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               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
 
  Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
  Act of 1934
 
  For the fiscal year ended December 31, 1998 or
 
  Transition Report Pursuant to Section 13 or 15(d) of the Securities
  Exchange Act of 1934
 
                       Commission File Number: 000-23275
 
                               ----------------
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
            (Exact name of Registrant as specified in its charter)
 
<TABLE>
<CAPTION>
                   Delaware                                        77-0423465
 <S>                                             <C>
 (State or other jurisdiction of incorporation       (I.R.S. Employer Identification Number)
               or organization)
<CAPTION>
               285 N. Wolfe Road
             Sunnyvale, California                                   94086
 <S>                                             <C>
   (address of principal executive offices)                        (Zip Code)
 
      Registrant's telephone number, including area code: (408) 773-9121
 
          Securities Registered Pursuant to Section 12(b) of the Act:
 
<CAPTION>
              Title of each class                  Name of each exchange on which registered
 <S>                                             <C>
                     None                                             N/A
</TABLE>
 
          Securities Registered Pursuant to Section 12(g) of the Act:
 
                        Common Stock, $0.001 par value
                               (Title of Class)
 
  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the 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. [_]
 
  The aggregate market value of stock held by non-affiliates of the
registrant, based upon the closing sale price of the Common Stock on March 10,
1999, as reported on the Nasdaq National Market, was approximately
$33,142,000.
 
  The number of shares of Common Stock outstanding as of March 10, 1999:
14,067,183 shares.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Part III of this Form 10-K incorporates information by reference from the
Registrant's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the close of the fiscal year.
 
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                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
                                   FORM 10-K
 
                               TABLE OF CONTENTS
 
<TABLE>
<S>        <C>                                                                    <C>
PART I...........................................................................       3
 
ITEM 1.    BUSINESS.............................................................        3
 
ITEM 2.    PROPERTIES...........................................................       22
 
ITEM 3.    LEGAL PROCEEDINGS....................................................       22
 
ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..................       22
 
PART II..........................................................................      23
 
ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
            MATTERS.............................................................       23
 
ITEM 6.    SELECTED FINANCIAL DATA..............................................       24
 
ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
            RESULTS OF OPERATIONS...............................................       25
 
ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...........       31
 
ITEM 8.    CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.............       32
 
ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
            FINANCIAL DISCLOSURE................................................       46
 
PART III.........................................................................      47
 
ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...................       47
 
ITEM 11.   EXECUTIVE COMPENSATION...............................................       48
 
ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.......       48
 
ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.......................       48
 
PART IV..........................................................................      49
 
ITEM 14.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.....       49
 
</TABLE>
 
 
                                       2
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                                    PART I
 
ITEM 1. BUSINESS
 
  This Report on Form 10-K contains certain forward looking statements
regarding future events. Actual events or results may differ materially as a
result of the factors described herein and in the documents incorporated
herein by reference, including, in particular, those factors described under
"Additional Risk Factors."
 
Company Overview
 
  Somnus was incorporated in Delaware in January 1996. We design, develop,
manufacture and market innovative medical devices that utilize our proprietary
radiofrequency ("RF") technology for the treatment of upper airway disorders.
The Somnus Somnoplasty(TM) System provides physicians with a suite of products
designed to offer minimally-invasive, curative treatment alternatives for
disorders of the upper airway, including obstructive sleep apnea ("OSA"),
enlarged turbinates and habitual snoring. Our Somnoplasty System shrinks
tissue in the upper airway by utilizing automated RF control units and a suite
of disposable, single-use, needle electrode devices, which deliver controlled
thermal energy to obstructed areas, while protecting the delicate mucosal
lining of the tissue. We have received Food and Drug Administration ("FDA")
and European clearance for the use of the Somnoplasty System in the treatment
of OSA, enlarged turbinates and snoring, and officially launched the marketing
of the Somnoplasty System at the American Academy of Otolaryngology-Head and
Neck Surgery Foundation, Inc. conference in September 1997.
 
  We have a direct sales force to market our products in the United States and
have a distributor in Canada. Our intention is to market the Somnoplasty
System primarily to:
 
  .ear, nose and throat physicians,
 
  .oral maxillofacial surgeons,
 
  .pulmonologists,
 
  .sleep medicine specialists and
 
  .other physicians who treat upper airway disorders.
 
  There are approximately 9,000 ear, nose and throat physicians, 7,000 oral
maxillofacial surgeons, and 6,800 pulmonologists and, we believe more than
1,800 sleep clinics in the United States. As of December 31, 1998, we have
shipped 297 control units in the United States, including 51 in the quarter
ended December 1998. We also intend to continuously expand our marketing
program directed primarily at the medical community and to a lesser extent at
consumers, to further establish awareness of the Somnoplasty ProcedureSM.
 
  We have a European Headquarters in The Netherlands primarily to establish
and manage relationships with distributors throughout Europe. In markets
outside the United States and Europe, we are in the process of establishing
relationships with distributors that can provide us with access to an
established network for the marketing and distribution of the Somnoplasty
System.
 
  At December 31, 1998, our commercial products included one control unit
model and three disposable devices designed to treat a variety of upper airway
disorders. Additional models of devices are under development. As of December
31, 1998, in the United States, we had 27 issued patents, and an additional 25
pending patent applications. We also had two issued foreign patents and 51
pending foreign patent applications.
 
                                       3
<PAGE>
 
Business Strategy
 
  Our strategy is to establish the Somnoplasty System, which utilizes our
proprietary radiofrequency technology, as the standard of care for the
treatment of a variety of upper airway disorders. The following are key
elements of the strategy:
 
 We provide minimally-invasive, curative treatments for upper airway
disorders.
 
  The Somnoplasty System provides physicians with a suite of products designed
to offer minimally-invasive, curative treatment alternatives for a number of
upper airway disorders. We believe that the clinical and patient benefits of
the Somnoplasty System include:
 
  .effectiveness,
 
  .quick procedure time,
 
  .outpatient setting,
 
  .use of local anesthesia and
 
  .low post-procedural pain.
 
  These benefits represent a significant advancement to physicians and
patients over existing treatment options, which, depending upon the disorder,
are highly-invasive, palliative and/or expensive.
 
 We intend to pursue additional indications for the Somnoplasty System.
 
  Somnus received 510(k) clearance in July 1997 for the use of the Somnoplasty
System for reduction of soft tissue, including the uvula and soft palate, for
the treatment of habitual snoring. We received the CE Mark for treatment of
upper airway disorders in June 1997. In December 1997, we received 510(k)
clearance for the treatment of enlarged turbinates associated with chronic
turbinate hypertrophy and in November 1998 we received 510(k) clearance for
the treatment of Upper Airway Resistance Syndrome ("UARS") and OSA. We intend
to seek 510(k) clearance of the Somnoplasty System for other new indications,
some of which are associated with OSA. Clinical trials have recently begun for
use of the Somnoplasty System in the treatment of hypertrophic ("enlarged")
tonsils.
 
 We are creating global distribution through a direct sales force and
collaborative relationships.
 
  We have established a direct sales and distribution capability in the United
States, initially targeting the estimated 9,000 ear, nose and throat
physicians, 7,000 oral maxillofacial surgeons, 6,800 pulmonologists and 1,800
sleep clinics. We may supplement our direct sales force with independent sales
representatives in selected areas of the United States. We have a distributor
in Canada.
 
  In September 1998, we established a European Headquarters in The
Netherlands. This headquarters is responsible for:
 
  .establishing and managing relationships with distributors throughout
  Europe,
 
  .marketing the Somnoplasty System throughout Europe and
 
  .providing clinical support.
 
  Product shipments are made directly from our facility in the United States
to the distributor. We have a distributor agreement in Brazil and letters of
intent ("LOI") in several other countries. We expect distribution agreements
following these LOI's to be finalized within the first and second quarters of
fiscal 1999. We also expect to continue to identify qualified distribution
partners intensifying our coverage of Europe.
 
                                       4
<PAGE>
 
  In markets outside the United States and Europe, we are in the process of
establishing relationships with distributors that can provide us with access
to an established network for the marketing and distribution of the
Somnoplasty System.
 
 We have acquired and may acquire or grant licensed complementary technologies
and products and may continue to pursue this strategy in the future.
 
  We have acquired complimentary technology through license agreements for
technology and patents during fiscal 1998. One such license from Medtronic,
Inc. allows the use of the lockout feature of the S-2 control unit to protect
patients against the reuse of disposable devices. We have also granted a
license to Conway Stuart Medical, Inc., for certain radiofrequency generator
technology for treatment of gastroesophageal disorders. We expect to continue
to compliment our core business and technological platform through
acquisitions that broaden our product line and help accelerate the market
acceptance and penetration of the Sopmnoplasty System.
 
Upper Airway Disorders
 
  The upper airway comprises the passages in the back of the mouth, the nose
and the throat and allows breathing, swallowing and speech vocalization. The
breathing function requires the upper airway tissue and musculature to be
stiff enough to prevent collapse during respiration, while swallowing and
speech require compliance and flexibility. The upper airway is susceptible to
a variety of ailments, including tissue obstructions. A common cause of
obstruction found in the upper airway is excess tissue in one or more
locations, including the uvula (the small conical fleshy tissue hanging from
the center of the soft palate), soft palate, base of the tongue, turbinates
(soft tissue in the nasal cavity) and tonsils. Obstructed breathing impedes
the normal flow of air to the respiratory system.
 
  Certain upper airway disorders, such as snoring and OSA, are present only
during sleep, when normal neurologic stimulation and upper airway muscle tone
are diminished. Such upper airway disorders are classified as sleep disorders
and can have an adverse impact on a person's everyday life. The consequences
of sleep disorders and sleep deprivation include reduced productivity,
decreased quality of life due to excessive daytime sleepiness and increased
risk of serious illness such as cardiovascular disease. Other disorders, such
as nasal congestion due to enlarged turbinates (for instance, as a consequence
of allergies, such as hay fever) or enlarged tonsils, are independent of the
wake/sleep cycle and affect people throughout the day as well as during sleep.
 
 Obstructive Sleep Apnea
 
  OSA occurs when tissues in the back of the mouth and in the throat cause
intermittent complete or partial blockage in the upper airway, resulting in an
inability to breathe properly. The brain, sensing that the body is suffocating
from a lack of oxygen, arouses the person to a light sleep, causing the throat
muscles to contract, thus allowing a small passage of air and producing a
gasping sound. The person falls back into deeper sleep until the muscles relax
again, blocking the upper airway and repeating the cycle of arousal.
 
  The cycle of complete or partial upper airway closure with subconscious
arousal to lighter levels of sleep can be repeated as many as several hundred
times during six to eight hours of sleep. Sufferers of OSA typically
experience ten or more such cycles per hour and experience two or more
clinical symptoms of OSA, such as excessive daytime sleepiness, reduced
cognitive function (including memory loss and lack of concentration) and
irritability. Several reports indicate that the oxygen desaturation, increased
heart rate and elevated blood pressure caused by OSA may be associated with
increased risk of cardiovascular morbidity and mortality due to angina, stroke
and heart attack.
 
  According to a 1993 report to Congress, the National Commission on Sleep
Disorders Research estimated that approximately 40 million people in the
United States suffer from chronic disorders of sleep and wakefulness, such as
OSA, insomnia and narcolepsy. They estimate that 20 million of these people
are afflicted with OSA, of whom an estimated 6.4 million are afflicted by the
disorder at a moderate to severe level. It is estimated that less than 3% of
those afflicted with OSA are diagnosed.
 
                                       5
<PAGE>
 
 Enlarged Turbinates
 
  Chronic obstruction of the nasal cavity can impact a person's health and
quality of life. Chronic nasal obstructions are most frequently caused by
enlarged turbinates. Turbinates can become chronically enlarged as a reaction
to diseases, such as chronic and drug-induced rhinitis, and allergy-causing
substances. Enlarged turbinates can partially obstruct or completely block the
nasal passages, resulting in an inefficient or non-existent nasal function.
During the day, enlarged turbinates can cause breathing through the nose to be
difficult and uncomfortable, and at night can contribute to snoring and OSA.
 
 Snoring
 
  Snoring occurs when throat muscles relax during sleep and tissues in the
back of the mouth and in the throat, unsupported by nearby bone structure,
collapse and partially block the upper airway. This partial obstruction causes
the sleeping person to inhale more deeply, creating a vacuum in the
collapsible part of the airway and pulling floppy tissue into the airway.
Snoring is the sound produced by these vibrating structures during breathing.
 
  Habitual snorers are individuals who snore almost every night at a noise
level that would be considered disturbing to others in the same room. We
estimate that there are more than 40 million habitual snorers in the United
States. Factors contributing to habitual snoring include male gender, obesity,
alcohol consumption, use of tranquilizers or muscle relaxants and smoking.
Research has shown that the frequent arousals from sleep caused by snoring may
affect a person's health and productivity during the day. The disruption of
normal sleep can lead to excessive daytime sleepiness, fatigue and loss of
memory and concentration in both the individual suffering from snoring and in
his or her companion. Moreover, snoring is often associated with, and may be a
precursor to, OSA.
 
Current Treatments for Upper Airway Disorders
 
  Currently, no standard modality dominates the treatment of upper airway
disorders. Traditional treatment methods for upper airway disorders range from
behavioral changes to highly invasive surgery. More recently, treatments such
as Continuous Positive Airway Pressure ("CPAP") and laser surgery have emerged
for OSA and snoring, respectively. Current treatments often result in lengthy
recovery periods, significant patient discomfort, and poor compliance by the
user and/or high medical expenses.
 
 Treatment of OSA
 
  The most common treatment for OSA is CPAP. With CPAP, the sleeping patient
wears a mask over the nose, and sometimes the mouth, while pressure from a
compressor forces air through the upper airway to keep excess tissues from
collapsing and obstructing the airway. CPAP machines range from compressors,
which deliver an unchanging, steady flow of air to compressors, which adjust
pressure during inspiration and expiration, to even more sophisticated
systems. Third-party reimbursement is generally available for CPAP.
 
  While CPAP is successful in addressing the symptoms of OSA, its use has a
number of disadvantages, including:
 
  .facial skin irritation,
 
  .abdominal bloating,
 
  .mask leaks,
 
  .sore eyes and
 
  .headaches.
 
                                       6
<PAGE>
 
  Additionally, CPAP is not a cure for OSA and, therefore, must be used on a
nightly basis for as long as the condition persists. The discomfort of the
mask, the inconvenience of use and the unsightly nature of the application
cause many patients to stop using CPAP machines. The American Sleep Disorders
Association ("ASDA") estimated CPAP compliance at only 46% in 1993.
 
  For patients with severe OSA, surgical treatments exist such as the
following:
 
  .  uvulopalatopharyngoplasty ("UPPP"), the surgical resection of the uvula,
     part of the soft palate, tonsils and excess tissue in the throat,
 
  .  maxillofacial surgery, a highly invasive procedure requiring the
     resection of the tongue or reconstruction of the jaw bones, and
 
  .tracheostomies, surgical openings through the neck which bypass the
  obstruction.
 
  UPPP and the other surgical alternatives have been successful in treating
OSA in certain patients. However, possibly due to the fact that UPPP does not
address obstructions at the base of tongue or in the turbinates, it has proven
effective in only about half the patients treated. The most significant
drawbacks of UPPP, maxillofacial surgery and tracheostomies are that they are
highly-invasive, involve significant post-operative morbidity, including a
painful and lengthy recovery, and are expensive.
 
 Treatment of Enlarged Turbinates
 
  Enlarged turbinates are associated with various causes of rhinitis, and
optimal treatment varies accordingly. The first line of treatment typically
involves the use of a variety of drugs. While antihistamines, corticosteroids
and sympathomimetic drugs are often effective for acute presentations of
enlarged turbinates, this method of treatment suffers from side-effects such
as decreased effectiveness over time, rebound congestion and even drug-induced
rhinitis. It is estimated that the 35 million people in the United States who
are currently under medical treatment represent approximately 13% of total
sufferers.
 
  Various surgical techniques exist to treat enlarged turbinates, with
different instrumentation and degrees of invasiveness. Scalpels,
electrocautery and laser devices are the more common instruments. Resection
can be limited to the soft tissue of the turbinate or extend to part of the
underlying boney structure. These procedures are generally effective, but lead
to significant discomfort in the form of occasional post-operative bleeding,
frequent and significant crusting. This requires time consuming post-operative
management of the patient on the part of the physician.
 
 Treatment of Snoring
 
  There are both nonsurgical and surgical methods for treating snoring.
Nonsurgical devices and appliances used to treat snoring include:
 
  .  nasal dilators, such as adhesive nasal tapes which widen the nostrils to
     create a larger passage and improve airflow, and
 
  .  oral appliances, which adjust the position of a patient's jaw or tongue
     during sleep to prevent collapse of the upper airway
 
  Surgical treatment for snoring is available today with laser-assisted
uvulopalatoplasty ("LAUP"). Published studies indicate a success rate for this
procedure in the treatment of snoring of 75% and greater. LAUP is the surgical
resection of the uvula and soft palate through the use of a surgical laser
that operates at temperatures in excess of 700(degrees)C (1,292(degrees)\F). A
LAUP procedure does not require an overnight stay in the hospital; however, it
does present a risk of significant swelling, scarring and post-operative pain.
 
  Third-party reimbursement is not available for the treatment of snoring.
Snoring sufferers most often seek treatment for quality of life rather than
medical reasons.
 
                                       7
<PAGE>
 
The Somnus Solution: Somnoplasty
 
  Our proprietary Somnoplasty System is designed to use radiofrequency energy
to provide a minimally-invasive, curative and relatively painless treatment of
upper airway disorders. The Somnoplasty System includes an automated RF
control unit with temperature monitoring and a suite of proprietary, single-
use, disposable needle electrode devices which deliver controlled thermal
energy into the uvula, soft palate, tongue and turbinates to reduce tissue
volume and stiffen overly-compliant soft tissue. The Somnoplasty System allows
physicians to perform a safe, minimally-invasive surgical procedure in the
office. The use of RF energy to reduce tissue volume treats the causes of
upper airway disorders by enlarging the airway passages and may reduce or
eliminate the need for other treatments.
 
  The procedure creates finely controlled coagulative lesions at precise
locations underneath the mucosal layer of tissue in the upper airway. An
insulating sleeve at the base of the needle electrode protects the mucosa from
thermal damage which prevents tissue sloughing, mucosal scarring, swelling,
bleeding and excessive post-operative pain. Thermocouples in the insulation
and at the tip of the needle electrode assist in the accurate monitoring of
tissue temperature. The control unit is preset to a target temperature of
approximately 75-85(degrees) C (185(degrees) F), ensuring optimal ablation in
a precisely located lesion while protecting the surface mucosa. The lesions
created by the procedure are naturally resorbed in approximately four to eight
weeks, reducing excess tissue volume.
 
  Somnus believes that the primary advantages of the Somnoplasty System
include:
 
  Minimal Discomfort and Reduced Recovery Time. The use of RF energy causes
significantly less swelling and post procedural pain than traditional and
laser-assisted surgery. Patients who undergo the Somnoplasty procedure for the
reduction of soft palate, uvula and enlarged turbinates typically require only
over-the-counter pain medication to treat the postoperative pain and typically
can return to work and resume their normal activities the same day.
 
  Clinical Effectiveness. Unlike treatments such as CPAP for OSA and over-the-
counter remedies for snoring, the Somnoplasty System is designed to be a
curative treatment directly addressing the obstructive tissues in the upper
airway. We believe that the treatment outcomes from the Somnoplasty System
will be equivalent to traditional surgical procedures without the deleterious
side effects of standard and laser-assisted surgical operations.
 
  Rapid Procedure Time. The Somnoplasty System, including patient preparation
and administration of local anesthesia, takes less than 30 minutes, for base
of tongue, enlarged turbinates, soft palate and uvula procedures with
typically less than five minutes necessary for the RF tissue coagulation
itself. We believe treatment requires a range of one to nine visits to a
trained physician and can be performed in an outpatient setting using local
anesthesia.
 
  Ease of Use. The Somnoplasty System is designed to be easy for physicians to
use, thereby minimizing physician training requirements. The Somnoplasty
procedure is less complicated than many minor surgical procedures performed by
dentists in their offices. We believe the benefits of the Somnoplasty System
include:
 
  .Patients: fast, curative outpatient procedure with minimal discomfort,
 
  .Physician: new flexible office based revenue generating system with
  ability to treat multiple conditions,
 
  .Payor: improved outcomes and lower costs.
 
Product Description
 
  We have developed devices for treatment of the tongue, turbinates, uvula and
soft palate. These devices deliver radiofrequency energy from our control
unit. All of our current products are commercially available in the United
States and have 510(k) clearance from the FDA. All of our products have CE
Mark approval and the control unit and uvula and soft palate device is
commercially available in Europe.
 
                                       8
<PAGE>
 
Somnoplasty Product Line
 
 Disposable Devices
 
  SP 1010. The SP 1010 is a single needle deployable electrode device for the
delivery of controlled RF energy into tissue in the soft palate and uvula. The
SP 1010 has a disposable needle device with a reusable handle and cable
assembly. The devices deliver the RF energy through a coagulating needle
electrode which can be positioned using direct visualization. The angle of
deployment may be adjusted prior to the procedure, allowing the physician to
adapt the instrument to individual patient requirements.
 
  SP 1100. The SP 1100 is a disposable single needle electrode device with a
cable assembly for use in enlarged turbinates. It delivers the RF energy
through a coagulating single needle electrode which can be positioned using
direct visualization. The angle of deployment is fixed.
 
  SP 1200. The SP 1200 is a disposable single needle deployable electrode
device with a cable assembly designed for the delivery of controlled RF energy
for patients suffering from OSA. The SP 1200 delivers the RF energy through a
coagulating needle electrode which is positioned using direct visualization.
 
 Control Units
 
  Our control unit is used for the treatment of tissue obstructions in the
upper airway by allowing the physician to efficiently control and monitor the
delivery of energy needed for the RF tissue volume reduction. The physician
determines the maximum amount of power to deliver, the length of time for the
tissue coagulation, the target temperature and the total energy applied. The
user interface of each control unit is designed to require minimal
interaction, allowing the surgeon to focus on the patient. The control unit
contains proprietary software that modulates the delivery of power based on
information transmitted from the disposable needle electrode devices.
 
  S-2 Control Unit. The S-2 control unit is a dual channel generator,
compatible with all of our needle electrode devices. A high-quality color
screen displays delivered power, energy and temperatures. An integral disk
drive captures procedure data and is also used for software upgrades as new
products are introduced.
 
Clinical and Regulatory Status
 
  United States. In July 1997, we received 510(k) clearance for use of the
Somnoplasty System for coagulation of soft tissue, including the uvula and
soft palate, which reduces the severity of snoring in some individuals. The
510(k) clearance was based on the results of a 24 patient, single-center
clinical trial completed in June 1997. The data from this trial indicated that
patients may require anywhere from one to six treatments to significantly
reduce snoring. We believe that most patients only require one to three
treatments to significantly reduce snoring.
 
  In December 1997, we received 510(k) clearance for the use of the
Somnoplasty System for the treatment of nasal obstruction due to chronic
turbinate hypertrophy. The 510(k) clearance was based on the results of 38
patients from the first two centers involved in this clinical trial. We
believe that most patients require one treatment to reduce enlarged
turbinates.
 
  In November 1998, we received 510(k) clearance for the use of the
Somnoplasty System for the reduction of the incidence of airway obstructions
in patients suffering from OSA or Upper Airway Resistance Syndrome ("UARS").
The 510(k) clearance was based on the results of a 18-patient, single-center
clinical trial completed in June 1998. The data from this trial indicated that
patients may require 2 to 9 treatments depending upon the severity of their
disorder. Factors such as the severity of the patient's upper airway
obstruction or improper use
of the Somnoplasty System by the treating physician could require more
treatments than were documented during the clinical trials.
 
                                       9
<PAGE>
 
  Following the tongue indications mentioned above, we intend to pursue FDA
clearance for the treatment of additional upper airway obstructions, some of
which may strengthen the claim for the treatment of OSA. We expect our 510(k)
submissions for these supplemental indications will require additional
clinical trials. In addition, we are continuing to conduct clinical trials for
indications with existing 510(k) clearance to broaden our portfolio of
clinical data.
 
  We have 510(k) clearance from the FDA for the use of the SP 1010 disposable
devices for the reduction of severity of snoring in some individuals, the SP
1100 for the treatment of enlarged turbinates, and the SP1200 for the
reduction of the incidence of airway obstructions in patients suffering from
UARS and OSA. In addition, the S-2 control unit has also received 510(k)
clearance for a general claim of tissue coagulation. Other clearances are
being pursued for various product enhancements. All Somnus products that have
been cleared by the FDA are Class II products.
 
  International. In June 1997, we received authorization from the European
Union (through a duly appointed Notified Body) to affix the CE Mark to our
commercially available products for treatment of upper airway obstructions. We
have been certified under the ISO 9001 Quality System Regulation ("QS Reg.")
by TUV Essen, a German Notified Body. We have also received a TGA listing for
Australia. We are also approved to ship product to Canada via Health Canada
Medical Device license approval, and are pursuing additional countries.
 
Research and Development
 
  We believe that we have a strong base of proprietary design, engineering,
manufacturing and prototype development capabilities. Our particular expertise
is in the core research and development areas relevant to the production of
new disposable needle electrode devices for use in conjunction with our
current RF control unit. Primarily through internal research and development
efforts, we plan to continue to develop new proprietary products, often in
collaboration with leading surgeons and sleep medicine professionals, that
allow surgeons to perform their current or future procedures in a less
traumatic manner with more precision, less surgical time and greater
simplicity. Specifically, we are developing new disposable devices which are
intended to address additional upper airway obstructions such as enlarged
tonsils. We believe that our experience in designing, developing and
manufacturing our current suite of disposable needle electrode devices gives
us a competitive advantage in implementing this strategy. In addition, we have
acquired complimentary technology through license agreements for technology
and patents and expect to continue to compliment our core business and
technological platform through acquisitions that broaden our product line and
help accelerate the market acceptance and penetration of the Sopmnoplasty
System.
 
  In fiscal 1998, 1997 and the period from inception (January 19, 1996) to
December 31, 1996 research and development expenses were $8,220,000,
$6,033,000 and $1,303,000, respectively. As of December 31, 1998, our research
and development staff consisted of 15 employees. We perform our research and
development activities at our offices in Sunnyvale, California. No assurance
can be given that we will complete the development of or successfully
introduce any or all of our devices under development or contemplated for
future development on a timely basis, if at all.
 
Sales, Marketing and Distribution
 
  In the United States, we have a direct sales force to target primarily:
 
  .ear, nose and throat physicians,
 
  .oral maxillofacial surgeons,
 
  .pulmonologists,
 
  .sleep medicine specialists and
 
  .other physicians who treat upper airway disorders.
 
                                      10
<PAGE>
 
  As of December 31, 1998, the sales organization in the United States
consisted of 17 employees, including 2 clinical specialists. We intend to
expand our sales effort during 1999 through the addition of sales
representatives, clinical specialists and customer service representatives.
 
  The primary customers in the United States for the Somnoplasty System are
currently the approximately 9,000 ear, nose and throat physicians and the
approximately 7,000 oral maxillofacial surgeons. We also market to the
approximately 6,800 pulmonologists, as well as sleep medicine specialists.
Certain products, such as the SP 1100 for the treatment of enlarged
turbinates, may appeal to a larger target market, including allergists and
primary care physicians. An important additional target for our sales efforts
is the approximately 1,800 sleep clinics which we believe exist in the United
States. These sleep clinics are multi-specialty practices dedicated to sleep
disorders and include specialists such as ear, nose and throat and oral
maxillofacial surgeons, pulmonologists and psychiatrists and are typically
chaired by physicians who are board certified in sleep medicine. The clinics
include facilities for overnight monitoring and have access to sophisticated
diagnostic equipment to determine the type and characteristics of sleep apnea.
To date, over 300 of these clinics have been accredited by the ASDA. Sleep
clinics are important not only as potential customers, but also for their role
in referring diagnosed patients for treatment.
 
  In September 1998, we established a European Headquarters in The
Netherlands. This headquarters is responsible for:
 
  .establishing and managing relationships with distributors throughout
  Europe,
 
  .marketing the Somnoplasty System throughout Europe and
 
  .providing clinical support.
 
  Product shipments are made directly from our facility in the United States
to the distributor. We have a distributor agreement in Brazil and LOIs in
several other countries. We expect distribution agreements following these
LOIs to be finalized within the first and second quarters of fiscal 1999. We
also expect to continue to identify qualified distribution partners
intensifying our coverage of Europe.
 
  In markets outside the United States and Europe, we are in the process of
establishing relationships with distributors that can provide us with access
to an established network for the marketing and distribution of the
Somnoplasty System.
 
  Our marketing and education efforts have been focused on early adopters with
emphasis on leading surgeons and sleep clinics. As we have approached
saturation of the "early adopter" market we have moved the focus our marketing
and education to the mainstream medical market and, as our products mature,
ultimately, will move to consumers so as to create patient demand for the
Somnoplasty procedure.
 
Manufacturing
 
  Our manufacturing facility is located in Sunnyvale, California in the United
States. The manufacturing process consists primarily of assembly of internally
manufactured and purchased components and subassemblies. We perform certain
processes in a controlled environment. Sterilization of devices is performed
by an ISO certified contract sterilizer.
 
  Raw materials, components and subassemblies are purchased from various
approved suppliers and are subject to quality specifications and inspections.
We have the right to conduct quality audits of our key suppliers, several of
whom are experienced in the supply of components to manufacturers of medical
devices. For certain of our components and subassemblies, there are relatively
few alternative sources of supply, and establishing additional or replacement
suppliers for such components and subassemblies could not be accomplished
quickly. Delays associated with any part shortages, particularly as we scale
up our manufacturing activities in support of increasing commercial demand,
would have a material adverse effect on our business, financial condition and
results of operations.
 
                                      11
<PAGE>
 
  The S-2 control unit is assembled at our facility. Our manufacturing
facilities are subject to periodic inspection by regulatory authorities, and
our operations must undergo compliance inspections conducted by the FDA and
corresponding state agencies. Our quality control group performs tests at
various steps in the manufacturing cycle to ensure compliance with our
specifications and the requirements of the various regulatory authorities.
There can be no assurance that our procedures will be sufficient to meet all
of the requirements of all of the regulatory agencies. Failure to pass
compliance inspections could result in any of the following actions, any one
of which would have a material adverse effect on our business, financial
condition and results of operations:
 
  .warning letters,
 
  .more frequent and rigorous inspections,
 
  .  suspension of FDA clearance to market certain or all of our products for
     a period until we meet the specifications.
 
  Our current facility is 20,000 square feet, of which approximately 6,300
square feet is dedicated to manufacturing, warehousing and distribution.
Through a remodeling effort, our plan is to increase the manufacturing,
warehousing and distribution area by approximately 1,500 square feet in the
first quarter of fiscal 1999. Our direct labor force includes one shift five
days per week assembling control units and one shift four days per week
assembling devices. With minimal additional equipment additions, we could add
more shifts increasing the capacity in both areas sufficiently to accommodate
expected demand for the next 12 months. There can be no assurance that demand
will grow in the magnitude that we expect or that we will be able to scale up
capacity and volume production in order to meet this demand.
 
Dependence upon Patents and Proprietary Technology; Risk of Infringement
 
  In the United States, at December 31, 1998, we had 27 issued patents, 5
allowed patents and an additional 20 pending patent applications. We also had
2 issued foreign patents and 51 pending foreign patent applications. These
patents and patent applications relate to our RF devices and methods for
reduction of tissue in the uvula, soft palate, tongue and tonsils, and design
of our control units and disposable devices. In addition, we may also
selectively license patents owned by others which we believe will complement
the technology and increase the value and strength of our intellectual
property portfolio. Our strategy has been to actively pursue patent protection
in the United States and foreign jurisdictions for all upper airway disorders
that can benefit from use of the Somnoplasty System.
 
  The patent and trade secret positions of medical device companies, including
those of Somnus, are uncertain and involve complex and evolving legal and
factual questions. The coverage sought in a patent application either can be
denied or significantly reduced before or after the patent is issued.
Consequently, there can be no assurance that any patents from pending
applications or from any future patent application will be issued, that the
scope of the patent protection will exclude competitors or provide competitive
advantages to Somnus, that any of our patents will be held valid if
subsequently challenged or that others will not claim rights in or ownership
of the patents and other proprietary rights held by Somnus. Since patent
applications are secret until patents are issued in the United States, or
corresponding applications are published in other countries, and since
publication of discoveries in the scientific or patent literature often lags
behind actual discoveries, we cannot be certain that we were the first to file
patent applications for such inventions. In addition, there can be no
assurance that competitors, many of which have substantial resources, will not
seek to apply for and obtain patents that will prevent, limit or interfere
with our ability to make, use or sell our products either in the United States
or in international markets. Further, the laws of certain foreign countries do
not protect our intellectual property rights to the same extent as do the laws
of the United States. Litigation or regulatory proceedings, which could result
in substantial cost and uncertainty to Somnus, may also be necessary to
enforce patent or other intellectual property rights of Somnus or to determine
the scope and validity of other parties' proprietary rights. There can be no
assurance that Somnus will have the financial resources to defend our patents
from infringement or claims of invalidity.
 
                                      12
<PAGE>
 
  Somnus also relies upon unpatented proprietary technology, and no assurance
can be given that others will not independently develop substantially
equivalent proprietary information and techniques or otherwise gain access to
or disclose our proprietary technology or that we can meaningfully protect our
rights in such unpatented proprietary technology. Our policy is to require
each of our employees, consultants, investigators and advisors to execute a
confidentiality agreement upon the commencement of an employment or consulting
relationship with Somnus. These agreements generally provide that all
inventions conceived by the individual during the term of the relationship
shall be the exclusive property of Somnus and shall be kept confidential and
not be disclosed to third parties except in specified circumstances. There can
be no assurance, however, that these agreements will provide meaningful
protection of our proprietary information in the event of unauthorized use or
disclosure of such information.
 
  Public Law 104-208 precludes medical practitioners and health care entities,
who practice these procedures, from being sued for patent infringement.
Therefore, depending upon how these limitations are interpreted by the courts,
they could have a material adverse effect on our ability to enforce any of our
proprietary methods or procedures deemed to be surgical or medical procedures
on a body.
 
  In addition, patent applications in the United States and foreign
jurisdictions are maintained in secrecy for a period after filing. Publication
of discoveries in the scientific or patent literature tends to lag behind
actual discoveries and the filing of related patent applications. Although we
have conducted searches of certain patents issued to other companies, research
and academic institutions and others, patents issued and patent applications
filed in the United States or internationally relating to medical devices are
numerous, and there can be no assurance that current and potential competitors
and other third parties have not filed, or in the future will not file
applications for, or have not received or in the future will not receive,
patents or obtain additional proprietary rights relating to products or
processes used or proposed to be used by Somnus. In the event any pending
applications provide proprietary rights to third parties relating to products
or processes used or proposed to be used by Somnus, we may be required to
obtain licenses to patents or proprietary rights of others.
 
  The medical device industry in general has been characterized by substantial
litigation. Litigation regarding patent and other intellectual property
rights, whether with or without merit, could be time-consuming and expensive
and could divert our technical and management personnel. We may be involved in
litigation to defend against claims of infringement by Somnus, to enforce
patents issued to Somnus or to protect trade secrets of Somnus. If any
relevant claims of third-party patents are held as infringed and not invalid
in any litigation or administrative proceeding, we could be prevented from
practicing the subject matter claimed in such patents or would be required to
obtain licenses from the patent owners of each such patent or to redesign our
products or processes to avoid infringement. In addition, in the event of any
possible infringement, there can be no assurance that we would be successful
in any attempt to redesign our products or processes to avoid such
infringement or in obtaining licenses on terms acceptable to Somnus, if at
all. Accordingly, an adverse determination in a judicial or administrative
proceeding or failure by us to redesign our products or processes or to obtain
necessary licenses could prevent us from manufacturing and selling the
Somnoplasty System, which would have a material adverse effect on our
business, financial condition and results of operations. Although, to date, we
have not been involved in any litigation, in the future, costly and time-
consuming litigation brought by us may be necessary to enforce patents issued
to Somnus, to protect trade secrets or know-how owned by Somnus or to
determine the enforceability, scope and validity of the proprietary rights of
others.
 
Competition
 
  The medical device industry is subject to intense competition. The market
for products designed to treat upper airway disorders is highly competitive,
and we expect competition to increase. Accordingly, our future success will
depend in part on our ability to respond quickly to medical and technological
change and user preference through the development and introduction of new
products that are of high quality and that address patient and surgeon
requirements. In the treatment of snoring, the Somnoplasty System is subject
to intense competition from existing products, such as nasal dilators and oral
appliances, and surgical procedures, such as LAUP. The U.S. market for the
treatment of enlarged turbinates, a market which we intend to enter in the
near
 
                                      13
<PAGE>
 
future, is dominated by pharmacological treatments, such as nasal sprays, and
surgical procedures, such as turbinectomies. The U.S. market for products for
the treatment of OSA is currently dominated by CPAP products produced by
Healthdyne Technologies Inc., Nellcor Puritan Bennett, Inc., a wholly owned
subsidiary of Mallinckrodt Inc., ResMed Inc. and Respironics, Inc. There can
be no assurance that the Somnoplasty System will successfully compete with or
replace any existing products for these or other indications. Most of our
competitors and potential competitors have greater financial, research and
development, manufacturing and sales and marketing resources than us. In
addition, some of our competitors and potential competitors sell additional
lines of products, and therefore can bundle products to offer higher discounts
or offer rebates or other incentive programs to gain a competitive advantage.
Our inability to compete effectively against existing or future competitors
would have a material adverse effect on our business, financial condition and
results of operations.
 
  We believe that the primary competitive factors in the market for treatment
of upper airway disorders include regulatory approvals, clinical and patient
acceptance, post-operative discomfort, ease of use, product performance,
product price, product supply, marketing and sales capability and the
enforceability of patent and other proprietary rights. We believe that we are
or will be competitive with respect to these factors. Nonetheless, because our
products have recently been introduced or are still under development, the
relative competitive position of Somnus in the future is difficult to predict.
 
Government Regulation
 
  The preclinical and clinical testing, manufacturing, labeling, distribution
and promotion of our products are subject to extensive and rigorous government
regulation in the United States and other countries. Noncompliance with
applicable requirements can result in enforcement action by the FDA or
comparable foreign regulatory bodies including, among other things, fines,
injunctions, civil penalties, recall or seizures of products, refusal to grant
premarket clearances or approvals, withdrawal of marketing approvals and
criminal prosecution.
 
 United States
 
  A medical device may be marketed in the United States only with the FDA's
prior authorization. Devices classified by the FDA as posing less risk are
placed in either in Class I or II and require the manufacturer to seek 510(k)
clearance from the FDA. Such clearance generally is granted when submitted
information establishes that a proposed device is "substantially equivalent"
in intended use and safety and effectiveness to a "predicate device," which is
either a Class I or II device already legally on the market or a
"preamendment" Class III device (i.e., one that has been in commercial
distribution since before May 28, 1976) for which the FDA has not called for
premarket application ("PMA"). We believe that it usually takes from 3 to 12
months from the date of submission to obtain 510(k) clearance, but it may take
longer, and there can be no assurance that 510(k) clearance will ever be
obtained. During this process, the FDA may determine that it needs additional
information or that a proposed device is precluded from receiving clearance
because it is not substantially equivalent to a predicate device. After a
device receives clearance, any modification that could significantly affect
our safety or effectiveness, or would constitute a major change in the
intended use of the device, will require a new 510(k) submission.
 
  The Somnoplasty System received 510(k) clearance on July 17, 1997 for the
intended use of coagulation (thermal ablation, tissue volume reduction) of
soft tissue, including the uvula and soft palate, and may reduce severity of
snoring in some individuals. In December 1997, we received 510(k) clearance to
use the Somnoplasty System for tissue coagulation (thermal ablation) in the
inferior turbinates to treat the symptoms of nasal obstruction due to chronic
turbinate hypertrophy. In November 1998 we received 510(k) clearance for the
use of the Somnoplasty system for the reduction of the incidence of airway
obstructions in patients suffering from UARS or OSA.
 
  We have made modifications to our cleared devices which we believe do not
require the submission of new 510(k) notices. There can be no assurance,
however, that the FDA would agree with any of our determinations not to submit
a new 510(k) notice for any of these changes or would not require Somnus to
submit a new 510(k)
 
                                      14
<PAGE>
 
notice for any of the changes made to the devices. If the FDA requires Somnus
to submit a new 510(k) notice for any device modification, we may be
prohibited from marketing the modified device until the 510(k) notice is
cleared by the FDA.
 
  A device that does not qualify for 510(k) clearance is placed in Class III,
which is reserved for devices classified by FDA as posing the greatest risk
(e.g., life-sustaining, life-supporting or implantable devices, or devices
that are not substantially equivalent to a predicate device). A Class III
device generally must obtain PMA approval, which requires the manufacturer to
establish the safety and effectiveness of the device to the FDA's
satisfaction. A PMA must provide extensive preclinical and clinical trial data
and also information about the device and our components regarding, among
other things, manufacturing, labeling and promotion. As part of the PMA
review, the FDA will inspect the manufacturer's facilities for compliance with
the Quality System Regulation ("QS Reg."), which includes elaborate testing,
control, documentation and other quality assurance procedures.
 
  Upon submission, the FDA determines if the PMA is sufficiently complete to
permit a substantive review, and if so, the application is accepted for
filing. The FDA then commences an in-depth review of the PMA, which we believe
typically takes one to two years, but may take longer. The review time is
often significantly extended as a result of the FDA asking for more
information or clarification of information already provided. The FDA also may
respond with a "not approvable" determination based on deficiencies in the
application and require additional clinical trials that are often expensive
and time consuming and can delay approval for months or even years. During the
review period, an FDA advisory committee, typically a panel of clinicians,
likely will be convened to review the application and recommend to the FDA
whether, or upon what conditions, the device should be approved. Although the
FDA is not bound by the advisory panel decision, the panel's recommendation is
important to the FDA's overall decision making process.
 
  If the FDA's evaluation of the PMA is favorable, the FDA typically issues an
"approvable letter" requiring the applicant's agreement to specific conditions
(e.g., changes in labeling) or specific additional information (e.g.,
submission of final labeling) in order to secure final approval of the PMA
application. Once the approvable letter is satisfied, the FDA will issue a PMA
for approved indications, which can be more limited than those originally
sought by the manufacturer. The PMA can include post approval conditions that
the FDA believes necessary to ensure the safety and effectiveness of the
device including, among other things restrictions on labeling, promotion, sale
and distribution. Failure to comply with the conditions of approval can result
in material adverse enforcement action, including the loss or withdrawal of
the approval. The PMA process can be expensive and lengthy, and no assurance
can be given that any PMA application will ever be approved for marketing.
Even after approval of a PMA, a new PMA or PMA supplement is required in the
event of a modification to the device, labeling or manufacturing process.
 
  We intend to seek 510(k) clearance of the Somnoplasty System for new
indications, some of which are associated with OSA. These future submissions
likely will need to include supporting clinical trial data. There can be no
assurance, however, that these new indications will receive 510(k) clearance
in a timely fashion, or at all. Delays in market introduction resulting from
the 510(k) clearance process could have a material adverse effect on our
business, financial condition and results of operations. If the FDA determines
that any of the new indications are not eligible for 510(k) clearance, we will
need to seek PMA approval. There can be no assurance that we will submit a PMA
for any such indications or that once submitted, the PMA will be accepted for
filing, found approvable or, if found approvable, will not include unfavorable
restrictions.
 
  A clinical trial in support of a 510(k) submission or PMA generally requires
an Investigational Device Exemption ("IDE") application approved in advance by
the FDA for a limited number of patients. The IDE application must be
supported by appropriate data, such as animal and laboratory testing results.
Clinical trials may begin if the IDE application is approved by the FDA and
the appropriate institutional review boards ("IRBs") at the clinical trial
sites. Submission of an IDE application does not give assurance that the FDA
will approve the IDE application and, if it is approved, there can be no
assurance that the FDA will determine that the data derived from these studies
support the safety and efficacy of the device or warrant the continuation of
 
                                      15
<PAGE>
 
clinical studies. If the device presents a "nonsignificant risk" to the
patient, a sponsor may begin the clinical trial after obtaining approval for
the study by one or more appropriate IRBs without the need for FDA approval.
We are sponsoring several clinical trials which have been determined by the
IRBs at the participating institutions to be nonsignificant risk studies.
There can be no assurance however, that the FDA would agree with these
determinations and not require us to obtain IDE approval before continuing the
studies. During a clinical trial, we are permitted to sell products used for
the study for an amount that does not exceed recovery of the costs of
manufacture, research, development and handling. Our failure to adhere to
regulatory requirements generally applicable to clinical trials or to the
conditions of an IDE approval could have a material adverse effect on our
business, financial conditions and results of operations, including an
inability to obtain marketing clearance or approval for our products.
 
  Any devices manufactured or distributed by Somnus pursuant to FDA clearances
or approvals will be subject to pervasive and continuing regulation by the FDA
and certain state agencies. We will be subject to routine inspection by the
FDA and the California Department of Health Services ("CDHS") and will have to
comply with the host of regulatory requirements that usually apply to medical
devices marketed in the United States, including labeling regulations, the QS
Reg., the Medical Device Reporting ("MDR") regulation and the FDA's
prohibitions against promoting products for unapproved or "off-label" uses. In
addition, Class II devices, such as our Somnoplasty System, can be subject to
additional special controls (e.g., performance standards, postmarket
surveillance, patient registries, and FDA guidelines) that do not apply to
Class I devices. Our failure to comply with applicable regulatory requirements
could result in enforcement action by the FDA, which could have a material
adverse effect on our business, financial condition and results of operations.
 
  Unanticipated changes in existing regulatory requirements, failure of Somnus
to comply with such requirements or adoption of new requirements could have a
material adverse effect on our business, financial condition and results of
operations. We also are subjected to numerous federal, state and local laws
relating to such matters as safe working conditions, manufacturing practices,
environmental protection, fire hazard control and hazardous substance
disposal. There can be no assurance that we will not be required to incur
significant costs to comply with such laws and regulations in the future or
that such laws or regulations will not have a material adverse effect upon our
business, financial condition and results of operations.
 
 European Union
 
  The primary regulatory environment in Europe is that of the European Union
("EU") which consists of 15 countries encompassing most of the major countries
in Europe. Certain other countries, such as Switzerland, have voluntarily
adopted laws and regulations that mirror those of the EU with respect to
medical devices. The EU has adopted numerous directives and standards
regulating the design, manufacture, clinical trial, labeling, and adverse
event reporting for medical devices. The principal directives prescribing the
laws and regulations pertaining to medical devices in the EU are the Medical
Devices Directive, 93/42/EEC.
 
  Devices that comply with the requirements of a relevant directive will be
entitled to bear CE conformity marking, indicating that the device conforms
with the essential requirements of the applicable directive and, accordingly,
can be commercially distributed throughout the EU. The method of assessing
conformity varies depending on the class of the product, but normally involves
a combination of self-assessment by the manufacturer and a third-party
assessment by a Notified Body. This third-party assessment may consist of an
audit of the manufacturer's quality system and specific testing of the
manufacturer's product. An assessment by a Notified Body in one country within
the EU is required in order for a manufacturer to commercially distribute the
product throughout the EU. Our Somnoplasty System received the CE Mark in June
1997.
 
  While no additional premarket approvals or individual EU countries are
required, prior to the marketing of a device bearing the CE Mark, practical
complications with respect to market introduction may occur. For example,
differences among countries have arisen with regard to labeling requirements.
 
                                      16
<PAGE>
 
Third-Party Reimbursement
 
  We believe that our products will generally continue to be purchased by
private practices, clinics, hospitals and sleep clinics. In the United States,
the purchasers of medical devices generally rely on Medicare, Medicaid,
private health insurance plans, health maintenance organizations and other
sources of reimbursement for health care costs ("Third-Party Payors") to
reimburse all or part of the cost of the procedure in which the medical device
is being used. Certain Third-Party Payors are moving toward a managed-care
system in which they contract to provide comprehensive health care for a fixed
cost per person. The fixed cost per person established by these Third-Party
Payors may be independent of the practice's cost incurred for the specific
case and the specific devices used. Medicare and other Third-Party Payors are
increasingly scrutinizing whether to cover new products and the level of
reimbursement for covered products.
 
  In the United States, we do not anticipate that the Somnoplasty System will
be subject to reimbursement for the treatment of snoring. Traditionally,
sufferers of snoring have paid for surgical and non-surgical treatment and
devices directly. However, the current treatment of OSA and outpatient
surgical procedures for the uvula, soft palate and turbinates are commonly
reimbursed by most carriers, and resection of the tongue is reimbursed as an
inpatient procedure.
 
  The Somnoplasty System is generally reimbursed for the treatment of enlarged
turbinates under existing reimbursement codes. However, there can be no
assurance that third-party reimbursement will be available for all such
procedures by all third-party payors.
 
  We believe that the Somnoplasty System may be reimbursed for treatment of
base of the tongue and OSA under existing reimbursement codes, based on
physician endorsement and the demonstration of improved quality of life for
specific patient groups. Quality of life issues will be included in our
clinical trials to provide data in support of this reimbursement strategy.
There can be no assurance that we will be able to demonstrate improvement in
quality of life or that reimbursement will ever be available for our products.
Our clinical sites do not reimburse us for Somnoplasty System control units or
disposable devices.
 
  Because our devices have been relatively recently launched for the treatment
of base of the tongue, OSA and enlarged turbinates, uncertainty exists
regarding the availability of third-party reimbursement for procedures that
would use our devices for such purposes. Failure by private practices,
clinics, hospitals, sleep clinics and other potential users of our devices to
obtain sufficient reimbursement from Third-Party Payors for the procedures in
which our devices are intended to be used could have a material adverse effect
on our business, financial condition and results of operations.
 
  International market acceptance of our current products and those under
development may 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. We do not
anticipate that use of the Somnoplasty System for treatment of snoring will be
a reimbursable expense. We believe that various levels of reimbursement will
be available in international markets for treatment of base of tongue, OSA and
enlarged turbinates. However, there can be no assurance that any international
reimbursement approvals will be obtained in a timely manner, if at all.
Failure to receive international reimbursement approvals could have a material
adverse effect on market acceptance of our products in the international
markets in which such approvals are sought.
 
  We believe that in the future, reimbursement will be subject to increased
restrictions both in the United States and in international markets. We
believe that the overall escalating cost of medical products and services will
continue to lead to increased pressures on the health care industry, both
domestic and international, to reduce the cost of products and services,
including our existing products and products currently under development.
There can be no assurance that third-party reimbursement and coverage will be
available or adequate in either the United States or international markets or
that future legislation, regulation or reimbursement policies of Third-Party
Payors will not otherwise adversely affect the demand for our existing
 
                                      17
<PAGE>
 
products or products currently under development or our ability to sell our
products on a profitable basis. The unavailability of Third-Party Payor
coverage or the inadequacy of reimbursement could have a material adverse
effect on our business, financial condition and results of operations.
 
Product Liability Exposure and Availability of Insurance
 
  Our business involves the risk of product liability claims. Although we have
not experienced any product liability claims to date, any such claims could
have a material adverse effect on us. We maintain product liability insurance
at coverage levels which we deem commercially reasonable; however, there can
be no assurance that product liability or other claims will not exceed such
insurance coverage limits or that such insurance will continue to be available
on commercially acceptable terms, or at all. We intend to periodically
evaluate, depending on changing circumstances, whether or not to obtain any
additional product liability insurance. Even if we obtain additional product
liability insurance, there can be no assurance that it would prove adequate or
that a product liability claim, insured or uninsured, would not have a
material adverse effect on our business, financial condition and results of
operations. Even if a product liability claim is not successful, the time and
expense of defending against such a claim may adversely affect our business,
financial condition and results of operations.
 
Employees
 
  As of December 31, 1998, we employed 78 individuals full time. Of our total
work force, 27 employees are engaged in manufacturing, 15 employees are
engaged in research and development activities, 23 employees are engaged in
sales and marketing activities and 13 employees are engaged in finance and
administrative activities. Our employees are not represented by a collective
bargaining agreement. We believe our relations with our employees are good.
 
Additional Risk Factors
 
  The risk factors set forth below contain forward-looking statements
(designated by an *), and the Company's actual results could differ materially
from those anticipated in these forward-looking statements as a result of
factors, including those set forth below. If any of the following risks
actually occur, our business, financial condition or results of operations
could be materially adversely affected. As a result, the trading price of our
common stock could decline, and you may lose all or part of your investment.
 
 Limited Operating History; Absence of Profitability.
 
  Somnus has generated only limited revenues from sales of the Somnoplasty
System and has limited experience in manufacturing, selling and marketing our
products in commercial quantities. There can be no assurance that the
Somnoplasty System will be sufficiently successful for us to achieve
significant revenues. From inception in 1996 through December 31, 1998, we
have had total revenues of approximately $9.9 million and incurred cumulative
losses of approximately $35.2 million. We expect to significantly increase
spending over the next several years with respect to sales and marketing,
manufacturing and to a lesser extent, ongoing research and development efforts
and clinical trials, and expects to incur significant additional losses for
the foreseeable future.* Whether we can successfully manage the transition to
a larger-scale enterprise will depend upon a number of factors, including our
ability to increase our commercial manufacturing and sales and marketing
capabilities. Our inability to establish such capabilities would have a
material adverse effect on our business, financial condition and results of
operations.
 
 We are dependent upon the Somnoplasty System, which has not been available
for sufficient time for us to know if it is effective on a long term basis.
 
  Our success depends upon the market acceptance of the Somnoplasty System for
the treatment of OSA, enlarged turbinates and snoring. Market acceptance will
depend, in large part, upon the effectiveness of the Somnoplasty System over
time.* There can be no assurance that the procedure will provide a permanent,
curative
 
                                      18
<PAGE>
 
treatment for patients. Independent factors, such as aging and weight gain,
may, over time, lead to the enlargement of tissue in areas previously treated
by our procedure.* Such regrowth of tissue could require further treatments,
making the procedure a potentially less attractive alternative to existing
surgical and non-surgical procedures, which could have a material adverse
effect upon our business, financial condition and results of operations.
 
 Several factors will impact our ability to achieve market acceptance.
 
  RF tissue volume reduction in the upper airway is a new and novel
development. Market acceptance of this procedure for the treatment of OSA,
enlarged turbinates and snoring could be adversely affected by numerous
factors, including:
 
  .the lack of availability of third-party reimbursement,
 
  .cost of the procedure,
 
  .clinical acceptance,
 
  .effective physician training and
 
  .patient acceptance.
 
  Third party reimbursement. We do not anticipate that patients will receive
third-party reimbursement for use of the Somnoplasty System in the treatment
of snoring.* Market acceptance of the Somnoplasty System for the treatment of
OSA and enlarged turbinates will depend, in large part, upon the availability
of third-party reimbursement for each of those indications, which is not
assured.*
 
  Cost of the procedure and clinical acceptance. Market acceptance will also
depend upon our ability to demonstrate that the Somnoplasty System is an
attractive alternative to existing procedures, which will depend upon
physicians' evaluations of the clinical safety and efficacy, ease of use,
reliability and cost-effectiveness of the Somnoplasty System in a clinical
setting.* We believe that recommendations and endorsements by influential
physicians will be essential to market acceptance.* There can be no assurance
that such recommendations or endorsements will be obtained.
 
  Physician training. Broad use of the Somnoplasty System will require
training for physicians on how to perform the Somnoplasty procedure and
educating physicians regarding the advantages of the Somnoplasty System over
currently available surgical and non-surgical approaches.* The time required
to complete such training and education could extend the sales cycle for our
products and delay or preclude commercial sales and market acceptance. If we
are unable to achieve broad market acceptance of the Somnoplasty System for
our current and anticipated indications, our business, financial condition and
results of operations would be materially adversely affected.
 
  Patient acceptance. Patient acceptance may be affected by numerous factors,
including the possibility that the Somnoplasty procedure will require
treatments on multiple occasions, which would be not only inconvenient for the
patient, but also more costly.* Patients may require anywhere from one to six
treatments to significantly reduce snoring; however, we anticipate that most
patients will only require one to three treatments to significantly reduce
snoring.* We anticipate that most patients will require fewer treatments to
reduce enlarged turbinates than required to reduce snoring and more to treat
OSA than snoring.* Factors such as poor training of the treating physician or
improper use of the Somnoplasty System by the treating physician could lead to
a patient requiring more treatments. Patient acceptance of the Somnoplasty
System for the treatment of snoring, turbinate reduction, OSA, and other
potential indications will also depend in part upon physician recommendations
as well as other factors, including the effectiveness and reliability of the
procedure as compared to existing surgical and non-surgical procedures.* There
can be no assurance that the Somnoplasty System will be accepted by the
patient community or that market demand for such system will be sufficient to
allow us to achieve profitable operations. In addition, publicity arising from
any adverse outcome or other problem occurring in the treatment of a
 
                                      19
<PAGE>
 
Somnoplasty patient for any reason, particularly during this early phase of
the commercialization of the Somnoplasty System, could materially adversely
affect patient demand for the procedure. Failure of the Somnoplasty System,
for whatever reason, to achieve significant patient acceptance would have a
material adverse effect on our business, financial condition and results of
operations.
 
 We have limited direct sales and marketing experience.
 
  We have only limited experience selling and marketing the Somnoplasty System
for the treatment of OSA, enlarged turbinates and snoring. We are directing
our sales effort in the United States on private practices, clinics, hospitals
and sleep clinics through a direct sales force. We currently have a small
direct sales force that covers certain regions of the United States and intend
to increase our sales and marketing force in the near future to accelerate
commercialization of the Somnoplasty System throughout the United States.*
There can be no assurance that we will be successful in building an effective
sales and marketing force, that we will be cost-effective or that we will
ultimately prove successful in selling the Somnoplasty System on a direct
basis in the United States in sufficient quantities for us to become
profitable. Market acceptance of the Somnoplasty System will also require us
to demonstrate that the cost of our products and procedures are competitive
with currently available alternatives.* The use of the Somnoplasty System
requires the healthcare provider to make an up-front investment in an RF
control unit. There can be no assurance that we will successfully generate
sufficient demand for the Somnoplasty System at the prices at which we
currently offer our control units and disposable devices. In the event the
required investment were to preclude us from placing sufficient quantities of
control units, our ability to sell disposable devices would be limited, which
would have a material adverse effect on our business, financial condition and
results of operations.
 
 We need to develop successful distributor relationships for international
sales.
 
  Our future success will depend, in part, on our ability to enter into and
successfully develop strategic and distributor relationships with other
parties with respect to the marketing and distribution of our products.* We
have a distributor in Canada.
 
  In September 1998, we established a European Headquarters in The
Netherlands. This headquarters is responsible for:
 
  .establishing and managing relationships with key distributors throughout
  Europe,
 
  .marketing the Somnoplasty System throughout Europe and
 
  .providing clinical support.
 
  Product shipments are made directly from our facility in the United States
to the distributor. We have a distributor agreement in Brazil and LOIs in
several other countries. We expect distribution agreements following these
LOIs to be finalized within the first and second quarters of fiscal 1999.* We
also expect to continue to identify qualified distribution partners
intensifying our coverage of Europe.*
 
  In markets outside the United States and Europe, we are in the process of
establishing relationships with distributors that can provide us with access
to an established network for the marketing and distribution of the
Somnoplasty System.* We have an agreement with a distributor in Canada.
 
  The success of our future strategic or distributor relationships, will
depend on the other parties' ability to perform the role contemplated by us.*
We may have limited or no control over the resources that any particular
strategic party or distributor devotes to our relationship with us. There can
be no assurance that we will be successful in locating or finalizing
agreements with further qualified parties with whom to enter into additional
strategic or distributor relationships or that any such relationships can be
maintained or will ultimately prove beneficial to us. In the event we are not
successful in developing such additional relationships, or if such
relationships do not prove to be successful, our business, financial condition
and results of operations would be materially adversely affected.
 
 
                                      20
<PAGE>
 
  International sales of the Somnoplasty System are subject to numerous risks.
Distribution, pricing and marketing structures, as well as regulatory
requirements, vary significantly from country to country. Additionally, such
sales can be adversely affected by:
 
  .limitations or disruptions caused by the imposition of government
  controls,
 
  .difficulty in obtaining export licenses,
 
  .political instability,
 
  .trade restrictions,
 
  .changes in foreign tax laws or tariffs or other trade regulations,
 
  .difficulties coordinating communications among and managing international
  operations,
 
  .the risk that distributors will fail to effectively promote our products,
 
  .the risk of financial instability of distributors,
 
  .fluctuations in overseas economic conditions and international currency
  exchange rates,
 
  .increases in duty rates and
 
  .competition.
 
  There can be no assurance that we will be able to successfully commercialize
the Somnoplasty System or any of our future products in any international
market, which would have a material adverse effect on our business, financial
condition and results of operations.
 
 We may experience manufacturing problems with regard to our control unit.
 
  In the past we purchased our 215 RF control unit as a finished assembly from
a single-source supplier. We discontinued selling the 215 RF control unit
model during fiscal 1998. The S-2 control unit is manufactured entirely by us.
There can be no assurance that we will not experience design or production
issues as Somnus commences such manufacturing activities.
 
  We launched the S-2 during the second quarter of fiscal 1998. The S-2
control unit is more expensive than the 215 RF control unit. There can be no
assurance that we will be able to successfully market and sell the S-2 control
unit. Further, there can be no assurance that we will not experience increased
levels of returns of the 215 RF control unit as a result of the launch of the
S-2 control unit or that we will not experience increased levels of warranty
costs associated with the new product. Further, we expect that we will
continuously bring new generation products to market that may compliment or
replace current products.* There can be no assurance that we can successfully
manage these product transitions.
 
 We are dependent on single-source suppliers for components.
 
  We purchase certain key components of our products from single-source
suppliers. There can be no assurance that the components obtained from the
single-source suppliers will continue to be available in adequate quantities
or, if required, that we will be able to locate alternative sources of such
components on a timely and cost-effective basis. To date, we have not
experienced significant adverse effects resulting from any shortage of
components. However, there can be no assurance that the single-source
suppliers will meet our future requirements for timely delivery of components
of sufficient quality and in sufficient quantity.* The components may take
several months to procure, and a significant increase of orders could lead to
significant delays and control unit or device shortages. Such delays or
shortages, particularly as we scale up our manufacturing activities in support
of sales and distributor orders, would have a material adverse effect on our
business, financial condition and results of operations.
 
                                      21
<PAGE>
 
 We are dependent upon key personnel.
 
  Our future success depends in significant part upon the continued service of
certain key scientific, technical and management personnel and our continuing
ability to attract and retain highly qualified scientific, technical and
managerial personnel.* Competition for such personnel is intense, and there
can be no assurance that we can retain our key scientific, technical and
managerial personnel or that we can attract, assimilate or retain other highly
qualified scientific, technical and managerial personnel in the future. We
have taken steps to retain our key employees, including the granting of stock
options that vest over time. The loss of key personnel, especially if without
advanced notice, or the inability to hire or retain qualified personnel could
have a material adverse effect upon our business, financial condition and
results of operations.
 
  Due to the factors noted above, our future earnings and stock price may be
subject to significant volatility, particularly on a quarterly basis. Any
shortfall in revenues or earnings from levels expected by security analysts
could have an immediate and significant adverse effect on the trading price of
our common stock.
 
ITEM 2. PROPERTIES
 
  We lease an approximately 20,000 square foot light industrial facility in
Sunnyvale, California, under a lease that terminates in 2002, with an option
to extend to 2007. We believe that our facility is adequate to meet our
current requirements. We anticipate requiring additional space within 12 to 18
months. In addition, we lease an approximately 2,500 square foot sales office
facility in Eindhoven, The Netherlands, under a lease that terminates in 2000.
 
ITEM 3. LEGAL PROCEEDINGS
 
  We are not party to any legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  Not applicable.
 
                                      22
<PAGE>
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  Our Common Stock is traded on the NASDAQ National Market under the symbol
"SOMN". The following table sets forth the range of the high and low sales
prices by quarter as reported on the NASDAQ National Market from November 5,
1997, the date the Common Stock commenced trading.
 
<TABLE>
<CAPTION>
   Quarter Ended                                                 High     Low
   -------------                                                 ----     ---
   <S>                                                          <C>     <C>
   1997: Fourth Quarter (from November 5, 1997)................ $14 1/4 $9 3/7
   1998: First Quarter......................................... $12 7/8 $8 1/8
   1998: Second Quarter........................................ $13 5/8 $6 13/16
   1998: Third Quarter......................................... $ 8 1/2 $3
   1998: Fourth Quarter........................................ $ 5 1/8 $1 3/16
</TABLE>
 
  As of December 31, 1998, the number of common stockholders of record was
157. We currently intend to retain any earnings for use in our business and do
not anticipate paying any cash dividends in the foreseeable future.
 
  In November 1997, we completed our initial public offering (the "IPO") of
4,600,000 shares (including the exercise of the underwriter's over-allotment
option consisting of 600,000 shares) of our Common Stock, $0.001 par value per
share, at a public offering price of $10.50 per share pursuant to a
registration statement on Form S-1 (File No. 333-35401) filed with the
Securities and Exchange Commission. All of the shares registered were sold.
J.P. Morgan & Co., UBS Securities and Smith Barney Inc. were the managing
underwriters of the IPO. Aggregate gross proceeds to us from the IPO (prior to
deduction of underwriting discounts and commissions and expenses of the
offering) were $48,300,000. There were no selling stockholders in the IPO.
 
  We paid underwriting discounts and commissions of approximately $3,400,000
and other expenses of approximately $1,100,000 in connection with the IPO. The
total expenses paid by us in the IPO were approximately $4,500,000 and the net
proceeds to us in the IPO were approximately $43,800,000.
 
  From November 5, 1997, the effective date of the Registration Statement, to
December 31, 1998, the approximate amount of net proceeds used from the
Offering were $4.9 million for research and development, clinical trials and
regulatory matters, $3.6 million to manufacture product and further develop
manufacturing expertise and capabilities, $7.7 million to improve and expand
financial capabilities, to enhance financial reporting systems, to expand
sales and marketing efforts, and for other general corporate purposes and
$700,000 for the acquisition of fixed assets. The remaining net proceeds from
the IPO continue to be held in temporary cash and cash equivalent investments.
 
  All amounts represent estimates of direct or indirect payments of amounts to
third parties. No amounts were paid directly or indirectly for the above
purposes to directors or officers of Somnus, other than in the ordinary course
of business, to persons owning ten percent or more of any class of equity
securities of Somnus, or to affiliates of Somnus. The use of proceeds
described above do not represent a material change in the use of proceeds
describe in the Offering prospectus.
 
                                      23
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA
 
                      Summary Consolidated Financial Data
 
<TABLE>
<CAPTION>
                                                                 Period from
                                                                  Inception
                                     Year Ended   Year Ended  (January 19, 1996)
                                    December 31, December 31,  to December 31,
                                        1998         1997            1996
                                    ------------ ------------ ------------------
                                      (in thousands, except per share amounts)
<S>                                 <C>          <C>          <C>
Consolidated Statements of
 Operations Data:
Total revenues....................    $  7,356     $  2,574        $   --
Costs and expenses:
  Manufacturing start-up costs and
   costs of revenues..............       5,565        3,110            403
  Research and development........       8,220        6,033          1,303
  Selling, general and
   administrative.................      14,953        6,741          1,489
                                      --------     --------        -------
Total costs and expenses..........      28,738       15,884          3,195
                                      --------     --------        -------
Loss from operations..............     (21,382)     (13,310)        (3,195)
Other income, net.................       2,054          553             98
                                      --------     --------        -------
Net loss..........................    $(19,328)    $(12,757)       $(3,097)
                                      ========     ========        =======
Net loss per share:
  Basic and Diluted...............    $  (1.41)    $  (3.02)       $ (1.61)
                                      ========     ========        =======
Shares used in computing per share
 amounts:
  Basic and Diluted...............      13,717        4,224          1,922
                                      ========     ========        =======
</TABLE>
 
<TABLE>
<CAPTION>
                                          December 31, December 31, December 31,
                                              1998         1997         1996
                                          ------------ ------------ ------------
                                                      (in thousands)
<S>                                       <C>          <C>          <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents................   $ 32,280     $ 45,145     $ 8,829
Working capital..........................     27,742       43,736       7,982
Total assets.............................     36,512       48,227      10,031
Long-term obligations....................        --           --          773
Accumulated deficit......................    (35,182)     (15,854)     (3,097)
Total stockholders' equity...............     29,428       45,620       8,353
</TABLE>
 
                                       24
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
  The information set forth in this Item 7 below contains forward-looking
statements (designated by an *), and the Company's actual results could differ
materially from those anticipated in these forward-looking statements as a
result of factors, including those set forth above under "Additional Risk
Factors."
 
Overview
 
  We design, develop, manufacture and market innovative medical devices that
utilize our proprietary RF technology for the treatment of upper airway
disorders. Our SomnoplastySM System provides physicians with a suite of
products designed to offer minimally invasive, curative treatment alternatives
for disorders of the upper airway, including obstructive sleep apnea (OSA),
enlarged turbinates and snoring.
 
  We have a limited history of operations that, to date, has consisted
primarily of research and development, product engineering, seeking clearance
of our products from the Food & Drug Administration (FDA), initial development
of a direct sales force in the United States and internationally, and training
international distributor employees for distribution of the Somnoplasty System
in the European Union (EU), Australia, Southeast Asia and certain other areas.
We commercially introduced the Somnoplasty System internationally, through
Medtronic, beginning in June 1997. One month later, after receiving 510(k)
clearance from the FDA for the use of the Somnoplasty System to treat snoring,
we began direct sales of the Somnoplasty System in the United States. We since
received FDA clearance to treat enlarged turbinates in December 1997 and OSA
in November 1998. During the third quarter of fiscal 1998 we terminated our
relationship with Medtronic and established a European headquarters in The
Netherlands. This headquarters is responsible for:
 
  .  establishing and managing relationships with key distributors throughout
     Europe,
 
  .  marketing the Somnoplasty System throughout Europe and
 
  .  providing clinical support.
 
  Product shipments are made directly from our facility in the United States
to the distributor. We have a distributor agreement in Brazil and LOIs in
several other countries. We expect distribution agreements following these
LOIs to be finalized within the first and second quarters of fiscal 1999.* We
also expect to continue to identify qualified distribution partners
intensifying our coverage of Europe.*
 
  In markets outside the United States and Europe, we are in the process of
establishing relationships with distributors that can provide us with access
to an established network for the marketing and distribution of the
Somnoplasty System.* We have an agreement with a distributor in Canada.
 
  We plan to continue to hire additional management and engineering personnel
to support and develop manufacturing expertise and larger scale manufacturing
capacity expansion as required to support the current and anticipated growth.*
Additionally, we will invest in further production equipment, vertical
integration and facility expansion to reduce manufacturing costs, reduce
manufacturing cycle time and increase production capacity.* During the fourth
quarter of fiscal 1998, we commenced certain manufacturing facility expansion
and improved layout for increased capacity, process improvement and quality
control to support such growth. Personnel hires and capital expenditures will
require operating capital on an ongoing basis. We will continue to expand our
internal reporting capabilities and further strengthen systems to manage our
expanding business.*
 
  This current and anticipated significant growth of our personnel, sales and
scope of operations may place considerable strain on our management,
financial, manufacturing and other capabilities, procedures and controls.
There can be no assurance that any existing or additional capabilities,
procedures or controls will be adequate to support our operations or that our
capabilities, procedures or controls will be designed, implemented or improved
in a timely and cost-effective manner. Failure to implement, improve and
expand such capabilities, procedures and controls in an efficient manner could
have a material adverse effect on our business, financial condition and
results of operations.
 
                                      25
<PAGE>
 
  We are building a direct sales force to cover the United States. Presently
the sales force consists of a Vice President of North American Sales, two
domestic regional sales managers, ten domestic sales representatives and one
clinical specialist. During fiscal 1998 we hired a Vice President and General
Manager of European Sales & Marketing and business managers to manage
distributors in European countries. Medtronic previously distributed our
products in Europe. Somnus and Medtronic have cooperatively transitioned
product distribution rights back to Somnus. Additionally, we have entered into
an agreement with a distributor in Canada and plan to enter into agreements
for product distribution in Japan and other international markets.* We
anticipate significant short-term expenditures in the development of our
direct and indirect sales infrastructure.*
 
  As of December 31, 1998, we have incurred cumulative losses from inception
of approximately $35,182,000. Moreover, we expect to incur significant
additional operating losses over the next couple of years primarily due to the
development of our manufacturing and sales and marketing capabilities along
with ongoing research and development efforts, including clinical studies and
expenses associated with our patent portfolio.* Our limited operating history
makes accurate prediction of future operating results difficult or impossible.
 
  Future revenues and results of operations may fluctuate significantly from
quarter to quarter or year to year and will depend upon numerous factors,
including the extent to which our products gain market acceptance, the scale-
up of manufacturing capabilities, the expansion of sales and marketing
activities, competition, the timing and success of new product introductions
by us or our competitors, the timing of regulatory clearances or approvals of
those new products and the ability of us to market our products in the United
States and internationally. Accordingly, interim period comparisons of our
operating results are not necessarily meaningful and should not be relied upon
as indicators of likely future performance or annual operating results.
 
  Our business and financial results could be materially adversely affected in
the event that we are unable to market the Somnoplasty System effectively,
anticipate customer demand accurately or effectively manage new product
launches, pricing and cost containment pressures in health care. Our
operations and financial results could also be significantly affected by
international factors, including oversight by numerous regulatory agencies,
changes in foreign currency exchange rates and foreign economic and political
conditions.
 
Results of Operations
 
 Net revenues
 
  Our revenues for fiscal 1998 and fiscal 1997 are derived primarily from
sales of our Somnoplasty System, consisting of the 215 RF and S-2 control
units and disposable devices, to private practices, hospitals, clinics and
sleep clinics. Net revenues increased in fiscal 1998 to $7,356,000 from
$2,574,000 in fiscal 1997, an increase of $4,782,000 or 186%. This increase
was primarily due to the sale of control units, boosted by the introduction of
the new S-2 control unit during the third quarter and increased handpiece
shipments driven off the higher installed base plus additional indications
treatable with the Somnoplasty system. During fiscal 1998 (our first full year
of product shipments) and 1997, net revenues were attributable to sales to
customers principally in the United States. We expect that the sale of control
units will continue to constitute a significant percentage of our total
revenues in the near term as we build an installed base of users. However, we
expect disposable devices to increase as a percentage of total revenue, year
over year.*
 
 Manufacturing start-up costs and costs of revenues.
 
  Manufacturing start-up costs and costs of revenues increased $2,455,000, 79%
to $5,565,000 in fiscal 1998 from $3,110,000, in the prior year. Manufacturing
start-up costs and costs of revenues consist of raw materials, subassemblies
and completed electronics, quality assurance and warranty costs. The cost of
product, salaries and employee related expenses, and the costs of establishing
and expanding manufacturing capabilities, including a one-time charge of
approximately $200,000 relating to certain manufacturing process issues in the
fourth quarter of fiscal 1998, account for the majority of the increase from
fiscal 1997 to fiscal 1998. We believe that manufacturing start-up costs and
costs of revenues will increase in absolute dollars but may fluctuate as a
percentage of revenues.*
 
                                      26
<PAGE>
 
 Research and development expenses.
 
  Research and development costs for fiscal 1998 were $8,220,000, compared to
$6,033,000 for the prior year, an increase of $2,187,000, 36%. Research and
development expenses are comprised of salaries, prototype development costs,
costs associated with intellectual property, and clinical trial and regulatory
approval expenses.
 
  The increase in expenses is primarily due to increased salaries and employee
related expenses of $2,533,000 in fiscal 1998 versus $1,794,000 in the prior
year, increased consulting fees of $1,145,000 compared to $400,000, increased
patent legal expenses of $835,000 versus $369,000 in the prior year period and
a higher level of general infrastructure costs, including facilities,
information systems and quality assurance. Included in the 1998 employee
related expenses is approximately $753,000 of non-cash stock compensation
charges resulting from stock option grants, compared to $548,000 for the prior
year period. These additional expenses were partially offset by lower spending
on clinical trial and prototype costs of approximately $1,640,000 as compared
to approximately $2,434,000 in the prior year period.
 
 Selling, general and administrative.
 
  Selling, general and administrative ("SG&A") expenses for fiscal 1998 were
$14,953,000, compared to $6,741,000 for fiscal 1997 an increase of
approximately, $8,212,000 or 122% including approximately $1,600,000 in one-
time charges. SG&A expenses consist of executive salaries, professional fees
(including consulting, accounting, legal and risk management), facilities
overhead, accounting and human resources and general office administration
expenses.
 
  The increase in SG&A is primarily due to increased salaries and employee
related expenses of $8,051,000 for fiscal 1998, compared to $2,838,000 for the
prior year period, due to increased headcount, higher levels of commission on
higher sales volumes, the European Office and one time charges of
approximately $1,645,000 in connection with the transition of our former Chief
Executive officer and Chairman of the Board to Chief Technical Officer and
Board Director, severance of our former Chief Financial Officer and certain
other executives. These one-time charges are comprised of approximately
$790,000 in non-cash stock compensation and approximately $855,000 of cash
related compensation. Employee related expenses also include expenses of
$2,058,000 increased from $699,000 for the prior year period relating to non-
cash stock compensation charges resulting from stock option grants including
our executive employment status changes noted above and consultant awards.
Increased selling expenses included commissions, travel and entertainment
costs of $882,000, versus $194,000 for the prior year period and sales samples
costs incurred in 1998 of $320,000. Costs of development of marketing
literature and campaigns, tradeshow attendance, and an extensive ongoing
public relations effort to promote the Somnoplasty System totaled
approximately $1,494,000 in fiscal 1998, compared to $620,000 for the prior
year period.
 
 Interest and other income.
 
  Interest and other income for fiscal 1998 was $2,059,000, compared to
$735,000 for the prior-year period. The increase is attributable to interest
income earned by Somnus on an increased outstanding balance of cash and cash
equivalents, invested from the proceeds of the IPO. Interest expense was
$5,000 for fiscal 1998, compared to $182,000 in the prior-year period. The
decrease was due to the repayment of borrowings under the equipment lease line
of credit.
 
 Net loss.
 
  The net loss was $19,328,000 for fiscal 1998 and $12,757,000 for fiscal
1997, respectively. We expect that our operating losses will continue for at
least the next couple of years and may increase in the short term, as we
continue to invest substantial resources in product development, manufacturing
and sales and marketing.
 
                                      27
<PAGE>
 
Fiscal 1997 Compared to the Period from Inception (January 19, 1996) to
December 31, 1996
 
 Net Revenues.
 
  Our revenues through December 31, 1997 were derived from sales of our
Somnoplasty System, consisting of the 215 RF Control unit and SP 1000 and SP
2000 disposable devices (now no longer commercially available), to private
practices, hospitals, clinics and sleep clinics. No revenues were recorded for
the period from inception (January 19, 1996) to December 31, 1996 ("fiscal
1996"). For the year ended December 31, 1997 ("fiscal 1997"), net revenues,
totaling $824,000, were attributable to sales to Medtronic and $1,750,000 to
other customers principally in the United States.
 
 Manufacturing start-up costs and costs of revenues.
 
  Manufacturing start-up costs and costs of revenues were $403,000 in fiscal
1996 and $3,110,000 in fiscal 1997. Manufacturing start-up costs and costs of
revenues consist of raw materials, subassemblies and completed electronics,
quality assurance and warranty costs. The cost of purchased materials, the
costs of prototypes, and the costs of establishing manufacturing capabilities
account for the majority of the increase from fiscal 1996 to fiscal 1997.
 
 Research and development expenses.
 
  Research and development expenses were $1,303,000 in fiscal 1996 and
$6,033,000 in fiscal 1997. Research and development expenses are comprised of
salaries, prototype development costs and clinical trial and regulatory
approval expenses. The increases between the comparison periods reflect the
increased expenditures incurred in the development of the Somnoplasty System,
new development efforts for the control units and the disposable devices,
initiation and expansion of clinical trials and expenses associated with
regulatory approvals in the United States, the European Union and Australia.
Clinical trial costs for fiscal 1997 were approximately $1,700,000 as compared
to approximately $174,000 in fiscal 1996. Salaries of research and development
personnel represented $322,000 and $1,130,000 in fiscal 1996 and fiscal 1997,
respectively. Prototype and patent legal expenses increased to approximately
$750,000 and $475,000 in fiscal 1997, as compared to $129,000 and $0 in fiscal
1996, respectively. The 1997 expenses also include approximately $548,000 of
non-cash stock compensation charges resulting from stock option grants.
 
 Selling, general and administrative.
 
  Selling, general and administrative (SG&A) expenses were $1,489,000 in
fiscal 1996 and $6,741,000 in fiscal 1997, respectively. SG&A expenses consist
of executive salaries, professional fees, facilities overhead, accounting and
human resources, general office administration expenses such as rent and
facility costs. SG&A for fiscal 1997 included legal and accounting costs of
approximately $426,000 and professional recruitment costs and other consultant
fees of $358,000. The 1997 expenses also include $699,000 of non-cash stock
compensation charges resulting from stock option grants. The increase between
the comparison periods reflects the hiring of additional personnel, increased
legal, accounting and insurance costs associated with being a public company,
development of marketing literature and campaigns, an extensive public
relations effort to promote the Somnoplasty System in conjunction with the
product launch in June 1997 and additional market research into new product
areas. The costs of public relations and advertising for the fiscal 1997 were
approximately $890,000.
 
 Interest and other income, net.
 
  Interest and other income, net were $98,000 in fiscal 1996 and $553,000 for
fiscal 1997. The increases were attributable to interest income earned by
Somnus on our outstanding balance of cash and cash equivalents, invested from
the proceeds of the Series C issuance and the IPO, net of interest expense on
our lease line of credit obligations. Interest expense was $24,000 in fiscal
1996 and $182,000 in fiscal 1997. The increase was due to increased borrowings
against the equipment lease line of credit.
 
                                      28
<PAGE>
 
Income Taxes
 
  As of December 31, 1998, we had federal and state net operating loss
carryforwards of approximately $27,700,000 and $12,900,000, respectively. We
also had federal and California research and development tax credit
carryforwards of approximately $500,000. The federal net operating loss and
credit carryforwards will expire at various dates beginning in the year 2011
through 2018, if not utilized. The State of California net operating losses
will expire at various dates beginning in 2001 through 2003, if not utilized.
Utilization of the net operating loss carryforwards may be subject to a
substantial annual limitation due to the ownership change limitations provided
by the Internal Revenue Code of 1986, as amended (the "Code"), and similar
state provisions. The annual limitation may result in the expiration of the
net operating loss carryforwards before becoming available to reduce our
federal income tax liabilities. As of December 31, 1998, we had deferred tax
assets of approximately $12,600,000, which have been fully offset by a
valuation allowance. Deferred tax assets relate primarily to the net operating
loss carryforwards.
 
Year 2000 Compliance
 
  Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. As a result, software
that records only the last two digits of the calendar year may not be able to
distinguish whether "00" means 1900 or 2000. This may result in software
failures or the creation of erroneous results.
 
  We have assessed and continue to assess our exposure to the Year 2000
problem. We believe our enterprise resource planning systems and networking
systems are compliant and we are upgrading our telecommunications systems for
Year 2000 compliance.* We also believe that our products are Year 2000
compliant. However, while we believe we have made significant progress in
resolving known Year 2000 issues, sufficient testing has not been completed to
fully validate the readiness of our systems and products. Additional testing
and upgrades are planned during fiscal 1999 to reasonably ensure Year 2000
compliance for our operations.*
 
  We have also assessed and continue to assess the possible effect on our
operations of the Year 2000 readiness of critical suppliers of products and
services.* Our reliance on our key suppliers, and therefore on the proper
functioning of their information systems and software, is increasing. We are
in the process of contacting critical suppliers to gain assurance of their
Year 2000 readiness. However, there can be no assurance all of these suppliers
will be Year 2000 compliant and their failure to address Year 2000 issues
could have an adverse effect on us.
 
  Although it is difficult to estimate the total Year 2000 project costs, our
preliminary estimate is that such costs will total between approximately
$100,000 and $200,000, which is not material to our business operations or
financial condition.* There can be no assurance that these estimates will be
achieved and actual results could differ materially from those anticipated. We
have incurred approximately $50,000 through December 31, 1998 on this project.
The expenses of the Year 2000 project are being funded from existing cash
reserves and through operating cash flows.
 
  Somnus has not developed a formal comprehensive contingency plan to address
situations that may result if we are unable to achieve Year 2000 readiness of
our operations. These contingency plans will be for certain mission critical
operations for the period immediately subsequent to January 1, 2000 and will
be formalized during the first half of fiscal 1999.* There can be no assurance
that we will be able to develop a contingency plan that will adequately
address issues that may arise in the year 2000. Our failure to develop and
implement, if necessary, an appropriate contingency plan could have a material
impact on our operations. Finally, we are also vulnerable to external forces
that might generally affect industry and commerce, such as utility or
transportation Year 2000 compliance failures and related service
interruptions.
 
  We believe that we are unlikely to experience a material adverse impact on
our financial condition or results of operations due to Year 2000 compliance
issues within our operations.* However, since the assessment process is
ongoing, Year 2000 compliance complications are not fully known, critical
suppliers of components, services
 
                                      29
<PAGE>
 
and others including utility companies are outside our control, and potential
liability issues are not clear, the full potential impact of the Year 2000 on
us is not known at this time.
 
Liquidity and Capital Resources
 
  Since inception through December 31, 1998, Somnus has financed our
operations primarily through the private placement of equity securities, bank
loans, lease lines of credit, stockholder loans and our November 1997 IPO.
From inception, we raised approximately $16,400,000 in net proceeds from
private equity financing. We raised an additional $43,756,000 from our IPO,
net of costs of $4,540,000.
 
  Cash and cash equivalents at December 31, 1998 were $32,280,000 compared to
$45,145,000 at December 31, 1997.
 
  Net cash used in operating activities was approximately $12,438,000 for the
twelve months ended December 31, 1998, compared to $9,521,000 for the prior-
year period. Net cash used in operating activities differs from our net loss
for these comparison periods primarily due to non-cash charges associated with
the amortization of deferred compensation, the depreciation of property and
equipment, and the increase in accounts payable and related accruals. These
sources of funds were offset partially by an increase in accounts receivable
and inventory, as we increase sales of our products and move more of the
manufacturing operations in-house. Net cash used in investing activities was
approximately $752,000 for the twelve months ended December 31, 1998, compared
to $1,957,000 for the prior-year period, the net cash used in investing
activities was primarily attributable to capital expenditures during these
periods. Net cash provided by financing activities was approximately $325,000
for the twelve months ended December 31, 1998 and $47,795,000 for the prior-
year period. Net cash provided by financing activities in 1998 is attributable
primarily to the exercise of options. The net cash provided by financing
activities for the twelve months ended December 31, 1997 included primarily
the issuance of preferred stock, borrowings under a lease line of credit and
proceeds from our IPO.
 
  We recorded deferred stock compensation expense for the difference between
the exercise price and the fair value of our Common Stock for certain options
granted and related to the severance of former executives including our Chief
Executive Officer and our Chief Financial Officer. The total unamortized
deferred stock compensation at December 31, 1998 is $450,000. We amortized
deferred compensation expenses of approximately $2,811,000 in the twelve
months ended December 31, 1998 compared to $1,252,000 for the respective 1997
period. The remainder of the deferred stock compensation will be amortized
over the corresponding vesting period of each respective option, which is
generally four years from date of original issuance.
 
  At December 31, 1998, our principal sources of liquidity consisted of
$32,280,000 in cash and cash equivalents. There were no other material unused
sources of liquid assets at December 31, 1998.
 
  We currently anticipate that our capital expenditure requirements will be
approximately $1.0 million for the next twelve months.* These requirements
relate primarily to the acquisition of computer hardware and software and for
additional leasehold improvements to handle anticipated manufacturing
expansion and headcount additions.*
 
  In October 1998, we announced that our board of directors has authorized a
stock repurchase program permitting the purchase of up to 1,000,000 shares, at
up to $5.00 per share, of our common stock in the open market. No shares had
been repurchased by Somnus as of December 31, 1998. Subsequently Somnus has
repurchased a nominal number of shares under the program.
 
  We anticipate that our existing resources will enable us to maintain our
current and planned operations at least through the next twelve months.*
However, there can be no assurance that we will not require additional funding
prior to such time. Our future capital requirements will depend on many
factors, including the ability of Somnus to establish and maintain strategic
distributor relationships, the time and cost in obtaining regulatory
 
                                      30
<PAGE>
 
clearances, competing technological and market developments, the cost of
manufacturing and other factors. There can be no assurance that additional
financing to meet our funding requirements will be available as needed. If
additional funds are raised by issuing equity securities, substantial dilution
to existing stockholders may result. Insufficient funds may require Somnus to
delay, scale back or eliminate some or all of our research or development
programs or to relinquish rights to products at an earlier stage of
development or on less favorable terms than we would otherwise seek to obtain.
The failure of Somnus to raise capital when needed would have a material
adverse effect on our business, financial condition and results of operations.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  The primary objective of our investment activities is to preserve principal
while at the same time maximizing yields without significantly increasing
risk. To achieve this objective, we invest in highly liquid and high quality
debt securities. Our investments in debt securities are subject to interest
rate risk. To minimize the exposure due to adverse shift in the interest rates
we invest in short term securities and have maintained an average maturity of
3 months or less. Due to the nature of short term investments we have
concluded that we do not have a material market risk exposure.
 
                                      31
<PAGE>
 
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
               Report of Ernst & Young LLP, Independent Auditors
 
The Board of Directors and Stockholders
Somnus Medical Technologies, Inc.
 
  We have audited the accompanying consolidated balance sheets of Somnus
Medical Technologies, Inc. as of December 31, 1998 and 1997, and the related
consolidated statements of operations, stockholders' equity, and cash flows
for the years ended December 31, 1998 and 1997 and for the period from
inception (January 19, 1996) to December 31, 1996. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Somnus
Medical Technologies, Inc. at December 31, 1998 and 1997, and the consolidated
results of its operations and its cash flows for the years ended December 31,
1998 and 1997 and for the period from inception (January 19, 1996) to December
31, 1996 in conformity with generally accepted accounting principles.
 
                                          /s/ Ernst & Young LLP
 
Palo Alto, California
February 2, 1999
 
                                      32
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
                          Consolidated Balance Sheets
                 (in thousands except share and per share data)
 
<TABLE>
<CAPTION>
                                                      December 31, December 31,
                                                          1998         1997
                                                      ------------ ------------
<S>                                                   <C>          <C>
Assets
Current assets:
  Cash and cash equivalents..........................   $ 32,280     $ 45,145
  Accounts receivable, net of allowances of $662 and
   $70 at December 31, 1998 and 1997, respectively...      1,329          662
  Inventories........................................        806          236
  Other current assets...............................        411          300
                                                        --------     --------
Total current assets.................................     34,826       46,343
Property and equipment...............................      1,601        1,822
Other assets.........................................         85           62
                                                        --------     --------
                                                        $ 36,512     $ 48,227
                                                        ========     ========
 
Liabilities and stockholders' equity
Current liabilities:
  Accounts payable...................................   $  1,521     $  1,112
  Accrued liabilities................................      2,174          542
  Accrued compensation...............................      1,858          509
  Accrued clinical costs.............................        675          269
  Deferred revenue...................................        856          175
                                                        --------     --------
Total current liabilities............................      7,084        2,607
 
Commitments
 
Stockholders' equity:
  Preferred stock, 5,000,000 shares authorized, par
   value $0.001 per share, no shares were outstanding
   at December 31, 1998 and 1997.....................        --           --
  Common stock, 50,000,000 shares authorized, par
   value $0.001 per share, shares issued and
   outstanding: 13,989,490 and 13,444,965 shares at
   December 31, 1998 and 1997, respectively..........         14           13
  Additional paid-in capital.........................     65,046       64,782
  Deferred stock compensation........................       (450)      (3,321)
  Accumulated deficit and accumulated comprehensive
   loss..............................................    (35,182)     (15,854)
                                                        --------     --------
Total stockholders' equity...........................     29,428       45,620
                                                        --------     --------
                                                        $ 36,512     $ 48,227
                                                        ========     ========
</TABLE>
 
                            See accompanying notes.
 
                                       33
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
                     Consolidated Statements of Operations
                    (in thousands, except per share amounts)
 
<TABLE>
<CAPTION>
                                                                 Period from
                                                                  Inception
                                     Year Ended   Year Ended  (January 19, 1996)
                                    December 31, December 31,  to December 31,
                                        1998         1997            1996
                                    ------------ ------------ ------------------
<S>                                 <C>          <C>          <C>
Total revenues....................    $  7,356     $  2,574        $   --
Costs and expenses:
  Manufacturing start-up costs and
   costs of revenues..............       5,565        3,110            403
  Research and development........       8,220        6,033          1,303
  Selling, general and
   administrative.................      14,953        6,741          1,489
                                      --------     --------        -------
Total costs and expenses..........      28,738       15,884          3,195
                                      --------     --------        -------
Loss from operations..............     (21,382)     (13,310)        (3,195)
Interest and other income.........       2,059          735            122
Interest expense..................          (5)        (182)           (24)
                                      --------     --------        -------
Net loss..........................    $(19,328)    $(12,757)       $(3,097)
                                      ========     ========        =======
Net loss per share:
  Basic and Diluted...............    $  (1.41)     $ (3.02)       $ (1.61)
                                      ========     ========        =======
Shares used in computing per share
 amounts:
  Basic and Diluted...............      13,717        4,224          1,922
                                      ========     ========        =======
</TABLE>
 
                            See accompanying notes.
 
                                       34
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
                Consolidated Statement of Stockholders' Equity
                    (in thousands except per share amounts)
 
<TABLE>
<CAPTION>
                           Convertible                                                       Accumulated
                            Preferred                                                        Deficit and
                              Stock       Common Stock  Additional Receivable    Deferred    Accumulated     Total
                          --------------  -------------  Paid-In      from        Stock     Comprehensive Stockholders
                          Shares  Amount  Shares Amount  Capital   Stockholder Compensation     Loss         Equity
                          ------  ------  ------ ------ ---------- ----------- ------------ ------------- ------------
<S>                       <C>     <C>     <C>    <C>    <C>        <C>         <C>          <C>           <C>
Issuance of common stock
 to founders at $0.001
 per share in exchange
 for cash and
 technology.............     --   $ --     2,335  $ 2    $   --       $ --        $  --       $    --       $      2
Issuance of common stock
 at $0.10 per share for
 services...............     --     --        30  --           3        --           --            --              3
Issuance of Series A
 convertible preferred
 stock at $1.00 per
 share in exchange for
 cash, net of issuance
 costs of $16...........   1,784      2      --   --       1,766        --           --            --          1,768
Issuance of Series B
 convertible preferred
 stock at $3.00 per
 share in exchange for
 cash, net of issuance
 costs of $845..........   3,500      3      --   --       9,651        --           --            --          9,654
Issuance of common stock
 upon exercise of stock
 options for cash,
 receivable and
 associated compensation
 related to 1996 stock
 option grants..........     --     --        98  --         549         (3)        (524)          --             22
Net loss and
 comprehensive loss.....     --     --       --   --         --         --           --         (3,097)       (3,097)
                          ------  -----   ------  ---    -------      -----       ------      --------      --------
Balances at December 31,
 1996...................   5,284      5    2,463    2     11,969         (3)        (524)       (3,097)        8,352
Issuance of Series C
 convertible preferred
 stock at $7.00 per
 share in exchange for
 cash, net of issuance
 costs of $60...........     714      1      --   --       4,939        --           --            --          4,940
Issuance of common stock
 upon exercise of stock
 options for cash.......     --     --       384  --          68        --           --            --             68
Repayment of receivable
 from stockholder.......     --     --       --   --         --           3          --            --              3
Conversion of Series A,
 B and C preferred stock
 to common stock upon
 consummation of IPO....  (5,998)    (6)   5,998    6        --         --           --            --            --
Issuance of common stock
 pursuant to IPO, net of
 issuance costs of
 $4,540.................     --     --     4,600    5     43,757        --           --            --         43,762
Deferred compensation
 related to grant of
 stock options..........     --     --       --   --       4,049        --        (4,049)          --            --
Amortization of deferred
 compensation...........     --     --       --   --         --         --         1,252           --          1,252
Net loss and
 comprehensive loss.....     --     --       --   --         --         --           --        (12,757)      (12,757)
                          ------  -----   ------  ---    -------      -----       ------      --------      --------
Balances at December 31,
 1997...................     --     --    13,445   13     64,782        --        (3,321)      (15,854)       45,620
Issuance of common stock
 upon exercise of stock
 options for cash.......     --     --       479    1        178        --           --            --            179
IPO issuance costs......     --     --       --   --        (127)       --           --            --           (127)
Deferred Compensation
 related to stock option
 grants.................     --     --       --   --         817        --          (817)          --            --
Amortization of deferred
 compensation...........     --     --       --   --         --         --         2,811           --          2,811
Reduction of deferred
 compensation upon
 cancellation of option
 grants.................     --     --       --   --        (877)       --           877           --            --
Issuance of shares under
 Employee Stock Purchase
 Plan...................     --     --        65  --         273        --           --            --            273
Net loss and
 comprehensive loss.....     --     --       --   --         --         --           --        (19,328)      (19,328)
                          ------  -----   ------  ---    -------      -----       ------      --------      --------
Balance at December 31,
 1998...................     --   $ --    13,989  $14    $65,046      $ --        $ (450)     $(35,182)     $ 29,428
                          ======  =====   ======  ===    =======      =====       ======      ========      ========
</TABLE>
 
                                       35
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
                     Consolidated Statements of Cash Flows
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                                   Period from
                                                                    Inception
                                                                   (January 19,
                                          Year Ended   Year Ended    1996) to
                                         December 31, December 31, December 31,
                                            1998          1997         1996
                                         ------------ ------------ ------------
<S>                                      <C>          <C>          <C>
Cash flows used in operating activities
Net loss...............................   $ (19,328)   $ (12,757)    $ (3,097)
 
Adjustments to reconcile net loss to
 net cash used in operating activities:
  Amortization of deferred
   compensation........................       2,811        1,252          --
  Depreciation and amortization........         716          800          143
  Net book value of property, plant and
   equipment retirements...............         257          476          --
  Issuance of stock for non-cash
   consideration.......................         --           --            25
  Changes in operating assets and
   liabilities:
    Other current assets...............        (111)        (242)         (46)
    Accounts receivable................        (667)        (662)         (12)
    Inventories........................        (570)        (236)         --
    Other assets noncurrent............         (23)         (58)          (4)
    Accounts payable and accrued
     liabilities.......................       2,041        1,022          632
    Accrued compensation...............       1,349          440           69
    Accrued clinical costs.............         406          269          --
    Deferred revenue ..................         681          175          --
                                          ---------    ---------     --------
Net cash used in operating activities..     (12,438)      (9,521)      (2,290)
 
Cash flows used in investing activities
Capital expenditures...................        (752)      (1,957)      (1,283)
 
Cash flows provided by financing
 activities
Net proceeds from issuance of
 convertible preferred stock...........         --         4,940       11,422
Net proceeds from issuance of common
 stock.................................         325       43,829            2
Repayment of shareholder loan..........         --             3          --
Proceeds from borrowings under lease
 line of credit........................         --         1,956          977
Repayment of lease line of credit......         --        (2,933)         --
                                          ---------    ---------     --------
Net cash provided by financing
 activities............................         325       47,795       12,401
                                          ---------    ---------     --------
Net increase (decrease) in cash and
 cash equivalents......................     (12,865)      36,317        8,828
Cash and cash equivalents at beginning
 of period.............................      45,145        8,828          --
                                          ---------    ---------     --------
Cash and cash equivalents at end of
 period................................   $  32,280    $  45,145     $  8,828
                                          =========    =========     ========
 
Supplemental disclosure of cash flow
 information
Cash paid for interest.................   $       5    $     182     $     24
 
Supplemental schedule of non-cash
 investing and financing activities
Property and equipment acquired under
 lease line of credit..................   $     --     $   1,957     $    977
Deferred compensation related to grant
 of stock options, net.................   $     (60)   $   4,049     $    524
Issuance of Series B preferred stock in
 exchange for services.................   $     --     $     --      $    180
</TABLE>
 
                            See accompanying notes.
 
                                       36
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
                  Notes to Consolidated Financial Statements
 
1. Summary of Significant Accounting Policies
 
 Organization, Ownership and Business
 
  Somnus Medical Technologies, Inc. ("Somnus"), was incorporated in Delaware
on January 19, 1996. Somnus designs, develops, manufactures and markets
medical devices that utilize proprietary radiofrequency technology for the
treatment of upper airway disorders. Our Somnoplasty System is intended to
offer minimally-invasive, curative treatment alternatives for disorders of the
upper airway, including snoring, obstructive sleep apnea, enlarged turbinates
and enlarged tonsils. In 1996, we established Somnus Medical Technologies Pty.
Ltd. in Australia for purposes of conducting clinical research studies on
behalf of Somnus. In September 1998 we established Somnus Medical Technologies
B.V. in The Netherlands for purposes of managing a sales distributor network
in Europe. Collectively, the entities are referred to as Somnus.
 
  From inception through mid 1997 our principal activities were recruiting
personnel, raising capital and performing research and development. During
1997 we received Food and Drug Administration ("FDA") 510(k) clearance for the
sale of our first products, to treat snoring and enlarged turbinates. In
November 1998 we received an additional 510(k) FDA clearance to treat
Obstructive Sleep Apnea ("OSA").
 
 Basis of Presentation
 
  The consolidated financial statements include the accounts of Somnus Medical
Technologies, Inc. and our wholly owned subsidiaries, Somnus Medical
Technologies Pty. Ltd and Somnus Medical Technologies, B.V. after elimination
of all material intercompany balances and transactions.
 
 Reclassifications
 
  Certain prior year amounts have been reclassified to conform to the current
year presentation.
 
 Revenue Recognition
 
  We generally recognize revenue at the time products are shipped or, for
sales which are financed through third parties, upon acceptance from a third
party leasing company of a customer lease and the related equipment. For
shipments to distributors made under agreements that do not provide for right
of return or price protection, revenue is generally recognized upon shipment.
Allowances for product returns are provided for at the time of revenue
recognition.
 
 Dependence on Distributors and Single-Source Suppliers
 
  Somnus entered into a Distribution Agreement with Medtronic Inc.
("Medtronic") on April 21, 1997 for a period of three years with defined
minimum annual purchase requirements. The Agreement granted Medtronic
exclusive distribution rights of certain of Somnus products in the European
Union, Australia, Southeast Asia and certain other areas until April 21, 2000.
As of September 1998 we terminated our relationship with Medtronic and
established a European headquarters in The Netherlands. During 1998 Medtronic
Europe was not a significant customer and in 1997 net sales of approximately
$824,000 were transacted with Medtronic's European operations. There were no
other single customers whose sales made up 10% or more of our revenue in
fiscal 1998 or 1997.
 
  During 1997 and through mid 1998 we purchased what was our only commercially
available radiofrequency ("RF") control unit from a single-source supplier.
During 1998 we launched a new control unit product which we manufacture in-
house, effectively replacing the prior version, which was manufactured by sub-
contractors. Certain components continue to be purchased from single-source
suppliers. Establishing additional or replacement suppliers for such control
unit or certain of the components used in our products, if required, may
 
                                      37
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
not be accomplished quickly and could involve significant additional costs.
Any supply interruption from suppliers or failure of Somnus to obtain
alternative suppliers for the control unit or such components would limit our
ability to manufacture and sell our products and would have a material adverse
effect on our business, financial condition and results of operations.
 
 Net Loss Per Share
 
  Basic and diluted earnings per share have been calculated using the weighted
average common shares outstanding during the periods in accordance with
Statements of Financial Accounting Standard No. 128 (SFAS 128) "Earnings Per
Share" issued by the Financial Accounting Standards Board and Securities and
Exchange Commission Staff Accounting Bulletin No. 98 (SAB 98).
 
  We have securities outstanding that could dilute basic earnings per share in
the future that were not included in the computation of net loss per share in
the periods presented as their effect is antidilutive. For additional
disclosures regarding potentially dilutive stock options, warrants and
convertible preferred stock, see Note 7.
 
 Employee Stock Plans
 
  We account for our stock option plans and our employee stock purchase plan
in accordance with the provisions of the Accounting Principles Board's Opinion
No. 25 (APB 25), "Accounting for Stock Issued to Employees" and have adopted
the disclosure-only alternative of SFAS 123.
 
 Accounting Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make certain estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported results of operations during the reporting period.
Actual results could differ from these estimates.
 
 Research and Development
 
  Research and development costs, which include clinical and regulatory costs,
are charged to expense as incurred.
 
 Inventory
 
  Inventories are stated at the lower of cost, determined on an average cost
basis, and market value.
 
 Property and Equipment
 
  Property and equipment are stated at cost, net of accumulated amortization
and depreciation. Property and equipment are depreciated on a straight-line
basis over the estimated useful lives of the assets, typically 1-5 years.
Leasehold improvements are amortized using the straight-line method over the
shorter of the estimated life of the asset or the remaining term of the lease.
 
  We periodically evaluate the carrying value of long-lived assets to be held
and used when events and circumstances indicate that the carrying amount of an
asset may not be recovered. Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset to future net cash
flows expected to be generated by the asset. If such assets are considered to
be impaired, the impairment to be recognized is measured by the amount by
which the carrying amount of the assets exceed the fair value of the assets.
Assets to be disposed of are reported at the lower of the carrying amount or
fair value less disposal costs.
 
                                      38
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
 
 Cash and Cash Equivalents
 
  Somnus considers all highly liquid investments with a maturity from date of
purchase of three months or less to be cash equivalents. Somnus maintains
deposits with a financial institution in the United States and we invest our
excess cash in U.S. government obligations and securities which bear minimal
risk. We had no short-term investments at December 31, 1998 or 1997.
 
  We classify our debt securities in accordance with SFAS 115, "Accounting for
Certain Investments in Debt and Equity Securities", at the time of purchase
and reevaluate such designation as of each balance sheet date. At December 31,
1998 and 1997, all debt securities are designated as available-for sale.
Available-for-sale securities are carried at fair value, with the unrealized
gains and losses reported in stockholders' equity. At December 31, 1998 and
1997, the fair value of investments approximates cost. The amortized cost of
debt securities in this category is adjusted for amortization of premiums and
accretion of discounts to maturity. Such amortization is included in interest
income. Realized gains and losses and declines in value judged to be other-
than-temporary on available-for-sale securities are included in interest
income and have been immaterial in all periods presented. The cost of
securities sold is based on the specific identification method. Interest and
dividends on securities classified as available-for-sale are included in
interest income.
 
 Concentration of Credit Risk
 
  Somnus invests cash which is not required for immediate operating needs
principally in a diversified portfolio of financial instruments issued by
institutions with strong credit ratings. By policy, the amount of credit
exposure to any one institution, with the exception of U.S. government-backed
securities, is limited. These investments are not collateralized and mature
within two years. We have not experienced significant losses on these
investments.
 
  Somnus maintains an allowance for uncollectible accounts receivable. Somnus
performs ongoing credit evaluations of customers but does not require
collateral. There have been no material losses on individual customer
receivables.
 
 Advertising Expenses
 
  We expense the costs of advertising as incurred.
 
 Comprehensive Loss
 
  Effective January 1, 1998, We adopted SFAS No. 130 "Reporting Comprehensive
Income". We have no material components of other comprehensive loss and,
accordingly, the comprehensive loss is the same as net loss for all periods
presented.
 
 Segment Information
 
  Effective January 1, 1998, we adopted SFAS No. 131 "Disclosures about
Segments of an Enterprise and Related Information", which establishes
standards for the way that public business enterprises report information
about operating segments in annual financial statements and requires that
those enterprises report selected information about operating segments in
interim financial reports. SFAS No. 131 also establishes standards for related
disclosures about products and services, geographic areas and major customers.
 
  We have organized the business in one operating segment which includes
activities relating to development, manufacturing and marketing of medical
devices that utilize proprietary radiofrequency technology for the
 
                                      39
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
treatment of upper airway disorders. Substantially all of our assets are in
the United States and through December 31, 1998 we have derived our revenue
primarily from our operations in the United States.
 
2. Financial Instruments
 
 The following is a table of available-for-sale securities (in thousands):
 
<TABLE>
<CAPTION>
                                                       December 31, December 31,
                                                           1998         1997
                                                       ------------ ------------
     <S>                                               <C>          <C>
     Money market funds...............................   $ 9,958      $ 6,958
     Certificates of deposit..........................     9,996       23,096
     Commercial paper.................................    11,947          --
     U.S. treasury bills..............................       --        14,893
                                                         -------      -------
                                                         $31,901      $44,947
                                                         =======      =======
</TABLE>
 
  Included in cash and cash equivalents at December 31, 1998 and 1997 are
$31,901,000 and $44,947,000, respectively, of available for sale securities,
recorded at amortized cost, which approximates market value. These securities
all mature within 3 months.
 
3. Property and Equipment
 
  Property and equipment consisted of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                       December 31, December 31,
                                                           1998         1997
                                                       ------------ ------------
     <S>                                               <C>          <C>
     Machinery and equipment..........................   $ 1,257       $1,169
     Computer equipment...............................       862          699
     Furniture and fixtures...........................       610          509
     Purchased software...............................       317          294
                                                         -------       ------
                                                           3,046        2,671
     Less accumulated depreciation and amortization...    (1,445)        (849)
                                                         -------       ------
     Property and equipment, net......................   $ 1,601       $1,822
                                                         =======       ======
</TABLE>
 
4. Inventories
 
  Inventories consisted of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                       December 31, December 31,
                                                           1998         1997
                                                       ------------ ------------
     <S>                                               <C>          <C>
     Raw materials....................................     $399         $ 71
     Work-in-process..................................      111           77
     Finished goods...................................      296           88
                                                           ----         ----
                                                           $806         $236
                                                           ====         ====
</TABLE>
 
5. Commitments
 
  We lease our Sunnyvale, California and The Netherlands facilities under
operating lease agreements which expire on March 31, 2002, and 2000,
respectively.
 
                                      40
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
 
  Future payments under non-cancelable operating lease arrangements at
December 31, 1998 are as follows:
 
<TABLE>
<CAPTION>
                                                                       Operating
                                                                        Leases
                                                                       ---------
     <S>                                                               <C>
     Years ending December 31 (in thousands):
     1999.............................................................  $  449
     2000.............................................................     466
     2001.............................................................     441
     2002.............................................................     111
     2003 and thereafter..............................................     --
                                                                        ------
     Total minimum payments...........................................  $1,467
                                                                        ======
</TABLE>
 
  Rent expense for the years ended December 31, 1998, and 1997 and for the
period from inception (January 19, 1996) to December 31, 1996 was
approximately $417,000, $353,000 and $71,000 respectively.
 
6. Related Party Transactions
 
  Our operations, until the April 1996 issuance of Series A preferred stock,
were funded by our former Chief Executive Officer's private holding company,
VidaCare International, Inc. ("VidaCare"). The expenses consisted primarily of
payroll, consultant and legal costs incurred in the establishment of the
corporation and initial research and development efforts. Of the $214,000
incurred by VidaCare, $64,000 was converted into 64,000 shares of Series A
preferred stock in May 1996 and $150,000 was repaid in cash in April 1996.
 
  Our Series B preferred stock issuance in September 1996 included a finder's
fee to an entity associated with a member of the Board of Directors totaling
7% of the aggregate proceeds received by Somnus from the sale of Series B
preferred stock. The agreement included a provision which allowed the entity
to receive not less than 25% of the fee owed by Somnus in equity or debt
instruments in Somnus. Pursuant to this clause, the total finder's fee owed of
$710,000 was paid with 60,000 shares of Series B preferred stock valued at
$3.00 per share and $530,000 in cash. The Series B preferred stock converted
to common stock in conjunction with our initial public offering. This
transaction has been included in the issuance costs of the Series B offering.
Additionally, in connection with the Series B preferred stock financing, the
entity associated with a director entered into an agreement with Somnus
whereby for each 1% of the shares actually sold in our initial public offering
that were purchased by investors or parties directly affiliated with the
investors placed by the entity in the Series B preferred stock financing, the
entity was granted options or warrants to purchase 1,000 shares of common
stock at a price equivalent to the initial public offering price. Such options
or warrants have a five-year term and are entitled to anti-dilution and
piggyback registration rights. A total of 5,000 warrants were issued in
January 1998 in consideration of this provision.
 
  During fiscal 1996, a company affiliated with a stockholder and member of
the board of directors leased equipment with a value of $78,000 to Somnus. The
lease agreement provides terms comparable to other lease agreements entered
into by Somnus.
 
  In March 1998, we entered a Technology License Agreement with a certain
company affiliated with a stockholder and member of the board of directors.
This agreement allows us to make, sell or use our model 215 RF control unit
with a certain field of radiofrequency volume tissue reduction related to the
treatment of airway obstructions and other disorders of the head and neck.
During fiscal 1998 we recorded a $50,000 one-time royalty fee. In June 1998 we
introduced our new generation S-2 Control Unit and discontinued making the 215
RF product. No further payments are required under this agreement.
 
  In December 1998, we granted an irrevocable non-exclusive, worldwide right
and license to a company affiliated to a stockholder and certain members of
the board of directors to manufacture, use and sell RF control units based on
 
                                      41
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
the licensed technology to treat structures, organs and tissues of the
digestive tract and specifically excludes treatment of any body structure
located above the upper esophageal sphincter. Under this agreement we received
175,000 shares of Series A Preferred Stock of that Company. We also received a
technology license fee of $125,000 payable in two installments of $62,500 in
December 1998 and $62,500 in February 1999. Documentation fees for design and
manufacturing of $35,000 each are due in January 1999. The agreement also
provides for reimbursement of 50% of an engineer's time commencing December
1998 and the provision of up to 20 control unit kits for $9,000 each. No kits
had been purchased as of December 31, 1998. For the life of this agreement
Somnus shall receive a royalty of 2.5% of the selling price on all RF control
units using this technology, sold by the licensee.
 
7. Stockholders' Equity
 
 Preferred Stock
 
  On November 6, 1997, we completed an initial public offering of our shares
pursuant to which we issued 4,600,000 common shares for net proceeds of
approximately $43,800,000. Upon the closing of the initial public offering,
all 5,998,000 outstanding shares of Convertible Preferred stock of Somnus were
automatically converted into Common Stock on a share for share basis.
 
  In November 1998, we announced the adoption of a Preferred Shares Purchase
Agreement (the agreement). Pursuant to the agreement, there will be a dividend
distribution of one Preferred Share Purchase Right on each outstanding share
of our Common Stock, commencing on November 18, 1998. Each right will entitle
stockholders to buy one one-thousandth of a share of Preferred Stock at an
exercise price of $18.00. The Rights will become exercisable following the
tenth day after a person or group announces acquisition of, or commencement of
a tender offer which would result in the acquisition of 15% or more of our
Common Stock. Subject to certain restrictions, we will be entitled to redeem
the Rights at $0.001 per Right at any time before they become exercisable.
Subject to certain restrictions, at any time after an event triggering
exercisability of the Rights at a discounted price and prior to the
acquisition by the acquiring person of 50% or more of the outstanding Common
Stock, the Board of Directors of Somnus may exchange the Rights (other than
those owned by the acquiring person or our affiliates) for Common Stock of
Somnus at an exchange ratio of one share of Common Stock per Right.
 
 Common Stock
 
  During 1996, we sold 2,335,000 and 30,000 shares of common stock to founders
for $0.001 and $0.10 per share, respectively, of which certain shares are
subject to repurchase rights which generally expire ratably over four years.
Upon termination of service, any unvested shares may be repurchased by Somnus
at the issuance price. The shares are not contingent upon any conditions other
than a time period of employment. At December 31, 1997 and 1998, 707,000 and
340,000 shares, respectively, were subject to these repurchase rights held by
Somnus. No shares have been repurchased by Somnus as of December 31, 1998.
 
  Somnus has reserved approximately 4,110,000 shares of common stock for
future issuance under all stock option plans and stock purchase plans at
December 31, 1998.
 
 1996 Stock Plan
 
  Under our 1996 Stock Plan (the "plan"), which was adopted in March 1996,
options may be granted for common stock or common stock may be issued,
pursuant to actions by the board of directors, to eligible participants.
Options granted are either incentive stock options or nonstatutory stock
options and are exercisable within the times or upon the events determined by
the board of directors as specified in each option agreement. Incentive stock
options granted under the Plan are at prices not less than 100% of the fair
value at the date of grant, as determined by the board of directors.
Nonstatutory options granted under the plan are at prices not less
 
                                      42
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
than 85% of the fair value on the date of the grant. Stock options granted to
a 10% stockholder shall not be less than 110% of the fair value at the date of
grant. Stock sold under issuances are subject to repurchase by Somnus upon
termination of the purchaser's employment or services at the price paid upon
issuance. Options granted generally vest over a period of four years, with 25%
of the options vesting on the first anniversary of the grant. The term of the
plan is ten years.
 
 1997 Director Option Plan
 
  In August 1997, our Board of Directors (the "Board") adopted the 1997
Director Option Plan ("Director Option Plan").
 
 1997 Employee Stock Purchase Plan
 
  In August 1997, the Board of Directors adopted the 1997 Employee Stock
Purchase Plan (the "Purchase Plan"), which is designed to allow eligible
employees of Somnus to purchase shares of common stock at semiannual intervals
through their periodic payroll deductions. The Purchase Plan has been
implemented in a series of successive offering periods, each with a maximum
duration of 24 months. Eligible employees can have up to 10% of their base
salary deducted that is to be used to purchase shares of common stock on
specific dates determined by the Board of Directors provided that in no event
shall an employee be permitted to purchase during each purchase period more
than 2,500 shares of our common stock, subject to a maximum of $25,000 worth
of common stock per calendar year. The price of common stock purchased under
the Purchase Plan will be equal to 85% of the lower of the fair market value
of the common stock on the commencement date of each offering period or the
specified purchase date. We do not recognize compensation cost related to
employee purchase rights under the Purchase Plan.
 
  The following table summarizes stock option activity (shares in thousands):
 
<TABLE>
<CAPTION>
                                                  Outstanding Stock Options
                                                  -------------------------
                                                                    Weighted
                                                                    Average
                                                                    Exercise
                                         Shares    Number of         Price
                                        Available    Shares        Per Share
                                        --------- ------------    -------------
     <S>                                <C>       <C>             <C>
     Original authorization of shares.      865
       Additional shares authorized
        for issuance..................    1,055
       Options granted................   (1,752)           1,752   $        0.17
       Options exercised..............      --               (98)  $        0.10
       Options canceled...............       16              (16)  $        0.10
                                         ------     ------------   -------------
     Balance at December 31, 1996.....      184            1,638   $        0.17
       Additional shares authorized
        for issuance..................    1,780
       Options granted................   (1,463)           1,463   $        3.59
       Options exercised..............      --              (383)  $        0.19
       Options canceled...............      281             (281)  $        1.12
                                         ------     ------------   -------------
     Balance at December 31, 1997.....      782            2,437   $        2.12
       Additional shares authorized
        for issuance..................    1,250
       Options granted................   (1,547)           1,547   $        4.88
       Options exercised..............      --              (479)  $        0.42
       Options canceled...............      893             (893)  $        6.22
                                         ------     ------------   -------------
     Balance at December 31, 1998.....    1,378            2,612   $        2.70
                                         ======     ============   =============
</TABLE>
 
                                      43
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
 
  At December 31, 1998 and 1997 options to purchase 915,000 and 385,000
shares, respectively, were exercisable.
 
  The following table summarizes information about options outstanding at
December 31, 1998 (shares in thousands):
 
<TABLE>
<CAPTION>
                        Options Outstanding       Weighted       Exercisable Options
                      ------------------------     Average     ------------------------
                                   Weighted       Remaining                 Weighted
     Range of         Number of    Average     ContractualLife Number of    Average
     Exercise Price    Shares   Exercise Price   (in years)     Shares   Exercise Price
     --------------   --------- -------------- --------------- --------- --------------
     <S>              <C>       <C>            <C>             <C>       <C>
     $ 0.10 - 0.10        404       $ 0.10          7.55          224        $ 0.10
       0.30 - 0.70        413         0.45          8.12          186          0.41
       3.00 - 3.50      1,554         3.23          8.24          408          3.08
       6.38 - 10.75       241         7.48          8.77           97          7.33
                        -----       ------          ----          ---        ------
     $ 0.10 - 10.75     2,612       $ 2.70          8.16          915        $ 2.26
                        =====       ======          ====          ===        ======
</TABLE>
 
  On September 18, 1998, we effected an option exchange program to allow
employees (excluding executive officers) to exchange 436,168 options to
purchase shares with an exercise price between $7.50 and $10.75 for options
with an exercise price of $3.375 (the fair value of our stock on September 18,
1998). All of the re-priced options continue to vest under the original terms
of the option grants. In exchange for the offer to re-price stock options,
employees agreed to a moratorium on exercising re-priced options until
September 18, 1999. Additionally, if an employee voluntarily terminates
employment with Somnus prior to September 18, 1999, all vested shares at the
date of termination relating to re-priced stock options will be canceled and
forfeited.
 
  In October 1998, we announced that our board of directors has authorized a
stock repurchase program permitting the purchase of up to 1,000,000 shares, at
up to $5.00 per share, of our common stock in the open market. No shares had
been repurchased by Somnus as of December 31, 1998. Subsequently Somnus has
repurchased a nominal number of shares under the program.
 
 Pro Forma Disclosures
 
  We elected to follow APB No. 25, "Accounting for Stock Issued to Employees"
and related interpretations, in accounting for our employee stock options
because, as discussed below, the alternative fair value accounting provided
for under SFAS No. 123 "Accounting for Stock-Based Compensation", requires use
of option valuation models that were not developed for use in valuing employee
stock options. Somnus, under APB No. 25, generally does not recognize
compensation expense as the exercise price of our employee stock options
equals the market price of the underlying stock on the date of the grant.
 
  Pro forma information regarding net loss and net loss per share is required
by SFAS No. 123, which also requires that the information be determined as if
we accounted for our employee stock options granted subsequent to December 31,
1995 under the fair value method of this statement.
 
  The fair value for options granted prior to our initial public offering in
November 1997 and granted in 1998 were estimated at the date of grant using
the minimum value method, assuming no dividends, an expected life of four
years for 1998 and between two and three years for 1997 and the period from
inception (January 19, 1996) to December 31, 1996, volatility of 70% for 1998
and nominal volatility for 1997 and the period from inception (January 19,
1996) to December 31, 1996 and a risk free interest rate of 5.2% for 1998 and
5.3% for 1997 and for the period from inception (January 19, 1996) to December
31, 1996.
 
                                      44
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
 
  Had compensation cost for our stock-based compensation plans been determined
based on the fair value at the grant dates for awards under those plans
consistent with the method of SFAS No.123, our net loss and loss per share
would have been increased to the pro forma amounts indicated below.
 
  For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period (for stock
options) and the six month purchase period for stock purchases under the Stock
Purchase Plan. Our pro forma information is as follows (in thousands, except
per share amounts):
 
<TABLE>
<CAPTION>
                                                                   Period from
                                                                    Inception
                                                 Year Ended        (January 19,
                                                December 31,         1996) to
                                             --------------------  December 31,
                                               1998       1997         1996
                                             ---------  ---------  ------------
     <S>                                     <C>        <C>        <C>
     Pro forma net loss..................... $ (21,818) $ (12,868)  $   (3,102)
     Pro forma basic and diluted net loss
      per share............................. $   (1.60) $   (3.05)  $    (1.61)
</TABLE>
 
  Because SFAS No. 123 is applicable only to options granted subsequent to
December 31, 1995, our pro forma effect will not be fully reflected until
subsequent years. The effects on pro forma disclosures of applying SFAS No.
123 are not likely to be representative of the effects on pro forma
disclosures in future years.
 
 Warrants
 
  In connection with equipment term loans in 1996, we issued warrants to
purchase 37,500 shares of Series A preferred stock at $1.00 per share and
25,000 shares of Series B preferred stock at $3.00 per share which were
converted to common stock warrants in conjunction with the IPO. These warrants
may be exercised at any time prior to June 24, 2006 and October 1, 2001,
respectively. The values of these warrants were determined by Somnus to be
immaterial for financial statement purposes. Warrants outstanding at December
31, 1998 were 62,500.
 
 Stock Compensation
 
  We recorded deferred compensation of approximately $4,049,000 and $546,000
during the year ended December 31, 1997 and during the period from inception
(January 19,1996) through December 31, 1996, respectively. These amounts
represent the difference between the exercise price and the deemed fair value
of certain of our stock options granted in these periods. Deferred
compensation recorded is amortized over the period that the options vest and
is adjusted for options which have been canceled. During the fiscal years
ended December 31, 1998 we recorded deferred compensation with respect to
stock options granted to consultants and as a result of changing the vesting
terms of certain employee stock options totaling $817,000. There were no
significant grants of stock options to consultants in 1997. Deferred
compensation expense was $2,811,000, $1,252,000 and $22,000, respectively,
during 1998, 1997 and the period from inception (January 19, 1996) to December
31, 1996.
 
  At December 31, 1998, Somnus has a total of $450,000 remaining to be
amortized over the corresponding vesting period of each respective option,
generally four years.
 
 
8. Employee Benefit Plan
 
  We have a 401(k) Plan which stipulates that all full-time employees with at
least 60 days of employment can elect to contribute to the 401(k) Plan,
subject to certain limitations, up to 15% of salary on a pretax basis. We have
the option to provide matching contributions but have not done so to date.
 
                                      45
<PAGE>
 
                       SOMNUS MEDICAL TECHNOLOGIES, INC.
 
            Notes to Consolidated Financial Statements--(Continued)
 
 
9. Income Taxes
 
  As of December 31, 1998, we had federal and state net operating loss
carryforwards of approximately $27,700,000 and $12,900,000, respectively. We
also had federal and California research and development tax credit
carryforwards of approximately $500,000. The federal net operating loss and
credit carryforwards will expire at various dates beginning in the year 2011
through 2018, if not utilized. The State of California net operating losses
will expire at various dates beginning in 2001 through 2003, if not utilized.
 
  Utilization of our net operating loss carryforwards and credits may be
subject to an annual limitation due to the "change in ownership" provisions of
the Internal Revenue Code of 1986 and similar state provisions. The annual
limitation may result in the expiration of net operating losses and credits
before utilization.
 
  Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets for financial reporting and the amount
used for income tax purposes. Significant components of our deferred tax
assets for federal and state income taxes are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                       December 31, December 31,
                                                           1998         1997
                                                       ------------ ------------
     <S>                                               <C>          <C>
     Net Operating Loss Carryforwards.................  $   10,200   $   5,000
     Research Credits Carryforwards...................         700         400
     Capitalized Research and Development.............         900         400
     Other............................................         800         --
                                                        ----------   ---------
     Total Deferred Tax Assets........................  $   12,600   $   5,800
     Valuation Allowance..............................     (12,600)     (5,800)
                                                        ----------   ---------
     Net Deferred Tax Assets..........................  $      --    $     --
                                                        ==========   =========
</TABLE>
 
  Because of our lack of earnings history, the deferred tax assets have been
fully offset by a valuation allowance. The valuation allowance increased by
$4,600,000 during the year ended December 31, 1997.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
  Not applicable
 
                                      46
<PAGE>
 
                                   PART III
 
  Certain information required by Part III is omitted from this Report on Form
10-K in that the Registrant will file a definitive proxy statement within 120
days after the end of our fiscal year pursuant to Regulation 14A with respect
to the 1998 Annual Meeting of Stockholders (the "Proxy Statement") and certain
information included therein is incorporated herein by reference.
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  Certain of the information required by this item relating to directors is
incorporated by reference to the information under the caption "Proposal No.
1 -- Election of Directors" in the Proxy Statement.
 
  The executive officers of the Registrant, who are elected by the board of
directors, are as follows:
 
<TABLE>
<CAPTION>
     Name                            Age Position
     ----                            --- --------
     <C>                             <C> <S>
     John G. Schulte(1)............. 50  President, Chief Executive Officer
                                         And Director
 
     Donald R. Bruce(2)............. 48  Vice President, Worldwide Sales
 
     Robert D. Campbell............. 44  Vice President, Sales
 
     Eve A. Conner, Ph.D............ 53  Vice President, Clinical And
                                         Regulatory Affairs
 
     Eric N. Doelling............... 40  Executive Vice President, Chief
                                         Operating Officer
 
     Stuart D. Edwards(3)........... 53  Chief Technical Officer and Director
 
     Robert D. McCulloch............ 37  Vice President, Finance, Chief
                                         Financial Officer (Principal
                                         Financial and Accounting Officer)
 
     Robert McNamara(2)............. 42  Executive Vice President, Chief
                                         Financial Officer
</TABLE>
--------
(1) Assumed this position on January 1, 1999.
 
(2) Discontinued employment during fiscal 1998.
 
(3) Transitioned from Chief Executive Officer and Chairman of the Board on
    January 1, 1999.
 
  JOHN G. SCHULTE has served as President, Chief Executive Officer and
Director of the Company since January 1999. From 1997 until December 1998, Mr.
Schulte was President, Surgical Products Division of Genzyme. Corporation.
From 1996 to 1997, he was Senior Vice President and General Manager for Target
Therapeutics, Inc. From 1992 to 1996, Mr. Schulte was President of the US
Catheters and Instruments Division of C. R. Bard, Inc.. Prior to that, Mr.
Schulte served as President and Chief Executive Officer of Crystals Products,
Inc., a start-up diagnostics firm. He is a member of the Board of Directors of
Spectranetics Corporation. Mr. Schulte holds a B.A. from the College of the
Holy Cross and an M.B.A. from Boston University.
 
  DONALD R. BRUCE served as Vice President, Worldwide Sales of the Company
from March 1997 to December 1998. From June 1996 until March 1997, he was a
Principal of drb International, a sales consulting firm to medical device
companies. From 1977 until June 1996, Mr. Bruce worked for Xomed, Inc., an
otolaryngology device company, in several capacities, including, most
recently, Vice President of International Sales and Marketing. Mr. Bruce holds
a B.S. in Biology from the University of Minnesota where he served as the
manager of the ear, nose and throat research laboratory.
 
  ROBERT D. CAMPBELL has served as Vice president of Sales for the Company
since June 1998. From 1997 to June 1998, Mr. Campbell was Western Regional
Sales Manager, Director of Sales and VP of North
 
                                      47
<PAGE>
 
American Sales for the Company. From 1995 to 1997 Mr. Campbell was a sales
representative with Karl Storz Endoscopy Inc. From 1994 to 1995, he was
Regional Manager for Enterprise Systems, Inc., a manufacturer of software for
hospital inventory management and scheduling. From 1992 to 1994 Mr. Campbell
owned and managed a business in a non-related industry. Prior to that Mr.
Campbell was Vice President of Corporate Accounts for Criticare Systems, Inc.,
and held several sales management positions at Nellcor Puritan Bennett Inc., a
developer of diagnostic and therapeutic products for respiratory disorders.
 
  EVE A. CONNER, PH.D. served as Vice President, Clinical and Regulatory
Affairs of the Company from August 1996 to December 1998. From October 1991 to
June 1996, she served as Vice President, Regulatory/Clinical Affairs and
Quality Assurance for Baxter Healthcare Corporation's Novacor Division.
Dr. Conner holds a B.A. in Biology and Chemistry from Keuka College and a
Ph.D. in Pharmacology/Toxicology from the University of Minnesota.
 
  ERIC N. DOELLING has served as Executive Vice President, Chief Operating
Officer of the Company since July 1996 and as a Director since November 1996.
From 1993 until 1996, Mr. Doelling was Vice President, Manufacturing of
Cardiac Pathways Corporation, a medical device company. Prior to that Mr.
Doelling was Vice President of Operations for Spectranetics, Inc. Mr. Doelling
holds both a B.S. and an M.B.A. from Rensselaer Polytechnic Institute.
 
  STUART D. EDWARDS is founder of the Company and has served as Chief
Technical Officer and Director of the Company since January 1999. From 1996 to
December 1998, Mr. Edwards served as Chairman of the Board, Chief Executive
Officer and President of the Company. From 1992 to 1995, Mr. Edwards served as
President, Chief Executive Officer and Chairman of the Board of VidaMed, Inc.,
a medical device company co-founded by Mr. Edwards which develops minimally
invasive surgical systems. He continued to serve as President and Chief
Executive Officer of VidaMed, Inc. until 1995. Mr. Edwards holds a Certificate
in Mechanical Engineering from the Union of Educational Institutions in
England.
 
  ROBERT D. MCCULLOCH has served as Vice President of Finance and Chief
Financial Officer of the Company from August 1998. From October 1997 to August
1998, he served as Controller of the Company. From 1996 to 1997, Mr. McCulloch
was Director of Accounting and Corporate Controller at Target Therapeutics,
Inc. From 1991 to 1995 he served as General Accounting Manager/Business
Process Manager at Anthem Electronics, Inc. He previously served eight years
in public accounting with Price Waterhouse Coopers, LLP. Mr. McCulloch is a
Chartered Accountant, a Certified Public Accountant, Cost and Management
Accountant and holds a Bachelor of Commerce and Certificate in the Theory of
Accountancy from Rhodes University.
 
  ROBERT E. MCNAMARA served as Chief Financial Officer of the Company from
August 1997 to August 1998. From April 1995 until August 1997, Mr. McNamara
served as Vice President of Finance and Administration and Chief Financial
Officer of Target Therapeutics, Inc., a medical device manufacturer. From 1994
until 1995, Mr. McNamara served as Chief Financial Officer of Guittard
Chocolate Co. From 1987 until 1994, Mr. McNamara held various financial
management positions at Tandem Computers, Inc. He holds a B.S. from the
University of San Francisco and an M.B.A. from the University of
Pennsylvania's Wharton School.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The information required by this item is incorporated by reference to the
information under the caption "Executive Compensation" in the Proxy Statement.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information required by this item is incorporated by reference to the
information under the caption "Record Date and Stock Ownership" in the Proxy
Statement.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The information required by this item is incorporated by reference to the
information under the caption "Certain Transactions" in the Proxy Statement.
 
                                      48
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
  (A)1. FINANCIAL STATEMENTS
 
      The following Financial Statements of Somnus Medical Technologies,
    Inc. and Report of Ernst & Young LLP, have been provided as Item 8,
    above:
 
    Report of Ernst & Young LLP, Independent Auditors
 
    Consolidated Balance Sheets at December 31, 1998 and 1997
 
      Consolidated Statements of Operations, for the years ended December
    31, 1998 and 1997 and for the period from inception (January 19, 1996)
    to December 31, 1996.
 
      Consolidated Statement of Stockholders' Equity, for the period from
    inception (January 19, 1996) to December 31, 1998
 
      Consolidated Statements of Cash Flows, for the years ended December
    31, 1998 and 1997 and for the period from inception (January 19, 1996)
    to December 31, 1996.
 
    Notes to Consolidated Financial Statements
 
   2.FINANCIAL STATEMENT SCHEDULES
 
      The financial statement schedule entitled "Valuation and Qualifying
    Accounts" is included at page 53 of this Form 10-K.
 
      All other schedules are omitted because they are not applicable or
    the required information is shown in the Financial Statements or the
    notes thereto.
 
   3.EXHIBITS
 
      Refer to (c) below.
 
  (B) REPORTS ON FORM 8-K
 
      Somnus was not required to and did not file any reports on Form 8-K
    during the period from December 31, 1998 to date of filing.
 
                                      49
<PAGE>
 
  (C) EXHIBITS
 
<TABLE>
<CAPTION>
     Exhibit No. Description
     ----------- --------------------------------------------------------------
     <C>         <S>
      3.1(1)     Amended and Restated Certificate of Incorporation.
      3.2(1)     Bylaws of the Registrant.
      4.1(1)     Specimen Common Stock Certificate.
     10.1(1)     Form of Indemnification Agreement for directors and officers.
     10.2(1)     Amended and Restated 1996 Stock Plan and form of agreement
                 thereunder.
     10.3(1)     Restated Investors' Rights Agreement between the Registrant
                 and the parties named therein dated as of April 21, 1997.
     10.4(1)     Letter Agreement dated June 6, 1996 between the Registrant and
                 Musket Research Associates.
     10.5(1)     Lease dated February 4, 1997 for the Registrant's headquarters
                 in Sunnyvale, California.
     10.6(1)     Amended and Restated Loan and Security Agreement dated April
                 2, 1997 between the Registrant and Venture Lending.
     10.7(1)     Employment Letter Agreement dated May 8, 1996 between the
                 Registrant and Eric N. Doelling, and amendment thereto dated
                 August 26, 1996.
     10.8(1)     1997 Employee Stock Purchase Plan.
     10.9(1)     1997 Director Option Plan.
     10.10(1)    Lease Agreement dated July 1, 1996 between the Registrant and
                 RGL Leasing Co.
     10.11       Employment Letter Agreement dated July 15, 1998 between the
                 Registrant and Robert D. McCulloch.
     10.12       Employment Letter Agreement dated October 20, 1998 between the
                 Registrant and John G. Schulte.
     10.13       Amended Employment Letter Agreement dated November 2, 1998
                 between the Registrant and Stuart D. Edwards.
     10.14*      International Distribution Agreement dated July 20, 1998
                 between the Registrant and Ferrari Ind. Com. Aparelhos Medicos
                 Ltda.
     10.15*      Patent License Agreement dated January 30, 1998 between the
                 Registrant and Medtronic, Inc.
     10.16*      Exclusive Distributor Agreement dated November 20, 1998
                 between the Registrant and Carl Zeis Canada.
     10.17       Further Amendment to Employment Letter Agreement dated October
                 21, 1998 between the Registrant and Eric N. Doelling.
     21.1(1)     List of Subsidiaries of the Registrant.
     23.1        Consent of Ernst & Young LLP, Independent Auditors
     25.1        Power of Attorney (see page 52).
     27.1        Financial Data Schedule.
</TABLE>
--------
 * Confidential Treatment has been requested for certain portions of this
   Exhibit.
 
(1) Filed as an Exhibit to Somnus Registration Statement on Form S-1 (File No.
    333-35401) and incorporated herein by reference.
 
                                       50
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of the Securities Act, the Registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
 
                                          SOMNUS MEDICAL TECHNOLOGIES, INC.
 
                                                    /s/ John G. Schulte
                                          By:________________________________
 
                                                      John G. Schulte
                                               President and Chief Executive
                                                          Officer
 
 
                                      51
<PAGE>
 
                               POWER OF ATTORNEY
 
  KNOW ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints John Schulte and Robert McCulloch, his
attorneys-in-fact, each with the power of substitution, for him in any and all
capacities, to sign any amendments to this Report on Form 10-K, and to file
the same, with exhibits thereto and other documents in connection therewith,
with the Securities and Exchange Commission, hereby ratifying and confirming
all that said attorneys-in-fact, or his or their substitute or substitutes,
may do or cause to be done by virtue thereof.
 
  Pursuant to the requirements of the Securities Act of 1934, this report
signed below by the following person on behalf of the Registrant and in the
capacities and on the date indicated.
 
       Signatures                      Title                        Date
       ----------                      -----                        ----
 
    /s/ John G. Schulte          President, Chief              March 29, 1999
-----------------------------    Executive Officer and
      (John G. Schulte)          Director
 
  /s/ Robert D. McCulloch        VP Finance, Chief             March 29, 1999
-----------------------------    Financial Officer
    (Robert D. McCulloch)        (Principal Financial and
                                 Accounting Officer)
 
     /s/ Gary R. Bang            Chairman of the Board of      March 29, 1999
-----------------------------    Directors
       (Gary R. Bang)
 
     /s/ Abhi Acharya            Director                      March 29, 1999
-----------------------------
       (Abhi Acharya)
 
   /s/ David L. Douglass         Director                      March 29, 1999
-----------------------------
     (David L. Douglass)
 
  /s/ Stuart D. Edwards          Chief Technical Officer       March 29, 1999
-----------------------------    and Director
     (Stuart D. Edwards)
 
 
    /s/ David B. Musket          Director                      March 29, 1999
-----------------------------
      (David B. Musket)
 
 /s/ Woodrow A. Myers, Jr.       Director                      March 29, 1999
-----------------------------
   (Woodrow A. Myers, Jr.)
 
                                      52
<PAGE>
 
                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
                                 (In thousands)
 
<TABLE>
<CAPTION>
                                     Balance at
                                     Beginning of                   Balance at
                                        Year      Charged to Costs  End of Year
                                    ------------- ----------------- -----------
<S>                                 <C>           <C>               <C>
Allowance for Doubtful Accounts
Year ended December 31, 1998.......     $  70           $ 591          $ 661
Year ended December 31, 1997.......     $ --            $  70          $  70
Year ended December 31, 1996.......     $ --            $ --           $ --
</TABLE>
 
                                       53