<PAGE>   1




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

                                    FORM 10-Q

[X]     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 
EXCHANGE ACT OF 1934
For the quarterly period ended March 29, 1997

                                       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: 0-27422

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

          DELAWARE                                      94-3180312
  (State of incorporation)                  (I.R.S. Employer Identification No.)
                                         
                               
                            595 North Pastoria Avenue
                           Sunnyvale, California 94086
                    (Address of principal executive offices)

                                 (408) 736-0224
              (Registrant's telephone number, including area code)


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 
                                         ---     ---

The number of shares outstanding of the registrant's common stock as of April
26, 1997 was 8,794,112.



<PAGE>   2
                             ARTHROCARE CORPORATION

                                      INDEX

<TABLE>
<CAPTION>
                                                                                PAGE
                                                                                ----
<S>                                                                            <C>
PART 1:  FINANCIAL INFORMATION

     ITEM 1.  FINANCIAL STATEMENTS

          Condensed Balance Sheets as of March 29, 1997 and                      3
             December 28, 1996.

          Condensed Statements of Operations for the three
             months ended March 29, 1997 and March 30, 1996.                     4

          Condensed Statements of Cash Flows for the three months
             ended March 29, 1997 and March 30, 1996.                            5

          Notes to the Condensed Financial Statements                            6

     ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF
        FINANCIAL CONDITION AND RESULTS OF OPERATIONS                           8-25

PART II:  OTHER INFORMATION

     ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K                                 26-28

SIGNATURE                                                                        29
</TABLE>



<PAGE>   3


                         PART 1 - FINANCIAL INFORMATION

                          ITEM 1. FINANCIAL STATEMENTS

                             ARTHROCARE CORPORATION
                            CONDENSED BALANCE SHEETS
                                 (In thousands)
<TABLE>
<CAPTION>

                                                                March 29,               December 28,
                 ASSETS                                           1997                      1996
                                                          -------------------        ------------------
                                                               (Unaudited)
<S>                                                               <C>                       <C>     
Current assets
     Cash and cash equivalents                                    $ 17,851                  $ 11,359
     Available-for-sale securities                                   4,162                    12,281
     Accounts receivable, net                                        1,256                     1,251
     Inventory                                                         944                       759
     Prepaid expenses and other current assets                         127                       155
                                                                  --------                  --------
          Total current assets                                      24,340                    25,805
                                                                                            
Property and equipment, net                                          1,466                     1,484
Related party receivables                                              310                       298
Available-for-sale securities                                        4,742                     5,641
Other assets                                                            63                        69
                                                                  --------                  --------
                                                                                            
               Total assets                                       $ 30,921                  $ 33,297
                                                                  ========                  ========
                                                                                            
               LIABILITIES                                                                  
                                                                                            
Current liabilities                                                                         
     Accounts payable                                             $    900                  $  1,001
     Related party payables                                             49                        54
     Accrued liabilities                                             1,096                     1,245
     Capital lease obligation, current                                  37                        37
                                                                  --------                  --------
          Total current liabilities                                  2,082                     2,337
                                                                                            
Capital lease obligation, net of current portion                         9                        21
Deferred rent                                                          162                       157
                                                                  --------                  --------
               Total liabilities                                     2,253                     2,515
                                                                  --------                  --------
                                                                                            
          STOCKHOLDERS' EQUITY                                                              
                                                                                            
Common stock                                                             9                         9
Additional paid in capital                                          48,882                    48,862
Notes receivable from stockholders                                     (92)                      (92)
Deferred compensation                                                 (349)                     (388)
Accumulated deficit                                                (19,785)                  (17,618)
Unrealized gain on investments                                           3                         9
                                                                  --------                  --------
     Total stockholders' equity                                     28,668                    30,782
                                                                  --------                  --------
                                                                                            
          Total liabilities and stockholders' equity              $ 30,921                  $ 33,297
                                                                  ========                  ========
                                                                        
</TABLE>


               The accompanying notes are an integral part of the
                       condensed financial statements
<PAGE>   4

                             ARTHROCARE CORPORATION
                       CONDENSED STATEMENTS OF OPERATIONS
                        (In thousands, except share data)
<TABLE>
<CAPTION>
                                                           Three months ended:
                                                  March 29,                  March 30,
                                                    1997                       1996
                                                -----------                -----------
                                                              (Unaudited)
<S>                                             <C>                        <C>        
Net sales                                       $     2,261                $     1,159
                                                                           
Cost of sales                                         1,679                      1,065
                                                -----------                -----------
                                                                           
Gross margin                                            582                         94
                                                -----------                -----------
                                                                           
Operating expenses:                                                        
     Research and development                           880                        864
     Sales and marketing                              1,365                        658
     General and administrative                         891                        576
                                                -----------                -----------
          Total operating expenses                    3,136                      2,098
                                                -----------                -----------
                                                                           
Loss from operations                                 (2,554)                    (2,004)
                                                                           
Interest and other income, net                          387                        261
                                                -----------                -----------
                                                                           
Net loss                                        $    (2,167)               $    (1,743)
                                                ===========                ===========                           

Net loss per share                              $     (0.25)               $     (0.25)
                                                ===========                ===========
                                                                           
Shares used in per share calculation              8,784,805                  6,856,086
                                                ===========                ===========
</TABLE>

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


<PAGE>   5

                     ARTHROCARE CORPORATION
               CONDENSED STATEMENTS OF CASH FLOWS
                         (In thousands)
<TABLE>
<CAPTION>
                                                                               Three months ended:
                                                                          March 29,         March 30,
                                                                             1997              1996
                                                                         -----------       -----------
                                                                                  (Unaudited)
<S>                                                                        <C>               <C>      
Cash flows from operating activities:
     Net loss                                                              $ (2,167)         $ (1,743)
     Adjustments to reconcile net loss to net cash used in                                   
       operating activities:                                                                 
          Depreciation and amortization                                         147                77
          Write-off of property and equipment                                    --               187
          Amortization of deferred compensation                                  39                41
          Provision for doubtful accounts                                       252                19
          Provision for excess and obsolete inventory                           183                 5
          Deferred rent                                                           5                15
          Changes in operating assets and liabilities:                                       
               Accounts receivable                                             (257)             (670)
               Related party receivables                                        (12)              (18)
               Inventory                                                       (368)             (632)
               Prepaid expenses and other current assets                         28               536
               Accounts payable                                                (105)              319
               Accrued liabilities                                             (150)              105
               Other assets                                                       6               (20)
                                                                           --------          --------
                    Net cash used in operating activities                    (2,399)           (1,779)
                                                                           --------          --------
Cash flows from investing activities:                                                        
     Purchases of property and equipment                                       (129)             (219)
     Net maturities (purchases) of available-for-sale securities              9,012            (9,863)
                                                                           --------          --------
                    Net cash provided by (used in) investing act              8,883           (10,082)
                                                                                             
Cash flows from financing activities:                                                        
     Repayment of capital leases                                                (12)               (8)
     Proceeds from issuance of Common Stock                                      20            31,896
     Proceeds from exercise of options to purchase Common Stock            --------          --------
                    Net cash provided by financing activities                     8            31,888
                                                                           --------          --------
Net increase in cash and cash equivalents                                     6,492            20,027
                                                                                             
Cash and cash equivalents, beginning of period                               11,359             4,774
                                                                           --------          --------
Cash and cash equivalents, end of period                                   $ 17,851          $ 24,801
                                                                           ========          ========
                                                                                             
Supplemental schedule of non-cash investing and financing activities:                        
     Issuance of common stock on conversion of preferred stock             $      -          $ 15,704
     Net unrealized gain on avaliable-for-sale securities                $      6          $     37
</TABLE>

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


<PAGE>   6


                             ARTHROCARE CORPORATION
                     NOTES TO CONDENSED FINANCIAL STATEMENTS
                                   (Unaudited)

1.  BASIS OF PRESENTATION

        In the opinion of management, the accompanying unaudited condensed
financial statements contain all adjustments (all of which are normal and
recurring in nature) necessary to present fairly the financial position, results
of operations and cash flows of ArthroCare Corporation ("the Company"). Interim
results of operations are not necessarily indicative of the results to be
expected for the full year. The notes to the financial statements contained in
the Form 10-K for the year ended December 28, 1996 should be read in conjunction
with these condensed financial statements. The balance sheet at December 28,
1996 was derived from audited financial statements; however, the financial
statements in this report do not include all disclosures required by generally
accepted accounting principles.

2.  COMPUTATION OF NET LOSS PER SHARE

        The net loss per share is based upon the weighted average number of
common and common equivalent shares outstanding. Common equivalent shares from
stock options, warrants and preferred stock are excluded from the computation as
their effect is anti-dilutive, except that, pursuant to the Securities and
Exchange Commission Staff Accounting Bulletin No. 83, common and common
equivalent shares issued by the Company during the twelve months preceding the
initial public offering at prices substantially below the initial public
offering price have been included in the calculations as if they were
outstanding for all of the periods presented (using the treasury stock method
and the public offering price per share).

3.  COMPONENTS OF INVENTORY:
<TABLE>
<CAPTION>
                                         March 29, 1997    December 28, 1996
                                         --------------    -----------------
                                           (Unaudited)
Inventory:                                          (In thousands)
<S>                                        <C>                 <C>       
     Raw materials                         $       182         $       345
     Work-in-process                               170                  32
     Finished goods                                592                 382
                                           -----------         -----------
                                           $       944         $       759
                                           ===========         ===========
</TABLE>

4.   RECENT ACCOUNTING PRONOUNCEMENTS

        In February 1997, the Financial  Accounting  Standards Board issued 
Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per
Share," which specifies the computation, presentation and disclosure
requirements for earnings per share. SFAS 128 supersedes Accounting Principles
Board Opinion No. 15 and is effective for financial statements issued for
periods after December 15, 1997. SFAS 128
                      

<PAGE>   7



PART 1. FINANCIAL INFORMATION (CONTINUED)
================================================================================

requires restatement of all prior-period earnings per share data presented after
the effective date. SFAS 128 will not have a material impact on the Company's
earnings per share.


<PAGE>   8


PART 1. FINANCIAL INFORMATION (CONTINUED)
================================================================================

                  ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
                 OF FINANCIAL CONDITION AND RESULTS OF OPERATION

OVERVIEW

        Since commencing operations in April 1993, ArthroCare Corporation (the
"Company" or "ArthroCare") has primarily engaged in the design, development,
clinical testing, manufacturing and sale of its Arthroscopic System. The
Arthroscopic System consists of a disposable, bipolar ArthroWand, a radio
frequency controller that powers the ArthroWand and a cable that connects the
ArthroWand to the controller. The ArthroWand ablates (removes) soft tissue with
minimal damage to surrounding healthy tissue, and simultaneously achieves
hemostasis (sealing of small bleeding vessels).

        The Company has a limited history of operations. The Company received
clearance of its 510(k) premarket notification from the FDA in March 1995 to
market its Arthroscopic System in the United States for use in arthroscopic
surgery of the knee, shoulder, elbow and ankle. The Company has since received
clearance for use in the wrist and hip. In December 1995, the Company
commercially introduced its Arthroscopic System through a network of
distributors in the United States. The Company's strategy includes placing
controllers that are intended to generate future wand revenues with arthroscopic
surgeons. The Company believes that if it places controllers with arthroscopic
surgeons, the controllers will be used by the surgeons and that the continued
use of the controllers will generate future wand sales. The Company's long term
strategy includes applying its proprietary platform technology to a range of
other soft tissue surgical procedures in the fields of urology, dermatology,
dental surgery, and gynecology. In that regard, the Company has received 510(k)
clearance for use of its technology in the field of urology and dental surgery.
In April 1997, the Company received 510(k) clearance for use of its technology
in the field of general dermatology but is seeking additional IDE and 510(k)
approvals for specific dermatology markets which it hopes to enter. The Company
is continuing to work with the FDA to obtain 510(k) clearance for use of its
technology in the field of gynecology. There can be no assurance that the
Company's 510(k) application for its gynecology system under development will be
cleared by the FDA on a timely basis, if at all, or that the products, if
cleared for marketing, will ever achieve commercial acceptance. See
"Additional Factors that Might Affect Future Results--Uncertainty of New
Product Development", "--Limited Domestic and International Marketing and
Sales Experience" and "--Uncertainty of Approvals; Extensive Government
Regulation."

        This Report on Form 10-Q contains certain forward looking statements
regarding future events with respect to the Company. Actual events or results
may differ significantly as a result of the factors described herein and in the
documents incorporated herein by reference including, in particular, those
factors described under "Additional Factors that Might Affect Future Results."


RESULTS OF OPERATIONS

<PAGE>   9
                             ARTHROCARE CORPORATION
                       CONDENSED STATEMENTS OF OPERATIONS
                                 (In thousands)
                                   (Unaudited)



<TABLE>
<CAPTION>
                                            Three months ended: 
                                            -------------------
                                     March 29,         %          March 30,         %
                                       1997          of Sales       1996         of Sales      % Chg
                                       ----          --------       ----         --------      -----
<S>                                  <C>            <C>          <C>            <C>          <C>  
Net sales                            $ 2,261        100.0%       $ 1,159        100.0%        95.1%
                                                                                           
                                                                                           
Cost of sales                          1,679         74.3%         1,065         91.9%        57.7%
                                     -------                     -------                   
                                                                                           
Gross margin                             582         25.7%            94          8.1%       519.1%
                                     -------                     -------                   
                                                                                           
Operating expenses:                                                                        
     Research & development              880         38.9%           864         74.5%         1.9%
                                                                                           
     Sales & marketing                 1,365         60.4%           658         56.8%       107.4%
                                                                                           
     General & administrative            891         39.4%           576         49.7%        54.7%
                                     -------                     -------                   
          Total operating expenses     3,136        138.7%         2,098        181.0%        49.5%
                                     -------                     -------                   
                                                                                           
Loss from operations                  (2,554)      -113.0%        (2,004)      -172.9%        27.4%
                                                                                          
                                                                                           
Interest income, Net                     387         17.2%           261         22.5%        48.3%
                                     -------                     -------                   
                                                                                           
Net loss                             $(2,167)       -95.8%       $(1,743)      -150.4%        24.3%
                                     =======                     =======               
                                                             
</TABLE>


Revenues

        Revenues for the three month period ended March 29, 1997 were $2.3
million. Revenues for the three month period ended March 30, 1996 were $1.2
million. The $1.1 million increase is primarily due to higher unit volume wand
sales and higher average selling price (ASP) compared to the year ago quarter.
The Company's strategy is to increase the installed base of controllers by
offering aggressive promotional programs which bundle a discounted controller
with volume wand sales or sales commitments. This strategy has had an adverse
impact on controller revenue, ASP and gross margins, partially offsetting the
positive impact of increased wand sales.

<PAGE>   10


        During the first quarter, the installed base of controllers increased by
166 units to a total installed base 748 units, which includes 548 units placed
with doctors and hospitals. The entire installed base of controllers generated
sales of approximately 18,000 wands during the quarter.

        Overall, wands were sold at or near list price during the quarter. The
wand ASP was higher in the three month period ended March 29, 1997 than in the
three month period ended March 30, 1996 due to the large number of wands sold to
dealers at discounts in the prior year quarter as dealers stocked initial
inventory. The Company does not expect wand ASP to continue to increase.

        During the three month period ended March 29, 1997, controller ASP was
adversely impacted by promotional programs which offer discounted controller
prices when packaged with volume wand purchases or purchase commitments. In the
three month period ended March 30, 1996, the controller ASP was higher as
dealers were purchasing their demonstration controllers and the current
controller promotional programs were not being offered. The Company expects to
continue these promotional programs as a strategy to increase controller
placements which could result in increased wand sales.

        The revenue mix between wands and controllers in the three month period
ended March 29, 1997 was approximately 93% wands and 7% controllers. During the
three month period ended March 30, 1996, the approximate mix of wands and
controllers was 52% wands and 48% controllers. The Company expects wand sales to
remain the primary component of revenues in the future.

        During the three month period ended March 29, 1997, approximately three
quarters of revenue generated was from sales of its Arthroscopic System to 
doctors and hospitals. The three month period ended March 30, 1996, was the
Company's first full quarter of shipments, and revenues were heavily weighted
toward dealers as they bought initial stocking inventory. The Company expects
sales to doctors and hospitals to remain high as a percentage of overall sales
in the future.

        The Company believes that, in its first five quarters of product
shipments, it has penetrated over 2% of the arthroscopic surgical tools market
in the United States and that approximately 60% of the Company's wand revenue is
being generated by wands purchased for use in shoulder procedures. The Company
believes that shoulder procedures are the fastest growing segment of the
arthroscopic market, and knee procedures represent the largest segment of
arthroscopic surgery in terms of the absolute number of procedures. Accordingly,
in order to achieve increasing wand sales over time, the Company must further
penetrate the market for knee procedures. The Company has introduced additional
wand styles designed to be used in both knee and shoulder arthroscopic
procedures which are intended to increase wand sales in both markets. There can
be no assurance that those wand styles will be adopted by doctors.

        The Company has limited sales and marketing experience and can make no 
assurance that current trends in sales and product acceptance will continue. See
"Additional Factors that Might Affect Future Results--Uncertainty of Market
Acceptance" and "--Limited Domestic and International Marketing and Sales
Experience."

<PAGE>   11

Cost of Sales

        Cost of sales was $1.7 million, or 74% of sales for the three months
ended March 29, 1997. During the three month period ended March 30, 1996, cost
of sales was $1.1 million or 92% of sales. As a percentage of sales, cost of
sales decreased 18 percentage points as the fixed and semi-fixed costs were
spread over higher wand manufacturing volume resulting in improved manufacturing
efficiency. Improvements to the manufacturing process also reduced costs by
improving efficiency. The $600,000 increase in cost of sales between the periods
was due to higher volume wand and controller shipments.

        The improved gross margin includes the effect of the controller
promotional programs during the quarter. The Company believes that if its
promotional programs maintain the same or higher number of wands bundled with a
discounted controller, and if the demand for the disposable wands increases over
a growing installed base of controllers, then the cost of sales will continue to
decrease as a percentage of revenue and gross margins will increase. However,
there can be no assurance the Company will be successful in maintaining the mix
of wands to discounted controllers in its promotional programs or increasing
demand for its disposable wands. See "Additional Factors that Might Affect
Future Results--History of Losses; Fluctuations in Operating Results; 
Substantial Losses Expected to Continue."

Operating Expenses

        Research and development expense, which includes expenditures for
regulatory compliance and quality assurance, was $900,000 in the three months
ended March 29, 1997, the same as in the prior year quarter.

        The Company believes that continued investment in its platform
technology is essential if it is to maintain its competitive position. The
Company expects to continue to make substantial expenditures on new product
development, regulatory affairs, clinical studies, and to increase research and
development spending. See "Additional Factors that Might Affect Future 
Results--Competition."

        Sales and marketing expense increased substantially to $1.4 million in
the three month period ended March 29, 1997 from $700,000 in the three month
period ended March 30, 1996. The increase is primarily due to dealer
commissions, promotional, staffing, and trade show expenses. The three month
period ended March 29, 1997 includes the sales and marketing expenses associated
with the numerous trade shows and conferences which typically happen in the
first part of the year. The Company currently anticipates that sales and
marketing spending will continue to increase due to dealer commissions,
promotional, demonstration and sample expenses, and additional investment in
sales, marketing and support staff necessary to market its products.

        General and administrative expense increased to $900,000 for the three
month period ended March 29, 1997 from $600,000 for the three month period ended
March 30, 1996 due to additional staffing, including management personnel,
provision for bad debts, the increased cost of being a public company, business
development activities, and consulting fees and expenses necessary to 


<PAGE>   12

expand the corporate infrastructure. The Company expects that general and
administrative expenses will continue to increase as the Company further expands
its staffing and other support operations.

Interest and Other Income

        Net interest income increased to $400,000 for the three month period
ended March 29, 1997 from $300,000 in the three month period ended March 30,
1996 due to interest received on the investment of the proceeds of the 1996
initial public offering of the Company's common stock. The Company expects that
interest income will decrease as the Company reduces its investments to meet the
cash needs of the business.

Net Loss

        Net loss was $2.2 million for the three month period ended March 29,
1997 compared to $1.7 million in the three month period ended March 30, 1996.
The increased loss is due to higher operating expenses resulting from higher
revenues and increased business activities including product development,
manufacturing ramp-up, dealer commissions, sales and marketing expenses
necessary to promote the product and building the corporate infrastructure. The
higher operating expense was partially offset by an improved gross margin and
higher interest income.

LIQUIDITY AND CAPITAL RESOURCES

        At March 29, 1997, the Company had $22.3 million in working capital and
its principal sources of liquidity consisted of $26.8 million in cash, cash
equivalents, and available-for-sale securities which include long-term
available-for-sale securities. The cash and cash equivalents are highly liquid
with original maturities of ninety days or less. The available-for-sale
securities consist mainly of bank notes, commercial paper, corporate bonds,
foreign debt securities rated A1/P1, A1/A or better and U.S. government
securities.

        The Company's cash used in operating activities increased to $2.4
million for three month period ended March 29, 1997 from $1.8 million for the
three month period ended March 30, 1996 due to higher levels of business
activity to support higher revenues and increased inventory.

        Accounts receivable of $1.3 million as of March 29, 1997 were unchanged
from the level at December 28, 1996. The Company expects accounts receivable to
increase in the future in line with growing sales.

        Inventories increased to $900,000 as of March 29, 1997 compared
to $800,000 as of December 28, 1996 due to the higher level of manufacturing
activity in support of sales during the quarter. The Company expects future
inventory levels to grow in absolute value.

        As of March 29, 1997, net property and equipment was unchanged from $1.5
million at December 28, 1996. In the remainder of 1997, the Company has planned
but has not committed to 


<PAGE>   13

approximately $1.3 million in capital expenditures consisting primarily of
computers, computer networking equipment and molds.

        The Company plans to finance its capital needs principally from cash,
cash equivalents, and available-for-sale securities which include long term
available-for-sale securities and related interest, existing capital resources
and to the extent available, lines of credit. The Company currently has no
commitments for any credit facilities such as revolving credit agreements or
lines of credit that could provide additional working capital. The Company
believes that its current cash, cash equivalents and available-for-sale
securities, together with interest thereon and the Company's existing capital
resources, will be sufficient to fund its operations at least through fiscal
1998. The Company's future liquidity and capital requirements will depend on
numerous factors including the Company's success of commercializing the
Arthroscopic System, the ability of the Company's suppliers to continue to meet
the demands of the Company by providing sufficient quantities at current prices,
obtaining and enforcing patents important to the Company's business, the status
of regulatory approvals and competition. There can be no assurance that the
Company will not be required to raise additional capital or that such capital
will be available on acceptable terms, if at all.

ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS

        ArthroCare became a public company in February 1996. Included here are
risk factors as updated from the Company's Annual Report on Form 10-K filed
March 28, 1997. The following factors represent current challenges to the
Company that create risk and uncertainty. Failure to adequately overcome any of
the following challenges, either singularly or in combination, could have a
materially adverse effect on the Company's results of operations, business, or
financial position.

Dependence Upon Arthroscopic System

        The Company commercially introduced the Arthroscopic System in December
1995 and by the quarter ended March 29, 1997, had reported 16 months of sales.
The Arthroscopic System is the Company's only commercial product and will
account for substantially all of the Company's revenue for the foreseeable
future. As such, the Company is highly dependent on its Arthroscopic System.
Currently, virtually all the Company's sales come from the United States. Before
the Arthroscopic System can be sold outside of the United States, Europe and
Australia, the Company will have to obtain foreign regulatory approvals and
establish foreign distribution capability. If such regulatory approval is
obtained, there can be no assurance that the Company will be able to establish a
successful foreign distribution capability.




Uncertainty of Market Acceptance
<PAGE>   14


        The Company's Arthroscopic System and potential products are based upon
a new method of tissue ablation, and there can be no assurance that any of these
products will gain market acceptance. Physicians will not use the Company's
products unless they determine, based on experience, clinical data and other
factors, that these systems are an attractive alternative to conventional means
of tissue ablation. The Arthroscopic System was only introduced in December 1995
and no independent published clinical reports exist to support the Company's
marketing efforts, which may have an adverse effect on its ability to obtain
physician acceptance. The Company believes that recommendations and endorsements
by influential physicians will continue to be essential for market acceptance of
its products. If the Arthroscopic System is not commercially successful, the
Company's business, financial condition and results of operations would be
materially adversely affected.

Limited Operating History

        The Company has a limited history of operations that, to date, has
consisted primarily of research and development, product engineering, obtaining
FDA clearance of its Arthroscopic System, developing a network of distributors
in the United States to market the Arthroscopic System and 16 months of product
sales. The Company has started to realize revenues from the sale of its
products, but continues to generate operating losses and anticipates generating
losses in the future. Whether the Company can successfully manage the transition
to a larger-scale commercial enterprise will depend upon increasing sales of
disposable ArthroWands from its domestic distribution network, obtaining foreign
regulatory approvals for the Arthroscopic System, obtaining domestic and foreign
regulatory approvals for potential products and maintaining its financial and
management systems, procedures and controls.

Limited Domestic and International Marketing and Sales Experience

        The Company has sold over 740 Arthroscopic System controller units and
more than 60,000 ArthroWands through the end of the first quarter of 1997. The
Company is marketing and selling its Arthroscopic System in the United States
through a network of independent orthopedic distributors. These distributors
sell orthopedic arthroscopy devices for a number of other manufacturers, and
there can be no assurance that they will commit the necessary resources to
effectively market and sell the Company's Arthroscopic System, or that they will
be successful in closing sales with doctors and hospitals. The Company has
offered its controller to these independent distributors at substantial
discounts and may be required to continue to offer such discounts on its
controller to generate demand for its ArthroWands. The inability to place
sufficient quantities of controllers would have a material adverse effect on the
Company's business, financial condition and results of operations.

        The Company has signed distribution agreements with independent
distributors to sell and market the Arthroscopic Systems in Australia, Mexico,
Brazil, Argentina and Korea. In April, the Company signed an exclusive
distribution agreement covering the European market. In other international
markets, the Company intends to collaborate with one or more marketing partners
to establish marketing and distribution channels for the Arthroscopic System and
to assist with regulatory requirements in such distributors' jurisdictions.
However, regulatory requirements vary by 


<PAGE>   15

region, and compliance with such regulations may be costly and time-consuming.
Accordingly, the distribution, pricing and marketing structure to be established
by the Company may vary from country to country.

        No assurance can be given that the Company will successfully sell its
product through its distributors in Europe, Australia, Mexico, Brazil, Argentina
or Korea, that the Company will secure marketing partners for other
international markets, successfully sell its Arthroscopic System in foreign
markets or that any of its foreign distributors and marketing partners will
commit the necessary resources to obtain additional necessary foreign regulatory
approvals on behalf of the Company and successfully sell the Arthroscopic System
in foreign markets.

Limited Manufacturing Experience

        The Company's manufacturing operations consist of an in-house assembly
operation for the manufacturing of ArthroWands. The Company has manufactured and
sold approximately 60,000 ArthroWands through the end of the first quarter of
1997. As a result, the Company has limited experience manufacturing the
ArthroWands in the volumes necessary for the Company to achieve significant
commercial sales, and there can be no assurance that reliable, high-volume
manufacturing can be achieved at commercially reasonable cost. In April 1995,
the Company filed an application with the State of California for a license to
manufacture medical devices. In September 1995, the State of California required
the Company to cease shipping products until a manufacturing license was
obtained, and the FDA, following a Good Manufacturing Practices ("GMP") audit,
instructed the Company to correct certain record-keeping practices and enter
into a written contract with the third party that sterilizes the ArthroWand.
There can be no assurance that the Company will not encounter any further
manufacturing difficulties, or that any of its contract manufacturers will not
experience similar difficulties, including problems involving production yields,
quality control and assurance, supplies of components or shortages of qualified
personnel.

        In October 1995, the Company discovered that the ArthroWand packaging
was subject to cracking due to a flawed design of the packaging tray and
undertook a voluntary product recall of the 61 ArthroWands affected. The Company
completed execution of its corrective action and received written confirmation
from the FDA that the recall has been closed. There can be no assurances that
there will be no further product recalls or required redesign of the Company's
packaging or products.

History of Losses; Fluctuations in Operating Results; Losses Expected to 
Continue

        The Company has experienced significant operating losses since inception
and, as of March 29, 1997, had an accumulated deficit of $19.8 million. The
Company expects to generate additional losses due to increased operating
expenditures primarily attributable to the expansion of marketing and sales
activities, increased research and development, and activities to support
regulatory applications. Results of operations may fluctuate significantly from
quarter to quarter due to the timing of such expenditures, absence of a backlog
of orders, timing of the receipt of orders, promotional discounts of the
Company's products, re-use of the Company's disposable products, in 


<PAGE>   16

addition to those detailed above. The Company's revenues and profitability will
be critically dependent on whether it can successfully continue to market its
Arthroscopic System. In addition, the Company's gross margins may be adversely
affected due to the necessity to promote and sell its product at significantly
reduced prices. There can be no assurance that significant profitability will
ever be achieved.

Patents and Proprietary Rights

        The Company's ability to compete effectively will depend in part on its
ability to develop and maintain proprietary aspects of its platform technology.
The Company owns four issued United States patents, 16 pending United States
patent applications and international patent applications in Europe (covering 16
separate countries), Japan, Canada, Australia and New Zealand corresponding to
three of the United States filings relating to its multielectrode technology.
The initial patent is currently set to expire in 2008, and the other three
issued patents are currently expected to expire between 2008 and 2012. Although
the Company believes that the issued patents cover the core technology used in
the Company's Arthroscopic System, none of the issued patents have specific
arthroscopic claims. There can be no assurance that the patents that have been
issued to the Company or any patents which may issue as a result of the
Company's United States or international patent applications will provide any
competitive advantages for the Company's products or that they will not be
successfully challenged, invalidated or circumvented in the future. In addition,
there can be no assurance that competitors, many of which have substantial
resources and have made substantial investments in competing technologies, will
not seek to apply for and obtain patents that will prevent, limit or interfere
with the Company's ability to make, use and sell its products either in the
United States or in international markets.

        A number of medical device and other companies, universities and
research institutions have filed patent applications or have issued patents
relating to monopolar and/or bipolar electrosurgical methods and apparatus. If
third-party patents or patent applications contain claims infringed by the
Company's technology and such claims are ultimately determined to be valid,
there can be no assurance that the Company would be able to obtain licenses to
those patents at a reasonable cost, if at all, or be able to develop or obtain
alternative technology, either of which would have a material adverse effect on
the Company's business, financial condition and results of operations. There can
be no assurance that the Company will not be obligated to defend itself in court
against allegations of infringement of third-party patents.

        In addition to patents, the Company relies on trade secrets and
proprietary know-how, which it seeks to protect, in part, through
confidentiality and proprietary information agreements. The Company requires its
key employees and consultants to execute confidentiality agreements upon the
commencement of an employment or consulting relationship with the Company. These
agreements generally provide that all confidential information, developed or
made known to the individual by the Company during the course of the
individual's relationship with the Company, is to be kept confidential and not
disclosed to third parties. These agreements also generally provide that
inventions conceived by the individual in the course of rendering services to
the Company shall be the exclusive property of the Company. There can be no
assurance that such agreements will not be 


<PAGE>   17

breached, that the Company would have adequate remedies for any breach or that
the Company's trade secrets will not otherwise become known to or be
independently developed by competitors.

Patent Litigation

        The medical device industry has been characterized by extensive
litigation regarding patents and other intellectual property rights, and
companies in the medical device industry have employed intellectual property
litigation to gain a competitive advantage. There can be no assurance that the
Company will not become subject to patent infringement claims or litigation or
interference proceedings declared by the United States Patent and Trademark
Office ("USPTO") to determine the priority of inventions. The defense and
prosecution of intellectual property suits, USPTO interference proceedings and
related legal and administrative proceeds are both costly and time-consuming.
Litigation may be necessary to enforce patents issued to the Company, to protect
trade secrets or know-how owned by the Company or to determine the
enforceability, scope and validity of the proprietary rights of others. Any
litigation or interference proceedings will result in substantial expense to the
Company and significant diversion of effort by the Company's technical and
management personnel. An adverse determination in litigation or interference
proceedings to which the Company may become a party could subject the Company to
significant liabilities to third parties, require disputed rights to be licensed
from third parties or require the Company to cease using such technology.
Although patent and intellectual property disputes in the medical device area
have often been settled through licensing or similar arrangements, costs
associated with such arrangements may be substantial and could include ongoing
royalties. Furthermore, there can be no assurance that necessary licenses would
be available to the Company on satisfactory terms, if at all. Adverse
determinations in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent the Company from manufacturing and selling its
products, which would have a material adverse effect on the Company's business,
financial condition and results of operations.

Competition

        The arthroscopic medical device industry is intensely competitive. The
Company competes with providers of laser systems, electrosurgical systems,
manual instruments and power shavers. Many of these competitors have
significantly greater financial, manufacturing, marketing, distribution and
technical resources than the Company. There can be no assurance that the Company
can effectively compete against such competitors. In addition, there can be no
assurance that these or other companies will not succeed in developing
technologies and products that are more effective than the Company's or that
would render the Company's technology or products obsolete or uncompetitive.

        Smith & Nephew Endoscopy, Inc. (which owns Acufex Microsurgical, Inc.
and Dyonics, Inc.), Bristol-Meyers Squibb Company (including its Linvatec
division) and Stryker Corp. each have large shares of the market for manual
instruments, power shavers and arthroscopes. These companies offer broad product
lines, which they may offer as a single package; have substantially greater
resources and name recognition than the Company; and frequently offer
significant discounts as a competitive tactic. In addition, Pfizer Inc.
(including its Valley Labs division) and Bristol-


<PAGE>   18

Meyers-Squibb Company each have large shares of the market for electrosurgical
systems, and Trimedyne, Inc. and Stryker Corp. each have large shares of the
market for laser systems. The Company expects that competition from these and
other well-established competitors will increase as will competition from
start-up and development stage medical device companies such as Gyrus Medical
Ltd., a company based in the United Kingdom, and Oratec Interventions, Inc., a
company based in Menlo Park, California. The Company is aware that Mitek (a
division of Johnson & Johnson) is marketing a bipolar electrosurgical tool
developed by Gyrus Medical Ltd. The Company anticipates that it may have to
continue to offer substantial discounts on its controller in order to stimulate
demand for the disposable ArthroWand. Such competition could have a material
adverse effect on the Company's business, financial conditions and results of
operations.

Uncertainty of Approvals; Extensive Governmental Regulation

United States

        The Company's products are regulated in the United States as medical
devices by the FDA under the Federal Food, Drug, and Cosmetic Act ("FDC Act")
and require premarket clearance or approval by the FDA prior to
commercialization. In addition, certain material changes or modifications to
medical devices also are subject to FDA review and clearance or approval.
Pursuant to the FDC Act, the FDA regulates the research, testing, manufacture,
safety, labeling, storage, record keeping, advertising, distribution and
production of medical devices in the United States. Noncompliance with
applicable requirements can result in warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or premarket
approval for devices, and criminal prosecution. Medical devices are classified
into one of three classes, Class I, II or III, on the basis of the controls
deemed by the FDA to be necessary to reasonably ensure their safety and
effectiveness. Class I devices are subject to general controls (e.g., labeling,
premarket notification for non-exempt devices and adherence to GMPs or QS
Regulations for most devices). Class II devices are subject to general controls
and to special controls (e.g., performance standards, postmarket surveillance,
patient registries, and FDA guidelines). Generally, Class III devices are those
that must receive premarket approval by the FDA to ensure their safety and
effectiveness (e.g., life-sustaining, life-supporting and implantable devices,
or new devices that have not been found substantially equivalent to legally
marketed devices), and generally require clinical testing to ensure safety and
effectiveness and FDA approval prior to marketing and distribution. The FDA also
has the authority to require clinical testing of Class I and Class II devices. A
PMA application must be filed if the proposed device is not substantially
equivalent to a legally marketed Class I or Class II predicate device or if it
is a Class III device for which the FDA has called for such applications.

        If human clinical trials of a device are required and if the device
presents a "significant risk," the manufacturer or the distributor of the device
is required to file an investigational device exemption ("IDE") application
prior to commencing human clinical trials. The IDE application must be supported
by data, typically including the results of animal and, possibly, mechanical
testing. If the FDA does not object to the IDE application within 30 days from
filing of the application, human clinical trials may begin as defined in the
IDE. Sponsors of clinical trials are permitted to sell 


<PAGE>   19

investigational devices distributed in the course of the study, provided such
costs do not exceed recovery of the costs of manufacture, research, development
and handling. The clinical trials must be conducted under the auspices of an
independent Institutional Review Board ("IRB") established pursuant to FDA
regulations, and with appropriate informed consent.

        Generally, before a new device can be introduced into the market in the
United States, the manufacturer or distributor must obtain FDA clearance of a
510(k) notification or approval of a PMA application. If a medical device
manufacturer or distributor can establish that a device is "substantially
equivalent" to a legally marketed Class I or Class II device, or to a Class III
device for which FDA has not called for PMAs, the manufacturer or distributor
may seek clearance from FDA to market the device by filing a 510(k)
notification. The 510(k) notification will need to be supported by appropriate
data establishing the claim of substantial equivalence to the satisfaction of
FDA. FDA recently has been requiring a more rigorous demonstration of
substantial equivalence.

        Following submission of the 510(k) notification, the manufacturer or
distributor may not place the device into commercial distribution until an order
is issued by the FDA. No law or regulation specifies the time limit by which FDA
must respond to a 510(k) notification. At this time, the FDA typically responds
to the submission of a 510(k) notification within 150 to 200 days, but it may
take longer. An FDA order may declare that the device is substantially
equivalent to another legally marketed device and allow the proposed device to
be marketed in the United States. The FDA, however, may determine that the
proposed device is not substantially equivalent or require further information,
including clinical data, to make a determination regarding substantial
equivalence. Such determination or request for additional information could
delay market introduction of the products that are the subject of the 510(k)
notification.

        The Company has received clearance of 510(k) premarket notifications to
market its Arthroscopic System for surgery of the knee, shoulder, elbow, wrist,
hip and ankle joints. In addition, the Company received clearance of 510(k)
premarket notifications to market products based upon its proprietary core
technology to treat certain dermatological, urological and periodontal
conditions. There can be no assurance that the Company will be able to obtain
necessary clearances or approvals to market any other products on a timely
basis, if at all, and delays in receipt or failure to receive such clearances or
approvals, the loss of previously received clearances or approvals, or failure
to comply with existing or future regulatory requirements could have a material
adverse effect on the Company's business, financial condition and results of
operations.

        If a manufacturer or distributor of medical devices cannot establish
that a proposed device is substantially equivalent to a legally marketed device,
the manufacturer or distributor must seek premarket approval of the proposed
device through submission of a PMA application. A PMA application must be
supported by extensive data, including, in many instances, preclinical and
clinical trial data, as well as extensive literature to prove the safety and
effectiveness of the device. Following receipt of a PMA application, if the FDA
determines that the application is sufficiently complete to permit a substantive
review, the FDA will "file" the application. Under the FDC Act, the FDA has 180
days to review a PMA application, although the review of such an application
more 


<PAGE>   20

often occurs over a protracted time period, and generally takes approximately
two years or more from the date of filing to complete.

        The PMA application approval process can be expensive, uncertain and
lengthy. A number of devices for which premarket approval has been sought have
never been approved for marketing. The review time is often significantly
extended by the FDA, which may require more information or clarification of
information already provided in the submission. During the review period, an
advisory committee likely will be convened to review and evaluate the
application and provide recommendations to the FDA as to whether the device
should be approved. In addition, the FDA will inspect the manufacturing facility
to ensure compliance with the FDA's GMP or QS Regulations requirements prior to
approval of an application. If granted, the approval of the PMA application may
include significant limitations on the indicated uses for which a product may be
marketed.

        If necessary, the Company will file a PMA application with the FDA for
approval to sell its potential products commercially in the United States when
it has developed such products. There can be no assurance that the Company will
be able to obtain necessary PMA application approvals to market such products on
a timely basis, if at all, and delays in receipt or failure to receive such
approvals, the loss of previously received approvals, or failure to comply with
existing or future regulatory requirements could have a material adverse effect
on the Company's business, financial condition and results of operations.

        The Company is also required to register as a medical device
manufacturer with the FDA and state agencies, such as the California Department
of Health Services ("CDHS") and to list its products with the FDA. As such, the
Company is subject to inspections by both the FDA and the CDHS for compliance
with the FDA's GMP or QS Regulations and other applicable regulations. These
regulations require that the Company maintain its documents in a prescribed
manner with respect to manufacturing, testing and control activities. Further,
the Company and the third party manufacturers of its products are required to
comply with various FDA requirements for design, safety, advertising and
labeling. In April 1995, the Company filed an application with the State of
California for a license to manufacture medical devices. In September 1995, the
State of California required the Company to cease shipping products until a
manufacturing license was obtained, and the FDA, following a GMP audit,
instructed the Company to correct certain record-keeping practices and enter
into a written contract with the third party that sterilizes the ArthroWand.
There can be no assurance that the Company will not encounter any further
manufacturing difficulties, or that any of its contract manufacturers will not
experience similar difficulties, including problems involving production yields,
quality control and assurance, supplies of components or shortages of qualified
personnel.

        The Company is required to provide information to the FDA on death or
serious injuries alleged to have been associated with the use of its medical
devices, as well as product malfunctions that would likely cause or contribute
to death or serious injury if the malfunction were to recur. In addition, the
FDA prohibits a cleared or approved device from being marketed for uncleared or
unapproved applications. If the FDA believes that a company is not in compliance
with the law, it can institute proceedings to detain or seize products, issue a
recall, enjoin future violations and 


<PAGE>   21

assess civil and criminal penalties against the Company, its officers and its
employees. Failure to comply with the regulatory requirements could have a
material adverse effect on the Company's business, financial condition and
results of operations.

        The advertising of most FDA-regulated products is subject to both FDA
and Federal Trade Commission jurisdiction. The Company also is subject to
regulation by the Occupational Safety and Health Administration and by other
governmental entities.

        Regulations regarding the manufacture and sale of the Company's products
are subject to change. The Company cannot predict the effect, if any, that such
changes might have on its business, financial condition or results of
operations.

International

        International sales of the Company's products are subject to the
regulatory agency product registration requirements of each country. The
regulatory review process varies from country to country. The Company has
obtained regulatory clearance to market the Arthroscopic System in Australia &
Europe but has not obtained any other international regulatory approvals
permitting sales of its products outside of the United States. The Company
intends to seek regulatory approvals in certain other international markets.
There can be no assurance, however, that such approvals will be obtained on a
timely basis or at all.

        In Europe, the Company and its third party manufacturers have received
ISO 9001 certification and the CE mark. ISO 9001 certification standards for
quality operations have been developed to ensure that companies know, on a
worldwide basis, the standards of quality to which they will be held. The
European Union has promulgated rules that require that medical products receive
by mid-1998 the CE mark, an international symbol of quality and compliance with
applicable European medical device directives. Failure to maintain the CE mark
will prohibit the Company from selling its products in Europe. ISO 9001
certification is one of the CE mark requirements. There can be no assurance that
the Company will be successful in maintaining certification requirements.

Uncertainty Relating to Third-Party Reimbursement

        In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices, such as the Company's Arthroscopic
System and potential products, generally rely on third-party payors, principally
federal Medicare, state Medicaid and private health insurance plans, to
reimburse all or part of the cost of the procedure in which the medical device
is being used. In addition, certain health care providers are moving toward a
managed care system in which such providers contract to provide comprehensive
health care for a fixed cost per person. Managed care providers are attempting
to control the cost of health care by authorizing fewer elective surgical
procedures, such as certain knee and shoulder ankle, wrist, elbow and hip
arthroscopic procedures. The Company is unable to predict what changes will be
made in the reimbursement methods used by third-party health care payors.
Furthermore, the Company could be adversely affected by changes in 


<PAGE>   22

reimbursement policies of governmental or private health care payors,
particularly to the extent any such changes affect reimbursement for procedures
in which the Company's products are used. Failure by physicians, hospitals and
other users of the Company's products to obtain sufficient reimbursement from
health care payors for procedures in which the Company's products are used or
adverse changes in governmental and private third-party payors, policies toward
reimbursement for such procedures would have a material adverse effect on the
Company's business, financial condition and results of operations.

        If the Company obtains the necessary foreign regulatory approvals,
market acceptance of the Company's products in international markets would be
dependent, in part, upon the availability of reimbursement within prevailing
health care payment systems. Reimbursement and health care payment systems in
international markets vary significantly by country, and include both
government-sponsored health care and private insurance. The Company intends to
seek international reimbursement approvals, although there can be no assurance
that any such approvals will be obtained in a timely manner, if at all.

Dependence on Single Contract Manufacturers and Sole Source Suppliers

        The Company subcontracts the manufacturing of its controllers to a
single contract manufacturer. The agreement between the Company and the contract
manufacturer requires the Company to purchase all of its controllers from the
contract manufacturer through July 1998. The Company and its contract
manufacturer are required to operate in conformance with QS Regulation
requirements, in order to produce products for sale in the United States, and
ISO 9001 standards, in order to produce products for sale in Europe. There can
be no assurance that the contract manufacturer will remain in compliance with QS
Regulations or ISO 9001 standards. Any failure by the Company or its contract
manufacturer to remain in compliance with QS Regulation or ISO 9001 standards
could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, the ArthroWand is sterilized
by a single subcontractor, and the connector housings at each end of the cable
are available only from a single source. There can be no assurance that an
alternate contract manufacturer, sterilizer or connector housing supplier could
be established if necessary or that available inventories would be adequate to
meet the Company's product needs during any prolonged interruption of supply. A
reduction or stoppage in supply of the sole-source component, or the Company's
inability to secure an alternative contract manufacturer or sterilizer, if
required, would limit its ability to manufacture the Arthroscopic System and
would have a material adverse effect on the Company's business, financial
condition and results of operations.

        Although the Company believes that its contract manufacturer,
subcontractors and suppliers are in compliance with applicable regulations,
there can be no assurance that the FDA, or a state, local or foreign regulator,
will not take action against a contract manufacturer, subcontractor or supplier
found to be violating such regulations.

Uncertainty of New Product Development

<PAGE>   23

        The Company has undertaken preliminary animal studies and development
for the use of its ablation technology with its controller in urology,
dermatology, periodontics and gynecology. The Company has received 510(k)
premarket notifications for clearance to market tissue ablation products to
treat certain urological, dermatological and periodontal conditions and has
filed 510(k) premarket notification for clearance to market gynecological
conditions. The FDA had indicated that the 510(k) submission for gynecological
conditions and expanded dermatological conditions must be supported by clinical
trials. Each of these products is at an early stage of development, and the
Company will be required to undertake time-consuming and costly development
activities and seek regulatory approval of these devices. There can be no
assurance that product development will ever be successfully completed, that
PMAs or 510(k)s, if applied for, will be granted by the FDA on a timely basis,
if at all, or that the products will ever achieve commercial acceptance. Failure
by the Company to develop, obtain necessary regulatory approval for or to
successfully market new products could have a material adverse effect on the
Company's business, financial condition and results of operations.

Product Liability Risk; Limited Insurance Coverage

        The development, manufacture and sale of medical products entail
significant risk of product liability claims. The Company's current product
liability insurance coverage limits are $5,000,000 per occurrence and $5,000,000
in the aggregate. There can be no assurance that such coverage limits are
adequate to protect the Company from any liabilities it might incur in
connection with the development, manufacture and sale of its Arthroscopic System
and potential products. In addition, the Company may require increased product
liability coverage if any potential products are successfully commercialized.
Product liability insurance is expensive and in the future may not be available
to the Company on acceptable terms, if at all. The Company has been selling its
product since December 1995 and has not experienced any product liability claims
to date. However, a successful product liability claim or series of claims
brought against the Company in excess of its insurance coverage could have a
material adverse effect on the Company's business, financial condition and
results of operations.

Dependence on Key Personnel and Key Consultants

        The Company is dependent upon a number of key management and technical
personnel. The loss of the services of one or more key employees or consultants
could have a material adverse effect on the Company. The Company's success will
also depend on its ability to attract and retain additional highly qualified
management and technical personnel. The Company faces intense competition for
qualified personnel, many of whom are often subject to competing employment
offers, and there can be no assurance that the Company will be able to attract
and retain such personnel. Furthermore, the Company's scientific advisory board
members all are otherwise employed on a full-time basis. As a result, the
scientific advisory board members are not available to devote their full time or
attention to the Company's affairs.

        A significant portion of the Company's research and development is 
performed by Philip E. Eggers, a director of the Company, pursuant to a
consulting agreement between the Company and 


<PAGE>   24

Eggers & Associates Inc. ("E&A"), a corporation wholly owned by Mr. Eggers. Mr.
Eggers is not employed by the Company on a full-time basis and, as a result, may
not be available to devote his full time or attention to the Company's affairs.

Control by Directors, Executive Officers and Affiliated Entities

        The Company's directors, executive officers and entities affiliated with
them, in the aggregate, beneficially own approximately 44.83% of the Company's
outstanding Common Stock. These stockholders, if acting together, will have
significant influence over all matters requiring approval by the stockholders of
the Company, including the election of directors and the approval of mergers or
other business combination transactions.

Potential Volatility of Stock Price

        The stock markets have experienced price and volume fluctuations that
have particularly affected medical technology companies, resulting in changes in
the market prices of the stocks of many companies that may not have been
directly related to the operating performance of those companies. Such broad
market fluctuations may adversely affect the market price of the Common Stock.
In addition, the market price of the Company's Common Stock may be highly
volatile. Factors such as variations in the Company's financial results,
comments by security analysts, announcements of technological innovations or new
products by the Company or its competitors, changing government regulations and
developments with respect to FDA submissions, patents, proprietary rights or
litigation may have a significant adverse effect on the market price of the
Common Stock.


<PAGE>   25


Anti-Takeover Effect of Stockholder Rights Plan and Certain Charter and Bylaw
Provisions

        In November 1996, the Company's Board of Directors adopted a Stockholder
Rights Plan. The Stockholder Rights Plan provides for a dividend distribution of
one Preferred Shares Purchase Right (a "Right") on each outstanding share of the
Company's Common Stock. Each Right entitles shareholders to buy 1/1000th of a
share of the Company's Series A Participating Preferred Stock at an exercise
price of $50.00. The Rights will become exercisable following the tenth day
after a person or group announces acquisition of 15 percent or more of the
Company's Common Stock, or announces commencement of a tender offer, the
consummation of which would result in ownership by the person or group of 15
percent or more of the Company's Common Stock. The Company will be entitled to
redeem the Rights at $0.01 per Right at any time on or before the tenth day
following acquisition by a person or group of 15 percent of more of the
Company's Common Stock.

        The Stockholder Rights Plan and certain provisions of the Company's
Certificate of Incorporation and Bylaws may have the effect of making it more
difficult for a third party to acquire, or of discouraging a third party from
attempting to acquire, control of the Company. This could limit the price that
certain investors might be willing to pay in the future for shares of the
Company's Common Stock. Certain provisions of the Company's Certificate of
Incorporation and Bylaws allow the Company to issue Preferred Stock without any
vote or further action by the stockholders, eliminate the right of stockholders
to act by written consent without a meeting, specify procedures for director
nominations by stockholders and submission of other proposals for consideration
at stockholder meetings, and eliminate cumulative voting in the election of
directors. Certain provisions of Delaware law applicable to the Company could
also delay or make more difficult a merger, tender offer or proxy contest
involving the Company, including Section 203, which prohibits a Delaware
corporation from engaging in any business combination with any interested
stockholder for a period of three years unless certain conditions are met. The
Stockholder Rights Plan, the possible issuance of Preferred Stock, the
procedures required for director nominations and stockholder proposals and
Delaware law could have the effect of delaying, deferring or preventing a change
in control of the Company, including without limitation, discouraging a proxy
contest or making more difficult the acquisition of a substantial block of the
Company's common stock. These provisions could also limit the price that
investors might be willing to pay in the future for shares of the Company's
Common Stock.

Lack of Dividends

        The Company has not paid any dividends and does not anticipate paying
any dividends in the foreseeable future.



<PAGE>   26


                               PART II. OTHER INFORMATION

        ITEM 1.  LEGAL PROCEEDINGS

               None

        ITEM 2.  CHANGES IN SECURITIES

               None

        ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

               None

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

               None

        ITEM 5.  OTHER INFORMATION

               None

        ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

               a)  Exhibits
<TABLE>

                      <S>    <C>                                  
                       3.2* Certificate of Incorporation of the Registrant.

                       3.3* Bylaws of the Registrant.

                       4.1* Specimen Common Stock Certificate.

                      10.1*  Form of Indemnification Agreement between the Registrant
                             and each of its directors and officers.

                      10.2*  Incentive Stock Plan and form of Stock Option Agreement
                             thereunder.

                      10.3*  Director Option Plan and form of Director Stock Option
                             Agreement thereunder.

                      10.4*  Employee Stock Purchase Plan and forms of agreements
                             thereunder.

                      10.5*  Form of Exclusive Distribution Agreement.
</TABLE>
<PAGE>   27
<TABLE>

                      <S>    <C>
                      10.6*  Form of Exclusive Sales Representative Agreement

                      10.7*  Consulting Agreement, dated May 10, 1993, between
                             the Registrant and Philip E. Eggers, and amendment
                             thereto.

                      10.8*  Consulting Agreement, dated May 20, 1993, between
                             the Registrant and Eggers & Associates, Inc., and
                             amendment thereto.

                      10.9*+ Development and Supply Agreement, dated March 1,
                             1994, between the Registrant and SeaMed
                             Corporation.

                      10.10* Lease Agreement, dated September 15, 1994,
                             between Registrant and The Arrillaga Foundation and
                             the Peery Foundation for the Registrant's facility
                             located at 595 North Pastoria Avenue, Sunnyvale,
                             California, 94086.

                      10.11* Employment Letter Agreement, dated October 21,
                             1994, between the Registrant and Allan Weinstein
                             and amendment thereto.

                      10.12* Purchase Assistance Promissory Note, dated
                             January 19, 1995, between Registrant and Allan
                             Weinstein.

                      10.13* Sublease Agreement, dated February 1, 1995,
                             between Registrant and Guided Medical Systems, Inc.
                             for the Registrant's former facility at 453 
                             Ravendale Drive, Mountain View, California, 94043.

                      10.14* Mortgage Assistance Promissory Note
                             Agreement, dated February 5, 1995, between the
                             Registrant and Allan Weinstein.

                      10.15* Restricted Stock Purchase and Security Agreement,
                             dated February 5, 1995, between the Registrant and
                             Allan Weinstein.

                      10.16* Employment Letter Agreement, dated July 18, 1995,
                             between the Registrant and Robert T. Hagan.

                      10.17* Restricted Stock Purchase and Security Agreement,
                             dated August 1, 1995, between the Registrant and
                             Robert T. Hagan.
</TABLE>
<PAGE>   28
<TABLE>
                <S>     <C>

                10.18*  Employment Letter Agreement, dated September 3, 1995,
                        between the Registrant and A. Larry Tannenbaum.

                10.19*+ Radiation Services Agreement, dated September 13, 1995,
                        between the Registrant and SteriGenics International.

                10.20*  Amended and Restated Stockholder Rights Agreement, dated
                        October 16, 1995, between the Registrant and certain
                        holders of the Registrant's securities.

                10.21*  Contribution Agreement, dated March 31, 1995, by and
                        among Philip E. Eggers, Robert S. Garvie, Anthony J.
                        Manlove, Hira V. Thapliyal and the Registrant.

                10.22** Preferred Stock Rights Agreement, dated November 14,
                        1996, between the Registrant and Norwest Bank Minnesota,
                        N.A.

                10.23++ Exclusive Distributor Agreement, dated April 15, 1997,
                        between the Registrant and Arthrex, Gmbh

                11.1    Calculation of net loss per share.

                27.1    Financial Data Schedule.

</TABLE>

<TABLE>
<S>     <C>    
*       Incorporated herein by reference to the same-numbered exhibit previously
        filed with the Registrant's Registration Statement on Form S-1 (Registration No.
        33-80453).

**      Incorporated here in by reference to exhibit 5 previously filed with the
        Registrant's Registration Statement on Form 8-A (Registration No. 000-27422).

+       Confidential treatment granted.

++      Confidential treatment requested.

        b)  Reports on Form 8-K
</TABLE>

               None

<PAGE>   29


SIGNATURE

Pursuant to the requirements 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.


                                             ARTHROCARE CORPORATION
                                             a Delaware corporation

Date: May 12, 1997

                                             /s/ A. LARRY TANNENBAUM
                                             --------------------------------
                                             A. Larry Tannenbaum
                                             Vice President, Finance &
                                             Administration, Chief Financial
                                             Officer and Assistant Secretary
                                             (Principal Financial Officer and
                                             Duly Authorized Officer)


Date: May 12, 1997

                                             /s/ HIRA V. THAPLIYAL
                                             --------------------------------
                                             Hira V. Thapliyal, Ph.D.
                                             President, Chief Executive Officer
                                             and Director


<PAGE>   30


                                  EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit                                                                        
Number                      Exhibit Description
------              ----------------------------------
         
<S>                 <C>
10.22++             Exclusive Distributor Agreement, dated April 15, 1997

11.1                Calculation of net loss per share.                        

27.1                Financial Data Schedule.
</TABLE>

---------
++                  Confidential treatment requested.