<PAGE>

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

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

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

                                   FORM 10-K

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

  For the fiscal year ended December 31, 2000

                                      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)

               Delaware                                77-0423465
     (State or other jurisdiction                   (I.R.S. Employer
   of incorporation or organization)             Identification Number)

           285 N. Wolfe Road                              94086
         Sunnyvale, California                         (Zip Code)
    (address of principal executive
               offices)

      Registrant's telephone number, including area code: (408) 773-9121

          Securities Registered Pursuant to Section 12(b) of the Act:

<TABLE>
<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 13,
2001, as reported on the Nasdaq National Market, was approximately
$20,357,585.

   The number of shares of Common Stock outstanding as of March 13, 2001:
14,805,516 Shares

-------------------------------------------------------------------------------
-------------------------------------------------------------------------------
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                                   FORM 10-K

                               TABLE OF CONTENTS

                                     PART 1

<TABLE>
 <C>       <S>                                                             <C>
 ITEM 1.   BUSINESS......................................................    3

 ITEM 2.   PROPERTIES....................................................   25

 ITEM 3.   LEGAL PROCEEDINGS.............................................   26

 ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........   26

                                    PART II

 ITEM 5    MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
            MATTERS......................................................   27

 ITEM 6.   SELECTED FINANCIAL DATA.......................................   27

 ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
            AND RESULTS OF OPERATIONS....................................   28

 ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK....   32

 ITEM 8.   CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA......   33

 ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
            AND FINANCIAL DISCLOSURE.....................................   48

                                    PART III

 ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............   48

 ITEM 11.  EXECUTIVE COMPENSATION........................................   51

 ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
            MANAGEMENT...................................................   53

 ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................   54

                                    PART IV

           EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM
 ITEM 14.   8-K..........................................................   55
</TABLE>

                                       2
<PAGE>

                                    PART I

ITEM 1. BUSINESS

   This Report on Form 10-K contains certain forward looking statements
regarding future events (designated by an *). Actual events or results may
differ materially as a result of the factors described herein including, in
particular, those factors described under "Additional Risk Factors."

Company Overview

   We were incorporated in Delaware in January 1996. We design, develop,
manufacture and market innovative medical devices that utilize our proprietary
temperature controlled radiofrequency, or TCRF, technology for the treatment
of upper airway disorders. The Somnus Somnoplasty 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 syndrome ("OSAS"), chronic turbinate hypertrophy and
habitual snoring, as well as coagulation of tissue in the head and neck which
may include tonsils. Our Somnoplasty System shrinks tissue in the upper airway
by utilizing automated TCRF 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, or outer lining of
the tissue. Our clinically proven, patented, temperature controlled,
radiofrequency technology ensures predictable and consistent tissue volume
reduction without cutting or bleeding, reducing pain and post procedure
complications. We have received Food and Drug Administration and European
clearance for the use of the Somnoplasty System in the treatment of OSAS,
Upper Airway Resistance Syndrome ("UARS"), chronic turbinate hypertrophy,
habitual snoring, and coagulation of tissue in the head and neck. We
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 and a manufacturers representative group to
market our products in the United States. Our intention is to market the
Somnoplasty System primarily to:

  . ear, nose and throat physicians,

  . oral maxillofacial surgeons,

  . pulmonologists,

  . sleep medicine specialists,

  . allergists 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 there are
more than 1,800 sleep clinics in the United States. As of December 31, 2000,
we have an installed base of 833 control units in the United States. We 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 Procedure.

   In January 2001, we announced a restructuring plan that is currently being
implemented. Until January 2001, we had a European headquarters in the
Netherlands primarily to manage relationships with our distributors throughout
Europe. As part of out restructuring plan, we shutdown our headquarters in the
Netherlands. In addition to our operations in Europe, we have distributors in
Latin America, Africa, Asia and the Pacific Rim. All international
distributors are now managed out of our headquarters in Sunnyvale, California.

   We have an exclusive distribution agreement with MC Medical, a subsidiary
of Mitsubishi Corporation, to distribute the Somnoplasty technology throughout
Japan. In July 2000, we secured regulatory "shonin" approval

                                       3
<PAGE>

to market our model 1010, 1100, and 1200 devices in Japan. We had previously
secured regulatory "shonin" approval to market our S2 control unit in Japan on
November 27, 1998.

   The restructuring plan announced in January 2001 is currently being
implemented and is designed to reduce operating expenses by $4,000,000 in
fiscal year 2001 and will result in a headcount reduction of approximately 10
percent of our employees. The plan encompasses the operational components of
sales and marketing, manufacturing, certain ongoing clinical programs, and
research and development. A restructuring charge for these items is estimated
to be between $500,000 to $600,000 and will be recorded in the first quarter
of 2001.* Subsequent to estimating the restructuring charge in January 2001,
we increased our estimate by $300,000 to $400,000 related to a facilities
consolidation, including rent, and the write off of leasehold improvements,
necessitated by the recent softening of the local real estate market and
resultant uncertainty as to our ability to sublease the facility subsequent to
executing the restructuring plan.* This will result in a total expected
restructuring charge to be recorded in the first quarter of 2001 of between
$800,000 to $1,000,000.

   At December 31, 2000, our commercial products included one control unit
model and four disposable devices designed to treat a variety of upper airway
disorders. Additional control unit models are under development. As of
December 31, 2000, in the United States, we had 42 issued patents, and an
additional 12 pending patent applications. We also had 5 granted, 9 published,
and 17 pending issued foreign.

Business Strategy

   Our strategy is to establish the Somnoplasty System, which utilizes our
proprietary temperature controlled radiofrequency technology, as the standard
of care for the management and 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,

  . reduced morbidity,

  . tissue shrinkage without cutting,

  . 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.

   We received 510(k) clearance in July 1997 for the use of the Somnoplasty
System for reduction of soft tissue, including the soft palate/uvula, for the
treatment of habitual snoring. The Somnoplasty System has received marketing
clearance in the European Economic Association "EEA", (CE Mark). In December
1997, we received 510(k) clearance for the treatment of enlarged turbinates
associated with chronic turbinate hypertrophy, in November 1998 we received
510(k) clearance for the treatment of OSAS/UARS. In May, 2000, we received
510(K) clearance for the Model 2420, (a dual needle device) in combination
with the Somnus Control Unit for coagulation of tissue in the head and neck.
Clinical trials are planned to obtain clearance from the FDA for an indication
designed to reduce enlarged tonsils.* We also intend to seek clearance of the
Somnoplasty System for other indications.*

                                       4
<PAGE>

   In July 2000, we secured regulatory "shonin" approval to market our model
1010, 1100, and 1200 devices in Japan. We had previously secured regulatory
"shonin" approval to market our S2 control unit in Japan on November 27, 1998.

 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.

   In the United States, we have a direct sales force and one sales
representative group. Until January 2001, our distributors located in Europe
were managed from our European headquarters in the Netherlands. In January
2001, we announced a restructuring plan which included the shutdown of our
European headquarters. All international sales are now managed out of our
headquarters in Sunnyvale, California.

   We may add additional sales personnel, representative groups, and
distributors as necessary to further penetrate markets in the United States
and around the world.*

   We have acquired and may acquire complimentary technology through license
agreements for technology and patents.* One such license from Medtronic, Inc.
allows the use of the lockout feature on the S2 control unit to protect
patients against surgeons' reusing disposable devices. We have granted
licenses for our technology and may continue to pursue this strategy in the
future.* We granted a license to Curon Medical, Inc. for certain
radiofrequency generator technology for treatment of gastroesophageal
disorders. We also granted a license to Novasys Medical, Inc. for certain
radiofrequency technology for treatment of urinary incontinence. 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 Somnoplasty System.

Upper Airway Disorders

   The upper airway comprises the passages in the nose, the back of the mouth,
and the throat and allows breathing, swallowing and speech vocalization.
Breathing 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 soft 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 OSAS/UARS, 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 Syndrome (OSAS)

   OSAS 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.

                                       5
<PAGE>

   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 OSAS typically
experience ten or more such cycles per hour and experience two or more
clinical symptoms of OSAS, 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 OSAS 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
OSAS, insomnia and narcolepsy. They estimate that 20 million of these people
are afflicted with OSAS, 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 OSAS are diagnosed.

   Obstruction in breathing due to large tonsils may cause snoring, disturbed
sleep patterns and obstructive sleep apnea syndrome. These sleep disorders and
interruptions can lead to excessive daytime sleepiness and increased risk of
serious illness such as cardiovascular disease in adults. Obstructive
tonsillar hypertrophy often produces loud disruptive snoring in children,
which may be accompanied by poor school performance, decreased attentions span
and enuresis.

   The annual number of tonsillectomies peaked in 1959 at 1.4 million and has
declined since. Although the total number of procedures has decreased, the
percentages of tonsillectomies that are performed for upper airway obstruction
has increased. The tonsillectomy procedure is still one of the most common
surgical procedures in the field of otolaryngology. There were 418,000
tonsillectomy procedures in the United States in 1996 (with or without
adenoidectomy). Of those procedures performed, 287,000 (69%) were in patients
under 15 years old. This represents approximately 14.5 per 10,000 of the total
population and 46.9 per 10,000 for those under 15 years of age. Ninety-two
percent of these surgeries were performed as ambulatory procedures in both the
total population and in the 15 and younger age group.

 Chronic Turbinate Hypertrophy

   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 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 OSAS.

 Habitual 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

                                       6
<PAGE>

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, OSAS.

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, or CPAP, and laser surgery have
emerged as treatment modalities for OSAS 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 OSAS

   The most common treatment for OSAS 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 OSAS, its use has a
number of disadvantages, including:

  . facial skin irritation,

  . abdominal bloating,

  . mask leaks,

  . sore eyes and

  . headaches.

   Additionally, CPAP is not a cure for OSAS 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 appliance cause
many patients to stop using CPAP machines. The American Sleep Disorders
Association estimated CPAP compliance at only 46% in 1993.

   For patients with mild to severe OSAS, surgical treatments exist such as
the following:

  . uvulopalatopharyngoplasty, or UPPP, which is 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,

  . tracheostomies, surgical openings through the neck which bypass the
    obstruction, and

  . tonsillectomy techniques such as cold, dissection, electrocautery, and
    laser.

   UPPP and the other surgical alternatives have been successful in treating
OSAS 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 30% the patients treated. The most significant
drawbacks of UPPP, maxillofacial surgery and tracheostomies are that they are
highly-invasive, involve significant post-operative risk of morbidity,
including a painful and lengthy recovery, and are expensive. If the surgical
procedures are not effective, it is sometimes difficult to successfully return
to CPAP, leaving patients with few alternatives for further treating their
conditions.

                                       7
<PAGE>

   Recurrent throat infections are the primary indication for performing
tonsillectomies although an increasing percent of tonsillectomies performed
today are for OSAS. The American Academy of Otolarynagolgoy, Head and Neck
Surgery currently recommends tonsillectomy procedures for hypertrophy of the
tonsils causing upper airway obstruction or sleep disorders.

   Current tonsillectomy techniques such as cold dissection, electrocautery or
laser can result in postoperative complications. These can include
hypernasality, hemorrhage, pain, nausea, vomiting, infections, velopharyngeal
insufficiency, odynophagia with associated dysphagia, causing dehydration,
local edema causing airway obstruction, and co-morbidities associated with the
need for narcotic analgesics. In the general population, the complication
rates range from <1% to 8%. Children with upper airway obstruction have a
higher rate of complications, ranging from 23-32%. Socio-economic implications
of current techniques include an average of 7 days sick leave from work and/or
school, and potential costs for hospitalization due to dehydration,
respiratory problems or bleeding. Patients with tonsillar hypertrophy and/or
parents/guardians often decline conventional surgical treatment due to the
associated discomforts and surgical risks.

 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. According to several large population surveys, approximately 20% of
the population, or more than 50 million Americans, suffer from some type of
chronic rhinitis.

   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 post-operative bleeding, frequent and
significant crusting. These conditions require time consuming post-operative
management of the patient on the part of the physician. Further, surgical
resection of turbinates may impact functionality of the turbinates for
temperature control and hydration.

 Treatment of Habitual Snoring

   There are both nonsurgical and surgical methods for treating habitual
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 habitual snoring is available today with laser-
assisted uvulopalatoplasty, or 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 700C. 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 and typically
require multiple treatments.

   Third-party reimbursement is not available for the treatment of habitual
snoring. Snoring sufferers most often seek treatment for quality of life
rather than medical reasons.

                                       8
<PAGE>

The Somnus Solution: Somnoplasty

   Our proprietary Somnoplasty System is designed to use temperature
controlled radiofrequency energy to provide a minimally-invasive, curative and
relatively painless treatment of upper airway disorders. The Somnoplasty
System includes an automated temperature controlled radiofrequency control
unit with continuous feedback for temperature monitoring and a suite of
proprietary, single use, disposable needle electrode devices which deliver
controlled thermal energy into soft tissues in the head and neck such as the
uvula, soft palate, tongue, turbinates, and tonsils 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 TCRF 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 preventing or reducing 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 75-85C (185F), ensuring optimal ablation in a
precisely located lesion while protecting the surface mucosa. The lesions
created by the procedure are naturally reabsorbed in approximately four to
eight weeks, reducing excess tissue volume.

   We believe that the primary advantages of the Somnoplasty System include:

   Tissue Reduction. Our clinically proven, patented temperature controlled
radiofrequency technology, or TCRF, ensures predictable and consistent tissue
volume reduction without cutting, reducing pain and post procedure
complications.

   Minimal Discomfort and Reduced Recovery Time. The use of TCRF 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 within 1-2 days.

   Clinical Effectiveness. Unlike treatments such as CPAP for OSAS 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 side effects
of standard and laser-assisted surgical operations.

   Rapid Procedure Time. The Somnoplasty System, including patient preparation
and administration of local anesthesia, takes 30 minutes, for base of tongue,
while enlarged turbinates, soft palate/uvula procedures typically take five to
ten minutes. We believe treatment requires a range of one to nine visits 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 minimally invasive compared to many other minor surgical
procedures performed by physicians and dentists in their offices.

   We believe the other 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.


                                       9
<PAGE>

Product Description

   We have developed devices for treatment of the tongue, turbinates, soft
palate/uvula, and coagulation of tissue in the head and neck which may include
tonsils. These devices deliver temperature controlled 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. The Somnoplasty
System has received marketing clearance in the European Economic Association
"EEA", (CE Mark), and the control unit and soft palate/uvula and turbinate
devices are commercially available in Europe. In July 2000, we secured
regulatory "shonin" approval to market our model 1010, 1100, and 1200 devices
in Japan. We had previously secured regulatory "shonin" approval to market our
S2 control unit in Japan on November 27, 1998.

Somnoplasty Product Line

 Disposable Devices

   SP 1010. The SP 1010 is a single needle deployable electrode device for the
delivery of temperature 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 TCRF 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. The SP 1100 has a disposable
needle device with a reusable handle and cable assembly. It delivers the TCRF
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 TCRF
energy to the tongue for patients suffering from OSAS. The SP 1200 has a
disposable needle device with a reusable handle and cable assembly. The SP
1200 delivers the TCRF energy through a coagulating needle electrode which is
positioned using direct visualization.

   SP 2420. The SP 2420 is a disposable dual needle coagulating electrode used
to deliver temperature-controlled radiofrequency energy for selective thermal
coagulation of tissue.

 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 TCRF tissue volume reduction through the use
of continuous feedback on temperature. The physician sets the control unit to
the total energy and target temperature to be applied to the tissue. The user
interface of each control unit is designed to require minimal interaction,
allowing the physician 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.

   S2 Control Unit. The S2 control unit is a dual channel control unit,
compatible with all of our needle electrode devices. A high-quality color
screen displays delivered power, energy and temperatures. A 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

                                      10
<PAGE>

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 obstructive sleep apnea syndrome or (OSAS) or Upper
Airway Resistance Syndrome, or (UARS). The 510(k) clearance was based on the
results of an 18-patient, single-center clinical trial completed in June 1998.
The data from this trial indicated that patients may require two to nine
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.

   In May, 2000, we received 510(K) clearance for the Model 2420 (a dual
needle device), in combination with the Somnus Control Unit for coagulation of
tissue in the head and neck.

   In 2000, we had 13 new articles published in peer-reviewed journals, for a
total of 23 published to date, giving us a broad clinical foundation.

   Following the 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 OSAS. 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. Clinical trials are planned to obtain clearance from the FDA
for an indication designed to reduce enlarged tonsils.

   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
1120 for the treatment of enlarged turbinates, the SP1200 for the reduction of
the incidence of airway obstructions in patients suffering from UARS and OSAS,
and the SP2420 for the coagulation of tissue in the head and neck which may
include tonsils. In addition, the S2 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 our 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 ("Quality
System Regulations") 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. In July 2000, we secured regulatory "shonin" approval to
market our model 1010, 1100, and 1200 devices in Japan. We had previously
secured regulatory "shonin" approval to market our S2 control unit in Japan on
November 27, 1998.

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 radiofrequency 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

                                      11
<PAGE>

surgical time and greater simplicity. 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 Somnoplasty System.

   In fiscal 2000, 1999, and 1998 research and development expenses were
$5,587,000, $5,733,000, and $8,220,000, respectively. As of December 31, 2000,
our research and development staff consisted of 10 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 and a manufacturers
representative group to target primarily:

  . ear, nose and throat physicians,

  . oral maxillofacial surgeons,

  . pulmonologists,

  . sleep medicine specialists,

  . allergists and

  . other physicians who treat upper airway disorders.

   As of December 31, 2000, the sales organization in the United States
consisted of 18 employees, including direct sales representatives and one
sales representative group.

   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
diagnosing and treating 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 American Sleep Disorders Association. Sleep clinics are
important not only as potential customers, but also for their role in
referring diagnosed patients for treatment.

   Until January 2001, we had a European Headquarters in The Netherlands
primarily to manage relationships with distributors throughout Europe. In
addition we have distributors in Latin American, Africa, Asia and the Pacific
Rim. In January 2001, we announced a restructuring plan which included the
shutdown of our European headquarters. All international distributors are
currently managed from our headquarters in Sunnyvale, California.

   Our marketing and education efforts have been focused on early adopters
with emphasis on leading surgeons and sleep clinics. At present we have
systems in over half of 108 the ENT residency-training programs throughout the
United States. As we have approached saturation of the "early adopter" market
we have moved the focus of 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.

                                      12
<PAGE>

Manufacturing

   The manufacturing facility for our disposable products is located in
Sunnyvale, California. The manufacturing process consists primarily of
assembly of internally manufactured, purchased components and subassemblies.
Disposable products are processed 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 if we were to
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.

   The S2 control unit is manufactured by a qualified third party. 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 process 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, and

  . suspension of FDA clearance to market certain or all of our products for
    a period until we meet the specifications.

   During 1998 and 1999 we operated from a 20,000 square feet facility, of
which approximately 6,300 square feet was dedicated to manufacturing,
warehousing and distribution. In January 2000 we leased an additional building
containing 20,000 square feet. In accordance with the restructuring proposal
announced in January 2001, we plan on subleasing the second facility for the
remaining portion of the lease which ends in February 2002.* At this time due
to the recent softening of the local real estate market, there can be no
assurance that we will be able to sublease the facility.

   Our direct labor force includes one shift five days per week assembling
devices. With minimal additional equipment additions, we could add more shifts
increasing the capacity 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, 2000, we had 42 issued patents, and
an additional 12 pending patent applications. We also had 5 granted, 9
published and 17 foreign patents. These patents and patent applications relate
to our radiofrequency devices and methods for reduction of tissue in the
uvula, soft palate, tongue, and coagulation of tissue in the head and neck,
and design of our control units and disposable devices. Where we do not have
ownership rights over the intellectual property, we may 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.


                                      13
<PAGE>

   The patent and trade secret positions of medical device companies,
including ours, 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 us, 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 us. 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 us, may also be necessary to enforce patent or other
intellectual property rights of ours or to determine the scope and validity of
other parties' proprietary rights. There can be no assurance that we will have
the financial resources to defend our patents from infringement or claims of
invalidity.

   We also rely 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 us. These agreements generally provide that all inventions
conceived by the individual during the term of the relationship shall be our
exclusive property 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 us. In the event any pending
applications provide proprietary rights to third parties relating to products
or processes used or proposed to be used by us, we may be required to obtain
licenses to patents or 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

                                      14
<PAGE>

patient and physician requirements. In the treatment of habitual 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 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 OSAS
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. Other companies offer products which
use radiofrequency for the treatment of upper airway disorders including
Elmed, Ellman, and Entec, a division of Arthrocare, Inc. There can be no
assurance of our ability to differentiate our products with temperature
control feature from these products. This could adversely affect our future
business, financial condition and results of operations. 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, our
relative competitive position 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 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

                                      15
<PAGE>

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 OSAS. In May, 2000, we received 510(K) clearance for
the Model 2420, (a dual needle device) in combination with the Somnus Control
Unit for coagulation of tissue in the head and neck.

   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 us to submit
a new 510(k) notice for any of the changes made to the devices. If the FDA
requires us 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 Regulations"), 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 "approval 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 approval 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 the management and treatment of
upper airway disorders. 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 our 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.

                                      16
<PAGE>

   A clinical trial in support of a PMA generally requires an Investigational
Device Exemption, or 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, or 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 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 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 we manufacture or distribute 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, or 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 Quality System Regulations, the Medical Device Reporting, or 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.

   Our facilities are subject to inspection by regulatory authorities,
including the FDA, for compliance with Quality System Regulations. The FDA
completed an inspection of our manufacturing facility in April 2000 and the
FDA inspector provided a list of observations indicating he believed we were
not in full compliance with applicable Quality System Regulations. In
addition, in July 2000, the FDA issued us a formal warning letter, which
stated that the methods used in, or the facilities or controls used for the
manufacture, packaging, storage, or installation of our devices are not in
conformance with applicable Quality System Regulations. The issuance of a
formal warning letter may materially impact our business, because:

  . Federal agencies are advised of the issuance and may take this
    information into account when considering the award of contracts;

  . The FDA will not clear pre-market submission for devices to which Quality
    System violations are reasonably related until the violations have been
    corrected; and

  . The FDA will not approve a request for Certificate for Products to Export
    which will prevent us from exporting to new foreign markets until the
    violations have been corrected.

   We implemented a plan to take corrective actions to address the FDA's
observations and submitted a written response to the FDA Warning Letter. In
August 2000, we commissioned an audit of the Quality System Regulations as
required by the FDA. The findings of this audit were submitted to the FDA The
FDA reinspected our facility in March, 2001. The FDA inspector provided a list
of three observations, none of which were identified in the warning letter. We
intend on responding to these observations in writing shortly and are in the
process of correcting them. The FDA could initiate another inspection to
verify that we have corrected these deficiencies. Failure to achieve and
maintain compliance with Quality System Regulations could have a significant
adverse effect on our ability to continue to manufacture and sell our
products, and in the most serious cases could result in the seizure or recall
of products, and injunction and/or civil fines.

                                      17
<PAGE>

   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,
or 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.

 Japan

   In July 2000, we secured regulatory "shonin" approval to market our model
1010, 1100, and 1200 devices in Japan. We had previously secured regulatory
"shonin" approval to market our S2 control unit in Japan on November 27, 1998.

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 Payers") to
reimburse all or part of the cost of the procedure in which the medical device
is being used. Certain Third-Party Payers have 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 Payers may
be independent of the practice's cost incurred for the specific case and the
specific devices used. Medicare and other Third-Party Payers are increasingly
scrutinizing whether to cover new products and the level of reimbursement for
covered products. We have recently been notified that the Health Care
Financing Administration, or HCFA, believes that existing coding is
appropriate for Medicare reimbursement for the use of the Somnoplasty
procedure in treating OSAS/UARS.

   In the United States, we do not anticipate that the Somnoplasty System will
be subject to reimbursement for the treatment of habitual snoring.
Traditionally, sufferers of snoring have paid for surgical and non-surgical
treatment and devices directly. However, the current treatment of OSAS and
outpatient surgical procedures for the uvula, soft palate and turbinates are
commonly reimbursed by most carriers, and resection of the tongue is
reimbursed either as an inpatient or outpatient procedure. Reimbursement is
also available in an inpatient setting for the coagulation of tissue in the
head and neck which may include tonsils.

                                      18
<PAGE>

   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 payers.

   We believe that the Somnoplasty System is reimbursed for the treatment of
base of the tongue for OSAS under existing reimbursement codes, based on
physician endorsement and the demonstration of improved quality of life for
specific patient groups. We are working to raise the reimbursement level.
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 the Somnoplasty System control units or disposable
devices.

   Although there is still uncertainty regarding the availability of third-
party reimbursement for procedures that would use our devices for the
treatment of OSAS/UARS (base of tongue), enlarged turbinates, and coagulation
of tissue in the head and neck which may include tonsils, these third party
payors are currently reviewing our clinical studies to assist in their
reimbursement decisions and are beginning to recognize our technology. Failure
by private practices, clinics, hospitals, sleep clinics and other potential
users of our devices to obtain sufficient reimbursement from Third-Party
Payers 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 habitual snoring will be a reimbursable expense. We believe that
various levels of reimbursement will be available in international markets for
treatment of OSAS/UARS (base of tongue), enlarged turbinates, and coagulation
of tissue in the head and neck. 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. During 2000,
specific reimbursement codes were designated by the Italian Ministry of Health
to be used for the FDA cleared treatment of obstruction sleep apnea syndrome,
chronic nasal obstruction, and habitual snoring.

   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
Payers will not otherwise adversely affect the demand for our existing
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

                                      19
<PAGE>

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, 2000, we employed 108 individuals full time. Of our
total work force, 47 employees are engaged in manufacturing, 19 employees are
engaged in research and development activities, 25 employees are engaged in
sales and marketing activities and 17 employees are engaged in finance and
administrative activities. The restructuring plan initiated in January 2001
resulted in a headcount reduction of 10 percent of our employees. Our
employees are not represented by a collective bargaining agreement. We believe
our relations with our employees are good.

Additional Risk Factors

 Our funds available for operations are low and we will need to either raise
 additional funds soon which will cause dilution to existing investors, or
 sell the company.

   We have incurred cumulative operating losses of $59 million, including a
net loss of $10.7 million for the year ending December 31, 2000. In addition,
our cash, cash equivalents, and short-term investments decreased from $19.9
million at December 31, 1999 to $5.4 million at December 31, 2000. These
conditions raise substantial doubt about our ability to continue as a going
concern.

   Within the next three months we expect we will raise additional funds
through the issuance of equity or debt securities in the public or private
markets in order to continue operations, or sell the company.* To this end, we
have engaged ING Barings to act as our exclusive financial advisor to provide
us with investment banking services and financial advice on strategic
opportunities, including raising capital through the sale of stock to the
public or to private investors, as well a possible sale of the company.
Additional financing and merger opportunities may not be available, or if
available, may not be on favorable terms. The availability of financing or
merger opportunities will depend, in part, on market conditions, which have
been depressed as of late. If we cannot raise sufficient new capital we may be
unable to successfully promote or produce products, continue supplying our
services, or pay our employees, or vendors any of which could seriously harm
our business. Any future equity financing would result in substantial dilution
to our stockholders. If we raise additional funds by issuing debt, we may be
subject to limitations on our operations, through debt covenants or other
restrictions.

 We may fail to meet continued Nasdaq listing standards which would result in
 a listing on a lesser known market within Nasdaq or a delisting altogether.
 Any change in market listing may adversely affect our ability to raise
 capital.

   Under the continued listing standards for inclusion of our stock on the
Nasdaq National Market we are required to maintain net tangible assets of $4.0
million. As of December 31, 2000, our net tangible assets were $6.6 million.
We are uncertain as to whether we will be able to raise sufficient capital or
otherwise increase the assets we own through sales of our products or asset
purchases to maintain minimum net tangible assets. There are other Nasdaq
maintenance standards as well, including a requirement that our stock cannot
close below $1.00 for 30 consecutive trading days. We can give no assurance
that our stock will continue to trade above $1.00. If we cannot maintain
Nasdaq maintenance standards we may be transferred from the Nasdaq National
Market to the Nasdaq Small cap or the pink sheets or delisted altogether. If
our stock is removed from the Nasdaq National Market, the liquidity and price
of our stock may be adversely affected. As a result, there may be less demand
for our stock and we may be unable to raise sufficient capital to funds our
operations.

                                      20
<PAGE>

 We have limited experience in selling and marketing our Somnoplasty System.
 We may be unable to generate significant revenue from the sale or our
 generators and the revenue resulting from sales of our handpieces may not be
 significant enough to make us profitable.

   We have only limited experience selling and marketing the Somnoplasty
System for the treatment of turbinate hypertrophy (chronic nasal obstruction),
soft palate/uvula (habitual snoring), base of tongue (obstructive sleep apnea
syndrome/upper airway resistance syndrome), and coagulation of tissue in the
head and neck which may include tonsils. The sale of our disposable handpieces
may not provide substantial revenue and we may ultimately prove unsuccessful
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 require us to demonstrate that the cost of our
products and procedures are competitive with currently available alternatives.
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 investments
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 effect on our business, financial condition and results of
operations.

 We have a history of operating losses and we expect those losses to continue.

   We have had significant operating losses since the commencement of our
operations in 1996. As of December 31, 2000, we have an accumulated deficit of
approximately $59 million. Despite our restructuring plan, we expect those
losses to continue based on our current and projected increased sales and
marketing, general and administrative, and research and development expenses.*
We may never become profitable. Our ability to become profitable depends on
many factors, including our ability to achieve market acceptance for the
Somnoplasty System, our ability to produce our products consistent with
government and regulatory standards, and our ability to obtain reimbursement
for both our products and the procedure from healthcare payors.

 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 turbinate hypertrophy (chronic nasal obstruction), soft
palate/uvula (habitual snoring), coagulation of tissue in the head and neck
which may include tonsils, and base of tongue (obstructive sleep apnea
syndrome/upper airway resistance syndrome). Market acceptance will depend, in
the large part, upon the effectiveness of the Somnoplasty System over time.
There can be no assurance that the procedure will provide a permanent,
curative 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. This could result in the need for 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.

 We rely on a third party manufacturer as our only supplier of the S-2 control
 unit and may experience design or production problems and delays as a result.

   The third party manufacturer of our S-2 control unit is our only supplier
for this product. The inability of this manufacturer to successfully produce
our S-2 control unit consistent with our quality standards and/or on a timely
basis may have a material adverse affect on our financial condition and
results of operations. In the event this supplier fails to fulfill our product
needs, we will be forced to locate alternative suppliers. We can give no
assurance that we will be able to locate suitable replacement suppliers. If we
are unable to secure adequate manufacturing capacity to meet our supply
requirements, our business will be materially harmed.

 We may experience problems with regard to our disposable devices which we
 manufacture ourselves.

   We currently manufacture our disposable devices in their entirety. We have
in the past experienced and we may in the future experience design or
production problems and delays as we manufacture these units. In

                                      21
<PAGE>

addition, certain parts may be discontinued or placed on allocation by their
manufacturers. We have had to qualify alternative vendors when parts could no
longer be obtained by the vendor we had been using. We may have to redesign
our products to use alternative parts when we switch vendors. These transfers
to new vendors can cause delays in our manufacturing operations. Additionally,
there can be no assurance that in the future we will be able to have parts
specifically manufactured, redesign our products to use other available parts
or, qualify alternative vendors, at all or without interrupting our ability to
meet customer demand. The inability to react to design or production issues
through the manufacturing of special parts, redesign of our products, and the
qualification of new vendors could have a material adverse effect on,
financial condition and results of operations.

 If our vendors are unable to satisfy our manufacturing requirements our
 business will be materially harmed.

   The S2 control unit and our disposable devices use electronic components.
Our vendors supply the electronic components we require to much larger
customers, with whom we have to compete for the limited supply. If we or our
third party manufacturer are not able to obtain such components in a timely
manner or in quantities necessary to meet our requirements, we may be unable
to fulfill orders and may lose customers.

   We have in the past and may in the future have vendors who are unable to
supply us with adequate quantities of components. In such a situation, we have
to identify and qualify one or more substitute suppliers for these components
needs. Incorporating new components or transferring existing components needs
to new vendors requires significant time and can cause products shipment
delays. In addition, the costs associated with manufacturing our products may
increase if we are required to use third party vendors. If we fail to satisfy
our manufacturing requirements, our business would be materially harmed.

 Several factors will impact our ability to achieve market acceptance.

   Temperature Controlled Radiofrequency tissue volume reduction in the upper
airway is a new and novel development. Market acceptance of this procedure for
the treatment of turbinate hypertrophy (chronic nasal obstruction), soft
palate/uvula (habitual snoring), coagulation of tissue in the head and neck
which may include tonsils and base of tongue (obstructive sleep apnea
syndrome/upper airway resistance syndrome) could be adversely affected by
numerous factors, including:

  . the lack of availability of third-party reimbursement,

  . cost of the procedure,

  . clinical acceptance,

  . differentiation of our temperature control feature, and

  . effective physician training and patient acceptance.

   Third party reimbursement. Patients do not receive third-party
reimbursement for use of the Somnoplasty System in the treatment of habitual
snoring. Market acceptance of the Somnoplasty System for the treatment of
turbinate hypertrophy (chronic nasal obstruction), coagulation of tissue in
the head and neck which may include tonsils and base of tongue (obstructive
sleep apnea syndrome/upper airway resistance syndrome) depends, in large part,
upon the availability and receipt of an acceptable level of third-party
reimbursement for each of those indications, which has not yet been
established on a consistent basis. Reimbursement for the treatment of habitual
snoring, turbinate hypertrophy (chronic nasal obstruction), coagulation of
tissue in the head and neck which may include tonsils and base of tongue
(obstructive sleep apnea syndrome/upper airway resistance syndrome) varies
significantly depending on the third party payor involved, the region in the
United States and type of medical facility where the procedure is performed.

   Cost of the procedure and clinical acceptance. Market acceptance also is
impacted by our ability to demonstrate that the Somnoplasty System is an
attractive alternative to other procedures, which depends upon physicians'
evaluations of the clinical safety and efficacy, ease of use, reliability and
cost-effectiveness of the

                                      22
<PAGE>

Somnoplasty System. Recommendations and endorsements by influential physicians
have been and we believe, will continue to be, essential to market acceptance.
* There can be no assurance that such recommendations or endorsements will
continue to be obtained.

   Competition and differentiation of our technology. There can be no
assurance that we will be able to successfully differentiate our technology
from competing products. In the treatment of habitual 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 products for the treatment of OSAS 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. Other companies offer products which use radiofrequency for the
treatment of upper airway disorders, including Elmed, Ellman, and Entec, a
division of Arthrocare, Inc. There can be no assurance of our ability to
differentiate our products with temperature control feature from these
products.

   Physician training. Broad adoption of the Somnoplasty System will require
us to train 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 has been and we believe will
continue to be affected by numerous factors, including the possibility that
the Somnoplasty procedure may require multiple treatments, which would be not
only inconvenient for the patient, but also more costly if not covered by
insurance. Patient acceptance of the Somnoplasty System for the treatment of
turbinate hypertrophy (chronic nasal obstruction), soft palate/uvula (habitual
snoring), coagulation of tissue in the head and neck which may include tonsils
and base of tongue (obstructive sleep apnea syndrome/upper airway resistance
syndrome) 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. We have not yet
obtained broad acceptance of the Somnoplasty System by the patient community,
and there can be assurance that we will achieve such broad acceptance, or that
market demand for our 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 Somnoplasty patient for any
reason 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.

 Our products could infringe the intellectual property rights of others and
 lead to costly litigation and/or substantial royalty payments.

   Our competitors or licensors may assert that our products infringe upon
their intellectual property. We may be forced to arbitrate or litigate to
protect our products from claims of infringement. One of our former licensors
has claimed royalty rights on our control unit. We do not believe this claim
is valid but cannot assure you that we will not have to pay retroactive and
future royalties as a result. We may have to litigate or arbitrate to protect
our interests in this matter. Litigation and arbitration are costly pursuits
and they consume time that management would otherwise dedicate to building our
business. In the event that our products infringe on the intellectual property
of others we may be required to pay significant damages.

 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.

                                      23
<PAGE>

   Following implementation of our restructuring plan, our distributors
worldwide are managed out of our headquarters in Sunnyvale, California. We may
add additional distributors as necessary to further penetrate markets around
the world. *

   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 we could 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.

   International sales of the Somnoplasty System are subject to numerous
risks. Distribution, pricing and marketing structures, as well a 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,

  . increase 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.

 Compliance with Quality System regulations is costly and time consuming and
 our failure to comply could lead to delays in filling product orders and loss
 of sales revenues.

   Our facilities are subject to inspection by regulatory authorities,
including the FDA, for compliance with Quality System regulations. The FDA
completed an inspection of our manufacturing facility in April 2000 and the
FDA inspector provided a list of observations indicating he believed were not
in full compliance with applicable Quality System regulations. In addition, in
July 2000, the FDA issued us a formal warning letter, which stated that the
methods used in, or the facilities or controls used for the manufacture,
packaging, storage, or installation of our devices are not in conformance with
applicable Quality System regulations. The issuance of a formal warning letter
may materially impact our business, because:

  . Federal agencies are advised of the issuance and may take this
    information into account when considering the award of contracts;

  . The FDA will not clear pre-market submission for devices to which Quality
    System violations are reasonably related until the violations have been
    corrected; and

                                      24
<PAGE>

  . The FDA will not approve a request for Certificate for Products to Export
    which will prevent us from exporting to new foreign markets until the
    violations have been corrected.

   We implemented a plan to take corrective actions to address the FDA's
observations and submitted a written response to the FDA Warning Letter. In
August 2000, we commissioned an audit of the Quality System regulations as
required by the FDA. The findings of this audit were submitted to the FDA. The
FDA reinspected our facility in March, 2001. The FDA inspector provided a list
of three observations, none of which were identified in the warning letter. We
intend on responding to these observations in writing shortly. In addition, we
are in the process of correcting the deficiencies identified by the FDA. The
FDA could initiate another inspection to verify that we have corrected the
observations. Failure to achieve and maintain compliance with Quality System
regulations could have a significant adverse effect on our ability to continue
to manufacture and sell our products, and in the most serious cases could
result in the seizure or recall of products, and injunction and/or civil
fines.

 We are dependent on single-source suppliers for components.

   We purchase certain key components of our products from single-source
suppliers. We have in the past and may in the future encounter shortages from
one of our single source suppliers. * In such a situation, we have had to
identify and qualify one or more substitute suppliers for these component
needs. There can be no assurance that in the future 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.

 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.

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 lease an additional 20,000 square foot light industrial
facility in Sunnyvale, California under a lease that terminates in 2002, with
an option to extend to 2005. As part of the restructuring plan, we announced
in January 2001, we consolidated our operations into one facility. We
currently sublease 7,500 square feet of the additional 20,000 square foot
facility leased in January 2000 and intend on subleasing the remaining 12,500
square feet of the facility.* At this time due to the weakness in the local
real estate market, there can be no assurance that we will be able to sublease
the facility. We believe that our current facilities are adequate to meet our
requirements for at least the next twelve months of continued operations.

                                      25
<PAGE>

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.

                                       26
<PAGE>

                                   PART III

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

   Our Common Stock has been quoted on the Nasdaq National Market under the
symbol SOMN since our initial public offering on November 5, 1997. Prior to
such time, there was no public market for the Common Stock. The following
table sets forth, for the periods indicated, the high and low sales prices per
share of the Common Stock as reported on the NASDAQ National Market:

<TABLE>
<CAPTION>
     Quarter Ended                                               High     Low
     -------------                                             -------- --------
     <S>                                                       <C>      <C>
     1999: First Quarter...................................... $  3 7/8 $  2 1/4
     1999: Second Quarter..................................... $  3 1/4 $  2 1/8
     1999: Third Quarter...................................... $ 3 5/16 $  2 1/8
     1999: Fourth Quarter..................................... $  2 3/4 $ 1 7/16
     2000: First Quarter...................................... $  6 3/8 $1 15/16
     2000: Second Quarter..................................... $4 15/16 $ 1 3/16
     2000: Third Quarter...................................... $  5 3/8 $  1 1/2
     2000: Fourth Quarter..................................... $  2 1/4 $    3/8
</TABLE>

   As of March 13, 2001, the number of common stockholders of record was 100.
We currently intend to retain any earnings for use in our business and do not
anticipate paying any cash dividends in the foreseeable future.

ITEM 6. SELECTED FINANCIAL DATA

                      Summary Consolidated Financial Data

<TABLE>
<CAPTION>
                                            Years Ended December 31,
                                       --------------------------------------
                                         2000      1999      1998      1997
                                       --------  --------  --------  --------
                                         (in thousands, except per share
                                                    amounts)
<S>                                    <C>       <C>       <C>       <C>
Consolidated Statements of Operations
 Data:
Product revenues                       $ 12,062  $ 11,665  $  7,356  $  2,574
Cost of sales.........................    6,373     6,468     5,565     3,110
                                       --------  --------  --------  --------
Gross Margin..........................    5,689     5,197     1,791      (536)
Operating expenses:
  Research and development............    5,587     5,733     8,220     6,033
  Selling, marketing, general and
   administrative.....................   11,548    14,053    14,953     6,741
                                       --------  --------  --------  --------
    Total operating expenses..........   17,135    19,786    23,173    12,774
                                       --------  --------  --------  --------
Loss from operations..................  (11,446)  (14,589)  (21,382)  (13,310)
Interest and other income.............      739     1,439     2,054       553
                                       --------  --------  --------  --------
Net loss.............................. $(10,707) $(13,150) $(19,328) $ 12,757
                                       ========  ========  ========  ========
Net loss per share, basic and
 diluted.............................. $  (0.74) $  (0.92) $  (1.41) $  (3.02)
                                       ========  ========  ========  ========
Shares used in computing net loss per
 share, basic and diluted.............   14,560    14,242    13,717     4,224
                                       ========  ========  ========  ========
</TABLE>

<TABLE>
<CAPTION>
                                              Years Ended December 31,
                                         --------------------------------------
                                           2000      1999      1998      1997
                                         --------  --------  --------  --------
                                                   (in thousands)
<S>                                      <C>       <C>       <C>       <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents............... $  5,396  $ 14,888  $ 32,280  $ 45,145
Short-term investments..................      --      4,972       --        --
Working capital.........................    4,109    15,138    27,742    43,736
Total assets............................   12,228    24,798    36,512    48,227
Accumulated deficit.....................  (59,039)  (48,332)  (35,182)  (15,854)
Total stockholders' equity..............    6,556    16,825    29,428    45,620
</TABLE>


                                      27
<PAGE>

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

Overview

   We design, develop, manufacture and market innovative medical devices that
utilize our proprietary temperature controlled radiofrequency technology for
the treatment of upper airway disorders. Our Somnoplasty 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 syndrome, OSAS, chronic turbinate hypertrophy and
habitual snoring, and coagulation of tissue in the head and neck which may
include tonsils.

   Our operations in 1996 and 1997 consisted largely of research and
development, product engineering, seeking clearance of our products from the
Food & Drug Administration, 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, or EU,
Australia, Southeast Asia and certain other areas. We commercially introduced
the Somnoplasty System internationally, beginning in June 1997. One month
later, after receiving 510(k) clearance from the FDA for the use of the
Somnoplasty System to treat habitual snoring, we began direct sales of the
Somnoplasty System in the United States. We received FDA clearance to treat
chronic turbinate hypertrophy in December 1997 and OSAS in November 1998.
During the third quarter of fiscal 1998 we established a European headquarters
in the Netherlands.

   During 1999, we continued to build our direct sales force in the United
States. During the fourth quarter of 1999, we hired a Director of
International Sales to manage our distributors in countries other than the
United States and Europe. In May, 2000, we received 510(K) clearance for the
Model 2420, (a dual needle device) in combination with the Somnus Control Unit
for coagulation of tissue in the head and neck. In July 2000, we secured
regulatory "shonin" approval to market our model 1010, 1100, and 1200 devices
in Japan. We had previously secured regulatory "shonin" approval to market our
S2 control unit in Japan on November 27, 1998. In January 2001, we announced a
restructuring plan which included the shutdown of the European headquarters in
the Netherlands. All international sales activities are managed from our
headquarters in Sunnyvale, California.

   We have incurred significant operating losses since the commencement of our
operations in 1996. As of December 31, 2000, we have an accumulated deficit of
approximately $59 million. We expect those losses to continue based on our
current and projected sales and marketing, general and administrative, and
research and development expenses.* Because our available funds are low we
will either need to raise cash soon or sell the company. We expect to raise
additional funds through the issuance of equity or debt, but the consummation
of a financing is uncertain.* If we are unable to raise sufficient new funds
it is unlikely that we will be able to continue our operations. We may never
generate sufficient revenue to sustain our business. Our ability to generate
revenue depends on many factors, including our ability to achieve market
acceptance for the Somnoplasty System, our ability to produce our products
consistent with government and regulatory standards, and our ability to obtain
reimbursement for both our products and the procedure from healthcare payors.

   The restructuring plan announced in January 2001 is currently being
implemented and is designed to reduce operating expenses by $4,000,000 in
fiscal year 2001 and will result in a headcount reduction of approximately 10
percent of our employees.* The plan encompasses the operational components of
sales and marketing, manufacturing, certain ongoing clinical programs, and
research and development. A restructuring charge for these items is estimated
to be between $500,000 to $600,000 and will be recorded in the first quarter
of 2001.* Subsequent to estimating the restructuring charge in January 2001,
we increased our estimate by $300,000 to $400,000 related to a facilities
consolidation, including rent, and the write off of leasehold improvements,
necessitated by the recent softening of the local real estate market and
resultant uncertainty as to our ability to sublease the facility subsequent to
executing the restructuring plan.* This will result in a total expected
restructuring charge to be recorded in the first quarter of 2001 of between
$800,000 to $1,000,000.

   Product shipments of control units and disposable devices are made directly
from our facility in Sunnyvale, California to domestic customers and
international distributors. As our installed base of control units has

                                      28
<PAGE>

increased, we have continued to receive an increasing percentage of our sales
revenue from the sale of disposable handpieces as opposed to the sales of
control units. We expect this shift in revenue from control units to
handpieces to increase in the future.*

   Our personnel, sales, and scope of operations 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 and 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.

   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 our ability 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 2000 and 1999 were derived primarily from sales of our
Somnoplasty System, consisting of the control units and disposable devices, to
private practices, hospitals, clinics and sleep clinics. Net revenues
increased in 2000 to $12,062,000 from $11,665,000 in 1999 and $7,356,000 in
1998. The year over year increase was $397,000 or 3.4 percent from 1999 to
2000 and $4,309,000 or 59 percent from 1998 to 1999. The increase from 1999 to
2000 is primarily attributable to increased revenue from disposable handpieces
due to the higher installed base offset by lower revenue from control units
due to a decrease in the average selling price per unit. The increase is also
attributable to a lower returns reserve requirement as the average selling
price for our control unit declined. The increase from 1998 to 1999 is due to
both the increased sale of control units, boosted by the introduction of the
S2 control unit during the third quarter of 1998 and increased disposable
handpiece shipments driven off the higher installed base and an increased use
of disposable devices per control unit. During 2000, about 83 percent of net
revenues were attributable to sales to customers in the United States about 17
percent from Europe and the rest of the world. These percentages compare with
1999 figures of approximately 88 percent in domestic sales and 12 percent of
sales in Europe and the rest of the world.

   Traditionally, the sale of control units has been the major part of our
total revenues. In 1998 about 68 percent of our domestic revenue came from the
sale of control units, with disposable handpieces representing about
32 percent of revenue. In 1999, 46 percent of our domestic revenue resulted
from sales of control units, with disposable handpieces generating 54 percent
of revenue. During 2000, revenue from disposable handpieces as a percentage of
total revenue increased dramatically and generated 89 percent of our total
revenue with revenue from control units comprising 11 percent of our total
revenue.

 Cost of sales and gross profit

   Cost of sales consists of raw materials, subassemblies and completed
electronics, quality assurance and warranty costs. Our gross profit increased
to $5,689,000 or 47 percent gross margin in 2000, from $5,197,000 or

                                      29
<PAGE>

45 percent gross margin in 1999, and $1,791,000, or 24 percent gross margin in
1998. Gross margin percentage has increased dramatically from 1998 to 2000 as
volume and cost reduction efforts contributed to better efficiency in our
manufacturing process. The improvement in gross margin is also due to
decreased warranty exposure as we continue to move to more company owned
control units where no warranty is required as opposed to customer owner
units. Cost of sales included a one-time charge of approximately $200,000
relating to certain manufacturing process issues which were experienced in the
fourth quarter of 1998. We believe that cost of sales will increase in
absolute dollars but may fluctuate as a percentage of revenues depending on
volume and product mix.*

 Research and development expenses

   Research and development expenses for 2000 were $5,587,000, compared to
$5,733,000 for the prior year, an increase of $146,000 or 2.5 percent.
Research and development expenses are comprised of salaries, prototype
development costs, costs associated with intellectual property, and clinical
trial and regulatory approval expenses. The slight increase in 2000 expenses
was primarily due to prototype expenses related to the development of the S1
generator.

   From 1998 to 1999, our research and development expenses decreased from
$8,220,000 to $5,733,000. This decrease of $2,487,000 or 30 percent was
primarily due to a shifting focus over a wide range of activities. We reduced
clinical trial expenses by $659,000, reduced prototype and engineering
expenses by $408,000, intellectual property and patent expenses by $556,000
and lowered personnel costs in the research and development category by
$578,000. These lower expenses resulted principally from our previously
receiving FDA approval for three indications and the introduction of our S2
control unit in 1998, which allowed us to reduce our 1999 activity in research
and development.

 Selling, marketing, general and administrative

   Selling, marketing, general and administrative, or SG&A, expenses for
fiscal 2000 were $11,548,000 compared to $14,053,000 for 1999 a decrease of
approximately, $2,505,000 or 17.8 percent. SG&A expenses consist of sales
salaries, sales and marketing expenses, executive salaries, professional fees
(including consulting, accounting, legal and risk management), facilities
overhead, accounting and human resources and general office administration
expenses.

   The decrease from the prior year is primarily attributable to a reduction
in personnel, bad debt, and promotional and advertising expenses. The
decreased bad debt expense is due primarily to a decrease in the risk profile
of our receivables as the average selling price for the initial sale of
control units decreased as well as the impact of an increased proportion of
receivables from on-going customers, which have a lower risk profile. The
decrease in SG&A from 1998 to 1999 results from a decrease in one-time charges
incurred in 1998 of approximately $1,600,000 in connection with the transition
of our former Chief Executive officer and Chairman of the Board to Chief
Technical Officer and Board of Director, severance of our former Chief
Financial Officer and certain other executives, offset by increased
advertising expenses of about $357,000 and increased investment in the
European sales effort of about $268,000.

 Interest and other income

   Interest and other income for 2000 was $739,000, compared to $1,439,000 for
1999 and $2,059,000 for 1998. The decrease from 1999 to 2000 is attributable
to a reduction in interest income earned on a decreasing balance of cash, cash
equivalents, and short-term investments as well as by nonrecurring technology
and documentation fees received from a related party during 1999 not received
during 2000. The decrease from 1998 to 1999 is attributable to a reduction in
interest income earned on a decreasing balance of cash, cash equivalents, and
short-term investments.

                                      30
<PAGE>

 Net loss

   The net loss was $10,707,000 for 2000, $13,150,000 for 1999, and
$19,328,000 for 1998. We expect that our operating losses will continue for at
least the next couple of years.

Income Taxes

   As of December 31, 2000, we had federal and state net operating loss
carryforwards of approximately $50,700,000 and $22,900,000, respectively. We
also had federal and California research and development tax credit
carryforwards of approximately $900,000 and $500,000, respectively. The
federal net operating loss and credit carryforwards will expire at various
dates beginning in the year 2011 through 2019, if not utilized. The state of
California net operating losses will expire at various dates beginning in 2001
through 2004, if not utilized. The deferred tax asset on the balance sheet has
been fully offset by a valuation allowances.

Liquidity and Capital Resources

   Since inception through December 31, 2000, we have 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 $43,800,000 from our IPO, net of
costs of $4,500,000.

   Cash and cash equivalents at December 31, 2000 were $5,396,000 compared to
$19,860,000 at December 31, 1999.

   Net cash used in operating activities was approximately $13,198,000 for the
year ended December 31, 2000, compared to $11,695,000 for 1999 and $12,438,000
in 1998. 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 other changes in operating assets and liabilities. The increase
in net cash used in operating activities from 1999 to 2000 is primarily
attributable to an increase in inventory, decrease in accrued compensation,
and a decrease in deferred revenue offset by a decrease in net loss.

   Net cash provided by investing activities was approximately $3,337,000 for
2000, compared to net cash used in investing activities of $5,748,000 for 1999
and $752,000 for 1998. The increase from 1999 to 2000 is due to the maturity
of short term investments offset by an increase in capital expenditures for
demonstration control units. The increase in net cash used in investing
activities from 1998 to 1999 was due to the purchase of short-term investments
in 1999.

   Net cash provided by financing activities was approximately $369,000 for
the year ended December 31, 2000, compared to $51,000 for 1999 and $325,000 in
1998. The increase in net cash provided by financing activities from 1999 to
2000 is due to an increase in stock option exercises in 2000 as well the
repurchase of common stock in 1999 of $289,000 that did not occur in 2000. The
decrease in net cash provided by financing activities from 1998 to 1999 is due
to the repurchase of common stock of $289,000 during 1999 that did not occur
in 1998.

   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. Deferred stock compensation
is fully amortized at December 31, 2000. We amortized deferred compensation
expenses of approximately $69,000 in the twelve months ended December 31, 2000
compared to $496,000 and $2,811,00 for the respective 1999 and 1998 periods.

   At December 31, 2000, our principal sources of liquidity consisted of
$5,396,000 in cash and cash equivalents and short term investments. There were
no other material unused sources of liquid assets at December 31, 2000.

                                      31
<PAGE>

   We currently anticipate that our capital expenditure requirements will be
approximately $1,500,000 for the next twelve months.* These requirements
relate primarily to the production of control units for placement with
customers under our placement sales program and demonstration S1 and S2
control units to be used by sales representatives.

   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. We did not
repurchase any shares in 1998. During 1999 we repurchased 100,000 shares
expending a total of $289,000 under the program. There were no purchases under
this program in 2000.

   Our existing resources will only be sufficient capital to support our
operations for a few months.* We have incurred cumulative operating losses of
$59 million, including a net loss of $10.7 million for the year ending
December 31, 2000. In addition, our cash, cash equivalents, and short-term
investments decreased from $19.9 million at December 31, 1999 to $5.4 million
at December 31, 2000. These conditions raise substantial doubt about our
ability to continue as a going concern.

   Within the next three months we expect we will either raise additional
funds through the issuance of equity or debt securities in the public or
private markets in order to continue operations, or sell the company.* To this
end, we have engaged ING Barings to act as our exclusive financial advisor to
provide us with investment banking services and financial advice on strategic
opportunities, including raising capital through the sale of stock to the
public or to private investors, as well a possible sale of the company.
Additional financing and merger opportunities may not be available, or if
available, may not be on favorable terms. The availability of financing or
merger opportunities will depend, in part, on market conditions, which have
been depressed as of late. If we cannot raise sufficient new capital we may be
unable to successfully promote or produce products, continue supplying our
services, or pay our employees, or vendors any of which could seriously harm
our business. Any future equity financing would result in substantial dilution
to our stockholders. If we raise additional funds by issuing debt, we may be
subject to limitations on our operations through debt covenants or other
restrictions.

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
about 4 months and a maximum maturity of 6 months. Due to the nature of short
term investments we have concluded that we do not have a material market risk
exposure.

                                      32
<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, 2000 and 1999, and the related
consolidated statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended December 31, 2000. Our audits
also included the financial statement schedule listed in the Index at Item 14
(A) 2. These financial statements and schedule 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 auditing standards generally
accepted in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

   In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Somnus
Medical Technologies, Inc. at December 31, 2000 and 1999, and the consolidated
results of their operations and their cash flows for each of the three years
in the period ended December 31, 2000 in conformity with accounting principles
generally accepted in the United States. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, present fairly in all material
respects, the information set forth therein.

   The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As more fully described in Note 1,
the Company has incurred cumulative operating losses of $59 million (including
a net loss of $10.7 million in the year ending December 31, 2000). In
addition, the Company's cash, cash equivalents and short-term investments
decreased from $19.9 million at December 31, 1999 to $5.4 million at December
31, 2000. These conditions raise substantial doubt about the Company's ability
to continue as a going concern. Management's plan in regards to these matters
are also described in Note 1. The financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and
classification of assets on the amounts and classification of liabilities that
may result from the outcome of this uncertainty.

                                          /s/ Ernst & Young LLP

Palo Alto, California
January 30, 2001

                                      33
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

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

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              2000      1999
                                                            --------  --------
<S>                                                         <C>       <C>
                          ASSETS
                          ------
Current assets:
  Cash and cash equivalents................................ $  5,396  $ 14,888
  Short-term investments...................................      --      4,972
  Accounts receivable, net of allowances of $258 and $724
   in 2000 and 1999, respectively..........................    1,895     1,906
  Inventories..............................................    2,066     1,181
  Other current assets.....................................      424       164
                                                            --------  --------
      Total current assets.................................    9,781    23,111
Property and equipment.....................................    2,359     1,603
Other assets...............................................       88        84
                                                            --------  --------
                                                            $ 12,228  $ 24,798
                                                            ========  ========

           LIABILITIES AND STOCKHOLDERS' EQUITY
           ------------------------------------

Current liabilities:
  Accounts payable......................................... $  2,041  $  1,623
  Accrued liabilities......................................      940     1,442
  Accrued compensation.....................................    1,357     2,167
  Accrued warranty.........................................      477       907
  Accrued clinical costs...................................      430       547
  Deferred revenue.........................................      427     1,287
                                                            --------  --------
      Total current liabilities............................    5,672     7,973
Commitments
Stockholders' equity:
  Preferred stock, 5,000,000 shares authorized, par value
   $0.001 per share, no shares were outstanding in 2000 and
   1999....................................................      --        --
  Common stock, 20,000,000 shares authorized, par value
   $0.001 per share, shares issued and outstanding:
   14,805,381 and 14,402,198 shares in 2000, and 1999
   respectively............................................       15        14
  Additional paid-in capital...............................   65,580    65,332
  Deferred stock compensation..............................      --       (189)
  Accumulated deficit and accumulated comprehensive loss...  (59,039)  (48,332)
                                                            --------  --------
      Total stockholders' equity...........................    6,556    16,825
                                                            --------  --------
                                                            $ 12,228  $ 24,798
                                                            ========  ========
</TABLE>

                            See accompanying notes.

                                       34
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

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

<TABLE>
<CAPTION>
                                                  Years Ended December 31,
                                                 ----------------------------
                                                   2000      1999      1998
                                                 --------  --------  --------
<S>                                              <C>       <C>       <C>
Product revenues................................ $ 12,062  $ 11,665  $  7,356
Cost of sales...................................    6,373     6,468     5,565
                                                 --------  --------  --------
Gross Margin....................................    5,689     5,197     1,791
Operating expenses:
  Research and development......................    5,587     5,733     8,220
  Selling, marketing, general and
   administrative...............................   11,548    14,053    14,953
                                                 --------  --------  --------
Total operating expenses........................   17,135    19,786    23,173
                                                 --------  --------  --------
Loss from operations............................  (11,446)  (14,589)  (21,382)
Interest and other income.......................      739     1,439     2,054
                                                 --------  --------  --------
Net loss........................................ $(10,707) $(13,150) $(19,328)
                                                 ========  ========  ========
Net loss per share, basic and diluted........... $  (0.74) $  (0.92) $  (1.41)
                                                 ========  ========  ========
Shares used in computing net loss per share,
 basic and diluted..............................   14,560    14,242    13,717
                                                 ========  ========  ========
</TABLE>


                            See accompanying notes.

                                       35
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                  Accumulated
                                                                  Deficit and
                          Common Stock   Additional   Deferred    Accumulated     Total
                          --------------  Paid-In      Stock     Comprehensive Stockholders
                          Shares  Amount  Capital   Compensation     Loss         Equity
                          ------  ------ ---------- ------------ ------------- ------------
<S>                       <C>     <C>    <C>        <C>          <C>           <C>
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)
                          ------   ----   -------     -------      --------      --------
Balances at December 31,
 1998...................  13,989     14    65,046        (450)      (35,182)       29,428
Issuance of common stock
 upon exercise of stock
 options for cash.......     409    --        116         --            --            116
Amortization of deferred
 compensation...........     --     --        --          261           --            261
Acceleration of unvested
 options................     --     --        235         --            --            235
Repurchase of common
 stock..................    (100)   --       (289)        --            --           (289)
Issuance of shares under
 Employee Stock Purchase
 Plan...................      88    --        189         --            --            189
Issuance of shares under
 the Patent Incentive
 Program................      16    --         35         --            --             35
Net loss and
 comprehensive loss.....     --     --        --          --        (13,150)      (13,150)
                          ------   ----   -------     -------      --------      --------
Balances at December 31,
 1999...................  14,402   $ 14   $65,332     $  (189)     $(48,332)     $ 16,825
Issuance of common stock
 upon exercise of stock
 options for cash.......     275      1       145         --            --            146
Amortization of deferred
 compensation...........     --     --        --           69           --             69
Reduction of deferred
 compensation upon
 cancellation of option
 grants.................     --     --       (120)        120           --            --
Issuance of shares under
 Employee Stock Purchase
 Plan...................     128    --        223         --            --            223
Net loss and
 comprehensive loss.....     --     --        --          --        (10,707)      (10,707)
                          ------   ----   -------     -------      --------      --------
Balances at December 31,
 2000...................  14,805     15   $65,580     $   --       $(59,039)     $  6,556
                          ======   ====   =======     =======      ========      ========
</TABLE>


                            See accompanying notes.

                                       36
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                   Years Ended December 31,
                                                  ----------------------------
                                                    2000      1999      1998
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Cash flows used in operating activities
  Net loss....................................... $(10,707) $(13,150) $(19,328)
  Adjustments to reconcile net loss to net cash
   used in operating activities:
    Amortization of deferred compensation........       69       496     2,811
    Depreciation.................................      879       774       716
    Net book value of property, plant and
     equipment retirements.......................      --        --        257
  Changes in operating assets and liabilities:
    Other current assets.........................     (260)      247      (111)
    Accounts receivable..........................       11      (577)     (667)
    Inventories..................................     (885)     (375)     (570)
    Other noncurrent assets......................       (4)        1       (23)
    Accounts payable, accrued liabilities and
     accrued warranty............................     (514)      277     2,041
    Accrued compensation.........................     (810)      309     1,349
    Accrued clinical costs.......................     (117)     (128)      406
    Deferred revenue.............................     (860)      431       681
                                                  --------  --------  --------
      Net cash used in operating activities......  (13,198)  (11,695)  (12,438)
Cash flows used in investing activities
  Purchase of short-term investments.............      --     (4,972)      --
  Maturity of short-term investments.............    4,972       --        --
  Capital expenditures...........................   (1,635)     (776)     (752)
                                                  --------  --------  --------
      Net cash provided by (used in) investing
       activities................................    3,337    (5,748)     (752)
Cash flows provided by financing activities
  Net proceeds from issuance of common stock.....      369       340       325
  Repurchase of common stock.....................      --       (289)      --
                                                  --------  --------  --------
      Net cash provided by financing activities..      369        51       325
                                                  --------  --------  --------
Net decrease in cash and cash equivalents........   (9,492)  (17,392)  (12,865)
Cash and cash equivalents at beginning of
 period..........................................   14,888    32,280    45,145
                                                  --------  --------  --------
Cash and cash equivalents at end of period....... $  5,396  $ 14,888  $ 32,280
                                                  ========  ========  ========
</TABLE>

                            See accompanying notes.

                                       37
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

 Organization, Ownership and Business

   Somnus was incorporated in Delaware on January 19, 1996. The Company
designs, develops, manufactures and markets medical devices that utilize
proprietary radiofrequency technology for the management and treatment of
upper airway disorders. The Company's Somnoplasty System is intended to offer
minimally-invasive, curative treatment alternatives for disorders of the upper
airway, including habitual snoring, obstructive sleep apnea syndrome, chronic
turbinate hypertrophy, and coagulation of tissue in the head and neck which
may include tonsils.

 Going concern and liquidity

   The financial statements have been prepared on a going concern basis. The
Company has incurred cumulative operating losses of $59 million, including a
net loss of $10.7 million for the year ending December 31, 2000. In addition,
the Company's cash, cash equivalents, and short-term investments decreased
from $19.9 million at December 31, 1999 to $5.4 million at December 31, 2000.
These conditions raise substantial doubt about the Company's ability to
continue as a going concern.

   Somnus expects within the next three months that it will raise additional
funds through the issuance of equity or debt securities in the public or
private markets in order to continue operations, or sell the company. To this
end, the Company has engaged ING Barings to act as its exclusive financial
advisor to provide it with investment banking services and financial advice on
strategic opportunities, including raising capital through the sale of stock
to the public or to private investors, as well a possible sale of the company.
Additional financing and merger opportunities may not be available, or if
available, may not be on favorable terms. The availability of financing or
merger opportunities will depend, in part, on market conditions, which have
been depressed as of late. If Somnus cannot raise sufficient new capital, the
Company may be unable to successfully promote or produce products, continue
supplying its services, or pay its employees, any of which could seriously
harm its business. Any future equity financing would result in substantial
dilution to the Company's stockholders. If Somnus raises additional funds by
issuing debt, it may be subject to limitations on its operations, through debt
covenants or other restrictions.

 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, Somnus Medical Technologies, B.V., and Somnus France,
SARL 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

   Somnus recognizes 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 product
shipments to our international distributors made under agreements that do not
provide for right of return or price protection, revenue is recognized upon
shipment to the final customer. Allowances for product returns are provided at
the time of revenue recognition.

 Dependence on Single-Source Suppliers

   During 2000, the Company transitioned the production of the control unit to
a subcontractor. The subcontractor is a single source supplier. Certain
components continue to be purchased from single-source

                                      38
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

suppliers. Establishing additional or replacement suppliers for such control
unit or certain of the components used in our products, if required, may 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 its ability to
manufacture and sell its products and would have a material adverse effect on
its business, financial condition and results of operations.

 Net Loss Per Share

   Basic and diluted net loss per share has been calculated using the weighted
average common shares outstanding during the periods presented. We have
securities outstanding that could dilute 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 and warrants, see Note 7.

 Stock Based Compensation

   The Company grants stock options for a fixed number of shares to employees
with an exercise price equal to the fair value of the shares at the date of
grant. The Company accounts for stock option grants in accordance with APB
Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related
Interpretations because the Company believes the alternative fair value
accounting provided for under FASB Statement No. 123, Accounting for Stock-
Based Compensation, (FAS 123) requires the use of option valuation models that
were not developed for use in valuing employee stock options. Under APB 25,
because the exercise price of the Company's employee stock options equals the
market price of the underlying stock on the date of grant, no compensation
expense is recognized.

 Accounting Estimates

   The preparation of financial statements in conformity with accounting
principles generally accepted in the United States 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 at standard cost
which approximates first-in, first-out (fifo) cost, or 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.

   Somnus periodically evaluates 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.

                                      39
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Cash Equivalents and Short-term Investments

   Somnus classifies investments as cash equivalents if the maturity of an
investment is three months or less from the purchase date. Cash equivalents
and short-term investments are stated at cost, which approximates market
value.

 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.

 Advertising Expenses

   The Company expenses the costs of advertising as incurred. For the years
ended December 31, 2000, 1999, and 1998 advertising expenses were $252,000,
$865,000, and $129,000, respectively.

 Segment Information

   Somnus has organized the business in one operating segment which includes
activities relating to development, manufacturing and marketing of medical
devices that utilize proprietary temperature controlled radiofrequency
technology for the management and treatment of upper airway disorders.
Substantially all of the Company's assets are in the United States and through
December 31, 2000, the Company has derived its revenue primarily from its
operations in the United States.

 New Accounting Standards

   In June 1998, the Financial Accounting Standards Board issued Statement No.
133, "Accounting for Derivative Instruments and Hedging Activities," which is
required to be adopted in years beginning June 15, 2000. Because of the
Company's minimal use of derivatives, management does not anticipate that the
adoption of the new Statement will have a significant effect on earnings or
the financial position of the Company.

2. Financial Instruments

   The following is a table of available-for-sale securities (in thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                             ------------------
                                                              2000      1999
                                                             -------  ---------
   <S>                                                       <C>      <C>
   Money market funds....................................... $ 5,396  $   4,694
   Certificates of deposit..................................     --       2,988
   Commercial paper.........................................     --      11,910
                                                             -------  ---------
                                                               5,396     19,592
   Amounts classified as cash equivalents...................  (5,396)  (14,620)
                                                             -------  ---------
   Short-term investments................................... $   --   $   4,972
                                                             =======  =========
</TABLE>

   Available for sale securities are recorded at amortized cost, which
approximates market value.

                                      40
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


3. Property and Equipment

   Property and equipment consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                2000     1999
                                                               -------  -------
   <S>                                                         <C>      <C>
   Machinery and equipment...................................  $ 2,132  $ 1,239
   Computer equipment........................................    1,189    1,140
   Furniture and fixtures....................................    1,007      628
   Leasehold improvements....................................      310      134
   Purchased software........................................      440      404
                                                               -------  -------
                                                                 5,078    3,545
   Less accumulated depreciation and amortization............   (2,719)  (1,942)
                                                               -------  -------
   Property and equipment, net...............................  $ 2,359  $ 1,603
                                                               =======  =======
</TABLE>

4. Inventories

   Inventories consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                                   December 31,
                                                                   -------------
                                                                    2000   1999
                                                                   ------ ------
   <S>                                                             <C>    <C>
   Raw materials.................................................. $1,204 $  406
   Work-in-process................................................    290    214
   Finished goods.................................................    572    561
                                                                   ------ ------
                                                                   $2,066 $1,181
                                                                   ====== ======
</TABLE>

5. Commitments

   We lease two facilities in Sunnyvale, California under operating lease
agreements which expire on March 31, 2002, and February 28, 2002, respectively.

   Future payments under non-cancelable operating lease arrangements at
December 31, 2000 are as follows:

<TABLE>
<CAPTION>
                                                          Gross   Lease
                                                          Lease  Sublease  Net
                                                          Amount Proceeds Amount
                                                          ------ -------- ------
   <S>                                                    <C>    <C>      <C>
   Years ending December 31 (in thousands):
   2001.................................................. $  837  $(209)   $628
   2002 .................................................    177  $( 18)   $159
                                                          ------  ------   ----
     Total minimum payments.............................. $1,014  $(227)   $787
                                                          ======  ======   ====
</TABLE>

   Rent expense for the years ended December 31, 2000, 1999, and 1998 was
approximately $686,000, $499,000, and $417,000, respectively.

   The Company has non-cancelable purchase order commitments totaling
$1,387,575 at December 31, 2000, relating both to the purchase of component
parts required to manufacture disposable handpieces and completed control
units.


                                       41
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

6. Related Party Transactions

   During 1998, we issued 5,000 warrants in connection with a previous
financing in exchange for services provided by an entity associated with a
member of the board of directors. The warrants have a five-year term at an
exercise price of $3.00 per share. The fair value of these warrants is not
material to these financial statements.

   In December 1998, we granted a non-exclusive, worldwide right and license
to a company affiliated with a stockholder and certain members of the board of
directors to manufacture, use and sell RF control units based on 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 shares of Series A
Preferred Stock of that Company. We also received a technology license fee
payable in two installments in December 1998 and in February 1999.
Documentation fees for design and manufacturing were received in 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. No
kits had been purchased as of December 31, 1998. During 1999, sales of kits to
this related party of $445,000 were included in total revenues. Somnus shall
receive a royalty on all RF control units using this technology, sold by the
licensee.

   The Company's former Chairman of the Board received a consulting fee of
$83,000 during 2000 and $100,000 during 1999.

7. Stockholders' Equity

 Preferred Stock

   In November 1998, Somnus announced the adoption of a Preferred Shares
Purchase Agreement (the "agreement"). Pursuant to the agreement, there is a
dividend distribution of one Preferred Share Purchase Right (the "Right" and
collectively the "Rights") on each outstanding share of the Company's common
stock. Each right entitles stockholders to buy one one-thousandth of a share
of Preferred Stock at an exercise price of $18.00. The Rights 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, the Company is 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.

 Warrants

   In connection with equipment term loans in 1996, the Company issued
warrants to purchase 37,500 shares at $1.00 per share and 25,000 shares at
$3.00 per share. 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. All
originally issued warrants were outstanding at December 31, 2000, 1999 and
1998.

 Common Stock

   At December 31, 2000 Somnus has reserved approximately 4,637,914 shares of
common stock for future issuance under all stock option plans, stock purchase
plans, and outstanding warrants.

   In October 1998, the Company announced that its board of directors had
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

                                      42
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

open market. During 1998 and 2000, no shares had been repurchased by Somnus.
During 1999, Somnus repurchased 100,000 shares for $289,000.

 1996 Stock Plan

   Under the Company's 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 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,
and the remaining shares continue to vest 1/48 monthly over the remaining
period. The term of the option is ten years. As of December 31, 2000, a total
of 3,806,504 shares of common stock have been reserved for issuance under the
Plan with 303,822 available for grant.

 1997 Director Option Plan

   In August 1997, the Company's Board of Directors (the "Board") adopted the
1997 Director Option Plan ("Director Option Plan"). A total of 435,000 shares
of common stock have been reserved for issuance under the Director Option Plan
which provides for the grant of nonstatutory options to non-employee directors
of the Company with 305,000 shares available for grant.

 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
enrollment 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. A total of 328,910 shares have
been reserved for issuance under this plan with 47,049 shares available for
purchase. The Company does not recognize compensation cost related to employee
purchase rights under the Purchase Plan.

                                      43
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table summarizes stock option activity (shares in thousands):

<TABLE>
<CAPTION>
                                                   Outstanding Stock Options
                                                 ------------------------------
                                                           Weighted   Weighted
                                                            Average   Average
                                                           Exercise     Fair
                                        Shares   Number of   Price     Value
                                       Available  Shares   Per Share Grant Date
                                       --------- --------- --------- ----------
<S>                                    <C>       <C>       <C>       <C>
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     $3.25
  Options exercised...................     --       (479)    $0.42
  Options canceled....................     893      (893)    $6.22
                                        ------     -----     -----
Balance at December 31, 1998..........   1,378     2,612     $2.70
  Additional shares authorized for
   issuance...........................     937       --
  Options granted.....................  (2,015)    2,015     $2.37     $ .85
  Options exercised...................     --       (410)    $0.26
  Options canceled....................     796      (796)    $2.69
                                        ------     -----     -----
Balance at December 31, 1999..........   1,096     3,421     $2.80
                                        ======     =====     =====
  Options granted.....................  (1,115)    1,115     $2.02     $ .75
  Options exercised...................     --       (275)    $ .93
  Options canceled....................     628      (628)    $2.78
                                        ======     =====     =====
Balance at December 31, 2000..........     609     3,633     $2.71
                                        ======     =====     =====
</TABLE>

   The following table summarizes information about options outstanding at
December 31, 2000 (shares in thousands):

<TABLE>
<CAPTION>
                               Options Outstanding                       Exercisable Options
                             ------------------------ Weighted Average ------------------------
                                          Weighted       Remaining                  Weighted
                             Number of    Average     Contractual Life Number of    Average
   Range of Exercise Price    Shares   Exercise Price    (in Years)     Shares   Exercise Price
   -----------------------   --------- -------------- ---------------- --------- --------------
   <S>                       <C>       <C>            <C>              <C>       <C>
   $ .30--1.97.............      970       $1.11            9.30           146       $1.07
    2.00--3.25.............    1,877        2.66            7.48           858        2.79
    3.38--3.75.............      446        3.51            7.82           244        3.46
    4.13--10.00............      340        6.43            7.53           200        7.31
                               -----                                     -----
   $ .30--10.75............    3,633       $2.71            8.01         1,448       $3.36
                               =====                                     =====
</TABLE>

   On September 18, 1998, Somnus 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 terminated
employment with Somnus prior to September 18, 1999, all vested shares at the
date of termination relating to re-priced stock options would be canceled and
forfeited.

                                      44
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Pro Forma Disclosures

   The Company elected to follow APB No. 25, "Accounting for Stock Issued to
Employees" and related interpretations, in accounting for its 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 its 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
the Company accounted for its employee stock options granted subsequent to
December 31, 1995 under the fair value method of this statement.

   The fair value of options granted in 2000, 1999 and 1998 were estimated at
the date of grant using the minimum value method, assuming no dividends, an
expected life of four years, volatility of 1.55 for 2000, 1.12 for 1999, .70
for 1998, and a risk free interest rate of 6.0% for 2000, and for 1999, and
5.2% for 1998.

   Had compensation cost for the Company's 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, the Company's 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>
                                                  Year Ended December 31,
                                                 ----------------------------
                                                   2000      1999      1998
                                                 --------  --------  --------
   <S>                                           <C>       <C>       <C>
   Pro forma net loss........................... $(11,865) $(15,065) $(21,818)
   Pro forma basic and diluted net loss per
    share....................................... $   (.82) $  (1.06) $  (1.60)
</TABLE>

   Because SFAS No. 123 is applicable only to options granted subsequent to
December 31, 1994, the Company's 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.

 Stock Compensation

   During the fiscal year ended December 31, 1998, Somnus 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. Deferred compensation recorded is amortized over the period
that the options vest and is adjusted for options which have been canceled.
There were no significant grants of stock options to consultants in 1999 or
2000. Deferred compensation expense was $69,000, $261,000, and $2,811,000
respectively, during 2000, 1999, and 1998.

8. Employee Benefit Plan

   The Company has a 401(k) Plan which stipulates that all full-time employees
can elect to contribute to the 401(k) Plan, beginning on the first of the
month following the start of their employment. Participants may contribute up
to 15% of salary on a pretax basis subject to certain limitations. The Company
has the option to provide matching contributions but has not done so to date.


                                      45
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

9. Income Taxes

   As of December 31, 2000, the Company had federal and state net operating
loss carryforwards of approximately $50,700,000 and $22,900,000, respectively.
The Company also had $900,000 of federal and $500,000 of California research
and development tax credit carryforwards. The federal net operating loss and
credit carryforwards will expire at various dates beginning in the year 2011
through 2019, if not utilized. The state of California net operating losses
will expire at various dates beginning in 2001 through 2004, if not utilized.

   Utilization of the Company's 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 the Company's deferred
tax assets and liabilities for federal and state income taxes are as follows
(in thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                             ------------------
                                                               2000      2001
                                                             --------  --------
   <S>                                                       <C>       <C>
   Deferred Tax Assets:
     Net operating loss carry forwards...................... $ 18,600  $ 14,900
     Research and other credits.............................    1,400     1,100
     Capitalized research expenses..........................      500     1,200
     Other..................................................    1,600     1,200
                                                             --------  --------
   Total Deferred Tax Assets................................ $ 22,100  $ 18,400
   Valuation Allowance......................................  (22,100)  (18,400)
                                                             --------  --------
   Net Deferred Taxes....................................... $    --   $    --
                                                             ========  ========
</TABLE>

   Because of the Company's lack of earnings history, the deferred tax assets
have been fully offset by a valuation allowance. The valuation allowance
increased by $3,700,000, $5,800,000, and $6,800,000 during the years ended
December 31, 2000, 1999, and 1998.

10. Subsequent Events (Unaudited)

   In January, 2001, the Company announced a restructuring plan that is
currently being implemented. The plan is designed to reduce operating expenses
by $4,000,000 in fiscal year 2001 and will result in a headcount reduction of
approximately 10 percent of its employees. The plan encompasses the
operational components of sales and marketing, manufacturing, certain ongoing
clinical programs, and research and development. A restructuring charge for
these items is estimated to be between $500,000 to $600,000 and will be
recorded in the first quarter of 2001. Subsequent to estimating the
restructuring charge in January 2001, we increased our estimate by $300,000 to
$400,000 related to a facilities consolidation, including rent, and the write
off of leasehold improvements necessitated by the recent softening of the
local real estate market and resultant uncertainty as to the Company's ability
to sublease the facility subsequent to executing the restructuring plan. This
will result in a total expected restructuring charge to be recorded in the
first quarter of 2001 of between $800,000 to $1,000,000.

   In March 2001, we entered in an agreement with a third party original
equipment manufacturer for the production of our S1 control unit. This
agreement provides for minimum purchase commitments of $122,500. In

                                      46
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

connection with their agreement, we issued a standby letter of credit of
$50,000 in favor of the third party original equipment manufacturer.

11. Summarized Quarterly Data (Unaudited)

   The following table sets forth certain consolidated statement of operations
data for each of the eight quarters beginning with the quarter ended March 31,
1999 through the quarter ended December 31, 2000. This quarterly information
is unaudited, but has been prepared on the same basis as the annual
consolidated financial statements and, in the opinion of management, reflects
all adjustments, consisting only of normal recurring adjustments necessary for
a fair representation of the information for the periods presented.

<TABLE>
<CAPTION>
                                                            Three Months Ended
                         -------------------------------------------------------------------------------------------
                                    June                                          June
                         March 31,   30,    September 30, December 31, March 31,   30,    September 30, December 31,
                           1999     1999        1999          1999       2000     2000        2000          2000
                         --------- -------  ------------- ------------ --------- -------  ------------- ------------
<S>                      <C>       <C>      <C>           <C>          <C>       <C>      <C>           <C>
Statement of Operations
 Data:
Net revenue.............  $ 2,342  $ 2,967     $ 3,175      $ 3,181     $ 3,201  $ 3,003     $ 2,937      $ 2,921
Gross margin............      836    1,301       1,634        1,426       1,322    1,200       1,525        1,639
Loss from operations....   (4,671)  (3,774)     (3,087)      (3,097)     (3,075)  (3,226)     (2,876)      (2,270)
Net loss................  $(4,139) $(3,444)    $(2,788)     $(2,787)    $(2,810) $(3,037)    $(2,713)     $(2,147)
Net loss per share,
 basic and diluted......  $ (0.29) $ (0.24)    $ (0.19)     $ (0.19)    $ (0.19) $ (0.21)    $ (0.19)     $ (0.15)
Weighted-average shares
 us in computing loss
 per share, basic and
 diluted................   14,077   14,211      14,324       14,357      14,420   14,522      14,589       14,706
</TABLE>

                                      47
<PAGE>

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

   Not applicable.

                                   PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   The 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......  52 Chief Executive Officer and President

 Robert D. McCulloch..  39 Vice President Finance, Chief Financial Office and
                            Chief Information Officer (Principal Financial and
                            Accounting Officer)

 Robert D. Campbell...  46 Vice President, Sales and Marketing

 Edward H. Luttich....  45 Vice President, Research and Development

 Kathryn A. Grenier...  45 Vice President, Clinical and Regulatory Affairs

 Brad L. Steadman.....  44 Vice President, Manufacturing

 Dominic Vogt.........  39 Vice President, International Sales
</TABLE>
--------

   John G. Schulte has served as our President, Chief Executive Office and
Director since January 1999. From 1997 through 1998, Mr. Schulte was
President, Surgical Products Division of Genzyme Corporation. From 1996 to
1997, he was Senior Vice President and General Manager at 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.

   Robert D. McCulloch joined us in October 1997 as Corporate Controller and
was promoted to Vice President of Finance and CFO in August 1998 and appointed
CIO in July 1999. From 1996 to 1997, Mr. McCulloch was Director of Accounting
and Finance at Target Therapeutics, Inc. where he played an integral role in
the growth of the company's revenues to more than $100 million, and was a key
member of the team that effected the $1.1 billion acquisition of Target by
Boston Scientific Corp. From 1991 to 1995, he served as General Accounting
Manager/Business Process Manager at Anthem Electronics, Inc., and also spent
more than eight years in public accounting with PricewaterhouseCoopers LLP.
Mr. McCulloch is a Chartered Accountant, a Certified Public Accountant and a
member of the Institute of Cost and Management Accountants. He holds a
Bachelor of Commerce degree from Rhodes University in South Africa.

   Robert D. Campbell has served as our Vice President of Sales and Marketing
since January 1999. From July 1998 to December 1998, Mr. Campbell served as
our Vice President of Sales. From August 1997 to June 1998, Mr. Campbell was
our Western Regional Sales Manager, Director of Sales and VP of North American
Sales. From July 1995 to August 1997, Mr. Campbell was a sales representative
with Karl Storz Endoscopy Inc. From June 1994 to July 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.

                                      48
<PAGE>

   Edward H. Luttich has served as our Vice President of Research and
Development since November 1999. Mr. Luttich comes to us after eight years at
Medtronic PS Medical, a manufacturer of implantable medical devices for
neurosurgery. Mr. Luttich held a series of technical and operations management
positions with Medtronic PS Medical. He served as Director of Operations from
December 1998 to November 1999, Director of Research, Development and
Engineering from August 1996 to December 1998, and as Directory of Engineering
from September 1991 to August 1996. Prior to its acquisition by Medtronic, he
was instrumental in the development and evolution of PS Medical's technical
and operations organizations. Under his leadership, the organization developed
and brought to market revolutionary processes to surface treat silicone
products, state of the art implanted application systems for spinal opiates
and market leading valve systems for treatment of hydrocephalus. He has a B.S.
in Mechanical Engineering from the University of Pennsylvania with advanced
course work at Wharton and Pepperdine Universities.

   Kathryn A. Grenier has served as our Vice President of Clinical Affairs
since April 2000 and recently assumed responsibilities for Regulatory Affairs.
From October 1997 to March 2000, Ms. Grenier served as Director of Clinical
and PreClinical Affairs. From 1996 to 1997 Ms. Grenier served as Director of
Clinical Research at Clinical pathways, a Clinical Research Organization
company that supports medical device and diagnostic start-up companies with
the initial clinical development phases. From 1989 to 1996, Ms. Grenier held a
number of clinical management and technical positions with Becton Dickinson
Immunocytometery Systems. From 1986 to 1989, Ms. Grenier was at the University
of Arizona, Cancer Center and worked in the area of cell biology research and
development. From 1983 to 1986, Ms Grenier was at the University of Utah,
Department of Pathology, Hematopathology. She has a B.S. in Medical
Technology, certificate in Business Management both from the University of
Utah.

   Brad L. Steadman has served as our Vice President of Manufacturing since
September 1999. Mr. Steadman has 20 years experience in the medical industry,
and was most recently Director of Operations in the plastics division at
Boston Scientific-Target from January 1997 to September 1999, where he was
responsible for manufacturing, production control, manufacturing engineering
and quality control. Also at Boston Scientific-Target, he served as Director
of Extrusion from April 1996 to January 1997. Prior to Target, he served as
General Manager with Quintex Corporation from January to August 1995. He has a
B.S. from the University of Arizona in Nuclear Engineering and a certificate
in Biomedical Engineering from the University of California at Irvine.

   Dominic Vogt has served as our Vice President of International Sales since
March 2001. From September 1999 to March 2001, Mr. Vogt was our Director of
International Sales & Marketing, Rest of the World. From May 1998 to August
1999, Mr. Vogt was Senior Marketing Manager Aneurysm Therapy at Boston
Scientific-Target. Also at Boston Scientific-Target, he served as
International Marketing Manager for Emerging Markets. Prior to the acquisition
of Target Therapeutics Inc. by Boston Scientific, he spent 4 years in Europe
as European Sales and Marketing Manager. Mr. Vogt has 13 years of experience
in the medical device industry. Mr. Vogt has an MBA in International
Management from the University of Dallas, Texas and a BBA in Finance from
Ecole des Cadres in Paris, France.

 Employment and Change of Control Agreements

   We have offer letters with each of our named executive officers as defined
in the Executive Compensation table in Item 11; Brad Steadman, our Vice
President of Manufacturing; Kathryn Grenier, our Vice President of Clinical
and Regulatory Affairs; and Dominic Vogt, our Vice President of International
Sales. The offer letters set forth each officer's:

  . Position and title

  . Salary and other compensation,

  . Health benefits,

  . Option grant and vesting schedule, and

  . Obligation to abide by confidentially provisions.

                                      49
<PAGE>

   Additionally, each offer letter states that employment with us is at-will
and may be terminated by either party at any time with or without notice or
cause.

   We also have change of control agreements with all of the above officers
except Mr. Vogt. Those agreements each provide for severance payments and
acceleration of option vesting in the event of a termination other than for
cause within 12 months of an acquisition, merger, or sale of a majority of the
our assets. If these two events occur each of these officers receive a
severance payment equal to 12 months salary plus projected bonus and an
additional payment equal to the prior year's bonus. In addition, upon the
occurrence of such events, each officer's outstanding stock options will fully
and immediately vest. We have an employment arrangement with Mr. McCulloch
that provides for this severance payment and vesting in the event of his
termination. In the event of an acquisition, merger or sale of a majority of
the our assets not followed by termination, Messrs. Steadman and Campbell and
Ms. Grenier will receive full and immediate vesting on 50% of their
outstanding stock options and Messrs. Schulte and McCulloch will receive full
and immediate vesting of 100% of their outstanding stock options.

Compliance with Section 16(a) Filing Requirements

   Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), requires our directors, officers and beneficial owners of
more than 10% of our Common Stock to file reports of ownership and reports of
changes in ownership with the Securities and Exchange Commission (the "SEC").
Such persons are required by SEC regulations to furnish us with copies of all
Section 16(a) forms they file.

   Based solely on its review of the copies of such reports received by it, or
written representations from reporting persons, we believe that during the
fiscal year ended December 31, 2000 (the "Last Fiscal Year"), Abhi Acharya,
David B Musket, Woodrow A. Meyers, Gary R. Bang and Stuart D. Edwards, our
directors, each failed to timely file one Form 5.

                                      50
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

   Summary Compensation Table. The following table sets forth information for
the years ended December 31, 2000, 1999 and 1998 regarding the compensation of
our Chief Executive Officer and each of our four other most highly compensated
executive officers whose total annual salary and bonus for such fiscal years
were in excess of $100,000 (our "Named Executive Officers"). The amounts
listed under the column captioned "All Other Compensation" represent car
allowances unless otherwise noted.

<TABLE>
<CAPTION>
                                   Annual
                                Compensation                Long-term Awards
                               --------------            -------------------------
                                                         Securities
                                                         Underlying    All Other
 Name and Principal Position   Year  Salary       Bonus   Options     Compensation
 ---------------------------   ---- ---------    ------- ----------   ------------
 <S>                           <C>  <C>          <C>     <C>          <C>
 John G. Schulte.............  2000 $ 264,365    $41,828   25,000       $64,141(1)
  President, Chief Executive   1999   250,000     57,700  510,000        99,594(2)
  Officer and Director

 Robert D. McCulloch.........  2000   174,481        --    75,000
  Vice President, Finance and  1999   161,308     33,322   20,000
  Chief Financial Officer      1998   128,069      8,410  132,000

 Robert D. Campbell..........  2000   173,943        --    10,000         7,200
  Vice President, Sales and                                40,000
  Marketing                    1999   150,000     30,293   20,000         7,200
                               1998   111,731      1,327   85,000        77,195(3)
                                                           25,000(4)


 Steven J. Ojala.............  2000   185,000(6)     --    20,000        18,000(5)
  Former Vice President,       1999    42,942             100,000
  Clinical, Regulatory, and
  Quality

 Edward H. Luttich...........  2000   160,423        --    40,000        38,654(7)
  Vice President, Research     1999    14,577(8)          100,000
  and Development
</TABLE>
--------
(1) Consists of $6,000 in car allowance and $58,141 in temporary housing
    reimbursement.
(2) Consists of $6,000 car allowance, $26,617 in moving expenses, and $66,977
    in temporary housing reimbursement.
(3) Consists of $6,925 in car allowance and $70,270 in commissions.
(4) In March 1998, Mr. Campbell received an option to purchase 25,000 shares
    of the Company's Common Stock, which was repriced from $9.25 to $3.375 in
    August 1998.
(5) Consists of $18,000 in housing allowance.
(6) Mr. Ojala joined the Company in October 1999 at an annual salary of
    $185,000.
(7) Consists of relocation expenses of $38,654.
(8) Mr. Luttich joined the Company in December 1999 at an annual salary of
    $160,000.

                                      51
<PAGE>

   Option Grants in Last Fiscal Year. The following table sets forth each
grant of stock options made during the fiscal year ended December 31, 2000 to
each of our Named Executive Officers:

                         Option Grants in Fiscal 2000

<TABLE>
<CAPTION>
                                                                  Potential Realizable Value
                                                                          at Assumed
                                     % of Total                     Annual Rates of Stock
                         Number of    Options                       Price Appreciation for
                         Securities  Granted to Exercise                    Option
                         Underlying  Employees   Price                     Term(2)
                          Options    in Fiscal    Per    Expiration ---------------------------
          Name            Granted       Year    Share(1)    Date         5%            10%
          ----           ----------  ---------- -------- ---------- ------------- -------------
<S>                      <C>         <C>        <C>      <C>        <C>           <C>
John G. Schulte.........   25,000(3)    2.20%    0.875    12/7/10          13,757        34,863

Robert D. McCulloch.....   25,000(3)    2.20%    0.875    12/7/10          13,757        34,863
                           50,000(4)    4.40%    0.875    12/7/10          27,514        69,726

Robert D. Campbell......   10,000(3)    0.90%    4.531    3/30/10          28,495        72,212
                           20,000(3)    1.80%    0.875    12/7/10          11,006        27,891
                           20,000(4)    1.80%    0.875    12/7/10          11,006        28,891

Steve J. Ojala..........   20,000(3)    1.85%    0.875    12/7/10          11,006        27,890

Edward H. Luttich.......   20,000(3)    1.80%    0.875    12/7/10          11,006        27,891
                           20,000(4)    1.80%    0.875    12/7/10          11,006        27,891
</TABLE>
--------
(1) The exercise price per share of each option was, unless repriced, equal to
    the closing price of the Common Stock at close of market on the date of
    grant.
(2) The potential realization value is calculated based on the ten-year term
    of the option at its time of grant. It is calculated assuming that the
    fair market value of our Common Stock on the date of the grant appreciates
    at the annual rate shown, compounded annually, from the date of grant
    until the expiration of the ten year option term. These numbers are
    calculated based on the requirements promulgated by the SEC and do not
    reflect the our estimate of future stock growth.
(3) Options were granted under the Stock Plan and vest over 48 months from the
    date of grant with 25% of the shares vesting after one year and 1/48 of
    the shares continuing to vest at the end of each full calendar month
    thereafter.
(4) Options were granted under the Stock Plan and vest over 24 months from
    date of grant with 25% of the shares vesting at the end of each full six
    calendar months.

   Option Exercises in Last Fiscal Year and Fiscal Year End Option Values. The
following table sets forth the information with respect to stock option
exercises during the year ended December 31, 2000, by our Named Executive
Officers, and the number and value of securities underlying unexercised
options held by our Named Executive Officers at December 31, 2000. The fair
market value of our Common Stock at the close of business on December 31,
2000, was $0.3750 per share.

     Aggregate Option Exercises in Fiscal 2000 and Year-End Option Values

<TABLE>
<CAPTION>
                                                   Number of
                                             Securities Underlying     Value of Unexercised
                          Shares              Unexercised Options     In-the-Money Options At
                         Acquired            At December 31, 2000        December 31, 2000
                           Upon    Value   ------------------------- -------------------------
          Name           Exercise Realized Exercisable Unexercisable Exercisable Unexercisable
          ----           -------- -------- ----------- ------------- ----------- -------------
<S>                      <C>      <C>      <C>         <C>           <C>         <C>
John G. Schulte.........    --     $  --     267,304      352,356       $ --         $ --
Robert D. McCulloch.....  4,083     5,252    129,834      153,083         --           --
Robert D. Campbell......    --        --      89,063      105,937         --           --
Steven J. Ojala.........    --        --      29,167       90,833         --           --
Edward H. Luttich.......    --        --      27,083      112,917         --           --
</TABLE>


                                      52
<PAGE>

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Security Ownership of Certain Beneficial Owners and Management

   The following table sets forth the beneficial ownership of the our Common
Stock as of March 13, 2001, by (i) each person or entity who is known by us to
own beneficially more than 5% of our outstanding shares of Common Stock, (ii)
each of our directors, (iii) each of our Named Executive Officers and (iv) all
of our directors and executive officers as a group. Beneficial ownership is
determined in accordance with the rules of the Securities and Exchange
Commission. In computing the number of shares beneficially owned by a person
or warrants held by that person that are currently exercisable or exercisable
within 60 days of March 13, 2001 are deemed outstanding. Percentage of
beneficial ownership is based on 14,805,516 shares of Common Stock outstanding
as of March 13, 2001. Except as otherwise noted, the stockholders named in the
table have sole voting and investment power with respect to all shares of
Common Stock shown as beneficially owned by them, subject to applicable
community property laws. The address of each person in this table, unless
otherwise noted, is as follows: c/o Somnus Medical Technologies, Inc., 285 N.
Wolfe Road, Sunnyvale, California 94086.

<TABLE>
<CAPTION>
                                                                          Shares    Approximate
                                                                       Beneficially   Percent
            Name of Beneficial Owner                                      Owned        Owned
            ------------------------                                   ------------ -----------
<S>                                                                    <C>          <C>
Medtronic Asset Management, Inc......................................
 Attn: Michael Ellwein
 7000 Central Avenue NE
 Minneapolis, MN 55432-3576                                             1,190,286       8.0%

The Travelers Insurance Group, Inc...................................
 Attn: Don Scudder
 One Tower Square
 Hartford, CT 06183                                                     1,000,000       6.8%

Larry N. Feinberg....................................................
 c/o Oracle Investment Management, Inc.
 712 Fifth Avenue
 45th Floor
 New York, NY 10019                                                       975,634       6.6%

HBP Associates LP....................................................
 Attn: Howard P. Berkowitz
 888 Seventh Avenue
 New York, NY 10106                                                       778,667       5.3%

Stuart D. Edwards....................................................     650,000       4.4%
John G. Schulte......................................................     344,082       2.3%
David B. Musket......................................................     249,559       1.7%
Robert D. McCulloch..................................................     173,672       1.2%
Robert D. Campbell...................................................     113,276         *
Edward H. Luttich(9).................................................      55,000         *
Woodrow A. Myers, Jr., M.D...........................................      33,459         *
Abhi Acharya.........................................................      21,250         *
Steven J. Ojala......................................................      17,523         *
Mark B. Logan........................................................      10,625         *
All directors and executive officers as a group (13 persons).........   1,814,359      12.3%
</TABLE>
--------
* Less than 1%


                                      53
<PAGE>

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   On August 25, 1998, the Company's Board of Directors approved an amendment
to reprice options outstanding under the Stock Plan with exercise prices over
$7.50 per share. Holders of such options were offered the choice of retaining
their existing options without amendment or accepting the amendment of their
stock options. The exercise price of the amended options is $3.375 per share,
which equals the fair market value of the Company's Common Stock on September
18, 1998. The principal features (including the number of shares, vesting and
expiration date) of the repriced options were not affected.

   The Company has employment and change of control agreements with certain of
its officers. See "Employment and Change of Control Agreements."

                                      54
<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, 2000 and 1999.

  Consolidated Statements of Operations, for the years ended December 31,
  2000, 1999, and 1998.

  Consolidated Statement of Stockholders' Equity, for the years ended
  December 31, 2000, 1999, and 1998.

  Consolidated Statements of Cash Flows, for the years ended December 31,
  2000, 1999, and 1998.

  Notes to Consolidated Financial Statements

   2. Financial Statement Schedules

   The financial statement schedule entitled "Valuation and Qualifying
Accounts" is included at page 58 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 did not file any reports on Form 8K during the three months ended
December 31, 2000.

                                      55
<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.

 10.7(1)    1997 Employee Stock Purchase Plan.

 10.8(1)    1997 Director Option Plan.

 10.9(4)    Employment Letter Agreement dated July 15, 1998 between the
            Registrant and Robert D. McCulloch.

 10.10(4)   Employment Letter Agreement dated October 20, 1998 between the
            Registrant and John G. Schulte.

 10.12* (4) Patent License Agreement dated January 30, 1998 between the
            Registrant and Medtronic, Inc.

 10.17(4)   Employment Letter Agreement dated September 7, 1999 between the
            Registrant and Brad L. Steadman.

 10.19(4)   Employment Letter Agreement dated September 27, 1999 between the
            Registrant and Edward Luttich

 10.20(4)   Lease dated January 3, 2000 between the Registrant and American
            Advantech Corporation.

 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 58)
</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.
(2) Filed as an Exhibit to Somnus Form 10Q for the quarterly period ended March
    31, 1999 (File No. 000-23275)
(3) Filed as an Exhibit to Somnus Form 10Q for the quarterly period ended June
    30, 1999 (File No. 000-23275)
(4) Filed on an Exhibit to Somnus For 10-K for the year ended December 31, 1999
    (File No. 000-23275)

                                       56
<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

                               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.

<TABLE>
<CAPTION>
              Signature                          Title                   Date
              ---------                          -----                   ----

<S>                                    <C>                        <C>
       /s/  John G. Schulte            President, Chief Executive   March 29, 2001
______________________________________  Officer and Director
           John G. Schulte

     /s/ Robert D. McCulloch           VP Finance, Chief            March 29, 2001
______________________________________  Financial Officer and
         Robert D. McCulloch            Chief Information Officer
                                        (Principal Financial and
                                        Accounting Officer)

         /s/ Abhi Acharya              Director                     March 29, 2001
______________________________________
             Abhi Acharya

      /s/ Stuart D. Edwards            Director                     March 29, 2001
______________________________________
          Stuart D. Edwards

       /s/ David B. Musket             Director                     March 29, 2001
______________________________________
           David B. Musket

    /s/ Woodrow A. Myers, Jr.          Director                     March 29, 2001
______________________________________
        Woodrow A. Myers, Jr.

        /s/ Mark B. Logan              Director                     March 29, 2001
______________________________________
            Mark B. Logan
</TABLE>

                                      57
<PAGE>

                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
                                 (In thousands)

<TABLE>
<CAPTION>
                                     Balance at  Charged
                                    Beginning of   to               Balance at
                                        Year      Costs  Deductions End of Year
                                    ------------ ------- ---------- -----------
<S>                                 <C>          <C>     <C>        <C>
Allowance for Doubtful Accounts
Year ended December 31, 2000.......     $724       --      $(466)      $258
Year ended December 31, 1999.......     $661      $ 63       --        $724
Year ended December 31, 1998.......     $ 70      $591                 $661

Return Reserves
Year ended December 31, 2000.......     $500       --      $(381)      $119
Year ended December 31, 1999.......     $391      $109       --        $500
Year ended December 31, 1998.......     $--       $391       --        $391

Inventory Reserve
Year ended December 31, 2000.......     $830      $200     $(103)      $927
Year ended December 31, 1999.......     $797      $ 33       --        $830
Year ended December 31, 1998.......     $599      $198       --        $797
</TABLE>

                                       58