SECURITIES AND EXCHANGE COMMISSION
                             Washington, D. C. 20549

                                   FORM 10-KSB

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

             For the fiscal year ended December 31, 1996. Commission
                              file number 0-14465.



                              SONEX RESEARCH, INC.


                        Incorporated in State of Maryland
                   23 Hudson Street, Annapolis, Maryland 21401

Telephone Number:(410)266-5556     I.R.S. Employer Identification No. 52-1188993


          Securities registered pursuant to Section 12(b) of the Act:

               Title of                 Name of each exchange on
              each class                    which registered
              ----------                    ----------------
                 None                             None

          Securities registered pursuant to Section 12(g) of the Act:

                          Common Stock, $.01 par value


Check  whether the Issuer (1) filed all reports  required to be filed by Section
13 or 15(d) of the Exchange Act during the preceding 12 months, and (2) has been
subject to such filing requirements for the past 90 days.   YES [X] NO [ ]


Check if there is no disclosure of delinquent  filers in response to Item 405 of
Regulation S-B in this form, and no disclosure will be contained, to the best of
registrant's   knowledge,   in  definitive   proxy  or  information   statements
incorporated  by reference  in Part III of this Form 10-KSB or any  amendment to
this Form 10-KSB. [ X ]


The number of shares  outstanding of the Issuer's $.01 par value Common Stock as
of March 31, 1997 was  17,134,539.  The  aggregate  market value of voting stock
held by non-affiliates of the Registrant was $13,334,656 as of March 31, 1997.


          Revenues for the year ended December 31, 1996 were $70,000.


                   Documents Incorporated by Reference: None.



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                         ITEM 1. DESCRIPTION OF BUSINESS

The Company
-----------

Sonex Research,  Inc.  ("Sonex" or the  "Company"),  incorporated in Maryland in
1980,  is  engaged  in the  research,  development  and  commercialization  of a
patented  technology  (the  "Sonex  Combustion  System",  "SCS" or "Ultra  Clean
Burn(TM)  technology")  which  controls  the  combustion  of  fuel  in  engines,
primarily  through  modification  of the piston.  The Company has shown  through
tests in  manufacturers'  engines and in computer models that its technology has
the ability to control  combustion  and allow fuel to be used more  efficiently,
and that engines using the Company's  technology  have  performance  superior to
conventional engines and emit fewer harmful exhaust emissions.

Management believes that the Company's technology can be applied to all types of
internal  combustion  engines,  including  those used in personal and commercial
vehicles (automobiles,  trucks, buses, boats and motorcycles) as well as engines
used in fixed or portable utility applications (motor generator sets, pumps, and
chain saws), whether spark ignited (SI) or compression ignited (CI), carburetted
or fuel injected, using either gasoline, diesel, alcohol and/or other fuels.

Sonex is  concentrating  its efforts on the  application  of its  technology  to
direct injected (DI) turbocharged diesel engines.  Demonstration and development
programs at various  stages of completion  are underway with some of the largest
multi-national  diesel  engine  manufacturers  in the  world.  The  goal of such
programs is to execute broad agreements with the diesel engine manufacturers and
their piston suppliers for industrial  production of Sonex pistons under license
from the Company. The demonstration  process involves many stages, from proof of
concept using screw-assembled prototype pistons fabricated in-house by Sonex, to
working with piston  suppliers for the  fabrication  of finished  pre-production
pistons  that  will  be used  in  field  trials  and  durability,  manufacturing
optimization,  and  other  tests  required  before  the  start  of  full  series
production.

To date, the Company has completed separate  demonstration  programs with two of
these  manufacturers,  and  each  has  verified  and  accepted  that the SCS can
substantially  reduce particulate  emissions in a DI turbocharged  diesel engine
for  medium  duty  trucks  while   maintaining   fuel   consumption  and  power.
Negotiations  are underway with one of the world's largest piston  suppliers and
with  these  manufacturers  for  licensing,   technology  transfer  and  further
development  programs.  In  October  1996 a  third  major  international  engine
manufacturer  executed  a  funded  agreement  with  the  Company  for a  similar
demonstration program.

In addition to diesel truck engine  applications,  the Company has  successfully
applied its  proprietary  combustion  technology  to the  conversion of a small,
lightweight,  SI gasoline fueled engine to start and operate on JP5/JP8 standard
military fuel while also  improving  fuel  consumption.  The  advantages of this
converted SI engine have been  demonstrated  successfully  in a small,  remotely
controlled Unmanned Aerial Vehicle (UAV).


Employees
---------

As of March 31,  1997,  the  Company  had six  employees:  its  three  executive
officers and three individuals who provide technical  services.  The Company has
never experienced a strike or work stoppage, and believes its relations with its
employees are good.


Description of the Company's technology
---------------------------------------

The SCS improves the process of combustion through a combination of chemical and
acoustic effects that occur by modifying the engine's combustion chamber and the
processes occurring within that chamber.  Sonex designs rely on a cavity of some
kind located in the piston, the cylinder head, or existing  temporarily  between
both the piston and cylinder head. Current Sonex diesel technology  involves the
installation  of a unique  geometric  design  of  microchambers  in the  piston,
placing one microchamber adjacent to each fuel injector spray. The


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microchambers  surround the piston bowl in the form of a segmented  annulus,  or
tubular  ring.  The  position  of  the  microchamber  is a  critical  factor  in
controlling the temperature of the chamber and the gases that may be resident in
the chamber at any one time.

Sonex  places  several  small  tubular  vents  between  the piston  bowl and the
microchamber.  These  vents  control  the  amount of fuel and air that enter the
microchamber  and also  control the amount of  turbulence  that is created  when
gases jet out of the microchambers through these vents into the piston bowl. The
size,  length,  angle and  position  of the vents are  critical  to the level of
emissions  reduction.  At different times during the combustion  cycle,  air and
fuel are  admitted  to the  microchamber,  compressed  under high  pressure  and
temperature,  reformed chemically, and then exhaled from the microchamber.  This
process,  which has no moving parts,  produces  lower  overall  emissions at all
engine speeds and loads and is self-driven by the combustion process.


Potential benefits of the SCS in the reduction of emissions
-----------------------------------------------------------

Government  agencies  in North  America,  Europe and Japan  continue  to mandate
increasingly  more strict  requirements  for the  reduction of allowable  diesel
truck emissions,  specifically  with respect to  smoke/particulates  and nitrous
oxide (NO).  The use of costly high pressure  injection  systems and  electronic
controls  may permit  truck  manufacturers  to attain some of these  reductions;
however,  it is  unlikely  any one  emissions  reduction  technique  will enable
manufacturers  to meet the emission  standards to be implemented in the next few
years.

High pressure injectors may reduce smoke/particulates, but they also increase NO
emissions  while doing so.  Manufacturers,  therefore,  may be able to eliminate
present  equipment such as particulate  traps,  but they likely will need larger
catalytic converters,  leading to an increase in fuel consumption and a decrease
in power,  all at a  significantly  higher cost.  Management  believes  that the
Company's  diesel  technology,  which consists of a relatively  simple change of
piston   design,    under   various    conditions    causes   a   reduction   in
smoke/particulates,   carbon  monoxide  (CO),   hydrocarbons  (HC),  and  NO  by
significant  amounts while  maintaining  or improving  upon brake  specific fuel
consumption  (BSFC)  and power.  In tests  conducted  in the  latest  production
engines  of  several  manufacturers  fitted  with a  variety  of Sonex  pistons,
including  aluminum screw assembled pistons,  electron beam welded pistons,  and
ferrous  crown  pistons,  the Company has  demonstrated  that the SCS may reduce
smoke/particulate  emissions  in excess  of 40% and HC  emissions  by 5%,  while
maintaining  equal NO  emissions  and BSFC  within 2% above or below that of the
stock engine.

The Company's  ability to reduce soot emissions has an added benefit towards the
reduction  of NO in diesel  engines.  Many  manufacturers  are  turning to using
exhaust gas recirculation  (EGR) to reduce NO. EGR is inert exhaust gas recycled
and pumped back into the engine cylinders for the next combustion cycle. EGR can
significantly  reduce  NO,  but the  soot  recirculated  with  EGR can  increase
particulate  emissions and increase engine wear. The SCS acts to reduce both the
engine wear and the quantity of particulates  in the emissions by  significantly
reducing the soot content of the emissions.

Management  believes  that Sonex Ultra Clean  BurnTM  technology  is perhaps the
least expensive  method of emissions  reduction,  but it is likely to be used in
conjunction with other  technologies to enable  manufacturers to meet the strict
diesel truck emission standards that will be introduced later in this decade.


Health risks attributed to particulate and soot emissions
---------------------------------------------------------

Management  also  believes  that the  public  will  pressure  regulators  to set
increasingly lower particulate and soot emissions standards following the recent
publication of the results of major studies in Europe and North America  showing
a direct  correlation  between these  emissions and the incidence of lung cancer
and asthma.  In a study conducted by researchers at the Harvard School of Public
Health,  Brigham Young  University  and the American  Cancer  Society,  the soot
content of particulate  emissions has been shown to  significantly  increase the
risk of a large variety of respiratory  diseases. As a result of these and other
studies, in June 1997 the U.S. Environmental Protection Agency (EPA) is expected
to issue new, more stringent National Ambient Air Quality Standards


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(NAAQS) on small size (2.5 or lower microns) soot  particulates.  It is believed
that conventional diesel engine soot particulates are mainly in this size range.


Competition
-----------

The Company's  competition comes from the extensive research  departments of the
world's major vehicle and engine  manufacturers as well as independent  research
organizations.   Although  the  experience   and  financial   resources  of  its
competitors  far exceed those of the Company,  management  believes that the SCS
can  provide  significant  advantages  over  the  competition  in terms of cost,
performance and simplicity.


Secrecy and non-disclosure
--------------------------

Due to the  highly  competitive  nature  of the  world's  automotive  and  truck
industries,  in connection with its contracts and/or demonstration programs with
such  manufacturers  the  Company is  required  to  execute  joint  secrecy  and
disclosure  agreements  that  expressly  prohibit the public  disclosure  of the
customers' names and other significant information. Failure by Sonex to maintain
this strict level of  confidentiality  would  jeopardize the relationship of the
Company with its customers.


Overview of engine testing
--------------------------

The combustion  process of an internal  combustion engine is extremely  complex,
involving a vast number of sequential and  simultaneous  reactions.  Even slight
adjustments to the system can create large changes to the reactions  forming the
combustion  process.  As a result of these factors,  the engine testing that the
Company  undertakes  is extremely  rigorous  and  time-consuming;  however,  the
experience  gained from this process over the past few years has gradually given
the  Company's  technical  staff an  increased  understanding  of how to rapidly
design the SCS into a diesel engine of a specific size and configuration.

In the highly  competitive  world  automotive and truck  industries,  very small
percentage changes in either fuel consumption,  power or emissions can translate
into success or failure in the marketplace. In addition, because current engines
burn much cleaner and are more  efficient  than those  produced only a few years
ago, the task of extracting even further  improvements in the combustion process
presents an enormous challenge.

The emission  targets set by the different  engine  manufacturers  vary from one
engine to another,  sometimes on the basis of the specific  market,  i.e.  North
America,  Europe or Japan, in which the manufacturer intends to sell the engine.
In addition to running the specific  emissions  test relating to a given market,
the   Company   must  test  each  engine  at  a  number  of   different   timing
configurations.  This work must be repeated  for each change that Sonex makes to
the geometry of its  microchambers  and vents. The testing process is repetitive
and laborious, yet necessary to satisfy the demands of the engine manufacturers.


Stages of technology demonstration and piston design
----------------------------------------------------

The major stages in the Company's  demonstration and development  process for DI
turbocharged diesel truck engines include the following:

  o   execution of secrecy and disclosure agreements;
  o   exchange of technical information;
  o   proof of concept with screw-assembled, Sonex-modified pistons fabricated
      by Sonex and tested by the engine manufacturer in its laboratories;
  o   testing at mandated  emissions and part-load cycles at Sonex on one of the
      manufacturer's latest engines, aimed at piston design improvement;


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  o   delivery of best  design,  screw-assembled,  Sonex-modified  pistons  that
      allow the test  engine to meet  specified  emission  and fuel  consumption
      targets to the engine manufacturer for verification  testing and to one or
      more piston  suppliers  for the  fabrication  of  finished  pre-production
      pistons;
  o   delivery by piston supplier of pre-production pistons for review, approval
      and testing through the same cycles as before, first by Sonex, then by the
      engine  manufacturer,  to insure  that the  performance  of these  pistons
      equals or exceeds that of the screw-assembled pistons.

The  Company has now  reached  the next stage with two such  programs,  that is,
optimization of the piston design for the fabrication of piston  prototypes that
will be used in field trials and  durability,  manufacturing  optimization,  and
other tests required before the start of full series  production.  (See "Current
diesel  engine  programs".)  The engine  manufacturers  have stated that the SCS
benefits could be in lower cost, less complexity and greater reliability.  These
three factors are now being addressed by the Company and its customers.


Collaboration with piston suppliers
-----------------------------------

In cooperation  with the engine  manufacturers,  the Company has worked with the
major  piston   suppliers   to  these   manufacturers,   providing   engineering
specifications and drawings for their use in evaluating  alternative  production
methods in anticipation of eventual piston orders from the engine manufacturers.
One of these companies, T&N Piston Products of the U.K., is widely recognized as
one of the world's  leading  suppliers  of pistons and other  components  to the
engine industry.

T&N has developed  innovative and economical  techniques of manufacturing  Sonex
pistons for series  production.  Additional  work by T&N involves finite element
analysis,  stress  analysis and thermal cycling to examine the effects of stress
on the Sonex piston under a variety of extreme conditions. Sonex and T&N believe
the  results  of the joint  development  work,  which has been  moved from T&N's
research facility to its advanced  technology center, will demonstrate to engine
manufacturers  that  Sonex  pistons  meet  their  technical  requirements  while
remaining cost effective.


Current diesel engine programs
------------------------------

On a  continuing  basis for the past  four  years,  the  Company  has  performed
extensive design and development work for two large multi-national  diesel truck
engine original equipment manufacturers (OEM's), in separate programs.

A funded agreement to develop Sonex pistons for industrial production for one of
these  companies  was executed in 1994.  This  program  advanced to the stage of
verification tests by this engine  manufacturer on an engine in its own facility
using  pre-production  finished  Sonex  pistons  fabricated  by T&N.  Successful
results  to that point led to initial  discussions  late in 1995 for  technology
transfer and licensing  agreements.  Such discussions remained preliminary while
the engine  manufacturer  investigated the manufacturing  costs of Sonex pistons
and initiated discussions for a joint program for the optimization of the piston
design to take place  primarily at the  manufacturer's  advanced engine division
laboratory in Europe. Late in 1996, however,  the focus of discussions  changed,
and it was agreed by all three parties that the Company  first should  execute a
commercial  license  with  T&N.  Under  this  approach,  the cost of any and all
royalties  payable to the Company  would be  included  in the selling  price for
Sonex pistons to be produced and sold by T&N to the engine  manufacturer.  Based
on the  progress  of  recent  discussions,  the  Company  hopes to have  such an
agreement in place by summer 1997.

The second large  multi-national OEM has verified Sonex test results on a set of
pre-production  Sonex pistons fabricated by T&N.  Subsequent  adjustments to the
manufacturing process of these pre-production pistons have been agreed to by all
parties, and further testing is planned in the summer of 1997.

In October  1996 a third  major  international  engine  manufacturer  executed a
funded  agreement with the Company for a similar  demonstration  program that is
expected  to be  completed  by the end of 1997,  with all engine  testing  being
conducted by the manufacturer in its own laboratories.


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In March 1996 Texaco Group,  Inc.  ("Texaco")  agreed to undertake a feasibility
demonstration  and  evaluation  of the SCS to confirm the  capability of a Sonex
piston to reduce  emissions  in a single  cylinder  DI diesel  research  engine.
Texaco is funding the SCS  investigation  in response to  increasingly  rigorous
federal fuel  specifications now under consideration that are intended to assist
engine  makers in  meeting  future  emissions  and  performance  targets.  Tests
conducted  by Texaco  and  others in the  petroleum  industry  have  shown  that
advanced  technology diesel engines exhibit less sensitivity to fuel composition
than current  technology  engines.  Texaco  believes that the  development of an
engine design meeting the forthcoming  low emissions  standards using the diesel
fuel being produced today will make  unnecessary  the manufacture of higher cost
diesel  fuel and avoid the  significant  impact  that  higher cost would have on
fleet owners and operators.

The engine  selected for this testing is a single  cylinder  OEM  generator  set
engine.  The Company first developed a full set of data for the baseline engine,
then fabricated and installed Sonex pistons in the engine. A  representative  of
Texaco observed the operating  performance of both configurations of this engine
in  Annapolis  in March 1997,  after which the engine was  delivered to Texaco's
research  facility  in Beacon,  New York,  for  confirmation  testing.  Assuming
satisfactory  results  are  achieved  in this  first  phase  of the  feasibility
demonstration, Texaco and Sonex will consider more extensive testing to document
optically the  in-cylinder  SCS behavior.  Upon  completion of the testing,  the
companies will publish  jointly the evaluation  findings in scientific and trade
publications.


Lightweight, spark-ignited (SI) engines
---------------------------------------

In 1994 Sonex delivered two prototype  lightweight,  SI, carburetted  two-stroke
engines,  which it  modified  to start  and run on  JP-5/JP8  standard  military
(diesel) fuel, to the U.S. Army's Fort Belvoir, Virginia, Research,  Development
& Engineering  Center.  The Army was  interested in such an engine to be used in
light-weight,  man-  portable  generator  sets for use in the  field.  While the
demonstration  of the prototypes was successful,  the Company was informed later
that the funding for the continuation of this program had been canceled.

In 1995, however, the U.S. Naval Research Laboratory (NRL) in Washington,  D.C.,
contacted the Company for the possible  application of this engine technology in
Unmanned  Aerial  Vehicles  (UAV's),   which  are  small,   remotely  controlled
surveillance aircraft.  Sonex subsequently  demonstrated and delivered an engine
to NRL  similar  to  those  delivered  to the  Army.  This  engine,  which  is a
lightweight,  two-stroke,  SI,  carburetted,  aircooled engine, was used in July
1996 in successful flight demonstrations by NRL of a UAV. The engine, originally
gasoline  fueled,  was  converted  by Sonex to operate with  JP5/JP8  fuel.  NRL
reported an increase of nearly 50% in fuel economy for the Sonex  engine  versus
the stock  gasoline  engine.  NRL is now  considering  this  technology  for its
possible  application in a larger engine,  although  funding for the project has
not yet become available.

Based upon the successful public demonstration of the Sonex NRL UAV, the results
of which were documented by NRL in a published  report, a U.S. OEM of two-stroke
engines  recently  contracted  the Company to  investigate  the  feasibility  of
applying that design in its high volume production  gasoline fueled engine since
the design  has other  beneficial  characteristics,  such as low  cylinder  head
temperatures. In addition, a second U.S. OEM has provided four-stroke engines to
the Company and is  negotiating a contract to  investigate  the  feasibility  of
applying the Sonex NRL UAV design to its SI engines using diesel fuel.


Alternative-fuel engines
------------------------

In the summer of 1994 the National  Renewable Energy Laboratory  Division (NREL)
of the  Midwest  Research  Institute,  which is the  field  manager  for the DOE
Alternative  Fuels  Utilization  Program,  awarded  the  Company a  contract  to
demonstrate  the SCS on a one liter per  cylinder  diesel  engine  running  on a
number of different fuels, including methanol,  ethanol,  biofuel and diesel. In
1995 the  Company  successfully  started  and ran such an  engine  on neat  M100
methanol fuel (100% methanol) at standard diesel  compression  ratio (17:5) with
no fuel additive,  ignition enhancer or in-cylinder  ignition device. The engine
was stable at all speeds and loads,  and achieved  power levels similar to those
of the same  engine  running on diesel  fuel.  These  results  were  achieved by
replacing


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the  engine's  stock  piston with a  Sonex-modified  piston,  in addition to the
standard modifications normally required to fuel a diesel engine on methanol.

On the basis of these results, the Company was informed by NREL that funding was
to be set aside to continue the program in a vehicular demonstration. Sonex then
submitted its final report to NREL,  which was required to distribute the report
for outside  review.  One such  reviewer,  an employee of Cummins  Engine Co., a
major U.S. diesel engine manufacturer, stated that "... Cummins sees very little
if no interest in using  alcohol  fuels in diesel  engines."  DOE now appears to
have adopted this position as well.  Sonex is now  participating  in discussions
with DOE and Sandia  National  Laboratories  to proceed on diesel fuel  programs
rather than methanol.


Patents and proprietary information
-----------------------------------

The Company has  endeavored  to protect its  technology by filing for patents in
the United  States  and in those  foreign  countries  in which it may be able to
commercialize the technology.  The Company has also developed a significant body
of  trade  secrets,   proprietary  information  and  know-how  relating  to  its
technology.  Although the  principles  underlying the SCS concept are capable of
being understood by experts in the field,  management  believes that it would be
difficult  to apply  the  Sonex  technology  successfully  to any  given  engine
configuration without the benefit of the trade secrets, know-how and proprietary
information owned by the Company.

Management  believes that the Company's business depends  substantially upon the
protection  afforded by its granted  and pending  patents,  as well as its trade
secrets, proprietary information and know-how. All contracts outside the Company
involving  any exchange of  confidential  technical  information  are made under
secrecy agreements approved by the Company's patent counsel. In addition, all of
the  management  and  technical  employees  of the Company are  required to sign
non-disclosure agreements respecting the Company's technology.

The Company  registered the name "SONEX" at the U.S. Patent and Trademark Office
in March 1987, and is in the process of registering  the name "Ultra Clean Burn"
technology at the U.S. Patent and Trademark Office.



                         ITEM 2. DESCRIPTION OF PROPERTY

The Company's principal executive offices and testing facility are located at 23
Hudson  Street,  Annapolis,  Maryland,  21401.  The  facility is  equipped  with
emissions  test equipment and machine shop and storage  facilities  necessary to
support the laboratory.  Management  believes that all of the Company's property
is adequately covered by insurance.  The building contains  approximately  6,000
square  feet and is being  occupied  by the  Company  pursuant  to an  extension
through  November 1997 under the terms of a long-term  operating lease agreement
that expired in 1994.

The Company  will either  attempt to  negotiate  a new  long-term  lease for its
current office and laboratory  facility once the current extension  expires,  or
continue to occupy the premises on a month-to-month basis under the terms of the
previous  lease,  pursuant  to which the  property  owner is required to provide
thirty days notice if he wants the  Company to vacate the  premises.  Management
may also  search for an  alternative  location  in the event  that an  agreement
cannot be  reached  for the  existing  premises.  Management  believes  that the
resolution of the uncertainty  with respect to the facility will not result in a
significant interruption in the operations of the Company.


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                            ITEM 3. LEGAL PROCEEDINGS

As described in detail below, the Company successfully defended itself against a
legal action,  initiated by two former officers of the Company,  which concluded
in 1996.  As of the date of this report,  management  is aware of no other legal
proceedings pending against the Company.

In June 1993 the Company eliminated the full-time positions of vice-president of
operations, vice-president of engineering, and vice-president international. One
of these individuals  accepted the Company's  financial  separation offer, while
the other two former officers,  Mr. Charles C. Failla and Mr. Theodore P. Naydan
(referred to as the  "Plaintiffs")  rejected the Company's offer and in November
1993 filed a Complaint in the Anne Arundel County, Maryland,  Circuit Court. The
Complaint  demanded  immediate  full  payment of  aggregate  unpaid  salaries of
$165,515 less approximately  $14,500  representing a loan payable to the Company
by Mr. Naydan,  alleging that the Company  breached  contractual  obligations by
failing to pay salary due under  previous  employment  agreements  and  violated
Maryland labor laws by failing to pay wages due upon  termination of employment.
The  Complaint  also sought  damages of up to three times the amount owed,  plus
prejudgment interest, attorney's fees and costs.

The  Company  denied  the  allegations  and  filed a  counterclaim  against  the
Plaintiffs  for breach of contract with respect to a February 12, 1992 agreement
known as the  "Consent  to  Deferral"  (See Item 6),  executed  by all  salaried
employees  of the Company,  including  the  Plaintiffs,  in  connection  with an
indispensable capital infusion. Pursuant to the Consent to Deferral, each signer
consented  to the past and future  deferral of portions  of their  salaries  and
agreed to defer payment of amounts so accumulated until the Company has achieved
commercial  success through the receipt of substantial  licensing  revenue.  The
Company also  maintained  that it was not liable for treble damages  because its
actions did not violate the relevant law,  which  requires an employer to pay an
employee all wages due upon termination of employment unless there exists a bona
fide dispute over payment.

Following a hearing in June 1994 on various  motions for  dismissal  and summary
judgment filed by the parties,  the hearing judge denied the  Plaintiffs  claims
for treble damages and recovery of attorneys' fees and costs,  dismissed most of
the other motions,  and ordered that a trial be held on the issue of whether the
Plaintiffs  received  consideration  in exchange  for  executing  the Consent to
Deferral.

At a trial held in November 1994 before a different  judge,  the Plaintiffs were
awarded judgment in the amount of $163,140 that included  pre-judgment  interest
from the date of  termination  of  employment  through the date of the trial and
reflected an offset for the $14,500  loan payable to the Company by Mr.  Naydan.
Following the trial,  the Company filed an appeal,  and the  Plaintiffs  filed a
motion to revise the  judgment  by seeking  to reverse  the prior  ruling of the
hearing  judge  denying  the  claim  for  treble  damages.  In order to stay the
Plaintiffs from initiating steps to collect on the judgment prior to a ruling on
the appeal, on November 30, 1994 the Company posted cash security with the court
in the amount of $177,088,  which figure  included  interest  over the estimated
period of the appeal process.

In February  1995 the trial judge  denied the  Plaintiffs'  motion to revise the
judgment,  following  which the Company  refiled  its appeal and the  Plaintiffs
filed an appeal of the decision to deny treble damages.  Oral arguments before a
panel of three judges of the Maryland Court of Special Appeals were presented in
November  1995.  In  December  1995 the Court of Special  Appeals  reversed  the
judgment awarded to the Plaintiffs by the trial court, and remanded the case for
consideration by the trial court of two issues not addressed in the trial. These
issues, which were to be addressed in a second trial, involved  clarification of
whether the reference to $2 million in licensing fees in the Consent to Deferral
refers to amounts  from only one  contract  or an  aggregate  from more than one
contract,  and a  determination  of whether the  Company  acted in good faith in
claiming an inability  to pay deferred  wages prior to the receipt of $2 million
in licensing fees.

In January 1996 the Plaintiffs  filed a Petition for Writ of Certiorari with the
Court of Appeals of Maryland seeking a review of the reversal of the judgment by
the Court of Special Appeals.  The Company  immediately  filed its opposition to
the Petition, and, in April 1996 the Petition was denied. In May 1996 a total of


                                  Page 8 of 40

<PAGE>

approximately  $184,000,  including  interest  earned  through  that  date,  was
returned to the Company,  and the parties  executed a  Stipulation  of Dismissal
with Prejudice pursuant to which all claims were dismissed.

In July 1996 the Company filed a Complaint in the Circuit Court for Anne Arundel
County  seeking  to collect  from Mr.  Naydan  principal  and  interest  owed in
connection  with the $14,500 loan payable to the Company  referred to above.  In
August  1996 Mr.  Naydan  filed a Motion to Dismiss  or, in the  alternative,  a
Motion for Summary Judgment,  asserting that all amounts due to the Company were
ruled at the November 9, 1994 trial to have been  satisfied by offset against an
equal amount of deferred salary owed by the Company to Mr. Naydan.  In September
1996 the Company  filed a Cross  Motion for Summary  Judgment in which it argued
that as a result of the overturn on appeal of the November 1994 judgment against
the Company, the ruling regarding the offset of the loan against deferred salary
had been vacated.  At a hearing in November  1996, the trial court ruled against
the Company and granted Mr. Naydan's motion for dismissal.  Although the Company
and its legal  counsel  feel  that  this  decision  was  incorrect  and could be
reversed upon appeal, the Company declined to appeal.



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

No  matters  were  submitted  to a vote of  security  holders  during the fourth
quarter of 1996.



         ITEM 5. MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's Common Stock currently is traded in the over-the-counter market on
the OTC Bulletin Board service under the symbol  "SONX".  The OTC Bulletin Board
is an electronic and screen-based  quotation  medium,  operated and regulated by
Nasdaq.  Quotation  information  on OTC  Bulletin  Board  stocks is available on
stockbrokers'  desktop  terminals.  The Company's Common Stock had traded on the
Nasdaq  Small-Cap  Market until  February 9, 1995, at which time its listing was
discontinued  for failure to maintain  the minimum bid price  required by Nasdaq
for continued listing.

The  Company  has never paid cash  dividends  on its  Common  Stock and does not
expect to pay any cash  dividends in the  foreseeable  future.  The high and low
closing  prices of the Common Stock for each  quarterly  period since January 1,
1995 were as follows (These prices, which are drawn from reports provided to the
Company by Nasdaq, reflect inter-dealer prices without mark-ups,  mark-downs, or
commissions, and may not necessarily represent actual transactions.):

     Quarter ended:                             High              Low
     --------------                             ----              ---
     March 31, 1995                             $3/4              $1/4
     June 30, 1995                               5/8             11/32
     September 30, 1995                        1 5/8              7/16
     December 31, 1995                        1 9/16                 1
     March 31, 1996                           2 1/16                 1
     June 30, 1996                            2 1/16                 1
     September 30, 1996                      1 11/32               7/8
     December 31, 1996                        1 9/32             11/16
     March 31, 1997                           1 9/16               5/8

As of March 31, 1997, there were 17,134,539 shares issued and outstanding,  with
approximately  1,050  holders of record.  The  shares  for  approximately  2,800
additional  beneficial owners of the Common Stock are held of record (in "street
name") by brokers, dealers, banks, and other entities holding such securities of
record in nominee  name or otherwise or as a  participant  in a clearing  agency
registered pursuant to Section 17A of the Securities Exchange Act of 1934.


                                  Page 9 of 40

<PAGE>

       ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL POSITION
                            AND RESULTS OF OPERATIONS

Losses accumulated during development stage
-------------------------------------------

Since its inception in 1980, the Company has generated  cumulative net losses in
excess of $19 million.  Operating funds have been raised  primarily  through the
sale of equity securities in both public and private  offerings,  while revenues
to date have not been significant. Accordingly, Sonex continues to be classified
as a development stage company.


Financial position and liquidity
--------------------------------

As of March  31,  1997,  the  Company  had  available  cash and  equivalents  of
approximately  $644,000 after having  completed two private  financings in March
1997 which yielded aggregate  proceeds of $580,000.  Based upon current spending
levels,  management  believes  that the cash on hand and  expected  revenue from
currently  executed  contracts  will be sufficient  to fund  operations at least
through  the end of the first  quarter  of 1998.  The  Company is  currently  in
negotiations  for  technology  transfer  and  licensing  agreements  which would
provide  substantial  operating  funds,  but execution of such agreements is not
assured. In the absence of the realization of significant  revenues,  additional
capital may be necessary to fund operations beyond the first quarter of 1998.


Salary deferrals by employees
-----------------------------

In order to help  conserve  the  Company's  limited cash  resources,  all of the
Company's employees, at the request of the Board of Directors, for several years
have been voluntarily  deferring  receipt of payment of significant  portions of
their authorized annual salaries.  From time to time,  portions of such deferred
amounts  have been paid  through the  issuance to the  employees  of shares,  or
discounted options to purchase shares, of the Company's Common Stock.

In February 1992 the Company sold $2 million in convertible  preferred stock and
common stock  purchase  warrants in a private  placement  pursuant to a proposal
from Proactive Partners, L.P. and certain of its affiliates  ("Proactive").  The
proposal called for immediate  payment to employees of a portion of the salaries
deferred  through that time.  As a condition  to the  Company's  receiving  this
indispensable financing, Proactive required that all salaried employees document
and agree in writing to the ongoing deferral of salaries described above.

Accordingly,  in February 1992 all of the Company's  salaried  employees jointly
executed an  agreement  referred to as the  "Consent to  Deferral"  in which the
employees  consented to the past and future deferral of portions of their annual
salaries,  and  agreed to defer  payment of  amounts  so  accumulated  until the
Company has received licensing revenue of at least $2 million or at such earlier
date as the  Board of  Directors  determines  that the  Company's  cash  flow is
sufficient to allow such payment.  Immediately  upon execution of the Consent to
Deferral  and in  accordance  with the terms of the  Proactive  investment,  the
Company  received the proceeds from the financing,  with which it paid a portion
of previously deferred salaries in cash and in Company stock.

Following the  completion  of this  investment,  Proactive  became the Company's
largest shareholder by virtue of its holdings of convertible preferred stock and
common stock purchase  warrants,  and two of the general  partners of Proactive,
Mr. Myron A. "Mike" Wick, III and Mr. Charles C. McGettigan, became directors of
the Company.

The conditions of the Consent to Deferral that would allow repayment of deferred
salaries have yet to occur. As of December 31, 1996, an aggregate of $595,620 of
wages so deferred is recorded  as accrued  compensation  in the  accounts of the
Company.

                                  Page 10 of 40

<PAGE>

Results of operations
---------------------

Development Contract Revenue:

                   1996                        $ 70,000
                   1995                        $223,141
                   1994                        $146,800

Development  contract revenue  consisted of the following  amounts from projects
more  fully  described  in Item 1: (1)  $70,000  in 1996  under a  demonstration
program  begun in October 1996 to apply the SCS to a truck  diesel  engine for a
major  international  OEM;  (2)  $150,000  in 1995 and $75,000 in 1994 earned in
connection with the development  program begun in 1994 on a diesel-fueled  truck
engine for a major  European  manufacturer;  (3)  $53,141 in 1995 and $46,800 in
1994 from NREL for a methanol-fueled diesel engine demonstration; (4) $20,000 in
1995 from the U.S.  Naval Research  Laboratory  for a generator set engine;  (5)
$25,000 in 1994 from the U.S.  Army's  Fort  Belvoir  RD&E Center for two engine
generator sets.

Management is unable to predict future changes to development  contract  revenue
because the amounts  earned to date under  previous  development  contracts have
been determined through  negotiations with individual  manufacturers  based upon
the level of effort required and the level of funding that each manufacturer has
been willing to commit. In addition,  not all of the Company's  development work
has been funded by manufacturers.  Management anticipates,  however, that future
revenue may also include  consulting  fees earned while  working  together  with
manufacturers  to optimize the results  achieved on a particular  manufacturer's
engine,  and,  ultimately,  license fees and royalty  revenue once the Company's
technology  is placed  into  production  engines  by  manufacturers.  The future
amounts of such other types of revenue, however, cannot be reasonably estimated.


Research and Development (R&D) Expenses:

                                 1996           1995           1994
                                 ----           ----           ----
  Personnel:
      Salaries                 $245,919       $248,923       $209,998
      Taxes/benefits             37,025         35,542         33,813
      Bonuses                    10,000         31,625
      Stock & options            27,125         61,250         24,000
                               --------       --------       --------
      Total personnel           320,069        377,340        267,811

  Patent amortization
    and maintenance fees         71,180         88,378        193,318
  Occupancy                      55,459         57,314         61,959
  Testing supplies               35,898         29,312         45,547
  Depreciation                   21,783         20,646         23,677
  Other expenses                 19,135         12,243         30,468
                               --------       --------       --------

      Total R&D                $523,524       $585,233       $622,780
                               ========       ========       ========

Total R&D expenses decreased $61,709,  or 11%, from 1995 to 1996,  primarily due
to a decrease  in R&D  personnel  costs of $57,271,  or 15%.  From 1994 to 1995,
total R&D  expenses  decreased  $37,547,  or 6%, as  higher  personnel  costs by
$109,529  were more than offset by a $113,665  decrease  in patent  amortization
expense.

R&D  salaries  increased  by  $38,925  from  1994 to 1995  primarily  due to the
inclusion of a full year's salary in 1995 versus one month's  salary in 1994 for
the  Company's  new director of research  hired in late 1994.  Also, in 1995 the
Company awarded bonuses  totaling  $31,625,  payable in stock and cash, to three
non-officer  employees in recognition of their continued deferral of portions of
their  salaries.  In 1996 the only bonus  awarded was a cash bonus of $10,000 to
the Company's chief executive officer. No bonuses were awarded in 1994.

                                  Page 11 of 40

<PAGE>

Compensation  cost for stock  options is measured as the excess,  if any, of the
market price of the Company's stock at the date of grant over the exercise price
of the option  granted,  and is  recognized  ratably  over the  related  vesting
period.  Charges for compensation  paid in the form of stock or stock options in
1994 of $24,000  represented  the value of consulting  fees paid in stock to the
Company's former  vice-president  -  international,  who now serves as corporate
liaison in  Europe.  Late in 1995 the form of  payment  to this  individual  was
changed to stock options, with related charges in 1995 of $30,000, while charges
for payments in stock in 1995 were $8,750.  Also in 1995 the Company  recorded a
charge to  operations  of  $22,500  for  below-market  options  granted to three
non-executive  employees.  Charges  in  1996  for  stock  option  grants  to the
Company's  corporate liaison in Europe were $14,000 while additional  charges of
$13,125  in 1996  related  to  option  grants  made  to  each  of the  Company's
employees.

The significant  decrease in amortization of patents and technology from 1994 to
1995 was primarily due to the fact that the total amount of capitalized costs of
patents and  technology  was far lower in 1995 as opposed to 1994 as a result of
the  write-off  at the end of 1994 of the  capitalized  costs of  certain  older
purchased  technologies  that were abandoned,  as described below. This decrease
was partially offset by the inclusion in amortization expense in 1995 of $18,862
of  additional  write-offs,  which  figure was also the  primary  reason for the
decrease in patent amortization and maintenance fee expense from 1995 to 1996 of
$17,198.

Occupancy  expenses have been declining for the last three years. When the lease
for the Company's  office and  laboratory  facility  expired in April 1994,  the
Company  negotiated a reduction  in the monthly rent from $5,400 to $4,500,  and
two  extensions  through  June 1995.  From July 1995  through  October  1996 the
Company occupied its facility on a  month-to-month  basis under the terms of the
expired lease agreement.  An extension  through November 1997 was then executed,
with a reduction in the monthly rental to $3,500.  Rent expense is allocated 80%
to R&D and 20% to G&A based on the proportionate share of floor space devoted to
each category.

Testing  supplies  include  motor  fuel,  engine  parts and other  items used or
consumed in engine testing and in the machine shop. Related costs fluctuate from
year to year  depending on the number and type of engines being tested,  and the
timing of purchases of certain items. The charges for 1994 included an unusually
large purchase of  specialized  testing fuel which was made to take advantage of
favorable volume discounts from the supplier.

Depreciation expense has been declining for the last three years, as most of the
Company's  equipment  that was  purchased  several  years ago has  become  fully
depreciated, while purchases of new equipment have not been significant.


General and Administrative (G&A) Expenses:

                                 1996           1995           1994
                                 ----           ----           ----
  Personnel:
      Salaries                 $104,753       $182,924       $193,524
      Taxes/benefits              9,523         13,084         13,123
      Bonuses                    10,000         35,000
                               --------       --------       --------
  Total personnel               124,276        231,008        206,647

  Legal fees                     18,524         40,143         46,802
  Stock transfer agent,
    proxy fees, etc.             21,183         23,907         13,302
  Occupancy                      13,159         16,983         15,988
  Travel                         22,583         17,810         25,826
  Telephone & postage            10,982         14,215         11,211
  Insurance                      11,789         10,939         16,338
  Audit fee                       9,815          9,720          9,772
  Other expenses                 28,132         29,358         32,661
                               --------       --------       --------

      Total G&A                $260,443       $394,083       $378,547
                               ========       ========       ========

                                  Page 12 of 40

<PAGE>

Total G&A expenses decreased $133,640,  or 34%, from 1995 to 1996, primarily due
to a decrease in G&A  personnel  costs of $106,732,  or 46%.  From 1994 to 1995,
total G&A expenses increased  $15,536,  or 4%, primarily due to higher personnel
costs by $24,361.

The increase in G&A personnel costs from 1994 to 1995 is largely due to the fact
that in 1995 the Company awarded a bonus of $35,000,  payable in stock and cash,
to its chief financial  officer,  while no bonus was awarded in 1994. In 1996 he
was awarded a cash bonus of  $10,000.  The  decrease of $78,171 in G&A  salaries
from 1995 to 1996 is nearly  entirely  due to a  reduction  of $76,000 in salary
expense for the Company's  president.  Effective January 1, 1996, his employment
commitment  was  changed  from  full-time  to  part-time,  with a  corresponding
reduction in salary from $100,000 per year, 40% of which amount was deferred, to
$2,000 per month with no portion deferred.

Total legal fees  decreased by $6,659 from 1994 to 1995 and by $21,619 from 1995
to 1996. The year to year decrease is explained in part by the reduction in fees
related to the  lawsuit  filed in  November  1993 by two former  officers of the
Company,  from  $27,934 in 1994 to $21,132 in 1995 to $7,155 in 1996.  Such fees
were lower in 1995 because more time from the  attorneys was needed in the early
stages of the litigation - in the first half of 1994 with respect to motions for
dismissal,  and in the  second  half  of  that  year  for  preparation  for  and
attendance  at the  November  1994  trial.  Less time was needed in 1995 for the
filing of appeal  briefs  and for  preparation  for and  attendance  at the oral
arguments in November 1995.  The  litigation was concluded  early in 1996 in the
Company's  favor,  resulting  in lower fees in 1996.  Legal fees for charges for
general legal and securities  related  services were $16,407 in 1994,  $6,204 in
1995 and $10,066 in 1996. Charges for services from the Company's patent counsel
were $2,461 in 1994, $12,807 in 1995 and $1,303 in 1996.

Charges for stock  transfer  agent fees and for mailing of proxy  materials  and
other  communications  to  shareholders  increased  by $9,065 from 1994 to 1995,
primarily due to the fact that the Company began to incur the additional expense
of sending all press  releases  and  shareholder  letters to its  "street  name"
holders as well as to those holding  stock in their own names,  whereas this was
not often done in the past.  Such charges in 1996 were only slightly  lower than
in 1995.


Write-off of Acquired Technology:

                   1995                        $ 80,000
                   1994                        $739,036

As  described  in  Note  7 to the  Company's  financial  statements,  management
determined  in 1994 that the value of  certain  of its  older  technologies  had
suffered a permanent impairment.  Accordingly, the net book value of the related
capitalized costs,  representing the unamortized portion of costs capitalized by
the Company in connection  with the  acquisition  and maintenance of these older
technologies,  was reduced to its  estimated  recoverable amount of $80,000,
resulting  in a  charge  to  operations  in  1994  of  $739,036.  In 1995 it was
determined that the remaining  balance of $80,000 was not recoverable,  and this
amount was also charged to operations.


Interest Expense:

                   1996                         $   670
                   1995                         $ 1,198
                   1994                         $32,864

Interest expense decreased by $31,666 from 1994 to 1995 because of the write-off
in late 1994 of the capitalized  costs of acquired  technology,  resulting in no
further  interest  expense  being  imputed on the  related  technology  purchase
obligations.

                                  Page 13 of 40

<PAGE>

Gains and Losses Related to Marketable Securities:

The  unrealized  gain on sales  of  marketable  securities  of  $42,625  in 1994
represents the reversal of unrealized  losses  recorded in 1993 upon the sale in
1994 of securities  for which the aggregate  cost exceeded the aggregate  market
value at December 31, 1993.  Sales of these securities made during 1994 resulted
in realized gains of $23,666.

The realized  gains on sales of  marketable  securities in 1996  represents  the
proceeds  from the sale of a portion  of the  Company's  investment  in  Digital
Dictation,  Inc., the corporation which in October 1995 was merged with and into
the Company's inactive subsidiary,  SonoChem, Inc., as further described in Note
13 to the accompanying financial statements. Because the recorded basis for this
investment is zero, all sales proceeds are recognized as gains.


Adoption of new accounting pronouncements
-----------------------------------------

The  adoption  by the Company in fiscal  1997 of new  accounting  pronouncements
which have a delayed effective date is not expected to have a material impact on
the financial statements of the Company.



                          ITEM 7. FINANCIAL STATEMENTS


Index to financial statements presented on pages 15 to 31:

     Report of independent accountants

     Financial statements:
         Balance sheets as of December 31, 1996 and 1995

         Statements of operations and accumulated deficit for the three years in
         the period ended  December  31, 1996, and for the period from April 9,
         1980 (inception) through December 31, 1996

         Statements  of  paid-in  capital  for the  period  from  April 9,  1980
         (inception) through December 31, 1996

         Statements  of cash  flows  for the  three  years in the  period  ended
         December  31, 1996,  and for the period from April 9, 1980  (inception)
         through December 31, 1996

     Notes to financial statements



                                  Page 14 of 40

<PAGE>

                        REPORT OF INDEPENDENT ACCOUNTANTS


To the Board of Directors and
Stockholders of Sonex Research, Inc.

In our  opinion,  the  financial  statements  listed in the  accompanying  index
present  fairly,  in all  material  respects,  the  financial  position of Sonex
Research,  Inc. (a development stage company) at December 31, 1996 and 1995, and
the results of its  operations and its cash flows for each of the three years in
the period  ended  December  31,  1996,  and for the  period  from April 9, 1980
(inception)  through  December 31, 1996, in conformity  with generally  accepted
accounting principles.  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 of these
statements  in accordance  with  generally  accepted  auditing  standards  which
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,  assessing the  accounting  principles
used and  significant  estimates made by management,  and evaluating the overall
financial  statement  presentation.   We  believe  that  our  audits  provide  a
reasonable basis for the opinion expressed above.

The  accompanying  financial  statements  have been  prepared  assuming that the
Company  will  continue  as a  going  concern.  As  described  in  Note 3 to the
financial  statements,  the  Company's  ability to emerge  from the  development
stage,  commence  generation  of  significant  revenue  and  ultimately  achieve
profitable  operations remains uncertain.  The Company has incurred  significant
net losses since its inception.  The Company's  future prospects depend upon its
ability to  demonstrate  commercial  viability of its products  and/or to obtain
capital sufficient to assure the completion of its development stage activities,
all of which raise  substantial doubt about the Company's ability to continue as
a going  concern.  Management's  plans  in  regard  to  these  matters  are also
described in Note 3. The  financial  statements  do not include any  adjustments
that might result from the outcome of this uncertainty.


PRICE WATERHOUSE LLP

Baltimore, Maryland
April 8, 1997

                                  Page 15 of 40

<PAGE>

                              SONEX RESEARCH, INC.
                          (A Development Stage Company)

                                 BALANCE SHEETS

                                                         December 31,
                                                         ------------
                                                    1996              1995
                                                    ----              ----
          Assets

Current assets
 Cash and equivalents                            $   89,739        $  256,139
 Cash posted as security for
   judgment (Note 4)                                                  182,687
 Marketable securities, available-
   for-sale (Note 5)                                 36,800
 Accounts receivable                                 50,000            63,741
 Prepaid expenses                                    38,692            29,861
 Loans to officers and employees (Note 6)            16,906            43,376
                                                 ----------        ----------
   Total current assets                             232,137           575,804

Loans to officers and employees (Note 6)             15,000            15,000

Patents and technology (Note 7)                     239,308           328,822

Property and equipment (Note 8)                      28,008            44,904
                                                 ----------        ----------

           Total assets                          $  514,453        $  964,530
                                                 ==========        ==========


     Liabilities and Stockholders' Equity

Current liabilities
 Accrued compensation (Note 9)                   $  620,620        $  580,785
 Accounts payable and accrued liabilities           170,371           118,477
                                                 ----------        ----------
   Total current liabilities                        790,991           699,262
                                                 ----------        ----------

Stockholders' equity (Note 12)
 Preferred stock, $.01 par value - 2,000,000
   shares issued; shares outstanding: 1,550,001
   in 1996 and 1,830,000 in 1995                     15,500            18,300
 Common stock, $.01 par value - shares issued
   and outstanding: 16,214,020 in 1996 and
   15,281,535 in 1995                               162,140           152,815
 Additional paid-in capital                      19,165,535        19,078,191
 Unrealized increase in value of
   marketable securities                             36,800
 Deficit accumulated during development stage   (19,656,513)      (18,984,038)
                                                 ----------        ----------
   Total stockholders' equity                      (276,538)          265,268
 
Commitments (Note 14)
                                                 ----------        ----------

   Total liabilities and stockholders' equity    $  514,453        $  964,530
                                                 ==========        ==========


    The accompanying notes are an integral part of the financial statements.

                                  Page 16 of 40

<PAGE>

                              SONEX RESEARCH, INC.
                          (A Development Stage Company)

                STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT

                                                                   April 9, 1980
                                                                    (inception)
                                      Year ended December 31,         through
                                      -----------------------       December 31,
                                  1996         1995         1994         1996
                                  ----         ----         ----         ----
Revenue
 Development contracts       $    70,000  $   223,141  $   146,800  $ 1,665,566
 Other                                                                  124,425
                                --------     --------     --------    ---------
                                  70,000      223,141      146,800    1,789,991
                                --------     --------     --------    --------- 
Costs and expenses
 Research and development        523,524      585,233      622,780   11,791,690
 General and administrative      260,443      394,083      378,547    7,181,003
 Interest                            670        1,198       32,864      866,949
 Write-off of acquired
   technology                                  80,000      739,036      819,036
                                --------    ---------    ---------   ----------
                                 784,637    1,060,514    1,773,227   20,658,678
                                --------    ---------    ---------   ----------

Net loss from operations        (714,637)    (837,373)  (1,626,427) (18,868,687)
                                --------     --------   ----------  ----------- 

Other income and expense
 Investment and other income      12,049       12,182        9,299      293,134
 Debt conversion expense                                             (1,112,350)
 Gain (loss) on sales of
   marketable securities          30,113                    23,666       31,390
 Unrealized gain on
   marketable securities                                    42,625
                                --------     --------   ----------  -----------

Net loss                        (672,475)    (825,191)  (1,550,837) (19,656,513)

Deficit accumulated during
 development stage
  Beginning of period        (18,984,038) (18,158,847) (16,608,010)
                             -----------  -----------  -----------  -----------

  End of period             $(19,656,513)$(18,984,038)$(18,158,847)$(19,656,513)
                            ============ ============ ============ ============ 


Net loss per share                $ (.04)      $ (.06)      $ (.12)
                                  ======       ======       ====== 

Weighted average number of
 common shares outstanding    15,968,491   14,368,760   13,032,717
                              ==========   ==========   ==========


    The accompanying notes are an integral part of the financial statements.

                                  Page 17 of 40

<PAGE>

                              SONEX RESEARCH, INC.
                          (A Development Stage Company)

                          STATEMENTS OF PAID-IN CAPITAL
               APRIL 9, 1980 (INCEPTION) THROUGH DECEMBER 31, 1996


                            Price  Preferred stock   Common stock     Additional
                             per  ($.01 par value) ($.01 par value)    paid-in
                            share  Shares  Amount   Shares  Amount     capital
                            -----  ------  ------  --------  ------  -----------

Note: Retroactive effect has been given to all previously declared stock splits.

April 1980 - property                             1,076,252 $10,764 $   (10,764)
December 1980 - cash        $1.08                   115,312   1,152     123,848
November 1981 - repurchase                         (115,312) (1,152)      1,077
November 1981 for services                           76,874     768        (718)
January, August 1982 - cash  2.25  200,000 $2,000                       448,000
January, August 1982 - cash   .26                    76,874     768      19,232
1982 stock issuance costs                                               (36,975)
February 1983 option exercise .30                   738,000   7,380     213,420
August, November 1983 - cash
  and services                .04                    53,812     538       1,712
January-December 1984 - cash  .78                   830,054   8,300     639,573
1984 stock issuance costs                                              (142,092)
1983 and 1984 anti-dilution        200,000  2,000   492,000   4,920      (6,920)
July, August 1984 - for past
  and future services         .78                   293,620   2,936     226,164
July 1984 conversion (.65 to 1)   (400,000)(4,000)  615,000   6,150      (2,150)
July 1984 note conversion     .78                   160,154   1,602     123,398
April 1985 IPO               2.50                 1,000,000  10,000   2,490,000
1985 stock issuance costs                                              (764,938)
1985 option exercise          .74                    61,494     615      44,585
July through November 1985 -
  exercise of warrants       3.00                       750       8       2,242
Dec. 1985 and Feb. 1986 -
  exercise of warrants       2.62                   521,788   5,218   1,361,079
July 1985 note conversion     .94                    32,030     320      29,680
1986 option exercise          .74                    99,834     998      72,988
1986 exercise of warrants    2.85                   155,943   1,560     442,815
December 1986 - cash         3.57                   280,000   2,800     997,200
1986 stock issuance costs                                              (213,402)
1986 distribution to stockholders                                       (18,772)
1986 deferred compensation -
  grant of stock options                                                276,500
April 1987 - cash            4.55                   220,000   2,200     997,800
May 1987 - cash              7.14                   140,000   1,400     998,600
1987 option exercise         3.50                    20,000     200      69,800
1987 stock issuance costs                                              (265,186)
1987 deferred compensation -
  grant of stock options                                                410,625
March, December 1988 option  3.00                    25,666     257      76,741
1988 exercise of warrants    2.50                     7,500      75      18,675
1988 for services            2.63                    11,428     114      29,886
1988 note conversion         2.00                   816,500   8,165   1,624,835
1988 debt conversion expense                                            737,500
1988 reclassification of
  issuance costs                                                       (176,981)
1988 forgiveness of interest
  on note conversion                                                     44,614
1988 deferred compensation -
  grant of stock options                                                 33,750
1989 for services            2.63                    11,429     114      29,886
1989 option exercise          .48                    36,903     369      17,432
March - June 1989 - cash     2.05                   281,000   2,810     572,200
1989 exercise of warrants    2.00                    28,840     288      57,392
1989 exchange offer          2.38                   604,200   6,042   1,428,933
1989 note conversion         2.38                    55,000     550     130,075
1989 technology rights       2.38                   250,000   2,500     591,250
1989 exercise of warrants    1.75                    73,650     737     128,151
1989 stock issuance costs                                              (252,950)
1989 deferred compensation -
  grant of stock options                                                 25,603
1990 for services             .59                     9,684      97       5,653
                                   -------  ----  --------- ------- -----------

Balance, December 31, 1990           -      -     9,156,279 $91,563 $13,651,066

                            (Continued on next page)

                                  Page 18 of 40

<PAGE>
                              SONEX RESEARCH, INC.
                          (A Development Stage Company)

                          STATEMENTS OF PAID-IN CAPITAL
               APRIL 9, 1980 (INCEPTION) THROUGH DECEMBER 31, 1996

                          Price  Preferred stock     Common stock    Additional
                           per   ($.01 par value)  ($.01 par value)    paid-in
                          share   Shares   Amount   Shares   Amount    capital
                          ----- --------- ------- --------- -------  ----------
                         (Continued from previous page)
Balance, December 31, 1990         -        -     9,156,279 $91,563 $13,651,066
March through December -
 debt issuance costs      $ .50                     765,000   7,650     374,850
May, September for services .50                      86,400     864      42,336
September - conversion of
 notes and interest         .33                     645,442   6,454     208,693
Adjustment to stock ledger                           (1,500)    (15)     (3,547)
                                --------- ------ ---------- -------  ----------
Balance, December 31, 1991         -        -    10,651,621 106,516  14,273,398
February for cash          1.00 1,750,000 17,500                      1,732,500
Feb. - loan conversion     1.00   250,000  2,500                        247,500
February - conversion of
 notes and interest         .33                     349,892   3,499     113,131
February - payment
 of accrued compensation    .50                     384,220   3,842     188,268
April - conversion (.35 to 1)     (20,000)  (200)    57,143     571        (371)
August, December option
 exercise                   .50                      14,050     141       6,884
December - exercise of
 Class A warrants          1.50                     431,775   4,318     643,344
December - exercise of
 Class B warrants          2.00                       1,800      18       3,582
December - exercise of
 warrants                  1.00                      21,429     214      21,215
Compensation - grant of
 stock options                                                           51,562
Stock issuance costs                                                   (164,836)
                                --------- ------ ---------- -------  ----------
Balance, December 31, 1992      1,980,000 19,800 11,911,930 119,119  17,116,177
May through December -
 option exercise            .50                     153,038   1,531      74,988
May - exercise of warrants 2.00                         833       8       1,658
Issuance of discounted
 options in payment of:
  Accrued compensation                                                  303,611
  Note payable to officer                                                28,000
Stock issuance costs                                                     (1,596)
                                --------- ------ ---------- -------  ----------
Balance, December 31, 1993      1,980,000 19,800 12,065,801 120,658  17,522,838
February through August -
 option exercise            .50                      75,379     754      36,936
April - conversion (.35 to 1)    (150,000)(1,500)   428,567   4,286      (2,786)
April - conversion of
 loan and interest          .75                     281,872   2,819     208,585
June and July for cash      .75                     766,666   7,666     567,334
October for services        .80                      30,000     300      23,700
Stock issuance costs                                                     (7,767)
                                --------- ------ ---------- -------  ----------
Balance, December 31, 1994      1,830,000 18,300 13,648,285 136,483  18,348,840
January - July for services .58                      15,000     150       8,600
June for cash               .25                   1,020,000  10,200     244,800
June - payment of
 accrued compensation       .25                     170,000   1,700      40,800
June - indemnification
 by officer                                                              15,000
September through November
 option exercise            .50                      88,250     882      43,243
December for cash          1.00                     340,000   3,400     336,600
Compensation - grant of
 stock options                                                           52,500
Stock issuance costs                                                    (12,192)
                                --------- ------ ---------- -------  ----------
Balance, December 31, 1995      1,830,000 18,300 15,281,535 152,815  19,078,191
January for services       1.00                       1,000      10         990
January through August
 option exercise            .50                     131,488   1,315      64,429
April and July -
 conversion (.35 to 1)           (279,999)(2,800)   799,997   8,000      (5,200)
Compensation - grant of
 stock options                                                           27,125
                                --------- ------ ---------- -------  ----------
Balance, December 31, 1996      1,550,001$15,500 16,214,020$162,140 $19,165,535
                                ========= ====== ========== ======= ===========

    The accompanying notes are an integral part of the financial statements.

                                  Page 19 of 40
<PAGE>
                              SONEX RESEARCH, INC.
                          (A Development Stage Company)

                            STATEMENTS OF CASH FLOWS
                                                                  April 9, 1980
                                                                   (inception)
                                     Year ended December 31,         through
                                     -----------------------       December 31,
                                   1996       1995        1994         1996
                                   ----       ----        ----         ----
Cash flows from operating
activities:
 Net loss                       $(672,475) $(825,191) $(1,550,837) $(19,656,513)
 Adjustments to reconcile net
  loss to net cash used in
  operating activities
   Depreciation                    21,783     20,646       23,680       665,515
   Amortization of patents        101,970     79,653      193,318     1,376,608
   Write-off of acquired
     technology                    80,000    739,036      819,036
   Compensation - stock options    27,125     52,500                    877,665
   Imputed interest expense                                23,328       551,247
   Interest credited to paid-
     in capital                                            44,614
   Debt conversion expense                                            1,112,350
   Current liabilities and
     charges paid in stock          1,000     51,250       35,404     1,124,380
   (Gain)/loss on sale of
     marketable securities        (30,113)                (23,666)      (31,390)
   Unrealized gain on sale of
     marketable securities                                (42,625)
   (Increase) decrease in
     accounts receivable           13,741     17,959      (81,700)      (50,000)
   (Increase) decrease in
     prepaid expenses              (8,831)     1,935       (5,300)      (38,692)
   Increase in accrued
     liabilities                   91,729    120,779      153,746       703,327
                                 --------   --------     --------   -----------
Net cash used in operating
activities :                     (454,071)  (400,469)    (535,616)  (12,501,853)
                                 --------   --------     --------   -----------
Cash flows from investing
activities:
  Purchase of marketable
    securities                                           (245,618)   (2,377,256)
  Proceeds from sales of
    marketable securities          30,113     17,292      822,617     2,408,646
  (Increase) decrease in
    loans to employees             26,470    (17,231)      (2,231)      (31,906)
  (Increase) decrease in cash
    posted as security
    for judgment                  182,687     (5,599)    (177,088)
  Acquisition of property
    and equipment                  (4,887)                 (3,462)     (544,036)
  Additions to patents
    and technology                (12,456)   (15,941)    (187,492)   (1,310,502)
                                 --------   --------     --------   -----------
Net cash provided by (used in)
investing activities:             221,927    (21,479)     206,726    (1,855,054)
                                 --------   --------     --------   -----------
Cash flows from financing
activities:
  Issuance of stock                65,744    639,125      612,690    15,107,655
  Issuance of convertible debt                                        2,287,500
  Indemnification by officer                  15,000                     15,000
  Repayment of convertible debt                                         (92,500)
  Stock and debt issuance costs              (12,192)      (7,768)   (2,038,916)
  Distribution to stockholders                                          (18,772)
  Reduction of technology
    purchase obligations                                               (797,500)
  Proceeds from borrowings                                 77,020     1,592,748
  Reduction of borrowings                     (9,898)    (320,707)   (1,608,569)
                                 --------   --------     --------   -----------
Net cash provided by
financing activities:              65,744    632,035      361,235    14,446,646
                                 --------   --------     --------   -----------
Increase (decrease) in cash:     (166,400)   210,087       32,345        89,739

Cash at beginning of period:      256,139     46,052       13,707
                                 --------   --------     --------   -----------
Cash at end of period:           $ 89,739   $256,139     $ 46,052      $ 89,739
                                 ========   ========     ========      ========


    The accompanying notes are an integral part of the financial statements.

                                  Page 20 of 40

<PAGE>
                              SONEX RESEARCH, INC.
                          (A Development Stage Company)

                          NOTES TO FINANCIAL STATEMENTS

NOTE 1 - THE COMPANY

Sonex Research,  Inc. has developed and acquired  technology  which controls the
combustion  of fuel in  engines.  The  Company is in the  process of  developing
several  commercial  applications  of its  technology,  referred to as the Sonex
Combustion   System  (SCS).   Sonex  expects  to  license   several   commercial
applications  of its  technology  and  commercially  exploit other  applications
itself.  Related  revenue  earned  to date has  been  derived  principally  from
development  contracts,  but such revenue  offsets  only a small  portion of the
related development expenditures.
Accordingly, Sonex Research, Inc. is classified as a development stage company.


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Presentation of financial statements
------------------------------------

Certain  reclassifications  have been made to the financial  statements of prior
years to conform to the classifications  used in 1996. The financial  statements
include the accounts of the Company and,  until its  disposition in October 1995
as described in Note 13,  SonoChem,  Inc. All  intercompany  balances  have been
eliminated in consolidation.  SonoChem,  Inc. has been an inactive company since
1988, and its recorded expenses since then have not been significant.


Cash and equivalents
--------------------

The Company's By-Laws restrict the types of permitted  investments to securities
issued by the U.S. Treasury, savings accounts insured by the U.S. Government, or
investment  companies that invest in  obligations of the U.S.  Government or its
agencies. The Company considers all short-term,  highly liquid investments which
are convertible into cash within three months or less to be cash equivalents.


Marketable  securities
----------------------

Securities  held by the  Company  are  classified  as  "available-for-sale"  for
financial  statement  purposes;  accordingly,  unrealized  gains and losses with
respect to such securities are reported as a separate component of stockholders'
equity.  Realized  gains and losses are reported in the  Company's  statement of
operations.


Patents  and  technology
------------------------

The costs associated with the filing of patent applications, computer models and
simulations  developed  by third  parties,  and the  acquisition  of patents and
technology  from third  parties  are  deferred.  Amortization  is  recorded on a
straight-line basis over the remaining legal life of patents,  commencing in the
year in  which  the  patent  is  granted,  or over a  five-year  period  for the
capitalized  costs of computer models and  simulations.  Costs related to patent
applications  which  ultimately fail to result in the grant of a patent,  either
through rejection by patent  authorities or through  abandonment by the Company,
are charged to operations at the time such determination is made.


Property and equipment
----------------------

Property  and  equipment  is stated at cost or, in the case of leased  equipment
under  capital  leases,  at the present  value of future  lease  payments,  less
accumulated  depreciation.  Major renewals and  betterments  are capitalized and
ordinary  repair and maintenance  expenditures  are charged to operations in the
year  incurred.  Depreciation  is computed  using the  straight  line method for
financial  reporting  purposes and accelerated  methods for income tax purposes.
Equipment  and  vehicles  are  depreciated  over  three  to seven  years,  while
leasehold  improvements  are depreciated  over the shorter of the useful life or
the remaining term of the related lease.


Revenue  recognition
--------------------

Revenue  derived from  development  contracts is  recognized  upon the Company's
completion of the milestones  and/or submission of progress reports specified in
each contract.  Commercial  development  contracts are executed in situations in
which a manufacturer is willing to provide funding to partially offset the

                                  Page 21 of 40
<PAGE>

development  costs  incurred by the Company in applying its technology to one of
the manufacturer's engines.  Development contracts are also executed for funding
supplied by a government or quasi-government agency.

Generally,  commercial  development contracts require the Company to demonstrate
that the manufacturer's engine, when modified with the Company's technology, can
meet  certain  emissions  reduction  and  performance  goals  specified  in  the
contract. In addition, these contracts sometimes provide that payment of part of
the contract amount will be made only if the Company meets the specified  goals.
The Company is not required to repay any funds  received in connection  with its
development  contracts.  To date, the development contract revenue earned by the
Company has offset only a small  percentage  of total  research and  development
expenditures.


Stock-based  compensation
-------------------------

The Company  accounts for  stock-based  compensation  using the intrinsic  value
method prescribed in Accounting Principles Board (APB) Opinion No. 25. Under APB
No. 25,  compensation  cost is  measured  as the  excess,  if any, of the quoted
market price of the Company's stock at the date of grant over the exercise price
of the  option  granted.  Compensation  cost  for  stock  options,  if  any,  is
recognized ratably over the vesting period. The Company provides  additional pro
forma  disclosures as required under SFAS No. 123  "Accounting  for  Stock-Based
Compensation".


Net loss per  share
-------------------

Net loss per share is computed based upon the weighted  average number of common
shares  outstanding  during the year. No  consideration  is given to convertible
preferred stock and exercisable stock options and warrants in these computations
since they would serve to reduce the loss per share.


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 amounts reported in the financial  statements and accompanying notes.
Actual results may differ from those estimates.


NOTE 3 - LIQUIDITY AND ABILITY TO EMERGE FROM THE DEVELOPMENT STAGE

Substantial  progress  toward  commercialization  of the SCS has been made under
joint development  programs with manufacturers,  and negotiations for production
piston development  programs and licensing agreements are currently in progress.
Until such time, however, as licensing  agreements are executed with one or more
major  engine  manufacturers,  substantial  doubt  remains  about the  Company's
ability to emerge from the development stage, commence generation of significant
revenues and ultimately achieve profitable operations.

Management  recognizes  that the  Company's  current  level of available  funds,
including  the  capital  raised  in  March  1997  pursuant  to the  transactions
described in Note 15, combined with revenue from current and future  development
contracts, may not provide sufficient operating capital to fund operations until
such time as a stream of royalty  revenue is realized  from the licensing of the
SCS.   Accordingly,   the  Company  will  continue  to  minimize  its  operating
expenditures  through a number of measures,  including the continued deferral by
officers and other salaried employees of significant portions of their salaries.
In the event that the  realization of significant  revenue from the licensing of
the SCS is further delayed,  the Company may need to raise additional capital to
fund its development stage activities.


NOTE 4 - CASH POSTED AS SECURITY FOR JUDGMENT

In connection with a judgment  stemming from a lawsuit against the Company filed
by two former  officers as  described  in Note 10, on  November  30,  1994,  the
Company placed $177,088 in cash on deposit with the court pending the resolution
of an appeal.  The  judgment was later  reversed on appeal,  and, in May 1996, a
total of approximately  $184,000,  including  interest earned through that date,
was returned to the Company.



                                  Page 22 of 40

<PAGE>

NOTE 5 - MARKETABLE SECURITIES

As described in Note 13, in October 1995 the  Company's  inactive,  public shell
subsidiary,  SonoChem,  Inc., was merged with and into Digital  Dictation,  Inc.
("Digital"),  a privately held Virginia medical transcription  services company.
In  connection  with the  merger,  the  Company  exchanged  all of its shares in
SonoChem for 125,133 shares of the common stock of Digital,  representing  2% of
the issued and  outstanding  shares of Digital.  A total of 5% of the issued and
outstanding  shares of Digital,  including  those  shares  held by Sonex,  began
trading in the  over-the-counter  market in April 1996.  During 1996 the Company
sold a total of 27,000  shares of its Digital  stock and realized  aggregate net
proceeds of $30,113.

At the time of this  exchange  in October  1995,  the fair value of neither  the
SonoChem stock nor the Digital stock was reasonably estimable.  As a result, the
Company's  carrying  basis in the SonoChem stock of zero is considered to be its
cost basis in the Digital  stock,  and no gain or loss was  recorded in the 1995
financial  statements  with respect to this  transaction.  Since public  trading
began in April 1996 and a readily  determinable fair value for the Digital stock
has become  available,  the  investment is now accounted for in accordance  with
SFAS  No.  115  and  classified  as a  current  asset  as  a  security  that  is
"available-for-sale". Accordingly, the Company's investment in the 98,133 shares
held  as of  December  31,  1996  is  recorded  in  the  accompanying  financial
statements  at its  aggregate  fair value of $36,800.  A  corresponding  amount,
representing the aggregate  unrealized gain in the fair value of this investment
in  excess  of  its  cost  basis,  is  reported  as  a  separate   component  of
stockholders'  equity.  Subsequent changes in the aggregate market value of this
investment will be similarly recorded.

During 1992 and early 1993  approximately  $778,000 of the Company's  funds were
invested in a publicly traded stock.  This investment was purchased on behalf of
the  Company  by its  president  pursuant  to  authority  granted  him under the
Company's  By-Laws in effect at the time,  although  without  the  knowledge  or
approval of the Company's Board of Directors.  The president subsequently agreed
to indemnify the Company against any losses on the sale of this investment,  and
the  Company's   By-Laws  were  amended  to  restrict  the  types  of  permitted
investments to those described in Note 1.

The  investment was sold in stages from December 1993 through March 1995 and, in
the aggregate,  the Company  recognized a net gain of $1,750 from such sales and
incurred  interest of $11,727 on borrowed funds secured by the  investment.  The
Company has since been indemnified by its president for net losses of $9,977. In
June 1995 the Company received an additional reimbursement from its president in
the amount of $5,023 for expenses  paid by the Company since late 1991 that were
subsequently  determined  to have been  incurred  by its  president  for matters
unrelated to the Company's operations. The aggregate indemnification and expense
reimbursement of $15,000 has been credited to additional  paid-in capital during
1995.


NOTE 6 - LOANS TO OFFICERS AND EMPLOYEES

Loans totaling  $37,180,  bearing  interest at six percent per annum,  were made
early in 1993 to four of the Company's officers and one non-officer employee for
the payment of income tax liabilities  incurred by these  individuals upon their
receipt  in 1992 of  shares  of  common  stock in  payment  of  deferred  wages.
Outstanding loan principal and accrued interest balances are secured by deferred
salaries  payable to each of the borrowers.  One of these loans in the principal
amount of $14,500 was made to the Company's vice-president of operations,  whose
employment was later terminated.  The former officer, however,  instituted legal
action against the Company in November 1993, as described in Note 10, to collect
additional amounts of deferred salary, net of the loan balance.  During 1996 the
Company unsuccessfully instituted legal action for collection of this amount; as
a result,  the  outstanding  loan  principal and interest was satisfied  through
offset against deferred salary payable to the former officer.

The maturity date for the loan principal and interest due from current employees
has been extended through December 31, 1997. As of December 31, 1996,  aggregate
loan principal of $13,580  remained  outstanding,  while accrued interest on the
loans aggregated $3,326.

                                  Page 23 of 40

<PAGE>

Loans  totaling  $15,000  were  made at the end of  December  1995 to one of the
Company's  officers and two non-officer  employees for the payment of income tax
liabilities  incurred by these  individuals upon their receipt in 1995 of shares
of common  stock in  payment  of bonus  compensation.  The loans are  secured by
deferred salaries payable to each of the borrowers, and become due within ninety
days of the date that the shares of common  stock  received by the  borrowers in
1995 first become saleable.  The loans originally bore a stated interest rate of
six percent per annum,  but were  amended  recently by the Board of Directors to
eliminate the accrual of interest.


NOTE 7 - PATENTS AND TECHNOLOGY

The capitalized costs of patents and technology consists of the following:

                                                      December 31,
                                                   ------------------
                                                   1996          1995
                                                   ----          ----
    Patent application fees and
      related legal costs                        $249,093      $236,637
    Computer models and simulations               237,164       237,164
                                                 --------      --------
                                                  486,257       473,801

    Accumulated amortization                     (246,949)     (144,979)
                                                 --------      --------

                                                 $239,308      $328,822
                                                 ========      ========

Following an extensive  evaluation in 1994 of the factors affecting the economic
value of all of the Company's  proprietary  technology,  the carrying  values of
certain technology developed internally,  other technology acquired from a third
party,  and  related  technology  purchase  obligations,  were  reduced to their
estimated recoverable amounts. Related charges to operations in the accompanying
financial statements aggregated $739,036 in 1994 and $80,000 in 1995.

The  Company  has  conducted  and  continues  to conduct  its own  research  and
development  activities which have resulted in additional proprietary technology
and patents.  Development of commercial  applications of certain elements of the
SCS has commenced and management  believes the  capitalized  cost of patents and
technology will be recovered  through revenue derived from the licensing of such
technology. Management closely monitors the patent application process and other
factors  which may affect the economic  value of the Company's  technology,  and
will further reduce the  capitalized  cost of patents and technology  should the
recovery of such cost no longer be sustainable.


NOTE 8 - PROPERTY AND EQUIPMENT

Property and equipment consists of the following:

                                                      December 31,
                                                   ------------------
                                                   1996          1995
                                                   ----          ----

    Shop equipment                               $394,182      $388,346
    Equipment under capital lease                                43,299
    Vehicles                                       11,053        11,053
    Office equipment                               24,806        22,902
    Leasehold improvements                                       31,367
                                                 --------      --------
                                                  430,041       496,967

    Accumulated depreciation                     (402,033)     (452,063)
                                                 --------      --------

                                                 $ 28,008      $ 44,904
                                                 ========      ========


                                  Page 24 of 40

<PAGE>

NOTE 9 - ACCRUED COMPENSATION

In order to help  conserve  the  Company's  limited cash  resources,  all of the
Company's salaried  employees for several years have been voluntarily  deferring
significant  portions  of the  salaries  due them  under the  terms of  previous
employment agreements or as otherwise established by the Board of Directors.  As
of December  31, 1996,  an  aggregate of $595,620 of wages so deferred  remained
unpaid and has been recorded as accrued  compensation  on the Company's  balance
sheet.  This  balance  includes  amounts  payable  to two  former  officers  who
unsuccessfully sought early repayment through the legal action described in Note
10. As a result of that  litigation  and a  subsequent  unsuccessful  collection
action filed by the Company in 1996,  approximately  $14,500 representing a loan
payable to the Company by one of the former officers, plus accrued interest, was
determined to have been  satisfied by offset against an equal amount of deferred
salary owed by the Company to the former officer.

As a condition of the Company's  receiving an indispensable  capital infusion in
February  1992,  the  investors,  Proactive  Partners,  L.P.  and certain of its
affiliates  ("Proactive") who became the Company's largest shareholder by virtue
of their  purchase of  convertible  preferred  stock and common  stock  purchase
warrants,  required  that the  voluntary  deferral  of  salaries  be  documented
formally.  Accordingly, all salaried employees executed an agreement referred to
as the  "Consent to  Deferral"  in which they  consented  to the past and future
deferral of portions of their annual  salaries,  and agreed to defer  payment of
amounts so accumulated  until the Company has received  licensing  revenue of at
least $2 million or at such earlier  date as the Board of  Directors  determines
that the Company's cash flow is sufficient to allow such payment.


NOTE 10 - LITIGATION

In  June  1993  the  Company   eliminated  the  positions  of  three   full-time
vice-presidents.  One of these  individuals  accepted the  Company's  separation
compensation  offer,  while the other two former  officers  (referred  to as the
"Plaintiffs") instituted legal action in November 1993, demanding immediate full
payment of aggregate  unpaid  salaries of $165,515  less  approximately  $14,500
representing  a loan  payable  to the  Company  by one of the  Plaintiffs.  This
lawsuit alleged that the Company breached contractual  obligations by failing to
pay salary due under previous employment  agreements and violated Maryland labor
laws by failing to pay wages due upon termination of employment.  The Plaintiffs
sought immediate full repayment of deferred  salaries and damages of up to three
times the amount owed, plus prejudgment interest, attorney's fees and costs.

Following  a hearing  in the trial  court in June 1994 on  various  motions  for
dismissal and summary  judgment  filed by the parties,  the hearing judge denied
the  Plaintiffs  claims for treble  damages and recovery of attorneys'  fees and
costs, and dismissed most of the other motions. At a trial held in November 1994
before a different  judge, the Plaintiffs were awarded judgment in the amount of
$163,140 that included  pre-judgment  interest from the date of  termination  of
employment through the date of the trial and reflected an offset for the $14,500
loan. Following the trial, the Company filed an appeal and, in order to stay the
Plaintiffs from initiating steps to collect on the judgment prior to a ruling on
the appeal, on November 30, 1994 the Company posted cash security with the court
in the amount of $177,088,  which figure  included  interest  over the estimated
period of the appeal process.

In December  1995 the Maryland  Court of Special  Appeals  reversed the judgment
awarded to the  Plaintiffs by the trial court,  following  which the  Plaintiffs
filed a Petition  for Writ of  Certiorari  with the Court of Appeals of Maryland
seeking  a review  of the  reversal  of the  judgment  by the  Court of  Special
Appeals.  In April 1996 the  Petition  was denied and,  in May 1996,  a total of
approximately  $184,000,  including  interest  earned  through  that  date,  was
returned to the Company. Also in May 1996, the parties executed a Stipulation of
Dismissal with Prejudice pursuant to which all claims were dismissed.


                                  Page 25 of 40

<PAGE>

NOTE 11 - INCOME TAXES

The  Company  has not  incurred  any  federal or state  income  taxes  since its
inception  due to operating  losses.  At December 31, 1996,  the Company had net
operating loss carryforwards of approximately  $16.5 million available to offset
future taxable income. If certain substantial changes in the Company's ownership
should  occur,  there  would  be an  annual  limitation  on  the  amount  of the
carryforwards   which  can  be  utilized.   The  Company's  net  operating  loss
carryforwards expire at various dates from 1997 through 2011, as follows:


    Expiring in 1997 - 1998                  $   947,000
    Expiring in 1999 - 2000                    2,005,000
    Expiring in 2001 - 2002                    3,907,000
    Expiring in 2003 - 2011                    9,667,000
                                             -----------

                                             $16,526,000
                                             ===========

The  difference  between the net  operating  loss  carryforwards  for income tax
reporting  purposes  and the  accumulated  deficit  reported in these  financial
statements results principally from temporary differences relating to the timing
of the recording of deferred  salaries and compensation  related to the grant of
stock options for income tax and financial reporting  purposes,  the differences
in the  accounting  for the  Company's  investment  in its  former  consolidated
subsidiary for income tax and financial reporting  purposes,  and as a result of
the  non-deductibility  for income tax purposes of the charge to operations  for
debt  conversion  expense in 1988.  The  potential  income tax  benefit of these
carryforwards  and temporary  differences of approximately  $6.4 million has not
been recorded in the financial  statements due to the uncertainty of realization
based on the Company's financial performance to date.


NOTE 12 - CAPITAL STOCK

Authorized capital stock
------------------------

The Company is presently authorized to issue 48 million shares of $.01 par value
common stock and 2 million shares of $.01 par value convertible preferred stock.
The preferred  stock has priority in liquidation  over the common stock,  but it
carries no stated  dividend.  The holders of the  preferred  stock,  voting as a
separate class,  have the right to elect that number of directors of the Company
which  represents a majority of the total  number of  directors.  The  preferred
stock is  convertible  at any time at the option of the holder into common stock
at the rate of $.35 per share of common stock.  As of December 31, 1996, a total
of 449,999 shares of preferred stock had been converted into 1,285,707 shares of
common stock.


Private placements of common equity
-----------------------------------

In June 1994 the Board of  Directors  accepted a proposal  from  Proactive,  the
Company's largest shareholder and two of whose general partners are directors of
the Company,  for an immediate private investment of $500,000 and the conversion
to common equity of loans payable to Proactive aggregating $200,000,  along with
accrued interest of $11,404.

In  consideration  of its $500,000 cash investment  Proactive  received  666,666
shares of common stock,  five-year warrants to purchase 333,333 shares of common
stock at $1.125 per share (the "$1.125  Warrants"),  and  five-year  warrants to
purchase  333,333  shares  of  common  stock  at $1.50  per  share  (the  "$1.50
Warrants").   The  Company  also  accepted  additional  investments  aggregating
$75,000,  on the same terms as the  Proactive  cash  investment,  from a limited
number  of other  shareholders.  The  outstanding  loans  and  accrued  interest
aggregating  $211,404 owed to Proactive  were  converted  into 281,872 shares of
common stock,  and Proactive  also received  140,936 of the $1.125  Warrants and
140,936 of the $1.50 Warrants.

In late May 1995 the Board of Directors  accepted a proposal from  Proactive for
an  immediate  private  investment  of  $200,000,  in  consideration  for  which
Proactive  received  800,000  shares  of common  stock,  five-year  warrants  to
purchase  400,000  shares  of  common  stock  at $.375  per  share  (the  "$.375
Warrants"), and five-year warrants to purchase 400,000 shares of common stock at
$.50 per share (the "$.50 Warrants"). The Company also accepted


                                  Page 26 of 40

<PAGE>

additional investments aggregating $55,000, in units of $5,000 on the same terms
as the Proactive cash investment,  from a limited number of other  shareholders.
In connection with this  financing,  the Company paid an advisory fee of $10,000
to an entity affiliated with Proactive.

In June 1995 accrued bonus compensation aggregating $42,500 due to the Company's
chief  financial  officer  and three  other  employees  of the  Company was paid
through  the  issuance  of common  stock and  warrants  on the same terms as the
Proactive cash investment.  In total, these employees received 170,000 shares of
common stock,  $.375 Warrants to purchase  85,000  shares,  and $.50 Warrants to
purchase 85,000 shares.

In connection with a private  financing in December 1995, the Board of Directors
accepted investments  aggregating  $340,000,  in units of $10,000,  from several
shareholders who are accredited investors. Each $10,000 Unit consisted of 10,000
shares of the  Company's  common  stock and  five-year  warrants  to purchase an
additional  10,000  shares  of  common  stock at $1.25  per  share  (the  "$1.25
Warrants").  The  Company  also  agreed  to file,  prior to June  30,  1996,  an
effective  registration statement covering the common stock issued in connection
with this private  placement and the common stock  issuable upon the exercise of
the $1.25 Warrants.

As  described  in Note 15, the Company  was unable to  complete a  registration,
initiated in 1996, of the  securities  issued in connection  with the financings
described  above.  Instead,  as of February  28, 1997,  the Company  offered the
holders  thereof a number of  amendments  to their  warrants.  As a result,  the
exercise prices of the $1.125 and $1.50 Warrants issued in June 1994 to purchase
an aggregate of 1,048,536  shares of common stock and the $1.25 Warrants  issued
in December 1995 to purchase 340,000 shares of comon stock were reduced to $.75.
In  addition,  all of these  warrants,  as well as the $.375  and $.50  Warrants
issued in May 1995 and June 1995,  were amended to permit  cashless  exercise at
the option of the holder and to provide for "piggy-back" registration rights.

As  described  in Note 15, in March 1997 the Company  raised  additional  equity
capital aggregating $580,000 from Proactive and other shareholders,  and amended
the terms of certain  warrants issued in February 1992 in addition to making the
amendments to the warrants described above.

No  separate  value  has been  reflected  in the  financial  statements  for the
warrants issued in the above transactions based on management's  belief that the
separate fair value of such warrants is not significant.


Stock options
-------------

The Company maintains a non-qualified stock option plan which has made available
for  issuance a total of five million  shares of common  stock.  All  directors,
full-time   employees   and   consultants   to  the  Company  are  eligible  for
participation.  Option awards are  determined at the  discretion of the Board of
Directors.  Upon a change in control of the  Company,  all  outstanding  options
become  vested with  respect to those  options  which have not  already  vested.
Options granted to date expire at various dates through August 2006.

In June 1995 the Board of Directors  approved the grant to each of the Company's
seven outside directors of ten-year options to purchase 200,000 shares of common
stock. These options vest at the rate of 25% per year beginning with the date of
grant and have an  exercise  price of $.50 per share,  which price was above the
then current  market price of the common stock.  Also in June 1995, the exercise
price of a total of 448,000  options  granted to outside  directors in June 1992
was reduced  from $1.25 per share to $.50 per share to reflect the fact that the
incentive  element  of these  options  had been  eliminated  as a result  of the
subsequent  sustained decline in the market price of the common stock to a value
substantially below the exercise price established at the date of grant of these
options.


                                  Page 27 of 40

<PAGE>

Between  January 1, 1994 and December 31,  1996,  the Company had the  following
activity in options to purchase shares of common stock:


                                                Weighted               Weighted
                                                 average                average
                                                exercise  # of shares  exercise
                                   # of shares    price   exercisable    price
                                   -----------  -------   -----------  --------

Unexercised at January 1, 1994      2,534,851     $.64     1,986,529     $.64
                                                           =========     ====
    Granted                            48,500      .50
    Exercised                         (75,379)     .50
    Lapsed or canceled                 (3,750)     .50
                                   -----------  -------

Unexercised at December 31, 1994    2,504,222      .64     2,270,067     $.64
                                                           =========     ====
    Granted                         1,611,000      .52
    Exercised                         (88,250)     .50
    Lapsed or canceled
                                   -----------  -------

Unexercised at December 31, 1995    4,026,972      .51     2,807,372     $.52
                                                           =========     ====
    Granted                           123,000      .80
    Exercised                        (131,488)     .50
    Lapsed or canceled                (45,000)     .50
                                   -----------  -------

Unexercised at December 31, 1996    3,973,484     $.51     3,195,734     $.53
                                    =========     ====     =========     ====


Of the options  exercisable  at December 31,  1996,  options for the purchase of
3,002,484, 53,250, and 140,000 shares, respectively,  were exercisable at prices
of $.50, $.75 and $1.00 per share, respectively. As of December 31, 1996, taking
into account options that expired, were cancelled or were exercised,  options to
purchase 397,182 shares of common stock remain available for future grant.

For certain options granted during 1996 and 1995, the Company  credited  $27,125
and $52,500,  respectively,  to additional  paid-in  capital,  representing  the
excess of the aggregate market value at the date of grant of shares under option
over the aggregate exercise price of such options,  and charged a like amount to
compensation expense.
No such charges were incurred in 1994.

The  Company  applies  APB  Opinion  No.  25  in  accounting  for  stock  option
compensation;  however,  SFAS No.  123  requires  the  Company  to make  certain
disclosures  as if the fair value based method of accounting had been applied to
the Company's  stock option grants made  subsequent  to 1994.  Accordingly,  the
Company  estimated the grant date fair value of each option  awarded in 1995 and
1996 using the  Black-Sholes  option  pricing model with the following  weighted
average  assumptions:  expected  volatility  of 124%,  risk-free  interest  rate
between 6.19% and 6.87%,  zero dividend  yield,  and expected terms of ten years
for options  granted to  employees,  officers and  directors and three years for
options granted to consultants.

Had  compensation  cost for the  Company's  stock  option  plan been  determined
consistent with the method of SFAS No. 123 using the weighted  average  estimate
of the fair value of each option  granted of $.59 in 1996 and $.58 in 1995,  the
Company's net loss and net loss per share (LPS) for 1996 and 1995 on a pro forma
basis would have been as indicated below:

                                       Net loss               LPS
                                      ----------             -----

         1996 - as reported           $  672,475             $.04
         1996 - pro forma             $  910,840             $.06

         1995 - as reported           $  825,191             $.06
         1995 - pro forma             $1,095,611             $.08


                                  Page 28 of 40

<PAGE>

These pro forma  disclosures are not  representative  of the effects on reported
net loss and net loss per share for future years due to the effects of vesting.

Common stock reserved for future issuance.  The number of shares of common stock
reserved  by the Company  for  issuance  for the  following  purposes  have been
adjusted to reflect the changes  resulting from the  transactions  in March 1997
described in Note 15 as if such changes had occurred as of December 31, 1996:


                         Purpose                                  # of shares
              -----------------------------                       -----------

Currently exercisable warrants:
 Exercisable at $.35 per share, expiring in February 2000            571,428
 Exercisable at $.375 per share, expiring in June 2000               595,000
 Exercisable at $.50 per share, expiring in June 2000                595,000
 Exercisable at $.75 per share, expiring on various dates
  from June 1999 through March 2002                                4,874,509
 Exercisable at $1.00 per share, expiring in December 1997           428,571
 Exercisable at $1.50 per share, expiring in December 1997           428,572
                                                                  ----------
                                                                   7,493,080
                                                                  ----------
Currently exercisable options:
 Exercisable at $.50 per share                                     3,002,484
 Exercisable at $.75 per share                                        53,250
 Exercisable at $1.00 per share                                      140,000
                                                                  ----------
                                                                   3,195,734
                                                                  ----------
Granted options becoming exercisable in the future:
 Exercisable at $.50 per share                                       744,000
 Exercisable at $.75 per share                                        33,750
                                                                  ----------
                                                                     777,750

Options available under plan for future grants                       397,182

Conversion of preferred stock                                      4,428,574
                                                                  ----------

 Total shares reserved                                            16,292,320
                                                                  ==========


NOTE 13 - INVESTMENT IN DIGITAL DICTATION, INC.

In October 1995 the Company's  inactive,  public company  subsidiary,  SonoChem,
Inc.,  effected a 1:10 reverse split of all of its issued and outstanding shares
of  common  stock,  leaving  312,874  post-split  shares,  and was  merged  (the
"Merger")  with and into  Digital  Dictation,  Inc.  ("DDI"),  a privately  held
Virginia  medical  transcription  services  company.  Pursuant  to  the  Merger,
SonoChem issued and exchanged 5,944,606 post-split shares of its common stock in
return for 100% of the issued and outstanding shares of common stock of DDI, and
SonoChem's  name was  changed  to  Digital  Dictation,  Inc.  ("Digital").  Upon
consummation  of the Merger,  the present  officers and directors of DDI, two of
whom are directors of the Company and general partners of Proactive,  became the
directors and officers of Digital.  See Note 5 for the  accounting  treatment of
this exchange and the subsequent  accounting for the Company's investment in the
Digital stock.


                                  Page 29 of 40

<PAGE>

NOTE 14 - COMMITMENTS

The  Company  does  not have  employment  agreements  with any of its  officers;
however,  as  detailed in Note 9, all  salaried  employees  have been  deferring
significant portions of their authorized salaries under the terms of the Consent
to Deferral in order to help conserve cash.

The  Company  occupies  its  office and  laboratory  facilities  pursuant  to an
extension  through November 1997 under the terms of an operating lease agreement
that has expired.  The lease  provides for monthly rent of $3,500,  and requires
the Company to pay all property related expenses.  Gross rent charges aggregated
$52,000,  $54,000 and $57,600 in 1996,  1995 and 1994,  respectively,  while the
Company also earned  sublease  income of $2,400 in 1996. The Company will either
attempt to negotiate a new long-term lease for its current office and laboratory
facility once the current extension expires,  or continue to occupy the premises
on a  month-to-month  basis under the terms of the previous  lease,  pursuant to
which the property  owner is required to provide  thirty days notice if he wants
the  Company  to  vacate  the  premises.  Management  may  also  search  for  an
alternative  location in the event that an  agreement  cannot be reached for the
existing  premises.  Management  believes that the resolution of the uncertainty
with respect to the facility  will not result in a significant  interruption  in
the operations of the Company.


NOTE 15 - SUBSEQUENT EVENTS

On February 28, 1997, the Company notified the holders of all of its outstanding
warrants to purchase  shares its common  stock of  proposed  amendments  to such
warrants.  These  amendments  were  offered  because  the  Company was unable to
complete a planned  registration  during 1996 of the common stock  issuable upon
the exercise of the warrants. The warrants, all of which had original expiration
dates  five years  from the  respective  acquisition  date,  were  issued in the
private  financings that took place in June 1994, June 1995 and December 1995 as
described in Note 12, and in February 1992. The proposed amendments included, in
various  combinations,  extensions of the  expiration  dates,  reductions in the
exercise  prices,   provisions  for  cashless   exercise,   and  provisions  for
"piggyback" registration rights.

The amendments  proposed for the warrants issued in February 1992 (the "February
1992  Warrants")  were  also  offered  in  connection  with  a  $250,000  equity
investment proposal from Proactive accepted by the Company on February 24, 1997.
In exchange  for this cash  investment,  Proactive  received  333,333  shares of
common stock and five-year  warrants to purchase  166,666 shares of common stock
at an exercise price of $.75 per share, along with a number of amendments to its
February 1992 warrants issued by the Company to Proactive and other investors in
connection  with  the  sale of $2  million  of  convertible  Preferred  Stock in
February 1992 (the "Preferred Stock Investment").

In  connection  with the  Preferred  Stock  Investment,  $1,525,000 of which was
provided  by  Proactive,  the  Company  had issued to  investors  the  following
February 1992 Warrants to purchase shares of common stock: 2,857,143 exercisable
at $1.00 per share and  2,857,143  exercisable  at $1.50 per share.  The Company
also issued  additional  February  1992 Warrants to purchase  571,428  shares at
$.35,  285,714 shares at $1.00,  and 285,714  shares at $1.50,  to Proactive and
others  for  investment  advisory  services  provided  in  connection  with  the
Preferred Stock Investment.  February 1992 Warrants to purchase 21,429 shares at
$1.00 were later exercised.

Under  the  terms of this  new  investment,  Proactive  received  the  following
amendments to their February 1992 Warrants:  reduction of the exercise prices of
warrants originally  exercisable at $1.00 and $1.50 per share to $.75 per share,
with a reduction in the number of shares purchaseable pursuant to these warrants
of 25% for the warrants originally exercisable at $1.00 and 50% for the warrants
originally  exercisable at $1.50;  and extension of the expiration dates for the
remaining warrants outstanding through February 12, 2000.

The  other  February  1992  investors  were  offered  the  opportunity  to  make
additional cash  investments on these same terms in amounts  proportional to the
original  investments  made in February  1992.  One investor,  a director of the
Company,  did remit $1,639 on those terms,  while the  remaining  investors  who
declined in writing to make a new


                                  Page 30 of 40

<PAGE>

investment  received an extension of the  expiration  date of their  warrants to
December 31, 1997. The warrants held by those investors who failed to respond to
the Company's offer expired as of March 15, 1997.

On March 31, 1997, the Company  completed a private financing in which it raised
$330,000  from  a  small  number  of the  Company's  existing  shareholders  who
qualified as accredited  investors.  A total of 440,000  shares of the Company's
common stock and five-year  warrants to purchase an additional 220,000 shares of
common stock at $.75 per share were issued in connection with this transaction.

If the  transactions  described  above had taken place on December 31, 1996, the
following  adjustments  would have been made to the December 31, 1996 historical
balance sheet:

                                     As previously
                                       reported     Adjustments    Pro forma
                                     -------------  -----------   ----------

  Cash                                $   89,739     $ 580,000     $ 669,739
                                      ==========     =========     =========

  Total stockholders' equity          $ (276,538)    $ 580,000     $ 303,462
                                      ==========     =========     =========

  Number of shares of common stock    16,214,020       773,333    16,987,353
                                      ==========       =======    ==========


Presented  below is a  schedule  summarizing  the  number,  exercise  prices and
expiration  dates of the  warrants  outstanding  as of March  31,  1997  both as
originally issued and as amended as described above and in Note 12.


                          Before amendments              After amendments
                   -----------------------------   -----------------------------
 Month issued        $   # of shares  Expiration     $   # of shares  Expiration
 ------------      ----  -----------  ----------   ----  -----------  ----------

February 1992      0.35     571,428   Feb. 1997    0.35     571,428   Feb. 2000
February 1992      1.00   3,121,428   Feb. 1997    0.75   1,858,928   Feb. 2000
                                                   1.00     428,571   Dec. 1997
February 1992      1.50   3,142,857   Feb. 1997    0.75   1,239,286   Feb. 2000
                                                   1.50     428,572   Dec. 1997
June 1994          1.125    524,268   June 1999    0.75     524,268   June 1999
June 1994          1.50     524,268   June 1999    0.75     524,268   June 1999
June 1995          0.375    595,000   June 2000    0.375    595,000   June 2000
June 1995          0.50     595,000   June 2000    0.50     595,000   June 2000
December 1995      1.25     340,000   Dec. 2000    0.75     340,000   Dec. 2000
                         -----------                     -----------

Totals                    9,414,249                       7,105,321
                          =========                       =========


                                  Page 31 of 40

<PAGE>

              ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
                     ON ACCOUNTING AND FINANCIAL DISCLOSURE

The Company has had no disagreements with its current  independent  accountants,
Price  Waterhouse  LLP, on any matter of  accounting  principles or practices or
financial  statement  disclosure.  Price  Waterhouse  LLP has been the Company's
independent accountants since 1985.


            ITEM 9. DIRECTORS, EXECUTIVE OFFICERS AND CONTROL PERSONS

Executive  officers are  appointed  and serve at the  discretion of the Board of
Directors. The Company's Board of Directors is divided into two categories:  (1)
"Preferred Stock"  directors,  who are elected by the holders of preferred stock
and who constitute a majority of the Board;  and (2) "Common  Stock"  directors,
who are  elected  by the  holders  of  common  stock.  These two  categories  of
directors are each further  divided into three classes as nearly equal in number
as possible.  The term of one class of directors  expires at each annual meeting
of  stockholders,  with the  members of each class to hold  office  until  their
successors  are elected and  qualified.  Directors of the Company do not receive
fees for their services, but are eligible to receive stock option grants and are
reimbursed for expenses related to their activities as directors.

The names, ages, dates first elected as directors, and principal occupations and
employment of the directors and executive  officers of the Company are set forth
below.

                                Term as
                                director
           Name             Age expires           Position
     ----------------       --- -------      -------------------

Preferred Stock Directors:

 Mr. Charles C. McGettigan   52   1999  Director
 Mr. Peter Y. Mills          42   1997  President and Director
 Mr. Craig A. Nalen          66   1998  Director
 Mr. Robert D. van Roijen    57   1998  Director
 Mr. Myron A. Wick, III      53   1999  Chairman of the Board

Common Stock Directors:

 Mr. Nuno Brandolini         43   1997  Vice Chairman of the Board
 Mr. Lawrence H. Hyde        72   1999  Director
 Mr. Ronald A. Glantz        55   1997  Director
 Dr. Andrew A. Pouring       65   1998  Chief Executive Officer, Chief Scientist
                                          and Vice Chairman of the Board
Other Executive Officers:

 Mr. George E. Ponticas      37         Vice President - Finance, Secretary,
                                          Treasurer and Chief Financial Officer


Background of Directors and Executive Officers
----------------------------------------------

Mr.  Charles C.  McGettigan  has been a director of the Company  since  February
1992.  He was a founding  partner in 1991 and is a general  partner of Proactive
Investment  Managers,  L.P., which is the general partner of Proactive Partners,
L.P.  In  1988  Mr.  McGettigan  co-founded  McGettigan,  Wick & Co.,  Inc.,  an
investment  banking  firm.  From  1984  to 1988  he was a  Principal,  Corporate
Finance,  of Hambrecht & Quist,  Inc. Prior to that Mr.  McGettigan was a Senior
Vice President of Dillon,  Read & Co. Inc. He currently  serves on the Boards of
Directors of Digital Dictation,  Inc., I-Flow  Corporation,  Modtech,  Inc., PMR
Corporation, and Onsite Energy, Inc.,


                                  Page 32 of 40

<PAGE>

of  which  he is the  Chairman.  Mr.  McGettigan  is a  graduate  of  Georgetown
University,  and  received  his MBA in Finance  from The  Wharton  School of the
University of Pennsylvania.

Mr.  Peter Y. Mills has been  President  and a  director  of the  Company  since
November  1991.  Mr.  Mills has nearly two  decades  of  international  business
experience  in managing,  financing,  and turning  around small high  technology
companies  in the U. K.,  the U. S. and  Canada.  He has also  been a  financial
consultant to companies that he has helped finance,  including Database Sapphire
Intl., IXI, Finamex Financial, All Computers, Inc., and Saracen Electronics. Mr.
Mills currently serves on the Board of Directors of WrayTech  Instruments,  Inc.
He was  educated  at  Winchester  College in the U.K.  and  Langues  Orientales,
Nouvelle Sorbonne in Paris, France.

Mr. Craig A. Nalen has been a director of the Company  since  February  1992. In
1990 Mr. Nalen founded U.S. Business  Centers,  Inc. (USBC) and currently serves
as its  Chairman of the Board.  USBC is presently  involved in the  development,
financing,  construction,  and management of major  commercial  office  building
complexes in Eastern Europe. From 1981 to 1990 Mr. Nalen served as President and
Chief Executive Officer of the U.S. Overseas Private  Investment Company (OPIC),
a post to which he was appointed by President Reagan and subsequently  confirmed
by the U.S.  Senate.  From 1972 to 1975 he was  Chairman,  President,  and Chief
Executive Officer of American Photograph Company,  and from 1975 to 1980, he was
Chairman,  President,  and Chief Executive Officer of the STP Company, a company
which develops and markets  premium  automotive  products.  Mr. Nalen  currently
serves on the Board of Directors of Firan Corp.  He received a B.A.  degree from
Princeton University and an MBA from Stanford University.

Mr. Robert D. van Roijen has been a director of the Company since February 1992.
Since 1988 he has been the  President of Tox  Financial  Company,  an investment
advisory and venture capital firm. From 1977 through 1987 Mr. van Roijen was the
Chairman of the Board of Control  Laser  Company,  serving also as President and
Chief Executive  Officer from 1981 to 1985. He currently  serves on the Board of
Directors of Applied  Digital  Technologies,  Commonwealth  Scientific,  Quixote
Corp. and Security Storage Company of Washington. Mr. van Roijen received a B.A.
degree in Economics and Philosophy from Harvard College.

Mr.  Myron A.  ("Mike")  Wick,  III,  has been a director of the  Company  since
November  1991 and was elected  Chairman of the Board of Directors in June 1993.
He was a  founding  partner  in  1991  and is a  general  partner  of  Proactive
Investment  Managers,  L.P., which is the general partner of Proactive Partners,
L.P. In 1988 Mr. Wick  co-founded  McGettigan,  Wick & Co.,  Inc., an investment
banking  firm.  From  1985 to 1988  Mr.  Wick was  Chief  Operating  Officer  of
California Biotechnology, Inc. in Mountain View, California. He currently serves
on the Boards of Directors of  Children's  Discovery  Centers of America,  Inc.,
Digital Dictation,  Inc.,  Modtech,  Inc., NDE  Environmental,  Phoenix Network,
Inc., and WrayTech Instruments, Inc., and serves as the Chairman of the Board of
Directors for Stat-Tech  International  Company. Mr. Wick received a B.A. degree
from Yale University and an MBA from the Harvard Business School.

Mr. Nuno  Brandolini  has been a director of the Company  since January 1982 and
was elected a Vice  Chairman of the Board in May 1988.  Since  November 1995 Mr.
Brandolini  has been the  Chairman of the Board and Chief  Executive  Officer of
Scorpion Holdings,  Inc., a merchant banking company. From December 1993 through
October  1995 he was a managing  director of  Rosecliff,  Inc.,  also a merchant
banking  company.  From June 1991 to November 1993 he was a Vice  President with
Salomon Brothers,  Inc. From 1988 to 1991 Mr. Brandolini was a part owner of The
Baltheus Group,  Inc., a management  consulting and financial  advisory firm. He
has a law degree  from the  University  of Paris and he received an MBA from The
Wharton School of the University of Pennsylvania.

Mr.  Ronald A. Glantz has been a director of the Company  since  November  1983.
Since  February 1990 he has been a Senior Vice  President and Head of West Coast
Research for Dean Witter Reynolds, Inc. From February 1985 through February 1990
Mr.  Glantz was a general  partner of Montgomery  Securities  in San  Francisco,
California.  He was Chief  Investment  Officer  and  Senior  Vice  President  at
PaineWebber Inc., which he joined in 1973,  between 1982 and July 1984.  Between
July 1984 and  February  1985 Mr.  Glantz  was the  Director  of  Economics  and
Financial  Markets  for  PaineWebber.  He was ranked  the number one  automobile
analyst on Wall


                                  Page 33 of 40

<PAGE>

Street for seven  consecutive  years by  Institutional  Investor  magazine.  Mr.
Glantz  received a B.A.  from Harvard  College,  an M.A. in  economics  from The
Fletcher School and an MBA from the Harvard Business School.

Mr.  Lawrence H. Hyde has been a director of the Company since  September  1986,
and served as Chairman of the Board from June 1987 to June 1993.  Mr. Hyde was a
director of Harris Graphics Corp. from 1983 to 1986,  where during 1985 and 1986
he also served as its Chairman of the Board and Chief Executive Officer.  He was
President and Chief  Executive  Officer of AM General Company from 1979 to 1985.
He joined  American  Motors in 1974 and remained until 1983. At various times he
had corporate wide responsibility for engineering,  international and marketing;
his last position was Executive Vice President responsible for International and
Engineering.  He was employed by Ford Motor  Company  from 1947 to 1965,  and by
Harris Corp. from 1965 to 1973. He is a director of Whatman plc and a trustee of
the American  University in Cairo,  where he is also chairman of the  University
Educational  Investment  Fund.  Mr.  Hyde is a graduate  of Harvard  College and
Harvard Business School.

Dr.  Andrew  A.  Pouring  has been a  full-time  employee,  director,  and Chief
Scientist  of the  Company  since  1980,  serving as  President  from April 1980
through  November  1991,  and as Chief  Executive  Officer  since May  1985.  In
November 1991 he was elected a Vice  Chairman of the Board of  Directors.  He is
the  principal  author of the  Company's  numerous  patents  and has  personally
contributed  most of the recently  patented  improvements  and extensions to the
original  discoveries.  He served as a Professor of Aerospace Engineering at the
U.S.  Naval  Academy  from  1964 to  1983,  and was  Chairman  of the  Academy's
Department of Aerospace  Engineering  from 1975 to 1978. Dr. Pouring is a member
of various professional and scientific societies, including the American Society
of Mechanical  Engineers and the Society of  Automotive  Engineers,  as has been
organizer  and  chairman  of many  symposia  for these  societies.  Dr.  Pouring
received  his  Bachelors  and Masters  degrees in  mechanical  engineering  from
Rensselaer Polytechnic  Institute.  He received his Doctor of Engineering degree
from Yale  University,  where he also was a post  doctoral  research  fellow and
lecturer.

Mr.  George E.  Ponticas has been Vice  President - Finance and Chief  Financial
Officer,  Secretary and Treasurer of the Company since  September 1991. From May
1987 through  August 1991, he served as the Company's  Controller  and Assistant
Secretary. From August 1981 through April 1987, Mr. Ponticas was a member of the
auditing  staff  of Price  Waterhouse  in  Baltimore,  Maryland,  attaining  the
position of audit  manager in July 1986. At Price  Waterhouse,  he worked on the
audits of a number of public and  private  companies,  with an emphasis on small
businesses.  Mr. Ponticas is a Certified Public  Accountant,  and is a member of
the  American  Institute  of  Certified  Public  Accountants  and  the  Maryland
Association of Certified Public Accountants. He received his B.S.
in Accounting from Loyola College in Maryland.


                         ITEM 10. EXECUTIVE COMPENSATION

In order to help  conserve  the  Company's  limited cash  resources,  all of the
Company's executive officers and other salaried employees for several years have
been voluntarily  deferring  significant portions of the salaries due them under
the terms of employment  agreements or as otherwise  established by the Board of
Directors.  In  February  1992 as a  condition  of the  Company's  receiving  an
indispensable  capital  infusion,   this  voluntary  deferral  of  salaries  was
documented  formally  through an  agreement  known as the  "Consent to Deferral"
executed by all salaried  employees.  Under this agreement,  each of the signers
consented to the past and future deferral of portions of their annual  salaries,
and agreed to defer  payment of amounts so  accumulated  until the  Company  has
received licensing revenue of at least $2 million or at such earlier date as the
Board of Directors  determines  that the  Company's  cash flow is  sufficient to
allow such  payment.  As of  December  31,  1996,  an  aggregate  of $595,620 in
deferred salaries is owed to current and former employees.

In an effort to avoid  long-term  financial  commitments,  the Company no longer
enters into  employment  agreements  with any of its employees.  The salaries of
executive officers are set by the Board of directors on an annual basis. For the
past several years Dr. Andrew A. Pouring, the Company's chief executive officer,
and Mr. Peter Y. Mills, the Company's president,  each has been deferring 40% of
his annual salary. As of December 31, 1996, the


                                  Page 34 of 40

<PAGE>

amounts of deferred  salary owed to Dr.  Pouring and Mr. Mills were $213,817 and
$115,769, respectively.  Effective January 1, 1996, the employment commitment of
Mr. Mills was changed  from  full-time  to  part-time.  He continues to serve as
president  of the Company  and is being paid $2,000 per month for his  services,
with no additional amount being deferred.

The following table sets forth the compensation paid by the Company to its chief
executive  officer  and  other  executive  officers  whose  annual  compensation
exceeded $100,000 (together referred to as the "Named Executives").


                            Summary Compensation Table
                            --------------------------
                                                        

                                       Annual salary              Long-term
                                   ---------------------         compensation -
  Name and position        Year    Cash paid    Deferred       options (shares)
----------------------     ----    ---------    --------       ----------------

Andrew A. Pouring          1996     $60,798      $40,531            25,000
 CEO & Chief Scientist     1995      60,798       41,531              -
                           1994      60,798       41,531              -

Peter Y. Mills             1996      24,000            0              -
 President                 1995      60,000       40,000              -
                           1994      60,000       40,000              -

With the  exception of the granting of stock  options,  the Company does not pay
its Named  Executives any bonuses or any type of long-term  compensation  in the
form of restricted stock awards, stock appreciation  rights (SARs) or other form
of long-term incentive plan payments.


               Aggregated Option/SAR Exercises in Last Fiscal Year
                      and Fiscal Year-end Option/SAR Values
               ---------------------------------------------------


                                    Number of securities    Value of unexercised
                                   underlying unexercised       in-the-money
                                      options/SARs at         options/SARs at
                                     December 31, 1996       December 31, 1996
          # of shares
          acquired on     Value         Exercisable/             Exercisable/
  Name     exercise     realized        unexercised             unexercised
--------  -----------   --------   ----------------------   -------------------

Pouring        -            -         134,250/153,000         $46,148/$52,594

Mills        55,000      $73,200      675,000/675,000        $232,031/$232,031


All options  held by the Named  Executives  are  exercisable  at $.50 per share,
which  price was below the  December  31,  1996  market  price of the  Company's
publicly traded common stock of $0.84375 per share.


            ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
                                 AND MANAGEMENT

The  following  table sets forth as of March 31,  1997  information  relating to
beneficial  ownership  by  directors  and  executive  officers  of the  Company,
directors  and  executive  officers  of the  Company  as a group,  and any other
persons  known by the  Company  to be the  beneficial  owner of more  than  five
percent of the currently issued and outstanding common stock of the Company. The
term "shares beneficially owned" encompasses those shares


                                  Page 35 of 40

<PAGE>

which the reporting person currently owns or has the right to acquire within the
next sixty days  through  the  exercise  of  currently  exercisable  options and
warrants  or  through  the  conversion  of  preferred  stock.  Shares  which the
reporting  person has the right to acquire are not deemed to be outstanding  for
computing the  percentage of  beneficial  ownership of any other person.  Unless
otherwise  noted,  all  shares  are  beneficially  owned  and  sole  voting  and
investment power is held by the persons named.


                              Common     Rights to    Total shares
                              shares      acquire     beneficially     Percent
 Name and address (1)         owned       shares (4)     owned        of class
 --------------------       ---------    ---------     ---------      --------

Nuno Brandolini                97,726      315,150       402,876         2.3
Ronald A. Glantz               17,517      176,500       194,017         1.1
Lawrence H. Hyde              272,986      536,000       808,986         4.6
Charles C. McGettigan       1,213,068    5,864,223     7,077,291 (3)    30.8
Peter Y. Mills                744,286      675,000     2,133,572        11.5
Craig A. Nalen                  2,186      211,522       213,708         1.2
George E. Ponticas            118,262      207,500       325,762         1.9
Andrew A. Pouring             688,239      134,250       822,489         4.8
Robert D. van Roijen           67,143      221,142       288,285         1.7
Myron A. Wick, III          1,213,068    5,864,223     7,077,291 (3)    30.8

All directors and officers
 as a group (10 persons)    3,211,413    9,055,573    12,266,986        46.8

Herbert J. Mitschele, Jr.     941,755      105,715     1,047,470         6.1
  Far Hills, NJ

Proactive , et.al. (2)      2,199,871    9,978,860    12,078,731        44.7
  San Francisco, CA

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

(1)   The business address for each director and named executive officer is 23
      Hudson Street, Annapolis, Maryland, 21401.
(2)   Includes  shares  beneficially  owned directly and indirectly by Proactive
      Partners,  L.P. and six affiliated  entities and  individuals  ("Proactive
      et.al."),  as reported in a Form 13D filing with the Securities and
      Exchange Commission.
(3)   Includes  6,913,291  shares  beneficially  owned  by  Proactive et.al.,
      which shares could be deemed to be beneficially owned by both Mr.
      McGettigan  and Mr.  Wick by  virtue  of  their  executive  and  ownership
      positions in Proactive Partners,  et.al. Both individuals  exercise shared
      voting and investment power with respect to such shares.
(4)   Includes shares which the reporting person has the right to acquire within
      the next sixty days through the exercise of currently exercisable options
      and warrants or through the conversion of preferred stock.


             ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

None.

                                  Page 36 of 40

<PAGE>

                 ITEM 13. EXHIBITS LIST AND REPORTS ON FORM 8-K


(a)   Exhibits.

     3    Articles of Incorporation  and Bylaws (as amended) - Incorporated
          by reference to the  Company's  Annual  Report on Form 10-KSB for
          the year ended December 31, 1992.

     4    Instruments defining the rights of security holders (contained in
          Exhibit 3 hereof).

  10.1    1987 Non-Qualified Stock Option Plan, as amended - Incorporated by
          reference to the Company's Registration Statement No. 33-34520 on
          Form S-8.

    21    Subsidiaries of the Registrant:  Sonex International, B.V. - The
          Netherlands; Sonex Engines, Inc. - Delaware (both are inactive
          subsidiaries).

    23    Consent of Price Waterhouse LLP (Sequential page number 39 of 40
          total pages)

    24    Power of Attorney -  Incorporated  by reference to the  Company's
          Annual Report on Form 10-K for the year ended December 31, 1991.

    27    Financial Data Schedule


(b)   Reports on Form 8-K.

               None.

                                  Page 37 of 40

<PAGE>

                                   SIGNATURES

In  accordance  with Section 13 or 15(d) of the  Exchange  Act , the  Registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

                       SONEX RESEARCH, INC.


April 15, 1997         By:           /s/ Andrew A. Pouring
                              ----------------------------------
                              Andrew A. Pouring
                              Principal Executive Officer

April 15, 1997         By:            /s/ George E. Ponticas
                              ----------------------------------
                              George E. Ponticas
                              Principal Financial and Accounting Officer

In  accordance  with the Exchange  Act, this report has been signed below by the
following  persons on behalf of the  Registrant and in the capacities and on the
dates indicated.


April 15, 1997                                  *
                              ----------------------------------
                              Myron A. Wick, III
                              Chairman of the Board of Directors

April 15, 1997                                  *
                              ----------------------------------
                              Nuno Brandolini
                              Vice Chairman of the Board of Directors

April 15, 1997                       /s/ Andrew A. Pouring
                              ----------------------------------
                              Andrew A. Pouring
                              Vice Chairman of the Board of Directors

April 15, 1997                       /s/ Peter Y. Mills
                              ----------------------------------
                              Peter Y. Mills
                              President and Director

April 15, 1997                                  *
                              ----------------------------------
                              Ronald A. Glantz
                              Director

April 15, 1997                                  *
                              ----------------------------------
                              Lawrence H. Hyde
                              Director

April 15, 1997                                  *
                              ----------------------------------
                              Charles C. McGettigan
                              Director

April 15, 1997                                  *
                              ----------------------------------
                              Craig A. Nalen
                              Director

April 15, 1997                                  *
                              ----------------------------------
                              Robert D. van Roijen
                              Director

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

*  Executed on behalf of these persons by George E.  Ponticas,  a duly appointed
   attorney-in-fact of each such person.


      /s/ George E. Ponticas
----------------------------------
George E. Ponticas, Attorney-In-Fact


The Registrant  will furnish its  shareholders  with copies of its annual report
and proxy statement after the date of this report.


                                  Page 38 of 40

<PAGE>





                       CONSENT OF INDEPENDENT ACCOUNTANTS



We  hereby  consent  to  the   incorporation  by  reference  in  the  Prospectus
constituting  part of the Registration  Statement on Form S-8 (No.  33-34520) of
Sonex  Research,  Inc. of our report dated April 8, 1997 appearing on page 15 of
this Form 10-KSB.



/s/PRICE WATERHOUSE LLP

Baltimore, Maryland
April 8, 1997




                                  Page 39 of 40