<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

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

                                    FORM 10-K

            (Mark One)

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

                   For the fiscal year ended December 31, 1999

                                       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 NUMBER 0-22302

                       ILLINOIS SUPERCONDUCTOR CORPORATION
             (Exact name of registrant as specified in its charter)

          DELAWARE                                             36-3688459
(State or other jurisdiction                                 (I.R.S. Employer
     of incorporation)                                       Identification No.)

                               451 KINGSTON COURT
                          MT. PROSPECT, ILLINOIS 60056
                                 (847) 391-9400
          (Address and telephone number of principal executive offices)

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

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

                               Title of each class
                           ---------------------------

                    Common Stock, par value $0.001 per share
                         Preferred Stock Purchase Rights

         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 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. [ ]

         On January 31, 2000, 21,374,027 shares of the registrant's Common Stock
were outstanding. The aggregate market value on January 31, 2000 of the
registrant's Common Stock held by non-affiliates of the registrant was
$48,612,837.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Certain portions of the registrant's definitive proxy statement for the
annual meeting of stockholders to be held on May 17, 2000 are incorporated by
reference in Part III of this Form 10-K (the "2000 Proxy Statement").

================================================================================
<PAGE>   2
                                TABLE OF CONTENTS

<TABLE>
                                     PART I

<S>                                                                                                         <C>
Item 1.    Business...........................................................................................1
Item 2.    Properties........................................................................................19
Item 3.    Legal Proceedings.................................................................................19
Item 4.    Submission of Matters to a Vote of Security Holders...............................................22

                                     PART II

Item 5.    Market for Registrant's Common Equity and Related Stockholder Matters.............................22
Item 6.    Selected Financial Data...........................................................................26
Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations.............27
Item 7a.   Quantitative and Qualitative Disclosures About Market Risk........................................30
Item 8.    Financial Statements and Supplementary Data.......................................................31
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..............57

                                    PART III

Item 10.   Directors and Executive Officers of the Registrant................................................58
Item 11.   Executive Compensation............................................................................58
Item 12.   Security Ownership of Certain Beneficial Owners and Management....................................58
Item 13.   Certain Relationships and Related Transactions....................................................58

                                     PART IV

Item 14.   Exhibits, Financial Statement Schedules and Reports on Form 8-K...................................59
</TABLE>


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                                A NOTE CONCERNING
                           FORWARD-LOOKING STATEMENTS

           Because Illinois Superconductor Corporation wants to provide
investors with more meaningful and useful information, this Annual Report on
Form 10-K ("Form 10-K") contains, and incorporates by reference, certain
"forward-looking statements" (as such term is defined in Section 21E of the
Securities Exchange Act of 1934, as amended) that reflect the Company's current
expectations regarding the future results of operations, performance and
achievements of the Company. These forward-looking statements are made pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. The Company has tried, wherever possible, to identify these
forward-looking statements by using words such as "anticipates," "believes,"
"estimates," "expects," "plans," "intends" and similar expressions.

           These statements reflect the Company's current beliefs and are based
on information currently available to it. Accordingly, these statements are
subject to certain risks, uncertainties and contingencies, which could cause the
Company's actual results, performance or achievements to differ materially from
those expressed in, or implied by, such statements. These factors include, among
others, the following: the Company's history of net losses and the lack of
assurance that the Company's earnings will be sufficient to cover fixed charges
in the future; the degree to which the Company is leveraged and the restrictions
imposed on the Company under its existing debt instruments, which may adversely
affect the Company's ability to finance its future operations, to compete
effectively against better capitalized competitors and to withstand downturns in
its business or the economy generally; the Company's inability to honor
redemption rights of holders of its debt instruments in the event of the
Company's failure to comply with its obligations under those debt instruments,
including its obligation to increase its authorized capital stock at its annual
meeting of stockholders to be held prior to June 30, 2000; the fact that the
Company's Common Stock is not currently listed on a national securities exchange
or the Nasdaq Stock Market, which may have a material adverse effect on the
liquidity of the Common Stock and the Company's ability to obtain additional
funding as needed; demand for, and acceptance of, the Company's products;
continued downward pressure on the prices charged for the Company's products due
to competition of rival manufacturers of filters for the wireless
telecommunications market; the timing and receipt of customer orders; the
Company's ability to attract and retain key personnel; and the effects of legal
proceedings and other factors described in this Form 10-K, including those
described under the heading "Risk Factors," or in other filings of the Company
with the Securities and Exchange Commission. The Company undertakes no
obligation to release publicly the results of any revisions to any such
forward-looking statements that may be made to reflect events or circumstances
after the date of this Form 10-K or to reflect the occurrence of unanticipated
events.


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                                     PART I

ITEM 1.  BUSINESS

GENERAL

     The Company uses its patented and proprietary high temperature
superconductor ("HTS") materials, radio frequency ("RF") filter designs and
cryogenic technologies to develop, manufacture and market high performance
products designed to enhance the quality, capacity, coverage and flexibility of
cellular, Personal Communications Services ("PCS") and other wireless
telecommunications services. Superconductor materials, when cooled below a
critical temperature, are able to transmit an electric current with either no or
minimal loss of energy. Because of this minimal energy loss, superconductors are
attractive for a wide range of commercial applications.

     RF filters refine the radio signals by passing radio waves through a series
of resonators (poles), which allow certain frequencies to pass while rejecting
other frequencies. The more poles in the RF filter, the more effective the RF
filter. Each pole, however, has electrical resistance which causes the loss
(insertion loss) of desired radio waves. Therefore, the more poles in a
conventional RF filter, the greater the insertion loss. The advantage of using
superconductors in RF filters is that more poles can be added without
significant increases in insertion loss. Adding superconductors does not,
however, change the fundamental fact that filter performance depends upon the
number of poles. The Company's highest performing RF filters have more than 30
poles, which the Company believes is significantly greater than any other
commercially available filter.

     Filters can be designed with a variety of structures including stripline,
microstrip, cavity, dielectric, and waveguide. The Company is able to produce RF
filters using any of these technologies, but has primarily focused on cavity
filters because of their high performance and tuning flexibility. The Company
uses its proprietary thick-film superconducting technology for its RF filters.
The Company believes that relative to other superconducting materials
technologies, thick-film provides for higher RF filter performance and lower
distortion levels. The Company also believes that its thick-film superconductor
technology is unique in its ability to handle high-powered transmit applications
while maintaining very low levels of intermodulation distortion. In addition,
thick-film technology does not require "clean" rooms for manufacturing, which
reduces the cycle time and cost of production. Superconductors become
superconducting at temperatures of roughly -200(Degree) C. These temperature
levels can be maintained using commercially available mechanical cooling
systems. The Company has developed cryogenic packaging systems for its RF
filters which are highly reliable over longer durations and minimize operating
costs.

     The Company was founded in 1989 by ARCH Development Corporation, an
affiliate of the University of Chicago, to commercialize superconductor
technologies initially developed by Argonne National Laboratory. The Company was
incorporated in Illinois on October 18, 1989 and reincorporated in Delaware on
September 24, 1993. The Company's facilities and principal executive offices are
located at 451 Kingston Court, Mt. Prospect, Illinois 60056 and its telephone
number is (847) 391-9400.

BUSINESS STRATEGY

     The Company's objective is to be the global leader in supplying high
performance RF filter products to the growing wireless telecommunications
market. Key elements of the Company's strategy include the following:

     -   Offering the Highest Performance RF Filter Systems in the Industry. The
         Company's proprietary thick-film and RF filter design technology
         permits the Company to build RF filters with a high level of adjacent
         band interference rejection coupled with a low level of desired signal
         loss. The Company believes that its success will depend upon
         maintaining its technological leadership.

     -   Supplying Price Competitive Products. The Company has been able to
         continually reduce its product cost, which has permitted the Company to
         more competitively price its products. Currently, the price for the
         Company's superconducting filters is approaching that of conventional
         filters. The Company's lowest price product currently sells for less
         than $14,000 per cell site. The Company believes that with superior
<PAGE>   5
         performance and competitive pricing it can become the dominant RF
         filter manufacturer in the world. In 1998, the Company reduced product
         costs by 40%, and in 1999 the Company reduced product costs by an
         additional 30%. The Company believes that it can continue to achieve
         further cost reductions in the coming years due to the design and
         development of new products.

     -   Providing Solutions for Different Market Needs. The Company has
         successfully expanded its product line in response to a wide variety of
         customer needs in a cost-effective manner. The Company recently
         announced the introduction of an expanded family of
         superconductor-based receiver front-end products based upon its
         proprietary ATP(TM)Technology, which combines the industry's
         superconductor-based filter with a unique failure-proof feature that
         ensures continued operation even in the event of a loss of electric
         power. This allows the fastest total-system footprint of any
         superconducting filter solution on the market. The Company has achieved
         this broad product portfolio through flexible designs which can quickly
         be adapted to different customer needs. By addressing the varied needs
         of the market at a reasonable price, the Company aims to provide real
         value to its customers.

     -   Superior Customer Support. The Company strives to exceed its customers'
         expectations for quality and responsiveness by minimizing service
         interruptions. Because of its superior quality and customer support,
         the Company was awarded Motorola's superior quality award in 1998.

     -   Best in Class Reliability. To insure maximum customer retention, the
         Company aims to provide the highest level of reliability to its
         customers. To achieve this, the Company introduced its proprietary
         ATP(TM) technology which insures that its RF filters continue to
         operate even when there is a cooling system or power failure. In
         addition, the Company has chosen its cooler vendor based on superior
         reliability and offers such features as redundant alarms and remote
         diagnostics.

     -   Focusing on Fast Growing Commercial Markets. The Company has focused on
         the fast growing wireless telecommunications market and has deferred at
         this time pursuing other commercial applications of its proprietary
         technology. This focus has minimized overhead costs and allowed the
         Company to be first to market with new RF products and a broader
         product portfolio than its competitors.

     -   Building Long-Term Relationships with Customers. Becoming the preferred
         RF filter vendor with customers will allow the Company to focus on
         expanding its business with new customers and in new markets. To date,
         the Company has established strong relationships with seven of the
         largest wireless operators in the United States. These customers have
         placed repeated orders in multiple markets.

     The Company has received orders from multiple wireless telecommunications
service providers located in the United States, Canada and Asia, including many
of the largest wireless operators in the United States. The Company's RF filters
are now installed in over 300 cell sites in market areas across the United
States.

     The Company is an approved vendor for one of the world's largest cellular
system equipment manufacturers and is pursuing similar relationships with other
OEMs. Being an approved vendor allows cellular and PCS service providers in the
U.S. and abroad to purchase the Company's products directly from the OEM, for
use in both new and existing cell sites.

RECENT DEVELOPMENTS

     On November 5, 1999, the Company entered into and closed a letter agreement
(the "Letter Agreement") with Elliott Associates, L.P. ("Elliott Associates"),
Westgate International, L.P. and Alexander Finance, L.P. (collectively, the
"Investors") in connection with a financing transaction by which the Company
issued to the Investors for $1 million the Company's senior convertible notes
plus warrants for 400,000 shares of the Company's Common Stock. The Investors
also received, under the Letter Agreement, the right, but not the obligation, to
invest, until August 5, 2000, up to an additional $5 million on the same terms,
of which they invested $1 million in December, 1999.

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<PAGE>   6

     The effect of the Letter Agreement and related matters may have been an
acquisition of control of the Company by the Investors and/or their designees to
the Company's board of directors, from the board of directors of the Company as
previously constituted.

     The Letter Agreement granted the Investors the right to designate for
selection as members of the Company's board of directors up to two-thirds of the
Company's board of directors, and affords the Investors the right to accelerate
certain convertible securities held by the Investors in the event that, with
certain exceptions, and after specified periods, such selections are not
appointed or elected as directors. On November 5, 1999, the board of directors
accepted the resignations of board members Messrs. Robert Mitchum and Terry
Parker, expanded the board to six members and, effective November 8, 1999,
appointed Messrs. Mark Brodsky and Samuel Perlman of Elliott Associates and Dr.
George Calhoun of Davinci Solutions, LLC, each a designee of the Investors, to
the Company's board of directors. Mr. Howard Hoffmann, who was designated by the
Investors in July 1998 to be a director of the Company, has served on the board
since that time and continues to serve as a director.

     On November 24, 1999, the Company announced the appointments of Dr. Calhoun
to the position of Chief Executive Officer, Mr. Dennis M. Craig to the position
of President and Mr. Brodsky to the position of Chairman of the Board. These
appointments filled the vacancy created by the departure of Dr. Ted Laves, who
resigned.

     The terms of the Letter Agreement are described below in greater detail
under "Risk Factors - Substantial Number of Shares Eligible for Future Issuance
on Conversion of Notes and Warrant and Option Exercise; Low Conversion and
Exercise Prices; Dilution."

RISK FACTORS

     The following factors, in addition to the other information contained
elsewhere herein, should be considered carefully in evaluating the Company and
its business.

Uncertain Market Acceptance of Superconducting Telecommunications Products

     The Company's RF filter products, which are based on the Company's HTS
technology, have not been sold in very large quantities and a sufficient market
may not develop for the Company's products. The Company's customers establish
demanding specifications for performance and reliability. The Company's RF
filter products may not continue to meet product performance and reliability
criteria set by cellular and PCS service providers. Also, the Company's products
may not operate reliably on a long-term basis, the Company may be unable to
manufacture adequate quantities of any products it develops at commercially
acceptable costs or on a timely basis, or the Company's current or future
products may not achieve market acceptance. The Company has experienced, and may
continue to experience, quarterly fluctuations in its results of operations as
its RF filter products attempt to gain market acceptance while being subject to
the lengthy purchase processes of customers. Failure to successfully develop,
manufacture and commercialize products on a timely and cost-effective basis will
have a material adverse effect on the Company's business, operating results and
financial condition.

Limited Operating History; History of Losses; and Uncertainty of Financial
Results

     The Company was founded in October 1989 and through 1996 was engaged
principally in research and development ("R&D"), product testing, manufacturing,
marketing and sales activities. The Company has only recently begun to generate
significant revenues from the sale of its RF filter products. Prior to the
commencement of these sales, the majority of the Company's revenues were derived
from R&D contracts, primarily from the U.S. government. The Company does not
expect revenues to increase dramatically until it ships a significantly larger
amount of its RF products. Accordingly, the Company has only a limited operating
history upon which an evaluation of the Company and its prospects can be based.
The Company must be considered in light of the risks, expenses and difficulties
frequently encountered by companies in their early stages of product
commercialization.


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     The Company has incurred substantial net losses in each year since its
inception. The Company expects to continue to incur operating losses through at
least the end of 2000 as it continues to devote significant financial resources
to its product development, manufacturing, marketing and sales efforts. Even if
the Company is able to overcome the significant remaining manufacturing and
marketing hurdles necessary to sell large quantities of its RF filter products,
the Company may never achieve a profitable level of operations or, if
profitability is achieved, it may not be sustained.

     The Company's customers are highly concentrated. The loss of an individual
customer may have a material adverse effect on the Company's business. The
wireless telecommunications market is currently experiencing an increasing rate
of consolidation among the largest wireless operators, which may cause a
significant disruption and/or delay in the sales of the Company's products. In
order to continue to grow revenues, the Company may be required to further
reduce the prices of its products. In the event of further price reductions, the
Company may not be able to reduce product costs sufficiently to achieve
acceptable product margins.

Future Capital Needs and Delisting of Common Stock

     To date, the Company has financed its operations primarily through public
and private equity and debt financings. The Company believes that it will
require substantial additional funds during the second quarter of 2000 to carry
on its operations, including the financing of its product development,
manufacturing, marketing and sales activities. In addition, the Company's
outstanding debt instruments contain certain restrictions which may adversely
impair the Company's ability to obtain additional financing. See "Substantial
Leverage; Restrictions Contained in Debt Instruments" below. If additional funds
are raised by issuing other equity or convertible debt securities, further
dilution to existing or future stockholders is likely to result. If adequate
funds are not available on acceptable terms when needed, the Company would be
required to substantially delay, scale-back or eliminate the manufacturing,
marketing or sales of one or more of its products and research and development
programs, or may be required to obtain funds through arrangements with
collaborative partners or others that may require the Company to relinquish
rights to certain of its technologies, product candidates or potential products
that the Company would not otherwise relinquish. This would materially adversely
affect the Company's business, operating results and financial condition.
Inadequate funding also could impair the Company's ability to compete in the
marketplace.

     The Company regularly examines opportunities to expand its technology base
and product line through means such as licenses, joint ventures and acquisitions
of assets or ongoing businesses, and may issue securities in connection with
such transactions. However, no commitments to enter into any such transactions
have been made at this time, and any such discussions may not result in any such
transaction being concluded.

     In addition, the Company currently has no unreserved authorized shares of
its Common Stock, $0.001 par value per share (the "Common Stock"), available for
future issuance in connection with financings. The Company plans to request that
its stockholders approve a substantial increase in the number of authorized
shares at the next annual meeting of the Company's stockholders, scheduled to be
held on May 17, 2000. Failure to obtain this approval would limit the Company's
ability to raise sufficient funds to support its business plans. In addition, if
the stockholders fail to approve the increase, the Investors would have the
right to have their outstanding Notes (as defined below under the caption
"Substantial Number of Shares Eligible for Future Issuance on Conversion of
Notes and Warrant and Option Exercise; Low Conversion and Exercise Prices;
Dilution") redeemed for an amount equal to the greater of (i) the outstanding
principal amount at the time such Notes are tendered to the Company (the "Tender
Date"), plus accrued and unpaid cash interest on the tendered Notes (at February
29, 2000, such interest would have been $589,981) or (ii) the average closing
bid price per share of the Common Stock for the 5 trading days preceding the
Tender Date multiplied by the number of shares the Investors would have received
if they had been able to convert the outstanding aggregate principal amount of
such Notes into shares of Common stock at a conversion price of $0.25 as
provided under the terms of the Notes (at February 29, 2000, such amount would
have been $772,438,511). The Company, at this time, does not have sufficient
liquid assets to comply with such a redemption demand. See "- Substantial Number
of Shares Eligible for Future Issuance on Conversion of Notes and Warrant and
Option Exercise; Low Conversion and Exercise Prices; Dilution."

     The Common Stock is not listed on the Nasdaq Stock Market. Instead, the
Common Stock trades in the over-the-counter market and is quoted on the National
Association of Securities Dealers, Inc. electronic bulletin board. These



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sources do not provide the same type of trading information as Nasdaq, and the
over-the-counter market does not provide the same liquidity for trading as
Nasdaq. This could be having a material adverse effect on the liquidity of the
Common Stock and on the Company's ability to obtain additional funding.

     The Company has applied to have its Common Stock listed on the Nasdaq
SmallCap Market. There can be no assurance, however, whether or when the
application will be approved and the Common Stock listed.

Substantial Leverage; Restrictions Contained in Debt Instruments

     The Company is substantially leveraged. The degree to which the Company is
leveraged may adversely affect the Company's ability to finance its future
operations, to compete effectively against better capitalized competitors and to
withstand downturns in its business or the economy generally. Although the
Company's outstanding Notes (as defined below under "Substantial Number of
Shares Eligible for Future Sale; Dilution") currently permit, subject to certain
restrictions, the Company to pay accrued interest on such securities in shares
of Common Stock, the Company may not be permitted to do so in the future. If the
Company is no longer permitted to pay accrued interest on the Notes in shares of
Common Stock, the Company may not be successful in generating sufficient cash
flows from its operations or raising additional equity or debt financing
sufficient to enable it to pay such interest in cash. Payments due on long-term
debt exceed $2 million in 2001 and $13.3 million in 2002. See Item 8, "Financial
Statements and Supplementary Data," at Note 7. The Company's outstanding Notes
also contain restrictions that may adversely affect the Company's ability to
raise additional equity or debt financing. Under the Notes, the Company is not
permitted, without the prior approval of the holders of the Notes, (i) to incur
any additional indebtedness (other than pursuant to a working capital line of
credit in an amount not to exceed $1 million or to trade creditors in the
ordinary course of business) or to create any lien, pledge, or encumbrance,
subject to certain exceptions, on any assets of the Company, (ii) for so long as
a significant portion of the Notes remain outstanding, to engage in certain sale
or merger transactions, or to engage in certain other transactions which require
the approval of the Company's stockholders, or (iii) to redeem, purchase or
otherwise acquire any equity or debt securities of the Company which are junior
in rights or preferences to the Notes, or to pay any dividend (other than in
shares of Common Stock) with respect to such securities. In addition, in the
event that the Company fails to achieve break-even or positive operating income
during the second quarter of 2001, the Notes may become immediately due and
payable unless the holders thereof agree to modify or waive such provision.
Under the Letter Agreement, the Investors have the right to designate up to
two-thirds of the Company's board of directors.

Volatility of Common Stock Price

     The market price of the Common Stock, like that of many other
high-technology companies, has fluctuated significantly and is likely to
continue to fluctuate in the future. Since January 1, 1999 and through March 13,
2000, the closing price of the Common Stock has ranged from a low of $0.3438 per
share to a high of $29.375 per share. See Item 5. "Market for Registrant's
Common Equity and Related Stockholder Matters." Announcements by the Company or
others regarding the receipt of customer orders, quarterly variations in
operating results, additional equity or debt financings, changes in
recommendations of securities analysts, results of customer field trials,
scientific discoveries, technological innovations, litigation, product
developments, patent or proprietary rights, government regulation and general
market conditions may have a significant impact on the market price of the
Common Stock. In addition, fluctuations in the price of the Common Stock could
affect the Company's ability to have the Common Stock accepted for listing on a
securities market or exchange.

Limited Experience in Manufacturing, Marketing and Sales

     For the Company to be financially successful, it must manufacture its
products in substantial quantities, at acceptable costs and on a timely basis.
Although the Company to date has produced limited quantities of its products for
commercial installations and for use in development and customer field trial
programs, production of large quantities at competitive costs presents a number
of technological and engineering challenges for the Company. The Company may be
unable to manufacture such products in sufficient volume. The Company has
limited experience in manufacturing, and substantial costs and expenses may be
incurred in connection with attempts to manufacture larger




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<PAGE>   9

quantities of the Company's products. The Company may be unable to make the
transition to large scale commercial production successfully.

     The Company's marketing and sales experience to date is very limited. The
Company will be required to further develop its marketing and sales force in
order to effectively demonstrate the advantages of its products over more
traditional products, as well as competitive superconductive products. The
Company may also elect to enter into agreements or relationships with third
parties regarding the commercialization or marketing of its products. If the
Company enters into such agreements or relationships, it will be substantially
dependent upon the efforts of others in deriving commercial benefits from its
products. The Company may be unable to establish adequate sales and distribution
capabilities, it may be unable to enter into marketing agreements or
relationships with third parties on financially acceptable terms, and any third
parties with whom it enters into such arrangements may not be successful in
marketing the Company's products.

     To date, the Company's products have been installed in over 300 cell sites
with a wide geographic dispersion. Although the Company's products have not
experienced any significant reliability problems to date, the Company's products
may develop quality problems in the future. Repeated or widespread quality
problems could result in significant warranty expenses and/or the loss of
customer confidence. The occurrence of such quality problems could have a
material adverse effect on the Company's business, operating results and
financial condition.

Competition

     The wireless telecommunications equipment market is very competitive. The
Company's products compete directly with products which embody existing and
future competing commercial technologies. In particular, in cellular and PCS
telecommunications applications, the Company competes with conventional RF
component manufacturers whose products are currently in use by the Company's
potential customers. Many of these companies have substantially greater
financial resources, larger R&D staffs and greater manufacturing and marketing
capabilities than the Company. Other emerging wireless technologies, including
"smart antennas" and tower mounted amplifiers, may also provide protection from
RF interference and offer enhanced range to cellular and PCS service providers
at lower prices and/or superior performance, and may therefore compete with the
Company's products. High performance RF filters may not become a preferred
technology to address the needs of cellular and PCS service providers. Failure
of the Company's products to improve performance sufficiently, reliably, or at
an acceptable price or to achieve commercial acceptance or otherwise compete
with conventional and new technologies will have a material adverse effect on
the Company's business, operating results and financial condition.

     Although the market for superconductive electronics currently is small and
in the early stages of development, the Company believes it will become
intensely competitive, especially if products with significant market potential
are successfully developed. In addition, if the superconducting industry
develops, additional competitors with significantly greater resources are likely
to enter the field. In order to compete successfully, the Company must continue
to develop and maintain technologically advanced products, reduce production
costs, attract and retain highly qualified personnel, obtain additional patent
or other protection for its technology and products and manufacture and market
its products, either alone or with third parties. The Company may be unable to
achieve these objectives. Failure to achieve these objectives would have a
material adverse effect on the Company's business, operating results and
financial condition.

     During the fourth quarter of 1998, the Company implemented a new pricing
strategy pursuant to which it reduced the prices for all of its products.
Although sales of the Company's products increased significantly during the
fourth quarter of 1998, such sales growth to date has not been consistently
sustained over subsequent periods. Similarly, the Company may not be able to
continue to reduce product costs sufficiently to achieve and maintain acceptable
product margins.

Management of Growth

     Any growth the Company experiences could cause a significant strain on its
management, operational, financial and other resources. The Company's ability to
manage its growth effectively will require it to implement and improve



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<PAGE>   10

its operational, financial, manufacturing and management information systems and
expand, train, manage and motivate its employees. These demands may require the
addition of new management personnel and the development of additional expertise
by management. Any increase in resources devoted to product development and
marketing and sales efforts could have an adverse effect on the Company's
financial performance in the next several fiscal quarters. If the Company were
to receive substantial orders, the Company may have to expand its current
facility, which could cause an additional strain on the Company's management
personnel and development resources. The failure of the Company's management
team to effectively manage growth could have a material adverse effect on the
Company's business, operating results and financial condition.

Rapid Technological Change; Possible Pursuit of Other Market Opportunities

     The field of superconductivity is characterized by rapidly advancing
technology. The success of the Company will depend in large part upon its
ability to keep pace with advancing superconducting technology, high performance
RF filter design and efficient, low cost cryogenic technologies. Rapid changes
have occurred, and are likely to continue to occur, in the development of
superconducting materials and processes. The Company will have to continue to
improve its ability to fabricate thick-film HTS devices, design high performance
RF filters and efficient cryogenic subsystems and produce significant quantities
of products based on these improvements. The Company's development efforts may
be rendered obsolete by the adoption of alternative solutions to current
wireless operator problems or by technological advances made by others. In
addition, other materials or processes, including other superconducting
materials or fabrication processes, may prove more advantageous for the
commercialization of high performance wireless products than the materials and
processes selected by the Company.

     Because HTS product development is a new and emerging field, there may in
the future be new opportunities that are more attractive than those initially
identified by the Company for its targeted markets. As a result, the Company may
elect in the future to commit its resources to such other potentially more
attractive market opportunities. Such election may require the Company to limit
or abandon its current focus on developing, manufacturing, marketing and selling
HTS products for cellular, PCS and other telecommunications markets. The risks
associated with other markets may be different from the risks associated with
the cellular, PCS and other wireless telecommunications markets.

Focus on Wireless Telecommunications Market; Current and Future Competitive
Technologies

     The Company has selected the wireless telecommunications market, in
particular the cellular and PCS markets, as the first principal target market
for its superconductor-based products. The devotion of substantial resources to
the wireless telecommunications market makes the Company vulnerable to adverse
changes in this market. Adverse developments in the wireless telecommunications
market, which could come from a variety of sources, including future
competition, new technologies or regulatory decisions, could affect the
competitive position of wireless systems. Any adverse developments in the
wireless telecommunications market during the foreseeable future would have a
material adverse effect on the Company's business, operating results and
financial condition.

     The Federal Communications Commission ("FCC") has adopted rules that
provide preferential licensing treatment for parties that develop new
communications services and technologies. These developments and further
technological advances may make available other alternatives to cellular or PCS
service, thereby creating additional sources of competition. Competition to
cellular or PCS technologies could adversely affect the market for the Company's
products, or result in changes in the Company's development and manufacturing
programs.

Dependence on a Limited Number of Customers

     To date, the Company's marketing and sales efforts have focused on major
cellular service providers in retrofit applications and, to a lesser extent, on
PCS operators and cellular and PCS original equipment manufacturers. Sales to
three of the Company's customers accounted for over 65% of the Company's total
revenues for 1999. See "Sales and Marketing." The Company expects that if its RF
filter products achieve market acceptance, a limited number of wireless service
providers and OEMs will account for a substantial portion of its revenue during
any period. Sales of many of the Company's RF filter products depend in
significant part upon the decision of prospective customers and



                                       7
<PAGE>   11

current customers to adopt and expand their use of the Company's products.
Wireless service providers and the Company's other customers are significantly
larger than, and are able to exert a high degree of influence over, the Company.
Customers' orders are affected by a variety of factors such as new product
introductions, regulatory approvals, end user demand for wireless services,
customer budgeting cycles, inventory levels, customer integration requirements,
competitive conditions and general economic conditions. The loss of one or more
of the Company's customers or the failure to attract new customers would have a
material adverse effect on the Company's business, operating results and
financial condition.

Lengthy Sales Cycles

     Wireless service providers, wireless equipment OEMs and the Company's other
customers are significantly larger than, and are able to exert a high degree of
influence over, the Company. Prior to selling its products to these customers,
the Company must generally undergo lengthy approval and purchase processes.
Technical and business evaluation by potential customers can take up to a year
or more for products based on new technologies such as HTS. The length of the
approval process is affected by a number of factors, including, among others,
the complexity of the product involved, priorities of the customers, budgets and
regulatory issues affecting customers. The Company may not obtain the necessary
approvals or ensuing sales of such products may not occur. The length of the
Company's customers' approval process or delays could have a material adverse
effect on the Company's business, operating results and financial condition.

Dependence on Limited Sources of Supply

     Certain parts and components used in the Company's RF filter products,
including substrates, vacuum components, and cryogenic refrigerators, are only
available from a limited number of sources. The Company's reliance on these
limited source suppliers exposes the Company to certain risks and uncertainties,
including the possibility of a shortage or discontinuation of certain key
components and reduced control over delivery schedules, manufacturing
capabilities, quality and costs. Any reduced availability of such parts or
components when required could materially impair the Company's ability to
manufacture and deliver its products on a timely basis and result in the
cancellation of orders, which could have material adverse effect on the
Company's business, operating results and financial condition. In addition, the
purchase of certain key components involves long lead times and, in the event of
unanticipated increases in demand for the Company's products, the Company may be
unable to manufacture products in a quantity sufficient to meet its customers'
demand in any particular period. The Company has no guaranteed supply
arrangements with its limited source suppliers, does not maintain an extensive
inventory of parts or components, and customarily purchases parts and components
pursuant to purchase orders placed from time to time in the ordinary course of
business.

     To satisfy customer requirements, the Company may be required to stock
certain long lead time parts in anticipation of future orders. The failure of
such orders to materialize as forecasted could limit resources available for
other important purposes or accelerate the Company's requirement for additional
funds. In addition, such excess inventory could become obsolete which would
adversely affect the Company's financial performance. Business disruption,
production shortfalls or financial difficulties of a limited source supplier
could materially and adversely effect the Company by increasing product costs or
reducing or eliminating the availability of such parts or components. In such
events, the inability of the Company to develop alternative sources of supply
quickly and on a cost-effective basis could materially impair the Company's
ability to manufacture and deliver its products on a timely basis and could have
a material adverse effect on its business, operating results and financial
condition.

Intellectual Property and Patents

     The Company's success will depend in part on its ability to obtain patent
protection for its products and processes, to preserve its trade secrets and to
operate without infringing upon the patent or other proprietary rights of others
and without breaching or otherwise losing rights in the technology licenses upon
which any Company products are based. As of December 31, 1999, the Company has
been issued 29 U.S. patents, has filed and is actively pursuing applications for
8 other U.S. patents, and is the licensee of 6 U.S. patents and patent
applications held by others. One of the



                                       8
<PAGE>   12

Company's patents is jointly owned with Lucent Technologies, Inc. The Company
believes that, since the discovery of HTS materials in 1986, a large number of
patent applications have been filed worldwide and many patents have been granted
in the U.S. relating to HTS materials. The claims in those patents often appear
to overlap and there are interference proceedings pending in the United States
Patent and Trademark Office (not currently involving the Company) regarding
rights to inventions claimed in some of the HTS materials patent applications.
The Company also believes there are a large number of patents and patent
applications covering RF filter products and other products and technologies
that the Company is pursuing. Accordingly, the patent positions of companies
using HTS materials technologies and RF technologies, including the Company, are
uncertain and involve complex legal and factual questions. The patent
applications filed by the Company or by the Company's licensors may not result
in issued patents or the scope and breadth of any claims allowed in any patents
issued to the Company or its licensors may not exclude competitors or provide
competitive advantages to the Company. In addition, patents issued to the
Company or its licensors may not be held valid if subsequently challenged or
others may claim rights in the patents and other proprietary technologies owned
or licensed by the Company. Others may have developed or may in the future
develop similar products or technologies without violating any of the Company's
proprietary rights. Furthermore, the Company's loss of any license to technology
that it now has or acquires in the future may have a material adverse effect on
the Company's business, operating results and financial condition.

     Some of the patents and patent applications owned or licensed by the
Company are subject to non-exclusive, royalty-free licenses held by various
governmental units. These licenses permit these U.S. government units to select
vendors other than the Company to produce products for the U.S. Government which
would otherwise infringe the Company's patent rights which are subject to the
royalty-free licenses. In addition, the U.S. Government has the right to require
the Company to grant licenses (including exclusive licenses) under such patents
and patent applications or other inventions to third parties in certain
instances.

     Patent applications in the U.S. are currently maintained in secrecy until
patents are issued. In foreign countries, this secrecy is maintained for a
period of time after filing. Accordingly, publication of discoveries in the
scientific literature or of patents themselves or laying open of patent
applications in foreign countries tends to lag behind actual discoveries and
filing of related patent applications. Due to this factor and the large number
of patents and patent applications related to HTS materials, RF technologies and
other products and technologies that the Company is pursuing, comprehensive
patent searches and analyses associated with HTS materials, RF technologies and
other products and technologies that the Company is pursuing are often
impractical or not cost-effective. As a result, the Company's patent and
literature searches cannot fully evaluate the patentability of the claims in the
Company's patent applications or whether materials or processes used by the
Company for its planned products infringe or will infringe upon existing
technologies described in U.S. patents or may infringe upon claims in patent
applications made available in the future. Because of the volume of patents
issued and patent applications filed relating to HTS materials, RF technologies
and other products and technologies that the Company is pursuing, the Company
believes there is a significant risk that current and potential competitors and
other third-parties have filed or will file patent applications for, or have
obtained or will obtain, patents or other proprietary rights relating to
materials, products or processes used or proposed to be used by the Company. In
any such case, to avoid infringement, the Company would have to either license
such technologies or design around any such patents. The Company may be unable
to obtain licenses to such technologies or, if obtainable, such licenses may not
be available on terms acceptable to the Company or the Company may be unable to
successfully design around these third-party patents.

     Participation in litigation or patent office proceedings in the U.S. or
other countries, which could result in substantial cost to and diversion of
effort by the Company, may be necessary to enforce patents issued or licensed to
the Company, to defend the Company against infringement claims made by others or
to determine the ownership, scope or validity of the proprietary rights of the
Company and others. The parties to such litigation may be larger, better
capitalized than the Company and better able to support the cost of litigation.
An adverse outcome in any such proceedings could subject the Company to
significant liabilities to third parties, require the Company to seek licenses
from third parties and/or require the Company to cease using certain
technologies, any of which could have a material adverse effect on the Company's
business, operating results and financial condition.



                                       9
<PAGE>   13

     The Company believes that a number of patent applications, including
applications filed by International Business Machines Corporation, Lucent
Technologies, Inc., and other potential competitors of the Company are pending
that may cover the useful compositions and uses of certain HTS materials
including yttrium barium copper oxide ("YBCO"), the principal HTS material used
by the Company in its present and currently proposed products. Therefore, there
is a substantial risk that one or more third parties may be granted patents
covering YBCO and other HTS materials and their uses, in which case the Company
could not use these materials without an appropriate license. As with other
patents, the Company has no assurance that it will be able to obtain licenses to
any such patents for YBCO or other HTS materials or their uses or that such
licenses would be available on commercially reasonable terms. Any of these
problems would have a material adverse effect on the Company's business,
operating results and financial condition.

Government Regulations

     Although the Company believes that its wireless telecommunications products
themselves would not be subject to licensing by, or approval requirements of,
the FCC, the operation of base stations is subject to FCC licensing and the
radio equipment into which the Company's products would be incorporated is
subject to FCC approval. Base stations and the equipment marketed for use
therein must meet specified technical standards. The Company's ability to sell
its wireless telecommunications products is dependent on the ability of wireless
base station equipment manufacturers and wireless base station operators to
obtain and retain the necessary FCC approvals and licenses. In order for them to
be acceptable to base station equipment manufacturers and to base station
operators, the characteristics, quality and reliability of the Company's base
station products must enable them to meet FCC technical standards. Any failure
to meet such standards or delays by base station equipment manufacturers and
wireless base station operators in obtaining the necessary approvals or licenses
could have a material adverse effect on the Company's business, operating
results and financial condition. In addition, HTS RF filters are on the U.S.
Department of Commerce's export regulation list. Therefore, exportation of such
RF filters to certain countries may be restricted or subject to export licenses.

     The Company is subject to governmental labor, safety and discrimination
laws and regulations with substantial penalties for violations. In addition,
employees and others may bring suit against the Company for perceived violations
of such laws and regulations. Defense against such complaints could result in
significant legal costs for the Company. Although the Company endeavors to
comply with all applicable laws and regulations, it may be the subject of
complaints in the future which could have material adverse effect on the
Company's business, operating results and financial condition.

     The Company uses certain hazardous materials in its research, development
and manufacturing operations. As a result, the Company is subject to stringent
federal, state and local regulations governing the storage, use and disposal of
such materials. It is possible that current or future laws and regulations could
require the Company to make substantial expenditures for preventive or remedial
action, reduction of chemical exposure, or waste treatment or disposal. The
Company believes it is in material compliance with all environmental regulations
and to date the Company has not had to incur significant expenditures for
preventive or remedial action with respect to the use of hazardous materials.
However, the operations, business or assets of the Company could be materially
and adversely affected by the interpretation and enforcement of current or
future environmental laws and regulations. In addition, although the Company
believes that its safety procedures for handling and disposing of such materials
comply with the standards prescribed by state and federal regulations, there is
the risk of accidental contamination or injury from these materials. In the
event of an accident, the Company could be held liable for any damages that
result. Furthermore, the use and disposal of hazardous materials involves the
risk that the Company could incur substantial expenditures for such preventive
or remedial actions. The liability in the event of an accident or the costs of
such actions could exceed the Company's resources or otherwise have a material
adverse effect on the Company's business, results of operations and financial
condition. The Company carries property and workman's compensation insurances in
full force and effect through nationally known carriers which include pollution
cleanup or removal and medical claims for industrial incidents.

Dependence on Key Personnel

     The Company's success will depend in large part upon its ability to attract
and retain highly qualified management,



                                       10
<PAGE>   14

administrative, manufacturing, marketing, sales and R&D personnel. Due to the
specialized nature of the Company's business, it may be difficult to locate and
hire qualified personnel. The loss of services of one of its executive officers
or other key personnel, or the failure of the Company to attract and retain
other executive officers or key personnel, could have a material adverse effect
on the Company's business, operating results and financial condition.

Business Interruptions and Dependence on a Single U.S. Facility

     The Company's primary operations, including engineering, manufacturing,
research, distribution and general administration, are housed in a single
facility in Mt. Prospect, Illinois. Any material disruption in the Company's
operations, whether due to fire, flooding, natural disaster, power loss or
otherwise, would have a material adverse effect on the Company's business,
operating results and financial condition. The Company carries property
insurance in full force and effect through a nationally known carrier which
extends coverage for most material disruptions.

Substantial Number of Shares Eligible for Future Issuance on Conversion of Notes
and Warrant and Option Exercise; Low Conversion and Exercise Prices; Dilution

     Under the Letter Agreement dated November 5, 1999 and related agreements
between the Company and the Investors, the Company received $2.0 million from
the Investors during the fourth quarter of 1999 in exchange for:

-    $2.0 million in aggregate principal amount of senior convertible notes,
     bearing annual interest at 10% payable in kind or, at the Company's option
     (or if the Company does not meet certain requirements commencing November
     5, 2001), in cash, which notes (the "New Notes") are convertible, based on
     their principal amount plus accrued interest to the extent such interest is
     payable in kind, into Common Stock at a conversion price of $0.25 per
     share, and mature on January 2, 2001;

-    five-year warrants (the "New Warrants") exercisable for an aggregate of
     800,000 shares of Common Stock at an exercise price of $0.25 per share; and

-    the right, but not the obligation, to invest up to an additional $4.0
     million during the nine months following execution of the Letter Agreement
     on the same terms as the Investors' acquisition of the New Notes and New
     Warrants.

Except for terms specified in the Letter Agreement, the New Notes and New
Warrants have the same terms as the notes and warrants issued by the Company in
March 1999.

     The Letter Agreement also reduced to $0.25 per share the conversion and
exercise prices, respectively, of (i) $11.8 million in aggregate principal
amount of outstanding senior convertible notes (the "Old Notes" and, together
with the New Notes, the "Notes"), and (ii) warrants to acquire 4,834,782 shares
(the "Old Warrants" and, together with the New Warrants, the "Warrants") held by
the Investors. The Old Notes and Old Warrants originally were issued in May 1998
and March 1999 and, in the case of the Old Warrants, October 1997.

     As of December 31, 1999, the Company had (i), including the Warrants,
outstanding warrants to purchase 6,735,681 shares of Common Stock at a weighted
average exercise price of $0.7976 per share and (ii) options to purchase
1,914,847 shares of Common Stock at a weighted average exercise price of $1.83
per share (1,516,566 of which have not yet vested) issued to employees,
directors and consultants pursuant to the Company's Amended and Restated 1993
Stock Option Plan, as amended, and individual agreements with management and
directors of the Company. In order to attract and retain key personnel, the
Company may issue additional securities, including stock options, in connection
with its employee benefit plans. During the terms of the Notes and such options
and warrants (including the Warrants), the holders thereof are given the
opportunity to benefit from a rise in the market price of the Common Stock.

     The conversion of the Notes into, or the exercise of options and warrants
(including the Warrants) for, Common Stock, as well as the sale or issuance by
the Company of additional shares of Common Stock and/or rights to purchase




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<PAGE>   15

Common Stock, would likely have an adverse or dilutive effect on the market
value of the Common Stock. The Company also may in the future offer equity
participation in connection with the obtaining of non-equity financing, such as
debt or leasing arrangements accompanied by warrants to purchase equity
securities of the Company. This could also have a dilutive effect upon the
holders of Common Stock.

Anti-Takeover Provisions

     The Company has certain arrangements which may be deemed to have a
potential "anti-takeover" effect in that such provisions may delay, defer or
prevent a change of control of the Company. In February 1996, the Board of
Directors of the Company (the "Board of Directors") adopted a stockholders
rights plan (the "Rights Plan"). By causing substantial dilution to a person or
group that attempts to acquire the Company on terms not approved by the Board of
Directors, the Series A Rights and Series B Rights of the Rights Plan may
interfere with certain acquisitions, including acquisitions that may offer a
premium over market price to some or all of the Company's stockholders. Further
discussion of the Rights Plan is set forth herein under the heading "Item 5.
Market for Registrant's Common Equity and Related Stockholder Matters-Rights
Plan." In addition, the Company's Certificate of Incorporation and By-Laws
provide that (i) stockholder action may be taken only at stockholders meetings;
(ii) the Board of Directors has authority to issue series of the Company's
preferred stock with such voting rights and other powers as the Board of
Directors may determine; (iii) prior specified notice must be given by a
stockholder making nominations to the Board of Directors or raising business
matters at stockholders meetings; and (d) the Board of Directors is divided into
three classes, each serving for staggered three-year terms. In addition, the
Company's outstanding debt instruments contain provisions which may be deemed to
have a potential "anti-takeover" effect. The interests of the holders of such
debt instruments could conflict with the interests of the Company's
stockholders. See "Substantial Leverage; Restrictions Contained in Debt
Instruments" above.

WIRELESS TELECOMMUNICATIONS INDUSTRY BACKGROUND

     The wireless telecommunications industry has experienced significant
growth, both domestically and internationally, in recent years. This growth
appears to be due to the increasing popularity of wireless telecommunications,
the entry of new service providers into the market as governments open up new RF
spectrum, the continuing decline in the price of service and wireless
telephones, and the introduction of new service features. Rapid growth has
intensified RF interference while increasing wireless operators' demand for
improved system quality, lower capital expenditures per customer, and
co-location of multiple antennas with other RF transmitters at a single cell
site.

     In the United States, wireless telecommunications services customers now
frequently have a choice of at least four wireless service providers. Digital
technologies such as Global System for Mobile Telecommunications ("GSM"), Code
Division Multiple Access ("CDMA"), and Time Division Multiple Access ("TDMA")
allow operators to offer such advanced features as short message service, fax,
three-way conferencing and call waiting. Wireless systems are also marketed as a
convenient and economical substitute for regular wireline telephone service. In
addition, service providers are also trying to differentiate themselves on the
basis of quality, price, coverage, and advanced service features. The rapid
growth in competition in wireless telecommunications services is forcing
operators to reduce costs and to seek out new cost effective solutions such as
high performance filters which can reduce capital costs while increasing network
capacity. Already, manufacturers and operators are beginning to plan a new and
more advanced form of wireless telecommunications called Third Generation
cellular or "3G." 3G is expected to provide full Internet access and video
teleconferencing services. The first 3G network is expected to become commercial
in Japan in 2001 and in Europe soon thereafter.

     Industry statistics demonstrate the rapid growth of the wireless
telecommunications industry. The Cellular Telecommunications Industry
Association ("CTIA") reports that as of June 1998 there were over 60 million
wireless customers in the United States. Industry publications, as well as other
industry sources, have estimated a total worldwide wireless customer base of
approximately 207 million at the end of 1997. Several industry sources have
estimated the customer base will exceed 830 million by the end of 2003. The
Company anticipates that the need to provide improved service on a cost
effective basis in an increasingly congested environment will lead wireless
service providers to invest in new infrastructure technologies such as high
performance RF filters.

                                       12
<PAGE>   16

     The rapid growth and increased competition experienced by the wireless
telecommunications industry has increased the difficulty of providing quality
wireless services. Wireless service providers face the challenge of providing
quality services in an environment increasingly characterized by RF interference
and congestion. In addition, the rapid rate of growth and community concerns
have affected the manner in which service providers locate their base stations.
Many communities are objecting to the proliferation of new towers to provide
wireless services. Base stations which provide the link between a wireless user
and the telecommunications network are being positioned closer together and
often in the same location, which results in RF interference problems. There has
also been a dramatic proliferation in the use of portable hand held phones which
transmit weaker signals than mobile or car-mounted phones. As a result, cellular
networks which were laid out based on mobile phone power levels have, in many
areas, developed coverage gaps which operators must fill in to satisfy their
goals of providing seamless coverage. To lower costs, many cellular and PCS
operators are sharing antenna sites with other cellular and PCS operators, and
with television stations, paging operators and two-way radio transmitters. Such
close proximity of radio transmitters can cause RF interference problems which
degrade the quality and capacity of wireless telecommunications systems.
Furthermore, in order to compete with these already broadly deployed cellular
networks, new PCS service providers need to deploy coverage quickly and with the
lowest possible capital investment.

     Recently, several wireless system operators have sold their antenna towers
to third party management companies which then lease space for base stations and
their antennas back to the system operator. In addition to managing the tower
site for the existing system operator, these management companies lease
additional space at the tower site to other wireless providers, including
television stations, paging operators and two-way radio transmitters. The
Company believes that the activities of these management companies will
facilitate an increase in the co-location of multiple wireless providers over
time. The Company believes that this trend may lead to an increase in the demand
for high performance filters as concerns over RF interference and congestion
increase.

THE COMPANY'S SOLUTION

     The Company's products are designed to address the high performance RF
front-end needs of domestic and international commercial wireless
telecommunication systems by providing the following advantages:

-    GREATER NETWORK CAPACITY AND UTILIZATION. The Company's RF front-end
     products can increase the capacity and utilization of a wireless base
     station by up to 18%. In some cases, capacity increases because channels
     which were previously unusable due to interference are recovered. In other
     cases, system utilization increases because of lower levels of blocked and
     dropped calls, and increases in the ability of the system to permit weak
     signals to be processed with acceptable call quality. In CDMA systems,
     increased capacity frequently results from lowering the system's noise
     floor.

-    REDUCED CDMA CELL SITE BREATHING. Coverage for CDMA digital systems
     decreases as the number of users increases. To maintain network coverage,
     an operator can increase the number of cell sites, add radio carriers, or
     use the Company's high performance RF filters with cooled low noise
     amplifiers ("LNAs").

-    IMPROVED BASE STATION RANGE. Based upon comparative field trials in
     multiple rural locations in the United States, and as confirmed by computer
     propagation models conducted by customers of the Company, the Company's RF
     front-end systems (high performance filter and cryogenically-cooled LNA)
     can extend the uplink range of a wireless system by up to 30%. Greater
     range can reduce a service operator's capital expenditure per customer in
     lower density areas by filling in coverage gaps in existing systems or by
     reducing the number of required cell sites for new system deployments. This
     is true for both analog and digital systems.

-    IMPROVED FLEXIBILITY IN LOCATING BASE STATIONS. The Company's RF front-end
     products can allow wireless telecommunications service providers to
     co-locate base stations near other RF transmitters. The



                                       13
<PAGE>   17
     Company's products allow the base station radio to better tolerate RF
     interference while reducing out-of-band signals that could interfere with
     other nearby wireless telecommunications operators.

-    IMPROVED CALL QUALITY. The Company's RF filter products improve call
     quality by reducing dropped and blocked calls. During commercial
     installations and field trials, the Company's RF filter products have
     frequently demonstrated a 20 to 40 percent reduction in dropped calls
     caused by out-of-band interference and base station front-end overloading.
     During these commercial installations and field trials, the Company's RF
     filter products have also demonstrated a similar reduction in blocked calls
     experienced in urban cellular locations. The Company's RF filter products
     also frequently improve audio fidelity by reducing noise and interference.

-    SIMPLER TRANSMITTER SYSTEM DESIGNS. The Company believes that its line of
     RF transmit filters can allow for simpler, less costly transmitters,
     particularly for digital systems. These RF transmit filters should improve
     system performance while diminishing system costs.

-    IMPROVED DIGITAL SYSTEM CAPACITY. The Company believes that its recently
     introduced line of transmit combiners allow increased capacity and range in
     CDMA systems as system loading increases. CDMA systems appear unable to
     offer multi-carrier systems without the use of a combiner, but traditional
     combiners reduce the power transmitted from the base station antenna. The
     Company's filter technology allows operators to use combiners with lower
     loss of desired signals.

PRODUCTS

     Recently the Company introduced the ATP(TM) Classic, an expansion of its
product line offering All Temperature Performance (ATP(TM)). ATP(TM), which was
first introduced in late 1998, is a unique and proprietary technology that
provides all the benefits of a superconducting filter when the system is
operating normally, and continues to provide good quality performance,
equivalent to conventional technology, when the product is not cryogenically
cool. The ATP(TM) feature essentially eliminates any concerns about loss of cell
site operation in the event of power or cooling system failure. In addition,
these products resume superconducting performance automatically when power is
restored, without the need for any mechanical bypass circuitry or backup
filters. This not only means greater peace of mind for the operators when
installing ATP(TM), but also means that, for new cell sites, ATP(TM) products
can serve as the only front-end filter system, eliminating the cost and space
associated with conventional filters bought with the base station equipment.

     The Company currently offers six basic product lines within two product
families to address the needs of cellular and PCS service providers. The
SpectrumMaster(R) product family represents a line of superconducting filters
designed primarily to improve the RF performance of cellular and PCS systems in
high interference environments, including urban areas and those sites near
airports. These RF performance improvements serve to maximize the capacity and
coverage of existing systems. The RangeMaster(R) product family combines the
interference rejection and low insertion loss advantages of a superconducting
filter with a cooled low noise amplifier (LNA). Products in the RangeMaster(R)
family are designed to serve two principal needs of cellular and PCS operators:
(i) range extension for those sites located in rural, suburban or small city
environments and (ii) increased capacity for digital cellular and PCS sites
located in all areas. Each of the product lines within a family provides
different filter performance levels to meet the different needs of system
operators. All of the Company's currently offered products can be supplied in
domestic and international frequencies for both cellular (800 MHz) and PCS (1900
MHz) applications.

     The Company has also produced duplexer and combiner products that are
offered in a PowerMaster(TM) product family. The PowerMaster(TM) product family
incorporates the Company's filter technologies into RF transmitter products. The
PowerMaster(TM) duplexer was designed to allow the co-location of multiple
wireless systems at a single site. The PowerMaster(TM) combiner was designed to
improve the range and capacity of multi-carrier CDMA systems.



                                       14
<PAGE>   18

     The Company believes that products in its SpectrumMaster(R) family offer
the world's highest performance commercial front-end R.F. filters for the
wireless telecommunications market. SpectrumMaster(R) improves the RF
performance of cellular and PCS systems in high interference environments,
including urban areas and those sites near airports. These RF performance
improvements allow a service provider to maximize the capacity and coverage of
cell sites in its system. SpectrumMaster(R) is available in two models; the
Ultra and the Extreme. The SpectrumMaster(R) Ultra is a high performance filter
with 16 filter poles for very noisy RF environments. SpectrumMaster(R) Ultra
provides superior rejection of unwanted signals over conventional filters, while
losing very little of the desired signals and providing an extremely linear
filter response for digital CDMA systems. The SpectrumMaster(R) Ultra has been
shown in testing to improve the uplink capacity of a cellular CDMA system by
lowering the noise floor at the base station receiver and allowing more
simultaneous calls to be supported. The SpectrumMaster(R) Extreme has been
developed for the even higher performance levels required by third generation
(3G) systems. A SpectrumMaster(R) Extreme filter was shipped to Japan for
testing with 3G systems under development there. The SpectrumMaster(R) Extreme
filter provides an unprecedented 19dB per 100 kHz of rejection from the edge of
its passband. The Company sold its first SpectrumMaster(R) product to cellular
service providers in the second half of 1996 and sales of SpectrumMaster(R) have
continued to grow since then.

     RangeMaster(R) products combines the interference rejection and low
insertion loss advantages of a superconducting filter with a cooled low noise
amplifier (LNA). RangeMaster(R) products lower the noise seen by a base station
receiver and improve its sensitivity, or ability to hear weaker signals. This
enables these products to meet the need of cellular and PCS operators to extend
the range of those cell sites that have difficulty in hearing the lower power
transmissions of portable phones. RangeMaster(R) products have also been shown
to improve the capacity of digital systems, especially those incorporating CDMA.
Capacity improvements of 30% to 50% have been recorded for both the uplink
(mobile phone to base station path) and downlink (base station to mobile phone
path) during testing at PCS frequencies. RangeMaster(R) is available in four
models: (i) the ATP(TM) 150 is designed primarily for rural and suburban range
extension, (ii) the ATP(TM) Classic provides filter rejection performance, and
is intended for either range extension or capacity improvement at higher
interference sites, (iii) the RangeMaster(R) Ultra is designed for either range
extension or capacity improvement situations at severe interference sites, and
the Company believes, provides the best filter performance available
commercially in the U.S. today, and (iv) the RangeMaster(R) Extreme is designed
for both range and capacity improvements for 3G systems being developed
internationally. Several RangeMaster(R) Extreme units have been shipped to OEMs
in Japan for evaluation with 3G systems under development there.

     For the fiscal years ended December 31, 1999, 1998 and 1997, sales to
customers within the United States accounted for approximately 93.9%, 93.3% and
84.6% of the Company's revenues. Sales to customers within Japan accounted for
most of the balance of the Company's revenues in such fiscal years.

TECHNOLOGY

     The Company possesses proprietary technology in three areas: the design of
high performance RF cavity filters, thick-film superconducting materials
fabrication and cryogenic packaging.

     The Company's products are based on its proprietary RF cavity filter
designs. The Company believes that cavity filter technology provides superior
filter performance with low intermodulation distortion when compared with
alternative technologies, such as RF stripline filter technology (which the
Company is also capable of using). The Company has been able to use its cavity
filter technology to offer filters with over 30 poles. The more poles in a
filter, the better its rejection of unwanted signals. The Company believes its
products are superior to other RF filters with regard to rejection of unwanted
signals.

     The Company is able to offer RF cavity filters with superior filtering, low
loss of unwanted signals, and high power handling because of its proprietary
thick-film superconducting fabrication technology. The Company's thick-film
fabrication technology allows the Company to utilize a variety of filter
technologies including cavity and strip line designs. The Company's
superconducting technology is simple and relatively inexpensive to manufacture
and offers superconducting yields consistently above 96%. The Company believes
the electrical performance of the



                                       15
<PAGE>   19

Company's products is superior to any alternative superconducting technology
currently available for RF filters. The Company's thick-film superconducting
technology can handle up to 70 watts of continuous power at 800 Mhz.

     High-temperature superconductors become superconducting at -200(Degree) C.
This temperature can be attained using widely available mechanical
refrigerators. The Company has developed proprietary technologies which provide
an efficient, low cost cryogenic package with a long life cycle and minimum
power consumption. Together, the Company believes that its technological
excellence in filter design, superconducting materials and cryogenic packaging
provide it with a unique and well-protected technology advantage over its
competitors.

SALES AND MARKETING

     The Company has focused its sales and marketing effort on U.S. wireless
service providers for retrofit applications. To date, the Company has sold its
products to many of the largest cellular operators in the United States as well
as to numerous mid-size and smaller U.S. wireless operators. The Company has
also sold or leased filters to two major international operators and has
successfully tested its PCS RangeMaster(R) product with two of the largest U.S.
PCS operators. The Company has also tested its PowerMasterTM line with two major
OEMs and is discussing specifications with others. The Company has been named as
an approved vendor to one of the largest OEMs, allowing cellular and PCS
operators throughout the world the opportunity to purchase the Company's
products directly from the OEM.

     The Company's marketing and sales personnel work directly with both PCS
service providers and PCS OEMs to enhance the probability of sales success in
this rapidly growing market. The Company has continued technical discussions
with multiple PCS OEM's regarding integrating the Company's RF filter products
into such OEM's PCS product line. To date, the Company's PowerMasterTM PCS
transmit filter/duplexer has been tested in the laboratories of two PCS
equipment OEMs.

During 1999, sales to three of the Company's customers, ALLTEL Corporation,
Cellular One and Cellular 2000, accounted for approximately 50%, 11% and 7% of
the Company's total revenues, respectively.

MANUFACTURING

     The Company's state-of-the-art manufacturing process provides predictable
product yields and can be easily expanded to meet increased customer demand.
Superconducting component yields are now consistently above 96%, with low scrap
levels. Manufacturing costs were reduced by 50% during 1997 due to volume,
design and yield efficiencies, and reduced by another 40% in 1998 due to
redesign and resourcing efforts, and 30% in 1999. The Company has focused its
manufacturing efforts on maintaining control of key technologies while avoiding
the cost and complexities of vertical integration. The Company's manufacturing
operations consist primarily of the manufacture of superconducting components
from raw materials, and the assembly, tuning, testing and quality verification
of the Company's products. All of these activities occur at the Company's
manufacturing facility in Mt. Prospect, Illinois, which began operations during
1996. The Company believes that the manufacture of its RF filter products
requires only moderate capital investments and is scaleable. The Company also
believes that capacity can be rapidly expanded to meet growing demand without
the need for large, upfront capital investments. The Company purchases all of
the components for its filter products, except for superconducting components,
from third party suppliers. The Company believes it has access to adequate
supplies of these purchased components, most of which are produced according to
the Company's proprietary designs and specifications. The Company is using its
just-in-time manufacturing capability to maximize quality, insure flexibility,
limit management complexity and minimize inventory cost.

RESEARCH AND DEVELOPMENT

     The Company's R&D efforts have been focused on developing and improving RF
filter products for wireless telecommunications systems. As a result of such
efforts, filter performance has been improved, product size has been reduced,
production costs have been lowered, product reliability has been increased, and
product packaging



                                       16
<PAGE>   20
has been streamlined. The Company expects to continue to invest in R&D to
further improve and adapt its filter products to meet and exceed market
expectations. The Company also intends to develop related products that are
synergistic with its core filter offerings and which utilize the Company's core
technical competencies in RF filter design, superconducting materials, and
cryogenic cooling systems.

     The Company's total R&D expenses during 1997, 1998 and 1999 were
approximately $4,132,000, $2,935,000 and $1,757,000, respectively.

INTELLECTUAL PROPERTY AND PATENTS

     The Company regards certain elements of its product design, fabrication
technology and manufacturing process as proprietary and protects its rights in
them through a combination of patents, trade secrets and non-disclosure
agreements. The Company also has obtained exclusive and non-exclusive licenses
for technology developed with or by its research partners, Argonne National
Laboratory ("Argonne") and Northwestern University, and expects to continue to
obtain licenses from such research partners and others. The Company believes
that its success will depend in part upon the protection of its proprietary
information, its patents and licenses of key technologies from third parties,
and its ability to operate without infringing on the proprietary rights of
others.

     As of December 31, 1999, the Company has been issued 29 U.S. patents, has
filed and is actively pursuing applications for 8 other U.S. patents, and is the
licensee of 6 patents and patent applications held by others. Such patents and
patent applications relate to various aspects of the Company's superconductor
technology, the design of HTS filters, methods for packaging and cooling, and
system implementation techniques. One of the Company's patent applications has
been filed jointly with Lucent Technologies, Inc. and relates to superconducting
filters. Additional inventions are the subject of a group of patent applications
currently under preparation. Furthermore, the Company expects to pursue foreign
patent rights on certain of its inventions and technologies critical to its
products.

     In 1994, the Company purchased from Ceramic Process Systems two additional
patents and the related technical know-how covering a process for producing
yttrium barium copper oxide ("YBCO") powder and manufacturing YBCO electrical
fibers. In 1994, the Company also purchased technology relating to the
fabrication of HTS thick-film components from the University of Birmingham (UK).
This thick-film technology complements the Company's existing patented processes
for making thick-film superconducting components.

     Through collaborative relationships with Argonne and Northwestern
University, the Company has licensed patents and patent applications issued or
filed in the United States and in certain foreign countries arising under or
related to such collaborative relationships. These licenses primarily relate to
the processing and composition of HTS materials, including the preferential
orientation of HTS materials and the processing of YBCO on a variety of metals,
as well as design technology for some of the Company's current and proposed
products. The Company's licenses from ARCH Development Corporation and
Northwestern University continue for the lives of the patent rights licensed
thereby, subject to termination on certain events, and permit the Company to
retain rights to its patentable improvements to the licensed technology. Certain
of the Company's research has been funded in part by Small Business Innovation
Research and other government contracts. Although the U.S. Government has or
will have certain rights in the technology developed with this funding, the
Company does not believe that these rights will have a material impact on the
Company's current RF filter products.

COMPETITION

     The market for wireless telecommunications products is very competitive.
The Company views its competition as (i) conventional RF filter products, (ii)
RF products based on new technologies and (iii) other superconductor-based RF
products.

     The Company's RF filter products compete against conventional RF filter
products produced by such companies as Celwave, certain divisions of the Allen
Telecom Group, Inc., Filtronic Comtek, Sinclair Radio Labs, Inc., K&L Microwave,
Inc., Wacom Technology Corp., EMR Corp. and TX-RX Systems, Inc., among others.



                                       17
<PAGE>   21

Although these conventional RF filter products are generally less expensive than
the Company's products, the Company believes its RF filter products are superior
on a cost/benefit basis.

     Other competitive RF products based on other technologies may provide
competition in the future to the Company's RF filter products. In addition to
competitive RF filter products, other companies including, Hazeltine Corp.,
Metawave Communications Corporation, Allen Telecom Group, Inc., Repeater
Technologies, Inc. and Array Com, Inc., among others, are developing products
based on "smart antenna," digital signal processing technologies, microcells and
repeaters which are also aimed at reducing interference problems or providing
range extension by means other than RF filtering. Furthermore, various vendors
are offering tower mounted amplifiers ("TMAs") which provide similar range
extension benefits to the Company's filters with cooled LNAs. TMAs are generally
less expensive than the Company's products but require greater maintenance costs
due to their location on top of the operator's antenna tower.

     Various filter companies appear to be experimenting with cooled dielectric
filters or with filters that combine dielectric materials and superconducting
technology. K&L Microwave, Inc. has been experimenting with a cooled dielectric
filter design. In addition, COM DEV International, Ltd., a Canadian corporation,
has published research in which a dielectric material is mounted on a
superconducting ground plane. The Company does not believe that either of these
efforts currently pose a competitive threat but cannot exclude them as
competition to the Company's product lines at some point in the future.

     Two other companies, Conductus, Inc. and Superconducting Technologies,
Inc., are currently marketing superconducting filters to the wireless
telecommunications marketplace. In addition, a number of large multinational
companies are engaged in R&D programs that could lead to the commercialization
of superconducting filters for the wireless telecommunications marketplace.
These companies include, among others, E.I. DuPont de Nemours & Co., Fujitsu
Corporation, NEC Corporation, Kyocera Corporation, and Matsushita Electric
Industrial Co., Ltd. The Company believes that all of these companies are
working on RF stripline filters using epitaxial thin-film superconducting
technology. None of these filters are expected to be commercially implemented in
the near future. The Company believes that RF stripline superconducting filters,
while smaller, are technically unable to provide equivalent rejection of
unwanted signals, competitively low levels of intermodulation distortion, as
large a number of filter poles, or similar levels of power handling.

     The Company believes that it competes on the basis of product performance,
price, breadth of product portfolio, customer support, quality, reliability and
focus on the wireless telecommunications market. Many of the Company's
competitors have substantially greater financial resources, larger R&D staffs
and greater manufacturing and marketing capabilities than the Company.

GOVERNMENT REGULATIONS

     Although the Company believes that its wireless telecommunications products
themselves are not licensed or governed by approval requirements of the Federal
Communications Commission ("FCC"), the operation of base stations is subject to
FCC licensing and the radio equipment into which the Company's products would be
incorporated is subject to FCC approval. Base stations and the equipment
marketed for use therein must meet specified technical standards. The Company's
ability to sell its RF filter products is dependent on the ability of wireless
base station equipment manufacturers and of wireless base station operators to
obtain and retain the necessary FCC approvals and licenses. In order to be
acceptable to base station equipment manufacturers and to base station
operators, the characteristics, quality, and reliability of the Company's base
station products must enable them to meet FCC technical standards.

     The Company uses certain hazardous materials in its research, development
and manufacturing operations. As a result, the Company is subject to stringent
federal, state and local regulations governing the storage, use and disposal of
such materials. It is possible that current or future laws and regulations could
require the Company to make substantial expenditures for preventive or remedial
action, reduction of chemical exposure, or waste treatment or disposal. The
Company believes it is in material compliance with all environmental regulations
and to date the Company has not had to incur significant expenditures for
preventive or remedial action with respect to the use of hazardous materials.


                                       18
<PAGE>   22

EMPLOYEES

     As of January 31, 2000, the Company had a total of 31 employees, ten of
whom hold advanced degrees. Of the employees, ten are engaged in manufacturing
and production, ten are engaged in research, development and engineering, and 11
are engaged in general management, marketing, sales, finance and administration.
The Company also periodically employs a number of consultants and independent
contractors. The Company considers its relations with its employees to be
satisfactory.

ITEM 2.  PROPERTIES

     The Company maintains its corporate headquarters in a 35,000 square foot
building located in Mt. Prospect, Illinois under a lease which expires in
October 2004. This facility also houses the Company's manufacturing, research,
development, engineering and marketing activities. The Company believes that
this facility is adequate and suitable for its current needs and that additional
space would be available on commercial terms as necessary to meet any future
needs.

ITEM 3.  LEGAL PROCEEDINGS

Siegler Litigation

     On June 5, 1996, Craig M. Siegler filed a complaint against the Company in
the Circuit Court of Cook County, Illinois, County Department, Chancery
Division. The complaint alleged that, in connection with the Company's private
placement of securities in November 1995, the Company breached and repudiated an
oral contract with Mr. Siegler for the issuance and sale by the Company to Mr.
Siegler of 370,370.37 shares of the Company's Common Stock, plus warrants
(immediately exercisable at $12.96 per share) to purchase an additional
370,370.37 shares of the Company's Common Stock, for a total price of
$4,000,000. The remedy sought by Mr. Siegler was a sale to him of such
securities on the terms of the November 1995 private placement. On August 16,
1996, the Company's motion to dismiss Mr. Siegler's complaint was granted with
leave to amend. On September 19, 1996, Mr. Siegler's motion for reconsideration
was denied.

     On October 10, 1996, Mr. Siegler filed his First Amended Verified Complaint
and Jury Demand, seeking a jury trial and money damages equal to the difference
between $8,800,000 (370,370.37 shares at $10.80 per share and 370,370.37 shares
at $12.96 per share) and 740,740.74 shares multiplied by the highest price at
which the Company's Common Stock traded on The Nasdaq Stock Market between
November 20, 1995 and the date of judgment. Mr. Siegler also preserved his claim
for specific performance for purposes of appeal. On November 1, 1996, the case
was transferred to the Circuit Court of Cook County, Illinois, County
Department, Law Division. The Company's Answer was filed on November 21, 1996
and the parties have completed discovery.

     The Company filed a motion for summary judgment against Mr. Siegler, which
is on hold pending the deposition of an expert retained by Mr. Siegler in the
case. The Company is scheduled to take the expert's deposition in March 2000,
after which the court will enter a briefing schedule on the motion for summary
judgement.

     The Company believes that the suit is without merit and intends to continue
to defend itself vigorously in this litigation. However, if Mr. Siegler prevails
in this litigation and is awarded damages in accordance with the formula
described above, such judgment would have a material adverse effect on the
Company's financial condition, results of operations and cash flows.

Note Litigation

     On July 10, 1997, the Company filed a complaint against Sheldon Drobny;
Howard L. "Buzz" Simons, joint tenant with Aric and Corey Simons; Aaron Fischer;
Stewart Shiman; Sharon D. Gonsky, d/b/a SDG Associates;



                                       19
<PAGE>   23

Gregg Rosenberg; Stacey Rosenberg; Merrill Weber & Co., Inc.; Drobny/Fischer
Partnership, an Illinois general partnership; and Ruben Rosenberg (collectively,
the "Borrowers"), and Paradigm Venture Investors, L.L.C. (the "Guarantor") in
the Circuit Court of Cook County, Illinois, County Department, Law Division. The
complaint seeks to enforce the terms of loans made to the Borrowers by the
Company and evidenced by promissory notes dated December 13, 1996, in the
aggregate principal amount of $698,508 ($680,696 of which remains unpaid as of
December 31, 1999) and the guarantee by the Guarantor of the Borrowers'
obligations under these promissory notes. The Borrowers' notes were issued to
the Company in connection with the Borrowers' exercise of warrants to purchase
shares of the Common Stock in December 1996.

     On September 30, 1997, the Borrowers and the Guarantor responded to the
Company's complaint. Concurrently, the Borrowers filed a counterclaim alleging
that they exercised the warrants in reliance on the Company's alleged fraudulent
representations to certain Borrowers concerning a third-party's future
underwriting of a secondary public offering of the Company's Common Stock.

     On February 22, 2000, the Company reached a settlement agreement with the
Borrowers, whereby the Company agreed to release the Borrowers' obligations
under the notes in return for the Borrowers' surrender of 210,196 warrants to
purchase common stock of the Company held by them and discharge of their
counterclaims. As a result of this settlement, the Company will record a charge
of $822,776 to additional paid-in capital in the first quarter of 2000,
reflecting the carrying amount of the notes of $680,696 and related accrued
interest of $142,080, which approximates the fair value of the warrants
surrendered.

Lipman Litigation

     On January 6, 1998, Jerome H. Lipman, individually and on behalf of all
others similarly situated, filed a complaint against the Company and eight of
its former or current directors: Leonard A. Batterson, Michael J. Friduss, Peter
S. Fuss, Edward W. Laves, Steven L. Lazarus, Tom L. Powers, Ora E. Smith and
Paul G. Yovovich (collectively, the "Named Directors") in the Circuit Court of
Cook County, Illinois, County Department, Chancery Division. The complaint
alleged that the Named Directors breached their duties of loyalty and due care
to the putative class of stockholders by selecting financing for the Company in
June 1997 which supposedly entrenched the Directors and reduced the Common Stock
price. The complaint also alleged that the Named Directors breached their duty
of disclosure by not informing the stockholders that the selected financing
would erode the Common Stock price. Mr. Lipman's complaint sought certification
of a class consisting of all owners of the Company's Common Stock during the
period from June 6, 1997 through November 21, 1997, excluding the Named
Directors and Sheldon Drobny. The complaint also seeks an unspecified amount of
compensatory and punitive damages, and attorneys' fees.

     The Company and the Named Directors regard the suit as without factual or
legal merit. Accordingly, on February 17, 1998, the Company and the Named
Directors filed a motion to dismiss Mr. Lipman's complaint. The motion presented
arguments that the claims of Mr. Lipman and the putative class are barred by the
business judgment rule and the plaintiff's failure to fulfill the legal
prerequisites for filing an action against the Named Directors. Prior to a
hearing on the Company's and the Named Directors' motion to dismiss, Mr. Lipman
filed a motion on March 16, 1998, seeking both to amend his proposed putative
class to include Mr. Drobny and to certify the class.

     On June 1, 1998, the court granted the Company's and the Named Directors'
motion to dismiss the complaint. Concurrently, Mr. Lipman withdrew his motion to
amend the proposed putative class and certify the class. On June 30, 1998, Mr.
Lipman filed an amended complaint against the Named Directors but excluding the
Company itself as a defendant. The amended complaint alleges that the Named
Directors breached their duties of loyalty and due care to the putative class of
stockholders by selecting financing for the Company in June 1997 and thereafter
drawing two tranches of the financing. The amended complaint seeks certification
of a class consisting of all owners of the Company's Common Stock during the
period from May 15, 1997 through December 31, 1997, excluding the Named
Directors. Mr. Lipman's amended complaint alleges that the stock owned by the
putative class lost $61 million due to the financing the Named Directors
selected, and seeks an unspecified amount of compensatory and



                                       20
<PAGE>   24

punitive damages. The Company and the Named Directors regard the amended
complaint as without factual or legal merit. Accordingly, the Named Directors
filed a motion to dismiss Mr. Lipman's amended complaint on July 29, 1998. The
court granted the motion to dismiss in December 1998, finding that Mr. Lipman
still had failed to fulfill the prerequisites for maintaining a shareholder
derivative action against the Named Directors. On January 12, 1999, Mr. Lipman
and two added former stockholders filed a second amended complaint against the
Named Directors and again including the Company itself as a defendant.

     The second amended complaint alleged that the Named Directors breached
their duties of loyalty and due care to the putative class and further alleged
that the purported devaluation of the plaintiffs' stock resulting from the June
1997 financing was an improper "assessment" on the plaintiffs' shares for which
they sought an unspecified amount of compensatory and punitive damages. In
February 1999, the Company and the Named Directors filed a motion to dismiss the
second amended complaint. The Court granted the motion to dismiss in April 1999,
finding that (i) the plaintiffs could not assert their stock devaluation claims,
except derivatively, and (ii) the plaintiffs still had failed to fulfill the
prerequisites for maintaining a shareholder derivative action against the Named
Directors. In May 1999, the plaintiffs filed a third amended complaint against
the Company and the Named Directors.

     The third amended complaint reiterated the plaintiffs' previous allegations
that the Named Directors breached their duties of loyalty, due care and candor
to the putative class, and again alleged the plaintiffs' claims of an improper
"assessment." The third amended complaint also asserted two claims of purported
common law fraud and a supposed violation of the Illinois Consumer Fraud Act
based on allegations that the Company and the Named Directors had selectively
disclosed "material, non-public confidential information" to the non-party
financier in order to obtain the financing that the Company selected in June
1997, which allegedly reduced the Common Stock price. The plaintiffs sought an
unspecified amount of compensatory and punitive damages, interest and attorneys'
fees. In June 1999, the Company and the Named Directors filed a motion to
dismiss the third amended complaint, arguing that the plaintiffs' allegations of
purported market manipulation by the financier, facilitated by supposedly
improper selective disclosure, are beyond the jurisdiction of the Illinois court
and fail to allege certain essential elements of common law fraud and the
Illinois Consumer Fraud Act. The defendants' motion also argued that the
plaintiffs still had failed to fulfill the prerequisites for asserting their
stock devaluation claims as a shareholder derivative action. In August 1999, the
Court granted the Company's and the Named Directors' motion, and dismissed the
suit with prejudice.

     Thereafter the plaintiffs filed a motion for reconsideration of the
dismissal; the Court denied the plaintiffs' reconsideration motion on September
23, 1999. On October 21, 1999, the plaintiff filed their notice of appeal from
the dismissal orders. The Company and the named Directors regard the appeal as
without merit and they intend to vigorously defend against the plaintiffs'
appeal from the Circuit Court's dismissal orders.

Greenwald Litigation

     On June 24, 1998, Jonathan Greenwald, derivatively on behalf of the
Company, filed a complaint against the Company and the Named Directors in the
court of Chancery of the State of Delaware in and for New Castle County. Mr.
Greenwald's complaint alleges that the Named Directors breached their duties of
good faith, loyalty, due care, and candor by selecting financing for the Company
in 1997 which purportedly reduced the Company's stock price and was supposedly
accepted to entrench the Named Directors. The complaint seeks an unspecified
amount of compensatory damages, various equitable relief and attorney's fees.

     The Company and the Named Directors regarded the suit as without factual or
legal merit. Accordingly, in January 1999, the Company and the Named Directors
filed a motion to dismiss the complaint arguing that the complaint is barred by
the business judgment rule and the plaintiffs' failure to fulfill the
prerequisites for maintaining a shareholder derivative action against the Named
Directors. In July 1999, the Court of Chancery granted the defendants' motion to
dismiss the complaint finding that the plaintiffs had failed to satisfy the
prerequisites for maintaining a shareholder derivative action under Delaware
law. By order dated August 11, 1999, the Court of Chancery granted the Company's
and the named Directors' motion to dismiss with prejudice the suit as it relates
to Mr. Greenwald, the named plaintiff.

                                       21
<PAGE>   25

16(b) Litigation

     On February 26, 1999, Mark Levy, derivatively on behalf of the Company,
filed a complaint against Southbrook International Investments, Ltd.
("Southbrook"), Elliott Associates, L.P. ("Elliott"), and Westgate
International, L.P. ("Westgate"), and against the Company as a "nominal
defendant." The complaint, filed in the United States District Court for the
Southern District of New York, alleges that Southbrook, Elliott and Westgate,
while having beneficial ownership of more than 10% of the Company's Common
Stock, incurred liability under Section 16(b) of the Securities Exchange Act of
1934 in connection with purchases and sales of Company securities within six
month periods. The complaint seeks to recover from Southbrook, Elliott and
Westgate their respective profits (in unspecified amounts) from those
transactions. No relief is sought against the Company as a nominal defendant.

     Elliott and Westgate are currently investors in the Company with
substantial rights to acquire Common Stock by conversion of notes and exercise
of warrants and have designated four of the five current five directors of the
Company, two of whom, Messrs. Mark Brodsky and Samuel Perlman, are employed by a
company that provides management services to, and is under common control with
Elliott and Westgate. See "Recent Developments," above.

     An amended complaint dated September 2, 1999 was served on the Company. The
amended complaint raises the same claims alleged in the original complaint.
Pursuant to stipulation, as of the date hereof, the Company has not yet
responded to the amended complaint.

     Motions to dismiss the action have been filed by Elliott, Westgate and
Southbrook.

     The Company intends to defend itself vigorously in the matters described
above and believes that the resolution of these matters will not have a material
adverse effect on the financial condition, results of operations or cash flows
of the Company.

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

     No matters were submitted to a vote of security holders during the quarter
ended December 31, 1999.

                                     PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
     The Common Stock has been quoted since April 1999 on the Nasdaq OTC
Bulletin Board under the symbol "ISCO." From 1993 until April 1999, the Common
Stock was quoted on the Nasdaq National Market. The following table shows, for
the periods indicated, the reported high and low sale prices for the Common
Stock.

                                                           HIGH        LOW
                                                           ----        ---

FISCAL YEAR ENDING DECEMBER 31, 1998
  First Quarter.................................          $3.88       $0.88
  Second Quarter................................          $3.25       $1.16
  Third Quarter.................................          $1.97       $0.81
  Fourth Quarter................................          $1.78       $0.75
FISCAL YEAR ENDING DECEMBER 31, 1999
  First Quarter.................................          $1.69       $0.94
  Second Quarter................................          $1.50       $0.47
  Third Quarter.................................          $1.13       $0.50
  Fourth Quarter................................          $2.06       $0.33



                                       22
<PAGE>   26

     On January 31, 2000, there were approximately 256 holders of record of the
Common Stock.

     The Company has never paid cash dividends on the Common Stock and the
Company does not expect to pay any dividends on its Common Stock in the
foreseeable future. In addition, the Company's existing debt instruments limit
the Company's ability to pay dividends. See "Risk Factors - Substantial
Leverage; Restrictions Contained in Debt Instruments."

     The Company has applied to have its Common Stock listed on the Nasdaq
SmallCap Market. There can be no assurance, however, whether or when the
application will be approved and the Common Stock listed.



                                       23
<PAGE>   27

RIGHTS PLAN

     In February 1996, the Board of Directors of the Company adopted a
stockholders rights plan (the "Rights Plan"). In connection with the adoption of
the Rights Plan, the Board of Directors created one series of Preferred Stock,
consisting of 10,000 shares of Series A Junior Participating Preferred Stock
(the "Series A Preferred"). Each share of the Series A Preferred, when and if
issued, entitles the holder thereof to receive dividends equal to 1,000 times
the dividends per share declared with respect to the Common Stock. Holders of
the Series A Preferred are entitled to exercise 1,000 votes per share on all
matters submitted to a vote of stockholders and, except as otherwise required by
law, vote together with the holders of Common Stock as a single class. In the
event of liquidation, such holders would receive a preference of 1,000 times the
aggregate amount to be distributed per share to the holders of Common Stock. In
general, each share of the Series A Preferred is intended to have a value and
voting rights equal to 1,000 shares of Common Stock, and appropriate
anti-dilutive adjustments will be made in accordance with the terms of such
Series A Preferred in the event of certain changes in Common Stock.

     Pursuant to the Rights Plan, a Series A Right is associated with, and
trades with, each share of Common Stock outstanding. The record date for
distribution of such Series A Rights was February 22, 1996 (the "Record Date")
and, for so long as the Series A Rights are associated with the Common Stock,
each new share of Common Stock issued by the Company will include one Series A
Right.

     Each Series A Right will entitle its holder to purchase one-thousandth of a
share of Series A Preferred of the Company for $200 (subject to adjustment). The
Series A Rights are not exercisable until the earlier of (i) ten days after any
person or group becomes the beneficial owner of 15% or more of the outstanding
Common Stock or (ii) 10 business days (unless extended by the Board of
Directors) after the commencement of a tender offer or exchange offer that would
result in a person or group beneficially owning 15% or more of the Common Stock.

     If any person or group acquires 15% or more of the Common Stock outstanding
(the "Shares Acquisition Date"), each holder of a Series A Right (except the
acquiring party) has the right to receive, upon exercise, (i) shares of Common
Stock of the Company having a market value of two times the exercise price of
the Series A Right and (ii) one Series B Right (Series A Rights and Series B
Rights are hereinafter collectively referred to as the "Rights"). The Board of
Directors has the option, after the Shares Acquisition Date but before there has
been a 50% acquisition of the Company, to exchange both (i) one share of Common
Stock (or one-thousandth of a share of preferred stock) and (ii) one Series B
Right, for each Series A Right (other than Series A Rights held by an acquiring
party). If, after the Series A Rights become exercisable, the Company is
involved in a merger or other business combination, or if the Company sells or
transfers more than 50% of its assets or earning power, or if an acquiring party
engages in certain "self-dealing" transactions with the Company, each Series A
Right and Series B Right then outstanding (other than Rights held by an
acquiring party) will be exercisable for common stock of the other party to such
transaction having a market value of two times the exercise price of the Right.
The Company has the right to redeem the Series A Rights for $.01 per Series A
Right (the "Redemption Price") prior to the Shares Acquisition Date. The Series
B Rights, once issued, are not redeemable. The Rights expire on February 9,
2006.

     The Rights have certain anti-takeover effects. The Rights should not
interfere with any merger or business combination approved by the Board of
Directors since the Series A Rights may be redeemed by the Company at the
Redemption Price prior to the time that a person or group has acquired
beneficial ownership of 15% or more of the Common Stock. However, by causing
substantial dilution to a person or group that attempts to acquire the Company
on terms not approved by the Board of Directors, the Rights may interfere with
certain acquisitions, including acquisitions that may offer a premium over
market price to some or all of the Company's shareholders. The Rights are not
intended to prevent an acquisition of the Company on terms that are favorable
and fair to all shareholders. See "Risk Factors - Anti-Takeover Provisions."

RECENT SALES OF UNREGISTERED SECURITIES

      On March 31, 1999, the Investors purchased, for an aggregate price of $3
million, an aggregate of $3 million initial principal amount (out of a private
placement of an aggregate of $3.3 million initial principal



                                       24
<PAGE>   28

amount) of senior convertible notes due May 15, 2002 (the "March Notes") and
warrants exercisable for an aggregate of 1.2 million shares of Common Stock (out
of an aggregate private placement of warrants exercisable for an aggregate of
1.32 million shares of Common Stock) ("March Warrants"). The balance of the
March Notes and March Warrants were purchased by State Farm Mutual Automobile
Insurance Company.

     Concurrently with the issuance of the March Notes, the Company amended
certain terms of $5.5 million initial principal amount of senior convertible
notes issued on May 15, 1998 (the "Amended May Notes"), of which $5 million in
aggregate initial principal amount of such Amended May Notes were held by the
Investors, and warrants exercisable for an aggregate of 2.2 million shares of
Common Stock that were also issued on May 15, 1998 (the "Amended May Warrants"),
of which Amended May Warrants for an aggregate of 2.0 million shares of Common
Stock were held by the Investors.

     On November 5, 1999, the board of directors, in order to address the
Company's critical lack of liquidity, approved the terms of the financing
transaction described above under "Risk Factors - Substantial Number of Shares
Eligible for Future Issuance on Conversion of Notes and Warrant and Option
Exercise; Low Conversion and Exercise Prices; Dilution."

     No underwriting commissions were paid in connection with the issuance of
securities referenced in this section, which were issued in reliance on the
exemption from registration contained in Section 4(2) of the Securities Act of
1933 for transactions by an issuer not involving a public offering. The
exemption was available because these transactions involved the Company's
privately negotiated sales to a small number of institutional investors with
which the Company had a pre-existing business relationship.



                                       25
<PAGE>   29
ITEM 6.  SELECTED FINANCIAL DATA

     The following table presents selected financial data with respect to the
Company as of and for the years ended December 31, 1995, 1996, 1997, 1998 and
1999. The selected financial data for each of the years in the five-year period
ended December 31, 1999 have been derived from the audited financial statements
of the Company. The information set forth below should be read in conjunction
with Item 7. "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and Item 8., "Financial Statements and Supplementary
Data."


<TABLE>
<CAPTION>
                                                ------------    ------------    ------------    ------------    ------------
                                                    1995            1996           1997            1998            1999
                                                ------------    ------------    ------------    ------------    ------------
<S>                                             <C>             <C>             <C>             <C>             <C>
STATEMENT OF OPERATIONS DATA:
  Net sales .................................   $     27,830    $    209,822    $  1,038,134    $  3,242,930    $  2,408,604
  Costs and expenses:
    Cost of revenues ........................         19,286          49,534       4,401,077       7,047,347       5,923,173
    Research and development ................      4,554,946       6,422,921       4,132,019       2,934,784       1,757,214
    Selling and marketing ...................        469,600       1,834,640       1,918,044       1,847,680       1,581,545
    General and administrative ..............      2,763,615       3,290,810       2,772,274       3,370,058       2,617,809
                                                ------------    ------------    ------------    ------------    ------------
    Operating loss ..........................     (7,779,617)    (11,388,083)    (12,185,280)    (11,956,939)     (9,471,137)

  Other income (expense):
    Interest income .........................        487,543         503,911         254,781         354,738          98,194
    Interest expense ........................        (39,600)        (29,602)        (17,969)    (10,247,919)    (12,634,745)
    Other income, net .......................           --              --              --              --            36,623
                                                ------------    ------------    ------------    ------------    ------------
                                                     447,943         474,309         236,812      (9,893,181)    (12,499,928)
                                                ------------    ------------    ------------    ------------    ------------
Loss before extraordinary item ..............     (7,331,674)    (10,913,774)    (11,948,468)    (21,850,120)    (21,971,065)
Extraordinary item-debt extinguishment ......           --              --              --              --          (745,197)
                                                ------------    ------------    ------------    ------------    ------------
Net loss ....................................     (7,331,647)    (10,913,774)    (11,948,468)    (21,850,120)    (22,716,262)

Preferred Stock dividends ...................           --              --          (143,302)        (61,834)
                                                ------------    ------------    ------------    ------------    ------------
Net loss plus Preferred Stock dividends .....   $ (7,331,674)   $(10,913,774)   $(12,091,770)   $(21,911,954)   $(22,716,262)
                                                ============    ============    ============    ============    ============

Basic and diluted loss per common share
  before extraordinary item .................   $      (2.01)   $      (2.41)   $      (2.34)   $      (1.93)   $      (1.71)
Extraordinary item-debt extinguishment ......           --              --              --              --             (0.06)
                                                ------------    ------------    ------------    ------------    ------------
Basic and diluted loss per common share .....   $      (2.01)   $      (2.41)   $      (2.34)   $      (1.93)   $      (1.77)
                                                ============    ============    ============    ============    ============
Weighted average number of
    common shares outstanding ...............      3,641,196       4,536,034       5,156,663      11,345,540      12,841,497
                                                ============    ============    ============    ============    ============
</TABLE>


<TABLE>
<CAPTION>
                                                ------------    ------------    ------------    ------------    ------------
                                                    1995            1996            1997            1998            1999
                                                ------------    ------------    ------------    ------------    ------------
<S>                                             <C>             <C>             <C>             <C>             <C>
BALANCE SHEET DATA:
Cash and cash equivalents .................     $    953,093    $  5,188,047    $  2,766,886    $  2,152,595    $    723,711
Working capital ...........................        5,458,474       5,207,923       4,668,982       4,190,548         831,724
Total assets ..............................       11,105,766      13,388,496      11,534,309      10,028,088       6,039,159
Long-term debt/capital lease
   obligations, less current portion ......          509,079          91,618          13,541       9,432,026      13,650,885
Stockholders' equity (net
   capital deficiency) ....................        9,185,379      11,520,128      10,046,569        (772,968)     (9,291,712)
</TABLE>



                                       26
<PAGE>   30


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

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

RESULTS OF OPERATIONS

Years Ended December 31, 1999 and 1998

     The Company's net sales decreased $834,326, or 25.7%, from $3,242,930 in
1998 to $2,408,604 in 1999, as a result of lower unit volume and reduced selling
prices of the Company's radio frequency ("RF") front-end products. Net sales in
the fourth quarter of 1999 were $452,812, as compared to $1,504,497 for the
fourth quarter of 1998. This decline was a result of lower unit volume in 1999
compared to 1998, when there was a large-scale deployment of the Company's
products by one of the largest cellular operators in the U.S. This large-scale
deployment did not reoccur in 1999. The Company anticipates its net sales to
remain flat in 2000 based on forecasts of domestic expansion by cellular
operators and a delayed deployment of sales to international markets. All of the
net sales in 1999 and 1998 were from commercial product sales. The Company has
concentrated its efforts on its commercial product research and development
programs and does not expect revenues to increase dramatically unless and until
it ships a significantly larger amount of its commercial products.

     Cost of products sold decreased to $5,923,173 from $7,047,347, a reduction
of $1,124,174 or 16.0%. The cost of products sold for 1999 and 1998 consisted of
direct material, labor and overhead costs associated with the products that were
shipped during the period, plus approximately $649,000 and $375,000,
respectively, of costs, which consisted primarily of allocated overhead costs,
incurred to produce units in ending finished goods inventory that exceed net
realizable value. Due to low utilization levels and excess capacity in the
Company's manufacturing facility, cost of products sold exceeded net sales for
1999 and 1998. The Company expects the cost of products sold to exceed net sales
until it manufactures and ships a significantly higher amount of its commercial
products.

     The Company's internally funded research and development expenses decreased
to $1,757,214 from $2,934,784, a reduction of $1,177,570 or 40.1%. These costs
were lower due to the successful development of the Company's core products,
increased efficiency in the Company's development processes, personnel
reductions, and the focusing of development efforts on products with a greater
probability of commercial sales. During 2000, the Company expects its research
and development expenditures to continue on a level consistent with that of
1999.

     Selling and marketing expenses decreased to $1,581,545 from $1,847,680, a
reduction of $266,135 or 14.4%. This decrease was due primarily to personnel
reductions and decreased trade show, travel and delivery expenses.

     General and administrative expenses decreased to $2,617,809 from
$3,370,058, a reduction of $752,249 or 22.3%. This expense reduction was
primarily due to personnel reductions and lower professional fees and office
supply expenses.

     Interest income decreased $256,544 from $354,738 in 1998 to $98,194 in
1999. This decrease is a result of lower average balances of cash and cash
equivalents on hand during 1999 compared to 1998.

     Interest expense increased $2,368,826 from $10,247,919 in 1998 to
$12,634,745 in 1999. This increase was primarily due to an increase of
$2,506,954 in non-cash interest charges related to the Company's Senior
Convertible Notes. See Note 7 to the Company's financial statements.

     An extraordinary charge of $745,197 was recorded in 1999 as a result of
amendments to the terms of certain of the Company's Senior Convertible Notes
issued in May 1998 and March 1999. These amendments increased the interest rate
of certain of the notes issued in May 1998 from 2% to 6% and reduced the
conversion prices of these



                                       27
<PAGE>   31

notes and the exercise prices of warrants issued in conjunction with these
notes. In March 1999, the conversion price of certain of the notes issued in May
1998 was reduced from $1.50 to $1.125 per share, and the exercise price of the
related warrants was reduced from $3.75 to $1.4625 per share. In November 1999,
the conversion price of certain of the notes issued in both May 1998 and March
1999 and the exercise price of the related warrants were reduced from $1.125 to
$0.25 per share and from $1.4625 to $0.25 per share, respectively. In addition,
the exercise price of certain of the Company's G Warrants was reduced from
$10.0625 to $0.25 per share. See Note 7 to the Company's financial statements.

Years Ended December 31, 1998 and 1997

     The Company's net sales increased $2,204,796 from $1,038,134 in 1997 to
$3,242,930 in 1998, as a result of increased sales of the Company's radio
frequency ("RF") front-end products. Net revenues in the fourth quarter of 1998
were $1,504,497, as compared to $282,384 for the fourth quarter of 1997. This
revenue growth was the result of the increased acceptance of the Company's
products by operators, price reductions that the Company implemented in October
1998 and a large scale deployment of the Company's products by one of the
largest cellular operators in the U.S. All of the net sales in 1997 and 1998
were from commercial product sales.

     Cost of product sales was $7,047,347 for the year ended December 31, 1998,
as compared to $4,401,077 for the year ended December 31, 1997. The cost of net
product sales for 1998 and 1997 consisted of direct material, labor and overhead
costs associated with the products that were shipped during the year, plus
approximately $375,000 and $529,000, respectively, of costs, which consisted
primarily of allocated overhead costs, incurred to produce units in ending
finished goods inventory that exceed net realizable value. Due to low
utilization levels and excess capacity in the Company's manufacturing facility,
cost of net product sales exceeded net sales for the years ended December 31,
1998 and 1997.

      The Company's internally funded research and development expenses
decreased $1,197,235 from $4,132,019 in 1997 to $2,934,784 in 1998. Research and
development costs were reduced during 1998, as compared to 1997, primarily due
to a reduction in personnel and operating costs during 1998.

     Selling and marketing expenses decreased to $1,847,680 in 1998 from
$1,918,044 in 1997. This decrease was due to lower advertising, recruiting and
consulting expenses during 1998 as compared to 1997. The decrease was partially
offset by increased salary and freight expenses in 1998.

     General and administrative expenses increased $597,784 from $2,772,274 in
1997 to $3,370,058 in 1998. The increase in general and administrative expenses
was due primarily to higher consultant, legal and office expenses during 1998 as
compared to 1997.

     Interest income increased $99,957 from $254,781 in 1997 to $354,738 in
1998. This increase was due to a higher average cash, cash equivalent and
investment balance during 1998.

     Interest expense increased $10,229,950 from $17,969 in 1997 to $10,247,919
in 1998. This increase was primarily due to $10,101,401 of non-cash interest
charges related to the Company's Senior Convertible Notes.

IMPACT OF YEAR 2000

     The Company completed its Year 2000 readiness initiatives and did not
experience any significant problems. The Company does not anticipate any
significant adverse business effects related to this issue. The Company did not
incur material costs related to Year 2000 remediation.

LIQUIDITY AND CAPITAL RESOURCES

     At December 31, 1999, the Company's cash and cash equivalents, including
restricted certificates of deposit, were $1,015,286, a decrease of $1,474,656
from the December 31, 1998 balance of $2,489,942.

                                       28
<PAGE>   32

     The continuing development of and expansion in sales of the Company's RF
filter product lines will require continued commitment of substantial funds to
undertake continued product development and manufacturing activities and to
market and sell its RF front-end products. The actual amount of the Company's
future funding requirements will depend on many factors, including: the amount
and timing of future revenues, the level of product marketing and sales efforts
to support the Company's commercialization plans, the magnitude of its research
and product development programs, the ability of the Company to improve product
margins, the cost of additional plant and equipment for manufacturing and the
costs involved in protecting the Company's patents or other intellectual
property.

     Despite the completion on November 5, 1999 of the issuance and sale of $1.0
million in principal amount of November 1999 Notes and completion on December
29, 1999 of the issuance and sale of $1.0 million in principal amount of
December 1999 Notes (See Note 7 to the Company's financial statements), the
Company believes that during the second quarter of 2000 it will require
substantial additional funds to finance its product development, manufacturing
and marketing activities and otherwise to maintain its operations. The Company's
strategy to generate sufficient working capital to fund its operations and cash
requirements in the future includes: increasing sales and advancing market
penetration by selling its products to original equipment manufacturers and
customers both domestically and in overseas markets; building strong and
enduring relationships with existing customers and expanding product offerings
to meet varying customer needs; and reducing product costs through redesign,
economies of scale in material purchases, the refinement of manufacturing
processes, and further reductions in overhead. The Company is actively seeking
financing in order to obtain working capital to continue its operations
according to its current operating plan through the second quarter of 2000 and
beyond. Certain of the purchasers of the Company's Senior Convertible Notes have
an option, but not an obligation, to make additional purchases of Senior
Convertible notes in the aggregate amount of $4,000,000 on the same terms and
conditions as the November 1999 and December 1999 Notes. This option expires on
August 5, 2000. Additionally, the Company has entered into a factoring
agreement, which expires on September 27, 2000 and is subject to renewal for
successive twelve month periods, whereby the Company may assign and sell its
interest, on a full recourse basis, of its present and future trade accounts
receivable. The Company has pledged its receivables and inventory as collateral
under the factoring agreement.

     The Company's Senior Convertible Notes issued in May 1998, March 1999,
November 1999 and December 1999 (collectively, the "Notes") contain restrictions
limiting the Company's ability to incur additional indebtedness or to pay
dividends (other than in shares of Common Stock) and are secured by the
Company's assets. This may adversely affect the Company's ability to raise
additional equity or debt financing. In the event that the Company fails to
achieve break-even or positive operating income during the second quarter of
2001, the Notes may become immediately due and payable unless the holders
thereof agree to modify or waive such provision. In addition, the Company's
Common Stock was de-listed from trading on the NASDAQ National Market in June
1999 due to the Company's continuing inability to meet the net tangible assets
requirement for continued listing. The Common Stock is now traded in the
over-the-counter market and quoted on the National Association of Securities
Dealers, Inc. electronic bulletin board. This does not provide the same
liquidity for the trading of securities as NASDAQ. In February 2000, the Company
applied to NASDAQ for re-listing of the Company's Common Stock. However, there
can be no assurance as to whether or when such re-listing will occur. If the
Company is unable to re-list the Common Stock for trading on NASDAQ or another
securities market or exchange this could adversely affect the Company's ability
to obtain additional funding as needed, and/or the terms of any such additional
funding.

     If the Company is unable to obtain adequate funds when needed in the
future, the Company would be required to substantially delay, scale-back or
eliminate the manufacturing, marketing or sales of one or more of its products
or research and development programs, or may be required to obtain funds through
arrangements with collaborative partners or others that may require the Company
to relinquish rights to certain of its technologies, or potential products that
the Company would not otherwise relinquish. In particular, if the Company does
not secure adequate additional financing through its existing investors' rights
to make additional purchases of the Company's Senior Convertible Notes or
through new or recurring sources during the second quarter of 2000, the Company
believes that it may not be able to continue as a going concern.



                                       29
<PAGE>   33

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      The Company does not have any material market risk sensitive instruments.



                                       30
<PAGE>   34


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                         REPORT OF INDEPENDENT AUDITORS


The Board of Directors
Illinois Superconductor Corporation

We have audited the accompanying balance sheets of Illinois Superconductor
Corporation as of December 31, 1999 and 1998, and the related statements of
operations, stockholders' equity (net capital deficiency), and cash flows for
each of the three years in the period ended December 31, 1999. Our audits also
included the financial statement schedule listed in the Index at Item 14(a).
These financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Illinois Superconductor
Corporation at December 31, 1999 and 1998, and the results of its operations and
its cash flows for each of the three years in the period ended December 31,
1999, in conformity with auditing standards generally accepted in the United
States. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.

The accompanying financial statements have been prepared assuming that Illinois
Superconductor Corporation will continue as a going concern. As more fully
described in Note 3, Illinois Superconductor Corporation has incurred ongoing
operating losses and does not currently have financing commitments in place to
meet expected cash requirements through 2000. These conditions raise substantial
doubt about Illinois Superconductor Corporation's ability to continue as a going
concern. Management's plans in regard to these matters are also described in
Note 3. The financial statements do not include any adjustments to reflect the
possible future effects on the recoverability and classification of assets or
the amounts and classification of liabilities that may result from the outcome
of this uncertainty.


                                                              Ernst & Young LLP

Chicago, Illinois
February 25, 2000



                                       31
<PAGE>   35



                       ILLINOIS SUPERCONDUCTOR CORPORATION

                                 BALANCE SHEETS


<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                            1999            1998
                                                        ------------    ------------
<S>                                                     <C>             <C>
ASSETS
Current assets:
   Cash and cash equivalents                            $    723,711    $  2,152,595
   Inventories                                             1,092,713       1,424,427
   Accounts receivable, net of allowance for doubtful
     accounts of $35,340 and $87,990 at December 31,
     1999 and 1998, respectively                             175,801       1,494,418
   Prepaid expenses and other                                428,475         396,926
                                                        ------------    ------------
Total current assets                                       2,420,700       5,468,366

Property and equipment:
   Leasehold improvements                                  4,218,511       4,218,511
   Lab equipment                                           1,457,597       1,694,840
   Manufacturing equipment                                 1,023,211         983,426
   Office equipment                                          754,142         759,443
   Furniture and fixtures                                    635,708         629,490
                                                        ------------    ------------
                                                           8,089,169       8,285,710
   Less: Accumulated depreciation                         (5,433,808)     (4,761,599)
                                                        ------------    ------------
                                                           2,655,361       3,524,111

Restricted certificates of deposit                           291,575         337,347
Patents and trademarks, net                                  592,823         615,879
Deferred financing fees, net                                  78,700          82,385

                                                        ------------    ------------
Total assets                                            $  6,039,159    $ 10,028,088
                                                        ============    ============
</TABLE>



             See the accompanying Notes which are an integral part
                          of the financial statements.



                                       32
<PAGE>   36

                       ILLINOIS SUPERCONDUCTOR CORPORATION

                                 BALANCE SHEETS

                                   (CONTINUED)


<TABLE>
<CAPTION>
                                                                                           DECEMBER 31,
                                                                                      1999            1998
                                                                                   ------------    ------------
<S>                                                                                <C>             <C>
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
Current liabilities:
   Accounts payable                                                                $    990,913    $    464,752
   Accrued liabilities                                                                  589,043         799,569
   Current portion of other long-term debt                                                9,020          13,497
                                                                                   ------------    ------------
 Total current liabilities                                                             1,588,976       1,277,818

Senior convertible notes, net of discount                                            13,002,068       9,302,651
Accrued interest on senior convertible notes                                            638,743         129,375
Other long-term debt, less current portion                                               10,074            --
Deferred occupancy costs                                                                 91,010          91,212

Stockholders' equity (net capital deficiency):
   Preferred Stock; 100,000 shares authorized; No shares issued and outstanding
     at December 31, 1999 and 1998                                                         --              --
   Common stock ($.001 par value); 60,000,000 and 30,000,000 shares authorized
     and 15,753,001 and 12,557,045 shares issued and outstanding at December 31,
     1999 and 1998, respectively                                                         15,753          12,557
   Additional paid-in capital                                                        74,249,643      60,055,321
   Notes receivable from stockholders                                                  (680,696)       (680,696)
   Accumulated deficit                                                              (82,876,412)    (60,160,150)
                                                                                   ------------    ------------
Total stockholders' equity (net capital deficiency)                                  (9,291,712)       (772,968)
                                                                                   ------------    ------------
Total liabilities and stockholders' equity (net capital deficiency)                $  6,039,159    $ 10,028,088
                                                                                   ============    ============
</TABLE>



             See the accompanying Notes which are an integral part
                          of the financial statements.


                                       33


<PAGE>   37
                       ILLINOIS SUPERCONDUCTOR CORPORATION

                            STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                                            YEAR ENDED DECEMBER 31,
                                                     1999            1998            1997
                                                 ------------    ------------    ------------
<S>                                              <C>             <C>             <C>
Net sales                                        $  2,408,604    $  3,242,930    $  1,038,134

Costs and expenses:
   Cost of sales                                    5,923,173       7,047,347       4,401,077
   Research and development                         1,757,214       2,934,784       4,132,019
   Selling and marketing                            1,581,545       1,847,680       1,918,044
   General and administrative                       2,617,809       3,370,058       2,772,274
                                                 ------------    ------------    ------------
Total costs and expenses                           11,879,741      15,199,869      13,223,414
                                                 ------------    ------------    ------------
Operating loss                                     (9,471,137)    (11,956,939)    (12,185,280)

Other income and (expense):
   Interest income                                     98,194         354,738         254,781
   Non-cash interest expense on  Senior
     convertible notes (Note 7)                   (12,608,355)    (10,101,401)           --
   Other interest expense                             (26,390)       (146,518)        (17,969)
   Other income, net                                   36,623            --              --
                                                 ------------    ------------    ------------
                                                  (12,499,928)     (9,893,181)        236,812
                                                 ------------    ------------    ------------
Loss before extraordinary item                    (21,971,065)    (21,850,120)    (11,948,468)
Extraordinary item - debt extinguishment             (745,197)           --              --
                                                 ------------    ------------    ------------
Net loss                                          (22,716,262)    (21,850,120)    (11,948,468)
Preferred Stock dividends                                --           (61,834)       (143,302)
                                                 ------------    ------------    ------------

Net loss plus Preferred Stock dividends          $(22,716,262)   $(21,911,954)   $(12,091,770)
                                                 ============    ============    ============

Basic and diluted loss per common share before
   extraordinary item                            $      (1.71)   $      (1.93)   $      (2.34)

Extraordinary item - debt extinguishment                (0.06)           --              --
                                                 ------------    ------------    ------------
Basic and diluted loss per common share          $      (1.77)   $      (1.93)   $      (2.34)
                                                 ============    ============    ============
Weighted average number of common shares
   outstanding                                     12,841,497      11,345,540       5,156,663
                                                 ============    ============    ============
</TABLE>


             See the accompanying Notes which are an integral part
                          of the financial statements.



                                       34
<PAGE>   38

                       ILLINOIS SUPERCONDUCTOR CORPORATION

           STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)

                  YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997


<TABLE>
<CAPTION>
                                           SERIES B CONVERTIBLE SERIES C CONVERTIBLE  SERIES G CONVERTIBLE
                                              PREFERRED STOCK     PREFERRED STOCK       PREFERRED STOCK           COMMON STOCK
                                           ----------------------------------------------------------------------------------------
                                           NUMBER               NUMBER                NUMBER                     NUMBER
                                            OF                    OF                    OF                         OF
                                           SHARES    AMOUNT     SHARES    AMOUNT      SHARES      AMOUNT         SHARES     AMOUNT
                                           ----------------------------------------------------------------------------------------
<S>                                        <C>     <C>         <C>     <C>            <C>       <C>             <C>        <C>
Balance as of December 31, 1996              --    $      --      --   $      --          --    $      --       5,023,352  $  5,023
   Exercise of stock options; $.184 -
     $18.25 per share                        --           --      --          --          --           --          17,821        18
   Exercise of warrants; $1.4679 -
     $13.50 per share                        --           --      --          --          --           --         138,820       139
   Payment of stockholder notes
     receivable                              --           --      --          --          --           --            --        --
   Issuance of preferred stock, net of
     offering costs                           600    3,000,000     600   3,000,000         700    3,500,000          --        --
   Preferred stock dividends                 --         13,534    --        38,424        --         30,206        19,940        20
   Conversion of preferred stock to
     common stock                            (505)  (2,525,000)   --          --          --           --         801,992       802
   Net loss                                  --           --      --          --          --           --            --        --
                                           ----------------------------------------------------------------------------------------
Balance as of December 31, 1997                95      488,534     600   3,038,424         700    3,530,206     6,001,925     6,002
   Additional offering costs related to
     issuance of preferred stock             --           --      --          --          --           --            --        --
   Exercise of stock options; $. 18 -
     $.23 per share                          --           --      --          --          --           --          33,942        34
   Payment of stockholder notes
     receivable                              --           --      --          --          --           --            --        --
   Preferred stock dividends                 --            260    --        24,377        --         37,197          --        --
   Conversion of preferred stock to
     common stock                            (95)    (488,794)   (600) (3,062,801)       (700)  (3,567,403)    6,521,178     6,521
   Discount on issuance of
     senior convertible notes (Note 7)       --           --      --          --          --           --            --        --
   Net loss                                  --           --      --          --          --           --            --        --
                                           ----------------------------------------------------------------------------------------
Balance as of December 31, 1998              --           --      --          --          --           --      12,557,045    12,557
   Exercise of stock options; $.18 -
     $.23 per share                          --           --      --          --          --           --          17,250        17
   Conversion of senior convertible
     notes to common stock                   --           --      --          --          --           --       3,178,706     3,179
   Discount on issuance of senior
     convertible notes (Note 7)              --           --      --          --          --           --            --        --
   Additional discount on amendments to
     certain senior convertible notes
     (Note 7)                                --           --      --          --          --           --            --        --
   Net loss                                  --           --      --          --          --           --            --        --
                                           ----------------------------------------------------------------------------------------
Balance as of December 31, 1999              --    $      --      --   $      --          --    $      --      15,753,001  $ 15,753
</TABLE>


              See the accompanying Notes which are an integral part
                          of the financial statements.



                                       35
<PAGE>   39
                       ILLINOIS SUPERCONDUCTOR CORPORATION

           STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)

                  YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997

                                   (CONTINUED)


<TABLE>
<CAPTION>
                                                             NOTES
                                            ADDITIONAL    RECEIVABLE
                                             PAID-IN         FROM         ACCUMULATED
                                             CAPITAL      STOCKHOLDERS      DEFICIT           TOTAL
                                          --------------------------------------------------------------
<S>                                       <C>             <C>             <C>             <C>
Balance as of December 31, 1996           $ 39,019,421    $ (1,142,754)   $(26,361,562)   $ 11,520,128
   Exercise of stock options; $.184 -
     $18.25 per share                           70,170            --              --            70,188
   Exercise of warrants; $1.4679 -
     $13.50 per share                          796,908            --              --           797,047
   Payment of stockholder notes                   --           444,246            --           444,246
     receivable
   Issuance of preferred stock, net of
     offering costs                           (336,572)           --              --         9,163,428
   Preferred stock dividends                   (82,184)           --              --              --
   Conversion of preferred stock to
     common stock                            2,524,178            --              --              --
   Net loss                                       --              --       (11,948,468)    (11,948,468)
                                          --------------------------------------------------------------
Balance as of December 31, 1997             41,991,941        (698,508)    (38,310,030)     10,046,569
   Additional offering costs related to
     issuance of preferred stock              (143,400)           --              --          (143,400)
   Exercise of stock options; $. 18 -
     $.23 per share                              7,387            --              --             7,421
   Payment of stockholder notes
     receivable                                   --            17,812            --            17,812
   Preferred stock dividends                   (61,834)           --              --              --
   Conversion of preferred stock to
     common stock                            7,112,477            --              --              --
   Discount on issuance of senior
     convertible notes (Note 7)             11,148,750            --              --        11,148,750
   Net loss                                       --              --       (21,850,120)    (21,850,120)
                                          --------------------------------------------------------------
Balance as of December 31, 1998             60,055,321        (680,696)    (60,160,150)       (772,968)
   Exercise of stock options; $.18 -
     $.23 per share                              3,769            --              --             3,786
   Conversion of senior convertible
     notes to common stock                     849,554            --              --           852,733
   Discount on issuance of senior
     convertible notes (Note 7)              1,904,000            --              --         1,904,000
   Additional discount on amendments to
     certain senior convertible notes
     (Note 7)                               11,436,999            --              --        11,436,999
   Net loss                                       --              --       (22,716,262)    (22,716,262)
                                          --------------------------------------------------------------
Balance as of December 31, 1999           $ 74,249,643    $   (680,696)   $(82,876,412)   $ (9,291,712)
</TABLE>



             See the accompanying Notes which are an integral part
                          of the financial statements.



                                       36
<PAGE>   40
                       ILLINOIS SUPERCONDUCTOR CORPORATION
                            STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                               YEARS ENDED DECEMBER 31,
                                                         1999            1998            1997
                                                     ------------    ------------    ------------
<S>                                                  <C>             <C>             <C>
OPERATING ACTIVITIES
Net loss                                             $(22,716,262)   $(21,850,120)   $(11,948,468)
Adjustments to reconcile net loss to net cash
   used in operating activities:
     Depreciation                                         953,971       1,107,360       1,533,705
     Amortization                                          28,434          14,881           6,994
     Extraordinary item                                   745,197            --              --
     Non-cash interest expense on senior
       convertible notes (Note 7)                      12,608,355      10,101,401            --
     Loss on available-for-sale securities                   --             4,963            --
     Gain on sale of property and equipment               (30,662)           --              --
     Write-off of capitalized patent costs                 57,741          61,333            --
     Changes in operating assets and liabilities:
         Accounts receivable                            1,318,617        (907,917)       (455,749)
         Inventories                                      331,714         301,714      (1,072,445)
         Prepaid expenses and other                       (31,549)         86,864         (35,876)
         Accounts payable                                 526,161        (252,673)       (411,584)
         Accrued liabilities                             (210,526)        341,659          92,778
         Deferred occupancy costs                            (202)           (200)         15,599
                                                     ------------    ------------    ------------
Net cash used in operating activities                  (6,419,011)    (10,990,735)    (12,275,046)

INVESTING ACTIVITIES
Sales of available-for-sale securities                       --           495,350            --
(Increase) decrease in restricted  certificates of
   deposit                                                 45,772          42,653         (30,000)
Payments of patent costs                                  (63,119)       (112,607)       (199,647)
Proceeds from sale of property and equipment               58,006            --              --
Acquisitions of property and equipment                    (85,450)       (108,417)       (310,956)
                                                     ------------    ------------    ------------
Net cash (used in) provided by investing
   activities                                             (44,791)        316,979        (540,603)

FINANCING ACTIVITIES
Proceeds  from  issuance of preferred  stock - net
   of offering costs                                         --          (143,400)      9,163,428
Exercise of stock options                                   3,786           7,421          70,188
Exercise of warrants                                         --              --           797,047
Payments on stockholder notes receivable                     --            17,812         444,246
Proceeds from issuance of senior convertible notes      5,300,000      10,350,000            --
Payment of deferred financing fees                       (247,349)        (94,247)           --
Payments on other long-term debt                          (21,519)        (78,121)        (80,421)
                                                     ------------    ------------    ------------
Net cash provided by financing activities               5,034,918      10,059,465      10,394,488
                                                     ------------    ------------    ------------
Decrease in cash and cash equivalents                  (1,428,884)       (614,291)     (2,421,161)
Cash and cash equivalents at beginning of period        2,152,595       2,766,886       5,188,047
                                                     ------------    ------------    ------------
Cash and cash equivalents at end of period           $    723,711    $  2,152,595    $  2,766,886
                                                     ============    ============    ============

Supplemental cash flow information:
Cash paid for interest                               $     26,390    $      8,994    $     17,969
                                                     ============    ============    ============
</TABLE>



             See the accompanying Notes which are an integral part
                          of the financial statements


                                       37
<PAGE>   41
                       ILLINOIS SUPERCONDUCTOR CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1.  DESCRIPTION OF BUSINESS

      Illinois Superconductor Corporation (the "Company") uses its patented and
proprietary high-temperature superconducting materials technologies to develop
and manufacture radio frequency front-end products designed to enhance the
quality, capacity, coverage and flexibility of cellular, PCS and other wireless
telecommunications services. The Company has historically marketed its products
to cellular, PCS and wireless telecommunications service providers located
primarily in the United States and expects to begin to market its products to
these same types of telecommunications service providers located in certain
international markets.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Cash and Cash Equivalents

      Cash and cash equivalents consist of demand deposits, time deposits, money
market funds, and commercial paper which have maturities of three months or less
from the date of purchase. Management believes that the financial institutions
in which it maintains such deposits are financially sound and, accordingly,
minimal credit risk exists with respect to these deposits.

Inventories

      Inventories are stated at the lower of cost (determined on a first in,
first out basis) or market.

Patents and Trademarks

      Patents and trademarks represent costs, primarily legal fees and expenses,
incurred in order to prepare and file patent applications related to various
aspects of the Company's superconductor technology and to its current and
proposed products. Patents and trademarks are recorded at cost and are amortized
using the straight-line method over the shorter of their estimated useful lives
or 17 years. The recoverability of the carrying values of patents and trademarks
is evaluated on an ongoing basis. During 1999 and 1998, the Company wrote off
$57,741 and $61,333, respectively, of patent-related costs. Total capitalized
patent and trademark costs are $647,084 and $655,678 at December 31, 1999 and
1998, respectively. Capitalized patent costs related to pending patents are
$218,143 and $315,177 at December 31, 1999 and 1998, respectively. Patents and
trademarks are net of accumulated amortization of $54,261 and $39,799 at
December 31, 1999 and 1998, respectively.

Property and Equipment

      Property and equipment are stated at cost, less accumulated depreciation,
and are depreciated over the estimated useful lives of the assets using
accelerated methods. Leasehold improvements are amortized using the
straight-line method over the shorter of the useful life of the asset or the
term of the lease. Amortization of leasehold improvements is included in
depreciation expense. The useful lives assigned to property and equipment for
the purpose of computing book depreciation are as follows:


                                       38
<PAGE>   42


                       ILLINOIS SUPERCONDUCTOR CORPORATION
                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)


2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

          Lab equipment                     5 years
          Manufacturing equipment           3 to 5 years
          Office equipment                  3 to 5 years
          Furniture and fixtures            5 years
          Leasehold improvements            Life of lease

Income Taxes

      Deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse.

Revenue Recognition and Product Warranty

      Revenues from product sales are generally recognized at the time of
shipment and are recorded net of estimated returns and allowances. The Company
has, under certain conditions, granted customers the right to return product
during a specified period of time after shipment. In these situations, the
Company establishes a liability for estimated returns and allowances at the time
of shipment. The Company has established a program which, in certain situations,
allows customers or prospective customers to field test the Company's products
for a specified period of time. Revenues from field test arrangements are
recognized upon customer acceptance of the products. The Company warrants its
products against defects in materials and workmanship typically for an
eighteen-month period from the date of shipment, except for superconducting
materials contained in the products, which are warranted for ten years from the
date of shipment. A provision for estimated future costs related to warranty
expenses is recorded when revenues are recognized. At December 31, 1999 and
1998, respectively, the Company has accrued $282,250 and $30,000 for warranty
costs. Returns and allowances were not significant in any period reported.

Advertising Costs

      Advertising costs are charged to expense in the period incurred.
Advertising expense for the years ended December 31, 1999, 1998 and 1997, was
approximately $26,000, $18,000 and $176,000, respectively.

Research and Development Costs

      Research and development costs related to both present and future products
are charged to expense in the period incurred.

Net Loss Per Common Share

      Basic and diluted net loss per common share are computed based upon the
weighted average number of common shares outstanding. Approximately 64.9 million
common shares issuable as of December 31, 1999 upon the exercise of options and
warrants and conversion of the Company's Senior Convertible Notes (Note 7) are
not included in the per share calculations since the effect of their inclusion
would be antidilutive.

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.


                                       39
<PAGE>   43
                       ILLINOIS SUPERCONDUCTOR CORPORATION
                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)


2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Description of Certain Concentrations and Risks

      The Company operates in a highly competitive and rapidly changing
industry. Product revenues are currently concentrated with a limited number of
customers, and the supply of certain materials is concentrated among a few
providers. The development and commercialization of new technologies by any
competitor could adversely affect the Company's results of operations.

Long Lived Assets

      The Company records impairment losses on long-lived assets used in
operations 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.

Reclassifications

     Certain amounts in the financial statements of prior years have been
reclassified to conform to the 1999 presentation.

3.  GOING CONCERN AND MANAGEMENT'S PLANS

      The Company has incurred, and continues to incur, losses from operations
and has a net capital deficiency. For the years ended December 31, 1999 and
1998, the Company incurred net losses of $22,716,262 and $21,850,120,
respectively. At December 31, 1999, the Company has a net capital deficiency of
$9,291,712, and its available resources are not presently sufficient to fund its
expected cash requirements through the end of 2000. These conditions raise
substantial doubt about the Company's ability to continue as a going concern.

      During 1999, the Company implemented a strategy to reduce its losses from
operations and cash used in operating activities. The Company's strategy
includes a reduction of the employee workforce, increasing the efficiency of the
Company's research and development processes, focusing development efforts on
products with a greater probability of commercial sales, reducing professional
fees and discretionary expenditures, and negotiating favorable payment
arrangements with suppliers and service providers. These efforts have already
resulted in a $4.6 million and $5.9 million reduction of the Company's net cash
used in operations in 1999 compared to 1998 and 1997 levels, respectively. The
Company's business strategy in the future also includes advancing relationships
with customers in overseas markets and introducing expanded product offerings to
meet varying customer needs.

      Despite the recently completed issuance of $2,000,000 aggregate principal
amount of senior convertible notes in the fourth quarter of 1999, the Company
believes that during the second quarter of 2000 it will require substantial
additional funding to finance its operations. The Company is actively seeking
financing in order to obtain working capital to continue its operations
according to its current operating plan through the second quarter of 2000 and
beyond.

      If the Company is unable to obtain adequate funds when needed in the
future, the Company would be required to substantially delay, scale-back or
eliminate the marketing or sales of one or more of its products or research and
development programs, or may be required to obtain funds through arrangements
with collaborative partners or others that may require the Company to relinquish
rights to certain of its technologies, product candidates or potential products
that the Company would not otherwise relinquish. This would materially and
adversely affect the Company's business, financial condition, results of
operations and cash flows.



                                       40
<PAGE>   44
                       ILLINOIS SUPERCONDUCTOR CORPORATION
                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)


4.  INVENTORIES

      Inventories consist of the following:


                                                   DECEMBER 31,
                                              1999          1998
                                           ----------    ----------

                  Raw materials              $735,787    $1,083,605
                  Work-in-process                --         60,456
                  Finished product            356,926       280,366
                                           ----------    ----------
                                           $1,092,713    $1,424,427
                                           ==========    ==========

      Cost of product sales for the years ending December 31, 1999 and 1998
includes approximately $649,000 and $375,000, respectively, of costs in excess
of the net realizable value of finished goods inventory.

5.  CAPITAL STOCK

      The Company has an authorized class of undesignated preferred stock
consisting of 100,000 shares. Preferred stock may be issued in series from time
to time with such designations, relative rights, priorities, preferences,
qualifications, limitations and restrictions thereof, to the extent that such
are not fixed in the Company's certificate of incorporation, as the Board of
Directors determines.

      On February 9, 1996, the Board of Directors adopted a shareholder rights
plan (the "Rights Plan"). In conjunction with the adoption of the Rights Plan,
the Company created one series of preferred stock, consisting of 10,000 shares
of Series A Junior Participating Preferred Stock ("Series A Preferred"). Each
share of Series A Preferred would entitle the holder to receive dividends equal
to 1,000 times the dividends per share declared with respect to the Company's
common stock and, in the event of liquidation, such holders would receive a
preference of 1,000 times the aggregate amount to be distributed per share to
the holders of the Company's common stock. Pursuant to the Rights Plan, a Series
A Right is associated with, and trades with, each share of common stock
outstanding.

      The record date for distribution of such Series A Rights was February 22,
1996, and for so long as the Series A Rights are associated with the common
stock, each new share of common stock issued by the Company will include a
Series A Right.

      Each Series A Right will entitle its holder to purchase one one-thousandth
of a share of Series A Preferred for $200, subject to adjustment as defined in
the Rights Plan. The Series A Rights are not exercisable until the earlier of
(i) 10 days after any person or group becomes the beneficial owner of 15% or
more of the Company's outstanding common stock, or (ii) 10 business days (unless
extended by the Board of Directors) after the commencement of a tender offer or
exchange offer that would result in a person or group beneficially owning 15% or
more of the Company's outstanding common stock.




                                       41
<PAGE>   45
                       ILLINOIS SUPERCONDUCTOR CORPORATION
                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)


5. CAPITAL STOCK (CONTINUED)

      If any person or group ("Acquiring Party") acquires 15% or more of the
Company's outstanding common stock ("Shares Acquisition Date"), each holder of a
Series A Right, except the Acquiring Party, has the right to receive upon
exercise (i) shares of the Company's common stock having a market value equal to
two times the exercise price of the Series A Right, and (ii) one Series B Right
(Series A Rights and Series B Rights are hereinafter collectively referred to as
the "Rights"). The Board of Directors has the option, after the Shares
Acquisition Date but before there has been a 50% acquisition of the Company, to
exchange one share of common stock (or one one-thousandth of a share of
preferred stock) and one Series B Right for each Series A Right (other than
Series A Rights held by the Acquiring Party).

      If, after the Series A Rights become exercisable, the Company is involved
in a merger or other business combination, or if the Company sells or transfers
more than 50% of its assets or earning power, or if an acquiring party engages
in certain "self-dealing" transactions with the Company, as defined in the
Rights Plan, each Right then outstanding (other than Rights held by the
Acquiring Party) will be exercisable for common stock of the other party to such
transaction having a market value of two times the exercise price of the Right.
The Company has the right to redeem each Series A Right for $0.01 prior to the
Shares Acquisition Date. The Series B Rights, once issued, are not redeemable.
The Rights expire on February 9, 2006.

      On November 14, 1995, the Company completed the private placement and
issuance of 356,473 Units, which raised $3,581,282, net of related expenses.
Each Unit consisted of one share of common stock and one detachable common stock
purchase warrant. Each warrant had a term of two years and was exercisable for
the purchase of one share of common stock at $13.00 per share. Warrants for
15,700 of these shares were exercised prior to December 23, 1996. The remaining
340,773 warrants were redeemed by the Company on December 23, 1996. In
conjunction with the redemption, the Company issued 340,773 shares of its common
stock in exchange for $3,287,304 in cash plus $1,142,754 of notes. The notes
bear interest at 8.25% per annum, were due on April 30, 1997, and are guaranteed
by an affiliate of a stockholder. Payments made during 1998 and 1997 on the
notes receivable totaled $17,812 and $444,246, respectively. The remaining
balance due of $680,696 was forgiven as part of a settlement agreement and will
be charged to additional paid-in capital in the first quarter of 2000 (Note 11).

      On June 6, 1997, the Company issued 600 shares of Series B Convertible
Preferred Stock ("Series B Stock") for $5,000 per share, or $3,000,000. In
connection with the sale, the Company issued warrants to purchase 62,500 shares
of common stock at $14.8125 per share expiring on June 6, 2001. On each of
August 29, 1997 and October 29, 1997, the Company issued 300 shares of Series C
Convertible Preferred Stock ("Series C Stock") for $5,000 per share, or
$3,000,000 in aggregate. In addition, on October 29, 1997, the Company issued
700 shares of Series G Convertible Preferred Stock ("Series G Stock") for $5,000
per share, or $3,500,000. In connection with the sale of Series G Stock, the
Company issued warrants to purchase an aggregate of 34,782 shares of common
stock at an original exercise price of $10.0625 per share, expiring on October
29, 2001. On November 5, 1999, in conjunction with certain amendments to the
Company's senior convertible notes (Note 7), these outstanding warrants were
amended to reduce the exercise price to $0.25 per share. Total proceeds for the
above issuances, net of related expenses, was $9,020,028. None of the Preferred
Stock has voting rights. The Series B Stock was convertible into common stock at
a conversion price equal to the lessor of (a) $11.85, or (b) 101% of the average
of the lowest per share market value for the five consecutive trading days
during the 60 trading days immediately preceding the date of the conversion. The
Series C Stock and Series G Stock was convertible into common stock at a
conversion price equal to the lessor of (a) $8.05 or (b) 101% of the average of
the lowest per share market value for the five consecutive trading days during
the 60 trading days immediately proceeding the date of conversion. The
conversion ratio was subject to adjustment. Dividends on the Series B, Series C
and Series G Convertible Preferred Stock were payable at the rate of 5% per
annum, and were payable in cash or shares of common stock, at the option of the
Company.


                                       42
<PAGE>   46
                       ILLINOIS SUPERCONDUCTOR CORPORATION
                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)


5.  CAPITAL STOCK (CONTINUED)

      During 1997, $2,525,000 (505 shares) of Series B Convertible Preferred
Stock were converted into 801,992 shares of common stock. Accrued dividends
thereon of $61,138 were also converted into 19,940 shares of common stock.

      During 1998, $475,000 (95 shares) of Series B Convertible Preferred Stock
were converted into 270,671 shares of common stock. Accrued dividends thereon of
$13,794 were also converted into 7,860 shares of common stock. In addition,
$3,000,000 (600 shares) of Series C Convertible Preferred Stock were converted
into 2,611,299 shares of common stock. Accrued dividends thereon of $62,801 were
also converted into 54,646 shares of common stock. In addition, $3,500,000 (700
shares) of Series G Convertible Preferred Stock were converted into 3,509,125
shares of common stock. Accrued dividends thereon of $67,403 were also converted
into 67,577 shares of common stock.

      On June 9, 1999, the stockholders of the Company approved an increase in
the number of shares of authorized common stock from 30,000,000 to 60,000,000.
At December 31, 1999, authorized but unissued shares of common stock have been
reserved for future issuance as follows:

    Warrants outstanding (Note 6) (1)                           6,525,485
    Options outstanding (Note 6)                                1,914,847
    Options reserved for future issuance under the 1993
       Stock Option Plan (Note 6)                                 553,493
    Shares currently issuable upon conversion of senior
       convertible notes (Note 7)(2)                           35,253,174
                                                               ----------
                                                               44,246,999
                                                               ==========

         (1)   Excludes 210,196 warrants outstanding at December 31, 1999 that
               were surrendered to the Company in February 2000 (Note 11).

         (2)   As of December 31, 1999, the Company's senior convertible notes,
               plus interest paid-in-kind, were convertible into approximately
               55,886,000 shares of the Company's common stock. However,
               conversions were limited by agreement with the holders to
               35,253,174 shares as of that date because the Company does not
               currently have enough authorized shares of common stock.

6.  STOCK OPTIONS AND WARRANTS

      On August 19, 1993, the Board of Directors adopted the 1993 Stock Option
Plan (the "Plan") for employees, consultants, and directors who are not also
employees of the Company (outside directors). The maximum number of shares
issuable under the Plan, as amended in 1999, is 2,511,486. The Plan is
administered by a committee (the "Committee") consisting of two or more outside
directors appointed by the board of directors of the Company.




                                       43
<PAGE>   47

                       ILLINOIS SUPERCONDUCTOR CORPORATION
                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

6.    STOCK OPTIONS AND WARRANTS (CONTINUED)

      For employees and consultants, the Plan provides for granting of Incentive
Stock Options (ISOs) and Nonstatutory Stock Options (NSOs). In the case of ISOs,
the exercise price shall not be less than 100% (110% in certain cases) of the
fair value of the Company's common stock, as determined by the Committee, on the
date of grant. In the case of NSOs, the exercise price shall not be less than
85% (110% in certain cases) of the fair value of the Company's common stock, as
determined by the Committee, on the date of grant. The term of options granted
to employees and consultants will be for a period not to exceed 10 years (five
years in certain cases). Options granted under the Plan generally vest over a
four year period (one-fourth of options granted vest after one year from the
grant date and the remaining options vest ratably each month thereafter). In
addition, the Committee may authorize option grants with vesting provisions that
are not based solely on employees' rendering of additional service to the
Company.

      For outside directors, NSOs only will be granted with an exercise price of
100% of the fair value of the stock, as determined by the Committee, on the date
of grant. The Plan provides that each outside director will be automatically
granted 10,000 NSOs on the date of their initial election to the board of
directors. On the date of the annual meeting of the stockholders of the Company,
each outside director who is elected, reelected, or continues to serve as a
director, shall be granted not less than 3,000 nor more than 10,000 NSOs, except
for those outside directors who are first elected to the Board of Directors at
the meeting or three months prior. The options granted vest ratably over three
years and expire after ten years from the grant date.

      The Company entered into stock option agreements with certain employees
and a consultant prior to the adoption of the Plan. These stock options expire
10 years from the date of grant. Exercise prices were determined by the Board of
Directors and represented estimated fair values of the Company's common stock at
the grant date.

      On May 10, 1999, the Board of Directors granted to each employee of the
Company (other than the executive officers of the Company) (collectively, the
"Non-Executive Employees") the option to (i) reduce the exercise prices of up to
a maximum of 15,000 of the unexercised stock options previously granted to such
Non-Executive Employee under the Plan to $.5625 per share (the closing price of
the Company's Common Stock on May 10, 1999) and (ii) cause all of such stock
options not otherwise scheduled to become fully vested on or before May 10, 2000
to become fully vested on such date. As a result thereof, an aggregate of
279,550 stock options previously granted under the Plan were amended as
described in the preceding sentence. In addition, on May 10, 1999 the Board of
Directors granted to the executive officers and certain Non-Executive Employees
of the Company additional non-statutory stock options to purchase an aggregate
of 343,575 shares of the Company's Common Stock under the Plan. Such stock
options become fully vested on the first anniversary of the date of grant, have
exercise prices of $.5625 per share and expire 10 years from the date of grant.

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



                                       44
<PAGE>   48
                       ILLINOIS SUPERCONDUCTOR CORPORATION
                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)


6.  STOCK OPTIONS AND WARRANTS (CONTINUED)

      Pro forma information regarding net income and earnings per share is
required under FASB 123, and has been determined as if the Company had accounted
for its stock options granted subsequent to December 31, 1994 under the fair
value method of that Statement. The fair value for these options was estimated
at the date of grant using a Black-Scholes option pricing model with the
following weighted-average assumptions for the years ended December 31, 1999,
1998 and 1997: risk-free interest rate of 6.0%, 5.6% and 6.3%, respectively; a
dividend yield of 0%; volatility factor of the expected market price of the
Company's common stock of 1.68, .96 and .74, respectively; and expected life of
the options of 4.0 years.

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

     For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma information is as follows:


<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                         1999             1998        1997
                                                      ------------   ------------   -------------
<S>                                                   <C>            <C>            <C>
         Pro forma net loss                           $(23,522,352)  $(22,863,252)  $(13,063,962)
         Pro forma basic and diluted loss per
          common share                                $      (1.83)  $      (2.02)  $      (2.53)
</TABLE>

      The table below summarizes all option activity during the three year
period ended December 31, 1999:


<TABLE>
<CAPTION>
                                                         EXERCISE
                                      OPTIONS             PRICE
                                    OUTSTANDING         PER SHARE
                                    --------------------------------
<S>                                 <C>              <C>
Outstanding at December 31, 1996      796,258          $ .18 - 27.00
Granted                               121,000           2.00 - 19.00
Exercised                             (17,821)           .18 - 18.25
Forfeited                            (216,104)          6.75 - 27.00
                                    ---------
Outstanding at December 31, 1997      683,333            .18 - 26.50
Granted                               780,900            1.03 - 2.00
Exercised                             (33,942)             .18 - .23
Forfeited                            (236,314)           .23 - 26.50
                                    ---------
Outstanding at December 31, 1998    1,193,977            .18 - 26.50
Granted                             1,935,125             .45 - 1.31
Exercised                             (17,250)             .18 - .23
Forfeited                          (1,197,005)           .48 - 26.50
                                    ---------
Outstanding at December 31, 1999    1,914,847          $ .18 - 26.50
                                    =========
</TABLE>


                                       45
<PAGE>   49

                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


6.  STOCK OPTIONS AND WARRANTS (CONTINUED)

      The weighted-average exercise price of options outstanding at December 31,
1999, 1998 and 1997, was $1.83, $6.71 and $12.92, respectively. The
weighted-average exercise price of options granted, exercised, and forfeited
during 1999 was $0.59, $0.22 and $4.70, respectively. The weighted-average fair
value of options granted during 1999, 1998 and 1997 was $0.53, $1.09, $7.94,
respectively.

      Following is additional information with respect to options outstanding at
December 31, 1999:


<TABLE>
<CAPTION>
                                            EXERCISE     EXERCISE    EXERCISE     EXERCISE     EXERCISE
                                           PRICE FROM   PRICE FROM  PRICE FROM   PRICE FROM   PRICE FROM
                                            $0.18 TO     $0.48 TO    $0.66 TO     $6.75 TO     $15.50 TO
                                              $0.45       $0.56        $2.00       $11.75       $26.50
                                          ---------------------------------------------------------------
<S>                                       <C>           <C>          <C>          <C>         <C>
     OUTSTANDING AT DECEMBER 31, 1999:
        Number of options                     301,725   1,093,535     356,000       71,639       91,948
        Weighted-average exercise price        $ 0.45      $ 0.51      $ 1.34       $ 9.76      $ 17.78
        Weighted-average remaining
          contractual life in years              9.90        9.19        8.73         4.43         5.94

     EXERCISABLE AT DECEMBER 31, 1999:
        Number of options                       1,725     156,342      85,063       69,839       85,312
        Weighted-average exercise price        $ 0.18      $ 0.56      $ 1.69       $ 9.80      $ 17.72
</TABLE>


      The total number of unvested options outstanding at December 31, 1999 was
1,516,566, all of which will vest based on employees' continued service to the
Company.

      On February 15, 2000, the Board of Directors of the Company granted to
certain executive level employees (i) an aggregate of 440,000 Deferred Stock
Units and (ii) an aggregate of 585,000 NSOs under the Plan. The NSOs have an
exercise price of $4.1875 per share (the closing price of the Company's common
stock on February 15, 2000). The Deferred Stock Units represent the right to
receive an equivalent number of restricted shares of the Company's common stock.
Both the Deferred Stock Units and the NSOs vest at the rate of 10%, 20%, 30% and
40% on the first, second, third and fourth anniversary, respectively, of the
date of grant. The executive level employees have the right to defer receipt of
the common stock subject to the Deferred Stock Units to a later date as elected
by the employee.





                                       46
<PAGE>   50

                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


6.    STOCK OPTIONS AND WARRANTS (CONTINUED)

      In December 1991 and January 1992, the Company issued common stock
purchase warrants for 34,063 and 74,938 shares, respectively, to preferred
stockholders in conjunction with short-term loans from the stockholders. These
warrants have an exercise price of $1.4679 per share and expire 10 years from
the date of issue. Warrants for 19,869, 34,063 and 13,625 of these shares were
exercised during 1997, 1996, and 1995, respectively.

      In connection with the July 1992 issuance of Series B convertible
preferred stock, the Company issued common stock purchase warrants for 213,780
shares to the Series B convertible preferred stockholders. These warrants have
an exercise price of $2.29 (71,260 shares), $2.75 (71,260 shares), and $3.21
(71,260 shares) per share and expire upon the seventh anniversary of issuance.
Warrants for 96,437 of these shares (36,107 shares at $2.29 per share, 36,107
shares at $2.75 per share and 24,223 shares at $3.21 per share) were exercised
during 1996. Warrants for 54,337 of these shares (17,779 shares at $2.29 per
share, 17,779 shares at $2.75 per share, and 18,779 shares at $3.21 per share)
were exercised during 1997. The remaining 63,006 unexercised warrants expired in
1999.

      The Company issued warrants to purchase 470,589 shares of common stock in
connection with the July 1993 issuance of Series C Preferred Stock. These
warrants are exercisable at $9.56 per share. Warrants for 64,614 and 69,020 of
these shares were exercised during 1997 and 1996, respectively. On February 22,
2000, 210,196 of these warrants were surrendered to the Company as part of a
settlement agreement (Note 11). The remaining 126,759 warrants expire in
November 2000.

      On June 6, 1997, the Company issued warrants to purchase 62,500 shares of
common stock in connection with the issuance of Series B Convertible Preferred
Stock (Note 5). These warrants have an exercise price of $14.8125 per share and
expire on June 6, 2001.

      On October 29, 1997, the Company issued warrants to purchase 34,782 shares
of common stock in connection with the issuance of Series G Convertible
Preferred Stock (Note 5). These warrants had an original exercise price of
$10.0625 per share and expire on October 29, 2001. On November 5, 1999, in
conjunction with certain amendments to the Company's senior convertible notes
(Note 7), these outstanding warrants were amended to reduce the exercise price
to $0.25 per share.

      On May 15, 1998, the Company issued warrants to purchase 4,140,000 shares
of common stock in connection with the issuance of the Company's senior
convertible notes (Note 7). Of the original warrants issued, 3,800,000 of these
warrants have an exercise price of $0.25 per share and 340,000 of these warrants
have an exercise price of $3.75 per share. These warrants expire on May 15,
2001.

      On March 31, 1999, the Company issued warrants to purchase 1,320,000
shares of common stock in connection with the issuance of the Company's senior
convertible notes (Note 7). Of the original warrants issued, 1,200,000 of these
warrants have an exercise price of $0.25 per share and 120,000 of these warrants
have an exercise price of $1.4625 per share. These warrants expire on March 31,
2002.


                                       47
<PAGE>   51
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


6.    STOCK OPTIONS AND WARRANTS (CONTINUED)

      On November 5, 1999 and December 29, 1999, the Company issued warrants to
purchase an aggregate total of 800,000 shares of common stock in connection with
the issuance of the Company's senior convertible notes (Note 7). These warrants
have an exercise price of $0.25 per share and expire on November 5, 2004.

      During the period from January 1, 2000 to February 25, 2000, 2,200,000
warrants issued in connection with the issuance of the Company's senior
convertible notes (Note 7) were exercised at an exercise price of $0.25 per
share.

7.  LONG-TERM DEBT

      On May 15, 1998, the Company issued and sold $10,350,000 in aggregate
principal amount of senior convertible notes due May 15, 2002 (the "May 1998
Notes") and issued warrants (the "May 1998 Warrants") to purchase 4,140,000
shares of the Company's common stock. The May 1998 Notes (based upon the terms
at their time of issue) bear interest at 2% per annum, payable in cash or shares
of Common Stock, at the Company's option (unless the Company does not meet
certain requirements commencing November 5, 2001, in which case interest must be
paid in cash). The May 1998 Notes mature on May 15, 2002 and (based upon the
terms at their time of issue) are convertible (based on the principal amount,
plus accrued and unpaid interest, if any) into shares of the Company's common
stock at a fixed conversion price of $1.50 per share. On and after May 15, 2000,
the Company may redeem all or a portion of the May 1998 Notes at a redemption
price equal to the principal amount plus accrued interest thereon, if any, under
certain conditions. The May 1998 Warrants (based upon the terms at their time of
issue) have an exercise price of $3.75 per share and expire on May 15, 2001.

      Since the May 1998 Notes were issued with a non-detachable conversion
feature that was "in-the-money" at the date of issuance, a portion of the
proceeds equal to the intrinsic value of the conversion feature (equal to
$9,918,750, and calculated as the difference between the conversion price and
the quoted market price of the Company's common stock on the date of issuance,
multiplied by the number of shares into which the May 1998 Notes are
convertible) was allocated to additional paid-in capital, thus creating a
discount to the debt. This discount was recognized as a charge to interest
expense using the effective interest method over the period from the date of
issuance to the date that the May 1998 Notes first became convertible (August
15, 1998 for up to one-half of the original principal amount and November 15,
1998 for the remaining principal amount). In addition, a portion of the proceeds
equal to the fair value of the May 1998 Warrants issued in conjunction with the
May 1998 Notes (equal to $1,230,000, and calculated using a Black-Scholes
valuation model) was allocated to additional paid-in capital, thus creating an
additional discount to the debt. This discount is being recognized as a charge
to interest expense using the effective interest method over the four year term
of the May 1998 Notes.

      On March 31, 1999, the Company issued and sold $3,300,000 in aggregate
initial principal amount of senior convertible notes due May 15, 2002 (the
"March 1999 Notes") and issued warrants (the "March 1999 Warrants") to purchase
1,320,000 shares of the Company's common stock. The March 1999 Notes bear
interest at 6% per annum, payable in kind or in cash, at the Company's option
(unless the Company fails to meet certain requirements commencing November 5,
2001, in which case interest must be paid in cash). Holders of the March 1999
Notes may convert the principal amount, plus accrued interest not paid in cash,
if any, into shares of the Company's common stock at a fixed conversion price of
$1.125 per share (based upon the terms at their time of issue). On and after May
15, 2000, the Company may redeem all or a portion of the March 1999 Notes at a
redemption price equal to the principal amount plus accrued interest thereon, if
any, under certain conditions. The March 1999 Warrants (based upon the terms at
their time of issue) have an exercise price of $1.4625 per share and expire on
March 31, 2002.


                                       48
<PAGE>   52
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


7.   LONG-TERM DEBT (CONTINUED)

      Concurrently with the issuance of the March 1999 Notes, the Company
amended certain terms of $5,500,000 in aggregate principal amount of the May
1998 Notes (the "Amended Notes") and May 1998 Warrants exercisable for an
aggregate of 2,200,000 shares of the Company's common stock (the "Amended
Warrants") issued in connection therewith (the "March 1999 Amendments"). The
Amended Notes, as so amended, bear interest at the rate of 6% per annum, payable
in cash or shares of the Company's common stock, at the Company's option (unless
the Company fails to meet certain requirements commencing November 5, 2001, in
which case interest must be paid in cash), and the fixed conversion price for
the Amended Notes was reduced from $1.50 to $1.125 per share. The exercise price
of the Amended Warrants was reduced from $3.75 to $1.4625 per share and the
expiration date was extended from May 15, 2001 to March 31, 2002.

      A portion of the proceeds of the March 1999 Notes equal to the fair value
of the March 1999 Warrants issued in conjunction with the March 1999 Notes
(equal to $300,000 and calculated using a Black-Scholes valuation model) was
allocated to additional paid-in capital, thus creating a discount to the debt.
This discount is being recognized as a charge to interest expense using the
effective interest method over the three year term of the March 1999 Notes. In
addition, the increase in fair value of the Amended Warrants as a result of the
decrease in exercise price (equal to $41,000 and calculated using a
Black-Scholes valuation model) was allocated to additional paid-in capital, thus
creating an additional discount on the Amended Notes. This discount is being
recognized as a charge to interest expense using the effective interest method
over the remaining three year term of the Amended Notes.

      On November 5, 1999, the Company issued and sold $1,000,000 in aggregate
principal amount of senior convertible notes due January 2, 2001 (the "November
1999 Notes") and issued warrants (the "November 1999 Warrants") to purchase
400,000 shares of the Company's common stock. The November 1999 Notes bear
interest at 10% per annum, payable in kind or in cash, at the Company's option
(unless the Company does not meet certain requirements commencing November 5,
2001, in which case interest must be paid in cash). Holders of the November 1999
Notes may convert the principal amount, plus accrued interest not paid in cash,
if any, into shares of the Company's common stock at a fixed conversion price of
$0.25 per share. The November 1999 Warrants have an exercise price of $0.25 per
share and expire on November 5, 2004.

      Concurrently with the issuance of the November 1999 Notes, the Company
amended certain terms of $11,800,000 in aggregate principal amount of the March
1999 Notes, the Amended Notes and the May 1998 Notes (the "Further Amended
Notes") and certain terms of the March 1999 Warrants, the Amended Warrants and
the May 1998 Warrants previously exercisable for an aggregate of 4,800,000
shares of the Company's common stock (the "Further Amended Warrants") issued in
connection therewith ("the "November 1999 Amendments"). The Further Amended
Notes were amended to reduce their fixed conversion price to $0.25 per share and
to provide that interest on the Further Amended Notes can be paid in cash or
shares of the Company's common stock, at the Company's option until November 5,
2000, after which interest must be paid in cash if the Company fails to meet
certain requirements. The exercise price of the Further Amended Warrants was
reduced to $0.25 per share.

      Since the November 1999 Notes were issued with a non-detachable conversion
feature that was "in-the-money" at the date of issuance, a portion of the
proceeds equal to the intrinsic value of the conversion feature (calculated as
the difference between the conversion price ($0.25 per share) and the quoted
market price of the Company's common stock on the date of issuance ($0.46875 per
share) multiplied by the number of shares into which the November 1999 Notes are
convertible (4,000,000 shares)) must be allocated to additional paid-in capital,
thus creating a discount to the debt. This discount, which was limited to
$844,000 because the intrinsic value of the beneficial conversion feature cannot
exceed the amount allocated to the convertible instrument, was recognized as a
charge to interest expense during the fourth quarter of 1999 since the November
1999 Notes are immediately convertible into common stock. In addition, a portion
of the proceeds of the November 1999 Notes equal to the fair value of the
November 1999 Warrants issued in conjunction with the November 1999 Notes (equal
to $156,000 and calculated using a Black-Scholes valuation model) was allocated
to additional paid-in capital, thus creating an additional discount to the debt.
This additional discount will be recognized as a charge to interest expense
using the effective interest method over the fourteen month term of the November
1999 Notes.



                                       49
<PAGE>   53
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


7.    LONG-TERM DEBT (CONTINUED)

      Since the Further Amended Notes were amended to reduce the non-detachable
conversion feature so that they were "in-the-money" on November 5, 1999, a
portion of the principal amount equal to the intrinsic value of the conversion
feature (calculated as the difference between the amended conversion price
($0.25 per share) and the quoted market price of the Company's common stock on
the amendment date ($0.46875) multiplied by the number of shares into which the
Further Amended Notes are convertible (47,200,000)) must be allocated to
additional paid-in capital, thus creating a discount to the debt. This discount,
which was limited to $10,264,000 because the intrinsic value of the beneficial
conversion feature cannot exceed the amount allocated to the convertible
instrument, was recognized as a charge to interest expense during the fourth
quarter of 1999 since the Further Amended Notes are immediately convertible into
common stock. In addition, the increase in fair value of the Further Amended
Warrants as a result of the decrease in exercise price (equal to $1,132,000 and
calculated using a Black-Scholes valuation model) was allocated to additional
paid-in capital, thus creating an additional discount on the Further Amended
Notes. This additional discount will be recognized as a charge to interest
expense using the effective interest method over the remaining term of the
Further Amended Notes.

      The March 1999 Amendments and the November 1999 Amendments were accounted
for and reported in the same manner as a debt extinguishment. This resulted in a
$745,197 charge, which is shown as an extraordinary item in the Company's
Statements of Operations for the year ended December 31, 1999.

      On December 29, 1999, the Company issued and sold $1,000,000 in aggregate
principal amount of senior convertible notes due January 2, 2001 (the "December
1999 Notes") and issued warrants (the "December 1999 Warrants") to purchase
400,000 shares of the Company's common stock. The December 1999 Notes bear
interest at 10% per annum, payable in kind or in cash, at the Company's option
(unless the Company does not meet certain requirements commencing November 5,
2001, in which case interest must be paid in cash). Holders of the December 1999
Notes may convert the principal amount, plus accrued interest not paid in cash,
if any, into shares of the Company's common stock at a fixed conversion price of
$0.25 per share. The December 1999 Warrants have an exercise price of $0.25 per
share and expire on November 5, 2004.

      Since the December 1999 Notes were issued with a non-detachable conversion
feature that was "in-the-money" at the date of issuance, a portion of the
proceeds equal to the intrinsic value of the conversion feature (equal to
$500,000, and calculated as the difference between the conversion price ($0.25
per share) and the quoted market price of the Company's common stock on the date
of issuance ($0.375 per share) multiplied by the number of shares into which the
December 1999 Notes are convertible (4,000,000 shares)) was allocated to
additional paid-in capital, thus creating a discount to the debt. This discount
was recognized as a charge to interest expense since the notes are immediately
convertible into common stock. In addition, a portion of the proceeds of the
December 1999 Notes equal to the fair value of the December 1999 Warrants issued
in conjunction with the December 1999 Notes (equal to $104,000 and calculated
using a Black-Scholes valuation model) was allocated to additional paid-in
capital, thus creating an additional discount to the debt. This additional
discount will be recognized as a charge to interest expense using the effective
interest method over the twelve month term of the December 1999 Notes.

      During 1999, $200,000 in aggregate principal amount of the Amended Notes
and $725,000 in aggregate principal amount of the Further Amended Notes, plus
accrued interest, were converted into 186,314 shares and 2,992,392 shares,
respectively, of common stock.

      The Company recognized $12,608,355 and $10,101,401 of non-cash interest
charges during 1999 and 1998, respectively as a result of amortizing the debt
discount and the deferred financing fees related to the Company's senior
convertible notes.


                                       50
<PAGE>   54
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


7.    LONG-TERM DEBT (CONTINUED)

      All of the Company's assets are pledged as security to certain of the
purchasers of the senior convertible notes. Additionally, the Note Purchase
Agreements contain several covenants which limit the Company's ability to incur
additional indebtedness and to create any further lien, pledge, or encumbrance
on any assets of the Company.

      Payments due on long-term debt, including interest accrued on the senior
convertible notes, during each of the five years subsequent to December 31, 1999
and in the aggregate are as follows:


                    2000                        $      9,020
                    2001                           2,025,025
                    2002                          13,348,792
                    2003                                  --
                    2004                                  --
                    Thereafter                            --
                                                ------------
                                                $ 15,382,837
                                                ============


      During the period from January 1, 2000 to February 25, 2000, $2,470,222 in
aggregate principal amount of Further Amended Notes, $500,000 in aggregate
principal amount of Amended Notes, $300,000 in aggregate principal amount of
March 1999 Notes, and $500,000 in aggregate principal amount of May 1998 Notes
were converted into 11,341,526 shares of common stock.

      It is not practicable to estimate the fair value of the Notes at December
31, 1999 because a quoted market price for such securities is not available, the
Company has not yet developed a valuation model necessary to make such an
estimate, and the cost of obtaining an independent valuation would be
prohibitive.

8.    INCOME TAXES

      The Company has net operating loss and research and development credit
carryforwards for tax purposes of approximately $60,584,000 and $1,075,000,
respectively, at December 31, 1999. The net operating loss carryforwards expire
in the following years:

                  YEAR                      AMOUNT
                  ----                    -----------
                  2005                    $     7,000
                  2006                        638,000
                  2007                        974,000
                  2008                      1,658,000
                  2009                      3,973,000
                  2010                      8,199,000
                  2011                     11,953,000
                  2012                     11,922,000
                  2013                     11,146,000
                  2014                     10,114,000
                                          -----------
                                          $60,584,000
                                          ===========



                                       51
<PAGE>   55
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


8.  INCOME TAXES (CONTINUED)

     Significant components of the Company's deferred tax assets and liabilities
are as follows:


                                                  DECEMBER 31,
                                             1999            1998
                                         ------------    ------------
Deferred tax assets:
   Net operating loss carryforward       $ 23,023,000    $ 19,140,000
   Research and development tax credit
     carryforwards                          1,075,000       1,050,000
   Deferred compensation                        3,000          27,000
   Accrued liabilities                        130,000            --
   Accounts receivable                         13,000          33,000
   Inventories                                324,000         223,000
                                         ------------    ------------
Total deferred tax assets                  24,568,000      20,473,000

Deferred tax liabilities:
   Patent costs                              (225,000)       (234,000)
   Property and equipment                     (29,000)       (101,000)
                                         ------------    ------------
                                             (254,000)       (335,000)
                                         ------------    ------------
Net deferred tax assets                    24,314,000      20,138,000
Valuation allowance                       (24,314,000)    (20,138,000)
                                         ------------    ------------
Net deferred tax assets                  $       --      $       --
                                         ============    ============


      The valuation allowance increased during 1999 and 1998 by $4,176,000 and
$4,313,000, respectively, due primarily to the increase in the net operating
loss carryforward. Based on the Internal Revenue Code and changes in the
ownership of the Company, utilization of the net operating loss carryforwards
will be subject to annual limitations.

9.  LEASES

      The Company leases its manufacturing and office space. Under the terms of
the lease, which expires October 2004, the Company is responsible for all real
estate taxes and operating expenses. The lease provides for a security deposit
($200,000 at December 31, 1999) that is secured by a certificate of deposit
owned by the Company.



                                       52
<PAGE>   56
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


9.    LEASES (CONTINUED)

      Future minimum payments under the operating lease consist of the following
at December 31, 1999:


                  YEAR                  AMOUNT
               -----------           -----------

               2000                  $ 231,300
               2001                    249,900
               2002                    249,900
               2003                    249,900
               2004                    208,300
               Thereafter                 --
                                    ----------
                                    $1,189,300
                                    ==========


      Rent expense totaled $227,535, $229,786 and $226,938, for the years ended
December 31, 1999, 1998, and 1997, respectively.

10.  401(k) PLAN

      The Company has a 401(k) plan covering all employees who meet prescribed
service requirements. The plan provides for deferred salary contributions by the
plan participants and a Company contribution. Company contributions, if any, are
at the discretion of the Board of Directors and are not to exceed the amount
deductible under applicable income tax laws. No Company contribution was made
for the years ended December 31, 1999, 1998, and 1997.

11.  LITIGATION

Siegler Litigation

      On June 5, 1996, Craig M. Siegler filed a complaint against the Company in
the Circuit Court of Cook County, Illinois, County Department, Chancery
Division. The complaint alleged that, in connection with the Company's private
placement of securities in November 1995, the Company breached and repudiated an
oral contract with Mr. Siegler for the issuance and sale by the Company to Mr.
Siegler of 370,370.37 shares of the Company's Common Stock, plus warrants
(immediately exercisable at $12.96 per share) to purchase an additional
370,370.37 shares of the Company's Common Stock, for a total price of
$4,000,000. The remedy sought by Mr. Siegler was a sale to him of such
securities on the terms of the November 1995 private placement. On August 16,
1996, the Company's motion to dismiss Mr. Siegler's complaint was granted with
leave to amend. On September 19, 1996, Mr. Siegler's motion for reconsideration
was denied.

      On October 10, 1996, Mr. Siegler filed his First Amended Verified
Complaint and Jury Demand, seeking a jury trial and money damages equal to the
difference between $8,800,000 (370,370.37 shares at $10.80 per share and
370,370.37 shares at $12.96 per share) and 740,740.74 shares multiplied by the
highest price at which the Company's Common Stock traded on The Nasdaq Stock
Market between November 20, 1995 and the date of judgment. Mr. Siegler also
preserved his claim for specific performance for purposes of appeal. On November
1, 1996, the case was transferred to the Circuit Court of Cook County, Illinois,
County Department, Law Division. The Company's Answer was filed on November 21,
1996, and the parties have completed discovery.




                                       53
<PAGE>   57
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


11.   LITIGATION (CONTINUED)

      The Company filed a motion for summary judgment against Mr. Siegler, which
is on hold pending the deposition of an expert retained by Mr. Siegler in the
case. The Company is scheduled to take the expert's deposition in March 2000,
after which the court will enter a briefing schedule on the motion for summary
judgement.

      The Company believes that the suit is without merit and intends to
continue to defend itself vigorously in this litigation. However, if Mr. Siegler
prevails in this litigation and is awarded damages in accordance with the
formula described above, such judgment would have a material adverse effect on
the Company's financial condition, results of operations and cash flows.

Note Litigation

      On July 10, 1997, the Company filed a complaint against Sheldon Drobny;
Howard L. "Buzz" Simons, joint tenant with Aric and Corey Simons; Aaron Fischer;
Stewart Shiman; Sharon D. Gonsky, d/b/a SDG Associates; Gregg Rosenberg; Stacey
Rosenberg; Merrill Weber & Co., Inc.; Drobny/Fischer Partnership, an Illinois
general partnership; and Ruben Rosenberg (collectively, the "Borrowers"), and
Paradigm Venture Investors, L.L.C. (the "Guarantor") in the Circuit Court of
Cook County, Illinois, County Department, Law Division. The complaint seeks to
enforce the terms of loans made to the Borrowers by the Company and evidenced by
promissory notes dated December 13, 1996, in the aggregate principal amount of
$698,508 ($680,696 of which remains unpaid as of December 31, 1999) and the
guarantee by the Guarantor of the Borrowers' obligations under these promissory
notes. The Borrowers' notes were issued to the Company in connection with the
Borrowers' exercise of warrants to purchase shares of the Common Stock in
December 1996.

      On September 30, 1997, the Borrowers and the Guarantor responded to the
Company's complaint. Concurrently, the Borrowers filed a counterclaim alleging
that they exercised the warrants in reliance on the Company's alleged fraudulent
representations to certain Borrowers concerning a third-party's future
underwriting of a secondary public offering of the Company's Common Stock.

      On February 22, 2000, the Company reached a settlement agreement with the
Borrowers, whereby the Company agreed to release the Borrowers obligations under
the notes in return for the Borrowers' surrender of 210,196 warrants to purchase
common stock of the Company held by them and discharge of their counterclaims.
As a result of this settlement, the Company will record a charge of $822,776 to
additional paid-in capital in the first quarter of 2000, reflecting the carrying
amount of the notes of $680,696 and related accrued interest of $142,080, which
approximates the fair value of the warrants surrendered.

Lipman Litigation

      On January 6, 1998, Jerome H. Lipman, individually and on behalf of all
others similarly situated, filed a complaint against the Company and eight of
its former or current directors: Leonard A. Batterson, Michael J. Friduss, Peter
S. Fuss, Edward W. Laves, Steven L. Lazarus, Tom L. Powers, Ora E. Smith and
Paul G. Yovovich (collectively, the "Named Directors") in the Circuit Court of
Cook County, Illinois, County Department, Chancery Division. The complaint
alleged that the Named Directors breached their duties of loyalty and due care
to the putative class of stockholders by selecting financing for the Company in
June 1997 which supposedly entrenched the Directors and reduced the Common Stock
price. The complaint also alleged that the Named Directors breached their duty
of disclosure by not informing the stockholders that the selected financing
would erode the Common Stock price. Mr. Lipman's complaint sought certification
of a class consisting of all owners of the Company's Common Stock during the
period from June 6, 1997 through November 21, 1997, excluding the Named
Directors and Sheldon Drobny. The complaint also seeks an unspecified amount of
compensatory and punitive damages, and attorneys' fees.



                                       54
<PAGE>   58
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


11.   LITIGATION (CONTINUED)

      The Company and the Named Directors regard the suit as without factual or
legal merit. Accordingly, on February 17, 1998, the Company and the Named
Directors filed a motion to dismiss Mr. Lipman's complaint. The motion presented
arguments that the claims of Mr. Lipman and the putative class are barred by the
business judgment rule and the plaintiff's failure to fulfill the legal
prerequisites for filing an action against the Named Directors. Prior to a
hearing on the Company's and the Named Directors' motion to dismiss, Mr. Lipman
filed a motion on March 16, 1998, seeking both to amend his proposed putative
class to include Mr. Drobny and to certify the class.

      On June 1, 1998, the court granted the Company's and the Named Directors'
motion to dismiss the complaint. Concurrently, Mr. Lipman withdrew his motion to
amend the proposed putative class and certify the class. On June 30, 1998, Mr.
Lipman filed an amended complaint against the Named Directors but excluding the
Company itself as a defendant. The amended complaint alleges that the Named
Directors breached their duties of loyalty and due care to the putative class of
stockholders by selecting financing for the Company in June 1997 and thereafter
drawing two tranches of the financing. The amended complaint seeks certification
of a class consisting of all owners of the Company's Common Stock during the
period from May 15, 1997 through December 31, 1997, excluding the Named
Directors. Mr. Lipman's amended complaint alleges that the stock owned by the
putative class lost $61 million due to the financing the Named Directors
selected, and seeks an unspecified amount of compensatory and punitive damages.
The Company and the Named Directors regard the amended complaint as without
factual or legal merit. Accordingly, the Named Directors filed a motion to
dismiss Mr. Lipman's amended complaint on July 29, 1998. The court granted the
motion to dismiss in December 1998, finding that Mr. Lipman still had failed to
fulfill the prerequisites for maintaining a shareholder derivative action
against the Named Directors. On January 12, 1999, Mr. Lipman and two added
former stockholders filed a second amended complaint against the Named Directors
and again including the Company itself as a defendant.

      The second amended complaint alleged that the Named Directors breached
their duties of loyalty and due care to the putative class and further alleged
that the purported devaluation of the plaintiffs' stock resulting from the June
1997 financing was an improper "assessment" on the plaintiffs' shares for which
they sought an unspecified amount of compensatory and punitive damages. In
February 1999, the Company and the Named Directors filed a motion to dismiss the
second amended complaint. The Court granted the motion to dismiss in April 1999,
finding that (i) the plaintiffs could not assert their stock devaluation claims,
except derivatively, and (ii) the plaintiffs still had failed to fulfill the
prerequisites for maintaining a shareholder derivative action against the Named
Directors. In May 1999, the plaintiffs filed a third amended complaint against
the Company and the Named Directors.

      The third amended complaint reiterated the plaintiffs' previous
allegations that the Named Directors breached their duties of loyalty, due care
and candor to the putative class, and again alleged the plaintiffs' claims of an
improper "assessment." The third amended complaint also asserted two claims of
purported common law fraud and a supposed violation of the Illinois Consumer
Fraud Act based on allegations that the Company and the Named Directors had
selectively disclosed "material, non-public confidential information" to the
non-party financier in order to obtain the financing that the Company selected
in June 1997, which allegedly reduced the Common Stock price. The plaintiffs
sought an unspecified amount of compensatory and punitive damages, interest and
attorneys' fees. In June 1999, the Company and the Named Directors filed a
motion to dismiss the third amended complaint, arguing that the plaintiffs'
allegations of purported market manipulation by the financier, facilitated by
supposedly improper selective disclosure, are beyond the jurisdiction of the
Illinois court and fail to allege certain essential elements of common law fraud
and the Illinois Consumer Fraud Act. The defendants' motion also argued that the
plaintiffs still had failed to fulfill the prerequisites for asserting their
stock devaluation claims as a shareholder derivative action. In August 1999, the
Court granted the Company's and the Named Directors' motion, and dismissed the
suit with prejudice.



                                       55
<PAGE>   59
                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


11.   LITIGATION (CONTINUED)

      Thereafter the plaintiffs filed a motion for reconsideration of the
dismissal; the Court denied the plaintiffs' reconsideration motion on September
23, 1999. On October 21, 1999, the plaintiff filed their notice of appeal from
the dismissal orders. The Company and the named Directors regard the appeal as
without merit and they intend to vigorously defend against the plaintiffs'
appeal from the Circuit Court's dismissal orders.

Greenwald Litigation

      On June 24, 1998, Jonathan Greenwald, derivatively on behalf of the
Company, filed a complaint against the Company and the Named Directors in the
court of Chancery of the State of Delaware in and for New Castle County. Mr.
Greenwald's complaint alleges that the Named Directors breached their duties of
good faith, loyalty, due care, and candor by selecting financing for the Company
in 1997 which purportedly reduced the Company's stock price and was supposedly
accepted to entrench the Named Directors. The complaint seeks an unspecified
amount of compensatory damages, various equitable relief and attorney's fees.

      The Company and the Named Directors regarded the suit as without factual
or legal merit. Accordingly, in January 1999, the Company and the Named
Directors filed a motion to dismiss the complaint arguing that the complaint is
barred by the business judgment rule and the plaintiffs' failure to fulfill the
prerequisites for maintaining a shareholder derivative action against the Named
Directors. In July 1999, the Court of Chancery granted the defendants' motion to
dismiss the complaint finding that the plaintiffs had failed to satisfy the
prerequisites for maintaining a shareholder derivative action under Delaware
law. By order dated August 11, 1999, the Court of Chancery granted the Company's
and the named Directors' motion to dismiss with prejudice the suit as it relates
to Mr. Greenwald, the named plaintiff.

16(b) Litigation

      On February 26, 1999, Mark Levy, derivatively on behalf of the Company,
filed a complaint against Southbrook International Investments, Ltd.
("Southbrook"), Elliott Associates, L.P. ("Elliott"), and Westgate
International, L.P. ("Westgate"), and against the Company as a "nominal
defendant." The complaint filed in the United States District Court for the
Southern District of New York, alleges that Southbrook, Elliott and Westgate,
while having beneficial ownership of more than 10% of the Company's common
stock, incurred liability under Section 16(b) of the Securities Exchange Act of
1934 in connection with purchases and sales of Company securities within six
month periods. The complaint seeks to recover from Southbrook, Elliott and
Westgate their respective profits (in unspecified amounts) from those
transactions. No relief is sought against the Company as a nominal defendant.

      Elliott and Westgate are currently investors in the Company with
substantial rights to acquire Company common stock by conversion of notes and
exercise of warrants and have designated four of the current five directors of
the Company, two of whom, Messrs. Mark Brodsky and Samuel Perlman, are employed
by a company that provides management services to, and is under common control
with, Elliott and Westgate.

      An amended complaint dated September 2, 1999 was served on the Company.
The amended complaint raises the same claims alleged in the original complaint.
Pursuant to stipulation, as of the date hereof, the Company has not yet
responded to the amended complaint.

      Motions to dismiss the action have been filed by Elliott, Westgate and
Alexander.




                                       56
<PAGE>   60

                      ILLINOIS SUPERCONDUCTOR CORPORATION
                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)


      The Company intends to defend itself vigorously in the matters described
above and believes that the resolution of these matters will not have a material
adverse effect on the financial condition, results of operations, or cash flows
of the Company.



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

      None.



                                       57
<PAGE>   61



                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

      Information in response to this item is incorporated by reference from the
"Election of Directors," "Executive Officers," and "Section 16(a) Beneficial
Ownership Reporting Compliance" sections of the 2000 Proxy Statement.

ITEM 11.  EXECUTIVE COMPENSATION

      Information in response to this item is incorporated by reference from the
section of the 2000 Proxy Statement captioned "Executive Compensation and
Certain Transactions."

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

      Information in response to this item is incorporated by reference from the
section of the 2000 Proxy Statement captioned "Security Ownership of Management
and Principal Stockholders."

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

      Information in response to this item is incorporated by reference from the
section of the 2000 Proxy Statement captioned "Executive Compensation and
Certain Transactions" and "Interests of Certain Persons in the Matters to be
Acted Upon at the Meeting."




                                       58
<PAGE>   62

                                     PART IV

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

(a) The following documents are filed as part of this Form 10-K:

      1. The following financial statements of the Company, with the report of
         independent auditors, are filed as part of this Form 10-K:

      Report of Independent Auditors
      Balance Sheets as of December 31, 1999 and 1998
      Statements of Operations for the Years Ended December 31, 1999, 1998, and
           1997
      Statements of Stockholders' Equity (Net Capital Deficiency) for the Years
           Ended December 31, 1999, 1998, and 1997
      Statements of Cash Flows for the Years Ended December 31,
           1999, 1998 and 1997 Notes to Financial Statements

      2. The following financial statement schedules of the Company are filed as
         part of this Form 10-K:

         Schedule II     Valuation and Qualifying Accounts

      All other financial schedules are omitted because such schedules are not
      required or the information required has been presented in the
      aforementioned financial statements.

      3. Exhibits are listed in the Exhibit Index to this Form 10-K.

(b) The following current reports on Form 8-K were filed during the quarterly
period ended December 31, 1999:

      1. On November 15, 1999, the Company filed with the Securities and
Exchange Commission a Current Report on Form 8-K, reporting on the entering into
and closing of the Letter Agreement.

      2. On November 30, 1999, the Company filed with the Securities and
Exchange Commission a Current Report on Form 8-K, reporting on changes in its
senior management effective on November 24, 1999.

      3. On December 30, 1999, the Company filed with the Securities and
Exchange Commission a Current Report on Form 8-K, reporting on an additional
$1.0 million investment in the Company by the Investors.



                                       59
<PAGE>   63
                                   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 the 22nd day of
March, 2000.

                                             ILLINOIS SUPERCONDUCTOR CORPORATION


                                             By:  /s/ GEORGE CALHOUN
                                                --------------------------------
                                                George Calhoun
                                                Chief Executive Officer


      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 indicated on the 22nd day of March, 2000.

<TABLE>
<CAPTION>
                SIGNATURE                                       TITLE
                ---------                                       -----
<S>                                                    <C>

                                                       Chief Executive Officer and Director
                /s/ GEORGE CALHOUN                     (Principal Executive Officer and Director)
    -------------------------------------------
                  George Calhoun

              /s/ CYNTHIA QUIGLEY                      Chief Financial Officer
    -------------------------------------------        (Principal Financial Officer)
                 Cynthia Quigley

                                                       Controller and Treasurer
                /s/ KENNETH E. WOLF                    (Principal Accounting Officer)
    -------------------------------------------
                 Kenneth E. Wolf

               /s/ MARK D. BRODSKY                     Director
    -------------------------------------------
                 Mark D. Brodsky

               /s/ HOWARD HOFFMANN                     Director
    -------------------------------------------
                 Howard Hoffmann

                /s/ SAMUEL PERLMAN                     Director
    -------------------------------------------
                  Samuel Perlman

               /s/ THOMAS L. POWERS                    Director
    -------------------------------------------
                 Thomas L. Powers
</TABLE>


                                       60
<PAGE>   64
                       ILLINOIS SUPERCONDUCTOR CORPORATION

                                   SCHEDULE II

                        VALUATION AND QUALIFYING ACCOUNTS
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997


<TABLE>
<CAPTION>
                                                         Balance at
                                                        beginning of                               Balance at end
                                                            Year       Additions   Deductions         of year
                                                        ------------  -----------  ----------      --------------
YEAR ENDED DECEMBER 31, 1999:
<S>                                                     <C>           <C>           <C>             <C>
   Deducted from asset accounts:
     Valuation allowance on deferred tax assets         $20,138,000   $ 4,176,000   $       0       $24,314,000

     Allowance for doubtful accounts                    $    87,990   $         0   $  52,650       $    35,340

     Reserve of obsolete inventory                      $   587,000   $   266,724   $       0       $   853,724

YEAR ENDED DECEMBER 31, 1998:

   Deducted from asset accounts:
     Valuation allowance on deferred tax assets         $15,825,000   $ 4,313,000   $       0       $20,138,000

     Allowance for doubtful accounts                    $    68,775   $    19,215   $       0       $    87,990

     Reserve for obsolete inventory                     $         0   $   587,000   $       0       $   587,000

YEAR ENDED DECEMBER 31, 1997:

   Deducted from asset accounts:
     Valuation allowance on deferred tax assets         $11,010,000   $ 4,815,000   $       0       $15,825,000

     Allowance for doubtful accounts:                   $         0   $    68,775   $       0       $    68,775

</TABLE>


                                       61

<PAGE>   65


                                  EXHIBIT INDEX

  EXHIBIT
  NUMBER                     DESCRIPTION OF EXHIBITS
  ------                     -----------------------

     3.1    Certificate of Incorporation of the Company, incorporated by
            reference to Exhibit 3.1 to the Company's Registration Statement on
            Form S-3/A, filed with the Securities and Exchange Commission
            ("SEC") on August 13, 1998, Registration No. 333-56601 (the "August
            1998 S-3").

     3.2    By-Laws of the Company, incorporated by reference to Exhibit 3.2 to
            Amendment No. 3 to the Company's Registration Statement on Form S-1,
            filed with the SEC on October 26, 1993, Registration No. 33-67756
            (the "IPO Registration Statement").

     3.3    Certificate of Amendment of Certificate of Incorporation of the
            Company, incorporated by reference to Exhibit 3.3 to the IPO
            Registration Statement.

     3.4    Certificate of Amendment of Certificate of Incorporation of the
            Company, incorporated by reference to Exhibit 4.3 to the Company's
            Registration Statement on Form S-3/A, filed with the SEC on July 1,
            1999, Registration No. 333-77337.

     4.1    Specimen stock certificate representing Common Stock, incorporated
            by reference to Exhibit 4.1 to the IPO Registration Statement.

     4.2    Form of Series B Warrants, incorporated by reference to Exhibit 4.2
            to the IPO Registration Statement.

     4.3    Form of Series C Warrants, incorporated by reference to Exhibit 4.3
            to the IPO Registration Statement.

     4.4    Form of Representative Warrant, incorporated by reference to Exhibit
            4.4 to the IPO Registration Statement.

     4.5    Rights Agreement dated as of February 9, 1996 between the Company
            and LaSalle National Trust, N.A., incorporated by reference to the
            Exhibit to the Company's Registration Statement on Form 8-A, filed
            with the SEC on February 12, 1996.

     4.6    Convertible Preferred Stock Purchase Agreement dated as of June 6,
            1997, by and between the Company and Southbrook International
            Investments, Ltd., incorporated by reference to Exhibit 4.3 to the
            Company's Registration Statement on Form S-3, filed with the SEC on
            June 23, 1997, Registration No. 333-29797 (the "June 1997 S-3").

     4.7    Registration Rights Agreement dated as of June 6, 1997, by and
            between the Company and Southbrook International Investments, Ltd.,
            incorporated by reference to Exhibit 4.5 to the June 1997 S-3.

     4.8    Warrant dated June 6, 1997 issued to Southbrook International
            Investments, Ltd., incorporated by reference to Exhibit 4.5 to the
            June S-3.

     4.9    Certificate of Designation, Preferences and Rights relating to the
            Company's Series C Convertible Preferred Stock, incorporated by
            reference to Exhibit 4.9 to the Company's Registration Statement on
            Form S-3, filed with the SEC on September 22, 1997, Registration No.
            333-36089.

     4.10   Certificate of Designation, Preferences and Rights relating to the
            Company's Series G Convertible Preferred Stock, incorporated by
            reference to Exhibit 4.8 to the Company's Registration Statement on
            Form S-3, filed with the SEC on December 8, 1997, Registration No.
            333-41731 (the "December 1997 S-3").


                                       62
<PAGE>   66

     4.11   Convertible Preferred Stock Purchase Agreement dated as of October
            29, 1997, by and between the Company and Elliott Associates, L.P.
            and Westgate International, L.P., incorporated by reference to
            Exhibit 4.9 to the December 1997 S-3.

     4.12   Registration Rights Agreement dated as of October 29, 1997, by and
            between the Company and Elliott Associates, L.P. and Westgate
            International, L.P., incorporated by reference to Exhibit 4.10 to
            the December 1997 S-3.

     4.13   Agreement dated as of October 29, 1997, by and between the Company
            and Brown Simpson Strategic Growth Fund, L.P. and Southbrook
            International Investments, Ltd., incorporated by reference to
            Exhibit 4.11 to the December 1997 S-3.

     4.14   Form of 2% Senior Convertible Note due May 15, 2002, incorporated by
            reference to Exhibit 4.2 to the August 1998 S-3.

     4.15   Form of Warrant dated May 15, 1998, incorporated by reference to
            Exhibit 4.3 to the August 1998 S-3.

     4.16   Securities Purchase Agreement dated as of May 15, 1998, by and
            between the Company and Elliott Associates, L.P., Westgate
            International, L.P., Alexander Finance, LP, State Farm Mutual
            Automobile Insurance Company, Spring Point Partners, L.P. and Spring
            Point Offshore Fund, incorporated by reference to Exhibit 4.5 to the
            August 1998 S-3.

     4.17   Registration Rights Agreement dated as of May 15, 1998, by and
            between the Company and Elliott Associates, L.P., Westgate
            International, L.P., Alexander Finance, LP, State Farm Mutual
            Automobile Insurance Company, Spring Point Partners, L.P. and Spring
            Point Offshore Fund, incorporated by reference to Exhibit 4.6 to the
            August 1998 S-3.

     4.18   Form of 6% Senior Convertible Note due May 15, 2002 incorporated by
            reference to Exhibit 4.18 to the Company's Annual Report on Form
            10-K for the year ended December 31, 1998.

     4.19   Form of Warrant dated March 31, 1999 incorporated by reference to
            Exhibit 4.19 to the Company's Annual Report on Form 10-K for the
            year ended December 31, 1998.

     4.20   Securities Purchase Agreement dated as of March 31, 1999, by and
            between the Company and Elliott Associates, L.P., Westgate
            International, L.P., Alexander Finance, LP and State Farm Mutual
            Automobile Insurance Company, incorporated by reference to Exhibit
            4.20 to the Company's Annual Report on Form 10-K for the year ended
            December 31, 1998.

     4.21   Registration Rights Agreement dated as of March 31, 1999, by and
            between the Company and Elliott Associates, L.P., Westgate
            International, L.P., Alexander Finance, LP and State Farm Mutual
            Automobile Insurance Company, incorporated by reference to Exhibit
            4.21 to the Company's Annual Report on Form 10-K for the year ended
            December 31, 1998.

     4.22   Amendment to Securities Purchase Agreement dated as of March 31,
            1999, by and between the Company and Elliott Associates, L.P.,
            Westgate International, L.P., Alexander Finance, LP, State Farm
            Mutual Automobile Insurance Company, Spring Point Partners, L.P. and
            Spring Point Offshore Fund, incorporated by reference to Exhibit
            4.22 to the Company's Annual Report on Form 10-K for the year ended
            December 31, 1998.

     10.1   1993 Amended and Restated Stock Option Plan, as amended,
            incorporated by reference to Exhibit B to the Company's Proxy
            Statement filed with the SEC on May 6, 1997.*


                                       63
<PAGE>   67

     10.2   Form of Amended and Restated Director Indemnification Agreement,
            incorporated by reference to Exhibit 10 to the Company's Quarterly
            Report on Form 10-Q for the quarterly period ended September 30,
            1998. *

     10.3   Third Amended and Restated Registration Rights Agreement dated as of
            July 14, 1993, as amended, incorporated by reference to Exhibit 10.4
            to the IPO Registration Statement.

     10.4   Public Law Agreement dated February 2, 1990 between Illinois
            Department of Commerce and Community Affairs and the Company,
            incorporated by reference to Exhibit 10.5 to the IPO Registration
            Statement.

     10.5   Public Law Agreement dated December 30, 1991 between Illinois
            Department of Commerce and Community Affairs and the Company,
            amended as of June 30, 1992, incorporated by reference to Exhibit
            10.6 to the IPO Registration Statement.

     10.6   Representative Warrant Agreement, incorporated by reference to
            Exhibit 10.7 to the IPO Registration Statement.

     10.7   Subcontract and Cooperative Development Agreement dated as of June
            1, 1993 between American Telephone and Telegraph Company and the
            Company, incorporated by reference to Exhibit 10.9 to the IPO
            Registration Statement.

     10.8   Intellectual Property Agreement dated as of June 1, 1993 between
            American Telephone and Telegraph Company and the Company,
            incorporated by reference to Exhibit 10.10 to the IPO Registration
            Statement.

     10.9   License Agreement dated January 31, 1990 between the Company and
            Northwestern University, incorporated by reference to Exhibit 10.13
            to the IPO Registration Statement.

     10.10  License Agreement dated February 2, 1990 between the Company and
            ARCH Development Corporation, incorporated by reference to Exhibit
            10.14 to the IPO Registration Statement.

     10.11  License Agreement dated August 9, 1991 between the Company and ARCH
            Development Corporation, incorporated by reference to Exhibit 10.15
            to the IPO Registration Statement.

     10.12  License Agreement dated October 11, 1991 between the Company and
            ARCH Development Corporation, incorporated by reference to Exhibit
            10.16 to the IPO Registration Statement.

     10.13  Public Law Agreement dated August 18, 1993 between Illinois
            Department of Commerce and Community Affairs and the Company,
            incorporated by reference to Exhibit 10.17 to the IPO Registration
            Statement.

     10.14  Form of Officer Indemnification Agreement incorporated by reference
            to Exhibit 10.17 to the Company's Annual Report on Form 10-K for the
            year ended December 31, 1998.*

     10.15  Employment Agreement dated November 9, 1998 between the Company and
            Dennis Craig incorporated by reference to Exhibit 10.18 to the
            Company's Annual Report on Form 10-K for the year ended December 31,
            1998.*

     10.16  Employment Agreement dated April 12, 1999 between the Company and
            Amr Abdelmonem, incorporated by reference to the Company's
            Registration Statement on Form S-2A, filed with the SEC on July 9,
            1999, Registration Number 333-77337.

     10.17  Single-Tenant Industrial building Lease between Teachers' Retirement
            System of the State of Illinois, landlord, and Illinois
            Superconductor Corporation, tenant, dated June 24, 1994,
            incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q
            for the quarterly period ending June 30, 1994.


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     10.18  Letter Agreement, dated November 5, 1999, by and among the Company
            and the Investors, incorporated by reference to Exhibit 10(a) to the
            Company's Current Report on Form 8-K filed with the SEC on November
            15, 1999.

     10.19  Letter Agreement re Modification of Covenants, dated November 5,
            1999, by and among the Company and the Investors, incorporated by
            reference to Exhibit 10(b) to the Company's Current Report on Form
            8-K filed with the SEC on November 15, 1999.

     10.20  Security Agreement, dated November 5, 1999, by and among the Company
            and the Investors, incorporated by reference to Exhibit 10(c) to the
            Company's Current Report on Form 8-K filed with the SEC on November
            15, 1999.

     10.21  Form of Letter Agreement dated November 12, 1999, amending the
            Letter Agreement filed as Exhibit 10.19, incorporated by reference
            to Exhibit 10(f) to the Company's Current Report on Form 8-K filed
            with the SEC on November 15, 1999.

     10.22  Form of Securities Purchase Letter Agreement dated December 28,
            1999, by and among the Company, Elliott Associates, Westgate and
            Alexander.

     23.    Consent of Independent Auditors.

     27.    Financial Data Schedule.

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

* Management contract or compensatory plan or arrangement required to be filed
as an exhibit on this Form 10-K.


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