UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                    FORM 10-K

(MARK ONE)
[X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES 
      EXCHANGE ACT OF 1934

      FOR THE YEAR ENDED DECEMBER 31, 1998

[ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
      EXCHANGE ACT OF 1934

                        COMMISSION FILE NUMBER 0-016607
                             ---------------------

                         ADVANCED TISSUE SCIENCES, INC.
             (Exact name of registrant as specified in its charter)



           DELAWARE                                        14-1701513
---------------------------------                     ----------------------
  (STATE OR OTHER JURISDICTION                           (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION)                     IDENTIFICATION NUMBER)

10933 NORTH TORREY PINES ROAD, LA JOLLA, CALIFORNIA           92037
----------------------------------------------------        ----------
    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                (ZIP CODE)

      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:  (619) 713-7300

       SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:  NONE

         SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

                       COMMON STOCK, $.01 PAR VALUE
                       ----------------------------
                             (TITLE OF CLASS)

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

     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 the registrant'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.  [X]

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

     As of March 24, 1999 there were 41,330,719 shares of Common Stock
outstanding.

     The aggregate market value of the Common Stock of the Registrant held by
non-affiliates on March 24, 1999 was approximately $80,357,180.

                       DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the Company's Proxy Statement for the Annual Meeting of
Stockholders to be held on May 25, 1999, as filed with the Commission pursuant
to Regulation 14A, are incorporated by reference into Part III of this report.

<PAGE>

                                     PART I

ITEM 1.  BUSINESS

INTRODUCTION

     This Annual Report on Form 10-K contains forward-looking statements that
involve risks and uncertainties.  Actual results could differ materially from
any forward-looking statements and from past performance as a result of such
risks and uncertainties.  See the "Factors That May Affect Future Results"
section of this Annual Report.

     Advanced Tissue Sciences, Inc. (the "Company" or "Advanced Tissue
Sciences") is a leading tissue engineering company engaged in the development
of human-based tissue products for therapeutic applications.  The Company is
currently focusing its efforts primarily on skin, cartilage and cardiovascular
products.  Utilizing principles of cell biology, bioengineering, biochemistry,
and polymer and transplant science, the Company has developed and is applying a
proprietary core technology in which living human cells are cultured in vivo or
ex vivo in a manner that allows the cells to develop and assemble into
functioning three-dimensional tissue.  With this proprietary technology,
Advanced Tissue Sciences has successfully replicated a variety of human tissues.

     Advanced Tissue Sciences' objective is to redefine tissue repair and
transplantation by developing, manufacturing and marketing products produced
through tissue engineering.  The Company's product strategy is to utilize its
patented core technology to develop multiple products which address unmet
therapeutic needs or offer improved, cost-effective alternatives to current
treatment modalities.  By building upon its base of scientific knowledge through
the continued application of its proprietary core technology, the Company
believes it will be able to achieve significant synergies in the development,
clinical testing and manufacture of successive tissue products.

     Leading the Company's product development efforts are therapeutic skin
products that address the burn and skin ulcer markets.  These products are based
on three-dimensional, human tissues designed by the Company as temporary or
permanent replacements for human dermis.  These products were developed for
conditions where the dermis (the inner skin layer) has been injured or
destroyed, such as in severe burns and chronic skin ulcers.  The dermis is
essential to normal skin function and healing and, unlike epidermis (the outer
skin layer), may not regenerate into normal tissue after injury.  The Company's
two skin products, Dermagraft(R) and TransCyte(TM), are currently being sold 
in certain markets and the Company has other products in various stages of 
development.

     The Company's first commercial product, TransCyte (formerly 
Dermagraft-TC(R)), a temporary covering for burns, was first approved for 
commercial sale by the U.S. Food and Drug Administration ("FDA") in March 1997 
for full-thickness, or third degree burns, and for partial-thickness, or second
degree burns, in October 1997.  Dermagraft for the treatment of diabetic foot 
ulcers, a living, human dermal replacement, was approved for sale in Canada 
in August 1997 and was launched in the United Kingdom late in 1997.  Both 
TransCyte and Dermagraft are being commercialized through a joint venture 
with Smith & Nephew plc ("Smith & Nephew").  The Company is also pursuing FDA 
approval for Dermagraft in the United States.

     In January 1998, the General and Plastic Surgery Devices Panel of the
Medical Devices Advisory Committee to the FDA recommended that the agency
approve Dermagraft for the treatment of diabetic foot ulcers with the conditions
that the Company perform a post-marketing study to confirm efficacy and provide
physician training.  However, in June 1998, the FDA indicated the Premarket
Approval ("PMA") application for Dermagraft was not approvable without
supportive data from the additional clinical trial.  In August, the Company
received approval from the FDA for the additional clinical trial of Dermagraft
in the treatment of diabetic foot ulcers.  The clinical trial began in late 1998
and, based on the clinical plan, the Company believes additional data could be
available for submission in twelve to eighteen months from the trial's
initiation, assuming a reasonable rate of patient enrollment and data 
consistent with the previous PMA submission.  See "Products - Skin Ulcer 
Products - Diabetic Foot Ulcers."

     TRANSCYTE.  TransCyte, originally developed as an alternative to human
cadaver skin to treat severely burned patients, is being used to treat both full
and partial-thickness burns.  TransCyte consists of a dermal tissue with an
ultra-thin synthetic covering that acts as a protective cover.  In
full-thickness burns, TransCyte is designed to help retain fluids and reduce the
risk of infection until a sufficient amount of the patient's own skin becomes
available

                                  1

<PAGE>

for grafting.  In partial-thickness burns, TransCyte, as compared to silver
sulfadiazine, has been shown to significantly heal burns faster.

     Of the approximately 1.2 million people who suffer burn injuries annually
in the United States, up to 13,000 are severely burned and require skin grafts.
TransCyte was initially approved to address the approximately 1,500 severely
burned patients with burns exceeding 20% body surface area.  Another 30,000 to
40,000 burn victims, often children, suffer the partial to mid-dermal burns also
being addressed by TransCyte.  These burns frequently result from household
hazards such as scalds from hot liquids, faulty heating pads or misuse of
ignition fluids.  TransCyte is being marketed for burns in the United States,
Canada and in the rest of the world, subject to regulatory approvals, through a
joint venture with Smith & Nephew.  See "Products - Burn Products."

     DERMAGRAFT.  Dermagraft is a dermal replacement product grown on a
bioabsorbable scaffold.  It is designed to provide a healthy, metabolically
active dermal matrix in chronic ulcers to support wound closure.  Healing skin
ulcers faster can potentially reduce the risk of infection (and, in the case of
diabetic foot ulcers, the subsequent risk of amputation), as well as the need
for skin grafting and reconstructive procedures.  Chronic skin ulcers that may
be addressed by Dermagraft include diabetic foot ulcers, venous ulcers and
pressure ulcers.  Approximately 800,000 diabetic foot ulcers are estimated to be
treated in the United States each year, approximately half of which are believed
to represent the target market for Dermagraft.  It is estimated that
more than 1.2 million patients are affected by acute pressure ulcers, over
200,000 nursing home patients suffer from chronic pressure ulcers and
approximately 500,000 patients are diagnosed with venous ulcers in the United
States each year.

     Dermagraft is also being developed and commercialized through the joint 
venture with Smith & Nephew.  Under the joint venture agreement, Advanced Tissue
Sciences has principal responsibility for manufacturing and Smith & Nephew has
primary responsibility for the worldwide sales and marketing of Dermagraft and
TransCyte.  Smith & Nephew is a world leader in wound care sales with an 
established sales force in over 90 countries.  Building upon the introduction 
of Dermagraft for the treatment of diabetic foot ulcers in the United Kingdom 
and approval in Canada, the joint venture plans, assuming successful 
completion of clinical trials and subject to obtaining regulatory approval, 
to introduce Dermagraft in the United States through Smith & Nephew's existing
sales representatives and dedicated Dermagraft specialists.  Smith & Nephew 
is known in the United States for its comprehensive training and customer 
education programs, and has successfully launched several advanced wound care 
products.  The joint venture began a pilot clinical trial of Dermagraft in 
the treatment of venous ulcers in March 1999 and expects to begin a pilot 
clinical trial of TransCyte in chronic pressure ulcers before the end of the 
year.  See "Products - Skin Ulcer Products."

     ORTHOPEDICS.  Through a separate joint venture with Smith & Nephew, the
Company is developing tissue engineered cartilage for orthopedic applications
utilizing its proprietary three-dimensional culture system.  Over the past
several years, the joint venture's activities have included the development of
human tissue-engineered articular cartilage product.  Tissue-engineered
articular cartilage could provide a significant opportunity to treat patients at
an earlier stage of joint degeneration, thereby delaying, or in some cases
eliminating, the need for total joint replacements.  Optimization of the product
continued in 1998 as the basis for advancing into clinical trials.  The joint
venture has also developed prototypes for a tissue-engineered meniscus and will
be continuing preclinical studies during 1999.  There are over 1.2 million
arthroscopic procedures for repair of the knee, including procedures involving
articular cartilage, meniscus and ligament, performed annually in the United
States.  See "Products - Orthopedic Products."

     CARDIOVASCULAR.  Through the use of its tissue engineering technology,
Advanced Tissue Sciences is working on developing blood vessels that will grow
and repair normally.  The Company's tissue-engineered products may provide
enhanced biocompatibility and improved patency with a reduced need for the
anticoagulant drugs required with currently available products.  In October
1997, Advanced Tissue Sciences was awarded a $2 million Advanced Technology
Program grant from the National Institute of Standards and Technology.  In
collaboration with the Department of Bioengineering at the University of
California, San Diego ("UCSD"), the Company is leading a multi-disciplinary
effort to design, construct and evaluate tissue-engineered vascular grafts
produced from cells grown on a biocompatible scaffold.  The grant is structured
to support this development program over a three-year period.  The project is
integrating current advances in cell culture, bioreactor technology,
biomaterials and in vivo blood vessel mechanics to create a unique, living
tissue replacement for blood vessels.  The successful integration of these
technologies through the collaboration

                                  2

<PAGE>

between the Company and UCSD could lead to the development of grafts to treat
coronary and peripheral artery vascular diseases.  See "Products -
Cardiovascular Products."

     In the United States, over 900,000 people die each year from cardiovascular
disease.  More specifically, 14 million people suffer from coronary artery
disease and over 380,000 coronary artery bypass procedures are performed
annually in the United States.  Likewise, each year approximately 70,000
patients undergo surgery for the replacement of peripheral vascular grafts.

     SMITH & NEPHEW PLC.  In April 1996, the Company entered into an agreement
with Smith & Nephew to form a fifty-fifty joint venture for the worldwide
commercialization of Dermagraft in the treatment of diabetic foot ulcers (the
"Dermagraft Joint Venture").  In January 1998, Advanced Tissue Sciences and
Smith & Nephew expanded the Dermagraft Joint Venture to include venous ulcers,
pressure ulcers, burns and other skin tissue wounds.  At that time, the Company
retained rights to market TransCyte for burns in the United States. In August
1998, the Dermagraft Joint Venture was further expanded to include the selling
and marketing of TransCyte for full and partial-thickness burns in the United
States beginning in October 1998.  Smith & Nephew is a worldwide healthcare
company with extensive sales and distribution capabilities.  It develops,
manufactures and markets a wide range of tissue repair products, principally
addressing the areas of bone, joints, skin and other soft tissue.

     As consideration for entering into the Dermagraft Joint Venture, Advanced
Tissue Sciences received a $10 million up front fee in 1996.  In conjunction
with the expansion of the joint venture, Smith & Nephew also made a $20 million
equity investment in the Company in January 1998 and paid the Company, through
the Dermagraft Joint Venture, $15 million in January 1999.  The Company also 
could receive, subject to the achievement of certain milestones related to 
regulatory approvals, reimbursement and sales levels, additional payments of 
up to $136 million. Advanced Tissue Sciences and Smith & Nephew are sharing 
equally in the revenues and expenses of the Dermagraft Joint Venture, except 
the Company will fund the first $6 million in expenses for conducting 
clinical trials and regulatory support for Dermagraft and TransCyte in the 
treatment of venous ulcers and pressure ulcers.  In addition, the Company 
will fund certain manufacturing and distribution costs and certain costs 
related to post-market studies of TransCyte through December 1999.  See 
"Collaborations and Strategic Alliances."

     In 1994, Smith & Nephew and Advanced Tissue Sciences entered into a
separate fifty-fifty joint venture for the worldwide development, manufacture
and marketing of human tissue-engineered cartilage for orthopedic applications
(the "Cartilage Joint Venture").  Under the terms of the Cartilage Joint Venture
agreement, Advanced Tissue Sciences will be responsible for supervising the
manufacturing of cartilage tissue products.  The Cartilage Joint Venture will
execute the research and development program, develop a worldwide marketing
plan, and will utilize Smith & Nephew's established selling and distribution
network to market the products.  Smith & Nephew Endoscopy, a world leader in
arthroscopy, is separately responsible for developing and manufacturing
instrumentation that could be used for the arthroscopic insertion of the joint
venture's cartilage products.  As specified in the Cartilage Joint Venture
agreement, Smith & Nephew contributed the first $10 million in Cartilage Joint
Venture funding and the Company contributed certain technology licenses.
Cartilage Joint Venture revenues and expenditures in excess of the first $10
million are being shared equally by the partners.  See "Collaborations and
Strategic Alliances."

     Advanced Tissue Sciences, Inc. was incorporated under the laws of the State
of Delaware in 1987.  The Company maintains its executive offices at 10933 North
Torrey Pines Road, La Jolla, California 92037, and its telephone number at that
address is (619) 713-7300.  Financial information regarding the Company's
financial condition and results of operations can be found in a separate section
of this Annual Report on Form 10-K beginning on page F-1.

                                  3

<PAGE>

PROPRIETARY CORE TECHNOLOGY

     The Company's tissue engineering technology involves the controlled in vivo
and ex vivo growth of living tissues and organs on three-dimensional support
structures.  The Company believes that its technology represents a major advance
in medical science.  Over the last several decades, technologies have been
developed that have made possible the growth of many of the over 200 different
types of cells found in the human body in laboratory containers filled with
nutrient media.  When grown on two-dimensional surfaces, the ability of cells to
interact and organize themselves into functioning tissues is limited.  In
contrast, a three-dimensional framework allows cells to develop and assemble
into tissues that more closely resemble their counterparts in the body.

     In normal growth and development, the body uses specialized connective
tissue cells to form "stroma" or a living matrix that provides the
three-dimensional structure for each organ.  Stroma also provides attachment
sites and produces growth factors that promote the development of organ cells
into functioning tissues.  While the specific components and configuration of
stroma may differ from organ to organ, the basic principle of three-dimensional
stromal support applies to most organs in the body.

     The Company has developed a proprietary core technology that combines the
principles of cell biology, biochemistry and polymer science to create a
three-dimensional living support stroma ex vivo.  The support stroma is made by
first seeding organ-specific stromal cells (cell biology) onto a mesh framework
(polymer science) in an environment that simulates the body.  The cells attach,
divide and secrete extracellular matrix proteins and growth factors
(biochemistry), using the mesh as a scaffolding.  This process results in a
completely human stromal tissue that, in turn, supports the growth of organ
cells into functional tissue.  Advanced Tissue Sciences has been issued United
States and European patents covering its core technology and numerous patents
related to applications of this technology.  In addition, the Company has
exclusive license rights to patents issued during 1998 covering the growth of
vascularized human tissues or organs on three-dimensional biocompatible,
biodegradable and non-biodegradable polymer scaffolds inside the body (in vivo).

     The Company believes that its tissue-engineered products may offer some or
all of the following benefits, depending upon the particular application of the
product:

*    Physiological Human Tissue -- The Company's patented core technology allows
     the cells to grow on a scaffold and develop into a three-dimensional human
     tissue.  The Company's products may then be transplanted as a physiological
     tissue, as contrasted with the transplantation of cells or scaffolds alone.

*    Multiple Factors For Healing -- The human cells produce multiple growth
     factors and tissue matrix proteins, all of which the Company believes are
     important in the tissue repair process.  Living, metabolically active 
     cells may also respond to the surrounding environment.

*    Human Tissue -- The tissue matrix proteins naturally secreted by the cells
     consist of human collagens, glycosaminoglycans and other human proteins, 
     rather than animal-derived matrix proteins, which may cause allergic or 
     immune reactions.

*    Safety Tested -- The human tissue materials used in the manufacture of the
     Company's products are extensively tested at independent laboratories for
     potential pathogens such as Hepatitis B and HIV.  All final product is 
     tested for sterility by performing United States Pharmacopeia (U.S.P.) 
     sterility tests on each product's growth medium.

*    Off-the-Shelf Products -- Medical research has shown that several tissues,
     including dermal tissue and certain cartilage tissue applications, are not
     subject to rejection by a recipient's body.  These tissue-engineered 
     products may, therefore, be utilized as universal, permanent replacement 
     products in such applications.

*    Prolonged Shelf Life -- The Company's dermal products can be frozen for
     long-term storage.  Similarly, it is expected that cartilage and some of 
     the other tissues in development will be able to be cryopreserved for a 
     long shelf life.

*    Ease of Use -- The Company's dermal products are easy for surgeons to apply
     using routine surgical techniques.  In addition, the ultimate objective
     is to delivery tissue-engineered cartilage in a single arthroscopic 
     procedure.

                                  4

<PAGE>

PRODUCTS

     The Company has a number of therapeutic tissue products that are in various
stages of commercialization, clinical trials, preclinical studies and research.
Currently, its primary product focus is directed toward skin (for burns and 
ulcers), orthopedic cartilage and cardiovascular products.  In addition, 
based on available resources, clinical results, markets and other cost
benefit considerations, the Company intends to bring other potential products to
market in the future.

BURN PRODUCTS

     Although there have been many advances in the care and treatment of
severely burned patients, available alternatives remain fairly limited and
success is highly dependent on the skills of burn surgeons and nurses.  As a
result of the need for improvements in patient care and the ability to closely
monitor product performance, the Company selected severe burns, often referred
to as third degree burns, as the target for its first therapeutic use of the
Company's tissue engineering technology.  In addition, dermal tissue has several
advantages over other tissues or organs in that it is grown from fibroblasts,
which are both readily available and not subject to rejection by the body.  The
Company's burn products are regulated as medical devices in the United States
and Canada.

     Currently, to treat large full-thickness burns (where both the epidermis
and the dermis are destroyed), burn surgeons typically excise the damaged tissue
and cover the wound as soon as possible.  Conventional treatment for large
full-thickness burns usually involves the use of temporary coverings to limit
infection, reduce pain and prevent the loss of body fluids, followed by grafting
of the patient's own skin ("autograft") as it becomes available.  In most cases,
permanent closure of severe burn wounds is achieved with autografts obtained by
surgically harvesting areas of the patient's skin which are still intact ("donor
sites").  The dermis at the donor site is typically "split" so that the removed
graft consists of the entire epidermis and the upper portion of the dermis (a
"split-thickness" graft), leaving the bottom portion of the dermis in the donor
site to facilitate healing.

     In partial-thickness burns, commonly known as second degree burns, the
dermis has not been entirely destroyed and grafting is generally not required.
In partial-thickness burns, the effort is to close the wound as quickly as
possible to reduce pain, the incidence of infection and scarring.
Partial-thickness burns are generally treated with antimicrobial agents, the
most common being silver sulfadiazine which is applied topically.  Dressing
changes are generally performed twice a day and can be quite painful.  At each
dressing change, the surgeons will typically remove any damaged tissue.  Goals
in the treatment of these patients include achieving rapid healing and reducing
pain, inflammation and scarring.

     BURN MARKET.  Of the approximately 51,000 burn patients hospitalized
annually in the United States, up to 13,000 are severely burned and require skin
grafts.  TransCyte was initially approved to address the approximately 1,500
severely burned patients requiring skin grafts with burns exceeding twenty
percent of body surface area.  Another 30,000 to 40,000 burn victims, often
children and the elderly, suffer partial to mid-dermal, or second degree, burns
each year in the United States.  These burns frequently result from household
hazards such as scalds from hot liquids, faulty heating pads or misuse of
ignition fluids.

     TRANSCYTE.  Patients with extensive full-thickness burns have only a
limited amount of undamaged skin that can be used as donor sites for autografts.
This shortage of donor sites prevents rapid closure of the burn wounds leaving
the patient susceptible to infections and fluid loss, both of which can be
life-threatening.  When sufficient autograft is not available, human cadaver
skin is often used as a temporary covering for the excised burns.  However,
cadaver skin may transmit infection and is immunologically rejected generally
within several weeks of application.  As a result, the patient may require
additional surgical procedures to cover the wound, increasing the overall cost
of treatment.  Rejection can also give rise to complicating infections of the
burn wounds and, in addition, repeated applications of cadaver skin can cause
more rapid rejection.  Removal of cadaver skin prior to autografting can be
difficult and cause significant bleeding.

     As an alternative to human cadaver skin, the Company developed TransCyte.
TransCyte consists of a dermal tissue grown on scaffold with an ultra-thin
synthetic covering that acts as a temporary epidermis that helps to retain
fluids and prevent infections of the wound bed.  As with cadaver skin, TransCyte
must ultimately be removed from the wound bed prior to grafting.  However, the
Company believes that TransCyte offers significant advantages over cadaver skin.
Cadaver skin has a number of limitations, such as limited availability, the
potential for 

                                  5

<PAGE>

immunological rejection that necessitates repeat applications, significant 
bleeding and inflammation of the wound bed and the potential for disease 
transmission.  However, TransCyte is manufactured, cryopreserved and
ready for use as needed, has reduced bleeding on removal and the human tissue
materials used in the manufacture of the Company's skin products, including
TransCyte, are extensively tested for potential pathogens.

     In March 1997, the FDA gave the Company approval to begin commercial sales
of TransCyte in the United States for use as a temporary covering for severe
burn wounds.  The approval was based on a pivotal clinical trial which
demonstrated that TransCyte was successful in adequately preparing the wound
bed for autografting, performing equal to or better than the cadaver skin
control.  In addition, TransCyte performed significantly better than the control
with respect to important secondary endpoints such as ease of removal, amount of
excision required, amount of bleeding upon excision and overall satisfaction
rating as a temporary covering among clinical investigators.  Under the
approval, the Company is to conduct post-marketing surveillance to generate
additional information relative to infection rates.

     In October 1997, the Company also received approval from the FDA to begin
commercial sales of TransCyte in the United States for partial-thickness burns.
In a clinical trial under a physician's IDE, TransCyte was evaluated as an
alternative to silver sulfadiazine in the treatment of patients with limited to
moderate partial-thickness burns.  In the trial, TransCyte was affixed to the
burns with adhesive strips and remained until the wound was closed.  TransCyte
was compared to silver sulfadiazine which had twice daily dressing changes and
wound debridement as per the burn center's standard practice.  The clinical
trial results indicated that TransCyte showed a substantially reduced time to
90% healing or epithelialization, and required less than half the time to heal.
Under this approval, the Company is to conduct post-market studies to evaluate 
infection rates and to generate data relative to patients who go on to require
autografting.

     TransCyte can offer several advantages in the treatment of
partial-thickness burns.  As compared to silver sulfadiazine, TransCyte may
reduce the pain, time and cost associated with once or twice daily dressing
changes and excision.  More rapid healing can also reduce the costs and time
associated with treatment and can potentially reduce the hypertropic scarring
often seen in these burn wounds.

     The manufacture of products for which a PMA is granted, such as TransCyte,
is subject to routine inspection by the FDA and certain state agencies for
compliance with the FDA's Quality Systems Regulation (QSR) requirements, 
adverse event reporting requirements, and other applicable regulations.  
TransCyte is currently available for sale in the United States, Canada, the
United Kingdom, Australia, New Zealand, Finland, Denmark and the Netherlands
through the Dermagraft Joint Venture and will be introduced in additional
countries subject to regulatory approvals.  Although some countries have not
yet determined how they will regulate TransCyte, this product is generally
regulated as a device.  See "Factors That May Affect Future Results - 
Government Regulation."

SKIN ULCER PRODUCTS

     Based on its early experience with Dermagraft in burns, chronic skin ulcers
were also selected as one of the Company's first therapeutic targets.  The
Company believes that its Dermagraft product provides a healthy, metabolically
active dermal matrix in the ulcer bed that will support growth of the patient's
epidermis from the edges of the wound and promote wound closure and, thereby,
reduce the time required to heal these wounds and potentially reduce the need
for skin grafting and reconstructive procedures.  The Company has also benefited
from the experience it has gained with TransCyte as both products use similar
raw materials (e.g., cell source and growth media), manufacturing processes,
freezing procedures, storage methods and packaging concepts.  No evidence has
been seen in any clinical trials of Dermagraft of any safety issues and no
incidents of immunologic rejections have been observed with Dermagraft.
Dermagraft is regulated by the United States, Canada and Australia as a medical
device.  Many European and other countries are regulating Dermagraft as a
pharmaceutical and some countries have not yet determined how they will regulate
Dermagraft.

     Traditionally, there have been two approaches to skin ulcer treatment.  The
most common treatment for less advanced ulcers is to allow normal healing to
occur by using dressings and topical medications to protect the wound.  Even
when successful, this therapy can require many months of repeated treatments to
achieve healing.  The second approach utilizes conventional skin grafts and is
typically used for more advanced skin ulcers.  However, the difficulty of
healing donor sites and the risks associated with general anesthesia in the

                                  6

<PAGE>

elderly, who suffer the large majority of chronic skin ulcers, often prevents
the use of skin grafts.  Both treatment approaches have a high failure rate.

     Dermagraft is a dermal replacement product grown on a bioabsorbable
scaffold.  It is designed to provide a healthy, metabolically active dermal
matrix in chronic and acute ulcers to support wound closure.  Healing skin 
ulcers faster can potentially reduce the risk of infection (and, in the case 
of diabetic foot ulcers, the subsequent risk of amputation), as well as the 
need for skin grafting and reconstructive procedures.  Chronic and acute skin 
ulcers that may be addressed by Dermagraft include diabetic foot ulcers, 
venous ulcers and pressure ulcers.  The Company also believes that TransCyte 
may have a market as a temporary covering in chronic pressure ulcers.

     ULCER MARKET.  Over 2.8 million cases of chronic, slow-healing or
non-healing skin ulcers are treated in the United States each year.  In these
wounds, the skin breaks down as a result of disruption of blood flow caused
either by prolonged pressure over a localized area or by chronic diseases that
affect the circulatory or peripheral nervous systems.  In many of these
patients, skin ulcers are open, often painful, wounds that are resistant to
healing for many months or years.  In part, because current therapies for skin
ulcers are often ineffective, the treatment of skin ulcers is an expensive
process.  Individual patient treatment can cost thousands of dollars per year.
Published sources estimate that the United States healthcare system spends more
than $5 billion each year for the treatment of severe skin ulcers.

     In the United States, approximately 800,000 persons with diabetes suffer
from chronic, non-healing foot ulcers each year, 400,000 of which are
full-thickness plantar ulcers that represent the Company's initial target
market.  Ulcers that do not heal leave the patients susceptible to infection,
which may lead to amputation of the foot or leg.  At least 60,000 amputations
occur each year in the United States, 85% of which are preceded by a diabetic
foot ulcer.  The five-year survival rate following amputation is only 50
percent.  In addition, it is estimated that more than 1.2 million patients
are affected by acute pressure ulcers, over 200,000 nursing home patients
suffer from chronic pressure ulcers and approximately 500,000 patients are 
diagnosed with venous ulcers in the United States each year.

     DIABETIC FOOT ULCERS.  Many diabetic patients experience circulatory
deficiencies and decreased nerve sensation in their legs and feet, which
prevents the normal shifting of weight in response to wound-provoking pressure.
The patient may be unaware of some injuries and can leave wounds unattended for
days, resulting in an ulcer.  Once the ulcer forms, it may heal poorly due to
the effects of diabetes on normal healing processes.  Unhealed diabetic ulcers
can result in gangrenous infection that may lead to amputation of the limb.
Over the course of their disease, patients with diabetes lose their ability to
form normal collagens, glycosaminoglycans and growth factors.  Dermagraft is
designed as a replacement to address these deficiencies in the diabetic
patient's own dermal tissue.  Dermagraft contains extracellular matrix proteins,
growth factors and glycosaminoglycans normally found in healthy human dermal
tissue.

     In January 1998, the General and Plastic Surgery Devices Panel of the
Medical Devices Advisory Committee to the FDA recommended that the agency
approve Dermagraft for the treatment of diabetic foot ulcers in the United
States, with the conditions that the Company perform a post-marketing study to
confirm efficacy and provide physician training.  The recommendation was based
on results of a pivotal clinical trial enrolling 281 patients and a 50-patient
supplemental trial.  The supplemental trial was performed to confirm the results
of the pivotal clinical trial with product produced in the Company's commercial
manufacturing systems and to commercial specifications.

     The patients enrolled in the treatment group of the pivotal clinical trial
and all the patients enrolled in the supplemental trial received a dosing
regimen of one piece of Dermagraft per week for up to eight weeks.  In the
pivotal trial, Dermagraft was compared to a control treatment of conventional
therapy consisting of sharp debridement, infection control, moist wound
treatment and standardized off-weight bearing strategies.  The primary endpoint
of both the trials was complete wound closure evaluated at twelve weeks.
Patients in both trials were also to be followed for a total of thirty-two weeks
to assess safety and long-term efficacy.

     In the pivotal clinical trial, 38.5% of the evaluable patients who received
Dermagraft healed completely in twelve weeks as compared to 31.7% of the
evaluable patients treated with conventional therapy.  In addition, 50.8% of
those evaluable Dermagraft patients receiving product in the pivotal clinical
trial produced to commercial specifications (i.e., within a specific
"therapeutic range") achieved complete wound closure within twelve weeks.  In
addition, at thirty-two weeks, or six months after the last application of
Dermagraft, 57.5% of the evaluable Dermagraft patients receiving product in the
pivotal trial manufactured to commercial 

                                  7

<PAGE>

specification achieved complete wound closure as compared to only 42.4% of 
those receiving conventional therapy alone.  In August 1997, approval was 
received from Canadian regulatory authorities for the marketing of Dermagraft
in the treatment of diabetic foot ulcers based on the results of this trial.

     The results of the supplemental trial at twelve weeks were closely 
consistent with those seen in the pivotal clinical trial for the product 
produced to commercial specifications.  In the supplemental trial, 51.3% of 
the evaluable Dermagraft patients achieved complete healing within twelve 
weeks as compared to the 50.8% achieving complete healing in the pivotal 
clinical trial.

     In June 1998, the FDA requested that an additional controlled clinical
trial be completed in support of the Company's PMA application of Dermagraft  
in the treatment of diabetic foot ulcers.  As had been previously reported, 
the FDA stated concerns about basing approval on a retrospective analysis on 
a subset of the data together with a post-marketing study to confirm efficacy.
The FDA indicated the PMA application was not approvable without supportive 
data from the additional clinical trial.

     In August 1998, the FDA granted approval of the Company's application for
the additional controlled clinical trial for Dermagraft in the treatment of
diabetic foot ulcers.  The additional clinical trial is to include up to thirty
centers and provides for enrollment of a total of 330 patients (165 per arm).
The study will have the same primary endpoint, complete wound closure by twelve
weeks, used in the previously conducted pivotal trial.  Unlike the previous
trial, a thirty-two week follow-up will not be required.

     An interim analysis will be performed after the first 180 patients have
completed the trial.  Showing statistical significance on an intent-to-treat
basis at the interim analysis would allow the Company to submit a PMA
application for approval at that time and stop further study enrollment.  The
Company has estimated data from the interim analysis could be available within
twelve months of trial initiation assuming a reasonable rate of patient
enrollment.  Otherwise, as specified in the approved protocol, the trial will
continue until 330 patients (165 per arm) have been enrolled.  The Company has
estimated that, if necessary, data from all 330 patients could be available for
submission to the FDA approximately eighteen months after trial initiation,
assuming a reasonable rate of patient enrollment and data consistent with
the previous PMA application.  The additional clinical trial was started in late
1998.  See "Factors That May Affect Future Results - Government Regulation."

     In connection with its review of the PMA application for Dermagraft, the
FDA suggested that a Treatment Investigational Device Exemption (IDE)
application be submitted.  The Treatment IDE is a new regulatory provision for
devices that permits companies to make available promising new products under an
agreed clinical protocol to patients with serious diseases for which there is no
satisfactory alternative.  In October 1998, the FDA approved the Company's
application for a Treatment IDE for Dermagraft in the treatment of diabetic foot
ulcers.  Under a Treatment IDE, companies are allowed to recover manufacturing
and distribution costs.

     Dermagraft for the treatment of diabetic foot ulcers is approved for sale
in Canada and has been commercially introduced in the United Kingdom and several
other European countries.  Dermagraft is to be marketed worldwide, subject to
regulatory approvals, through the Dermagraft Joint Venture with Smith & Nephew.
See "Collaborations and Strategic Alliances."  Failure of the Company to gain
FDA approval of Dermagraft for the treatment of diabetic foot ulcers in the
United States in a timely manner or, if approved, to achieve significant market
acceptance of the product would have a material adverse effect on the Company's
business, financial condition and future results of operations.  As with
TransCyte, the manufacture of Dermagraft must be in compliance with QSR
requirements, adverse event reporting requirements and other applicable
regulations.  See "Factors That May Affect Future Results - Government
Regulation."

     VENOUS ULCERS.  Venous ulcers result when damage to the valves of the deep
leg veins reduces their ability to return blood to the upper body, leading to
pooling of blood in the legs and subsequent breakdown of the skin.  Venous
ulcers that do not respond to medical treatment often must be closed surgically
by the use of skin grafts.

     In 1994, the Company completed a pivotal clinical trial of a single
application of Dermagraft under an Investigational Device Exemption from the
FDA.  In that trial, patients were tracked for a period of twenty-four weeks to
evaluate wound closure.  Analysis of the data from the pivotal trial showed no
statistical differences between the patients in the control group and those
treated with a single application of Dermagraft.  Analysis of the six-month
follow-up data from patients in this trial did, however, show a statistically
significant difference 

                                  8

<PAGE>

in the recurrence rate of Dermagraft-treated patients (6%) versus control 
patients (20%) indicating a positive effect on the quality and durability of 
the ulcers healed by Dermagraft.  As noted above for diabetic foot ulcers,
an important goal in the treatment of chronic skin ulcers is to prevent the
recurrence of the wound, which both lowers the cost of treatment and improves
overall patient care.

     Through the Dermagraft Joint Venture with Smith & Nephew, the Company began
a pilot clinical trial of Dermagraft in the treatment of venous ulcers in March
1999.  The trial is expected to evaluate the number of pieces of Dermagraft
needed to achieve wound closure.  In this trial, the Company intends to
capitalize on and apply the knowledge gained from the diabetic foot ulcer trials
with respect to product efficacy to venous ulcers.  See "Diabetic Foot Ulcers"
above.

     PRESSURE ULCERS.  Pressure ulcers are common in hospital and nursing home
patients.  Pressure ulcers form in skin that is continually compressed under the
weight of a bedridden or wheelchair-bound patient, who does not periodically
turn or roll to relieve the compressed skin.  The compressed skin does not
receive blood flow for excessive time, ultimately forming a wound.  Severe
pressure ulcers frequently must be closed by use of skin grafts or major
reconstructive surgery.

     The Company, through the Dermagraft Joint Venture with Smith & Nephew,
anticipates beginning a pivotal clinical trial of Dermagraft for the treatment
of acute pressure ulcers during 1999.  The pivotal trial will be based on the
results of an earlier pilot clinical trial.  In the pilot clinical trial, fifty
patients were segregated into three dosing groups and one control group.  Wound
closure was evaluated over a period of twelve weeks.  The treatment group
showing the best results received two pieces of Dermagraft every two weeks for a
total of eight pieces.  Complete wound healing was achieved in 46% of these
patients as compared to 25% of the patients in the control group.  The joint 
venture also expects to begin a pilot clinical trial of TransCyte in chronic 
pressure ulcers before the end of the year.

ORTHOPEDIC PRODUCTS

     Knowledge gained from developing the Company's existing skin products has
also been applied to the growth of orthopedic tissues.  The Company believes
that its core technology and proprietary manufacturing systems allow the
regulation of critical environmental factors, including oxygen tension, pressure
and media composition, that may provide the necessary conditions for the
production of a high tensile-strength cartilage capable of withstanding the high
shear and load forces present in human joints.  Similar to the skin, the Company
believes, and scientific research supports, that tissue-engineered cartilage
products will be non-immunogenic given a dense matrix around the cartilage cells
(chondrocytes).

     Traumatic injuries often cause permanent damage to tissues in human joints
such as cartilage, ligaments, tendon and bone.  The body has a limited ability
to repair these tissues on its own, and there are few treatment options
available to replace damaged tissue.  The Company is focusing its initial
product development efforts on tissue-engineered cartilage.  Cartilage and
cartilage-like tissue serves diverse functions in many parts of the body such as
providing a gliding surface for smooth joint motion (articular cartilage), and
serving to absorb both impact and load-force transmitted to the axial skeleton
(meniscus).  In many cases, damage to cartilage tissue subsequently leads to
further deterioration and osteoarthritis which can eventually require a total
joint replacement.

     The Company is developing its orthopedic cartilage products through the
Cartilage Joint Venture with Smith & Nephew.  See "Collaborations and Strategic
Alliances."  The Cartilage Joint Venture also has a right of first negotiation
to develop other tissue-engineered products for orthopedic applications such as
ligament, tendon and bone.

     ORTHOPEDIC MARKETS.  In the United States each year, there are over 1.2
million arthroscopic procedures of the knee performed, including procedures
involving articular cartilage, meniscus and ligaments.  By intervening early in
the degenerative process, the Cartilage Joint Venture hopes to delay or perhaps
even avoid some of the 260,000 total knee replacement surgeries performed
annually in the United States.  There are an additional 400,000 arthroscopic
procedures performed each year in the United States in joints such as the
shoulder, elbow, wrist, hip and ankle which could also be candidates for the
joint venture's articular cartilage products.

                                  9

<PAGE>

     ARTICULAR CARTILAGE.  Articular (joint) cartilage covers the opposing
surfaces of all moving joints in the body.  Even small defects in the articular
cartilage can cause pain and subsequent restriction of joint motion.  These
defects greatly increase the probability of degenerative cartilage problems,
such as arthritis, later in life.  The primary treatment for these articular 
defects is to trim away intruding cartilage fragments via arthroscopy which 
increases joint mobility but does not prevent long-term degenerative changes.  
Injuries resulting from sports trauma are a common cause of these cartilage 
defects.  To the Company's knowledge, other than autologous transplants of 
the patient's own cells, there are no commercially available products either 
synthetic or natural which can replace damaged cartilage in the human body.  
Tissue-engineered articular cartilage could provide a significant opportunity 
to treat patients at an earlier stage of joint degeneration, thereby delaying,
or in some cases eliminating, the need for total joint replacements.  
Products to repair articular cartilage may ultimately be used in any joint in 
the body, such as knees, shoulders, elbows, wrists, hips and ankles.

     The Company, as part of the Cartilage Joint Venture with Smith & Nephew,
had submitted an IDE in December 1996 requesting approval to begin a human pilot
clinical trial with human tissue-engineered articular cartilage for the repair
of articular surfaces in knee joints.  The FDA requested additional information
with respect to the IDE.  However, as a result of knowledge gained from the
clinical trials of Dermagraft with respect to the importance of metabolic
activity, the Cartilage Joint Venture has been working to further develop and
identify those critical factors believed necessary for the clinical success of
an articular cartilage product.  These efforts are continuing and will be the
basis for providing additional information to the FDA under a revised IDE.

     The IDE submission was based on a preclinical safety study using a small
animal model.  Through twenty-four months of follow-up, no adverse events were
observed with the product.  Additionally, significant improvement in the repair
of defects was observed in grafted versus ungrafted control sites.  The grafted
tissue had a significantly more hyaline-like appearance, greater content of
sulfate glycosaminoglycans and smoother articular surface as compared to the
untreated defects.  These results demonstrated the safety of the product and
also that the repair tissue is of better quality and more closely resembles
adjacent normal tissue than allowing the defects to heal by natural processes.
The Cartilage Joint Venture has also performed a normal healing study using a
large animal model.  The results of this study thus far have demonstrated that
untreated defects heal with scar tissue, as has been shown in humans, and,
therefore, the model may be representative of the effects of tissue-engineered
cartilage on progression of degenerative joint diseases.

     MENISCAL CARTILAGE.  The meniscus is a cushion that acts as a shock
absorber in the knee.  It is frequently damaged or destroyed by sports injury or
other trauma.  Current repair procedures for avascular meniscal injuries have
limited success in producing a long-term repair.  The Company believes that its
tissue engineering approach could offer a benefit in the repair and eventual
total replacement of the meniscus.  The Cartilage Joint Venture has conducted
collaborative preclinical studies with scientists under a sponsored research
program which has shown that successful repair was achieved using tissue-
engineered meniscal allografts, in comparison to failure to heal in a control
group.  In pilot preclinical studies, further sponsored research performed at
Children's Hospital in Boston ("Children's Hospital") showed that tissue-
engineered meniscus can be generated and may be used for total meniscal
replacement.  In 1997, the joint venture developed a prototype for a tissue-
engineered meniscus.  Preclinical studies were successfully performed with the
prototype during 1998.

     LIGAMENT/TENDON.  Frequently, sports injuries involve damage to ligaments
and tendons, particularly injury to the anterior cruciate ligament.  The Company
has successfully utilized degradable polymers shaped into tendon-like structures
combined with fibroblasts to engineer a living ligament.  Research work on the
optimization of this technique for replacement of ligament and tendon was in
collaboration with scientists at the Massachusetts Institute of Technology
("MIT") and Children's Hospital.  Through this sponsored research, the Company
has explored growth conditions that may allow it to grow tissue-engineered
ligament and tendon with biomechanical properties similar to those found in the
human body.

     BONE.  In collaboration with researchers at MIT and Children's Hospital,
the Company has successfully grown tissue-engineered bone.  Research has shown
that three-dimensional bone grown ex vivo secreted extracellular matrix proteins
and retained biomechanical properties analogous to those tissues in the human
body, eliminating the need for extracting bone from other areas of the patient's
body.  The use of tissue-engineered bone to replace long bones, such as the
femur, has been successful in preclinical studies.

                                  10

<PAGE>

CARDIOVASCULAR PRODUCTS

     Cardiovascular tissue consists of a number of cell types including cardiac
fibroblasts, smooth muscle cells and endothelial cells.  Cardiac fibroblasts are
closely related to the dermal fibroblasts that the Company uses to manufacture
its existing skin products.  Accordingly, dermal fibroblasts may be useful in
the growth of vascular grafts and other cardiovascular products.  The Company 
is also investigating the utility of smooth muscle cells, a functional 
component of the native artery, to add strength to the tissue-engineered 
vessels.  Endothelial cells line the interior of blood vessels and are 
important to avoid clotting and the build up of plaque, or atherosclerosis.  
Matrix proteins and growth factors secreted by fibroblasts or smooth muscle 
cells may induce endothelial cell migration into the tissue-engineered grafts.
The Company believes its cardiovascular products will be regulated as medical 
devices in the United States, similar to its skin and cartilage products.

     CARDIOVASCULAR MARKET. In the United States, over 900,000 people die each
year from cardiovascular disease.  More specifically, 14 million people suffer
from coronary artery disease and over 380,000 coronary artery bypass procedures
are performed annually in the United States.  Likewise, each year approximately
70,000 patients undergo surgery for the replacement of peripheral vascular
grafts.  The application of tissue-engineered vascular grafts could provide
these patients with a viable alternative treatment.  An aging population is
likely to increase the incidence of these diseases and the need for
cost-effective treatments in the future.  Another 60,000 patients or more have
prosthetic heart valves implanted each year.  While there are many effective
treatments for these patients, there are also many problems to be overcome such
as biocompatibility, durability and availability.  Tissue-engineered
cardiovascular products, such as off-the-shelf blood vessels, may potentially
solve some of these issues.

     BLOOD VESSELS.  Vascular grafts are used to repair or replace segments of
arterial and venous blood vessels that are weakened, damaged or obstructed due
to trauma or disease such as aneurysms and atherosclerosis.  Grafts are either
autografts (the patient's own veins or arteries), prosthetic grafts made of
synthetic materials such as polyesters or other composite materials, or
non-viable preserved biological tissue from cadavers or other species.  The
harvesting of autografts requires extensive surgery which is time consuming,
costly and traumatic.  In addition, patients requiring multiple bypass surgeries
may not have enough suitable vessels to harvest.  Cyropreserved allograft veins
from cadavers are sometimes used, but availability is limited and patency rates
are lower than autograft vessels.  Prosthetic vascular grafts are generally used
for large or medium diameter (>6mm) grafts as small diameter synthetic grafts
have generally demonstrated poor performance.  Prosthetic vascular grafts often
show insufficient tissue integration and re-endothelization.  Problems
associated with small diameter synthetic grafts include stenosis (or a
narrowing), pseudoaneurysm formation, and acute occlusion due to platelet
aggregation.

     Many companies are attempting to develop small diameter vascular grafts
(3mm to 5mm) with characteristics similar to biological grafts.  These companies
are employing a variety of technologies to reduce thrombosis and promote a rapid
ingrowth of tissue such as different weaves and knits, chemical coatings and
gelatins, and freeze drying.  Advanced Tissue Sciences' research has focused on
using specialized polymer constructs, bioreactor design and colonization
techniques to create a human vessel.  Bioreactors have been developed to
generate the mechanical forces similar to that encountered in the body to
stimulate the cells to align concentrically, to absorb stress as in a normal
vasculature, and to establish a matrix similar to native blood vessels.
Imposing such forces allows for greater structural and mechanical integrity in
the tissue-engineered vascular grafts.  Biochemical and immunohistochemical
analysis of bioengineered blood vessels demonstrates an increase in tissue
deposition over time in culture and the synthesis of elastin and other matrix
proteins which are essential to blood vessel formation and function.  These
matrix proteins, along with various growth factors that are naturally secreted
by the grafts, may also induce endothelial cell migration and host cell
integration.

     The Company has worked, both internally and through collaborations with The
Georgia Institute of Technology ("Georgia Tech"), MIT and Children's Hospital,
on the development of tissue-engineered blood vessels in vitro that have
adequate biomechanical and structural properties to function in vivo and to
minimize or eliminate the potential for clotting or thrombogenecity.  Georgia
Tech has performed biomechanical property tests of the bioengineered vascular
grafts and native coronary vessels.  As previously reported, through sponsored
research with MIT and Children's Hospital, feasibility studies were performed
with small diameter (3mm to 3.5mm) bioengineered blood vessels.  These blood 
vessels were created by seeding a synthetic biodegradable tube with
fibroblasts and other vascular cell types.  These blood vessels have been
implanted into 

                                  11

<PAGE>

large animal models and have shown normal function up to eight weeks.  
Researchers have also shown the ability of large diameter (15mm) tissue-
engineered grafts to persist, remain durable and grow normally in preclinical
studies.

     In 1997, Advanced Tissue Sciences was awarded a $2 million Advanced
Technology Program grant from the National Institute of Standards and
Technology.  In collaboration with the Department of Bioengineering at UCSD, the
Company is leading a multi-disciplinary effort to design, construct and evaluate
tissue-engineered vascular grafts produced from cells grown on a biocompatible
scaffold.  The grant is structured to support this development program over a
three-year period which began in 1998.  The collaboration will integrate current
advances in cellular mechanics, bioreactor technology, and blood vessel
mechanics to create a unique living tissue replacement for blood vessels.

     HEART VALVES.  The valves open and close with every beat of the heart.
When a valve becomes damaged or diseased, the heart must work harder to pump the
same volume of blood.  As the condition worsens, the valve has to be replaced.
Currently, either mechanical or porcine valves are used to replace the native
human valves; however, each has its drawbacks.  With mechanical valves, patients
are required to take anticoagulant medication for the rest of their lives to
reduce the likelihood of thromboembolic events (i.e., blood clots).  Porcine
valves have problems with durability and calcification, frequently requiring
additional and costly surgery to implant replacement valves.

     The Company's past preclinical studies to develop tissue-engineered valves
on synthetic scaffolds under sponsored research performed by researchers at MIT
and Children's Hospital demonstrated the feasibility of utilizing tissue
engineering to create heart valves using a three-dimensional biodegradable
scaffolding.  In these feasibility studies, tissue-engineered valve leaflets
were created by seeding a synthetic biodegradable fiber matrix with fibroblasts,
endothelial and other cells.  The tissue-engineered leaflets were then implanted
in large animals which were followed for up to eleven weeks.  The leaflets
tolerated surgical handling and sutures, and were found to increase in size to
accommodate for valve growth over the period of implant.  Additionally, the
valve exhibited no evidence of stenosis and had trivial, clinical insignificant,
regurgitation.  Total protein and collagen analysis showed the development of an
extracellular matrix, including elastin, and histologies of the constructs
resembled native tissue.

     STENTS.  Stents are generally synthetic materials that are inserted in a
vessel after angioplasty (the mechanical removal of an occlusion by the
insertion and inflation of a balloon catheter) in an attempt to prevent
restenosis or re-occlusion of the vessel.  Without stent intervention,
approximately 40% of patients will experience restenosis of the vessel within
two years of plaque removal.  Using a living, bioengineered stent comprised of
healthy human cells, either alone or in conjunction with a mechanical stent,
could potentially provide a more stable vascular lining, thereby preventing or
reducing thrombosis or restenosis.

OTHER THERAPEUTIC TISSUES

     Many other organ tissues have been successfully grown using the Company's
technology that could potentially be developed into therapeutic products.
Further development and commercialization of these or other tissues, such as
pancreas, gastrointestinal and blood/brain barrier tissues, is dependent on a
number of factors, including the Company's assessment of each tissue type's
market potential and the availability of sufficient resources, either internally
or through collaborations with future corporate partners.

     RECONSTRUCTIVE APPLICATIONS.  There may be several applications for the
Company's cartilage and bone products in reconstructive surgery.  Reconstructive
implants may offer an important alternative at a time when silicon, Teflon, and
other implant materials are being taken off the market.  Under Company-sponsored
research, scientists have performed pilot preclinical studies with engineered
cartilage and bone for reconstructive applications and have even constructed an
entire joint consisting of bone, cartilage and ligament.

     CARTILAGE.  Studies sponsored by the Company have shown that cartilage
implants retain their shape for up to one year after implantation into the
facial regions of animals.  In addition, researchers in this collaboration have
developed an injectable cartilage product that has been successfully utilized to
construct total ear and nose implants.  Such implants have persisted in animals
for over twelve months.  An injectable cartilage may also be useful for
cartilage augmentation, total meniscus replacement, and intravertebral disc
repair.

                                  12

<PAGE> 

     BONE.  An engineered bone tissue could be useful in joint replacement, bone
grafting and facial bone reconstruction.  Scientists have shown that
three-dimensional bone grown in vitro secreted extracellular matrix proteins and
retained biomechanical properties analogous to those tissues in the human body,
eliminating the need for extracting bone from other areas of the patient's body.
Research has also advanced in the growth of bone/cartilage composites which 
could offer additional solutions to reconstructive surgery.  Studies have 
shown that full thickness cranial bone defects in animals can be corrected by 
implantation of tissue-engineered bone.  Scientists have successfully 
replaced long bones, such as the femur, in preclinical studies.

     LIVER.  The liver is the body's major metabolic organ.  The only treatment
for liver failure today is a liver transplant and currently there is an
insufficient supply of transplantable livers.  While more than 4,000 liver
transplants are performed each year, it is estimated that 25,000 people die
each year from chronic liver disorders, including many who are waiting for
a transplant.

     Advanced Tissue Sciences has demonstrated the ability to culture
enzymatically active animal and human liver cells (hepatocytes) in long-term
cultures.  The Company's system allows for the active growth of liver cells
which retain their ability to manufacture a variety of liver proteins and
enzymes required for normal hepatic function.  The Company has reported
successful engraftment and persistence of liver tissue implanted in various
regions in rats, including subcutaneous, intraperitoneal, and supra hepatic
sites.  In addition, the Company has conducted pilot preclinical trials that
involved implantation of engineered liver tissue into both small and large
animal models.  In these trials, the implants have functioned well for
approximately three months (the duration of the experiment).

     BONE MARROW.  Bone marrow is ultimately responsible for the production of
all of the body's blood and immune cells.  The Company believes that a universal
bone marrow cultured ex vivo could be used as a replacement in patients whose
bone marrow has been damaged or destroyed during radiation or chemotherapy
treatments.  The Company has successfully replicated animal and human bone
marrow and natural killer cells (a component of the immune system) and has
conducted pilot preclinical trials involving the infusion of replicated bone
marrow cells.  In addition, the Company has also grown and grafted bone marrow
cultures with high percentages of stem cells on biodegradable polymer scaffolds.

     GENE THERAPY.  During 1998, the Company received a U.S. patent covering
three-dimensional, tissue-engineered products made with genetically-modified
cells for gene therapy applications.  Under the technology described in the
patent, genetically-modified tissue can be grown on a biocompatible scaffold
using genetically-engineered stromal cells, genetically-engineered parenchymal
cells or both.  Genetically-modified tissue products may provide a safe unique
delivery vehicle for such indications as hemophilia (Factor VIII), short stature
(growth hormone), anemia (erythropoietin), cancer or cardiovascular disease.
Research utilizing this approach has shown expression of a genetically-
engineered protein for up to 150 days in vivo (inside the body).

     Tissue engineering may provide a safe and effective means of delivering
therapeutic proteins to patients using state of the art gene therapy techniques.
Delivering genes in three-dimensional tissue may allow long-term expression in
vivo by providing an environment for cells that is more similar to that found in
the body.  Obtaining long-term expression is one of the key technical hurdles
that the gene therapy industry is facing today.  Although gene therapy has 
been recognized as a revolutionary way to treat disease, progress has been 
slow due to the many challenges associated with gene delivery and in obtaining
long-term expression in vivo.

COLLABORATIONS AND STRATEGIC ALLIANCES

     The Company's strategy for the development, clinical testing, manufacture
and commercialization of certain of its proposed tissue replacement products
includes entering into various collaborations with corporate partners, licensees
and others from time to time.  The Company is currently involved in a number of
collaborative arrangements in connection with its product development
activities.

     SMITH & NEPHEW PLC.  In April 1996, the Company entered into an agreement
with Smith & Nephew to form a fifty-fifty joint venture for the worldwide
commercialization of Dermagraft, the Company's tissue-engineered dermal
replacement, for the treatment of diabetic foot ulcers (the "Dermagraft Joint
Venture").  Smith & Nephew is a worldwide healthcare company with extensive
sales and distribution capabilities.  It manufactures a wide range of tissue
repair products, principally addressing the areas of bone, joints, skin and
other soft tissue.  In January 

                                  13

<PAGE>

1998, the Company and Smith & Nephew expanded the Dermagraft Joint Venture to 
include, with certain exceptions, any products using the Company's technology 
for the medical care and treatment of skin tissue wounds, such as pressure 
and venous ulcers, burns and skin tissue defects.  The Dermagraft Joint 
Venture was further expanded in August giving Smith & Nephew the exclusive 
right to market TransCyte as a temporary covering for full and partial-
thickness burns in the United States, beginning in October 1998.  Under the 
terms of the Dermagraft Joint Venture agreements, Advanced Tissue Sciences 
is responsible for supervising the manufacturing of Dermagraft and TransCyte.
Smith & Nephew's existing wound care sales force and distribution network in 
over ninety countries is to be used to market the products.  See "Products - 
Burn Products" and "Products - Skin Ulcer Products."

     As consideration for entering into the Dermagraft Joint Venture, Advanced
Tissue Sciences received a $10 million up front fee in 1996.  In connection with
the 1998 expansion of the joint venture, Smith & Nephew made a $20 million
equity investment in the Company in January 1998.  The Company also received an
additional $15 million payment from Smith & Nephew, through the Dermagraft
Joint Venture, in January 1999 and could receive, subject to the achievement 
of certain milestones related to regulatory approvals, reimbursement and 
sales levels, additional payments of up to $136 million.  No assurance can be 
given that the Dermagraft Joint Venture or the Company will receive FDA 
approvals, obtain reimbursement or successfully commercialize such products.
Accordingly, there can be no assurance that the Company will receive any or 
all of these milestone payments.  See "Factors That May Affect Future Results."

     Advanced Tissue Sciences and Smith & Nephew will share equally in the
expenses and revenues of the Dermagraft Joint Venture except, as provided in the
expansion agreements, the Company will fund the first $6 million of expenses for
conducting clinical trials and for regulatory support of Dermagraft and
TransCyte in the treatment of venous and pressure ulcers.  In addition, the
Company will fund certain manufacturing and distribution costs and certain costs
related to post-market studies of TransCyte through December 1999.

     In 1994, Smith & Nephew and the Company entered into a separate fifty-fifty
joint venture for the worldwide development, manufacture and marketing of
human-based, tissue-engineered cartilage for orthopedic applications.  Under the
agreement, Smith & Nephew contributed the first $10 million in Cartilage Joint
Venture funding and the Company contributed certain technology licenses.  Joint
venture revenues and expenditures in excess of the first $10 million are being
shared equally by the partners.  In addition, the Company has been drawing
against a $10 million loan commitment from Smith & Nephew to fund the Company's
share of the joint venture's expenditures.  The Cartilage Joint Venture also has
the right of first negotiation to develop tissue-engineered bone, tendon and
ligament for orthopedic applications.  Advanced Tissue Sciences has retained all
rights to non-orthopedic cartilage applications.

     Under the terms of the Cartilage Joint Venture agreement, Advanced Tissue
Sciences will be responsible for supervising the manufacturing of the cartilage
tissue products.  The Cartilage Joint Venture will execute the research and
development program, develop a worldwide marketing plan, and will utilize Smith
& Nephew's established selling and distribution network to market the products.
Smith & Nephew Endoscopy, a world leader in arthroscopy, is separately
responsible for developing and manufacturing instrumentation that could be used
for the arthroscopic insertion of the joint venture's cartilage products.  The
Cartilage Joint Venture's initial product development efforts are being focused
on the repair or replacement of damaged articular and meniscus cartilage in knee
joints.  See "Products - Orthopedic Products."

     MASSACHUSETTS INSTITUTE OF TECHNOLOGY/CHILDREN'S HOSPITAL IN BOSTON.  In
connection with an acquisition in September 1992, the Company entered into
sponsored research and license agreements with MIT and Children's Hospital.
Under the research agreement, the Company sponsored a minimum of $1 million a
year for early stage research conducted at MIT and Children's Hospital from 1993
through 1997.  Although the Company substantially reduced its commitment to MIT
and Children's Hospital in 1998, under the license agreement, the Company
continues to have rights to certain MIT and Children's Hospital patents and
technology which relate to tissue engineering, organ transplantation and polymer
science.  To retain these rights, the Company will be required to meet certain
diligence requirements with respect to advancing the licensed technology.  The
Company also remains responsible for associated patent application costs and
related maintenance fees.

                                  14

<PAGE>

     GEORGIA TECH.  Georgia Tech is recognized as having a leading academic
program in biomedical engineering.  In 1997, the Company entered into a
one-year research agreement providing for the investigation of the effect of
fluid flow on chondrocyte metabolism.  In 1998, the Company entered into
additional research collaborations with Georgia Tech relating to the study of
bioreactor fluid mechanics.  Georgia Tech has also collaborated with the 
Company on its cardiovascular program, performing biomechanical property 
tests of bioengineered vascular grafts as compared to native coronary vessels.
The relationship between the Company and Georgia Tech is further strengthened 
by the Company's participation in an internship program for students in the 
Bioengineering Program at Georgia Tech.  The Company is also an active member 
of the Georgia Tech Educational Partners Program.

     UNIVERSITY OF CALIFORNIA, SAN DIEGO.  In October 1997, Advanced Tissue
Sciences was awarded an Advanced Technology Program grant from the National
Institute of Standards and Technology to develop tissue-engineered vascular
grafts for the treatment of coronary and peripheral artery vascular diseases.
The grant proposal was submitted in collaboration with the Department of
Bioengineering at University of California, San Diego.  Under the award, the
Company is leading a multi-disciplinary effort in collaboration with the UCSD
Bioengineering Department to design, construct and evaluate tissue-engineered
vascular grafts produced from cells grown on a biocompatible scaffold.  The
collaboration will integrate current advances in cellular mechanics, bioreactor
technology, and blood vessel mechanics to create unique living tissue
replacements for blood vessels.

SALES AND MARKETING

     TransCyte was approved in the United States for use as a temporary covering
for excised full-thickness burns in March 1997 and for use in partial-thickness
burns in October 1997.  Prior to October 1998, TransCyte was marketed through
the Company's direct sales force in the United States where the markets are
relatively concentrated in specialized burn centers.  Eighty of the
approximately 140 specialized burn centers in the United States treat
approximately seventy-five percent of all burn patients.  TransCyte has also
been approved in Canada and is being introduced in several European countries
including the United Kingdom for severe and partial-thickness burns.  In October
1998, the Company eliminated its direct sales force and TransCyte is now being
marketed for burns in the United States, Canada and in the rest of the
world, subject to regulatory approvals, through the Dermagraft Joint Venture by
Smith & Nephew.  See "Collaborations and Strategic Alliances - Smith & Nephew
plc."

     It is estimated that there are approximately 800,000 diabetic foot ulcer
patients treated each year in the United States.  More than half of those ulcer
patients are believed to be treated by podiatrists, with approximately ten
percent of all podiatrists accounting for the treatment of over forty percent of
these patients.  Subject to regulatory approvals, Dermagraft for diabetic foot
ulcers will be marketed through the Dermagraft Joint Venture by Smith & Nephew.
Dermagraft is currently being marketed through the Dermagraft Joint Venture by
Smith & Nephew in Canada, the United Kingdom and several other European
countries.  See "Collaborations and Strategic Alliances - Smith & Nephew plc."

     The Company has collected health economics data with respect to the
treatment of diabetic foot ulcers throughout the pivotal clinical trial.
Utilizing the data collected from the trial, economic models for each key
country have been completed or are being prepared to support the commercial
introduction of Dermagraft.  The Company believes that doctors and third party
payors recognize the high cost of treating diabetic foot ulcers, and the
Dermagraft Joint Venture intends to price Dermagraft to be cost effective to the
customer.

RESEARCH AND DEVELOPMENT

     The Company has invested a substantial portion of its resources into
research related to the Company's core technology, the development and clinical
trials of products related to such technology, and the development of
manufacturing systems and processes.  The Company has incurred research and
development costs of $14,398,000, $17,984,000 and $23,699,000 in the years ended
December 31, 1998, 1997 and 1996, respectively, of which approximately
$8,509,000, $10,975,000 and $3,564,000 represent costs incurred for customer
sponsored research.  The Company expects to continue to incur substantial
research and development costs related to its core technology, clinical trials
of products related to such technology and the development of manufacturing
processes and systems.

                                  15

<PAGE>

     The Company has established its own research and development laboratory
facilities, is collaborating with academic and medical institutions, and has
entered into agreements with several other companies and institutions to assist
in developing its technology.  In the event the Company is unable to obtain or
maintain these arrangements, the Company may need to expand its own facilities
for research and development, and clinical testing.  The Company may also 
enter into additional arrangements with third parties for certain proposed 
applications of its technology; however, there can be no assurance that such 
arrangements can be obtained.  The failure to obtain or maintain such 
arrangements on desirable terms could have an adverse impact on the Company.

EMPLOYEES

     As of March 4, 1999, the Company employed 207 people, of whom 64 were
engaged in research and development, 102 in operations, and 41 in marketing and
administrative functions.  The Company's staff includes twenty-one employees
with Ph.D. or M.D. degrees.  None of the Company's employees are represented by
a labor union, and the Company believes that its employee relations are good.

FACTORS THAT MAY AFFECT FUTURE RESULTS

     THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS THAT
INVOLVE RISKS AND UNCERTAINTIES.  SUCH STATEMENTS INCLUDE, BUT ARE NOT LIMITED
TO, STATEMENTS CONTAINING THE WORDS "BELIEVES", "ANTICIPATES," "EXPECTS,"
"ESTIMATES" AND WORDS OF SIMILAR IMPORT.  THE COMPANY'S ACTUAL RESULTS COULD
DIFFER MATERIALLY FROM ANY FORWARD-LOOKING STATEMENTS, WHICH REFLECT
MANAGEMENT'S OPINIONS ONLY AS OF THE DATE HEREOF, AS A RESULT OF SUCH RISKS AND
UNCERTAINTIES.  THE COMPANY UNDERTAKES NO OBLIGATION TO REVISE OR PUBLICLY
RELEASE THE RESULTS OF ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS.
READERS SHOULD CAREFULLY REVIEW THE RISK FACTORS SET FORTH BELOW AND IN OTHER
DOCUMENTS THE COMPANY FILES FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE
COMMISSION, INCLUDING ITS QUARTERLY REPORTS ON FORM 10-Q.

UNCERTAINTY OF MARKET ACCEPTANCE

     The Company believes that its profitability and growth over the next
several years will depend in large part upon broad market acceptance of
Dermagraft for the treatment of diabetic foot ulcers and, to a lesser extent, of
TransCyte in the United States and key international markets targeted by Smith &
Nephew.  Early in 1998, an FDA Advisory Panel recommended approval of the
Company's PMA application for Dermagraft in the treatment of diabetic foot
ulcers subject to certain conditions to be satisfied after the Company's
commercial introduction of such product in the United States.  However, in June
1998, the FDA requested that an additional controlled clinical trial be
completed in support of its PMA application for Dermagraft in the treatment of
diabetic foot ulcers.  The Company is currently conducting this additional U.S.
pivotal clinical trial of Dermagraft in the treatment of diabetic foot ulcers.
Commercial introduction within the United States is still subject to successful
completion of the additional trial and approval of the Company's PMA application
by the FDA.  (See "Government Regulation.")  The Company has received FDA
approval to market TransCyte and has been marketing that product since March
1997.  Accordingly, the commercial acceptance of Dermagraft for the treatment of
diabetic foot ulcers has yet to be tested in the United States and both
Dermagraft and TransCyte have been marketed and sold by the Dermagraft Joint
Venture for a limited period of time.

     Each of these products is based on new and innovative technologies and
there can be no assurance that such products will be broadly accepted by either
the medical community or the general population as alternatives to existing
methods of treatment.  The acceptance of the Company's products may be adversely
affected by their respective cost, concerns related to efficacy, the
effectiveness of alternative methods of treatment and the insufficiency of
third-party reimbursement.  Any future reported adverse events or other
unfavorable publicity involving patient outcomes from use of the Company's
products could also adversely affect acceptance of such products.  The Company
has limited direct experience marketing or obtaining third-party reimbursement
for its products.

     In addition, the Company will have to rely on Smith & Nephew or on
arrangements with others to market its products domestically and
internationally.  Moreover, in the near term, the Company's success in
generating initial market acceptance of Dermagraft will depend in large part on
the marketing efforts of Smith & Nephew.  The Company cannot control the amount
and timing of resources that Smith & Nephew may devote to marketing and selling
the Company's skin products, and there can be no assurance that Smith & Nephew
will perform its 

                                  16

<PAGE>

obligations under the Dermagraft Joint Venture as expected.  The failure of 
the Company to achieve broad acceptance of Dermagraft for the treatment of 
diabetic foot ulcers and, to a lesser extent, TransCyte for burn care, would 
have a material adverse effect on the Company's business, financial
condition and results of operations.

ABSENCE OF PROFITABLE OPERATIONS; NEED FOR ADDITIONAL FUNDS

     To date, the Company has experienced significant operating losses in
funding the research, development, testing and marketing of its products and
expects to continue to incur substantial operating losses.  The Company has
incurred cumulative net operating losses of $218.5 million through December 31,
1998.  The Company's ability to achieve profitability depends in part upon its
ability, either independently or in collaboration with Smith & Nephew, to
successfully manufacture and market Dermagraft and TransCyte for skin ulcers and
burns.  There can be no assurance that the Company will ever achieve a
profitable level of operations or that profitability, if achieved, can be
sustained on an ongoing basis.

     The further development of the Company's technology and products as well as
any further development of manufacturing capabilities or the establishment of
any additional sales, marketing and distribution capabilities will require the
commitment of substantial funds.  While the Company believes that its existing
working capital, the milestone payments under the expanded Dermagraft Joint
Venture, its borrowing capacity under the Cartilage Joint Venture, and its
access to funds under an equity line will be sufficient to meet its present
operating and capital requirements for at least the next twelve months, the
Company may ultimately need to raise additional funds to support its long-term
product development and commercialization programs.  The Company could acquire
such additional funding through collaborative arrangements, the extension of
existing arrangements, additional public or private offerings of debt or equity
securities or other means.

     There can be no assurance that the Company will satisfy the milestones for
additional funds under the Dermagraft or Cartilage Joint Ventures or that
adequate funds will be available under other existing or future arrangements
when such funds are needed or, if available, on terms acceptable to the Company.
In certain circumstances, funds under the Company's equity line could be 
limited or, in some cases, completely unavailable.  Any drawing by the Company 
under the equity line may not exceed $15 million and, in any event, the 
investor group may, in its sole disrection, refuse to fund any drawing if such 
drawing, when aggregated with other drawings within the preceding three months 
and other Company securities held by the investor group, would result in the
investor group owning more than 4.9% of the outstanding shares of Common
Stock.  Any shares sold under the equity line will be sold at a 5% discount to
the average low trading price of the Company's Common Stock over a
specified period as determined by market volume.  A drawing cannot be made
during the pricing period for an earlier drawing under the equity line.  In
addition, the Company may not effect a drawing under the equity line if the
Common Stock is trading at less than $2 per share, trading of the Common
Stock on the Nasdaq National Market has been suspended or the Common Stock
has been delisted from the Nasdaq National Market, or there is not in effect
a registration statement under the Securities Act of 1933 covering the
issuance and resale of the Common Stock to be issued pursuant to the
drawing.

     Insufficient funds may require the Company to delay, scale back or 
eliminate certain of its research and product development programs or to 
license third parties the right to commercialize products or technologies 
that the Company would otherwise commercialize itself.  See "Management's 
Discussion and Analysis of Financial Condition and Results of Operations - 
Liquidity and Capital Resources."

UNCERTAINTY OF COLLABORATIVE ARRANGEMENTS AND STRATEGIC ALLIANCES

     The Company is particularly dependent on Smith & Nephew with respect to the
Dermagraft and the Cartilage Joint Ventures.  Although the Company believes that
Smith & Nephew has a significant economic motivation to succeed in performing
its contractual responsibilities under the Dermagraft and Cartilage Joint
Venture agreements, the amount and timing of resources to be devoted to such
performance are not within the control of the Company, and there can be no
assurance that Smith & Nephew will perform its obligations as expected.
Moreover, the Dermagraft and Cartilage Joint Ventures would be materially and
adversely affected if Smith & Nephew had a strategic shift in its business
focus.  In addition, the Dermagraft and Cartilage Joint Venture agreements
provide that they may be terminated prior to their expiration under certain
circumstances that are outside the control of the Company.  A termination of
such agreements, or a failure of Smith & 

                                  17

<PAGE>

Nephew to adequately perform its obligations thereunder, would have a material 
adverse effect on the Company's ability to successfully complete the develop-
ment and testing of the products covered thereby and to successfully penetrate 
the markets for such products.  Any such event could have a material adverse 
effect on the Company's business, financial condition and results of operations.

     The Company continually seeks and considers collaborative arrangements to
obtain funding for the development of its products.  Such arrangements may
involve the issuance of additional equity or debt securities and marketing
rights to the funding party.  The Company may seek collaborative arrangements
and separate funding for its programs which may include joint ventures, third
party equity investments or other financing structures.  There can be no
assurance however that the Company will be able to negotiate additional
collaborative arrangements in the future on acceptable terms, if at all, or that
such collaborative arrangements will be successful.  To the extent that the
Company chooses not to or is unable to establish such arrangements, it would
experience increased capital requirements to undertake research, development and
marketing of its proposed products at its own expense.  In addition, the Company
may encounter significant delays in introducing its proposed products into
certain markets or find that the development, manufacture or sale of its
proposed products in such markets is adversely affected by the absence of such
collaborative agreements.

STAGE OF PRODUCT DEVELOPMENT

     Although TransCyte has been approved for commercial sale and clinical
trials are underway using Dermagraft for the treatment of diabetic foot ulcers
and venous ulcers, the remainder of the Company's other products are at earlier
stages of research, development and testing.  These products will require
significant additional research and development, including extensive preclinical
and clinical testing, and regulatory approvals prior to commercialization.  In
addition, upon completion of the additional Dermagraft clinical trial, there can
be no assurance that FDA will approve the marketing of Dermagraft.  See
"Government Regulation."

     All of the Company's products are subject to the risks of failure inherent
in the development of products based on innovative technologies.  Such risks
include the possibilities that any or all of these products are found to be
unsafe or ineffective or otherwise fail to receive necessary regulatory
approvals, that products are uneconomical to market, that third parties may hold
proprietary rights that preclude the Company from marketing its products, or
that the Company's products fail to achieve market acceptance in light of
competing technologies and products.  See "Patents and Proprietary Rights."

UNCERTAINTIES REGARDING HEALTHCARE REIMBURSEMENT AND REFORM

     The Company's ability to commercialize products successfully may depend in
part on the extent to which reimbursement for the costs of such products and
related treatments will be available from government health administration
authorities, private health insurers and other organizations.  In the United
States, government and other third-party payors are increasingly attempting to
contain healthcare costs by limiting both coverage and the level of
reimbursement for new products approved for marketing by the FDA, and by
refusing, in some cases, to provide any coverage for uses of approved products
for indications for which the FDA has not granted marketing approval.
Initiatives to reform healthcare delivery are increasing these cost containment
efforts.  As managed care organizations continue to expand as a means of
containing healthcare costs, the Company believes there may be attempts by such
organizations to restrict the use of, delay authorization to use, or limit
coverage and the level of reimbursement for, new products, such as those being
developed and commercialized by the Company, pending completion of cost/benefit
analyses of such products by those managed care organizations.  Internationally,
where national healthcare systems are prevalent, little if any funding may be
available for new products, and cost containment and cost reduction efforts can
be more pronounced than in the United States.

     The Company has supported health economics studies and research and has
developed cost offset or cost-effectiveness models with respect to its TransCyte
and Dermagraft products in an effort to help obtain appropriate and adequate
third party coverage and reimbursement for these products.  However, these
products are novel and as such are subject to inherent uncertainty in the area
of reimbursement.  There can be no assurance that adequate government or private
payor coverage or levels of reimbursement will be available for any of the
Company's products or for the Company to maintain price levels sufficient for
the realization of an appropriate return on its investment in such products.
Failure to obtain sufficient coverage and reimbursement 

                                  18

<PAGE>

levels for uses of the Company's products could have a material adverse 
effect on the market acceptance of such products and the Company's business, 
financial condition and results of operations.

     In connection with its review of the PMA application for Dermagraft in the
treatment of diabetic foot ulcers, the FDA has approved the Company's
application for a Treatment Investigational Device Exemption (IDE).  The
Treatment IDE is a new regulatory provision for devices that permit companies to
make available promising new products under an agreed protocol to patients with
serious diseases for which there is no satisfactory alternative.  Under a
Treatment IDE, companies are allowed to recover manufacturing and distribution
costs.  There can be no assurance, however that the Company will be successful
in obtaining reimbursement, if any, under the Treatment IDE.

PRODUCT LIABILITY CLAIMS AND INSURANCE

     The use of any of the Company's products, whether for commercial
applications or during clinical trials, exposes the Company to an inherent risk
of product liability claims in the event such products cause injury, disease or
result in adverse effects.  Such liability might result from claims made
directly by healthcare institutions, contract laboratories or others selling 
or using such products.  The Company currently maintains product liability 
insurance coverage; however, there can be no assurance that the level or 
breadth of any insurance coverage will be sufficient to fully cover potential 
claims.  Such insurance can be expensive and difficult to obtain.  There can 
be no assurance that adequate insurance coverage will be available in the 
future at an acceptable cost, if at all, or in sufficient amounts to protect 
the Company against such liability.  The obligation to pay any product 
liability claim in excess of whatever insurance the Company is able to 
acquire could have a material adverse effect on the Company's business, 
financial condition and results of operations.

     The Company's tissue repair and transplantation products are complex and
must be manufactured under well-controlled and sterile conditions, in addition
to meeting strict product release criteria.  Any manufacturing errors or
defects, or uncorrected impurity or variation in a raw material, either unknown
or undetected by the Company, could affect the quality and safety of the
Company's products.  If any of the defects were material, the Company could be
required to undertake a market withdrawal or recall of the affected products.
There can be no assurance a product recall will not occur.  The cost of a market
withdrawal or product recall could be significant and could have a material
adverse effect on the Company's business, financial condition and results of
operations.

TECHNOLOGICAL CHANGE AND COMPETITION

     The biomedical technology industry is subject to rapid, unpredictable and
significant technological change.  Competition from universities, research
institutions and pharmaceutical, chemical and biotechnology companies is
intense.  Many competitors or potential competitors have greater financial
resources, research and development capabilities and manufacturing and marketing
experience than the Company.  In general, the first biomedical product to be
commercialized for a particular therapeutic indication is often at a significant
competitive advantage relative to later entrants to the market.  Accordingly,
the relative speed with which the Company can develop products, complete
clinical trials, obtain regulatory approvals and develop commercial
manufacturing capability may be determinative factors in establishing the
Company's competitive position.  The Company's ability to attract and retain
qualified scientific, manufacturing, marketing and other personnel, obtain and
maintain patent protection and secure funding are also expected to be key
competitive factors for the Company.

     In the field of tissue engineering and the treatment of damaged or diseased
tissue, the Company competes with several companies which are developing various
tissue replacement products, including skin substitutes and cultured cartilage.
In addition, the Company is aware of a number of biotechnology, pharmaceutical,
medical device and chemical companies that are developing other types of
products as alternatives to tissue replacement for a variety of indications,
including burns and chronic skin ulcers.  These treatments employ a variety of
approaches such as growth factors, tri-peptides and completely synthetic
materials.

     In the area of burns, the Company competes primarily with cadaver skin or
porcine tissue.  The Company is also aware of several companies that have
developed technologies involving processed cadaver skin used as a dermal
replacement (LifeCell Corporation), or sheets of epidermis grown from the
patient's own skin (Genzyme Tissue Repair and Cell Culture Technology).  Integra
Life Sciences ("Integra") is marketing Integra 

                                  19

<PAGE>

Artificial Skin, consisting of a bovine collagen and glycosaminoglycan matrix 
with a synthetic polymer covering, for the treatment of burn wounds.  In 
addition, the Company is aware that Ortec International, Inc. has completed a 
pilot clinical trial with its composite cultured skin product, consisting of 
fibroblasts and keratinocytes on a bovine collagen sponge, for the treatment 
of burn wounds.  Several other companies are also developing or plan to 
develop growth factors as a treatment for partial-thickness or small full-
thickness wounds.

     In the area of diabetic foot ulcers, Chiron Corporation and the
Ortho-McNeil division of Johnson & Johnson, have received FDA approval and are
marketing a platelet-derived growth factor ("PDGF") for the treatment of
diabetic foot ulcers.  In addition, Organogenesis, Inc. ("Organogenesis") has
completed clinical trials for the use of Apligraf, a product using cultured
human cells seeded onto a bovine collagen matrix, for the treatment of diabetic
foot ulcers.  Organogenesis received FDA approval to market Apligraf in the
treatment of venous ulcers in May 1998.  Organogenesis has also entered into an
alliance with Novartis Pharma AG for the marketing of Apligraf.

     With respect to cartilage repair, Genzyme Tissue Repair is currently
selling a service to process a patient's own cartilage cells as a treatment for
articular defects in the knee.  The Company is aware that Integra and Osiris
Therapeutics, Inc. are also engaged in research on cultured cartilage products.
The Company is not aware of any competitor that is developing an off-the-shelf,
human cartilage tissue that can be arthroscopically inserted.

     For all of its products, the Company expects to compete primarily on the
uniqueness of its technology and product features, on the quality and
cost-effectiveness of its products, and on the timing of commercial
introduction.  The Company believes that its tissue-engineered products may have
many attributes that differentiate it from other competitors, including the fact
that the Company's products are human-based tissue products designed to be
available "off-the-shelf" to the end-users.  However, other factors such as its
ability to secure regulatory approval for its products, to implement production
and marketing plans and to secure adequate capital resources, will also impact
its competitive position.  There can be no assurance that the Company will have
the resources to compete successfully with such companies or that competition
generally will not adversely affect the Company's results of operations or
ability to successfully market its products.

PATENTS AND PROPRIETARY RIGHTS

     The Company's ability to compete effectively will depend, in part, on its
ability to maintain the proprietary nature of its technology and manufacturing
processes.  The Company relies on patents, trademarks, trade secrets and
know-how to maintain its competitive position.  As of March 24, 1999, 
the Company owns thirty-one issued and five allowed patents in the United 
States.  In addition, twenty-eight foreign counterparts to some of the United 
States patents have issued in several foreign countries.  The United States 
patents expire at various times between 2005 and 2016.

     In October 1990, the Company received a United States patent on its core
technology.  This product patent covers three-dimensional living stromal tissue
produced by culturing stromal cells in vitro on a biocompatible framework.  The
stromal tissue provides the growth factors and structural proteins used in the
Company's three-dimensional matrix to grow organ tissues.  This patent expires
in October 2007.  In September 1995, the Company was granted a corresponding
patent by the European Patent Office covering a three-dimensional stromal tissue
and methods of use to grow skin, bone marrow and liver tissue.  The patent will
expire in April 2007.

     In November 1993, the Company received a United States patent relating to
Dermagraft, covering both three-dimensional dermal tissue and full-thickness
skin tissue cultured on living stromal tissue prepared in vitro and, in August
1995, received a United States patent covering the growth and implantation of
its Dermagraft dermal skin replacement.  These patents expire in November 2010
and August 2012, respectively.  In October 1995, a United States patent was
issued relating to TransCyte.  This product patent covers a variety of
transitional burn coverings that use a synthetic membrane with an attached
dermal component.  This patent will expire in October 2012.

     Two new U.S. patents were received in 1998.  In July 1998, the Company
received a U.S. patent covering three-dimensional tissue products made with
genetically-modified cells for gene therapy applications.  Under the technology
described in the patent, genetically-modified tissues can be grown on a
biocompatible scaffold 

                                  20

<PAGE>

using genetically-engineered stromal cells, genetically-engineered 
parenchymal cells or both.  The patent comprises both product and method of 
use claims.  This patent will expire in July 2015.  In December 1998,
the Company received a U.S. patent covering an apparatus for the growth and
packaging of three-dimensional tissue constructs.  The apparatus is presently
being used by the Company as a "bioreactor" for the automated production of
Dermagraft and TransCyte products.  This patent expires in December 2015.

     Furthermore, in June 1998, three U.S. patents covering the growth of
vascularized human tissues or organs on three-dimensional biocompatible,
biodegradable and non-biodegradable polymer scaffolds inside the body (in vivo)
were issued to the Massachusetts Institute of Technology and Children's
Hospital, Boston. These patents, which have been licensed to the Company for a
broad range of tissues and organs, complement Advanced Tissue Sciences' core
patents covering the growth of tissues outside the body (ex vivo).  The rights
to these patents extend until October 2013.

     The Company's other patents issued in the United States cover tissue-
engineered compositions, apparatus and methods for preparing same, and processes
for therapeutic applications and laboratory testing.  These patents expire
between 2005 and 2016.  The Company has additional United States and foreign
patent applications relating to its tissue engineering technology.  In addition,
the Company has certain licensing rights to United States and foreign patents
and patent applications filed by MIT related to cell growth and organ
regeneration and repair, and biodegradable polymers, subject to certain
limitations as to applicable tissues and fields of use, and by the University of
Florida related to a stem cell proliferation factor.

     There can be no assurance that any applications will result in issued
patents or that any current or future issued or licensed patents, trade secrets
or know-how will afford protection against competitors with similar technologies
or processes, or that any patents issued will not be infringed upon or designed
around by others.  In addition, there can be no assurance that others will not
independently develop proprietary technologies or processes which are the same
as or substantially equivalent to those of the Company.  The Company could also
incur substantial costs in defending itself in suits brought against it on such
patents or in bringing suits to protect the Company's patents or patents
licensed by the Company against infringement.  In addition to patent protection,
the Company relies on trade secrets, proprietary know-how and technological
advances which the Company seeks to protect in part by confidentiality
agreements with its collaborative partners, employees and consultants.  There
can be no assurance that these agreements will not be breached, that the Company
will have adequate remedies for any breach, or that the Company's trade secrets
will not otherwise become known or independently discovered by competitors.

GOVERNMENT REGULATION

     Regulation by governmental authorities in the United States and foreign
countries is a significant factor in the manufacture and marketing of the
Company's present and proposed products and in its ongoing research and product
development activities.  The Company's preclinical studies and clinical trials
and the manufacturing and marketing of its products are subject to extensive,
costly and rigorous regulation by various governmental authorities in the United
States and other countries.  Many of the Company's proposed products will
require regulatory approval prior to commercialization.  In particular, human
therapeutic products are subject to rigorous preclinical and clinical testing as
a condition of approval by the FDA and by similar authorities in foreign
countries.  The process of obtaining required regulatory approvals by the FDA
and other regulatory authorities often takes many years, is expensive and can
vary significantly based on the type, complexity and novelty of the product.
There can be no assurance that any products developed by the Company,
independently or in collaboration with others, will meet applicable regulatory
criteria to receive the required approvals for manufacturing and marketing.

     In the United States, the FDA regulates the clinical testing, manufacture,
distribution and promotion of medical devices, biologics and pharmaceuticals
pursuant to the Federal Food, Drug and Cosmetic Act (the "FDC Act") and
regulations promulgated thereunder.  The Company's TransCyte and Dermagraft
products and cartilage products are subject to regulation by the FDA as medical
devices.  The Company's other tissue replacement products, currently in various
stages of development, could be regulated as medical devices, biologic products
or pharmaceutical products.  Legislative and regulatory initiatives concerning
the regulation of tissue and organ transplants are ongoing and could possibly
affect the future regulation of the Company's tissue-engineered products.  It is
not possible at the present time to predict accurately either the time frame for

                                  21

<PAGE>

such action, or the ultimate effect that such initiatives could have, if any, on
the products under development by the Company.  Unlike PMA submissions for
medical devices, the FDA has no regulatory time limit within which it must
review and act upon submissions treated as biologics.  As a result, the time
period for final action often takes several years from submission, usually
exceeding that expected for a PMA application.

     To obtain FDA approval to market medical devices that are not substantially
equivalent to existing devices, the FDA requires proof of safety and efficacy in
human clinical trials performed under an Investigational Device Exemption (an
"IDE").  An IDE application must contain preclinical test data demonstrating the
safety of the product for human investigational use, information on
manufacturing processes and procedures, and proposed clinical protocols.  If the
IDE application is approved, human clinical trials may begin.  The results
obtained from these trials, if satisfactory, are accumulated and submitted to
the FDA in support of a PMA application.  Premarket approval or clearance from
the FDA is required before commercial distribution of medical devices can be
undertaken in the United States.

     The PMA application for a medical device must be supported by extensive
data, including preclinical and human clinical trial data, to prove the safety
and efficacy of the device, and information about the device and its components
including, among other things, manufacturing, labeling and promotion.  By
regulation, the FDA has 180 days to review a PMA application and during that
time an advisory committee may evaluate the application and provide
recommendations to the FDA.  While the FDA has responded to PMA applications
within the allotted time period, reviews more often occur over a significantly
protracted period, often twelve to thirty-six months, and a number of devices
for which a PMA application was submitted by other companies have never been
cleared for marketing.  The 180-day review time is often significantly exceeded,
as the FDA may need additional information or clarification of information
provided.  The FDA may also make a determination that, based on deficiencies in
the application or its interpretation of the information provided, additional
clinical trials are required.  The PMA process is lengthy and expensive and
there can be no assurance that such FDA approval will be obtained.

     If the FDA's evaluation of the PMA application is favorable, the FDA
typically issues a letter requiring the applicant's agreement to specific
conditions (e.g., changes in labeling) or specific additional information to
secure final approval of the PMA application.  Once the requirements are
satisfied, the FDA will issue a PMA for the approved indications, which can be
more limited than those originally sought by the manufacturer.  The PMA can
include post-approval conditions that the FDA believes necessary to ensure the
safety and effectiveness of the device, such as restrictions on labeling,
promotion, sale and distribution.  Failure to comply with the conditions of
approval can result in adverse enforcement action, including the loss or
withdrawal of the approval.  Even after approval of a PMA, a new PMA or PMA
supplement is required in the event of a modification to the device, its
labeling or its manufacturing process.

     In addition, FDA regulations obligate a manufacturer to inform the FDA
whenever there is reasonable evidence to suggest that one of its devices may
have caused or contributed to death or serious injury, or where one of its
devices malfunctions and, if the malfunction were to recur, the device would be
likely to cause or contribute to a death or serious injury.

     In December 1996, the Company submitted a PMA application requesting
approval of Dermagraft for the treatment of diabetic foot ulcers.  In February
1997, the FDA accepted the application for filing.  The PMA submission was based
on the results of a pivotal trial from patients receiving Dermagraft within a
therapeutic range identified retrospectively from the clinical trial.  Patients
receiving Dermagraft within the therapeutic range represented a majority but not
all the evaluable patients in the trial.  The Company believes the data from
patients receiving Dermagraft within the therapeutic range demonstrate a
statistically significant improvement in complete healing at twelve and
thirty-two weeks.  For all evaluable patients, although statistical significance
was not seen at twelve weeks in the pivotal clinical trial, a statistically
significant improvement in complete healing as compared to the control treatment
was seen at thirty-two weeks.

     In January 1998, the General and Plastic Surgery Devices Panel of the
Medical Devices Advisory Committee to the FDA recommended that the FDA approve
Dermagraft for the treatment of diabetic foot ulcers in the United States, with
the conditions that the Company perform a post-marketing study to confirm
product efficacy at twelve weeks and provide physician training.  During the
advisory panel meeting, certain panel members and representatives of the FDA
raised questions and concerns regarding the use and nature of the 

                                  22

<PAGE>

retrospective analyses performed by the Company in identifying the therapeutic 
range.  Nevertheless, the advisory panel recommended approval of the product by
a vote of seven to two (one of the dissenting panel members voted against the
recommendation on the grounds that a post-marketing study was too burdensome).

     After the advisory panel meeting, the FDA continued to raise concerns about
approving the PMA application based on the Company's retrospective efficacy
analysis of the twelve week data and the use of a post-marketing study to
confirm efficacy at twelve weeks.  In June 1998, the FDA indicated the PMA
application was not approvable without supportive data from an additional
clinical trial.  The Company is currently conducting the additional clinical 
trial of Dermagraft in the treatment of diabetic foot ulcers as requested by 
the FDA.  See "Products - Skin Ulcer Products - Diabetic Foot Ulcers."

     The Company has constructed a commercial manufacturing facility for its
TransCyte and Dermagraft products.  This facility must be registered, inspected,
and licensed by various regulatory authorities, including the California
Department of Health and Human Services, and must comply with FDA's QSR,
which elaborates testing, control, documentation and other quality assurance 
procedures.  The manufacturing facility was initially inspected and found to 
be satisfactory by the FDA in 1996, prior to the approval of TransCyte for 
the treatment of full-thickness burns.

     Following an inspection of the manufacturing facility early in 1998 in
conjunction with the Company's PMA application for the approval of Dermagraft
for the treatment of diabetic foot ulcers, the FDA notified the Company of
numerous objectionable conditions under a Form FDA 483 list of observations with
respect to the Company's manufacturing processes and systems for Dermagraft and
TransCyte.  In March 1998, the FDA issued a warning letter requiring the Company
to investigate and correct the conditions identified by the FDA.  Specifically,
the warning letter required the Company to address objectionable conditions with
respect to (i) the control of environmental conditions, (ii) procedures for
implementing corrective and preventive actions, (iii) procedures for acceptance
of products, (iv) investigations of complaints, (v) compliance with medical
device reporting regulations, and (vi) justification of extended expiration
dates.  In September 1998, the Company successfully completed a reinspection by
the FDA of its manufacturing facility and quality systems for compliance with
QSR and other applicable regulations.

     In general, if as a result of FDA inspections, adverse event reports or
information derived from any other source, the FDA believes the Company is not
in compliance with laws or regulations or that the Company's products pose a
significant health risk, the FDA can refuse to approve pending PMA applications;
withdraw previously approved PMA applications; require notification to users
regarding risks; request corrective labeling, promotional or advertising
materials; issue warning letters; require the Company to temporarily suspend
marketing or undertake product recalls; impose civil penalties; or institute
legal proceedings to detain or seize products, enjoin future violations, or seek
criminal penalties against the Company, its officers or employees.  Civil
penalties may not be imposed for QSR violations unless the violations involve a
significant or knowing departure from the requirements of the FDC Act or a risk
to public health.  The FDA provides manufacturers with an opportunity to be
heard prior to the assessment of civil penalties.  If civil penalties are
assessed, judicial review is available.

     With respect to the manufacture of products for which premarket approval is
granted, the Company will be subject to routine inspection by the FDA and
certain state agencies, including the California Department of Health and Human
Services, for compliance with QSR requirements, adverse event reporting
requirements, and other applicable regulations.  In addition, Congress has
approved the Food and Drug Administration Modernization Act of 1997 (the
"Modernization Act").  The Modernization Act makes changes to the device
provisions of the FDC Act and other provisions in the Modernization Act affect
the regulation of devices.  Among other things, the changes will affect the IDE
and PMA processes, and also will affect device standards and data requirements,
procedures relating to humanitarian and breakthrough devices, tracking and
post-market surveillance, accredited third party review, and the dissemination
of off label information.  The Company cannot predict how or when these changes
will be implemented or what effect the changes will have on the regulation of
the Company's products.  There can be no assurance that the Company will not
incur significant costs to comply with laws and regulations in the future or
that laws and regulations will not have a material adverse effect upon the
Company's business, financial condition or results of operations.

                                  23

<PAGE>

     Although the FDA has classified TransCyte as a medical device, the State of
California and the State of New York have notified the Company that it must
register as a tissue bank in order to manufacture or distribute TransCyte in
those states.  Although many states do not regulate tissue banks, there are
certain other states besides California and New York that do.  Such states could
take a position similar to California and New York with regard to the regulatory
status of TransCyte.  In June 1997, the Company submitted a request to the FDA
for an advisory opinion that the FDA's regulation of this product as a medical
device preempts New York from regulating it as human tissue under a different
licensing scheme.  Both New York and California have provided written
submissions to the FDA urging the agency to deny the Company's request.  To
date, the FDA has not ruled.  If states are permitted to regulate TransCyte as a
human tissue, the Company and its customers could be subjected to a costly new
layer of regulation.  In addition, under the laws of some states that regulate
tissue, including New York and Florida, the sale of human tissues for valuable
consideration is prohibited.  The Company is currently distributing TransCyte in
the State of New York under a provisional tissue banking license.  Due to the
similarities of the products, regulations applicable to TransCyte are also
expected to apply to the Company's Dermagraft product as well.

     Whether regulated by the FDA as a medical device or biologic, or otherwise
by any state or foreign authorities, the approval process for all of the
Company's products is expensive and time consuming and no assurance can be given
that the FDA or any regulatory agency will grant its approval.  The inability to
obtain, or delays in obtaining, such approvals would adversely affect the
Company's ability to commence marketing therapeutic applications of its
technology.  There is no assurance that the Company will have sufficient
resources to complete the required testing and regulatory review processes.
Furthermore, the Company is unable to predict the extent of adverse governmental
regulation which might arise from future United States or foreign legislative or
administrative action.  In addition, any products distributed by the Company
pursuant to the above authorizations are subject to pervasive and continuing
regulation by the FDA.  Labeling and promotional activities are subject to
scrutiny by the FDA and, in certain instances, by the Federal Trade Commission.

     The Company's research and development activities and operations involve
the controlled use of small quantities of radioactive compounds, chemical
solvents and other hazardous materials.  In addition, the Company's business
involves the growth of human tissues.  Although the Company believes that its
safety procedures for handling and disposing of such materials comply with the
standards prescribed by federal, state and local regulations, the risk of
accidental contamination or injury from these materials cannot be completely
eliminated.  In the event of such an accident, the Company could be held liable
for any damages that result and any liability could have a material adverse
effect on the Company's business, financial condition and results of operations.
The Company is also subject to various federal, state and local laws,
regulations and recommendations relating to such matters as safe working
conditions, laboratory and manufacturing practices.  Although the Company
believes it is in compliance with these laws and regulations in all material
respects, there can be no assurance that the Company will not be required to
incur significant costs to comply with such laws or regulations in the future.

DEPENDENCE ON KEY PERSONNEL

     The Company's success will depend in large part upon its ability to attract
and retain qualified scientific, administrative and management personnel as well
as the continued contributions of its existing senior management and scientific
and technical personnel.  The Company faces strong competition for such
personnel and there can be no assurance that the Company will be able to attract
or retain such individuals.  In particular, the loss of the services of either
Arthur J. Benvenuto, the Company's Chairman and Chief Executive Officer, or Dr.
Gail K. Naughton, its President and Chief Operating Officer, would have a
material adverse effect on the Company.

DEPENDENCE ON CERTAIN SUPPLIERS

     Although most of the raw materials used in the manufacture of the Company's
Dermagraft products are available from more than one supplier, changes in
certain critical components could cause the FDA to require the Company to prove
equivalency of the materials or potentially to modify or perform additional
clinical trials for its Dermagraft and TransCyte products, which could have 
the effect of restricting product available for sale.  To date, the Company 
has not experienced difficulty in obtaining necessary raw materials.

                                  24

<PAGE>

     The mesh framework used by the Company in Dermagraft is available under a
supply agreement with only one FDA-approved manufacturing source.  Similarly,
the synthetic mesh framework used by the Company in TransCyte is only available
under a supply agreement with a different FDA-approved manufacturing source.
Because the FDA approval process requires manufacturers to specify their
proposed suppliers of active ingredients and certain component parts and
packaging materials in their applications, FDA approval of a new supplier would
be required if these materials become unavailable from the current supplier.

     Although the Company has not experienced difficulty acquiring these
materials for the manufacture of its Dermagraft and TransCyte products, no
assurance can be given that interruptions in supplies will not occur in the
future or that the Company would not have to obtain substitute vendors for these
materials.  Any significant supply interruption would adversely affect the
Company's clinical trials as well as its product development and marketing
programs.  In addition, an uncorrected impurity or supplier's variation in a raw
material, either unknown to the Company or incompatible with the Company's
manufacturing process, could have a material adverse effect on the Company's
ability to manufacture products.

POSSIBLE VOLATILITY OF STOCK PRICE

     The market price of the Company's Common Stock, like that of the securities
of other biotechnology companies, has fluctuated significantly in recent years
and is likely to fluctuate in the future.  From time to time, the market for
securities of biotechnology companies has in fact experienced significant price
and volume fluctuations that are unrelated to the operating performance of such
companies.  In addition, announcements by the Company or others regarding
scientific discoveries, technological innovations, commercial products, patents
or proprietary rights, the progress of clinical trials or government regulation,
public concern as to the safety of devices or drugs, the issuance of securities
analysts' reports and general market conditions may all have a significant
effect on the market price of the Common Stock.  Fluctuations in financial
performance from period to period also may have a significant impact on the
market price of the Common Stock.

YEAR 2000 COMPLIANCE

     The Year 2000 ("Y2K") issue is a situation that results from computer
systems and software products being coded using two digits rather than four to
define the applicable year.  The Company's computer systems and software
products utilize embedded technology that is time-sensitive and may recognize 
a date as the year 1900 rather than the year 2000 which could cause computer 
system failures and errors leading to a disruption of business operations.

     The Company has substantially completed the process of evaluating its
information systems, equipment and significant vendor relationships considered
critical to the Company's operations and which could be affected by the Y2K
issue.  Although its assessment of its Y2K issues is not complete, Advanced
Tissue Sciences believes that its internal systems are Y2K compliant or will be
replaced or upgraded to comply with Y2K requirements.

     To date, the Company has not identified any Y2K issues that will require a
significant investment to be made by the Company to resolve; however, it is not
possible to predict with any certainty that (i) the Company will identify all
significant Y2K issues which could be material to its operations, (ii)
significant vendors will not be affected by Y2K problems and therefore may be
unable to meet their commitments to the Company, (iii) the Company will not
identify Y2K issues that result in material costs to the Company, or (iv) the
Company will be able to adequately resolve or develop satisfactory contingency
plans for identified Y2K issues.  See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

     The foregoing Y2K discussion contains forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995.  Such
statements, including, without limitation, estimated costs and timelines to
complete certain actions, are based on management's best current estimates,
which were derived utilizing numerous assumptions about future events, including
the continued availability of certain resources, representations received from
third parties and other factors.  However, there can be no guarantee that these
estimates will be achieved, and actual results could differ materially from
those anticipated.  Specific factors that might cause such material differences
include, but are not limited to, the ability to identify and remediate all
relevant Y2K issues, results of Y2K testing, adequate resolution of Y2K issues
by third-party vendors and 

                                  25

<PAGE>

suppliers of goods and services to the Company, unanticipated system costs, 
the adequacy of and ability to develop and implement contingency plans and 
similar uncertainties.

ITEM 2.  PROPERTIES

     The Company leases approximately 85,000 square feet of space at its
headquarters facility, of which approximately 89% is allocated to manufacturing
and research.  The leases for this facility expire in September 2000, subject to
an option to renew for an additional five years.  In addition, the Company
leases approximately 6,900 square feet of manufacturing and research space under
a five-year lease that expires in 2002.  The Company also leases approximately
36,000 square feet which is used for both research and administration.  This
lease expired and converted to a month-to-month agreement in January 1999.  In
1997, the Company executed a 15-year operating lease agreement, which commenced
in November 1998 with the completion of a new 104,000 square foot research and
administration building.  The Company is currently evaluating its space
requirements and expects to terminate or sublease a significant portion of its
leased facilities, to the extent feasible.  The Company's facilities are all
located in San Diego, California.

     The Company believes that its property and equipment are generally well
maintained, in good operating condition and, as noted above, exceed its current
needs.

ITEM 3.  LEGAL PROCEEDINGS

     In June 1998, several shareholders filed lawsuits against the Company 
and two of its officers in the United States District Court for the Southern 
District of California.  The lawsuits allege violations of the federal 
securities laws, and purport to seek damages on behalf of a class of share-
holders who purchased Advanced Tissue Sciences, Inc. Common Stock during the 
period from January 13, 1997 through June 11, 1998.  In October 1998, the
Court appointed lead plaintiffs and, following several extensions of time,
plaintiffs are scheduled to file a consolidated complaint by March 31, 1999.
The Company will have forty-five days from the filing of the consolidated
complaint to file a responsive pleading.  The Company believes that the 
lawsuits are without merit and intends to defend against them vigorously.
In addition, the Company believes the ultimate resolution will not have a
material adverse impact on the Company's financial condition, results of
operations or liquidity.  However, there can be no assurance that an adverse
result would not have a material adverse effect on the Company.  See Note 11 
to the Company's consolidated financial statement on page F-19.  There is no 
other material litigation pending against the Company.

     In October 1998, the Court appointed lead plaintiffs and, following
several extensions of time, plaintiffs are scheduled to file a consolidated
complaint by March 31, 1999.  The Company will have forty-five days from
the filing of the consolidated complaint to file a responsive pleading.

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

     The Company held a Special Meeting of Stockholders of Advanced Tissue
Sciences, Inc. on February 16, 1999, such meeting having been adjourned from
January 27, 1999 in order to obtain a quorum.  During the Special Meeting
stockholders approved the following proposals:

     (1)  the issuance by the Company of shares of Common Stock upon conversion
          of, or as dividends on, its Series B Convertible Preferred Stock with
          19,692,798 shares in favor of the Proposal, 2,073,611 shares opposed 
          and 402,569 shares abstaining; and
     (2)  an amendment to the Company's Restated Certificate of Incorporation to
          increase the number of authorized shares of Common Stock, $.01 par 
          value per share, from 100,000,000 shares to 125,000,000 shares with 
          20,180,812 shares in favor of the Proposal, 2,233,714 shares opposed 
          and 361,432 shares abstaining.

                                  26

<PAGE>

                                     PART II

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

MARKET INFORMATION

     The Company's Common Stock is traded on the National Association of
Securities Dealers Automated Quotation ("Nasdaq") National Market under the
symbol ATIS.  The last reported high and low sales prices as reported for the
Company's Common Stock by Nasdaq for the last two fiscal years are set forth
below.


                                                 HIGH          LOW
                                               --------      -------
     YEAR ENDED DECEMBER 31, 1998:
       First Quarter                           $ 15.63       $ 9.13
       Second Quarter                            11.38         3.50
       Third Quarter                              5.25         1.75
       Fourth Quarter                             4.09         2.03

     YEAR ENDED DECEMBER 31, 1997:
       First Quarter                           $ 14.75       $ 9.88
       Second Quarter                            13.50        10.00
       Third Quarter                             18.50        11.63
       Fourth Quarter                            18.44        11.50

HOLDERS

     As of December 31, 1998, there were 1,441 holders of record of the 
Company's Common Stock.

DIVIDENDS

     The Company has never paid cash dividends on its Common Stock and does 
not expect to pay any cash dividends in the foreseeable future.

ITEM 6.  SELECTED FINANCIAL DATA

     The selected financial data of the Company appears in a separate section of
this Annual Report on Form 10-K on page F-1.

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

     Management's discussion and analysis of financial condition and results of
operations appears in a separate section of this Annual Report on Form 10-K
beginning on page F-2.

ITEM 7A.  MARKET RISK

     Information concerning market risk relating to the Company's financial
instruments is presented in management's discussion and analysis of financial
condition and results of operations beginning on page F-2 of this Annual Report
on Form 10-K.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The Company's financial statements and schedules, as listed under Item 14,
appear in a separate section of this Annual Report on Form 10-K beginning on
page F-9.

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

     During the two years prior to the date of the most recent financial
statements and the subsequent interim period, the Company has not had a change
in its independent auditors nor have there been any disagreements between the
Company and its independent auditors.

                                  27

<PAGE>

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The sections titled "Directors and Nominees" and "Executive Officers"
appearing in the Company's Proxy Statement for the 1999 Annual Meeting of
Stockholders are incorporated herein by reference.

ITEM 11.  EXECUTIVE COMPENSATION

     The section titled "Executive Compensation" appearing in the Company's
Proxy Statement for the 1999 Annual Meeting of Stockholders is incorporated
herein by reference.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The section titled "Principal Stockholders" appearing in the Company's
Proxy Statement for the 1999 Annual Meeting of Stockholders is incorporated
herein by reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The section titled "Certain Transactions" appearing in the Company's Proxy
Statement for the 1999 Annual Meeting of Stockholders is incorporated herein by
reference.

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

   (a)(1)  Financial Statements:
           --------------------

     The following financial statements of the Company and of the Dermagraft
Joint Venture are included in a separate section of this Annual Report on Form
10-K commencing on the pages referenced below:

                                                                     Page
                                                                   --------
    Consolidated Financial Statements of Advanced 
      Tissue Sciences, Inc.:
         Consolidated Balance Sheets as of 
           December 31, 1998 and 1997............................     F-9
         Consolidated Statements of Operations for the 
           Years Ended December 31, 1998, 1997 and 1996..........     F-10
         Consolidated Statements of Cash Flows for the 
           Years Ended December 31, 1998, 1997 and 1996..........     F-11
         Consolidated Statements of Stockholders' Equity 
           for the Years Ended December 31, 1998, 1997 and 1996..     F-12
         Notes to the Consolidated Financial Statements..........  F-13 to F-25
         Report of Ernst & Young LLP, Independent Auditors.......     F-26
    Combined Financial Statements of the Dermagraft Joint Venture:
         Combined Balance Sheets as of December 31, 
           1998 and 1997.........................................     F-27
         Combined Statements of Operations for the Years
           Ended December 31, 1998 and 1997 and for the
           Period April 29, 1996 (inception) to
           December 31, 1996.....................................     F-28
         Combined Statements of Cash Flows for the Years 
           Ended December 31, 1998 and 1997 and for the
           Period April 29, 1996 (inception) to
           December 31, 1996.....................................     F-29
         Combined Statements of Partners' Capital for the Years 
           Ended December 31, 1998 and 1997 and for the Period
           April 29, 1996 (inception) to December 31, 1996.......     F-30
         Notes to the Combined Financial Statements..............  F-31 to F-33
         Report of Ernst & Young LLP, Independent Auditors.......     F-34

    (2)  Financial Statement Schedules:
         -----------------------------

     All schedules have been omitted, since they are not applicable, not
required or the information is included in the financial statements or the notes
thereto.

                                  28

<PAGE>


    (3)  Exhibits:
         --------

  Exhibit
    No.           Title                                   Method of Filing
  -------         -----                                   ----------------

   3.1      Restated Certificate of Incorporation     Filed Herewith
            of Advanced Tissue Sciences, Inc. as  
            in effect on February 16, 1999              

   3.2      Restated By-Laws of the Registrant        Incorporated by Reference
            Dated September 17, 1991                  to Exhibit 3 to the 
                                                      Registrant's Form 10-Q for
                                                      the Quarter Ended 
                                                      October 31, 1991

   3.3      Certificate of Designations,              Incorporated by Reference
            Preferences and Rights of Series B        to Exhibit 3.1 to the
            Convertible Preferred Stock of            Registrant's Current 
            Advanced Tissue Sciences, Inc.            Report on Form 8-K dated
                                                      July 10, 1998

   4.1      Rights Agreement, Dated as of             Incorporated by Reference
            January 6, 1995, between the Company      to Exhibit 1 to the
            and Chemical Trust Company of             Registrant's Current
            California, including the Certificate     Report on Form 8-K Dated
            of Determination for the Series A         January 5, 1995
            Junior Participating Preferred Stock 
            as Exhibit A, the Form of Summary of 
            Rights to Right Certificate as Exhibit 
            B and the Purchase Preferred Shares as 
            Exhibit C

   4.2      Investment Agreement between Advanced     Incorporated by Reference
            Tissue Sciences, Inc. and Ramius          to Exhibit 4.1 to the
            Hatteras Partners, L.P., Dated            Registrant's Current
            February 9, 1996                          Report on Form 8-K dated 
                                                      February 9, 1996

   4.2(a)   Amendment No. 1 to Investment             Incorporated by Reference
            Agreement between Advanced Tissue         to Exhibit 4.1 to the
            Sciences, Inc. and Hatteras Partners,     Registrant's Current
            L.P. (formerly Ramius Hatteras Partners,  Report on Form 8-K dated
            L.P.), Dated January 26, 1998             January 26, 1998

   4.2(b)   Amendment No. 2 to Investment             Incorporated by Reference
            Agreement between Advanced Tissue         to Exhibit 4.1 to the
            Sciences, Inc. and Hatteras Partners,     Registrant's Current
            L.P. (formerly Ramius Hatteras Partners,  Report on Form 8-K dated
            L.P.) dated July 10, 1998                 July 10, 1998

  10.1      Form of Indemnification Agreement         Incorporated by Reference
            Between the Company and Each of the       to Exhibit 10.6 to the
            Directors of the Company                  Registrant's Annual 
                                                      Report on Form 10-K for
                                                      the Year Ended January 31,
                                                      1991

  10.2      Nonqualified Stock Option Agreement,      Incorporated by Reference
            Dated June 3, 1991 between the            to Exhibit 19.1 to the
            Company and Arthur J. Benvenuto           Registrant's Form 10-Q for
                                                      the Quarter Ended July 
                                                      31, 1991

  10.3      Nonqualified Stock Option Agreement,      Incorporated by Reference
            Dated June 3, 1991 between the            to Exhibit 19.2 to the
            Company and Dr. Gail K. Naughton          Registrant's Form 10-Q for
                                                      the Quarter Ended July 
                                                      31, 1991

  10.4**    Advanced Tissue Sciences, Inc. 1997       Incorporated by Reference
            Stock Incentive Plan                      to Exhibit 99.1 to the 
                                                      Registrant's Registration
                                                      Statement No. 333-36879
                                                      on Form S-8

  10.4(a)   Form of Stock Option Agreement            Incorporated by Reference
                                                      to Exhibit 99.2 to the 
                                                      Registrant's Registration
                                                      Statement No. 333-36879 
                                                      on Form S-8


                                  29

<PAGE>

  10.4(b)   Form of Addendum to Stock Option          Incorporated by Reference
            Agreement re: Involuntary                 to Exhibit 99.3 to the
            Termination                               Registrant's Registration
                                                      Statement No. 333-36879
                                                      on Form S-8

  10.4(c)   Form of Stock Issuance Agreement          Incorporated by Reference
                                                      to Exhibit 99.4 to the 
                                                      Registrant's Registration
                                                      Statement No. 333-36879
                                                      on Form S-8

  10.4(d)   Form of Addendum to Stock Issuance        Incorporated by Reference
            Agreement re: Involuntary                 to Exhibit 99.5 to the
            Termination                               Registrant's Registration
                                                      Statement No. 333-36879
                                                      on Form S-8

  10.4(e)   Form of Automatic Stock Option            Incorporated by Reference
            Agreement                                 to Exhibit 99.6 to the 
                                                      Registrant's Registration
                                                      Statement No. 333-36879
                                                      on Form S-8

  10.5      Form of Special Addendum to Certain       Incorporated by Reference
            Employee Stock Option Agreements          to Exhibit 10.1 to the 
                                                      Registrant's Form 10-Q for
                                                      the Quarter Ended March
                                                      31, 1996

  10.6(a)   Licensing Agreement between the           Incorporated by Reference
            Massachusetts Institute of Technology     to Exhibit 10.8(a) to the
            and Advanced Tissue Sciences, Inc.        Registrant's Transition
            Dated July 24, 1992                       Report on Form 10-k for
                                                      the Eleven Months Ended
                                                      December 31, 1992

  10.6(b)*  Sponsored Research Agreement between      Incorporated by Reference
            the Massachusetts Institute of Tech-      to Exhibit 10.8(b) to the
            nology and Advanced Tissue Sciences,      Registrant's Transition
            Inc. Dated July 24, 1992                  Report on Form 10-K for
                                                      the Eleven Months Ended
                                                      December 31, 1992

  10.7*     Agreement between Advanced Tissue         Incorporated by Reference
            Sciences, Inc. and Smith & Nephew plc     to Exhibit 10.1 to the
            Dated May 6, 1994                         Registrant's Form 10-Q for
                                                      the Quarter Ended March
                                                      31, 1994

  10.8      Heads of Agreement between Advanced       Incorporated by Reference
            Tissue Sciences, Inc. and Smith &         to Exhibit 10.1 to the
            Nephew plc Dated April 29, 1996           Registrant's Form 10-Q for
                                                      the Quarter Ended March
                                                      31, 1996

  10.9      Promissory Note Between Advanced          Incorporated by Reference
            Tissue Sciences, Inc. and Smith &         to Exhibit 10.1 to the
            Nephew SNATS, Inc. Dated March 31, 1997   Registrant's Form 10-Q for
                                                      the Quarter Ended March
                                                      31, 1997

  10.10     Promissory Note Between Advanced          Incorporated by Reference
            Tissue Sciences, Inc. and Smith &         to Exhibit 10.2 to the
            Nephew SNATS, Inc. Dated June 11, 1997    Registrant's Form 10-Q for
                                                      the Quarter Ended June 
                                                      30, 1997

  10.11(a)  U.S. $16,000,000 Loan Facility to         Incorporated by Reference
            DermEquip, L.L.C. Provided by The         to Exhibit 10.1 to the
            Chase Manhattan Bank Dated August         Registrant's Form 10-Q for
            12, 1997                                  the Quarter Ended 
                                                      September 30, 1997

  10.11(b)  Guaranty Between Advanced Tissue          Incorporated by Reference
            Sciences, Inc. and The Chase              to Exhibit 10.2 to the
            Manhattan Bank Dated August 8, 1997       Registrant's Form 10-Q for
                                                      the Quarter Ended 
                                                      September 30, 1997

  10.12(a)  Heads of Agreement Dated January 14,      Incorporated by Reference
            1998 between Advanced Tissue Sciences,    to Exhibit 10.1 to the
            Inc. and Smith & Nephew plc               Registrant's Current 
                                                      Report on Form 8-K
                                                      Dated January 14, 1998

                                  30

<PAGE>

  10.12(b)  Common Stock Purchase Agreement,          Incorporated by Reference
            Dated January 14, 1998, between           to Exhibit 10.2 to the
            Advanced Tissue Sciences, Inc. and        Registrant's Current 
            Smith & Nephew SNATS, Inc.                Report on Form 8-K Dated 
                                                      January 14, 1998

  10.13     Heads of Agreement between Advanced       Incorporated by Reference
            Tissue Sciences, Inc. and Smith &         to Exhibit 10.1 to the
            Nephew plc Dated August 6, 1998           Registrant's Form 10-Q for
                                                      the Quarter Ended June 
                                                      30, 1998

  10.14*    Lease Agreement Between TPSC II           Incorporated by Reference
            Limited Partnership (Landlord) and        to Exhibit 10.15 to the
            Advanced Tissue Sciences, Inc. (Tenant)   Registrant's Annual 
            Dated October 15, 1997                    Report on Form 10-K for
                                                      the Year Ended December
                                                      31, 1997

  10.15(a) Securities Purchase Agreement by and       Incorporated by Reference
           among Advanced Tissue Sciences, Inc. and   to Exhibit 10.1 to the
           the Investors Dated July 10, 1998          Registrant's Current
                                                      Report on Form 8-K dated
                                                      July 10, 1998

  10.15(b) Registration Rights Agreement by and       Incorporated by Reference
           among Advanced Tissue Sciences, Inc. and   to Exhibit 10.2 to the
           the Investors Dated July 10, 1998          Registrant's Current
                                                      Report on Form 8-K dated
                                                      July 10, 1998

  10.15(c) Redemption Amendment Agreement by and      Incorporated by Reference
           among Advanced Tissue Sciences, Inc. and   to Exhibit 10.1 to the
           the Buyers of Series B Convertible         Registrant's Current
           Preferred Stock Dated November 6, 1998     Report on Form 8-K dated 
                                                      November 6, 1998

  21       Subsidiaries of the Registrant             Filed Herewith

  23       Consent of Ernst & Young LLP,              Filed Herewith
           Independent Auditors

  27       Financial Data Schedule                    Filed with Electronic
                                                      Copy Only

___________________
*   The Company has requested confidential treatment with respect to certain 
    portions of these documents.
**  Key employees (including officers and directors), non-employee Board 
    members and independent consultants are eligible to participate in the 
    1997 Stock Incentive Plan.

    (b)  Reports on Form 8-K
         -------------------

     The Company filed a Current Report on Form 8-K dated November 6, 1998 under
Item 5 reporting that it had entered into a Redemption Amendment Agreement with
the buyers of the Company's Series B Convertible Preferred Stock modifying the
buyers' rights to require redemption of the preferred shares upon occurrence of
certain events.

                                  31

<PAGE>

                                   SIGNATURES


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

                                        ADVANCED TISSUE SCIENCES, INC.



Date:  March 24, 1999                   By:  /s/ Arthur J. Benvenuto
       -------------------                 -------------------------
                                           Arthur J. Benvenuto
                                           Chairman of the Board of Directors
                                           and Chief Executive Officer

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

     SIGNATURE                     TITLE                            DATE
     ---------                     -----                            ----


/s/ Arthur J. Benvenuto       Chairman of the Board of         March 24, 1999
-----------------------       Directors and Chief
 Arthur J. Benvenuto          Executive Officer
                              (principal executive officer)


/s/ Dr. Gail K. Naughton      Director, President and Chief    March 24, 1999
------------------------      Operating Officer
 Dr. Gail K. Naughton



/s/ Michael V. Swanson        Vice President, Finance and      March 24, 1999
----------------------        Administration (principal
 Michael V. Swanson           financial and accounting officer)



/s/ Jerome E. Groopman, M.D.  Director                         March 24, 1999
----------------------------
 Jerome E. Groopman, M.D.



/s/ Jack L. Heckel            Director                         March 24, 1999
------------------                                   
 Jack L. Heckel



/s/ Ronald L. Nelson          Director                         March 24, 1999
--------------------                                     
 Ronald L. Nelson



/s/ Dayton Ogden              Director                         March 24, 1999
----------------
 Dayton Ogden



/s/ David S. Tappan, Jr.      Director                         March 24, 1999
------------------------                                         
 David S. Tappan, Jr.



/s/ Dr. Gail R. Wilensky      Director                         March 24, 1999
------------------------
 Dr. Gail R. Wilensky

                                  32

<PAGE>


                        SELECTED FINANCIAL DATA

     See Note 1 to the accompanying consolidated financial statements for a
discussion of the basis of presentation.  This summary of selected financial
data should be read in conjunction with the consolidated financial statements
and notes presented on pages F-9 to F-25.

<TABLE>
<CAPTION>

                                                         Year Ended December 31,
                                        ----------------------------------------------------------
                                           1998        1997        1996        1995        1994
                                        ----------  ----------  ----------  ----------  ----------
                                                 (In thousands, except per share amounts)
<S>                                     <C>         <C>         <C>         <C>         <C>
Revenues:
  Product sales (1)                     $   11,962  $    2,166  $    1,018  $    1,177  $    1,042
  Contracts and fees (2) (3)                 8,519      10,985      13,574       2,388         923
Research and development
   expenses                                 14,398      17,984      23,699      18,498      16,459
Equity in losses of joint
 ventures (3)                              (17,628)    (11,990)         --          --          --
Net loss                                   (43,285)    (36,089)    (22,401)    (23,125)    (22,775)
Net loss applicable to common
   stock                                   (43,863)    (36,089)    (22,401)    (23,125)    (22,775)

Basic and diluted loss per
 common share                           $    (1.11)  $    (.96)  $    (.61) $     (.72) $     (.75)

Weighted average shares used in 
  the calculation of basic and 
  diluted loss per common share             39,373      37,548      36,556      33,266      30,250

</TABLE>

<TABLE>
<CAPTION>


                                                                 December 31,
                                        -----------------------------------------------------------
                                           1998         1997        1996        1995        1994
                                        ----------   ----------  ----------  ----------  ----------
                                                                (In thousands)
<S>                                     <C>          <C>         <C>         <C>         <C>
Cash, cash equivalents and 
  short-term investments (4)            $   23,054   $   17,086  $   40,217  $   18,929  $   22,033
Working capital                             20,442       13,216      35,984      15,747      19,037
Total assets                                53,985       50,460      56,501      31,141      33,426
Long-term debt, capital lease 
  obligations and redeemable 
  preferred stock                           32,260       26,157          61          25          36
Accumulated deficit                       (218,456)    (175,171)   (139,082)   (116,681)    (93,556)
Stockholders' equity (4)                    12,527       13,966      48,380      25,900      28,350

</TABLE>

----------
(1)  Product sales for the year ended December 31, 1998 include sales of
     TransCyte(TM) (formerly Dermagraft-TC(R)) to unrelated customers of 
     $1,035,000 and sales of TransCyte and Dermagraft(R) at cost to a related
     party in the amount of $10,927,000.  Product sales for the year ended 
     December 31, 1997 include sales of TransCyte of $976,000 and sales of 
     Dermagraft at cost to a related party in the amount of $1,190,000.  
     Product sales in 1996 and prior years are for sales of the Company's 
     Skin2(R) laboratory testing kits.  The Company discontinued sales
     of its Skin2 laboratory testing kits in October 1996.

(2)  Contracts and fees for the year ended December 31, 1996 include a $10
     million up front payment from Smith & Nephew plc upon the formation of a 
     joint venture for the commercialization of Dermagraft for the treatment 
     of diabetic foot ulcers.

(3)  In April 1996, the Company formed a joint venture (the "Dermagraft
     Joint Venture") with Smith & Nephew for the commercialization of 
     Dermagraft for the treatment of diabetic foot ulcers.  The Company had 
     formed a separate joint venture for the commercialization of tissue-
     engineered cartilage for orthopedic applications in April 1994.  
     Contracts and fees include revenues for research and development, 
     marketing and other activities performed for the joint ventures.  
     Advanced Tissue Sciences and Smith & Nephew began sharing in the 
     revenues and expenses of the joint ventures in January 1997.

(4)  In January 1999, the Company received $15 million from Smith & Nephew,
     through the Dermagraft Joint Venture, in connection with a 1998 
     expansion of the Dermagraft Joint Venture to include Dermagraft for 
     venous and pressure ulcers and the marketing of TransCyte outside the 
     United States.

                                  F-1

<PAGE>

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


     Advanced Tissue Sciences, Inc. (the "Company" or "Advanced Tissue
Sciences") is engaged in the development and manufacture of human-based tissue
products for tissue repair and transplantation using its proprietary tissue
engineering technology.  The Company's leading therapeutic products are tissue-
engineered skin products, TransCyte(TM) (formerly Dermagraft-TC(R)) for the 
temporary covering of severe and partial-thickness burns and Dermagraft(R)  
for the treatment of severe skin ulcers.  In addition to its TransCyte and 
Dermagraft skin products, the Company is focusing its resources on the 
development of tissue-engineered cartilage and cardiovascular products.

     In March 1997, the Company received marketing approval in the United States
from the U.S. Food and Drug Administration (the "FDA") for its first therapeutic
product, TransCyte, as a temporary covering for severe, full-thickness, or
third degree burns. In addition, in October 1997, the Company received FDA 
approval to market TransCyte for partial-thickness, or second degree burns in 
the United States.  Through September 1998, TransCyte was marketed for burns 
by Advanced Tissue Sciences through a direct sales force in the United States.
As of October 1998, TransCyte is being marketed in the United States and 
throughout the rest of the world for burn and wound care applications under a 
recently expanded joint venture with Smith & Nephew plc ("Smith & Nephew").

     Dermagraft for the treatment of diabetic foot ulcers was approved for 
sale in Canada in August 1997, and was introduced in the United Kingdom and 
several other European countries late in 1997 through the joint venture with 
Smith & Nephew.  The Company also submitted a Premarket Approval (PMA) 
application to the FDA for approval to market Dermagraft for the treatment of 
diabetic foot ulcers in the United States.  In January 1998, an FDA advisory 
panel recommended approval of Dermagraft with the condition that the Company 
perform a post-marketing study to confirm efficacy and provide physician 
training.  However, in June 1998, the FDA decided the PMA application was not 
approvable without supportive data from an additional controlled clinical 
trial.  The Company has received approval from the FDA and has begun the 
requested clinical trial.  Based on the clinical plan, the Company believes 
the additional data could be available for submission in twelve to eighteen 
months after trial initiation, assuming a reasonable rate of patient
enrollment and data consistent with its previous PMA submission.

     In October 1998, the FDA approved the Company's application for a Treatment
Investigational Device Exemption (IDE) for Dermagraft, allowing the Company to
make Dermagraft for the treatment of diabetic foot ulcers available to 
selected centers in the United States under an approved clinical protocol.  
The Treatment IDE is a new regulatory provision for devices that (1) permits 
companies to make available promising new products to patients with serious 
diseases for which there is no satisfactory alternative, and (2) allows 
companies to recover the costs of manufacturing and distributing the product.
The Treatment IDE is being conducted concurrently with the ongoing clinical 
trial of Dermagraft in the treatment of diabetic foot ulcers in the United
States.

     In April 1996, the Company entered into an agreement with Smith & Nephew to
form a joint venture (the "Dermagraft Joint Venture") for the worldwide
commercialization of Dermagraft in the treatment of diabetic foot ulcers.  Under
the joint venture agreement, all expenses and revenues associated with the
development and commercialization of Dermagraft for diabetic foot ulcers from
January 1997 are shared equally by the joint venture partners.  In January 1998,
Advanced Tissue Sciences and Smith & Nephew expanded the Dermagraft Joint
Venture to include additional technology for the treatment of skin tissue wounds
and applications such as venous ulcers, pressure ulcers and burns.  In August
1998, the Company and Smith & Nephew expanded the Dermagraft Joint Venture 
further to include exclusive rights to TransCyte for full and partial-
thickness burns in the United States effective October 1998.  Under the 
expanded joint venture, Advanced Tissue Sciences and Smith & Nephew will 
continue to share equally in the expenses and revenues of the Dermagraft 
Joint Venture, except the Company will fund the first $6 million in expense 
for conducting clinical trials and regulatory support of Dermagraft and 
TransCyte in the treatment of venous ulcers and pressure ulcers.  In addition, 
the Company will fund certain manufacturing and distribution costs and 
certain costs related to post-market studies of TransCyte through December 
1999.  See Note 3 to the consolidated financial statements.

     In May 1994, the Company and Smith & Nephew entered into a separate joint
venture (the "Cartilage Joint Venture") for the worldwide development,
manufacture and marketing of human tissue-engineered cartilage for orthopedic
applications.  In January 1997, the joint venture partners began sharing equally
in the Cartilage Joint Venture's expenses.  See Note 3 to the consolidated
financial statements.

                                  F-2

<PAGE>

     In October 1997, the Company was awarded a $2 million Advanced Technology
Program grant from the National Institute of Standards and Technology to fund
collaborative cardiovascular research with the University of California, San
Diego over a three-year period.  Funding under the grant began in 1998.  From
1993 through 1997, the Company sponsored at least $1 million annually in early 
stage research programs at the Massachusetts Institute of Technology ("MIT") 
and Children's Hospital in Boston ("Children's Hospital") directed toward the 
tissue engineering of cartilage, liver and numerous other tissues and several 
polymer technologies.  The Company substantially reduced its commitment to 
MIT and Children's Hospital in 1998; however, additional research is being 
sponsored at several other academic institutions.

     The Company has incurred, and expects to continue to incur, substantial
expenditures in support of the commercialization, development and clinical
trials of its TransCyte and Dermagraft products for burn and skin ulcer
applications, for manufacturing systems and in advancing other applications of
the Company's core technology.  In particular, the Company will incur, either
directly or through the Dermagraft Joint Venture, substantial and increasing
costs for the additional clinical trial of Dermagraft in the treatment of
diabetic foot ulcers and in support of clinical trials and post-market studies
of Dermagraft and TransCyte in venous, pressure and diabetic foot ulcers and for
full and partial-thickness burns.

RESULTS OF OPERATIONS

Year Ended December 31, 1998 as Compared to the Year Ended December 31, 1997

     Product sales totaled $11,962,000 in 1998, as compared to $2,166,000 in
1997.  Product sales include sales to related parties of $10,927,000 and
$1,190,000 and to others of $1,035,000 and $976,000 in 1998 and 1997,
respectively.

     Product sales to related parties reflect sales of Dermagraft and TransCyte
to the Dermagraft Joint Venture at cost.  See Note 3 to the consolidated
financial statements.  The Company manufactures Dermagraft and TransCyte to meet
the Dermagraft Joint Venture's forecasted requirements for sales, marketing and
clinical trials.  Increased product sales to the Dermagraft Joint Venture in
1998 reflect increased manufacturing costs as discussed with respect to cost of
goods sold below and the fact that commercial sales to the Dermagraft Joint 
Venture did not begin until the second quarter of 1997.  In addition to product
attributes and competition, growth in sales in 1999 and beyond will continue to
be sensitive to the Dermagraft Joint Venture's success in obtaining 
regulatory approvals and product reimbursement from both national healthcare 
systems and private insurers.

     As discussed above, TransCyte sales and marketing were transferred from the
Company to the Dermagraft Joint Venture effective October 1998.  As a result,
product sales to others include sales of TransCyte in the United States from
January through September 1998.  Product sales in 1997 reflect sales for the
period April through December 1997.  There were no sales to outside customers in
the first quarter of 1997, as TransCyte was first introduced in April 1997 for
full-thickness burns and in October 1997 for partial-thickness burns.

     Revenues from contracts and fees were $8,519,000 for 1998, compared to
$10,985,000 in 1997.  Contract revenues decreased $2,466,000 for 1998 reflecting
lower contract revenues recognized for research and development and clinical
activities performed for the Dermagraft and the Cartilage Joint Ventures and for
associated administrative costs.  See Note 3 to the consolidated financial
statements.  Future contract revenues will include costs associated with
clinical trials and post-market studies of Dermagraft in venous, pressure and
diabetic foot ulcers and TransCyte for full and partial-thickness burns.

     Cost of goods sold for 1998 represents the cost of the Company's TransCyte
product sold domestically and the cost of TransCyte and Dermagraft sold to the
Dermagraft Joint Venture.  Cost of goods sold in 1997 represents costs to
manufacture TransCyte since its introduction in April 1997 and sales to the
Dermagraft Joint Venture beginning in the second quarter of 1997.  Products are
being sold to the Dermagraft Joint Venture at cost to manufacture including
period costs.  The Company initiated production of Dermagraft in its commercial
facility in January 1998 and, accordingly, cost of goods sold has reflected
costs associated with that facility such as depreciation and overhead since that
date.  As a result of the FDA's decision to require additional clinical data for
Dermagraft in the treatment of diabetic foot ulcers, the Company expects to
continue to incur significant costs associated with excess production capacity
within its manufacturing facility.

                                  F-3

<PAGE>

     Research and development expenditures decreased 20% to $14,398,000 for
1998, compared to $17,984,000 in 1997.  The decrease in research and development
costs primarily reflects lower costs for sponsored research programs, for both
clinical trials and production for clinical trials of TransCyte and Dermagraft
and for the development of commercial manufacturing processes.  Research and
development costs are expected to increase during 1999 reflecting clinical
trials and post-market studies of Dermagraft in venous, pressure and diabetic
foot ulcers and TransCyte for full and partial-thickness burns.

     Selling, general and administrative costs were $13,409,000 in 1998, a
decrease of $655,000 from $14,064,000 in 1997.  The decrease primarily reflects
lower expenditures for selling and marketing costs related to the
commercialization of products partially offset by higher compensation costs.  
Selling and marketing costs decreased during the fourth quarter of 1998 due 
to the transfer of sales and marketing of TransCyte to the Dermagraft Joint 
Venture effective October 1998.

     Professional and consulting costs for legal, accounting and other
consulting services incurred in 1998 were $2,263,000, compared to $2,941,000 in
1997.  The decrease in professional and consulting fees in 1998 principally
reflects lower legal and recruiting fees and lower costs for Dermagraft-related
marketing consultants partially offset by higher costs in preparation for the 
reinspection of the Company's manufacturing facility.

     Equity in losses of joint ventures was $17,628,000 in 1998, as compared to
$11,990,000 in 1997.  These amounts represent the Company's share of the 
losses of the Dermagraft and Cartilage Joint Ventures.  The increase in 1998 
primarily reflects increased manufacturing costs and selling, general and 
administrative expenses in the Dermagraft Joint Venture.  As the Company 
sells products to the Dermagraft Joint Venture at its cost to manufacture, 
costs of the commercial facility began to be recognized in cost of goods sold 
for the Dermagraft Joint Venture in January 1998.  Selling, general and 
administrative expenses in the Dermagraft Joint Venture have increased to 
support the commercial introduction of Dermagraft and TransCyte in certain 
markets.  The joint ventures' losses are expected to continue in 1999 as 
Dermagraft and TransCyte are commercially introduced in certain markets, as 
these products are manufactured in support of clinical trials and as 
orthopedic cartilage research and development efforts continue.

     Interest income and other was $1,320,000 in 1998, which compared to 
$1,252,000 in 1997 as higher cash balances in the second half of 1998 from a 
$25 million private placement of Convertible Series B Preferred Stock offset 
lower cash balances in the first half of the year as compared to 1997.  
Interest expense was $2,343,000 in 1998, compared to $877,000 in 1997.  The 
increase in 1998 principally reflects interest on notes payable to Smith & 
Nephew and The Chase Manhattan Bank (see Note 8 to the consolidated financial 
statements).

Year Ended December 31, 1997 as Compared to the Year Ended December 31, 1996

     Product sales totaled $2,166,000 in 1997, as compared to $1,018,000 in
1996.  Product sales to related parties reflect sales of Dermagraft to the
Dermagraft Joint Venture at cost (see Note 3 to the consolidated financial
statements).  Sales to outside customers of $976,000 in 1997 are from sales of
TransCyte for full-thickness burns introduced in April and for partial-thickness
burns introduced in October, following marketing approvals from the FDA.  Sales
in 1996 were from the Company's Skin product line which was discontinued in
October 1996 (see Note 4 to the consolidated financial statements).

     Sales of TransCyte fluctuated from quarter to quarter in 1997.  Although
sales of $173,000 were down in the third quarter as compared to sales of
$450,000  in the introductory second quarter, sales increased to $353,000 in the
fourth quarter primarily driven by approval of the partial-thickness indication.
The Company focused its efforts during 1997 on educating the market as to the
benefits and attributes of TransCyte and in having additional burn centers trial
the product.

     Revenues from related parties for contracts and fees were $10,975,000 in
1997, as compared to $13,564,000 in 1996.  Revenues reported for 1996 included a
$10 million up front fee from Smith & Nephew upon signing an agreement to enter
into the Dermagraft Joint Venture.  Contract revenues, excluding the $10 million
payment, increased $7,411,000 in 1997, principally reflecting contract revenues
recognized for research and development and other activities performed for the
Dermagraft Joint Venture.  Such funding began in January 1997.  See Note 3 to

                                  F-4

<PAGE>

the consolidated financial statements.  1997 and 1996 also include revenues
recognized for research and development performed for the Cartilage Joint
Venture.

     Cost of goods sold in 1997 represents the cost of the Company's TransCyte
product since its introduction in April 1997 and the cost of Dermagraft sold to
the Dermagraft Joint Venture.  Products are being sold to the Dermagraft Joint
Venture at cost to manufacture including period costs (see Note 3 to the
consolidated financial statements).  Cost of goods sold in 1996 represents the
cost of the Company's Skin2 laboratory testing kits.  As noted above, the 
Company discontinued its Skin2 business in October 1996.

     Research and development expenditures decreased 24% to $17,984,000 in 1997,
from $23,699,000 in 1996.  The decrease in research and development costs
primarily reflects lower costs for both clinical trials and production for
clinical trials of TransCyte and Dermagraft and for the development of
commercial manufacturing processes.  These decreases were partially offset by
increased research and development costs to support the development of tissue-
engineered cartilage.

     Selling, general and administrative costs increased 37% to $14,064,000 in
1997, as compared to $10,260,000 in 1996.  The increase in selling, general and
administrative expenses principally reflects higher selling and marketing costs
related to the commercialization of TransCyte and costs associated with
supporting the Dermagraft and Cartilage Joint Ventures.  These increases are
reflected primarily in higher costs for selling and promotional materials, and
personnel and associated costs.

     Professional and consulting costs for legal, accounting and other
consulting services incurred in 1997 were $2,941,000 as compared to $3,378,000
in 1996.  The decrease in professional and consulting fees in 1997 principally
reflects the absence of fees paid to financial advisors related to the
Dermagraft Joint Venture and the Company's In Vitro Laboratory Testing business
in 1996 and lower fees for regulatory consultants.  This was partially offset by
increased costs for marketing consultants and for the recruitment of personnel.

     Equity in losses of joint ventures was $11,990,000 in 1997, and represents
the Company's share of the losses of the Dermagraft and Cartilage Joint
Ventures.  The Company began sharing in such costs in January 1997 (see Note 3
to the consolidated financial statements).

     Interest and other income decreased to $1,252,000 in 1997 from $1,719,000
in 1996.  The decrease primarily reflects a decline in interest income from
lower average cash balances in 1997 as compared to 1996.  The decrease was
partially offset by interest charged to the Dermagraft Joint Venture for capital
employed.

     Interest expense was $877,000 for 1997, as compared to $6,000 in 1996.  The
increase reflects interest expense on borrowings from Smith & Nephew and The
Chase Manhattan Bank during 1997.  See Note 8 to the consolidated financial
statements.

LIQUIDITY AND CAPITAL RESOURCES

     As of December 31, 1998, the Company had available working capital of
$20,442,000, an increase of $7,226,000 from December 31, 1997.  In addition, the
Company received a payment of $15 million in January 1999 from Smith & Nephew,
through the Dermagraft joint venture, in connection with the January 1998 
expansion of the Dermagraft Joint Venture discussed above.  The increase in 
working capital from 1997 principally reflects the effect of the $20 million 
sale of Common Stock to Smith & Nephew in January 1998, the $25 million 
Convertible Series B Preferred Stock private placement in July 1998 (see 
Note 12 to the consolidated financial statements), $4 million in 
borrowings, including $1.4 million from The Chase Manhattan Bank and $2.3
million from Smith & Nephew, during the year (see Note 8 to the consolidated
financial statements), and $1.5 million in lease financing (see Note 9 to the 
consolidated financial statements) offset by the use of funds for operations, 
capital expenditures, and debt payments, and to support the Dermagraft and 
Cartilage Joint Ventures.  Capital expenditures of $3,740,000 for 1998 relate 
primarily to the Company's manufacturing facility and related process 
equipment and furniture and equipment for research and administration.

     The Company expects to use working capital as it continues to incur
substantial research and development expenses; additional costs in support of
clinical trials; selling, general and administrative costs in support of product
commercialization; and additional expenditures for capital equipment and patents
both directly and in support of the 

                                   F-5

<PAGE>

Dermagraft and Cartilage Joint Ventures.  These increases are expected to be 
only partially offset by revenues received from the Dermagraft and Cartilage 
Joint Ventures with Smith & Nephew.

     In addition to available working capital, the Company has entered into an
equity line with an investor group which could provide up to $50 million in
funding through the sale of Common Stock pursuant to drawings made from time to
time by the Company.  Subject to certain conditions, the equity line is
available through February 2000 (see Note 12 to the consolidated financial
statements).  Any drawing by the Company under the equity line may not exceed
$15 million and, in any event, the investor group may, in its sole discretion, 
refuse to fund any drawing if such drawing, when aggregated with other drawings
within the preceding three months and other Company securities held by the 
investor group, would result in the investor group owning more than 4.9% of 
the outstanding shares of Common Stock.  Any shares sold under the equity line 
will be sold at a 5% discount to the average low trading price of the Company's 
Common Stock over a specified period as determined by market volume.  A drawing
cannot be made during the pricing period for an earlier drawing under the 
equity line.  In addition, the Company may not effect a drawing under the 
equity line if the Common Stock is trading at less than $2 per share, trading 
of the Common Stock on the Nasdaq National Market has been suspended or the 
Common Stock has been delisted from the Nasdaq National Market, or there is 
not in effect a registration statement under the Securities Act of 1933 covering
the issuance and resale of the Common Stock to be issued pursuant to the 
drawing.  Subject to the foregoing, any decision to draw any funds under the 
equity line and the timing of any such draw are solely at the Company's 
discretion.

     The Company currently believes it has sufficient funds, including those
available under the equity line and from borrowings through its joint venture
arrangements, to support its operations through 1999.  To the extent necessary,
further sources of funds may include existing or future strategic alliances or
other joint venture arrangements which provide funding to the Company, and
additional public or private offerings of debt or equity securities, among
others.  There can be no assurance, however, that funds from these sources or
those outlined above will be available when needed or on terms favorable to the
Company, under existing arrangements or otherwise, or that the Company will be
successful in entering into any other strategic alliances or joint ventures.

     The Company continually reviews its product development activities in an
effort to allocate its resources to those products the Company believes have the
greatest commercial potential.  Factors considered by the Company in determining
the products to pursue include projected markets and need, potential for
regulatory approval and reimbursement under the existing healthcare system as
well as anticipated healthcare reforms, technical feasibility, expected and
known product attributes and estimated costs to bring the product to market.
Based on these and other factors which the Company considers relevant, the
Company may from time to time reallocate its resources among its product
development activities.  Additions to products under development or changes in
products being pursued can substantially and rapidly change the Company's
funding requirements.

FINANCIAL CONDITION

     Cash, cash equivalents and short-term investments as of December 31, 1998
increased by $5,968,000 from December 31, 1997 reflecting principally the effect
of the $20 million sale of Common Stock to Smith & Nephew in January 1998, the
$25 million Convertible Series B Preferred Stock private placement in July 1998
(see Note 12 to the consolidated financial statements), $4 million in
borrowings (see Note 8 to the consolidated financial statements) and $1.5 
million from the operating lease financing of certain equipment (see Note 9 
to the consolidated financial statements) partially offset by the use of cash 
to fund operations, to support the Dermagraft and Cartilage Joint Ventures 
and for capital expenditures and the payment of debt.  Accrued expenses at 
December 31, 1998 declined from year-end 1997 primarily due to reductions in 
amounts accrued for sponsored research, clinical studies and payroll costs, 
partially offset by an increase in joint venture obligations.  Preferred 
stock at December 31, 1998 reflects the private placement of the Convertible
Series B Preferred Stock in July 1998.

MARKET RISK

     The Company is exposed to changes in interest rates primarily from its
long-term debt arrangements and, secondarily, its investments in certain
securities.  Under its current policies, the Company does not use interest 
rate derivative instruments to manage exposure to interest rate changes.  The 
Company believes that a hypothetical 100 basis point adverse move in interest 
rates along the entire interest rate yield curve would not materially affect 
the fair value of the Company's interest sensitive financial instruments at 
December 31, 1998.

                                  F-6

<PAGE>

YEAR 2000 COMPLIANCE

     The Year 2000 ("Y2K") issue is a situation which results from computer
systems and software products being coded using two digits rather than four to
define the applicable years.  The Company's computer systems and software
products utilize embedded technology that is time-sensitive and may recognize 
a date as the year 1900 rather than the year 2000 which could cause computer 
system failures and errors leading to a disruption in business operations.  
The Y2K issue could affect not only the Company's operations but also the 
operations of its business partners, customers, suppliers and regulatory 
agencies among others.

     In response to the risks presented by the Y2K issue, the Company developed
and is currently implementing a Y2K compliance plan.  A multi-disciplinary team
was established with responsibility to (i) identify Y2K problems, (ii) set
timetables for correcting Y2K problems, (iii) establish a new procurement policy
which addresses the Y2K issue, (iv) determine the criticality of equipment to
the business process, (v) identify critical suppliers and verify their Y2K
compliance status, (vi) assess the potential impact of Y2K problems on partners,
customers, vendors and regulatory agencies, (vii) review the solution process,
(viii) develop and perform testing plans and procedures, (ix) verify corrective
action, and (x) formulate the backup strategy for critical processes that might
fail and establish critical date contingencies.

     The Company has approached the Y2K issue in two specific phases.  Phase I
involves the review and analysis of computer systems, software products,
equipment and vendor relationships considered critical to the Company's
operations to (i) determine Y2K compliance or non-compliance, and (ii) take
corrective action to the extent possible to assure compliance in areas of
non-compliance.  Phase II involves the review and analysis of computer systems,
software products, equipment and vendor relationships not considered critical to
the Company's operations.  In both phases, qualified independent consultants are
being utilized to achieve compliance goals.  The Company currently estimates
that the cost of Phase I and II activities to be approximately $175,000 and 
$100,000, respectively, exclusive of internal manpower costs.  These estimated 
costs are primarily for consulting services and equipment upgrades and are 
not material to the Company's financial condition or results of operations.

     With respect to Phase I, all required system modifications have been made
to computer servers, operating systems and telecommunication network equipment.
Major application software has been tested and verified for Y2K compliance.  All
other software has been identified and compliance documentation has been
obtained from the software vendors.  Each computer workstation has been tested
for its ability to successfully roll over the date on January 1, 2000, and each
workstation is currently being updated with the latest modifications to ensure
Y2K compliance for operating systems.  The Company has identified several pieces
of manufacturing and laboratory equipment and facility access control systems
which still need to be upgraded.  These upgrades should be in place by mid-year
1999 and the cost of upgrades is included in the cost estimate for Phase I
presented above.  The Company believes that all significant Y2K problems
relating to computer systems, product software and vendor relationships
considered critical to the Company's operations have been identified and
specific plans are in place to assure Y2K compliance by mid-year 1999 thus
reducing the risk of a critical Y2K failure or error.  As noted above, the Phase
I cost to the Company to assure Y2K compliance of these systems, software and
vendor relationships is not expected to have a material impact on the Company's
financial condition or operating results.

     In Phase II, the Company has identified approximately 150 non-critical
items to be tested for Y2K compliance, and will need to assess approximately 260
vendor relationships.  While these systems and relationships are not considered
critical to the Company's business operations, every reasonable effort will be
made to identify and correct those that are not Y2K compliant.  The Company
expects to complete Phase II by mid-year 1999 utilizing both independent
consultants and Advanced Tissue Sciences personnel.  As noted above, the Phase
II cost to the Company to assure Y2K compliance of these systems and
relationships is not expected to have a material impact on the Company's
financial condition or operating results.

     The Company has not yet completed its formal contingency plan relative to
undetected Y2K problems; however, at the current time, there does not appear to
be any critical piece of equipment for which backup cannot be provided.  The
worst case scenario would likely involve adding additional short-term labor to
perform repetitive manufacturing tasks.  There could also be some incremental
costs of replacing current testing capabilities if the Company's on-site test
equipment should fail.  While these extra costs have not yet been estimated by
the Y2K 

                                  F-7

<PAGE>

team, they would not be expected to have a material impact on the Company's 
financial condition or operating results.

                                  F-7

<PAGE>

     The foregoing Y2K discussion contains forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995.  Such
statements, including, without limitation, estimated costs and timelines to
complete certain actions, are based on management's best current estimates, 
which were derived utilizing numerous assumptions about future events, 
including the continued availability of certain resources, representations 
received from third parties and other factors.  However, there can be no 
guarantee that these estimates will be achieved, and actual results could 
differ materially from those anticipated.  Specific factors that might cause 
such material differences include, but are not limited to, the ability to 
identify and remediate all relevant Y2K issues, results of Y2K testing, 
adequate resolution of Y2K issues by third-party vendors and suppliers of 
goods and services to the Company, unanticipated system costs, the adequacy 
of and ability to develop and implement contingency plans and similar 
uncertainties.

OTHER INFORMATION

     THE DISCUSSIONS IN THIS ANNUAL REPORT ON FORM 10-K, PARTICULARLY THOSE
RELATING TO STRATEGIC ALLIANCES (INCLUDING POTENTIAL REVENUES FROM CERTAIN
EXISTING JOINT VENTURES), THE USE OF WORKING CAPITAL, THE SUFFICIENCY AND
AVAILABILITY OF FUNDS TO SUPPORT OPERATIONS, ADDITIONAL CLINICAL TRIALS, Y2K
READINESS AND COMMERCIALIZATION OF THE COMPANY'S PRODUCTS, ARE FORWARD-LOOKING
STATEMENTS INVOLVING RISKS AND UNCERTAINTIES WITHIN THE MEANING OF THE
SECURITIES ACT OF 1933 AND THE SECURITIES EXCHANGE ACT OF 1934.  NO ASSURANCE
CAN BE GIVEN THAT THE COMPANY WILL SUCCESSFULLY COMPLETE CLINICAL TRIALS, OBTAIN
U.S. FOOD AND DRUG ADMINISTRATION APPROVAL, SCALE UP MANUFACTURING PROCESSES,
SUCCESSFULLY MARKET SUCH PRODUCTS, ACHIEVE THE MILESTONES REQUIRED TO RECEIVE
ADDITIONAL FUNDING, IDENTIFY AND CORRECT ALL Y2K ISSUES, OR ENTER INTO NEW
STRATEGIC ALLIANCES.  THESE AND OTHER RISKS ARE DETAILED IN THE COMPANY'S
PUBLICLY AVAILABLE FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION,
INCLUDING THIS ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998.
THE FORWARD-LOOKING STATEMENTS ARE QUALIFIED IN THEIR ENTIRETY BY REFERENCE TO
THE RISKS AND RISK FACTORS DESCRIBED IN SUCH REPORTS.

                                  F-8

<PAGE>

                         ADVANCED TISSUE SCIENCES, INC.

                           CONSOLIDATED BALANCE SHEETS
                (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


<TABLE>
<CAPTION>

                                                           December 31,
                                                     ------------------------
                                                        1998          1997
                                                     ----------    ----------
<S>                                                  <C>           <C>
     ASSETS

Current assets:
  Cash and cash equivalents                          $   16,551    $   15,086
  Short-term investments                                  6,503         2,000
  Inventory                                               3,364         4,643
  Other current assets                                    2,412         1,395
                                                     ----------    ----------
    Total current assets                                 28,830        23,124
  Property - net                                         20,624        23,190
  Patent costs - net                                      1,846         1,608
  Other assets                                            2,685         2,538
                                                     ----------    ----------
    Total assets                                     $   53,985    $   50,460
                                                     ==========    ==========

  LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
   Accounts payable                                  $      894    $      958
   Accrued expenses                                       4,805         7,011
   Current portion of long-term debt
    and capital lease obligations                         2,689         1,939
                                                     ----------    ----------
     Total current liabilities                            8,388         9,908
Long-term debt and capital lease obligations             27,260        26,157
Other long-term liabilities                                 558           245
Minority interest in consolidated subsidiary                252           184
                                                     ----------    ----------
     Total liabilities                                   36,458        36,494
                                                     ----------    ----------

Redeemable Convertible Series B Preferred Stock, 
  $.01 par value; 1,000 shares authorized, 100
  shares issued and outstanding at December 31,
  1998 and none at December 31, 1997 (aggregate
  redemption and liquidation value of $5,119 at
  December 31, 1998)                                      5,000            --
                                                     ----------    ----------
Commitments and contingencies (Notes 9, 10 and 11)

Stockholders' equity:
  Convertible Series B Preferred Stock; $.01 par
   value; 350 shares issued and outstanding at
   December 31, 1998 and none at December 31, 1997 
   (aggregate liquidation value of $17,917 at
   December 31, 1998).                                       --            --
  Accrued cumulative preferred stock dividends              536            -- 
  Common Stock, $.01 par value; 100,000,000 shares 
   authorized; issued and outstanding, 40,353,524 
   shares at December 31, 1998 and 37,673,983 
   shares at December 31, 1997                              403           377 
  Additional paid-in capital                            230,963       189,679 
  Accumulated deficit                                  (218,456)     (175,171)
                                                     ----------    ----------
                                                         13,446        14,885
  Less note received in connection with the 
    sale of Common Stock                                   (919)         (919)
                                                     ----------    ----------
    Total stockholders' equity                           12,527        13,966 
                                                     ----------    ----------
    Total liabilities and stockholders' equity       $   53,985    $   50,460
                                                     ==========    ==========

</TABLE>

        See accompanying notes to the consolidated financial statements.

                                  F-9

<PAGE>

                         ADVANCED TISSUE SCIENCES, INC.

                      CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



<TABLE>
<CAPTION>

                                                 Year Ended December 31,
                                        --------------------------------------
                                           1998          1997          1996
                                        ----------    ----------    ----------
<S>                                     <C>           <C>           <C>
Revenues:
  Product sales -
     Related parties                    $   10,927    $    1,190    $       --
     Others                                  1,035           976         1,018
  Contracts and fees -
     Related parties                         7,935        10,975        13,564
     Others                                    584            10            10
                                       -----------    ----------    ----------
     Total revenues                         20,481        13,151        14,592
                                       -----------    ----------    ----------
Costs and expenses:
  Research and development                  14,398        17,984        23,699
  Selling, general and administrative       13,409        14,064        10,260
  Cost of goods sold                        15,045         2,636         1,369
  Professional and consulting                2,263         2,941         3,378
                                       -----------    ----------    ----------
     Total costs and expenses               45,115        37,625        38,706
                                       -----------    ----------    ----------

Loss from operations before equity
  in losses of joint ventures              (24,634)      (24,474)      (24,114)

Equity in losses of joint ventures         (17,628)      (11,990)           --
                                       -----------    ----------    ----------
Loss from operations                       (42,262)      (36,464)      (24,114)

Other income (expense):
  Interest income and other                  1,320         1,252         1,719
  Interest expense                          (2,343)         (877)           (6)
                                       -----------    ----------    ----------
Net loss                                   (43,285)      (36,089)      (22,401)

Dividends on preferred stock                  (578)           --            --
                                       -----------    ----------    ----------
Net loss applicable to common stock    $   (43,863)   $  (36,089)   $  (22,401)
                                       ===========    ==========    ==========
Basic and diluted loss per 
  common share                         $     (1.11)   $     (.96)   $     (.61)
                                       ===========    ==========    ==========
Weighted average number of common 
  shares used in the computation 
  of basic and diluted loss per 
  common share                              39,373        37,548        36,556
                                       ===========    ==========    ==========

</TABLE>



        See accompanying notes to the consolidated financial statements.

                                  F-10

<PAGE>

                         ADVANCED TISSUE SCIENCES, INC.

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>

                                                  Year Ended December 31,
                                           ------------------------------------
                                              1998         1997         1996
                                           ----------   ----------   ----------
<S>                                        <C>          <C>          <C>
Operating activities:
  Net loss                                 $  (43,285)  $  (36,089)  $  (22,401)
  Adjustments to reconcile net loss to 
    cash used in operating activities:
      Depreciation and amortization             4,756        2,120        1,774
      Compensation for services paid in 
        stock options or warrants               1,092          438          976
      Equity in losses of joint ventures       17,628       11,990           --
      Other adjustments to net loss               162          366           66
      Changes in assets and liabilities:
        Inventory                               1,279       (3,364)        (761)
        Other current assets                   (1,017)       1,153       (1,032)
        Accounts payable                          (64)      (1,274)       1,049
        Accrued expenses                       (2,206)       1,206        1,783
                                          -----------   ----------   ----------
          Net cash used in operating 
            activities                        (21,655)     (23,454)     (18,546)
                                          -----------   ----------   ----------
Investing activities:
  Purchases of short-term investments         (17,449)      (6,234)     (45,730)
  Maturities and sales of short-term
    investments                                12,946       16,544       33,420
  Acquisition of property                      (3,740)     (15,567)      (3,104)
  Proceeds from sale of furniture         
    and equipment                               1,502           --           --
  Investment in joint ventures                (23,436)     (11,040)          --
  Distributions from joint ventures             3,909          605           -- 
  Patent application costs                       (284)        (439)        (356)
  Other long-term assets                        1,739       (3,118)        (114)
                                          -----------   ----------   ----------
         Net cash used in investing
           activities                         (24,813)     (19,249)     (15,884)
                                          -----------   ----------   ----------
Financing activities:
  Proceeds from borrowings                      3,993       28,000           --
  Payments of borrowings                       (2,140)         (38)         (12)
  Net proceeds from sale of Preferred 
    Stock                                      24,915           --           --
  Net proceeds from sale of Common Stock       20,000           --       40,253
  Options and warrants exercised                  852        1,675        3,167
  Other long-term obligations                     313          245           --
                                          -----------   ----------   ----------
        Net cash provided by financing
          activities                           47,933       29,882       43,408
                                          -----------   ----------   ----------
Net increase (decrease) in cash and 
  cash equivalents                              1,465      (12,821)       8,978
Cash and cash equivalents at beginning
  of year                                      15,086       27,907       18,929 
                                          -----------   ----------   ----------
Cash and cash equivalents at end 
  of year                                 $    16,551   $   15,086   $   27,907
                                          ===========   ==========   ==========

</TABLE>

              See accompanying notes to the consolidated financial statements.

                                  F-11

<PAGE>


                         ADVANCED TISSUE SCIENCES, INC.

                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                             (DOLLARS IN THOUSANDS)


<TABLE>
<CAPTION>

                                                                                       Additional
                                       Preferred Stock             Common Stock          Paid-In
                                   -----------------------    ----------------------
                                     Shares       Amount        Shares      Amount       Capital
                                   ----------   ----------    ----------  ----------  -------------    
<S>                                <C>           <C>          <C>           <C>        <C>
Balance, December 31, 1995                                    33,885,928    $    339   $  143,161 

Sale of Common Stock                                           3,223,800          32       39,595 
Warrants issued as commitment
   fee under equity line                                                                      875 
Valuation adjustment of
   Common Stock issued in
   private placement                                                                          626 
Warrants granted for services                                                                 500 
Options and warrants exercised                                   364,949           4        3,249 
Net loss                                                      
                                                              ----------    --------   ----------
Balance, December 31, 1996                                    37,474,677         375      188,006 

Options exercised                                                199,306           2        1,673 
Net loss
                                                              ----------    --------   ----------
Balance, December 31, 1997                                    37,673,983         377      189,679 

Sale of Common Stock                                           1,533,115          15       19,985 
Sale of Preferred Stock                   400    $     --                                  19,915 
Conversion of Preferred Stock             (50)         --      1,012,394          10          (10)
Preferred Stock dividends                                         16,957          --         (536)
Warrants granted for services                                                               1,079 
Options exercised                                                117,075           1          851 
Net loss
                                   ----------    --------    -----------    --------   ----------
Balance, December 31, 1998                350    $     --    40,353,524     $    403   $   230,963 
                                   ==========    ========    ==========     ========   ===========
</TABLE>


<TABLE>
<CAPTION>

                                                         Accrued        Total
                                                       Dividends/      Stock-
                                       Accumulated        Note        Holders'
                                         Deficit       Receivable      Equity
                                      -------------   ------------   ----------
<S>                                   <C>              <C>           <C>
Balance, December 31, 1995            $   (116,681)    $     (919)   $   25,900

Sale of Common Stock                                                     39,627
Warrants issued as commitment
   fee under equity line                                                    875 
Valuation adjustment of
   Common Stock issued in
   private placement                                                        626 
Warrants granted for services                                               500 
Options and warrants exercised                                            3,253 
Net loss                                   (22,401)                     (22,401)
                                     -------------     -----------   ----------
Balance, December 31, 1996                (139,082)           (919)      48,380

Options exercised                                                         1,675 
Net loss                                   (36,089)                     (36,089)
                                     -------------     -----------   ----------
Balance, December 31, 1997                (175,171)           (919)      13,966 

Sale of Common Stock                                                     20,000 
Sale of Preferred Stock                                                  19,915 
Conversion of Preferred Stock                                                -- 
Preferred Stock dividends                                      536           -- 
Warrants granted for services                                             1,079 
Options exercised                                                           852 
Net loss                                   (43,285)                     (43,285)
                                     -------------     -----------   ----------
Balance, December 31, 1998           $    (218,456)    $      (383)  $  12,527 
                                     =============     ============  ==========
</TABLE>

           See accompanying notes to the consolidated financial statements.

                                  F-12

<PAGE>


                         ADVANCED TISSUE SCIENCES, INC.

                 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1 - BASIS OF PRESENTATION

Organization - Advanced Tissue Sciences, Inc. (the "Company") is a tissue
engineering company utilizing its proprietary technology to develop and
manufacture human-based tissue products for tissue repair and transplantation.
The Company is focusing on the worldwide commercialization of skin, cartilage
and cardiovascular products.  The Company's leading therapeutic products are
tissue-engineered skin products for the temporary covering of severe and
partial-thickness burns, which is on the market in the United States, and for
the treatment of diabetic foot ulcers, which is in clinical trials in the United
States and on the market in Canada, the United Kingdom and several other
European countries through a joint venture with Smith & Nephew plc ("Smith &
Nephew").

Principles of Consolidation - The consolidated financial statements include the
accounts of the Company, its wholly owned subsidiaries and DermEquip, L.L.C.
("DermEquip"), a limited liability company owned jointly with Smith & Nephew.
All intercompany accounts and transactions have been eliminated.  The Company's
other interests in joint ventures with Smith & Nephew are accounted for under
the equity method (see Note 3).

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
related disclosures at the date of the financial statements, and the amounts of
revenues and expenses reported during the period.  Actual results could differ
from those estimates.

Dependence on Certain Suppliers - The mesh frameworks used by the Company in its
therapeutic products are sourced from single manufacturers.  Any significant
supply interruption would adversely affect the Company's product manufacturing.
In addition, an uncorrected impurity or supplier's variation in a raw material,
either unknown to the Company or incompatible with the Company's manufacturing
process, could have a material adverse effect on the Company's ability to
manufacture its products.

Reclassification - Certain reclassifications have been made to prior year
amounts to conform to the presentation for the year ended December 31, 1998.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Cash Equivalents and Short-term Investments - In addition to investments in
money market funds, cash equivalents consist primarily of investments in
commercial paper and obligations issued or guaranteed by the United States
Government with maturities of three months or less at the date of acquisition.
Cash equivalents were approximately $14,509,000 and $15,064,000 as of December
31, 1998 and 1997, respectively.  Short-term investments are valued on the basis
of quoted market value and consist primarily of investments in commercial paper
and obligations issued or guaranteed by the United States Government with
maturities of one year or less but more than three months at the date of
acquisition.  Cash equivalents and short-term investments are stated at
amortized cost, which approximates market value.  As of December 31, 1998 and
1997, the Company's cash equivalents and short-term investments were classified
as available-for-sale and consisted of (in thousands):

                                                       1998          1997
                                                     --------      --------

   Debt securities of U.S. Government agencies       $  6,503      $  2,002
   United States treasury bills                            --         1,984
   Commercial paper                                     5,578            --
   Money market funds                                   8,931        13,078
                                                     --------      --------
   Total cash equivalents and short-term 
     investments                                     $ 21,012      $ 17,064
                                                     ========      ========

These investments all mature in less than one year.  There were no significant
unrealized or realized gains or losses related to such securities during the
years ended December 31, 1998 or 1997.  Cash and cash equivalents include

                                  F-13

<PAGE>

$2,145,000 and $1,878,000, respectively, as of December 31, 1998 and 1997 held
by DermEquip.  Such funds are available to support the operations of DermEquip.
In January 1999, the Company received $15 million from Smith & Nephew, through
the Dermagraft Joint Venture, in conjunction with the expansion of the 
Dermagraft Joint Venture (see Note 17).

Inventory - Inventories manufactured for sale to the Dermagraft Joint Venture
are stated at cost, principally standard costs which approximate actual costs on
a first-in, first-out basis reflecting the price at which such goods will be
sold to the joint venture (see Note 3).  Other inventories are carried at the
lower of cost or market.

Property is recorded at cost and is depreciated using estimated useful lives
which range from 3 to 10 years.  For financial statement purposes, depreciation
is generally computed using the straight-line method.  For tax purposes,
depreciation is generally computed by accelerated methods on allowable useful
lives.  Amortization of capitalized leases is included with depreciation
expense.  Costs related to the validation of new manufacturing facilities and
equipment are capitalized prior to the assets being placed in service.  In
addition, interest is capitalized related to the construction of such assets.
Such costs and capitalized interest are amortized over the estimated useful
lives of the related assets.  During 1997, $444,000 of interest expense was
capitalized.  No interest was capitalized in 1998 or 1996.  Depreciation expense
for the years ended December 31, 1998, 1997 and 1996 amounted to approximately
$4,710,000, $2,077,000 and $1,739,000, respectively.

Patents - The Company owns and has patents pending in the United States and
abroad to protect the processes and products being developed by the Company.
Direct patent application and maintenance costs related to patents issued are
amortized over the estimated useful life of the patent, approximately 17 years.
Such costs related to pending applications are deferred until the patent is
issued or charged to operations at the time a determination is made not to
pursue an application.  Patents are presented net of accumulated amortization of
approximately $259,000 and $213,000 as of December 31, 1998 and 1997,
respectively.  Patent application and maintenance costs related to licensing
agreements are expensed as incurred.

Industry Segment and Geographic Information - The Company operates in a single
industry segment - the development and commercialization of human-based tissue
products for tissue repair and transplantation.  Export sales of the Company's
laboratory testing kits (see Note 4), principally to Europe and Asia, totaled
approximately $621,000 in the year ended December 31, 1996.  During the years
ended December 31, 1997 and 1998, international sales have been through the
Dermagraft Joint Venture (see Note 3).  The Company has no foreign operations.

Revenue Recognition - Revenues from product sales to third parties are
recognized when products are shipped.  Revenues from product sales to related
parties (see Note 3) are recognized at such time as the related party is
contractually obligated to purchase the product, generally upon the completion
of manufacture.  Such product sales to the Dermagraft Joint Venture are equal to
the Company's cost.  Revenues under collaborative research agreements are
recognized as costs are incurred over the related period of the agreement.
Revenues from government grants are recognized based on the performance
requirements of the grant or as the grant expenditures are incurred.  Expenses
related to such agreements and grants are classified as research and development
expenses.

Research and Development Costs are expensed as incurred.  Such costs include
proprietary research and development activities and expenses associated with
collaborative research agreements.

Basic and Diluted Loss Per Common Share - Financial Accounting Standards Board
Statement No. 128, "Earnings Per Share," ("FAS No. 128") prescribes the method
used to calculate basic and diluted earnings per share.  Basic earnings per
share are determined based on the weighted average number of shares outstanding
during the period.  Diluted earnings per share include the weighted average
number of shares outstanding and give effect to potentially dilutive common
shares such as options and warrants outstanding.

Both the basic and diluted loss per common share for the years ended December
31, 1998, 1997 and 1996 are based on the weighted average number of shares of
Common Stock outstanding during the periods.  Potentially dilutive securities
include options and warrants outstanding (see Notes 12 and 14) and debt and
convertible preferred stock (see Notes 8, 12 and 13); however, such securities 
have not been included in the calculation of the diluted loss per share as 
their effect is antidilutive.  Since such securities are antidilutive, there 
is no difference between basic and diluted loss per share for any of the 
periods presented.  The net loss applicable to common shares used in the

                                  F-14

<PAGE>

calculation of basic and diluted loss per common share for the year ended 
December 31, 1998 includes dividends of $578,000 accrued on the Company's 
Convertible Series B Preferred Stock during such period.

Stock Options - As permitted under Financial Accounting Standards Board
Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS No. 123"),
the Company follows Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees," in accounting for outstanding stock
options and warrants.  Under APB Opinion No. 25, compensation expense relating
to employee stock options is determined based on the excess of the market price
of the Company's stock over the exercise price on the date of grant and does not
require the recognition of compensation expense for stock issued under plans
defined as noncompensatory.  Adoption of FAS No. 123 requires recognition of
compensation expense for virtually all options based on their computed "fair
value" on the date of grant.  See Note 14.

New Accounting Standards - In June 1997, the Financial Accounting Standards
Boards issued Financial Accounting Standards No. 130, "Reporting Comprehensive 
Income" ("FAS No. 130") and No. 131, "Segment Information" ("FAS No. 131). 
Both of these standards are effective for fiscal years beginning after 
December 15, 1997 and have been adopted by the Company.  FAS No. 130 requires 
that all components of comprehensive income, including net income, be reported 
in the financial statements in the period in which they are recognized.  
Comprehensive income is defined as the change in equity during a period from 
transactions and other events and circumstances from non-owner sources.  Net 
income and other comprehensive income, including foreign currency translation 
adjustments, and unrealized gains and losses on investments, shall be reported,
net of their related tax effect, to arrive at comprehensive income.  The 
Company's comprehensive loss is not materially different than net loss for
the periods presented.  FAS No. 131 amends the requirements for public
enterprises to report financial and descriptive information about its reportable
operating segments.  Operating segments as defined in FAS No. 131, are
components of an enterprise for which separate financial information is
available and is evaluated regularly by the Company in deciding how to allocate
resources and in assessing performance.  The financial information is required
to be reported on the basis that is used internally for evaluating the segment
performance.  As stated above, the Company believes it currently operates in 
one business and operating segment and that the adoption of this standard does 
not have a material impact on the Company's financial statements.

NOTE 3 - STRATEGIC ALLIANCES

In April 1996, the Company entered into an agreement with Smith & Nephew to form
a joint venture for the worldwide commercialization of Dermagraft(R), the 
Company's tissue-engineered dermal skin replacement, for the treatment of 
diabetic foot ulcers (the "Dermagraft Joint Venture").  In January 1998, the 
Company and Smith & Nephew expanded the Dermagraft Joint Venture to include 
venous ulcers, pressure ulcers, burns and other skin tissue wounds.  At that 
time, the Company retained the exclusive right to market TransCyte(TM) 
(formerly Dermagraft-TC(R)), a temporary covering for full and partial-
thickness burns, in the United States, while the Dermagraft Joint Venture was 
granted the right to market TransCyte for other skin wounds in the United 
States.  In August 1998, the Company and Smith & Nephew further expanded the 
Dermagraft Joint Venture to include exclusive rights to TransCyte for full 
and partial-thickness burns in the United States effective October 1998.  
Smith & Nephew is a worldwide healthcare company with extensive sales and 
distribution capabilities.  It manufactures a wide range of tissue repair 
products, principally addressing the areas of bone, joints, skin and other 
soft tissue.

As consideration for entering into the Dermagraft Joint Venture, Advanced Tissue
Sciences received a $10 million up front fee in 1996.  In addition, as a part of
the agreement to expand the joint venture, Smith & Nephew purchased $20 million,
or 1,533,115 newly-issued shares, of the Company's Common Stock at approximately
$13.05 per share in January 1998 (see Note 12).  The Company also received an
additional $15 million in January 1999, and could receive, subject to the
achievement of certain milestones related to regulatory approvals, reimbursement
and sales levels, further payments of up to $136 million.  In the expanded joint
venture, the Company and Smith & Nephew share equally in the expenses and
revenues of the Dermagraft Joint Venture, except the Company will fund the first
$6 million of expenses for conducting clinical trials and for regulatory support
of Dermagraft and TransCyte in the treatment of venous and pressure ulcers.  In
addition, the Company will fund certain manufacturing and distribution costs and
certain costs related to post-market studies of TransCyte through December 1999.
However, such manufacturing and distribution costs are to be returned to the
Company out of future gross margin or net profits, if any, from sales of
TransCyte for burns in the United States.  During 1997, the Company and Smith &
Nephew shared equally in the expenses and revenues of the joint venture.  
Under the expanded joint 

                                  F-15

<PAGE>

venture, the Company will continue to manufacture and Smith & Nephew will
continue to market and sell the joint venture's products.

During the years ended December 31, 1998 and 1997, the Company recognized
$5,598,000 and $7,041,000, respectively, in contract revenues for research and
development, marketing and other activities performed for the Dermagraft Joint
Venture.  In addition, during the years ended December 31, 1998 and 1997,
product sales to related parties include products sold to the Dermagraft Joint
Venture of $10,927,000 and $1,190,000, respectively.  Such product sales to the
Dermagraft Joint Venture are equal to the Company's cost of goods sold for such
products.

In 1994, Smith & Nephew and the Company entered into a separate joint venture
for the development of tissue-engineered cartilage for orthopedic applications
(the "Cartilage Joint Venture").  Under the Cartilage Joint Venture, Smith &
Nephew contributed the first $10 million in funding and the Company contributed
certain technology licenses.  The Cartilage Joint Venture's total funding since
inception reached $10 million in January 1997 and, as provided in the joint
venture agreement, the Company and Smith & Nephew began sharing equally in
Cartilage Joint Venture revenues and expenditures.  During the years ended
December 31, 1998, 1997 and 1996, the Company recognized $2,337,000, $3,934,000
and $3,564,000, respectively, in contract revenues for research and development
activities performed for the Cartilage Joint Venture.

The results of operations of the joint ventures for the years ended December 31,
1998, 1997 and 1996 are as follows (in thousands):

                                                1998       1997       1996
                                              --------   --------   --------
Dermagraft Joint Venture
------------------------
     Net sales                                $    632   $     36   $     --
     Cost of goods sold                         10,054        824         --
     Other costs and expenses                   20,874     17,052     10,000 
     Net loss                                  (30,296)   (17,840)   (10,000)

     Current assets                              3,296        373         -- 
     Non-current assets                            237        304         -- 
     Current liabilities                         2,767      3,737         -- 
     Partners' capital                             766     (3,060)        -- 

Cartilage Joint Venture
-----------------------
     Costs and expenses                      $   4,468   $   7,150  $  6,889 
     Net loss                                   (4,468)     (7,150)   (6,889)

     Current assets                                 55         79         82 
     Non-current assets                            400        591        717 
     Current liabilities                           338        535      1,554 
     Partners' capital                             117        135       (755)

NOTE 4 - IN VITRO LABORATORY TESTING BUSINESS

In October 1996, the Company closed its In Vitro Laboratory Testing ("IVLT")
business to focus all of its resources on its therapeutic programs.  Although
the Company was a leader in the in vitro testing business and continuously
broadened applications of it products, the market for in vitro laboratory
testing products was evolving too slowly for the Company to continue to devote
its resources to this business.  The statement of operations for the year ended
December 31, 1996 includes charges of approximately $1.0 million for costs
associated with the closure of the IVLT business (substantially all of which are
reflected in selling, general and administrative expenses).  Exclusive of these
charges, costs associated with operations of the IVLT business were $2,528,000
for the year ended December 31, 1996.

                                  F-16

<PAGE>

NOTE 5 - INVENTORIES

Inventories consist of the following components as of December 31, 1998 and 1997
(in thousands):

                                              1998          1997
                                            --------      --------

     Raw materials and supplies             $  2,965      $  3,295
     Work-in-process                             399           347
     Finished goods                               --         1,001
                                            --------      --------
                                            $  3,364      $  4,643
                                            ========      ========


NOTE 6 - PROPERTY

The major classes of property as of December 31, 1998 and 1997 are as follows 
(in thousands):

                                              1998         1997
                                            --------     --------

     Equipment                              $ 20,992     $ 11,645
     Furniture and fixtures                      622          586
     Leasehold improvements                   10,754        6,254
     Equipment under capital leases              110          110
     Construction in progress                     87       12,689
                                            --------     --------
                                              32,565       31,284
     Less accumulated depreciation
       and amortization                      (11,941)      (8,094)
                                            --------     --------
     Net property                           $ 20,624     $ 23,190
                                            ========     ========

Construction in progress in 1997 primarily relates to an expansion of the
Company's manufacturing facilities and related process equipment that was placed
in service in January 1998.

NOTE 7 - ACCRUED EXPENSES

Accrued expenses as of December 31, 1998 and 1997 consisted of (in thousands):

                                                    1998           1997
                                                  --------       --------

     Salaries and benefits                        $  2,083       $  2,606
     Dermagraft Joint Venture                        1,316            683
     Sponsored research                                401          1,562
     Clinical studies                                   57            667
     Other                                             948          1,493
                                                  --------       --------
                                                  $  4,805       $  7,011
                                                  ========       ========

NOTE 8 - LONG-TERM DEBT

In August 1997, DermEquip entered into a term loan agreement with The Chase
Manhattan Bank to borrow up to $16 million (the "Chase Loan") through June 1998.
During the first half of 1998, DermEquip completed drawdowns under the loan
agreement to a total of $16 million.  Principal is payable in equal quarterly
installments from June 1998 through June 2004.  The Chase Loan bears interest
payable quarterly at the 90-day London Interbank Offered Rate ("LIBOR") plus
1/4 percent (5.56% at December 31, 1998).  DermEquip's obligations with 
respect to the Chase Loan are jointly and severally guaranteed by Smith & 
Nephew and the Company.  The guaranties are secured by DermEquip's assets, 
having a carrying value of $14,485,000 as of December 31, 1998, and by each 
company's interest in DermEquip.

In March 1997, the Company borrowed $10 million from Smith & Nephew pursuant to
a commitment as a part of the agreement to form the Dermagraft Joint Venture
(see Note 3).  The loan is unsecured and bears interest at 90-day LIBOR plus 4%
(9.31% at December 31, 1998)and is due on the earlier of (i) March 2000 or (ii)
the date on which the Company no longer has an ownership interest in the
Dermagraft Joint Venture.  At the option of the Company, the loan may be paid in
cash or Common Stock valued at the then current fair market value.

                                  F-17

<PAGE>

Through December 1998, the Company has borrowed $5.7 million from Smith & Nephew
pursuant to a commitment as a part of the agreement to form the Cartilage Joint
Venture (see Note 3).  Under the terms of that joint venture agreement, the
Company may borrow up to a total of $10 million.  The loan is unsecured and
bears interest at 90-day LIBOR plus 4% (9.31% at December 31, 1998) and is due
on the earlier of (i) June 2000 or (ii) the date on which the Company no longer
has an ownership interest in the Cartilage Joint Venture.

Debt and capital lease obligations as of December 31, 1998 and 1997 were as
follows (in thousands):

                                              1998              1997
                                            --------          --------

     Chase Loan                             $ 14,080          $ 14,600 
     Smith & Nephew notes:
       Dermagraft Joint Venture               10,000            10,000 
       Cartilage Joint Venture                 5,685             3,400 
     Obligations under capital leases 
      and other                                  184                96 
     Less current portion                     (2,689)           (1,939)
                                            --------          --------      
                                            $ 27,260          $ 26,157 
                                            ========          ========      

Maturities of long-term debt and capital lease obligations over the next five
years are $2,689,000 in 1999, $18,272,000 in 2000, $2,588,000 in 2001,
$2,560,000 in 2002, $2,560,000 in 2003 and $1,280,000 thereafter.  As
substantially all of the Company's debt carries interest at variable rates, the
fair market value of such instruments is estimated to approximate their carrying
value.

NOTE 9 - LEASE COMMITMENTS

Operating lease commitments relate primarily to the Company's manufacturing,
research and administrative facilities.  The leases for the Company's primary
facility, which include manufacturing, research and administrative facilities,
expire in September 2000; however, these leases include an option to extend the
term for an additional five years.  These leases include the cost of some of the
utilities and certain services, and provide for annual rental increases ranging
from a minimum of 3% to a maximum of 7% based on changes in the Consumer Price
Index.

The Company also leases two other facilities for manufacturing, research and
administration.  One lease has a two-year term which expired in July 1998;
however, the Company has exercised its option to extend the term of the lease
for six months and has been leasing the space on a month-to-month basis since
January 1999.  The lease includes the operating costs for the facility and
provides for a 4% annual rent increase.  The other lease has a five-year term
and expires in January 2002.  The lease provides that the Company will pay rent,
which increases 4% annually, as well as the operating costs of the leased
facility.

In October 1997, the Company entered into a 15-year lease agreement for
additional research and administrative space.  The facility was completed and
the lease began in the fourth quarter of 1998.  The lease provides for a 4%
annual rent increase during the first five years, 3% during the second five
years and 2.5% during the final five years.  Under the lease, the Company will
also be responsible for all operating costs.  The Company also has options to
extend the term of the lease for two five-year periods.  In December 1998, the
Company completed the financing of $1.5 million of office and laboratory 
furniture and equipment for the new research and administrative facility under 
three operating leases with terms ranging from three to four years.

                                  F-18

<PAGE>

The following is a summary of the annual future minimum lease commitments as 
of December 31, 1998 (in thousands):


                                                    CAPITAL        OPERATING
                                                    LEASES          LEASES
                                                   ---------      -----------
     Year Ending December 31:
        1999                                       $      36      $     5,806
        2000                                              36            5,615
        2001                                              30            4,212
        2002                                              --            3,960
        2003                                              --            3,630
     Thereafter                                           --           41,063
                                                   ---------       ----------
     Total minimum lease payments                        102       $   64,286
                                                                   ==========
     Less amount representing interest                   (25)
                                                   ---------
     Present value of net minimum lease payments   $      77 
                                                   =========

Rental expense charged to operations under operating leases for facilities and
equipment for the years ended December 31, 1998, 1997 and 1996 amounted to
approximately $4,219,000, $3,412,000 and $2,778,000, respectively.

NOTE 10 - COMMITMENTS AND CONTINGENCIES

Under agreements with several universities, the Company has entered into
commitments to sponsor research for a minimum of $1.0 million in 1999.  In
addition, in 1997, the Company was awarded a $2 million grant by the
National Institute of Standards and Technology under their Advanced Technology
program to support the development of tissue-engineered vascular grafts over a
three-year period beginning in 1998.  The grant requires the Company to meet 
certain minimum levels of program funding in order to receive the grant 
funding.  In addition, the second and third years of funding will be 
contingent on the availability of funds from Congress, subject to satisfactory 
performance by the Company and at the sole discretion of the National 
Institute of Standards and Technology.

The Company is also responsible for patent application costs and associated
maintenance fees related to inventions under certain licensing agreements.  The
Company seeks to protect its proprietary technology through the use of various
aspects of United States and foreign patent law and contractual arrangements.
However, there can be no assurance that the Company's patents or patent
applications will afford protection against competitors with similar technology,
nor can there be any assurance that the Company's present patents will not be
infringed upon or designed around by others.  Substantial costs could be
incurred to protect against infringement or defend the Company's patents and
licensed patents.

Under the terms of its joint venture agreements, the Company has agreed to fund
its share of the costs of the Dermagraft and Cartilage Joint Ventures.  See Note
3.

NOTE 11 - LEGAL PROCEEDINGS

Since June 1998, several lawsuits have been filed in the United States District
Court for the Southern District of California against the Company and two of its
officers.  The lawsuits allege violations of the federal securities laws arising
out of alleged misstatements and alleged failures to disclose certain material
facts concerning the clinical trials and obtaining United States Food and Drug
Administration approval of Dermagraft for the treatment of diabetic foot ulcers.
The lawsuits purport to seek damages on behalf of a class of shareholders who 
purchased Advanced Tissue Sciences, Inc. Common Stock during the period 
generally from January 13, 1997 through June 11, 1998.  The complaints in the 
lawsuits do not specify an amount of claimed damages.  The Company believes 
that the lawsuits are without merit and intends to defend against them 
vigorously.  In addition, the Company believes the ultimate resolution will 
not have a material adverse effect on the Company's financial condition, 
results of operations or liquidity.  However, there can be no assurance that 
an adverse result would not have a material adverse effect on the Company.

                                  F-19

<PAGE>

NOTE 12 - CAPITAL STOCK

As of December 31, 1998, the Company had 49,973,115 shares of Common Stock
reserved for issuance under options and warrants, and for the conversion of and
the payment of dividends on the Company's Convertible Series B Preferred Stock.

In January 1995, the Company adopted a Shareholder Rights Plan and pursuant
thereto issued one preferred share purchase right ("Right") on each outstanding
share of Common Stock.  The Rights are exercisable only if a person or group
acquires, or makes a tender offer to acquire, 15% or more of the Company's
Common Stock.  In connection with the adoption of the Shareholder Rights Plan,
the Company's Board of Directors designated and reserved 500,000 shares of the
Company's authorized Preferred Stock as Series A Junior Participating Preferred
Stock, par value $.01 per share (the "Series A Preferred Stock").  The Rights
have no voting privileges and expire on January 6, 2005.

When exercisable, each Right entitles its holder to buy one-hundredth of a share
of the Series A Preferred Stock at an exercise price of $55, subject to certain
antidilution adjustments.  In addition, if at any time after the Rights become
exercisable, should (i) the Company be acquired in a merger or other business
combination transaction, or sell 50% or more of its consolidated assets or
earnings power, each Right will entitle its holder to purchase a number of the
acquiring company's common shares having a market value at the time of twice the
Right's exercise price or (ii) a person or group acquire 15% or more of the
Company's outstanding Common Stock, each Right will entitle its holder, other
than the acquirer, to purchase, at the Right's then-current exercise price, a
number of shares of the Company's Common Stock having a market value of twice
the Right's exercise price.  The rights are redeemable for one cent per Right at
any time up to and including ten days after the acquisition of 15% of the then
outstanding Common Stock.

In July 1998, the Company raised $25 million through a private placement of
Convertible Series B Preferred Stock (the "Series B Preferred Stock") to a group
of investors (the "Investors").  Subject to adjustment in certain events, the
Series B Preferred Stock is convertible into Common Stock of the Company at
$4.77 per share (the "Conversion Price").  The Conversion Price will be
increased by one-half the amount by which the market price of the Common Stock
on the date of conversion exceeds $7.96 per share, if any.  Conversely, should
the average daily trading price (as defined in the agreements) prior to a
conversion be equal to or below $3.58 per share, the Conversion Price will be
equal to such average daily trading price.  The Series B Preferred Stock accrues
dividends at 5% per annum.  Dividends are payable quarterly in Common Stock or
cash at the option of the Company beginning in the first quarter of 1999.  To
the extent not previously converted, the Series B Preferred Stock is, at the
election of the Company, redeemable at $50,000 per share plus accrued dividends
or convertible into Common Stock three years from the date of issuance subject
to extension in certain circumstances.  Twenty percent of the Series B
Preferred Stock is redeemable at the option of the holders on the occurrence
of certain events (see Note 13).  During 1998, fifty shares of the Series B
Preferred Stock were converted into 1,012,394 shares of Common Stock at an
average price of $2.47 per share.  See Note 17 with respect to conversions of
Series B Preferred Stock subsequent to the end of 1998.

In connection with an expansion of the Dermagraft Joint Venture, Smith & Nephew
purchased $20 million, or 1,533,115 newly-issued shares, of the Company's Common
Stock in January 1998 at approximately $13.05 per share.  Smith & Nephew has the
right to request registration of the shares.

In February 1998, the Company extended an investment agreement (the "Investment
Agreement") with an investment group for an equity line which allows the Company
to access up to $50 million through sales of its Common Stock.  In connection
with the extension, the Company granted the investment group a warrant to
purchase 50,000 shares of Common Stock at an exercise price of $14.00 per share.
In July 1998, the Investment Agreement was further extended, subject to certain
minimum requirements, to February 2000 at no cost to the Company.  Any decision
to draw any funds under the Investment Agreement and the timing of any such draw
are solely at the Company's discretion.

The Investment Agreement provides that the Company can obtain up to $15 million
at any one time through the sale of Common Stock.  Any sales against the equity
line will be at a five percent discount to the average low sales prices of the
Company's Common Stock over a specified period of time as determined by market
volume at the time of the draw.  The Company's ability to draw under the
Investment Agreement is subject to certain conditions

                                  F-20

<PAGE>

including, but not limited to, registration of the shares, a minimum trading
price of $2.00 per share, and certain limitations on the number of shares of
Common Stock held by the investment group at any point in time.

NOTE 13 - REDEEMABLE PREFERRED STOCK

Twenty percent of the Series B Preferred Stock issued in the July 1998 private
placement of $25 million of series preferred stock is classified as redeemable.
These shares of the Series B Preferred Stock are redeemable at 125% of 
liquidation value at the option of the holders upon the occurrence of certain 
events such as a change in control or suspension or delisting from The Nasdaq 
National Market, or at the Conversion Price plus accrued dividends on a 
failure to have adequate shares authorized, registered and available for 
conversion of such preferred stock.  Accordingly, $5 million of the Series B 
Preferred Stock has been reflected as redeemable preferred stock in the 
accompanying balance sheet.  See Note 12 for additional terms of the Series B 
Preferred Stock.

NOTE 14 - EMPLOYEE BENEFIT PLANS

The Company's Stock Incentive Plan (the "1997 Plan") provides for the grant of
incentive stock options, non-qualified stock options and stock issuances to
employees and consultants and automatic 50,000-share grants to non-employee
directors, currently to a maximum of 7,450,000 shares of Common Stock.  At
December 31, 1998, a total of 6,092,826 shares were outstanding under options or
available for grant under the 1997 Plan.  The Company has elected to continue to
account for its employee stock option plans under APB Opinion No. 25 rather than
adopt FAS No. 123 (see Note 2).

Under the 1997 Plan, all employees are granted stock options on their date of
employment and on promotion.  The number of shares granted is based on the
employee's position and responsibilities.  The options granted generally become
exercisable in equal annual amounts over five years.  The options generally have
a term of ten years as long as the employee remains in the service of the
Company.  The Company also began to make annual grants to employees in 1997.
Non-employee directors receive an automatic grant of 50,000 shares upon joining
the Board and generally every third year thereafter.  These options generally
are immediately exercisable, become vested in equal annual amounts over three
years and have a term of ten years assuming continued service on the Company's
Board of Directors.

In August 1998, the Board of Directors approved a plan whereby each employee
option holder under the 1997 Plan, excluding officers and directors of the
Company, could exchange all of their current vested and unvested options with an
exercise price in excess of $7.00 per share for new options priced at market
value as of August 6, 1998.  Specifically, existing options with exercise prices
between $7.01 and $11.00 per share were exchangeable three shares for two and
existing options priced above $11.00 were exchangeable two shares for one.  A
total of 649,210 existing option shares at an average price of $12.68 were
exchanged for 360,534 replacement option shares with an exercise price of $3.34.
These replacement options vest on the same basis as the replaced options but
require that the employee continue their employment with the Company for a
minimum of one year from the date of grant in order for any of the shares to
vest.  The replacement options are included as both grants and cancellations in
the stock option activity table shown below.

In addition to the 1997 Plan, the Company has issued options and warrants to
directors, consultants, employees and others as compensation for services.
These options vest and are exercisable over a variety of periods as determined
by the Company's Board of Directors.


                                  F-21

<PAGE>

The following table summarizes activity under the 1997 Plan and for other
options and warrants for Common Stock for the years ended December 31, 1998,
1997 and 1996:


<TABLE>
<CAPTION>

                                        1997 Plan            Other Options and Warrants
                                --------------------------  ----------------------------
                                              Weighted                     Weighted
                                  Number    Average Price      Number    Average Price
                                 of Shares    Per Share       of Shares    Per Share
                                ----------- --------------   ----------- ---------------
<S>                             <C>            <C>           <C>            <C>
Outstanding, December 31, 1995   2,317,515      $6.28         1,460,299      $6.81
 Granted                         1,660,450     $14.05           275,000     $10.50
 Exercised                         (99,290)     $8.87          (265,659)     $8.61
 Canceled                         (104,974)     $8.10                --         --
                                ----------                   ----------
Outstanding, December 31, 1996   3,773,701      $9.58         1,469,640      $7.18
 Granted                           691,885     $13.82                --         --
 Exercised                        (189,306)     $8.75           (10,000)     $1.69
 Canceled                         (161,130)    $11.48                --         --
                                ----------                   ----------
Outstanding, December 31, 1997   4,115,150     $10.26         1,459,640      $7.21
 Granted                         1,075,529      $6.23            50,000     $14.00
 Exercised                        (117,075)     $7.28                --         --
 Canceled                       (1,175,882)    $12.31                --         --
                                ----------                   ----------
Outstanding, December 31, 1998   3,897,722      $8.62         1,509,640      $7.44
                                ==========                   ==========
</TABLE>


The weighted average fair value of options granted was $4.47, $10.09, and $9.60
under the 1997 Plan in 1998, 1997, and 1996, respectively, and $9.71 and $5.00
for other options and warrants in 1998 and 1996, respectively.  The number of 
shares exercisable under the 1997 Plan at December 31, 1998, 1997 and 1996 were
2,104,429, 2,083,170 and 1,713,872, respectively, with a weighted average price
per share of $7.81, $7.09 and $5.52, respectively.  All of the shares 
reflected as outstanding under other options and warrants granted were
exercisable as of December 31, 1998, 1997 and 1996 at the weighted average 
price per share shown above.

Included in other options and warrants granted are warrants issued to an
investment group during 1998 and 1996, which are exercisable for 50,000 and
175,000 shares of Common Stock at an exercise price of $14.00 and $10.50
per share, respectively.  These warrants were issued as a commitment fee
on the equity line (see Note 12).  During the years ended December 31, 1998,
1997 and 1996, $430,000, $438,000 and $390,000, respectively, were charged
to expense reflecting the amortization of the fair market value of these
warrants over the commitment period.  In addition, the Company charged
$588,000 and $586,000 to expense in 1998 and 1996, respectively, in
connection with options or warrants granted to employees and consultants.

                                  F-22

<PAGE>

The following table summarizes by price ranges the number of shares, weighted
average exercise price and weighted average remaining life (in years) of options
and warrants exercisable and outstanding as of December 31, 1998.


<TABLE>
<CAPTION>

                                       Exercisable                     Total Outstanding
                             -------------------------------  -----------------------------------
                              Number of    Weighted Average    Number of     Weighted Average
                                                                          ----------------------
   Price Range                 Shares       Exercise Price      Shares    Exercise Price    Life
-----------------            -----------  ------------------  ---------  -----------------  ----
<S>                           <C>               <C>           <C>             <C>            <C>
1997 Plan:
  $1.69                          775,000         $1.69          775,000        $1.69         0.5
  $1.96 - 3.93                    51,540         $3.55          643,242        $3.26         7.3
  $3.94 - 5.89                   103,690         $5.51          113,410        $5.52         4.7
  $5.90 - 7.85                    30,125         $7.54          119,400        $6.91         8.3
  $7.86 - 9.81                   245,535         $8.67          362,775        $8.66         5.7
  $9.82 - 11.78                  220,239        $10.89          259,900       $10.93         6.0
  $11.79 - 13.74                 506,427        $13.35        1,292,670       $13.36         7.2
  $13.75 - 15.70                  46,054        $14.76           78,275       $14.71         6.9
  $15.71 - 17.66                 125,819        $17.30          253,050       $17.11         7.7
                              ----------                      ---------                         
    Total 1997 Plan            2,104,429         $7.81        3,897,722        $8.62         5.7
                              ==========                      =========                         

Other Options and Warrants:
  $1.47 - 1.67                   300,000         $1.57          300,000        $1.57         4.5
  $4.50                           10,000         $4.50           10,000        $4.50         1.7
  $8.11 - 10.50                1,149,640         $8.71        1,149,640        $8.71         2.7
  $14.00                          50,000        $14.00           50,000       $14.00         6.1
                              ----------                      ---------                         
    Total Other                1,509,640         $7.44        1,509,640        $7.44         3.1
                              ==========                      =========                         

</TABLE>

The following table reflects the Company's pro forma net loss applicable to
common stock and basic and diluted loss per common share for the years ended 
December 31, 1998, 1997 and 1996 had the expense provisions of FAS No. 123 been
implemented (in thousands except per share amounts):


                                           1998        1997         1996
                                        ----------  ----------   ----------
  Net loss applicable to common stock:
     As reported                        $ (43,863)  $ (36,089)   $ (22,401)
     Pro forma                            (51,040)    (43,224)     (27,971)

  Basic and diluted loss per share:
     As reported                        $   (1.11)   $   (.96)   $    (.61)
     Pro forma                              (1.30)      (1.15)        (.77)

Because the Statement 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the above pro forma information may not be
representative of that to be expected in future years.

The fair value of each option grant has been estimated on the date of grant
using the Black-Scholes option pricing model.  The following weighted average
assumptions were used for grants made under the 1997 Plan in 1998, 1997 and
1996: (i) risk-free interest rates of 3.97% to 5.60% for 1998, 6.1% to 6.7% for
1997 and 5.3% for 1996; (ii) expected lives of one year to eight years for 1998,
four to nine years for 1997 and seven years for 1996; and (iii) volatility of
69% to 100% for 1998, 63% to 64% for 1997 and 64% for 1996.  It is assumed that
no dividends are paid on the stock in all the Black-Scholes option pricing model
estimates.  The estimated value of warrants issued in 1998 and 1996 for services
were based on the value of the services rendered.

The Company has a 401(k) Plan (the "401(k) Plan") under which employees meeting
certain eligibility requirements may elect to participate and contribute to the
401(k) Plan.  Under the 401(k) Plan, the Company may elect to match a
discretionary percentage of contributions.  No such matching contributions have
been made to the 401(k) Plan since its inception.

                                  F-23

<PAGE>

NOTE 15 - INCOME TAXES

The Company has federal and California net operating loss carryforwards of
approximately $200 million and $34 million, respectively, as of December 31,
1998.  The difference between the federal and California operating tax loss
carryforwards principally results from a fifty percent limitation on California
loss carryforwards, the Company not having operations in California until late
1989 and the capitalization of certain research and development expenses for
California purposes.  As of December 31, 1998, the Company also has federal and
California research and development tax credit carryforwards of approximately
$5.4 million and $2.1 million, respectively, and has California manufacturer's
investment tax credit carryforwards of approximately $559,000.  The federal net
operating loss and research and development tax credit carryforwards will begin
expiring in 2000 and 2001, respectively, and the California research and
development tax credit carryforwards and the California manufacturer's
investment tax credit carryforwards will begin expiring in 2004, unless
previously utilized.  California net operating loss carryforwards of
approximately $5 million expired in 1998, and $5 million and $4 million will
expire in 1999 and 2000, respectively, if not previously utilized.

Utilization of future net operating loss carryforwards could be limited if
certain cumulative changes in the Company's ownership were to occur.  Included
in the federal net operating loss carryforwards, and subject to an annual
limitation, are approximately $5 million of losses related to an acquisition.

Net deferred tax assets have been completely offset by a valuation allowance as
realization of the deferred tax assets is uncertain.  During the year ended
December 31, 1998, the valuation allowance increased by $12,609,000.
Significant components of the Company's net deferred tax assets as of December
31, 1998 and 1997 are as follows (in thousands):



                                                  1998             1997
                                               ----------       ----------
     Deferred tax assets:
       Net operating loss carryforwards        $   72,085       $   60,920
       Tax credit carryforwards                     7,156            6,303
       Capitalized research and development         4,905            4,472
       Other                                        1,529            1,198
                                               ----------       ----------
         Total deferred tax assets                 85,675           72,893
                                               ----------       ----------
     Deferred tax liabilities:
       Patent expense                                (830)            (657)
                                               ----------       ----------
         Total deferred tax liability                (830)            (657)
                                               ----------       ----------
     Net deferred tax assets before 
      valuation allowance                          84,845           72,236 
     Valuation allowance                          (84,845)         (72,236)
                                               ----------       ----------
     Net deferred tax assets                   $       --       $       -- 
                                               ==========       ==========


Approximately $7 million of the valuation allowance for deferred tax assets
relates to benefits of stock option deductions which, when and if recognized,
will be allocated directly to additional paid-in capital.

NOTE 16 - SUPPLEMENTAL CASH FLOW INFORMATION

The following summarizes the significant non-cash investing and financing
activities of the Company and provides other supplemental cash flow information.

During 1998, non-cash financing activities included the issuance of warrants
exercisable for Common Stock as a commitment fee with a value of $418,000 
representing the amount of the fee as negotiated between the parties.  Non-
cash financing and investing activities during the year ended December 31, 
1997 included the financing of $50,000 of equipment through capital leases.
During the year ended December 31, 1996, non-cash financing and investing 
activities included the issuance of warrants exercisable for Common Stock as 
a commitment fee and for consulting services, and the financing of $60,000 of
equipment through a capital lease.  The commitment fee of 1.75% of the equity
line (see Note 12), or $875,000, was negotiated between the Company and the 
investment group providing the equity line and represents the estimated fair 
value of the warrant.  The warrant granted for consulting services has been 
valued at an estimated fair market value of $500,000 representing the 
estimated fair market value of the services to be provided as negotiated 
between the parties.  The value of the warrants was amortized over the 
commitment period and over the period the services were provided.  Other non-
cash activities have involved the issuance of compensatory stock options to 
employees and consultants (see Note 14).

                                  F-24

<PAGE>

Net cash from operating activities reflects cash payments for interest expense
of approximately $1,368,000, $868,000, $6,000 for the years ended December 31,
1998, 1997 and 1996, respectively.

NOTE 17 - SUBSEQUENT EVENTS

Payment in Connection with Expansion of Strategic Alliance

In January 1999, the Company received a $15 million payment from Smith & Nephew,
through the Dermagraft Joint Venture, in connection with the 1998 expansion 
of the Dermagraft Joint Venture to include venous ulcers, pressure ulcers, 
burns and other skin wounds.  See Note 3.

Increase in Authorized Common Stock (Unaudited)

In February 1999, the Common Stockholders of Advanced Tissue Sciences, Inc,
approved an amendment to the Company's Restated Certificate of Incorporation to
increase the number of authorized shares of Common Stock from 100,000,000 shares
to 125,000,000.

Conversion of Convertible Series B Preferred Stock (Unaudited)

In February 1999, approximately 36 shares of the Company's Convertible Series 
B Preferred Stock were converted into 743,005 shares of Common Stock at an 
average price of $2.44 per share.  See Note 12.

                                  F-25

<PAGE>



                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


The Board of Directors and Stockholders
Advanced Tissue Sciences, Inc.

We have audited the accompanying consolidated balance sheets of Advanced Tissue
Sciences, Inc. as of December 31, 1998 and 1997, and the related consolidated
statements of operations, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1998.  These financial statements
are the responsibility of the Company's management.  Our responsibility is to
express an opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Advanced Tissue
Sciences, Inc. at December 31, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles.



                                                             ERNST & YOUNG LLP

San Diego, California
January 29, 1999

                                  F-26




<PAGE>

                            DERMAGRAFT JOINT VENTURE

                             COMBINED BALANCE SHEETS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>

                                                       December 31,
                                                  ----------------------
                                                    1998          1997
                                                  --------      --------
<S>                                               <C>           <C>
     ASSETS
Current assets:
  Cash                                            $     72      $     12
  Accounts receivable from partners 
   and affiliates                                    1,538            --
  Inventory                                          1,462           361
  Other current assets                                 224            --
                                                  --------      --------
     Total current assets                            3,296           373
Property - net                                         237           160
Other assets                                            --           144
                                                  --------      --------
     Total assets                                 $  3,533      $    677
                                                  ========      ========

     LIABILITIES AND PARTNERS' CAPITAL
Current liabilities:
  Payable to partners and affiliates              $  2,767      $  3,609
  Accounts payable                                      --            35
  Accrued expenses                                      --            93
                                                  --------      --------
     Total current liabilities                       2,767         3,737

Partners' capital                                      766        (3,060)
                                                  --------      --------
    Total liabilities and partners' capital       $  3,533      $    677
                                                  ========      ========

</TABLE>


          See accompanying notes to the combined financial statements.

                                  F-27

<PAGE>

                            DERMAGRAFT JOINT VENTURE

                        COMBINED STATEMENTS OF OPERATIONS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>

                                                                           April 29, 1996
                                                                           (inception) to
                                              Year Ended December 31,
                                          -----------------------------      December 31,
                                               1998            1997             1996
                                          -------------  --------------  ----------------
<S>                                       <C>             <C>             <C>
Product sales                             $         632   $          36   $            -- 
                                          -------------   -------------   ---------------

Operating expenses:
  Research and development                        2,907           5,118                -- 
  Selling, general and administrative            17,779          11,204                -- 
  Cost of goods sold                             10,054             824                -- 
                                          -------------   -------------   ---------------

    Total operating expenses                     30,740          17,146                -- 
                                          -------------   -------------   ---------------

Loss from operations                            (30,108)        (17,110)               -- 

Other income (expense):
  Interest income                                    93             108                -- 
  Interest charges from related parties            (622)           (454)               -- 
  License fee to related party                       --              --           (10,000)
  Other income (expense)                            341            (384)               -- 
                                          -------------   -------------   ---------------

Net loss                                  $     (30,296)  $     (17,840)  $       (10,000)
                                          =============   =============   ===============
</TABLE>




          See accompanying notes to the combined financial statements.

                                  F-28


<PAGE>

                            DERMAGRAFT JOINT VENTURE

                        COMBINED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>

                                                                                April 29, 1996
                                                                                (inception) to
                                                   Year Ended December 31,
                                               ------------------------------    December 31,
                                                    1998            1997             1996
                                               --------------  --------------  ----------------
<S>                                            <C>             <C>             <C>
Operating activities:
  Net loss                                     $     (30,296)  $     (17,840)  $       (10,000)
  Adjustments to reconcile net loss to cash
    used in operating activities:
  Depreciation                                            40               3                -- 
  Other adjustments to net loss                          144               6                -- 
  Changes in assets and liabilities:
    Accounts receivable from partners
     and affiliates                                   (1,538)             --                -- 
    Inventory                                         (1,101)           (361)               -- 
    Other current assets                                (224)             --                -- 
    Accounts payable                                     (35)             35                -- 
    Payable to partners and affiliates                  (842)          3,609                -- 
    Accrued expenses                                     (93)             93                -- 
                                               -------------   -------------   ---------------
      Net cash used in operating activities          (33,945)        (14,455)          (10,000)
                                               -------------   -------------   ---------------

Investing activities:
  Acquisition of property                               (117)           (163)               -- 
                                               -------------   -------------   ---------------

Financing activities:
  Contributions from partners                         39,175          15,284            10,000 
  Distributions to partners                           (5,053)           (654)               -- 
                                               -------------   -------------   ---------------
     Net cash provided by financing activities        34,122          14,630            10,000 
                                               -------------   -------------   ---------------

Net increase in cash                                      60              12                -- 
Cash at beginning of period                               12              --                -- 
                                               -------------   -------------   ---------------
Cash at end of period                          $          72   $          12   $            -- 
                                               =============   =============   ===============
</TABLE>




          See accompanying notes to the combined financial statements.

                                  F-29

<PAGE>

                            DERMAGRAFT JOINT VENTURE

                    COMBINED STATEMENTS OF PARTNERS' CAPITAL
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>

                                        Advanced
                                         Tissue         Smith &
                                     Sciences, Inc.    Nephew plc     Total
                                    ----------------  ------------  ---------
<S>                                 <C>               <C>           <C>
From April 29, 1996 (inception)
 to December 31, 1996
   Capital contributions            $          --     $    10,000   $  10,000 
   Net loss                                    --         (10,000)    (10,000)
                                    -------------     -----------   ---------
Balance, December 31, 1996                     --              --          -- 
   Capital contributions                    7,780           7,746      15,526 
   Capital distributions                     (390)           (356)       (746)
   Net loss                                (8,920)         (8,920)    (17,840)
                                    -------------     -----------   ---------
Balance, December 31, 1997                 (1,530)         (1,530)     (3,060)
   Capital contributions                   20,111          19,336      39,447
   Capital distributions                   (2,504)         (2,821)     (5,325)
   Net loss                               (15,694)        (14,602)    (30,296)
                                    -------------     -----------   ---------
Balance, December 31, 1998          $         383     $       383   $     766 
                                    =============     ===========   =========
</TABLE>





          See accompanying notes to the combined financial statements.

                                  F-30


<PAGE>

                            DERMAGRAFT JOINT VENTURE

                   NOTES TO THE COMBINED FINANCIAL STATEMENTS

NOTE 1 - BASIS OF PRESENTATION

Organization - Advanced Tissue Sciences, Inc. ("Advanced Tissue Sciences") and
Smith & Nephew plc ("Smith & Nephew") entered into a fifty-fifty joint venture
(the "Dermagraft Joint Venture") for the worldwide commercialization of
Dermagraft(R), a tissue-engineered dermal replacement, for the treatment of
diabetic foot ulcers in April 1996.  Advanced Tissue Sciences is a tissue
engineering company utilizing its proprietary core technology to develop and
manufacture living human tissue products for tissue repair and transplantation.
Smith & Nephew is a worldwide healthcare company with extensive sales and
distribution capabilities.  It develops, manufactures and markets a wide range
of tissue repair products, principally addressing the areas of bone, joints,
skin and other soft tissue.

The Dermagraft Joint Venture became responsible for the further development and
commercialization of Dermagraft for diabetic foot ulcers effective January 1997.
In January 1998, the Dermagraft Joint Venture was expanded to include venous
ulcers, pressure ulcers, burns and other skin tissue wounds.  At that time,
Advanced Tissue Sciences retained the exclusive right to market TransCyte(TM)
(formerly Dermagraft-TC(R)), a temporary covering for full and partial-thickness
burns, in the United States, while the Dermagraft Joint Venture was granted the
right to market TransCyte for other skin wounds in the United States.  In August
1998, the joint venture was further expanded to include exclusive rights to
TransCyte for full and partial-thickness burns in the United States effective
October 1998.  TransCyte is currently being marketed in the United States for 
burns, and Dermagraft for the treatment of diabetic foot ulcers is in clinical 
trials in the United States and on the market in Canada, the United Kingdom 
and several other European countries.

In the expanded joint venture, Advanced Tissue Sciences and Smith & Nephew will
continue to share equally in the expenses and revenues of the Dermagraft Joint
Venture, except Advanced Tissue Sciences has agreed to fund the first $6 million
of expenses for conducting clinical trials and for regulatory support of
Dermagraft and TransCyte in the treatment of venous ulcers and pressure sores.
In addition, Advanced Tissue Sciences will fund certain manufacturing and
distribution costs and certain costs related to post-market studies of TransCyte
through December 1999.  Such manufacturing and distribution costs are to be
returned to Advanced Tissue Sciences out of future gross margin on net profits,
if any, from sales of TransCyte for burns in the United States.

References herein to Advanced Tissue Sciences and Smith & Nephew include their
subsidiaries and certain affiliates.

Principles of Combination - The combined financial statements include the
accounts of Dermagraft U.S. and Dermagraft International, which are Delaware
general partnerships formed between subsidiaries of Advanced Tissue Sciences and
Smith & Nephew, and the revenues and expenses of Advanced Tissue Sciences, Smith
& Nephew and their affiliates associated with the worldwide commercialization of
Dermagraft and TransCyte.  All intercompany accounts and transactions have 
been eliminated.

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
related disclosures at the date of the financial statements, and the amounts of
revenues and expenses reported during the period.  Actual results could differ
from those estimates.

Dependence on Certain Suppliers - The mesh frameworks used in the manufacture of
Dermagraft and TransCyte are sourced from single manufacturers.  Any significant
supply interruption would adversely affect product manufacturing.  In addition,
an uncorrected impurity or supplier's variation in raw material, either unknown
or incompatible with the manufacturing process, could have a material adverse
effect on the manufacture of the product.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Inventories are valued at the lower of cost or market using the first-in,
first-out method.  The Dermagraft Joint Venture, under contractual obligation,
purchases product at cost from Advanced Tissue Sciences.

                                  F-31

<PAGE>

Property is recorded at cost and depreciation is calculated on a straight-line
basis using an estimated useful life of five years.

Revenue/Expense Recognition - Revenues from product sales are recognized when
products are shipped to the customer.  Research and development costs are
expensed as incurred.

New Accounting Standards - In June 1997, the Financial Accounting Standards
Board issued Financial Account Standard No. 130, "Reporting Comprehensive 
Income" ("FAS No. 130").  This standard is effective for fiscal years 
beginning after December 15, 1997 and has been adopted by the joint venture.  
FAS No. 130 requires that all components of comprehensive income, including 
net income, be reported in the financial statements in the period in which 
they are recognized.  Comprehensive income is defined as the change in equity 
during a period from transactions and other events and circumstances from 
non-owner sources.  Net income and other comprehensive income, including 
foreign currency translation adjustments, and unrealized gains and losses on 
investments, shall be reported, net of their related tax effect to arrive at 
comprehensive income.  The joint venture's comprehensive loss is not 
materially different than net loss for the periods presented.

NOTE 3 - INVENTORIES

Inventories consist of the following components as of December 31, 1998 and 1997
(in thousands):

                                             1998             1997
                                           --------         --------
    Work-in-process                        $    461         $    288
    Finished goods                            1,001               73
                                           --------         --------
                                           $  1,462         $    361
                                           ========         ========

Inventories are net of reserves of $213,000 and zero as of December 31, 1998 
and 1997, respectively.

NOTE 4 - PROPERTY

The following is a summary of property and accumulated depreciation as of 
December 31, 1998 and 1997 (in thousands):

                                              1998             1997
                                            --------         --------
     Equipment, at cost                     $    280         $    163
     Less accumulated depreciation               (43)              (3)
                                            --------          -------
     Net property                           $    237          $   160
                                            ========          =======

Depreciation expense charged to operations was $40,000 in 1998 and $3,000 in 
1997.

NOTE 5 - RELATED PARTY TRANSACTIONS

Under the joint venture agreements, Advanced Tissue Sciences is manufacturing
and Smith & Nephew is selling and marketing Dermagraft and TransCyte for the
Dermagraft Joint Venture.  In addition, Advanced Tissue Sciences and Smith &
Nephew are providing research, development and administrative services to the
Dermagraft Joint Venture.  All such expenses are reflected in the combined
financial statements at their estimated cost.  The Dermagraft Joint Venture also
pays the partners interest on the use of their working capital in support of the
joint venture's operations.  The following table summarizes related party
revenues and expenses for the years ended December 31, 1998 and 1997 (in
thousands):

                                           Advanced
                                       Tissue Sciences       Smith & Nephew
                                     -------------------  -------------------
                                       1998       1997      1998       1997
                                     --------   --------  --------   --------
  Sales                              $     --   $     --  $    632   $     36
  Cost of goods sold                   10,054        824        --         --
  Research and development              2,260      4,476       465        642
  Selling, general and 
    administrative                      2,979      2,750    14,161      7,101

                                  F-32

<PAGE>

Upon entering into the Dermagraft Joint Venture in April 1996, Smith & Nephew
agreed to pay Advanced Tissue Sciences an up front fee of $10 million.  This fee
was funded through a capital contribution to the Dermagraft Joint Venture by
Smith & Nephew and paid by the joint venture to Advanced Tissue Sciences.  Under
the joint venture agreements, the $10 million expense is allocated to Smith &
Nephew's capital account.  As the Dermagraft Joint Venture did not begin
operations until January 1, 1997, the $10 million fee represents the only
activity in the Dermagraft Joint Venture from April 29, 1996 (inception) to
December 31, 1996 (see Note 1).  Smith & Nephew has also agreed to pay up to an
additional $136 million on the achievement of certain milestones related to
product approval, gaining product reimbursement and on attaining specific sales
milestones.  These milestones, if achieved, are to be funded and paid to
Advanced Tissue Sciences either directly by Smith & Nephew or through the
Dermagraft Joint Venture in the same manner as the up front fee.

NOTE 6 - SUPPLEMENTAL CASH FLOW INFORMATION

The Joint Venture's non-cash investing and financing activities for the year
ended December 31, 1998 included $325,000 in interest charges contributed as
capital by the partners.

NOTE 7 - SUBSEQUENT EVENT

In January 1999, the joint venture received a $15 million payment from Smith
& Nephew and then paid the same amount to Advanced Tissue Sciences in
connection with the 1998 expansion of the Dermagraft Joint Venture to include
venous ulcers, pressure ulcers, burns and other skin wounds.  As discussed in
Note 5 above, the $15 million expense will be allocated to Smith & Nephew's
capital account.

NOTE 8 - YEAR 2000 COMPLIANCE (UNAUDITED)

The Year 2000 ("Y2K") issue results from computer systems and software products
being coded using two digits rather than four to define the applicable years.
Computer systems and software products utilize embedded technology that is time-
sensitive and may recognize a date as the year 1900 rather than the year 2000 
which could cause computer system failures and errors leading to a disruption 
in business operations.  The Y2K issue could affect not only the joint 
venture's operations but also the operations of its business partners, 
customers, suppliers and regulatory agencies among others.

The joint venture purchases substantially all significant materials and
services from the joint venture's partners.  In response to the risks 
presented by the Y2K issue, the joint venture's partners have developed and 
are currently implementing Y2K compliance plans.  Although their assessment 
of the Y2K issue is not complete, the partners believe their internal systems 
are Y2K compliant or will be replaced or upgraded to comply with Y2K require-
ments.  While a portion of the partners' Y2K compliance costs are being 
charged to the joint venture, such costs are not expected to have a material 
impact on the joint venture's financial condition or operating results.


                                  F-33

<PAGE>




                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS


The Board of Directors
ATS Dermagraft, Inc. and Smith & Nephew SNATS, Inc.

We have audited the accompanying combined balance sheets of the Dermagraft Joint
Venture as of December 31, 1998 and 1997, and the related combined statements of
operations, partners' capital and cash flows for the years ended December 31,
1998 and 1997 and for the period April 29, 1996 (inception) through December 31,
1996.  These financial statements are the responsibility of the joint venture'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 financial statements referred to above present fairly, in
all material respects, the combined financial position of the Dermagraft Joint
Venture at December 31, 1998 and 1997, and the combined results of its
operations and its cash flows for the years ended December 31, 1998 and 1997 and
for the period April 29, 1996 (inception) through December 31, 1996, in
conformity with generally accepted accounting principles.



                                                             ERNST & YOUNG LLP

San Diego, California
January 18, 1999