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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, 1996
                                       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
(State or other jurisdiction of                         (I.R.S. Employer
incorporation or organization)                          Identification No.)

  6743 Southpoint Drive, North
    Jacksonville, Florida                                   32216-0980
(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. [X]

The aggregate market value of Registrant's Common Stock held by non-affiliates
based on the closing price on March 12, 1997 was $63,547,037.

As of March 12, 1997 there were 7,333,899 shares of Common Stock $.01 par value
outstanding.

                       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, 1997 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."

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. 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. For the year ended
December 31, 1996, approximately 84.5% of Xomed's revenues were derived from
disposable or implantable products. The Company distributes its products on a
worldwide basis through a 76-person direct sales organization in the U.S. and
selected other countries and through a network of 121 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 32%
of the Company's net sales was derived from international markets for the year
ended December 31, 1996. With over 25 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 beginning a conversion from
conventional surgical approaches to less-traumatic approaches that involves 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 may be 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 was established in 1970 to manufacture and distribute
ventilation tube implants for the middle ear. In 1979, the business was acquired
by Bristol-Myers Squibb Company ("Bristol-Myers"). 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") and of
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 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 $6.1 million related to the

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surgical drapes segment which was sold in July 1995 and has been presented as
discontinued operations. As a result, amortization of intangibles (over a
25-year life) has been significantly increased. Further, the value of inventory
of continuing operations was increased by $4.8 million and was charged to cost
of goods sold for the 1994 period following the Xomed Acquisition ($3.9 million)
and the first quarter of 1995 ($0.9 million) (the "Inventory Valuation
Adjustment"). These costs reduced gross profit in these periods. Other
intangible assets relating to foreign distribution rights were valued in
connection with the acquisition, and as a result, amortization of intangibles
was increased by $0.8 million for the 1994 period following the Xomed
Acquisition and $0.2 million for the first quarter of 1995 (the "International
Distribution Rights Amortization"). In addition, interest expense increased due
to the increased borrowings to finance the Xomed Acquisition.

     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 the closing of manufacturing operations in Puerto
Rico and the elimination of certain overhead in other facilities.

     Discontinued Operations. In connection with the Xomed Acquisition on April
15, 1994, the tangible assets related to the surgical drapes segment, which
consisted primarily of inventory and equipment, were separately identified and
recorded at fair value. The goodwill related to this segment was also determined
as of April 15, 1994 based on an independent valuation. In July 1995, the
Company decided to dispose of the surgical drapes segment and finalized an
agreement to exchange the segment's assets for cash, notes receivable, inventory
and fixed assets of several otology product lines of an unrelated entity (the
"Otology Acquisition"). There were no significant intangibles such as customer
lists or patents acquired in connection with the Otology Acquisition, nor was
any work force transferred. Due to the significance of the monetary assets
received, the transaction was recorded at fair value which resulted in a loss on
discontinuance of approximately $2.5 million (after a $1.4 million tax benefit)
in the third quarter of 1995. See Note 3 to Notes to Consolidated Financial
Statements. There was no intent to dispose of the surgical drapes segment at the
time of the Xomed Acquisition. The surgical drapes segment has been presented as
discontinued operations.

     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 sales force to distributing this line through an independent dealer
network. 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.

     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. 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. The Company's acquisition of TreBay Medical
Corporation ("TreBay") in April 1996 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. Estimated costs to achieve technological
feasibility are approximately $300,000 which are expected to be incurred over
the next two years and are related to clinical testing and product design
modifications. The acquisition was funded through the issuance of approximately
$2.8 million of redeemable preferred stock and $3.7 million of convertible
preferred stock.

     Restructuring 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

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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 the Company
expects these actions 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. As of December 31, 1996, the Company had paid out
approximately $2.0 million or 83% of the severance benefits and had paid out
approximately $100,000 in other exit costs.

     Other Recent Events. In December 1995, the Company became the worldwide
distributor of Implantech Associates, Inc.'s line of facial plastic implants to
the ENT market. In April 1996, the Company became the exclusive distributor of
BOSS Instruments Ltd.'s line of hand instrumentation products to the U.S. ENT
market. The Company introduced in the second quarter of 1996 its Wizard Plus
powered tissue-removal system and NIM-2(R) XL nerve monitoring system. In the
fourth quarter of 1996, the Company introduced the Powerforma electric drill
system.

     On October 11, 1996, the Company completed its initial public stock
offering, followed on October 31, 1996 by the underwriters' exercise of their
overallotment option. The Company raised net proceeds of $54.0 million through
the sale of 2,875,000 shares of its Common Stock, $.01 par value ("Common
Stock"). The net proceeds were used to repay the Company's term loan totaling
$20.8 million including interest, repay $8.2 million under its revolving line of
credit and redeem $25 million of Redeemable Preferred Stock.

Market Opportunity

     More than an estimated 20,000 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., an
estimated 3,300 currently practice facial plastic and reconstructive surgery.

     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.



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     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 Instrumentation0 . The Company believes
that the introduction of new tools and instrumentation will enable ENT surgeons
to better address the current challenges of ENT procedures. For example, powered
cutting devices adapted for use in particular surgical procedures will 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 Company anticipates that the
blades for these newly developed powered cutting devices will be disposable and
thus sales of these blades will represent a significant portion of the market
growth of these devices. 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 which 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 will
readily adopt 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 will
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 capital investment.

Strategy

     The Company's objective is to enhance its position in the ENT market. The
principal elements of its strategy to meet this objective are outlined below.

     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 increase penetration of its
existing customer base.

     Facilitate ENT Market Conversion to Less-Traumatic Approaches. The Company
believes that the ENT market is beginning 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 tonsils and adenoids, face and
brow lifts and facial sculpting. To facilitate this conversion, the Company
plans to continue 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 the
development of 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.

      Continue to Innovate;  Emphasize  Internal  Research and Development.  The
Company  plans to develop new  proprietary  products  and  product  enhancements
primarily through internal research and development efforts. The

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Company expects that it will invest approximately $3.8 million in research and
development in 1997. The Company has introduced numerous technological
advancements in the ENT market.

     Maintain a Broad Line of ENT Products; Emphasize 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 approximately 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 84.5%
of the Company's sales in 1996, as compared with 82.7% of the total 1994 sales
of the Company and of Xomed-Treace, which the Company acquired in 1994. One of
the Company's principal objectives is to continue to develop additional
disposable products for use with its instrumentation systems.

     Continue to 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
76-person direct sales force in the U.S. and selected other countries and
through a network of 121 independent distributors. The Company's core ENT
products are sold in the U.S. only on a direct sales basis. Approximately 29% of
the Company's net sales in 1995 and 32% of its net sales in 1996 were made
outside the U.S. through direct operations in the United Kingdom, Canada,
France, Germany and Australia, as well as through 102 independent international
distributors, many of whom distribute the Company's products exclusively.


Major ENT Subspecialties

     The three major ENT 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 and also experience
significant difficulty gaining the control needed to remove the tissue
effectively. This 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. Overall operating time of procedures performed
with this method can be reduced by approximately 25% from that of traditional
surgical methods due to the greater ease of accessing structures, the improved
visualization at the site and the quicker removal of tissue with powered
instrumentation.

     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.





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  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).

     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 are presently
removed using either 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 in conjunction with 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 hair line,
pulls the facial muscles and skin taut and then stitches the long incision made
at the hair line. In addition to the post-operative swelling and bruising from
the procedure, the patient is left with a relatively large scar at the hair line
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.






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  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 1.0 million of these procedures performed in 1996 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, and nearly 60,000 reconstructive middle ear
procedures are performed in the U.S. each year. Re-engineering in the design and
material of the prostheses has, in recent years, improved surgeon technique and
patient hearing outcomes.


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 during ophthalmic and
orthopaedic procedures. Set forth below is a description of the Company's
products by related subspecialty:


   Sinus and Rhinology

     Approximately 34% of the Company's net sales in 1996 and 28% of its net
sales in 1995 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 microdebrider product designed exclusively for use in ENT
procedures. The Company's Wizard Plus product cuts soft tissue and bone through
a unique oscillating blade design powered by a small, lightweight, surgical
handpiece. This system, which employs disposable blades, enables the surgeon to
target and remove diseased tissue endoscopically with less trauma to adjacent
healthy tissue and less bleeding. Integrated suction and irrigation aid in
cutting and removal of the tissue, and reduce the incidence of blade clogging.
In 1995, the Company introduced the Typhoon family of disposable endoscopic
blades for use with most competitors' power handpieces. In the first quarter of
1997, the Company introduced its XPS powered tissue-removal system. This new
system, which employs disposable blades, offers the ENT surgeon significantly
increased power with limited blade clogging.

     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
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.

     Hand Instrumentation. In April 1996, the Company became the exclusive
distributor for BOSS Instruments, Ltd. in the U.S. ENT market, and as a result
now provides a complete line of sinus surgery hand instrumentation. Over 400
patterns have been developed to provide surgeons with an ergonomic design and
performance that affords surgeons precision during surgical procedures.


<PAGE>9



     Rhinology Products. The Company's products for use during surgical repair
of the nose include internal and external nasal splints, nasal catheters and
airway and irrigation catheters.


   Head and Neck

     Approximately 25% of the Company's net sales in 1996 and 24% of its net
sales in 1995 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, powered systems and facial plastic
implant products. Surgical techniques are being developed in the head and neck
subspecialty 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. The Company is currently
developing powered tissue-removal instrumentation systems for use in various
head and neck procedures that incorporate the Company's technology for its
powered sinus tissue-removal instrumentation systems. These powered systems are
being designed for use in uvulopharyngoplasty and facial sculpting as well as in
the removal of polyps, lesions and tumors located on the vocal cords. The
Company anticipates that these powered systems will employ disposable blades. In
the case of vocal cord polyps, the Company believes that these new procedures
will not only decrease patient trauma associated with existing methods but will
also, unlike lasers and electrocautery devices, enable samples of the affected
tissue to be tested pathologically following surgical removal. In the cases of
uvuloplasty and facial sculpting, the Company believes that the use of
less-traumatic procedures employing powered tissue-removal will increase patient
demand for these procedures.

     Powered Drill Systems. Precision, high-powered drilling is required in head
and neck surgery 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 electric drill system introduced in
the fourth quarter of 1996 which consists of a power console, surgical handpiece
and disposable and reusable cutting burrs. This new system, which employs
disposable and reusable cutting burrs, 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
(EMG) 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. In December 1995, the Company became the
worldwide distributor for Implantech Associates, Inc. in the ENT market, and as
a result now provides a broad line of facial plastic implants, including
implants to augment the chin, nose and cheek.

     Hand  Instrumentation.  As the exclusive  distributor for BOSS Instruments,
Ltd.  in the  U.S.  ENT  market,  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.






<PAGE>10


   Otology

     Approximately 21% of the Company's net sales in each of 1996 and 1995 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.

     Ventilation Tubes. Vent tubes are small tubes surgically implanted into the
ear drum 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 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, hydroxylapatite and
other bio-compatible 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. They also include the Company's
proprietary Redi-Bur(R), the only disposable micro drill available for ENT
procedures. The Company also produces and markets the Skeeter(R) otologic drill
system which is designed for middle ear procedures.

   Ophthalmic and Other

     Approximately 21% of the Company's net sales in 1996 and 27% of its net
sales in 1995 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 trademark
through 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 procedures are
micro knives, cannulae, trephines, blades, sponges, cauteries, pen lights and
other miscellaneous products and kits. The Company recently has dedicated a
senior executive to managing 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.




<PAGE>11




   Launch of New Products and Sales Policies

     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.


Sales and Marketing

     The Company has an established worldwide distribution system with an
ENT-focused direct sales force, international distributor alliances and
independent distributors for select product specialties and geographic markets.

     The Company sells to substantially all of the 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 those
surgeons at leading academic institutions who 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 nine 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 through 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 using distribution partners. Prior to its divestiture from Bristol-Myers
in 1994, the Company shared sales and service personnel with Zimmer
International, a division of Bristol-Myers, in selected countries. The Company
believes it has experienced significant international sales gains as a result of
creating in certain markets a dedicated sales force focused exclusively on
selling its products.

     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 to the
ENT surgeons attending ICOT in the form of partial tuition. 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 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 dealers specializing in ophthalmic product sales. Outside
of the U.S., the Solan ophthalmic product line is marketed through the same
direct and independent distributor system as the Company's ENT product lines.
The TreBay brand of orthopaedic products is marketed in the U.S. through
independent orthopaedic product distributors.


Product Development

     The Company believes that it has a strong base of proprietary engineering,
manufacturing and bio-materials capabilities. Although it has in the past relied
in part on strategic acquisitions and licensing of third-party technology to
develop a broad line of ENT products, the Company believes it has gained
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 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 gives it a competitive advantage in implementing this strategy.

<PAGE>12


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 its variety of hand instruments, implants,
electrical powered systems, polymer products and disposable products. Currently,
the Company's research and development department consists of eleven engineers
experienced in various technical specialties that complement 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 that
will complement current products and new "state of the art" devices that fit
within the overall Company's business strategy of being the industry leader in
innovative microendoscopic instrumentation and implants. During 1996, 1995 and
1994, the Company spent $3.7 million, $2.4 million, and $2.0 million,
respectively, in connection with research and development activities. The
Company expects that its expenditures for research and development in 1997 will
be comparable to that in 1996.


Suppliers

     Although most of the purchased components utilized by the Company in
manufacturing are available from more than one vendor, certain materials,
including TPE-based materials and certain fluoropolymers used in its ventilation
tubes, are only supplied by a single vendor. Although it is not presently the
case, if the supply of materials from a single source vendor 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 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.

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 instrumentation 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 and complete approval or
clearance processes and supply commercial 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 of 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
Bristol-Myers) 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

<PAGE>13


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 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 from the FDA marketing clearance 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 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 products that are under development or 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. 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 Company's currently-marketed products either have received FDA
marketing clearance pursuant to 510(k) pre-market notifications 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 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 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.


<PAGE>14



     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 GMP. These regulations require
that the Company manufacture its products and maintain its documents in a
prescribed manner with respect to 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 malfunction 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 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 those 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 EU, in January 1995, CE mark certification procedures
became available for medical devices, the successful completion of which would
allow certified devices to be placed on the market in all EU countries. In order
to obtain the right to affix the CE mark to its products, medical device
companies must obtain certification that its processes meet European quality
standards, including certification that its design and manufacturing facility
complies with ISO 9001 standards. After June 1998, medical devices may not be
sold in EU countries unless they display the CE mark. 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.



<PAGE>15


     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.

     During the past several years, the 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 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.

     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 products
suppliers.

     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 December  31, 1996,  the Company held 47 U.S.  patents and 11 foreign
patents,  and had filed 25 additional  U.S.  patent  applications  and 11 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 prosecuting 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

<PAGE>16


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.

     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 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,
including maintaining general liability and commercial liability insurance
policies which include adequate coverage for product liability claims. These
policies currently provide $25 million in aggregate coverage. 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 or insurance coverage for
these actions, and that the ultimate outcome of these actions will not have a
material adverse effect on the Company.

Employees

     As of December 31, 1996, the Company had 454 full-time employees and 10
temporary employees, including 234 in production, 52 in professional and
technical positions, 49 in administration and 129 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 Obsolescence from Rapid Technological Change; Uncertainty as to
Market Acceptance of Company's Products. The health care industry is
characterized by rapidly changing technology and frequent new product
introductions. The Company believes that its ability to develop and
commercialize new products and enhancements of existing products is critical to
its continued growth and profitability. There can be no assurance that the
Company will continue to be successful in identifying, developing and marketing
new products or enhancing its existing products. The Company's business will be
adversely affected if the Company incurs delays in developing new products or
enhancements or if such products or enhancements do not gain market acceptance.
Market acceptance of the Company's products will be determined in large part by
the Company's ability to demonstrate the surgical

<PAGE>17


advantages, safety and efficacy, cost effectiveness and performance features of
such products, as well as to train surgeons and other operating staff in their
use. The Company believes that use and acceptance by physicians and hospitals
will be essential for market acceptance of certain of its products, and there
can be no assurance that its products will be used or accepted. There can be no
assurance that products or technologies developed by others will not render the
Company's products or technologies noncompetitive or obsolete.

     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 New 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 majority of whom have joined the Company since April
1996 in connection with the Company's acquisition of TreBay. At the time of the
TreBay acquisition, the Board of Directors determined to replace members of the
Company's senior management with members of the senior management of TreBay who
the Board believed were better suited to implement the Company's business
strategy. Although the Company's new management has extensive experience in
managing medical device companies, the inability of new management to become
integrated fully into the operations of the Company could have a material
adverse effect on the Company's business, financial condition and results of
operations. In addition, the loss of the services of certain of these
individuals or of other key personnel could have a similar 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 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 to grow and operate profitably. See
"--Employees."

     Risks Associated with Newly Established International Sales Operations;
Currency Exchange Risks. Within the past three years the Company has established
direct sales operations in five countries. The failure of these new 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 32% of the Company's
net sales in fiscal 1996 and 29% of net sales in 1995, and the Company expects
that international sales will continue to be a significant portion of the
Company's business. The Company's international business may be affected by
fluctuations in currency exchange rates as well as increases in duty rates and
difficulties in obtaining export licenses. 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. At present, the Company does not engage in hedging transactions
to protect against uncertainty in the level of future exchange rates between
particular foreign currencies and the U.S. dollar because a majority of the
sales of the Company's direct international sales operations are denominated in
what the Company believes to be relatively stable currencies.

     Seasonality and Quarterly Fluctuations; Recent Net Loss. 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

<PAGE>18


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. During 1996, the Company experienced a net
loss of $1.2 million. This net loss resulted from (i) allocating $2.4 million of
the excess of the cost of the Company's TreBay acquisition over the net assets
acquired to in-process research and development and charging such allocated
amount to expense during the second quarter of 1996 and (ii) a restructuring
charge of approximately $1.9 million after tax during the second quarter of 1996
primarily to reflect the cost of severance payments to terminated employees as
well as other restructuring charges. See "Management's Discussion and Analysis
of 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
upon 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. 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
coverage and adequate reimbursement levels are not provided by government or
third-party payors for use of the Company's technologies or 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 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 are 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.

     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 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
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 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, 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.



<PAGE>19


     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
would 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 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). 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 in 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, all of the products manufactured by the Company and its
contract manufacturers must be manufactured in compliance with the FDA's Good
Manufacturing Practice ("GMP") regulations. Ongoing compliance with GMP 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 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
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 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.

     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. After June
1998, medical devices may not be sold in European Union ("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 certification that its processes meet European quality
standards, including certification that its design and manufacturing facility
complies with ISO 9001 standards. There can be no assurance that the Company
will be able to obtain 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."

     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.  However,  the patent  positions of medical  device  companies  are
generally uncertain and

<PAGE>20


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. For example, in a currently
pending case, the U.S. Supreme Court will consider whether to alter or replace
the traditional standards for determining patent infringement under the doctrine
of equivalents. 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 can ultimately protect meaningful rights to such unpatented proprietary
technology.

     Legislation is pending in Congress that may limit the ability of medical
device manufacturers in the future to obtain patents on surgical and medical
procedures. Any limitation or reduction in the patentability of medical and
surgical technology could have a material adverse effect on the Company's
ability to protect its proprietary methods and procedures.

     The commercial success of the Company will also depend in part on its
neither infringing patents issued to others nor 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 conversion of the licenses
from being exclusive to nonexclusive in nature or termination of the licenses.

     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 others' proprietary rights. 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 or
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. 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 thermoplastic elastomer
(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 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 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. See "--Suppliers."



<PAGE>21


     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 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.

     Influence by Existing Stockholders. Warburg, Pincus Investors, L.P. ("WP
Investors") beneficially owns approximately 45% of the outstanding shares of
Common Stock as of March 12, 1997. A stockholders agreement among the Company
and substantially all of its current stockholders provides that WP Investors has
the right to designate specified numbers of persons to the Company's Board of
Directors so long as WP Investors maintains specified levels of ownership of the
outstanding Common Stock. WP Investors currently has under the stockholders
agreement the right to designate three persons to be appointed or nominated to
the Company's Board of Directors. Such share ownership and minority
representation on the Company's Board of Directors may confer upon WP Investors
significant influence over the affairs and actions of the Company.

     Anti-takeover Considerations. The Company's 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 stock of the Company
and could adversely affect the prevailing market price of the Common Stock. The
rights of the holders or 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

<PAGE>22


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 52,000 square-foot corporate headquarters and
manufacturing facility and leases a 36,863 square-foot warehouse and
distribution facility in Jacksonville, Florida. At its Jacksonville corporate
headquarters and manufacturing facility, which has 30,000 square feet dedicated
to manufacturing, the Company produces all of the products that it manufactures
other than fluid-control products. The Company has numerous manufacturing
capabilities at the Jacksonville facility, including: injection molding; insert
molding; CNC machining; CAD/CAM; form, fill and seal; ETO sterilization
utilizing a Joslyn 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.

     The Company also owns a 34,000 square-foot manufacturing facility and a
6,300 square-foot distribution facility in Mystic, Connecticut. The Company's
Merocel product line of fluid-control products is manufactured at the Mystic
facility. In December, 1996 the Company closed a 6,400 square-foot manufacturing
facility in St. Louis, Missouri.

     Currently, the Company operates two manufacturing shifts at both of its
manufacturing facilities and has the ability to increase production levels of
its current product line without expanding its facilities. The Company believes
that the properties are adequate to serve the Company's business operations for
the foreseeable future, and if it were unable to renew the leases on any of its
leased facilities, other suitable facilities would be available to meet the
Company's needs.




<PAGE>23




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 1996.

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 high sales price for the Common Stock during the
fourth quarter of 1996 was $27.25 per share and the low sales price was $18 per
share.

     The total number of holders of record of Common Stock as of March 25,
1997 was approximately 65.

     The Company historically has not paid cash dividends on the Common Stock
and does not anticipate paying cash dividends in the foreseeable future.

     The following information is furnished with regard to all securities sold
by the Company during 1996 which were not registered under the Securities Act of
1933, as amended (the "Securities Act").

     On April 16, 1996, in connection with the Company's acquisition of TreBay,
the Company:

     1.   Issued an aggregate of 390,000 shares of Series A Convertible
          Preferred Stock and 28,470 shares of Series C Redeemable Preferred
          Stock to certain stockholders of TreBay for an aggregate consideration
          of 650,000 shares of TreBay Common Stock; and

     2.   Issued stock options (outside of Xomed's Second Amended and Restated
          1996 Stock Option Plan (the "Stock Option Plan") to purchase an
          aggregate of 41,166 shares of Common Stock for an aggregate exercise
          price of $385,313 to certain optionholders of TreBay in exchange for
          stock options to purchase an aggregate of 68,609 shares of TreBay
          Common Stock.


<PAGE>24



     The sales described above were made in reliance upon the exemption from
registration set forth in Section 4(2) of the Securities Act, relating to sales
by an issuer not involving any public offering. The foregoing transactions did
not involve a distribution or public offering. No underwriters were engaged in
connection with the foregoing issuances of securities and no commissions or
discounts were paid.



<PAGE>25




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, 1996. 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 their Annual Report on Form 10-K.
<TABLE>
<CAPTION>

                                                         1996        1995       1994(1)       1993        1992
                                                         ----        ----       -----         ----        ----
                                                                 (in thousands, except per share data)
<S>                                                 <C>        <C>          <C>         <C>          <C>

FINANCIAL RESULTS
Sales, net.........................................    $65,664     $59,865     $42,475      $10,071      $8,160
Cost of sales......................................     25,926      22,256      15,350        2,876       2,357
Amortization  of  acquisition   costs  allocated  to
   inventory.......................................         --         919       3,883           --          --
                                                      ---------    --------   ---------     --------    --------
Gross profit.......................................     39,738      36,690      23,242        7,195       5,803

OPERATING EXPENSES
   Selling, general and administrative                  26,799      27,077      19,126        6,074       3,914
   Research and development                              3,659       2,405       1,958          311         211
   Amortization of intangibles                           2,421       2,579       2,652          394         391
   Write-off of acquired research and development        2,380          --          --           --          --
   Restructuring charges                                 3,093          --          --           --          --
                                                     ---------    --------   ---------     --------    --------
Total operating expenses(2)........................     38,352      32,061      23,736        6,779       4,516
                                                     ---------    --------   ---------     --------    --------
Operating income (loss) from continuing operations.      1,386       4,629        (494)         416       1,287
Interest expense, net..............................     (2,205)     (3,063)     (2,148)        (102)        (73)
Other income, net..................................        525         114         313           26          47
                                                      ---------    --------   ---------     --------    --------
Income  (loss)  from  continuing  operations  before
   income tax expense (benefit)                           (294)      1,680      (2,329)         340       1,261

Income tax expense (benefit).......................        873       1,355        (774)         121         592
                                                      ---------    --------   ---------     --------    --------
Income (loss) from continuing operations...........    $(1,167)   $    325     $(1,555)      $  219     $   669
                                                      =========    ========   =========     ========    ========
PRO FORMA STATEMENT OF OPERATIONS DATA(3)
Income (loss) from continuing operations...........    $(1,243)   $   (149)
Preferred stock dividends..........................      1,170          --
Income (loss) from continuing  operations  available   ----------  ----------
   to common shareholders..........................    $(2,413)   $   (149)
                                                       ==========  ==========

PRO FORMA PER SHARE(3)
Income (loss) from continuing  operations  available
   to common shareholders..........................    $  (.46)   $   (.03)
                                                       ==========  ==========
Pro forma weighted average common shares outstanding     5,238       4,617
                                                       ==========  ==========

FINANCIAL CONDITION
Working capital....................................    $18,331     $12,234     $12,744     $  3,126    $  2,108
Cost in excess of net assets acquired, net.........     44,389      46,381      54,300           --          --
Total assets.......................................     94,056      93,123      95,720        9,484       8,483
Long-term debt including redeemable preferred stock      3,563      90,488      89,985       11,308      10,157
Total shareholders' equity (deficit)...............     79,567     (13,058)     (7,336)      (3,091)     (2,554)

<FN>

--------
(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) The pro forma presentations have been adjusted to reflect: (i) the
acquisition of TreBay as if the acquisition had occurred on January 1, 1995 (see
Notes to Consolidated Financial Statements--Pro Forma Statement of Operations
(Unaudited)); (ii) the capital contribution of accrued cumulative preferred
stock dividends of $7,559,000 in connection with the acquisition of TreBay;
(iii) the conversion of all Series A Convertible Preferred Stock and Series B
Convertible Preferred Stock outstanding as of April 16, 1996 into Common Stock;
(iv) the exercise of all outstanding options to purchase Common Stock; (v) the
conversion of 60,225 shares of Series C Redeemable Preferred Stock into 300,354
shares of Common Stock on the date of the initial public offering, based upon
the offering price of $21.00 per share; and (vi) the conversion of 426,777
shares of Nonvoting Common Stock into voting Common Stock.
</FN>

</TABLE>


<PAGE>26

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.

Year Ended December 31, 1996 Compared to Year Ended December 31, 1995

     Net Sales. Net sales increased 9.7% to $65.7 million in 1996 from $59.9
million in 1995. In the core businesses of sinus and rhinology, head and neck
and otology, sales increased 19.6% in 1996 over 1995, which resulted in these
product lines representing 79.5% of the Company's revenue in 1996 as compared to
72.9% in 1995. The increase in sales was principally the result of several new
products introduced late in 1995 and in 1996 including the Company's Wizard and
Wizard Plus powered tissue-removal systems, the BOSS line of ENT hand
instruments, the Activent anti-microbial vent tube line, an otology implant line
acquired in the Otology Acquisition in the third quarter of 1995 and a line of
facial implant products. In addition, several existing product lines showed
strong sales growth over the prior period including the Merocel fluid-control
products and nerve monitoring systems. The increase in Merocel products sales
was due partly to price increases resulting from moving the distribution of
these products, effective on January 1, 1996, from an independent dealer network
to the Company's U.S. direct sales force. Sales in this line would have been
approximately $1.2 million lower in 1996 without this distribution channel
change. Sales were adversely affected, however, by a change in the distribution
system for the Company's ophthalmic product line. On January 1, 1996, the
Company commenced distribution of its ophthalmic line through an independent
dealer network, with the Company selling to dealers at wholesale prices. During
1995, these products were distributed through the Company's direct sales force
at retail pricing. This change was made to better focus the direct sales force
on the ENT market. Although unit volume in the ophthalmic business grew
approximately 7% during the year, net sales decreased approximately $2.1 million
in 1996 as a result of the price differential from changing the distribution
channel. Associated ophthalmic operating expenses also declined. Sales also
increased in several other product lines due to increased penetration of
international markets through recently established direct sales sites.
International sales increased 19.3% during the period and represented 32.0% of
the Company's revenue in 1996 compared to 29.4% in 1995.

     Cost of Sales. Cost of sales increased 11.9% to $25.9 million in 1996 from
$23.2 million in 1995. As a percent of sales, cost of sales increased to 39.5%
in 1996 from 38.7% in 1995. In accounting for the Xomed Acquisition, the Company
effected the Inventory Valuation Adjustment in which a portion of the excess
cost of the acquisition over book value of the net assets acquired was allocated
to inventory. This allocation resulted in an increase in inventory value of $5.3
million, of which $4.8 million was allocated to the inventory of continuing
operations. The inventory valued on this basis was charged to cost of sales on a
FIFO basis as it was sold. This increased cost of sales in 1995 by $0.9 million.
No such adjustment affected 1996. Without this charge, cost of sales would have
increased 16.5% to $25.9 million in 1996 from $22.3 million in the prior
comparable period and cost of sales as a percent of sales would have increased
to 39.5% in 1996 from 37.2% in the prior comparable period. This increase was
primarily due to the change in the distribution method described above for the
ophthalmic line which resulted in lower average selling prices. This increase
was partially offset by the change in the distribution of the Merocel product
line which resulted in a higher average selling price.

     Gross Profit. Gross profit as a percent of sales decreased to 60.5% in 1996
from 61.3% in 1995. Without the effects of the Inventory Valuation Adjustment
discussed above, gross profit as a percent of sales would have decreased to
60.5% in 1996 from 62.8% in the prior comparable period for the reasons
discussed above.

     Selling, General and Administrative Expenses. Selling, general and
administrative expenses decreased 1.0% to $26.8 million in 1996 from $27.1
million in 1995. This decrease was primarily due to cost savings realized as a
result of the previously discussed restructuring actions. See
"Business--Overview". These savings were partially offset by commissions on a
larger sales base, an increase in the average commission rate, the operating
expenses of a new direct sales subsidiary in Germany, which began operations in
the first quarter of 1996, and promotional expenses related to the Company's
line of sinus endoscopy systems. As a percent of sales, selling, general and
administrative expenses decreased to 40.8% in 1996 from 45.2% in 1995.

     Research and Development. Research and development expenses increased 52.1%
to $3.7 million in 1996 from $2.4 million in 1995 and increased as a percent of
sales to 5.6% from 4.0% during the same comparable period. This increase is
primarily the result of project expenses related to the development of the new
XPS powered tissue-removal system and the Powerforma drill system. Although it
has in the past relied in part on strategic acquisitions and licensing of
third-party technology to develop its broad line of ENT products, the Company
believes it has a

<PAGE>27


strong base of proprietary engineering, manufacturing and bio-material
capabilities upon which to build its future research and development efforts.

     Amortization. Amortization expense in 1996 and in 1995 related principally
to approximately $49.9 million of goodwill related to continuing operations
generated from the Xomed Acquisition in April 1994, which is being amortized
over 25 years.

     Write-off of Acquired Research and Development. The TreBay acquisition was
accounted for under the purchase method of accounting. Accordingly, the purchase
price of approximately $6.6 million was allocated to the individual TreBay
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 $4.4 million, of which $2.4 million was
allocated to in-process research and development and charged to expense in the
second quarter of 1996.

     Restructuring Charges. As noted previously under "Business--Background" the
Company initiated cost savings programs and recorded 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.

     Interest and Other. Interest expense decreased to $2.2 million in 1996 from
$3.1 million in 1995. Interest expense related principally to the Company's
secured term loan (the "Term Loan") borrowings, which were repaid in October
1996 from the net proceeds of the initial public offering, and the Company's
secured revolving credit facility (the "Revolving Credit Facility") as described
below in "--Liquidity and Capital Resources." Other income of $525,000 in 1996
was $411,000 higher than in 1995 related principally to royalty income on a
product licensed to a third party.

     Income Taxes. The Company's tax expense of $873,000 on a $294,000 loss for
the year ended December 31, 1996 varies from an effective tax rate of
approximately 40% due to the lack of tax benefit related to the write-off of
in-process research and development costs, described above. Tax expense for the
comparable period of 1995 was $1.4 million on income of $1.7 million for an
effective tax rate of 81%. The tax rate for 1995 was higher than 40% due to
losses recorded on a less than 80% owned subsidiary and losses incurred in
foreign subsidiaries for which a valuation account was provided on the potential
carry forward benefit.


Year Ended December 31, 1995 Compared to Year Ended December 31, 1994

     The principal reason for the increases in the Company's operating data from
1994 to 1995 was the effect on results of operations and the related balance
sheet data of the Xomed Acquisition in April 1994. The year ended December 31,
1995 contains a full year of operating results of Xomed-Treace compared to eight
and one-half months in 1994. See "Business--Background" and Note 1 to Notes to
Consolidated Financial Statements.

     Net Sales. Net sales increased 40.9% to $59.9 million in 1995 from $42.5
million in 1994, principally as a result of the inclusion of Xomed-Treace's
operations for the full year 1995 as compared to eight and one-half months in
1994. In addition, new product sales increased from the Company's Wizard powered
tissue-removal system, which was introduced during the third quarter of 1995, a
line of sinus microendoscopy instrumentation and sales generated from the
acquisition of an otology implant line acquired in the Otology Acquisition
during the third quarter of 1995. New international direct sales operations were
established in Canada and Australia during the third quarter of 1994 and in the
United Kingdom and France during the first quarter of 1995, which resulted in
increased penetration of existing and new products in these markets as well as
higher pricing for these products because of the change to distributing directly
rather than through wholesale distribution channels. International sales
increased 22.8% during the year and represented 29.4% of the Company's revenue
in 1995 compared to 25.9% in 1994.

     Cost of Sales. Cost of sales increased 20.5% to $23.2 million in 1995 from
$19.2 million in 1994 principally as a result of the inclusion of Xomed-Treace's
operations for the full year 1995 as compared to eight and one-half months in
1994. As a percent of sales, cost of sales decreased to 38.7% in 1995 from 45.3%
in 1994. Cost of sales included charges related to the Inventory Valuation
Adjustment from the Xomed Acquisition consisting of $0.9 million in 1995 and
$3.9 million in 1994. Without the impact of this change, cost of sales as a
percent of sales would have increased to 37.2% in 1995 from 36.1% in 1994. The
increase in cost of sales as a percent of sales is principally

<PAGE>28


due to the inclusion of Xomed-Treace's operations for a full year in 1995 as
compared to eight and one-half months in 1994. Xomed-Treace's product lines had
generally higher cost products as a percent of sales than the Merocel product
line. The increase from the product mix change described above was partially
offset by higher margins on sales achieved through international direct sales
operations established during 1994 and early 1995.

     Gross Profit. Gross profit as a percent of sales increased to 61.3% in 1995
from 54.7% in 1994 principally due to the effect of the change in amortization
related to the Inventory Valuation Adjustment previously discussed. Without the
impact of this adjustment, gross profit as a percent of sales would have
decreased to 62.8% from 63.9% for the reasons described above.

     Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased 41.6% to $27.1 million in 1995 from $19.1
million in 1994. Of the increase, $5.4 million or 67.8% represents the inclusion
of Xomed-Treace's operations for the full year 1995 as compared to eight and
one-half months in 1994. The balance of the increase is due to higher
international expenses related to the establishment of direct sales operations
in Canada, Australia, the United Kingdom and France during the latter part of
1994 and early 1995 and expenses associated with the integration of the
prosthetic implant devices and ventilation tube product line acquired during the
year in the Otology Acquisition. Selling, general and administrative expenses
increased slightly as a percent of sales to 45.2% in 1995 from 45.0% in 1994.

     Research and Development. Research and development expenses increased 22.8%
to $2.4 million in 1995 from $2.0 million in 1994 principally as a result of the
inclusion of Xomed-Treace's operations for the full year 1995 as compared to
eight and one-half months in 1994. The increase was partially offset by savings
from restructuring actions implemented in 1994.

     Amortization. Amortization decreased 2.8% to $2.6 million in 1995 from $2.7
million in 1994. The net decrease consists of an increase due to the inclusion
of Xomed-Treace's operations for the full year 1995 as compared to eight and
one-half months in 1994, which was more than offset by International
Distribution Rights Amortization that was greater in 1995 than in 1994.

     Interest and Other. Interest expense increased 42.6% to $3.1 million in
1995 from $2.1 million in 1994 principally as a result of incurring a full year
of interest expense in 1995 related to the Xomed Acquisition in April 1994.
Other income of $0.3 million in 1994 represented royalty income from a product
licensed to a third party.

     Income Taxes. A tax provision of $1.4 million was recorded in 1995 compared
with a tax benefit of $0.8 million in 1994. The tax benefit in 1994 was
primarily due to losses generated by amortization expenses related to the Xomed
Acquisition in that year. The effective tax rate increased to 81% in 1995 from
33% in 1994. The increase was primarily due to losses incurred by foreign direct
sales subsidiaries in 1995 during their start-up stages whose related tax
benefits were not recorded due to uncertainty about their ultimate realization.


Liquidity and Capital Resources

     The Company historically has financed its operations (including capital
expenditures) through cash flows from operations. Since the Xomed Acquisition in
April 1994, which was financed in part by the incurrence of $45.9 million of
debt under the Term Loan and the Revolving Credit Facility, all cash flow
generated from operations has been applied to repay the outstanding principal on
the Term Loan or the Revolving Credit Facility.

     During 1996, the Company generated cash from operating activities of $4.8
million as compared with $6.3 million in the prior comparable period. In both
1996 and 1995, the net increase in the amount of inventory, receivables and
other operating assets less accounts payable, accrued expenses and other
operating liabilities created a use of approximately $1.6 million of cash.
Significant components of the 1996 change in operating assets and liabilities
are a decrease in receivables of $2.5 million related to collection of
approximately $1.7 million from one customer with which the Company effected the
sale of the surgical drapes segment described below, and an increase in
inventory of $2.7 million related to new products introduced during 1996 and
early 1997. The reduction in cash from operations in 1996 as compared to 1995 of
approximately $1.4 million resulted principally from an approximate $1.1 million
cash gain (before goodwill write-off) in 1995 related to the sale of the
surgical drapes segment. During 1995, the Company generated cash flow from
operations of $6.3 million compared with $4.0

<PAGE>29


million in 1994. The change in cash flow between the years relates principally
to the inclusion of the operations of Xomed-Treace for eight and one-half months
in 1994 as compared with a full year in 1995.

     Working capital at December 31, 1996 was $18.3 million as compared with
$12.2 million at December 31, 1995. The increase in working capital relates to
the net $1.6 million increase noted above and the repayment of the current
portion of long-term debt during 1996 totaling $4.6 million. Working capital at
December 31, 1995 was $12.2 million as compared to $12.7 million at December 31,
1994. The Company believes cash flow from operations combined with the amounts
available for borrowing under the Revolving Credit Facility will be sufficient
to finance working capital needs for the next 24 months.

     Cash used in investing activities was $112,000 in 1996 as compared to cash
used in investing activities of $4.0 million in the prior comparable period.
During the second quarter of 1996, the Company acquired TreBay by issuing
preferred stock. The assets acquired in this transaction included $2.0 million
in cash, which is reported as a source of cash from investing activities. In
addition, certificates of deposit related to a foreign subsidiary matured during
the first half of 1996 generating $0.7 million in cash. These sources of cash
were offset by capital expenditures of $2.4 million in 1996 and $3.0 million in
1995 which related principally to purchases of manufacturing equipment.
Purchases of other assets totaled $0.8 million and $1.4 million in 1996 and
1995, respectively. This reduction in purchases of other assets results from the
opening of three international distribution sites in 1995 compared to none in
1996. Cash used in investing activities was $4.0 million in 1995 as compared
with $83.4 million in 1994, during which period $80.9 million related to the
Xomed Acquisition.

     Cash used in financing activities was $4.5 million in 1996 as compared with
$2.1 million in 1995. This use in 1996 reflects the repayment of debt net of the
initial public offering proceeds, noted above. This use of cash in financing
activities equals approximately the net cash from operating activities during
the period.  In general, all cash generated from operations that is not used in
investing activities is used to reduce outstanding debt under the Term Loan and
the Revolving Credit Facility. Cash used in financing activities in 1995 of
$2.1 million compared with cash provided by financing activities of $78.3
million in 1994, during which period cash was received from the establishment
of the Term Loan and the Revolving Credit Facility as well as from the issuance
of preferred stock related to the Xomed Acquisition.

     Under the terms of the Revolving Credit Facility, the Company may borrow up
to $14.0 million for working capital and operating needs. The amount available
to the Company at any given time is based upon various percentages of the
Company's outstanding inventories and accounts receivable as determined
periodically throughout the year (the "Borrowing Base"). Any excess of the
principal amount outstanding under the Revolving Credit Facility over the
Borrowing Base must be repaid by the Company. The outstanding principal under
the Revolving Credit Facility which was $3.1 million as of December 31, 1996 is
due and payable on April 15, 1999. The Revolving Credit Facility is secured by
substantially all the assets of the Company, contains restrictions regarding
payment of dividends, incurrence of additional debt and capital expenditures and
requires compliance with various financial covenants. The Company has obtained a
letter of commitment from the Company's lender to amend the Revolving Credit
Facility to allow the Company to borrow up to $25.0 million thereunder. The
indebtedness under the amended Revolving Credit Facility, which the Company
expects to complete in April 1997, will bear interest, at the Company's
election, either at an annual rate of a "base rate" (8.25% at February 28,
1997), or at 1.5% plus a "eurodollar rate" (5.44% at February 28, 1997).

Sales Composition

     Xomed-Treace was acquired by the Company in a purchase transaction on April
15, 1994. These companies were non-related entities and, under generally
accepted accounting principles, the historical financial statements of the
companies are required to be presented separately for periods prior to the Xomed
Acquisition. However, solely to enable the assessment of the revenue trends of
the two companies for analytical purposes, the total of the sales of the Company
and Xomed-Treace are presented for periods prior to the acquisition as well as
for periods subsequent thereto; the measures presented in the following tables
of the total of sales of the Company and Xomed-Treace before the acquisition do
not present measures pursuant to generally accepted accounting principles. This
data does not purport to represent the revenues that would have been earned by
the Company if the Xomed Acquisition had occurred at an earlier date.




<PAGE>30

  Sales by Market

     The Company derives and Xomed-Treace derived 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 and Xomed-Treace have other product offerings,
including a line of ophthalmic products, which the Company has recently
converted from distributing through its direct sales force to distributing
through independent dealers. The following table summarizes the Company's and
Xomed-Treace's worldwide product line sales during the periods indicated and has
been prepared by summarizing the historical data of Merocel with Xomed-Treace
for periods prior to the Xomed Acquisition:

<TABLE>
<CAPTION>

                                                           Years Ended December 31,
                                                         -------------------------------
                                                         1996        1995        1994
                                                         ----        ----        ----
                                                                (in thousands)
<S>                                                <C>         <C>          <C>

Sales:
   Sinus and Rhinology
     The Company...................................    $22,247     $17,038     $13,389
     Xomed-Treace..................................         --          --       2,252(1)
                                                      ---------   ---------   ---------
       Total Company and Xomed-Treace Sales........    $22,247     $17,038     $15,641
                                                      =========   =========   =========

   Head and Neck
     The Company...................................    $16,114     $14,187    $  9,847
     Xomed-Treace..................................         --          --       3,119(1)
                                                      ---------   ---------   ---------
       Total Company and Xomed-Treace Sales........    $16,114     $14,187     $12,966
                                                      =========   =========   =========

   Otology
     The Company...................................    $13,841     $12,406    $  7,395
     Xomed-Treace..................................         --          --       3,571(1)
                                                      ---------   ---------   ---------
       Total Company and Xomed-Treace Sales........    $13,841     $12,406     $10,966
                                                      =========   =========   =========
         Total Core Business
           The Company.............................    $52,202     $43,631     $30,631
           Xomed-Treace............................         --          --       8,942(1)
                                                      ---------   ---------   ---------
              Total Company and Xomed-Treace Sales.    $52,202     $43,631     $39,573
                                                      =========   =========   =========

   Ophthalmic and Other
     The Company...................................    $13,462     $16,234     $11,844
     Xomed-Treace..................................         --          --       3,859(1)
                                                      ---------   ---------   ---------
       Total Company and Xomed-Treace Sales........    $13,462     $16,234     $15,703
                                                      =========   =========   =========

   Total
     The Company...................................    $65,664     $59,865     $42,475
     Xomed-Treace..................................         --          --      12,801(1)
                                                      ---------   ---------   ---------
       Total Company and Xomed-Treace Sales........    $65,664     $59,865     $55,276
                                                      =========   =========   =========

<FN>

--------
(1)  Three and one-half months ended April 15, 1994, the period prior to the
     Xomed Acquisition. Sales subsequent to the Xomed Acquisition are included
     with the Company.
</FN>

</TABLE>

<TABLE>
<CAPTION>


                                                                 Years Ended December 31,
                                                               ----------------------------
                                                                1996       1995       1994
                                                                ----       ----       ----
<S>                                                         <C>        <C>        <C>

Percentage of Total Company and Xomed-Treace Sales:
   Sinus and Rhinology......................................    33.9%       28.5%      28.3%
   Head and Neck............................................    24.5        23.7       23.5
   Otology..................................................    21.1        20.7       19.8
                                                              ------      ------     ------
        Total Company and Xomed-Treace Core Business........    79.5        72.9       71.6
   Ophthalmic and Other.....................................    20.5        27.1       28.4
                                                              ------      ------     ------
          Total Company and Xomed-Treace....................   100.0%      100.0%     100.0%
                                                              ======      ======     ======
</TABLE>



<PAGE>31




   Sales by Geographic Market

     The Company distributes its products on a worldwide basis through a
76-person direct sales force in the U.S. and selected other countries and
through a network of 121 independent distributors. The Company's core ENT
products are sold in the U.S. only on a direct sales basis.

     Prior to its acquisition in 1994, Xomed-Treace's sales and distribution
were conducted jointly with Zimmer International, a division of Bristol-Myers
and a former affiliate. Since that time, the Company has developed its own
international sales and distribution network. Approximately 32.0% of the
Company's net sales in 1996 and 29.4% of its net sales in 1995 were made outside
the U.S. through direct operations in the United Kingdom, Canada, France,
Germany and Australia, as well as through 102 independent international
distributors, many of whom distribute the Company's products exclusively. The
following table summarizes the Company's U.S. and international sales for the
periods indicated and has been prepared by summarizing the historical data of
Merocel with Xomed-Treace for periods prior to the Xomed Acquisition:

<TABLE>
<CAPTION>

                                                         Years Ended December 31,
                                                        ---------------------------
                                                        1996        1995       1994
                                                        ----        ----       ----
                                                              (in thousands)
<S>                                              <C>          <C>         <C>

Sales:
   U.S.
     The Company................................     $44,647       $42,249    $30,943
     Xomed-Treace...............................         --           --        9,991(1)
                                                     -------       -------    -------

          Total Company and Xomed-Treace
             U.S. Sales                              $44,647       $42,249    $40,934
                                                     =======       =======    =======
   International
     The Company................................     $21,017       $17,616    $11,532
                                                         --           --        2,810(1)
                                                     -------       -------    -------

          Total Company and Xomed-Treace
             International Sales                     $21,017       $17,616    $14,342
                                                     =======       =======    =======
   Total
     The Company................................     $65,664       $59,865    $42,475
     Xomed-Treace...............................          --          --       12,801(1)
                                                     -------       -------    -------

          Total Company and Xomed-Treace
             Sales                                   $65,664       $59,865    $55,276
                                                     =======       =======    =======
Percentage of Total Company and Xomed-
   Treace Sales:
     U.S.                                               68.0%        70.6%       74.1%
     International..............................        32.0         29.4        25.9
                                                     -------       ------     -------
          Total Company and Xomed-Treace........       100.0%       100.0%      100.0%
                                                     =======       ======     =======
<FN>

---------
(1) Three and one-half months ended April 15, 1994, the period prior to the
    Xomed Acquisition. Sales subsequent to the acquisition are included with the
    Company.
</FN>

</TABLE>


<PAGE>32


   Sales by Product Type

     The Company places particular emphasis on disposable products and
implantable devices, which represented 84.5% of sales in 1996, as compared with
82.7% of the total of the Company's and Xomed-Treace's sales in 1994. One of the
Company's principal objectives is to continue to develop additional disposable
products for use with its instrumentation systems. The following table
summarizes the Company's sales of equipment and instrumentation products as well
as disposable and implantable products for the periods indicated and has been
prepared by summarizing the historical data of Merocel with Xomed-Treace for
periods prior to the Xomed Acquisition:

<TABLE>
<CAPTION>

                                                                 Years Ended December 31,
                                                             --------------------------------
                                                               1996       1995        1994
                                                               ----       ----        ----                     
<S>                                                     <C>          <C>         <C>
Sales:
   Equipment and Instrumentation Products
     The Company......................................        $10,178  $  9,396    $ 7,271
     Xomed-Treace.....................................            --         --      2,275(1)
                                                              -------  ---------   -------
          Total Company and Xomed-Treace Sales........        $10,178  $  9,396    $ 9,546
                                                              ======= =========    =======

   Disposable and Implantable Products
     The Company......................................        $55,486   $50,469    $35,204
     Xomed-Treace.....................................            --         --     10,526(1)
                                                              -------   -------    -------
          Total Company and Xomed-Treace Sales........        $55,486   $50,469    $45,730
                                                              =======   =======   ========
   Total
     The Company......................................        $65,664   $59,865    $42,475
     Xomed-Treace.....................................            --         --     12,801(1)
                                                              -------   -------    -------

          Total Company and Xomed-Treace Sales........        $65,664   $59,865    $55,276
                                                              =======   =======   ========
Percentage of Total Company and Xomed-
   Treace Sales:
     Equipment and Instrumentation Products...........          15.5%      15.7%     17.3%
     Disposable and Implantable Products..............          84.5       84.3      82.7
                                                              -------   --------  --------
          Total Company and Xomed-Treace..............         100.0%     100.0%    100.0%
<FN>
                                                              =======   ========  ========
----------
(1) Three and one-half months ended April 15, 1994, the period prior to the
Xomed Acquisition. Sales subsequent to the acquisition are included with the
Company.
</FN>

</TABLE>


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The Financial Statements are included on pages F-1 to F-24 in this Annual
Report on Form 10-K.

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

     Not applicable.


<PAGE>33


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 to be held on May
28, 1997 (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.

             3. Exhibits

            Exhibit No.       Description
            -----------       -----------
            **3.1.2       Second Restated Certificate of
                          Incorporation
                         
            **3.2.2       Restated By-Laws
                         
              3.2.3       Restated By-Laws as amended on February 5, 1997
                         
           ***4.          Specimen of Company's Common Stock certificate
                         
            *10.1         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,
                    
<PAGE>34


                         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.
                        
           *10.2         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.
                        
           *10.3         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,
                         Inernationale Nederlanden (U.S.) Capital Corporation
                         and Bank of Boston Connecticut, as Agent.
                        
           *10.4         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.
                        
           *10.5         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.
                        
           *10.6         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.
                        
           *10.7         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.
                        
           *10.8         1996 Stock Option Plan
                        
           *10.9         Employment Agreement, dated as of April 16, 1996,
                         between the Company and James T.  Treace
                        
         *10.10          Employment Agreement, dated as of April 16, 1996,
                         between the Company and F. Barry Bays.
                        
        **10.11          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.
                        
            **10.12      Separation Agreement, dated as of May 10,
                         1996, between the Company and Mark K. Adams.
                        
           ***10.13      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. 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.
                        
           ***10.14      Compliance Agreement, dated as of April 1,
                         1996, by and between Daikin America, Inc. and Xomed
                         Surgical Products, Inc.
                        
           ***10.15      Supply Agreement, dated as of November 9, 1994, by
                         and between TreBay Medical Corporation (formerly
                         known as Micromed Development Corporation) and
                         Consolidated Polymer Technologies.
                        
                   
<PAGE>35


             10.16        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.
                         
             11           Statement Re: Computation of Earnings Per Share
                         
             *21          Subsidiaries
                         
             23.2         Consent of Ernst & Young LLP
                         
             27           Financial Data Schedule
                         
    ----------
  *   Incorporated by reference to the identically numbered
      exhibit to the Registrant's Registration Statement
      on Form S-1 (Registration No. 333-10515).

  **  Incorporated by reference to the identically numbered
      exhibit to Amendment No. 1 to the Registrant's Registration
      Statement on Form S-1 (Registration No. 333-10515).

  *** Incorporated by reference to the identically numbered
      exhibit to Amendment No. 3 to the Registrant's Registration
      Statement on Form S-1 (Registration No. 333-10515).


         (b)   Reports on Form 8-K

              None


<PAGE>36


                                   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 25, 1997.

                                    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.


SIGNATURES                                  TITLE                    DATE
----------                                  -----                    ----

                                   President, Chief Executive
                                   Officer and Chairman of the
/s/ James T. Treace                Board (Principal Executive    March 25, 1997
--------------------------------   Officer)
James T. Treace

                                   Vice President and Chief
                                    Financial Officer
/s/ Thomas E. Timbie                (Principal Financial and     March 25, 1997
--------------------------------   Accounting Officer)
Thomas E. Timbie


                                          Director            
--------------------------------
Richard B. Emmitt


                                          Director            
--------------------------------
Paul H. Klingenstein


                                          Director            
--------------------------------
William R. Miller


/s/ Rodman W. Moorhead, III               Director               March 25, 1997
--------------------------------
Rodman W. Moorhead, III


/s/ James E. Thomas                       Director               March 25, 1997
--------------------------------
James E. Thomas


/s/ Elizabeth H. Weatherman               Director               March 25, 1997
--------------------------------
Elizabeth H. Weatherman



<PAGE>


                                  Exhibit Index

              Exhibit No.                   Description
              -----------                   -----------
                    3.2.3                   Restated By-Laws as amended on 
                                            February 5, 1997

                    10.16                   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.

                    11                      Statement Re: Computation of
                                            Earnings Per Share

                    23.2                    Consent of Ernst & Young LLP

                    27                      Financial Data Schedule







<PAGE>F-1




                          INDEX TO FINANCIAL STATEMENTS

                                 

                                                                       Page
                                                                      Number
                                                                  --------------

Report of Independent Auditors                                        F-2

Consolidated Balance Sheets at
 December 31, 1996 and 1995                                           F-3

Consolidated Statements of Operations for each
   of the three years in the
   period ended December 31, 1996                                     F-4

Consolidated Statements of Changes in Shareholders'
   Equity for each of the three years in the
   period ended December 31, 1996                                     F-5

Consolidated Statements of Cash Flows for each of
   the three years in the period ended December 31, 1996              F-7

Notes to Consolidated Financial Statements                            F-8





                                      
<PAGE>F-2



                         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, 1996
and 1995, 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, 1996. 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, 1996 and 1995,
and the  consolidated  results of their operations and their cash flows for each
of the three years in the period  ended  December  31, 1996 in  conformity  with
generally accepted accounting principles.


                                                 ERNST & YOUNG LLP




February 26, 1997
Jacksonville, Florida


<PAGE>F-3




 CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)

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

Assets
Current assets.............................................
   Cash and cash equivalents...............................  $   629  $   417
   Accounts receivable, less allowance for doubtful
   accounts of $400 and $483 at December 31, 1996
   and 1995, respectively..................................    9,935    11,951
   Other receivables.......................................    1,056     1,348
   Inventories.............................................   14,846    11,994
   Prepaid expenses........................................      853       564
   Income taxes receivable.................................      217       274
   Deferred income taxes...................................    1,721     1,379
                                                             --------- ---------
Total current assets.......................................   29,257    27,927

Investments................................................      140       861
Notes receivable from officers.............................      724       332
Property, plant and equipment, net.........................   15,377    15,355
Cost in excess of net assets acquired, net.................   44,389    46,381
Other assets...............................................    3,133     2,068
Deferred income taxes......................................    1,036       199
                                                             --------- ---------
Total assets...............................................  $94,056   $93,123
                                                             ========= =========

Liabilities and shareholders' equity
Current liabilities:
   Accounts payable........................................ $  4,848  $  5,841
   Accrued expenses........................................    4,835     4,512
   Accrued restructuring costs.............................    1,155       695
   Current portion long-term debt and                             88     4,645
     capital lease obligations
                                                             -------  --------
Total current liabilities..................................   10,926    15,693

Long-term debt and capital lease obligations,
 less current portion                                          3,563    32,719

Redeemable preferred stock:
   Series C, nonvoting, cumulative, $1.00 par value,
     364,673 shares  authorized,
     -0- shares issued and outstanding.....................       --    31,454
Redeemable convertible preferred stock:
   Series A, convertible,  voting, cumulative,
     $1.00 par value; 1,200,000 shares
     authorized, -0- shares issued and
     outstanding...........................................       --     3,841
   Series B, convertible, nonvoting, cumulative,
     $1.00 par value; 3,500,000 shares authorized,
      -0- shares issued and outstanding....................       --    22,474
Shareholders' equity (deficit):
   Common stock:
     Common Stock, voting, $.01 par value;
       30,000,000 shares authorized, 7,261,549 shares
       issued and outstanding..............................        73        6
     Common Stock, non-voting, $.01 par value;
        4,000,000 shares authorized, -0- shares
        issued and outstanding.............................       --         4
   Accumulated deficit.....................................    (9,589) (12,719)
   Shareholders' notes receivable..........................       --      (349)
   Additional paid-in capital..............................    89,475       --
   Deferred stock compensation.............................      (392)      --
                                                             --------- --------
Total shareholders' equity (deficit).......................    79,567  (13,058)
                                                             --------- --------
Total liabilities and shareholders' equity.................   $94,056  $93,123
                                                              ======== ========

                             See accompanying notes.



<PAGE>F-4

<TABLE>


CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share data)

                                                                                       Years Ended December 31,

<S>                                                                         <C>                <C>               <C>


                                                                            1996               1995              1994
                                                                            ----               ----              ----

Sales, net....................................................             $65,664            $59,865           $42,475
Cost of sales.................................................              25,926             23,175            19,233
                                                                          --------           ---------         --------
Gross profit..................................................              39,738             36,690            23,242
Operating expenses:
     Selling, general and administrative......................              26,799             27,077            19,126
     Research and development.................................               3,659              2,405             1,958
     Amortization of intangibles..............................               2,421              2,579             2,652
     Write-off of acquired research and development...........               2,380               --                --
     Restructuring charges....................................               3,093               --                --
                                                                          ---------        -----------        ---------
Total operating expenses......................................              38,352             32,061            23,736
                                                                          --------          ----------        ---------
Operating income (loss) from continuing operations............               1,386              4,629              (494)

Interest expense..............................................              (2,205)            (3,063)           (2,148)
Other income, net.............................................                 525                114               313
                                                                        ----------         -----------       ----------
Income (loss) from continuing operations before income
  tax expense (benefit)                                                       (294)             1,680            (2,329)
Income tax expense (benefit)..................................                 873              1,355              (774)
                                                                        ----------          ----------        ----------
Income (loss) from continuing operations......................              (1,167)               325            (1,555)
Discontinued operations:
     Income from  operations  of  discontinued  surgical
        drapes segment (less applicable income tax expense
        of $203 and $309 for the periods ended
        December 31, 1995 and 1994, respectively).............                  --                306               463
     Loss on disposal of surgical drapes segment (less ap-
        plicable income tax benefit of $1,386)                                  --             (2,485)             --
                                                                         ---------          ----------        ----------
Net loss......................................................             $(1,167)          $ (1,854)         $ (1,092)
                                                                           ========          =========         =========
Pro forma:
     Loss from continuing operations..........................             $(1,243)         $    (149)
     Preferred stock dividends................................               1,170                 --
                                                                          --------          ---------
     Loss from continuing operations available to
        common shareholders                                                 (2,413)              (149)
     Interest expense, net of taxes...........................               1,204              1,656
     Preferred stock dividends                                               1,170                 --
                                                                         ---------          ---------
     Supplementary income (loss) from continuing
        operations............................................         $      (39)          $   1,507
                                                                        ===========          ========
Pro forma per share:
     Loss from continuing operations available to
        common shareholders...................................          $    (.46)          $   (.03)
                                                                       ===============     ==========

     Supplementary income (loss) from continuing
        operations available to common shareholders...........          $    (.01)          $    .21
                                                                       ===============     ==========

Pro forma weighted average common shares outstanding..........              5,238              4,617
                                                                         =========           ========
Supplementary pro forma weighted average common
   shares outstanding.........................................              7,496              7,117
                                                                         =========         ===========

</TABLE>

                             See accompanying notes.




<PAGE>F-5


CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(dollars in thousands)



Balance at December 31, 1993..................................................

Net loss......................................................................
Stock repurchase, August 1994.................................................
Stock sale....................................................................
Dividends paid, August 1994...................................................
Accretion of cumulative preferred stock dividends.............................
Shareholders' notes receivable................................................
Balance at December 31, 1994..................................................

Net loss......................................................................
Stock options exercised.......................................................
Accretion of cumulative preferred stock dividends.............................
Balance at December 31, 1995..................................................

Net loss......................................................................
Accretion of cumulative preferred stock dividends.............................
Forgiveness of cumulative preferred stock dividends...........................
Stock options exercised.......................................................
Shareholders stock returned...................................................
Acquisition of minority interest in subsidiary................................
Stock compensation, net of tax................................................
Proceeds from initial public stock offering...................................
Conversion of preferred stock to common stock.................................
Conversion of non-voting common stock to voting common stock..................
Balance at December 31, 1996..................................................



                             See accompanying notes.



<PAGE>F-6


<TABLE>


CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(dollars in thousands)


                                  Non-Voting Common                      Shareholders'    Additional
          Common Stock                  Stock            Accumulated        Note          Paid-in       Unearned
     Shares      Amount         Shares        Amount      Deficit        Receivable        Capital    Compensation      Total
     ------      ------         ------        -----      -----------     ------------    ----------   ------------      -----
<S> <C>          <C>           <C>            <C>          <C>              <C>                <C>         <C>        <C>

    574,471       $  6         426,777        $  4         $(3,101)         $  --              $ --        $  --      $ (3,091)

         --         --              --          --          (1,092)            --                --           --        (1,092)
     (1,351)        --              --          --              --             --                --           --            --
         --         --              --          --              --             --                --           --            --
         --         --              --          --            (105)            --                --           --          (105)
         --         --              --          --          (2,699)            --                --           --        (2,699)
         --         --              --          --              --           (349)               --           --          (349)
 ----------       ----      ----------          --          -------         -------              ---       ------    -----------
    573,120          6         426,777           4          (6,997)          (349)               --           --        (7,336)

         --         --              --          --          (1,854)            --                --           --        (1,854)
     19,000         --              --          --              --             --                22           --            22
         --         --              --          --          (3,868)            --               (22)          --        (3,890)
 ----------        ---      ----------        ----        ---------        ------          ---------      ------     ----------
    592,120          6         426,777           4         (12,719)          (349)               --                    (13,058)

         --         --              --          --          (1,167)            --                --           --        (1,167)
         --         --              --          --          (3,262)            --                --           --        (3,262)
         --         --              --          --           7,559             --                --           --         7,559
    104,600          1              --          --              --             --               188           --           189
         --         --              --          --              --            162                --           --           162
      8,000         --              --          --              --             --               180           --           180
         --         --              --          --              --             --               596         (392)          204
  2,875,000         29              --          --              --             --            53,976           --        54,005
  3,255,052         33              --          --              --            187            34,535           --        34,755
    426,777          4        (426,777)         (4)             --             --                --           --            --
 ----------      -----       ----------     -------      ---------           ----        ----------       ------    ----------
  7,261,549        $73              --         $--         $(9,589)           $--           $89,475        $(392)      $79,567
  =========        ===      ==========         ===         ========           ===           =======        ======      =======



</TABLE>





<PAGE>F-7


<TABLE>



CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
                                                                                  Years Ended December 31

                                                                                 1996        1995     1994
                                                                                -----        -----    ----
<S>                                                                           <C>         <C>       <C>

Operating activities
Net loss................................................                      $(1,167)    $ (1,854) $  (1,092)
Adjustments to reconcile net loss to net cash provided by
  operating activities:
    Depreciation.........................................                       2,285        2,038      1,549
    Amortization of intangibles..........................                       2,564        2,702      2,825
    Loss on disposal of property and equipment...........                         301        4,963        742
    Write-off of acquired research and development.......                       2,380          --         --
    Changes in operating assets and liabilities net of effects of
      purchased business
        (Increase) decrease in accounts and other receivables, net              2,497       (3,228)    (1,038)
        (Increase) decrease in inventories, net..........                      (2,701)         535      3,786
        Decrease (increase) in deferred income taxes.....                         266         (494)       628
        (Increase) decrease in other assets..............                          30          130       (538)
        Increase (decrease) in accounts payable and accrued
          expenses.......................................                      (1,099)       2,510      2,442
        (Decrease) increase in accrued restructuring costs                       (512)      (1,045)    (5,315)
                                                                            ----------    ---------  --------
Net cash provided by operating activities................                       4,844        6,257      3,989

Investing activities
Purchases of property and equipment......................                      (2,379)      (2,969)    (2,183)
Loans to officers........................................                         353          --        (332)
Proceeds from certificates of deposit....................                         721          338        --
Purchase of other assets.................................                        (807)      (1,388)       --
Purchases of businesses (including cash received)........                       2,000           --    (80,873)
                                                                            ---------     --------   --------

Net cash used in investing activities....................                        (112)      (4,019)   (83,388)

Financing activities
Proceeds from issuance of debt...........................                          --          --      45,919
Proceeds from revolving line of credit...................                      29,416       28,810      9,275
Payments on revolving line of credit.....................                     (37,034)     (24,986)   (15,692)
Payments on term notes payable and capital lease.........                     (26,096)      (5,927)    (2,801)
Exercise of stock options................................                         189           --         --
Issuance of stock........................................                      54,005           22     43,503
Repurchases of redeemable preferred stock................                     (25,000)                 (1,870)
                                                                            ----------    --------   --------
Net cash provided by (used in) financing activities......                      (4,520)      (2,081)    78,334
                                                                           -----------    --------   --------
                                                                                            

Net increase (decrease) in cash and cash equivalents.....                         212          157     (1,065)
Cash and cash equivalents at beginning of period.........                         417          260      1,325
                                                                           ----------     --------   --------
                                                                                            
Cash and cash equivalents at end of period...............                   $     629     $    417   $    260
                                                                            =========     ========   ========
                                                                                           

Supplemental disclosures of cash flow information
  Cash paid during the period for:
    Interest.............................................                     $ 2,499     $  3,118   $  2,205
                                                                              =======     =========  ========
    Taxes................................................                    $    579     $    228   $    428
                                                                             ========     =========  ========

  Increase (decrease) preferred stock attributable to accretion or
forgiveness
    of cumulative preferred stock dividends:
    Series A.............................................                     $  (141)    $    209   $    143
    Series B.............................................                      (1,473)       1,223        866
    Series C.............................................                      (2,684)       2,458        143
                                                                              -------     ---------  --------
                                                                              $(4,298)    $  3,890   $  1,152
                                                                              =======     =========  ========
  Non-Cash financing and investing activities
    Note receivable accepted in exchange for surgical
     drapes segment assets...............................                          --     $  1,125        --
                                                                              =======     ========   ========

    Purchase of business with preferred stock,
      net of cash received                                                    $4,583      $    --         --
                                                                              =======     ========   ========

    Conversion of preferred stock to common..............                     $34,755     $     --        --
                                                                              =======     ========   ========

                             See accompanying notes.

</TABLE>




<PAGE>F-8




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-Treace) 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-Treace  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.  All  operating  results  and  changes  in
shareholders'  equity  as  reported  for the  periods  prior to April  15,  1994
represent those of Merocel.

     The acquisition of  Xomed-Treace  has been accounted for under the purchase
method of accounting.  Accordingly,  the purchase price of approximately $81,000
was  allocated to the  individual  assets  acquired and  liabilities  assumed of
Xomed-Treace based upon their respective fair values at the date of acquisition.
The  transaction  resulted in cost in excess of net assets  acquired of $55,988.
The  acquisition  was funded  primarily  through the issuance of preferred stock
($43,502) and proceeds from long-term debt.

     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 sales force  domestically  and third party
distributors  and  wholly-owned  subsidiaries  internationally.  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 April 16, 1996, the Company acquired TreBay Medical Corporation (TreBay)
which was involved in the development of ear, nose and throat surgical specialty
products.  The  acquisition  which was  accomplished  through  the  issuance  of
preferred  stock,  was  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  approximately  $4.4 million,  of which
$2.4  million 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 7). The  acquisition  was funded through the
issuance of  approximately  $2.8 million of redeemable  preferred stock and $3.7
million of convertible preferred stock.


2.   Summary of Significant Accounting Policies

   Principles of Consolidation

     The consolidated  financial statements of the Company includes the accounts
of  Merocel  and  subsidiary,   TreBay,   and  Xomed-Treace  and   subsidiaries.
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.



<PAGE>F-9




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.  Market for raw  materials is based on
replacement costs and for  work-in-process  and finished goods on net realizable
value.

   Investments

     Investments  consist of a  certificate  of deposit  which is stated at cost
which  approximates  market value.  The  certificate of deposit was purchased in
connection  with a tax exemption grant from the government of Puerto Rico, for a
period not to exceed five years.

   Property, Plant and Equipment

     Property,  plant  and  equipment  are  stated  at  cost.  Expenditures  for
maintenance   and  repairs  are  charged  to  income  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 3 to 15 years.


   Income Taxes

     The Company  accounts  for income  taxes in  accordance  with  Statement of
Financial  Accounting  Standard No. 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 (see Note 6). Amortization of other intangibles is amortized straight-line
over the life of the related agreement ranging from four to 15 years.

   Research and Development

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





<PAGE>F-10




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


2.   Summary of Significant Accounting Policies (continued)

   Translation Adjustments

     The remeasurement gains and losses of foreign currencies related to foreign
operations  are included in income (loss) from  operations  and totaled  $41
(loss), $67 (gain) and $50 (loss) for the years ended December 31, 1996,
1995 and 1994, respectively.

   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.

   New Accounting Pronouncements

     In March  1995,  the FASB issued  Statement  No.  121,  Accounting  for the
Impairment of  Long-Lived  Assets and for  Long-Lived  Assets to Be Disposed Of,
which  requires  impairment  losses to be  recorded on  identifiable  long-lived
assets used in operations and related goodwill when indicators of impairment are
present and the  undiscounted  cash flows  estimated  to be  generated  by those
assets are less than the assets' carrying  amount.  If an asset is determined to
be impaired,  a loss is to be recorded  based upon the  difference  between fair
value of the asset and its carrying  value.  Fair value is to be estimated based
on estimated selling prices or discounted  future cash flows.  Statement No. 121
also addresses the accounting for the expected disposition of long-lived assets.

     The Company has adopted  Statement No. 121 effective  January 1, 1996,  and
the effect of adoption was not material to the financial position or the results
of operations of the Company.

     The  FASB  also  issued  Statement  No.  123,  Accounting  for  Stock-Based
Compensation,  which provides an alternative for income statement recognition of
costs  associated  with  stock-based  employee  compensation  plans and requires
expanded  disclosures  with  respect to such  plans.  The Company  adopted  this
standard in 1996 by making the required footnote  disclosures  only.  Therefore,
the adoption of this standard did not have an effect on the Company's  financial
position or results of operations.

3.   Discontinued Operations

     During mid 1995, the Company approved a plan to dispose of and finalized an
agreement  for the  disposal of all  operating  assets,  inventory,  patents and
license  agreements of its surgical  drapes segment in exchange for cash,  notes
receivable,  inventory and fixed assets related to several otology product lines
of a nonrelated entity.  Management decided the surgical drapes were not part of
the  Company's  core  business and disposed of this product line in exchange for
the head and neck product line of another entity which is more  compatible  with
the  Company's  other  products.  There was no intent to dispose of the surgical
drapes  segment  at the  time of the  Xomed-Treace  acquisition.  The  operating
results of the  otology  product  lines were not  significant  to the  Company's
overall results of operations during 1995.

     Certain financial  information related to the surgical drapes product line,
which was acquired from Xomed-Treace on April 15, 1994, is as follows:


                                                   Year Ended December 31,
                                                  1996       1995      1994
                                                  ----       ----      ----
Sales.........................................    $--       $5,385    $5,586
                                                  ====      ======    ======
Pre-tax income................................    $--       $ 509     $ 772
                                                  ====      ======    ======
Income tax expense............................    $--       $ 203     $ 309
                                                  ====      ======    ======
Net income....................................    $--       $ 306     $ 463
                                                  ====      ======    ======



<PAGE>F-11




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

3.   Discontinued Operations (continued)

     The surgical drapes business accounts  consisted  principally of inventory,
fixed assets and related goodwill  aggregating  approximately $7,100 on the date
of disposition.  Interest expense  attributed to the drapes business was $79 and
$56 for 1994 and 1995, respectively.  The Company realized a net loss of $2,485,
after income tax benefits of $1,386,  on this  transaction  and has restated its
financial statements for the discontinued  operations.  The loss on disposal was
computed as the  difference  between the carrying  value of the surgical  drapes
segment assets  disposed of and the estimated fair value of the assets  received
related to the otology product lines. There were no significant intangibles such
as customer  lists or patents  acquired in connection  with the otology  product
lines,  nor was any  work  force  transferred.  The  components  of the  loss on
disposal in 1995 are as follows:

         Cash and notes receivable acquired........................  $2,250
         Less: Transaction fees....................................    (316)
               Goodwill related to the surgical drapes segment.....  (5,805)
                                                                    --------
         Pre-tax loss..............................................   3,871
         Tax benefit...............................................  (1,386)
                                                                    --------
         Net loss on disposition...................................  $2,485
                                                                    ========

     The inventory and fixed assets of the otology  product lines  acquired were
recorded at fair values of $1,170 and $154, respectively, which approximated the
aggregate  carrying value of assets  disposed of related to the surgical  drapes
business.

     Included in other  receivables and other assets as of December 31, 1996 are
notes receivable of $375 and $375,  respectively,  related to this  transaction.
Included in other  receivables  and other  assets at December 31, 1995 are notes
receivable  of  approximately  $1,000  and $750,  respectively,  related to this
transaction. As part of the transaction both parties agreed to manufacture their
existing products through the end of 1995 and supply those products to the other
party at cost. As a result of this agreement, amounts totaling $1,704 and $1,564
are  included  in trade  receivables  and  accounts  payable,  respectively,  at
December 31, 1995.


4.   Inventories

     Inventories are summarized as follows:

                                                                 December 31,
                                                              1996         1995
                                                              ----         ----
   Finished goods.....................................   $   7,825    $   6,972
   Work in process....................................       2,006        1,572
   Raw materials and packaging........................       6,066        3,851
   Reserve for obsolescence...........................      (1,051)        (401)
                                                         ---------    ---------
                                                         $  14,846    $  11,994
                                                         =========    =========

     The reserve for  obsolescence  reflected  increases in the reserve of $650,
$61, and $340 for 1996, 1995, and 1994, respectively.




<PAGE>F-12




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)



5.   Property, Plant and Equipment

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

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

            Land and land improvements..............       $  1,413   $  1,413
            Building and building improvements......          6,360      6,061
            Machinery and equipment.................         13,317     10,625
                                                           --------   --------
                                                             21,090     18,099
            Allowances for depreciation.............         (6,685)    (4,353)
                                                           --------   --------
                                                             14,405     13,746
            Capital projects in process.............            972      1,609
                                                           --------   --------
                                                            $15,377    $15,355
                                                           ========   ========

Depreciation   expense,   including   expense  on  assets  under  capital  lease
obligations,  is  approximately  $2,285,  $2,038 and $1,549 for the years  ended
December 31, 1996, 1995 and 1994, respectively.


6.   Cost in Excess of Net Assets Acquired

     The cost in  excess of net  assets  acquired  relates  to  goodwill  in the
acquisition  of  Xomed-Treace,  which  is being  amortized  over 25 years on the
straight line basis and is summarized as follows:

                                                        December 31,
                                                     1996           1995
                                                     ----           ----
     Cost in excess of net assets acquired
       at beginning of period...................   $50,078         $55,988
     Other/purchase price adjustments...........        --            (105)
     Surgical drape product line disposition....        --          (5,805)
                                                   -------         --------
                                                    50,078          50,078
     Cumulative amortization....................    (5,689)         (3,697)
                                                   -------         -------
     Cost in excess of net assets acquired
       at end of period.........................   $44,389         $46,381
                                                   =======         =======

     The  recoverability of goodwill is periodically  assessed by the Company 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 by the
estimated shortfall of discounted cash flows.

     The $5,805  reduction of goodwill  ($6,100 at purchase date) relates to the
disposal of the surgical  drapes segment in July 1995 and is included in loss on
disposal of discontinued operations.


7.   Accrued Restructuring Costs

     Incident to the acquisition of Xomed-Treace,  the Company  initiated a plan
to restructure  certain of its operations and established a reserve of $3,258 as
part of the cost of the acquired  business  associated  primarily with closing a
plant  facility and  significantly  reducing the Company's  work force.  Accrued
restructuring costs related to the acquisition of Xomed-Treace  totaled $-0- and
$695 at December 31, 1996 and 1995, respectively.


<PAGE>F-13




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)



7.   Accrued Restructuring Costs (continued)

     In conjunction with the purchase of TreBay, the Company recorded an accrual
totaling $647 related to severance and relocation ($598) and lease termination
($49) costs. All employees of TreBay were terminated, except the officers and
two other individuals who relocated to Jacksonville, Florida, the corporate
headquarters of the Company. The Company anticipates that all costs will be paid
out by the third quarter of 1997. For the period from the acquisition date
through December 31, 1996, $250 was paid related to termination and relocation
benefits and $49 was paid related to lease termination costs.

     Simultaneous with the purchase of TreBay and a plan by new management to
combine certain operations, (see Note 1), the Company recorded a restructuring
accrual of $3.1 million which was comprised of $2.5 million of termination
benefits and $600 of other exit costs. The reductions included 20 management and
administrative employees 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 $2.0 million 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.

8.   Long-Term Debt and Capital Lease Obligations

     The  Company  was  obligated   under   long-term  debt  and  capital  lease
obligations as follows:

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

 Term notes payable to financial  institutions
    in quarterly principal installments  ranging
    from $975 to $1,775 through April 15, 1999,
    plus interest payable quarterly (interest at
    LIBOR (5.71875% at December 31, 1995) plus
    2.25% or lender's base rate plus 1%)..............       $ --    $25,985
 Revolving line-of-credit agreement with interest
    payable monthly and all outstanding principal
    due April 15, 1999 (interest at LIBOR
    (5.25% at December 31, 1996) plus 2.25%
    or lender's base rate plus 1%)....................      3,148     10,765
 Note payable under capital lease obligation to
    vendor in quarterly principal and interest
    installments of $36 through October 1, 1997
    and a final payment of $415 on January 1, 1998.
    The Note carries interest at 10.8% and is
    collateralized by equipment with a net book
    value of $726 at December 31, 1996.  Total
    future interest payments are $60..................        503        614
                                                            -----     -- ---
                                                            3,651     37,364
 Less current portion.................................         88      4,645
                                                            -----     ------
                                                           $3,563    $32,719
                                                           ======    =======

<PAGE>F-14




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)



8.   Long-Term Debt and Capital Lease Obligations (continued)

Annual   maturities  of  long-term  debt  and  the  capital  lease   obligations
outstanding at December 31, 1996 are as follows:



            Year Ending December 31,                        Total
            ------------------------                        -----

            1997.........................................   $   88
            1998.........................................      415
            1999.........................................    3,148
                                                           -------
                                                            $3,651
                                                           =======

     During  1995,  the Company was  required  to make an  additional  principal
payment of $1,440  based on excess  cash flow  achieved.  Also,  the Company was
required to make an additional principal payment of $1,125 based on the proceeds
from the disposal of the surgical drapes segment.

     Under the terms of the revolving line-of-credit  agreement, the Company may
borrow up to a maximum  capacity of $14,000 to be used for  working  capital and
operating  needs. The amount available to the Company at any given time is based
upon various percentages of the Company's  outstanding  inventories and accounts
receivable as determined  periodically throughout the year (borrowing base). Any
principal amounts  outstanding on the  line-of-credit in excess of the borrowing
base must be repaid by the Company.  In any event, all outstanding  principal on
the  line-of-credit  is due and payable on April 15,  1999.  The Company  pays a
quarterly  commitment  fee equal to 0.5% per annum on the average  daily  unused
balance on the  line-of-credit  during the preceding calendar quarter from April
15, 1994 through April 15, 1999.

     The  Company  has a signed  letter of intent  from the  lender to amend the
revolving  line-of-credit to provide for the borrowing of up to $25 million at a
maximum rate of LIBOR plus 1.5%.

     The  line-of-credit  is  collateralized by all assets of the Company except
for those collateralized under the capital lease obligations. The debt agreement
has restrictions  regarding payment of dividends,  incurrence of additional debt
and require compliance with various financial covenants.


9.   Shareholders' Equity and Redeemable Preferred Stock

        In October  1996,  in  conjunction  with the  Company's  Initial  Public
Offering  of  stock,  all  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 and the 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.

        On April 15, 1994,  the Company  issued  574,471 shares of Common Stock;
426,777  shares  of  Non-Voting  Common  Stock;   340,454  shares  of  Series  A
Convertible Preferred Stock;  2,127,838 shares of Series B Convertible Preferred
Stock; and 289,853 shares of Series C Redeemable Preferred Stock in exchange for
the outstanding stock of Merocel and the acquisition of Xomed,  except that cash
equal to the  redemption  value of $100.00  per share was  received  for 198,561
shares of the Series C Redeemable  Preferred  Stock.  The acquisition of Merocel
was accounted for under the  historical  cost basis due to the common  ownership
between  the  Company and  Merocel,  and the  acquisition  of  Xomed-Treace  was
accounted for under the purchase method of accounting.


<PAGE>F-15




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


9.   Shareholders' Equity and Redeemable Preferred Stock (continued)

     The  following  securities  were issued by the Company in  connection  with
raising the funds necessary to complete the acquisition of Xomed-Treace:

                                            Cash Value  Number of
                      Description            per share   Shares      Value
            --------------------------      ----------  --------- -----------

            Redeemable Preferred
               Stock Series C                  $100     198,561   $19,856,100
            Series A and B Convertible
               Preferred Stock                $9.58   2,468,292    23,646,237
                                                                   ----------
                                                                  $43,502,337
                                                                  ===========

     The shares  were valued  based upon cash  proceeds  received by  individual
stock issue,  which the Company believes is representative of fair market value.
The $81.0  million  purchase  price for  Xomed-Treace  was  funded  through  the
issuance of the above preferred shares and bank borrowings.

     In August 1994, the Company  repurchased  18,698 shares of its  outstanding
Series C Redeemable  Preferred Stock,  which were originally issued at April 15,
1994, from holders of the stock.  The stock was repurchased at a price of $1,870
which  represented the amount originally paid by the shareholders for the stock.
The repurchase was the result of the partial refund of the purchase price by the
seller for Xomed (see Note 1). In addition,  cash dividends of $105 were paid in
August 1994 to the remaining holders of the Series C Redeemable Preferred Stock,
also from the proceeds of the partial refund of the Xomed purchase price.

     Also in August  1994,  the  Company  issued  23,761  shares of its Series A
Convertible  Preferred  Stock  and  1,908  shares  of its  Series  C  Redeemable
Preferred  Stock to certain  officers and members of management  (purchasers) of
the Company.  The Series A Convertible  Preferred  Stock was issued at $9.58 per
share (equal to its redemption  value) for a total price of approximately  $227.
The Series C Redeemable  Preferred  Stock was issued at $100.00 per share (equal
to its redemption  value) for a total price of approximately  $191. Of the total
purchase price for all shares issued of $418,  the Company  received $69 in cash
and the  remaining  $349 of notes  receivable  was  reflected  as a component of
shareholders' equity in the accompanying balance sheets. During 1996, stock with
a value of $187 was repaid and notes receivable totaling $162 were canceled.

     During the year ended  December  31,  1995,  the Company  issued  19,000 of
Common Stock under the employee  stock  incentive  plan. The stock was issued at
option  prices  of  between  $1.00 to $2.00 per  share  and  resulted  in $22 of
additional paid-in capital (see Note 11).

   Common Stock

     Each share of Common Stock and Non-Voting Common Stock (collectively Common
Equity)  entitles its holder to receive  dividends as declared by the  Company's
Board of Directors, subject to the preferences and other rights of the Series A,
Series B and Series C  Redeemable  Preferred  Stock.  Each  share of  Non-Voting
Common  Stock is  convertible  into one share of Common Stock at the election of
the shareholder.

     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.


<PAGE>F-16




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


9.   Shareholders' Equity and Redeemable Preferred Stock (continued)

   Redeemable Preferred Stock

     Each  share  of  Series  A  and  Series  B  Convertible   Preferred   Stock
(collectively  Convertible  Preferred  Stock)  entitles its holder to receive an
annual cumulative cash dividend at the rate of six percent per annum, payable on
a quarterly  basis. At the election of the Board of Directors,  dividends may be
paid  in  shares  of  Series  A  or  Series  B  Convertible   Preferred   Stock,
respectively,  in lieu of cash.  Dividends are cumulative and must be paid prior
to any  dividends  being paid on the Common  Equity.  The Company at its option,
with the majority consent of the holders of the Convertible Preferred Stock, may
redeem any or all of the outstanding  shares of the Convertible  Preferred Stock
at a price of $9.58 per share, plus accrued dividends.  The Series A Convertible
Preferred Stock is voted along with the Common Equity on an as converted  basis,
whereas the Series B has no voting rights.

     In any event, any outstanding shares of the Convertible  Preferred Stock at
April 15, 2001 are  required to be redeemed on that date by the Company at $9.58
per share, plus accrued dividends. Each share of Convertible Preferred Stock, at
the election of the holder, may be converted for one share of like Common Equity
(the conversion rate being subject to adjustment from time-to-time).  All shares
of Convertible  Preferred Stock will be  automatically  converted into shares of
Common  Equity  at  the  conversion  rate  in  effect  upon  the  closing  of an
underwritten  public  offering  made  pursuant  to  an  effective   registration
statement under the Securities Act of 1933.

     Each  share of Series C  Redeemable  Preferred  Stock  (Series C  Preferred
Stock) entitles its holder to receive an annual  cumulative cash dividend at the
rate of nine percent per annum, payable on a quarterly basis. At the election of
the Board of  Directors,  dividends  may be paid in shares of Series C Preferred
Stock in lieu of cash.  Dividends are  cumulative  and must be paid prior to any
dividends being paid on the Common Equity.  The Company at its option,  with the
majority  consent of the holders of the Series C Preferred Stock, may redeem any
or all of the  outstanding  shares of the Series C Preferred Stock at a price of
$100.00 per share, plus accrued dividends.

     In any event,  any  outstanding  shares of the Series C Preferred  Stock at
April 15,  2001 are  required  to be  redeemed  on that date by the  Company  at
$100.00 per share, plus accrued dividends.

     In April 1996, the Company acquired all of the outstanding  stock of TreBay
in  exchange  for 390,000  shares of Series A  convertible  preferred  stock and
28,470 shares of Series C redeemable preferred stock.


<PAGE>F-17




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


9.   Shareholders' Equity and Redeemable Preferred Stock (continued)

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

<TABLE>

                                                 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, 1993.............     68,900   $ 8,957        8,498  $    1,053       --  $    --
Forgiveness of accretion of dividends....        --     (2,067)         --         (203)      --       --
Exchange of shares outstanding...........    (68,900)   (6,890)      (8,498)       (850)      --       --
Issuance of shares.......................    340,454     3,262    2,127,838      20,385   289,853    28,985
Repurchase of preferred stock............        --       --            --          --    (18,698)   (1,870)
Issuance of preferred stock..............     23,761       227          --          --      1,908       191
Accretion of dividends...................        --        143          --          866       --      1,690
                                          ----------- ----------  ---------  -----------  -------- --------

Balance at December 31, 1994.............    364,215     3,632    2,127,838      21,251   273,063    28,996
Accretion of dividends...................         --       209          --        1,223       --      2,458
                                          ----------- ----------  ---------  -----------  -------- --------

Balance at December 31, 1995.............    364,215     3,841    2,127,838      22,474   273,063    31,454
   Accretion of dividends................        --        263          --          922       --      2,077
   Forgiveness of dividends..............        --       (404)         --       (2,395)      --     (4,761)
   Shareholders stock returned...........     (9,563)      (91)         --          --     (2,074)    (208)
   Issuance of shares in acquisition of
     TreBay Medical                          390,000     3,736                             28,470     2,847
                                                                        --          --
Redemption of preferred stock............        --         --          --          --   (235,327)  (25,000)
Conversion of preferred stock to common
  stock..................................   (744,652)   (7,345)  (2,127,838)    (21,001)  (64,132)   (6,409)
                                          ----------- ----------  ---------  -----------  -------- --------

Balance at December 31, 1996.............          -- $     --               $      --         --  $     --
                                          =========== ==========  =========  ===========  ======== ========

</TABLE>

10.   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, 1996,  1995 and
1994 was approximately $510, $520 and $295, respectively.


<PAGE>F-18




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


11.   Employee Stock Incentives

     The Company has reserved an aggregate of 415,000 shares of its Common Stock
(see Note 9) for grant or sale to key employees of the Company. 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  and  provide  for  vesting  over a number of
years. The following table summarizes  option activity which may be exercised at
various dates through January 2000:


<TABLE>

                                                 Weighted
                                                 Average
                                              Exercise Price         1996              1995             1994
                                              --------------         ----              ----             ----
<S>                                           <C>                    <C>               <C>              <C>

Options outstanding beginning
 of the period.............................        $5.67           251,350          257,100           132,850
Options granted............................         9.15           421,666            8,000           131,000
Options exercised..........................         1.81          (104,600)          (6,750)           (6,750)
Options canceled...........................         8.87           (99,550)          (7,000)              --
                                                               ---------------  ----------------  --------------
Options outstanding end of period..........         8.99           468,866          251,350           257,100
                                                               ===============  ================  ===============
Range of option prices on options granted..                     $9.36-$10.65         $9.58             $9.58
                                                             
Range of option prices on options                              ===============  ================  ===============  
 exercised.................................                       $1.00-$9.58      $1.00-2.00        $1.00-2.00     
                                                               ===============  ================  ===============  
                                                               
                                                               
</TABLE>



     The Company has adopted the  disclosure-only  provisions  of  Statement  of
Financial   Accounting   Standards   No.  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. Statement No. 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 .31; 2)
a  risk-free  interest  rate of 6.5%;  and 3) an  expected  life of options of 3
years. The weighted-average grant date fair value of options granted in 1996 was
$4.01. Had compensation cost for the Company's stock option plan been determined
based on the fair value at the grant date for awards in 1995 and 1996 consistent
with the  provisions  of SFAS No. 123, the  Company's  net loss from  continuing
operations and loss per share from continuing operations would be as follows:

                                                1996              1995
                                                ----              ----

Pro forma Net loss--as reported.........      $(2,413)           $ (149)
Pro forma Net loss--adjusted............      $(2,545)           $ (150)
Pro forma loss per share--as reported...      $ (0.46)           $(0.03)
Pro forma loss per share--adjusted......      $ (0.49)           $(0.03)


<PAGE>F-19




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


12.   Income Taxes

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

                                      1996        1995         1994
                                      ----        ----         ----
     Current:
          Federal...............       $496      $   206      $(292)
          State.................        206           33        (47)
                                      -----      -------      ------
                                        702          239       (339)
     Deferred:
          Domestic..............        540        1,116       (435)
          Foreign tax benefit...       (369)          --         --
                                      -----      -------      ------
                                       $873       $1,355      $(774)
                                      =====      =======      ======



     During 1996,  the Company's tax liability was decreased $150 and additional
paid-in  capital  increased  due to the  early  disposition  of stock by a stock
option holder.

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

                                          1996         1995              1994
                                          ----         ----              ----
       Federal tax (benefit) at
        statutory rate.................  $(103)      $   588            $(815)

       Purchased in-process research
        and development................    833            --               --

       State income taxes (benefit)
        (net of federal income tax
        effect)........................     92           136              (78)

       Unrecognized loss from
        foreign operations.............     --           387               45

       Loss from unconsolidated
        subsidiary for tax purposes....     --           192              114

       Other, net......................     51            52              (40)
                                          ----        ------            ------
                                          $873        $1,355            $(774)
                                          ====        ======            ======




<PAGE>F-20




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


12.   Income Taxes (continued)

     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:

                                                          December 31,
                                                        1996         1995
                                                        ----         ----
  Deferred income tax assets:
       Net operating loss carryforwards..........      $1,131        $ --
       Losses from foreign operations and
          unconsolidated subsidiary                     1,068          579
       Amortization of goodwill..................          --           84
       Severance accruals........................         566          275
       Patents and other intangibles.............         553          358
       Inventory.................................         728          291
       AMT credit................................         333          161
       Non-deductible accrued expenses...........         436          778
                                                      --------    ---------
                                                        4,815        2,526
       Valuation allowance.......................        (585)        (579)
                                                      --------    ---------
                                                        4,230        1,947
  Deferred income tax liabilities:
       Amortization of goodwill..................        (570)        --
       Depreciation..............................        (562)        (339)
       Purchased research and development........        (298)        --
       Deductible prepaid expenses...............         (27)         (30)
                                                      --------    ---------
                                                       (1,457)        (369)
                                                      --------    ---------  
                                                       $2,773       $1,578
                                                      ========    =========

            The  valuation  allowance  at December  31, 1996 and 1995 related to
certain losses from foreign  operations  incurred prior to 1996 which management
believes the ultimate realization of the related tax benefits is not more likely
than not at the present time. Foreign losses totaling approximately $2.4 million
can be carried forward for periods ranging from five years to indefinitely.

13. Related Party Transactions

           At December 31, 1996 and 1995, the Company had notes  receivable from
its officers for advances made to acquire the  Company's  stock (see Note 9) and
for other purposes as follows:
                                                         December 31,
                                                        1996        1995
                                                        ----        ----

            Shareholders' notes.................       $  --      $   349
            Other notes receivable..............         724          332
                                                       ------     --------
            Total notes receivable..............        $724      $   681
                                                       ======     ========

     The other notes receivable  outstanding at December 31, 1996,  relates to a
note receivable from an officer, which is collateralized by 44,460 shares of the
Company's common stock, bears interest at 10%, becomes a demand note on November
7, 2000 and, in any event, is payable in full by November 7, 2002.


<PAGE>F-21




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)



13.   Related Party Transactions (continued)


     The 1995 notes bear  interest at rates ranging from 7% to 8% and are due in
annual  installments  payable  from the  annual  bonuses  (if  any)  paid to the
officers.  During 1996,  $162 of notes were  canceled due to the return of stock
which was securing the notes.

     The loans made to the  officers  to acquire the  Company's  stock and other
notes from officers have been reflected as  shareholders'  notes receivable as a
component  of  shareholder's   equity  and  non-current  notes  receivable  from
officers, respectively, in the accompanying balance sheets.

     In connection with the  acquisition of TreBay Medical  Corporation 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 $1.9  million.  The
notes are secured by a total of 172,173  shares of the  Company's  common stock,
bear interest at 7% and become  payable in full on April 16, 2001.  The officers
are  obligated to apply 50% of the  after-tax  amount of any Company  bonuses to
unpaid interest and principal.

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  $790,  $417 and $431  for the  years  ended
December  31, 1996,  1995 and 1994,  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:

       Year Ending December 31,
       1997........................................  $   673
       1998........................................      374
       1999........................................      163
       2000........................................       90
       2001 and thereafter.........................       36
                                                    --------
                                                      $1,336
                                                    ========

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.





<PAGE>F-22




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


16.   Segment Information

     The Company's  subsidiaries operate distribution  facilities in a number of
foreign countries. Currently,  international subsidiaries are present in Canada,
Australia,  United Kingdom,  France and Germany.  These  subsidiaries  represent
approximately 16% of 1996 total sales of the Company,  with France  representing
the largest  portion of this with 5% of total  sales.  Inter-area  sales are not
significant to the total sales of any one geographic area.

                                 Information about the Company's Operations in
                                         Different Geographic Areas
                                 ---------------------------------------------
                                                   Income
                                  Sales         (Loss) from       Identifiable
                                                 Operations          Assets
                                 -------        -----------       ------------
 1996:
    United States                $55,034            $ 628           $88,788
    International Operations      10,630             (922)            5,268
                                 -------        -----------       ------------
    Consolidated                 $65,664            $(294)          $94,056
                                 =======        ===========       ============

 1995:
    United States                $51,644           $2,801           $87,873
    International Operations       8,221           (1,121)            5,250
                                 -------        -----------       ------------
    Consolidated                 $59,865           $1,680           $93,123
                                 =======        ===========       ============

 1994:
    United States                $40,716          $(2,102)          $93,709
    International Operations       1,759             (227)            2,011
                                 -------        -----------       ------------
    Consolidated                 $42,475          $(2,329)          $95,720
                                 =======        ===========       ============


     The  Company  had export  sales of $10.4  million,  $9.4  million and $12.7
million in 1996, 1995 and 1994,  respectively,  representing 16%, 15% and 30% of
total sales, respectively.


<PAGE>F-23




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


17.   Pro Forma Statement of Operations (Unaudited)


Pro Forma Statement of Operations

     The  following  unaudited pro forma  statements of operations  for the year
ended December 31, 1996 and 1995 reflects: 1) the statement of operations of the
Company for the periods presented as if TreBay was purchased on January 1, 1995;
and 2) excludes the  discontinued  operations  of the Company for the year ended
December  31, 1995.  The pro forma  statement  of  operations  should be read in
conjunction with the financial  statements and notes thereto included  elsewhere
herein.

<TABLE>

                                                     Year Ended      Three Months Ended
                                                 December 31, 1996     March 30, 1996
                                                 -----------------   ------------------
                                                                                                            Pro
                                                       Xomed            TreBay           Adjustments       Forma
                                                       -----            ------           -----------       -----
<S>                                                   <C>             <C>             <C>                  <C>

Sales, net......................................      $ 65,664        $      279      $        --          $65,943
Cost of sales...................................        25,926               219               --           26,145
                                                      --------        -----------     ------------          ------
Gross profit....................................        39,738                60               --           39,798

Operating Expenses:
     Selling, general and administrative........        26,799               299             (154)(a)       26,944
     Research and development...................         3,659               138              (66)(a)        3,731
     Amortization of intangibles................         2,421               --                --            2,421
     Write-off of acquired research and
        development.............................         2,380               --                --            2,380
     Restructuring charges......................         3,093               --                --            3,093
                                                      --------        -----------     ---------------        -----

Total operating expenses........................        38,352               437             (220)          38,569
                                                      --------        -----------     ---------------       ------

Operating income (loss) from continuing
   operations...................................         1,386              (377)             220            1,229
                                                      --------        -----------     ---------------       -------

Interest expense................................        (2,205)              --               --            (2,205)
Other income, net...............................           525                54              --               579
                                                      --------        -----------     ---------------       ------

Income (loss) before income tax expense
    (benefit)...................................          (294)             (323)             220             (397)
Income tax expense (benefit)....................           873               --               (27) (a)         846
                                                      --------        ----------      ----------------  -----------
Net income (loss)...............................      $ (1,167)       $     (323)      $      247           (1,243)
                                                      =========       ===========      ===============
Preferred stock dividends.......................                                                             1,170
                                                                                                        -----------
Net (loss) attributable to common
   shareholders                                                                                            $(2,413)
                                                                                                        -----------
Pro forma net (loss) per share (b)..............                                                        $     (.46)
                                                                                                        ===========
Pro forma weighted average shares outstand-
   ing (b)......................................                                                             5,238
                                                                                                        ===========
</TABLE>

-------------
(a)  Elimination of general and  administrative  expenses which are  duplicative
     and will not be incurred  subsequent to the purchase date,  amortization of
     acquired developed research and development,  non-cash compensation expense
     related  to stock  options  granted,  closing of the  TreBay  facility  and
     calculation of income tax benefit on the TreBay loss after adjustments.
(b)  See Note 18.


<PAGE>F-24




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

17.   Pro Forma Statement of Operations (Unaudited) (continued)

<TABLE>


                                                              Year Ended
                                                          December 31, 1995
                                                          -----------------
                                                           Xomed       TreBay    Adjustments   Pro Forma
                                                           -----       ------    -----------   ---------
<S>                                                        <C>         <C>       <C>           <C>


Sales, net.............................................    $59,865       $450     $    --      $ 60,315
Cost of sales..........................................     23,175        528          --        23,703
                                                           -------     -------    ----------   --------
Gross profit...........................................     36,690        (78)         --        36,612
Operating expenses:
   Selling, general and administrative.................     27,077      1,084        (713)(a)    27,448
   Research and development............................      2,405        443         (49)(a)     2,799
   Amortization........................................      2,579        --           --         2,579
                                                           -------     -------    ----------   --------
Total operating expenses...............................     32,061      1,527        (762)       32,826
                                                           -------     -------    ----------   --------
Operating income (loss) from continuing operations.....      4,629     (1,605)        762         3,786

Interest expense.......................................     (3,063)       --           --        (3,063)
Other income (expense), net............................        114        109          --           223
                                                           -------     -------    ----------   --------
Income (loss) before income tax expense (benefit)......      1,680     (1,496)        762           946
Income tax expense (benefit)...........................      1,355         --        (260)(a)     1,095
                                                           -------     -------    ----------   --------

Net income (loss)......................................    $   325    $(1,496)    $ 1,022          (149)
                                                           =======    ========    ==========
Dividends on preferred stock...........................                                             --
                                                                                               --------
Net income available to common shareholders............                                        $   (149)
                                                                                               ========
Pro forma net income (loss) per share(b)...............                                        $  (0.03)
                                                                                               ========
Pro forma weighted average shares outstanding(b).......                                           4,617
                                                                                               ========
</TABLE>

(a)  Elimination of general and  administrative  expenses which are  duplicative
     and will not be incurred  subsequent to the purchase date,  amortization of
     acquired developed research and development,  non-cash compensation expense
     related  to stock  options  granted,  closing of the  TreBay  facility  and
     calculation of income tax benefit on the TreBay loss after adjustment.
(b)  See Note 18.


18.   Pro Forma and Supplementary Pro Forma Net Income Per Share

     Pro forma net income per share is computed  based on the  weighted  average
number of shares of common stock outstanding  assuming  conversion on January 1,
1995 of: 1) all Series A and B Convertible  Preferred  Stock  outstanding  as of
December 31, 1995;  2) 390,000  shares of Series A Convertible  Preferred  Stock
issued in the purchase of TreBay;  3) all stock  options  including  the options
issued after  December 31, 1995 which have been assumed to be  outstanding as of
January 1, 1995;  and 4) the  conversion  of 60,225 shares of Series C Preferred
Stock into  300,354  shares of Common  Stock  subsequent  to the initial  public
offering, based upon the initial public offering price of $21.00 per share.


<PAGE>F-25




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


18.   Pro Forma and Supplementary Pro Forma Net Income Per Share (continued)

     Supplementary pro forma net income per share is computed upon the basis
stated above and giving effect to the Company's initial public offering of
2,875,000 shares of Common Stock and paydown of approximately $20.8 million of
term notes payable including interest, approximately $8.2 million of revolving
line of credit and $25.0 million of Series C Preferred Stock as if the offering
was effective January 1, 1995. Interest expense, net of tax benefit, totaled
$1,204 and $1,656 for the years ended December 31, 1996 and 1995, respectively,
and has been eliminated as a result of the assumed paydown of debt. The
supplementary pro forma income (loss) per share from continuing operations for
the year ended December 31, 1996 and 1995 and was $(.01) and $.21, respectively.