UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-K

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

                     For the fiscal year ended June 30, 1997

                         Commission file number 0-27802


                       ARTERIAL VASCULAR ENGINEERING, INC.
              (Exact name of Company as specified in its charter)

              Delaware                                     94-3144218
     (State or other jurisdiction of       (I.R.S. Employer Identification No.) 
      incorporation or organization)

     3576 Unocal Place, Santa Rosa, California              95403
     (Address of principal executive offices)             (Zip code)

                                 (707) 525-0111
                (Company's telephone number, including area code)

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

           Securities registered pursuant to Section 12(g) of the Act:
                         Common Stock, $0.001 Par Value

Indicate by check mark whether the Company (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 periods as the Company 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 Company's  knowledge,  in  definitive  proxy or  information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

As of August 31, 1997, there were 31,132,138 shares of Common Stock outstanding.
The aggregate market value of voting stock held by non-affiliates of the Company
was approximately  $655,432,000 based upon the closing price of the Common Stock
on August 29, 1997 (the last trading day prior to August 31, 1997) on the Nasdaq
National Market tier of The Nasdaq Stock Market.  Shares of Common Stock held by
each  officer,  director  and holder of five percent or more of the Common Stock
outstanding as of August 31, 1997 have been excluded in that such persons may be
deemed  to  be  affiliates.  This  determination  of  affiliate  status  is  not
necessarily conclusive.

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

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions  of the Proxy  Statement  of  Company  for the 1997  Annual  Meeting of
Stockholders are incorporated by reference into Part III of this Form 10-K.

================================================================================

<PAGE>

                                     PART I

         The following  trademarks of Arterial  Vascular  Engineering,  Inc. are
used in this Form 10-K:  Arterial  Vascular  Engineering(TM),  Micro  Stent(TM),
Micro Stent II(TM), Micro Stent II XL(TM),  Micro Stent 2.5(TM),  Micro Stent II
LP(TM),  GFX(TM),  GFX 2.5(TM),  GFX XL(TM),  Bridge(TM),  Nike(TM),  Elite(TM),
Peak(TM) and LTX(TM).

ITEM 1.  BUSINESS

         The statements  contained in this Form 10-K that are not historical are
forward-looking  statements  within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the  Securities  Exchange Act of 1934,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future.  Forward-looking statements and risk factors in
this Item 1 include,  without  limitation,  statements  regarding  the Company's
industry, products and strategy under "Company Strategy", "AVE Stent Technology"
and "Additional  Business Risks",  statements regarding the extent and timing of
product development,  future revenues,  customer demand,  competitive  products,
pricing   pressure,   the  intellectual   property   positions  of  competitors,
reimbursement  and future  technological  change  under  "Product  Development,"
"Distribution,  Sales and Marketing," "Competition,"  "Third-Party Reimbursement
and "Patents and Proprietary Rights," and statements regarding expected clinical
trial results and regulatory  approvals and  compliance  under  "Clinical  Trial
Activities"  and  "Government   Regulation."  All  forward-looking   information
included in this document is based on information available to the Company as of
the date  hereof,  and the  Company  assumes  no  obligation  to update any such
forward-looking  statements.  It is important to note that the Company's  actual
results could differ materially from those in such  forward-looking  statements.
Additional  forward-looking  statements and risk factors include those discussed
in the sections  entitled  "Item 2.  Properties,"  "Item 3. Legal  Proceedings,"
"Item 5.  Market for the  Registrant's  Common  Equity and  Related  Stockholder
Matters," "Item 7. Management's  Discussion and Analysis of Financial  Condition
and Results of Operations," and "Item 8. Financial  Statements and Supplementary
Data,"  as well as those  that  may be set  forth  in the  reports  filed by the
Company from time to time on Forms 10-Q and 8-K.

General

         Arterial Vascular  Engineering,  Inc. ("AVE" or the "Company") designs,
develops, manufactures and markets a variety of highly specialized stent systems
and percutaneous  transluminal  coronary angioplasty ("PTCA") balloon catheters.
The Company's  stents are used as arterial  support  devices in connection  with
balloon  angioplasty or other minimally  invasive  treatments of atherosclerosis
(the  formation of deposits in the  arteries) and to prevent  abrupt  closure of
vessels in higher-risk angioplasty procedures.  The Company commenced operations
in 1991 and began  marketing  its PTCA balloon  catheters in October  1993,  its
coronary  stent systems in October  1994,  and its  peripheral  stent systems in
December 1996. To date, the Company has sold over 160,000 coronary stent systems
and over 38,000 PTCA balloon  catheters  in more than 40  countries  outside the
United States,  primarily in Europe and Japan.  In April 1996, the Company began
its first  direct  sales  operation  in  Europe,  and  currently  it has  direct
operations in each of France,  Germany,  the Netherlands (to service the Benelux
countries),  Switzerland and the United Kingdom. In Japan, the Company currently
sells  only  PTCA  balloon  catheters.  In June  1997,  the  Company's  Japanese
distributor  received regulatory approval for the sale in Japan of the Company's
coronary stent systems;  however,  as of the date hereof, the Company's Japanese
distributor had not yet received the related  reimbursement  approval there. The
Company does not expect reimbursement  approval in Japan prior to November 1997,
and there can be no assurance  when or if such  approval  will be  obtained.  In
August 1997, the Company submitted a premarket  approval ("PMA")  application to
the United States Food and Drug  Administration  (the "FDA") in connection  with
its ongoing efforts to gain approval to begin  commercial  sales of its coronary
stent systems in the United States.  The Company does not expect FDA approval of
its stent systems for sale in the United States prior to 1998,  and there can be
no assurance when or if such approval will be obtained. As a result, the Company
expects  international  sales to account for  substantially  all of its revenues
until at least 1998.

AVE Stent Technology

         AVE believes  that its line of coronary and  peripheral  stent  systems
incorporates a number of unique and proprietary  design features that enable the
Company  to address  effectively  a variety  of lesion  and  vessel  types.  The
Company's  stents are  constructed of seamless,  medical grade  stainless  steel
rings that are precision-formed into sinusoidal shaped elements.  These elements
are  polished  and  connected  in a  helical  pattern  utilizing  a  proprietary
manufacturing  process in order to form a fully connected,  yet flexible,  stent
device.  The Company  believes its stent design provides more consistent  vessel
support and radial force than coiled stent  designs as well as more  flexibility
and easier  delivery than tubular  slotted or mesh stent designs.  The Company's
stent  products  are  available  in a variety of  diameters  and lengths and are
provided  pre-mounted on both  over-the-wire and rapid exchange delivery systems
(available only outside the United States) with the same advanced  technology as
the Company's PTCA balloon  catheters.  The Company's  coronary stents have been
used in a variety  of  applications,  including  vessels  in which  other  stent
procedures  have  failed,  as well as in the  treatment  of lesions in curved or
tortuous vessels. The Company also sells stent systems for use in the peripheral
vessels.   The  Company  believes  the  following   technical  features  of  its
proprietary  stent  systems  provide  the Company  with a number of  competitive
advantages:

                                       1
<PAGE>

         Smooth Edge Design and  Sheathless  Deployment  System.  The  Company's
stent products consist of highly polished,  rounded,  sinusoidal-shaped elements
at either end of the stent  (unlike mesh  stents,  which have flat edges at each
end). The Company believes that the smooth edges of its stent products  optimize
their ability to be moved through a vessel without  causing tears or dissections
or halting  movement of the  delivery  catheter,  thereby  minimizing  trauma to
treated  vessels.  The  smooth  edges of the stent  also  permit the stent to be
delivered  without the protective  sheath necessary for use of certain competing
stent products.  The Company  believes that  eliminating the need to monitor and
remove a protective sheath enhances the ease of use of its products.

         High Stent Flexibility and System Trackability.  The Company's products
consist of  sinusoidal-shaped  elements that are connected in a helical  pattern
designed to provide a highly flexible stent.  Increased stent flexibility allows
the Company's stent products to be more easily maneuvered and placed at the site
of a lesion,  particularly  through  curved or tortuous  vessels or around other
deployed stents.  In addition,  flexible stent design allows the use of a single
stent in the  treatment  of a lesion in a curved  vessel,  as  compared  to more
inflexible  designs that may require the use of multiple stents to treat a long,
curved lesion.  The Company believes that the ease of use and enhanced  handling
characteristics  of its stent delivery  systems,  coupled with stent flexibility
and  smooth  edge  design,  allow  it  to  provide  a  stent  system  with  high
trackability.  The  ability  to  easily  access  or  "track  to" a lesion  is an
important  stent  system  characteristic  in the  treatment of a distant site or
tortuous vessel.  The Company currently offers stents in lengths as long as 40mm
for use in the treatment of long, diffuse lesions.

         Improved  Stent  Strength and  Stability.  The advanced  designs of the
Company's GFX and Micro Stent II family of stent  products  combines high radial
strength,  which minimizes vessel recoil,  and axial  stability,  which provides
consistent  vessel  support  along the entire  length of the stent.  The Company
believes  these  features allow a physician to better control and optimize final
minimal lumen diameter  ("MLD").  Studies have indicated that optimizing the MLD
of a vessel following use of a stent product generally reduces the likelihood of
subsequent restenosis.

         Moderate   Radiopacity.   The  Company   believes   that  the  moderate
radiopacity  of its  devices  optimizes  angiographic  identification  of  stent
position and enhances  post-procedure stent assessment.  Physicians commonly use
low level x-rays to accurately  monitor the placement and deployment of a stent,
including final expansion using a high pressure  balloon,  as well as to conduct
post-operative assessment of MLD. As a result, a lack of radiopacity,  which may
prevent  illumination  of a  stent,  or an  excess  of  radiopacity,  which  may
overilluminate  the stent and impede its visual  identification,  may affect the
outcome of stent procedures and subsequent diagnosis of treated vessels.

         Proprietary, Pre-Mounted Delivery Systems. Unlike certain other stents,
which may require the  physician to hand-crimp  the stent on a balloon  delivery
device,  the Company's  stents are  pre-mounted  onto its  proprietary  delivery
systems.  The Company believes that  pre-mounting its stents on balloon delivery
systems helps ensure more consistent and accurate stent delivery and deployment,
particularly  as stents are used by a broader group of  physicians  with varying
levels of experience  with stents.  In addition,  the Company  believes that the
ease of use of its product has promoted physician acceptance.

         Adaptable Design Characteristics.  The Company believes that the design
features  of its  stents  allow  it to  modify  one or  more  stent  performance
characteristics,  such  as mass or  flexibility,  as  necessary  to  produce  an
effective device for a particular application. To date, the Company has utilized
its stent  technologies  to develop  families  of more than ten  distinct  stent
products.  Each product  also is offered in a variety of lengths and  diameters,
allowing  the  physician  to choose  the  device  that best suits the needs of a
patient based on lesion  characteristics.  The Company believes the adaptability
of its stent  designs  will allow  their use as  platform  technologies  for the
development  of a variety  of other  coronary  and  non-coronary  products.  For
example, in fiscal 1997 the Company introduced in selected international markets
stents  designed  for use in the  peripheral  renal and iliac  vessels.  See "--
Products."

         Despite such advantages, due to the number of clinical applications for
stent  systems  and the  variety of  available  products,  the  Company's  stent
products may not be superior to  competitive  products in all  applications.  In
addition,  many of the Company's  competitors have substantially greater capital
resources,  name  recognition  and  expertise in  manufacturing,  marketing  and
product  approval,  which  factors  provide  a  competitive  advantage  to  such
companies,  in  connection  with the sale of these stent  products.  The medical
indications  that can be  treated  by stents  can also be  treated  by  surgery,
minimally invasive bypass procedures,  drugs or other medical devices, including
stand-alone  balloon catheters,  atherectomy  catheters,  irradiated devices and
lasers.  Many of the  alternative  treatments are widely accepted in the medical
community and have a long history of use.

Company Strategy

         The  Company's  goal is to expand its  position  as one of the  leading
worldwide providers of coronary stent systems.  The key elements of its strategy
are as follows:

         Introducing   New   Products  for  Both   Coronary   and   Non-Coronary
Applications.  The Company  intends to build on its stent designs to broaden the
coronary and  non-coronary  applications  for its stents.  For example,  the GFX

                                       2
<PAGE>

stent system introduced by the Company in fiscal 1997 was designed for increased
flexibility and  trackability  and improved vessel coverage and support,  with a
goal of  increasing  the types of medical  indications  that may be treated with
stents.  The Company believes that the inherent  adaptability and flexibility of
the  Company's  stent  designs  will  augment  its  ability to meet  specialized
coronary  needs,  as well as to provide  stents for use in  peripheral  vessels,
saphenous vein grafts and other applications. The Company has recently created a
separate  operating  division,  "Peripheral  AVE," whose purpose is to focus its
efforts on the design,  development,  manufacture and marketing of the Company's
peripheral stent systems.

         Continuing  Integration of Research and Development  and  Manufacturing
Operations.   The   Company   believes   that  the   design  of   products   for
manufacturability and the rapid manufacture of products to satisfy market demand
are key  success  factors  in new  product  development  in the  medical  device
industry. To support these capabilities,  the Company has designed and developed
internally  the  technology   necessary  to  perform  a  number  of  proprietary
production  processes  and has developed the expertise to fabricate the majority
of the components of its stent and PTCA balloon catheter  products.  The Company
has also begun  construction  of a 130,000 square foot building  adjacent to its
corporate  headquarters in Santa Rosa,  California,  at an estimated cost of $20
million,  which,  when  completed,  will be  largely  devoted  to  manufacturing
activities.  The  design of the new  facility  is  intended  to allow  continued
integration  of  the  Company's   research  and  development  and  manufacturing
operations  as well  as a  significant  expansion  of the  Company's  production
capabilities.  The Company intends to leverage its vertically integrated product
development and manufacturing approach to rapidly introduce innovative products.

         Continuing  to  Expand  Sales  and  Marketing   Efforts.   The  Company
continually  seeks to increase its market share and build  product  awareness in
each of the over 40 countries outside of the United States in which its products
are marketed.  The Company has direct sales  operations in its principal  target
markets in Europe -- France,  Germany,  the  Netherlands (to service the Benelux
countries),   Switzerland  and  the  United  Kingdom  --  and  operates  through
unaffiliated  distributors  in  other  countries  internationally.  The  Company
believes that its direct sales presence allows it to focus greater  attention on
such countries' physician  communities,  which it believes helps to increase the
advocacy base for the Company's  products in Europe and other  countries as well
as facilitating more direct feedback to the Company on its products. The Company
also believes  that,  in addition to building  stronger  relationships  with its
customers,  this direct sales  strategy  provides the Company with more complete
control of the  distribution  and growth of the Company's  full product line, as
well as allowing it to better manage the pricing and regulatory approval process
for its products.  The Company has also centralized its distribution services by
contracting  with  a  provider  in  the  Netherlands  to  support  direct  sales
operations and distributions throughout Europe. The Company intends to utilize a
direct  sales  force in the United  States if and when  regulatory  approval  is
received  for the sale of its  products in the United  States,  and has begun to
develop such a sales force.  The Company may continue to implement  direct sales
operations  in selected  markets where it believes such an approach will benefit
its competitive position.

         Broadening   Product   Offerings  to  Provide  More  Complete   Therapy
Solutions. The Company believes that an ability to offer a more complete line of
therapeutic products may enhance the Company's ability to compete effectively in
the interventional  marketplace.  For example,  the Company believes its current
line of PTCA  balloon  catheters  has  provided  the Company  with  expertise in
balloon  delivery  and  deployment.  The Company  continually  reviews  possible
strategic  acquisitions,  third  party  technology  licenses  and  marketing  or
distribution  relationships with companies that have medical products in certain
complementary product areas. However, there can be no assurance that the Company
will enter into any such arrangements.

         Pursuing   Regulatory   Approval  in  the  United  States  and  Abroad;
Conducting  Clinical  Trials  to  Promote  Market  Acceptance  of the  Company's
Products.  The Company is seeking FDA  approval to allow sale of its products in
the United  States,  which the Company  believes  represents  the largest  stent
market in the world.  In August 1997, the Company  submitted a PMA to the FDA in
connection with its ongoing efforts to gain approval to begin  commercial  sales
of its coronary  stent systems in the United States.  Clinical  studies under an
Investigational  Device  Exemption  (an  "IDE")  are  ongoing  with other of the
Company's  products.  The  Company  does not  expect FDA  approval  of its stent
systems  for  sale in the  United  States  prior to 1998,  and  there  can be no
assurance  when or if such approval will be obtained.  In addition to its United
States clinical  program,  the Company is sponsoring  several  ongoing  clinical
studies in several countries  outside the United States.  The Company intends to
use data from these trials to obtain  regulatory  approvals  in new markets,  to
promote market acceptance of its products and to expand clinical applications of
the Company's products.

         Developing and Maintaining  Relationships with Leading Physicians.  AVE
develops and maintains relationships with leading physicians worldwide.  Through
these  relationships,  the Company  seeks to work with  opinion  leaders who can
foster market  awareness of the Company's  products.  The Company supports these
efforts  through  group  training  programs   designed  to  increase   physician
familiarity with the Company's products.  The Company also has assembled a staff
of clinical  specialists to expand its physician  training,  service and support
activities.  These  specialists  help provide an increased  presence at industry
trade  shows and produce  marketing  material  targeted  toward  physicians.  In
addition,  the Company  maintains an active  program of  collaborating  with key
physicians and medical centers to obtain feedback for new product development.

                                       3
<PAGE>
<TABLE>
Products

         The Company  currently  markets its stent systems in most  countries in
Europe, including Germany, France and the United Kingdom, and in other countries
outside of the United States in both  over-the-wire  and rapid exchange catheter
delivery forms. In addition, the Company offers a line of PTCA balloon catheters
outside of the United  States.  The  following  table  identifies  the Company's
current  products,  their  principal  clinical  application  and  their  current
commercialization status:

CURRENT PRODUCTS
------------------------------------------------------------------------------------------------------------------------------------
<CAPTION>
CORONARY STENT SYSTEMS
                                                                     Initial
                                                                     Release
     Product                 Description/Application                   Date                              Status
     -------                 -----------------------                   ----                              ------
<S>                  <C>                                           <C>                     <C>
GFX Stent Systems

   GFX               Third-generation  coronary  stent  system     September 1996          Available for sale in over 40 countries. 
                     designed   to   provide   lower   profile                             PMA submitted to the FDA in August 1997. 
                     (most  sizes  capable  of being  used in 6
                     French guide catheters) and greater radial
                     strength and flexibility than Micro Stent 
                     II.
   GFX 2.5           Coronary   stent   designed  for  use  in     June 1997               Available  for sale in over 40 countries 
                     vessels as small as 2.5mm in diameter.                                outside the United States.  Supplemental 
                                                                                           IDE   application   was   submitted   in 
                                                                                           September 1997.                          
                                                                   
   GFX XL            Coronary  stent  designed  for use in the     June 1997               Available  for sale in over 40 countries 
                     treatment of long and diffuse lesions.                                outside   the   United    States.    IDE 
                                                                                           application was  conditionally  approved 
                                                                                           by the FDA in July 1997.                 
                                                                                          
Micro Stent II Systems                                             
                                                                   
   Micro Stent II    Second-generation    product,   featuring     October 1995            Available  for sale in over 40 countries 
                     helical  connections  and enhanced radial                             outside the United States. PMA submitted 
                     strength.  Designed  for use in a variety                             to the FDA in August 1997.               
                     of coronary applications.                                             
   Micro Stent 2.5   Coronary   stent   designed  for  use  in     December 1995           Available  for sale in over 40 countries 
                     vessels as small as 2.5mm in diameter.                                outside the United States.  IDE received 
                                                                                           in June 1996.                            
   Micro Stent II XL Coronary stent designed for use in the        December 1995           Available  for sale in over 40 countries 
                     treatment of long and diffuse lesions.                                outside the United States. PMA submitted 
                                                                                           to the FDA in August 1997                
                                                                                           
   Micro Stent II LP Similar  configuration  as the Micro Stent    June 1996               Available in markets  outside the United 
                     II product with the added  capability of                              States  that   prefer  6  French   guide 
                     being used in 6 French guide catheters.                               catheters.  Being  replaced  by the GFX, 
                                                                                           and is  generally  distributed  only  in 
                                                                                           countries where pre-market  approval for 
                                                                                           GFX has not been obtained.               
                                                                                           
PERIPHERAL STENT SYSTEMS                                           
                                                                     Initial
                                                                     Release
      Product                 Description/Application                  Date                       Status
      -------                 -----------------------                  ----                       ------
                                                                   
Bridge Renal Stent   Peripheral  stent designed for use in the     December 1996           Limited      release     in     selected 
  -- Extra Support   renal arteries.                                                       international markets.                   
Bridge Iliac Stent   Peripheral  stent designed for use in the     December 1996           Limited     release     in     selected  
  -- Extra Support   iliac vessels.                                                        international markets.
Bridge Iliac Stent   Peripheral  stent  designed  for  use  in     July 1997               Limited     release     in     selected  
  -- Flexible        more tortuous iliac vessels.                                          international markets.
Bridge Biliary Stent Peripheral  stent designed for use in the         N/A                 510(k)  submitted  to the FDA in  April  
                     biliary tract.                                                        1997.
                                                                   
PTCA BALLOON CATHETERS                                             
                                                                     Initial
                                                                     Release
      Product                 Description/Application                  Date                       Status
      -------                 -----------------------                  ----                       ------
                                                                   
Nike                                                               
                     Rapid exchange,  semi-compliant  PTCA         October 1994            Approved for use in Japan and  available 
                     catheter,  featuring  a  flexible                                     for  sale  in over  40  other  countries 
                     proximal    shaft.                                                    outside the United States.
                                                                                           
Elite                Rapid   exchange,   semi-compliant   PTCA     November 1994           Approved for use in Japan and  available 
                     catheter,  incorporating stiffer proximal                             for  sale  in over  40  other  countries 
                     shaft.                                                                outside the United States.
Peak                 Over-the-wire,     semi-compliant    PTCA     July 1995               Approved for use in Japan and  available 
                     catheter.                                                             for  sale  in over  40  other  countries 
                                                                                           outside the United States.  IDE clinical 
                                                                                           studies in the United  States  commenced 
                                                                                           in early 1997.
LTX                  Lower    profile,     higher    pressure,     September 1997          Limited      release     in     selected 
                     minimally    compliant    PTCA    balloon                             international markets.
                     catheter  with  hydrophilic  coating  for                             
                     improved   performance,   in  both  rapid     
                     exchange and over-the-wire models.            
------------------------------------------------------------------------------------------------------------------------------------

</TABLE>
                                       4
<PAGE>

Coronary Stent Systems

         The Company currently markets the following  families of coronary stent
products, all of which are pre-mounted on a catheter and balloon delivery system
produced by the Company:

     GFX Stent Systems

         GFX. The GFX stent has a modified,  six crown sinusoidal  configuration
and  utilizes a stent  component  of 2mm in length.  The  product is designed to
allow improved stent flexibility and  trackability,  vessel coverage and support
while  providing the capability of using most sizes with guiding  catheters with
outer diameters as small as 6 French (approximately 2.0mm), which may be helpful
in certain applications. The GFX is offered in lengths of 8, 12, 18, 24 and 30mm
with diameters of 3.0, 3.5 and 4.0 mm.

         GFX 2.5. The GFX 2.5 generally incorporates the same design features as
the GFX (although it utilizes a four-crown  configuration),  but is designed for
application in vessels as small as 2.5mm in diameter.  The GFX 2.5 is offered in
8, 12, and 18mm lengths with a diameter of 2.5mm.

         GFX  XL.  The  GFX XL is a  longer  stent  made  up of  multiple  stent
components that is designed to be used in treating  diffuse arterial disease and
longer lesions with a single stent.  Because the GFX XL retains the  flexibility
of the  Company's  GFX  stent  design,  the  Company  believes  it  will  enable
physicians  to treat longer  lesions with a single  stent,  thereby  potentially
reducing  procedure  time and cost.  The  product  incorporates  the same design
features as the GFX. It is offered in lengths of 30 and 40mm with  diameters  of
3.0, 3.5 and 4.0mm.

     Micro Stent II Systems

         Micro Stent II. The Micro Stent II utilizes a stent component of 3mm in
length.  The helical  connection  and reduced length of the stent elements allow
for increased  flexibility,  thereby enhancing the handling  characteristics and
trackability  of  the  stent  system.  The  Micro  Stent  II  also  incorporates
engineering  advances  related  to  radial  strength  and  materials  processing
designed  to allow  greater  control  of minimal  lumen  diameter.  The  Company
currently  produces  the Micro  Stent II in 6, 9, 12, 18 and 24mm  total  length
configurations with diameters of 3.0, 3.5 and 4.0mm.

         Micro  Stent 2.5.  The Micro  Stent 2.5  incorporates  the same  design
features as the Micro Stent II, but is designed  for  application  in vessels as
small as 2.5mm in  diameter.  The Micro Stent 2.5 is offered in 6, 9, 12, 18 and
24mm lengths with a diameter of 2.5mm.

         Micro Stent II XL. The Micro Stent II XL is a longer stent  designed to
be used in treating  diffuse  arterial  disease and longer lesions with a single
stent.  Because the Micro Stent II XL retains the  flexibility  of the Company's
core stent  design,  the Company  believes it will  enable  physicians  to treat
longer lesions with a single stent,  thereby potentially reducing procedure time
and cost. The product  incorporates  the same design features as the Micro Stent
II. It is  offered  in lengths  of 30 and 39mm with  diameters  of 3.0,  3.5 and
4.0mm.

         Micro Stent II LP. The Company's  Micro Stent II family of products are
generally  designed for use within guiding catheters with an outer diameter of 7
French  (approximately  2.3mm) or greater.  In  response  to clinical  demand in
certain international markets, the Company developed the Micro Stent II LP for 6
French guide catheter compatibility.  This product is being replaced by the GFX,
and is generally distributed only in countries where pre-market approval for the
GFX has not yet been obtained. The Micro Stent II LP is offered in lengths of 12
and 18mm with diameters of 3.0 and 3.5mm.

Peripheral Stent Systems

         In addition to the Company's  coronary stent systems,  the Company also
offers a line of stent systems designed for the treatment of  atherosclerosis in
peripheral vessels of the body.

         Bridge Extra Support Renal Stent.  The Bridge extra support renal stent
is designed to be used in the renal  arteries  and is offered in diameters of 5,
6, and 7mm and  lengths of 16mm.  Initial  release of the  product  occurred  in
December 1996.

         Bridge Extra Support Iliac Stent.  The Bridge extra support iliac stent
is designed to be used in the iliac vessels and is offered in diameters of 6, 7,
8, 9 and 10mm  and  lengths  of 40 and  60mm.  Initial  release  of the  product
occurred in December 1996.

         Bridge Flexible Iliac Stent. The Bridge flexible iliac stent is a lower
profile,  more flexible peripheral stent designed for use in more tortuous iliac
vessels and is offered in diameters of 6, 7, 8, 9 and 10mm and a length of 40mm.
Initial release of the product occurred in May 1997.

                                       5
<PAGE>


         Bridge Biliary  Stent.  The Bridge biliary stent is designed to be used
in the  biliary  tract and is  offered in  diameters  of 6, 7, 8, 9 and 10mm and
lengths of 16, 20 and 40mm. A 510(k)  application  was submitted with the FDA in
April 1997, but the product has not yet been released for commercial sale in any
country.

PTCA Balloon Catheters

         In  addition  to the balloon  catheters  sold as part of the  Company's
stent systems, the Company also offers a broad line of balloon catheters for use
in PTCA balloon  procedures.  All of such currently  marketed  balloon  catheter
products  are  semi-compliant,  with rated burst  pressures  of between 8 and 10
atmospheres.  The Company  offers PTCA catheters with balloons in lengths of 20,
30 and 40mm and diameters ranging from 1.5mm to 4.0mm as discussed below.

         Nike.  The Nike is a rapid exchange  catheter with a flexible  proximal
(nearer to the operator) shaft design coupled with a low profile distal (further
from the operator)  shaft.  It is designed to allow greater access to smaller or
more tortuous vessels.

         Elite.  The Elite is a rapid exchange  catheter with a smaller proximal
shaft  diameter.  It  incorporates  the Nike distal  shaft design with a stiffer
metallic type of proximal shaft construction  designed to allow greater operator
control in maneuvering the balloon catheter while enhancing vessel imaging.

         Peak. The over-the-wire  Peak catheter  incorporates a stiffer proximal
shaft for  enhanced  control and a flexible  distal  shaft for ease of access to
more tortuous vessels. It was designed for the Japanese market,  which generally
favors over-the-wire catheters, although it is also sold in other countries.

         LTX.  The LTX  utilizes a lower  profile,  higher  pressure,  minimally
compliant  PTCA balloon  rated at 14  atmospheres.  Among other  things,  higher
pressure  PTCA  balloons are useful in  follow-up  dilatation  treatment,  since
higher pressure balloons  generally more fully expand implanted stents.  Initial
release of the product occurred in selected markets in September 1997.

Research and Development Program

         The  Company  maintains  an active  research  and  development  program
designed to exploit its core technical expertise in stent systems,  PTCA balloon
catheters and related medical  technologies.  The Company has made a significant
investment in developing its  proprietary  stent  technologies  and believes its
research and development  commitment in this area is critical to its competitive
position.  During fiscal 1997, the Company significantly  increased its research
and development  expenditures and personnel.  Research and development  expenses
for  fiscal  1997,  1996 and 1995  were  approximately  $11,422,000,  $6,480,000
($3,880,000  after  excluding a one-time charge of $2,600,000 in connection with
the   termination  of  certain  patent  royalty   obligations),   and  $987,000,
respectively.

         The Company is reviewing potential products in several areas, including
stent use in carotid and  neurological  applications,  radiation  and the use of
alternative stent materials.  There can be no assurance that any of the products
above will be successfully  developed,  commercially released or accepted by the
market  or  that  regulatory  clearance  will be  obtained  from  the  necessary
international or United States regulatory agencies.

Clinical Trial Activities

         Clinical  trials have not been required in most European  markets prior
to the initiation of commercial  sales.  By contrast,  certain other  countries,
including the United States and Japan,  require government  pre-market approval,
rigorous in vitro and/or pre-clinical data and the completion of clinical trials
prior to commercialization of new products.  In Japan,  following the submission
of the  results of  clinical  trials to Japanese  regulators  in late 1996,  the
Company's Japanese distributor received in June 1997 government approval for the
sale in Japan of the Company's  coronary stent systems.  The approval covers the
entire  line of the  Company's  coronary  stent  systems,  including  the  rapid
exchange  and  over-the-wire  delivery  systems for each of such  products.  The
approval includes the entire GFX product line, including the low profile GFX 2.5
for  smaller  vessels and the GFX XL for longer  lesions,  as well as the entire
Micro Stent II product  line.  As of the date  hereof,  however,  the  Company's
Japanese  distributor had not yet received the related  reimbursement  approval.
The Company  does not expect  reimbursement  approval in Japan prior to November
1997,  and there can be no assurance  when or if such approval will be obtained.
The Company's  Japanese  distributor  has  previously  received  approval of the
Company's Nike, Peak and Elite PTCA balloon catheter systems.

         With respect to the United States, in August 1997 the Company submitted
a PMA to the FDA in  connection  with its  ongoing  efforts to gain  approval to
begin commercial  sales of its coronary stent systems in the United States.  The
PMA was based on a 661-patient, multi-center, randomized clinical study with the
Company's  Micro Stent II device in the United  States under an  Investigational
Device  Exemption  ("IDE").  The study,  entitled  SMART (Study of Micro stent's
Ability to limit Restenosis Trial),  evaluated the treatment of both de novo and
restenotic lesions in native coronary arteries,  utilizing the  Palmaz-Schatz(R)
stent of Cordis (a Johnson & Johnson  company)  as a  control.  The study had an
elective indication for use and required follow up, utilizing a primary endpoint
of clinically  driven target site  revascularization  at nine months and various
secondary  endpoints   (including   angiographic   restenosis).   The  data  for

                                       6
<PAGE>

preliminary  six-month  data,  as presented in late August 1997 by the principal
investigator for the study, indicated that the target site revascularization for
the Micro Stent II at six months was  approximately  8.4% and was  statistically
equivalent to the results for the Palmaz-Schatz(R) product. The Company included
in  supplemental  registries  to the study  patients with long lesions that were
treated with the Micro Stent II XL as well as patients treated with the GFX, and
certain data relating to the GFX was included in the August 1997 PMA submission.
The  Company  has  also  commenced  U.S.   clinical   trials  of  the  Company's
single-operator  stent  delivery  system and of the Company's  Peak PTCA balloon
catheter,  although  such systems were not included in the PMA  submission.  The
Company does not expect FDA approval of any of its stent systems for sale in the
United  States  prior to 1998,  and  there can be no  assurance  when or if such
approval will be obtained.  The Company has incurred, and expects to continue to
incur,  substantial  clinical  research  and  other  costs  in  connection  with
obtaining  regulatory  approvals  for its stent systems in the United States and
other countries.

         In  addition  to its United  States  clinical  program,  the Company is
sponsoring  several ongoing  clinical studies in several  countries  outside the
United States.  In addition to fulfilling the  regulatory  requirements  for the
sale of its products in certain countries,  the Company intends to use data from
these trials to promote market acceptance of its products and to expand clinical
applications  of the  Company's  products.  The Company  believes  that clinical
trials  are an  important  method of  demonstrating  performance  and  expanding
potential  applications  of the  Company's  products  to  physicians  at leading
medical centers participating in such trials. Accordingly,  the Company believes
that the  results  of such  trials  can be an  important  part of the  Company's
marketing  programs and  competitive  positioning of the Company.  In sponsoring
clinical trials, the Company generally is involved in the design of the protocol
for such trials, makes its stents available to the trials' investigators free of
charge or at discounted rates, and aids with the patient  enrollment  procedures
and other ministerial aspects of the trial as necessary,  but otherwise does not
participate in the performance of the trials.

         Clinical results are inherently unpredictable and are influenced by the
indications and endpoints chosen and the procedures used.  Results from clinical
trials sponsored by the Company, its competitors or a third party could delay or
prevent regulatory approvals, reduce market demand and therefore have a material
adverse  effect on the Company's  business,  financial  condition and results of
operations.   In  addition,  there  can  be  no  assurance  that  the  Company's
interpretation  of data from its clinical  trials will be accepted by the FDA or
other regulatory authorities or the medical community at large.

Distribution, Sales and Marketing

         The  Company  markets  its GFX and  Micro  Stent II  families  of stent
systems and its PTCA balloon  catheters in over 40 countries  outside the United
States.  Until  April 1996,  substantially  all of the  Company's  sales were to
international  distributors  who resell products to health care  providers.  The
Company  terminated its relationship with distributors in Germany and the United
Kingdom in April and May 1996, respectively, and in France, Switzerland, Belgium
and the Netherlands  effective September 30, 1996. The Company believes that the
establishment  and  maintenance of direct sales forces in France,  Germany,  the
Netherlands  (to  service  the Benelux  countries),  Switzerland  and the United
Kingdom  has  resulted  in   increased   revenues  and  market  share  in  those
territories.  The Company also  believes that its direct sales  operations  have
enabled it to build  stronger  relationships  with  customers,  more  completely
control the  distribution  and growth of the Company's full product line, and to
better manage the pricing and regulatory approval process for its products.  The
Company has also  centralized its  distribution  services by contracting  with a
provider in the  Netherlands to support direct sales  operations and independent
distributors  throughout  Europe. The Company may establish a direct sales force
in one or more  additional  countries  in the future  where it believes  such an
approach  will  benefit  its  competitive   position.   The   establishment  and
maintenance  of direct sales  forces has  required and will  continue to require
significant  ongoing  expenditures,  additional  management  resources  and  has
resulted,  and may continue to result, in additional costs to eliminate existing
distributor  relationships  (including litigation by former  distributors).  The
Company's  former   distributors  in  Belgium,   France,   the  Netherlands  and
Switzerland  have commenced  legal action against the Company in connection with
the termination of the distribution  relationships in those countries. See "Item
3. Legal Proceedings."

         In all other  countries,  the  Company  currently  sells  its  products
through independent  distributors.  Such distributors  generally are granted the
right  to sell  the  Company's  products  within  a  defined  territory  and are
typically permitted to sell other non-competing  medical products.  All sales to
distributors are denominated in U.S.  dollars,  while sales effected through the
Company's  direct sales  operations are denominated in the local  currency.  The
Company's distributors purchase the Company's products at discounts that vary by
product  and  market.  The  distributors  resell  the  products  to health  care
providers  such as hospitals at prices that are  determined by the  distributor.
The  Company's  use of  distributors  in  certain  countries  does not allow the
Company to control  end-market  prices charged for its products in those markets
and may not result in the same level of sales and marketing efforts as would the
use of a direct  sales  force by the Company in those  markets.  The Company has
written agreements with most of its more significant distributors, including the
Company's Japanese distributor.

                                       7
<PAGE>

         Over 40% of the Company's fiscal 1997 revenues were derived from export
sales  to  non-affiliated  international  distributors.  No  single  distributor
accounted for more than 5% of the  Company's net sales in fiscal 1997.  However,
upon any receipt of reimbursement  approval for the sale of the Company's stents
in Japan,  the  Company's  Japanese  distributor  is  expected  to account for a
significantly  increased  portion of the  Company's  sales for the  remainder of
fiscal 1998. The Company anticipates that substantially all of its revenues from
product  sales will be derived  from sales in foreign  countries  until at least
1998.  International  sales are  subject to  certain  risks,  including  foreign
medical  regulations,  export/import  licenses,  foreign currency  fluctuations,
economic or political instability, shipping delays and tariffs and other various
trade  restrictions,  all of  which  could  have  a  significant  impact  on the
Company's  ability to deliver products on a competitive and timely basis. As the
Company continues to develop an international  sales force it expects to be more
directly  subject to foreign  currency  fluctuations  to the extent  such direct
sales may be  denominated  in foreign  currency.  In the third fiscal quarter of
fiscal  1997,  the Company  incurred  losses of  approximately  $550,000  due to
foreign  currency  fluctuations.  The Company  has since  entered  into  certain
currency hedging transactions in the form of forward exchange contracts that the
Company believes should limit its exposure to such currency fluctuations.  There
can be no  assurance,  however,  that the Company  will not incur  losses due to
foreign currency fluctuations in the future.

         The Company continually reviews its existing distributor  arrangements.
Establishing  a  direct  sales  force  requires  significant  time,   management
resources and  expenditures  and may result in substantial  additional  costs to
eliminate  existing  distribution  relationships  or  legal  actions  by  former
distributors.  The Company  expects to  establish a direct sales force in one or
more additional  countries in the future where it believes such an approach will
benefit  its  competitive  position.  Failure  by the  Company  to  quickly  and
cost-effectively  establish effective sales forces in such additional  countries
could  have a  material  adverse  effect on the  Company's  business,  financial
condition and results of operations.

         The Company has  implemented  a marketing  and  development  program to
support its sales in foreign  markets as well as to increase its visibility with
leading  physicians.  The Company has  implemented  a series of physician  group
training  sessions  in Europe and Japan  designed  to  increase  exposure to the
Company's products and allow "hands on" demonstration and training. In addition,
the Company has  developed a staff of clinical  specialists  to help  coordinate
clinical trials, work directly in the training of physicians and certain aspects
of patient  care,  provide an  increased  presence  at industry  tradeshows  and
produce marketing material targeted toward physicians.  The Company  anticipates
that,  because of the diverse needs of the market for peripheral stents and some
of the other  markets  for which the  Company is  developing  products,  it will
develop separate clinical support and sales forces to take advantage of clinical
and technical expertise specific to those markets.

         In the United States,  the Company intends to market its coronary stent
products,  if and when  approved by the FDA for sale there,  with a direct sales
organization.  The  Company  has  begun  to  develop  a U.S.  sales  force,  but
additional  resources  will be  required  to  develop a sales  force  capable of
effectively  commercializing  the Company's  products in the United States.  The
Company also  anticipates  that its various sales forces,  particularly its U.S.
sales force, will need to actively pursue approval of the Company as a qualified
supplier for hospital group purchasing  organizations  that negotiate  contracts
with suppliers of medical  products.  Qualification  with such group  purchasing
organizations,  which exist on both a national  and regional  level,  has become
increasingly important in recent years in response to cost containment pressures
and health  care  reform.  Failure  to build an  effective  sales and  marketing
organization  in the United States could have a material  adverse  effect on the
Company's business, financial condition and results of operations.

Manufacturing

         The Company  performs most of the steps for  fabrication  of its stents
internally,   including  cutting,   forming,   connecting  through   proprietary
attachment processes and  electropolishing  high quality medical grade stainless
steel. To support this capability,  the Company has designed  manufacturing  and
testing  equipment that has enabled the development and execution of proprietary
processes not  currently  available  from outside  suppliers.  For example,  the
Company has its own balloon and catheter extrusion  equipment,  which allows for
rapid  prototyping  and  adherence to strict design  specifications  and quality
standards in manufacturing.

         In addition to the technological  advantages of its stent designs,  the
Company believes that its vertically  integrated  manufacturing and research and
development operations provide a competitive advantage in quickly developing and
bringing to market  sophisticated stent and catheter products.  This integration
allowed  the  Company to develop  and bring to market  several  new  products in
fiscal 1997,  including the GFX and the Bridge renal and iliac  peripheral stent
systems. The Company's manufacturing engineers participate in the product design
process  so as to  insure  the  Company's  ability  to  achieve  rapid  and cost
effective manufacturing  capabilities for its products. The Company is committed
to  manufacturing   internally  as  many  of  its  products  and  components  as
practicable  and believes that such a process better enables it to set,  achieve
and  control  high  standards  for the  quality of its  devices,  reduce time to
market, manage costs, maintain control over proprietary information, and execute
improvements in design and  manufacturing  processes.  In mid-1998,  the Company
expects  to  move a  significant  portion  of its  United  States

                                       8
<PAGE>

manufacturing operations to a new facility currently under construction adjacent
to  its  headquarters  facility  in  Santa  Rosa,  California.  There  can be no
assurance  that  the  Company  will be able to  cost-effectively  complete  such
transition  or that it will not result in a stoppage or reduction of  production
capacity or efficiency, any of which events could have a material adverse effect
on the Company business, financial condition or results of operations.

         The design,  manufacture and assembly of certain proprietary components
and materials used in the Company's PTCA balloon  angioplasty and stent delivery
catheters take place in the Company's  facilities in Santa Rosa,  California and
those of Arterial Vascular  Engineering Canada,  Inc. ("AVEC"),  a subsidiary of
the Company located in Richmond,  British Columbia.  Though catheter  components
are  fabricated  in  both  facilities,   all  of  the  Company's  products  sold
commercially are currently finished and packaged in the Canadian facility,  with
the  Company's  finished  medical  devices  then being  shipped  from  Canada to
distributors outside of the United States. However, if and when the FDA approves
the  commercial  sale of the  Company's  coronary  stent  products in the United
States,  the  Company  expects  that it will  supply  the United  States  market
directly from its  manufacturing  facilities in Santa Rosa. The Company executes
all  critical  assembly  operations  in  controlled  environment  rooms in which
bacterial and airborne particulate levels are monitored.

         The Company has obtained the right to affix CE  (Conformite  Europeene)
marking  to all of its  coronary  stent  systems  sold in all  countries  of the
European  Economic  Area and  Switzerland.  CE marking  is a European  symbol of
conformance to strict product  manufacturing  and quality system  standards.  As
part of the CE marking  process,  the Company  also  received  ISO  9001/EN46001
certification  with respect to the  manufacturing  of all of its coronary  stent
products.  With respect to the United States, the FDA is expected to inspect the
Company's  manufacturing  facilities and processes for compliance with the FDA's
Quality  System  Regulation  before  the FDA  will  approve  the  Company's  PMA
application  for  commercial  sale of its coronary  stent  systems in the United
States.  Such  facilities  have not yet been inspected by the FDA.  Furthermore,
additional  manufacturing  sites  (such  as the  130,000  square  foot  facility
currently  under  construction  in  Santa  Rosa,   California)  and  changes  in
manufacturing  processes  will also be  subject  to  regulatory  inspection  for
compliance  with United States and  international  regulations.  There can be no
assurance  that  the  Company  will  be  able  to  demonstrate  or  continue  to
demonstrate  the compliance of its existing or future  facilities  with any such
regulations. See "--Government Regulation."

         The Company relies on some outside sources for catheter  components and
from time to time the  Company has  experienced  shortages  of certain  supplied
materials that have significantly affected its ability to produce enough product
to satisfy market demand. The Company currently relies upon a single supplier of
the medical grade stainless steel from which the Company's  stents are machined.
In fiscal 1995, the Company  experienced a shortage in acceptable  medical-grade
stainless  steel and was  unable to supply  products  for a period of time.  The
Company is continually  reviewing its own  capabilities  and the capabilities of
other potential suppliers of medical grade stainless steel,  although to date no
such other suppliers have been able to produce  materials  meeting the Company's
quality  standards.  The failure to obtain  sufficient  quantities  of component
materials  could  have a  material  adverse  effect on the  Company's  business,
financial condition and results of operations.

         The  anticipated  commencement  of  commercial  sales of the  Company's
coronary  stent systems in the United  States,  if FDA approval is received,  is
expected to increase  production  requirements to a level not yet experienced by
the  Company.   Manufacturers   often   encounter   difficulties  in  increasing
production, including problems involving production yields, adequate supplies of
components,  quality control and assurance and shortages of qualified personnel.
In 1995, the Company experienced difficulties in producing sufficient volumes of
products to satisfy demand,  due in part to lower production  yields  associated
with the commencement of large scale  manufacturing  of new products.  Moreover,
the Company  developed a significant  short-term  backlog during January 1997 in
connection with the scale-up of manufacturing of its GFX stent system. There can
be no  assurance  that  the  Company  will  be  successful  in  scaling  up  its
manufacturing   operations,   or  that  it  will  not  experience  manufacturing
difficulties  in  the  future.   Difficulties  experienced  by  the  Company  in
manufacturing  scale-up  could have a material  adverse  effect on the Company's
business, financial condition and results of operations.

         The  Company  believes  that its  current  manufacturing  space will be
sufficient to serve its needs through at least early 1998. The Company has begun
to produce inventory for the short-term supply of the potential U.S. market, and
it has begun  construction  of a 130,000  square foot  building  adjacent to its
corporate  headquarters in Santa Rosa,  California,  at an estimated cost of $20
million,  which,  when  completed,  will be  largely  devoted  to  manufacturing
activities.  However,  there can be no  assurance  that  such new  manufacturing
facility will be completed in time to allow the Company to adequately supply the
potentially  significant  demands of the U.S. market on a long-term  basis,  nor
that such new facility  will pass  regulatory  inspection  for  compliance  with
United States and international regulations.

Competition

         Competition in the market for the treatment of  cardiovascular  disease
is intense and is expected to  increase.  The Company  competes  primarily  with
Boston Scientific Corporation, C.R. Bard, Inc., Cook, Inc., Guidant Corporation,
Cordis (Johnson & Johnson),  Medtronic,  Inc. and Pfizer, Inc., among others, in
the development,  production and marketing of stents and stent  technology.  The
Company  believes  that Cordis  (Johnson & Johnson) is 

                                       9
<PAGE>

currently  the  worldwide  market leader with a majority of the market for stent
devices.  As of the date of this report,  Cordis  (Johnson & Johnson),  Cook and
Medtronic  have the only stents which have been  approved by the FDA for sale in
the United States. In addition, Guidant submitted a PMA to the FDA for its stent
product in June 1997,  while the  Company's  PMA was  submitted  in August 1997.
Earlier  entrants in the market in a therapeutic  area often obtain and maintain
significant market share relative to later entrants. Moreover, in many countries
in which the Company  markets its  products,  neither  pre-market  approval  nor
clinical  studies  are  required  prior to  marketing  a  product.  As a result,
competitive  products  have been and continue to be quickly  introduced in these
markets.  Many of the  Company's  competitors  and  potential  competitors  have
substantially  greater  name  recognition  and capital  resources  than does the
Company and also have greater  resources  and expertise in the areas of research
and development,  obtaining regulatory  approvals,  manufacturing and marketing.
There can be no assurance  that the  Company's  competitors  will not succeed in
developing stents or stent systems,  competing technologies or therapeutic drugs
that are more effective or more effectively  marketed than products  marketed by
the Company or that render the Company's technology obsolete. Additionally, even
if the Company's products provide performance  comparable to competing products,
there can be no  assurance  that the  Company  will be able to obtain  necessary
regulatory  approvals or compete against  competitors in terms of manufacturing,
marketing and sales.

         The Company believes that the primary competitive factors in the market
for stent  technology  include product safety,  quality,  ease of use,  clinical
performance (radial strength, flexibility,  radiopacity, low thrombosis risk and
long term efficacy), delivery system characteristics (flexibility,  reliability,
ease  of  use),  price,   customer  service  and  availability  of  third  party
reimbursement.  In  addition,  the length of time  required  for  products to be
developed and to receive regulatory approval is an important competitive factor.
The Company  believes  it  competes  favorably  with  respect to these  factors,
although there can be no assurance that it will be able to continue to do so.

         An additional competitive factor is the current healthcare environment.
Particularly in the United States,  this environment has  increasingly  centered
around managed care  organizations,  group  purchasing  organizations,  hospital
consolidations  and  other  factors  resulting  in  increased  cost  containment
pressures  for  medical  procedures  generally,   including  the  less  invasive
procedures  for which the Company  markets its  products.  Many of the Company's
competitors  have a greater  strategic  mass and offer broader  product lines in
minimally invasive procedures generally than does the Company,  allowing them to
market their stent systems and PTCA balloon catheters to medical  specialists as
part of a broad  package of other needed  minimally  invasive  medical  devices.
There can be no assurance  that the  Company's  competitors  will not succeed in
developing  more  effective  marketing  programs  than  the  Company  in such an
environment.

         The  Company  believes  that the  increasing  number of  devices in the
international  stent market and the desire of  companies to obtain  market share
has  resulted in increased  price  competition,  particularly  in the second and
third quarters of fiscal 1997,  which has caused the Company to reduce prices on
its stent  systems.  Price  reductions  effected  by the  Company in response to
competitive pressure reduced net sales in the second quarter of fiscal 1997, but
were offset by increased  unit sales in the third and fourth  quarters of fiscal
1997. The Company  expects such price  competition to continue,  particularly in
Germany.  If the  Company is forced to effect  further  price  reductions,  such
reductions  would reduce net sales in future  periods if not offset by increased
unit sales or other  factors.  Price  reductions  by the  Company in response to
competitive  pressure,  particularly in Germany,  could have a material  adverse
affect on the Company's business, financial condition and results of operations.

         In addition,  the ability to use patents or other proprietary rights to
prevent sales by  competitors  is an important  competitive  tool in the medical
device  industry.  The Company  believes  that patents held by  competitors  may
restrict its ability to market its current  products in the United  States.  See
"-- Patents and Proprietary Rights."

         The  stent  market  is  characterized  by rapid  technical  innovation.
Product development involves a high degree of risk and there can be no assurance
that the Company's  competitors  and potential  competitors  will not succeed in
developing and marketing  technologies and products that are more effective than
those developed and marketed by the Company,  or that would render the Company's
technology and products obsolete or noncompetitive. The medical indications that
can be treated by stents can also be  treated  by  surgery,  minimally  invasive
bypass procedures, drugs, or other medical devices including stand alone balloon
catheters,  atherectomy  catheters and lasers, many of which are widely accepted
in the medical community.  Although the use of stents is increasingly  supported
by the professional community, there is no assurance that procedures using stent
technology will replace such  established  treatments or that clinical  research
will  continue  to  support  the  use  of  stents.  Additionally,  new  surgical
procedures  and  medications  could be  developed  that  replace  or reduce  the
importance of current procedures that use the Company's products.

Patents and Proprietary Rights

         The Company has filed U.S. and foreign patent  applications  to protect
its proprietary  position in stents and stent delivery systems. The Company also
relies on trade  secrets,  technical  know-how and  technological  innovation to
maintain  its  competitive  position.  The  Company's  policy is to protect  and
enforce its patent and other intellectual property rights by appropriate action.

                                       10
<PAGE>

         The Company holds one issued United States patent, has received notices
of  issuance on two of its United  States  patent  applications  and has several
United States patent applications pending. It also holds two Australian patents,
one European patent and has additional  foreign patent  applications  filed. The
Company's  issued United States patent relates to stent  technology  used in the
Company's current stent systems. The Company also has a license to make and sell
stents and balloon angioplasty catheters using technology covered by patents and
patent  applications of a third party.  The application for a stent patent which
resulted in the  Company's  only issued  United  States patent was acquired from
Endothelial Support Systems,  Inc.  (subsequently known as Endovascular  Support
Systems,  Inc.) ("ESS").  In June 1996, two former  shareholders of ESS, each of
whom  currently  holds shares of Common  Stock of the  Company,  filed an action
against the Company seeking, among other things, to rescind the transfer of such
technology  from ESS and to transfer  such patent to ESS.  No  assurance  can be
given as to the outcome of any such litigation.  Loss or impairment of the right
to produce  products based on such patents could have a material  adverse effect
on the Company's business,  financial  condition and results of operations.  See
"Item 3. Legal Proceedings."

         A number of  medical  device  and  other  companies,  universities  and
research institutions have filed patent applications or have been issued patents
relating  to  catheters,   stents  and  delivery  systems  and  there  has  been
substantial  litigation in this area.  The Company's  success will depend on its
products not infringing patents issued to competitors. The Company is aware that
a  portion  of the  technology  used  in  its  current  stent  systems  may,  if
challenged,  be determined to be in conflict with certain  United States patents
held by competitors of the Company,  which  competitors are larger and have more
substantial  resources than the Company.  These  competitors  can be expected to
expend significant resources to attempt to enforce and/or defend the validity of
their patents. The validity, scope and enforceability of one such patent held by
a competitor  was recently  challenged in litigation  not involving the Company.
The parties to that litigation  settled their dispute privately before receiving
a court  decision as to the validity,  scope or  enforceability  of such patent.
Subsequently, the validity and enforceability of that patent has separately been
challenged in other litigation not involving the Company. In the event that such
litigation is resolved unfavorably from the Company's  perspective,  the Company
may be precluded  from selling its current  stent  products in the United States
for the life of such patent.

         In anticipation  of receiving  approval for sale of its products in the
United  States,  the Company is reviewing  whether it may be necessary to modify
its current  technology or develop new products to avoid infringement under such
United States patents.  If the Company's products are determined to infringe and
it cannot  obtain a  license  on  commercially  reasonable  terms or modify  its
current technology or develop new products to avoid  infringement,  such outcome
could require the Company to cease its  commercial  activities  and sales of the
affected  products in the United States and could have a material adverse effect
on the  Company's  business,  financial  condition  and  results of  operations.
Modification  of the Company's  products or development of new products to avoid
infringement may require the Company to conduct  additional  clinical trials for
such new or  modified  products in  connection  with  United  States  regulatory
approval and to revise its filings with the FDA or other regulatory agencies.

         The Company is  continually  reviewing  the scope of United  States and
foreign  patents  and the status of any  litigation  with  respect to patents of
interest of which it is aware.  The question of  infringement  involves  complex
legal and factual issues and is highly uncertain. There can be no assurance that
any conclusion reached by the Company regarding  infringement will be consistent
with the  resolution  of such  issue  by a court.  In the  event  the  Company's
products  are found to infringe  patents  held by  competitors,  there can be no
assurance that the Company will be able to  successfully  modify its products to
avoid  infringement,   or  that  any  modified  products  will  be  commercially
successful.  Failure in such event to either develop a  commercially  successful
alternative or to obtain a license to such patent on reasonable terms could have
a material  adverse effect on the Company's  business,  financial  condition and
results of operations.  In any event, there can be no assurance that the Company
will  not  be  obliged  to  defend  itself  in  court  against   allegations  of
infringement  of third party  patents.  Patent  litigation is very expensive and
could subject the Company to significant liabilities, require disputed rights to
be  licensed  from third  parties or require  the  Company to cease  selling its
products.

         The  validity  and  breadth  of claims in  medical  technology  patents
involve  complex  legal and  factual  questions  and,  therefore,  may be highly
uncertain.  No assurance can be given that any patents  based on pending  patent
applications  or any future patent  applications  of the Company will be issued,
that the scope of any patent  protection  will  exclude  competitors  or provide
competitive  advantages  to the Company,  that any of the  Company's  patents or
patents  to which it has  licensed  rights  will be held  valid if  subsequently
challenged  or that others will not claim  rights in or ownership of the patents
and other proprietary rights held or licensed by the Company. Furthermore, there
can be no assurance  that others have not developed or will not develop  similar
products,  duplicate any of the Company's  products or design around any patents
issued to or  licensed by the Company or that may be issued in the future to the
Company.  Since  patent  applications  in the United  States are  maintained  in
secrecy until patent  issue,  the Company also cannot be certain that others did
not first file  applications  for  inventions  covered by the Company's  pending
patent  applications,  nor can the Company be certain  that it will not infringe
any patents that may be issued to others on such applications.

                                       11
<PAGE>


         The Company relies upon trade secret  protection for certain aspects of
its proprietary  technology.  The Company's  policy is to have each employee and
consultant  enter  into  a  confidentiality   agreement  containing   provisions
prohibiting  the  disclosure of  confidential  information to anyone outside the
Company  and  requiring  disclosure  to  the  Company  of  ideas,  developments,
discoveries  or  inventions   conceived  during   employment  or  service  as  a
consultant,  and assignment to the Company of proprietary rights to such matters
related  to  the  business  and  technology  of  the  Company.  There  can be no
assurance,  however, that these agreements will provide meaningful protection or
adequate  remedies for the Company's  trade secrets in the event of unauthorized
use or  disclosure  of such  information  or that others will not  independently
develop  substantially  equivalent  proprietary  information  and  techniques or
otherwise gain access to the Company's trade secrets and proprietary know-how.

Government Regulation

         International  sales of  medical  devices  are  subject  to  regulatory
requirements  in many  countries.  The regulatory  review  process  required for
commercial sales varies from country to country.  The products currently sold by
the Company are subject to pre-market approval in Belgium, Canada, Italy, Japan,
Norway,  Spain and Sweden as well as to other  regulatory  requirements in these
and other countries. The Company received approvals to market its coronary stent
systems in Belgium,  Italy,  Norway and Sweden prior to or early in fiscal 1997.
The Company  received such approval in Spain when it obtained the right to affix
CE  marking  to its  stent  systems  in June  1997.  Pre-market  approvals  from
particular  countries within the European Economic Area (the 15 countries of the
European  Union and Norway and Iceland)  will not be required  after the Company
has achieved  compliance with the requirements of the Medical Devices  Directive
(the "MDD") discussed below. Additionally,  in June 1997, the Company's Japanese
distributor  received  approval  for the  sale  in  Japan  of all the  Company's
coronary stent systems to date;  however,  to date such  distributor had not yet
received the related reimbursement  approval there. It had earlier obtained such
approval for the Company's Peak, Nike and Elite PTCA balloon  catheter  systems.
The  Company is also  currently  working  with  Canadian  authorities  regarding
approval of its stent  products for sale in Canada.  In certain  countries,  the
Company  may also be subject to  regulations  governing  clinical  trials of its
products. The Company currently exports and sells its coronary stent systems and
its PTCA balloon  catheters in over 40 countries  outside of the United  States,
with full or limited release of the Company's line of Bridge  peripheral  stents
and its LTX high pressure PTCA balloon catheter system currently in progress.

         In fiscal 1997,  the Company began taking an active role in the receipt
of pre-market approvals and compliance with clinical trial requirements in those
countries that require them, particularly in those countries where it has direct
sales  operations.  However,  to some  extent the Company  continues  to rely on
distributors  in those  countries  where it continues to use  distributors.  The
Company's  distributors  have received  pre-market  approvals in those countries
that require them and in which the Company currently has commercial sales. There
can be no  assurance  that the Company  will  continue to be able to quickly and
cost-effectively  establish and maintain regulatory  compliance  operations with
respect to those countries  where it establishes  direct sales  operations.  The
Company has in the past discovered instances of regulatory  noncompliance by its
distributors,  and has, in response,  caused the applicable  distributor to file
revised governmental notifications,  ceased to sell commercially its products in
the  applicable  countries  or  otherwise  acted  so  as  to  halt  any  ongoing
noncompliance  in such countries.  While the Company is not aware of any pending
or threatened governmental action against it in any country in which it has done
business,  any enforcement action by regulatory authorities with respect to past
or any future regulatory  noncompliance  could have a material adverse effect on
the Company's business, financial condition and results of operations.

         Generally,  in  order to  continue  selling  its  products  within  the
European Economic Area and Switzerland following June 14, 1998, the Company will
be required to achieve  compliance with the requirements of the MDD and affix CE
marking on its products to attest to such compliance;  the Company believes that
products  which have already  been  delivered  to  distributors  will be able to
continue  to be  sold  by  such  distributors  during  a  subsequent  three-year
transition period. To achieve  compliance,  the Company's products must meet the
"Essential  Requirements"  of the MDD relating to safety and performance and the
Company must  successfully  undergo  verification  of its regulatory  compliance
("conformity  assessment")  by a Notified  Body  selected  by the  Company.  The
Company has  selected  TUV Product  Service of Munich,  Germany as its  Notified
Body.  The  nature of such  assessment  depends on the  regulatory  class of the
product,  and the Company's  coronary stent products are currently in Class III,
the highest risk class, and therefore subject to the most rigorous controls.

         In March 1997, the Company received ISO 9001/EN46001 certification from
its Notified Body with respect to the manufacturing of all of its coronary stent
products. This certification applies to the manufacturing  operations in each of
the Company's Santa Rosa facilities and AVEC's facility in Canada. In June 1997,
the Company  obtained the right to affix CE marking to all of its coronary stent
systems sold in all countries of the European Economic Area and Switzerland. The
Company will be subject to continued  supervision  by its Notified Body and will
be  required  to  report  any  serious  adverse  incidents  to  the  appropriate
authorities.  The  Company  also  will be  required  to comply  with  additional
national  requirements that are beyond the scope of the MDD. With respect to its
Bridge line of  peripheral  stent  systems,  its LTX high  pressure PTCA balloon
catheter system and any additional  products not already cleared for CE marking,
the Company will need to comply with the CE marking  requirements  prior to June
14,  1998,  or else it will

                                       12
<PAGE>

be unable to sell its  products in the  European  Economic  Area or  Switzerland
unless and until  compliance  is achieved.  Failure to achieve  such  compliance
could have a material  adverse  effect upon the  Company's  business,  financial
condition and results of operations.  There can be no assurance that the Company
will be able to achieve or maintain compliance required for CE marking on all or
any of its products or that it will be able to timely and profitably produce its
products while complying with the  requirements of the MDD and other  regulatory
requirements.

         In the United States, the Company is subject to extensive regulation of
medical devices by the FDA as well as state and local authorities, including the
California  Department of Health  Services.  Generally,  unless a medical device
manufacturer  can  establish to the FDA's  satisfaction  that a newly  developed
device is "substantially  equivalent" to a legally marketed device that does not
itself require pre-market approval, the Federal Food, Drug and Cosmetic Act (the
"FDC Act") requires that the manufacturer submit a PMA for the device and obtain
the  FDA's  approval  of the PMA prior to  marketing  the  device in the  United
States. It is expected that all of the Company's coronary stent products will be
subject  to the PMA  process.  The first  step in the PMA  approval  process  is
usually the submission to the FDA of the results of laboratory and  pre-clinical
studies,  which  typically  must be  conducted  in  compliance  with  the  FDA's
regulations governing Good Laboratory Practices, and a request for permission to
clinically  evaluate the device in humans under an IDE.  Initiation of the study
requires  the approval of the FDA and of the  institutional  review board of the
hospital or clinic  participating  in the  clinical  trial and written  informed
consent from all participating  patients.  Furthermore,  FDA regulations subject
sponsors of IDEs to certain requirements including proper monitoring of clinical
investigations,  selection of qualified investigators,  recordkeeping, reporting
of  unanticipated  adverse  device events and  submission  of periodic  progress
reports. In addition,  a sponsor is prohibited from promoting or commercializing
a device prior to PMA approval.  The PMA must contain,  among other things,  the
results of the  clinical  trials,  the  results  of all  relevant  bench  tests,
laboratory and pre clinical  studies,  a complete  description of the device and
its  components,  and a detailed  description  of the  methods,  facilities  and
controls  used for  manufacture,  including  the  method  of  sterilization.  In
addition,  the  submission  must  include  the  proposed  labeling,  advertising
literature and physician training methods (if required).  In general,  data from
adequate and well-controlled  independent,  statistically  significant  clinical
trials must  demonstrate the safety and  effectiveness of the device in order to
obtain approval of the PMA.

         After  completion of the FDA's  preliminary  review,  the submission is
ordinarily  sent  to an  FDA-selected  scientific  advisory  panel  composed  of
physicians  and scientists  with expertise in the particular  field which (after
holding any public hearings it deems necessary) then issues a recommendation  to
the FDA that may include  conditions  for approval.  The FDA is not bound by the
recommendations of the advisory panel. Toward the end of the PMA review process,
the FDA will conduct an  inspection of the  manufacturer's  facilities to ensure
that the facilities are in compliance with applicable  quality system regulation
("QSR") requirements. If the FDA evaluations of both the PMA application and the
manufacturing facilities are favorable, the FDA will issue an approvable letter,
which  usually  contains  a number of  conditions  which must be met in order to
secure final approval of the PMA. When those  conditions  have been fulfilled to
the  satisfaction  of the FDA,  the  agency  will  issue a PMA  approval  order,
authorizing  commercial  marketing  of the device for certain  indications.  The
sponsor  may not promote  the device for uses not  approved by the FDA.  The FDA
also has the authority to impose  certain  post-approval  requirements  in a PMA
approval order, including post-approval  surveillance studies further evaluating
the safety, efficacy and reliability of the device. Additional post-approval FDA
requirements  include  Medical Device  Reporting (MDR)  requirements  and device
tracking requirements. Failure to comply with any post-approval requirements may
lead  to  withdrawal  of FDA  approval.  The PMA  review  and  approval  process
generally  takes more than a year to complete from the date of acceptance by the
FDA for  filing,  and may take  substantially  longer.  In  response  to  public
concerns, the FDA has recently made efforts to reduce the time required to clear
PMAs and PMA  supplements,  but review times for products  such as the Company's
remain long and there can be no assurance  that the  Company's  PMA will receive
any  kind of  expedited  review.  The FDA may  also  determine  that  additional
clinical trials are necessary,  in which case the PMA may be delayed for several
years  while  additional  clinical  trials are  conducted  and  submitted  in an
amendment  to the PMA.  Certain  modifications  to medical  devices  require FDA
clearance,  either  under  the  IDE or in a PMA  supplement.  Such  IDE  and PMA
supplements relating to product modifications require the submission of the same
type of  information  required  for an initial  application,  but  because  such
subsequent  filings  need only  contain  sufficient  information  to support the
change,  they  are  generally  more  brief.  The FDA  generally  does not use an
advisory panel review for PMA supplements.

         In August  1997 the Company  submitted  a PMA to the FDA in  connection
with its ongoing efforts to gain approval to begin  commercial  sales of certain
of its  coronary  stent  systems  in the United  States.  The PMA was based on a
661-patient,  multi-center,  randomized  clinical study with the Company's Micro
Stent II device in the  United  States  under an IDE.  The study  evaluated  the
treatment of both de novo and restenotic  lesions in native  coronary  arteries,
utilizing the Palmaz-Schatz(R)  stent of Cordis (a Johnson & Johnson company) as
a control.  The study had an elective indication for use and required follow-up,
utilizing a primary endpoint of clinically driven target site  revascularization
at  nine  months  and  various  secondary  endpoints   (including   angiographic
restenosis).  The data for  preliminary  six-month  data,  as  presented in late
August 1997 by the  principal  investigator  for the study,  indicated  that the
target  site  revascularization  for  the  Micro  Stent  II at  six  months  was
approximately  8.4% and was  statistically  equivalent  to the  results  for the
Palmaz-Schatz(R) product. The Company included in supplemental registries to the

                                       13

<PAGE>

study patients with long lesions that were treated with the Micro Stent II XL as
well as patients  treated with the GFX, and certain data relating to the GFX was
included in the August  1997 PMA  submission.  The  Company  has also  commenced
clinical  trials of the Company's  single-operator  stent delivery system and of
the Company's Peak PTCA balloon catheter system. Such systems were not, however,
included in the PMA submission  made in August 1997. The Company does not expect
FDA approval of any of its stent  systems for sale in the United States prior to
1998,  and there can be no assurance  when or if such approval will be obtained.
The Company has incurred, and expects to continue to incur, substantial clinical
research and other costs in connection with obtaining  regulatory  approvals for
its stent systems in the United States and other countries.

         With respect to its commercial  product sales,  which  currently  occur
only outside of the United States, the Company's Santa Rosa facilities currently
manufacture only components (not finished  devices) and the finished devices are
currently assembled in the AVEC facility.  However, the Company anticipates that
it will supply the United  States  market,  if and when the sale of its products
are  approved  by the  FDA for  sale  there,  directly  from  its  manufacturing
facilities  in Santa  Rosa.  Under  current  law,  at such  time as the  Company
manufactures finished devices in the United States or imports or offers finished
devices for import into the United States  (except as may be covered by an IDE),
the QSR  requirements  will  apply  and the  Company  expects  that the FDA will
inspect the Company's manufacturing facilities on a regular basis for compliance
with  applicable  FDA  regulations,  including  the  QSR  requirements.  The QSR
requirements  mandate that the Company manufacture its products and maintain its
documents in a  prescribed  manner with  respect to  manufacturing,  testing and
control activities. The Company will also be required to comply with various FDA
requirements  for  labeling.  Furthermore,  in  accordance  with the  FDA's  MDR
requirements  the Company will be required to provide  information to the FDA on
death or serious  injuries  alleged to have been  associated with the use of its
medical  devices,  as well as product  malfunctions  that would  likely cause or
contribute  to death or  serious  injury if the  malfunction  were to recur.  In
addition,  the  FDA  prohibits  an  approved  device  from  being  marketed  for
unapproved applications. If the FDA believes that a company is not in compliance
with the law, it can institute proceedings to detain or seize products,  issue a
recall, enjoin future violations and assess civil and criminal penalties against
the Company, its officers and its employees.

         The Company  currently  exports to its  Canadian  subsidiary  its stent
components,   stent  delivery  system   components  and  PTCA  balloon  catheter
components for final assembly and  distribution.  The Company  believes that its
export of these  components  does not  currently  subject  the Company to export
approval requirements under the FDC Act. However, the FDA could determine in the
future that the Company's export of components is not in compliance with the FDC
Act or the  FDA's  regulations  or  policies,  or  that  such  exports  will  be
prohibited  in the  future.  Failure  to  comply  with  applicable  FDA or other
applicable  regulatory  requirements  can  result  in fines,  injunction,  civil
penalties,  recall or  seizure  of  products,  total or  partial  suspension  of
production and criminal prosecution.  In addition, the manufacturing  operations
at the facilities of AVEC are subject to Canadian medical device regulations. In
February 1996, a medical device inspector with the Canadian government inspected
AVEC's  facility and determined  that AVEC's  operations were in compliance with
such regulations.  However,  Canadian  authorities could determine in the future
that AVEC's operations are no longer in compliance with such regulations,  and a
restriction or  prohibition  against the export by the Company of components for
final  assembly in Canada or another  country  could require the Company to make
substantial changes to its manufacturing  operations and have a material adverse
effect on the Company's business, financial condition and results of operations.

Third-Party Reimbursement

         Sales  volumes  and  prices  of  the  Company's  products  are  heavily
dependent on the availability of reimbursement from third party payors,  such as
government and private  insurance plans,  health  maintenance  organizations and
other sources of  reimbursement  for health care costs  ("Third-Party  Payors").
Individuals are seldom,  if ever,  willing or able to pay directly for the costs
associated  with  the  use  of  the  Company's  products.  In  foreign  markets,
reimbursement  is  obtained  from a variety of sources,  including  governmental
authorities,  private health insurance plans and labor unions. The market in the
United  States is moving  rapidly in the  direction  of managed  care,  in which
Third-Party  Payors attempt to shift  financial risk to providers of health care
through  mechanisms  that,  among other  things,  involve  fixed  payments for a
defined treatment or episode of care. In addition, Third-Party Payors attempt to
contain health care costs by influencing the clinical  decision making of health
care providers in the direction of what is deemed to be "cost  effective  care."
Some  Third-Party  Payors may also contract on an exclusive  basis with a single
provider of an ancillary  service or product to obtain the lowest possible price
and  then  induce  providers  or  insured  individuals  to deal  only  with  the
contracted source by limiting routine insurance coverage to services or supplies
obtained from that source.

         The federal Medicare program and other major Third-Party  Payors in the
United  States  generally  reimburse  most acute,  general  care  hospitals  for
inpatient  medical  treatment,  including all operating  costs and all furnished
items or services,  including devices such as the Company's,  at a prospectively
fixed  rate  based on the  diagnosis-related  group  ("DRG")  that  covers  such
treatment,  as established  by the federal Health Care Financing  Administration
(the "HCFA"). For interventional  procedures, the fixed rate of reimbursement is
based on the procedure or procedures  performed and is unrelated to the specific
devices used in that procedure.  In addition, each interventional DRG payment is
calculated

                                       14
<PAGE>

to reflect the costs of a specific  procedure  or type of  procedure.  Effective
October 1, 1996, the HCFA created a new procedure code for the implantation of a
coronary artery stent. In accordance with HCFA policy, that code was assigned to
the DRG category  used for  predecessor  codes,  not  specifically  designed for
coronary artery stents: DRG 112 -- "Percutaneous Cardiovascular Procedures." DRG
112  includes  PTCA  procedures.  This DRG does not reflect  the  current  costs
associated  with the use of the Company's  stent  systems,  and therefore  would
likely  result  in  under-reimbursement  in the  event  that  the  Company  were
permitted to sell such products to parties subject to such reimbursement  level.
As of the date of this report,  the HCFA was  reevaluating  this DRG assignment,
based on hospital  resource data, as part of its annual DRG review process,  and
considering  whether to re-assign coronary stent implant procedures from DRG 112
to DRG 116 (a code which includes cardiac  pacemaker  implants) as of October 1,
1997. The Company believes that the reimbursement rate established in connection
with such new DRG code would be higher than that currently established under DRG
112 and that such rate would generally reflect the current costs associated with
the use of the Company's stent systems. There can be no assurance, however, that
the HCFA will  re-assign  coronary  stent  procedures to DRG 116 or that any new
reimbursement  rates will  sufficiently  reflect  the  current  or future  costs
associated with the use of the Company's stent systems.

         Third-Party  Payors  that  do  not  use  prospectively  fixed  payments
increasingly  use other  cost  containment  devices,  such as  having  exclusive
suppliers  or  approved  lists of  devices  deemed to be "cost  effective,"  and
requiring  discretionary,  prior  authorization  for  exceptions.  In  addition,
Third-Party Payors may deny reimbursement if they determine that the device used
in a  treatment  was not a  covered  device or was  unnecessary,  inappropriate,
experimental,  used for a nonapproved indication or not cost effective. In other
situations,  Third-Party Payor cost containment efforts may pose barriers to the
use of the  Company's  products  if,  for  example,  the  products  are not on a
Third-Party  Payor's  approved  list of  devices.  Accordingly,  providers  must
determine that the clinical  benefits of stents  justify the additional  cost or
the additional effort required to obtain prior authorization or coverage and the
uncertainty of actually obtaining such authorization or coverage.  Reimbursement
of  angioplasty  procedures  is covered  under a DRG,  but because the amount of
reimbursement is fixed by Medicare and some other Third-Party Payors, the amount
of potential  profit  relating to the procedure may be reduced by the additional
cost associated with use of the Company's stent systems.

         While the Company  believes  that the use of stents may  continue to be
cost  effective  for  many  medical  indications,   the  Company  believes  that
reimbursement in the future is becoming subject to increased  restrictions  such
as those described above, both in the United States and in foreign markets.  The
Company  believes  that the  overall  escalating  cost of medical  products  and
services  has led to and will  continue to lead to  increased  pressures  on the
health care industry,  both foreign and domestic, to reduce the cost of products
and  services,  including  products  offered  by the  Company.  There  can be no
assurance  as to either  United  States or  foreign  markets  that  third  party
reimbursement  and  coverage  will  be  available  and  adequate,  that  current
reimbursement  amounts  will  not be  decreased  in the  future  or that  future
legislation, regulation or reimbursement policies of Third-Party Payors will not
otherwise  adversely affect the demand for the Company's products or its ability
to sell its products on a profitable basis, particularly if the Company's stents
are more expensive  than competing  stents.  The  unavailability  of Third-Party
Payor coverage or the inadequacy of reimbursement  could have a material adverse
effect on the Company's business, financial condition and results of operations.

Product Liability and Insurance

         The design,  manufacture  and marketing of medical devices of the types
produced by the Company  entail an inherent risk of product  liability and other
liability claims in the event that the use of the Company's  products results in
personal injury claims.  The Company's  products are designed to be implanted in
the human body indefinitely,  and are used in life-threatening  situations where
there is a high risk of serious  injury or death.  From time to time the Company
has received  inquiries  regarding  particular  medical  procedures in which its
products  were used,  but to date the  Company has not  experienced  any product
liability  claims.  Any such claims could have a material  adverse effect on the
Company's business,  financial condition and results of operations.  The Company
maintains  liability  insurance with coverage of $20 million both per occurrence
and in the aggregate.  There can be no assurance that product liability or other
claims will not exceed such insurance  coverage  limits,  or that such insurance
will continue to be available on commercially acceptable terms or at all.

Environmental Matters

         The  Company  is  subject  to  federal,  state and local  laws,  rules,
regulations and policies governing the use,  generation,  manufacture,  storage,
air emission, effluent discharge, handling and disposal of certain hazardous and
potentially   hazardous   substances  used  in  connection  with  the  Company's
operations.  Although the Company  believes that it has complied with these laws
and  regulations  in all material  respects and to date has not been required to
take any action to correct any noncompliance, there can be no assurance that the
Company  will  not be  required  to  incur  significant  costs  to  comply  with
environmental regulations in the future.

                                       15
<PAGE>

Additional Business Risks

         The Company has recently experienced rapid growth in its facilities and
the number of its  employees,  the number of  products  under  development,  the
number and amount of products  manufactured and sold and the geographic scope of
its sales.  In order to support  increased  levels of sales in the future and to
augment its long-term competitive position, the Company anticipates that it will
be  required  to make  significant  additional  expenditures  in  manufacturing,
research and  development,  sales and  marketing,  and  administration,  both in
absolute dollars and as a percentage of sales.  Among other things,  the Company
expects to spend  approximately  $20 million on its new  manufacturing  facility
currently under  construction in Santa Rosa,  California.  While the Company has
commenced the  implementation of improved financial and management  systems,  is
increasing personnel and expects to increase  substantially its efforts in these
areas,  there  can be no  assurance  that such  systems  and  personnel  will be
efficiently  integrated or will be adequate for the  management of the Company's
current or future  operations,  or that the Company  will be able to manage such
growth effectively.

         The Company has a limited operating history upon which an evaluation of
its prospects can be made.  There can be no assurance that the Company will grow
or that the Company's future financial  results will be comparable to its recent
results.  Future  operating  results will depend on many factors,  including the
demand for the Company's  products,  the level of product and price competition,
the levels of third-party reimbursement,  the Company's success in expanding its
direct sales force and distribution channels and whether the Company can develop
and market new products and control  costs.  In addition,  the Company's  future
prospects  must be considered in light of the risks,  expenses and  difficulties
frequently  encountered  in  establishing  a new business in the medical  device
industry,  which is characterized by intense  competition,  rapid  technological
change and significant regulation.

         The Company's success is dependent upon acceptance of its stent systems
and PTCA balloon catheters by the medical  community as reliable,  safe and cost
effective.  The Company has only limited clinical data regarding the efficacy of
the stent systems it currently  sells. The Company and other producers of stents
are  engaged in  clinical  studies  of stent  systems,  including  in some cases
comparison of the Company's stents to those of competitors. Clinical results are
inherently  unpredictable  and are influenced by the  indications  and endpoints
chosen and the  procedures  used.  There can be no  assurance  that results from
clinical trials sponsored by the Company, its competitors, or a third party will
not  delay  or  prevent  regulatory  approvals,  reduce  market  demand  for the
Company's  products  or that  the  Company's  interpretation  of data  from  its
clinical trials will be accepted by the FDA or other  regulatory  authorities or
the medical community at large.

         In fiscal  1997,  the vast  majority  of the  Company's  net sales were
derived from sales of its stent systems. In addition,  over 40% of the Company's
net sales for fiscal 1997,  and over 70% of its net sales for the fourth quarter
of fiscal 1997,  were derived from products  introduced  during fiscal 1997. The
success of these  products  depends,  among other  things,  on the nature of the
technological advances inherent in the products' design, clinical trial results,
market  acceptance  of the  products,  and the  Company's  receipt of regulatory
approvals  for the  products.  There can be no  assurance  that  clinical  trial
results will be favorable,  that required regulatory approvals will be obtained,
or that  recently  introduced  products  or future  products  will  gain  market
acceptance.  Unfavorable  clinical trial results,  failure to obtain  regulatory
approvals  or failure  to gain  market  acceptance  for the  Company's  recently
introduced  products or future products could have a material  adverse effect on
the Company's business,  financial condition and results of operations. The life
cycle of the  Company's  products is difficult to predict.  To the extent demand
for any of the Company's  products  declines and the Company's newly  introduced
products are not commercially accepted, there could be a material adverse effect
on the Company's business, financial condition and results of operations.

         The medical device industry is  characterized  by rapid and significant
technological  change. The Company's future success will depend in large part on
whether the Company can continue to respond to such changes,  and whether it can
expand the indications and applications for which its products are used, through
the timely development and successful  introduction of enhanced and new versions
of its stents systems and balloon  catheters.  Product  research and development
will require  substantial  expenditures and has inherent risks, and there can be
no assurance  that the Company will be  successful in  identifying  products for
which  demand  exists,  in  developing  products  that have the  characteristics
necessary to treat particular  applications,  or that any new product introduced
will receive regulatory approval or be commercially successful.

         The Company's Amended and Restated Certificate of Incorporation and the
Delaware  General  Corporation  Law contain  certain  provisions,  including the
requirements of Section 203 of the Delaware  General  Corporation  Law, that may
delay or prevent an attempt by a third party to acquire  control of the Company.
In  addition,  in  February  1997 the  Company's  Board of  Directors  adopted a
stockholder  rights  plan,  commonly  referred  to as a "poison  pill,"  that is
intended to deter  hostile or coercive  attempts  to acquire  the  Company.  The
stockholder rights plan enables  stockholders to acquire shares of the Company's
common stock, or the common stock of an acquiror,  at a substantial  discount to
the public  market price should any person or group acquire more than 15% of the
Company's  common stock  without the  approval of the Board of  Directors  under
certain  circumstances.  The Company has reserved  1,000,000  shares of Series A
Junior  Participating  Preferred  Stock  for  issuance  in  connection  with the
stockholder  rights  plan.  The  Company is  authorized  to issue an  additional
4,000,000 shares of preferred stock in one or more series with terms to be fixed
by

                                       16

<PAGE>

 the  Board of  Directors  without  a  stockholder  vote.  While  the Board of
Directors  has no  current  intentions  or plans to issue any  preferred  stock,
issuance of these shares could also be used as an anti-takeover device.

         The Company is dependent  upon a limited  number of key  management and
technical  personnel.  The  loss of the  services  of one or  more  of such  key
employees  could have a material  adverse effect on the Company's  business.  In
addition,  the  Company's  success  will be dependent on whether the Company can
attract and retain additional highly qualified sales, management,  manufacturing
and research and development personnel. The Company faces intense competition in
its recruiting activities and there can be no assurance that the Company will be
able to attract and/or retain qualified personnel.

Employees

         At August 31, 1997,  the Company and its  subsidiaries  had 869 regular
and  temporary  employees  worldwide of which 100 were  involved in research and
development,  534 in manufacturing  and manufacturing  support,  77 in sales and
marketing,  118 in quality  assurance and regulatory and clinical affairs and 40
in finance and  administration.  None of the Company's employees is covered by a
collective bargaining agreement. The Company believes that its relationship with
its employees is good.

<TABLE>
Executive Officers of the Company

         The  executive  officers of the Company and their ages and positions as
of August 31, 1997 are as follows:
<CAPTION>
         Name               Age                       Position
         ----               ---                       --------
<S>                         <C>     <C>
Bradly A. Jendersee         36      Chairman of the Board of Directors
Scott J. Solano             40      President, Chief Executive Officer and Director
Robert D. Lashinski         36      Vice President of Research and Development and Director
John D. Miller              40      Vice President of Finance, Chief Financial Officer, Treasurer and Director
W. Kevin Bedsole            37      Vice President of Worldwide Sales and Marketing
Gregory M. French           36      Vice President of Manufacturing
John A. Schiek              42      Vice President of Quality, Clinical & Regulatory Affairs
Creg W. Dance               44      Vice President of International Operations
Edward G. Schrader Jr.      45      Vice President of Health Care Strategies and Director of Business Development
Lawrence J. Fassler         37      General Counsel and Secretary
</TABLE>
         Bradly A.  Jendersee  is a founder  of the  Company  and has  served as
Chairman of the Board of Directors since August 1993, as Chief Executive Officer
and  President  from August  1993 to August  1997,  as Director of Research  and
Development from inception to June 1992 and as Vice President of Operations from
June 1992 to August 1993. Prior to joining the Company,  Mr. Jendersee served as
a Principal Research and Development Engineer at Schneider (USA) Inc., a medical
device manufacturer and subsidiary of Pfizer Inc. ("Schneider"), as the Research
and Development  Engineering  Manager of Angioplasty  Products with Mallinckrodt
Medical,  Inc.,  Cardiology Division,  a medical device  manufacturer,  and with
Advanced  Cardiovascular  Systems,  Inc.,  a  subsidiary  of Eli Lilly & Company
("ACS"). Mr.
Jendersee holds a B.S. degree from the University of Minnesota.

         Scott J. Solano has served as President,  Chief Executive Officer and a
Director of the Company since August 1997,  after serving as the Company's Chief
Operating Officer since February 1997. Prior to joining the Company,  Mr. Solano
served as Vice  President  of Research  and  Development  at the Ohmeda  medical
device division of The BOC Group from February 1995 to February 1997. Mr. Solano
also served as Vice President of New Product  Development  and Operations at the
interventional   vascular   division  of  Medtronic,   Inc.,  a  medical  device
manufacturer,  from  September  1994 to  February  1995,  and as Director of New
Product  Development there from March 1991 to September 1994. Mr. Solano holds a
B.S.  degree from the State  University of New York at Albany and a M.S.  degree
from Rensselaer Polytechnic Institute.

         Robert D.  Lashinski  has  served as Vice  President  of  Research  and
Development  since  January  1995  after  joining  the  Company  in July 1992 as
Director  of  Research  and  Development.  Mr.  Lashinski  has also  served as a
director of the Company  since  August 1993.  Mr.  Lashinski  was employed  with
Schneider from October 1990 to June 1992 in both  manufacturing and research and
development  capacities.  Prior to that  time,  Mr.  Lashinski  was a founder of
Danforth  Biomedical  Inc.,  which  focuses on the research and  development  of
vascular  therapeutic  devices,  and also served with ACS in the  capacities  of
Advanced  Development  Engineer and Manager of Equipment  Design and Development
for its pilot and  manufacturing  facilities.  Mr. Lashinski holds a B.S. degree
from the University of Minnesota.

         John D. Miller,  C.P.A.,  is a founder of the Company and has served as
Vice  President  of  Finance  since  January  1996,  Secretary  from May 1995 to
December 1996 and Chief  Financial  Officer,  Treasurer and a Director since the
Company's  inception.  Prior to his position as Vice  President of Finance,  Mr.
Miller  served as Director of Finance  from the  Company's  inception to January
1996.  Mr. Miller  performed his duties to the Company as a consultant  from

                                       17
<PAGE>

the Company's  inception to January 1995 when he began devoting his full working
time to the  Company.  Mr.  Miller was a partner in a New York  accounting  firm
until 1990, when he went into private  practice.  Mr. Miller holds a B.B.A. from
Hofstra University.

         W. Kevin  Bedsole has served as Vice  President of Worldwide  Sales and
Marketing  since  January  1996 and served as  Director of  Worldwide  Sales and
Marketing  from March 1993 to January  1996.  Prior to joining the Company,  Mr.
Bedsole spent seven years in interventional  cardiology device sales with Cordis
Corporation, a medical device manufacturer. Mr. Bedsole holds a B.S. degree from
Florida State University.

         Gregory M. French has served as Vice President of  Manufacturing  since
January  1996 and served as  Director  of  Manufacturing  from  October  1992 to
January 1996.  From January 1989 to October 1992,  Mr. French  managed  Northern
California  manufacturing  operations  for  Peripheral  Systems Group, a medical
device manufacturer and a division of Eli Lilly ("PSG"),  and also managed PSG's
Advanced  Development  Group.  Mr.  French has also served with ACS. Mr.  French
holds a B.S. degree from the California  Polytechnic State University,  San Luis
Obispo.

         John A. Schiek has served as Vice President of Quality,  Regulatory and
Clinical Affairs since January 1996 and served as Director of Regulatory Affairs
and Quality  Assurance from February 1993 to January 1996.  From January 1989 to
1992, Mr. Schiek was the quality and reliability engineering department head and
from 1992 to 1993 was a member  of the  executive  staff in  charge  of  Quality
Assurance and Regulatory Affairs at PSG. Mr. Schiek has also worked for ACS as a
Quality  Engineering  Specialist  and  has  worked  in  the  fields  of  quality
assurance,  product  development and program  evaluation  since 1979. Mr. Schiek
holds a B.A.  degree from the  University  of  Wisconsin  Milwaukee  and an M.S.
degree in Quality Assurance from San Jose State University.

         Creg W. Dance has served as Vice President of International  Operations
since December 1996 and previously served as Director of Canadian  Operations at
AVEC since joining the Company in January 1995.  From 1989 to January 1995,  Mr.
Dance was Director of Research  and  Development  and Clinical  Research at Lake
Region  Manufacturing  Co., Inc., a medical device  manufacturer.  Mr. Dance has
also served as Manager of Research and Development and Manufacturing -- Catheter
Division  with  Medtronic,   Inc.,  a  medical  device   manufacturer,   and  as
Manufacturing  Engineering  Manager of ACS. Mr.  Dance holds a B.S.  degree from
Southern Illinois University.

         Edward G.  Schrader  Jr. has served as Vice  President  of Health  Care
Strategies  and Director of Business  Development  since  August 1997.  Prior to
joining the Company,  Mr.  Schrader  served from November 1992 to August 1997 as
Corporate Director  Cardiology  Clinical Markets at VHA, Inc., a national health
care alliance.  From June 1990 to August 1992, Mr.  Schrader served as corporate
sales manager at Menlo Care, Inc., a medical device  manufacturer.  Mr. Schrader
was also  employed for seven years in various  sales and  operations  management
roles at Mallinckrodt  Medical,  Inc. Mr. Schrader  studied at Sam Houston State
University and at the University of Houston School of Business Management.

         Lawrence J. Fassler has served as General  Counsel  since  October 1996
and Secretary  since  December 1996.  Prior to joining the Company,  Mr. Fassler
served as an attorney  with Cooley  Godward LLP from August 1995 to October 1996
and with Shearman & Sterling from March 1991 to June 1995.  Mr.  Fassler holds a
B.S.  degree from the  University  of  California  at Berkeley and a J.D./M.B.A.
degree from Columbia University.

ITEM 2.  PROPERTIES

         The statements  contained in this Form 10-K that are not historical are
forward-looking  statements  within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the  Securities  Exchange Act of 1934,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future.  Forward-looking statements and risk factors in
this Item 2 include, without limitation,  statements regarding the construction,
timing,  operational  sufficiency  and  regulatory  compliance  of  existing  or
proposed production facilities.  All forward-looking statements in this document
are based on information available to the Company as of the date hereof, and the
Company assumes no obligation to update any such forward-looking  statement.  It
is important to note that the Company's  actual results could differ  materially
from  those  in  such  forward-looking  statements.  Additional  forward-looking
statements  and risk factors  include those  discussed in the sections  entitled
"Item 1.  Business,"  "Item 3.  Legal  Proceedings,"  "Item  5.  Market  for the
Registrant's  Common  Equity and Related  Stockholders,"  "Item 7.  Management's
Discussion and Analysis of Financial  Condition and Results of Operations,"  and
"Item 8. Financial Statements and Supplementary Data," as well as those that may
be set forth in the reports filed by the Company from time to time on Forms 10-Q
and 8-K.

         The  Company  owns  a  65,000  square  foot  building  in  Santa  Rosa,
California that serves as the Company's  corporate  headquarters and houses most
of its administrative offices, research laboratories and component manufacturing
facilities.  The Company also leases or subleases  approximately  59,000  square
feet in Santa Rosa,  California,  or nearby  communities  which house additional
administrative  offices and manufacturing and warehouse facilities.  Such leases
and  subleases  expire at various  times from  February  1999 to July 2002.  The
Company's wholly owned subsidiary, AVEC, leases approximately 25,000 square feet
in Richmond, British Columbia, which house AVEC's offices and assembly facility.
The lease for such facility expires in August 2001. The Company's  international

                                       18
<PAGE>

subsidiaries  maintain  international  sales  offices  in France,  Germany,  the
Netherlands  (to  service the Benelux  countries),  Switzerland,  and the United
Kingdom. The Company's European  subsidiaries  collectively lease administrative
offices and warehouse space of approximately 6,500 square feet under leases that
expire at various times between September 1997 and May 2006.

         The Company believes that its facilities are adequate to meet its space
requirements  through at least early 1998. The Company has begun construction of
a 130,000 square feet building  adjacent to its corporate  headquarters in Santa
Rosa,  California,  at an estimated cost of $20 million,  which, when completed,
will be largely devoted to manufacturing  activities.  However,  there can be no
assurance  that such new  manufacturing  facility  will be  completed in time to
allow the Company to adequately  supply the potentially  significant  demands of
the U.S.  market on a  long-term  basis,  nor that such new  facility  will pass
regulatory  inspection  for  compliance  with  United  States and  international
regulations.

ITEM 3.  LEGAL PROCEEDINGS

         The statements  contained in this Form 10-K that are not historical are
forward-looking  statements  within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the  Securities  Exchange Act of 1934,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future.  Forward-looking statements and risk factors in
this Item 3 include,  without limitation,  statements  regarding the anticipated
outcome of litigation. All forward-looking statements in this document are based
on information  available to the Company as of the date hereof,  and the Company
assumes  no  obligation  to update  any such  forward-looking  statement.  It is
important to note that the Company's actual results could differ materially from
those in such forward-looking statements.  Additional forward-looking statements
and risk factors  include  those  discussed in the  sections  entitled  "Item 1.
Business," "Item 2.  Properties,"  "Item 5. Market for the  Registrant's  Common
Equity and Related Stockholders," "Item 7. Management's  Discussion and Analysis
of  Financial  Condition  and  Results of  Operations,"  and "Item 8.  Financial
Statements  and  Supplementary  Data," as well as those that may be set forth in
the reports filed by the Company from time to time on Forms 10-Q and 8-K.

         ESS  Litigation.  Effective as of October  1992,  a  subsidiary  of the
Company purchased  substantially all the assets of Endothelial  Support Systems,
Inc.  (subsequently  known as  Endovascular  Support  Systems,  Inc.) ("ESS") in
consideration  of certain royalty  payments  payable by the Company based on the
net sales of  products  using or  adapted  from such  assets.  The  Company  was
informed that the  shareholders of ESS ratified the transaction on May 27, 1993.
The purchased  assets  included an application for a stent patent which resulted
in a patent owned by the Company.  Following  such asset  purchase,  the Company
between June 1993 and March 1995 purchased in several  transactions  100% of the
shares of capital stock of ESS from its  shareholders in consideration of shares
of common stock of the Company and, in certain instances,  other  consideration,
and ESS was merged into the Company.  In June 1996, the Company  received notice
of a lawsuit  filed by Dr.  Azam  Anwar and  Benito  Hidalgo,  each of whom is a
former  shareholder  of ESS  (who  together  held  approximately  48%  of  ESS's
outstanding  shares of common stock) and each of whom currently  holds shares of
common stock of the Company, in the District Court of Dallas County,  Texas. The
suit names as defendants  the Company,  Bradly A.  Jendersee and John D. Miller,
each a director,  officer and principal stockholder of the Company, Dr. Simon H.
Stertzer,  a director and principal  stockholder of the Company,  and Dr. Gerald
Dorros, a principal  stockholder of the Company. In January 1997, the plaintiffs
filed   an   amended   petition    alleging   common   law   fraud,    negligent
misrepresentation,  securities fraud pursuant to the Texas Securities Act, fraud
pursuant to the Texas Business and Commercial  Code,  control person  liability,
aider and abetter  liability of the  individual  defendants,  civil  conspiracy,
breach  of  fiduciary  duty,  and  constructive  fraud  in  connection  with the
Company's  acquisition  of ESS and the  Company's  acquisition  of shares of ESS
capital stock from the  plaintiffs.  The plaintiffs  seek  unspecified  damages,
rescission of the  Company's  acquisition  of the ESS assets and its  subsequent
acquisition of the ESS stock,  reconstitution of ESS, punitive damages, interest
and  attorneys'  fees and other relief.  On February 10 and 12, 1997,  the court
overruled  defendants'  special  appearances  and denied  motions  objecting  to
jurisdiction,  motions to dismiss based on forum non conveniens,  and motions to
abate or stay the Texas proceedings. The defendants, including the Company, have
filed an  answer  denying  plaintiff's  claims,  and also  filed a  counterclaim
against the plaintiffs.  The counterclaim alleges claims against Mr. Hidalgo for
specific performance, breach of contract, breach of the implied covenant of good
faith and fair dealing,  and declaratory relief based on comparative  indemnity,
contribution  and absence of fraud. The  cross-complaint  alleges claims against
Dr. Anwar for intentional and negligent  interference  with contract,  equitable
estoppel and declaratory  relief based on absence of fraud. The Company believes
it has meritorious defenses to the claims alleged by the plaintiffs, and that it
has meritorious claims against the plaintiffs,  in the Texas action. However, no
assurance  can be given as to the outcome of the action.  The  inability  of the
Company to prevail in the action,  including the loss or impairment of the right
to produce products based on the Company's issued patents, could have a material
adverse  effect on the Company's  business,  financial  condition and results of
operations.

         The Company also  received  notice in August 1996 of a lawsuit filed by
Messrs.  Anwar and Hidalgo in the Superior Court of Sonoma  County,  California,
which names the same  defendants  as in the Texas action and alleges  claims for
securities  fraud and unregistered  securities  under the California  securities
laws,  breach of  fiduciary  duty

                                       19
<PAGE>

and fraud. The plaintiffs seek unspecified damages,  rescission of the Company's
acquisition of the ESS assets and its  subsequent  acquisition of the ESS stock,
reconstitution of ESS and other relief.  The defendants,  including the Company,
have   filed  an  answer   denying   plaintiff's   claims,   and  also  filed  a
cross-complaint  against the  plaintiffs.  The  cross-complaint  alleges  claims
against Mr. Hidalgo for specific performance,  breach of contract, breach of the
implied covenant of good faith and fair dealing, and declaratory relief based on
comparative  indemnity,  contribution and absence of fraud. The  cross-complaint
alleges claims against Dr. Anwar for intentional and negligent interference with
contract,  equitable  estoppel and declaratory relief based on absence of fraud.
Mr.  Hidalgo  and Dr.  Anwar have filed an answer  generally  denying the claims
contained in the cross-complaint.

         On July 11, 1996,  the Company,  along with the  individual  defendants
named in the Texas and Sonoma  County  actions,  filed two  actions  against Mr.
Hidalgo in the Superior Court of San Mateo County,  California. The first action
alleges  claims for  specific  performance,  breach of  contract,  breach of the
implied covenant of good faith and fair dealing, and declaratory relief based on
indemnity.  These claims arise out of a stock  exchange  agreement  entered into
between  Mr.  Hidalgo and the  Company,  and out of Mr.  Hidalgo's  actions as a
director of ESS. The second  action  alleges  claims for  specific  performance,
breach of  contract,  and breach of the implied  covenant of good faith and fair
dealing.  These claims arise out of a separation and release  agreement  entered
into between Mr.
Hidalgo and the Company.

         On December 6, 1996, the Superior  Court of Sonoma County,  California,
pursuant to the stipulation of the parties, transferred the Sonoma County action
to the Superior  Court of San Mateo County.  On December 11, 1996,  the Superior
Court  of San  Mateo  County,  pursuant  to  the  stipulation  of  the  parties,
consolidated  all three  pending  California  actions into a single  action (the
"Consolidated  Action"),  and ordered that the pleadings  from the Sonoma County
action shall be the operative pleadings in the Consolidated  Action. A motion by
the Company and the  individual  defendants  for  summary  judgment  against Mr.
Hidalgo in the Consolidated Action was denied by the Superior Court of San Mateo
County  on May 5, 1997  with  respect  to each of the  plaintiffs'  claims.  The
Company  believes that it has meritorious  defenses to the claims alleged by the
plaintiffs,  and that it has meritorious  claims against the plaintiffs,  in the
Consolidated Action. However, no assurance can be given as to the outcome of the
Consolidated Action. The inability of the Company to prevail in the Consolidated
Action,  including the loss or impairment of the right to produce products based
on the Company's  issued  patents,  could have a material  adverse effect on the
Company's business, financial condition and results of operations.

         The Company has agreed to indemnify  each of the  individuals  named as
defendants in the lawsuits against the Company relating to the ESS transaction.

         Claims of Terminated  Distributors.  In  connection  with the Company's
termination of certain distributor  relationships,  several of such distributors
have filed, or have threatened to file,  claims against the Company with respect
to such terminations.

         In November 1996, in connection  with the Company's  termination of its
distribution  relationship with  Alfatec-Medicor  N.V.  ("Alfatec-Medicor")  and
Medicor  Nederland B.V.  ("Medicor  Nederland") in Belgium and the  Netherlands,
respectively,  effective  September 30, 1996, the Company  received  notice of a
lawsuit filed by  Alfatec-Medicor  in the Second Chamber of the Commercial Court
of  Brussels,   Belgium,  alleging  insufficient  notice  of  termination  of  a
distribution   agreement  between  the  parties,   promotion  costs,   personnel
restructuring  claims  and  additional   compensation.   Alfatec-Medicor   seeks
compensation of BF189,389,135 (approximately $5.0 million using current exchange
rates),  of  which  BF30,000,000   (approximately   $797,000)  is  sought  as  a
provisional  payment.  The  Company has entered  counterclaims  for  $257,000 in
unpaid accounts  receivable and has requested from  Alfatec-Medicor  information
that would support its claims for indemnification, but has not yet received such
information.  Following a hearing on April 18, 1997, the court postponed further
consideration  of the matter  until the parties have  conducted  an  appropriate
exchange of information and prepared  written  pleadings.  On February 20, 1997,
the Company  commenced an action against Medicor  Nederland before the Amsterdam
District Court for payment of $269,000 in unpaid  accounts  receivable.  On July
23,  1997,  Medicor  Nederland  filed a  statement  of  defense  and  entered  a
counterclaim  for  DG2,284,379.30  (approximately  $1.1  million  using  current
exchange  rates)  on the  basis  of  insufficient  notice  of  termination  of a
distribution agreement between the parties and unjust enrichment.

         On August 19, 1996, in connection with the Company's termination of its
distribution  relationship in Switzerland with Medicor AG,  effective  September
30, 1996,  such  distributor  filed an action  against the Company in the United
States District Court for the Northern District of California alleging breach of
written, oral and implied-in-fact contracts,  inducement to breach an employment
contract with one of such distributor's employees, intentional interference with
contractual  relations,  intentional and negligent interference with prospective
economic  advantage,  misappropriation  of trade secrets,  and  intentional  and
negligent  misrepresentation.   On  October  11,  1996,  the  court  denied  the
distributor's  request for  preliminary  and  temporary  injunctive  relief.  On
January 30, 1997,  the court  entered an order  dismissing  the entire action on
forum non conveniens grounds. As part of the dismissal, AVE has agreed to submit
to the jurisdiction of the appropriate  forum in Switzerland,  waive any defense
of statute of limitations to any  substantially  similar claims made there, make
available witnesses and documents there and satisfy any judgment entered against
it  there.  On  January  27,  1997,  the  Company  filed an  action  in the debt
collection office of Cham,

                                       20
<PAGE>

Switzerland  against  the  distributor  for  $93,000  plus  accrued  interest in
connection  with unpaid accounts  receivable from the distributor  relationship.
The distributor  obtained a preliminary stay on the debt collection  proceedings
and a hearing with respect to the Company's motion to lift such stay was held on
March 11, 1997. On July 14, 1997, the District Court of Zug denied the Company's
motion to lift such stay in a summary proceeding.  The Company intends to file a
claim in ordinary court  proceedings  with the District Court of Zug to have the
stay lifted.

         In  connection  with  the  Company's  termination  of its  distribution
relationship  in France with Medi  Service,  S.A.R.L./Fournitures  Hospitalieres
S.A.  effective  September  30,  1996,  the  Company  received  notice from such
distributor  that it had filed an action before the Tribunal de Grande  Instance
of Mulhouse in France seeking  compensation  for breach of an alleged  exclusive
distribution  agreement for an  indeterminate  period  between the parties.  The
action  included  a claim  for  compensation  equal to the  total  value of such
distributor's   business,   which  the  distributor   valued  at   FF400,000,000
(approximately   $65  million  using  current  exchange   rates).   The  Company
counterclaimed for unpaid accounts  receivable of approximately $1.8 million and
for damages for abusive legal  proceedings.  On September 23, 1996, the Tribunal
rejected the distributor's  claims for damages for unlawful  termination as well
as the  Company's  counterclaim  for abusive  legal  proceedings.  The  Tribunal
reserved judgement with respect to the repurchase of the distributor's inventory
of AVE  products  and the payment of unpaid  accounts  receivable  sought by the
Company.  The parties  have  submitted  briefs on these  issues and a procedural
hearing was held on March 10, 1997, at which the distributor filed an additional
brief.  A procedural  hearing was held on May 9, 1997, at which time the Company
added  a  counterclaim  for  unfair  competition.  On  February  10,  1997,  the
distributor  filed an appeal of the  Tribunal's  decision of September 23, 1996,
with the Court of Appeals of Colmar,  and the parties have  exchanged  briefs in
the appellate proceeding. A procedural hearing with respect to both the original
and the appellate proceedings is set for September 19, 1997.

         With respect to each of the  aforementioned  distributors,  the Company
has consulted with local counsel in the applicable country and believes that the
termination of each of the  distributor  relationships  was lawful.  The Company
understands that under the laws of certain countries,  including Belgium and the
Netherlands, under certain circumstances,  certain indemnities may be claimed by
distributors   for   insufficient   notice  of   termination   and/or   goodwill
compensation.  The Company  intends to vigorously  defend itself against pending
claims and any other  claims  that may be brought  by such  distributors  and to
pursue claims for unpaid accounts receivable against such distributors. However,
no  assurance  can be given  as to the  outcome  of any  pending  or  threatened
litigation,  and any successful claim for damages or injunctive relief by one or
more of such  distributors,  or the  failure  by the  Company  to succeed on its
claims  against its former  French  distributor,  could have a material  adverse
effect on the Company's business, financial condition and results of operations.

         From time to time,  the Company is involved in other legal  proceedings
arising in the  ordinary  course of its  business.  As of the date  hereof,  the
Company is not a party to any other legal  proceedings  with respect to which an
adverse outcome would, in management's  opinion,  have a material adverse effect
on the Company's business, financial condition or results of operations.

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

         Not applicable.

                                       21

<PAGE>


                                     PART II

ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
           STOCKHOLDER MATTERS

         The statements  contained in this Form 10-K that are not historical are
forward-looking  statements  within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the  Securities  Exchange Act of 1934,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future.  Forward-looking statements and risk factors in
this Item 5 include,  without limitation,  statements regarding factors that may
affect the market  price of the  Company's  common  stock.  All  forward-looking
statements in this document are based on information available to the Company as
of the date hereof,  and the Company  assumes no  obligation  to update any such
forward-looking  statement.  It is important to note that the  Company's  actual
results could differ materially from those in such  forward-looking  statements.
Additional  forward-looking  statements and risk factors include those discussed
in the sections  entitled "Item 1.  Business,"  "Item 2.  Properties,"  "Item 3.
Legal Proceedings,"  "Item 7. Management's  Discussion and Analysis of Financial
Condition and Results of  Operations,"  and "Item 8.  Financial  Statements  and
Supplementary Data," as well as those that may be set forth in the reports filed
by the Company from time to time on Forms 10-Q and 8-K.

Market Information

         The Company's common stock trades on the Nasdaq National Market tier of
The Nasdaq Stock Market  ("Nasdaq") under the symbol "AVEI." The following table
sets forth the high and low closing sales prices for the Company's  common stock
since public trading  commenced on April 3, 1996, as furnished by Nasdaq.  These
prices reflect  prices between  dealers,  without retail  markups,  markdowns or
commissions, and may not represent actual transactions.

                                                   High             Low
                                                   ----             ---
Year ended June 30, 1997
         Fourth Quarter                           $32.25          $12.25
         Third Quarter                            $19.25          $11.50
         Second Quarter                           $29.125         $ 9.00
         First Quarter                            $36.25          $18.25

Year ended June 30, 1996
         Fourth Quarter (beginning April 3)       $49.50          $29.50

         As of August 20, 1997,  there were  approximately  173  stockholders of
record  (which number does not include the number of  stockholders  whose shares
are held of record by a brokerage house or clearing agency but does include such
brokerage house or clearing agency as one record holder).  The Company  believes
it has in excess of 5,000 beneficial  holders of the Company's Common Stock. The
Company's  stock price has been and may  continue  to be subject to  significant
volatility,  particularly  on a quarterly  basis.  Any  shortfall  in revenue or
earnings from levels expected by securities analysts could have an immediate and
significant adverse effect on the trading price of the Company's Common Stock in
any given period.  Additionally,  the Company  participates  in a highly dynamic
industry,  which has and may continue to result in significant volatility of the
price of the Company's common stock.  Announcements of technological innovations
or new products by the Company or its competitors  (including future competitors
with  alternative  technologies),  release of reports  by  securities  analysts,
developments or disputes  concerning patents or proprietary  rights,  regulatory
developments,  changes in regulatory or medical reimbursement policies, economic
and other external  factors,  as well as  period-to-period  fluctuations  in the
Company's  financial results,  may have a significant impact on the market price
of the Common Stock. In addition,  the securities markets have from time to time
experienced  significant price and volume fluctuations that are unrelated to the
operating performance of particular companies or industries.

Dividend Policy

         The Company has not  historically  paid cash  dividends  and  currently
intends  to  retain  any  future  earnings  for  use in  its  business  for  the
foreseeable future.

                                       22
<PAGE>

<TABLE>
ITEM 6.  SELECTED FINANCIAL DATA
<CAPTION>

                                                                               Fiscal Year Ended June 30,
                                                                   ----------------------------------------------------
                                                                    1997        1996       1995       1994        1993  
                                                                   -------     ------     ------     ------      ------
                                                                             (in thousands, except per share data)
<S>                                                                <C>        <C>        <C>         <C>        <C>
Consolidated Statements of Operations Data:
Net sales                                                          $79,420    $55,228    $17,141     $2,897     $   15
Cost of sales
                                                                    16,217     10,565      4,515      1,631          5
                                                                   -------    -------    -------     ------     ------

Gross profit                                                        63,203     44,663     12,626      1,266         10
Operating expenses:
         Research and development                                   11,422      6,480        987        594        398
         Selling, general and administrative                        22,510      8,437      1,807        870        973
         Settlement costs
                                                                        --         --        425        358         --
                                                                   -------    -------    -------     ------     ------

Operating income (loss)                                             29,271     29,746      9,407       (556)
                                                                                                                (1,361)
Interest and other income
                                                                     4,190      1,460        237         21        549
                                                                   -------    -------    -------     ------     ------

Income (loss) before provision for income taxes                     33,461     31,206      9,644       (535)
                                                                                                                  (812)
Provision for income taxes
                                                                    11,711     10,766      3,004          3          2
                                                                   -------    -------    -------     ------     ------

Net income (loss)
                                                                   $21,750    $20,440     $6,640     $ (538)    $ (814)
                                                                   =======    =======    =======     =======    =======

Net income (loss) per share                                          $0.69    $  0.71     $ 0.24     $(0.03)    $(0.04)
Shares used in per share calculation                                31,644     28,260     27,194     21,290     20,045

                                                                                        June 30,
                                                                   ----------------------------------------------------
                                                                    1997        1996       1995       1994        1993  
                                                                   -------     ------     ------     ------     -------
                                                                                     (in thousands) 
Consolidated Balance Sheet Data:
Cash and cash equivalents                                          $25,036    $59,238     $2,533     $1,882        $82
Working capital                                                    114,486    106,925      4,413        415        161
Total assets                                                       147,979    122,157     13,089      3,086        706
Retained earnings (accumulated deficit)                             46,902     25,152      4,712     (1,928)    (1,390)
Total stockholders' equity                                         138,200    116,571      8,129      1,004        607
</TABLE>


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

         The statements  contained in this Form 10-K that are not historical are
forward-looking  statements  within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the  Securities  Exchange Act of 1934,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future.  Forward-looking statements and risk factors in
this Item 7 include,  without  limitation,  statements  regarding the extent and
timing  of  new  product  introductions,   competition,   regulatory  approvals,
expenditures and margin levels,  and the establishment of direct sales forces in
targeted countries. All forward-looking statements in this document are based on
information  available  to the  Company as of the date  hereof,  and the Company
assumes  no  obligation  to update  any such  forward-looking  statement.  It is
important to note that the Company's actual results could differ materially from
those in such forward-looking statements.  Additional forward-looking statements
risk  factors  include  those  discussed  in  the  sections  entitled  "Item  1.
Business," "Item 2. Properties,"  "Item 3. Legal  Proceedings,"  "Item 5. Market
for the  Registrant's  Common  Equity and  Related  Stockholders,"  and "Item 8.
Financial  Statements and  Supplementary  Data" as well as those that may be set
forth in the reports  filed by the  Company  from time to time on Forms 10-Q and
8-K.

Overview

         The Company is engaged in the design,  development,  manufacturing  and
marketing of stent systems and PTCA balloon catheters designed to be utilized in
connection with less invasive  treatment of  atherosclerosis.  The Company began
commercial  sales of its PTCA balloon  catheters in October  1993,  its coronary
stent systems in October 1994 and its peripheral stent systems in December 1996.
The  Company's  products  are  currently  commercially  sold only outside of the
United States,  primarily in Europe and Japan.  In April 1996, the Company began
its first  direct  sales  operation  in  Europe,  and  currently  it has  direct
operations in each of France,  Germany,  the Netherlands (to service the Benelux
countries),  Switzerland and the United Kingdom. In Japan, the Company currently
sells only balloon catheters.  In June 1997, the Company's Japanese  distributor
received  regulatory  approval for the sale in Japan of the  Company's  coronary
stent systems;  however,  as of the date hereof,  such  distributor  had not yet
received  the  related  reimbursement  approval.  The  Company  does not  expect
reimbursement  approval  in Japan prior to  November  1997,  and there can be no
assurance when or if such approval will be obtained.

         In August 1997,  the Company  submitted a PMA to the FDA in  connection
with its  ongoing  efforts to gain  approval  to begin  commercial  sales of its
coronary stent systems in the United States.  Clinical  studies under an IDE are
ongoing with certain of the Company's products.  The Company does not expect FDA
approval of its stent systems

                                       23
<PAGE>

for sale in the United States prior to 1998,  and there can be no assurance when
or if  such  approval  will  be  obtained.  As a  result,  the  Company  expects
international  sales to account for  substantially  all of its revenues until at
least  1998.  The  Company  has  incurred,  and  expects to  continue  to incur,
substantial  clinical  research  and other costs in  connection  with  obtaining
regulatory  approvals  for its stent  systems  in the  United  States  and other
countries.

         The Company has a limited  history of  operations.  The increase in the
Company's  sales to date has been due to greater demand for the Company's  stent
systems and, to a lesser degree, its PTCA balloon catheter systems.  The Company
believes  that it is currently  one of the leading  providers  of stent  systems
internationally. In order to support increased levels of sales in the future and
to augment its long term competitive  position,  the Company anticipates that it
will be required  to make  continuing  significant  additional  expenditures  in
manufacturing, research and development (including clinical study and regulatory
costs), sales and marketing and administration,  both in absolute dollars and as
a  percentage   of  net  sales.   The  Company  has  also   experienced   higher
administrative  expenses  resulting from its  obligations as a public  reporting
company.

         Until  April 1996,  substantially  all of the  Company's  sales were to
international  distributors  who resell products to health care  providers.  The
Company  terminated its relationship with distributors in Germany and the United
Kingdom in April and May 1996, respectively, and in France, Switzerland, Belgium
and the Netherlands  effective September 30, 1996. The Company believes that the
establishment  and  maintenance of direct sales forces in France,  Germany,  the
Netherlands  (to  service  the Benelux  countries),  Switzerland  and the United
Kingdom  has  resulted  in   increased   revenues  and  market  share  in  those
territories.  The  establishment  and  maintenance  of direct  sales  forces has
required  and  will  continue  to  require  significant  ongoing   expenditures,
additional management resources and has resulted, and may continue to result, in
additional  costs to eliminate  existing  distributor  relationships  (including
litigation by former distributors). See "Item 3. Legal Proceedings."

         Generally, the Company manufactures and ships product shortly after the
receipt of orders,  and it  anticipates  that it will do so in the  future.  The
Company  developed a  significant  short-term  backlog  during  January  1997 in
connection  with the scale-up of  manufacturing  of its GFX stent product.  This
backlog was  significantly  reduced  during the same fiscal  quarter in which it
arose. There can be no assurance,  however,  that the Company will be successful
in  scaling  up  production  of new  products  or that it  will  not  experience
manufacturing difficulties in the future.

        The Company anticipates that its results of operations may fluctuate for
the foreseeable future due to several factors, including variations in operating
expenses,  the costs  and the  outcome  of  litigation,  competition  (including
pricing   pressures),   costs  and  the  timing  of  establishing  direct  sales
operations,  the timing of research and development expenses (including clinical
trial  related  expenditures),  the  timing  of  new  product  introductions  or
transitions  to new  products,  sales by  distributors,  the mix of sales  among
distributors  and the Company's  direct sales force,  timing of  regulatory  and
third party reimbursement approvals, the level of third-party reimbursement, the
Company's ability to manufacture its products efficiently,  and seasonal factors
impacting  the number of  elective  angioplasty  procedures.  In  addition,  the
Company's  results of operations  could be affected by the timing of orders from
distributors,  changes in the Company's  distributor network (including expenses
in  connection  with  termination  of former  distributors),  the ability of the
Company's  distributors  to effectively  promote the Company's  products and the
ability of the Company to quickly and cost-effectively establish or maintain and
manage an effective  direct  sales force in targeted  countries.  The  Company's
limited operating history makes accurate  prediction of future operating results
difficult or impossible.  Although the Company has experienced  growth in recent
years,  there can be no assurance that, in the future,  the Company will sustain
revenue  growth or remain  profitable on a quarterly or annual basis or that its
growth will be consistent  with  predictions  made by securities  analysts.  The
Company has  experienced,  and may  experience  in one or more future  quarters,
operating  results that are below the expectations of public market analysts and
investors.  In such event, the price of the Company's common stock has been, and
would likely be, materially and adversely affected.

Results of Operations - Years Ended June 30, 1997 and 1996

         Net sales.  For fiscal 1997, net sales  increased to $79.4 million from
$55.2 million for fiscal 1996.  The increase in net sales was due to significant
increases in sales of the Company's stent systems,  particularly the GFX and the
Micro Stent II family of  products.  The GFX was  released in certain  countries
internationally  in  September  1996,  and the Micro  Stent II was  released  in
certain countries internationally in October 1995.

         The  Company  anticipates  that stent  system  sales will  continue  to
constitute the vast majority of total net sales. In the fourth quarter of fiscal
1996, the Company  commenced  direct sales  operations in the United Kingdom and
Germany,  and in the second  quarter of fiscal  1997 the Company  began  selling
directly  in  France,  Switzerland,  Belgium  and  the  Netherlands.  All  other
commercial sales made by the Company were through unaffiliated distributors. The
Company  believes  that the  increasing  number of devices in the  international
stent market and the desire of companies to obtain  market share has resulted in
increased  price  competition,  particularly in the second and third quarters of
fiscal 1997, which has caused the Company to reduce prices on its stent systems.
Price  reductions in response to competitive  pressure  reduced net sales in the
second  quarter of fiscal 1997,  but were offset by increased  unit sales in the
third and  fourth  quarters  of fiscal  1997.  The  Company  expects  such price
competition to continue,  particularly  in Germany.  If

                                       24
<PAGE>

the Company is forced to effect further price reductions,  such reductions would
reduce  net sales in future  periods if not  offset by  increased  unit sales or
other factors.

         Cost of Sales.  Cost of sales increased to $16.2 million in fiscal 1997
from $10.6 million in fiscal 1996, and increased as a percentage of net sales to
20% in fiscal 1997 from 19% in fiscal  1996.  The  increase in absolute  dollars
during fiscal 1997 was  primarily a result of the  increased  volume of products
sold and, to a lesser extent, the costs of additional manufacturing capacity and
personnel  necessary  to support  increased  sales  volume.  The  increase  as a
percentage  of net sales during  fiscal 1997 was  primarily  the result of lower
unit pricing compared to fiscal 1996.

         The Company  expects  cost of sales to continue to increase in absolute
dollars as the Company increases the volume of products sold and adds additional
manufacturing capacity and personnel.

         Research and  Development.  Research and  development  expenses,  which
include clinical study and regulatory costs increased to $11.4 million in fiscal
1997 from $6.5 million in fiscal 1996 and increased as a percentage of net sales
to 14% in fiscal 1997 from 12% in fiscal 1996. A one-time charge of $2.6 million
was included in fiscal 1996 in connection with the termination of certain patent
royalty  obligations.   Excluding  the  effect  of  this  charge,  research  and
development  expenses  increased from $3.9 million or 7% of net sales for fiscal
1996.  The increase in absolute  dollars and as a percentage of net sales during
fiscal  1997 was  primarily  due to the  addition of  research  and  development
personnel,  increased  levels of spending in connection  with  clinical  studies
relating  to the GFX,  Micro  Stent II and Micro  Stent II XL systems  and costs
incurred in connection with the development of additional products.

         The Company expects  research and  development  expenses to continue to
increase in absolute dollars as the Company increases  clinical trial activities
and pursues development of next generation products.

         Selling,    General   and   Administrative.    Selling,   general   and
administrative expenses increased in absolute dollars to $22.5 million in fiscal
1997 from $8.4 million in fiscal  1996,  and  increased  as a percentage  of net
sales to 28% in fiscal 1997 from 15% in fiscal 1996.  A one-time  charge of $2.6
million was  included  in fiscal  1996 in  connection  with the  termination  of
certain  patent  royalty  obligations.  Excluding  the  effect  of this  charge,
selling,  general and administrative expenses increased from $5.8 million or 11%
of net sales for fiscal  1996.  The  increase  during  fiscal  1997 in  absolute
dollars and as a percentage of sales  primarily  reflected  additional  costs of
marketing and other personnel necessary to support the Company's higher level of
operations,  including  the recent  commencement  of direct sales  operations in
France, Germany, the Netherlands (to service the Benelux countries), Switzerland
and the United  Kingdom.  Additionally,  the increase  reflects  increased legal
costs relating  primarily to litigation  with former  shareholders of ESS, which
resulted in related legal expenses of $3.4 million during fiscal 1997.

         The  Company  expects  selling,  general  and  administrative  costs to
continue to increase in absolute  dollars in the future  primarily due to direct
sales operations in certain European countries, the increased level of sales and
product support,  and increases in finance,  legal and  administrative  costs in
connection with public company obligations and ESS and other ongoing litigation.

         Substantially all of the Company's  revenues are currently derived from
sales outside of the United States. As a result, the Company's financial results
will be affected  by changes in foreign  currency  exchange  rates to the extent
that such sales may be denominated in foreign  currency.  The Company is exposed
to fluctuations in currencies in western Europe.  During the year ended June 30,
1997,  the  Company  began a  program  of  entering  into  derivative  financial
instruments  in the form of forward  exchange  contracts  in order to reduce the
uncertainty of foreign exchange rate movement on inter-Company sales denominated
in foreign  currencies.  These  contracts  are  designed to  specifically  hedge
against gains or losses incurred from foreign currency  transactions and are not
used for trading or speculative purposes. Forward exchange contracts are used to
hedge material foreign  currency-denominated  receivables and payables. They are
generally  settled  between three to six months with gains or losses recorded in
"Selling,  general and  administrative"  expenses  to offset  gains or losses on
foreign currency receivables and payables.

         Interest and Other Income. The Company had interest and other income of
$4.2  million  in fiscal  1997  compared  to $1.5  million in fiscal  1996.  The
increase was primarily due to additional interest income earned on the Company's
increased cash and cash equivalents and short-term  investment  balances arising
from the  utilization of proceeds from the Company's  initial public offering in
April 1996.
         Provision  for Income Taxes.  The Company's  provision for income taxes
was $11.7 million in fiscal 1997,  compared to $10.8 million in fiscal 1996. The
increase in this  provision  during  fiscal  1997 was a result of the  Company's
higher earnings during fiscal 1997.
         If the FDA approves the  commercial  sale of the Company's  products in
the United  States,  the income tax rate on any such sales will likely be higher
than that currently enjoyed with respect to the Company's  international  sales,
which receive a benefit from the Company's foreign sales corporation.

         Net  Income.  The  Company  had net income of $21.8  million for fiscal
1997,  compared to $20.4 million for fiscal 1996 ($23.9  million if the one-time
charge is excluded).

                                       25
<PAGE>

Results of Operations - Years Ended June 30, 1996 and 1995

         Net sales.  The Company's net sales for fiscal 1996 were $55.2 million,
an  increase of $38.1  million or 223% from $17.1  million in fiscal  1995.  The
increase in net sales principally  reflected  additional unit sales of the Micro
Stent family of products,  particularly  the Micro Stent II that was released in
certain  countries  internationally  in October 1995.  In the fourth  quarter of
fiscal 1996, the Company commenced direct sales operations in the United Kingdom
and Germany.

         Cost of sales.  Cost of sales  increased  in absolute  dollars to $10.6
million in fiscal 1996 from $4.5  million in fiscal  1995,  and  decreased  as a
percentage  of net sales to 19% in fiscal  1996  from 26% in  fiscal  1995.  The
increase in  absolute  dollars  was  primarily  a result of the  increase in the
volume  of  products  sold and,  to a lesser  extent,  the  costs of  additional
manufacturing  capacity  and  personnel  necessary  to support  increased  sales
volume.  The decrease as a percentage of net sales  resulted  primarily from the
leveraging of certain fixed overhead  expenses across a higher base of sales and
as a result of the change in sales mix towards higher margin stent systems.  The
direct sales  operations  that commenced in the fourth quarter of fiscal 1996 in
the United Kingdom and Germany did not significantly affect the gross margin.

         Research and development.  Research and development  expenses increased
to $6.5  million in fiscal  1996 from $1.0  million in fiscal  1995.  A one-time
charge of $2.6  million was  recognized  in fiscal 1996 in  connection  with the
termination of certain patent royalty obligations discussed below. Excluding the
effect of this  charge,  research  and  development  expenses  increased to $3.9
million or 7% of net sales for fiscal 1996 from $1.0  million or 6% of sales for
fiscal  1995.  The increase  was  primarily  due to the addition of research and
development  personnel and the  commencement  of clinical  trials with the Micro
Stent II following FDA clearance in November 1995.

         Selling,    general   and   administrative.    Selling,   general   and
administrative  expenses  increased  to $8.4  million  in fiscal  1996 from $1.8
million in fiscal 1995.  A one-time  charge of $2.6  million was  recognized  in
fiscal  1996 in  connection  with the  termination  of  certain  patent  royalty
obligations  discussed  below.  Excluding  the effect of this  charge,  selling,
general  and  administrative  expenses  increased  in  absolute  dollars to $5.8
million  or 11% of net sales for  fiscal  1996 from $1.8  million  or 11% of net
sales for fiscal 1995.  The  increase in absolute  dollars  primarily  reflected
additional  costs of  marketing  and other  personnel  necessary  to support the
Company's  increased  level of  operations  and,  to a lesser  extent,  expenses
resulting from the Company's status as a public company.

         Interest and other income.  Interest and other income increased to $1.5
million  in  fiscal  1996  from  $0.2  million  in  fiscal  1995.  The  increase
principally   reflects  additional  interest  on  increased  cash  balances  and
short-term  investments  arising  from  the  utilization  of  proceeds  from the
Company's initial public offering in April 1996.

         Provision for income taxes. The Company's effective tax rate for fiscal
1996 was 34.5%  resulting  in a  provision  for income  taxes of $10.8  million,
compared to 31%  resulting  in a provision  for income taxes of $3.0 million for
fiscal 1995. The rates reflect the benefits  derived from the Company's  foreign
sales corporation and appropriate  research credits. The increase in the rate in
fiscal 1996 was primarily as a result of the Company's  higher  earnings in that
year and due to the  utilization of net operating loss  carryforwards  in fiscal
1995.

         Net income. The Company had net income of $20.4 million for fiscal 1996
compared to $6.6  million for fiscal  1995.  Net income  excluding  the one-time
charge of $5.2 million discussed below,  together with the associated income tax
benefits of $1.7 million, would have been $23.9 million for fiscal 1996.

         In February  1996, the Company  entered into certain  amendments to the
employment agreements of Bradly A. Jendersee and Robert D. Lashinski,  executive
officers  and  directors of the Company.  Pursuant to such  amendments,  each of
Messrs.  Jendersee  and  Lashinski  agreed  to  the  elimination  of  provisions
entitling  them to certain  royalties from the sale or license by the Company of
products  covered by patents for which such persons were named as inventors.  In
connection with such amendments,  the Company agreed to pay to Messrs. Jendersee
and  Lashinski  an  aggregate  of  approximately  $3.9  million in cash (less an
estimated  amount of  approximately  $2.6 million required to be withheld by the
Company  on behalf of  Messrs.  Jendersee  and  Lashinski  with  respect  to the
delivery  of the cash and shares  under  applicable  federal  and state law) and
issue to them an aggregate  of 110,000  shares of Common  Stock  (55,000  shares
each)  at an  attributed  value  of $12 per  share.  Such  payments  to  Messrs.
Jendersee  and  Lashinski  resulted  in the  recognition  by the  Company in the
quarter ending March 31, 1996, of a one-time charge of $5.2 million.

Liquidity and Capital Resources

         Net cash used in  operating  activities  was $20.0  million  for fiscal
1997.  Net cash used in operating  activities in fiscal 1996 was $20.5  million,
and net cash  provided by operating  activities in fiscal 1995 was $3.3 million.
The net cash used in operating activities for fiscal 1997 included the Company's
purchase of short-term  investments  totaling  $29.8  million.  Excluding  these
investments,  the Company had net cash provided by operating  activities of $9.9
million for fiscal 1997,  principally arising as a result of positive net income
for the  period.  The net cash used in  operating  activities  for  fiscal  1996
included  the  Company's  purchase  of  short-term  investments  totaling  $31.1
million,  and the net cash provided by operating activities in fiscal 1995 was a
result of positive net income from  operations  during such 

                                       26
<PAGE>

period. Cash, cash equivalents and short-term  investments totaled $87.2 million
at June 30, 1997 as compared to $91.6 million at June 30, 1996.  Working capital
increased  to $114.5  million at June 30, 1997 as compared to $106.9  million at
June 30, 1996.  Inventories increased to $7.3 million at June 30, 1997 from $3.4
million at June 30,  1996,  primarily  due to the  commencement  of direct sales
operations in France,  Switzerland,  Belgium and the  Netherlands  in the second
quarter of fiscal  1997.  Included  in accounts  receivable  at June 30, 1997 is
approximately $2.4 million was due from former  distributors of the Company that
have  threatened or commenced  litigation in connection  with the termination of
distribution  relationships.  The Company has commenced  litigation against such
terminated  distributors to collect such amounts.  The Company expects  accounts
receivable  and  inventories  to increase in  absolute  dollar  amounts as sales
increase. 

         In August 1997, the Company entered into a bank credit  agreement for a
revolving  credit  facility of $20 million.  Such revolving  credit  facility is
secured  by  certain  of the  Company's  short-term  investments  and is due and
payable on August 31,  1998.  The bank  credit  agreement  contains  no material
restrictive  covenants.  As of August  31,  1997,  the  Company  had drawn  down
approximately  $1.0  million of such  revolving  credit  facility.

         The Company expects to incur substantial  additional  costs,  including
costs relating to capital equipment and other costs associated with expansion of
the  Company's  manufacturing   capabilities,   increased  sales  and  marketing
activities  (including  the  establishment  of direct sales forces in the United
States and internationally), and increased research and development expenditures
in  connection  with seeking  regulatory  approvals  and  conducting  additional
clinical trials.  Among other things, the Company expects to spend approximately
$20 million on a new  manufacturing  facility  currently  under  construction in
Santa  Rosa,  California.  The Company  may  require  additional  equity or debt
financing to address its working capital needs or to provide funding for capital
expenditures in the future. Furthermore,  any additional equity financing may be
dilutive  to  stockholders,  and  debt  financing,  if  available,  may  involve
restrictive covenants.  There can be no assurance that events in the future will
not require the Company to seek additional  capital or, if so required,  that it
will be available on terms acceptable to the Company.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         See Item  14(a) for an index to the  Company's  consolidated  financial
statements  as of June 30,  1997 and 1996 and for each of the three years in the
period ended June 30, 1997.

         The statements  contained in this Form 10-K that are not historical are
forward-looking  statements  within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the  Securities  Exchange Act of 1934,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future.  Forward-looking statements and risk factors in
this Item 8 include,  without limitation,  statements regarding factors that may
affect the Company's results of operations.  All  forward-looking  statements in
this document are based on  information  available to the Company as of the date
hereof, and the Company assumes no obligation to update any such forward-looking
statement.  It is  important to note that the  Company's  actual  results  could
differ  materially  from those in such  forward-looking  statements.  Additional
forward-looking  statements  and risk  factors  include  those  discussed in the
sections  entitled  "Item 1.  Business,"  "Item 2.  Properties,"  "Item 3. Legal
Proceedings,"  "Item 5. Market for the  Registrant's  Common  Equity and Related
Stockholders,"  and "Item 7.  Management's  Discussion and Analysis of Financial
Condition and Results of  Operations," as well as those that may be set forth in
the reports filed by the Company from time to time on Forms 10-Q and 8-K.

<TABLE>
Quarterly Results of Operations

         The following table sets forth certain unaudited  consolidated  results
of  operations  for the  fiscal  years  ended  June  30,  1997  and  1996.  This
information has been derived from unaudited  consolidated  financial  statements
that, in the opinion of management,  reflect all adjustments (consisting only of
normally  recurring  adjustments)  necessary to fairly present this information.
The results of operations for any quarter are not necessarily  indicative of the
results to be expected for any future period.
<CAPTION>
                                                     First             Second             Third            Fourth
                                                    Quarter            Quarter           Quarter           Quarter
                                                    -------            -------           -------           -------
                                                                (in thousands, except per share data)
<S>                                                <C>                <C>              <C>                <C>
Year ended June 30, 1997
Net sales                                          $18,568            $18,228          $20,402            $22,222
Gross profit                                        15,657             14,495           15,806             17,245
Operating income                                    10,670              6,032            6,257              6,311
Net income                                           7,765              4,606            4,633              4,746
Net income per share                                  0.25               0.15             0.15               0.15

Year ended June 30, 1996
Net sales                                          $10,572            $11,142          $15,589            $17,926
Gross profit                                         8,081              8,715           12,693             15,174
Operating income                                     7,087              7,246            4,625             10,787
Net income                                           4,756              4,871            3,101              7,712
Net income per share                                  0.17               0.18             0.11               0.25
</TABLE>
                                       27
<PAGE>

         Results of the Company's  operations may fluctuate  significantly  from
quarter to quarter and will depend on numerous factors, including (i) variations
in  operating  expenses,  (ii)  the  costs  and  outcome  of  litigation,  (iii)
competition  (including  pricing  pressures),  (iv) the costs and the  timing of
establishing direct sales operations, (v) the timing of research and development
expenses (including clinical trial related expenditures), (vi) the timing of new
product  introductions  or transitions  to new products,  (vii) the mix of sales
among  distributors and the Company's  direct sales force,  (viii) the timing of
regulatory  and third  party  reimbursement  approvals,  (ix) the level of third
party  reimbursement,  (x) the  Company's  ability to  manufacture  its products
efficiently,   and  (x)  seasonal  factors  impacting  the  number  of  elective
angioplasty  procedures.  Announcements or expected announcements by the Company
or its  competitors  of new products or  technologies  could cause  customers to
defer  purchases  of  existing  products  of the  Company  and  alter the mix of
products  sold by the  Company,  which  could  materially  adversely  affect the
Company's business,  financial condition and results of operations. There can be
no assurance that future  products or product  enhancements  can be successfully
introduced or that such  introductions  will not adversely affect the demand for
existing products. Since the Company believes there are typically fewer elective
interventional  procedures during the summer months due to vacation schedules of
patients and health care providers, especially in Europe, sales of the Company's
products may slow during the  Company's  first fiscal  quarter of each year (the
quarter ending  September 30). The Company expects that its quarterly  operating
results will fluctuate in the future as a result of these and other factors. Due
to  such  quarterly  fluctuations  in  operating  results,  quarter  to  quarter
comparisons of the Company's  operating  results are not necessarily  meaningful
and should not be relied upon as  indicators  of likely  future  performance  or
annual operating results.

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

          None.

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         Information  regarding  the Company's  directors and the  compliance of
certain reporting  persons with Section 16(a) of the Securities  Exchange Act of
1934 will be set forth under the caption "Election of Directors" and "Compliance
with the Reporting  Requirements  of Section 16(a)" in Company's proxy statement
for use in  connection  with the Annual  Meeting of  Stockholders  to be held on
October 29,  1997 (the "1997 Proxy  Statement")  and is  incorporated  herein by
reference.  The 1997  Proxy  Statement  will be filed  with the  Securities  and
Exchange Commission within 120 days after the end of the Company's fiscal year.

         Information regarding Company's executive officers is set forth in this
Form 10-K in Part I, Item 1.

ITEM 11.  EXECUTIVE COMPENSATION

         The  information  required  by this  item  is  incorporated  herein  by
reference  from  the  information   set  forth  under  the  caption   "Executive
Compensation" in the Company's 1997 Proxy Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required by this item is incorporated by reference into
this Form 10-K  from the  information  set  forth  under the  caption  "Security
Ownership of Certain  Beneficial  Owners and  Management"  in the Company's 1997
Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The  information  required  by this  item  is  incorporated  herein  by
reference   from  the   information   set  forth  under  the  caption   "Certain
Transactions" in the Company's 1997 Proxy Statement.

                                       28
<PAGE>

                                     PART IV
<TABLE>
<CAPTION>
ITEM 14.  EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K

(a)   The following documents are filed as part of this Form 10-K:
                                                                                                                  Page
<S>                                                                                                                <C>

      (1)  Consolidated Financial Statements

           Report of Ernst & Young LLP, Independent Auditors                                                       34
           Consolidated Balance Sheets at June 30, 1997 and 1996                                                   35
           Consolidated Statements of Operations for the three years ended June 30, 1997                           36
           Consolidated Statements of Stockholders' Equity for the three years ended June 30, 1997                 37
           Consolidated Statements of Cash Flows for the three years ended June 30, 1997                           38
           Notes to Consolidated Financial Statements                                                              39

      (2)  Financial Statement Schedules

           Schedule II     Valuation and Qualifying Accounts                                                       53

                  All other schedules are omitted because they are not required,
            they are not applicable or the  information  is already  included in
            the financial statements or notes thereto.

      (3)  Exhibits
</TABLE>
 Exhibit
 Number                                              Description of Document
 ------                                              -----------------------

     3.1    Amended and Restated  Certificate  of  Incorporation  of the Company
            (incorporated   by  reference  to  Exhibit  3.1  to  the   Company's
            Registration Statement on Form S-1 No. 333-00824,  filed February 1,
            1996).

     3.2    Amended By-laws of the Company (incorporated by reference to Exhibit
            3.2  to  the  Company's   Registration  Statement  on  Form  S-1  No
            333-00824, filed February 1, 1996).

     3.3    Certificate  of  Amendment of Amended and  Restated  Certificate  of
            Incorporation (incorporated by reference to Exhibit 3.3 to Amendment
            No.  1 to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed March 7, 1996).

     3.4    Certificate  of   Designation  of  Series  A  Junior   Participating
            Preferred Stock of the Company (incorporated by reference to Exhibit
            2 to the Company's  Current  Report on Form 8-K,  filed February 27,
            1997).

     4.1    Specimen stock certificate (incorporated by reference to Exhibit 4.1
            to Amendment No. 1 to the Company's  Registration  Statement on Form
            S-1 No. 333-00824, filed March 7, 1996).

     10.1*  Company's 1996 Equity Incentive Plan.

     10.2   Company's   1996   Non-Employee   Directors'   Stock   Option   Plan
            (incorporated  by reference to Exhibit 10.2 of the Company's  Annual
            Report on Form 10-K for the fiscal year ended June 30,  1996,  filed
            September 26, 1996).

     10.3*  Company's 1997 Employee Stock Purchase Plan.

     10.4   Distribution  Agreement  dated July 17, 1993 between the Company and
            Century Medical, Inc.  (incorporated by reference to Exhibit 10.3 to
            the  Company's  Registration  Statement  on Form S-1 No.  333-00824,
            filed February 1, 1996).

     10.5   Importing and Distribution  Agreement dated December 2, 1993 between
            the Company and Japan Lifeline Co., Ltd  (incorporated  by reference
            to Exhibit 10.4 to the Company's  Registration Statement on Form S-1
            No. 333-00824, filed February 1, 1996).

     10.6   Termination  Agreement dated August 11, 1995 between the Company and
            Century Medical, Inc.  (incorporated by reference to Exhibit 10.5 to
            the  Company's  Registration  Statement  on Form S-1 No.  333-00824,
            filed February 1, 1996).

     10.7   International  Distribution Agreement, dated as of January 22, 1997,
            between Japan  Lifeline Co., Ltd. and the Company  (incorporated  by
            reference to Exhibit 10.26 to the Company's Quarterly Report on Form
            10-Q for the period  ended  December 31,  1996,  filed  February 14,
            1997).   (Confidential  treatment  applies  to  certain  information
            contained in this  document  pursuant to an order of the  Securities
            and Exchange Commission. Such information has been omitted and filed
            separately with the Securities and Exchange  Commission  pursuant to
            Rule 24b-2 of the Securities Exchange Act of 1934, as amended.)

     10.8*  Amendment,   dated  as  of  July  9,  1997,  to  the   International
            Distribution Agreement,  dated as of January 22, 1997 between  Japan
            Lifeline Co., Ltd. and the Company. (Confidential treatment has been
            requested for certain information  contained in this document.  Such
            information   has  been  omitted  and  filed   separately  with  the
            Securities  and  Exchange  Commission  pursuant to Rule 24b-2 of the
            Securities Exchange Act of 1934, as amended).

                                       29
<PAGE>

     10.9*  Amendment No. 2, dated as of August 22, 1997,  to the  International
            Distribution  Agreement  dated as of January 22, 1997 between  Japan
            Lifeline Co., Ltd. and the Company. (Confidential treatment has been
            requested for certain information  contained in this document.  Such
            information   has  been  omitted  and  filed   separately  with  the
            Securities  and  Exchange  Commission  pursuant to Rule 24b-2 of the
            Securities Exchange Act of 1934, as amended).

     10.10  Employment  Agreement,  dated  as of March  17,  1995,  between  the
            Company  and  Bradly A.  Jendersee  (incorporated  by  reference  to
            Exhibit 10.6 to the Company's Registration Statement on Form S-1 No.
            333-00824, filed February 1, 1996).

     10.11  Employment  Agreement  Amendment  between  the Company and Bradly A.
            Jendersee  (incorporated  by  reference to Exhibit 10.7 to Amendment
            No.  1 to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed March 7, 1996).

     10.12  Employment  Agreement,  dated  as of March  17,  1995,  between  the
            Company  and  Robert D.  Lashinski  (incorporated  by  reference  to
            Exhibit 10.8 to the Company's Registration Statement on Form S-1 No.
            333-00824, filed February 1, 1996).

     10.13  Employment  Agreement  Amendment  between  the Company and Robert D.
            Lashinski  (incorporated  by  reference to Exhibit 10.9 to Amendment
            No.  1 to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed March 7, 1996).

     10.14  Employment  Agreement,  dated  as of March  17,  1995,  between  the
            Company and John D. Miller  (incorporated  by  reference  to Exhibit
            10.10  to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed February 1, 1996).

     10.15  Employment  Agreement,  dated  as of March  17,  1995,  between  the
            Company and W. Kevin Bedsole  (incorporated  by reference to Exhibit
            10.11  to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed February 1, 1996).

     10.16  Employment  Agreement,  dated  as of March  17,  1995,  between  the
            Company and Gregory M. French. (incorporated by reference to Exhibit
            10.12  to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed February 1, 1996).

     10.17  Employment  Agreement,  dated  as of March  17,  1995,  between  the
            Company and John A. Schiek  (incorporated  by  reference  to Exhibit
            10.13  to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed February 1, 1996).

     10.18  Employment  Agreement,  dated as of  February  3, 1997,  between the
            Company and Scott J. Solano  (incorporated  by  reference to Exhibit
            10.28 to the Company's  Quarterly Report on Form 10-Q for the period
            ended December 31, 1996, filed February 14, 1997).

     10.19  Form of Change in  Control  Option  Vesting  Acceleration  Agreement
            between  the  Company and  Lawrence  J.  Fassler  and certain  other
            employees  (incorporated  by  reference  to  Exhibit  10.27  to  the
            Company's  Quarterly  Report  on  Form  10-Q  for the  period  ended
            December 31, 1996, filed February 14, 1997).

     10.20  Form of  Indemnification  Agreement  between the Company and each of
            its executive  officers and directors  (incorporated by reference to
            Exhibit 10.25 to the Company's Quarterly Report on Form 10-Q for the
            period ended September 30, 1996, filed November 13, 1996).

     10.21  Rights Agreement, dated as of February 26, 1997, between the Company
            and The First National Bank of Boston  (incorporated by reference to
            Exhibit  1 to the  Company's  Current  Report  on  Form  8-K,  filed
            February 27, 1997).

     10.22  Stock Exchange Agreement, dated as of December 22, 1994, between the
            Company and Benito  Hidalgo  (incorporated  by  reference to Exhibit
            10.14  to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed February 1, 1996).

     10.23  Stock Exchange  Agreement,  dated as of March 27, 1995,  between the
            Company and Michael D. Bonneau (incorporated by reference to Exhibit
            10.15  to the  Company's  Registration  Statement  on  Form  S-1 No.
            333-00824, filed February 1, 1996).

     10.24  Lease,  dated August 5, 1996, and First Amendment  thereto,  between
            Ruth  Waltenspiel,  Dixie  Walker and the  Company,  concerning  the
            facilities at 5341,  5343,  5345 and 5347 Skylane  Boulevard,  Santa
            Rosa, California  (incorporated by reference to Exhibit 10.24 to the
            Company's  Quarterly  Report  on  Form  10-Q  for the  period  ended
            September 30, 1996, filed November 13, 1996).

     10.25  Second Amendment to Lease,  dated May 5, 1997, to that certain Lease
            dated August 5, 1996 between Dixie Walker,  Ruth Waltenspiel and the
            Company,  as amended  (incorporated by reference to Exhibit 10.30 to
            the  Company's  Quarterly  Report on Form 10-Q for the period  ended
            March 31, 1997, filed May 15, 1997).

     10.26* Lease,  dated as of April 28, 1997,  between  Bruce and Sandra Rocco
            and the Company  concerning the facility at 5355 Skylane  Boulevard,
            Santa Rosa, California.

     10.27* Sublease,  dated  as of June  30,  1997,  between  the  Company  and
            Verticom,  Inc.  concerning  the facility at 1201  Corporate  Center
            Parkway, Santa Rosa, California.

     10.28* Lease,  dated  as of May  19,  1997,  between  the  Company  and SBR
            Development  concerning  the facility at 7975 Cameron  Center Drive,
            Buildings 100 and 300, Santa Rosa, California.

                                       30
<PAGE>


     10.29* Lease,  dated  August 10,  1994,  between  Bentall  Properties  Ltd,
            Westminster Management Corporation and Arterial Vascular Engineering
            Canada, Inc., concerning the facility at 13155 Delf Place, Richmond,
            British Columbia.

     10.30* Addendum to Lease and Lease Amending Agreement, dated as of July 21,
            1997, between Arterial Vascular Engineering Canada, Inc. and Bentall
            Properties  Ltd.  concerning  13140  Delf  Place  Richmond,  British
            Columbia.

     10.31* Business Loan  Agreement,  dated as of August 21, 1997,  between the
            Company and Bank of America National Trust Association.

     11.1*  Statement regarding calculation of net income (loss) per share.

     16.1   Letter, dated March 5, 1996, from Anthony Capeci regarding change in
            certifying accountant  (incorporated by reference to Exhibit 16.1 to
            Amendment No. 1 to the Company's  Registration Statement on Form S-1
            No. 333-00824, filed March 7, 1996).

     16.2   Letter, dated May 10, 1996, from Coopers & Lybrand L.L.P.  regarding
            change  in  certifying  accountant  (incorporated  by  reference  to
            Exhibit 16.2 to the Company's Form 8-K, filed May 10, 1996).

     21.1*  Subsidiaries of the Company.

     23.1*  Consent of Ernst & Young LLP, Independent Auditors.

     24.1*  Power of Attorney  (reference is made to the signature  page of this
            Form 10-K).

     27*    Financial Data Schedule

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

*        Filed herewith.

(b)      Reports on Form 8-K

         No  reports on Form 8-K were filed  during the  quarter  ended June 30,
         1997.

(c)      See Exhibits listed under Item 14(a)(3).

(d)      The  financial  statement  schedules  required  by this Item are listed
         under Item 14(a)(2).

                                       31

<PAGE>


                                   SIGNATURES

Pursuant to the  requirements of Section 13 or 15(d) of the Securities  Exchange
Act of 1934,  the Company has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.

                                             ARTERIAL VASCULAR ENGINEERING, INC.


Date: September 12, 1997                      /s/ Bradly A. Jendersee
                                              -----------------------------
                                              Bradly A. Jendersee
                                              Chairman of the Board of Directors


KNOWN ALL PERSONS BY THESE PRESENTS,  that each person whose  signature  appears
below constitutes and appoints Bradly A. Jendersee,  Scott J. Solano and John D.
Miller, and each of them, as his true and lawful  attorneys-in-fact  and agents,
with full power of  substitution  and  resubstitution,  for him and in his name,
place,  and stead, in any and all capacities,  to sign any and all amendments to
this Report on Form 10-K, and to file the same, with all exhibits  thereto,  and
other  documents  in  connection  therewith,  with the  Securities  and Exchange
Commission,  granting unto said  attorneys-in-fact and agents, and each of them,
full  power  and  authority  to do and  perform  each and  every  act and  thing
requisite  and  necessary to be done in  connection  therewith,  as fully to all
intents and  purposes as he might or could do in person,  hereby  ratifying  and
confirming that all said  attorneys-in-fact  and agents, or any of them or their
or his substitute or substituted,  may lawfully do or cause to be done by virtue
hereof.

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


Date: September 12, 1997      /s/ Bradly A. Jendersee
                              --------------------------------------------------
                              Bradly A. Jendersee
                              Chairman of the Board of Directors
                              (Principal Executive Officer)


Date: September 12, 1997      /s/ Scott J. Solano
                              --------------------------------------------------
                              Scott J. Solano
                              President, Chief Executive Officer and Director
                              (Principal Executive Officer)


Date: September 12, 1997      /s/ John D. Miller
                              --------------------------------------------------
                              John D. Miller
                              Vice President of Finance, Chief Financial Officer
                              Treasurer and Director
                              (Principal Financial and Accounting Officer)


Date: September 12, 1997      /s/ Robert D. Lashinski
                              --------------------------------------------------
                              Robert D. Lashinski
                              Vice  President  of Research and  Development  and
                              Director


Date: September 12, 1997      /s/ Dr. Simon H. Stertzer
                              --------------------------------------------------
                              Dr. Simon H. Stertzer
                              Director


Date: September 12, 1997      /s/ Dr. J. Irawan Sugeng
                              --------------------------------------------------
                              Dr. J. Irawan Sugeng
                              Director


Date: September 12, 1997      /s/ Craig E. Dauchy
                              --------------------------------------------------
                              Craig E. Dauchy
                              Director

                                       32

<PAGE>


              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES

                        CONSOLIDATED FINANCIAL STATEMENTS

                    YEARS ENDED JUNE 30, 1997, 1996, AND 1995

                                      with

                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

                                       33

<PAGE>


                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



Board of Directors and Stockholders
Arterial Vascular Engineering, Inc. and Subsidiaries

We have  audited  the  accompanying  consolidated  balance  sheets  of  Arterial
Vascular  Engineering,  Inc. and  Subsidiaries as of June 30, 1997 and 1996, and
the related  consolidated  statements of operations,  stockholders'  equity, and
cash flows for each of the three years in the period ended June 30, 1997.  These
consolidated  financial  statements  are  the  responsibility  of the  Company's
management.  Our  responsibility  is to express  an  opinion on these  financial
statements based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly,  in all  material  respects,  the  consolidated  financial  position  of
Arterial Vascular Engineering,  Inc. and Subsidiaries at June 30, 1997 and 1996,
and the  consolidated  results of its  operations and its cash flows for each of
the three years in the period ended June 30, 1997,  in  conformity  with general
accepted accounting principles.





                                                               ERNST & YOUNG LLP


Palo Alto,  California
July 25, 1997, except as to the first
paragraph of Note 5 as to which the
date is August 21, 1997

                                       34

<PAGE>
<TABLE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                      (In thousands, except per share data)
<CAPTION>

                                                                                        June 30,
                                                                             ------------------------------
                                                                                   1997             1996
                                                                             -------------    -------------
<S>                                                                              <C>              <C>
                                   ASSETS
Current assets:
     Cash and cash equivalents                                                   $ 25,036         $ 59,238
     Short-term investments                                                        62,192           32,354
     Accounts receivable, net of allowance for doubtful accounts of $1,080
          and $290 at June 30, 1997 and 1996
                                                                                   22,850           13,213
     Inventories                                                                    7,302            3,352
     Deferred income tax                                                            2,413            2,016
     Prepaid expenses and other current assets                                      4,472            2,338
                                                                             -------------    -------------
        Total current assets                                                      124,265          112,511

Deferred income tax                                                                 1,598              172
Property, plant and equipment, net                                                 21,759            8,974
Purchased technology and other intangible assets, net                                 357              500
                                                                             -------------    -------------
        Total assets                                                             $147,979         $122,157
                                                                             =============    =============


                                LIABILITIES
Current liabilities:
     Accounts payable                                                            $  4,035         $  1,671
     Accrued expenses                                                               5,744            2,479
     Income taxes payable                                                               -            1,436
                                                                             -------------    -------------
        Total current liabilities                                                   9,779            5,586
                                                                             -------------    -------------

Commitments and contingencies (Note 9)

                            STOCKHOLDERS' EQUITY
Preferred Stock, $0.001 par value
     Authorized: 5,000 shares
     Issued and outstanding: None                                                       -                -
Common Stock, $0.001 par value
     Authorized: 100,000 shares
     Issued and outstanding, including shares in treasury:
        31,047 and 30,862 shares at June 30, 1997 and 1996                             31               31
Additional paid-in capital                                                         93,021           91,776
Notes receivable for common stock                                                       -             (301)
Deferred compensation                                                                   -              (87)
Treasury Stock, at cost; 30 shares at June 30, 1997                                  (390)               -
Cumulative translation adjustment                                                  (1,364)               -
Retained earnings                                                                  46,902           25,152
                                                                             -------------    -------------
        Total stockholders' equity                                                138,200          116,571
                                                                             -------------    -------------
        Total liabilities and stockholders' equity                               $147,979         $122,157
                                                                             =============    =============

<FN>
The  accompanying  notes are an integral  part of these  consolidated  financial
statements
</FN>
</TABLE>
                                       35
<PAGE>
<TABLE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                      (In thousands, except per share data)
<CAPTION>

                                                                         Year Ended June 30,
                                                               -----------------------------------------
                                                                  1997           1996           1995
                                                               -----------    -----------    -----------
<S>                                                             <C>            <C>            <C>

      Net sales                                                 $  79,420      $  55,228      $  17,141
      Cost of sales                                                16,217         10,565          4,515
                                                               -----------    -----------    -----------
      Gross profit                                                 63,203         44,663         12,626
                                                               -----------    -----------    -----------

      Operating expenses:
          Research and development                                 11,422          6,480            987
          Selling, general and administrative                      22,510          8,437          1,807
          Settlement costs                                              -              -            425
                                                               -----------    -----------    -----------
             Total operating expenses                              33,932         14,917          3,219
                                                               -----------    -----------    -----------

      Operating income                                             29,271         29,746          9,407
      Interest and other income                                     4,190          1,460            237
                                                               -----------    -----------    -----------
      Income before provision for income taxes                     33,461         31,206          9,644
      Provision for income taxes                                   11,711         10,766          3,004
                                                               ----------     ----------     -----------
      Net income                                                $  21,750      $  20,440      $   6,640
                                                               ===========    ===========    ===========

      Net income per share                                      $    0.69      $    0.71      $    0.24

      Shares used in per share calculation                         31,644         28,260         27,194
<FN>
The  accompanying  notes are an integral  part of these  consolidated  financial
statements
</FN>
</TABLE>
                                       36
<PAGE>
<TABLE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (In thousands)
<CAPTION>
                                                          Notes                                             Retained
                                           Additional   Receivable                            Cumulative    Earnings
                       Common Stock         Paid-in     For Common    Deferred     Treasury   Translation (Accumulated
                     ------------------
                     Shares      Amount     Capital       Stock     Compensation     Stock     Adjustment    Deficit)        Total
                     --------   --------   ----------   ----------  -------------  ---------   ----------   ------------  ----------
<S>                  <C>        <C>        <C>          <C>         <C>            <C>         <C>          <C>           <C>
                     
Balances, June       
 30, 1994            17,897     $    18    $  3,393     $    --     $   (479)      $    --     $     --     $ (1,928)     $  1,004
                     
Issuance of          
 common stock           110          --         100          --           --            --           --           --           100
                     
Common stock         
repurchased          
and canceled           (275)         --        (300)         --           --            --           --           --          (300)
                     
Issuance of          
 common stock for     
 stock in             
 Endovascular         
 Support Systems,     
 Inc                    511           1         463          --           --            --           --           --           464
                     
Issuance of          
 common stock for     
 notes receivable     3,438           3       3,123      (3,126)          --            --           --           --            --
                     
Deferred             
 compensation            --          --          91          --          (91)           --           --           --            --
                     
Cancellation of      
 deferred             
 compensation            --          --         (50)         --           50            --           --           --            --
                     
Amortization of      
 deferred             
 compensation            --          --          --          --          221            --           --           --           221
                     
Net income               --          --          --          --           --            --           --        6,640         6,640
                     --------   --------   ----------   ----------  -------------  ---------   ----------   ------------  ----------
Balances, June       
 30, 1995            21,681          22       6,820      (3,126)        (299)           --           --        4,712         8,129
                     
Issuance of          
 common stock           110          --       1,321          --           --            --           --           --         1,321
                     
Issuance of          
 common stock         
 upon exercise of     
 stock options        4,821           4          31          --           --            --           --           --            35
                     
Common stock         
 offering (Note       
 10)                  4,250           5      81,310          --           --            --           --           --        81,315
                     
Amortization of      
 deferred             
 compensation            --          --          --          --          212            --           --           --           212
                     
Income tax           
 reduction            
 relating to          
 stock plans             --          --       2,294          --           --            --           --           --         2,294
                     
Repayment of         
 notes receivable        --          --          --       2,825           --            --           --           --         2,825
                     
Net income               --          --          --          --           --            --           --       20,440        20,440
                     --------   --------   ----------   ----------  -------------  ---------   ----------   ------------  ----------
Balances, June       
 30, 1996            30,862          31      91,776        (301)         (87)           --           --       25,152       116,571
                     
Issuance of              
 common stock         
 upon exercise of     
 stock options          185          --         204          --           --            --           --           --           204
                     
Treasury stock             
 purchased               --          --          --          --           --          (390)          --           --          (390)
                     
Amortization of            
 deferred             
 compensation            --          --          --          --           87            --           --           --            87
                     
Income tax                 
 reduction            
 relating to          
 stock plans             --          --       1,041          --           --            --           --           --         1,041
                     
Repayment of              
 notes receivable        --          --          --         301           --            --           --           --           301
                     
Translation          
 adjustment              --          --          --          --           --            --       (1,364)          --        (1,364)
                     
Net income               --          --          --          --           --            --           --       21,750        21,750
                     --------   --------   ----------   ----------  -------------  ----------   ---------    ----------   ----------
Balances, June       
30, 1997             31,047     $    31    $ 93,021     $    --     $     --       $  (390)     $(1,364)     $46,902      $ 138,200
                     ========   ========   ==========   ==========  =============  ==========   ==========   ===========  ==========
<FN>
The  accompanying  notes are an integral  part of these  consolidated  financial
statements
</FN>
</TABLE>
                                       37
<PAGE>
<TABLE>

               ARTERIAL VASULAR ENGINEERING, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In thousands)
<CAPTION>

                                                                                     Year Ended June 30,
                                                                           ---------------------------------------
                                                                              1997          1996          1995
                                                                           ------------  -----------  ------------
<S>                                                                          <C>          <C>           <C>

Cash flows from operating activities:
 Net income                                                                  $ 21,750     $ 20,440      $ 6,640


 Adjustments to reconcile net income to
  net cash provided by (used in) operating activities:
    Depreciation and amortization                                               1,706          817          274
    Provision for doubtful accounts                                               804          186          100
    Provision for obsolete inventory                                              317          261           60
    Amortization of deferred compensation                                          87          212          221
    Income tax reduction relating to stock plans                                1,041        2,294           --
    Deferred income taxes                                                      (1,823)      (1,100)      (1,088)
    Changes in assets and liabilities:                                                                 
       Short-term investments                                                 (29,838)     (31,054)          --
       Accounts receivable                                                    (11,348)      (8,422)      (4,713)
       Inventories                                                             (4,912)      (2,693)        (795)
       Prepaids and other current assets                                       (1,904)      (2,068)        (204)
       Accounts payable                                                         2,405        1,319           13
       Accrued liabilities                                                      3,392        1,315          778
       Customer deposits                                                           --       (1,405)          11
       Income taxes payable                                                    (1,633)        (603)       2,039
                                                                             --------     --------     --------
           Net cash provided by (used in) operating activities                (19,956)     (20,501)       3,336
                                                                             --------     --------     --------
                                                                                                       
Cash flows from investing activities:                                                                  
 Proceeds (purchase) of investments                                                --          100       (1,400)
 Acquisition of property, plant and equipment                                 (14,379)      (8,390)        (977)
 Acquisition of stock in Endovascular Support                                                           
    Systems, Inc.                                                                  --           --         (108)
                                                                             --------     --------     --------
           Net cash used in investing activities                              (14,379)      (8,290)      (2,485)
                                                                             --------     --------     --------
                                                                                                       
Cash flows from financing activities:                                                                  
 Proceeds from issuance of common stock                                           204       82,671          100
 Common stock repurchased                                                          --           --         (300)
 Treasury stock purchased                                                        (390)          --           --
 Repayment of notes receivable                                                    301        2,825           --
                                                                             --------     --------     --------
           Net cash provided by (used in) financing activities                    115       85,496         (200)
                                                                             --------     --------     --------
                                                                                                       
Effect of exchange rate changes on cash and cash equivalents                       18           --           --
Net increase (decrease) in cash and cash equivalents                          (34,202)      56,705          651
Cash and cash equivalents, at beginning of year                                59,238        2,533        1,882
                                                                             --------     --------     --------
Cash and cash equivalents, at end of year                                    $ 25,036     $ 59,238     $  2,533
                                                                             ========     ========     ========
                                                                                                       
Supplemental cash flow information:
  Income taxes paid                                                          $ 14,206     $ 10,175     $  2,075
Supplemental disclosures of noncash investing and financing activities:
  Issuance of common stock for stock in
     Endovascular Support Systems, Inc.                                      $     --     $     --     $    464
  Issuance of common stock for notes receivable                              $     --     $     --     $  3,126
  Transfer of available-for-sale investments to trading                      $     --     $  1,300     $     --
<FN>
The  accompanying  notes are an integral  part of these  consolidated  financial
statements
</FN>
</TABLE>
                                       38
<PAGE>

              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENT



1.   Formation and Business of the Company

     Arterial Vascular Engineering, Inc., formerly Applied Vascular Engineering,
     Inc., (the "Company") was  incorporated in Delaware in July 1991 to address
     the rapidly expanding market for angioplasty products. The Company designs,
     develops,  manufactures and markets a variety of highly  specialized  stent
     systems and percutaneous transluminal coronary angioplasty ("PTCA") balloon
     catheters.  The Company's  stents are used as arterial  support  devices in
     connection with balloon  angioplasty or other minimally invasive treatments
     of  atherosclerosis  (the  formation  of deposits in the  arteries)  and to
     prevent abrupt closure of vessels in  higher-risk  angioplasty  procedures.
     The  Company  commenced  operations  in 1991 and began  marketing  its PTCA
     balloon  catheters in October 1993,  its coronary  stent systems in October
     1994, and its peripheral stent systems in December 1996. In April 1996, the
     Company began its first direct sales operation in Europe,  and currently it
     has direct  operations  in each of France,  Germany,  the  Netherlands  (to
     service the Benelux countries), Switzerland and the United Kingdom.

2.   Summary of Significant Accounting Policies

     Basis of Presentation

     The consolidated  financial  statements include the accounts of the Company
     and its wholly owned subsidiaries.  All significant  intercompany  accounts
     and transactions have been eliminated in consolidation.

     Use of Estimates

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

     Cash and Cash Equivalents

     The Company  considers  all highly  liquid  investments  purchased  with an
     original maturity of three months or less to be cash equivalents.  Cash and
     cash  equivalents are maintained with financial  institutions in the United
     States, Canada and Europe. Deposits in these banks may exceed the amount of
     insurance  provided on such  deposits.  These deposits may be redeemed upon
     demand and,  therefore,  bear minimal risk. The Company has not experienced
     any losses on its deposits of cash and cash equivalents.

     Investments

     The Company  classifies all investments as trading securities in accordance
     with Statement of Financial  Accounting  Standards No. 115, "Accounting for
     Certain  Investments  in Debt and Equity  Securities  (SFAS No. 115)." Such
     investments  are recorded at market value and unrealized  holding gains and
     losses are  reflected in earnings.  Market value is  determined by the most
     recent traded price of the security at the balance sheet date. Net realized
     gains or losses are determined on the specific identification cost method.

     During  the  year  ended  June  30,  1996,  the  Company  re-evaluated  its
     investment  policies and  reclassified  all investments  previously held as
     available-for-sale  to trading  securities.  The  reclassification  did not
     result in any unrealized gains or losses being included in net income.

     Inventories

     Inventories are stated at the lower of cost (using the first-in,  first-out
     method) or market value. Provisions are made in each year for the estimated
     effects of excess and  obsolete  inventories.  Actual  excess and  obsolete
     inventories  may differ from the Company's  estimates and such  differences
     could be material to the consolidated financial statements.

     Property, Plant and Equipment

     Property,   plant  and  equipment  are  stated  at  cost  less  accumulated
     depreciation and  amortization.  Depreciation and amortization of property,
     plant and  equipment is computed  using the  straight-line  method over the
     estimated useful lives of the respective  assets (three to forty years), or
     over  the  shorter  of the  lease  term  or the  estimated  useful  life of
     leasehold improvements.

                                       39

<PAGE>

              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

2.   Summary of Significant Accounting Policies (continued)

     Construction  in  progress  consists  of  expenditures   incurred  for  the
     expansion of the Company's existing facilities.  Depreciation  commences as
     these assets are placed in service.

     Purchased Technology and Other Intangible Assets

     Purchased   technology   is   capitalized   at  cost  and  amortized  on  a
     straight-line basis over its useful life estimated of five years.

     Other intangible  assets consist  primarily of organization  costs, and are
     carried at cost less accumulated amortization. Costs are amortized over the
     estimated  useful  lives of the related  assets.  At June 30,  1997,  other
     intangible assets were fully amortized.

     Research and Development

     Research and development costs are expensed as incurred.

     Revenue Recognition

     The  Company  recognizes  revenue  upon  shipment  of product to  customers
     provided there is no conditional payment upon sale by the customer to other
     third  parties  and  provided  there  is  no  right  of  return  on  unsold
     merchandise.

     Income Taxes

     Income  taxes are  accounted  for under the asset and  liability  method of
     Statement of Financial Accounting Standards No. 109, "Accounting for Income
     Taxes  (SFAS No.  109)."  Under  SFAS No.  109,  deferred  tax  assets  and
     liabilities are recognized for the future tax consequences  attributable to
     differences  between the financial  statement  carrying amounts of existing
     assets and liabilities and their respective tax bases.  Deferred tax assets
     and liabilities are measured using enacted tax rates in effect for the year
     in which the differences  are expected to affect taxable income.  Valuation
     allowances are established  when necessary to reduce deferred tax assets to
     the amounts expected to be realized.

     Foreign Currency Translation

     The assets and  liabilities,  capital  accounts  and  revenue  and  expense
     accounts of the Company's  foreign  subsidiaries have been translated using
     the exchange rates at the balance sheet date,  historical  exchange  rates,
     and the  weighted  average  exchange  rates for the  period,  respectively.
     Adjustments  arising from the  translation of assets and  liabilities  held
     outside the United  States are  recorded as a  component  of  stockholders'
     equity.

     Net Income Per Share

     Net income  per share is  computed  using the  weighted  average  number of
     common and common  stock  equivalent  shares,  when  dilutive,  outstanding
     during the period.  Common  equivalent  shares comprise stock options using
     the  treasury  stock  method.  Pursuant  to  the  Securities  and  Exchange
     Commission Staff Accounting Bulletins,  common and common equivalent shares
     issued by the Company at prices  below the initial  public  offering  price
     during the twelve-month  period prior to the offering have been included in
     the calculation as if they were outstanding for all periods presented prior
     to the  offering  date  (using the  treasury  stock  method and the initial
     public offering price).

     In February 1997, the Financial Accounting Standards Board issued Statement
     No. 128,  "Earnings  per Share (SFAS No. 128)," which is effective for both
     interim and annual  financial  statements  for periods ended after December
     15, 1997. The Company will be required to change the method  currently used
     to compute  earnings per share and to restate all prior periods.  Under the
     new requirements for calculating primary (or basic) earnings per share, the
     dilutive  effect of stock options will be excluded.  The impact is expected
     to result in an increase in primary  earnings per share for the years ended
     June 30, 1996 and 1997.  The impact of Statement 128 on the  calculation of
     fully  diluted  earnings per share for these  periods is not expected to be
     material.

     Stock Split

     On January 26, 1996 the Company  effected a 5.5-for-1 common stock split in
     connection with the public offering of its stock.  All common stock data in
     the accompanying  consolidated  financial statements has been retroactively
     adjusted to reflect the stock split.

                                       40

<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

2.   Summary of Significant Accounting Policies (continued)

     Stock-Based Compensation

     The Company has adopted the  disclosure-only  provisions  of  Statement  of
     Financial   Accounting  Standards  No.  123,  "Accounting  for  Stock-Based
     Compensation (SFAS 123)",  effective for fiscal 1997. Relevant  disclosures
     are presented in note 10  "Stockholders'  Equity."  Accordingly the Company
     continues to account for stock-based compensation using the intrinsic value
     method as  permitted  under  Accounting  Principles  Board  Opinion No. 25,
     "Accounting for Stock Issued to Employees (APB 25)."

3.   Acquisition of Endovascular Support Systems, Inc.

     In October 1992, Proprietary Extrusion  Technologies,  Inc. (PET), a wholly
     owned subsidiary of the Company, acquired the patent rights to Endovascular
     Support  Systems,  Inc.'s  ("ESS") stent products in exchange for royalties
     between 5% and 12% of PET's worldwide stent sales for the remaining life of
     the ESS stent patent.

     In June 1993,  the Company  acquired a 15%  interest in ESS in exchange for
     110,000 shares of the Company's common stock valued at $40,000. In a series
     of transactions  initiated in 1994 and completed in March 1995, the Company
     acquired all of the remaining  shares of ESS for $108,000 and an additional
     511,000  shares of the  Company's  common  stock at a fair market  value of
     $464,000.  The acquisition was accounted for as a purchase  transaction and
     the  results  of the  operations  of ESS were  included  with  those of the
     Company after March 1995, the date the acquisition was consummated.  At the
     acquisition  date,  ESS had net  liabilities  of $38,000.  The  acquisition
     terminated  PET's  obligations  to ESS under a royalty  agreement  on stent
     sales.  ESS's shares were canceled in April 1995 and the  remaining  assets
     and liabilities of ESS were transferred to the Company.

     Purchased completed  technology of $650,000 was recorded at March 1995, and
     is  being  amortized  over a  period  of  five  years.  At June  30,  1997,
     accumulated amortization totaled $293,000.

4.   Settlement of Litigation

     In July 1995, the Company settled a legal proceeding in which the plaintiff
     alleged the Company breached a joint venture agreement.  Under the terms of
     the settlement  agreement,  the Company paid the plaintiff $425,000 in full
     and final settlement.  The Company had established a provision for $425,000
     at June 30, 1995.

5.   Financial Instruments

     Revolving Credit Agreement

     In August 1997,  the Company  signed a revolving  credit  agreement  with a
     financial  institution under which the Company may borrow up to $20 million
     for the construction of new manufacturing facilities at its headquarters in
     Santa Rosa,  California.  The credit  facility is secured by certain of the
     Company's short-term investments.  The credit facility terminates on August
     31, 1998, at which time the Company is required to repay the total borrowed
     amount.  The interest rate on the revolving  credit agreement is LIBOR plus
     one-half of one percent.

     Foreign Currency Instruments

     Substantially  all of the  Company's  revenues are  currently  derived from
     sales outside of the United States.  As a result,  the Company's  financial
     results will be affected by changes in foreign  currency  exchange rates to
     the extent  that such sales may be  denominated  in foreign  currency.  The
     Company is exposed to fluctuations in currencies in western Europe.

     During  the year  ended  June 30,  1997,  the  Company  began a program  of
     entering  into  derivative  financial  instruments  in the form of  forward
     exchange  contracts  ("forwards")  in order to reduce  the  uncertainty  of
     foreign  exchange  rate  movement on  inter-company  sales  denominated  in
     foreign  currencies.  These  contracts are designed to  specifically  hedge
     against gains or losses incurred from foreign currency transactions and are
     not used for trading or speculative purposes. The Company has established a
     control   environment  that  includes  policies  and  procedures  for  risk
     assessment and the approval,  reporting and monitoring of foreign  currency
     hedging  activities.  Forwards are used to hedge material  foreign currency
     denominated  receivables and payables.  They are generally  settled between
     three to six months with gains or losses recorded in "Selling,  general and
     administrative"  expenses,  to offset  gains or losses on foreign  currency
     receivables and payables.

                                       41

<PAGE>

              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)


6.   Inventories

     Inventories comprise (in thousands):



                                                                 June 30,
                                                          ----------------------
                                                               1997        1996
                                                          ----------  ----------

                 Raw materials                            $     925   $     456
                 Work in process                              3,044       1,211
                 Finished goods                               3,333       1,685
                                                          ----------  ----------
                                                          $   7,302   $   3,352
                                                          ==========  ==========

7.   Property, Plant and Equipment

     Property, plant and equipment comprise (in thousands):

                                                                June 30,
                                                          ----------------------
                                                               1997        1996
                                                          ----------  ----------

                 Land                                     $   2,891   $   1,909
                 Buildings                                    8,590       3,616
                 Manufacturing equipment                      5,486       2,226
                 Computers and equipment                      2,218         824
                 Furniture and fixtures                       1,737         490
                 Leasehold improvements                         872         768
                                                          ----------  ----------
                                                             21,794       9,833
                 Less accumulated depreciation 
                 and amortization                            (2,575)     (1,053)
                                                          -----------  ---------
                                                             19,219       8,780
                 Construction in progress                     2,540         194
                                                          ----------  ----------
                                                          $  21,759   $   8,974
                                                          ==========  ==========

8.   Accrued Expenses

     Accrued expenses comprise (in thousands):


                                                                June 30,
                                                          ----------------------
                                                             1997       1996
                                                          ----------  ----------

                 Accrued payroll and related benefits     $   2,261   $     861
                 Accrued professional and other fees          1,089         617
                 Accrued clinical trial costs                   432         213
                 Value added tax                              1,160         393
                 Other accrued expenses                         802         395
                                                          ---------   ----------
                                                          $   5,744   $   2,479
                                                          ==========  ==========


                                       42
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)


9.   Commitments and Contingencies

     Commitments

     The Company leases its facilities under operating lease agreements expiring
     in 1997 through 2006.  Total rent expense  under all  operating  leases was
     $139,000, $369,000 and $898,000 for the years ended June 30, 1995, 1996 and
     1997, respectively. In addition, the Company leases vehicles for certain of
     its European staff.

     The  future  minimum  annual  lease  payments  as of June  30,  1997  under
     operating leases are as follows:


                     Year Ending June 30,                         (In thousands)
                    --------------------
                     1998                                              $  1,223
                     1999                                                 1,145
                     2000                                                   762
                     2001                                                   459
                     2002                                                   169
                     Thereafter                                             344
                                                                      ----------
                                                                       $  4,102
                                                                      ==========

     The  Company  has  entered  into a  contract  to  build  new  manufacturing
     facilities at its headquarters in Santa Rosa, California. The total cost of
     construction  is expected  to be  approximately  $20 million  (see Note 5 -
     Financial  Instruments).  Additionally,  the Company has commitments  under
     various other construction contracts totaling $2 million.

     Contingencies

     ESS  Litigation.  Effective as of October 1992, a subsidiary of the Company
     purchased substantially all the assets of Endothelial Support Systems, Inc.
     (subsequently  known as  Endovascular  Support  Systems,  Inc.)  ("ESS") in
     consideration  of certain royalty  payments payable by the Company based on
     the net sales of products  using or adapted from such  assets.  The Company
     was informed that the  shareholders  of ESS ratified the transaction on May
     27, 1993. The purchased  assets  included an application for a stent patent
     which  resulted  in a patent  owned by the  Company.  Following  such asset
     purchase, the Company between June 1993 and March 1995 purchased in several
     transactions  100%  of  the  shares  of  capital  stock  of  ESS  from  its
     shareholders in consideration of shares of common stock of the Company and,
     in certain  instances,  other  consideration,  and ESS was merged  into the
     Company.  In June 1996, the Company  received  notice of a lawsuit filed by
     Dr. Azam Anwar and Benito Hidalgo,  each of whom is a former shareholder of
     ESS (who together held  approximately  48% of ESS's  outstanding  shares of
     common  stock) and each of whom  currently  holds shares of common stock of
     the Company, in the District Court of Dallas County,  Texas. The suit names
     as defendants the Company,  Bradly A. Jendersee and John D. Miller,  each a
     director,  officer and principal  stockholder of the Company,  Dr. Simon H.
     Stertzer,  a director and  principal  stockholder  of the Company,  and Dr.
     Gerald Dorros, a principal stockholder of the Company. In January 1997, the
     plaintiffs filed an amended petition  alleging common law fraud,  negligent
     misrepresentation,  securities  fraud pursuant to the Texas Securities Act,
     fraud pursuant to the Texas Business and  Commercial  Code,  control person
     liability, aider and abetter liability of the individual defendants,  civil
     conspiracy,  breach of fiduciary duty, and constructive fraud in connection
     with the  Company's  acquisition  of ESS and the Company's  acquisition  of
     shares of ESS  capital  stock  from the  plaintiffs.  The  plaintiffs  seek
     unspecified  damages,  rescission of the Company's  acquisition  of the ESS
     assets and its subsequent  acquisition of the ESS stock,  reconstitution of
     ESS,  punitive  damages,  interest and attorneys' fees and other relief. On
     February  10  and  12,  1997,  the  court  overruled   defendants'  special
     appearances  and  denied  motions  objecting  to  jurisdiction,  motions to
     dismiss  based on forum non  conveniens,  and  motions to abate or stay the
     Texas  proceedings.  The defendants,  including the Company,  have filed an
     answer denying  plaintiff's  claims, and also filed a counterclaim  against
     the  plaintiffs.  The  counterclaim  alleges claims against Mr. Hidalgo for
     specific performance, breach of contract, breach of the implied covenant of
     good faith and fair dealing,  and  declaratory  relief based on comparative
     indemnity,  contribution and absence of fraud. The cross-complaint  alleges
     claims against Dr. Anwar for  intentional and negligent  interference  with
     contract,  equitable  estoppel and  declaratory  relief based on absence of
     fraud.  The  Company  believes  it has  meritorious  defenses to the claims
     alleged by the plaintiffs,  and that it has meritorious  claims against the
     plaintiffs,  in the Texas action.  However, no assurance can be given as to
     the outcome of the action.  The  inability of the Company to prevail in the
     action,  including the loss or impairment of the right to produce  products
     based on the Company's issued patents, could have a material adverse effect
     on the Company's business, financial condition and results of operations.

                                       43
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

9.   Commitments and Contingencies (continued)

     The  Company  also  received  notice in August  1996 of a lawsuit  filed by
     Messrs.  Anwar  and  Hidalgo  in  the  Superior  Court  of  Sonoma  County,
     California,  which  names the same  defendants  as in the Texas  action and
     alleges claims for securities fraud and  unregistered  securities under the
     California  securities  laws,  breach  of  fiduciary  duty and  fraud.  The
     plaintiffs   seek   unspecified   damages,   rescission  of  the  Company's
     acquisition  of the ESS assets and its  subsequent  acquisition  of the ESS
     stock,  reconstitution of ESS and other relief.  The defendants,  including
     the Company,  have filed an answer  denying  plaintiff's  claims,  and also
     filed a cross-complaint against the plaintiffs. The cross-complaint alleges
     claims  against Mr. Hidalgo for specific  performance,  breach of contract,
     breach  of the  implied  covenant  of good  faith  and  fair  dealing,  and
     declaratory relief based on comparative indemnity, contribution and absence
     of  fraud.  The  cross-complaint  alleges  claims  against  Dr.  Anwar  for
     intentional and negligent  interference with contract,  equitable  estoppel
     and declaratory relief based on absence of fraud. Mr. Hidalgo and Dr. Anwar
     have  filed  an  answer  generally  denying  the  claims  contained  in the
     cross-complaint.

     On July 11, 1996, the Company,  along with the individual  defendants named
     in the Texas and Sonoma  County  actions,  filed two  actions  against  Mr.
     Hidalgo in the Superior  Court of San Mateo County,  California.  The first
     action alleges claims for specific performance,  breach of contract, breach
     of the implied  covenant of good faith and fair  dealing,  and  declaratory
     relief  based on  indemnity.  These  claims  arise out of a stock  exchange
     agreement entered into between Mr. Hidalgo and the Company,  and out of Mr.
     Hidalgo's  actions as a director of ESS. The second action  alleges  claims
     for specific  performance,  breach of  contract,  and breach of the implied
     covenant  of good  faith  and fair  dealing.  These  claims  arise out of a
     separation and release  agreement  entered into between Mr. Hidalgo and the
     Company.

     On December  6, 1996,  the  Superior  Court of Sonoma  County,  California,
     pursuant to the  stipulation of the parties,  transferred the Sonoma County
     action to the Superior Court of San Mateo County. On December 11, 1996, the
     Superior  Court of San Mateo  County,  pursuant to the  stipulation  of the
     parties,  consolidated all three pending  California  actions into a single
     action (the "Consolidated Action"), and ordered that the pleadings from the
     Sonoma County action shall be the operative  pleadings in the  Consolidated
     Action.  A motion by the Company and the individual  defendants for summary
     judgment against Mr. Hidalgo in the  Consolidated  Action was denied by the
     Superior  Court of San Mateo  County on May 5, 1997 with respect to each of
     the  plaintiffs'  claims.  The  Company  believes  that it has  meritorious
     defenses  to  the  claims  alleged  by  the  plaintiffs,  and  that  it has
     meritorious  claims against the  plaintiffs,  in the  Consolidated  Action.
     However,  no assurance  can be given as to the outcome of the  Consolidated
     Action. The inability of the Company to prevail in the Consolidated Action,
     including the loss or impairment of the right to produce  products based on
     the Company's  issued patents,  could have a material adverse effect on the
     Company's business, financial condition and results of operations.

     The  Company  has  agreed to  indemnify  each of the  individuals  named as
     defendants  in the  lawsuits  against  the  Company  relating  to  the  ESS
     transaction.

     Claims  of  Terminated  Distributors.  In  connection  with  the  Company's
     termination  of  certain   distributor   relationships,   several  of  such
     distributors  have filed,  or have  threatened to file,  claims against the
     Company with respect to such terminations.

     In November  1996, in  connection  with the  Company's  termination  of its
     distribution relationship with Alfatec-Medicor N.V. ("Alfatec-Medicor") and
     Medicor   Nederland   B.V.   ("Medicor   Nederland")  in  Belgium  and  the
     Netherlands,  respectively,  effective  September  30,  1996,  the  Company
     received notice of a lawsuit filed by Alfatec-Medicor in the Second Chamber
     of the Commercial Court of Brussels,  Belgium, alleging insufficient notice
     of termination of a distribution  agreement between the parties,  promotion
     costs,   personnel   restructuring  claims  and  additional   compensation.
     Alfatec-Medicor  seeks  compensation of BF189,389,135  (approximately  $5.0
     million using current exchange rates), of which BF30,000,000 (approximately
     $797,000)  is sought as a  provisional  payment.  The  Company  has entered
     counterclaims for $257,000 in unpaid accounts  receivable and has requested
     from  Alfatec-Medicor   information  that  would  support  its  claims  for
     indemnification,  but has not yet received  such  information.  Following a
     hearing on April 18, 1997, the court postponed further consideration of the
     matter  until  the  parties  have  conducted  an  appropriate  exchange  of
     information  and prepared  written  pleadings.  On February  20, 1997,  the
     Company  commenced an action against Medicor Nederland before the Amsterdam
     District Court for payment of $269,000 in unpaid  accounts  receivable.  On
     July 23, 1997, Medicor Nederland filed a statement of defense and entered a
     counterclaim for DG2,284,379.30  (approximately  $1.1 million using current
     exchange  rates) on the basis of  insufficient  notice of  termination of a
     distribution agreement between the parties and unjust enrichment.

                                       44
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)


9.   Commitments and Contingencies (continued)

     On August 19, 1996, in connection  with the  Company's  termination  of its
     distribution   relationship  in  Switzerland  with  Medicor  AG,  effective
     September 30, 1996, such distributor filed an action against the Company in
     the United States  District  Court for the Northern  District of California
     alleging breach of written, oral and implied-in-fact contracts,  inducement
     to breach an employment contract with one of such distributor's  employees,
     intentional  interference  with  contractual  relations,   intentional  and
     negligent     interference    with    prospective    economic    advantage,
     misappropriation   of  trade  secrets,   and   intentional   and  negligent
     misrepresentation.  On October 11, 1996, the court denied the distributor's
     request for preliminary  and temporary  injunctive  relief.  On January 30,
     1997, the court entered an order  dismissing the entire action on forum non
     conveniens grounds.  As part of the dismissal,  AVE has agreed to submit to
     the jurisdiction of the appropriate forum in Switzerland, waive any defense
     of statute of limitations to any  substantially  similar claims made there,
     make  available  witnesses  and  documents  there and satisfy any  judgment
     entered  against it there. On January 27, 1997, the Company filed an action
     in the debt collection office of Cham,  Switzerland against the distributor
     for $93,000  plus  accrued  interest  in  connection  with unpaid  accounts
     receivable from the distributor  relationship.  The distributor  obtained a
     preliminary  stay on the debt  collection  proceedings  and a hearing  with
     respect  to the  Company's  motion  to lift such stay was held on March 11,
     1997.  On July 14,  1997,  the District  Court of Zug denied the  Company's
     motion to lift such stay in a summary  proceeding.  The Company  intends to
     file a claim in ordinary court  proceedings  with the District Court of Zug
     to have the stay lifted.

     In  connection   with  the  Company's   termination  of  its   distribution
     relationship   in   France   with   Medi   Service,    S.A.R.L./Fournitures
     Hospitalieres  S.A.  effective  September  30, 1996,  the Company  received
     notice  from  such  distributor  that it had  filed an  action  before  the
     Tribunal de Grande Instance of Mulhouse in France seeking  compensation for
     breach of an alleged exclusive  distribution agreement for an indeterminate
     period between the parties.  The action  included a claim for  compensation
     equal  to the  total  value  of  such  distributor's  business,  which  the
     distributor  valued  at  FF400,000,000  (approximately  $65  million  using
     current exchange  rates).  The Company  counterclaimed  for unpaid accounts
     receivable of approximately  $1.8 million and for damages for abusive legal
     proceedings. On September 23, 1996, the Tribunal rejected the distributor's
     claims  for  damages  for  unlawful  termination  as well as the  Company's
     counterclaim for abusive legal proceedings. The Tribunal reserved judgement
     with  respect  to the  repurchase  of the  distributor's  inventory  of AVE
     products  and the  payment  of  unpaid  accounts  receivable  sought by the
     Company. The parties have submitted briefs on these issues and a procedural
     hearing  was held on March  10,  1997,  at which the  distributor  filed an
     additional  brief.  A procedural  hearing was held on May 9, 1997, at which
     time the Company added a counterclaim for unfair  competition.  On February
     10, 1997, the  distributor  filed an appeal of the  Tribunal's  decision of
     September  23, 1996,  with the Court of Appeals of Colmar,  and the parties
     have exchanged  briefs in the appellate  proceeding.  A procedural  hearing
     with respect to both the original and the appellate  proceedings is set for
     September 19, 1997.

     With respect to each of the  aforementioned  distributors,  the Company has
     consulted  with local counsel in the  applicable  country and believes that
     the termination of each of the distributor  relationships  was lawful.  The
     Company  understands  that under the laws of certain  countries,  including
     Belgium  and  the  Netherlands,   under  certain   circumstances,   certain
     indemnities  may be  claimed by  distributors  for  insufficient  notice of
     termination and/or goodwill compensation. The Company intends to vigorously
     defend  itself  against  pending  claims and any other  claims  that may be
     brought by such  distributors  and to pursue  claims  for  unpaid  accounts
     receivable against such distributors. However, no assurance can be given as
     to the outcome of any pending or threatened litigation,  and any successful
     claim for damages or injunctive relief by one or more of such distributors,
     or the failure by the  Company to succeed on its claims  against its former
     French  distributor,  could have a material adverse effect on the Company's
     business, financial condition and results of operations.

     From time to time,  the  Company is  involved  in other  legal  proceedings
     arising in the ordinary course of its business.  As of the date hereof, the
     Company is not a party to any other legal proceedings with respect to which
     an adverse outcome would, in management's  opinion, have a material adverse
     effect  on the  Company's  business,  financial  condition  or  results  of
     operations.

                                       45

<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)


10.  Stockholders' Equity

     Common and Preferred Stock

     During the year ended June 30, 1995, the Company  entered into a Restricted
     Stock Purchase  Agreement with certain directors and other  individuals.  A
     total of  3,438,000  shares  were  issued at fair  market  value under this
     agreement at $0.9091 per share.  All  purchases  of stock were  financed by
     issuance of notes  accumulating  interest at 8% per annum until repaid. The
     notes  were fully  repaid as at June 30,  1997.  All shares are  subject to
     repurchase by the Company pursuant to vesting over periods ranging from one
     to five  years  or upon  termination  of  employment.  At  June  30,  1997,
     1,346,000 shares were subject to repurchase.

     In January 1996, the Board of Directors  approved the Company's Amended and
     Restated  Certificate of  Incorporation  increasing the authorized  capital
     stock of the  Company  to  50,500,000  and  reducing  the par  value of the
     capital stock to $0.001 from $0.01.

     In February 1996, the Company amended its Certificate of  Incorporation  to
     increase the authorized capital stock of the Company to 105,000,000 shares.
     One hundred million (100,000,000) shares are designated common stock with a
     par value of $0.001,  and five million  (5,000,000)  shares are  designated
     preferred stock with a par value of $0.001.

     In April 1996, the Company  completed an initial public offering and issued
     4,250,000 shares of common stock, raising net proceeds of approximately $81
     million.

     In February  1997 the  Company's  Board of Directors  adopted a stockholder
     rights plan,  commonly  referred to as a "poison pill," that is intended to
     deter hostile or coercive attempts to acquire the Company.  The stockholder
     rights plan enables  stockholders to acquire shares of the Company's common
     stock, or the common stock of an acquiror, at a substantial discount to the
     public market price should any person or group acquire more than 15% of the
     Company's common stock without the approval of the Board of Directors under
     certain circumstances.  The Company has reserved 1,000,000 shares of Series
     A Junior Participating  Preferred Stock for issuance in connection with the
     stockholder  rights plan.  The Company is authorized to issue an additional
     4,000,000  shares of preferred stock in one or more series with terms to be
     fixed by the Board of Directors without a stockholder vote.

     Stock Repurchase Program

     During the first quarter of fiscal 1997, the Board of Directors  authorized
     a stock  repurchase  program  pursuant to which the Company may  repurchase
     shares of its common  stock with an  aggregate  value of up to $10 million.
     The  repurchases  may be made  from  time to time  on the  open  market  at
     prevailing  market  prices or in  negotiated  transactions  off the market.
     Although the Company does not currently  intend to repurchase a significant
     number of additional shares under the repurchase program,  the program will
     continue  until  discontinued  by the Board of  Directors.  The Company has
     used, and plans to use,  existing cash balances to finance any repurchases.
     The  Company  may use the  repurchased  shares to offset  grants  under its
     employee  equity  incentive  plan.  As of June 30,  1997,  the  Company had
     repurchased  30,000  shares of its  common  stock at an  aggregate  cost of
     $390,000.

     Stock Option Plans

     From  1991 to 1996,  the Board of  Directors  granted  non-statutory  stock
     options allowing  employees,  directors,  and consultants of the Company to
     purchase  shares of the Company's  common  stock.  Stock option grants were
     awarded at the discretion of the Board of Directors and generally vest over
     a period of three years from the date of the grant, and unexercised options
     expire  upon  termination  of  employment  with the  Company  or after  the
     expiration  of five years  from the date of the grant.  No shares of common
     stock  under  stock  options  granted  from  1991 to 1996  are  subject  to
     repurchase.

                                       46

<PAGE>

              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

10.  Stockholders' Equity (continued)

     In January 1996,  the Company  adopted the 1996 Equity  Incentive Plan (the
     "Incentive  Plan") under which 800,000  shares of common stock are reserved
     for issuance  upon exercise of options  granted to employees,  officers and
     consultants of the Company.  In December  1996, the Company's  stockholders
     approved an increase in the number of shares of common  stock  reserved for
     issue under the  Incentive  Plan from  800,000 to  1,500,000.  If any stock
     award granted under the Incentive Plan or any stock option granted pursuant
     to the Company's  previous stock option program shall for any reason expire
     or otherwise terminate,  in whole or in part, without having been exercised
     in full, the stock not acquired  shall revert to and again become  issuable
     under the Incentive  Plan.  Options  granted to employees  and  consultants
     after  January  1996 are made under the terms of the  Incentive  Plan.  The
     Incentive  Plan is  administered  by the Board of  Directors or a committee
     appointed by the Board, which determines  recipients and types of awards to
     be granted,  including the exercise price,  number of shares subject to the
     award and the  exercisability  thereof.  The terms of stock options granted
     under the  Incentive  Plan  generally  may not exceed 10 years.  Restricted
     stock  purchase  awards  granted  under the  Incentive  Plan may be granted
     pursuant to a repurchase  option in favor of the Company in accordance with
     a service vesting  schedule  determined by the Board.  Stock bonuses may be
     awarded in  consideration  for past  services  without a purchase  payment.
     Stock appreciation  rights authorized for issuance under the Incentive Plan
     may be tandem stock  appreciation  rights,  concurrent  stock  appreciation
     rights or independent  stock  appreciation  rights.  To date, no restricted
     stock awards,  stock bonuses or stock appreciation rights have been granted
     under the  Incentive  Plan.  The Incentive  Plan will  terminate in January
     2006, unless terminated sooner by the Board of Directors.

     In January 1996, the Board adopted the 1996  Non-Employee  Directors' Stock
     Option Plan (the  "Directors'  Plan") to provide for the automatic grant of
     options to purchase shares of common stock to non-employee directors of the
     Company. The Directors' Plan is administered by the Board, unless the Board
     delegates  administration  to a committee of disinterested  directors.  The
     maximum  number of shares of common  stock that may be issued  pursuant  to
     options granted under the Directors' Plan is 100,000. Pursuant to the terms
     of the  Directors'  Plan,  each person serving as a director of the Company
     and who is not an employee of the Company (a "Non-Employee  Director"),  on
     the effective date of the initial public  offering of the Company's  common
     stock,  or the date such person first becomes a Non-Employee  Director will
     then automatically be granted an option to purchase 12,000 shares of common
     stock.  Each person  elected to be a  Non-Employee  Director and who is not
     elected  for  the  first  time,  on the  date  of  the  annual  meeting  of
     stockholders  each year  following  the first  registration  of any  equity
     securities  under Section 12 of the Securities  Exchange Act of 1934,  will
     automatically  be  granted  an option to  purchase  4,000  shares of common
     stock. Options under the Directors' Plan will vest in 4 annual installments
     commencing on the date one year after the grant date. The exercise price of
     options  granted  under the  Directors'  Plan must equal or exceed the fair
     market  value of the common stock  granted on the date of grant.  No option
     granted under the Directors'  Plan may be exercised after the expiration of
     ten years from the date it was granted.
<TABLE>

     A summary of the  activity  under the stock  option plans is as follows (in
     thousands, except per share data):
<CAPTION>
                                      
                                       Reserved                      Optioned Shares
                                         but         -------------------------------------------------------
                                      Unoptioned     Number of            Price            Weighted Average
                                        Shares         Shares           Per Share           Exercise Price
                                      -----------    ----------     ------------------     -----------------

<S>                                      <C>           <C>           <C>                        <C>    
 Balances, June 30, 1994                  2,296         5,695        $0.0018-$0.0661            $0.0065
      Options granted                      (182)          182        $0.0018-$0.9091            $0.7716
      Options canceled                       55           (55)           $0.0018                $0.0018
                                      -----------    ----------
 Balances, June 30, 1995                  2,169         5,822        $0.0018-$0.9091            $0.0304
      Shares reserved - 1996 plans          900             -               -                         -
      1991 option plan termination       (2,008)            -               -                         -
      Options exercised                       -        (4,821)       $0.0018-$0.0661            $0.0073
      Options granted                      (491)          491        $9.5455-$35.125            $17.148
      Options canceled                       40           (40)       $0.0018-$35.125            $ 9.162
                                      -----------    ----------
 Balances, June 30, 1996                    610         1,452        $0.0018-$35.125            $ 5.653
      Shares reserved - 1996 plan           700             -               -                         -
      Options exercised                       -          (185)       $0.0018-$21.000            $ 1.075
      Options granted                      (898)          898        $13.000-$24.875            $15.187
      Options canceled                       74           (74)       $13.000-$22.750            $16.515
                                      -----------    ----------
 Balances, June 30, 1997                    486         2,091        $0.0018-$35.125            $ 9.764
                                      ===========    ==========
</TABLE>
                                                         47
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)


10.  Stockholders' Equity (continued)

     The following  table  summarizes  information  concerning  outstanding  and
     exercisable  options as of June 30,  1997 (in  thousands,  except per share
     data):

                         Options Outstanding               Options Exercisable
                ---------------------------------------- -----------------------
                             Weighted                                  
                              Average        Weighted                  Weighted 
Range of          Number     Remaining        Average      Number      Average  
Exercise           of       Contractual      Exercise        of        Exercise 
Prices            Shares       Life            Price       shares       Price   
---------       ----------  ------------  -------------- ----------- -----------

$0.0018-$0.9090    680         1.2           $0.0018         636       $0.0018
$0.9091-$12.000    305         6.6           $ 6.454         100       $ 6.325
$12.001-$13.000    516         9.6           $13.000           -             -
$13.001-$21.375    459         9.1           $18.786          67       $20.410
$21.376-$35.125    131         9.4           $23.811          11       $24.658
                ----------  ------------  -------------- ----------- -----------
                 2,091         6.3           $ 9.764         814       $ 2.790
                ==========  ============  ============== =========== ===========


     At June 30, 1996 and 1995, options to purchase 745,000 and 5,197,500 shares
     of common stock were  exercisable at weighted  average  exercise  prices of
     $0.0487 and $0.0069, respectively.

     The Company has elected to continue to follow  Accounting  Principles Board
     Opinion No. 25,  "Accounting  for Stock Issued to  Employees  (APB 25)" and
     related  interpretations  in  accounting  for its  employee  stock  options
     because the alternative fair value accounting prescribed under Statement of
     Financial   Accounting  Standards  No.  123,  "Accounting  for  Stock-Based
     Compensation  (SFAS 123)" requires the use of option  valuation models that
     were not developed for use in valuing employee stock options. Under APB 25,
     no  compensation  expense is recognized  because the exercise  price of the
     Company's  employee stock options equals the market price of the underlying
     stock on the date of grant.

     Pro forma  information  regarding  net  income and net income per share has
     been  determined  as if the Company had  accounted  for its employee  stock
     options  granted  subsequent  to June 30, 1995 under the fair value  method
     prescribed  by SFAS 123. The fair value for these  options was estimated at
     the date of grant  using a  Black-Scholes  option  pricing  model  with the
     following weighted average assumptions for 1997 and 1996: Expected dividend
     yield of 0%, expected stock price volatility of 55% (0% in the period prior
     to the Company's initial public offering), risk free interest rates ranging
     from 3.50 percent to 7.75  percent,  and the expected  life of options of 4
     years.

     The  Black-Scholes   option  valuation  model  was  developed  for  use  in
     estimating  the  fair  value  of  traded  options  which  have  no  vesting
     restrictions  and are fully  transferable.  In addition,  option  valuation
     models  require the input of highly  subjective  assumptions  including the
     expected  stock price  volatility.  Because the  Company's  employee  stock
     options have characteristics  significantly  different from those of traded
     options,  and  because  changes in the  subjective  input  assumptions  can
     materially  affect the fair value  estimate,  in  management's  opinion the
     existing models do not necessarily provide a reliable single measure of the
     fair value of its employee stock options.

     For  purposes of pro forma  disclosures,  the  estimated  fair value of the
     options is  amortized  to expense over the  options'  vesting  period.  The
     Company's pro forma  information  follows (in  thousands,  except per share
     data):


                                                         Year ended June 30,
                                                        -----------------------
                                                          1997         1996
                                                        ----------  -----------

          Net income - as reported                      $  21,750    $  20,440
          Net income - pro forma                        $  20,698    $  20,424
          Net income per share - as reported            $    0.69    $    0.71
          Net income per share - pro forma              $    0.65    $    0.71


     The weighted  average fair value of options  granted in the year ended June
     30, 1997 and 1996 was $5.48 and $3.55 per share respectively.

                                       48
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)


10.  Stockholders' Equity (continued)

     The pro forma  effect on net income for 1997 is not  representative  of the
     pro forma  effect on net  income in future  years  because it does not take
     into  consideration pro forma  compensation  expense related to grants made
     prior to 1996 and the  compensation  expense  that  will be  recognized  in
     future years as the graded vesting periods become exercisable.

     The  difference  between the  exercise  price and fair market  value of the
     Company's  common  stock at the date of issue  of  certain  stock  options,
     totaling  $902,000  has  been  recorded  as  deferred  compensation  and  a
     component of stockholders'  equity. The entire compensation of $902,000 has
     been recognized as an expense through June 30, 1997.

     Employee Stock Purchase Plan

     In July  1997,  the Board of  Directors  adopted  the 1997  Employee  Stock
     Purchase Plan (the "ESPP") under which 1,500,000 shares of common stock are
     reserved  for  issuance  under  the  terms of the  ESPP.  The ESPP  permits
     eligible  employees to purchase  common stock  through  payroll  deductions
     (which cannot exceed 20% of the employees eligible  compensation) at 85% of
     its fair market  value on specified  dates.  The first  scheduled  purchase
     under the ESPP is due on January 31, 1998.  Thereafter,  purchases  will be
     made  at six  monthly  intervals.  No  shares  were  purchased  or  payroll
     deductions withheld in the year ended June 30, 1997. The ESPP is subject to
     stockholder approval.

11.  Income Taxes

     The provision for income taxes is as follows (in thousands):


                                                     June 30,
                                  ----------------------------------------------
                                      1997            1996             1995
                                  -------------    ------------     ------------

Federal                             $  11,611       $  10,756       $    3,108
State                                   1,000           1,006              977
Foreign                                   923             104                8
                                  -------------    ------------     ------------
                                       13,534          11,866            4,093
Deferred taxes                         (1,823)         (1,100)          (1,089)
                                  -------------    ------------     ------------
                                    $  11,711       $  10,766       $    3,004
                                  =============    ============     ============


The Company's effective tax rate differs from the U.S. federal statutory rate as
follows:


                                                     June 30,
                                  ----------------------------------------------
                                      1997            1996             1995
                                  -------------    ------------     ------------

Federal tax at statutory rate          35.0%            35.0%            34.0%
State tax, net of federal benefit       1.7              2.2              5.9
Utilization of net operating loss       -                -               (3.8)
FSC benefit                            (3.6)            (4.6)            (5.0)
Other                                   1.9              1.9             (0.1)
                                  -------------    ------------     ------------
                                       35.0%            34.5%            31.0%
                                  =============    ============     ============

                                       49
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

11.  Income Taxes (continued)

     Significant  components of the Company's deferred tax assets are as follows
(in thousands):


                                                               June 30,
                                                      --------------------------
                                                         1997          1996
                                                      ------------  ------------
         Foreign deferred profits and losses          $        594  $      1,039
         Depreciation and amortization                       1,598           171
         State taxes, net of federal benefit                   300           297
         Net operating losses                                  -              31
         Reserves and accruals                                 718           255
         Deferred compensation                                 218           186
         Inventories                                           517           152
         Other                                                  66            57
                                                      ------------  ------------
                                                      $      4,011  $      2,188
                                                      ============  ============
         

12.  Employee Agreements

     In March  1995  and  February  1996,  the  Company  entered  into  employee
     agreements  with certain key officers and  directors  over terms of four to
     five years.  Employees under contract have an aggregate annual compensation
     of $1,410,000,  and have been granted  4,877,500 options to purchase common
     stock of the Company at exercise  prices of between  $0.0018 and $13.25 per
     share of which  4,410,000  options had been exercised at June 30, 1997. The
     Company may terminate any agreement  for cause,  and the  compensation  and
     benefits under the employee  agreements  shall cease effective upon date of
     termination.  If an agreement is  terminated by reason of  disability,  the
     employee's  compensation  and benefits  shall continue for the first twelve
     weeks of the incapacity.

     In February  1996,  the Company  entered  into  certain  amendments  to the
     employee  agreements  of  Bradly A.  Jendersee  and  Robert  D.  Lashinski,
     executive  officers  and  directors  of  the  Company.   Pursuant  to  such
     amendments,   each  of  Messrs.  Jendersee  and  Lashinski  agreed  to  the
     elimination of provisions entitling them to certain royalties from the sale
     or license by the  Company of  products  covered by patents  for which such
     persons were named as inventors.  In connection with such  amendments,  the
     Company  agreed to pay Messrs.  Jendersee  and  Lashinski  an  aggregate of
     approximately  $3.9  million  in cash  and  issue to them an  aggregate  of
     110,000  shares of Common  stock.  Such  payments to Messrs.  Jendersee and
     Lashinski  resulted in the  recognition  by the Company,  in the year ended
     June 30, 1996, a one-time compensation expense of $5.2 million.

13.  Employee Benefit Plan

     During 1994,  the Company  established a Retirement  Savings and Investment
     Plan (the "Plan") under which employees may defer a portion of their salary
     up to the maximum  allowed under IRS rules.  The Company has the discretion
     to make  contributions  to the Plan.  In the year ended June 30, 1997,  the
     Company contributed $88,000 to the Plan.

                                       50

<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)


14.  Geographic Area Information and Concentration of Credit and Other Risks

     The Company operates in the medical products  industry sector and currently
     markets and sells  substantially  all of its  products  internationally  in
     Europe  and Asia.  Over 40% of the  Company's  fiscal  1997  revenues  were
     derived from export sales to non-affiliated international distributors.  In
     addition,  over 40% of the Company's net sales for fiscal 1997 were derived
     from products  introduced  during fiscal 1997. For the years ended June 30,
     1995 and 1996, the Company had sales to three customers  representing  26%,
     16% and 14% and 20%,  16% and 10% net of sales,  respectively.  The Company
     performs  ongoing  credit  evaluations  of its  customers  and  provides an
     allowance  for  expected  losses.  There  have been no  material  losses on
     customer receivables.  Sales to both distributors and directly to hospitals
     and clinics as a percentage of total net sales by  geographical  region are
     as follows:


                             Year Ended June 30,
                      -----------------------------------
                         1997         1996         1995
                      ---------    ---------    ---------

Europe                     75%          76%          79%
Asia                        9%          16%          19%
Rest of World              16%           8%           2%
                      ---------    ---------    ---------
                          100%         100%         100%
                      =========    =========    =========


15.  Quarterly Financial Data (unaudited, in thousands except per share data)


                       First       Second        Third       Fourth      Fiscal
                      Quarter      Quarter      Quarter      Quarter      Year
                      ---------    --------     --------    ---------   --------
Net sales
  1997                 $18,568     $18,228      $20,402      $22,222     $79,420
  1996                  10,572      11,142       15,589       17,926      55,228
Gross profit
  1997                  15,657      14,495       15,806       17,245      63,203
  1996                   8,081       8,715       12,693       15,174      44,663
Net income
  1997                   7,765       4,606        4,633        4,746      21,750
  1996                   4,756       4,871        3,101        7,712      20,440
Net income per share
  1997                    0.25        0.15         0.15         0.15        0.69
  1996                    0.17        0.18         0.11         0.25        0.71


                                       51

<PAGE>


                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
                         ON FINANCIAL STATEMENT SCHEDULE


         We have  audited  the  consolidated  financial  statements  of Arterial
Vascular  Engineering,  Inc. and  Subsidiaries as of June 30, 1997 and 1996, and
for each of the three years in the period ended June 30,  1997,  and have issued
our report thereon dated July 25, 1997, except as to the first paragraph of Note
5 as to which the date is August 21,  1997  (included  elsewhere  in this Annual
Report on Form 10-K). Our audits also included the financial  statement schedule
listed in Item 14(a) of this Annual  Report on Form 10-K.  This  schedule is the
responsibility of the Company's management.  Our responsibility is to express an
opinion based on our audits.

         In our opinion,  the financial  statement  schedule  referred to above,
when considered in relation to the basic financial  statements taken as a whole,
present fairly in all material respects the information set forth therein.





                                                               ERNST & YOUNG LLP




Palo Alto, California
July 25, 1997

                                       52


<PAGE>
                                                                     SCHEDULE II


              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                 VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
                                 (In thousands)


                          Description        Balance at   Charged to  Balance at
                          -----------       Beginning of  Costs and     End of  
                                             the Period    Expenses   the Period
                                            ------------------------------------
Balances for the year ended June 30, 1995:
   Allowance for doubtful accounts receivable    $   4        $100       $104
   Allowance for obsolete inventory                 --          60         60
Balances for the year ended June 30, 1996:
   Allowance for doubtful accounts receivable      104         186        290
   Allowance for obsolete inventory                 60         261        321
Balances for the year ended June 30, 1997:
   Allowance for doubtful accounts receivable      290         790      1,080
   Allowance for obsolete inventory                321         314        635