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

                                    FORM 10-K

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

                   For the fiscal year ended December 31, 1998

                                       OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934 For the transition period from __________ to __________

                          Commission File No. 000-21517

                          XOMED SURGICAL PRODUCTS, INC.
             ------------------------------------------------------
             (Exact name of registrant as specified in its charter)

                DELAWARE                                         06-1393528 
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    (State or other jurisdiction of                          (I.R.S. Employer
     incorporation or organization)                         Identification No.)

      6743 SOUTHPOINT DRIVE, NORTH
         JACKSONVILLE, FLORIDA                                   32216-0980
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(Address of principal executive offices)                         (Zip Code)

Registrant's telephone number, including area code:            (904) 296-9600 
                                                          ----------------------

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

       TITLE OF EACH CLASS             NAME OF EACH EXCHANGE ON WHICH REGISTERED
       -------------------             -----------------------------------------
         Not applicable                             Not applicable

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

                          COMMON STOCK, $.01 PAR VALUE
                          ----------------------------
                                (Title of class)

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

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

The aggregate market value of registrant's Common Stock (the "Common Stock")
held by non-affiliates based on the closing price on February 16, 1999 was
$432,538,875.

As of February 16, 1999 there were outstanding 12,142,691 shares of Common
Stock, $.01 par value.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's definitive Proxy Statement to be filed with the
Securities and Exchange Commission prior to April 30, 1999 are incorporated by
reference in Part III of this Form 10-K.

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PART I

ITEM 1. BUSINESS 

     AS USED IN THIS ANNUAL REPORT ON FORM 10-K, REFERENCES TO THE "COMPANY" OR
"XOMED" REFER TO XOMED SURGICAL PRODUCTS, INC. AND ITS DIRECT AND INDIRECT
SUBSIDIARIES, UNLESS OTHERWISE INDICATED OR THE CONTEXT OTHERWISE REQUIRES.

     THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS WHICH
INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER
SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE FORWARD-LOOKING STATEMENTS.
FACTORS THAT MIGHT CAUSE SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE
DISCUSSED IN "RISK FACTORS" UNDER THIS ITEM AND IN "MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." READERS ARE
CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH
SPEAK ONLY AS OF THE DATE HEREOF. THE COMPANY DOES NOT UNDERTAKE ANY OBLIGATION
TO PUBLICLY RELEASE ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS TO REFLECT
EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCE OF
UNANTICIPATED EVENTS.

     THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH SELECTED
HISTORICAL FINANCIAL INFORMATION (ITEM 6) AND THE CONSOLIDATED FINANCIAL
STATEMENTS OF THE COMPANY, WHICH ARE INCLUDED IN THIS FORM 10-K.

OVERVIEW

     Xomed is a leading developer, manufacturer and marketer of a broad line of
surgical products for use by ear, nose and throat ("ENT") specialists and
ophthalmic surgeons. The Company's broad line of products includes, in its core
ENT market, powered tissue-removal systems and other microendoscopy instruments,
implantable devices, nerve monitoring systems, disposable fluid-control products
and image guided surgery systems. The Company also offers a line of ophthalmic
and other products. For the year ended December 31, 1998, approximately 77% of
Xomed's revenues were derived from disposable and implantable products. The
Company distributes its products through a direct sales organization of nearly
100 persons in the U.S. and selected other countries and through a network of
over 130 independent distributors. Xomed is the only major manufacturer and
marketer of ENT surgical products with a direct U.S. sales force exclusively
serving ENT specialists. Approximately 29% of the Company's net sales were
derived from international markets for the year ended December 31, 1998. With
nearly 30 years of industry experience, Xomed believes that it has established a
long-standing reputation for innovative, high-quality products and is uniquely
positioned as the only major surgical products company focused on the ENT
market.

     Xomed believes that the ENT market is in the midst of a conversion from
conventional surgical approaches to less-traumatic approaches that involve the
use of advanced surgical tools, such as powered tissue-removal systems and
small-diameter surgical endoscopes, thereby minimizing patient trauma and
reducing procedure times. Xomed believes that the adoption of these
less-traumatic techniques is being driven by several factors, including economic
pressures and patient demand. Minimally invasive techniques have the potential
to expand the number of ENT procedures that can be performed in lower-cost
outpatient or day surgery settings. Patient demand is likely to increase due to
the reduced morbidity and improved outcomes. Xomed believes that the conversion
in the ENT market to less-traumatic approaches will be similar to recent
conversions in the general surgery market to less invasive techniques and the
orthopaedic surgery market to powered instrumentation systems.

BACKGROUND

     The business of Xomed, Inc., the Company's predecessor, was established in
1970 to manufacture and distribute ventilation tube implants for the middle ear.
In 1979, Bristol-Myers Squibb Company ("Bristol-Myers") acquired the business.
In 1989, Bristol-Myers acquired Treace Medical, Inc. and merged the two
companies together forming Xomed-Treace, Inc. On April 15, 1994, Bristol-Myers
sold Xomed-Treace, Inc. to the Company for a purchase price of approximately
$81.0 million (the "Xomed Acquisition"). The Company is a Delaware corporation
formerly known as Merocel/Xomed Holdings, Inc., which was organized for the
purpose of acquiring all of the outstanding stock of Merocel Corporation
("Merocel"), Xomed-Treace, Inc. and Xomed-Treace, P.R. Inc. (collectively,
"Xomed-Treace"). Merocel, which was formed in 1970, manufactures and markets a
line of disposable fluid-control 


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products primarily used in sinus surgery and rhinology. The Company, prior to
April 15, 1994, consisted solely of Merocel.

     XOMED ACQUISITION. The Xomed Acquisition has significantly affected the
Company's results of operations following the April 15, 1994 consummation of the
transaction. The Xomed Acquisition has been accounted for under the purchase
method of accounting. Accordingly, the purchase price of approximately $81.0
million was allocated to the assets acquired and liabilities assumed, based upon
their respective fair values at date of acquisition. The excess of the purchase
price over the fair market value of the net assets acquired of approximately
$56.0 million was allocated to goodwill. Of this amount, $49.9 million related
to continuing operations and is being amortized over a 25-year life; $6.1
million related to the surgical drapes segment, which was sold in July 1995. As
a result of this goodwill and certain other intangible assets, amortization of
intangibles is a significant expense in the Company's Consolidated Income
Statement (2.6% of net sales).

     The Xomed Acquisition and the Company's initial working capital were funded
primarily through the issuance of $43.5 million of preferred stock and from the
incurrence of approximately $45.9 million in long-term debt. In connection with
the Xomed Acquisition, management implemented a restructuring plan for
Xomed-Treace that included closing manufacturing operations in Puerto Rico and
eliminating certain overhead in other facilities.

     CHANGE IN DISTRIBUTION CHANNELS. On January 1, 1996, the Company effected
two changes in its product distribution to focus the Company's resources on its
core product lines of sinus and rhinology, head and neck and otology. The first
involved changing from distributing its ophthalmic product line through its
direct ENT sales force to distributing this line through an independent dealer
network. The Company effected this change to enable the Company's direct ENT
sales force to focus exclusively on ENT products. As a result of this change,
the Company's net sales were approximately $2.1 million lower in 1996 than they
would have been if the ophthalmic product line had continued to be distributed
through the Company's direct sales force. In a further effort to improve
ophthalmic sales, during 1998 the Company replaced several of these independent
dealers with direct sales representatives devoted exclusively to the ophthalmic
product line.

     The second change involved moving the distribution of the Company's Merocel
fluid-control products from an independent dealer network to the Company's U.S.
direct sales force. The Company effected this change so that its entire
portfolio of ENT products could be distributed through a single distribution
channel focused exclusively on ENT products. As a result of this change, the
Company's net sales were approximately $1.2 million higher in 1996 than they
would have been if the Merocel product line had continued to be distributed
through independent dealers.

     ACQUISITION OF TREBAY. In April 1996 the Company acquired TreBay Medical
Corporation ("TreBay") which acquisition has been accounted for under the
purchase method of accounting. Accordingly, the purchase price of approximately
$6.6 million was allocated to the individual assets acquired and liabilities
assumed, based upon their respective fair values at the date of acquisition. The
transaction resulted in cost in excess of net assets acquired of $4.4 million,
of which $2.4 million was allocated to in-process research and development and
charged to expense in the second quarter of 1996. The in-process research and
development was valued based upon an independent valuation utilizing
management's projections of cash flows and cost to achieve technological
feasibility of the products. The products acquired from TreBay have either
achieved technological feasibility or are no longer under development, and
therefore, no additional costs are required to achieve technological
feasibility.

     RESTRUCTURING AND OTHER CHARGES. During the second quarter of 1996, the
Company's new management team initiated cost savings programs that resulted in
reductions of 50 employees at the Company's three domestic locations. The
reductions included 20 management and administrative employees at the Company's
Mystic, Connecticut manufacturing facility, 17 management and administrative
employees at the Company's Jacksonville, Florida headquarters and 13 management
and production employees at the Company's St. Louis, Missouri manufacturing
facility that was closed in December 1996. The restructuring eliminated
redundant overhead at the sites and was undertaken to yield cost savings
primarily in general and administrative expense. The Company incurred a
restructuring charge of approximately $3.1 million during the second quarter of
1996 primarily to reflect the cost of the severance payments to terminated
employees. Most of the affected employees were terminated in the second quarter
of 1996 with severance beginning at that time. The Company had completed its
cost-saving programs as of December 31, 1997. See Note 6 of the Consolidated
Financial Statements included in this Annual Report on Form 10-K.


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     During the fourth quarter of 1998, the Company incurred special charges
related primarily to an acquisition, supplier terminations, restructuring
charges and an asset impairment. These special charges totaled $3.8 million and
were comprised of: (i) $1.2 million related to the write-off of acquired
in-process research and development resulting from the Company's acquisition of
Micro-France in December, 1998; (ii) $1.0 million related to the termination of
two supplier agreements; (iii) $0.8 million in restructuring charges related to:
(a) the transfer of a portion of the manufacturing process for Merocel sinus
packing material from the Company's facility in Mystic, Connecticut to its main
facility in Jacksonville, Florida and (b) the closure of the Company's sales
office in Paris, France, which is being consolidated into its recently acquired
Micro-France office in St. Aubin, France, and (iv) $0.8 million related to the
write-down of the Company's portfolio of investments, which loss is deemed to be
other-than temporary. See Note 6 of the Consolidated Financial Statements
included in this Annual Report on Form 10-K.

     PUBLIC OFFERING. On July 14, 1998, the Company completed a secondary
offering of its Common Stock raising net proceeds of $20.2 million through the
sale of 1,092,000 shares (split adjusted) of its Common Stock. The net proceeds
were added to the Company's investment portfolio and will be utilized for
general corporate purposes and acquisitions. Certain shareholders of the Company
also sold 1,495,500 shares (split adjusted) of Common Stock during the offering
generating net proceeds to those shareholders of $28.7 million.

     ACQUISITION OF MICRO-FRANCE. On December 30, 1998, the Company acquired,
through its subsidiary Xomed France Holdings, SNC, all of the issued and
outstanding capital shares of Etablissements Boutmy, S.A., a French company that
manufactures and distributes hand-held surgical instruments in the ENT,
laporoscopy and orthopaedic markets under the name Micro-France
("Micro-France"). See Note 1 of the Consolidated Financial Statements included
in this Annual Report on Form 10-K.

OTHER RECENT EVENTS

     STOCK SPLIT. Effective November 30, 1998, the Company declared a stock
split whereby each shareholder of record on November 16, 1998 received as a
dividend for every two shares of Common Stock held, one additional share of
Common Stock. The shareholders received cash in lieu of fractional shares.

     WARBURG, PINCUS INVESTORS, L.P. STOCK DISTRIBUTION. Warburg, Pincus
Investors, L.P. ("Warburg") informed the Company that, on November 4, 1998, it
distributed to its partners approximately 1.2 million shares of Common Stock,
representing approximately 51% of Warburg's holdings in the Company and 15% of
the Company's outstanding Common Stock. Further, on January 12, 1999, Warburg
distributed substantially all of its remaining holdings in the Company to its
partners. Warburg also informed the Company that the distribution is consistent
with Warburg's practice of distributing the shares of investments it deems
successful directly to its partners. The partners receiving the distribution
consist primarily of institutional investors including several large public and
private pension funds. After the distributions, Warburg's remaining holdings
represented less than 1% of the Company's outstanding stock.

     PRODUCT AND MARKET DEVELOPMENTS. In December 1997, the Company introduced
the XPS(R) 2000 microresector system, which includes enhancements to its
original XPS StraightShot(R) system. Both systems are utilized in endoscopic
sinus surgery as well as in certain head and neck procedures including the
removal of adenoids and laryngeal polyps. In July 1998, the Company received
approval to market the XPS(R) 2000 in Japan. In September 1998, the Company
entered a strategic alliance with Sofamor Danek (acquired by Medtronics in
January 1999) to distribute Sofamor Danek's image guided surgery technology into
the ENT market. The Company began shipping this product in December 1998.

MARKET OPPORTUNITY

     More than an estimated 25,000 ENT specialists, also known as
otorhinolaryngologists, currently practice in the U.S., Canada, Western Europe,
Japan, Australia, South America and the Middle East (collectively, "worldwide"),
with approximately 9,000 of those specialists practicing in the U.S. ENT
practitioners specialize in the diagnosis and treatment of diseases and
conditions affecting the ear, nose and throat. ENT surgeons are also typically
experts in tumor-related diseases of the head and neck. Increasingly, ENT
surgeons are expanding their practice to include facial plastic and
reconstructive surgery. Of the estimated 9,000 ENT specialists in the U.S.,
approximately 3,300 currently practice facial plastic and reconstructive
surgery.


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     ENT procedures currently pose the following challenges:

     (i)  In many of these procedures, the target tissue is adjacent to critical
          anatomy, including the brain, sensory centers and facial motor nerves,
          limiting the surgeon's maneuverability and requiring very small,
          precise movements;

     (ii) The anatomy in the region generally contains many blood vessels,
          leading to significant blood loss during surgery that may obscure the
          surgeon's vision, as well as increase patient complications or
          morbidity;

     (iii)The affected areas are often very small in size and require the
          surgeon to perform microsurgery through the use of magnifying devices
          such as small-diameter surgical endoscopes ("microendoscopy"); and

     (iv) The affected areas are often behind significant bony structures,
          including the skull, the penetration of which can entail significant
          patient trauma and lengthy procedure times.

     Conventional hand-held surgical instruments typically used during ENT
procedures do not provide the surgeon with sufficient power or precision to
minimize trauma and blood loss during the procedure and can contribute to
unnecessary pain, swelling and scarring following the procedure. In addition,
the need to repeatedly remove and reinsert conventional hand-held
instrumentation from the surgical site during procedures can increase patient
trauma and operating time. The Company believes that the limitations of
conventional hand-held surgical instruments create a significant opportunity for
the development of instruments designed for specific ENT procedures, including
powered tissue-removal instrumentation and visualization products, that will
make these procedures easier and faster to perform and less traumatic to the
patient.

     The Company believes that the following factors will drive growth in the
market for surgical instruments, devices and supplies for ENT surgeons:

     ADVANCEMENTS IN PROCEDURE-SPECIFIC INSTRUMENTATION . The Company believes
that the introduction of new tools and instrumentation is enabling ENT surgeons
to better address the current challenges of ENT procedures. For example, powered
cutting devices adapted for use in particular surgical procedures allow surgeons
to cut and extract tissue and penetrate bone with more speed, control and
precision than conventional hand-held instruments, thereby minimizing patient
trauma and reducing procedure times. The blades for these newly developed
powered cutting devices are disposable and thus sales of these blades represent
a significant portion of the market growth of these devices. In addition, recent
technological advances in computer-assisted image guided surgery are allowing
ENT surgeons to perform more complex procedures. By providing ENT surgeons with
greater access to difficult-to-reach surgical sites and reducing trauma to the
patient, new procedure-specific instruments potentially will increase the total
number of procedures performed.

     CLINICAL AND COST BENEFITS FOR PATIENT, SURGEON AND PAYOR. The Company
believes that the adoption of these less-traumatic ENT procedures may be driven,
in part, by economic pressures. Due to the reduced patient morbidity associated
with less traumatic techniques, certain procedures previously performed in
hospitals and requiring longer stays can now be performed in lower-cost
outpatient or day surgery settings. In addition, powered tissue-removal
instrumentation allows for reduced operating times.

     DEMAND FROM SIGNIFICANT PATIENT POPULATIONS. Sizable patient populations
suffer from conditions that can be treated by ENT surgical procedures. As
less-traumatic instrumentation and techniques become available, the portion of
these patients who will elect to undergo these procedures is likely to increase.
In particular, patient demand for endoscopic sinus surgery as well as facial
plastic surgery will, in the Company's view, increase as the pain and morbidity
associated with these procedures is reduced through better instrumentation and
techniques.

     EASE OF MARKET CONVERSION. The Company believes that ENT surgeons are
readily adopting new devices and instrumentation designed to meet the challenges
of specific surgical procedures because of the advantages they offer over
conventional instrumentation. The Company further believes that physicians
require minimal additional training (usually two to three days) to use these
instruments. In addition to its functional advantages, powered instrumentation
should, in the Company's view, be attractive to ENT surgeons because it requires
only a relatively modest (approximately $10,000) capital investment.


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STRATEGY

     The Company's objective is to enhance its leading position in the ENT
market and to enter new markets. The Company's strategy for achieving this
objective is to:

     CONTINUE TO FOCUS ON THE ENT MARKET. The Company believes that, as the only
major provider of surgical products with a direct sales force exclusively
serving the ENT surgeon, it is well positioned to participate in any growth in
the ENT surgical market. The Company intends to continue to develop and maintain
close relationships with ENT specialists from whom it has gained significant
brand recognition and loyalty. The Company believes that it presently sells
products to substantially all the ENT specialists in the U.S. Accordingly, the
Company believes that a significant opportunity exists to leverage these
relationships with new and existing products and increase penetration of its
existing customer base.

     FACILITATE ENT MARKET CONVERSION TO LESS-TRAUMATIC APPROACHES. The ENT
market is in the midst of a conversion to less-traumatic approaches that is
similar to recent conversions in the general surgery market to less invasive
techniques and the orthopaedic surgery market to powered instrumentation
systems. The Company intends to facilitate conversion of high volume ENT
procedures to less-traumatic techniques. The procedures targeted by the Company
include sinus surgery, the removal of adenoids, laryngeal procedures, face and
brow lifts and facial sculpting. As part of facilitating this conversion, the
Company is continuing its collaborative efforts with leading ENT surgeons to
create products that allow physicians to re-engineer standard operating
procedures to reduce patient trauma and operating time. The Company believes
that continued advances in powered tissue-removal instrumentation systems for
use in ENT procedures will play a central role in this conversion and
accordingly will continue in its efforts to develop and introduce such powered
instrumentation.

     EMPHASIZE PRODUCT INNOVATIONS THROUGH INTERNAL RESEARCH AND DEVELOPMENT AND
CORPORATE ALLIANCES. The Company plans to develop new proprietary products and
product enhancements primarily through internal research and development
efforts. The Company will invest significantly in research and development in an
effort to introduce technological advancements in the ENT market. When
appropriate, the Company may augment its internal development programs by
acquiring or licensing products or technology from other organizations.

     MAINTAIN A BROAD LINE OF ENT PRODUCTS WITH PARTICULAR EMPHASIS ON
DISPOSABLE AND IMPLANTABLE PRODUCTS. The Company seeks to maintain a broad
product line that addresses all of the surgical needs of ENT specialists. The
Company's current product line consists of over 4,000 stock keeping units
(SKUs), including equipment, disposable products and implantable devices. The
Company places particular emphasis on disposable products and implantable
devices, which represented approximately 77.0% of the Company's sales in 1998.
One of the Company's principal goals is to continue to develop additional
disposable products for use with its instrumentation systems.

     EXPAND ITS GLOBAL DISTRIBUTION NETWORK. The Company believes that
significant growth opportunities exist through the expansion of its global
distribution network. The Company distributes its products worldwide through a
direct sales force of nearly 100 persons in the U.S. and selected other
countries and through a network of over 130 independent distributors. The
Company's core ENT products are sold in the U.S. only on a direct sales basis.
Approximately 29% of its net sales in 1998 were made outside the U.S. through
direct operations in the United Kingdom, Canada, France, Germany and Australia,
as well as through over 120 independent international distributors, many of whom
distribute the Company's products exclusively.

     LEVERAGE CORE COMPETENCIES BY ENTERING NEW MARKETS. The Company intends to
enter new medical and surgical products markets through acquisition and new
product development. The Company believes that it can leverage its core
competencies, including the ability to rapidly develop innovative new products,
expertise in commercializing clinical knowledge, relationships with physicians
and managerial expertise, beyond the ENT market to enter new markets on a
selective basis. Potential areas for new market entry and expansion include
plastic and reconstructive surgery, ophthalmology, and orthopaedics.


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MAJOR ENT SUBSPECIALTIES

     The three major subspecialties within the ENT market are sinus and
rhinology, head and neck and otology.

   SINUS AND RHINOLOGY

     The majority of surgical procedures within the sinus and rhinology
subspecialty address disease and inflammation of the sinuses due to enlarged
tissue, deviated septum, infection, trauma or allergies.

     ENDOSCOPIC SINUS SURGERY. Large numbers of the U.S. population suffer from
chronic sinusitis. Although sinus medications provide temporary relief from
symptoms, they may not resolve the underlying cause of the disease or
inflammation and surgery is frequently required. ENT specialists utilize several
methods of treatment, including medication and surgical intervention, to provide
patients with symptomatic relief of sinus disease. In traditional sinus surgical
procedures, surgeons remove the affected tissue or obstruction, such as a polyp,
through the use of forceps. However, with traditional surgical instruments, ENT
surgeons may have limited ability to visualize and gain access to the deeper
sinus cavities through the natural sinus passageways. ENT surgeons also
experience significant difficulty gaining the control needed to remove the
tissue effectively. These limitations can result in uneven cutting and tearing,
which in turn causes trauma to the surrounding tissue. In some cases, bony
structures and tissue obstruct the nasal passageway, further complicating the
procedure.

     Although a less traumatic method for performing sinus surgery with powered
tissue-removal instrumentation was introduced in 1993, much of the
instrumentation used at the time was originally designed for arthroscopic
procedures (less invasive knee surgery). Since this instrumentation was not
designed specifically for sinus surgery, its use for these procedures was
cumbersome and prone to clogging. Because powered instrumentation designed
specifically for sinus surgery enables greater access to structures, improves
visualization at the site and enables quicker removal of tissue, overall
operating time can be reduced by approximately 25% from that of traditional
surgical methods with general surgical instruments.

     Surgeons performing complex endoscopic sinus procedures often utilize a
series of CAT scans or MRI scans taken prior to surgery to assist in identifying
key anatomical landmarks. During surgery, the physician refers to these static
images and the real-time image displayed via the endoscope. Recent advancements
in computer-assisted image guided systems now allow the CAT scan information to
be loaded into a computer and correlated to the surgeon's instruments. As a
result, the surgeon can determine the precise location of his instrument within
the operative field even when direct visualization is limited. This is
especially useful during revision or complicated surgeries due to distorted
normal anatomical landmarks. The Company believes this new technology, referred
to as image guided surgery, represents a significant growth opportunity as it
may allow surgeons to perform complex procedures that previously might not have
been attempted. Additionally, as surgeons become more comfortable with the
technology, the Company believes that image guided surgery could become the
standard of care for all but the most routine sinus procedures.

     RHINOPLASTY AND SEPTOPLASTY. Rhinoplasty involves the surgical
reconstruction of the nose to treat bone defects or trauma or to improve the
appearance of the nose cosmetically. ENT surgeons generally use either a bone
shaver or a rasp to shape or reduce the targeted area or a chisel to cut the
bone. The use of a shaver or rasp results in significant post-operative swelling
and the use of a chisel carries with it a significant risk of error.
Septoplasty, the surgical correction of a defect, disease or trauma to the
septum, is often done in conjunction with sinus surgery or rhinoplasty.

   HEAD AND NECK

     The head and neck subspecialty encompasses a wide range of procedures,
including laryngeal (throat) surgery, skull-base surgery, facial tumor removal
and facial plastic surgery.

     LARYNGEAL SURGERY. Throat-based procedures include the removal of the
tonsils (tonsillectomy) and adenoids (adenoidectomy), the removal of lesions,
polyps and tumors on the throat or vocal cords, and the surgical reduction of
the uvula (the flap of tissue at the back of the throat and the soft palate).


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     Tonsillectomies and adenoidectomies are performed to treat chronic
inflammation and soreness. In traditional tonsillectomies, surgeons use either
forceps or snares to grasp and pull the tonsils out, or alternatively they cut
away the tonsils with an electrocautery device. The use of these instruments can
cause swelling, pain and post-operative bleeding. For adenoidectomies, surgeons
traditionally utilize a curette, a small hand instrument, to scrape out the
inflamed tissue. Due to the limited precision of a curette in removing this
tissue, adenoidectomies involve many of the same problems experienced in
tonsillectomies.

     Lesions, polyps or tumors on the throat or vocal cords have typically been
removed by using hand instrumentation, an electrocautery device or a laser. The
use of hand instrumentation, electrocautery devices or lasers may result in
damage to the surrounding tissue. In addition, lasers and electrocautery devices
can destroy the affected tissue and thus prevent the subsequent pathological
testing of a tissue sample.

     Uvulopharyngoplasty is a procedure in which the uvula and the soft palate
are surgically reduced in the throat to reduce snoring and breathing
interruptions (sleep apnea). The use of electrocautery devices or lasers to
perform this procedure is again associated with swelling and pain.

     SKULL-BASE SURGERY. Skull-base surgery includes those procedures in which
the affected anatomy, generally a tumor, is located within or near the skull. A
common skull-base procedure is the removal of an acoustic neuroma, a benign
tumor located on the cranial nerve adjacent to the inner ear. The symptoms of
this condition include hearing loss, ringing in the ears, loss of balance, pain
and headaches. Surgical removal is the only treatment alternative for persons
with an acoustic neuroma; however, the traditional procedure involves drilling
through the dense bone behind the ear to access the nerve, a procedure that
generally takes between six to eight hours to perform and frequently results in
a residual hearing loss.

     FACIAL TUMOR REMOVAL. ENT surgeons perform numerous procedures in order to
remove facial tumors from the head and neck area. Surgical resections in this
area are particularly critical procedures to perform because of the numerous
motor nerve branches within the surgical area. Due to the potential
complications from severing a nerve, the identification and monitoring of nerves
during most facial tumor procedures are becoming a standard of care. These
surgeries frequently require laser incisions in cosmetically important areas and
post-operative cosmetic and functional defects are common.

     FACIAL PLASTIC SURGERY. Approximately one-third of ENT surgeons in the U.S.
currently perform facial plastic procedures. The number of elective procedures
for cosmetic purposes is likely to increase due to the general aging demographic
trend of the U.S. The procedures covered in this area include: the placement of
facial implants to correct defects or augment features in the face; correction
and smoothing of wrinkles; facial lifts, which involve stretching the muscles
and skin of the face; and facial sculpting, which involves the removal of fat
around the neck.

     Other common facial plastic surgical procedures include face and brow
lifts. During these procedures, the surgeon peels the skin at the hairline,
pulls the facial muscles and skin taut and then stitches the long incision made
at the hairline. In addition to the post-operative swelling and bruising from
the procedure, the patient is left with a relatively large scar at the hairline
from the long incision needed to access the entire facial region. During facial
sculpting, the surgeon removes fat away from the neck area using a suction
cannula, a device which evacuates fat from the facial tissue. As a result of the
aggressive way in which the suction cannula evacuates the fat from the neck
area, the patient experiences significant swelling and bruising following the
surgical procedure.

   OTOLOGY

     Common otology procedures include myringotomies (which generally involve
the insertion of ventilation tubes in the middle ear) and stapedectomies (the
replacement of middle ear bones with middle ear prosthetic implants).

     Ventilation tubes are used to treat chronic middle ear infection. Their
placement is one of the most common surgical procedures performed in children,
with over 1.3 million of these procedures performed in 1997 in the U.S.
Conductive hearing loss is caused by damage to the ossicular bone chain in the
middle ear from disease, trauma or aging. The replacement of diseased bones of
the middle ear with specially designed implants is the preferred method to
restore hearing to these patients. Re-engineering in the design and material of
the prostheses has, in recent years, improved surgeon technique and patient
hearing outcomes.


                                       8
<PAGE>

PRODUCTS

     The Company designs, develops, manufactures, and markets surgical
instruments and related disposables and accessories for use by ENT surgeons. The
Company believes its broad product lines focused on ENT procedures allow it to
be a complete provider to its ENT customer base. The Company also designs,
develops and manufactures surgical products for use in ophthalmic and
orthopaedic procedures. Set forth below is a description of the Company's
products by related subspecialty:

   SINUS AND RHINOLOGY

     Approximately 43%, 37% and 34% of the Company's net sales in 1998, 1997 and
1996, respectively, were derived from a broad line of powered tissue-removal
instrumentation systems, visualization products, fluid-control products and hand
instruments designed for microendoscopic sinus surgery. The Company has devoted
a significant portion of its investment in research and development to the
development of procedure-specific products to capitalize on and facilitate the
conversion to microendoscopic sinus surgery.

     POWERED TISSUE-REMOVAL INSTRUMENTATION SYSTEMS. To date, the most
significant product innovation facilitating the conversion of sinus procedures
to less-traumatic techniques has come from the introduction of powered
instrumentation designed for ENT procedures. In 1995, the Company introduced the
first powered microresector product designed exclusively for use in ENT
procedures. These products cut soft tissue and bone through a unique oscillating
blade design powered by a small, lightweight surgical handpiece. In the first
quarter of 1997, the Company introduced its XPS(R) powered tissue-removal system
and in the fourth quarter of 1997, the Company introduced its enhanced XPS(R)
2000 Straight Shot(R) system. This new ENT specific system, which employs
straight and curved disposable blades and burs, offers the ENT surgeon
significantly increased power with limited blade clogging. The XPS(R) system
accounted for approximately 65% of Xomed's core ENT business sales growth during
1998 and the Company had over 1,750 units in place worldwide at the end of 1998.

     VISUALIZATION PRODUCTS. The Company produces and distributes a competitive
line of visualization endoscopic equipment designed for use in less-traumatic
sinus, head and neck and otology surgery. These products include the
Sharpsite(TM) rigid endoscopes and EndoScrub(R) endoscope lense cleaning system.
The EndoScrub(R) endoscope lens cleaning system, which was introduced in 1992
and is exclusive to the Company, allows the ENT surgeon to clean a scope lens
during surgical procedures without the need to remove and reposition the scope
repeatedly.

     MEROCEL FLUID-CONTROL PRODUCTS. The Company maintains a strong franchise
with its proprietary disposable fluid-control products (surgical sponges),
developed with proprietary polymer technology to control blood loss and
simultaneously minimize adhesions at the surgical site. Under its Merocel brand
name, the Company markets its fluid-control products in a broad array of sizes
and shapes, designed primarily for use in sinus and rhinology procedures.

     IMAGE GUIDED SURGERY. In September 1998, the Company entered a strategic
alliance with Sofamor Danek (acquired by Medtronics in January 1999) to
distribute Sofamor Danek's image guided surgery technology into the ENT market.
Under the terms of the agreement, Xomed is responsible for distributing the ENT
image guided system under its trade name "LandmarX(TM)" and Sofamor Danek is
responsible for product development, manufacturing and support. This system,
specifically developed for ENT surgery, allows the surgeon to navigate through
the procedure using the additional information supplied by CAT scan x-ray
images. In addition to these x-ray images, the surgeon has access to the direct,
real time surgical images viewed through the endoscope. The Company began
shipping this product in December 1998.

     HAND INSTRUMENTATION. The Company provides a complete line of sinus surgery
hand instrumentation comprised of over 400 patterns that have been developed to
provide surgeons with an ergonomic design and enhanced precision during surgical
procedures.

     RHINOLOGY PRODUCTS. The Company's products for use during surgical repair
of the nose include internal and external nasal splints, nasal catheters, airway
and irrigation catheters and powered sinus burs.


                                       9
<PAGE>

   HEAD AND NECK

     Approximately 23%, 23% and 25% of the Company's net sales in 1998, 1997 and
1996, respectively, were derived from products and devices related to the head
and neck anatomy. The Company has a strong brand franchise in this product
subspecialty with its nerve monitoring systems, powered systems and facial
plastic implant products. Head and neck surgical techniques are being developed
which use the more precise tissue removal of powered instrumentation systems,
similar to those being used in sinus surgery, to lessen trauma and bleeding. The
Company believes there is significant opportunity to capitalize on and
facilitate the conversion of this subspecialty to these new techniques.

     POWERED TISSUE-REMOVAL INSTRUMENTATION SYSTEMS. In mid-1997, the Company
introduced several procedure specific blades to address perceived market
opportunities for the conversion of certain head and neck procedures to powered
instrumentation, thereby further leveraging the Company's installed base of XPS
StraightShot(R) systems. Specifically, the Company has introduced cutter blades
for use in facial sculpting procedures where facial fatty tissue is removed for
cosmetic and other reasons; adenoidectomy blades for more complete and less
traumatic removal of adenoids; and laryngeal blades for the removal of polyps,
lesions and tumors located on the vocal cords. The Company believes that the
market opportunity for conversion of these procedures to powered technology is
at least as significant as the powered sinus conversion opportunity.

     POWERED DRILL SYSTEMS. Head and neck surgery requires precision,
high-powered drilling to access tumors or tissue behind bone structures. The
Company manufactures and markets a line of electric and air-powered drilling
systems for such procedures, including the PowerForma(R) electric drill system
that uses the XPS(R) console and includes a surgical handpiece and disposable
and reusable cutting burs. This new system provides the ENT surgeon with
significantly increased cutting speed and precision that will reduce the time
necessary to complete these head and neck surgical procedures.

     NERVE MONITORING SYSTEMS. The Company's NIM-2(R) XL nerve monitor products,
which were first introduced in February 1995, identify and monitor crucial motor
nerve branches during various head and neck procedures. The identification of
nerves during many head and neck procedures is becoming a standard of care
because the inadvertent cutting of any branches of these nerves could result in
facial paralysis. The NIM-2(R) XL provides surgeons with visual and audio
indicators through a system which includes a battery-powered electromyographic
monitor, disposable electrodes and nerve stimulators.

     FACIAL PLASTICS PRODUCTS. Increasingly, ENT surgeons are performing more
facial plastic procedures, including face and brow lifts, facial sculpting and
cosmetic facial implants. The Company provides a broad array of products and
devices for the facial plastic market. The Company is a worldwide distributor
for Implantech Associates, Inc. in the ENT market, providing a broad line of
facial plastic implants, including implants to augment the chin, nose and cheek.

     HAND INSTRUMENTATION. The Company provides a broad line of hand
instrumentation for facial plastic surgery. These products are designed to
increase surgeon precision and reduce patient swelling and recovery time.

     SPECIALTY PRODUCTS. The Company's Laser-Shield II(R) is a laser resistant
endotracheal tube used in throat-related surgery performed with lasers. The
Company believes that the Laser-Shield II(R) is safer and more reliable than
current alternatives.

   OTOLOGY

     Approximately 17%, 19% and 21% of the Company's net sales in 1998, 1997 and
1996, respectively, were derived from otology products. The Company possesses a
strong franchise and significant market share in this segment of the ENT market.
The Company's otology products include ventilation tubes, middle ear implants
and instrumentation used to repair conductive hearing loss and correct other
problems associated with the ear. The Company believes that the conversion of
ENT procedures to less traumatic techniques is more likely to have a significant
effect on the sinus and rhinology and head and neck subspecialties than on the
otology subspecialty.


                                       10
<PAGE>

     VENTILATION TUBES. Vent tubes are small tubes surgically implanted into the
eardrum to provide ventilation to the middle ear. Vent tubes are primarily used
in younger children with severe middle ear infection. The Company markets a full
line of vent tubes, including its proprietary Activent(TM) anti-microbial tube.

     MIDDLE EAR IMPLANTS. The Company develops and markets middle ear prostheses
used to reconstruct any or all of the three bones of the middle ear, primarily
in cases of otosclerosis and chronic middle ear infection. These permanent
implants are made of stainless steel, porous polyethylene, hydroxyapatite and
other biocompatible materials.

     MICROSURGICAL INSTRUMENTS. The Company sells a broad line of microsurgical
hand-held instruments such as otoscopes, vent tube inserters, disposable blades,
proprietary suction irrigators and specialized instruments to insert and implant
middle ear prostheses.

     SPECIALTY PRODUCTS. The Company's specialty otology products include
absorbent dressings, ear plugs, ear protectors, disposable kits for ear surgery
and other disposable surgical instruments. The Company also produces and markets
the Skeeter(R) otologic drill system, which is designed for middle ear
procedures.

   OPHTHALMIC AND OTHER

     Approximately 17% of the Company's net sales in 1998 and 21% of its net
sales in 1997 and 1996 were derived from ophthalmic and other products, with
substantially all of such sales from ophthalmic products. The Company develops
and manufactures instruments and disposable products for use during various
ophthalmic procedures. These products are marketed under the Solan(TM) trademark
through a combination of direct sales representatives and distributors
specializing in the ophthalmic products market. These instruments include
forceps, needle holders, hooks, probes and scissors. The Company's disposable
products relating to ophthalmic surgery and other surgical procedures are micro
knives, cannulae, trephines, blades, sponges, cauteries, penlights and other
miscellaneous products and kits. In addition, in the fourth quarter of 1998, the
Solan division introduced the Flapmaker(TM)(1) microkeratome device, which is
used during LASIK refractive surgery procedures. The system includes a console
and a disposable microkeratome, which creates a flap on the cornea to allow the
refractive surgery to take place. The Company's Solan division team has a
management team dedicated to the marketing of its ophthalmic products. In
connection with its acquisition of TreBay in April 1996, the Company acquired
certain devices and disposable products for use during orthopaedic surgery which
the Company markets through distributors under the TreBay name. The net sales of
orthopaedic products totaled 6%, 9% and 0% of the ophthalmic and other category
for 1998, 1997 and 1996, respectively.

SALES AND MARKETING

     The Company has an established worldwide distribution system with an
ENT-focused direct sales force and independent distributors for select product
specialties and geographic markets. The Company sells to substantially all of
the approximately 9,000 ENT specialists in the U.S. through its direct sales
force. The Company is the only major manufacturer and marketer of ENT surgical
products with a direct sales force exclusively serving ENT specialists. The
Company's U.S. sales force focuses its efforts on developing and maintaining
business relationships with ENT specialists and surgeons at leading academic
institutions whom are considered to be influential in the ENT field. The ability
of the Company to build and maintain these relationships within the medical
community provides a powerful base for the distribution network and what the
Company believes to be a significant competitive advantage, especially in the
area of product development. The Company's direct U.S. sales representatives are
compensated exclusively through sales commissions. The Company's marketing
personnel specialize according to subspecialty within the ENT market as well as
by category of product.

     In the international market, the Company sells through both a direct sales
force and over 120 independent distributors. The Company maintains a direct
sales presence in Canada, the United Kingdom, France, Australia and Germany. The
Company sells its products to other countries in Europe, Asia Pacific, Africa,
Central and South America and the Middle East using independent distributors.
The Company believes it has experienced significant international sales gains as
a result of creating a dedicated sales force in certain markets focused
exclusively on selling its products.

--------
(1) Flapmaker is a trademark of Hawken Industries, Inc.

                                       11
<PAGE>

     The Company has an exclusive arrangement with the International Center for
Otologic Training ("ICOT"), an organization affiliated with the Georgia Ear
Institute in Savannah, Georgia. The charter of ICOT is to train internationally
based ENT surgeons, many from developing countries, in new and advanced ENT
surgical techniques. The Company provides financial support and equipment to
ICOT in connection with the training of these ENT surgeons. As a result of this
relationship with the Company, the Company believes that these physicians and
their affiliated hospitals will be more inclined to purchase the Company's
products upon returning to their respective countries.

     The Company utilizes a combination of direct sales representatives and
specialty distributors to market its non-ENT products in the U.S. The Company's
Solan ophthalmic products are marketed in the U.S. through a network of direct
sales representatives and dealers specializing in ophthalmic product sales.
Outside of the U.S., the Solan ophthalmic product line is typically marketed
through the same direct and independent distributor system as the Company's ENT
product lines. The TreBay brand of orthopaedic hip revision instruments is
marketed in the U.S. through an exclusive arrangement with a major orthopaedic
company.

     The Company seeks to maintain inventory levels that provide its customers
with a high standard of service. In addition, the Company may build inventories
in advance of new product launches to support sales as well as to provide its
sales force with product samples. The Company generally allows its customers to
return products for any reason within 45 days of shipment.

PRODUCT DEVELOPMENT

     In each of the last four years, new products have accounted for an
increasing percentage of the Company's total sales. In 1998, 1997 and 1996,
products introduced within the last three years of the relevant fiscal year
represented approximately 35%, 29%, and 23% of the Company's ENT sales,
respectively.

     The Company believes that it has a strong base of proprietary engineering,
manufacturing and biomaterials capabilities. The Company also believes it has
expertise in the core research and development areas relevant to the production
of new ENT surgical products. Primarily through internal research and
development efforts, the Company plans to continue to develop new proprietary
products, often in collaboration with leading ENT and head and neck surgeons,
that allow surgeons to perform their current or future procedures in a
less-traumatic manner with more precision, less surgical time and greater
simplicity. The Company believes that the strong network it has built through
its marketing focus on ENT specialists helps implement this strategy. The
Company also from time to time may evaluate strategic acquisitions and licensing
of third party technology to further expand and enhance its product line.

     The Company has entered into royalty agreements or, in certain cases,
consulting agreements, with more than 30 ENT specialists as part of its product
development activities. The royalty agreements generally provide that the
specialist is entitled to a percentage of the revenues generated from the
Company's sales of products developed by the Company in collaboration with the
specialist. In addition, the royalty agreements generally provide that all
products developed in collaboration between the specialist and the Company will
be the exclusive property of the Company, subject to the specialist's right to
receive royalties. The Company is not obligated to make material payments under
any of the royalty or consulting agreements.

     The Company employs mechanical, electrical, materials and polymer engineers
to develop the various products offered or contemplated by the Company. The
Company's research and development department has a broad range of
electro-mechanical skills to address the Company's various hand instruments,
implants, electrical powered systems, polymer products and disposable products.
Currently, the Company's research and development department consists of
thirteen engineers experienced in various technical specialties relevant to the
Company's core products.

     The research and development engineers work closely with leading surgeons
in assessing new surgical procedures for opportunities to develop products
intended to complement current products and new "state of the art" devices that
fit within the overall Company's business strategy. During 1998, 1997 and 1996,
the Company spent $4.7 million, $4.1 million, and $3.7 million, respectively, in
connection with research and development activities.

     The Company also is pursuing research and development projects that target
markets outside of ENT. The Company currently has active projects to develop
products for the plastic and reconstructive surgery market. 

                                       12
<PAGE>

SUPPLIERS

     Although most of the purchased components utilized by the Company in
manufacturing are available from more than one supplier, certain materials,
including thermoplastic elastomer ("TPE") based materials and certain
fluoropolymers used in its ventilation tubes, are obtained from a single
supplier. Daikin America, Inc. supplies the Company with the TPE-based materials
and is not obligated to supply the materials to the Company for any fixed period
of time. If the supply of materials from a single source supplier were
interrupted in the future, replacement or alternative sources may not be readily
obtainable due to the regulatory requirements that the Company certify as to the
quality and suitability of the new or alternate material. In addition, a new or
supplemental filing would need to be approved prior to the Company's marketing a
product containing new material. This approval process may take a substantial
period of time, and there is no assurance that the Company would be able to
identify, certify or obtain the necessary regulatory approval for the new
material to be used in the Company's products. In addition, certain suppliers
could terminate or limit the sales of certain materials to the Company for use
in medical devices in an attempt to limit their potential exposure to product
liability claims.

     In addition to purchased components for manufacturing, the Company also
sources certain finished products or near finished products from third parties
for distribution into the ENT and ophthalmic markets. Although most products
obtained in this manner are available from more than one supplier, certain
products, including the Company's LandmarX(TM) image guided surgery system and
the Company's Flapmaker(TM) microkeratome system include proprietary technology
which is owned by the respective suppliers. If the supply of these products were
to be interrupted, replacement or alternative sources may not be readily
obtainable due to the high cost and expertise required to develop replacement
technology internally or the inability to secure similar technology from
alternative suppliers.

COMPETITION

     The markets served by the Company are highly competitive. The Company
believes that the primary competitive factors affecting its business are the
reliability, cost-effectiveness, ease of use, safety and effectiveness of its
products; surgeon and purchaser familiarity with its products; and third-party
reimbursement policies. For certain of the Company's potential products, an
important factor in competition may be the timing of market introduction of its
or its competitors' products. Accordingly, the relative speed with which the
Company can develop products, complete approval or clearance processes and
supply sufficient quantities of the products to the market are also important
competitive factors. The Company believes that its ability to compete
successfully in the ENT markets will depend on its ability to maintain market
share with its core product base and to facilitate the conversion of traditional
surgical procedures to microendoscopy surgical techniques using innovative
technology developed by the Company. See "Risk Factors--Possible Adverse Effects
of Significant Competition."

     The Company competes with Smith & Nephew ENT (a division of Smith & Nephew
plc formerly known as Richards Medical Company) in substantially all of the
Company's ENT product lines. Stryker Corporation, Smith & Nephew Endoscopy (a
division of Smith & Nephew plc) and Linvatec Corporation (a division of Conmed
Corporation) offer endoscopic equipment and sinus power systems that compete
with those of the Company. A number of other medical products companies offer
products which are directly competitive to certain products or product lines
marketed by the Company. Many of the Company's competitors and potential
competitors have substantially greater capital resources than the Company. Some
of the Company's competitors may have long term or preferential supply
arrangements with hospitals. Such arrangements may act as a barrier to market
entry.

GOVERNMENT REGULATION

     The Company's products, product development activities, promotional and
marketing activities and manufacturing processes are subject to extensive and
rigorous regulation by the U.S. Food and Drug Administration ("FDA") and
comparable agencies in foreign countries. In the U.S., the FDA regulates the
interstate commerce of medical devices as well as manufacturing, labeling,
promotion and recordkeeping procedures for such devices. For purposes of these
regulations, the Company's products are generally treated as medical "devices."
In order for the Company to market its products in the U.S., the Company must
obtain marketing clearance from the FDA through what is known as a 510(k)
pre-market notification or obtain approval through a more detailed application
process resulting in what is known as pre-market approval ("PMA"). The process
of obtaining marketing clearance for new medical devices from the FDA can be
costly and time-consuming. There is no assurance that such clearance will be


                                       13
<PAGE>

granted for any of the Company's products that are under development or any of
its future products on a timely basis, if at all, or that FDA review will not
involve delays that will adversely affect the Company's ability to commercialize
additional products or expand permitted uses of existing products.

     A manufacturer may seek FDA clearance to distribute a new medical device by
filing a 510(k) pre-market notification. A 510(k) pre-market notification
requires the manufacturer of a medical device to establish that the device is
"substantially equivalent" to medical devices legally marketed in the U.S. The
510(k) pre-market notification must be accompanied by appropriate information or
data establishing the claim of substantial equivalence, which, depending on the
type of product, may require animal or human clinical data. If this substantial
equivalence is established to the satisfaction of the FDA, the manufacturer will
receive FDA clearance for marketing of the medical device. The 510(k) pre-market
notification process generally takes at least three months. If the manufacturer
cannot establish substantial equivalence or if the FDA determines that a device
requires a more rigorous review, the FDA will require that the manufacturer
submit a PMA application prior to obtaining approval to market the device in the
U.S. The PMA process requires laboratory and animal studies, the submission to
the FDA of a request for permission to clinically evaluate the medical device in
humans under an Investigational Device Exemption ("IDE"), the conduct of human
studies meeting the requirements of the institutional review board of the study
institution, the written informed consent of all participating patients, the
submission of a PMA application, the review of the human studies by an
FDA-selected scientific advisory panel and final review (including manufacturing
facilities review) and approval by the FDA. This process is expensive and
time-consuming, generally taking more than a year and often substantially
longer.

     All of the products currently marketed by the Company either have received
FDA marketing clearance pursuant to 510(k) pre-market notifications or PMA
applications filed by the Company and cleared by the FDA, or are exempt from
obtaining marketing clearance by virtue of their status as pre-amendment devices
(I.E., devices introduced into interstate commerce prior to May 28, 1976).
Although the Company anticipates that, at least in the near term, its products
generally will be evaluated under the 510(k) pre-market notification process,
there can be no assurance that the Company's current or future products may not
be subjected to the PMA process or that the Company's current or future products
in development will receive FDA marketing clearance.

     Even if regulatory clearance to market a device is obtained from the FDA,
this clearance may entail limitations on the indicated uses of the device.
Marketing clearance can also be withdrawn by the FDA due to the failure to
comply with regulatory standards or the occurrence of unforeseen problems
following initial clearance. The Company may be required to make further filings
with the FDA under certain circumstances such as the addition of new product
claims. The Company has made modifications to its cleared products, which the
Company believes do not require submission of new 510(k) notices. There can be
no assurance, however, that the FDA would agree with any of the Company's
determinations and not require the Company to submit new 510(k) notices for any
of the changes made to its products and/or to stop marketing until new 510(k)s
are cleared by the FDA.

     Failure to comply with applicable regulatory requirements could result in,
among other things, warning letters, fines, injunctions, civil monetary
penalties, recall or seizure of products, total or partial suspension of
production, refusal of the government to grant pre-market clearance or
pre-market approval for devices, withdrawal of approvals and criminal
prosecution.

     The Company is also required to register with the FDA as a medical device
manufacturer. As such, the Company's manufacturing facilities are subject to
inspection on a routine basis for compliance with the FDA's Quality System
Regulations ("QSR"). These regulations require that the Company manufacture its
products and maintain its documents in a prescribed manner with respect to
design, manufacturing, testing and quality control activities. As a medical
device manufacturer, the Company is further required to comply with FDA
requirements regarding the reporting of allegations of death or serious injury
associated with the use of its medical devices, as well as product malfunctions
that would likely cause or contribute to death or serious injury if the
malfunctions were to recur. Other FDA requirements govern product labeling and
prohibit a manufacturer from marketing an approved device for unapproved
applications. If the FDA believes that a manufacturer is not in compliance with
the law, it can institute proceedings to detain or seize products, issue a
recall, enjoin future violations and assess civil and criminal penalties against
the manufacturer, its officers and employees.

     The Company is also subject to numerous federal, state and local laws
relating to such matters as safe working 


                                       14
<PAGE>

conditions, manufacturing practices, environmental protection, fire hazard
control and disposal of hazardous or potentially hazardous substances. There can
be no assurance that the Company will not be required to incur significant costs
to comply with such laws and regulations in the future or that such laws or
regulations will not have a material adverse effect upon the Company's ability
to do business.

     The Company may become subject to future legislation and regulations
concerning the manufacture and marketing of medical devices. This could increase
the cost and time necessary to begin marketing new products and could affect the
Company in other respects not presently foreseeable. The Company cannot predict
the effect of possible future legislation and regulations.

     Sales of medical devices outside the U.S. are subject to foreign regulatory
requirements that vary widely from country to country. These laws and
regulations range from simple product registration requirements in some
countries to complex clearance and production controls in others. As a result,
the processes and time periods required to obtain foreign marketing approval may
be longer or shorter than that necessary to obtain FDA approval. These
differences may affect the efficiency and timeliness of international market
introduction of the Company's products, and there can be no assurance that the
Company will be able to obtain regulatory approvals or clearances for its
products in foreign countries.

     For countries in the European Union ("EU"), CE mark certification
procedures became available in January 1995 for medical devices. Since June
1998, medical devices must display the CE mark to be sold in EU countries.
Successful completion of these procedures allows certified devices to be placed
on the market in all EU countries. In order to obtain the right to affix the CE
mark to their products, medical device companies must obtain certification that
their processes meet European quality standards, including certification that
their design and manufacturing facilities comply with ISO 9001 standards. All of
the Company's products marketed in the countries comprising the EU have been CE
marked. The Company successfully obtained certification under the ISO 9001
standards in November 1995. In addition, international sales of medical devices
manufactured in the U.S. but not approved by the FDA for distribution in the
U.S. are subject to FDA export requirements. Under these requirements, the
Company must assure that the product is not in conflict with the laws of the
country for which it is intended for export, in addition to complying with the
other requirements of Sections 801(e) and/or 802 of the United States Food, Drug
and Cosmetic Act.

THIRD-PARTY REIMBURSEMENT

     In the U.S., health care providers that purchase medical devices generally
rely on third-party payors, such as Medicare, Medicaid, private health insurance
plans and health maintenance organizations, to reimburse all or a portion of the
cost of the devices. The Medicare program is funded and administered by the
Health Care Financing Administration ("HCFA"), while the Medicaid program is
jointly funded by HCFA and the states, which administer the program under
general federal oversight. The Company believes its current products and the
procedures in which such products are used are generally eligible for coverage
under these third-party reimbursement programs. The Company also believes that
the products it is developing and the procedures in which such products will be
used will be eligible for third-party reimbursement. The competitive position of
certain of the Company's products will be partially dependent upon the extent of
coverage and adequate reimbursement for such products and for the procedures in
which such products are used.

     The federal government and certain state governments are currently
considering a number of proposals to reform the Medicare and Medicaid health
care reimbursement system. The Company is unable to evaluate what legislation
may be drafted and whether or when any such legislation will be enacted and
implemented. Certain of the proposals, if adopted, could have an adverse effect
on the Company's business, financial condition and results of operations.

     Other trends in third party reimbursement programs may impact the Company's
results of operations and financial position. During the past several years,
major third-party payors have substantially revised their reimbursement
methodologies in an attempt to contain their health care reimbursement costs.
Medicare reimbursement for inpatient hospital services is based on a fixed
amount per admission based on the patient's specific diagnosis. As a result, any
illness to be treated or procedure to be performed will be reimbursed only at a
prescribed rate set by the government that is known in advance to the health
care provider. If the treatment costs less, the provider is still reimbursed 


                                       15
<PAGE>

for the entire fixed amount; if it costs more, the provider cannot bill the
patient for the difference. No separate payment is made in most cases for
products such as the Company's instrumentation when they are furnished or used
in connection with inpatient care. Many private third-party payors and some
state Medicaid programs have also adopted similar prospective payment systems.

     The Company intends to seek international reimbursement approvals for its
products, although there can be no assurance that such approvals will be
obtained in a timely manner or at all. Reimbursement and health care payment
systems in international markets vary significantly by country and include both
government-sponsored health care and private insurance. To the extent that any
of the Company's products are not entitled to reimbursement in any international
market, market acceptance of such products in such international market would be
adversely affected.

PATENTS, TRADE SECRETS AND PROPRIETARY RIGHTS

     Proprietary protection for the Company's products and know-how is important
to the Company's business. Thus, the Company's policy is to prosecute and
enforce its patents and proprietary technology. The Company intends to continue
to file patent applications to protect technology, inventions and improvements
that are considered important to the development of its business. The Company
also relies upon trade secrets, know-how, continuing technological innovation
and licensing opportunities to develop and maintain its competitive position.

     As of January 31, 1999, the Company held 62 U.S. patents and 11 foreign
patents, and had filed 40 additional U.S. patent applications and 4 patent
applications in certain major industrial countries. The Company is also licensed
under 9 patents owned by third parties.

     The patent positions of medical device companies, including the Company,
are generally uncertain and involve complex legal and factual questions.
Consequently, even though the Company currently is pursuing its patent
applications with the U.S. Patent and Trademark Office and certain foreign
patent authorities, the Company does not know whether any of its remaining
applications will result in the issuance of any patents or, if any patents are
issued, whether they will provide significant proprietary protection or will be
circumvented or invalidated. Because patent applications in the U.S. are
maintained in secrecy until patents issue, and since publication of discoveries
in the scientific or patent literature tend to lag behind actual discoveries by
several months and there may be material patents or publications of which the
Company is not aware, the Company cannot be certain that it was the first
creator of inventions claimed by pending patent applications or that it was the
first to file patent applications for such inventions.

     The medical device industry is characterized by frequent and substantial
intellectual property litigation, particularly with respect to newly developed
technology. Intellectual property litigation is complex and expensive, and the
outcome of such litigation is difficult to predict. Any future litigation,
regardless of the outcome, is likely to result in substantial expense to the
Company and significant diversion of the efforts of the Company's technical and
management personnel. An adverse determination in any such proceeding could
subject the Company to significant liabilities to third parties, require
disputed rights to be licensed from such parties if licenses to such rights
could be obtained, and/or require the Company to cease using such technology.
There can be no assurance that if such licenses were obtainable, they would be
obtainable at costs reasonable to the Company. If forced to cease using such
technology, there can be no assurance that the Company would be able to develop
or obtain alternate technology. Additionally, if third-party patents containing
claims affecting the Company's technology are issued and such claims are
determined to be valid, there can be no assurance that the Company would be able
to obtain licenses to such patents at costs reasonable to the Company, if at
all, or be able to develop or obtain alternative technology. Accordingly, an
adverse determination in a judicial or administrative proceeding or failure to
obtain necessary licenses could prevent the Company from manufacturing, using or
selling certain of its products, which could have a material adverse effect on
the Company's business, financial condition and results of operations.
Additionally, such an adverse determination could require the company to pay
retroactive license fees or other monetary damages.

     The Company's practice is to require its employees, consultants, outside
collaborators and researchers and other advisors to execute confidentiality
agreements upon the commencement of employment or consulting relationships with
the Company. These agreements provide that all confidential information
developed or made known to the individual during the course of the individual's
relationship with the Company is to be kept confidential and not disclosed to
third parties, subject to a right to publish certain information in the
scientific literature in certain 


                                       16
<PAGE>

circumstances and subject to other specific exceptions. In the case of
employees, the agreements provide that all inventions conceived by the
individual shall be the exclusive property of the Company. There can be no
assurance, however, that these agreements will provide meaningful protection for
the Company's trade secrets or adequate remedies in the event of unauthorized
use or disclosure of such information.

PRODUCT LIABILITY AND INSURANCE

     The business of the Company entails the risk of product liability claims
and any such claims could have an adverse impact on the Company. The Company has
taken and will continue to take what it believes are appropriate precautions
against this risk, including maintaining general liability and commercial
liability insurance policies which include adequate coverage for product
liability claims. The Company evaluates its insurance requirements on an ongoing
basis to enable it to maintain adequate levels of coverage. There can be no
assurance that product liability claims will not exceed such insurance coverage
limits or that such insurance will be available on commercially reasonable terms
or at all. The Company currently is involved in certain legal proceedings
involving product liability claims. Based on information presently available to
the Company, the Company believes that it has adequate legal defenses and/or
insurance coverage for these actions, and that the ultimate outcome of these
actions will not have a material adverse effect on the Company's business,
financial condition and results of operation.

EMPLOYEES

     As of December 31, 1998, the Company had 724 full-time employees and 5
temporary employees, including 309 in production, 122 in professional and
technical positions, 100 in administration and 198 in sales and marketing. The
Company believes that its future success will depend in large part upon the
continued service of its senior management personnel, most of whom joined the
Company in April 1996, and upon the Company's continuing ability to attract and
retain highly qualified managerial, operational, technical and sales and
marketing personnel. Competition for highly qualified personnel is intense and
there can be no assurance that the Company will be able to retain its key
personnel or that it will be able to attract and retain additional qualified
personnel in the future. The Company has not experienced any work stoppage and
considers its relations with its employees to be satisfactory.

RISK FACTORS

     THE FOLLOWING FACTORS ARE AMONG THOSE THAT MAY CAUSE THE COMPANY'S ACTUAL
RESULTS TO DIFFER SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE
FORWARD-LOOKING STATEMENTS CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K.

     POSSIBLE ADVERSE EFFECTS OF SIGNIFICANT COMPETITION. The Company encounters
significant competition in all markets in which it participates. Many of the
Company's competitors and potential competitors have substantially greater
resources, including capital, name recognition, research and development
experience and regulatory, manufacturing and marketing capabilities. Many of
these competitors offer well-established, broad product lines and ancillary
services not offered by the Company. Some of the Company's competitors have
long-term or preferential supply arrangements with hospitals, which may act as a
barrier to market entry. Other large health care companies may enter the market
for the Company's products in the future. Competing companies may succeed in
developing products that are more efficacious or less costly than any that may
be developed and marketed by the Company, and such companies also may be more
successful than the Company in production and marketing. Competing companies may
also exert competitive pricing pressures that may adversely affect the Company's
sales levels and margins. Rapid technological development by others may result
in the Company's products becoming obsolete before the Company recovers a
significant portion of the research, development and commercialization expenses
incurred with respect to those products. There can be no assurance that the
Company will be able to continue to compete successfully with existing
competitors or will be able to compete successfully with new competitors.

     DEPENDENCE ON MANAGEMENT AND OTHER KEY PERSONNEL. The Company's future
success depends to a significant extent on the efforts and abilities of its
executive officers. The Company does not maintain key man life insurance that
provides for the payment of proceeds to the Company on any of its employees. The
loss of the services of certain of these individuals or of other key personnel
could have a material adverse effect on the Company. Although the Company has
entered into an employment agreement with each of James T. Treace, its
President, Chief Executive Officer and Chairman, and F. Barry Bays, its Senior
Vice President, Operations and Chief Operating Officer, that includes
non-competition covenants, there can be no assurance that either of these
individuals or any 


                                       17
<PAGE>

other key employee will not terminate his or her employment with the Company.
The Company believes that its future success also will depend significantly upon
its ability to attract, motivate and retain additional highly skilled
managerial, operational, technical and sales and marketing personnel.
Competition for such personnel is intense, and there can be no assurance that
the Company will be successful in attracting, assimilating and retaining the
personnel it requires. See "Employees."

     RISKS ASSOCIATED WITH DIRECT INTERNATIONAL SALES OPERATIONS AND CURRENCY
EXCHANGE RISKS. Within the past four years, the Company has established direct
sales operations in five countries. The failure of these direct sales operations
to develop successfully may have a material adverse effect on the Company's
business, financial condition or results of operations. International sales
(including export sales) accounted for approximately 29% of the Company's net
sales in fiscal 1998 and 30% of net sales in 1997, and the Company expects that
international sales will continue to be a significant portion of the Company's
business. Fluctuations in currency exchange rates, as well as increases in duty
rates, and difficulties in obtaining export licenses may adversely affect the
Company's international business. The Company's establishment of direct
international sales operations further increases its exposure to fluctuations in
currency exchange rates, which may adversely affect reported sales and earnings,
because the sales of these operations are denominated in local currency and not
in U.S. dollars. Although the Company in 1997 began hedging its intercompany
foreign currency receivables to protect against uncertainty in the level of
future exchange rates, there can be no assurance that such hedging will succeed
in protecting against such uncertainty. International sales in emerging
economies are also subject to potential political and economic instability,
regional conflicts, unexpected changes in regulatory requirements, longer
payments cycles, great difficulty in receivable collection, potentially adverse
tax consequences and trade restrictions. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."

     SEASONALITY AND QUARTERLY FLUCTUATIONS. The Company's sales and operating
results have varied, and are expected to continue to vary, significantly from
quarter to quarter as a result of seasonal patterns, the timing of new product
introductions and promotional activities. The Company believes that its business
is seasonal in nature, with the third quarter of each year typically having the
lowest sales and the fourth quarter of each year typically having the highest
sales. Quarterly results of operations for any particular quarter may not be
indicative of results of operations for future periods. There can be no
assurance that future seasonal and quarterly fluctuations will not adversely
affect the Company's business, financial condition and results of operations.

     UNCERTAINTY RELATING TO THIRD-PARTY REIMBURSEMENT FOR COSTS OF PRODUCTS.
Demand for the Company's products is likely to depend in part on the extent to
which reimbursement for the cost of such products and the procedures in which
such products are used will be available from government third-party payors
(including the Medicare and Medicaid programs), government health administration
authorities, private health insurers and other organizations. These third-party
payors may deny coverage if they determine that a procedure was not reasonable
or necessary as determined by the payor, was experimental or was used for an
unapproved indication. In addition, certain health care providers are moving
towards a managed care system in which such providers contract to provide
comprehensive health care for a fixed cost per person, irrespective of the
amount of care actually provided. Such providers, in an effort to control health
care costs, are increasingly challenging the prices charged for medical products
and services and, in some instances, have pressured medical suppliers to lower
their prices. Although the Company believes that the development of
procedure-specific instrumentation for use in less traumatic procedures may in
certain cases reduce overall operating time and therefore reduce the aggregate
cost of those procedures, there can be no assurance that the development of such
products will have this effect or that third-party payors will reimburse the
costs of such instrumentation. In addition, although the Company does not depend
on reimbursement from third-party payors with respect to its products used in
surgical cosmetic procedures, there can be no assurance these procedures will
not become subject to third-party reimbursement in the future. Third-party
payors have recently increased their emphasis on managed care, which has led to
an increased emphasis on cost-effective medical devices by health care
providers. In addition, through their purchasing power, these payors often seek
discounts, price reductions or other incentives from medical product suppliers.
The Company is unable to predict what changes will be made in the reimbursement
methods utilized by third-party health care payors. Furthermore, the Company
could be adversely affected by changes in reimbursement policies of governmental
or private health care payors, particularly to the extent any such changes
affect reimbursement for procedures in which the Company's products are used. If
government or third-party payors does not provide coverage and adequate
reimbursement levels for use of the Company's products, the Company's business,
financial position and ability to market its technologies or products will be
adversely affected. Reimbursement and health care payment systems in
international markets vary significantly 


                                       18
<PAGE>

by country, and include both government-sponsored health care and private
insurance. To the extent that any of the Company's products are not entitled to
reimbursement in an international market, market acceptance of such products in
such international market would be adversely affected. See "Third-Party
Reimbursement."

     UNCERTAINTY OF EFFECT OF POTENTIAL HEALTH CARE REFORM MEASURES. Federal,
state and local officials and legislators (and certain foreign government
officials and legislators) have proposed or are reportedly considering proposing
a variety of reforms to the health care systems in the U.S. and abroad. The
Company cannot predict what health care reform legislation, if any, will be
enacted in the U.S. or elsewhere. Significant changes in the health care system
in the U.S. or elsewhere is likely to have a substantial impact over time on the
manner in which the Company conducts its business. Such changes could have a
material adverse effect on the Company's business, financial condition and
results of operations.

     EXTENSIVE GOVERNMENT REGULATION. The Company's products, product
development activities, promotional and marketing activities and manufacturing
processes are subject to extensive and rigorous regulation by the FDA and
comparable agencies in foreign countries. In the U.S., the FDA regulates the
interstate commerce of medical devices as well as the manufacturing, labeling,
promotion and recordkeeping procedures for such devices. In order for the
Company to market its products in the U.S., the Company must obtain from the FDA
marketing clearance through a 510(k) pre-market notification or obtain approval
through a more detailed application process resulting in a PMA. The process of
obtaining marketing clearance for new medical devices from the FDA can be costly
and time consuming, and there can be no assurance that such clearance will be
granted for the Company's future products on a timely basis, if at all, or that
FDA review will not involve delays that will adversely affect the Company's
ability to commercialize additional products or expand permitted uses of
existing products.

     Even if regulatory clearance to market a device is obtained from the FDA,
the clearance may entail limitations on the indicated uses of the device. The
clearance can also be withdrawn by the FDA due to the failure to comply with
regulatory standards or the occurrence of unforeseen problems following initial
clearance. The Company may be required to make further filings with the FDA
under certain circumstances such as the addition of new product claims. The FDA
could also limit or prevent the manufacture or distribution of the Company's
products and has the power to seize or require the recall of such products. The
Company has made modifications to its 510(k) cleared devices which the Company
believes do not require submission of new 510(k)s. There can be no assurance,
however, that the FDA would agree with any of the Company's determinations and
will not require the Company to submit new 510(k)s for any of the changes made
to the devices and/or to stop marketing until new 510(k)s are cleared by the
FDA.

     All of the products currently marketed by the Company either have received
marketing clearance pursuant to 510(k) pre-market notifications or PMA
applications filed by the Company and cleared by the FDA, or are exempt from
obtaining marketing clearance by virtue of (1) their status as pre-amendment
devices (I.E. devices introduced into interstate commerce prior to May 28, 1976)
or (2) their 510(k) exemption by regulation where applicable. A 510(k)
pre-market notification requires the manufacturer of a medical device to
establish that the device is "substantially equivalent" to medical devices
legally marketed in the U.S. For future products, there can be no assurance that
the FDA will concur with the Company's 510(k) request for clearance or that the
FDA will not require the Company to file PMA applications. The process of
obtaining a PMA can be expensive, uncertain and lengthy, frequently requiring
anywhere from one to several years from the date of submission, if approval is
obtained at all. Significant delay or cost in obtaining, or failure to obtain
FDA clearance to market products, or any FDA limitations on the use of the
Company's products could have a material adverse effect on the business,
financial condition and results of operations of the Company.

     In addition, the FDA's Quality System Regulations ("QSR") must be adhered
to with respect to all of the products manufactured by the Company and its
contract manufacturers. Ongoing compliance with QSR and other applicable
regulatory requirements is monitored through periodic inspection by state and
federal agencies, including the FDA. The FDA may inspect the Company and its
facilities from time to time to determine whether the Company is in compliance
with regulations relating to medical device manufacturing companies, including
regulations concerning design, manufacturing, testing, quality control, record
keeping and product labeling practices.

     FDA regulations depend heavily on administrative interpretation, and there
can be no assurance that future interpretations made by the FDA or other
regulatory bodies, with possible retroactive effect, will not adversely affect


                                       19
<PAGE>

the Company. In addition, changes in the existing regulations or adoption of new
governmental regulations or policies could prevent or delay regulatory approval
of the Company's products.

     Failure to comply with applicable regulatory requirements could result in,
among other things, warning letters, fines, injunctions, civil monetary
penalties, recall or seizure of products, total or partial suspension of
production, refusal of the government to grant pre-market clearance or
pre-market approval for devices, withdrawal of approvals and criminal
prosecution. Any of the actions could result in adverse publicity for the
Company and could damage the Company's reputation.

     A portion of the Company's revenue is dependent upon sales of its products
outside the U.S. Foreign regulatory bodies have established carrying regulations
governing product standards, packaging requirements, labeling requirements,
import restrictions, tariff regulations, duties and tax requirements. Since June
1998, medical devices cannot be sold in EU countries unless they display the CE
mark, an international symbol of adherence to quality assurance standards and
compliance with applicable European medical device directives. In order to
obtain the right to affix the CE mark to its products, the Company must obtain
and maintain certification that its processes meet European quality standards,
including certification that its design and manufacturing facility complies with
ISO 9001 standards. All of the Company's products marketed in the countries
comprising the trading members of the EU have been CE marked. There can be no
assurance that the Company will be able to maintain CE mark certification for
its products. The inability or failure of the Company or its international
distributors to comply with varying foreign regulations or the imposition of new
regulations could restrict or, in certain countries, result in the prohibition
of the sale of the Company's products internationally and thereby adversely
affect the Company's business, financial condition and results of operations.
See "Government Regulation."

     The Company also is subject to various federal and state laws pertaining to
health care "fraud and abuse," including anti-kickback laws and false claims
laws. Anti-kickback laws make it illegal to knowingly and willfully offer, pay
solicit or receive any remuneration (including any kickback, bribe or rebate)
directly or indirectly, overtly or covertly, in cash or in kind in return for or
to induce (a) the referral of an individual for the furnishing or arranging for
the furnishing of any item or service, or (b) the purchasing, leasing, ordering,
or arranging for or recommending purchasing, leasing, or ordering of any good,
facility, service, or item. False claims laws prohibit anyone from knowingly and
willfully presenting, or causing to be presented, claims for payment that
contain false or fraudulent information. Violations of these laws are punishable
by criminal and/or civil sanctions including, in some instances, imprisonment
and exclusion from participation in federal health care programs, including
Medicare and Medicaid. The Company has never been challenged by a governmental
authority under these laws and believes that, based on this history, its
operations are in material compliance with such laws. However, because of the
broad scope of some of these laws, there can be no assurance that one or more of
the Company's practices would not be challenged by governmental authorities
under certain of these laws, that the Company would not be required to alter its
practices as a result, or that the occurrence of one or more of these events
would not result in material adverse effect on the Company's business, financial
condition and results of operations.

     UNCERTAINTY REGARDING PATENTS AND PROPRIETARY RIGHTS. The Company's success
will depend in part on its ability to develop patentable products, obtain patent
protection for its products both in the U.S. and in other countries and enforce
its patents. The Company's competitive position and business operations do not
materially depend on any expired patents or patents expiring in the near future.
However, the patent positions of medical device companies are generally
uncertain and involve complex legal and factual questions. No assurance can be
given that patents will issue from any patent applications owned by or licensed
to the Company or that, if patents do issue, the claims allowed will be
sufficiently broad to protect the Company's technology. In addition, no
assurance can be given that any issued patents owned by or licensed to the
Company will not be challenged, invalidated or circumvented, or that the rights
granted thereunder will provide competitive advantages to the Company. The
enforceability of patents issued with respect to biomedical products can be
highly uncertain. Federal court decisions establishing legal standards for
determining the validity and scope of patents are in transition. There can be no
assurance that the historical legal standard surrounding questions of validity
and scope will continue to be applied or that current defenses as to issued
patents in the field will offer protection in the future. The Company also
relies on unpatented trade secrets to protect its proprietary technology, and no
assurance can be given that others will not independently develop or otherwise
acquire substantially equivalent techniques or otherwise gain access to the
Company's proprietary technology or that the Company would ultimately be able to
protect meaningful rights to such unpatented proprietary technology.


                                       20
<PAGE>

     The commercial success of the Company will also depend in part on its not
infringing patents issued to others or breaching the licenses upon which the
Company's products might be based. The Company's licenses of patents and patent
applications impose various commercialization, sublicensing, insurance, royalty
and other obligations on the Company. Failure of the Company to comply with
these requirements could result in termination of the licenses or conversion of
the licenses from being exclusive to nonexclusive in nature.

     The medical device industry has been characterized by extensive litigation
regarding patents and other intellectual property rights. Litigation, which
would likely result in substantial cost to the Company, may be necessary to
enforce any patents issued or licensed to the Company and/or to determine the
scope and validity of proprietary rights of other parties. In particular,
competitors of the Company and other third parties hold issued patents and are
assumed by the Company to hold pending patent applications, which may result in
claims of infringement against the Company or other patent litigation. The
Company also may have to participate in interference proceedings declared by the
U.S. Patent and Trademark Office, which could result in substantial cost to the
Company, to determine the priority of inventions. Furthermore, the Company may
have to participate at substantial cost in International Trade Commission
proceedings to abate importation of products which would compete unfairly with
products of the Company.

     The Company relies on confidentiality agreements with its collaborators,
employees, advisors, vendors and consultants. There can be no assurance that
these agreements will not be breached, that the Company would have adequate
remedies for any breach or that the Company's trade secrets will not otherwise
become known or be independently developed by competitors. Failure to obtain or
maintain patent and trade secret protection, for any reason, could have a
material adverse effect on the Company's business, financial condition and
results of operations. See "Patents, Trade Secrets and Proprietary Rights."

     DEPENDENCE UPON KEY SUPPLIERS. Although the Company believes that there are
a number of possible vendors for most of the components and subassemblies
required for its products, certain materials, including TPE-based materials and
certain fluoropolymers used in certain of its ventilation tubes, currently are
obtained from a single source. Although it is not presently the case, if the
supply of materials from a single source vendor were interrupted, replacement or
alternative sources might not be readily obtainable due to the regulatory
requirements that the Company certify as to the quality and suitability of the
new or alternate material. In addition, a new or supplemental filing would be
required to be approved prior to the Company's marketing a product containing
new material. This approval process may take a substantial period of time, and
there is no assurance that the Company would be able to identify, certify or
obtain the necessary regulatory approval for the new material to be used in the
Company's products. In addition, certain suppliers could terminate or limit the
sales of certain materials to the Company for use in medical devices in an
attempt to limit their potential exposure to product liability claims.

     In addition to purchased components for manufacturing, the Company also
sources certain finished products or near finished products from third parties
for distribution into the ENT and ophthalmic market. Although most products
obtained in this manner are available from more than one supplier, certain
products including the Company's LandmarX(TM) image guided surgery system and
the Company's Flapmaker(TM) microkeratome system include proprietary technology
which is owned by the respective suppliers. If the supply of these products were
interrupted in the future, replacement or alternative sources may not be readily
obtainable due to the high cost and expertise required to develop replacement
technology internally or the inability to secure similar technology from
alternative suppliers. See "Suppliers."

     PRODUCT LIABILITY RISK; LIMITED INSURANCE COVERAGE. The manufacture and
sale of medical instrumentation entail significant risk of product liability
claims in the event that the use of such instrumentation is alleged to have
resulted in adverse effects on a patient. The Company has taken and will
continue to take what it believes are appropriate precautions, including
maintaining general liability and commercial liability insurance policies which
include coverage for product liability claims. Although the Company maintains
what it believes to be adequate insurance, there can be no assurance that the
Company's existing insurance coverage limits are adequate to protect the Company
from any liabilities it might incur in connection with the sale of its products.
In addition, the Company may require, or desire to obtain, increased product
liability coverage in the future. Product liability insurance is expensive and
in the future may not be available on acceptable terms, if at all. A successful
product liability claim or series of claims brought against the Company in
excess of its insurance coverage could have a material adverse effect 

                                       21
<PAGE>

on the Company's business, financial condition and results of operations.
Additionally, it is possible that adverse product liability actions could
negatively affect the Company's ability to obtain and maintain regulatory
approval for its products, as well as damage the Company's reputation in any or
all markets in which it participates. See "Product Liability and Insurance."

     ENVIRONMENTAL MATTERS. The past and present business operations of the
Company and the past and present ownership and operations of real property by
the Company are subject to extensive and changing federal, state, and local
environmental laws and regulations. The Company believes it is in material
compliance with all such applicable laws and regulations. The Company cannot
predict what environmental legislation or regulations will be enacted in the
future, how existing or future laws or regulations will be administered or
interpreted or what environmental conditions may be found to exist. Compliance
with more stringent laws or regulations or stricter interpretations of existing
laws may require additional expenditures by the Company, some of which may be
material.

     ANTI-TAKEOVER CONSIDERATIONS. The Company's Second Restated Certificate of
Incorporation authorizes the issuance of preferred stock without stockholder
approval and upon such terms as the Board of Directors may determine. The
issuance of preferred stock could have the effect of making it more difficult
for a third party to acquire, or of discouraging a third party from acquiring or
making a proposal to acquire, a majority of the outstanding Common Stock of the
Company and could adversely affect the prevailing market price of the Common
Stock. The rights of the holders of Common Stock will be subject to, and may be
adversely affected by, the rights of holders of preferred stock that may be
issued in the future. The Company has no present plans to issue any shares of
preferred stock. In addition, the Company is subject to the provisions of
Section 203 of the Delaware General Corporation Law, which could prohibit or
delay a merger, takeover or other change in control of the Company and therefore
discourage attempts to acquire the Company.

ITEM 2. PROPERTIES 

     The Company owns its 109,000 square foot corporate headquarters and
manufacturing facility located in Jacksonville, Florida. Over 30,000 square feet
is dedicated to manufacturing and a new 45,000 square foot
distribution/warehouse facility was completed in November of 1998. The Company
has numerous manufacturing capabilities at the Jacksonville facility, including:
injection molding; insert molding; computerized numerical control machining;
CAD/CAM; form, fill and seal; ethylene oxide gas sterilization utilizing a
Joslyn gas reclamation system; specialty surgical instrument manufacturing; tool
design and manufacturing; design and production of manufacturing equipment;
electronics assembly; bar code technology; and automated storage systems.
Construction of additional administrative offices has begun and is scheduled to
be completed in 1999.

     The Company owns a 34,000 square-foot manufacturing facility and a 6,300
square-foot distribution facility in Mystic, Connecticut where the Company's
Merocel product line of fluid-control products is manufactured. Also, the
Company owns a 26,000 square-foot manufacturing facility in St. Aubin, France
where it manufactures precision hand-held instruments.

     In addition to these owned properties, the Company leases office and
warehouse space at its direct sales locations in Mississauga, Canada; Bristol,
England; Gilching, Germany; Sydney, Australia; and Paris, France (which will be
closed in 1999 as a result of the acquisition of Micro-France). See Note 6 of
the Consolidated Financial Statements included in this Annual Report on Form
10-K.

     Currently, the Company operates two manufacturing shifts in Jacksonville
and one shift in Mystic and St. Aubin and has the ability to increase production
levels of its current product line without expanding its manufacturing
facilities. The Company believes that the properties, in conjunction with the
planned expansion, are adequate to serve the Company's business operations for
the at least the next two years.



                                       22
<PAGE>

ITEM 3. LEGAL PROCEEDINGS 

     The Company is currently involved in certain legal proceedings incidental
to the normal conduct of its business. The Company does not believe that any
liabilities relating to the legal proceedings to which it is a party are likely
to be, individually or in the aggregate, material to its consolidated financial
position or results of operations.

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

     There were no matters submitted to a vote of security holders during the
fourth quarter of 1998.

PART II

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

     The Common Stock began trading on the NASDAQ National Market on October 11,
1996 at $21 per share.

     The following shows the high and low market prices for each quarter over
the last two years:

<TABLE>
<CAPTION>
                    FIRST                  SECOND                  THIRD                  FOURTH
-----------  ---------------------  ----------------------  ---------------------  ---------------------
MARKET
PRICE          1998       1997        1998        1997        1998       1997        1998       1997
-----------  ---------  ----------  ----------  ----------  ---------  ----------  ---------  ----------
<S>          <C>        <C>         <C>         <C>         <C>        <C>         <C>        <C>
High         $19-5/8    $13-1/3     $22-1/8     $20-7/16    $27-1/8    $16-7/16    $32-5/8    $16
Low          $14        $7-13/16    $17-3/4     $10-3/16    $18-1/2    $12-7/16    $24-5/8    $13-3/16
</TABLE>

     The total number of holders of record of Common Stock as of February 26,
1999 was approximately 120. The Company's Common Stock closed at $36.375 on that
date.

     The Company historically has not paid cash dividends on the Common Stock
and does not anticipate paying cash dividends in the next few years. In
addition, the Company's Amended and Restated Credit Agreement with its bank
restricts the payment of dividends.



                                       23
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

     The following selected financial data have been derived from the
consolidated financial statements of the Company for each of the five years
ended December 31, 1998. The information set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operation" and the consolidated financial statements and notes
thereto included in this Annual Report on Form 10-K.

<TABLE>
<CAPTION>
                                                             1998           1997            1996            1995           1994(l)
                                                          ---------       ---------       ---------       ---------       ---------
                                                                 (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                       <C>             <C>             <C>             <C>             <C>      
FINANCIAL RESULTS
Sales, net ..........................................     $  91,383       $  77,240       $  65,664       $  59,865       $  42,475
Cost of sales .......................................        35,284          30,475          25,926          22,256          15,350
Amortization of acquisition costs allocated to
   inventory ........................................            --              --              --             919           3,883
                                                          ---------       ---------       ---------       ---------       ---------
Gross margin ........................................        56,099          46,765          39,738          36,690          23,242

OPERATING EXPENSES
   Selling, general and administrative ..............        34,335          30,334          26,799          27,077          19,126
   Research and development .........................         4,681           4,088           3,659           2,405           1,958
   Amortization of intangibles (2) ..................         2,417           2,374           2,421           2,579           2,652
   Write-off of acquired research and development (3)         1,153              --           2,380              --              --
   Restructuring and other charges (4) ..............         1,809              --           3,093              --              --
                                                          ---------       ---------       ---------       ---------       ---------
Total operating expenses ............................        44,395          36,796          38,352          32,061          23,736
                                                          ---------       ---------       ---------       ---------       ---------
Operating income from continuing operations .........        11,704           9,969           1,386           4,629            (494)

Interest income (expense), net ......................           559            (104)         (2,205)         (3,063)         (2,148)
Loss on impairment of investments (5) ...............          (828)             --              --              --              --
Other income, net ...................................            69             234             525             114             313
                                                          ---------       ---------       ---------       ---------       ---------

Income before income tax expense (benefit) ..........        11,504          10,099            (294)          1,680          (2,329)
Income tax expense (benefit) ........................         4,424           3,969             873           1,355            (774)
                                                          ---------       ---------       ---------       ---------       ---------
Income (loss) from continuing operations ............     $   7,080       $   6,130       $  (1,167)      $     325       $  (1,555)
                                                          =========       =========       =========       =========       =========

PER SHARE (6)
Income (loss) from continuing operations available
   to common shareholders ...........................     $    0.61       $    0.56       $    0.76       $   (2.35)      $   (3.47)
                                                          =========       =========       =========       =========       =========
Income (loss) from continuing operations available
   to common shareholders - diluted .................     $    0.59       $    0.54       $   (0.15)      $   (2.35)      $   (3.47)
                                                          =========       =========       =========       =========       =========
Weighted average common shares outstanding-diluted ..        12,088          11,268           7,802           1,514           1,227
                                                          =========       =========       =========       =========       =========

FINANCIAL CONDITION
Working capital .....................................     $  32,534       $  26,106       $  18,460       $  12,234       $  12,744
Cost in excess of net assets acquired, net ..........        49,488          42,399          44,389          46,381          54,300
Total assets ........................................       141,996          95,727          94,056          93,123          95,720
Long-term debt including redeemable preferred stock .        13,062              --           3,563          90,488          89,985
Total shareholders' equity (deficit) ................       114,242          86,509          79,567         (13,058)         (7,336)
</TABLE>

--------
(1)  The statement of operations data includes the results of operations of
     Xomed-Treace since the date of its acquisition by the Company in April
     1994.
(2)  Amortization of intangibles included in total operating expenses includes
     amortization of foreign distribution rights of $162,000 and $838,000,
     respectively, for the years ended December 31, 1995 and 1994, respectively.
(3)  Research and development acquired in the purchase of TreBay Medical for the
     year ended December 31, 1996. Research and development acquired in the
     purchase of Micro-France for the year ended December 31, 1998. See Note
     No.1 to the Consolidated Financial Statements included in this Annual
     Report on Form 10-K.
(4)  Restructuring charge related to combination of certain operations and
     termination of employees for the year ended December 31, 1996.
     Restructuring charge related to combination of certain operations and
     termination of certain employees and termination of two supplier agreements
     for the year ended December 31, 1998. See Note No.6 to the Consolidated
     Financial Statements included in this Annual Report on Form 10-K.
(5)  Loss recorded related to a portion of the Company's portfolio of
     investments. See Note No. 5 to the Consolidated Financial Statements
     included in this Annual Report on Form 10-K.
(6)  The earnings per share have been adjusted to give effect to the
     three-for-two split of the Company's Common Stock effective November 30,
     1998. See Note 8 to the Consolidated Financial Statements included in this
     Annual Report on Form 10-K. Additionally, basic earnings per share for 1994
     and 1995 were reduced by accreted preferred stock dividends of $2.20 and
     $2.57 per share, respectively, and increased in 1996 by $1.04 per share
     related to dividend forgiveness. Diluted earnings per share was affected
     similarly in 1994 and 1995, but not affected in 1996 due to the dilutive
     effect of the preferred shares using the if-converted method of calculating
     per share earnings when preferred stock is outstanding.


                                       24
<PAGE>

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

     THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS WHICH
INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER
SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE FORWARD-LOOKING STATEMENTS.
FACTORS THAT MIGHT CAUSE SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE
DISCUSSED IN "BUSINESS--RISK FACTORS" AND BELOW. READERS ARE CAUTIONED NOT To
PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS OF
THE DATE HEREOF. THE COMPANY DOES NOT UNDERTAKE ANY OBLIGATION TO PUBLICLY
RELEASE ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR
CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCE OF
UNANTICIPATED EVENTS.

     THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH SELECTED
HISTORICAL FINANCIAL INFORMATION (ITEM 6) AND THE CONSOLIDATED FINANCIAL
STATEMENTS OF THE COMPANY, WHICH ARE INCLUDED IN THIS FORM 10-K.

YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997

     NET SALES. Net sales increased 18.3% to $91.4 million in 1998 from $77.2
million in 1997. 65.3% of the increase relates to growth of the XPS(R) powered
tissue removal system and related disposable products. The Company's core ENT
business of sinus and rhinology, head and neck and otology increased 23.4%,
which resulted in these product lines representing 82.6% of the Company's
revenue in 1998 as compared to 79.2% in 1997. Non-ENT business decreased 1.1%,
relating primarily to a reduction in sales of orthopaedic instruments under a
contract with one customer and discontinuance of certain product lines in the
international market. These decreases were partially offset by a 5.9% increase
in sales of Solan ophthalmic products. Total domestic sales increased 20.1% and
international sales increased 14.1% in 1998 over 1997. Increased sales to Japan
accounted for 37.7% of the total increase in international sales. During 1998,
the Company received regulatory approval to sell its XPS(R) system and
PowerForma(R) drill in Japan. Excluding the unfavorable effects of foreign
currency comparisons, international sales were up 16.3% from 1997.

     COST OF SALES. Cost of sales increased 15.8% to $35.3 million in 1998 from
$30.5 million in 1997. As a percent of sales, cost of sales was 38.6% in 1998 as
compared to 39.5% in 1997. Gross profit was 61.4% in 1998 as compared to 60.5%
in 1997. The improvement in gross profit primarily relates to increased sales of
disposable products for the XPS(R) system, manufacturing cost reductions, and
price increases in certain product lines.

     SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased 13.2% to $34.3 million from $30.3 million in
1997. For 1998, as a percent of sales, selling, general and administrative
expenses were 37.6% as compared to 39.3%, in 1997. This decrease, as a percent
of sales, is due to increasing sales and certain semi-fixed general and
administrative expenses.

     RESEARCH AND DEVELOPMENT. Research and development expenses increased 14.5%
to $4.7 million in 1998 but decreased as a percent of sales to 5.1% in 1998 from
5.3% during 1997. Major new product spending in 1998 related to straight and
curved cutter blades, enhancements to the XPS(R) system, development of the
NIM-Response(TM) nerve integrity monitor, increased clinical and regulatory
activity, and other projects. The Company believes it has a strong base of
proprietary engineering, manufacturing and biomaterial capabilities upon which
to build its future research and development efforts.

     AMORTIZATION. Amortization expense increased to $2,417 million from $2,374
million in 1997. The amortization relates primarily to approximately $49.9
million of goodwill generated from the Xomed Acquisition in April 1994, which is
being amortized over 25 years.

     WRITE-OFF OF ACQUIRED RESEARCH AND DEVELOPMENT. The Micro-France
acquisition was accounted for under the purchase method of accounting.
Accordingly, the purchase price of approximately $13.0 million, net of cash
acquired, was allocated to the individual assets acquired and liabilities
assumed, based upon their respective fair values at the date of acquisition. The
transaction resulted in a cost in excess of net assets acquired of $10.2
million, of which $1.2 million was allocated to in-process research and
development and charged to expense in the fourth quarter of 1998. The in-process
research and development was valued based on management's projections of cash
flows, the estimated stage of completion of the development project and costs to
achieve technological feasibility of 


                                       25
<PAGE>

the products. Estimated costs to achieve technological feasibility are less than
$50,000.

     RESTRUCTURING AND OTHER CHARGES. As noted previously under "Business--
Background", the Company incurred restructuring and other charges in the fourth
quarter of 1998 of $1.8 million consisting of (i) $580,000 related to the
transfer of a portion of the manufacturing process for Merocel sinus packing
material from the Company's facility in Mystic, Connecticut to its main facility
in Jacksonville, Florida, (ii) $ 261,000 related to the closure of the Company's
sales office in Paris, France, which is being consolidated into its recently
acquired Micro-France office in St. Aubin, France, and (iii) $1.0 million
related to the termination of two supplier agreements. See Note 6 of the
Consolidated Financial Statements included in this Annual Report on Form 10-K.

     INTEREST AND OTHER. Interest expense decreased 70.1% to $84,000 in 1998
from $280,000 in 1997 due to lower average debt levels during the current
period. Interest and dividend income increased 265.3% to $643,000 in 1998 from
$176,000 in 1997. The increase of $467,000 relates to a higher average balance
of invested assets during the current period due to proceeds from a secondary
stock offering as previously discussed in "Business--Background". Other income
decreased to $69,000 in 1998 from $234,000 in 1997. The majority of this
decrease relates to foreign currency exchange costs.

     LOSS ON IMPAIRMENT OF INVESTMENT. In the fourth quarter of 1998, the
Company recognized a loss of $828,000 related to a write-down of the Company's
portfolio of investments, which loss was deemed to be other-than temporary. See
Note 5 of the Consolidated Financial Statements included in this Annual Report
on Form 10-K.

     INCOME TAXES. The Company's effective tax rate was 38.5% for 1998 as
compared to 39.3% in 1997. This difference related principally to the
dividend-received exclusion on dividend income.

     NET INCOME. Net income increased 15.5% to $7.1 million in 1998 from $6.1
million in 1997. As discussed above, the Company incurred $3.8 million of
special charges ($2.3 million after tax) consisting of (i) $1.2 million related
to the write-off of acquired research and development, (ii) $1.8 million related
to restructuring and other charges and (iii) $828,000 related to loss on
impairment of investments. Excluding the effect of these items, net income would
have been $9.4 million, which represents an increase of 53.2% over the $6.1
million reported in 1997.

YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996

     NET SALES. Net sales increased 17.6% to $77.2 million in 1997 from $65.7
million in 1996. On a sequential quarter basis, the Company generated overall
sales growth of 9.2% in the first quarter of 1997, 15.4% in the second quarter,
17.7% in the third quarter and 27.9% in the fourth quarter when compared to the
prior year's comparable quarters. The improvement in sales growth in each
successive quarter of 1997 relates principally to accelerating growth in sinus
and rhinology product lines as a result of the Company's introduction of its XPS
Straight Shot(R) system used in endoscopic sinus procedures and an overall
improvement in the Company's international business in the third and fourth
quarters due to recent new product introductions and improving availability of
funding in certain international healthcare systems in which the Company
competes. In the core businesses of sinus and rhinology, head and neck and
otology, sales increased 17.2% in 1997 over 1996, which resulted in these
product lines representing 79.2% of the Company's revenue in 1997 as compared to
79.5% in 1996. Total domestic sales increased 20.5% in 1997 compared with 1996,
and international sales increased 11.5% in 1997 compared with 1996. Excluding
the unfavorable effects of foreign currency comparisons, international sales
were up 15% from 1996.

     COST OF SALES. Cost of sales increased 17.6% to $30.5 million in 1997 from
$25.9 million in 1996. As a percent of sales, cost of sales was 39.5% in 1997
and 1996. Gross profit was 60.5% for both 1997 and 1996. The margin in 1997 was
depressed due to higher volumes of lower margin products, including the
orthopaedic instrument line, which was offset by higher margins in sinus and
rhinology attributed to new product introductions.

     SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased 13.2% to $30.3 million from $26.8 million in
1996. For 1997, as a percent of sales, selling, general and administrative
expenses were 39.3%, as compared to 40.8% in 1996. This decrease, as a percent
of sales, is due to increasing sales and certain semi-fixed general and
administrative expenses.


                                       26
<PAGE>

     RESEARCH AND DEVELOPMENT. Research and development expenses increased 11.7%
to $4.1 million in 1997 from $3.7 million in 1996, but decreased as a percent of
sales to 5.3% in 1997 from 5.6% during 1996. Major new product spending in 1997
related to straight and curved cutter blades, enhancements to the XPS(R)
microresector system - coupled with the introduction of the XPS(R) 2000
microresector system in December 1997 - as well as other projects.

     OPERATING INCOME. Operating income for 1997 was $10.0 million compared to
$1.4 million for 1996. The increase in operating income of $8.6 million for 1997
from 1996 relates to the discussion above, and also to a $3.1 million
restructuring charge and the $2.4 million write-off of in-process research and
development in conjunction with the purchase of TreBay, both of which were
recorded in the second quarter of 1996. For 1997, operating income as a percent
of sales was 12.9% compared to 10.4% for 1996, after adding back the
restructuring and write-off charges which occurred only in 1996. This increase
as a percent of sales related to fixed amortization expense and semi-fixed
expenses within the general and administrative category.

     INTEREST AND OTHER. Interest expense decreased 88.3% to $280,000 for 1997
from $2.4 million in 1996 due to lower average debt levels during the current
period. Other income, net was $234,000 for 1997 compared to $525,000 in 1996.
This decrease of $291,000 related principally to the expiration of a royalty
agreement in late 1996.

     INCOME TAXES. The Company's effective tax rate was 39.3% for 1997. The
Company had tax expense of $873,000 on a loss of $294,000 for the year ended
December 31, 1996. The Company incurred tax expense instead of a tax benefit on
the loss due to the lack of tax benefit related to the write-off of in-process
research and development costs.

NEW ACCOUNTING PRONOUNCEMENTS

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES, which is required to be adopted for fiscal
years beginning after June 15, 1999, although earlier application is permitted
as of the beginning of any fiscal quarter. SFAS 133 will require the Company to
recognize all derivatives on the balance sheet at fair value. Derivatives that
are not hedges must be adjusted to fair value through income. If the derivative
is a hedge, changes in the fair value of the derivatives are offset against the
change in fair value of the hedged assets or liabilities and either included as
a component of comprehensive income or recognized in earnings. The Company is in
the process of determining what effect the adoption of SFAS 133 will have on the
Company's results of operations, cash flows or financial position.

RECENT EVENTS

     STOCK SPLIT. Effective November 30, 1998, the Company declared a stock
split whereby each shareholder of record on November 16, 1998 received as a
dividend for every two shares of Common Stock held, one additional share of
Common Stock. The shareholders received cash in lieu of fractional shares.

     WARBURG, PINCUS INVESTORS, L.P. STOCK DISTRIBUTION. Warburg, Pincus
Investors, L.P. ("Warburg") informed the Company that, on November 4, 1998, it
distributed to its partners approximately 1.2 million shares of Common Stock,
representing approximately 51% of Warburg's holdings in the Company and 15% of
the Company's outstanding Common Stock. Further, on January 12, 1999, Warburg
distributed substantially all of its remaining holdings in the Company to its
partners. Warburg also informed the Company that the distribution is consistent
with Warburg's practice of distributing the shares of investments it deems
successful directly to its partners. The partners receiving the distribution
consist primarily of institutional investors including several large public and
private pension funds. After the distributions, Warburg's remaining holdings
represented less than 1% of the Company's outstanding stock.

LIQUIDITY AND CAPITAL RESOURCES

     The Company entered into an Amended and Restated Credit Agreement with its
bank in May 1997 under which it may borrow through a revolving credit facility
(the "line of credit") up to $25 million to be used for working 

                                       27
<PAGE>

capital needs and potential acquisitions. See Note No. 7 to the Consolidated
Financial Statements included in this Annual Report on Form 10-K.

     For the year ended December 31, 1998, the Company generated $9.7 million
from operating activities as compared with $6.4 million cash generated in the
prior year. In 1998, the Company had a net use of cash of $4.7 million within
inventory, accounts receivable and accounts payable as compared to a net use of
cash within these components of $6.6 million in 1997. An increase in inventories
of $4.8 million comprised a significant use of cash in 1998 primarily due to
increased inventories of instruments, XPS(R)-related products and
nerve-monitoring products which is related to the Company's growth in sales.

     Cash used in investing activities was $40.7 million in 1998 as compared to
$2.3 million used in 1997. $17.4 million of the proceeds from the secondary
stock offering was invested in preferred stocks pending use for other operating
and investing purposes. The Company acquired Micro-France at the end of 1998 for
$13.0 million net of cash acquired. Property and equipment expenditures were
$7.7 million in 1998 as compared to $2.4 million in 1997, primarily related to
expansion of the warehouse and production facilities at Jacksonville, Florida.
During 1998, the Company paid certain suppliers $2.5 million related to product
distribution rights.

     Cash provided by financing activities was $33.5 million in 1998 compared to
$3.0 million used in 1997. The Company received $20.2 million from a secondary
stock offering in July 1998. The borrowing on the line of credit increased $13.1
million in 1998 to finance the acquisition of Micro-France. During 1998,
$292,000 was received from the exercise of stock options as compared to $655,000
in 1997.

     The Company expects to spend approximately $9.7 million in 1999 on capital
acquisitions of which $5.7 million relates to its corporate headquarters
expansion (See Item 2--Properties). The Company expects to fund these
expenditures with cash from operations.

     Based on the Company's ability to generate cash flow from operations and
with the availability of borrowing under its line of credit, the Company
believes it will be able to finance its working capital and expansion needs for
the next 24 months.

YEAR 2000

     The Company has undertaken an internal assessment of its operations,
including its information systems, financial systems and its manufacturing
processes, in order to determine the extent to which the Company may be
adversely affected by Year 2000 issues. The Company's focus on this issue is to
avoid any adverse effect on business operations and ensure that transactions
with customers, suppliers, and financial institutions are fully supported. This
internal assessment is approximately 90% complete at present, and the Company
expects to finish the assessment process by June 1999. The Company plans to
devote the necessary resources to resolve any significant Year 2000 issues in a
timely manner. To date, the Company has performed limited testing of systems,
and may conduct further testing and/or an external audit following the
conclusion of its assessment. To date, only internal time and costs have been
incurred related to investigating and testing related to the Year 2000 issue.
These costs are immaterial to date. Present estimates for further expenditures
of both employee time and expenses to address Year 2000 issues are between
$50,000 and $100,000, respectively.

     The Company has surveyed its significant suppliers, customers and other
third parties to determine their Year 2000 readiness and, to date, has received
responses from approximately 60% of those surveyed, a majority of whom have
certified they are compliant. The Company has conferred with significant
customers to assure that various systems used for data and information exchanges
between them will be compatible following December 31, 1999. The Company has
also initiated a formal program to advise customers, distributors and suppliers
of the Year 2000 issue; however, the Company believes it has no material
exposure to contingencies related to the Year 2000 issue for the products it has
sold.


                                       28
<PAGE>
     Based on its assessments to date, the Company believes it will not
experience any material disruption as a result of Year 2000 issues in internal
manufacturing processes, information processing or interface with key customers,
or with processing orders and billing. Possible Year 2000 worst case scenarios
include the interruption of significant parts of the Company's business as a
result of critical information systems failure or the failure of suppliers,
distributors or customers. Any such interruption may have a material adverse
impact on future results. Since their possibility cannot be eliminated, the
Company is incorporating Year 2000 concerns into its contingency plans for
dealing with catastrophic events. Although the Company expects its remediation
efforts will be completed on a timely basis, failure to do so could have a
material adverse effect on the Company's systems and results of operations which
could lead to an inability to process customer orders, ship products, bill
customers and collect payments. While the Company has taken the steps outlined
above, there can be no certainty that the systems and products of other
companies on which the Company relies will not have a material adverse effect on
the Company's operations. In addition, if certain third party service providers,
such as those supplying electricity, water or telephone service, experience
difficulties resulting in disruption of service to the Company, a shutdown of
the Company's facilities could occur for the duration of the disruption. At
present, the Company has not developed contingency plans but intends to
determine whether to develop any such plan in fiscal year 1999. Based on
existing information, the Company believes the anticipated spending to become
Year 2000 compliant will not have a material adverse effect on the Company's
financial condition, cash flows or results of operations. Nevertheless, there
can be no assurance that Year 2000 issues will not have a material adverse
effect on the Company's business, results of operation and financial condition.

SALES

     SALES BY PRODUCT CLASSIFICATION. The Company derives sales from various
markets within the ENT industry. Sinus and rhinology, head and neck and otology
are the three core markets in which the Company operates. In addition to
products for these markets, the Company has other product offerings, including a
line of ophthalmic products, which the Company distributes through independent
dealers as well as a direct sales force. The following table summarizes the
Company's worldwide product line sales during the periods indicated:

<TABLE>
<CAPTION>
                                                           YEARS  ENDED   DECEMBER   31,
                                                        ---------------------------------
                                                          1998        1997         1996
                                                        --------    --------     --------
                                                                (IN THOUSANDS)
SALES:
<S>                                                     <C>         <C>          <C>    
   Sinus and Rhinology.............................     $38,981     $28,848      $22,247
   Head and Neck...................................      21,372      17,847       16,114
   Otology.........................................      15,124      14,465       13,841
                                                        -------     -------      -------
     Total Core Business...........................      75,477      61,160       52,202
   Ophthalmic and Other............................      15,906      16,080       13,462
                                                        -------     -------      -------
     Total.........................................     $91,383     $77,240      $65,664
                                                        =======     =======      =======

                                                           YEARS  ENDED   DECEMBER   31,
                                                        ---------------------------------
                                                          1998        1997         1996
                                                        --------    --------     --------

PERCENTAGE OF TOTAL SALES:
   Sinus and Rhinology...............................      42.7%       37.4%        33.9%
   Head and Neck.....................................      23.4        23.1         24.5
   Otology...........................................      16.5        18.7         21.1
                                                        -------     -------      -------
        Total Core Business..........................      82.6        79.2         79.5
   Ophthalmic and Other..............................      17.4        20.8         20.5
                                                        -------     -------      -------
     Total                                                100.0%      100.0%       100.0%
                                                        =======     =======      =======
</TABLE>

     SALES BY GEOGRAPHIC MARKET. The Company distributes its products on a
worldwide basis through an almost 100-person direct sales force in the U.S. and
selected other countries and through a network of over 130 independent
distributors. The Company's core ENT products are sold in the U.S. only on a
direct sales basis.

     Approximately 29%, 30% and 32% of the Company's net sales in 1998, 1997 and
1996, respectively, were made outside the U.S. through direct operations in the
United Kingdom, Canada, France, Germany and Australia, as 

                                       29
<PAGE>

well as through independent international distributors, many of whom distribute
the Company's products exclusively. The portion of sales made outside the U.S.
in 1998 was lower than 1997 primarily due to economic difficulties in the Asia
region as well as the unfavorable effects of foreign currency rate comparisons
in international markets in 1998. The portion of sales made outside the U.S. in
1997 was lower than 1996 primarily due to international markets only having six
months of sales from the Company's new XPS(R) system compared with the twelve
months in the U.S. due to a later international introduction date as well as the
unfavorable effects of foreign currency rate comparisons in international
markets in 1997. The following table summarizes the Company's U.S. and
international sales for the periods indicated:

<TABLE>
<CAPTION>
                                                                  YEARS  ENDED 
                                                                  DECEMBER 31,
                                                       ----------------------------------
                                                          1998        1997         1996
                                                       --------     --------     --------
                                                                (IN THOUSANDS)
<S>                                                    <C>          <C>            <C>     
SALES:
   U.S..........................................       $ 64,625     $ 53,798     # 44,647  
   International................................         26,758       23,442       21,017  
                                                       --------     --------     --------
          Total ................................       $ 91,383     $ 77,240     # 65,664  
                                                       ========     ========     ========
PERCENTAGE OF TOTAL SALES:
     U.S. ......................................           70.7%        69.7%        68.0%
     International..............................           29.3%        30.3%        32.0%
                                                       --------     --------     --------
          Total.................................          100.0%       100.0%       100.0%
                                                       ========     ========     ========
</TABLE>

     SALES BY EQUIPMENT VS. DISPOSABLE PRODUCTS. The Company places particular
emphasis on disposable products and implantable devices, which represented 77.0%
of sales in 1998 as compared with 79.6% of the total in 1997. One of the
Company's principal objectives is to continue to develop additional disposable
products for use with its instrumentation systems. The portion of sales from
disposable and implantable products was lower in 1998 than in 1997 primarily due
to increased sales of instruments and LandmarX(TM) image guided surgery systems
as previously described under "Products - Sinus and Rhinology". The portion of
sales from disposable and implantable products was lower in 1997 than 1996
primarily due to the addition of orthopaedic instrument sales in 1997 which did
not occur in 1996 and the introduction of the XPS(R) system during 1997 which
initially generates equipment sales followed by on-going revenues from
disposable products in later periods. The following table summarizes the
Company's sales of equipment and instrumentation products as well as disposable
and implantable products for the periods indicated:

<TABLE>
<CAPTION>
                                                                  YEARS  ENDED 
                                                                  DECEMBER 31,
                                                       ----------------------------------
                                                          1998        1997         1996
                                                       --------     --------     --------
<S>                                                    <C>          <C>          <C>        
SALES:
     Equipment and Instrumentation Products......      $ 20,983     $ 15,768     $ 10,178   
     Disposable and Implantable Products.........        70,400       61,472       55,486   
                                                       --------     --------     --------
          Total..................................      $ 91,383     $ 77,240     $ 65,664   
                                                       ========     ========     ========   
PERCENTAGE OF TOTAL SALES:
     Equipment and Instrumentation Products......          23.0%        20.4%        15.5%
     Disposable and Implantable Products.........          77.0         79.6%        84.5% 
                                                       --------     --------     --------
          Total..................................         100.0%       100.0%       100.0%
                                                       ========     ========     ========
</TABLE>

ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

FOREIGN CURRENCY

     A portion of the Company's operations consists of sales activities in
foreign markets. The Company manufactures its products in the United States and
sells them outside the U.S. through a combination of international distributors
and five wholly-owned subsidiaries. Sales to the third party distributors are in
U.S. dollars and sales to the wholly-owned subsidiaries are in their local
currencies.
                                       30
<PAGE>

     As a result, the Company's financial results could be significantly
affected by factors such as changes in foreign currency exchange rates or weak
economic conditions in those foreign markets. The principal exposure on sales to
third party distributors stems from the potential for weak economic conditions
in the foreign market, thus weakening the foreign currency, decreasing the
customers' buying power and potentially decreasing the Company's sales. The
Company does not currently hedge this exposure. The Company's exposure on sales
to its subsidiaries in their currencies is two-pronged: (1) the exposure related
to the weakening of local currency when payment of the trade payable is made,
thus translating into fewer dollars; and (2) upon translation of the
subsidiaries' monthly financial statements, that a weakening local currency
would cause lower market sales to be recorded in U.S. Dollars than what would
have occurred had the currency been stable as compared to the U.S. Dollar.
However, in the latter instance, cost of goods sold and operating expenses would
also be translated at lower amounts and accordingly, the effect on net income
would be mitigated.

     To mitigate the effects of item (1) described above, the Company enters
into short-term forward exchange contracts on those foreign currency receivables
to hedge almost the entire amounts. The exposures hedged include the Australian
and Canadian Dollars, French Franc, German Deutschmark and British Pound.
Hypothetically, if exchange rates were to change by 10% as compared to the U.S.
Dollar, the effects on the Company's receivables from its foreign receivables
would be materially offset by the Company's hedge. Foreign currency exchange
cost charged to expense for 1998 was approximately $58,000.

     As a result of item (2) described above, the Company's earnings are
affected by fluctuations in the value of the U.S. Dollar as compared to the
currencies of the foreign markets in which the Company has subsidiaries. This
exposure relates to the translation of the foreign subsidiaries' earnings from
their respective functional currencies into the U.S. Dollar. As of the beginning
of 1998, the result of a uniform 10% strengthening in the value of the U.S.
Dollar relative to the currencies in which the Company's foreign subsidiaries
operate would affect income from operations by less than $25,000 for the year
ending December 31, 1998. This calculation assumes that each exchange rate would
change in the same direction relative to the U.S. Dollar. In addition, the
Company's sensitivity analysis of the effects of changes in foreign currency
exchange rates does not consider a potential change in sales levels or local
currency prices.

INTEREST RATE EXPOSURE

     The Company is exposed to interest rate risk stemming from its preferred
stock portfolio. The Company has entered into short sales of U.S. Treasury Bond
futures ("derivatives") in order to hedge the effects of interest rates on these
investments. The Company believes that the value of the U.S. Treasury Bond
futures correlates inversely to the value of the preferred stocks upon changes
in interest rates. Accordingly, the Company's objective is to offset any gain or
loss on the exposed investments with gains or losses from the derivatives. The
Company does not use the derivatives for trading or speculative purposes.
Additionally, by adopting this strategy the Company is exposed to the
possibility that the gains and losses realized on the derivatives will not
correlate inversely with the gains and losses on the investments. As noted
previously in "Management's Discussion and Analysis of Financial Condition and
Results of Operations," this situation occurred in the third and fourth quarters
of 1998 and the Company recorded losses of $828,000.

     As of December 31, 1998, the Company holds positions in short sales of U.S.
Treasury Bonds ("Bonds") with a notional amount of $10.9 million based on a
price of $127.78. Upon closing out the short sale contracts, the Company could
experience gains and losses depending on the price of the Bonds. Assuming a
hypothetical increase or decrease of 10%, the price range of $115 to $140.56
would result in a potential gain of $1 million or a potential loss of $1
million. However, these ranges reflect the effect of interest rates on the hedge
strategy and not the exposed risk. Over the past ten years, investments in
preferred stocks at the Company's level would typically react inversely to the
amounts noted above and materially offset the gains or losses noted above.

     Based on the Company's current program of liquidating these investments
over the next several months, the Company's belief that market conditions for
these investments are improving, and the valuation reserves established at
December 31, 1998, the Company does not anticipate incurring material future
losses on its investment portfolio. Based on the uncertainty of market
conditions, however, there can be no assurance that material future losses will
be avoided.


                                       31
<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The Financial Statements begin on page F-1 in this Annual Report on Form
10-K.

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

     Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The information required by this item is hereby incorporated by reference
to such information contained in the Company's definitive proxy statement
relating to the Annual Meeting of Stockholders of the Company scheduled to be
held on May 13, 1999 (the "Proxy Statement"), which is expected to be filed
pursuant to Regulation 14A of the Securities and Exchange Act of 1934 not later
than 120 days after the end of the fiscal year covered by this report.

ITEM 11. EXECUTIVE COMPENSATION

     The information required by this item is hereby incorporated by reference
to such information contained in the Proxy Statement, which is expected to be
filed pursuant to Regulation 14A of the Securities and Exchange Act of 1934 not
later than 120 days after the end of the fiscal year covered by this report.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information required by this item is hereby incorporated by reference
to such information contained in the Proxy Statement, which is expected to be
filed pursuant to Regulation 14A of the Securities and Exchange Act of 1934 not
later than 120 days after the end of the fiscal year covered by this report.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by this item is hereby incorporated by reference
to such information contained in the Proxy Statement, which is expected to be
filed pursuant to Regulation 14A of the Securities and Exchange Act of 1934 not
later than 120 days after the end of the fiscal year covered by this report.

PART IV

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

     (a)  1.  FINANCIAL STATEMENTS

              The financial statements listed in the accompanying Index to
              Financial Statements are filed as part of this Annual Report on
              Form 10-K.

          2.  FINANCIAL STATEMENT SCHEDULES

              All schedules have been omitted since the required information is
              not present or not present in amounts sufficient to require
              submission of the schedule or because the information required is
              included in the consolidated financial statements, including the
              summary of significant accounting policies and the notes to the
              consolidated financial statements.


                                       32
<PAGE>

         3.  EXHIBITS

             EXHIBIT NO.                    DESCRIPTION
             -----------                    -----------

                2.1     Stock Purchase Agreement among The Stockholders of
                        Etablissements Boutmy, S.A. and Xomed France Holdings,
                        S.N.C. dated December 30, 1998. 1
                3.1     Second Restated Certificate of Incorporation. 1
                3.2     Restated By-Laws. 1
                3.3     Stockholders Agreement, dated as of April 16, 1996,
                        among the Company, Warburg, Pincus Investors, L.P.,
                        Accel IV L.P., Accel Investors '94 L.P., Accel Keiretsu
                        L.P., Elmore C. Patterson Partners, Prospect Partners,
                        Vertical Fund Associates, L.P., Vertical Medical
                        Partners, L.P., Vertical Partners, L.P., Mark K. Adams,
                        Solomon Rosenblatt, Ronald J. Cercone, William R.
                        Miller, Robert A. Reeves, First Union Capital Partners,
                        Inc., James T. Treace, John R. Treace, Daniel H. Treace
                        and F. Barry Bays. 2
                4       Specimen of Company's Common Stock Certificate. 3
                10.1    Credit Agreement, dated as of April 15, 1994, by and
                        among Merocel/Xomed Holdings, Inc., Merocel Corporation,
                        Xomed-Treace, Inc., Xomed-Treace, P.R. Inc., Bank of
                        Boston Connecticut, certain other lenders which are or
                        may become parties and Bank of Boston Connecticut, as
                        Agent. 2
                10.2    Fourth Amendment and Waiver Agreement, dated as of June
                        7, 1996, by and among Xomed Surgical Products, Inc.,
                        formerly known as Merocel/Xomed Holdings, Inc., Merocel
                        Corporation, Xomed, Inc., formerly known as
                        Xomed-Treace, Inc., Xomed-Treace, P.R. Inc., TreBay
                        Medical Corporation, Bank of Boston Connecticut,
                        Chemical Bank, Bank of Scotland, International
                        Nederlanden (U.S.) Capital Corporation and Bank of
                        Boston Connecticut, as Agent. 2
                10.3    Third Amendment and Waiver Agreement, dated as of April
                        15, 1996, by and among Xomed Surgical Products, Inc.,
                        formerly known as Merocel/Xomed Holdings, Inc., Merocel
                        Corporation, Xomed, Inc., formerly known as
                        Xomed-Treace, Inc., Xomed-Treace, P.R. Inc., Bank of
                        Boston Connecticut, Chemical Bank, Bank of Scotland,
                        Internationale Nederlanden (U.S.) Capital Corporation
                        and Bank of Boston Connecticut, as Agent. 2
                10.4    Second Amendment and Waiver Agreement, dated as of July
                        3, 1995, by and among Merocel/Xomed Holdings, Inc.,
                        Merocel Corporation, Xomed-Treace, Inc., Xomed-Treace,
                        P.R. Inc., Bank of Boston Connecticut, Chemical Bank,
                        Bank of Scotland, Internationale Nederlanden (U.S.)
                        Capital Corporation and Bank of Boston Connecticut, as
                        AGENT. 2
                10.5    Amendment and Waiver Agreement, dated as of March 31,
                        1995, by and among Merocel/Xomed Holdings, Inc., Merocel
                        Corporation, Xomed-Treace, Inc., Xomed-Treace, P.R.
                        Inc., Bank of Boston Connecticut, Chemical Bank, Bank of
                        Scotland, Internationale Nederlanden (U.S.) Capital
                        Corporation and Bank of Boston Connecticut, as Agent. 2
                10.6    First Amendment Agreement, dated as of June 24, 1994, by
                        and among Merocel/Xomed Holdings, Inc., Merocel
                        Corporation, Xomed-Treace, Inc., Xomed-Treace, P.R.
                        Inc., Bank of Boston Connecticut, Chemical Bank, Bank of
                        Scotland, Internationale Nederlanden (U.S.) Capital
                        Corporation and Bank of Boston Connecticut, as Agent. 2
                10.7    Fifth Amendment and Waiver Agreement, dated as of
                        September 3, 1996, by and among Xomed Surgical Products,
                        Inc., formerly known as Merocel/Xomed Holdings, Inc.,
                        Merocel Corporation, Xomed, Inc., formerly known as
                        Xomed-Treace, Inc., Xomed-Treace, P.R. Inc., TreBay
                        Medical Corporation, Bank of Boston Connecticut, The
                        Chase Manhattan Bank (formerly known as Chemical Bank),
                        Bank of Scotland, Internationale Nederlanden (U.S.)
                        Capital Corporation and Bank of Boston Connecticut, as
                        Agent. 4
                10.8    Separation Agreement, dated as of May 10, 1996, between
                        the Company and Mark K. Adams. 4
                10.9    Agreement, dated as of September 12, 1996, by and among
                        the Company, Warburg, Pincus Investors, L.P., Accel IV
                        L.P., Accel Investors '94 L.P., Accel Keiretsu L.P.,
                        Elmore C. Patterson Partners, Prospect Partners,
                        Vertical Fund Associates, L.P., Mark K. 


                                       33
<PAGE>

                        Adams, Solomon Rosenblatt, Ronald J. Cercone, William R.
                        Miller, Robert A. Reeves, First Union Capital Partners,
                        Inc., James T. Treace, John R. Treace, Dan H. Treace, F.
                        Barry Bays, Thomas E. Timbie, Thomas Drury and David R.
                        Grant. 3
                10.10   Compliance Agreement, dated as of April 1, 1996, by and
                        between Daikin America, Inc. and Xomed Surgical
                        Products, Inc. 3
                10.11   Supply Agreement, dated as of November 9, 1994, by and
                        between TreBay Medical Corporation (formerly known as
                        Micromed Development Corporation) and Consolidated
                        Polymer Technologies. 3
                10.12   Sixth Amendment and Waiver Agreement, dated as of
                        December 30, 1996, by and among Xomed Surgical Products,
                        Inc., formerly known as Merocel/Xomed Holdings, Inc.,
                        Merocel Corporation, Xomed, Inc., formerly known as
                        Xomed-Treace, Inc., Xomed-Treace, P.R. Inc., TreBay
                        Medical Corporation, Bank of Boston Connecticut, The
                        Chase Manhattan Bank (formerly known as Chemical Bank),
                        Bank of Scotland, Internationale Nederlanden (U.S.)
                        Capital Corporation and Bank of Boston Connecticut, as
                        Agent.5
                10.13.1 Xomed Surgical Products, Inc. 1996 Stock Option Plan. 2
                10.13.2 Third Amended and Restated Xomed Surgical Products, Inc.
                        1996 Stock Option Plan.6
                10.13.3 Third Amended and Restated Xomed Surgical Products, Inc.
                        1996 Stock Option Plan (incorporating amendments
                        approved at May 21, 1998 annual meeting of
                        stockholders). 1
                10.14   Amended and Restated Credit Agreement dated as of May 5,
                        1997 among the Company, Bank of Boston Connecticut, as
                        agent, and the Banks named therein. 6
                10.15   Employment Agreement dated as of February 24, 1999
                        between the Company and James T. Treace. 1
                10.16   Employment Agreement dated as of February 24, 1999
                        between the Company and F. Barry Bays. 1
                21      Subsidiaries. 1
                23      Consent of Ernst & Young LLP. 1
                27      Financial Data Schedule. 1

     (b)   REPORTS ON FORM 8-K

           None
-------------------------------

                1   Filed herewith.
                2   Incorporated by reference to the Registrant's Registration 
                    Statement on Form S-1 (Registration No. 333-10515).
                3   Incorporated by reference to Amendment No. 3 to the 
                    Registrant's Registration Statement on Form S-1 
                    (Registration No. 333-10515).
                4   Incorporated by reference to Amendment No. 1 to the
                    Registrant's Registration Statement on Form S-1 
                    (Registration No. 333-10515). 
                5   Incorporated by reference to the Registrant's Annual Report 
                    on Form 10-K dated December 31, 1996. 
                6   Incorporated by reference to the Registrant's Quarterly 
                    Report on Form 10-Q dated June 28, 1997.



                                       34
<PAGE>


                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on March 22, 1999.

     XOMED SURGICAL PRODUCTS, INC.



     By:    /s/ JAMES T. TREACE                       
        ---------------------------
     James T. Treace
     President, Chief Executive Officer and
     Chairman of the Board of Directors

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

<TABLE>
<CAPTION>
SIGNATURES                                               TITLE                           DATE
----------                                               -----                           ----
<S>                                      <C>                                        <C>
                                         President, Chief Executive Officer and
                                                 Chairman of the Board
/s/ James T. Treace                           (Principal Executive Officer)         March 22, 1999
--------------------------------
James T. Treace

                                           Vice President and Chief Financial
                                            Officer (Principal Financial and
/s/ Thomas E. Timbie                               Accounting Officer)              March 22, 1999
--------------------------------
Thomas E. Timbie

/s/ Richard B. Emmitt                                   Director                    March 22, 1999
--------------------------------
Richard B. Emmitt

/s/ William R. Miller                                   Director                    March 22, 1999
--------------------------------
William R. Miller

/s/ Rodman W. Moorhead, III                             Director                    March 22, 1999
--------------------------------
Rodman W. Moorhead, III

/s/ James E. Thomas                                     Director                    March 22, 1999
--------------------------------
James E. Thomas

/s/ Elizabeth H. Weatherman                             Director                    March 22, 1999
--------------------------------
Elizabeth H. Weatherman
</TABLE>


                                       35
<PAGE>

                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                           REFERENCE
                                                                                        -----------------
                                                                                         FORM 10-K PAGE
                                                                                             NUMBER
                                                                                        -----------------
<S>                                                                                           <C>
Report of Independent Auditors                                                                F-2

Consolidated Balance Sheets at December 31, 1998 and 1997                                     F-3

Consolidated  Statements of Operations for each of the three years in the
   period ended December 31, 1998                                                             F-4

Consolidated  Statements of Changes in  Shareholders'  Equity for each of
   the three years in the period ended December 31, 1998                                      F-5

Consolidated  Statements of Cash Flows for each of the three years in the
   period ended December 31, 1998                                                             F-6

Notes to Consolidated Financial Statements                                                    F-7
</TABLE>




                                      F-1
<PAGE>


                         REPORT OF INDEPENDENT AUDITORS

Board of Directors
Xomed Surgical Products, Inc. and Subsidiaries

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

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

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

                                       ERNST & YOUNG LLP

February 22, 1999
Jacksonville, Florida

                                      F-2
<PAGE>

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

<TABLE>
<CAPTION>
                                                                                DECEMBER 31,
                                                                       --------------------------------
                                                                            1998             1997
                                                                       ---------------  ---------------
<S>                                                                       <C>             <C>      
                                ASSETS
Current assets:
   Cash and cash equivalents .......................................      $   4,256       $   1,712
   Accounts receivable, less allowance for doubtful accounts of $901
     and $735 at December 31, 1998 and 1997, respectively ..........         18,516          13,277
   Other receivables ...............................................            287             620
   Inventories .....................................................         22,368          16,238
   Prepaid and other assets ........................................          1,203           1,083
   Deferred income taxes ...........................................             96           1,404
                                                                          ---------       ---------
Total current assets ...............................................         46,726          34,334

Investment securities ..............................................         16,584              --
Notes receivable from officers .....................................            826             724
Property, plant and equipment, net .................................         21,769          15,403
Cost in excess of net assets acquired, net .........................         49,488          42,399
Other assets .......................................................          4,293           2,867
Deferred income taxes ..............................................          2,310              --
                                                                          ---------       ---------
Total assets .......................................................      $ 141,996       $  95,727
                                                                          =========       =========

                 LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
   Accounts payable ................................................      $   5,325       $   3,493
   Accrued expenses ................................................          4,923           2,403
   Accrued payroll and commissions .................................          2,989           2,332
   Accrued restructuring costs .....................................            955              --
                                                                          ---------       ---------
Total current liabilities ..........................................         14,192           8,228

Deferred credits ...................................................            500             990
Long-term debt .....................................................         13,062              --

Shareholders' equity:
   Preferred stock, $1.00 par value,  1,000,000 shares authorized,
     -0- shares issued and outstanding .............................             --              --
   Common Stock, voting, $.01 par value, 30,000,000 shares
     authorized, 12,140,068 shares issued and outstanding ..........             81              73
   Accumulated earnings (deficit) ..................................          3,621          (3,459)
   Additional paid-in capital ......................................        110,831          90,264
   Cumulative translation adjustments ..............................           (122)            (88)
   Deferred stock compensation .....................................           (169)           (281)
                                                                          ---------       ---------
Total shareholders' equity .........................................        114,242          86,509
                                                                          ---------       ---------
Total liabilities and shareholders' equity .........................      $ 141,996       $  95,727
                                                                          =========       =========
</TABLE>


                             See accompanying notes.


                                      F-3
<PAGE>

                      CONSOLIDATED STATEMENTS OF OPERATIONS

                  (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
                                                                               YEARS ENDED DECEMBER 31,
                                                                        --------------------------------------
                                                                          1998            1997           1996
                                                                        --------       --------       --------
<S>                                                                     <C>            <C>            <C>     
Sales, net .......................................................      $ 91,383       $ 77,240       $ 65,664
Cost of sales ....................................................        35,284         30,475         25,926
                                                                        --------       --------       --------
Gross profit .....................................................        56,099         46,765         39,738
Operating expenses:
     Selling, general and administrative .........................        34,335         30,334         26,799
     Research and development ....................................         4,681          4,088          3,659
     Amortization of intangibles .................................         2,417          2,374          2,421
     Write-off of acquired research and development ..............         1,153             --          2,380
     Restructuring and other charges .............................         1,809             --          3,093
                                                                        --------       --------       --------
Total operating expenses .........................................        44,395         36,796         38,352
                                                                        --------       --------       --------
Income from operations ...........................................        11,704          9,969          1,386

Interest and dividend income .....................................           643            176            194
Interest expense .................................................           (84)          (280)        (2,399)
Other income, net ................................................            69            234            525
Loss on impairment of investments ................................          (828)            --             --
                                                                        --------       --------       --------
Income (loss) before income tax expense ..........................        11,504         10,099           (294)
Income tax expense ...............................................         4,424          3,969            873
                                                                        --------       --------       --------
Net income (loss) ................................................      $  7,080       $  6,130       $ (1,167)
                                                                        ========       ========       ======== 

Per share :
     Net income (loss) available to common shareholders ..........      $    .61       $   0.56       $   0.76
                                                                        ========       ========       ========
     Net income (loss) available to common shareholders - assuming
          dilution                                                      $    .59       $   0.54       $  (0.15)
                                                                        ========       ========       ======== 

Weighted average common shares outstanding .......................        11,513         10,985          4,133
                                                                        ========       ========       ======== 
Weighted average common shares outstanding - diluted .............        12,088         11,268          7,802
                                                                        ========       ========       ======== 
</TABLE>


                             See accompanying notes.



                                      F-4
<PAGE>


           CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

                             (DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                          NON-VOTING                                
                                                              COMMON STOCK               COMMON STOCK       ADDITIONAL   ACCUMULATED
                                                       ------------------------     ---------------------     PAID-IN     EARNINGS/ 
                                                         SHARES       AMOUNT       SHARES        AMOUNT       CAPITAL     (DEFICIT) 
                                                       ----------   ----------   ----------    ----------   ----------   ---------- 
<S>                                                       <C>       <C>             <C>        <C>          <C>          <C>        
Balance at December 31, 1995.........................     888,180   $        6      640,166    $        4   $       --   $  (12,719)

Net loss.............................................          --           --           --            --           --       (1,167)
Accretion of cumulative preferred stock dividends....          --           --           --            --           --       (3,262)
Forgiveness of cumulative preferred stock dividends..          --           --           --            --           --        7,559 
Stock options exercised..............................     156,900            1           --            --          188           -- 
Shareholders stock returned..........................          --           --           --            --           --           -- 
Acquisition of minority interest in subsidiary.......      12,000           --           --            --          180           -- 
Stock compensation, net of tax.......................          --           --           --            --          596           -- 
Proceeds from initial public stock offering..........   4,312,500           29           --            --       53,976           -- 
Conversion of preferred stock to Common Stock........   4,882,578           33           --            --       34,535           -- 
Conversion of non-voting Common Stock to voting 
   Common Stock......................................     640,166            4     (640,166)           (4)          --           -- 
                                                       ----------   ----------   ----------    ----------   ----------   ---------- 
Balance at December 31, 1996.........................  10,892,324           73           --            --       89,475       (9,589)

Comprehensive income:
   Net income........................................          --           --           --            --           --        6,130 
   Foreign currency translation......................          --           --           --            --           --           -- 
Comprehensive income.................................          --           --           --            --           --           -- 
Stock options exercised..............................     111,150           --           --            --          655           -- 
Net tax benefits from stock options..................          --           --           --            --          134           -- 
Amortization of unearned compensation................          --           --           --            --           --           -- 
                                                       ----------   ----------   ----------    ----------   ----------   ---------- 
Balance at December 31, 1997.........................  11,003,474           73           --            --       90,264       (3,459)

Comprehensive income:
   Net income........................................          --           --           --            --           --        7,080 
   Foreign currency translation......................          --           --           --            --           --           -- 
Comprehensive income.................................          --           --           --            --           --           -- 
Proceeds from secondary stock offering...............   1,092,000            8           --            --       20,149           -- 
Stock options exercised..............................      44,594           --           --            --          292           -- 
Net tax benefits from stock options..................          --           --           --            --          126           -- 
Amortization of unearned compensation................          --           --           --            --           --           -- 
                                                       ----------   ----------   ----------    ----------   ----------   ---------- 
Balance at December 31, 1998.........................  12,140,068   $       81           --    $       --   $  110,831   $    3,621 
                                                       ==========   ==========   ==========    ==========   ==========   ========== 
                                                                                
</TABLE>
<TABLE>
<CAPTION>
                                                         ACCUMULATED                   
                                                           OTHER     SHAREHOLDERS'
                                                       COMPREHENSIVE     NOTE        UNEARNED
                                                       INCOME/(LOSS)  RECEIVABLE   COMPENSATION     TOTAL
                                                       ------------  ------------- ------------  ----------
<S>                                                    <C>           <C>           <C>           <C>        
Balance at December 31, 1995.........................  $       --    $     (349)   $       --    $  (13,058)
                                                       
Net loss.............................................          --            --            --        (1,167)
Accretion of cumulative preferred stock dividends....          --            --            --        (3,262)
Forgiveness of cumulative preferred stock dividends..          --            --            --         7,559
Stock options exercised..............................          --            --            --           189
Shareholders stock returned..........................          --           162            --           162
Acquisition of minority interest in subsidiary.......          --            --            --           180
Stock compensation, net of tax.......................          --            --          (392)          204
Proceeds from initial public stock offering..........          --            --            --        54,005
Conversion of preferred stock to Common Stock........          --           187            --        34,755
Conversion of non-voting Common Stock to voting        
   Common Stock......................................          --            --            --            --
                                                       ----------    ----------    ----------    ----------
Balance at December 31, 1996.........................          --            --          (392)       79,567
                                                       
Comprehensive income:
   Net income........................................          --            --            --         6,130
   Foreign currency translation......................         (88)           --            --           (88)
                                                                                                 ----------
Comprehensive income.................................          --            --            --         6,042
                                                                                                 ----------
Stock options exercised..............................          --            --            --           655
Net tax benefits from stock options..................          --            --            --           134
Amortization of unearned compensation................          --            --           111           111
                                                       ----------    ----------    ----------    ----------
Balance at December 31, 1997.........................         (88)           --          (281)       86,509
                                                       
Comprehensive income:................................  
   Net income........................................          --            --            --         7,080
   Foreign currency translation......................         (34)           --            --           (34)
                                                                                                 ----------
Comprehensive income.................................          --            --            --         7,046
                                                                                                 ----------
Proceeds from secondary stock offering...............          --            --            --        20,157
Stock options exercised..............................          --            --            --           292
Net tax benefits from stock options..................          --            --            --           126
Amortization of unearned compensation................          --            --           112           112
                                                       ----------    ----------    ----------    ----------
Balance at December 31, 1998.........................  $     (122)   $       --    $     (169)   $  114,242
                                                       ==========    ==========    ==========    ==========
</TABLE>

                            See accompanying notes.

                                      F-5
<PAGE>


                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                             (DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                     YEARS ENDED DECEMBER 31  
                                                                             --------------------------------------
                                                                                1998           1997          1996
                                                                             --------       --------       --------
<S>                                                                          <C>            <C>            <C>      
OPERATING ACTIVITIES
Net income (loss) .....................................................      $  7,080       $  6,130       $ (1,167)
Adjustments to reconcile net income (loss) to net cash provided by
  Operating activities:
    Depreciation ......................................................         2,352          2,340          2,285
    Amortization ......................................................         2,709          2,776          2,564
    Loss on disposal of property and equipment and investments ........           876             60            301
    Translation adjustments ...........................................           (34)           288             41
    Write-off of acquired research and development ....................         1,153             --          2,380
    Changes in operating assets and liabilities net of effects of
       purchased business:
      (Increase) decrease in accounts and other receivables, net ......        (2,568)        (3,282)         2,456
      (Increase) decrease in inventories, net .........................        (4,825)        (1,563)        (2,530)
      (Increase) decrease in deferred income taxes ....................        (1,002)         2,002            266
      (Increase) decrease in other assets .............................           345           (251)          (141)
      Increase (decrease) in accounts payable and accrued expenses ....         2,646           (980)        (1,099)
      Increase (decrease) in accrued restructuring costs ..............           955         (1,155)          (512)
                                                                             --------       --------       --------
Net cash provided by operating activities .............................         9,687          6,365          4,844

INVESTING ACTIVITIES
Purchases of property and equipment ...................................        (7,706)        (2,426)        (2,379)
Purchases of investment securities ....................................       (17,428)            --             --
Loans to officers .....................................................            --             --            353
Proceeds from certificates of deposit .................................            --            140            721
Purchase of other assets ..............................................        (2,500)            --           (807)
Purchases of businesses (including cash received in 1996) .............       (13,020)            --          2,000
                                                                             --------       --------       --------
Net cash provided by (used in) investing activities ...................       (40,654)        (2,286)          (112)

FINANCING ACTIVITIES
Proceeds from revolving line of credit ................................        13,062         12,302         29,416
Payments on revolving line of credit ..................................            --           (503)       (37,034)
Payments on term notes payable and capital lease ......................            --        (15,450)       (26,096)
Exercise of stock options .............................................           292            655            189
Issuance of stock .....................................................        20,157             --         54,005
Repurchases of redeemable preferred stock .............................            --             --        (25,000)
                                                                             --------       --------       --------
Net cash provided by (used in) financing activities ...................        33,511         (2,996)        (4,520)
                                                                             --------       --------       --------

Net increase in cash and cash equivalents .............................         2,544          1,083            212
Cash and cash equivalents at beginning of period ......................         1,712            629            417
                                                                             --------       --------       --------
Cash and cash equivalents at end of period ............................      $  4,256       $  1,712       $    629
                                                                             ========       ========       ========

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
  Cash paid during the period for:
    Interest ..........................................................      $     84       $    282       $  2,499
                                                                             ========       ========       ========
    Income Taxes ......................................................      $  4,882       $  1,529       $    579
                                                                             ========       ========       ========
  Decrease in preferred stock attributable to forgiveness of cumulative
  preferred stock dividends:
    Series A ..........................................................      $     --       $     --       $    141
    Series B ..........................................................            --             --          1,473
    Series C ..........................................................            --             --          2,684
                                                                             --------       --------       --------
                                                                             $     --       $     --       $  4,298
                                                                             ========       ========       ========
  Non-cash financing and investing activities:
    Purchase of business with preferred stock, net of cash received ...      $     --       $     --       $  4,583
                                                                             ========       ========       ========
    Conversion of preferred stock to common ...........................      $     --       $     --       $ 34,755
                                                                             ========       ========       ========
</TABLE>


                             See accompanying notes.


                                      F-6
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


1.   ORGANIZATION

     Xomed Surgical Products, Inc. (the "Company"), a Delaware corporation, was
organized on April 5, 1994 for the purpose of acquiring, on April 15, 1994, all
of the outstanding stock of Xomed-Treace, Inc. and Xomed-Treace, P.R. Inc.
(collectively, "Xomed, Inc.") and Merocel Corporation ("Merocel"). The Company
had no operations or material assets prior to this transaction. As the owners of
the Company were also owners of Merocel, these transactions have been accounted
for as if Xomed, Inc. were acquired by Merocel. Therefore, the assets and
liabilities of Merocel were not revalued and are presented in the accompanying
balance sheet at historical cost.

     Xomed is a leading developer, manufacturer and marketer of a broad line of
surgical products for use by ear, nose and throat ("ENT") specialists. The
Company's broad line of products, includes in its core ENT market, powered
tissue-removal systems and other microendoscopy instruments, implantable
devices, nerve monitoring systems and disposable fluid-control products. The
Company also offers a line of ophthalmic and other products. The Company sells
its products worldwide utilizing a direct sales force in the U.S. and selected
other countries and third party distributors outside the U.S. Trade credit is
extended based on consideration of the financial capabilities of the customer
and letters of credit are obtained in certain situations. Concentrations of
credit risk with respect to the Company's extending of trade credit, which
generally is not collateralized, is limited due to the large number of customers
and their dispersion across different geographic areas.

     On December 30, 1998 the Company purchased 100% of the stock of
Etablissements Boutmy, S.A. ("Micro-France") of Saint Aubin, France. The stock
was acquired by a subsidiary of the Company from the shareholders of
Micro-France. Micro-France develops, manufactures and distributes hand-held
instruments for the ENT, plastic surgery and endoscopy markets. The purchase
price was $13,020, net of approximately $4,000 in cash. The purchase resulted in
cost in excess of assets acquired of $9,000 (amortized straight-line over a
25-year period) and $1,153 of cost allocated to in-process research and
development, which was written-off immediately. The purchased assets have been
included in the Company's December 31, 1998 Consolidated Balance Sheet. See Note
17 for proforma operations data.

     On April 16, 1996 the Company acquired TreBay Medical Corporation
("TreBay") which was involved in the development of ENT surgical specialty
products. The acquisition, which was accomplished through the issuance of
preferred stock, was accounted for under the purchase method of accounting and
accordingly, the results of operations have been included in the Company's
consolidated financial statements since the date of acquisition. The purchase
price of approximately $6,600 was allocated to the individual assets acquired
and liabilities assumed based upon their respective fair values at the date of
acquisition. The transaction resulted in cost in excess of net assets acquired
of approximately $4,400, of which $2,400 was allocated to in-process research
and development and was subsequently written off. The executive management of
TreBay replaced former management of the Company (see Note 6). The acquisition
was funded through the issuance of approximately $2,800 of redeemable preferred
stock and $3,700 of convertible preferred stock.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

   PRINCIPLES OF CONSOLIDATION

     The consolidated financial statements of the Company include the accounts
of Merocel and subsidiary, TreBay, and Xomed, Inc. and subsidiaries. As of
December 31, 1998, the Consolidated Balance Sheet includes the assets and
liabilities and excess of purchase cost over the fair values of net assets
purchased of Micro-France. Significant intercompany transactions and balances
between entities have been eliminated.

   CASH AND CASH EQUIVALENTS

     The Company considers all highly liquid short-term investments with
original maturities of three months or less when purchased to be cash
equivalents.


                                      F-7
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

   INVENTORY VALUATION

     Inventories are generally stated at average cost on a first-in, first-out
valuation basis not in excess of market value. Market value for raw materials is
based on replacement cost and for work-in-process and finished goods on net
realizable value.

   PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment are stated at cost. Expenditures for
maintenance and repairs are charged to expense as incurred. Additions,
improvements and major replacements are capitalized. The costs and accumulated
depreciation related to assets sold or retired are removed from the accounts and
any gain or loss is credited or charged to income. Depreciation is computed
using the straight-line method based on the estimated useful lives of the
related asset categories as follows--building and building improvements 27 to 35
years and machinery and equipment including assets under capital leases 3 to 15
years.

   INCOME TAXES

     The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards ("SFAS") 109, ACCOUNTING FOR INCOME TAXES, which
requires the use of the liability method of accounting for deferred income
taxes.

   REVENUE RECOGNITION

     The Company recognizes revenue when inventory is shipped to the customer.

   AMORTIZATION

     Amortization of cost in excess of assets acquired is amortized over 25
years. Accumulated amortization totaled $9,671 and $7,680 as of December 31,
1998 and 1997, respectively. Amortization of other intangibles is amortized on a
straight-line basis over the life of the related agreements ranging from four to
15 years.

     The Company periodically assesses the recoverability of goodwill at the
product line level. Cash flows and profitability of each product line as well as
changes in the operations of businesses acquired are reviewed to determine if
impairment exists. If this review indicates that goodwill will not be
recoverable, the Company's carrying value of the goodwill is reduced to the
estimated value of the discounted cash flows.

   RESEARCH AND DEVELOPMENT

     Expenditures related to research and development of new products and
processes, including research related to product alternatives, are expensed as
incurred.

   TRANSLATION ADJUSTMENTS

     Prior to the fourth quarter of 1997, translation gains and losses of
foreign currencies related to foreign operations are included in income from
operations and totaled $341 (loss), and $41 (loss) for the ten months ended
October 31, 1997, and year ended December 31, 1996, respectively. The financial
results of these foreign operations were translated using a combination of
current and historical rates. Subsequent to October 1997, translation gains and
losses are included as a component of shareholder's equity, assets and
liabilities of the foreign operations are translated at current rates, and
revenues and expenses are translated at average rates during the period. This
change resulted from a change in the designation of the functional currency from
the U.S. Dollar to the foreign currency.


                                      F-8
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

due to decreased dependence of the foreign operations on their parent for
financing, marketing and distribution activities.

   STOCK COMPENSATION

     The Company follows the intrinsic value method of accounting for stock
based compensation prescribed in ACCOUNTING PRINCIPLES BOARD OPINION NO. 25 -
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. Accordingly, stock compensation
expense 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.

   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 could differ from those estimates.

   EARNINGS PER SHARE

     In 1997, the Financial Accounting Standards Board ("FASB") issued SFAS 128,
EARNINGS PER SHARE. SFAS 128 replaced the calculation of primary and fully
diluted earnings per share with basic and diluted earnings per share. Unlike
primary earnings per share, basic earnings per share exclude any dilutive
effects of options, warrants and convertible securities. Diluted earnings per
share are very similar to the previously reported fully diluted earnings per
share. All earnings per share amounts for all periods have been presented and,
where appropriate, restated to conform to SFAS 128 requirements.

   COMPREHENSIVE INCOME

     The FASB issued SFAS 130, REPORTING COMPREHENSIVE INCOME, effective for
fiscal years beginning after December 15, 1997. SFAS 130 requires companies to
report another measure of operations called Comprehensive Income. This measure,
in addition to "net income", includes as income or loss the following items,
which if present are included in the equity section of the Balance Sheet: (1)
unrealized gains and losses on certain investments in debt and equity
securities; (2) foreign currency translation; and (3) minimum pension liability
adjustments. The Company has presented the applicable items of comprehensive
income in the Consolidated Statement of Changes in Shareholders' Equity. Income
tax expense (benefit) has not been provided on the translation adjustments
because earnings will be permanently reinvested in those foreign subsidiaries.

   SEGMENT DISCLOSURES

     Effective January 1, 1998, the Company adopted the FASB's SFAS 131,
DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. SFAS 131
supersedes SFAS 14, FINANCIAL REPORTING FOR SEGMENTS OF A BUSINESS ENTERPRISE.
SFAS 131 establishes standards for the way that public business enterprises
report information about operating segments and also establishes standards for
related disclosures about products and services, geographic areas, and major
customers. The adoption of SFAS 131 did not affect results of operations or
financial position but did affect the disclosure of segment information. See
Note 16, Segment Information.

   ACCOUNTING FOR DERIVATIVE INSTRUMENTS

     In June 1998, the FASB issued SFAS 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES. The Company expects to adopt SFAS 133
effective January 1, 2000. SFAS 133 will require the Company to recognize all
derivatives on the balance sheet at fair value. The Company does not anticipate
that the adoption of this Statement 


                                      F-9
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

will have a significant effect on its results of operations or financial
position. See Note 5, Investments and Financial Instruments.

   RECLASSIFICATIONS

     Certain prior year amounts in the consolidated financial statements have
been reclassified to conform to the current year presentation.

3.   INVENTORIES

     Inventories are summarized as follows:

                                                            DECEMBER 31,
                                                      1998               1997
                                                    --------           --------
     Finished goods ........................        $ 14,332           $ 10,224
     Work in process .......................           2,817              1,447
     Raw materials and packaging                       8,144              6,584
     Reserve for obsolescence ..............          (2,925)            (2,017)
                                                    ========           ========
                                                    $ 22,368           $ 16,238
                                                    ========           ========

     Reserves for obsolescence were increased by $1,782, $1,213 and $1,209 for
1998, 1997 and 1996, respectively. Reserve reductions from inventory written off
were $874, $247 and $559 for 1998, 1997 and 1996, respectively. The reserve for
obsolescence was $1,051, and $401 as of December 31, 1996 and December 31, 1995,
respectively.

4.   PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment, at cost, less allowances for depreciation,
is as follows:

                                                         DECEMBER 31,
                                                   1998               1997
                                                 --------           --------
     Land and land improvements .......          $  1,774           $  1,413
     Building and building improvements            10,984              6,564
     Machinery and equipment ..........            18,025             14,959
                                                 --------           --------
                                                   30,783             22,936

     Allowances for depreciation ......           (11,030)            (8,734)
                                                 --------           --------
                                                   19,753             14,202

     Capital projects in process ......             2,016              1,201
                                                 ========           ========
                                                 $ 21,769           $ 15,403
                                                 ========           ========

     Depreciation expense, including expense on assets under capital lease
obligations, is approximately $2,352, $2,340 and $2,285 for the years ended
December 31, 1998, 1997 and 1996, respectively.

5.   INVESTMENTS AND FINANCIAL INSTRUMENTS

   FOREIGN CURRENCY

     The Company enters into foreign currency forward exchange contracts to
hedge intercompany trade accounts receivable from its foreign subsidiaries. The
Company's forward exchange contracts do not subject the Company to risk from
exchange rate movements because gains and losses on such contracts offset gains
and losses on the trade



                                      F-10
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


5.   INVESTMENTS AND FINANCIAL INSTRUMENTS (CONTINUED)

accounts receivable being hedged. If the counterparties to the forward exchange
contracts do not fulfill their obligations to deliver the contracted currencies,
the Company could be at risk for any currency exchange rate movements.

     For intercompany receivables, the contracts require the Company to sell
foreign currencies (Australian Dollar, Canadian Dollar, British Pound, French
Franc and the German Deutschmark) in exchange for the U.S. Dollar. At December
31, 1998, the Company held $954, $1,365, $1,205, $1,876 and $1,193,
respectively, in foreign currency forward exchange contracts which mature in
early 1999. These contracts are marked to market each month. The resulting gains
or losses are included in other income and are generally offset by gains or
losses on the exposures being hedged. Foreign currency exchange cost charged to
expense for 1998 was approximately $58.

   INVESTMENTS

     Investments consist of marketable preferred stocks and variable rate
corporate and educational institution bonds both of which are designated as
available for sale. Accordingly, the securities and bonds are marked to market,
and the unrealized gains and losses are included, net of taxes, as a separate
component of shareholders' equity. The investments consist of preferred stocks
valued at $14.9 million and cash held in a money market fund totaling $1.7
million.

     Net losses recognized in the Company's statement of operations for 1998
total $828, and were comprised of losses realized on the Company's investments
of $253 as well as its hedging strategy, noted below, of $575.

     In order to manage the interest rate risk on the preferred stock, the
Company has entered into derivative financial instruments with off-balance sheet
risk. The Company enters into short sales of futures contracts on U.S. Treasury
Bonds in order to hedge the effect of interest rate risk on its preferred stock
portfolio. The futures contracts are designated at inception as a hedge of the
interest rate risk on the preferred stocks based on the assumption that changes
in interest rates on U.S. Treasury Bonds are inversely correlated with changes
in the market value of the preferred stocks. The Company entered these short
sales of U.S. Treasury Bond futures when the price was at approximately
$123-$124 during late August and September 1998. Due to uncertainties in the
U.S. political arena and world economic crises, much of the liquidity in the
money markets was used to purchase U.S. Treasury Bonds ("flight to quality").
Thus the price of the bonds increased at a time when the Company was
contractually required to close out the short sales. Accordingly, the Company
realized losses during the process of closing out the contracts and rolling into
new quarterly contracts. Traditionally, interest rate changes would be the cause
of increases or decreases in the prices of Treasury Bonds. Because interest
rates were not decreasing as would have been expected given an increase in
Treasury Bond prices, there was not a corresponding offsetting gain in the
preferred stock portfolio. In fact, due to credit risk issues in some of the
financial institutions in which the Company had positions, net losses were
incurred.

     The Company believed that both the credit risk issues noted above and the
"flight to quality" were temporary. The hedging technique of short selling the
U.S. Treasury Bonds has had a direct inverse correlation with the value of
preferred stocks for over 10 years, and the Company did not believe these losses
were other than temporary. Accordingly, as of the end of September 26 1998, the
Company had deferred realized and unrealized losses of $307 and $338,
respectively.

     On December 30, 1998, as noted in Note 1, the Company purchased
Micro-France for $13,020 net of approximately $4,000 in cash and made the
decision to liquidate its preferred stock portfolio in an orderly manner in late
winter and spring of 1999. The Company still believes that there is an inverse
correlation between interest rates on the U.S. Treasury Bond and the market
value of preferred stocks. However, due to the fact that the stock portfolio had
taken on a short-term nature because of the decision to liquidate, the Company
reduced its hedge exposure (and therefore its ability to generate any offsetting
future gains). As a result, the Company presently believes there will not be a
turnaround in the value of the investments as a whole and that the losses are
other than


                                      F-11
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


5.   INVESTMENTS AND FINANCIAL INSTRUMENTS (CONTINUED)

temporary. As of December 31, 1998, the Company had realized losses of $450 and
unrealized losses of $378. The total of these losses of $828 was written off as
of December 31, 1998.

     As of December 31, 1998, the Company holds positions in short sales of U.S.
Treasury Bonds (the "Bonds") with a zero carrying value and a notional amount of
$10,861 and has a put of U.S. Treasury Bonds with a notional value of $6,100.
The put is a purchased option, has a value of $16 and will not cost the Company
funds in addition to the premium, which was paid and expensed. Upon closing out
the short sale contracts, the Company could experience gains or losses depending
on the price of the Bonds. Of course, if traditional market forces are driving
the theoretical charges noted above, the Company would likely incur offsetting
losses or gains, as the case may be, in the preferred stocks' valuations.

6.   RESTRUCTURING AND OTHER CHARGES
     
     1998 RESTRUCTURING AND OTHER CHARGES

     The Board of Directors of the Company, in the fourth quarter of 1998,
approved a restructuring of its manufacturing operations at its Merocel facility
in Mystic, Connecticut. The Merocel facility produces surgical sponge material
for post-operative sinus packing. Due to an ongoing shortage of available labor
in the Mystic, Connecticut area, most of the secondary operations, which include
packaging, assembly and warehousing functions, will be transferred to the
Company's main facility in Jacksonville, Florida where similar activities for
other products currently take place. Approximately 34 production employees in
the Merocel facility will be displaced due to the product transfer. As a result,
the Company incurred a charge in the fourth quarter totaling $580 related to
anticipated severance payments of $434 and assets to be disposed with a net book
value of $146. The transfer is expected to be substantially complete by the
second quarter of 1999 and fully implemented by the end of 1999. The Merocel
facility will continue with its primary operations related to the chemical
processes involved in the production of surgical sponge material. To date, the
operation has not had difficulty in retaining the more highly skilled labor
involved with these processes.

     In conjunction with the acquisition of Micro-France in 1998, the Company
will close its direct selling site, Xomed France, located in Paris, France and
will incur costs of $135 related to severance pay, $104 related to lease
termination fees and $22 related to other exit costs. At December 31, 1998, $261
was accrued for these costs, which are expected to be paid in the first half of
1999. The reduction includes 6 employees who will not be relocating to
Saint-Aubin, France, and who do not represent any particular group of employees.

     The Company also wrote-off the amortized portion of license fees in 1998
related to two distribution agreements which were ended and accrued other
related costs. The Company terminated its distribution agreement with an
instrument maker whereby the Company distributed the hand-held instruments in
the U.S. In addition, the Company's relationship with another supplier ended. In
connection with these agreements the Company wrote-off license fees of $788,
equipment of $120 and accrued legal fees and other costs of $60.

     1996 RESTRUCTURING CHARGES

     In conjunction with the purchase of TreBay in 1996, the Company recorded an
accrual totaling $647 related to severance and relocation costs of $598 and
lease termination costs of $49. All employees of TreBay were terminated, except
the officers and two other individuals who relocated to Jacksonville, Florida,
the corporate headquarters of the Company. For the period from the acquisition
date through December 31, 1996, $250 was paid related to termination and
relocation benefits, $49 was paid related to lease termination costs and $162
was paid related to other acquisition costs. During 1997 the Company utilized
the remaining reserve as follows: $82 was paid related to termination and
relocation, $61 was paid related to lease termination, and $43 related to other
exit costs.


                                      F-12
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


6.   RESTRUCTURING AND OTHER CHARGES (CONTINUED)

     Simultaneous with the purchase of TreBay in 1996 and a plan by new
management to combine certain opera-tions (see Note 1), the Company recorded a
restructuring accrual of $3,100 which was comprised of $2,500 of termination
benefits and $600 of other exit costs. The reductions included 20 management and
administrative employees at the Company's Mystic, Connecticut manufacturing
facility, 17 management and administrative employees at the Company's
Jacksonville, Florida headquarters, 13 management and production employees at
the Company's St. Louis, Missouri manufacturing facility and 2 management level
employees internationally. For the period from the accrual date through the end
of 1996, the Company had paid out termination benefits totaling $2,000 and paid
approximately $100 related to other exit costs. As of December 31, 1996, the
Mystic, Connecticut facility maintained only manufacturing operations, and in
December 1996, the St. Louis facility was closed. During 1997, the Company
utilized the remaining reserve as follows: paid termination benefits of $500,
wrote off property related to the St. Louis facility closure of approximately
$300, paid other exit costs of $100 and reversed the remaining reserve of
approximately $100 against selling, general and administrative expenses.

7.   LONG-TERM DEBT

     The Company was obligated under a revolving line-of-credit agreement with
interest payable monthly and all outstanding principal due May 5, 2000; interest
at LIBOR (5.0604% at December 31, 1998) plus 1.25% or at the lender's base rate
(7.75% at December 31, 1998).

     In May 1997 the Company entered into an Amended and Restated Credit
Agreement (the "Credit Agreement") with its bank. Under the terms of the Credit
Agreement, the Company may borrow under a line-of-credit up to a maximum
capacity of $25,000 to be used for working capital and operating needs and
acquisitions. The amount available to the Company at any given time is based
upon various percentages of the Company's outstanding inventories and accounts
receivable and certain other assets. Availability at December 31, 1998 was
approximately $23,600. The Company must repay any principal amounts outstanding
on the line-of-credit in excess of the borrowing base. In any event, all
outstanding principal on the line-of-credit is due and payable on May 5, 2000.
The Company pays a quarterly commitment fee which varies from .25% to .125% per
annum on the average daily unused balance on the line-of-credit during the
preceding calendar quarter.

     The line-of-credit is collateralized by the receivables and inventory of
the Company and certain land and buildings at the Mystic, Connecticut facility
with a net book value of $41,005. The Credit Agreement has restrictions
regarding payment of dividends and incurrence of additional debt and requires
compliance with various financial covenants.

8.   SHAREHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK

     In October 1996 in conjunction with the Company's initial public offering
of stock, all then outstanding Series A and B Convertible Preferred shares were
converted to Common Stock. Approximately 80% of the Series C Redeemable
Preferred Stock was redeemed for cash and the balance was converted to Common
Stock. The Class B Common Stock ("Non-Voting Common Stock") was converted to
Common Stock.

     In September 1996 the Company authorized 1,000,000 shares of a new issue of
preferred stock. The stock is undesignated as to its rights, preferences and
limitations, which the Board of Directors is authorized to set at a future date
prior to issuance.

     In July 1998 the Company completed a second public stock offering in which
the Company raised $20.2 million through the sale of 1,092,000 shares of its
Common Stock.


                                      F-13
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


8.   SHAREHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK (CONTINUED)

   COMMON STOCK

     Each share of Common Stock entitles its holder to receive dividends as
declared by the Company's Board of Directors, subject to the preferences and
other rights of any Preferred Stock issued in the future.

     During 1996, the Company amended and restated its Restated Certificate of
Incorporation to, among other things, (i) change the designation of its Class A
Common Stock to "Common Stock," (ii) change the designation of its Class B
Common Stock to "Non-Voting Common Stock," (iii) increase the number of
authorized shares of Common Stock to 30,000,000 and (iv) authorize a class of
undesignated Preferred Stock, par value $.01 per share.

   REDEEMABLE PREFERRED STOCK

     The Series A, B and C Redeemable Preferred Stock, which was issued in 1994,
related to the purchase of the Company and was redeemed or converted into Common
Stock in the Company's initial public offering, was cancelled by a vote of
shareholders at the 1998 Annual Meeting of Stockholders.

     The following table presents changes in redeemable preferred stock (in
thousands):

<TABLE>
<CAPTION>
                                                    SERIES A                      SERIES B                      SERIES C
                                                 PREFERRED STOCK               PREFERRED STOCK               PREFERRED STOCK
                                             -----------------------       -----------------------       -----------------------
                                              SHARES         AMOUNT         SHARES         AMOUNT         SHARES          AMOUNT
                                             --------       --------       --------       --------       --------       --------
<S>                                            <C>          <C>               <C>         <C>                 <C>       <C>     
Balance at December 31, 1994 ..........           546       $  3,632          3,192       $ 21,251            410       $ 28,996
Accretion of dividends ................            --            209             --          1,223             --          2,458
                                             --------       --------       --------       --------       --------       --------
Balance at December 31, 1995 ..........           546          3,841          3,192         22,474            410         31,454
Accretion of dividends ................            --            263             --            922             --          2,077
Forgiveness of dividends ..............            --           (404)            --         (2,395)            --         (4,761)
Shareholders stock returned ...........           (14)           (91)            --             --             (3)          (208)
Issuance of shares for TreBay Medical .           585          3,736             --             --             43          2,847
Redemption of preferred stock .........            --             --             --             --           (353)       (25,000)
Conversion of preferred stock to common
   Stock ..............................        (1,117)        (7,345)        (3,192)       (21,001)           (97)        (6,409)
                                             --------       --------       --------       --------       --------       --------

Balance at December 31, 1996 ..........            --       $     --             --       $     --             --       $     --
                                             ========       ========       ========       ========       ========       ========
</TABLE>

9.   RETIREMENT BENEFITS

     Retirement benefits are provided to all eligible employees through the
participation in defined contribution plans maintained by the Company which
comply with the provisions of Section 401(k) of the Internal Revenue Code (the
"Savings Plans"). The provisions of the Savings Plans differ with respect to
employee contributions, employer matching percentages and profit sharing
depending on the country in which the employees work. Expense recorded by the
Company for the various plans for the years ended December 31, 1998, 1997 and
1996 was approximately $525, $481, and $510, respectively.

10.   EMPLOYEE STOCK INCENTIVES

     The Company has reserved an aggregate of 2,367,000 shares of its Common
Stock for grant or sale to key employees of the Company. As of December 31, 1998
and 1997, 752,114 and 443,301 options, respectively, were available for
additional grants. These shares may be issued in such amounts and in such a
manner (including stock options, restricted stock grants, stock bonuses, or
other stock incentive programs) as determined by the Company's Board of
Directors from time-to-time. In general, the options are granted at exercise
prices equal to the fair market value of Common Stock on the date of grant, have
a life of 10 years and provide for vesting over a four-year period. As of
December 31, 1998, 396,138 shares were exercisable. Total stock based
compensation cost recognized in the


                                      F-14
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


10.   EMPLOYEE STOCK INCENTIVES (CONTINUED)

 Statement of Operations for the years ended December 31, 1998, 1997 and 1996
was $111, $111, and $54, respectively. During 1996, the Company granted 209,250
options with exercise prices below the then estimated fair market values. These
options have a weighted average exercise price of $7.10 and weighted average
fair value of $5.69.

     The exercise price for options outstanding at the end of 1998 ranged from
$1.33 to $27.91. The following table summarizes option activity, which may be
exercised at various dates through January 2008:


<TABLE>
<CAPTION>
                                                      1998                             1997                           1996  
                                                    WEIGHTED                         WEIGHTED                       WEIGHTED
                                      1998          AVERAGE            1997          AVERAGE         1996           AVERAGE
                                    OPTIONS      EXERCISE PRICE      OPTIONS     EXERCISE PRICE     OPTIONS      EXERCISE PRICE
                                 -------------   --------------  --------------  --------------  -------------   --------------
<S>                              <C>                 <C>          <C>                <C>           <C>             <C>
Beginning of the period
options outstanding...........       875,649         $ 7.99          703,299         $ 5.99          377,025       $  3.78
Options granted................      455,250          19.03          303,000          10.51          632,499          6.10
Options exercised..............      (44,594)          6.59         (111,150)          5.56         (156,900)         1.21
Options canceled...............      (12,587)         10.79          (19,500)          8.09         (149,325)         5.91
                                 ---------------                 ---------------                 --------------
End of period options
outstanding....................    1,273,718          11.96          875,649           7.99          703,299          5.99
                                 ===============                 ===============                 ==============
Options granted range of
option prices..................  $17.15 - $27.91                  $10.04-$13.59                    $6.24-$7.10
                                 ===============                 ===============                 ==============
Options exercised range of                                                                        
option prices..................  $1.33 - $10.04                   $0.67-$7.03                      $0.67-$6.39
                                 ===============                 ===============                 ==============
Options exercisable at end of
year ..........................      396,138         $ 7.39          240,587         $ 6.47         182,271        $  5.94
                                 ===============                 ===============                 ==============
</TABLE>

     The Company has adopted the disclosure-only provisions of SFAS 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION. Accordingly, no compensation cost has
been recognized for stock options issued with exercise prices equal to the fair
value of the Common Stock on the date of grant. SFAS 123 requires the
determination of fair value of all options utilizing stock option valuation
models. In management's opinion, existing stock option valuation models do not
provide a reliable single measure of the fair value of employee stock options
that have vesting provisions and are not transferable. In providing the pro
forma disclosures below, the Company used the Black-Scholes option pricing model
with the following weighted average assumptions: (1) an expected volatility
factor for the Company's stock of .40; (2) a risk-free interest rate of 6.15%;
(3) an expected life of options of 3 years; and (4) no dividend payments. The
weighted-average grant date fair value of options granted in 1998, 1997 and 1996
was $6.76, $4.59 and $4.01, respectively. Had compensation cost for the
Company's stock option plan been determined based on the fair value at the grant
date for awards consistent with the provisions of SFAS 123, the Company's net
income from continuing operations and income per share from continuing
operations would have been as follows:

                                                    1998      1997       1996
                                                   ------    ------    ------
Net income--as reported.......................     $7,080    $6,130    $3,130
Net income--adjusted..........................     $6,608    $5,908    $2,997
Net income per share--as reported.............     $ 0.61    $ 0.56    $ 0.76
Net income per share--adjusted................     $ 0.58    $ 0.54    $ 0.73



                                      F-15
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


11.   EARNINGS PER SHARE

     The following table sets forth the computation of shares for purposes of
the earnings per share calculation (in thousands):

<TABLE>
<CAPTION>
                                                                 1998                 1997               1996
                                                                ------               ------             -----
<S>                                                             <C>                  <C>                <C>  
     Weighted average shares outstanding ............           11,513               10,985             4,133
     Net effect of dilutive securities:
      Stock options...................................             575                  283               161
      Convertible preferred stock.....................              --                   --             3,508
                                                                ------               ------             -----
     Totals..........................................           12,088               11,268             7,802
                                                                ======               ======             =====
</TABLE>

     Income from continuing operations and net income for 1996 for purposes of
computing earnings per share-basic include net forgiveness of dividends of
$4,297.

12.   INCOME TAXES

     The provision for income taxes (benefit) consists of the following:

<TABLE>
<CAPTION>
                                                              1998           1997         1996   
                                                            -------        -------      -------
<S>                                                         <C>            <C>          <C>    
     Current:
               Domestic:
               Federal...................................   $ 4,192        $ 1,801      $   496
               State.....................................       463            360          206
               Foreign...................................        96             65           --
                                                            -------        -------      -------
                                                              4,751          2,226          702

     Deferred:
               Domestic..................................      (390)         1,527          540
               Foreign...................................        63            216         (369)
                                                            -------        -------      -------
                                                            $ 4,424        $ 3,969       $  873
                                                            =======        =======       ======
</TABLE>

     During 1998, 1997 and 1996 the Company's tax liability was decreased $126,
$134 and $150, respectively, and additional paid-in capital increased due to the
early disposition of stock by a stock option holder. During 1997 the Company
utilized approximately $650 of operating loss carryforwards thereby reducing its
current liability.

     Income tax expense (benefit) reconciled to the amount computed at statutory
rates is as follows:

<TABLE>
<CAPTION>
                                                                         1998         1997        1996
                                                                       ------        ------     -------- 
<S>                                                                    <C>           <C>        <C>      
     Federal tax (benefit) at statutory rate......................     $4,025        $3,434     $   (103)
     Purchased in-process research and development................         --            --          833
     State income taxes (net of federal income tax effect)........        407           442           92
     Increase in valuation allowance..............................        199           156           --
     Tax benefits related to export sales.........................       (154)         (209)          --
     Other, net...................................................        (53)          146           51
                                                                       ------        ------     -------- 
                                                                       $4,424        $3,969     $    873
                                                                       ======        ======     ========
</TABLE>

     Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred income taxes are as follows:



                                      F-16
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


12.   INCOME TAXES (CONTINUED)

<TABLE>
<CAPTION>
                                                                     DECEMBER 31,
                                                                  1998          1997
                                                                -------       -------
<S>                                                             <C>           <C>    
     Deferred income tax assets:
               Net operating loss carryforwards ..........      $ 1,522       $ 1,505
               Losses from foreign operations ............        1,068         1,008
               Patents and other intangibles .............          743           511
               Inventory .................................        1,361           997
               Non-deductible accrued expenses ...........          949           583
               Purchased in-process research & development          297            --
               AMT credit ................................           --            44
               Severance accruals ........................          282            27
                                                                -------       -------
                                                                  6,222         4,675
               Valuation allowance .......................         (940)         (741)
                                                                -------       -------
                                                                  5,282         3,934
                                                                -------       -------

     Deferred income tax liabilities:
               Amortization of goodwill ..................       (2,134)       (2,118)
               Depreciation ..............................         (742)         (712)
               Purchased research and development ........           --          (215)
                                                                -------       -------
                                                                 (2,876)       (3,045)
                                                                -------       -------
     Total deferred income taxes, net ....................      $ 2,406       $   889
                                                                =======       =======
</TABLE>

     The valuation allowance at December 31, 1998 and 1997 relates to certain
losses from foreign operations incurred prior to 1996 and short-term capital
losses which management believes the ultimate realization of the related tax
benefits is not more likely than not at the present time. This allowance was
increased $199, $156 and $6 for 1998, 1997 and 1996, respectively, for losses of
these foreign operations. Foreign losses totaling approximately $2,029 can be
carried forward for periods ranging from five years to indefinitely.
Undistributed earnings reinvested indefinitely in foreign subsidiaries as
working capital and plant and equipment aggregated $393. Domestic loss
carryforwards total $3,854 and expire in 2009 through 2011.

13.  RELATED PARTY TRANSACTIONS

     At December 31, 1998 and 1997, the Company had outstanding a note
receivable totaling $826 and $724, respectively from an officer, which is
collateralized by 36,000 shares of Common Stock. In March of 1998, the note was
amended and restated. The interest rate was changed from 10% to 5.32%. At that
time, accrued interest of $102 was added to the principal portion of the note.
The note becomes a demand note on November 7, 2000 and, in any event, is payable
in full by November 7, 2002.

     In connection with the acquisition of TreBay in April 1996, a significant
shareholder of the Company made loans to three officers to acquire the Company's
stock. At December 31, 1996, the aggregate principal value of notes payable to
the shareholder from the officers was $1,900. The notes were paid in July 1998.

14.  LEASE COMMITMENTS

     The Company was committed under noncancelable operating leases with terms
in excess of one year involving certain property and equipment. Rental expense
on all rental agreements totaled $580, $706, and $790 for the years ended
December 31, 1998, 1997 and 1996, respectively. In general, the Company has
options to renew its leases for varying periods of time. Annual minimum rental
commitments under these leases are as follows:



                                      F-17
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


14.   LEASE COMMITMENTS (CONTINUED)

               YEAR ENDING DECEMBER 31,

               1999.....................................................  $237
               2000.....................................................   183
               2001.....................................................   140
               2002.....................................................   107
               2003 and thereafter......................................    40
                                                                          ----
                                                                          $707

15.   CONTINGENCIES

     The Company is subject to various claims and legal proceedings covering a
wide range of matters that arise in the ordinary course of its business
activities, including product liability claims. Management believes that any
liability that may ultimately result from the resolution of these matters will
not have a material adverse effect on the financial condition or results of
operations of the Company.

     The Internal Revenue Service is currently examining tax returns for years
1994 through 1996. Management believes the ultimate resolution of this
examination will not result in a material adverse effect to the Company's
financial position or results of operations.

16.   SEGMENT INFORMATION

     The Company manufactures and distributes medical devices and supplies for
use by ENT physicians. The Company has a dedicated Vice President of Sales and
Vice President of Marketing devoted solely to its U.S. core ENT market. The
Company also offers a line of products for ophthalmic surgeons, which segment is
the sole focus of another Vice President. These two markets represent segments
identified for evaluating profitability and asset allocation. The "other"
category is comprised principally of orthopaedic sales. Sales of ophthalmic
products internationally are not as material proportionally as they are in the
U.S. Additionally, the President of Xomed International, Inc. is directly
responsible for all sales outside the U.S. International is the third segment
identified and measured. No other segments or operations are material to
consolidated sales or assets.

     DISCLOSURES FOR PURPOSES OF SEGMENTAL REPORTING. Sales are recorded in the
geographical segment when and where products are delivered to the end user.
Related cost of sales reflects only economic costs (I.E., no intersegment
profit). Segment assets are reported based on specific identification where
possible, or if not, based on an allocation as a percentage of sales. Goodwill
is not allocated among the different segments.



                                      F-18
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


16.   SEGMENT INFORMATION (CONTINUED)

<TABLE>
<CAPTION>
                                                          DOMESTIC
                                       --------------------------------------------------
                                       CORE ENT     OPHTHALMIC       OTHER         TOTAL    INTERNATIONAL  CONSOLIDATED
                                       --------     ----------     --------      --------   -------------  ------------
<S>                          <C>       <C>           <C>           <C>           <C>           <C>           <C>     
Sales                        1998      $ 53,236      $  9,540      $  1,849      $ 64,625      $ 26,758      $ 91,383
                             1997        42,736         8,954         2,108        53,798        23,442        77,240
                             1996        35,071         8,359         1,217        44,647        21,017        65,664

Depreciation Expense         1998      $  1,879      $     84      $     63      $  2,026      $    326      $  2,352
                             1997         1,783            86            70         1,939           401         2,340
                             1996         1,869            78            71         2,018           267         2,285

Segment Profit               1998      $ 20,127      $  2,765      $    705      $ 23,597      $  7,024      $ 30,621
                             1997        15,161         2,892           883        18,936         5,115        24,051
                             1996         9,834         3,297           868        13,999         5,282        19,281

Segment Assets               1998      $102,241      $ 12,583      $    939      $115,763      $ 26,233      $141,996
                             1997        76,214        10,739         1,224        88,177         7,550        95,727
                             1996        73,117        11,542         2,136        86,795         7,261        94,056

Capital Expenditures         1998      $  6,638      $    662      $    166      $  7,466      $    240      $  7,706
                             1997         2,454           262            14         2,730           612         3,342
                             1996         2,140            73            21         2,234           137         2,371
</TABLE>


Reconciliation of Segment Profit to income (loss) before tax:

<TABLE>
<CAPTION>
                                                             1998                   1997                  1996
                                                           ------                  ------                 ------
<S>                                                        <C>                     <C>                    <C>   
Indirect operating expenses:
  General and administrative.........................     $ 8,857                 $ 7,620                $ 6,342
  Amortization of intangibles........................       2,417                   2,374                  2,421
  Write-off of acquired research and development.....       1,153                      --                  2,380
  Restructuring charges and other....................       1,809                      --                  3,093
  Research and development...........................       4,681                   4,088                  3,659
                                                          -------                 -------                -------
Total indirect expenses..............................      18,917                  14,082                 17,895
                                                          -------                 -------                -------
Income from operations...............................      11,704                   9,969                  1,386
Interest, net........................................         559                    (104)                (2,205)
Loss on impairment of investments....................        (828)                     --                     --
Other income, net....................................          69                     234                    525
                                                          =======                 =======                ======= 
Income (loss) before income taxes....................     $11,504                 $10,099                $  (294)
                                                          =======                 =======                ======= 
</TABLE>


                                      F-19
<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)


17.   PROFORMA STATEMENT OF OPERATIONS (UNAUDITED)

     The following Statements of Income show the proforma results of operations
as if the acquisition of Micro-France had occurred on January 1, 1997:

<TABLE>
<CAPTION>
                                                    YEAR ENDED                                YEAR ENDED
                                                DECEMBER 31, 1998                          DECEMBER 31, 1997
                                       -------------------------------------     --------------------------------------
                                         XOMED    MICRO-FRANCE    PRO FORMA        XOMED    MICRO-FRANCE    PRO FORMA
<S>                                     <C>          <C>           <C>           <C>           <C>          <C>     
Sales, net...........................   $91,383      $ 8,440       $99,823       $77,240       $ 8,196      $ 85,436
Cost of sales........................    35,284        3,790        39,074        30,475         3,649        34,124
                                        -------      -------       -------       -------       -------      --------
Gross profit.........................    56,099        4,650        60,749        46,765         4,547        51,312

Operating expenses:

Selling, general and administration..    34,335        2,331        36,666        30,334         2,532        32,866
Amortization of intangibles..........     2,417          365(1)      2,782         2,374           365(1)      2,739
Write-off of acquired research
   and development...................     1,153           --         1,153            --            --            --
Restructuring and other charges......     1,809           --         1,809            --            --            --
Research and development.............     4,681           --         4,681         4,088            --         4,088
                                        -------      -------       -------       -------       -------      --------
Total operating expenses.............    44,395        2,696        47,091        36,796         2,897        39,693

Income from operations...............    11,704        1,954        13,658         9,969         1,650        11,619

Interest; net........................      (269)        (740)(2)    (1,009)         (104)         (792)(2)      (896)
Other income, net....................        69           --            69           234            --           234
                                        -------      -------       -------       -------       -------      --------

Income before income taxes...........    11,504        1,214        12,718        10,099           858        10,957

Income tax expense...................     4,424          506         4,930         3,969           358         4,327
                                        -------      -------       -------       -------       -------       -------
Proforma net income..................   $ 7,080      $   708       $ 7,788       $ 6,130       $   500      $  6,630
                                        =======      =======       =======       =======       =======      ========

Proforma net income per share........                              $  0.64                                  $   0.59
                                                                   =======                                  ========

Weighted average shares outstanding..                               12,088                                    11,268
                                                                   =======                                  ========
</TABLE>

(1)  Represents proforma amortization of excess of purchase cost over net book
     value of assets acquired.
(2)  Proforma interest expense calculated based on funds required to acquire
     Micro-France less cash acquired and cash flows in 1997 and 1998.


                                      F-20
<PAGE>

                                 EXHIBIT INDEX


EXHIBIT                                  DESCRIPTION
-------                                  -----------

  2.1       Stock Purchase Agreement among The Stockholders of Etablissements
            Boutmy, S.A. and Xomed France Holdings, S.N.C. dated December 30,
            1998.

  3.1       Second Restated Certificate of Incorporation.

  3.2       Restated By-Laws.
             
  10.13.3   Third Amended and Restated Xomed Surgical Products, Inc. 1996 Stock
            Option Plan (incorporating amendments approved at May 21, 1998
            annual meeting of stockholders).
               
  10.15     Employment Agreement dated as of February 24, 1999 between the
            Company and James T. Treace.  

  10.16     Employment Agreement dated as of February 24, 1999 between the
            Company and F. Barry Bays.

  21        Subsidiaries.

  23        Consent of Ernst & Young LLP.

  27        Financial Data Schedule.