The Discovery system incorporates a number of important technological advances over our earlier NexES IHC and special staining systems. The principal advance is the ability to accurately control the reaction temperature. In contrast the NexES IHC and special stain modules heat the entire reaction chamber to a pre-set temperature and maintain that temperature during the entire processing cycle. Individual slide heaters in the Discovery permit an optimal protocol to be developed for each test. It also permits the unwinding or denaturing step that is critical to detecting DNA abnormalities to be tightly controlled. We have filed a number of patents to protect inventions incorporated into the Discovery system.

      In November of 1998, we acquired all of the oncology assets of Oncor, Inc. These assets consisted primarily of gene-based tests used in drug discovery. Some of these tests have clinical potential.

      Our ISH systems are currently being used, or tested for use, in the following drug discovery applications:

	•	Processing DNA and RNA Assays. These assays are used to identify genes that are possible targets for drug therapy and pinpoint the mutation in these genes. Our Discovery instrument can be used to process DNA and RNA assays.

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	•	Processing Tissue Assays. Tissue assays are an emerging drug discovery tool that validate the value of target genes and proteins in human tissue. Our instruments can be used to automate the processing of these assays.
	•	Processing Individual Tissue Samples. Instead of using tissue assays, many companies engaged in pharmaceutical drug discovery are testing genes and proteins in traditional tissue slides. Our Discovery instrument can be used to identify genetic mutations in the tissue. In addition, our IHC systems can be used in conjunction with our Discovery system to identify abnormal proteins or abnormal protein levels in tissue.

Research & Development

      Our research and development group is divided into two teams: one that is responsible for instrument development and a second which develops staining protocol and reagents. We have focused our efforts on the development of innovative combined instrument-reagent systems. We are developing new instruments and enhancing existing instruments. In addition, we are developing reagents for our installed base of instruments as well as for new products.

      As of December 31, 1999, our research and development organization consisted of 57 persons, many of whom have graduate degrees. Our research and development activities are performed primarily in-house by our own employees. These efforts are supplemented by consulting services and assistance from scientific advisors. We spent $7.1 million in 1999, $5.1 million in 1998 and $3.1 million in 1997 on research and development.

  Instrumentation Development Projects

      Our instrumentation development is focused on continuous product improvement and new product development. We believe that the modular platform used by our NexES IHC system has enabled us to develop new products more rapidly. We implemented this strategy with the launch of the NexES Special Stains system in 1998 and our new Discovery System launched in late 1999. We expect to continue this modular development strategy in the future. We continue to explore new opportunities in instrument systems that add value to the customer, including automating other manual processes in the histology lab.

  Reagent Development Projects

      Our reagent development is divided into four principal areas:

	•	new antibody development;
	•	detection chemistries;
	•	special stain chemistries; and
	•	ISH chemistries.

      We continue to monitor third-party development of new primary antibodies and will license or purchase these as appropriate. Primary antibodies are used to assist pathologists in recommending treatment protocols for cancer patients. We also continue to improve the sensitivity and specificity of our detection chemistries. New detection chemistries with higher signal strength and lower background noise were introduced in early 1999.

      Reagent development also supports the development of new instrument systems. A complete reagent product line was introduced in conjunction with the October 1998 launch of the special stain module. Development of reagents to support our Discovery ISH instrument is ongoing. We are also developing reagents for our clinical ISH instrument which we plan to launch in late 2000. We are currently in discussion with various universities, hospitals, and commercial organizations regarding other potential areas of opportunities for the ISH system.

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Customers

      Our customers consist of clinical histology labs and the drug discovery labs of large pharmaceutical companies, biotechnology and genomic companies and medical research centers. Our instruments have been placed in forty of the top fifty U.S. cancer centers, which are recognized as leaders in cancer research and treatment as reported in the July 1999 issue of U.S. News and World Reports, including Johns Hopkins Hospital, the Mayo Clinic, Memorial Sloan-Kettering Cancer Center and M.D. Anderson Medical Center. We have also placed our instruments in more than 1,500 hospital-based clinical histology labs worldwide. None of our customers accounts for more than 5% of our consolidated revenues in 1999 or 1998; in 1997, sales to a European distributor accounted for approximately 20% of consolidated net sales.

Patents and Proprietary Rights

      We have pursued a strategy of patenting key technologies that relate to both the automation and chemistry of analyzing cells and tissues on microscope slides. We presently own 32 United States patents and numerous corresponding foreign patents. We have also filed patent applications in the U.S. and abroad that cover research and development as it relates to existing and future products. In 1999, three of our U.S. patents issued. We also have access to some key technology through exclusive and nonexclusive licenses, such as patented Human Papilloma Virus sequences.

      Our patent portfolio is divided roughly into two segments: instruments and reagents. Patents and applications related to instruments include:

	•	three U.S. patents directed to the Liquid Cover Slip™ technology;
	•	the suite of patents related to the TechMate instrument that covers all aspects of the instrument including the algorithm for the interleaving of steps of a run;
	•	two separate U.S. patents on reagent dispenser designs;
	•	apparatus for automated IHC tissue staining; and
	•	independently heatable slide staining apparatus.

      Reagent patents and applications include:

	•	tissue fixatives;
	•	hybridization methods and compositions;
	•	IHC staining methods and reagents;
	•	biotin/avidin formulations and methods; and
	•	compositions for manual and automated assessment of various types of cancer, including, breast, leukemia and prostate.

Sales and Marketing

      Our histology lab strategy involves providing customers with superior levels of customer service. We believe this can only be achieved by selling our products directly to customers, rather than through distributors, in our major markets and by controlling our own telephone and field service forces.

      Based on our experience in the industry, we believe we have the world’s largest direct sales force covering histology labs. We believe that the size and quality of our direct sales coverage will permit us to maximize instrument placements and maximize revenue stream per placement. This sales force is organized geographically by region in North America and by country internationally. In North America we also have a separate sales organization focused solely on national and key accounts. In North America, Japan and in most major European markets we sell all of our products (except our ultramicrotomes) on a direct basis. In most other countries, we rely on distributors to sell and service our products.

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      In addition to maintaining direct sales organizations in our major markets, we also maintain direct customer telephone and field service operations. This permits us to maintain a close relationship with our customers which we hope to exploit from instrument placement, through reagent and consumable sales to instrument replacement. This relationship will also allow us to provide high quality and rapid service in response to customer instrument or reagent problems.

      We also have a comprehensive customer education program, which includes on-site technical training in instrument use, user group meetings and sponsored national teleconferences with leading medical experts who regularly update our customers on diagnostic and testing developments.

Competition

      We face a wide array of different competitors in the histology lab and drug discovery markets. In many product segments our competitors have substantially greater experience than us and far greater name recognition by our customers. In most product segments competition is intense and is based on product performance and price, the breadth of a company’s product line, and after-sales service.

  Histology

      Our competitors in histology vary by product category. Our principal competitor in tissue processing is Sakura Fine Technical Co., Ltd., a privately held Japanese company with far greater market share, experience and name recognition than we have. Additional competitors in tissue processing include Leica Microsystems Group, a German based competitor, and Thermo BioAnalysis Group, a U.S. public company that owns Shandon Lipshaw, a formidable competitor worldwide in histology lab equipment. Despite the strong entrenched competition in this segment we believe we are increasing our market share through strong sales increases of our Renaissance tissue processor.

      Our competitors in tissue sectioning include Leica and Micron, the German based subsidiary of U.S. based and publicly traded Sybron International Corp. In addition to these two competitors, who combined hold around 80% of the worldwide microtome market, a large number of additional competitors are trying to establish themselves in the market. Sakura and Shandon Lipshaw also market a line of microtomes. We have a small share of the microtome market and do not expect this share to increase significantly in the near term due to fierce competition and low gross product margin.

      We are the market share leader in automated IHC staining. We have a worldwide installed base of instruments that exceeds all of our competitors combined. Historically, we have also placed more new instruments each year than all of our competitors combined. Nevertheless, we face strong competition on two fronts. Indirect competition comes from the manual method of performing IHC tests. A number of histology labs in the U.S. and the majority of histology labs outside the U.S. still perform their IHC slide staining manually. Significant barriers to automation of this process exists in some countries where reimbursement for IHC tests by insurance companies and government health care plans is low. Further, significant barriers to automation exist in a number of labs where pathologists prefer manually stained slides which were created using their own staining protocols.

      Direct competition currently comes from four competitors who market instrument-reagent IHC staining systems. The competitors are DAKO, a privately held Danish company that dominates the market for manual IHC reagents; BioGenex Laboratories, Inc., a privately held U.S. company that markets its own instrument and line of reagents; Labvision Corporation, another privately held U.S. company that supplies DAKO with instruments and also markets its own instruments both on a direct basis and through distributors in most major markets; and Diagnostics Products Corp., which markets a high volume IHC slide stainer, principally in Europe.

      Two automated special staining systems compete with our special staining module. CytoLogix Corp., a venture-backed, U.S.-based, early-stage company markets the Artisan Staining System. The CytoLogix system will reportedly be expanding its menu of reagents to include IHC stains and potentially ISH stains. BioGenex also markets a line of special stains instruments called Optimax which was originally designed

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  Pharmaceutical Drug Discovery

      Our Discovery ISH staining system launched in late 1999 is primarily used by organizations engaged in drug discovery and other related research. Virtually all ISH staining is currently performed manually. We currently do not face a direct competitor in this market. A Japanese company markets an ISH staining system in Japan only, but we believe its performance is not comparable with the Discovery. We also anticipate that our Discovery system will face competition in the future.

Manufacturing

      We manufacture all of our own products except the Techmate 500 and Techmate 250 instruments. Both of these products are produced by third-party manufacturers and account for only a small portion of our total sales. We maintain three manufacturing facilities — an instrument manufacturing facility located in Tucson, Arizona, a separate reagent manufacturing facility also located in Tucson, Arizona and a second reagent manufacturing facility located in Gaithersburg, Maryland.

      Our instrument manufacturing facility in Tucson is operated under the leadership of a single instrument manufacturing manager who is responsible for component purchasing, product scheduling, production, materials management and shipping.

      Our reagent manufacturing facility located in Tucson, Arizona produces the majority of the reagent and accessory consumables that we sell. This facility is also a focused facility under the leadership of a manufacturing manager who is responsible for purchasing, scheduling, production, materials management and shipping.

      Our second reagent manufacturing facility is located in Gaithersburg, Maryland, and was acquired with the acquisition of the oncology assets of Oncor. This facility has been approved by the FDA for the production of our pre-market approval, or PMA, approved Inform® test for measuring Her-2/neu gene overamplification in breast tumors. We use this facility to produce the products we acquired from Oncor. We also plan to use it in the future to produce additional products that receive FDA PMA approval.

      Our manufacturing operations are required to follow the FDA Quality Systems Regulations. These regulations require us to maintain documentation and process control in a prescribed manner with respect to manufacturing, testing and quality control. We are also subject to FDA inspections to verify compliance with FDA requirements. We also intend to implement manufacturing policies and procedures that will enable us to receive ISO 9001 certification. ISO 9001 standards are global standards for design and manufacturing process control and quality assurance. Finally, we are required to obtain the CE mark for sale of our products in the countries comprising the European Union. The CE mark is an international symbol of quality assurance and compliance with applicable European Union medical device directives.

Contracts

      We place instruments through direct sales, including nonrecourse leases, instrument rentals and our Performance Evaluation Period program. The program is intended to permit a customer to use an instrument, generally for a period of up to three months, provided that the customer purchases all the consumables needed to operate the instrument from us. At the end of the three month period, the customer elects to purchase, rent or return the system. For placement of instruments under this program, we incur the cost of manufacturing instruments and we recognize revenue only at the time the instrument is either sold or rented rather than at the time of instrument placement. The cost of manufacturing the instrument placed through the program or rental is charged to cost of goods sold by depreciating the cost of the instrument over a period of four years.

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Suppliers

      We do not depend upon any single supplier. Because we have multiple sources of supply, we have not experienced difficulties in obtaining adequate sources of supply and adequate alternatives to satisfy our customers. We do not have formal purchase contracts for our supplies, but instead we generally purchase items under individual purchase orders.

Employees

      As of December 31, 1999 we had approximately 412 full-time employees, including our 8 officers.

Warranties

      We offer one year parts and labor warranties on all of our instruments. We have historically not had a large number of claims made under warranties.

Cautionary Factors That May Affect Future Results

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		make instruments in a timely fashion could be impaired and our results of operations would suffer.
Some of our manufacturing processes involve the use of environmentally hazardous materials		Certain of our manufacturing processes, primarily those involved in manufacturing certain of our reagent products, require the use of potentially hazardous and carcinogenic chemicals. We are required to comply with applicable federal, state and local laws regarding the use, storage and disposal of these materials.
— we could incur substantial liability if it is found that either we or the third party disposal service we use has violated any environmental laws		We currently use third-party disposal services to remove and dispose of the hazardous materials we use. We could in the future encounter claims from individuals, governmental authorities or other persons or entities in connection with exposure to or disposal or handling of these hazardous materials or violations of environmental laws by us or our contractors. We could also be required to incur additional expenditures for hazardous materials management or environmental compliance. The costs associated with environmental claims, violations of environmental laws or regulations, hazardous materials management and compliance with environmental laws could cause our results of operations to suffer.
When we introduce a new product we may incur a charge for older instruments that are still in our inventory		When we introduce a new instrument, we may incur charges for inventory obsolescence in connection with unsold inventory of older generations of products. To date, however, we have not incurred material charges or expenses associated with inventory obsolescence in connection with new product introductions.
The price of our common stock may vary significantly in the short term due to:		The securities of medical device and life science companies have historically shown a large amount of price volatility. As can be seen from the market information on page 24, our common stock has shown this price volatility and it is likely that this volatility will occur in the future.
— large fluctuations in the stock market in general		The stock market has also experienced extreme price and volume fluctuations that have affected the market price of many companies. These fluctuations have often been unrelated to the operating performance of particular companies. Our common stock price may be affected by these fluctuations.
— fluctuations in our operating results, new technology, government regulations, or recommendations by financial analysts		Other factors such as fluctuations in our operating results, announcements of technological innovations or new products by us or our competitors, FDA and other government regulation, developments with respect to patents or proprietary rights, public concern as to the safety of products developed by us or others, changes in financial analysts’ estimates or recommendations regarding us and general market conditions may have a material adverse effect on the market price of our common stock. Our results of operations may, in future periods, fall below the expectations of financial analysts and investors and, in such event, the market price of our common stock could be materially adversely affected.

Item 2.  PROPERTIES

      Currently, our U.S. research laboratories, instrument and reagent manufacturing facilities and administrative offices are located in approximately 90,000 square feet of leased space in Tucson, Arizona and Gaithersburg, Maryland. The leases for these facilities expire at various times between January 2001 and November 2004, subject to renewal terms. We are presently in negotiations to purchase a piece of vacant land in Tucson where we plan to build a 185,000 square foot mixed-use facility to house all of our operations that are now resident in various locations around Tucson. Construction of this facility is expected to begin in 2000

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      Currently, our European operations are located in approximately 9,000 square feet of leased office and warehouse space in two facilities in Strasbourg, France. One facility is approximately 6,500 square feet with a lease which expires on December 31, 2000. The other facility is approximately 2,500 square feet with a lease which expires on June 1, 2000. We are also planning to purchase a dedicated facility to house all of our future European operations. This facility will be purchased in June of 2000 and will be approximately 39,000 square feet in size. We will not use all of this space immediately. Therefore, we plan to lease space to others until we need it.

      Our Japanese operations are located in 3,000 square feet of leased office space in Tokyo. The lease for this space expires on May 31, 2001. We intend to renew the lease on this facility if we can negotiate acceptable terms.

      Once we complete the construction of the Tucson facility and the purchase of the building in Strasbourg we believe that we will have sufficient space for the foreseeable future.

Item 3.  Legal Proceedings

      In January 1997, four individuals who are former BioTek noteholders who held in the aggregate approximately $1.1 million in principal amount of BioTek notes filed an action, Tse, et al v. Ventana Medical Systems, Inc., et al. No. 97-37 (“Tse Action”), against us and certain of our then current directors and stockholders in the United States District Court for the District of Delaware. The complaint alleges, among other things, that we violated federal and California securities laws and engaged in common law fraud in connection with the BioTek shareholders’ consent to the February 1996 merger of BioTek into Ventana and the related conversion of BioTek notes into Ventana notes, which were subsequently repaid. Plaintiffs seek substantial compensatory damages several times in excess of the principal amount of their BioTek notes, as well as substantial punitive damages, and fees and costs. On April 25, 1997, plaintiffs filed an Amended Complaint. The Amended Complaint makes the same allegations as the original Complaint, and adds a claim under North Carolina securities laws. In May of 1997, we made a motion to transfer the action to the district of Arizona, or alternately to the Central District of California, which was denied by the court. On December 16, 1997, we filed a motion to dismiss the Amended Complaint. This motion was partially accepted and partially denied by the Court. On March 8, 1999, plaintiffs filed a Second Amended Complaint. The Second Amended Complaint makes the same allegations as the original and Amended Complaints, deletes the claim made under North Carolina securities laws and the claim made under California Blue Sky laws, and adds stockholders as defendants. Based on the facts known to date, we believe that the claims are without merit and we intend to vigorously contest this suit. After consideration of the nature of the claims and the facts relating to the merger and the BioTek note exchange, we believe we have meritorious defenses to the claims and that resolution of this matter will not have a material adverse effect on our business, financial condition and results of operations; however, the results of the proceedings are uncertain and there can be no assurance to that effect.

      In April 1999, a former BioTek noteholder filed an action, Leung, et al. v. Jack W. Schuler, et al., No. 17089, against us and certain of our then current directors and stockholders in the Delaware State Chancery Court, New Castle County. The complaint, brought individually and on behalf of a purported class, makes virtually the same allegations made in the Tse Action and seeks recovery under breach of contract and breach of fiduciary duty theories. On May 6, 1999 we filed a motion to dismiss the complaint. On February 29, 2000, the court issued a memorandum opinion granting our motion and dismissing the complaint in its entirety.

      On December 9, 1999 we filed an action, Ventana Medical Systems, Inc. v. Cytologix Corp., No. CIV99-606 TUC FRZ, alleging patent infringement seeking monetary damages and injunction relief in the United States District Court for the District of Arizona. We believe our claims are meritorious and that we will prevail, however, because the action is relatively new, results of the proceedings are uncertain and there can be no assurance to that effect.

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      On June 15, 1999 we filed a proof of claim against Oncor, Inc. in an action pending in the United States Bankruptcy Court for the District of Delaware titled In re Oncor, Inc., No. 9-437 (JJF). Our claims arise out of an Asset Purchase Agreement dated November 23, 1998 and related documents wherein we acquired Oncor’s unincorporated In Situ Hybridization Technology Division and rights related thereto. In February 2000, we filed an amended proof of claim alleging, enter alia, Oncor breached the terms of the Asset Purchase Agreement by purporting to transfer or assign to us Oncor’s rights under a license agreement, which were not transferable or assignable under the circumstances then existing. The amended proof of claim seeks damages of no less than $7,321,000. We believe our claims are meritorious and that we will prevail, however, the results of the proceedings are uncertain and there can be no assurance to that effect.

      In February 2000, we settled the lawsuit in the Northern District of California filed by a former employee.

Item 4.  Submission of Matters to a Vote of Security Holders.

      We did not submit any matter for a vote by our shareholders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report.

PART II

      Our common stock is listed on the Nasdaq National Market. The closing price of our common stock on March 13, 2000 was $51.50. The following table shows the high and low bid prices in dollars per share for the last two years as reported by Nasdaq. These prices may not be the prices that you would pay to purchase a share of our common stock during the periods shown. These prices are what a securities dealer would pay for a share of our common stock and do not include any commissions you might have to pay or any retail mark-ups or mark-downs.

      As of December 31, 1999, there were approximately 291 beneficial holders of our common stock.

Dividend Policy

      Holders of our common stock are entitled to receive dividends only when declared by our Board of Directors. Our line of credit with Bank of America forbids us from declaring dividends on any of our equity securities. To date dividends have never been declared or paid and we do not plan to make any dividend payments in the future. Instead we will reinvest in the expansion and development of our business. If the Board of Directors decides to declare a dividend in the future, the decision will be based on our earnings, financial condition, cash requirements, and any other factors they deem relevant.

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Item 6.  Selected Financial Data

Selected Consolidated Financial Data

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      The Following table contains summary unaudited quarterly consolidated statements of operations for the four quarters ended December 31, 1999 and the four quarters ended December 31, 1998. We have prepared the quarterly consolidated statements of operations data on the same basis as the Consolidated Statements of Operations beginning on page F-3. Our results of operations have varied and may continue to fluctuate significantly from quarter to quarter. Results of operations in any period should not be considered indicative of the results to be expected for any future period.

Summary Quarterly

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Introduction

      In Management’s Discussion and Analysis we explain our general financial condition and the results of operations including:

	•	what factors affect our business,
	•	what our earnings and costs were in 1999 and 1998,
	•	why those earnings and costs were different from the year before,
	•	where our earnings came from,
	•	how all of this affects our overall financial condition, and
	•	what our research and development expenditures were in 1997 through 1999 and what we expect to spend in the near future.

Forward-Looking Statements

      Some statements contained in this Annual Report, including, without limitation, statements containing the words “believes,” “anticipates,” “estimates,” “expects,” and words of similar import, constitute “forward-looking statements.” You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described in the Cautionary Factors section beginning on page 14, among others, and those included in other documents we file with the SEC. Our revenue growth and our net earnings in the first three quarters of 2000 may be less than corresponding quarters in the previous year due to a revamping of our sales force in January 2000 and the expected launch of new products and improved products in the second half of the year. Although we expect revenue and pretax income for the full year to exceed that of last year, we expect net income for 2000 to be lower than 1999 due to the tax gain we recognized in 1999.

Results of Operations

  Comparison of 1999 and 1998

      Net sales increased to $69.4 million in 1999 from $47.7 million in 1998. This 45% increase was primarily a result of a full year’s product availability of our special stains instrument system and tissue processor line (both introduced commercially in late 1998), successful entrance into the genomics market with the launch of the Discovery ISH system in late 1999 and strong performance from our core IHC business. Sales in 1999 grew 29% in North America and 152% internationally from 1998. The strong growth in North America is primarily being driven by market demand as well as the overall economic health within this region. The growth in international sales is attributed to strong commercial operations driving a clear leadership position.

      Gross margin in 1999 of 69% was consistent with 1998 performance. Improvement in the overall margin structure of our instruments and reagents was offset by a slight mix shift towards instrument sales in 1999 as a percent of total revenue (35%) versus 1998 (33%).

      Research and development expenses increased by $2 million in 1999 compared with 1998 expenditures, to 10.2% of net sales from 10.6% in 1998. The spending increase reflects our ongoing research and development efforts in a variety of areas such as the introduction of our Discovery ISH instrument, expansion of our special stains reagent menu and in situ hybridization prognostic markers. For the near future, research and development expenses are expected to increase at a rate similar to or slightly greater than the sales growth rate, as we continue to invest in technology to address potential market opportunities.

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      Selling, general and administrative expenses increased by $8.6 million in fiscal 1999 over fiscal 1998, but decreased as a percent of net sales to 47% in 1999 from 50% in fiscal 1998. The spending increase is due principally to the growth in the size of our direct sales force and its commissions, and the expansion of our geographic distribution channels. The increase also reflects our efforts to invest in key areas such as product strategy and customer support coverage in order to be positioned to take advantage of future market opportunities. We anticipate selling, general and administrative costs increasing at a rate similar to or slightly less than our sales growth rate in the near future.

      Amortization expense increased to $1.1 million in 1999 from $0.6 million in 1998, reflecting a full years’ amortization of intangibles acquired in the fourth quarter of 1998.

      Interest and other income, net, was an expenditure of $0.4 million in 1999 versus income of $1.1 million in 1998. Interest income in 1999 was reduced as a result of decreased investment balances attributed to the acquisitions of the assets of Oncor, Inc. and the stock of Biotechnology Tools, Inc. in late 1998. The Company also settled some litigation in 1999.

      In the fourth quarter of 1999, we deemed it “more likely than not” that our deferred tax assets would be realized in the future. This judgement reflects the fact that 1999 marked the third consecutive year of profitable North American operations, and the fact we expect to operate profitably on a worldwide basis in 2000. This resulted in an income tax benefit of $5.5 million.

      As a result of the above, our net income increased to a record $12.8 million, a 686% improvement over 1998 results.

  Comparison of 1998 and 1997

      Net sales for the year ended December 31, 1998 increased by 48% to $47.7 million from $32.2 million for the year ended December 31, 1997. Instrument sales increased over the prior year by 70% and reagent sales increased over the prior year by 40%. Instrument sales growth in 1998 was attributed to a full years’ product availability of our NexES IHC instrument introduced late in 1997, sales of the NexES special stains instrument introduced late in 1998, and sales of BTTI instruments acquired late in 1998. Reagent and other sales in 1998 increased due to new instruments placed during the year, increased sales to existing customers, and service revenues from the growing installed base coming off warranty.

      Gross profit for the year ended December 31, 1998 increased to $33.2 million from $21.0 million in the year ended December 31, 1997. Gross margin was 70% in 1998 as compared to 65% in 1997. The increase in gross margin from 1997 to 1998 was primarily due to the introduction of the NexES IHC instrument, which has a lower manufacturing cost than the ES and due to higher margins on reagents from the implementation of aggressive cost reduction programs.

      Research and development expense in the year ended December 31, 1998 increased to $5.1 million from $3.1 million in the year ended December 31, 1997. Research and development expenses for 1998 related primarily to the development of new reagents and instruments, including the Special Stains instrument and new prognostic markers. Research and development expense in 1997 related primarily to the development of new reagents and instruments, including the NexES IHC instrument, the Gen II instrument and development of additional primary antibodies.

      Selling, general and administrative (SG&A) expense in the year ended December 31, 1998 increased to $23.8 million from $17.0 million in the year ended December 31, 1997. SG&A expense as a percentage of net sales was 50% in 1998, which was a decrease from 53% of net sales in 1997. The fluctuation in SG&A expense from period to period reflects the growth of Ventana’s internal sales and marketing organization to implement its market expansion strategy and a corresponding increase in infrastructure expenses to support a larger business base and ongoing clinical practice standardization programs. The growth in sales and marketing expense is the result of our decision to service the market through our own sales and marketing staff and the expenses necessary to support our growth. The increase in administrative expense is associated with our regulatory strategy, costs associated with supporting an expanding business

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Liquidity and Capital Resources

      Cash and equivalents were $1.8 million at December 31, 1999, a decrease of $0.6 million from December 31, 1998. The decrease is primarily a result of our investment in the growth of the business, including working capital, property and equipment, partially offset by cash generated from operations, financing activities and the exercise of employee stock options.

      Accounts receivable increased 26% during 1999. Days sales outstanding in receivables improved to 90 days as of December 31, 1999, from 104 days as of December 31, 1998. Inventories increased 22% between 1999 and 1998, which reflects new product introductions, continued growth in our distribution system, and the need to maintain shorter lead times on certain products. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times. Accounts payable increased by 14% during 1999 primarily due to increasing levels of raw material purchases. At December 31, 1999, we had a line of credit totaling $10 million. There were no outstanding borrowings under this agreement as of December 31, 1999 (see Note 6 to our consolidated financial statements). We believe that our current cash and equivalents, line of credit, and cash generated from operations will satisfy our expected working capital, capital expenditure, and investment requirements through fiscal 2000.

Foreign Currency Risk

      We do not currently hedge against foreign currency fluctuations, because we do not believe that we run a serious risk of experiencing permanent impairment to any material assets denominated in foreign currency, but we intend to re-evaluate this situation from time to time. As a result, to the extent local currency revenues and expenses in our foreign subsidiaries are translated into U.S. dollars at differing rates over time, we may experience fluctuations in our operating results. We conduct a relatively small but growing portion of our business in the Euro and Japanese Yen.

      Effective January 1999 we changed the functional currency of our foreign subsidiaries from the local currency to the U.S. dollar (see F-7).

Year 2000 Disclosure

      We experienced no significant disruptions in mission critical information technology and non-information technology systems with respect to the Year 2000 date change. We are not aware of any material problems resulting from Year 2000 issues, either with our products, our internal systems or the products and services of third parties. We will continue to monitor our mission critical computer applications and those of our suppliers and vendors throughout the year 2000 to ensure any latent risks that may arise are addressed promptly.

Item 7A.  Quantitative and Qualitative Disclosures about Market Risk.

      Our interest rate risk is very limited, as we have only a minimal amount of fixed-rate (primarily 7%) long-term debt. Future cash outflows relating to our long-term debt follow ($000):

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Although we do experience some foreign currency risk due to our overseas operations, we have not entered into any foreign currency contracts to limit the exposure that we may have. You can find more information about this above under the heading “Foreign Currency Risk.”

Item 8.  Financial Statement and Supplementary Data

      The Independent Auditor’s Report, Consolidated Financial Statements and Notes to Consolidated Financial Statements begin on Page F-1.

      Not applicable.

PART III

Item 10.  Directors and Executive Officers

      Pursuant to our Certificate of Incorporation, as amended, our Board of Directors currently consists of eight persons, divided into three classes serving staggered terms of three years. Currently there are two Class I directors, three Class II directors and three Class III directors. The terms of the Class I directors will expire at the 2000 Annual Meeting of Shareholders. The terms of the Class II and Class III directors will expire in 2001 and 2002 respectively.

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		Purdue University and received a B.S. from California State Polytechnic University and an M.B.A. from St. Mary’s College of California.
Rex J. Bates (Age 76)		Mr. Bates has served as a director of Ventana since April of 1996. From August 1991 to May 1995, Mr. Bates served on the Board of Directors of
Class II Director Member of the Audit Committee		Twentieth Century Industries and was a member of its compensation committee. Prior to Twentieth Century Industries, Mr. Bates served as the Vice-Chairman of the Board of Directors of the State Farm Mutual Automobile Insurance Company. Mr. Bates also served as State Farm’s Chief Investment Officer. In March of 1991, Mr. Bates retired from State Farm. Prior to Mr. Bates’ employment with State Farm, he was a partner in the investment firm of Stein, Roe & Farnham in Chicago. Mr. Bates received a B.S. and an M.S. from the University of Chicago.
Edward M. Giles (Age 64) Class II Director Member of the Compensation and Nominating Committees		Mr. Giles has served as a director of Ventana since September 1992. Mr. Giles has served as Chairman of The Vertical Group, Inc., a venture capital investment firm, since January 1989. Mr. Giles was previously President of F. Eberstadt & Co., Inc., a securities firm, and Vice Chairman of Peter B. Cannell & Co., Inc., an investment management firm. He is currently a director of McWhorter Technologies, Inc. and Synthetech, Inc. Mr. Giles received a B.S.Ch.E. in chemical engineering from Princeton University and an M.S. in industrial management from the Massachusetts Institute of Technology.
Thomas M. Grogan, M.D   (Age 54) Class III Director Member of the Audit Committee		Dr. Grogan is a founder, a director and Chairman Emeritus of Ventana. He has served as a director since the founding of the Company in June 1985 and as Chairman of the Board of Ventana from June 1985 to November 1995. He is currently a professor of pathology at the University of Arizona, College of Medicine, where he has taught since 1979. He received a B.A. in biology from the University of Virginia and an M.D. from George Washington School of Medicine. Dr. Grogan completed a post-doctorate fellowship at Stanford University.
Henry T. Pietraszek (Age 53) Class I Director		Mr. Pietraszek has served as a director of Ventana since March 1997. From the time of him joining Ventana in March 1997 until May 1999, Mr. Pietraszek served as President and Chief Executive Officer of Ventana. Prior to joining the Company, Mr. Pietraszek served as President and Chief Executive Officer of Biostar, Inc., a medical diagnostic company. From 1975 to 1994, Mr. Pietraszek held a variety of executive positions at Abbott Laboratories and Takeda Chemical Industries. From 1982 to 1986, he served as President of Dainabot K.K., a joint venture between Abbott and Dainippon Pharmaceutical Company of Japan and from 1980 to 1982 he was Vice President of Field Service Operations for Abbott’s Diagnostic Division. He is a director of Specialty Laboratories. Mr. Pietraszek received a B.S. in marketing from Gannon University.
James R. Weersing (Age 60) Class I Director Member of the Audit and Nominating Committees		Mr. Weersing has served as a director of Ventana since October 1994. Since 1984, Mr. Weersing has been a Managing Director of MBW Venture Partners, a venture capital investment firm. Mr. Weersing has also served as President of JRW Technology, Inc., a consulting firm. Mr.  Weersing served as a director of Circadian, Inc., an asthma dosage management company, from December 1993 until January 1996. Circadian filed a petition under Chapter 7 of the federal bankruptcy laws in January  1996. Mr. Weersing received an B.S.M.E. and an M.B.A. from Stanford University.

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Section 16(a) Beneficial Ownership Reporting Compliance

      During the last year Mr. Questier failed to file one report on Form 5 in a timely manner. Such transaction has subsequently been reported.

Item 11.  Executive Compensation

      The following table sets forth all compensation paid by us to the chief executive officer and the most highly compensated executive officers and key employees whose total remuneration exceeded $100,000 for services rendered in all capacities to us during the last three completed fiscal years.

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      Aggregate Option Exercises in the Last Fiscal Year and Year-End Values. The following table sets forth, for each of the executives named in the summary compensation table below, information with respect to each exercise of stock options during the fiscal year ended December 31, 1999, and the value of unexercised options at December 31, 1999.

Aggregate Option Exercises in Fiscal 1999 and Year-End Values

Employment Agreements

      We have an employment agreement with Pierre Sicé, our Director of Special Operations. The agreement provides for employment from July 1, 1999 through September 30, 2000 with monthly compensation of $7,081 from July 1, 1999 through June 30, 2000 and $3,500 monthly from July 1, 2000 through September 30, 2000.

      We have an employment agreement with Bernard O.C. Questier, our Vice President of European Operations. The agreement provides for annual compensation of $153,000, which is fixed to the French Franc to protect against currency fluctuations should the United States Dollar depreciate relative to the French Franc; however, if the United States dollar appreciates relative to the French Franc, Mr. Questier’s salary shall remain unchanged. The agreement states that if Mr. Questier is terminated, he will continue to be paid through the quarter in which notice of termination is given plus one additional full quarter. The agreement does not provide for any specified term of employment. We currently have no employment contracts or agreements with any other officers named in the Summary Compensation Table or with any other person.

Compensation Committee Interlocks and Insider Participation in Compensation Decisions

      The Compensation Committee of the Board of Directors consists of Jack W. Schuler, James Weersing and Edward M. Giles. The Compensation Committee makes recommendations to the Board of Directors concerning salaries and incentive compensation for our employees and consultants. However, the Compensation Committee has full power and authority to grant stock options to our executive officers under the 1996 Stock Option Plan.

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Option Grants in the Last Fiscal Year

      The following table sets forth information with respect to each grant of stock options made during the fiscal year ended December 31, 1999 to each executive officer named in the Summary Compensation Table above:

Individual Grants

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Management

      The following table sets forth information, as of February 29, 2000 with respect to the number of shares of our common stock beneficially owned by individual directors, by all of our directors and officers as a group, and by persons known by us to own more than 5% of our common stock. We have no other class of voting stock outstanding.

	1.	Except as indicated in the footnotes to this table and pursuant to applicable community property laws, the persons named in the table have sole voting and investment power with respect to all shares of Common Stock.
	2.	Applicable percentage of ownership is based on 13,593,640 shares of common stock outstanding as of December 31, 1999, together with shares issuable pursuant to applicable options and warrants of such stockholder which may be exercised within 60 days after February 29, 2000. Shares of common stock subject to options and/or warrants currently exercisable or exercisable within 60 days after February 29, 2000, are deemed outstanding for computing the percentage ownership of the person

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		holding such options and/or warrants, but are not deemed outstanding for computing the percentage of any other person.
	3.	Includes 162,059 shares issuable upon the exercise of warrants held by MBW Venture Partners, L.P. Mr. Weersing, one of our directors, is Managing Director of MBW Venture Partners Limited. Mr. Weersing disclaims beneficial ownership of the shares beneficially owned by MBW Venture Partners, L.P. except to the extent of his proportional partnership interest therein. Also includes 26,500 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000. Includes 6,209 shares beneficially owned by James R. Weersing and Mary H. Weersing, Trustees of the Weersing Family Trust U/D/T dated April 24, 1991.
	4.	Includes 119,526 shares issuable upon the exercise of warrants and 155,875 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000, held by Mr. Schuler; 73,512 shares beneficially owned by Mr. Schuler, as custodian for Tanya Eva Schuler; 73,512 shares beneficially owned by Mr. Schuler, as custodian for Therese Heidi Schuler; and 73,512 shares beneficially owned by Mr. Schuler, as custodian for Tino Hans Schuler; and 10,000 shares beneficially owned by The Schuler Family Foundation, and 1,250 shares owned by Mrs. Schuler.
	5.	Includes 270,486 shares beneficially owned by Vertical Fund Associates, L.P. Also includes 26,500 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000, held by Edward M. Giles. Also includes 33,426 shares beneficially owned by Edward M. Giles IRA plus 5,156 shares issuable upon the exercise of warrants held by Edward M. Giles IRA. Mr. Giles, one of our directors, is Chairman of The Vertical Group, Inc. Mr.  Giles disclaims beneficial ownership of the shares beneficially owned by such entities affiliated with The Vertical Group, Inc., except to the extent of his partnership interest therein.
	6.	Includes 96,689 shares issuable upon the exercise of warrants and 168,375 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000, held by Mr.  Patience as well as 4,800 shares held in the name of Mrs. Patience.
	7.	Includes 158,810 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000, held by Mr.  Pietraszek.
	8.	Includes 9,612 shares beneficially owned by Andrew Grogan and 10,612 shares beneficially owned by Emily Grogan including 7,710 shares beneficially owned by C. Ovens, Inc. (of which 459 shares are issuable upon the exercise of warrants held by C. Ovens, Inc.); and 47,454 shares issuable upon exercise of options exercisable within 60 days of December 31, 1998, held by Dr. Grogan.
	9.	Includes 11,173 shares issuable upon the exercise of warrants and 26,500 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000, held by Mr.  Bates.

10.	Includes 65,037 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000, held by Dr.  Powers.
11.	Includes 60,324 shares issuable upon the exercise of options exercisable within 60 days of February 29, 2000, held by Mr.  Questier.
12.	Includes 44,596 shares issuable upon exercise of options exercisable within 60  days of February 29, 2000, held by Mr. Tateiwa.
13.	Includes 16,667 shares issuable upon exercise of options exercisable within 60  days of February 29, 2000, held by Mr. Gleeson.
14.	Includes 15,669 shares issuable upon exercise of options exercisable within 60  days of February 29, 2000, held by Mr. Hendrick.

Item 13.  Certain Relationships and Related Transactions

      On January 26, 1999, our Board of Directors unanimously approved, with Messrs. Patience and Schuler abstaining, the hiring of Messrs. Patience and Schuler as employees effective January 1, 1999. For their services, they each received $2,000 per month and stock options in the amount of 45,000 shares vesting on a monthly basis over 12 months commencing February 26, 1999. The options carry an exercise

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      In August 1999, Messrs. Schuler and Patience ceased to receive the $2,000 per month compensation although the options granted on January 1, 1999 continued to vest. On November 4, 1999 our Board of Directors unanimously approved, with Messrs. Schuler and Patience abstaining, an additional option to purchase 75,000 shares to each of Messrs. Schuler and Patience. These options carry an exercise price of $22.625 per share, which was equal to the fair market value of our common stock on the date of grant. The options vest on a monthly basis over a 12 month period commencing on February 26, 2000. This grant was a renewal of an arrangement that has been in place since February 26, 1996 by which Messrs. Schuler and Patience devote a significant portion of their work time to our business.

PART IV

Item 14.  Exhibits and Reports on Form 8-K.

      1.  Financial Statements

      The following consolidated financial statements of Ventana Medical Systems, Inc. and Report of Ernst & Young, LLP, Independent Auditors, are in this Form 10-K.