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

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

                                   FORM 10-K

 Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
                                    of 1934

                For the fiscal year ended December 31, 1999 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 Identification Number)
            of incorporation or organization)

                     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:

      Title of each class        Name of each exchange on which registered
              None                                 N/A

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

                        Common Stock, $0.001 par value
                               (Title of Class)

   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the 90 days. Yes [X]  No [ ]

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

   The aggregate market value of stock held by non-affiliates of the
registrant, based upon the closing sale price of the Common Stock on March 10,
2000, as reported on the Nasdaq National Market, was approximately
$81,267,000.

   The number of shares of Common Stock outstanding as of March 10, 2000:
14,447,438 shares.

                      DOCUMENTS INCORPORATED BY REFERENCE

   Part III of this Form 10-K incorporates information by reference from the
Registrant's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the close of the fiscal year.

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                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                                   FORM 10-K

                               TABLE OF CONTENTS

<TABLE>
<S>                                                                        <C>
PART I....................................................................   1

ITEM 1. BUSINESS..........................................................   1

ITEM 2. PROPERTIES........................................................  20

ITEM 3. LEGAL PROCEEDINGS.................................................  20

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............  20

PART II...................................................................  21

ITEM 5  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
        MATTERS...........................................................  21

ITEM 6. SELECTED FINANCIAL DATA...........................................  22

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS.............................................  23

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.......  27

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..........  28

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE..............................................  42

PART III..................................................................  43

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...............  43

ITEM 11. EXECUTIVE COMPENSATION...........................................  45

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT...  45

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS...................  45

PART IV...................................................................  45

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-
         K................................................................  45
</TABLE>

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                                    PART I

ITEM 1. BUSINESS

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

Company Overview

   Somnus was incorporated in Delaware in January 1996. We design, develop,
manufacture and market innovative medical devices that utilize our proprietary
temperature controlled radiofrequency ("TCRF") technology for the treatment of
upper airway disorders. The Somnus Somnoplasty(R) 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"), enlarged turbinates and habitual
snoring. 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 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 ("FDA") and European clearance for the
use of the Somnoplasty System in the treatment of OSAS, Upper Airway
Resistance Syndrome ("UARS"), chronic turbinate hypertrophy and habitual
snoring, and officially launched the marketing of the Somnoplasty System at
the American Academy of Otolaryngology-Head and Neck Surgery Foundation, Inc.
conference in September 1997.

   We have a direct sales force 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 more than
1,800 sleep clinics in the United States. As of December 31, 1999, we have an
installed base of 568 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.

   We have a European Headquarters in The Netherlands primarily to manage
relationships with our 9 distributors throughout Europe. In addition we have 9
distributors in Latin America, Africa, Asia and the Pacific Rim.

   On October 20, 1999 we announced our exclusive distribution agreement with
MC Medical, a subsidiary of Mitsubishi Corporation, to distribute the
Somnoplasty technology throughout Japan. We have applied for clearance to sell
our products in Japan through the "Shonin" process. We received clearance of
the S2 generator for tissue reduction in the head and neck area, for the
treatment of habitual snoring and OSAS. We are awaiting approval for the
disposable handpieces.

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   At December 31, 1999, our commercial products included one control unit
model and three disposable devices designed to treat a variety of upper airway
disorders. Additional devices are under development. As of December 31, 1999,
in the United States, we had 29 issued patents, and an additional 22 pending
patent applications. We also had 3 issued foreign patents and 19 pending
foreign patent applications.

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.

   Somnus 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. We received the CE Mark
for treatment of upper airway disorders in June 1997. In December 1997, we
received 510(k) clearance for the treatment of enlarged turbinates associated
with chronic turbinate hypertrophy and in November 1998 we received 510(k)
clearance for the treatment of OSAS/UARS. We intend to seek 510(k) clearance
of the Somnoplasty System for other new indications, some of which are
associated with OSAS. Clinical trials have recently begun for use of the
Somnoplasty System in the treatment of hypertrophic ("enlarged") tonsils.

   In 2000, we plan to file for FDA clearance and, if such clearance is
obtained, to launch a tonsil handpiece to address the market for treatment of
enlarged tonsils, currently estimated at more than half a million annually.

 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, our direct sales force of 10 representatives and one
sales representative group is supported by three clinical specialists whose
role is to support the physicians in the use of the system for increased sales
and patient satisfaction. In Europe our 9 distributors are managed from our
European

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headquarters in The Netherlands. Our sales in the rest of the world are
coordinated by the Director of International Sales, hired in 1999 and based in
Sunnyvale.

   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 or grant licensed complementary technologies
 and products and may continue to pursue this strategy in the future.

   We acquired complimentary technology through license agreements for
technology and patents during fiscal 1998. One such license from Medtronic,
Inc. allows the use of the lockout feature of the S2 control unit to protect
patients against the reuse of disposable devices. We have also granted a
license to Conway Stuart Medical, Inc., for certain radiofrequency generator
technology for treatment of gastroesophageal disorders. We expect to continue
to compliment our core business and technological platform through
acquisitions that broaden our product line and help accelerate the market
acceptance and penetration of the 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. The
breathing function requires the upper airway tissue and musculature to be
stiff enough to prevent collapse during respiration, while swallowing and
speech require compliance and flexibility. The upper airway is susceptible to
a variety of ailments, including tissue obstructions. A common cause of
obstruction found in the upper airway is excess tissue in one or more
locations, including the uvula (the small conical fleshy tissue hanging from
the center of the soft palate), soft palate, base of the tongue, turbinates
(soft tissue in the nasal cavity) and tonsils. Obstructed breathing impedes
the normal flow of air to the respiratory system.

   Certain upper airway disorders, such as snoring and 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.

   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,

                                       3
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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.

 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 nasal function.
During the day, enlarged turbinates can cause breathing through the nose to be
difficult and uncomfortable, and at night can contribute to snoring and 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 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 ("CPAP") and laser surgery have emerged
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,


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  . 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 application
cause many patients to stop using CPAP machines. The American Sleep Disorders
Association ("ASDA") estimated CPAP compliance at only 46% in 1993.

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

  . uvulopalatopharyngoplasty ("UPPP"), the surgical resection of the uvula,
   part of the soft palate, tonsils and excess tissue in the throat,

  . maxillofacial surgery, a highly invasive procedure requiring the
   resection of the tongue or reconstruction of the jaw bones, and

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

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

 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 occasional post-operative bleeding,
frequent and significant crusting. This requires 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

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   Surgical treatment for habitual snoring is available today with laser-
assisted uvulopalatoplasty ("LAUP"). Published studies indicate a success rate
for this procedure in the treatment of snoring of 75% and greater. LAUP is the
surgical resection of the uvula and soft palate through the use of a surgical
laser that operates at temperatures in excess of 700(degrees)C. A LAUP
procedure does not require an overnight stay in the hospital; however, it does
present a risk of significant swelling, scarring and post-operative pain.

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

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 the uvula, soft palate, tongue and turbinates
to reduce tissue volume and stiffen overly-compliant soft tissue. The
Somnoplasty System allows physicians to perform a safe, minimally-invasive
surgical procedure in the office. The use of 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 which prevents tissue sloughing, mucosal scarring, swelling,
bleeding and excessive post-operative pain. Thermocouples in the insulation
and at the tip of the needle electrode assist in the accurate monitoring of
tissue temperature. The control unit is preset to a target temperature of
approximately 75-85(degrees)C (185(degrees)F), ensuring optimal ablation in a
precisely located lesion while protecting the surface mucosa. The lesions
created by the procedure are naturally reabsorbed in approximately four to
eight weeks, reducing excess tissue volume.

   Somnus believes that the primary advantages of the Somnoplasty System
include:

   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.

   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 the same day.

   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 15-45 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 to a trained physician and can be performed in an outpatient setting
using local anesthesia.

   Ease of Use. The Somnoplasty System is designed to be easy for physicians
to use, thereby minimizing physician training requirements. The Somnoplasty
procedure is minimally invasive compared to many minor surgical procedures
performed by dentists in their offices.

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   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.

Product Description

   We have developed devices for treatment of the tongue, turbinates, and soft
palate/uvula. 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. All of
our products have CE Mark approval and the control unit and soft palate/uvula
and turbinate devices are commercially available in Europe.

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 OSA. 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. The angle of deployment may be adjusted
prior to the procedure, allowing the physician to adapt the instrument to
individual patient requirements.

 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 determines the maximum
amount of power to deliver, the length of time for the tissue coagulation, the
target temperature and the total energy applied. The user interface of each
control unit is designed to require minimal interaction, allowing the surgeon
to focus on the patient. The control unit contains proprietary software that
modulates the delivery of power based on information transmitted from the
disposable needle electrode devices.

   S2 Control Unit. The S2 control unit is a dual channel generator,
compatible with all of our needle electrode devices. A high-quality color
screen displays delivered power, energy and temperatures. An integral disk
drive captures procedure data and is also used for software upgrades as new
products are introduced.

Clinical and Regulatory Status

   United States. In July 1997, we received 510(k) clearance for use of the
Somnoplasty System for coagulation of soft tissue, including the uvula and
soft palate, which reduces the severity of snoring in some

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individuals. The 510(k) clearance was based on the results of a 24 patient,
single-center clinical trial completed in June 1997. The data from this trial
indicated that patients may require anywhere from one to six treatments to
significantly reduce snoring. We believe that most patients only require one
to three treatments to significantly reduce snoring.

   In December 1997, we received 510(k) clearance for the use of the
Somnoplasty System for the treatment of nasal obstruction due to chronic
turbinate hypertrophy. The 510(k) clearance was based on the results of 38
patients from the first two centers involved in this clinical trial. We
believe that most patients require one treatment to reduce enlarged
turbinates.

   In November 1998, we received 510(k) clearance for the use of the
Somnoplasty System for the reduction of the incidence of airway obstructions
in patients suffering from OSAS or Upper Airway Resistance Syndrome ("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 1999, we had five new articles published in peer-reviewed journals, for
a total of nine published to date, giving us a broad clinical foundation. The
most recent was in the November issue of The Laryngoscope, written by Dr.
Timothy L. Smith, outlining a new study about the long-term effectiveness of
Somnoplasty to treat chronic nasal obstruction. Patients in the study showed a
significant decrease in the degree and frequency of nasal obstruction for one
year following Somnoplasty treatment.

   Following the indication 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.

   We have 510(k) clearance from the FDA for the use of the SP 1010 disposable
devices for the reduction of severity of snoring in some individuals, the SP
1100 for the treatment of enlarged turbinates, and the SP1200 for the
reduction of the incidence of airway obstructions in patients suffering from
UARS and OSAS. 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 Somnus products that have
been cleared by the FDA are Class II products.

   International. In June 1997, we received authorization from the European
Union (through a duly appointed Notified Body) to affix the CE Mark to our
commercially available products for treatment of upper airway obstructions. We
have been certified under the ISO 9001 Quality System Regulation ("QS Reg.")
by TUV Essen, a German Notified Body. We have also received a TGA listing for
Australia. We are also approved to ship product to Canada via Health Canada
Medical Device license approval, and are pursuing additional countries. We
have submitted documentation to the Pharmaceutical Safety Bureau in Japan, and
anticipate a "Shonin" or product approval in 2000.

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

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surgical time and greater simplicity. Specifically, we are developing new
disposable devices which are intended to address additional upper airway
obstructions such as enlarged tonsils. We believe that our experience in
designing, developing and manufacturing our current suite of disposable needle
electrode devices gives us a competitive advantage in implementing this
strategy. In addition, we have acquired complimentary technology through
license agreements for technology and patents and expect to continue to
compliment our core business and technological platform through acquisitions
that broaden our product line and help accelerate the market acceptance and
penetration of the Somnoplasty System.

   In fiscal 1999, 1998, and 1997 research and development expenses were
$5,773,000, $8,220,000 and $6,033,000 respectively. As of December 31, 1999,
our research and development staff consisted of 16 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, 1999, the sales organization in the United States
consisted of 24 employees, including 3 clinical specialists. We intend to
expand our sales effort during 2000 through the addition of sales
representatives, clinical specialists and customer service representatives, as
appropriate.

   During the fourth quarter of fiscal 1999, we hired a Director of
International Sales and Marketing to manage distributors in countries other
than the United States and Europe. We refer to this as the rest of the world
(ROW). We currently have 9 distributors distributing Somnus product in each of
Europe and ROW.

   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 ASDA. Sleep clinics are important not only as potential
customers, but also for their role in referring diagnosed patients for
treatment.

   We have a European Headquarters in The Netherlands primarily to manage
relationships with 9 distributors throughout Europe. In addition we have 9
distributors in Latin American, Africa, Asia and the Pacific Rim.

   On October 20, 1999 we announced our exclusive distribution agreement with
MC Medical, a subsidiary of Mitsubishi Corporation to distribute the
Somnoplasty technology throughout Japan. We have applied for

                                       9
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clearance to sell our products in Japan through the "Shonin" process. We
received clearance of the S2 generator for tissue reduction in the head and
neck area, for the treatment of habitual snoring and OSAS. We are awaiting
approval for the disposable handpieces.

   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 the 108 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.

Manufacturing

   Our manufacturing facility is located in Sunnyvale, California in the
United States. We leased additional space in early 2000, to expand the area
available for manufacturing. 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 as we scale
up our manufacturing activities in support of increasing commercial demand,
would have a material adverse effect on our business, financial condition and
results of operations.

   The S2 control unit is assembled at our facility. Our manufacturing
facilities are subject to periodic inspection by regulatory authorities, and
our operations must undergo compliance inspections conducted by the FDA and
corresponding state agencies. Our quality control group performs tests at
various steps in the manufacturing cycle to ensure compliance with our
specifications and the requirements of the various regulatory authorities.
There can be no assurance that our procedures will be sufficient to meet all
of the requirements of all of the regulatory agencies. Failure to pass
compliance inspections could result in any of the following actions, any one
of which would have a material adverse effect on our business, financial
condition and results of operations:

  . warning letters,

  . more frequent and rigorous inspections,

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

   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, of which we will use approximately 12,500
square feet for administrative personnel and plan to sublease the remainder
for one to two years. We will allocate an additional 3,000 to 5,000 square
feet of the current facility to manufacturing personnel.

   Our direct labor force includes one shift five days per week assembling
control units and devices. With minimal additional equipment additions, we
could add more shifts increasing the capacity in both areas sufficiently to
accommodate expected demand for the next 12 months. There can be no assurance
that demand will grow in the magnitude that we expect or that we will be able
to scale up capacity and volume production in order to meet this demand.

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<PAGE>

Dependence upon Patents and Proprietary Technology; Risk of Infringement

   In the United States, at December 31, 1999, we had 29 issued patents, 2
allowed patents and an additional 22 pending patent applications. We also had
3 issued foreign patents and 19 pending foreign patent applications. These
patents and patent applications relate to our RF devices and methods for
reduction of tissue in the uvula, soft palate, tongue and tonsils, and design
of our control units and disposable devices. In addition, we may also
selectively license patents owned by others which we believe will complement
the technology and increase the value and strength of our intellectual
property portfolio. Our strategy has been to actively pursue patent protection
in the United States and foreign jurisdictions for all upper airway disorders
that can benefit from use of the Somnoplasty System.

   The patent and trade secret positions of medical device companies,
including those of Somnus, are uncertain and involve complex and evolving
legal and factual questions. The coverage sought in a patent application
either can be denied or significantly reduced before or after the patent is
issued. Consequently, there can be no assurance that any patents from pending
applications or from any future patent application will be issued, that the
scope of the patent protection will exclude competitors or provide competitive
advantages to Somnus, that any of our patents will be held valid if
subsequently challenged or that others will not claim rights in or ownership
of the patents and other proprietary rights held by Somnus. Since patent
applications are secret until patents are issued in the United States, or
corresponding applications are published in other countries, and since
publication of discoveries in the scientific or patent literature often lags
behind actual discoveries, we cannot be certain that we were the first to file
patent applications for such inventions. In addition, there can be no
assurance that competitors, many of which have substantial resources, will not
seek to apply for and obtain patents that will prevent, limit or interfere
with our ability to make, use or sell our products either in the United States
or in international markets. Further, the laws of certain foreign countries do
not protect our intellectual property rights to the same extent as do the laws
of the United States. Litigation or regulatory proceedings, which could result
in substantial cost and uncertainty to Somnus, may also be necessary to
enforce patent or other intellectual property rights of Somnus or to determine
the scope and validity of other parties' proprietary rights. There can be no
assurance that Somnus will have the financial resources to defend our patents
from infringement or claims of invalidity.

   Somnus also relies upon unpatented proprietary technology, and no assurance
can be given that others will not independently develop substantially
equivalent proprietary information and techniques or otherwise gain access to
or disclose our proprietary technology or that we can meaningfully protect our
rights in such unpatented proprietary technology. Our policy is to require
each of our employees, consultants, investigators and advisors to execute a
confidentiality agreement upon the commencement of an employment or consulting
relationship with Somnus. These agreements generally provide that all
inventions conceived by the individual during the term of the relationship
shall be the exclusive property of Somnus and shall be kept confidential and
not be disclosed to third parties except in specified circumstances. There can
be no assurance, however, that these agreements will provide meaningful
protection of our proprietary information in the event of unauthorized use or
disclosure of such information.

   Public Law 104-208 precludes medical practitioners and health care
entities, who practice these procedures, from being sued for patent
infringement. Therefore, depending upon how these limitations are interpreted
by the courts, they could have a material adverse effect on our ability to
enforce any of our proprietary methods or procedures deemed to be surgical or
medical procedures on a body.

   In addition, patent applications in the United States and foreign
jurisdictions are maintained in secrecy for a period after filing. Publication
of discoveries in the scientific or patent literature tends to lag behind
actual discoveries and the filing of related patent applications. Although we
have conducted searches of certain patents issued to other companies, research
and academic institutions and others, patents issued and patent applications
filed in the United States or internationally relating to medical devices are
numerous, and there can be no assurance that current and potential competitors
and other third parties have not filed, or in the future will not file
applications for, or have not received or in the future will not receive,
patents or obtain additional proprietary

                                      11
<PAGE>

rights relating to products or processes used or proposed to be used by
Somnus. In the event any pending applications provide proprietary rights to
third parties relating to products or processes used or proposed to be used by
Somnus, we may be required to obtain licenses to patents or proprietary rights
of others.

Competition

   The medical device industry is subject to intense competition. The market
for products designed to treat upper airway disorders is highly competitive,
and we expect competition to increase. Accordingly, our future success will
depend in part on our ability to respond quickly to medical and technological
change and user preference through the development and introduction of new
products that are of high quality and that address patient and 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 OSA is
currently dominated by CPAP products produced by Healthdyne Technologies Inc.,
Nellcor Puritan Bennett, Inc., a wholly owned subsidiary of Mallinckrodt Inc.,
ResMed Inc. and Respironics, Inc. There can be no assurance that the
Somnoplasty System will successfully compete with or replace any existing
products for these or other indications. Other companies offer products which
use radiofrequency for the treatment of upper airway disorders. 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, the
relative competitive position of Somnus in the future is difficult to predict.

Government Regulation

   The preclinical and clinical testing, manufacturing, labeling, distribution
and promotion of our products are subject to extensive and rigorous government
regulation in the United States and other countries. Noncompliance with
applicable requirements can result in enforcement action by the FDA or
comparable foreign regulatory bodies including, among other things, fines,
injunctions, civil penalties, recall or seizures of products, refusal to grant
premarket clearances or approvals, withdrawal of marketing approvals and
criminal prosecution.

 United States

   A medical device may be marketed in the United States only with the FDA's
prior authorization. Devices classified by the FDA as posing less risk are
placed 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

                                      12
<PAGE>

or that a proposed device is precluded from receiving clearance because it is
not substantially equivalent to a predicate device. After a device receives
clearance, any modification that could significantly affect our safety or
effectiveness, or would constitute a major change in the intended use of the
device, will require a new 510(k) submission.

   The Somnoplasty System received 510(k) clearance on July 17, 1997 for the
intended use of coagulation (thermal ablation, tissue volume reduction) of
soft tissue, including the uvula and soft palate, and may reduce severity of
snoring in some individuals. In December 1997, we received 510(k) clearance to
use the Somnoplasty System for tissue coagulation (thermal ablation) in the
inferior turbinates to treat the symptoms of nasal obstruction due to chronic
turbinate hypertrophy. In November 1998 we received 510(k) clearance for the
use of the Somnoplasty system for the reduction of the incidence of airway
obstructions in patients suffering from UARS or OSAS.

   We have made modifications to our cleared devices which we believe do not
require the submission of new 510(k) notices. There can be no assurance,
however, that the FDA would agree with any of our determinations not to submit
a new 510(k) notice for any of these changes or would not require Somnus to
submit a new 510(k) notice for any of the changes made to the devices. If the
FDA requires Somnus to submit a new 510(k) notice for any device modification,
we may be prohibited from marketing the modified device until the 510(k)
notice is cleared by the FDA.

   A device that does not qualify for 510(k) clearance is placed in Class III,
which is reserved for devices classified by FDA as posing the greatest risk
(e.g., life-sustaining, life-supporting or implantable devices, or devices
that are not substantially equivalent to a predicate device). A Class III
device generally must obtain PMA approval, which requires the manufacturer to
establish the safety and effectiveness of the device to the FDA's
satisfaction. A PMA must provide extensive preclinical and clinical trial data
and also information about the device and our components regarding, among
other things, manufacturing, labeling and promotion. As part of the PMA
review, the FDA will inspect the manufacturer's facilities for compliance with
the Quality System Regulation ("QS Reg."), which includes elaborate testing,
control, documentation and other quality assurance procedures.

   Upon submission, the FDA determines if the PMA is sufficiently complete to
permit a substantive review, and if so, the application is accepted for
filing. The FDA then commences an in-depth review of the PMA, which we believe
typically takes one to two years, but may take longer. The review time is
often significantly extended as a result of the FDA asking for more
information or clarification of information already provided. The FDA also may
respond with a "not approvable" determination based on deficiencies in the
application and require additional clinical trials that are often expensive
and time consuming and can delay approval for months or even years. During the
review period, an FDA advisory committee, typically a panel of clinicians,
likely will be convened to review the application and recommend to the FDA
whether, or upon what conditions, the device should be approved. Although the
FDA is not bound by the advisory panel decision, the panel's recommendation is
important to the FDA's overall decision making process.

   If the FDA's evaluation of the PMA is favorable, the FDA typically issues
an "approvable letter" requiring the applicant's agreement to specific
conditions (e.g., changes in labeling) or specific additional information
(e.g., submission of final labeling) in order to secure final approval of the
PMA application. Once the approvable letter is satisfied, the FDA will issue a
PMA for approved indications, which can be more limited than those originally
sought by the manufacturer. The PMA can include post approval conditions that
the FDA believes necessary to ensure the safety and effectiveness of the
device including, among other things restrictions on labeling, promotion, sale
and distribution. Failure to comply with the conditions of approval can result
in material adverse enforcement action, including the loss or withdrawal of
the approval. The PMA process can be expensive and lengthy, and no assurance
can be given that any PMA application will ever be approved for marketing.
Even after approval of a PMA, a new PMA or PMA supplement is required in the
event of a modification to the device, labeling or manufacturing process.


                                      13
<PAGE>

   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 with OSAS. These future submissions likely will need to
include supporting clinical trial data. There can be no assurance, however,
that these new indications will receive 510(k) clearance in a timely fashion,
or at all. Delays in market introduction resulting from the 510(k) clearance
process could have a material adverse effect on our business, financial
condition and results of operations. If the FDA determines that any of the new
indications are not eligible for 510(k) clearance, we will need to seek PMA
approval. There can be no assurance that we will submit a PMA for any such
indications or that once submitted, the PMA will be accepted for filing, found
approvable or, if found approvable, will not include unfavorable restrictions.

   A clinical trial in support of a 510(k) submission or PMA generally
requires an Investigational Device Exemption ("IDE") application approved in
advance by the FDA for a limited number of patients. The IDE application must
be supported by appropriate data, such as animal and laboratory testing
results. Clinical trials may begin if the IDE application is approved by the
FDA and the appropriate institutional review boards ("IRBs") at the clinical
trial sites. Submission of an IDE application does not give assurance that the
FDA will approve the IDE application and, if it is approved, there can be no
assurance that the FDA will determine that the data derived from these studies
support the safety and efficacy of the device or warrant the continuation of
clinical studies. If the device presents a "nonsignificant risk" to the
patient, a sponsor may begin the clinical trial after obtaining approval for
the study by one or more appropriate IRBs without the need for FDA approval.
We are sponsoring several clinical trials which have been determined by the
IRBs at the participating institutions to be nonsignificant risk studies.
There can be no assurance however, that the FDA would agree with these
determinations and not require us to obtain IDE approval before continuing the
studies. During a clinical trial, we are permitted to sell products used for
the study for an amount that does not exceed recovery of the costs of
manufacture, research, development and handling. Our failure to adhere to
regulatory requirements generally applicable to clinical trials or to the
conditions of an IDE approval could have a material adverse effect on our
business, financial conditions and results of operations, including an
inability to obtain marketing clearance or approval for our products.

   Any devices manufactured or distributed by Somnus pursuant to FDA
clearances or approvals will be subject to pervasive and continuing regulation
by the FDA and certain state agencies. We will be subject to routine
inspection by the FDA and the California Department of Health Services
("CDHS") and will have to comply with the host of regulatory requirements that
usually apply to medical devices marketed in the United States, including
labeling regulations, the QS Reg., the Medical Device Reporting ("MDR")
regulation and the FDA's prohibitions against promoting products for
unapproved or "off-label" uses. In addition, Class II devices, such as our
Somnoplasty System, can be subject to additional special controls (e.g.,
performance standards, postmarket surveillance, patient registries, and FDA
guidelines) that do not apply to Class I devices. Our failure to comply with
applicable regulatory requirements could result in enforcement action by the
FDA, which could have a material adverse effect on our business, financial
condition and results of operations.

   Unanticipated changes in existing regulatory requirements, failure of
Somnus to comply with such requirements or adoption of new requirements could
have a material adverse effect on our business, financial condition and
results of operations. We also are subjected to numerous federal, state and
local laws relating to such matters as safe working conditions, manufacturing
practices, environmental protection, fire hazard control and hazardous
substance disposal. There can be no assurance that we will not be required to
incur significant costs to comply with such laws and regulations in the future
or that such laws or regulations will not have a material adverse effect upon
our business, financial condition and results of operations.

 European Union

   The primary regulatory environment in Europe is that of the European Union
("EU") which consists of 15 countries encompassing most of the major countries
in Europe. Certain other countries, such as Switzerland, have voluntarily
adopted laws and regulations that mirror those of the EU with respect to
medical devices. The EU has adopted numerous directives and standards
regulating the design, manufacture, clinical trial, labeling, and

                                      14
<PAGE>

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

   We have applied for clearance to sell our products in Japan through the
"Shonin" process. We received clearance of the S2 generator for tissue
reduction in the head and neck area, for the treatment of habitual snoring and
OSAS. We are awaiting approval for the disposable handpieces. While we
anticipate clearance of disposable handpieces this year, there can be no
assurance this will occur.

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 are moving toward a managed-care
system in which they contract to provide comprehensive health care for a fixed
cost per person. The fixed cost per person established by these Third-Party
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. The Company has recently been notified
that the Health Care Financing Administration (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 as an inpatient procedure.

   The Somnoplasty System is generally reimbursed for the treatment of
enlarged turbinates under existing reimbursement codes. However, there can be
no assurance that third-party reimbursement will be available for all such
procedures by all third-party payers.

   We believe that the Somnoplasty System is reimbursed, currently less than
50 percent of the time, 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

                                      15
<PAGE>

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.

   Because our devices have been relatively recently launched for the
treatment of OSAS/UARS (base of tongue) and enlarged turbinates, uncertainty
exists regarding the availability of third-party reimbursement for procedures
that would use our devices for such purposes. Failure by private practices,
clinics, hospitals, sleep clinics and other potential users of our devices to
obtain sufficient reimbursement from Third-Party 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) and enlarged turbinates. However, there can be no
assurance that any international reimbursement approvals will be obtained in a
timely manner, if at all. Failure to receive international reimbursement
approvals could have a material adverse effect on market acceptance of our
products in the international markets in which such approvals are sought.

   We believe that in the future, reimbursement will be subject to increased
restrictions both in the United States and in international markets. We
believe that the overall escalating cost of medical products and services will
continue to lead to increased pressures on the health care industry, both
domestic and international, to reduce the cost of products and services,
including our existing products and products currently under development.
There can be no assurance that third-party reimbursement and coverage will be
available or adequate in either the United States or international markets or
that future legislation, regulation or reimbursement policies of Third-Party
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 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, 1999, we employed 108 individuals full time. Of our
total work force, 47 employees are engaged in manufacturing, 16 employees are
engaged in research and development activities, 30 employees are engaged in
sales and marketing activities and 15 employees are engaged in finance and
administrative activities. Our employees are not represented by a collective
bargaining agreement. We believe our relations with our employees are good.


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Additional Risk Factors

   The risk factors set forth below contain forward-looking statements
(designated by an *), and the Company's actual results could differ materially
from those anticipated in these forward-looking statements as a result of
factors, including those set forth below. If any of the following risks
actually occur, our business, financial condition or results of operations
could be materially adversely affected. As a result, the trading price of our
common stock could decline, and you may lose all or part of your investment.

 Limited Operating History; Absence of Profitability.

   Somnus has generated only limited revenues from sales of the Somnoplasty
System and has limited experience in manufacturing, selling and marketing our
products in commercial quantities. There can be no assurance that the
Somnoplasty System will be sufficiently successful for us to achieve
significant revenues. From inception in 1996 through December 31, 1999, we
have had total revenues of approximately $21.6 million and incurred cumulative
losses of approximately $48.3 million. We expect to significantly increase
spending over the next several years with respect to sales and marketing,
manufacturing and to a lesser extent, ongoing research and development efforts
and clinical trials, and expect to incur significant additional losses for the
foreseeable future.* Whether we can successfully manage the transition to a
larger-scale enterprise will depend upon a number of factors, including our
ability to increase our commercial manufacturing and sales and marketing
capabilities. Our inability to establish such capabilities would have a
material adverse effect on our business, financial condition and results of
operations.

 We are dependent upon the Somnoplasty System, which has not been available
 for sufficient time for us to know if it is effective on a long term basis.

   Our success depends upon the market acceptance of the Somnoplasty System
for the treatment of OSAS/UARS, chronic turbinate hypertrophy and habitual
snoring. Market acceptance will depend, in large part, upon the effectiveness
of the Somnoplasty System over time.* There can be no assurance that the
procedure will provide a permanent, curative treatment for patients.
Independent factors, such as aging and weight gain, may, over time, lead to
the enlargement of tissue in areas previously treated by our procedure.* Such
regrowth of tissue could require further treatments, making the procedure a
potentially less attractive alternative to existing surgical and non-surgical
procedures, which could have a material adverse effect upon our business,
financial condition and results of operations.

 Several factors will impact our ability to achieve market acceptance.

   TCRF tissue volume reduction in the upper airway is a new and novel
development. Market acceptance of this procedure for the treatment of OSAS,
enlarged turbinates and habitual snoring 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,

  . effective physician training and

  . patient acceptance.

   Third party reimbursement. We do not anticipate that patients will receive
third-party reimbursement for use of the Somnoplasty System in the treatment
of habitual snoring.* Market acceptance of the Somnoplasty System for the
treatment of OSAS and chronic turbinate hypertrophy will depend, in large
part, upon the availability of third-party reimbursement for each of those
indications, which is not assured.*


                                      17
<PAGE>

   Cost of the procedure and clinical acceptance. Market acceptance will also
depend upon our ability to demonstrate that the Somnoplasty System is an
attractive alternative to existing procedures, which will depend upon
physicians' evaluations of the clinical safety and efficacy, ease of use,
reliability and cost-effectiveness of the Somnoplasty System in a clinical
setting.* We believe that recommendations and endorsements by influential
physicians will be essential to market acceptance.* There can be no assurance
that such recommendations or endorsements will be obtained.

   Differentiation. We believe our temperature controlled radiofrequency
technology provides more predictable and consistent tissue volume reduction
than competing radiofrequency products. There can be no assurance that we will
be able to successfully differentiate our technology from competing products.

   Physician training. Broad use of the Somnoplasty System will require
training for physicians on how to perform the Somnoplasty procedure and
educating physicians regarding the advantages of the Somnoplasty System over
currently available surgical and non-surgical approaches.* The time required
to complete such training and education could extend the sales cycle for our
products and delay or preclude commercial sales and market acceptance. If we
are unable to achieve broad market acceptance of the Somnoplasty System for
our current and anticipated indications, our business, financial condition and
results of operations would be materially adversely affected.

   Patient acceptance. Patient acceptance may be affected by numerous factors,
including the possibility that the Somnoplasty procedure will require
treatments on multiple occasions, which would be not only inconvenient for the
patient, but also more costly.* Patients may require anywhere from one to six
treatments to significantly reduce snoring; however, we anticipate that most
patients will only require one to three treatments to significantly reduce
snoring.* We anticipate that most patients will require fewer treatments to
reduce enlarged turbinates than required to reduce snoring and more to treat
OSAS than snoring which can require from one to nine treatments.* Factors such
as poor training of the treating physician or improper use of the Somnoplasty
System by the treating physician could lead to a patient requiring more
treatments. Patient acceptance of the Somnoplasty System for the treatment of
habitual snoring, turbinate reduction, OSAS/UARS, and other potential
indications will also depend in part upon physician recommendations as well as
other factors, including the effectiveness and reliability of the procedure as
compared to existing surgical and non-surgical procedures.* There can be no
assurance that the Somnoplasty System will be accepted by the patient
community or that market demand for such system will be sufficient to allow us
to achieve profitable operations. In addition, publicity arising from any
adverse outcome or other problem occurring in the treatment of a Somnoplasty
patient for any reason, particularly during this early phase of the
commercialization of the Somnoplasty System, could materially adversely affect
patient demand for the procedure. Failure of the Somnoplasty System, for
whatever reason, to achieve significant patient acceptance would have a
material adverse effect on our business, financial condition and results of
operations.

 We have limited direct sales and marketing experience.

   We have only limited experience selling and marketing the Somnoplasty
System for the treatment of OSAS, chronic turbinate hypertrophy and habitual
snoring. We are directing our sales effort in the United States on private
practices, clinics, hospitals and sleep clinics through a direct sales force
and a manufacturers representative group. We currently have a small direct
sales force that covers certain regions of the United States and intend to
increase our sales and marketing force in the near future to accelerate
commercialization of the Somnoplasty System throughout the United States.*
There can be no assurance that we will be successful in building an effective
sales and marketing force, that we will be cost-effective or that we will
ultimately prove successful in selling the Somnoplasty System on a direct
basis in the United States in sufficient quantities for us to become
profitable. Market acceptance of the Somnoplasty System will also require us
to demonstrate that the cost of our products and procedures are competitive
with currently available alternatives.* The use of the Somnoplasty System may
require the healthcare provider to make an up-front investment in an RF
control unit. There can be no assurance that we will successfully generate
sufficient demand for the Somnoplasty System at

                                      18
<PAGE>

the prices at which we currently offer our control units and disposable
devices. In the event the required investment were to preclude us from placing
sufficient quantities of control units, our ability to sell disposable devices
would be limited, which would have a material adverse effect on our business,
financial condition and results of operations.

 We need to develop successful distributor relationships for international
 sales.

   Our future success will depend, in part, on our ability to enter into and
successfully develop strategic and distributor relationships with other
parties with respect to the marketing and distribution of our products.*

   In the United States, our direct sales force of 10 representatives and one
sales representative group is supported by three clinical specialists whose
role is to support the physicians in the use of the system for increased sales
and patient satisfaction. In Europe our 9 distributors are managed from the
European headquarters in The Netherlands. Our sales in the rest of the world
are coordinated by the Director of International Sales, hired in 1999 and
based in Sunnyvale.

   We may add additional sales personnel, representative groups, and
distributors as necessary to further penetrate markets in the United States
and 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 to enter into additional
strategic or distributor relationships or that any such relationships can be
maintained or will ultimately prove beneficial to us. In the event we are not
successful in developing such additional relationships, or if such
relationships do not prove to be successful, our business, financial condition
and results of operations would be materially adversely affected.
International sales of the Somnoplasty System are subject to numerous risks.
Distribution, pricing and marketing structures, as well as regulatory
requirements, vary significantly from country to country. Additionally, such
sales can be adversely affected by:

  . limitations or disruptions caused by the imposition of government
    controls,

  . difficulty in obtaining export licenses,

  . political instability,

  . trade restrictions,

  . changes in foreign tax laws or tariffs or other trade regulations,

  . difficulties coordinating communications among and managing international
    operations,

  . the risk that distributors will fail to effectively promote our products,

  . the risk of financial instability of distributors,

  . fluctuations in overseas economic conditions and international currency
    exchange rates,

  . 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.

 We may experience manufacturing problems with regard to our control unit.

   The S2 control unit is manufactured entirely by Somnus. There can be no
assurance that we will not experience design or production issues as Somnus
manufactures these units. In addition, certain parts in our

                                      19
<PAGE>

control unit may be discontinued by their manufacturers. We may have to have
such parts specifically manufactured or redesign the unit to use other
available parts. In the past we purchased our 215 RF control unit as a
finished assembly from a single-source supplier. We discontinued selling the
215 RF control unit model during fiscal 1998.

 We are dependent on single-source suppliers for components.

   We purchase certain key components of our products from single-source
suppliers. There can be no assurance that the components obtained from the
single-source suppliers will continue to be available in adequate quantities
or, if required, that we will be able to locate alternative sources of such
components on a timely and cost-effective basis. To date, we have not
experienced significant adverse effects resulting from any shortage of
components. However, there can be no assurance that the single-source
suppliers will meet our future requirements for timely delivery of components
of sufficient quality and in sufficient quantity.* The components may take
several months to procure, and a significant increase of orders could lead to
significant delays and control unit or device shortages. Such delays or
shortages, particularly as we scale up our manufacturing activities in support
of sales and distributor orders, would have a material adverse effect on our
business, financial condition and results of operations.

 We are dependent upon key personnel.

   Our future success depends in significant part upon the continued service
of certain key scientific, technical and management personnel and our
continuing ability to attract and retain highly qualified scientific,
technical and managerial personnel.* Competition for such personnel is
intense, and there can be no assurance that we can retain our key scientific,
technical and managerial personnel or that we can attract, assimilate or
retain other highly qualified scientific, technical and managerial personnel
in the future. We have taken steps to retain our key employees, including the
granting of stock options that vest over time. The loss of key personnel,
especially if without advanced notice, or the inability to hire or retain
qualified personnel could have a material adverse effect upon our business,
financial condition and results of operations.

   Due to the factors noted above, our future earnings and stock price may be
subject to significant volatility, particularly on a quarterly basis. Any
shortfall in revenues or earnings from levels expected by security analysts
could have an immediate and significant adverse effect on the trading price of
our common stock.

ITEM 2. PROPERTIES

   We lease an approximately 20,000 square foot light industrial facility in
Sunnyvale, California, under a lease that terminates in 2002, with an option
to extend to 2007. We 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. We intend to sub-lease about 7,500 square feet of
this additional facility for one to two years. We believe that our facilities
are adequate to meet our current requirements. In addition, we lease an
approximately 2,500 square foot sales office facility in Windhaven, The
Netherlands, under a lease that terminates in 2000.

ITEM 3. LEGAL PROCEEDINGS

   We are not party to any legal proceedings.

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

   Not applicable.

                                      20
<PAGE>

                                    PART II

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>
   1998: First Quarter........................................ $12 7/8  $8 1/8
   1998: Second Quarter....................................... $13 5/8  $6 13/16
   1998: Third Quarter........................................ $ 8 1/2  $3
   1998: Fourth Quarter....................................... $ 5 1/8  $1 3/16
   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
</TABLE>

   As of March 10, 2000, the number of common stockholders of record was 130.
We currently intend to retain any earnings for use in our business and do not
anticipate paying any cash dividends in the foreseeable future.

   In November 1997, we completed our initial public offering (the "IPO") of
4,600,000 shares (including the exercise of the underwriter's over-allotment
option consisting of 600,000 shares) of our Common Stock, $0.001 par value per
share, at a public offering price of $10.50 per share pursuant to a
registration statement on Form S-1 (File No. 333-35401) filed with the
Securities and Exchange Commission. All of the shares registered were sold.
J.P. Morgan & Co., UBS Securities and Smith Barney Inc. were the managing
underwriters of the IPO. Aggregate gross proceeds to us from the IPO (prior to
deduction of underwriting discounts and commissions and expenses of the
offering) were $48,300,000. There were no selling stockholders in the IPO.

   We paid underwriting discounts and commissions of approximately $3,400,000
and other expenses of approximately $1,100,000 in connection with the IPO. The
total expenses paid by us in the IPO were approximately $4,500,000 and the net
proceeds to us in the IPO were approximately $43,800,000.

   From November 5, 1997, the effective date of the Registration Statement, to
December 31, 1999, the approximate amount of net proceeds used from the
Offering were $11.1 million for research and development, clinical trials and
regulatory matters, $9.0 million to manufacture product and further develop
manufacturing expertise and capabilities, $21.8 million to improve and expand
financial capabilities, to enhance financial reporting systems, to expand
sales and marketing efforts, and for other general corporate purposes and $1.9
million for the acquisition of fixed assets.

   All amounts represent estimates of direct or indirect payments of amounts
to third parties. No amounts were paid directly or indirectly for the above
purposes to directors or officers of Somnus, other than in the ordinary course
of business, to persons owning ten percent or more of any class of equity
securities of Somnus, or to affiliates of Somnus. The use of proceeds
described above do not represent a material change in the use of proceeds
described in the Offering prospectus.

                                      21
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

                      Summary Consolidated Financial Data

<TABLE>
<CAPTION>
                                                  Years Ended December 31,
                                                 ----------------------------
                                                   1999      1998      1997
                                                 --------  --------  --------
<S>                                              <C>       <C>       <C>
Consolidated Statements of Operations Data:
Product revenues................................ $ 11,665  $  7,356  $  2,574
Cost of sales...................................    6,468     5,565     3,110
                                                 --------  --------  --------
Gross Margin....................................    5,197     1,791      (536)

Operating expenses:
 Research and development.......................    5,733     8,220     6,033
 Selling, marketing, general and
  administrative................................   14,053    14,953     6,741
                                                 --------  --------  --------
   Total operating expenses.....................   19,786    23,173    12,774
                                                 --------  --------  --------
Loss from operations............................  (14,589)  (21,382)  (13,310)
Interest and other income.......................    1,439     2,059       735
Interest expense................................      --         (5)     (182)
                                                 --------  --------  --------
Net loss........................................ $(13,150) $(19,328) $(12,757)
                                                 ========  ========  ========
Net loss per share, basic and diluted........... $  (0.92) $  (1.41) $ (3.02)
                                                 ========  ========  ========
Shares used in computing net loss per share,
 basic and diluted..............................   14,242    13,717     4,224
                                                 ========  ========  ========
<CAPTION>
                                                  Years Ended December 31,
                                                 ----------------------------
                                                   1999      1998      1997
                                                 --------  --------  --------
<S>                                              <C>       <C>       <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents....................... $ 14,888  $ 32,280  $ 45,145
Short-term investments..........................    4,972       --        --
Working capital.................................   15,138    27,742    43,736
Total assets....................................   24,798    36,512    48,227
Accumulated deficit.............................  (48,332)  (35,182)  (15,854)
Total stockholders' equity......................   16,825    29,428    45,620
</TABLE>

                                       22
<PAGE>

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

   The information set forth in this Item 7 below contains forward-looking
statements (designated by an *), and the Company's actual results could differ
materially from those anticipated in these forward-looking statements as a
result of factors, including those set forth above under "Additional Risk
Factors."

Overview

   We design, develop, manufacture and market innovative medical devices that
utilize our proprietary 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.

   Our operations in 1996 and 1997 consisted largely of research and
development, product engineering, seeking clearance of our products from the
Food & Drug Administration (FDA), development of a direct sales force in the
United States and internationally, and training international distributor
employees for distribution of the Somnoplasty System in the European Union
(EU), Australia, Southeast Asia and certain other areas. We commercially
introduced the Somnoplasty System internationally, 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. Presently, the sales force consists of a Vice President of Sales and
Marketing, two domestic regional sales managers, ten domestic sales
representatives, one independent representative group and three clinical
specialists. During 1998, we hired a Vice President and General Manager of
European Sales and Marketing to manage distributors in European countries.
During the fourth quarter of 1999, we hired a Director of International Sales
to manage our 9 distributors in countries other than the United States and
Europe. We anticipate significant short-term expenditures in the development
of our direct and indirect sales infrastructure.*

   Product shipments of control units and disposable devices are made directly
from our facility in Sunnyvale, California to domestic customers and
international distributors. As the Company's sales have grown, the dollar
volume of products has shifted from a mix of about 68 percent control units
and 32 percent disposables during 1998 to a mix of about 38 percent control
units and 62 percent disposables during the fourth quarter of 1999.

   We plan to continue to hire additional management and engineering personnel
to support and develop manufacturing expertise and larger scale manufacturing
capacity expansion as required to support the current and anticipated growth.*
Additionally, we will invest in further production equipment, vertical
integration and facility expansion to reduce manufacturing costs, reduce
manufacturing cycle time and increase production capacity.* Personnel hires
and capital expenditures will require operating capital on an ongoing basis.
We will continue to expand our internal reporting capabilities and further
strengthen systems to manage our expanding business.*

   This current and anticipated significant growth of our personnel, sales and
scope of operations may place considerable strain on our management,
financial, manufacturing and other capabilities, procedures and controls.
There can be no assurance that any existing or additional capabilities,
procedures or controls will be adequate to support our operations or that our
capabilities, procedures or controls will be designed, implemented or improved
in a timely and cost-effective manner. Failure to implement, improve and
expand such capabilities, procedures and controls in an efficient manner could
have a material adverse effect on our business, financial condition and
results of operations.

                                      23
<PAGE>

   As of December 31, 1999, we have incurred cumulative losses from inception
of approximately $48,332,000. Moreover, we expect to incur significant
additional operating losses over the next couple of years primarily due to the
development of our manufacturing and sales and marketing capabilities along
with ongoing research and development efforts, including clinical studies and
expenses associated with our patent portfolio, as well as due to costs
associated with the implementation of the appropriate infrastructure to
support and grow the business operations.* Our limited operating history makes
accurate prediction of future operating results difficult or impossible.

   Future revenues and results of operations may fluctuate significantly from
quarter to quarter or year to year and will depend upon numerous factors,
including the extent to which our products gain market acceptance, the scale-
up of manufacturing capabilities, the expansion of sales and marketing
activities, competition, the timing and success of new product introductions
by us or our competitors, the timing of regulatory clearances or approvals of
those new products and 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 1999 and 1998 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 1999 to $11,665,000 from $7,356,000 in 1998 and $2,574,000 in
1997. The year over year increase was $4,309,000 or 59 percent from 1998 to
1999 and $4,782,000 or 186 percent from 1997 to 1998. These increases were due
to both the increased sale of control units, boosted by the introduction of
the new 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 1999, about 88
percent of net revenues were attributable to sales to customers in the United
States and about 12 percent from Europe and the rest of the world. This
compares with about 93 percent domestic sales in 1998, with Europe and the
rest of the world about 7 percent.

   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. In 1999, only 46 percent of our domestic revenue represented sales of
control units, with disposable handpieces representing 54 percent of revenue.
In the fourth quarter of 1999, handpieces represented about 62 percent of
total sales compared to the fourth quarter of 1998 where disposables
represented 42 percent of revenue. We expect disposable devices to increase as
a percentage of total revenue, year over year, as we implement sales programs
that reduce the price of control units.*

 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 $5,197,000 in 1999, or 45 percent gross margin, from $1,791,000
representing a 24 percent gross margin in 1998. During 1997, our initial year
of product sales, we sustained a negative gross profit of ($536,000), due to
manufacturing start up costs. During 1999 and 1998 increased volume and cost
reduction efforts contributed to better efficiency in our manufacturing
process. 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.*

                                      24
<PAGE>

 Research and development expenses

   Research and development expenses for 1999 were $5,733,000, compared to
$8,220,000 for the prior year, a decrease of $2,487,000 or 30 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 decrease in 1999 expenses was
primarily due to a shifting of 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, thus reducing our 1999 activity in research and
development.

   From 1997 to 1998 our research and development expenses increased from
$6,033,000 to $8,220,000. This increase of $2,187,000 or 36 percent was
primarily due to increased salaries and employee related expenses of
$2,533,000 in 1998 versus $1,794,000 in 1997, increased consulting fees of
$1,145,000 compared to $400,000, and increased patent legal expenses of
$835,000 versus $369,000 in the prior year period.

 Selling, marketing, general and administrative

   Selling, marketing, general and administrative ("SG&A") expenses for 1999
were $14,053,000 compared to $14,953,000 for 1998 a decrease of approximately,
$900,000 or 6 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 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 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. Selling, general and administrative
("SG&A") expenses for 1997 were $6,741,000 compared to $14,953,000 for 1998,
an increase of approximately $8,212,000 or 122 percent, including
approximately $1,600,000 in one-time charges in 1998. The other increases in
SG&A costs are primarily due to increased salaries and employee related
expenses of $5,213,000 due to increased headcount, higher levels of commission
on higher sales volumes, and the opening of the European headquarters.

 Interest and other income

   Interest and other income for 1999 was $1,439,000, compared to $2,059,000
for 1998 and $735,000 for 1997. The increase from 1997 to 1998 is attributable
to interest income earned by Somnus on an increased outstanding balance of
cash, cash equivalents and short-term investments, invested from the proceeds
of the IPO. In 1999 interest income decreased as invested cash balances
decreased. Interest expense was $0 for 1999, compared to $5,000 in 1998 and
$182,000 in 1997. The decrease was due to the repayment of borrowings under
the equipment lease line of credit.

 Net loss

   The net loss was $13,150,000 for 1999, $19,328,000 for 1998, and
$12,757,000 for 1997. We expect that our operating losses will continue for at
least the next couple of years, as we continue to invest substantial resources
in product development, manufacturing, sales, marketing and infrastructure
development.

Income Taxes

   As of December 31, 1999, we had federal and state net operating loss
carryforwards of approximately $40,100,000 and $21,800,000, respectively. We
also had federal and California research and development tax

                                      25
<PAGE>

credit carryforwards of approximately $700,000 and $700,000, 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.

Impact of Year 2000

   In prior years, the Company discussed the nature and progress of its plans
to become Year 2000 ready. In late 1999, the Company completed its remediation
and testing of systems. As a result of those planning and implementation
efforts, the Company experienced no significant disruptions in mission
critical information technology and non-information technology systems and
believes those systems successfully responded to the Year 2000 date change.
The Company is not aware of any material problems resulting from Year 2000
issues, either with its products, its internal systems, or the products and
services of third parties. The Company will continue to monitor its mission
critical computer applications and those of its suppliers and vendors
throughout the year 2000 to ensure that any latent Year 2000 matters that may
arise are addressed promptly.

Liquidity and Capital Resources

   Since inception through December 31, 1999, Somnus has financed its
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 and short-term investments at December 31, 1999
were $19,860,000 compared to $32,280,000 at December 31, 1998.

   Net cash used in operating activities was approximately $11,695,000 for the
year ended December 31, 1999, compared to $12,438,000 for 1998 and $9,521,000
in 1997. 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. Net cash
used in investing activities for capital expenditures was approximately
$776,000 for 1999, compared to $752,000 for 1998 and $1,957,000 for 1997.

   Net cash provided by financing activities was approximately $51,000 for the
year ended December 31, 1999, compared to $325,000 for 1998 and $47,795,000 in
1997. This was due to the exercise of stock options of approximately $340,000
in 1999 and $325,000 in 1998. The net cash provided by financing activities
for the twelve months ended December 31, 1997 primarily included the issuance
of preferred stock, borrowings under a lease line of credit and proceeds from
our IPO. During 1999, the Company repurchased $289,000 of its common stock.

   We recorded deferred stock compensation expense for the difference between
the exercise price and the fair value of our Common Stock for certain options
granted and related to the severance of former executives including our Chief
Executive Officer and our Chief Financial Officer. The total unamortized
deferred stock compensation at December 31, 1999 is $189,000. We amortized
deferred compensation expenses of approximately $261,000 in the twelve months
ended December 31, 1999 compared to $2,811,000 and $1,252,000 for the
respective 1998 and 1997 periods. The remainder of the deferred stock
compensation will be amortized over the corresponding vesting period of each
respective option, which is generally four years from date of original
issuance.

   At December 31, 1999, our principal sources of liquidity consisted of
$19,860,000 in cash and cash equivalents and short term investments. There
were no other material unused sources of liquid assets at December 31, 1999.

                                      26
<PAGE>

   We currently anticipate that our capital expenditure requirements will be
approximately $1.2 million for the next twelve months.* These requirements
relate primarily to the acquisition of additional leasehold improvements,
manufacturing equipment, computer hardware and software to handle anticipated
manufacturing expansion and headcount additions.

   In October 1998, we announced that our board of directors has authorized a
stock repurchase program permitting the purchase of up to 1,000,000 shares, at
up to $5.00 per share, of our common stock in the open market. No shares had
been repurchased by Somnus as of December 31, 1998. During 1999 the Company
purchased 100,000 shares for a total of $289,000 under the program.

   We anticipate that our existing resources will enable us to maintain our
current and planned operations at least through the next twelve months.*
However, there can be no assurance that we will not require additional funding
prior to such time. Our future capital requirements will depend on many
factors, including the ability of Somnus to establish and maintain strategic
distributor relationships, the time and cost in obtaining regulatory
clearances, competing technological and market developments, the cost of
manufacturing and other factors. There can be no assurance that additional
financing to meet our funding requirements will be available as needed. If
additional funds are raised by issuing equity securities, substantial dilution
to existing stockholders may result. Insufficient funds may require Somnus to
delay, scale back or eliminate some or all of our research or development
programs or to relinquish rights to products at an earlier stage of
development or on less favorable terms than we would otherwise seek to obtain
or to scale back and eliminate certain sales and marketing initiatives. The
failure of Somnus to raise capital when needed would have a material adverse
effect on our business, financial condition and results of operations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   The primary objective of our investment activities is to preserve principal
while at the same time maximizing yields without significantly increasing
risk. To achieve this objective, we invest in highly liquid and high quality
debt securities. Our investments in debt securities are subject to interest
rate risk. To minimize the exposure due to adverse shift in the interest rates
we invest in short term securities and have maintained an average maturity of
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.

                                      27
<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, 1999 and 1998, and the related
consolidated statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended December 31, 1999. Our audits
also included the financial statement schedule listed in the Index at Item 14
(A) 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 Sates. 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, 1999 and 1998, and the consolidated
results of their operations and their cash flows for each of the three years
in the period ended December 31, 1999 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.

                                          /s/ Ernst & Young LLP

Palo Alto, California
February 4, 2000

                                      28
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                          Consolidated Balance Sheets
                (in thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1999      1998
                                                            --------  --------
<S>                                                         <C>       <C>
Assets
Current assets:
  Cash and cash equivalents................................ $ 14,888  $ 32,280
  Short-term investments...................................    4,972       --
  Accounts receivable, net of allowances of $724 and $662
   at December 31, 1999 and 1998, respectively.............    1,906     1,329
  Inventories..............................................    1,181       806
  Other current assets.....................................      164       411
                                                            --------  --------
Total current assets.......................................   23,111    34,826
Property and equipment.....................................    1,603     1,601
Other assets...............................................       84        85
                                                            --------  --------
                                                            $ 24,798  $ 36,512
                                                            ========  ========

Liabilities and stockholders' equity
Current liabilities:
  Accounts payable......................................... $  1,623  $  1,521
  Accrued liabilities......................................    1,442     1,562
  Accrued compensation.....................................    2,167     1,858
  Accrued warranty.........................................      907       612
  Accrued clinical costs...................................      547       675
  Deferred revenue.........................................    1,287       856
                                                            --------  --------
Total current liabilities..................................    7,973     7,084

Commitments

Stockholders' equity:
  Preferred stock, 5,000,000 shares authorized, par value
   $0.001 per share, no shares were outstanding at December
   31, 1999 and 1998.......................................      --        --
Common stock, 50,000,000 shares authorized, par value
 $0.001 per share, shares issued and outstanding:
 14,402,198 and 13,989,490 shares at December 31, 1999, and
 1998 respectively.........................................       14        14
Additional paid-in capital.................................   65,332    65,046
Deferred stock compensation................................     (189)     (450)
Accumulated deficit and accumulated comprehensive loss.....  (48,332)  (35,182)
                                                            --------  --------
    Total stockholders' equity.............................   16,825    29,428
                                                            --------  --------
                                                             $24,798  $ 36,512
                                                            ========  ========
</TABLE>

                            See accompanying notes.

                                       29
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                     Consolidated Statements of Operations
                    (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                  Years Ended December 31,
                                                 ----------------------------
                                                   1999      1998      1997
                                                 --------  --------  --------
<S>                                              <C>       <C>       <C>
Product revenues................................ $ 11,665  $  7,356  $  2,574
Cost of sales...................................    6,468     5,565     3,110
                                                 --------  --------  --------
Gross Margin....................................    5,197     1,791      (536)

Operating expenses:
 Research and development.......................    5,733     8,220     6,033
 Selling, marketing, general and
  administrative................................   14,053    14,953     6,741
                                                 --------  --------  --------
Total operating expenses........................   19,786    23,173    12,774
                                                 --------  --------  --------
Loss from operations............................  (14,589)  (21,382)  (13,310)
Interest and other income.......................    1,439     2,059       735
Interest expense................................      --         (5)     (182)
                                                 --------  --------  --------
Net loss........................................ $(13,150) $(19,328) $(12,757)
                                                 ========  ========  ========
Net loss per share, basic and diluted........... $  (0.92) $  (1.41) $  (3.02)
                                                 ========  ========  ========
Shares used in computing net loss per share,
 basic and diluted..............................   14,242    13,717     4,224
                                                 ========  ========  ========
</TABLE>


                            See accompanying notes.

                                       30
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                Consolidated Statement of Stockholders' Equity
                   (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                           Convertible                                                        Accumulated
                            Preferred                                                         Deficit and
                              Stock       Common Stock   Additional Receivable    Deferred    Accumulated     Total
                          --------------  --------------  Paid-In      from        Stock     Comprehensive Stockholders
                          Shares  Amount  Shares  Amount  Capital   Stockholder Compensation     Loss         Equity
                          ------  ------  ------  ------ ---------- ----------- ------------ ------------- ------------
<S>                       <C>     <C>     <C>     <C>    <C>        <C>         <C>          <C>           <C>
Balances at December 31,
 1996...................   5,284  $   5    2,463   $ 2    $11,969      $  (3)      $ (524)     $ (3,097)     $  8,352
Issuance of Series C
 convertible preferred
 stock at $7.00 per
 share in exchange for
 cash, net of issuance
 costs of $60...........     714      1      --    --       4,939        --           --            --          4,940
Issuance of common stock
 upon exercise of stock
 options for cash.......     --     --       384   --          68        --           --            --             68
Repayment of receivable
 from stockholder.......     --     --       --    --         --           3          --            --              3
Conversion of Series A,
 B and C preferred stock
 to common stock upon
 consummation of IPO....  (5,998)    (6)   5,998     6        --         --           --            --            --
Issuance of common stock
 pursuant to IPO, net of
 issuance costs of
 $4,540.................     --     --     4,600     5     43,757        --           --            --         43,762
Deferred compensation
 related to grant of
 stock options..........     --     --       --    --       4,049        --        (4,049)          --            --
Amortization of deferred
 compensation...........     --     --       --    --         --         --         1,252           --          1,252
Net loss and
 comprehensive loss.....     --     --       --    --         --         --           --        (12,757)      (12,757)
                          ------  -----   ------   ---    -------      -----       ------      --------      --------
Balances at December 31,
 1997...................     --     --    13,445    13     64,782        --        (3,321)      (15,854)       45,620
Issuance of common stock
 upon exercise of stock
 options for cash.......     --     --       479     1        178        --           --            --            179
IPO issuance costs......     --     --       --    --        (127)       --           --            --           (127)
Deferred Compensation
 related to stock option
 grants.................     --     --       --    --         817        --          (817)          --            --
Amortization of deferred
 compensation...........     --     --       --    --          --        --         2,811           --          2,811
Reduction of deferred
 compensation upon
 cancellation of option
 grants.................     --     --       --    --        (877)       --           877           --            --
Issuance of shares under
 Employee Stock Purchase
 Plan...................     --     --        65   --         273        --           --            --            273
Net loss and
 comprehensive loss.....     --     --       --    --         --         --           --        (19,328)      (19,328)
                          ------  -----   ------   ---    -------      -----       ------      --------      --------
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
                          ------  -----   ------   ---    -------      -----       ------      --------      --------
</TABLE>

                            See accompanying notes.

                                       31
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                     Consolidated Statements of Cash Flows
                                 (in thousands)

<TABLE>
<CAPTION>
                                                   Years Ended December 31,
                                                  ----------------------------
                                                    1999      1998      1997
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Cash flows used in operating activities
Net loss......................................... $(13,150) $(19,328) $(12,757)
Adjustments to reconcile net loss to net cash
 used in operating activities:
  Amortization of deferred compensation and
   acceleration of unvested options..............      496     2,811     1,252
  Depreciation...................................      774       716       800
  Net book value of property, plant and equipment
   retirements...................................      --        257       476
Changes in operating assets and liabilities:
  Other current assets...........................      247      (111)     (242)
  Accounts receivable............................     (577)     (667)     (662)
  Inventories....................................     (375)     (570)     (236)
  Other noncurrent assets........................        1       (23)      (58)
  Accounts payable, accrued liabilities and
   accrued warranty..............................      277     2,041     1,022
  Accrued compensation...........................      309     1,349       440
  Accrued clinical costs.........................     (128)      406       269
  Deferred revenue...............................      431       681       175
                                                  --------  --------  --------
Net cash used in operating activities............  (11,695)  (12,438)   (9,521)

Cash flows used in investing activities
Purchase of short-term investments...............   (4,972)      --        --
Capital expenditures.............................     (776)     (752)   (1,957)
                                                  --------  --------  --------
Net cash used in investing activities............   (5,748)     (752)   (1,957)

Cash flows provided by financing activities
Net proceeds from issuance of convertible
 preferred stock.................................      --        --      4,940
Net proceeds from issuance of common stock.......      340       325    43,829
Repayment of shareholder loan....................      --        --          3
Proceeds from borrowings under lease line of
 credit..........................................      --        --      1,956
Repayment of lease line of credit................      --        --     (2,933)
Repurchase of common stock.......................     (289)      --        --
                                                  --------  --------  --------
Net cash provided by financing activities........       51       325    47,795
                                                  --------  --------  --------
Net (decrease) increase in cash and cash
 equivalents.....................................  (17,392)  (12,865)   36,317
Cash and cash equivalents at beginning of
 period..........................................   32,280    45,145     8,828
                                                  --------  --------  --------
Cash and cash equivalents at end of period....... $ 14,888  $ 32,280  $ 45,145
                                                  ========  ========  ========

Supplemental disclosure of cash flow information
Cash paid for interest........................... $    --   $      5  $    182

Supplemental schedule of non-cash investing and
 financing activities
Property and equipment acquired under lease line
 of credit....................................... $    --   $    --   $  1,957
Deferred compensation related to grant of stock
 options, net.................................... $    --   $    (60) $  4,049
</TABLE>

                            See accompanying notes.

                                       32
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

                  Notes to Consolidated Financial Statements

1. Summary of Significant Accounting Policies

 Organization, Ownership and Business

   Somnus Medical Technologies, Inc. ("Somnus"), was incorporated in Delaware
on January 19, 1996. Somnus designs, develops, manufactures and markets
medical devices that utilize proprietary radiofrequency technology for the
management and treatment of upper airway disorders. Our Somnoplasty System is
intended to offer minimally-invasive, curative treatment alternatives for
disorders of the upper airway, including habitual snoring, obstructive sleep
apnea syndrome, and chronic turbinate hypertrophy. In 1996, we established
Somnus Medical Technologies Pty. Ltd. in Australia for purposes of conducting
clinical research studies on behalf of Somnus. In September 1998, we
established Somnus Medical Technologies B.V. in The Netherlands for purposes
of managing a sales distributor network in Europe. Collectively, the entities
are referred to as Somnus.

   From inception through mid 1997, our principal activities were recruiting
personnel, raising capital and performing research and development. During
1997 we received Food and Drug Administration ("FDA") 510(k) clearance for the
sale of our first products, to treat habitual snoring and chronic turbinate
hypertrophy. In November 1998, we received an additional 510(k) FDA clearance
to treat Obstructive Sleep Apnea Syndrome ("OSAS").

 Basis of Presentation

   The consolidated financial statements include the accounts of Somnus
Medical Technologies, Inc. and our wholly owned subsidiaries, Somnus Medical
Technologies Pty. Ltd and Somnus Medical Technologies, B.V. after elimination
of all material intercompany balances and transactions.

 Reclassifications

   Certain prior year amounts have been reclassified to conform to the current
year presentation.

 Revenue Recognition

   We recognize revenue at the time products are shipped or, for sales which
are financed through third parties, upon acceptance from a third party leasing
company of a customer lease and the related equipment. For shipments to
distributors made under agreements that do not provide for right of return or
price protection, revenue is recognized upon shipment to the final customer.
Allowances for product returns are provided at the time of revenue
recognition.

 Dependence on Distributors and Single-Source Suppliers

   Somnus entered into a Distribution Agreement with Medtronic Inc.
("Medtronic") on April 21, 1997 for a period of three years with defined
minimum annual purchase requirements. The Agreement granted Medtronic
exclusive distribution rights of certain of Somnus products in the European
Union, Australia, Southeast Asia and certain other areas until April 21, 2000.
As of September 1998, we terminated our relationship with Medtronic and
established a European headquarters in The Netherlands. During 1998 Medtronic
Europe was not a significant customer and in 1997 net sales of approximately
$824,000 were transacted with Medtronic's European operations. There were no
other single customers whose sales made up 10% or more of our revenue in 1999
or 1998.

   During 1997 and through mid 1998, we purchased what was our only
commercially available radiofrequency ("RF") control unit from a single-source
supplier. During 1998, we launched a new control unit

                                      33
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

product which we manufacture in- house, effectively replacing the prior
version, which was manufactured by sub- contractors. Certain components
continue to be purchased from single-source suppliers. Establishing additional
or replacement suppliers for such control unit or certain of the components
used in our products, if required, may not be accomplished quickly and could
involve significant additional costs. Any supply interruption from suppliers
or failure of Somnus to obtain alternative suppliers for the control unit or
such components would limit our ability to manufacture and sell our products
and would have a material adverse effect on our business, financial condition
and results of operations.

 Net Loss Per Share

   Basic and diluted net loss per share has been calculated using the weighted
average common shares outstanding during the periods in accordance with
Statements of Financial Accounting Standard No. 128 (SFAS 128) "Earnings Per
Share" issued by the Financial Accounting Standards Board and Securities and
Exchange Commission Staff Accounting Bulletin No. 98 (SAB 98).

   We have securities outstanding that could dilute earnings per share in the
future that were not included in the computation of net loss per share in the
periods presented as their effect is antidilutive. For additional disclosures
regarding potentially dilutive stock options, warrants and convertible
preferred stock, see Note 7.

 Employee Stock Plans

   We account for our stock option plans and our employee stock purchase plan
in accordance with the provisions of the Accounting Principles Board's Opinion
No. 25 (APB 25), "Accounting for Stock Issued to Employees" and have adopted
the disclosure-only alternative of SFAS 123.

 Accounting Estimates

   The preparation of financial statements in conformity with 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.

   We periodically evaluate the carrying value of long-lived assets to be held
and used when events and circumstances indicate that the carrying amount of an
asset may not be recovered. Recoverability of assets to be

                                      34
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

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.

 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. Short-term
investments principally consist of time deposits and temporary money-market
instruments. 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. In 1999, Somnus wrote off $105,000 as expenses related to one
customer. All other losses were immaterial. There were no material losses on
individual customer receivables in 1998.

 Advertising Expenses

   We expense the costs of advertising as incurred. For the years ended
December 31, 1999, 1998 and 1997 advertising expenses were $865,000, $129,000,
and $890,000, respectively.

 Comprehensive Loss

   We have no material components of other comprehensive loss and,
accordingly, the comprehensive loss is the same as net loss for all periods
presented.

 Segment Information

   We have 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 our assets are in the United States and through December
31, 1999 we have derived our revenue primarily from our 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.

                                      35
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


2. Financial Instruments

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

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1999      1998
                                                            --------  --------
   <S>                                                      <C>       <C>
   Money market funds...................................... $  4,694  $  9,958
   Certificates of deposit.................................    2,988     9,996
   Commercial paper........................................   11,910    11,947
                                                            --------  --------
                                                              19,592    31,901
   Amounts classified as cash equivalents.................. $(14,620) $(31,901)
                                                            --------  --------
   Short-term investments.................................. $  4,972  $    --
                                                            ========  ========
</TABLE>

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

3. Property and Equipment

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

<TABLE>
<CAPTION>
                                                               December 31,
                                                              ----------------
                                                               1999     1998
                                                              -------  -------
   <S>                                                        <C>      <C>
   Machinery and equipment................................... $ 1,239  $ 1,257
   Computer equipment........................................   1,140      862
   Furniture and fixtures....................................     762      610
   Purchased software........................................     404      317
                                                              -------  -------
                                                                3,545    3,046
   Less accumulated depreciation and amortization............ $(1,942) $(1,445)
                                                              -------  -------
   Property and equipment, net............................... $ 1,603  $ 1,601
                                                              =======  =======
</TABLE>

4. Inventories

   Inventories consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                                      December
                                                                         31,
                                                                     -----------
                                                                      1999  1998
                                                                     ------ ----
   <S>                                                               <C>    <C>
   Raw materials.................................................... $  406 $399
   Work-in-process..................................................    214  111
   Finished goods...................................................    561  296
                                                                     ------ ----
                                                                     $1,181 $806
                                                                     ====== ====
</TABLE>

                                       36
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


5. Commitments

   We lease two facilities in Sunnyvale, California and one facility in the
Netherlands under operating lease agreements which expire on March 31, 2002,
February 28, 2000 and 2000, respectively.

   Future payments under non-cancelable operating lease arrangements at
December 31, 1999 are as follows:

<TABLE>
   <S>                                                                   <C>
   Years ending December 31 (in thousands):
   2000................................................................. $  822
   2001.................................................................    836
   2002.................................................................    210
                                                                         ------
     Total minimum payments............................................. $1,868
                                                                         ======
</TABLE>

   Rent expense for the years ended December 31, 1999, 1998, and 1997 was
approximately $499,000, $417,000 and $353,000, respectively.

6. Related Party Transactions

   Our Series B preferred stock issuance in September 1996 included a finder's
fee to an entity associated with a member of the Board of Directors totaling 7%
of the aggregate proceeds received by Somnus from the sale of Series B
preferred stock. The agreement included a provision which allowed the entity to
receive not less than 25% of the fee owed by Somnus in equity or debt
instruments in Somnus. Pursuant to this clause, the total finder's fee owed of
$710,000 was paid with 60,000 shares of Series B preferred stock valued at
$3.00 per share and $530,000 in cash. The Series B preferred stock converted to
common stock in conjunction with our initial public offering. This transaction
has been included in the issuance costs of the Series B offering. Additionally,
in connection with the Series B preferred stock financing, the entity
associated with a director entered into an agreement with Somnus whereby for
each 1% of the shares actually sold in our initial public offering that were
purchased by investors or parties directly affiliated with the investors placed
by the entity in the Series B preferred stock financing, the entity was granted
options or warrants to purchase 1,000 shares of common stock at a price
equivalent to the initial public offering price. Such options or warrants have
a five-year term and are entitled to anti-dilution and piggyback registration
rights. A total of 5,000 warrants were issued in January 1998 in consideration
of this provision.

   In March 1998, we entered a Technology License Agreement with a certain
company affiliated with a stockholder and member of the board of directors.
This agreement allows us to make, sell or use our model 215 RF control unit
with a certain field of radiofrequency volume tissue reduction related to the
treatment of airway obstructions and other disorders of the head and neck.
During 1998, we recorded a $50,000 one-time royalty fee. In June 1998 we
introduced our new generation S2 Control Unit and discontinued making the 215
RF product. No further payments are required under this agreement.

   In December 1998, we granted an irrevocable non-exclusive, worldwide right
and license to a company affiliated to a stockholder and certain members of the
board of directors to manufacture, use and sell RF control units based on the
licensed technology to treat structures, organs and tissues of the digestive
tract and specifically excludes treatment of any body structure located above
the upper esophageal sphincter. Under this agreement, we received 175,000
shares of Series A Preferred Stock of that Company. We also received a
technology license fee of $125,000 payable in two installments of $62,500 in
December 1998 and $62,500 in February 1999. Documentation fees for design and
manufacturing totaling $70,000 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 for $9,000 each. No kits
had been purchased as of December 31, 1998. During 1999, sales

                                       37
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

of kits to this related party of $445,000 were included in total revenues. For
the life of this agreement Somnus shall receive a royalty of 2.5% of the
selling price on all RF control units using this technology, sold by the
licensee. No royalty payments have been received under the license agreement.

In addition, the Company's Chairman of the Board received a consulting fee of
$100,000.

7. Stockholders' Equity

 Preferred Stock

   On November 6, 1997, we completed an initial public offering of our shares
pursuant to which we issued 4,600,000 common shares for net proceeds of
approximately $43,800,000. Upon the closing of the initial public offering,
all 5,998,000 outstanding shares of Convertible Preferred stock of Somnus were
automatically converted into Common Stock on a share for share basis.

   In November 1998, we announced the adoption of a Preferred Shares Purchase
Agreement (the agreement). Pursuant to the agreement, there will be a dividend
distribution of one Preferred Share Purchase Right on each outstanding share
of our common stock, commencing on November 18, 1998. Each right will entitle
stockholders to buy one one-thousandth of a share of Preferred Stock at an
exercise price of $18.00. The Rights will become exercisable following the
tenth day after a person or group announces acquisition of, or commencement of
a tender offer which would result in the acquisition of 15% or more of our
common stock. Subject to certain restrictions, we will be entitled to redeem
the Rights at $0.001 per Right at any time before they become exercisable.
Subject to certain restrictions, at any time after an event triggering
exercisability of the Rights at a discounted price and prior to the
acquisition by the acquiring person of 50% or more of the outstanding common
stock, the Board of Directors of Somnus may exchange the Rights (other than
those owned by the acquiring person or our affiliates) for Common Stock of
Somnus at an exchange ratio of one share of common stock per Right.

 Common Stock

   During 1996, we sold 2,335,000 and 30,000 shares of common stock to
founders for $0.001 and $0.10 per share, respectively, of which certain shares
are subject to repurchase rights which generally expire ratably over four
years. Upon termination of service, any unvested shares may be repurchased by
Somnus at the issuance price. The shares are not contingent upon any
conditions other than a time period of employment. At December 31, 1998 and
1999, 340,000 and 6,000 shares, respectively, were subject to these repurchase
rights held by Somnus. No shares have been repurchased by Somnus as of
December 31, 1999.

   Somnus has reserved approximately 4,517,000 shares of common stock for
future issuance under all stock option plans and stock purchase plans at
December 31, 1999.

   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. During 1998, no
shares had been repurchased by Somnus. During 1999, we repurchased 100,000
shares.

 1996 Stock Plan

   Under our 1996 Stock Plan (the "plan"), which was adopted in March 1996,
options may be granted for common stock or common stock may be issued,
pursuant to actions by the board of directors, to eligible participants.
Options granted are either incentive stock options or nonstatutory stock
options and are exercisable within the times or upon the events determined by
the board of directors as specified in each option agreement. Incentive stock
options granted under the Plan are at prices not less than 100% of the fair
value at the date of

                                      38
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

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. The term of the plan is ten years. As of
December 31, 1999, a total of 4,081,898 shares of common stock have been
reserved for issuance under the Plan.

 1997 Director Option Plan

   In August 1997, our 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.

 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. We do not recognize
compensation cost related to employee purchase rights under the Purchase Plan.

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

<TABLE>
<CAPTION>
                                                     Outstanding Stock Options
                                                     --------------------------
                                                               Weighted Average
                                            Shares    Number    Exercise Price
                                           Available of Shares    Per Share
                                           --------- --------- ----------------
<S>                                        <C>       <C>       <C>
Balance at December 31, 1996..............     184     1,638        $0.17
 Additional shares authorized for
  issuance................................   1,780       --
 Options granted..........................  (1,463)    1,463        $3.59
 Options exercised........................     --       (383)       $0.19
 Options canceled.........................     281      (281)       $1.12
                                            ------     -----        -----

Balance at December 31, 1997..............     782     2,437        $2.12
 Additional shares authorized for
  issuance................................   1,250       --
 Options granted..........................  (1,547)    1,547        $4.88
 Options exercised........................      --      (479)       $0.42
 Options canceled.........................     893      (893)       $6.22
                                            ------     -----        -----

Balance at December 31, 1998..............   1,378     2,612        $2.70
 Additional shares authorized for
  issuance................................     937       --
 Options granted..........................  (2,015)    2,015        $2.37
 Options exercised........................     --       (410)       $0.26
 Options canceled.........................     796      (796)       $2.69
                                            ------     -----        -----
Balance at December 31, 1999..............   1,096     3,421        $2.80
                                            ======     =====        =====
</TABLE>

                                      39
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   At December 31, 1999 and 1998, options to purchase 1,088,000 and 915,000
shares, respectively, were exercisable.

   The following table summarizes information about options outstanding at
December 31, 1999 (shares in thousands):

<TABLE>
<CAPTION>
                  Options Outstanding     Weighted Average    Exercisable Options
               --------------------------    Remaining     --------------------------
    Range of    Number   Weighted Average Contractual Life  Number   Weighted Average
    Exercise   of Shares  Exercise Price     (in years)    of Shares  Exercise Price
    --------   --------- ---------------- ---------------- --------- ----------------
   <S>         <C>       <C>              <C>              <C>       <C>
   $0.10-1.47      580        $0.87             8.39           239        $0.20
   1.91-3.38     2,360         2.74             8.34           591         3.11
   3.50-7.50       464         5.28             8.20           248         5.72
   9.25-10.00       14         9.89             8.36             7         9.90
    10.75-
    10.75            3        10.75             8.03             3        10.75
   ----------    -----        -----             ----         -----        -----
   $0.10-
    10.75        3,421        $2.80             8.33         1,088        $3.12
   ==========    =====        =====             ====         =====        =====
</TABLE>

   On September 18, 1998, we effected an option exchange program to allow
employees (excluding executive officers) to exchange 436,168 options to
purchase shares with an exercise price between $7.50 and $10.75 for options
with an exercise price of $3.375 (the fair value of our stock on September 18,
1998). All of the re-priced options continue to vest under the original terms
of the option grants. In exchange for the offer to re-price stock options,
employees agreed to a moratorium on exercising re-priced options until
September 18, 1999. Additionally, if an employee voluntarily terminates
employment with Somnus prior to September 18, 1999, all vested shares at the
date of termination relating to re-priced stock options will be canceled and
forfeited.

 Pro Forma Disclosures

   We elected to follow APB No. 25, "Accounting for Stock Issued to Employees"
and related interpretations, in accounting for our employee stock options
because, as discussed below, the alternative fair value accounting provided
for under SFAS No. 123 "Accounting for Stock-Based Compensation", requires use
of option valuation models that were not developed for use in valuing employee
stock options. Somnus, under APB No. 25, generally does not recognize
compensation expense as the exercise price of our employee stock options
equals the market price of the underlying stock on the date of the grant.

   Pro forma information regarding net loss and net loss per share is required
by SFAS No. 123, which also requires that the information be determined as if
we accounted for our employee stock options granted subsequent to December 31,
1995 under the fair value method of this statement.

   The fair value of options granted in 1999, 1998 and 1997 were estimated at
the date of grant using the minimum value method, assuming no dividends, an
expected life of four years, volatility of 112% for 1999, 70% for 1998, and a
nominal volatility for 1997, and a risk free interest rate of 6.0% for 1999,
5.2% for 1998, and 5.3% for 1997.

   Had compensation cost for our stock-based compensation plans been
determined based on the fair value at the grant dates for awards under those
plans consistent with the method of SFAS No.123, our net loss and loss per
share would have been increased to the pro forma amounts indicated below.

                                      40
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   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,
                                              --------------------------------
                                                 1999       1998       1997
                                              ---------- ---------- ----------
   <S>                                        <C>        <C>        <C>
   Pro forma net loss........................ $ (15,065) $ (21,818) $ (12,868)
   Pro forma basic and diluted net loss per
    share.................................... $   (1.06) $   (1.60) $   (3.05)
</TABLE>

   Because SFAS No. 123 is applicable only to options granted subsequent to
December 31, 1994, our pro forma effect will not be fully reflected until
subsequent years. The effects on pro forma disclosures of applying SFAS No.
123 are not likely to be representative of the effects on pro forma
disclosures in future years.

 Warrants

   In connection with equipment term loans in 1996, we issued warrants to
purchase 37,500 shares of Series A preferred stock at $1.00 per share and
25,000 shares of Series B preferred stock at $3.00 per share which were
converted to common stock warrants in conjunction with the IPO. These warrants
may be exercised at any time prior to June 24, 2006 and October 1, 2001,
respectively. The values of these warrants were determined by Somnus to be
immaterial for financial statement purposes. Warrants outstanding at December
31, 1999 and 1998 were 62,500.

 Stock Compensation

   We recorded deferred compensation of approximately $4,049,000 during the
year ended December 31, 1997. This amount represent the difference between the
exercise price and the deemed fair value of certain of our stock options
granted in these periods. Deferred compensation recorded is amortized over the
period that the options vest and is adjusted for options which have been
canceled. During the fiscal year ended December 31, 1998, we recorded deferred
compensation with respect to stock options granted to consultants and as a
result of changing the vesting terms of certain employee stock options
totaling $817,000. There were no significant grants of stock options to
consultants in 1999 or 1997. Deferred compensation expense was $261,000,
$2,811,000, and $1,252,000 respectively, during 1999, 1998, and 1997.

   At December 31, 1999, Somnus has a total of $189,000 remaining to be
amortized over the corresponding vesting period of each respective option,
generally four years.

8. Employee Benefit Plan

   We have a 401(k) Plan which stipulates that all full-time employees 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. We have the option
to provide matching contributions but have not done so to date.

9. Income Taxes

   As of December 31, 1999, the Company had federal and state net operating
loss carryforwards of approximately $40,100,000 and $21,800,000, respectively.
The Company also had $700,000 of federal and $700,000 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.


                                      41
<PAGE>

                       SOMNUS MEDICAL TECHNOLOGIES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

   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,
                                                             ------------------
                                                               1999      1998
                                                             --------  --------
   <S>                                                       <C>       <C>
   Deferred Tax Assets:.....................................
    Net operating loss carry forwards....................... $ 14,900  $ 10,200
    Research and other credits..............................    1,100       700
    Capitalized research expenses...........................    1,200       900
    Other...................................................    1,200       800
                                                             --------  --------
   Total Deferred Tax Assets................................ $ 18,400  $ 12,600
   Valuation Allowance......................................  (18,400)  (12,600)
                                                             --------  --------
   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 $5,800,000 and $6,800,000 during the years ended December 31,
1999 and December 31, 1998.

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

   Not applicable

                                      42
<PAGE>

                                   PART III

   Certain information required by Part III is omitted from this Report on
Form 10-K in that the Registrant will file a definitive proxy statement within
120 days after the end of our fiscal year pursuant to Regulation 14A with
respect to the 2000 Annual Meeting of Stockholders (the "Proxy Statement") and
certain information included therein is incorporated herein by reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   Certain of the information required by this item relating to directors is
incorporated by reference to the information under the caption "Proposal No. 1
-- Election of Directors" in the Proxy Statement.

   The executive officers of the Registrant, who are elected by the board of
directors, are as follows:

<TABLE>
<CAPTION>
 Name                  Age                       Position
 ----                  ---                       --------
 <C>                   <C> <S>
 John G. Schulte......  51 Chairman of the Board, Chief Executive Officer and
                           President
 Robert D. McCulloch..  38 Vice President Finance, Chief Financial Officer and
                           Chief Information Officer (Principal Financial and
                           Accounting Officer)
 Ron Byron............  42 Vice President and General Manager, Somnus Europe
 Robert D. Campbell...  45 Vice President, Sales and Marketing
 Edward H. Luttich....  44 Vice President, Research and Development
 John C. Meyer........  55 Vice President, Human Resources
 Steven J. Ojala......  53 Vice President, Clinical, Quality and Regulatory
                           Affairs
 Brad L. Steadman.....  43 Vice President, Manufacturing
</TABLE>

   John G. Schulte has served as President, Chief Executive Officer and
Director of the Company 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 disgnostics 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 Somnus 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.

   Ron D. Byron, formerly European Business Manager of Medtronic, Inc.'s Upper
Airway Venture, has served as Vice President and General Manager for Somnus
Europe since July 1998. Mr. Byron has 12 years of sales/marketing experience
in the pharmaceutical and medical device industry and served as European
Business Manager of Medtronic, Inc.'s Upper Airway Venture from April 1998 to
July 1998. Prior to that, Mr. Byron was International Marketing Manager for
St. Jude Medical from July 1995 to March 1998. While at St. Jude, Mr. Byron
covered several international territories including Europe, the Middle East
and South Africa. From 1990 to 1995, Mr. Byron held several sales and
marketing positions at American Cyanamid, Inc. (Lederle Pharmaceutical
Division). Mr. Byron holds a B.Sc. from the Academy of Sport Science &
Physical Education in Arnhem, The Netherlands and an MBA from the Glasgow
University Business School in Scotland.

                                      43
<PAGE>

   Robert D. Campbell has served as Vice President of Sales and Marketing for
the Company since January 1999. From July 1998 to December 1998, Mr. Campbell
served as Vice President of Sales for the Company. From August 1997 to June
1998, Mr. Campbell was Western Regional Sales Manager, Director of Sales and
VP of North American Sales for the Company. 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.

   Edward H. Luttich has served as Vice President of Research and Development
for the Company since November 1999. Mr. Luttich comes to Somnus 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 Director
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.

   John C. Meyer has served as Vice President of Human Resources for the
Company since January 1999. He has a broad track record covering 25 years at
the executive level of Human Resources. Prior to joining Somnus, he was Vice
President of Human Resources at Vivus, Inc. a urology company, from February
to December 1998. He also served as Vice President of Human Resources at
Target Therapeutics, an interventional neuroradiology company which was
acquired in 1997 by Boston Scientific, from January 1996 to September 1997.
Prior to that, he served as Vice President of HR at Chipcom, Inc. from 1991 to
1995. Chipcom designs, manufactures, markets and services intelligent
switching systems including a broad range of hub, internetworking and network
management products. Mr. Meyer has a B.S. in Business from Colorado State
University.

   Steven J. Ojala has served as Vice President of Clinical, Quality and
Regulatory Affairs for the Company since October 1999. Dr. Ojala brings 25
years experience in the medical device, pharmaceutical and biological product
industries to Somnus. Most recently, he served as Vice President of
Regulatory, Clinical and Quality for IMPRA, a leading manufacturer of
implantable vascular grafts, from October 1998 to September 1999. Prior to
this assignment, from February 1997 to February 1998, Dr. Ojala was Corporate
Vice President and Chief Technology Officer at R.P. Scherer, a drug delivery
company, where he managed worldwide operations for Research and Development,
Corporate Engineering, Regulatory, Quality and Information Technology. He
previously spent May 1994 to January 1997 in Copenhagen, Denmark as Senior
Vice President of Quality and Regulatory operations at Novo-Nordisk, a $3
billion diversified pharmaceutical, biotechnology and industrial enzyme
company. Dr. Ojala received his undergraduate degree from the University of
California, Berkeley, an MBA from Golden Gate University in San Francisco, and
his Ph.D. from West Virginia University.

   Brad L. Steadman has served as Vice President of Manufacturing for the
Company 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 Vice President of Operations for Autogenics, a heart valve start up
from December 1995 to April 1996 and 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.

                                      44
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

   The information required by this item is incorporated by reference to the
information under the caption "Executive Compensation" in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

   The information required by this item is incorporated by reference to the
information under the caption "Record Date and Stock Ownership" in the Proxy
Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   The information required by this item is incorporated by reference to the
information under the caption "Certain Transactions" in the Proxy Statement.

                                    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, 1999 and 1998.

   Consolidated Statements of Operations, for the years ended December 31,
1999, 1998 and 1997.

   Consolidated Statement of Stockholders' Equity, for the years ended
December 31, 1999, 1998 and 1997.

   Consolidated Statements of Cash Flows, for the years ended December 31,
1999, 1998 and 1997 .

   Notes to Consolidated Financial Statements

2. FINANCIAL STATEMENT SCHEDULES

     The financial statement schedule entitled "Valuation and Qualifying
  Accounts" is included at page 53 of this Form 10-K.

     All other schedules are omitted because they are not applicable or the
  required information is shown in the Financial Statements or the notes
  thereto.

3. EXHIBITS

   Refer to (c) below.

(B) REPORTS ON FORM 8-K

     Somnus was not required to and did not file any reports on Form 8K
  during the three months ended December 31, 1999.

                                      45
<PAGE>

(C) EXHIBITS

<TABLE>
<CAPTION>
 Exhibit
   No.                                  Description
 -------                                -----------
 <C>        <S>
   3.1(1)   Amended and Restated Certificate of Incorporation.

   3.2(1)   Bylaws of the Registrant.

   4.1(1)   Specimen Common Stock Certificate.

  10.1(1)   Form of Indemnification Agreement for directors and officers.

  10.2(1)   Amended and Restated 1996 Stock Plan and form of agreement
            thereunder.

  10.3(1)   Restated Investors' Rights Agreement between the Registrant and the
            parties named therein dated as of April 21, 1997.

  10.4(1)   Letter Agreement dated June 6, 1996 between the Registrant and
            Musket Research Associates.

  10.5(1)   Lease dated February 4, 1997 for the Registrant's headquarters in
            Sunnyvale, California.

  10.6(1)   Employment Letter Agreement dated May 8, 1996 between the
            Registrant and Eric N. Doelling, and amendment thereto dated August
            26, 1996.

  10.7(1)   1997 Employee Stock Purchase Plan.

  10.8(1)   1997 Director Option Plan.

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

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

  10.11     Amended Employment Letter Agreement dated November 2, 1998 between
            the Registrant and Stuart D. Edwards.

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

  10.13     Further Amendment to Employment Letter Agreement dated October 21,
            1998 between the Registrant and Eric N. Doelling.

  10.14(3)  Consulting agreement dated December 28, 1998 between the Registrant
            and Gary R. Bang.

  10.15     Employment Letter Agreement dated January 28, 1999 between the
            Registrant and John C. Meyer.

  10.16*(4) Development and Supply Agreement

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

  10.18     Employment Letter Agreement dated September 27, 1999 between the
            Registrant and Steven J. Ojala.

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

  10.20     Lease effective December 1, 1999 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 47).

  27.1      Financial Data Schedule.
</TABLE>
--------
 * Confidential Treatment has been requested for certain portions of this
   Exhibit.
(1) Filed as an Exhibit to Somnus Registration Statement on Form S-1 (File No.
    333-35401) and incorporated herein by reference.
(2) Filed as an Exhibit to Somnus Form 10K for the year ended December 31,
    1998 (File No. 000-23275) and incorporated herein by reference.
(3) Filed as an Exhibit to Somnus Form 10Q for the quarterly period ended
    March 31, 1999 (File No. 000-23275) and incorporated herein by reference.
(4) Filed as an Exhibit to Somnus Form 10Q for the quarterly period ended June
    30, 1999 (File No. 000-23275) and incorporated herein by reference.

                                      46
<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.

                                          By: /s/ 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/                    President, Chief Executive      March 29, 2000
____________________________________ Officer and Director
          (John G. Schulte)

              /s/                    VP Finance, Chief Financial     March 29, 2000
____________________________________ Officer and Chief
        (Robert D. McCulloch)        Information Officer
                                     (Principal Financial and
                                     Accounting Officer)

              /s/                    Chairman of the Board of        March 29, 2000
____________________________________ Directors
            (Gary R. Bang)

              /s/                    Director                        March 29, 2000
____________________________________
            (Abhi Acharya)

              /s/                    Director                        March 29, 2000
____________________________________
           (Mark B. Logan)

              /s/                    Chief Technical Officer and     March 29, 2000
____________________________________ Director
         (Stuart D. Edwards)

              /s/                    Director                        March 29, 2000
____________________________________
          (David B. Musket)

              /s/                    Director                        March 29, 2000
____________________________________
       (Woodrow A. Myers, Jr.)
</TABLE>

                                      47
<PAGE>

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

<TABLE>
<CAPTION>
                                                Balance at Charged
                                                Beginning    to    Balance at
                                                   Year     Costs  End of Year
                                                ---------- ------- -----------
<S>                                             <C>        <C>     <C>
Allowance for Doubtful Accounts Year ended
 December 31, 1999.............................    $661     $ 63      $724
Year ended December 31, 1998...................    $ 70     $591      $661
Year ended December 31, 1997...................    $--      $ 70      $ 70

Inventory Reserve Year ended December 31,
 1999..........................................    $797     $ 33      $830
Year ended December 31, 1998...................    $599     $198      $797
Year ended December 31, 1997...................    $--      $599      $599

Return Reserves Year ended December 31, 1999...    $391     $109      $500
Year ended December 31, 1998...................    $--      $391      $391
Year ended December 31, 1997...................    $--      $--       $--
</TABLE>

                                       48