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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                   -----------
                                    FORM 10-K

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

                For the Fiscal Year Ended December 31, 1998, or

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

            For the Transition period from __________ to __________.

                         COMMISSION FILE NUMBER: 0-19707
                                 INNERDYNE, INC.
             (Exact name of registrant as specified in its charter)

                       DELAWARE                             87-0431168
           (State or other jurisdiction of               (I.R.S. Employer
            incorporation or organization)              Identification No.)

                   1244 Reamwood Avenue, Sunnyvale, CA 94089
           (Address of principal executive offices)        (Zip Code)
       Registrant's telephone number, including area code: (408) 745-6010

                                   -----------

           Securities registered pursuant to Section 12(b) of the Act:
        None Securities registered pursuant to Section 12(g) of the Act:
                     Common Stock, $0.01 par value per share
                         Preferred Share Purchase Rights
                                (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 past 90 days.
YES  [X]  NO  [ ]  

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

        The aggregate market value of the voting stock held by non-affiliates of
the Registrant was approximately $30,717,227 as of February 26, 1999, based upon
the closing sale price of the issuer's Common Stock on the Nasdaq National
Market reported for such date. Shares of Common Stock held by each officer and
director and by each person who owns 5% or more of the outstanding Common Stock
have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.

There were 22,877,422 shares of issuer's Common Stock issued and outstanding as
of February 26, 1999.

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DOCUMENTS INCORPORATED BY REFERENCE

        Parts of the Proxy Statement for Registrant's 1999 Annual Meeting of
Stockholders to be held on May 27, 1999 are incorporated by reference into Part
III of this Form 10-K.

                                     PART I

ITEM 1.  BUSINESS
THE COMPANY

    InnerDyne, Inc. (the "Company" or "InnerDyne") is primarily focused upon the
development and commercialization of access products based on its proprietary
radial dilation technology used to perform minimally invasive surgical
("M.I.S.") procedures. InnerDyne designs, develops, manufactures and
commercializes minimally invasive surgical access products incorporating its
proprietary radial dilation technology. The Company is evaluating the
application of its radial dilation technology to enhance percutaneous access for
vascular procedures. The Company has proprietary technology in the areas of
biocompatible coatings, radiation delivery for the treatment of restenosis and
cancer, and drug attachment technologies, which it intends to continue to
develop either internally or through strategic alliances. InnerDyne, Inc. common
stock is traded on the Nasdaq National Market under the symbol IDYN.

        Except for the historical information contained in this Annual Report on
Form 10-K, the matters discussed throughout this Annual Report on Form 10-K are
forward-looking statements that are subject to certain risks and uncertainties
that could cause the actual results to differ materially from those projected.
Factors that could cause actual results to differ materially include, but are
not limited to, the impact of intense competition in the Company's market, the
extent of market acceptance of the Company's Step(TM) family of products, the
timely development and market acceptance of new products and technologies, the
compliance of the Company's manufacturing facilities with Good Manufacturing
Practices ("GMP") and ISO 9000 standards and regulations, the continued
acceptance of minimally invasive surgical procedures, the Company's ability to
further expand into international markets, public policy relating to health care
reform in the United States and other countries, approval of the Company's
products by government agencies such as the United States Food and Drug
Administration (the "FDA") and the risks set forth in greater detail below under
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations, and included from time to time in the Company's other Securities
and Exchange Commission ("SEC") reports and press releases, copies of which are
available from the Company upon request or by accessing the Company's website at
www.innerdyne.com. The Company undertakes no obligation to publicly release the
result of any revisions to these forward-looking statements that may be made to
reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events.

INDUSTRY BACKGROUND

Minimally Invasive Surgical Procedures

        Medical practitioners have, for many years, sought means to improve the
care of their patients and minimize the trauma and recovery time associated with
such care. In recent years, as life expectancy has increased, overall health
care costs have outpaced the average inflation rate. The performance of surgical
procedures utilizing minimally invasive techniques has been a response to both
the need to continuously improve the quality of patient care and the increasing
pressures to control the total cost of providing that care. Minimally invasive
surgical procedures typically involve a few small incisions rather than the
large incisions used in traditional open surgery, thereby reducing patient
trauma. M.I.S. procedures involve three basic capabilities: (1) a means to gain
access to the treatment site; (2) a means to assess the treatment site; and (3)
a means to provide therapy.

        Although less invasive alternatives to traditional open surgery have
existed for a number of years, the trend toward minimally invasive techniques
was not widespread until the late 1980s. At that time, surgeons developed and
perfected a technique for gall bladder removal through the use of specialized
access, diagnostic and treatment devices. By 1998, an estimated 95% of the
approximately 675,000 gall bladder procedures in the United States were
performed using minimally invasive techniques. A number of surgical procedures,
other than gall bladder surgery, are undergoing 


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conversion to minimally invasive approaches, including the treatment of
gynecological disorders and the diagnosis and treatment of diseases of the
vasculature. In addition, M.I.S. procedures may be useful for intra-organ
diagnosis and treatment. It is estimated that in 1997 over 1.0 million
procedures traditionally accomplished through open surgery were performed in the
United States using M.I.S. techniques. M.I.S. procedure growth is expected to
significantly outpace increases in total surgical procedures for the balance of
the decade. It is estimated that more than 5.0 million surgical procedures
performed in 1997 were considered to be potential candidates for minimally
invasive approaches.

M.I.S. Access Devices

         A trocar is the conventional device that is used by surgeons to access
a possible treatment site in an M.I.S. procedure. A trocar is generally a
sharp-pointed cutting instrument surrounded by a rigid sheath, or cannula, that
is forced through the abdominal wall by the surgeon and cuts through the muscle
and skin layers which make up the abdominal wall. Trocar insertion is normally
preceded by the insertion of an insufflation (inflation) needle into the
abdominal cavity through which a gas can be pumped to insufflate the abdominal
cavity as a means of providing working space and added clearance, such that
internal body organs are less likely to be damaged as a sharp-bladed trocar is
inserted. Once a trocar has penetrated the abdominal wall, the cutting portion
of the device is removed, leaving the cannula through which instruments and
diagnostic tools can be placed into the abdominal cavity of the patient. The
proximal end of the trocar, which remains outside the body, is normally equipped
with a valve system designed to allow the passage of instruments while
maintaining insufflation gas pressure. Trocars are most commonly provided in
5mm, 10mm and 12mm working channel sizes, and leave residual wounds which
approximate these nominal sizes. From one to as many as six trocars are used for
access in M.I.S. procedures depending on the extent and complexity of the
particular procedure. In addition, anchors are frequently used with trocars to
assure maintenance of insufflation pressure and to prevent slippage of the
trocars as instruments are passed through them during a procedure. These anchor
devices, when used, can enlarge the wound size and increase trauma to adjacent
tissues.

        Trocars consist of two types: disposable and reusable. Industry sources
estimate that in 1997 sales of disposable trocars in the United States totaled
approximately $230 to $240 million, and global sales totaled more than $300
million. Reusable trocars are used to a greater extent internationally than in
the United States. Reusable trocars must be sharpened from time to time when
they become dull. As a result, a reusable trocar may not consistently and
cleanly cut through the muscle and skin layers that make up the abdominal wall.
The potential risk of serious trauma to the patient may be increased because
greater pressure can be required to force the trocar through the abdominal wall,
causing the abdominal cavity to partially collapse and reduce the space created
by insufflation. In addition, medical personnel that handle and clean reusable
trocars are also subject to the risk of cuts and skin punctures because a trocar
is a sharp cutting instrument.

        Another device commonly used in M.I.S. procedures is a percutaneous
catheter. A number of minimally invasive percutaneous catheter-based therapies
have been developed to treat vascular disease, including coronary and peripheral
transluminal angioplasty, atherectomy and vascular stenting. In addition,
minimally invasive catheter-based diagnostic procedures such as angiography and
ultrasound imaging are used by physicians in connection with therapeutic
procedures. Industry sources estimate that in 1997 approximately 4.7 million
minimally invasive vascular access procedures were performed worldwide. In
addition, approximately 1.2 million interventional radiology procedures
utilizing minimally invasive vascular access were performed in 1997.

        The conventional technique used to access the vasculature suffers from
certain drawbacks. If a physician needs to utilize a device that exceeds the
diameter of the introducer sheath, the physician must insert a new sheath with a
larger diameter. Depending on the size and number of devices used by the
physician, this process can increase the likelihood of trauma to the vessel.
Additionally, following catheter-based procedures, the physician must close the
access site. In current practice, anticoagulation therapy is generally
discontinued for up to four hours prior to closure of the access site to allow
the patient's clotting function to normalize. During this period the patient
must remain immobile to prevent bleeding at the access site. The Company
believes that a less traumatic means of vascular access could potentially offer
advantages over conventional techniques.
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        Advanced M.I.S. access devices may also prove useful for intra-organ
surgical procedures. The surgical treatment of an organ deep within the
abdominal cavity or an organ such as the kidney lying on either side of the
vertebral column, posterior to the peritoneum, is typically conducted through
open surgery, involving a three to five inch or larger incision that is made in
the abdominal wall to gain access to the organ. Open surgery typically requires
a hospital stay and a prolonged recovery period. Alternatively, the organ can be
treated through a less invasive technique that involves the insertion of a long
flexible channel and scope through a natural body orifice such as the mouth or
the rectum to gain access to the organ. However, this technique is limited in
its effectiveness due to the restricted size of the channel and the torturous
path that must be navigated.

Biocompatible Coating Technologies

        Cardiovascular disease is a leading cause of death in the United States.
Atherosclerosis, the principal cause of cardiovascular disease, results from the
progressive accumulation of plaque caused by the deposit of cholesterol and
other fatty materials on the walls of arteries. Atherosclerosis results in
reduced blood flow to the muscles of the heart and peripheral anatomy.
Atherosclerosis in the coronary arteries can ultimately lead to heart attack and
death. Arteries diseased with atherosclerosis may be treated with medical
procedures designed to increase blood flow. Established treatments include open
heart surgery, a highly invasive surgical procedure, and less invasive
percutaneous catheter-based procedures such as coronary and peripheral
transluminal angioplasty.

        In recent years, a number of new percutaneous catheter-based therapies
have been developed to increase blood flow, including atherectomy and vascular
stenting. Industry sources estimate that during 1997 approximately 1,000,000
balloon angioplasty, atherectomy and stenting procedures were performed
worldwide. Industry sources also indicate that cardiovascular stenting is
increasingly used to treat cardiovascular disease due to its demonstrated
ability to reduce the occurrence of restenosis, a re-narrowing of a treated
blood vessel that typically occurs within six months of treatment in
approximately 20 - 30% of patients who undergo percutaneous catheter-based
procedures. Stents are implantable medical devices that reduce arterial
obstruction by providing a rigid scaffolding to maintain patency in an occluded
blood vessel. Once placed, stents exert radial force against the walls of blood
vessels to enable the blood vessels to remain open and functional.

        Preliminary indications are that restenosis following stenting can be
reduced through the coating of stents with radioactivity or anti-proliferative
drugs. The Company believes that opportunities may exist for companies with
technology to effectively coat stents with radiation or anti-proliferative
drugs.

        In recent years there has been a resurgence in the use of interstitial
irradiation, or brachytherapy, in the management of clinically localized
prostate cancer. Brachytherapy is an established nuclear therapeutic modality in
which radiation is introduced into or onto a cancer, and is widely used to
successfully treat a variety of cancers, including those of the prostate,
breast, cervix, ovary, skin, brain, head and neck. Brachytherapy can be used as
a stand-alone therapy or used in concert with external beam therapy to boost the
dose delivered to the tumor. Brachytherapies involve the use of both sealed and
unsealed sources. Among the sealed sources, seeds, wires, and needles using
I-125, Pd-103, and Ir-192 are the most commonly used isotopes in therapy for
solid tumors.

INNERDYNE'S PRODUCTS AND TECHNOLOGY

Radial Dilation Technology

        The primary focus of the Company is the development and commercial
application of its proprietary radial dilation technology. The key feature of
this proprietary technology is the capability to enter the body of a patient by
creating a small puncture wound which can subsequently be dilated, or increased
in size, to create a larger working channel. Employment of radial dilation
within an expandable sheath permits the dilation to be accomplished in a manner
that tends to minimize tissue trauma. Upon completion of a procedure, the
dilation sequence is reversed; resulting in a smaller residual wound than would
be experienced through the employment of similarly sized conventional access
devices. Potential benefits of radial dilation technology include reduced risk,
less patient trauma and reduced procedure time.


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        Step Product Line. The Company has developed a family of products
utilizing InnerDyne's proprietary radial dilation technology. The initial Step
products were introduced commercially in late 1994 and are designed to provide
access to the abdominal cavity in order to facilitate the visualization and
treatment of target areas within the cavity while minimizing the tissue trauma
associated with such access.

        Step. The Step device incorporates the Company's proprietary radial
dilation technology and was InnerDyne's first product to be launched on a
commercial basis. The Company has received 510(k) clearances from the FDA to
market this device for laparoscopic and thorascopic M.I.S. procedures. The
Company's Step access device replaces trocars, eliminating the risk of internal
organ damage from contact with the sharp surfaces of a trocar. In contrast to
conventional trocars, the Step device utilizes a standard insufflation needle
for penetration through the abdominal wall, creating only a small puncture
wound. Following removal of the needle, a sheath that surrounds the needle is
then dilated to a larger working channel through the insertion of a tapered
dilator and cannula. Following dilation, the dilator is removed, leaving a rigid
sheath that serves as a working channel with an integral insufflation valve at
the proximal end. The radial dilation of tissue to an appropriately sized
working channel holds the cannula in place and obviates the need for an
anchoring system, which may cause a larger residual wound. After completion of a
procedure, the rigid cannula is removed and the sheath retracts permitting the
opening in each of the muscular layers of the abdominal wall to recover. The
residual wound is approximately half the size of that made using a conventional
trocar of similar size. The Step product is currently utilized primarily in
minimally invasive general, gynecological and pediatric surgical procedures.

        Management believes that positive attributes of the Step product could
significantly affect health care system costs and patient satisfaction with
M.I.S. procedures in which trocars have traditionally been used. The results of
a Company-sponsored retrospective comparative outcome study examining this issue
were released during late 1995. The study included 98 patients and compared an
almost equal number of procedures performed using Step devices and conventional
trocars for access. Statistically significant results of that study indicated
that Step reduced device-related complications during surgery by over 90% and
resulted in an approximate 22% savings in surgery time. Based upon published
operating room costs, this time savings would equate to dollar savings of $345
to $515 per procedure, a substantial outcome for a product that is believed to
be competitively priced with conventional trocars. Management also believes that
post-procedure complications, such as infection and incisional hernias at access
sites, may be reduced with the use of the Step device as compared to
conventional trocars. Two randomized prospective studies involving 331 patients
intended to replicate the findings of the initial outcome study were completed
during 1997. Results of both studies indicate that Step virtually eliminates
complications associated with the use of conventional trocars. These results
have been presented at major international conferences and have been submitted
for publication.

        On January 13, 1999, InnerDyne reported the acceptance by the FDA of the
Company's 510(k) premarket notification based on the demonstrated safety and
clinical performance of the Step (TM) line of minimally invasive surgical access
devices based on InnerDyne's proprietary radial dilation technology. The product
safety premarket notification resulted from the submittal of substantial
information related to the comparative safety of the Step radially expanding
dilation technology for surgical access versus standard cutting trocars. The FDA
clearance acknowledged that the Step radially expanding surgical access
technology had been shown in independent clinical comparative studies versus
conventional cutting trocars to provide safety benefits including, but not
limited to: (1) a lower prevalence of abdominal wall bleeding; (2) a lower
prevalence of bowel and bladder injuries; (3) a lower incidence of post
operative incisional hernias; and (4) a lower prevalence of major vascular
injury. In addition, the FDA clearance noted that a substantial number of
patients reported reduced pain from Step access sites when compared to
conventional trocar sites.

        Short Step. The Short Step is a conventional Step device that has been
reduced in length to be particularly suitable for M.I.S. procedures involving
smaller individuals, especially children and thin females. The Short Step was
commercially introduced in 1995. In January 1996, the Company announced that its
Short Step device had been awarded the Seal of Acceptance by the Alliance of
Children's Hospitals, Inc. ("Alliance"). The Alliance is a wholly owned
subsidiary of Child Health Corporation of America, which is comprised of 35
free-standing children's hospitals across the United States. The Alliance
selected the Step system, after extensive research and review, based upon its
ability to reduce both the trauma and operative complications associated with
pediatric laparoscopic surgical procedures. In exchange for an ongoing royalty
payment, the Company is entitled to use this seal in connection with the
marketing and sale of its Step line of products. The Company hopes that the Seal
of Acceptance will help the Company expand awareness and sales of


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its Step product line for use in the pediatric environment.

        Reposable Step. Launched in 1996, the Reposable Step incorporates the
radial dilation features of disposable Step devices in a partially reusable
access device. A substantial market for reusable trocars exists, and management
expects a trend toward a somewhat more frequent usage of reusable devices. The
Reposable Step includes a number of reusable components consisting of a
combination of metal and plastic parts that may be cleaned and sterilized by
most conventional methods. The dilator, cannula and needle are reusable, while
the sheath and valve are single use components designed to be disposed of
following surgery.

        Mini Step. The Mini Step is a small-diameter radially dilating access
device designed for use in tubal ligation, pediatric procedures, and
micro-laparoscopic surgeries utilizing small instruments. The working diameter
of the Mini Step ranges from a nominal 2mm to 8mm. Like the Step device, Mini
Step is expected to offer clinicians the potential to reduce device-related
surgical complications and surgery time. The Mini Step devices were commercially
introduced in 1997.

        One-Step. The One-Step is a device with a universally adjustable valve
and seal system designed to eliminate the need for a reducer. The device is
intended to maintain insufflation while accommodating most conventional surgical
instruments. The One-Step device was commercially introduced in 1998.

        Open Step. The Open-Step is a device designed to establish access into
the abdominal cavity using a technique known as open laparoscopy. The Open-Step
device was commercially introduced in 1998.

        Distribution of Step Products. The Step family of products is
distributed to health care professionals in both domestic and international
markets. In the United States, the Company's M.I.S. access product line is
generally sold directly to health care professionals by a network of sales
representatives, a limited number of whom are employees of the Company.
InnerDyne management employees manage these sales representatives on a regional
basis. In order to enhance the effectiveness of these domestic sales activities,
agreements with buying groups that represent multiple provider institutions have
been pursued. InnerDyne signed two buying group agreements in 1997. These
agreements cover approximately 1,350 hospitals across the United States. In
selected foreign countries, local distributors purchase products from the
Company for subsequent resale to their respective countries' health care
systems. Distributors in selected foreign markets can and have been changed when
the Company has deemed the performance of individual distributor organizations
to be unsatisfactory.

        Other Applications. During the second quarter of 1997, InnerDyne
established a business unit to better define the value that radial dilation
technology can bring to interventional cardiology and radiology procedures and
to develop access products based on this assessment. The Company proceeded with
animal studies and device refinements in the third and fourth quarters of 1997
and continued testing the product concept in conjunction with cardiology
advisors in the first quarter of 1998. The study results were positive and human
use trials to demonstrate the clinical benefits were initiated in Europe during
the second quarter of 1998. In September 1998, InnerDyne announced that it had
received clearance from the FDA of a 510(k) application for its radially
dilatable access device for use in gaining percutaneous access for the
performance of vascular procedures. If clinical benefits are confirmed in
continuing usage, the Company will explore alternative methods of effective
distribution in the interventional vascular marketplace and may launch a radial
dilation vascular access device in the United States in 1999 or subsequent
years.

        Management believes that the positive attributes of the Step product
line may also enable minimally invasive access to organs within the abdominal
cavity. The only current alternative for this type of access involves the
insertion of a long flexible channel and scope through a natural body orifice
such as the mouth or the rectum, and only limited procedures are possible due to
the restricted size of the channel and the tortuous path that must be navigated.
The Step product line has been shown to enable laparoscopic access through the
abdominal wall and across the peritoneal space into the stomach for the
treatment of benign tumors. InnerDyne believes that the use of Step products
could substantially reduce recovery times for these types of procedures. The
Company expects that the enhanced capabilities of radially expanding dilation
may enable additional surgical procedures to be performed through minimally
invasive techniques.


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The Company may file an additional 510(k) with respect to intra-organ access in
1999. The Company anticipates that market evaluation and testing of the product
concept in conjunction with surgical advisors will be concluded in late 1999. If
the trial results are positive and subsequent human use demonstrates clinical
benefits, the Company may begin distribution in the marketplace and may launch
an intra-organ access device during 1999 or in subsequent years.

        Additionally, the Company is exploring the potential use of its
proprietary radial dilation technology in other applications such as access for
urologic, thoracic and tracheal procedures, and plans to increase resources
associated with the pursuit of percutaneous kidney and bladder access in the
ensuing quarters. The Company filed an additional 510(k) for urologic access in
1999. Developmental expenditures for new applications for the Company's
proprietary radial dilation technology may reduce the Company's level of
profitability. There can be no assurance that these new applications will
demonstrate clinical benefits or that the Company can develop a product that
will be commercially accepted.

        InnerDyne announced an agreement covering the development and potential
use of its proprietary radial dilation technology for specialized vascular
access with EndoTex Interventional Systems ("EndoTex") in 1996. In January 1999,
the management of EndoTex notified InnerDyne that it was ceasing to make
payments required for EndoTex to use radial dilation for specialized vascular
access. The Company does not expect the termination of the EndoTex agreement to
have a material adverse affect on the Company's business, financial condition,
and results of operations.

        The Company entered into an agreement covering the development of a less
traumatic means of placing enteral feeding tubes with Sherwood-Davis & Geck
("SDG") in 1997. The Company announced that it had received the single
regulatory milestone payment associated with the SDG agreement during the second
quarter of 1997. In the first quarter of 1998, InnerDyne and SDG terminated the
development agreement when SDG was acquired. In the future, the Company may
continue to develop a feeding tube placement system.

        InnerDyne also committed resources to an investigation of the potential
market opportunity in arthroscopic procedures during 1997 and early 1998.
Limited clinical usage of the initial design accompanied by substantial exposure
and feedback from arthroscopic surgeons was completed during the last half of
1997. InnerDyne completed the arthroscopic market opportunity assessment in the
second quarter of 1998. The Company is exploring the potential this product may
have, if any, and alternative distribution methods in the arthroscopic
marketplace. It is unlikely that an arthroscopic access product will be brought
to market unless a suitable distribution partner can be found.

Thermal Ablation Technology

        The Company has developed proprietary technology that is intended to
thermally ablate the lining of a body organ. The Company's EnAbl (TM) Thermal
Ablation System (the "EnAbl System") is based on this proprietary technology and
is designed to treat menorrhagia, or excessive uterine bleeding, by thermally
ablating the endometrial lining of the uterus through the controlled
introduction and heating of a normal saline solution in situ.

        In December 1996, InnerDyne announced that it had signed an agreement
which granted U.S. Surgical Corporation ("U.S. Surgical") exclusive worldwide
sales and marketing rights for the EnAbl System. Under the terms of the
agreement, in exchange for initial license fees, milestone payments, and
royalties based upon future sales, U.S. Surgical gained the rights to complete
development of the EnAbl system and to manufacture and market the technology on
a worldwide basis. The agreement also provides U.S. Surgical with an option to
purchase rights to the technology for defined applications. In July 1997, the
Company announced that U.S. Surgical had made the first milestone payment due
under the terms of the agreement. In August 1998, InnerDyne announced it had
received notification from U. S. Surgical indicating they would not pursue
development or commercialization of the Company's EnAbl System. The Company does
not presently intend to proceed with commercial development of this product
without a corporate partner.


<PAGE>   8



Biocompatible Coating Technologies

        The Company possesses certain proprietary technologies in the area of
biocompatible coatings. The technologies that comprise the Company's
thromboresistant coating ("TRC") capability are believed to have application
when foreign objects remain in contact with various areas of the body,
particularly within the blood stream, for sustained periods of time. These
technologies include the ability to deposit an extremely thin layer
(approximately one micron) of siloxane on a surface and the ability to graft a
bioactive substance, such as the drug heparin, to that siloxane layer. The
Company's TRC utilizes a "tether" molecule to attach heparin, other bioactive
molecules or radioisotopes to the previously applied siloxane subsurface. One
end of the tether molecule is covalently bonded to the siloxane coating and the
other end of the tether molecule is covalently bonded to the bioactive molecule
or radioisotope. Because both points of attachment utilize covalent bonds, the
Company believes that its coating process may result in a stronger bond to the
surface of a device than many other methods presently in use, which it believes
generally use a weaker ionic bond in at least one of the attachment points. TRC
coatings, employed with the siloxane layer alone or in combination with
bioactive substances, can extend the life of blood-gas exchange devices or
provide the capability to extend the duration of contact of a coated device with
blood or other body fluids while minimizing the physiological impacts of such
contact. InnerDyne is developing a proprietary technology that coats materials
with a coating to which rhenium-188 or another radioisotope can be attached to
reduce restenosis in patients who have had interventional vascular procedures.

        The Company has begun a research program aimed at developing absorbable
brachytherapy products for the treatment of focal or site-specific cancers such
as breast, prostate, cervical, and neurological cancers. The program's goal is
to develop biocompatible and bio-absorbable brachytherapy sources for use in
radiotherapy or simultaneous radiotherapy and chemotherapy drug delivery. These
novel combined brachytherapy/chemotherapeutic drug sources are being designed
for use in the local-regional treatment of primary cancer, including treatment
of the tumor bed after removal of a tumor. The final product could fundamentally
differ from both current brachytherapy sources and drug-delivery sources and
could provide a highly efficient mechanism to control cancer growth and limit
cancer reccurrence. The advantage of localized radiotherapy over other therapies
is that local radiotherapy can eliminate cancerous cells while sparing normal
cells. Other therapies, such as systemic chemotherapy and external beam
radiation, affect both cancerous and non-cancerous cells and can result in
greater pain, longer recovery times, and higher treatment costs. In contrast,
local radiotherapy can lower the cost of the therapeutic procedure, reduce
hospital stays, and reduce the pain and suffering experienced by the patient.

        In December 1997, InnerDyne and Oak Ridge National Laboratory ("ORNL")
announced that the Department of Energy had awarded ORNL and Brookhaven National
Laboratories ("BNL") a cooperative research and development agreement ("CRADA")
for the development of InnerDyne's proprietary method of labeling or attaching
radioactivity to implantable devices. Initially, the ORNL researchers helped to
optimize chemical methods required to efficiently attach a radioactive source to
stents. Generators from ORNL and the new technology were provided to
investigators at BNL who, in conjunction with the Interventional Cardiology
Group at the State University of New York at Stonybrook, prepared radioactive
stents and implanted them into the arteries of swine and rabbits to evaluate the
effectiveness of this unique and potentially powerful new approach to inhibit
restenosis. Initial testing confirmed the Company's ability to attach
radionuclides to metal stents and other substrates. Additional testing to
demonstrate the efficacy in animals of InnerDyne's technology for the treatment
of restenosis continues at the Washington Heart Center (WHC) and BNL.

        In October 1998, the CRADA's scope of work was modified to include the
development of absorbable brachytherapy devices for the treatment of focal
cancers because of the rapid strides made under the radiation coated stent
development program.

        Management believes that the combination of InnerDyne and Oak Ridge
National Laboratory technologies, if successful, may positively impact the
overall costs associated with stenting procedures by providing a method of
attaching a radioisotope just prior to implantation to inhibit restenosis.
Additionally, management believes that an absorbable brachytherapy device which
can deliver both radiation and a drug or chemotherapy agent concurrently could
positively impact the treatment outcomes of focal cancers by lowering the cost
of the therapeutic procedure, reducing hospital stays, and reducing the pain and
suffering experienced by the patient.


<PAGE>   9



        In January 1999, InnerDyne announced that it had been awarded a
California Cancer Research Program (CRP) Cycle I grant, a Community Initiated
Research Collaboration Award (CIRCA), to examine the clinical benefits and the
development of absorbable brachytherapy devices. The commercial objective of
this project is to develop bioabsorbable brachytherapy sources for use in
radiotherapy or simultaneous radiotherapy and chemotherapy drug delivery. These
novel combined brachytherapy/chemotherapeutic drug sources will be designed
utilizing a proprietary InnerDyne technology for potential use in the treatment
of site-specific prostate, breast, and neurological cancers.

        In 1994, the Company signed a license agreement with SENKO Medical
Manufacturing Co., Ltd. ("SENKO"), a Japan-based manufacturer and marketer of
membrane oxygenators used in open-heart surgery, pursuant to which the Company
licensed one of its TRC technologies to SENKO. In connection with this
agreement, the Company transferred its siloxane coating technology to SENKO for
the coating of microporous hollow fibers used in production of oxygenators. The
initial technology transfer was completed during the first quarter of 1995, at
which time the Company received the balance of an initial payment from SENKO,
and the royalty payment period commenced. In 1996, InnerDyne received an order
from SENKO to build a second fiber coating system which was delivered during the
first half of 1997. In April 1998, SENKO licensed InnerDyne's less complex
method for coating devices with heparin on a non-exclusive basis. The addition
of this new means of attaching the drug heparin to prevent the formation of
blood clots on a surface is expected to further enhance SENKO's oxygenator
product offering.

        In April 1996, the Company announced the signing of an agreement with
Boston Scientific Corporation ("Boston Scientific") covering the potential
application and use of InnerDyne's proprietary biocompatible coating
technologies with Boston Scientific's stents, grafts, vena cava filters and
other implantable medical devices. The agreement involved an equity investment
by Boston Scientific in InnerDyne, initial research support and future license
fees and royalty payments. Boston Scientific Corporation notified InnerDyne in
August 1998 that it had decided to proceed with the transfer of technology for
the application and use of InnerDyne's proprietary biocompatible coating
technology with Boston Scientific's stents, grafts, vena cava filters, and other
implantable medical devices. The transfer of the technology is expected to be
completed during 1999, though the Company may continue to conduct related
research if requested by Boston Scientific.

        In June 1998, InnerDyne announced the signing of an agreement with U.S.
Surgical covering the licensing of InnerDyne's proprietary siloxane coating
technology to enhance the performance of selected products used in minimally
invasive surgical procedures. Under the terms of the agreement, InnerDyne will
construct a custom coating system and provide coated product samples for testing
by U.S. Surgical in exchange for payment of initial license fees and capital
equipment costs. Assuming the testing confirms that coated samples meet U.S.
Surgical's requirements, InnerDyne will receive a final license fee payment and
will assist in the transfer of the system to a location designated by U.S.
Surgical. Coincident with transfer and system startup, a royalty payment period
would begin.

        Because of the strength of the covalent bonds used in the Company's TRC
technology and other properties noted above, the Company believes that its
technology may have advantages over presently available bioactive coating
technologies. Potential applications include the treatment of restenosis and
specific focal cancers when vascular stents, grafts, vena cava filters and other
implantable devices are coated using InnerDyne's proprietary technology with
drugs and/or isotopes. The Company has undertaken a number of discussions with
potential licensees of the Company's coating technologies, and samples of coated
products have been provided to several companies. These discussions have been
with parties interested in the use of the technologies to enhance drug delivery
or gas exchange, as well as third parties interested in the possible coating of
in-dwelling devices for various applications.


<PAGE>   10



RESEARCH AND DEVELOPMENT

        The Company has made significant investments in the research and
development of its proprietary technologies, including radial dilation, thermal
ablation and biocompatible coatings. Research, development, clinical and
regulatory expenses for the years ended December 31, 1998, 1997, and 1996 were
approximately $2.9 million, $3.3 million, and $2.8 million, respectively. The
increases in 1997 and 1996 were primarily the result of expenses related to new
product development programs, including costs associated with development,
clinical trials and regulatory submissions. The decrease in 1998 is primarily
the result of a decrease in the reimbursed development expenses related to the
EnAbl thermal ablation system. As of December 31, 1998, the Company had 20
full-time employees engaged in research, development, clinical and regulatory
activities. Currently, the Company's research and development efforts are
primarily focused on providing support for the Step product line, other access
products based on InnerDyne's proprietary radial dilation technology, the REVAS
vascular access product, and biocompatible coating technologies.

        In December 1996, InnerDyne announced that it had signed an agreement
granting U.S. Surgical exclusive worldwide sales and marketing rights for the
EnAbl System. In August 1998, InnerDyne announced it had received notification
from U. S. Surgical indicating they would not pursue development or
commercialization of the Company's EnAbl System. The Company does not presently
intend to proceed with commercial development of this product without a
corporate partner.

        In December 1997, InnerDyne and Oak Ridge National Laboratory announced
that the Department of Energy had awarded ORNL and Brookhaven National
Laboratories a cooperative research and development agreement (CRADA) to support
development of InnerDyne's proprietary method of labeling or attaching
radioactivity to implantable devices.

        The Company's proprietary biocompatible coating technologies have been
evaluated by a number of potential licensees. Agreements are in place with SENKO
covering the coating of gas exchange fibers; with Boston Scientific for the
potential coating of stents, grafts, vena cava filters and other implantable
devices; and with U.S. Surgical covering the licensing of its proprietary
siloxane coating technology for potential use by U.S. Surgical to enhance the
performance of selected products used in minimally invasive surgical procedures.

        The future success of the Company will depend upon its ability to
develop and gain regulatory clearance for new and enhanced versions of products
in a timely fashion. In addition, the Company may seek to identify opportunities
to obtain products or technologies from third parties. There can be no assurance
that the Company will be able to successfully develop or acquire new products or
technologies, license its proprietary technologies to third parties, obtain
regulatory clearance for its products, or gain market acceptance of new and
enhanced products. Delays in development, clearance or acceptance of new
products could have a material adverse effect on the Company's business, results
of operations and financial condition.

SALES AND MARKETING

        The Company is marketing its M.I.S. access products mainly to general
surgeons, gynecologists and pediatric laparoscopists.

        The Step family of products is distributed to health care professionals
in both domestic and international markets. In the United States, the Company's
M.I.S. access product line is generally sold directly to health care
professionals by a network of sales representatives, a limited number of which
are employees of the Company. InnerDyne Sales/Marketing management manages the
sales representatives on a regional basis. To enhance the effectiveness of these
domestic sales activities, agreements with buying groups that represent multiple
provider institutions have been pursued. InnerDyne signed two buying group
agreements in the third quarter of 1997. These agreements cover approximately
1,350 hospitals across the United States and may allow the Company to more
effectively compete for a portion of the minimally invasive surgical access
business in these hospitals.


<PAGE>   11



        In selected foreign countries, local distributors purchase products from
the Company for subsequent resale to their respective country's health care
systems and medical professionals. Distributors in selected foreign markets can
and have been changed when the Company has deemed the performance of individual
distributor organizations to be unsatisfactory. As of December 31, 1998, orders
had been received from distributors in 37 countries. Management expects to make
additional progress in this regard during 1999 and expects foreign sales to
positively impact future revenue growth.

        The Company has limited experience in marketing its products and faces
substantial competition from well-entrenched and formidable competitors. As a
result, there can be no assurance that the Company will successfully achieve
acceptable levels of product sales at prices that provide an adequate return or
that the Company will be able to build a network of international distributors
capable of effectively marketing its M.I.S. access products or that such
distributors will generate significant sales of such products. Failure to do so
would have a material adverse impact on the Company's business, results of
operations and financial condition.

MANUFACTURING

        The Company initiated manufacture of commercial quantities of its Step
device in its Salt Lake City, Utah facility in late 1994. Current manufacturing
operations consist primarily of the assembly and testing of purchased components
to produce finished products, which are then packaged for sterilization in an
outside facility. The Company has implemented steps to automate selected
portions of the Step assembly operation to help reduce product costs and to
achieve a more uniform standard of product consistency. During the assembly
process and following sterilization, the Company conducts appropriate tests and
inspection of its products in an effort to assure that products meet established
specifications and to verify appropriate levels of product sterility. 

        The Company has limited experience in manufacturing M.I.S. access
products or other products in commercial quantities at acceptable costs. The
Company is registered as a manufacturer of medical devices with appropriate
state and federal authorities, including the FDA, and is registered to
International Standards Organization 9000 ("ISO 9000") standards, which confirms
compliance with a number of foreign quality systems. See "--Government
Regulation." The Company's success will depend in part on its ability to
manufacture its products in compliance with the FDA's GMP regulations, and ISO
9000 and other regulatory requirements in sufficient quantities and on a timely
basis, while maintaining product quality and acceptable manufacturing costs.
Manufacturers often encounter difficulties in scaling up production of new
products, including problems involving production yields, quality control and
assurance, component supply and shortages of qualified personnel. Failure to
maintain or increase production volumes in a timely or cost-effective manner
would have a material adverse effect on the Company's business, financial
condition and results of operations.

        Regulatory changes currently being introduced by the FDA are likely to
result in a system of United States regulatory requirements for manufacturers of
medical devices which more closely resembles the ISO 9000 series of quality
systems standards adopted by most European countries. The Company's ISO 9001
registration is expected to aid efforts to achieve compliance with revised
United States regulatory requirements.

        The materials utilized in the Company's M.I.S. products consist of both
standard and custom components that are purchased from a variety of independent
sources. The plastic parts used in the Step product are injection molded by
outside vendors. The majority of these parts are produced utilizing molds that
have been specially machined for and are owned by the Company. Although the
Company maintains significant inventories of molded parts, any inability to
utilize these molds for any reason might have a material adverse effect upon the
Company's ability to meet its customer's demand for product. In addition to
plastic parts produced from injection molds owned by the Company, a number of
other materials are available only from a limited number of sources at the
present time, including the sheath component of the Company's Step products.
Efforts to identify and qualify additional sources of this sheath component and
other key materials and components are continuing. Although InnerDyne believes
that alternative sources of these components can be obtained, internal testing
and qualification of substitute vendors could require significant lead times and
additional regulatory submissions. There can be no assurance that such internal
testing and qualification or additional regulatory


<PAGE>   12



approvals will be obtained in a timely fashion, if at all. Any interruption of
supply of raw materials could have a material adverse effect on the Company's
ability to manufacture its products, and therefore on its business, financial
condition and results of operations. "See Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations--Risk
Factors--Dependence on Sole Sources."

PATENTS AND PROPRIETARY RIGHTS

        It is the Company's policy to aggressively protect its technology by,
among other things, filing patent applications for the patentable technologies
that it considers important to the development of its business. The Company
holds eleven issued United States patents covering various aspects of its core
M.I.S. technology. The Company also has a license agreement giving it exclusive
rights, assuming certain defined minimum payments are met, to a related access
technology that is covered by two issued and one pending patent. In addition,
during 1995, the Company obtained a non-exclusive license to a patent covering a
specialized access device which facilitates the placement of a vision device
into the abdominal cavity.

        The Company holds eight issued United States patents relating to its
thermal ablation system technology. The Company also holds five issued United
States patents relating to its biocompatible coating technologies. The Company
has continued to pursue the expansion of its coating-related intellectual
property as opportunities for business partnerships in this area have been
pursued. See "--InnerDyne's Products and Technology--Biocompatible Coating
Technologies." The Company also holds a number of issued foreign patents, and
has filed additional United States and foreign patent applications relating to
its various technologies. In addition to patent rights related to its radial
dilation, thermal ablation and biocompatible coating technologies, the Company
also has a number of issued and pending patents relating to its blood gas
exchange, pumping and other technologies. There can be no assurances that any
pending patent applications will be issued in their present scope, or at all.

        The Company's success will depend in large part on its ability to obtain
patent protection for products and processes, to preserve its trade secrets and
to operate without infringing the proprietary rights of third parties. Although
InnerDyne has obtained certain patents and applied for additional United States
and foreign patents covering certain aspects of its technology, no assurance can
be given that any additional patents will be issued or that the scope of any
patent protection will exclude competitors or provide a competitive advantage,
or that any of the Company's patents will be held valid if subsequently
challenged. The validity and breadth of claims covered in medical technology
patents involve complex legal and factual questions and therefore may be highly
uncertain. InnerDyne also relies upon unpatented trade secrets, and no assurance
can be given that others will not independently develop or otherwise acquire
substantially equivalent trade secrets. In addition, whether or not the
Company's patents are issued, others may hold or receive patents that contain
claims having a scope that covers products developed by InnerDyne.

        There has been substantial litigation regarding patent and other
intellectual property rights in the medical device industry, and companies in
the medical device industry have used litigation to gain competitive advantage.
Litigation involving the Company would result in substantial cost to and
diversion of management attention from the day-to-day operation of the business,
but could be necessary to enforce patents issued to the Company, to protect
trade secrets and other specialized knowledge unknown to outside parties, to
defend the Company against claimed infringement of the rights of others or to
determine the scope and validity of the proprietary rights of others. An adverse
determination in litigation could subject the Company to significant liabilities
to third parties, could require the Company to seek licenses from third parties
under less favorable terms than might otherwise be possible and could prevent
the Company from manufacturing, selling or using its products, any of which
could have a material adverse effect on the Company's business, financial
condition and results of operations.

        The Company has in the past, and may in the future, receive
correspondence from third parties claiming that the Company's products or
technology infringe intellectual property rights of such third parties. The
Company and its patent counsel thoroughly review such claims, and no such
outstanding claims currently exist. However, there can be no assurance that
InnerDyne will not receive additional claims that its products or technology
infringe third party rights or


<PAGE>   13



that third parties will not litigate such claims. Any such occurrence could have
a material adverse effect on the Company's business, financial condition and
results of operations. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations--Risk Factors--Patents and
Proprietary Rights."

COMPETITION

        The primary industry in which the Company competes, minimally invasive
surgery, is dominated by two large, well-positioned entities that are intensely
competitive and frequently offer substantial discounts as a competitive tactic,
U.S. Surgical and the Ethicon Endosurgery Division of Johnson and Johnson
("Ethicon"). U.S. Surgical, which has been acquired by Tyco International Ltd.,
is primarily engaged in developing, manufacturing and marketing surgical wound
management products, and had historically been the firm most responsible for
providing products that led to the growth of the industry. U.S. Surgical
supplies a broad line of products to the M.I.S. industry, including products
that facilitate access, assessment and treatment. The merger with Tyco is
expected to significantly expand the combined product offering to the M.I.S.
industry. Ethicon has made a major investment in the M.I.S. field in recent
years and the parent company is one of the leading suppliers of hospital
products in the world. Furthermore, U.S. Surgical and Ethicon each utilize
purchasing contracts that link discounts on the purchase of one product to
purchases of other products in their broad product lines. Substantially all of
the hospitals in the United States have purchasing contracts with one or both of
these entities. Accordingly, customers may be dissuaded from purchasing access
products from the Company rather than U.S. Surgical or Ethicon to the extent it
would cause them to lose discounts on products that they regularly purchase from
U.S. Surgical or Ethicon.

        Notwithstanding the challenges faced by the Company in selling into a
market dominated by two large competitors, the majority of the Company's
revenues since the fourth quarter of 1994 have come from product sales in this
market. U.S. Surgical and Ethicon purchasing contracts typically include
provisions allowing a certain percentage of purchases from other vendors, or
permitting new technology products to be considered outside of a purchasing
agreement. The Company has taken and intends to continue to take advantage of
such provisions.

        The Company faces a formidable task in gaining significant revenues
within the M.I.S. access market. In order to succeed, management believes that
the Company will need to objectively demonstrate substantial product benefits,
and its sales effort must be able to effectively present such benefits to both
clinicians and health care administrators. The M.I.S. access market segment is
dominated by U.S. Surgical and Ethicon. Both entities introduced new access
devices with added features during the past two years. A number of other
entities participate in various segments of the M.I.S. access market.

        There can be no assurance that the Company will be able to successfully
compete in the M.I.S. access market, and failure to do so would have a material
adverse effect on the Company's business, financial condition and results of
operations.

        There can be no assurance that competitors will not succeed in
developing technologies and products that are more effective than any which have
been or are being developed by the Company or that would render the Company's
technologies or products obsolete or not competitive. Such competition could
have a material and adverse effect on the Company's business, financial
condition and results of operations See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations--Risk Factors--Intense
Competition."

GOVERNMENT REGULATION

        Clinical testing, manufacture and sale of the Company's products,
including the Step product line, the REVAS product line and the Company's
biocompatible coating technology, are subject to regulation by the FDA and
corresponding state and foreign regulatory agencies. Pursuant to the Federal
Food, Drug, and Cosmetic Act, and the regulations promulgated thereunder, the
FDA regulates the preclinical and clinical testing, manufacture, labeling,
distribution and promotion of medical devices. Noncompliance with applicable
requirements can result in, among other things, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of


<PAGE>   14



the government to grant premarket clearance or premarket approval for devices,
withdrawal of marketing approvals and criminal prosecution. The FDA also has the
authority to request recall, repair, replacement or refund of the cost of any
device manufactured or distributed by the Company.

        In the United States, medical devices are classified into one of three
classes (i.e., Class I, II or III) on the basis of the controls deemed necessary
by the FDA to reasonably ensure their safety and effectiveness. Class I devices
are subject to general controls (e.g., labeling, premarket notification and
adherence to GMP's) and Class II devices are subject to general and special
controls (e.g., performance standards, postmarket surveillance, patient
registries and FDA guidelines). Generally, Class III devices are those which
must receive premarket approval by the FDA to ensure their safety and
effectiveness (e.g., life-sustaining, life-supporting and implantable devices,
or new devices which have been found not to be substantially equivalent to
legally marketed devices).

        Before a new device can be introduced in the market, the manufacturer
must generally obtain FDA clearance of a 510(k) notification or approval of a
Premarket Approval ("PMA") application. A PMA application must be filed if a
proposed device is not substantially equivalent to a legally marketed Class I or
Class II device, or if it is a Class III device for which the FDA has called for
PMAs. The PMA application must contain the results of clinical trials, the
results of all relevant bench tests, laboratory and animal studies, a complete
description of the device and its components, and a detailed description of the
methods, facilities and controls used to manufacture the device. The FDA's
review of a PMA application generally takes one to two years from the date the
PMA is accepted for filing, but it may take significantly longer. The review
time is often significantly extended by the FDA asking for more information or
clarification of information already provided in the submission. Modifications
to a device that is the subject of an approved PMA, its labeling or
manufacturing process may require approval by the FDA of PMA supplements or new
PMAs. The PMA process can be expensive, uncertain and lengthy, and a number of
devices for which FDA approval has been sought by other companies have never
been approved for marketing.

        If human clinical trials of a device are required and the device
presents a "significant risk", the sponsor of the trial (usually the
manufacturer or the distributor of the device) will have to file an
Investigational Device Exemption ("IDE") application prior to commencing human
clinical trials. The IDE application must be supported by data, typically
including the results of animal and laboratory testing. If the IDE application
is approved by the FDA and one or more appropriate Institutional Review Boards
("IRB's"), human clinical trials may begin at a specific number of
investigational sites with a specific number of patients, as approved by the
FDA. If the device presents an "insignificant 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. Sponsors of clinical
trials are permitted to sell investigational devices distributed in the course
of the study provided such compensation does not exceed recovery of the costs of
manufacture, research, development and handling. An IDE supplement must be
submitted to and approved by the FDA before a sponsor or investigator may make a
change to the investigational plan that may affect its scientific soundness or
the rights, safety or welfare of human subjects.

        A 510(k) clearance will be granted if the submitted information
establishes that the proposed device is "substantially equivalent" to a legally
marketed Class I or Class II medical device or a Class III medical device for
which the FDA has not called for PMA's. The FDA recently has been requiring more
rigorous demonstration of substantial equivalence than in the past, including in
some cases requiring submission of clinical trial data. The FDA may determine
that the proposed device is not substantially equivalent to a predicate device,
or that additional information is needed before a substantial equivalence
determination can be made. It generally takes from two to twelve months from
submission to obtain 510(k) premarket clearance, but may take longer. The FDA
may determine that a proposed device is not substantially equivalent to a
legally marketed device, or that additional information is needed before a
substantial equivalence determination can be made. A "not substantially
equivalent" determination, or a request for additional information, could
prevent or delay the market introduction of new products that fall into this
category and could have a material adverse effect on the Company's business,
financial condition and results of operations. For any of the Company's devices
cleared through the 510(k) process, modifications or enhancements that could
significantly affect the safety or effectiveness of the device or that
constitute a major change to the intended use of the device will require a new
510(k) submission. There can be no assurance that the Company will obtain 510(k)
premarket clearance within a reasonable time frame, or at all, for any of the
devices or modifications for which it may file a 510(k).


<PAGE>   15



        The Company has received clearance from the FDA for the marketing of its
Step device for use in accessing the abdominal and thoracic cavities for the
performance of minimally invasive surgical procedures. The Company has also
received FDA clearance for the marketing of its Radially Expanding Dilator
(R.E.D.) product for use in the areas of gastrostomy, cystostomy,
cholecystotomy, the dilation of biliary and urethral strictures, laparoscopy and
enterostomy. The Company has also received market clearance for alternative
versions of its Step and R.E.D. products, including products designed to employ
its radial dilation technology in vascular and arthroscopic applications and for
biliary indications. Although the Company has been successful in preparing
requests for 510(k) clearance, there can be no assurance that 510(k) clearances
for future products or product modifications can be obtained in a timely manner,
or at all, or that any existing clearance can be successfully maintained. A
delay in receipt of, or failure to receive or maintain, such clearances would
have a material adverse effect on the Company's business, financial condition
and results of operations.

        Although the Company is strictly limited to marketing its products for
the indications for which they were cleared, physicians are not prohibited by
the FDA from using the products for indications other than those cleared by the
FDA. There can be no assurance that the Company will not become subject to FDA
action resulting from physician use of its products outside of their approved
indications.

        The Company has made modifications to its cleared devices that the
Company believes do not require the submission of new 510(k) notices. There can
be no assurance, however, that the FDA would agree with any of the Company's
determinations not to submit a new 510(k) notice for any of these changes or
would not require the Company to submit a new 510(k) notice for any of the
changes made to the device. If the FDA requires the Company to submit a new
510(k) notice for any device modification, the Company may be prohibited from
marketing the modified device until the 510(k) notice is cleared by the FDA.

        Any devices manufactured or distributed by the Company pursuant to FDA
clearance or approval are subject to pervasive and continuing regulation by the
FDA and certain state agencies and various foreign governments. Manufacturers of
medical devices for marketing in the United States are required to adhere to
applicable regulations setting forth detailed GMP requirements, which include
testing, control and documentation requirements. Manufacturers must also comply
with Medical Device Reporting ("MDR") requirements that a firm report to the FDA
any incident in which its product may have caused or contributed to a death or
serious injury, or in which its product malfunctioned and, if the malfunction
were to recur, it would be likely to cause or contribute to a death or serious
injury. Labeling and promotional activities are subject to scrutiny by the FDA
and, in certain circumstances, by the Federal Trade Commission.

        The Company is registered as a manufacturer of medical devices with the
FDA. The Company is subject to routine inspection by the FDA and certain state
agencies for compliance with GMP requirements, MDR requirements and other
applicable regulations. Failure of the Company to maintain satisfactory GMP
compliance could have a significant adverse effect on the Company's ability to
continue to manufacture and distribute its products and, in the most serious
cases, result in the seizure or recall of products, injunctions and/or civil
fines.

        The FDA has proposed and is implementing changes to the GMP regulations
that may increase the cost of compliance with GMP requirements. Changes in
existing requirements or adoption of new requirements could have a material
adverse effect on the Company's business, financial condition and results of
operations. There can be no assurance that the Company will not incur
significant costs to comply with laws and regulations in the future or that laws
and regulations will not have a material adverse effect upon the Company's
business, financial condition or results of operations.

        The Company has received certification to ISO 9000 standards, permitting
it to affix the CE Mark to its products, allowing unencumbered movement of its
products within the European Union. The Company is required to undergo periodic
surveillance audits to assure continuing compliance with these standards.
Failure to demonstrate satisfactory compliance on an ongoing basis could
adversely impact InnerDyne's ability to distribute its products within the
European Union.


<PAGE>   16




PRODUCT LIABILITY AND INSURANCE

        The development, manufacturing and sale of the Company's products entail
the risk of product liability claims, involving both potential financial
exposure and associated adverse publicity. To date, InnerDyne has not
experienced any product liability claims. The Company's current product
liability insurance coverage limits are $3,000,000 per occurrence and $3,000,000
in the aggregate, and there can be no assurance that such coverage limits are
adequate to protect the Company from any liabilities it might incur in
connection with the development, manufacture, and sale of its current and
potential products. Product liability insurance is expensive and may not be
available in the future on acceptable terms, or at all. In addition, if such
insurance is available, there can be no assurance that the limits of coverage of
such policies will be adequate. A successful product liability claim in excess
of the Company's insurance coverage could have a material adverse effect on the
Company's business, financial condition and results of operations. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Risk Factors--Product Liability; Claims in Excess of Insurance
Coverage."

EMPLOYEES

        At December 31, 1998, the Company had 121 full-time and seven temporary
and part-time employees. Of the temporary and part-time employees, four are
located in the Company's Sunnyvale facility, of which three are assigned to the
REVAS product development project. Three temporary employees worked at the
Company's Salt Lake City facility, and are involved in manufacturing and support
activities related to the Company's M.I.S. access products. Of the 121 full-time
employees on December 31, 1998, 65 were involved in manufacturing operations, 13
in research and development and regulatory/clinical affairs, four in
biocompatible coatings development, 12 in administration, and 27 in sales,
marketing and customer service.

        None of the Company's employees is covered by a collective bargaining
agreement and management believes that its relationship with its employees is
good.


<PAGE>   17



EXECUTIVE OFFICERS OF THE COMPANY

        The Company has corporate officers that are not executive officers. As
of February 28, 1999, the executive officers of the Company, who are elected by
and serve at the discretion of the Board of Directors, were as follows:
<TABLE>
<CAPTION>

                NAME                          AGE                                POSITION

<S>                                            <C>         <C>
        William G. Mavity                      49          President, Chief Executive Officer and Director

        Robert A. Stern                        42          Vice President and Chief Financial Officer

        Daniel J. Genter                       62          Senior Vice President, Sales and Marketing

        Michael Orth                           36          Vice President, Research & Development
</TABLE>


        William G. Mavity joined the Company as President, Chief Executive
Officer and a director in October 1993, after having spent more than twenty
years in various capacities with the 3M Company ("3M"), including more than ten
years within a number of the operating units of 3M's health care business. From
August 1992 until October 1993, Mr. Mavity served as Operations Director for
3M's Medical Device Division. From April 1989 until August 1992, Mr. Mavity
served as General Manager of 3M's Sarns cardiovascular surgery business unit.
From July 1988 until April 1989, Mr. Mavity served as Manufacturing Manager for
the Sarns subsidiary. Mr. Mavity holds a B.E.A. degree from the University of
Delaware.

        Robert A. Stern joined the Company in January 1996 as Vice President and
Chief Financial Officer. From October 1991 to January 1996, Mr. Stern held the
position of Chief Financial Officer, Vice President of Corporate Finance and
member of the Board of Directors of RhoMed Incorporated, a New Mexico-based
biopharmaceutical company. Mr. Stern has had ten years experience in investment
banking and cash management, and was the principal stockholder and Managing
Director of R.A. Stern & Associates from December 1986 to April 1990. R. A.
Stern & Associates was sold to PaineWebber in 1989. Mr. Stern received a B.S.
from the University of New Hampshire, Whittemore School of Business and
Economics and an MBA from the University of New Mexico, Anderson School of
Management.

        Daniel J. Genter joined the Company in April 1996 as Senior Vice
President of Sales and Marketing. From May 1993 to April 1996, Mr. Genter held
the position of Divisional Vice President of the Kanetta Pharmacal Division of
Sanofi Winthrop Pharmaceuticals, a business unit established for the
development, manufacture and marketing of sterile parenteral multisource
pharmaceutical products. From December 1990 to May 1993, Mr. Genter served as
Vice President of Marketing for Schein Pharmaceutical, Inc., a manufacturer and
distributor of pharmaceutical products. Mr. Genter spent over twenty years with
Johnson & Johnson in its McNeil Laboratories, Critikon and Home Health Care
companies, holding positions in general management, sales management, marketing
and clinical development. Mr. Genter also served as President of Sharplan
Lasers, Inc., a medical laser manufacturer. Mr. Genter studied Mechanical
Engineering at Tulane University and holds a B.S. in Mathematics from the State
University of New York and an MBA from Pepperdine University.

        Michael J. Orth joined InnerDyne in March 1995. Prior to joining the
Company, he was the Director, R&D for UNISURGE, Inc., a manufacturer of
minimally invasive surgical products, for two years. From November 1987 to July
1992, he was with Advanced Cardiovascular Systems, including an assignment as a
Business Unit Manager. He had earlier worked for Techmedica, an orthopedic
products supplier. Mr. Orth holds Bachelor of Science degrees from the
California Polytechnic University in Mechanical Engineering and Engineering
Technology, and an MBA from Santa Clara University.


<PAGE>   18



ITEM 2.  PROPERTIES

        InnerDyne leases approximately 20,500 square feet in Sunnyvale,
California to house the Company's administrative personnel, research and
development, marketing and sales support activities. The Sunnyvale facility is
leased through December 2003.

        Additional space is leased in two separate buildings, totaling
approximately 27,000 square feet, in Salt Lake City, Utah. These facilities
house administrative personnel, manufacturing operations, biocompatible coating
research activities and the Company's primary distribution function. The leases
for the Salt Lake City buildings expire in August 1999.

        Management believes that currently leased facilities will be sufficient
for the immediate future, and that adequate additional space is available within
the same geographical areas. If additional space were required, and it could not
be obtained in near proximity to current facilities at an acceptable cost, it
could have a material adverse effect on the Company's operations.

ITEM 3.  LEGAL PROCEEDINGS

        The Company is not a party to any material pending legal proceedings.

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

        No matters were submitted to a vote of stockholders of the Company
during the fourth quarter of the fiscal year ended December 31, 1998.


<PAGE>   19



                                     PART II

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

        The Company's Common Stock has been traded on the Nasdaq National Market
under the symbol IDYN since the merger in April 1994 with InnerDyne Medical,
Inc. From January 1992 to April 1994, the Company's Common Stock traded on the
Nasdaq National Market under the symbol CRDS. The prices per share reflected in
the table below represent the range of low and high closing sale prices for the
Company's Common Stock as reported on the Nasdaq National Market for the
quarters indicated. These prices reflect inter-dealer prices, without retail
mark-up, markdown or commission and may not represent actual transactions.

<TABLE>
<CAPTION>

                                                               HIGH         LOW
<S>                                                           <C>          <C> 
                              FISCAL 1997
              First quarter ended March 31, 1997                4-1/4      1-23/32
              Second quarter ended June 30, 1997               3-3/16      1-23/32
              Third quarter ended September 30, 1997            3-5/8        2-5/8
              Fourth quarter ended December 31, 1997            4-1/8        2-1/2
                              FISCAL 1998
              First quarter ended March 31, 1998                3-1/2       3-1/16
              Second quarter ended June 30, 1998                3-1/8        3-3/8
              Third quarter ended September 30, 1998            1-3/4          7/8
              Fourth quarter ended December 31, 1998          1-15/32        31/32
</TABLE>

        As of February 26, 1999, there were 292 stockholders of record; however,
the Company believes it has a minimum of 4,000 beneficial stockholders.

        The Company has not historically paid cash dividends. The Company
currently intends to retain all future earnings, if any, for use in its business
and does not anticipate paying any cash dividends in the foreseeable future. The
Company is prohibited from paying dividends or making any other distributions
under the terms of its credit agreement with Silicon Valley Bank. See Note 6 of
Notes to Financial Statements.

        During 1998, the Company issued and sold (without payment of any selling
commission to any person) the following unregistered securities: In March 1998
and June 1998, the Company issued 6888 shares and 675 shares respectively, of
its Common Stock to a single entity in connection with a license agreement with
such entity. The Company did not receive any cash proceeds from such issuances.
The Company expects to continue issuing shares under this license agreement in
the future.

        There were no underwriters employed in connection with any of the
transactions set forth above. The issuances of the securities set forth above
were deemed to be exempt from registration under the Securities Act of 1933, as
amended (the "Act") in reliance on Section 4(2) of the Act as transactions by an
issuer not involving any public offering. The recipients of securities in each
such transaction represented their intentions to acquire the securities for
investment only and not with a view to or for sale in connection with any
distribution thereof, and appropriate legends were affixed to the securities
issued in such transactions. All recipients had adequate access, through their
relationship with the Company, to information about the Company.

ITEM 6.  SELECTED FINANCIAL DATA

        The following selected financial data of the Company is qualified by
reference to and should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
with the Company's financial statements and notes thereto included in this
Annual Report on Form 10-K. The statements


<PAGE>   20



of operations data for the years ended December 31, 1998, 1997, and 1996 and the
balance sheet data as of December 31, 1998 and 1997 are derived from, and are
qualified by reference to, the audited financial statements included elsewhere
in this Annual Report on Form 10-K. The statements of operations data for the
years ended December 31, 1994 and 1995, and the balance sheet data as of
December 31, 1994, 1995, and 1996 are derived from, and are qualified by
reference to, audited financial statements not included in this Annual Report on
Form 10-K.
<TABLE>
<CAPTION>

                                                                YEAR ENDED DECEMBER 31,
                                          --------------------------------------------------------------------
                                               1994          1995         1996          1997            1998
                                          ------------   ----------     --------        ------          ------
                                                         (In thousands, except per share data)
<S>                                       <C>           <C>            <C>           <C>            <C>   
STATEMENT OF OPERATIONS DATA:
Revenues                                   $   879          5,275          9,086         15,664         17,610


 Net income/(loss)                         $(9,904)        (5,627)        (4,659)          (907)           425
                                           =======        =======        =======        =======        =======
 Net income/(loss) per diluted share       $  (.61)          (.32)          (.23)          (.04)           .02
                                           =======        =======        =======        =======        =======
BALANCE SHEET DATA:
Total assets                               $ 7,847          5,370         11,362         11,319         11,089
Long-term debt, excluding current
  installments                             $    30            187            630            649            349

</TABLE>

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

        This Annual Report on Form 10-K contains, in addition to historical
information, forward-looking statements which involve risks and uncertainties.
The Company's actual results may differ significantly from the results discussed
in the forward-looking statements. Factors that might cause such a difference
include those discussed below, as well as those discussed elsewhere in this
Annual Report on Form-10-K for the year ended December 31, 1998, and other
filings with the Securities and Exchange Commission and press releases, copies
of which are available from the Company upon request. The Company undertakes no
obligation to publicly release the result of any revisions to these
forward-looking statements that may be made to reflect events or circumstances
after the date hereof or to reflect the occurrence of unanticipated events.

        BACKGROUND

        InnerDyne, Inc. (the "Company" or "InnerDyne") is primarily focused upon
the development and commercialization of access products based on its
proprietary radial dilation technology used to perform minimally invasive
surgical ("") procedures. The Company possesses biocompatible coating
technologies which have utility in enhancing the compatibility and performance
of devices placed in contact with human body fluids and tissues, and in
delivering selected pharmaceuticals and radioactive isotopes to areas within a
human body. The Company intends to continue developing its radial dilation and
biocompatible coating technologies, internally or through strategic alliances.

        RISK FACTORS

        History of Losses; Profitability Uncertain. InnerDyne experienced
operating losses from 1985 into mid 1998. InnerDyne reported net income of
$425,000 on revenues of $17.6 million, and losses of $907,000 on revenues of
$15.7 million, and $4.6 million on revenues of $9.1 for the fiscal years ended
December 31, 1998, 1997, and 1996, respectively. As of December 31, 1998,
InnerDyne had an accumulated deficit of approximately $51.8 million.

        In the future, the Company may incur additional operating losses and
have cash outflow requirements as a result of expenditures related to expansion
of sales and marketing capability, expansion of manufacturing capacity, research
and


<PAGE>   21



development activities, compliance with regulatory requirements, and possible
investment in or acquisition of additional complementary products, technologies
or businesses. The timing and amounts of these expenditures will depend upon
many factors, such as the availability of capital, progress of the Company's
research and development, and factors that may be beyond the Company's control,
such as the results of product trials, the requirements for and the time
required to obtain regulatory approval for existing products and any other
products that may be developed or acquired, and the market acceptance of the
Company's products. The cash needs of the Company have changed significantly as
a result of the merger completed during 1994 and the support requirements of the
added business focus areas. There can be no assurance that the Company will not
incur future losses, that the Company will be able to raise cash as necessary to
fund operations or that the Company will maintain profitability.

        Intense Competition. The primary industry in which the Company competes,
minimally invasive surgery, is dominated by two large, well-positioned entities
that are intensely competitive and frequently offer substantial discounts as a
competitive tactic. U.S. Surgical is primarily engaged in developing,
manufacturing and marketing surgical wound management products, and has
historically been the firm most responsible for providing products that have led
to the growth of the industry. U.S. Surgical supplies a broad line of products
to the M.I.S. industry, including products which facilitate access, assessment
and treatment. Ethicon has made a major investment in the M.I.S. field in recent
years and is one of the leading suppliers of hospital products in the world.
Furthermore, U.S. Surgical and Ethicon each utilize purchasing contracts that
link discounts on the purchase of one product to purchases of other products in
their broad product lines. Substantially all of the hospitals in the United
States have purchasing contracts with one or both of these entities.
Accordingly, customers may be dissuaded from purchasing access products from the
Company rather than U.S. Surgical or Ethicon to the extent it would cause them
to lose discounts on products that they regularly purchase from U.S. Surgical or
Ethicon.

        The Company faces a formidable task in successfully gaining significant
revenues within the M.I.S. access market. In order to succeed, management
believes that the Company will need to objectively demonstrate substantial
product benefits, and its sales effort must be able to effectively present such
benefits to both clinicians and health care administrators. The M.I.S. access
market is dominated by U.S. Surgical and Ethicon. Both entities introduced new
access devices during the past two years. A number of other entities participate
in various segments of the M.I.S. market, including access.

        There can be no assurance that the Company will be able to successfully
compete in the M.I.S. access market, and failure to do so would have a material
adverse effect on the Company's business, financial condition and results of
operations.

        There can be no assurance that competitors will not succeed in
developing technologies and products that are more effective than any which have
been or are being developed by the Company or that would render the Company's
technologies or products obsolete or not competitive. Such competition could
have a material adverse effect on the Company's business, financial condition
and results of operations. As a result of the entry of large and small companies
into the market, the Company expects competition for devices to increase. See
"Item 1. Business--Competition."

        Continued Dependence on Step Products. To date, substantially all of the
Company's revenues from product sales are attributable to Step products, and
InnerDyne currently anticipates that sales of Step products will represent the
majority of the Company's revenues for the immediate future. Accordingly, the
success of the Company is largely dependent upon increased market acceptance of
its Step product line by the medical community as a reliable, safe and
cost-effective access product for minimally invasive surgery. InnerDyne
commenced commercial sales of its Step product in the fourth quarter of 1994
and, to date, sales have been made to a relatively limited number of physicians
and hospitals. Recommendations and endorsements by influential members of the
medical community are important for the increased market acceptance of the
Company's Step products, and there can be no assurance that existing
recommendations or endorsements will be maintained or that new ones will be
obtained. Failure to increase market acceptance of the Company's Step products
would have a material adverse effect upon the Company's business, financial
condition and results of operations. See "Item 1. Business--InnerDyne's Products
and Technology."


<PAGE>   22



        Reliance on Future Products and New Applications; Uncertainty of
Technology Changes. The medical device industry is characterized by innovation
and technological change. The Company has made significant investments in
researching and developing its proprietary technologies, including radial
dilation and biocompatible coatings. During 1999, the Company expects to
commercially introduce an intra-organ product, and possibly the REVAS vascular
access product, each of which is a further enhancement of its radial dilation
technology. The future success of the Company will depend in part on the timely
commercial introduction and market acceptance of these and other possible
products. There can be no assurance that these products will be timely
introduced in commercial quantities, if at all, or that such products will
achieve market acceptance. A failure by the Company to timely introduce such
products or a failure of such products to achieve market acceptance could have a
material adverse effect on the Company's business, financial condition and
results of operations. The future success of the Company will also depend upon,
among other factors, the ability to develop and gain regulatory clearance for
new and enhanced versions of products in a timely fashion. There can be no
assurance that the Company will be able to successfully develop new products or
technologies, manufacture new products in commercial volumes, obtain regulatory
approvals on a timely basis or gain market acceptance of such products. Delays
in development, manufacturing, regulatory approval or market acceptance of new
or enhanced products could have a material adverse impact on the Company's
business, financial condition and results of operations. See "Item 1.
Business--Research and Development."

        Limited Manufacturing Experience; Compliance with Good Manufacturing
Practices. The Company initiated manufacture of commercial quantities of its
Step access device in its Salt Lake City, Utah facility during late 1994.
Accordingly, the Company has limited experience in manufacturing M.I.S. access
products or other products in commercial quantities at acceptable costs. The
Company's success will depend in part on its ability to manufacture its products
in compliance with the FDA's GMP regulations and other regulatory requirements
in sufficient quantities and on a timely basis, while maintaining product
quality and acceptable manufacturing costs. Manufacturers often encounter
difficulties in scaling up production of new products, including problems
involving production yields, quality control and assurance, component supply and
shortages of qualified personnel. In connection with its ISO 9001 certification,
InnerDyne now undergoes periodic audits by a regulatory body. The Company
believes that regulatory changes currently being introduced by the FDA will
result in a system of United States regulatory requirements for manufacturers of
medical devices which more closely resembles the ISO 9000 series of quality
systems standards adopted by most European countries. Failure to maintain
satisfactory regulatory system compliance could have a significant impact on the
Company's ability to continue to manufacture and distribute its products and, in
the most serious cases, result in the seizure or recall of products. Failure to
maintain production volumes or increase production volumes in a timely or
cost-effective manner would have a material adverse effect on the Company's
business, financial condition and results of operations. See "Item 1.
Business--Manufacturing."

        Potential Fluctuations in Operating Results. The Company's quarterly
operating results have in the past fluctuated and will continue to fluctuate
significantly in the future depending on the timing and shipment of product
orders, new product introductions and changes in pricing policies by the Company
or its competitors, the timing and market acceptance of the Company's new
products and product enhancements, the continued market acceptance of
InnerDyne's Step product line by the medical community, the Company's product
mix, the mix of distribution channels through which the Company's products are
sold, the extent to which the Company recognizes non-product revenues during a
quarter, and the Company's ability to obtain sufficient supplies of sole or
limited source components for its products. In particular, fluctuations in
production volumes affect gross margins from quarter to quarter. Furthermore,
gross margins and net income or loss can fluctuate from quarter to quarter to
the extent the Company recognizes non-product revenue during a quarter because
the Company typically derives higher margins from non-product revenue than from
product sales. In response to competitive pressures or new product
introductions, the Company may take certain pricing or other actions that could
materially and adversely affect the Company's operating results. In addition,
new product introductions by the Company could contribute to quarterly
fluctuations in operating results as orders for new products commence and orders
for existing products decline.

        The Company's expense levels are based, in part, on its expectations of
future revenues. Because a substantial portion of the Company's revenue in each
quarter normally results from orders booked and shipped in the final weeks of


<PAGE>   23



that quarter, revenue levels are extremely difficult to predict. If revenue
levels are below expectations, net income will be disproportionately affected
because only a small portion of the Company's expenses varies with its revenue
during any particular quarter. In addition, the Company typically does not
operate with any material backlog as of any particular date.

        As a result of the foregoing factors and potential fluctuations in
operating results, results of operations in any particular quarter should not be
relied upon as an indicator of future performance. In addition, in some future
quarter the Company's operating results may be below the expectations of public
market analysts and investors. In such event, the price of the Company's Common
Stock would likely be materially and adversely affected.

        Reliance on Collaborative Relationships; Restrictions on Activities. The
Company has entered into, and intends to continue to pursue, collaborative
arrangements with corporations and research institutions with respect to the
research, development, regulatory approval and marketing of certain of its
potential products. InnerDyne's future success may depend, in part, on its
relationship with such third parties, their strategic interest in the potential
products under development and, eventually, their success in marketing or
willingness to purchase any such products. The Company's existing and
anticipated contracts with such third parties may restrict the rights of
InnerDyne to engage in certain areas of product development, manufacturing and
marketing. In addition, these third parties may have the unilateral right to
terminate any such arrangement without significant penalty. There can be no
assurance that InnerDyne will be successful in establishing or maintaining any
such collaborative arrangements or that any such arrangements will be
successful.

        Limited Sales, Marketing and Distribution Experience. InnerDyne began
commercial sales of its first M.I.S. access product in the fourth quarter of
1994 and, therefore, has limited sales, marketing and distribution experience.
The Company is marketing its M.I.S. access products mainly to general surgeons,
gynecologists and pediatric laparoscopists. In the United States, InnerDyne
markets its products primarily through direct representatives who are employed
by the Company within selected geographical areas and a network of independent
sales representatives who typically sell other complementary M.I.S. products to
the same customer base. If the need arises, the Company may expand its sales
force, which will require recruiting and training additional personnel. There
can be no assurance that the Company will be able to recruit and train such
additional personnel in a timely fashion. Loss of a significant number of
InnerDyne's current sales personnel or independent sales representatives, or
failure to attract additional personnel, could have a material adverse effect on
the Company's business, financial condition and results of operations.

        The Company markets its products outside of the United States through
international distributors in selected foreign countries after regulatory
approvals, if necessary, are obtained. Although InnerDyne currently has
relationships with a limited number of international distributors, there can be
no assurance that the Company will be able to build a network of international
distributors capable of effectively marketing its M.I.S. access products or that
such distributors will generate significant sales of such products. The Company
has limited experience in marketing its products and faces substantial
competition from well-entrenched and formidable competitors. As a result, there
can be no assurance that the Company will successfully achieve acceptable levels
of product sales at prices which provide an adequate return. Failure to do so
would have a material adverse effect on the Company's business, financial
condition and results of operations. See "Item 1. Business--Sales and
Marketing."

        Patents and Proprietary Rights. The Company's success will depend in
large part on its ability to obtain patent protection for products and
processes, to preserve its trade secrets and to operate without infringing the
proprietary rights of third parties. Although InnerDyne has obtained certain
patents and applied for additional United States and foreign patents covering
certain aspects of its technology, no assurance can be given that any additional
patents will be issued or that the scope of any patent protection will exclude
competitors or provide a competitive advantage, or that any of the Company's
patents will be held valid if subsequently challenged. The validity and breadth
of claims covered in medical technology patents involves complex legal and
factual questions and therefore may be highly uncertain. InnerDyne also relies
upon unpatented trade secrets, and no assurance can be given that others will
not independently develop or otherwise acquire substantially equivalent trade
secrets. In addition, whether or not the Company's patents are issued, others
may hold or receive patents that contain claims having a scope that covers
products developed by InnerDyne.


<PAGE>   24



        There has been substantial litigation regarding patent and other
intellectual property rights in the medical device Industry, and companies in
the medical device industry have used litigation to gain competitive advantage.
Litigation involving the Company would result in substantial cost to and
diversion of management attention from the day-to-day operation of the business,
but could be necessary to enforce patents issued to the Company, to protect
trade secrets and other specialized knowledge unknown to outside parties, to
defend the Company against claimed infringement of the rights of others or to
determine the scope and validity of the proprietary rights of others. An adverse
determination in litigation could subject the Company to significant liabilities
to third parties, could require the Company to seek licenses from third parties
under less favorable terms than might otherwise be possible and could prevent
the Company from manufacturing, selling or using its products, any of which
could have a material adverse effect on the Company's business, financial
condition and results of operations.

        The Company has in the past, and may in the future, receive
correspondence from third parties claiming that the Company's products or
technology infringe intellectual property rights of such third parties. The
Company and its patent counsel thoroughly review such claims and no such
outstanding claims currently exist. However, there can be no assurance that
InnerDyne will not receive additional claims that its products or technology
infringe third party rights or that third parties will not litigate such claims.
Any such occurrence could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Item 1.
Business--Patents and Proprietary Rights."

        Government Regulation. Clinical testing, manufacture and sale of the
Company's products, including the Step product line, and the Company's
biocompatible coating technology, are subject to regulation by the FDA and
corresponding state and foreign regulatory agencies. Pursuant to the Federal
Food, Drug, and Cosmetic Act, and the regulations promulgated thereunder, the
FDA regulates the preclinical and clinical testing, manufacture, labeling,
distribution and promotion of medical devices. Noncompliance with applicable
requirements can result in, among other things, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or premarket
approval for devices, withdrawal of marketing approvals and criminal
prosecution. The FDA also has the authority to request recall, repair,
replacement or refund of the cost of any device manufactured or distributed by
the Company.

        Before a new device can be introduced in the market, the manufacturer
must generally obtain FDA clearance of 510(k) notification or approval of a PMA.
A PMA application must be filed if a proposed device is not "substantially
equivalent" to a legally marketed Class I or Class II device, or if it is a
Class III device for which the FDA has called for PMAs. The PMA process can be
expensive, uncertain and lengthy, and a number of devices for which FDA approval
has been sought by other companies have never been approved for marketing.

        A 510(k) clearance will be granted if the submitted information
establishes that the proposed device is substantially equivalent to a legally
marketed Class I or Class II medical device or a Class III medical device for
which the FDA has not called for PMAs. For any of the Company's devices cleared
through the 510(k) process, modifications or enhancements that could
significantly affect the safety or effectiveness of the device or that
constitute a major change to the intended use of the device will require a new
510(k) submission. There can be no assurance that the Company will obtain 510(k)
premarket clearance within a reasonable time frame, or at all, for any of the
devices or modifications for which it may file a 510(k).

        The Company has received clearance from the FDA for the marketing of its
Step device for use in accessing the abdominal and thoracic cavities for the
performance of minimally invasive surgical procedures. The Company has also
received FDA clearance for the marketing of its R.E.D. product for use in the
areas of gastrostomy, cystostomy, cholecystotomy, the dilation of biliary and
urethral strictures, laparoscopy and enterostomy. The Company has also received
market clearance for alternative versions of its Step and R.E.D. products,
including products designed to employ its radial dilation technology in vascular
and arthroscopic applications and for biliary indications. Although the Company
has been successful in preparing requests for 510(k) clearance, there can be no
assurance that 510(k) clearances for future products or product modifications
can be obtained in a timely manner or at all, or that any existing clearance can
be successfully maintained. A delay in receipt of, or failure to receive or
maintain, such clearances would have a material


<PAGE>   25



adverse effect on the Company's business, financial condition and results of
operations. Although the Company is strictly limited to marketing its products
for the indications for which they were cleared, physicians are not prohibited
by the FDA from using the products for indications other than those cleared by
the FDA. There can be no assurance that the Company will not become subject to
FDA action resulting from physician use of its products outside of their
approved indications.

        The Company has made modifications to its cleared devices that the
Company believes do not require the submission of new 510(k) notices. There can
be no assurance, however, that the FDA would agree with any of the Company's
determinations not to submit a new 510(k) notice for any of these changes or
would not require the Company to submit a new 510(k) notice for any of the
changes made to the device. If the FDA requires the Company to submit a new
510(k) notice for any device modification, the Company may be prohibited from
marketing the modified device until the 510(k) notice is cleared by the FDA.

        Any devices manufactured or distributed by the Company pursuant to FDA
clearance or approval are subject to pervasive and continuing regulation by the
FDA and certain state agencies and various foreign governments. Manufacturers of
medical devices for marketing in the United States are required to adhere to
applicable regulations setting forth detailed GMP requirements, which include
testing, control and documentation requirements. Manufacturers must also comply
with requirements that a firm report to the FDA any incident in which its
product may have caused or contributed to a death or serious injury, or in which
its product malfunctioned and, if the malfunction were to recur, it would be
likely to cause or contribute to a death or serious injury.

        The Company is registered as a manufacturer of medical devices with the
FDA. The Company is subject to routine inspection by the FDA and certain state
agencies for compliance with GMP requirements, MDR requirements and other
applicable regulations. Failure of the Company to maintain satisfactory GMP
compliance could have a significant adverse effect on the Company's ability to
continue to manufacture and distribute its products and, in the most serious
cases, could result in the seizure or recall of products, injunctions and/or
civil fines. See "Item 1. Business--Manufacturing and --Government Regulation."

        Dependence on Sole Sources. The materials utilized in the Company's
M.I.S. products consist of both standard and custom components that are
purchased from a variety of independent sources. The plastic parts used in the
Step product are injection molded by outside vendors. The majority of these
parts are produced utilizing molds that have been specially machined for and are
owned by the Company. Although the Company maintains significant inventories of
molded parts, any inability to utilize these molds for any reason might have a
material adverse effect on the Company's ability to meet its customer's demand
for product. In addition to plastic parts produced from injection molds owned by
the Company, a number of other materials are available only from a limited
number of sources at the present time, including the sheath component of the
Company's Step products. Efforts to identify and qualify additional sources of
this sheath component and other key materials and components are underway.
Although InnerDyne believes that alternative sources of these components can be
obtained, internal testing and qualification of substitute vendors could require
significant lead times and additional regulatory submissions. There can be no
assurance that such internal testing and qualification or additional regulatory
approvals will be obtained in a timely fashion, if at all. Any interruption of
supply of raw materials could have a material adverse effect on the Company's
ability to manufacture its products and, therefore, on its business, financial
condition and results of operations. See "Item 1. Business--Manufacturing."

        Uncertainty Relating to Third Party Reimbursement. In the United States,
health care providers that purchase medical devices, such as the Company's
products, generally rely on third-party payors, principally federal Medicare,
state Medicaid and private health insurance plans, to reimburse all or part of
the cost of the procedure in which the medical device is being used. In
addition, certain health care providers are moving toward a managed care system
in which such providers contract to provide comprehensive health care for a
fixed cost per person. Managed care providers are attempting to control the cost
of health care by authorizing fewer elective surgical procedures. The Company is
unable to predict what changes will be made in the reimbursement methods
utilized by third-party health care payors. Furthermore, the Company could be
adversely affected by changes in reimbursement policies of governmental or
private health care payors, particularly to the extent any such changes affect
reimbursement for procedures in which the Company's products


<PAGE>   26



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

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

        Dependence on International Sales. In the future, the Company expects to
derive an increasing portion of its revenue from international sales. To the
extent that the Company's international sales increase in future periods, a
significant portion of the Company's revenues could be subject to the risks
associated with international sales, including economic or political
instability, shipping delays, changes in applicable regulatory policies,
fluctuations in foreign currency exchange rates and various trade restrictions,
all of which could have a significant impact on the Company's ability to deliver
products on a competitive and timely basis. Future imposition of, or significant
increases in the level of, customs duties, import quotas or other trade
restrictions could have an adverse effect on the Company's business, financial
condition and results of operations. The regulation of medical devices,
particularly in the European Economic Community, continues to expand, and there
can be no assurance that new laws or regulations will not have an adverse effect
on the Company.

        Dependence on Key Personnel. InnerDyne is dependent upon a limited
number of key management and technical personnel. The Company's future success
will depend in part upon its ability to attract and retain highly qualified
personnel. The Company will compete for such personnel with other companies,
academic institutions, government entities and other organizations. There can be
no assurance that the Company will be successful in hiring or retaining
qualified personnel. The loss of key personnel or the inability to hire or
retain qualified personnel could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Item 1.
Business--Employees", "Item 1. Business--Executive Officers of the Company" and
"Item 10. Directors and Executive Officers of Registrant."

        Product Liability; Claims in Excess of Insurance Coverage. The
development, manufacture and sale of the Company's products entail the risk of
product liability claims, involving both potential financial exposure and
associated adverse publicity. The Company's current product liability insurance
coverage limits are $3,000,000 per occurrence and $3,000,000 in the aggregate,
and there can be no assurance that such coverage limits are adequate to protect
the Company from any liabilities it might incur in connection with the
development, manufacture and sale of its current and potential products. Product
liability insurance is expensive and may not be available in the future on
acceptable terms, or at all. In addition, if such insurance is available, there
can be no assurance that the limits of coverage of such policies will be
adequate. A successful product liability claim in excess of the Company's
insurance coverage could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Item 1.
Business--Product Liability and Insurance."

        Stock Price Volatility. The stock market in general and stocks of
medical device companies in particular, have from time to time experienced
significant price and volume fluctuations that are unrelated to the operating
performance of particular companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock. In addition,
the market price of the Company's Common Stock has been and is likely to
continue to be highly volatile. Factors such as fluctuations in the Company's
operating results, announcements of technological innovations or new products by
the Company or its competitors, FDA and international regulatory actions,
actions with respect to reimbursement matters, developments with respect to
patents or proprietary rights, public concern as to the safety of products
developed by the Company or others, changes in health care policy in the United
States and internationally, changes in stock market analyst recommendations
regarding the Company, other medical device companies or the 


<PAGE>   27

medical device industry generally or general market conditions may have a
significant effect on the market price of the Common Stock. See "Item 5. Market
for Registrant's Common Stock and Related Stockholder Matters."

        Environmental Regulations. The Company is subject to a variety of local,
state and federal governmental regulations relating to the use, storage,
handling, manufacture and disposal of toxic and other hazardous substances used
to manufacture the Company's products. The Company believes that it is currently
in compliance in all material respects with applicable governmental
environmental regulations. Nevertheless, the failure by the Company to comply
with current or future environmental regulations could result in the imposition
of substantial fines on the Company, suspension of production, alteration of its
manufacturing processes or cessation of operations. Compliance with such
regulations could require the Company to acquire expensive remediation equipment
or to incur substantial expenses. Any failure by the Company to control the use,
disposal, removal or storage of, or to adequately restrict the discharge of, or
assist in the cleanup of, hazardous or toxic substances, could subject the
Company to significant liabilities, including joint and several liability under
certain statutes. The imposition of such liabilities could have a material
adverse effect on the Company's business, financial condition, and results of
operations.

        Control by Directors and Principal Stockholders. As of February 28,
1999, directors and principal stockholders of the Company, and certain of their
affiliates, beneficially owned approximately 26% of the Company's outstanding
Common Stock. Accordingly, these persons, as a group, may be able to control the
Company and significantly affect the direction of the Company's affairs and
business, including any determination with respect to the acquisition or
disposition of assets by the Company, future issuances of Common Stock or other
securities by the Company and the election of directors. Such concentration of
ownership may also have the effect of delaying, deferring or preventing a change
in control of the Company.

        Anti-Takeover Effect of Certain Charter Provisions of Common Stock.
Provisions of the Company's Certificate of Incorporation that allow the Company
to issue Preferred Stock without any vote or further action by the stockholders,
the fact that the Company's Certificate of Incorporation does not permit
stockholders to cumulate votes in the election of directors as well as the
Company's adoption of a poison pill Preferred Share Purchase Rights plan in
September 1997 may have the effect of making it more difficult for a third party
to acquire, or of discouraging a third party from attempting to acquire, control
of the Company. Certain provisions of Delaware law applicable to the Company
could also delay or make more difficult a merger, tender offer or proxy contest
involving the Company, including Section 203, which prohibits a Delaware
corporation from engaging in any business combination with any interested
stockholder for a period of three years unless certain conditions are met. The
possible issuance of Preferred Stock, the inability of stockholders to cumulate
votes in the election of directors, the poison pill and provisions of Delaware
law could have the effect of delaying, deferring or preventing a change in
control of the Company, including without limitation, discouraging a proxy
contest or making more difficult the acquisition of a substantial block of the
Company's Common Stock. The possible issuance of Preferred Stock, the poison
pill and these provisions could also limit the price that investors might be
willing to pay in the future for shares of the Company's Common Stock.

        Risks Associated With Software and Hardware and the Year 2000. InnerDyne
relies on a variety of internal computer systems and programs in the operation
of its business. The Company is currently in the process of testing and
upgrading, where necessary, the software and hardware products used in its
operations with respect to the year 2000 issue. The Company's internal systems
run on personal computers and microprocessor-based computer servers set up in a
workstation environment which the Company believes are not susceptible to
universal failures. Were system failures to occur as a result of the year 2000
issue, the Company believes that its on-site engineers and technical personnel
should be able to address and resolve such issues prior to the occurrence of any
material adverse effect on the Company's business operations.

        The failure of certain of the systems upon which the Company relies,
such as payroll and banking services, could be disruptive to the Company's
business operations if such systems were unavailable for an extended period of
time. The Company is in the process of making inquiries with the providers of
such types of services to determine their year 2000 readiness. However, the
Company believes that its business operations would not be materially adversely
effected by short disruptions in such services and that the providers of such
services (who also typically service many other business customers) will take
steps to rectify any failures as soon as possible. More generally, the Company
does not believe that 


<PAGE>   28

the power grid or general communications, building security and similar systems
expose the Company to any unique year 2000 risks as compared to other
businesses.

        The Company faces year 2000 risk from third-party suppliers.
Notwithstanding written assurances from the Company's vendors regarding year
2000 compliance, there is no guarantee that the year 2000 will not cause a
disruption in the supply of critical components necessary for the Company's
products. Given the Company's reliance on suppliers of critical, sole-sourced
components, the Company is relying on these suppliers to address the year 2000
issues in their own products and operations, and the failure of such suppliers
to adequately address these issues could have a material adverse effect on the
Company's business, financial condition and results of operations. As a
contingency plan in the event that any of such suppliers do not or are unable to
address material year 2000 issues, the Company intends to stockpile an inventory
of raw materials and molded parts in order to maintain a one month backlog of
such components.

        The Company has not incurred substantial costs to date to address the
year 2000 issue and estimates that the additional cost, if any, arising from
actions taken by the Company to address year 2000 problems will not be material.

        Despite the Company's efforts to address the year 2000 impact on its
internal systems and business operations, the year 2000 issue may result in a
material disruption of its business or have a material adverse effect on the
Company's business, financial condition or results of operations.

RESULTS OF OPERATIONS

        Total revenues of $17,610,237 were realized during the year ended
December 31, 1998, compared to total revenues of $15,664,365 in 1997, and
$9,086,127 in 1996. Total revenues are comprised of revenues from product sales
and licensing, contract and grant revenues. Revenues from product sales
increased to $16,268,375 in 1998 from $12,149,395 in 1997 and $7,773,547 in
1996, reflecting increased sales of the Step device in each year. Licensing,
contract and grant revenues were $1,341,862, $3,514,970, and $1,312,580 in 1998,
1997 and 1996, respectively. These revenues related to agreements with third
parties covering the development of the Company's proprietary thermal ablation
technology, and licensing of the Company's proprietary biocompatible coating and
radial dilation technology. Licensing, contract and grant revenues will continue
to fluctuate from year to year, and from quarter to quarter, based upon the
number of agreements in effect and the amount and timing of the payments to be
made to InnerDyne pursuant to such agreements, and may depend on whether the
Company or the licensee can satisfy performance milestones.

        Total costs and expenses were $17,357,916 in 1998 compared to
$16,789,068 in 1997 and $13,946,878 in 1996. Expenses in 1998, 1997 and 1996
grew because of increased costs of sales on higher sales volume, and included
clinical, research and development and regulatory expenses related to the EnAbl
System REVAS, and higher sales and marketing expenses related to the
commercialization of the Company's M.I.S. products, including Step, One Step,
Open Step, and Reposable Step.

        Cost of sales was $5,631,031 in 1998 compared to $5,070,946 in 1997, and
$4,363,367 in 1996. Cost of sales is primarily comprised of direct material
costs of components for finished products, as well as labor costs and an
allocated portion of overhead expenses. The increase each year was due to the
production of higher volumes of the Step device. Although the Company
anticipates that cost of sales will continue to increase in absolute dollars in
future periods, cost of sales as a percentage of revenue is expected to decrease
in 1999 if sales and production volumes increase.

        Research, development, regulatory and clinical expenses were $2,908,929
in 1998 compared to $3,292,775 in 1997, and $2,839,556 in 1996. Research,
development, regulatory and clinical expenses are primarily comprised of salary
and benefits, costs incurred in protecting the Company's intellectual property
and an allocated portion of overhead expenses. The decrease in 1998 was the
result of lower reimbursed research costs associated with the EnAbl thermal
ablation system, while the increase in 1997 represented the additional
development funding and clinical expenses related to the development of the
One-Step and Mini Step, as well as vascular and arthroscopic access devices The
Company anticipates that research, development, regulatory and clinical
expenditures are likely to increase in future periods.
<PAGE>   29

        Sales and marketing expenses were $6,824,228 compared to $6,161,934 in
1997, and $4,740,050 in 1996. Sales and marketing expenses are primarily
comprised of salary, benefits and commissions; an allocated portion of overhead
expenses; advertising, promotional and customer service expenses; and cost of
product samples. The increase each year reflects the expansion of sales and
marketing functions for M.I.S. products as sales volumes increased. InnerDyne
expects that sales and marketing expenses will continue to increase in absolute
dollars.

        General and administrative expenses were $1,993,728 compared to
$2,263,413 in 1997, and $2,003,905 in 1996. General and administrative expenses
are primarily comprised of salary and benefits, an allocated portion of overhead
expenses, as well as legal, accounting, insurance and other general corporate
expenses. The decrease in expenses in 1998 related to negotiating lower
insurance premiums, as well as lower professional services and consulting costs.
The increase in expenses in 1997 reflects additional staffing to support
investor relations, financial functions, and professional services. The Company
anticipates that general and administrative expenses will increase in absolute
dollars to support expanding operations.

        Interest income was $293,227 in 1998, $327,943 in 1997, and $263,679 in
1996. The decrease in 1998 was due to lower interest earned as the Company's
average cash and cash equivalent balances decreased. Interest expense was
$120,061 in 1998, $117,338 in 1997, and $62,011 in 1996. This increase in
interest expense was primarily the result of an increase in debt incurred to
finance equipment to support operations of the Company.

        Primarily for the reasons outlined above, InnerDyne earned net income of
$425,030 or $.02 per share on both a basic and diluted basis in 1998 and
incurred net losses of ($907,466) or ($.04) per share on both a basic and
diluted basis in 1997, and ($4,659,083) or ($.23) per share on both a basic and
diluted basis in 1996.

LIQUIDITY AND CAPITAL RESOURCES

        From its inception to December 31, 1998, the Company has incurred a
cumulative deficit of approximately $51.8 million. Prior to fiscal year 1998,
the Company's cash expenditures exceeded its revenues. Prior to 1992, the
Company was funded primarily through private placements of equity securities. In
1992, the Company completed an initial public offering of 2,875,000 shares of
its Common Stock at $11.00 per share, which raised approximately $28.8 million
(net of underwriter's discounts and offering expenses). The 1994 acquisition of
InnerDyne Medical, Inc. was accomplished through the issuance of additional
Common Stock of the Company. In June 1995, the Company closed a private
placement of 1,435,599 shares of the Company's Common Stock and warrants to
purchase 287,200 additional shares of Common Stock, with gross proceeds to the
Company of approximately $3.2 million. In March and April of 1996, holders of
warrants to purchase an aggregate of 242,952 shares of Common Stock exercised
such warrants, resulting in gross proceeds to the Company of $704,561. The
Company concluded a public offering on May 20, 1996, with the sale of 2,650,000
shares of Common Stock at $3.50 per share, which raised $8,015,268 (net of
underwriter's discounts and offering expenses).

        At December 31, 1998, cash and cash equivalents totaled $5,757,538
compared to $6,091,497 at December 31, 1997. The Company had $359,739, $427,276,
and $776,901 in capital expenditures in the years ended December 31, 1998, 1997,
and 1996, respectively. Working capital totaled $8,157,672 at December 31, 1998,
and the Company had long-term debt, excluding current installments, totaling
$348,723 relating to financing of equipment.

        In June 1998, the Company renewed its credit facility with Silicon
Valley Bank. Subject to certain covenants and conditions, the Company may borrow
up to $2,000,000 through June 18, 1999 on a revolving credit basis at prime plus
 .75% based on eligible receivables. The Company also has an equipment advance
line of credit, which allows the Company to borrow up to $750,000 per year based
on eligible equipment purchases. Amounts outstanding on this equipment advance
line of credit are periodically converted to 48 month term loans bearing
interest at prime plus .75%.

        As of December 31, 1998, the Company had drawn $300,000 for financing of
working capital needs on the revolving line of credit, secured by certain
accounts receivable, and had borrowed $58,467 for the financing of fixed assets
with Silicon Valley Bank. Debt balances as of December 31, 1998 on the Company's
balance sheet also include 


<PAGE>   30

amounts loaned to the Company under current and previous equipment lines of
credit agreements with Silicon Valley Bank.

        In the future, the Company may incur operating losses and cash outflow
requirements as a result of expenditures related to expansion of sales and
marketing capability, expansion of manufacturing capacity, research and
development activities, compliance with regulatory requirements, and possible
investment in, or acquisition of, additional complementary products,
technologies or businesses. The timing and amounts of these expenditures will
depend upon many factors, such as the availability of capital, progress of the
Company's research and development, and factors that may be beyond the Company's
control, such as the results of product trials, the requirements for and the
time required to obtain regulatory approval for existing products and any other
products that may be developed or acquired, and market acceptance of the
Company's products.

         The Company's capital requirements will depend on numerous factors,
including market acceptance and demand for its products; the resources the
Company devotes to the development, manufacture and marketing of its products;
the progress of the Company's clinical research and product development
programs; the receipt of, and the time required to obtain, regulatory clearances
and approvals; the resources required to protect the Company's intellectual
property; and other factors. The timing and amount of such capital requirements
cannot be accurately predicted. Funds may also be used for the acquisition of
businesses, products and technologies that are complementary to those of the
Company. Consequently, although the Company believes that the proceeds of the
public offering of shares of its Common Stock completed in May 1996, together
with revenues, credit facilities and other sources of liquidity, will provide
adequate funding to meet its cash needs through at least 1999, the Company may
be required to raise additional funds through public or private financings,
collaborative relationships or other arrangements. There can be no assurance
that the Company will not require additional funding or that such additional
funding, if needed, will be available on terms attractive to the Company, or at
all. Any additional equity financings may be dilutive to stockholders, and debt
financing, if available, may involve restrictive covenants.

ITEM 7A.       QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        The following discusses our exposure to market risk related to changes
in interest rates, equity prices, and foreign currency exchange rates. This
discussion contains forward-looking statements that are subject to risks and
uncertainties. Actual results could vary materially as a result of a number of
factors including those set forth in the Risk Factors section.

INTEREST RATE RISK

        As of December 31, 1998, InnerDyne had short-term investments of
$6,008,650. Substantially all of these short-term investments consist of highly
liquid money market funds and commercial paper investments with remaining
maturities at the date of purchase of less than ninety days. These investments
are subject to interest rate risk and will decrease in value if market interest
rates increase. A hypothetical increase or decrease in market interest rates by
10 percent from the December 31, 1998 rates would cause the fair market value of
these short-term investments to change by an immaterial amount. We have the
ability to hold these investments until maturity, and therefore, we do not
expect the value of these investments to be affected to any significant degree
by the effect of a sudden change in market interest rates. Declines in interest
rates over time will, however, reduce our interest income. The Company has not
used derivative financial instruments.

        InnerDyne does not own any equity investments. Therefore, we do not
currently have any direct equity price risk.

        All InnerDyne revenues are realized in U.S. dollars; therefore, we do
not believe that the Company currently has any significant direct foreign
currency exchange rate risk.


<PAGE>   31




FOREIGN CURRENCY RISK

        International revenues were less than 10% of total revenues.
International sales are made mostly through international distributors with
payments to the Company typically denominated in U.S. dollars. The Company's
international business is subject to risks typical of an international business,
including, but not limited to differing economic conditions, changes in
political climate, differing tax structures, other regulations and restrictions,
and foreign exchange rate volatility. Accordingly, the Company's future results
could be materially adversely impacted by changes in these or other factors. The
effect of foreign exchange rate fluctuations on the Company in 1998 was not
material.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

          See pages F-1 through F-18.

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

          None.



<PAGE>   32



                                    PART III

        Certain information required by Part III is omitted from this report
because the Registrant will file a definitive proxy statement within 120 days
after the end of its fiscal year pursuant to Regulation 14A (the "Proxy
Statement") for its annual meeting of stockholders to be held May 27, 1999, and
the information included therein is incorporated herein by reference.

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

        Information with respect to directors of the Company is incorporated by
reference from the information under the caption "Election of Directors --
Nominees" in the Registrant's Proxy Statement. See "Item 1. Business--Executive
Officers of the Company" for information with respect to the executive officers
of the Company.

        Information with respect to compliance with Section 16(a) of the
Securities Exchange Act of 1934 is incorporated by reference from the
information under the caption "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Registrant's Proxy Statement.

ITEM 11.  EXECUTIVE COMPENSATION

        The information required by this item is incorporated by reference from
the information under the captions "Compensation of Executive Officers" and
"Certain Relationships and Related Transactions" in the Registrant's Proxy
Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The information required by this item is incorporated by reference from
the information under the caption "Common Stock Ownership of Certain Beneficial
Owners and Management" in the Registrant's Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        The information required by this item is incorporated by reference from
the information under the captions "Compensation of Executive Officers" and
"Certain Relationships and Related Transactions" in the Registrant's Proxy
Statement.


<PAGE>   33



                                     PART IV

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

(a)     The following documents are filed as part of this Report:

        1.     Financial Statements and Schedules

                        Financial Statements - See pages F-1 to F-16. Schedule
                        II - Valuation and Qualifying Accounts - See pages F-17
                        to F-18.

               Schedules other than those listed above are omitted because they
               are not required or the information required to be set forth
               therein is included in the Financial Statements or notes thereto.

        2.     Exhibits

<TABLE>
<CAPTION>
               EXHIBIT          DESCRIPTION
               NUMBER

<S>                             <C> 
               3.1(7)           Restated Certificate of Incorporation of Registrant.
               3.2(2)           Bylaws of Registrant.
               10.1*(4)         1987 Stock Option Plan, as amended.
               10.2*(8)         1991 Directors' Stock Option Plan, as amended.
               10.3*(8)         1991 Employee Stock Purchase Plan, as amended.
               10.4(1)          Purchase Agreement (Series C) dated as of June 26, 1990, as
                                amended.
               10.6(1)          Form of Indemnification Agreement between the Registrant and
                                its officers and directors.
               10.7*(1)         Defined Contribution "401(k)" Plan as amended January 1, 1990.
               10.9(2)          Lease dated June 1989 between the Registrant and William J.
                                Lowenberg.
               10.13*(3)        Letter Agreement with William G. Mavity.
               10.14*(4)        Consulting Agreement with Robert M. Curtis dated January 12,
                                1994.
               10.16(5)         Lease Extension with BSL Associates.
               10.17(5)         Lease Agreements with QED Associates.
               10.18(5)(9)      Licensing Agreement with SENKO Medical Instrument Mfg. Co.,
                                Ltd.
               10.19*(5)        InnerDyne Medical, Inc. 1989 Incentive Stock Plan.
               10.20*(5)        Interventional Thermodynamics Inc. 401(k) Plan.
               10.22(6)(9)      License and Development Agreement dated as of August 25, 1994
                                by and among InnerDyne, Inc., InnerDyne Medical, Inc. and
                                CooperSurgical, Inc.
               10.23(7)         Loan and Security Agreement and Collateral
                                Assignment, Patent Mortgage and Security
                                Agreement dated as of February 23, 1995 between
                                the Registrant and Silicon Valley Bank.
               10.24(8)         Common Stock and Warrant Purchase Agreement
                                dated as of June 2, 1995 by and among the
                                Registrant and the purchasers named therein,
                                including form of Common Stock Warrant.
               10.25(10)        Amendment to Loan and Security Agreement dated
                                as of February 29, 1996 between the Registrant
                                and Silicon Valley Bank.
               10.26*(10)       1996 Stock Option Plan.
               10.27(9)(10)     Licensing, Development and Manufacturing Agreement dated as of
                                February 2, 1996 between the Registrant and
                                EndoTex Interventional Systems, Inc.

</TABLE>
<PAGE>   34

<TABLE>

<S>                             <C>                        
               10.28(9)(10)     National Contract dated October 1995 between the Registrant
                                and Surgical Care Affiliates, Inc.
               10.29(9)(10)     License Agreement dated as of January 1, 1996
                                between the Registrant and Alliance of
                                Children's Hospitals, Inc.
               10.31*(10)       Letter Agreement with Robert A. Stern dated January 10, 1996.
               10.32*(11)       Change of Control Agreement dated as of September 12, 1996
                                between the Registrant and William G. Mavity.
               10.33(9)(11)     License Agreement dated as of December 20, 1996 by and among
                                the Registrant and United States Surgical Corporation.
               10.34(9)(11)     License, Supply and Distribution Agreement dated as of January
                                6, 1997 by and between the Registrant and
                                Sherwood Medical Company.
               10.35*(11)       Letter Agreement with Daniel J. Genter dated March 13, 1996.
               10.36(11)        Amendment to Loan and Security Agreement dated as of February
                                4, 1997 between the Registrant and Silicon Valley Bank.
               10.37*(11)       Form of Senior Management Change of Control Agreement.
               10.38(12)        Loan modification Agreement dated as of June 18, 1998 by and
                                between the Registrant and Silicon Valley Bank.
               10.39 (13)       Termination of License, Supply and Distribution Agreement by
                                and between the Registrant and Sherwood Medical Company dated
                                March 12, 1998.
               10.40+           Letter Agreement with United States Surgical Corporation dated
                                May 26, 1998.
               10.41+           Letter Agreement with Boston Scientific dated July 29, 1998.
               10.42+           Letter Agreement with United States Surgical Corporation dated
                                August 14, 1998.
               10.43            Third Addendum to the Lease with QED Associates dated August
                                31, 1998.
               23.1             Consent of Independent Certified Public Accountants
               24.1             Power of Attorney
               27.1             Financial Data Schedule
</TABLE>

     * Management compensatory plan or arrangement.
     + Confidential treatment requested as to certain portions of this Exhibit.

(1) Incorporated by reference to exhibits filed in response to Item 16(a),
"Exhibits," of the Registrant's Registration Statement on Form S-1, as amended
(File No. 33-44361), filed December 4, 1991.

(2) Incorporated by reference to exhibits filed in response to Item 14(a)(3),
"Exhibits," of the Registrant's Annual Report on Form 10-K for the year ended
December 31, 1992.

(3) Incorporated by reference to exhibits filed in response to Item 6, "Exhibits
and Reports on Form 8-K," of the Registrant's Quarterly Report on Form 10-Q for
the quarterly period ended September 30, 1993.

(4) Incorporated by reference to exhibits filed in response to Item 21,
"Exhibits and Financial Statement Schedules," of the Registrant's Registration
Statement on Form S-4, as amended (File No. 33-74624), filed January 31, 1994.

(5) Incorporated by reference to exhibits filed in response to Item 6, "Exhibits
and Reports on Form 8-K," of the Registrant's Quarterly Report on Form 10-QSB
for the quarterly period ended June 30, 1994.

(6) Incorporated by reference to exhibits filed in response to Item 6 "Exhibits
and Reports on Form 8-K," of the Registrant's Quarterly Report on Form 10-QSB
for the quarterly period ended September 30, 1994.
<PAGE>   35

(7) Incorporated by reference to exhibits filed in response to Item 13, "Exhibit
List and Reports on Form 8-K," of the Registrant's Annual Report on Form 10-KSB
for the year ended December 31, 1994.

(8) Incorporated by reference to exhibits filed in response to Item 6, "Exhibits
and Reports on Form 8-K" of the Registrant's Quarterly Report on Form 10-QSB for
the quarterly period ended June 30, 1995.

(9) Confidential treatment granted for portions of this exhibit by order of the
Securities and Exchange Commission.

(10) Incorporated by reference to exhibits filed in response to Item 13,
"Exhibit List and Reports on Form 8-K," of the Registrant's Annual Report on
Form 10-KSB for the year ended December 31, 1995.

(11) Incorporated by reference to exhibits filed in response to Item 14,
"Exhibits, Financial Statement Schedules and Reports on Form 8-K," of the
Registrant's Annual Report on Form 10-K for the year ended December 31, 1996.

(12) Incorporated by reference to exhibits filed in response to Item 6,
"Exhibits and Reports on Form 8-K," of the Registrant's Quarterly Report on Form
10-Q for quarterly period ended June 30, 1998.

(13) Incorporated by reference to exhibits filed in response to Item 14,
"Exhibits, Financial Statement Schedules and Reports on Form 8-K," of the
Registrant's Annual Report on Form 10-K for the year ended December 31, 1997

(b)     Reports on Form 8-K:  None


<PAGE>   36



                                 INNERDYNE, INC.
                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>

                                                                         PAGE
                                                                         ----
<S>                                                                      <C>
Report of KPMG LLP, Independent Auditors...............................   F-2
Balance Sheets.........................................................   F-3
Statements of Operations...............................................   F-4
Statements of Stockholders' Equity.....................................   F-5
Statements of Cash Flows...............................................   F-6
Notes to Financial Statements..........................................   F-7

</TABLE>



<PAGE>   37



                          INDEPENDENT AUDITORS' REPORT



The Board of Directors and Stockholders
InnerDyne, Inc.:


        We have audited the accompanying balance sheets of InnerDyne, Inc. as of
December 31, 1998 and 1997, and the related statements of operations,
stockholders' equity, and cash flows for each of the years in the three-year
period ended December 31, 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

        In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of InnerDyne, Inc. as
of December 31, 1998 and 1997, and the results of its operations and its cash
flows for each of the years in the three-year period ended December 31, 1998, in
conformity with generally accepted accounting principles.

                                                               /s/KPMG LLP


San Francisco, California
January 29, 1999


                                             F-2


<PAGE>   38



                                 InnerDyne, INC.

                                 Balance Sheets

                           December 31, 1998 and 1997

<TABLE>
<CAPTION>

                                Assets                                          1998                1997
                                                                            ------------        ------------

<S>                                                                         <C>                 <C>         
Current assets:
Cash and cash equivalents                                                   $  5,757,538        $  6,091,497
   Accounts receivable, less allowance for doubtful
     accounts of $121,054 in 1998 and $177,930 in 1997 (note 4)                2,670,811           1,920,966
   Interest and other receivables                                                383,726             702,606
   Inventories (note 3)                                                        1,202,982           1,454,266
   Prepaid expenses                                                              213,831             116,821
                                                                            ------------        ------------
         Total current assets                                                 10,228,888          10,286,156
                                                                            ------------        ------------
Equipment and leasehold improvements:
   Equipment (note 4)                                                          3,677,624           3,595,696
   Leasehold improvements                                                        209,245             198,826
                                                                            ------------        ------------
                                                                               3,886,869           3,794,522
   Less accumulated depreciation and amortization                              3,072,749           2,807,281
                                                                            ------------        ------------
         Net equipment and leasehold improvements                                814,120             987,241
Deposits                                                                          45,695              45,695
                                                                            ------------        ------------
                                                                            $ 11,088,703        $ 11,319,092
                                                                            ============        ============
                 Liabilities and Stockholders' Equity
Current liabilities:
   Line of credit (note 4)                                                  $    300,000        $    300,000
   Current installments of long-term debt (note 4)                               391,040             340,543
   Accounts payable                                                              260,132             489,602
   Accrued payroll                                                               346,879             585,157
   Accrued commissions                                                           300,000             219,286
   Accrued clinical costs                                                             --             209,686
   Other accrued expenses                                                        473,165             490,207
                                                                            ------------        ------------
         Total current liabilities                                             2,071,216           2,634,481
Long-term debt, excluding current installments (note 4)                          348,723             649,061
Commitments (note 5)
Stockholders' equity (note 6):
   Preferred stock, $.01 par value.  Authorized 1,000,000
     shares; no shares issued and outstanding in 1998 and 1997                        --                  --

   Common stock, $.01 par value. Authorized 40,000,000 shares; issued
     and outstanding 21,891,388 shares in 1998 and 21,754,862
     shares in 1997                                                              218,914             217,549

   Additional paid-in capital                                                 60,206,865          60,000,046
   Accumulated deficit                                                       (51,757,015)        (52,182,045)
                                                                            ============        ============
         Net stockholders' equity                                              8,668,764           8,035,550
                                                                            ============        ============
                                                                            $ 11,088,703        $ 11,319,092
                                                                            ============        ============
</TABLE>


See accompanying notes to financial statements.


                                       F-3


<PAGE>   39



                                 InnerDyne, INC.

                            Statements of Operations

                  Years ended December 31, 1998, 1997, and 1996


<TABLE>
<CAPTION>


                                                                              1998                   1997                   1996
                                                                         ------------           ------------           ------------
<S>                                                                      <C>                    <C>                    <C>         
Revenues:

   Product sales                                                         $ 16,268,375           $ 12,149,395           $  7,773,547

   Licensing, contract, and grant revenue (note 8)                          1,341,862              3,514,970              1,312,580
                                                                         ------------           ------------           ------------
         Total revenues                                                    17,610,237             15,664,365              9,086,127
Costs and expenses:

   Cost of sales                                                            5,631,031              5,070,946              4,363,367

   Research, development, regulatory, and clinical                          2,908,929              3,292,775              2,839,556

   Sales and marketing                                                      6,824,228              6,161,934              4,740,050

   General and administrative                                               1,993,728              2,263,413              2,003,905
                                                                         ------------           ------------           ------------
         Total costs and expenses                                          17,357,916             16,789,068             13,946,878
                                                                         ------------           ------------           ------------
         Operating profit (loss)                                              252,321             (1,124,703)            (4,860,751)
Other income (expense):

   Interest income                                                            293,227                327,943                263,679

   Interest expense                                                          (120,061)              (117,338)               (62,011)

   Gain (loss) on asset disposal                                                 (457)                 6,632                     --
                                                                         ------------           ------------           ------------
         Total other income                                                   172,709                217,237                201,668
                                                                         ------------           ------------           ------------
         Net income (loss)                                               $    425,030           $   (907,466)          $ (4,659,083)
                                                                         ============           ============           ============
Basic and diluted net income (loss) per share                            $       0.02           $      (0.04)          $      (0.23)

  Weighted average basic and diluted common shares outstanding:
         Basic                                                             21,814,271             21,671,604             20,324,033
                                                                         ============           ============           ============
         Diluted                                                           22,271,919             21,671,604             20,324,033
                                                                         ============           ============           ============
</TABLE>




See accompanying notes to financial statements.


                                       F-4


<PAGE>   40



                                 InnerDyne, INC.

                       Statements of Stockholders' Equity

                  Years ended December 31, 1998, 1997, and 1996
<TABLE>
<CAPTION>

                                                                                       Additional                           Net
                                                                           Common        paid-in       Accumulated    stockholders'
                                                                           stock         capital         deficit         equity
                                                                        ------------   ------------    ------------   ------------

<S>                                                                    <C>            <C>             <C>            <C>         
Balances at December 31, 1995                                           $    183,155   $ 50,442,159    $(46,615,496)  $  4,009,818
    Issuance of shares upon exercise of stock options and under
       employee stock purchase plan                                            1,609        172,113              --        173,722
    Issuance of shares upon warrant exercise                                   2,429        702,132              --        704,561
    Issuance of shares in public offering (net of underwriters' and
       issuance expenses of $1,259,732)                                       26,500      7,988,768              --      8,015,268
    Issuance of shares for services rendered                                      60         14,940              --         15,000
    Issuance of common stock for cash (note 8)                                 1,667        498,333              --        500,000
    Net loss                                                                      --             --      (4,659,083)    (4,659,083)
                                                                        ------------   ------------    ------------   ------------

Balances at December 31, 1996                                                215,420     59,818,445     (51,274,579)     8,759,286
    Issuance of shares upon exercise of stock options and under
       employee stock purchase plan                                            2,069        197,093              --        199,162
    Issuance of shares for services rendered                                      60         14,940              --         15,000
    Additional expenses related to 1996 public offering                           --        (30,432)             --        (30,432)
    Net loss                                                                      --             --        (907,466)      (907,466)
                                                                        ------------   ------------    ------------   ------------

                                                                             217,549     60,000,046     (52,182,045)     8,035,550
Balances at December 31, 1997
    Issuance of shares upon exercise of stock options and under
       employee stock purchase plan                                            1,289        187,638              --        188,927
    Issuance of shares for services rendered                                      76         19,181              --         19,257
    Net income                                                                    --             --         425,030        425,030
                                                                        ------------   ------------    ------------   ------------

Balances at December 31, 1998                                           $    218,914   $ 60,206,865    $(51,757,015)  $  8,668,764
                                                                        ============   ============    ============   ============

</TABLE>

See accompanying notes to financial statements.


                                             F-5


<PAGE>   41



                                 InnerDyne, INC.

                            Statements of Cash Flows

                  Years ended December 31, 1998, 1997, and 1996

<TABLE>
<CAPTION>

                                                                                           1998           1997            1996
                                                                                      ------------   ------------    ------------
<S>                                                                                   <C>            <C>             <C>          
 Cash flows from operating activities:
     Net income (loss)                                                                $    425,030   $   (907,466)   $ (4,659,083)
     Adjustments to reconcile net income (loss) to net cash provided by (used in)
        operating activities:
          Depreciation and amortization of equipment and leasehold improvements            530,903        596,426         565,887
          Provision for doubtful accounts                                                   26,469         45,687         108,566
          Provision for obsolete inventory                                                 130,587        185,203         238,517
          (Gain) loss on asset disposal                                                        457         (6,632)             --
          Common stock issued for services rendered                                         19,257         15,000          15,000
          Increase in accounts receivable, interest,
             and other receivables                                                        (457,434)    (1,094,541)       (751,727)
          Decrease (increase) in inventories                                               120,697       (480,371)       (812,492)
          Decrease (increase) in prepaid expenses and deposits                             (97,010)        35,654         (11,960)
          Increase (decrease) in accounts payable                                         (229,470)       187,656          95,626
          Increase (decrease) in accrued expenses                                         (384,292)       357,459         294,842
                  Net cash provided by (used in) operating activities                       85,194     (1,065,925)     (4,916,824)
                                                                                      ------------   ------------    ------------
 Cash flows from investing activities:
     Maturities of marketable investment securities                                             --             --         997,604
      Capital expenditures                                                                (359,739)      (427,276)       (776,901)
Proceeds from disposal of equipment and
                                                                                      ------------   ------------    ------------
leasehold improvements                                                                       1,500          9,550              --
                  Net cash provided by (used in) investing activities                     (358,239)      (417,726)        220,703
                                                                                      ------------   ------------    ------------
 Cash flows from financing activities:
     Proceeds from issuance of long-term debt                                               58,467        284,639         670,072
     Proceeds from line of credit                                                               --             --         300,000
     Proceeds from issuance of common stock, net                                           188,927        199,162       9,393,551
     Additional expenses related to 1996 public offering                                        --        (30,432)             --
     Principal payments under capital leases                                                    --             --         (29,683)
     Principal payments on long-term debt                                                 (308,308)      (148,506)        (88,348)
                                                                                      ------------   ------------    ------------
                  Net cash provided by (used in) financing activities                      (60,914)       304,863      10,245,592
                                                                                      ------------   ------------    ------------
 Net increase (decrease) in cash and cash equivalents                                     (333,959)    (1,178,788)      5,549,471

 Cash and cash equivalents at beginning of year                                          6,091,497      7,270,285       1,720,814
                                                                                      ------------   ------------    ------------

 Cash and cash equivalents at end of year                                             $  5,757,538   $  6,091,497    $  7,270,285
                                                                                      ============   ============    ============
 Supplemental Disclosure of Cash Flow Information

 Cash paid for interest                                                               $    113,874   $    117,338    $     62,011

</TABLE>

See accompanying notes to financial statements

                                       F-6


<PAGE>   42



                                 INNERDYNE, INC.

                          Notes to Financial Statements

                        December 31, 1998, 1997, and 1996



(1)   DESCRIPTION OF THE COMPANY

      InnerDyne, Inc. (the Company) is engaged primarily in the development and
commercialization of access products used to perform minimally invasive surgery
(MIS) procedures. The Company markets its MIS access products domestically
through a network of direct and independent representatives, mainly to general
surgeons and gynecologists, who represent the primary medical disciplines
performing MIS procedures in the U.S. Internationally, the Company markets its
MIS products through independent distributors for resale to foreign health care
institutions. In addition, the Company has licensing agreements and/or is
pursuing licensing opportunities related to its proprietary radial dilation,
biocompatible coating, and thermal ablation technologies.

(2)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      (a)  CASH EQUIVALENTS

      The Company considers all highly liquid investments with original
      maturities of three months or less to be cash equivalents. Cash
      equivalents consist of money market funds and commercial paper of
      $6,008,650 and $5,043,065 at December 31, 1998 and 1997, respectively.

      (b)  INVENTORIES

      Raw materials and supplies inventories are stated at the lower of cost or
      market. Finished goods are stated on the basis of accumulated
      manufacturing costs, but not in excess of market (net realizable value).
      Cost is determined using the first-in, first-out (FIFO) method.

      (c)  EQUIPMENT AND LEASEHOLD IMPROVEMENTS

      Equipment and leasehold improvements are stated at cost. Depreciation and
      amortization of equipment and leasehold improvements is provided using the
      straight-line method over the estimated useful lives of the assets which
      range from two to five years.


      (d)  INTANGIBLE ASSETS

      Patent costs related to products and technologies still in the development
stage are expensed as incurred.


      (e)  REVENUE RECOGNITION

      Revenues are recognized upon shipment of products.

      (f)  RESEARCH AND DEVELOPMENT COSTS

      Research and development costs are expensed as incurred.


                                       F-7



<PAGE>   43




      (g)  EARNINGS (LOSS) PER COMMON SHARE

      Basic earnings (loss) per common share is the amount of earnings (loss)
      for the period available to each share of common stock outstanding during
      the reporting period. Diluted earnings (loss) per common share is the
      amount of earnings (loss) for the period available to each share of common
      stock outstanding during the reporting period and to each share that would
      have been outstanding assuming the issuance of common shares for all
      dilutive potential common shares outstanding during the period.

      In calculating earnings (loss) per common share, the earnings (loss) were
      the same for both the basic and diluted calculation. A reconciliation
      between the basic and diluted weighted average number of common shares for
      1998, 1997, and 1996, is summarized as follows:
<TABLE>
<CAPTION>

                                                      1998                1997                1996
                                                   ----------          ----------          ----------

<S>                                                <C>                 <C>                 <C>       
Basic weighted average number of common
   shares outstanding during the period            21,814,271          21,671,604          20,324,033

Weighted-average number of dilutive
   common stock options outstanding
   during the period                                  457,648                  --                  --
                                                   ----------          ----------          ----------

Diluted weighted average number of common
   and common equivalent shares
   outstanding during the period                   22,271,919          21,671,604          20,324,033
                                                   ==========          ==========          ==========
</TABLE>

      Potential common shares of 2,741,347, 3,031,267, and 2,536,469 outstanding
      during the twelve month periods ended December 31, 1998, 1997, and 1996,
      respectively, that could potentially dilute basic earnings per share in
      the future were not included in the computation of diluted earnings per
      share because to do so would have been anti-dilutive for the period.

      (h)  INCOME TAXES

      The Company accounts for income taxes using the asset and liability
      method. Under the asset and liability method, deferred tax assets and
      liabilities are recognized for the future tax consequences attributable to
      differences between the financial statement carrying amounts of existing
      assets and liabilities and their respective tax bases. Deferred tax assets
      and liabilities are measured using enacted tax rates expected to apply to
      taxable income in the years in which those temporary differences are
      expected to be recovered or settled. The effect on deferred tax assets and
      liabilities of a change in tax rates is recognized in income in the period
      that includes the enactment date.

      (i)  STOCK BASED COMPENSATION

      The Company employs the footnote disclosure provisions of Statement of
      Financial Accounting Standards (SFAS) No. 123, Accounting for Stock
      Based Compensation. SFAS 123 encourages entities to adopt a fair value
      based method of accounting for stock options or similar equity
      instruments. However, it also allows an entity to continue measuring
      compensation cost for stock based compensation using the intrinsic-value
      method of accounting prescribed by Accounting Principles Board (APB)
      Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). The
      Company has elected to continue to apply the provisions of APB 25 and
      provide pro forma footnote disclosures required by SFAS No. 123.

                                       F-8



<PAGE>   44




       (j) CONCENTRATION OF RISK

       Substantially all of the Company's revenues from product sales are
       attributable to Step products, and the Company currently anticipates that
       sales of Step products will represent substantially all of the Company's
       revenues in the immediate future.

       In the normal course of business, the Company provides unsecured credit
       terms to its domestic customers. Accordingly, the Company performs
       ongoing credit evaluations of its customers and maintains allowances for
       possible losses which, when realized, have been within the range of
       management's expectations. Additionally, the Company provides credit
       terms to its foreign customers, substantially all of which amounts are
       insured by a third party insurance agency.

       (k) OPERATING SEGMENTS

       The Company operates in one line of business, the development, and
       commercialization of access products for MIS procedures. The Company has
       and/or is also pursuing licensing opportunities related to is proprietary
       radial dilation, biocompatible coating, and thermal ablation technologies
       previously developed in connection with related product development. As
       such, the Company has only one reportable operating segment as defined by
       the Financial Accounting Standards Board Statement No. 131, Disclosures
       About Segments of an Enterprise and Related Information.

       (l) USE OF ESTIMATES

       The preparation of financial statements in conformity with generally
       accepted accounting principles requires management to make estimates and
       assumptions that affect the reported amounts of assets and liabilities
       and disclosure of contingent assets and liabilities at the date of the
       financial statements and the reported amounts of revenues and expenses
       during the reporting period. Actual results could differ from those
       estimates.

      (m)  FAIR VALUE DISCLOSURE

       At December 31, 1998 and 1997, the book value of the Company's financial
       instruments approximates fair value.



                                       F-9


<PAGE>   45




(3)     INVENTORIES

      Inventories consist of the following:
<TABLE>
<CAPTION>

                                      1998                  1997
                                    -----------           -----------

<S>                                 <C>                   <C>        
Raw materials and supplies          $   936,191           $ 1,110,989
Finished goods                          551,791               583,639
Reserve for obsolescence               (285,000)             (240,362)
                                    ===========           ===========
                                    $ 1,202,982           $ 1,454,266
                                    ===========           ===========
</TABLE>

(4)   LONG-TERM DEBT AND LINE OF CREDIT

      Long-term debt consists of the following:
<TABLE>
<CAPTION>

                                                                          1998              1997
                                                                         --------          --------
<S>                                                                     <C>               <C>     
8.50% - 9.50% term loans payable to bank, secured by equipment,
  payable in monthly installments of
  $27,847 including interest through 2002                                $739,763          $989,604
Less current installments                                                 391,040           340,543
                                                                         ========          ========
         Long-term debt, excluding current installments                  $348,723          $649,061
                                                                         ========          ========
</TABLE>

        The aggregate maturities of long-term debt for the years subsequent to
        December 31, 1998 are as follows: 1999, $391,040; 2000, $245,148; 2001,
        $69,050, and 2002, $34,525.

        The Company may borrow up to $2,000,000 through June 18, 1999 on a
        revolving line of credit with a commercial bank at prime plus
        three-quarters of one percent based on eligible receivables. The Company
        also has an equipment advance line of credit that allows the Company to
        borrow up to $750,000 based on eligible equipment purchases. Amounts
        outstanding on this equipment advance line of credit are periodically
        converted to 48 month term loans bearing interest at prime plus
        three-quarters of one percent. As of December 31, 1998, the Company had
        drawn $300,000 for financing of working capital needs on the revolving
        line of credit, secured by certain accounts receivable, and had borrowed
        $58,467 for the financing of fixed assets. The loans are subject to
        certain covenants and conditions. Debt balances summarized above also
        include amounts loaned to the Company under the current and previous
        equipment line of credit agreements.





                                      F-10


<PAGE>   46



(5)   LEASES

      The Company has several noncancelable operating leases, primarily for its
      facilities, that expire over the next five years. It is generally expected
      that, in the normal course of business, operating leases that expire will
      be renewed or replaced by other leases with similar terms. Rental expense
      for all operating leases was $369,054 in 1998, $421,317 in 1997, and
      $425,798 in 1996.

      Future minimum lease payments under noncancelable operating leases (with
      initial or remaining lease terms in excess of one year) as of December 31,
      1998 are:

<TABLE>
<CAPTION>
                  Year ending December 31:

<S>                                                              <C>      
                     1999                                         $ 470,790
                     2000                                           382,017
                     2001                                           389,857
                     2002                                           398,579
                     2003                                           373,983
                                                                    -------
                           Total minimum lease payments          $2,015,226
                                                                 ===========
</TABLE>

(6)   CAPITAL STOCK AND STOCK BASED COMPENSATION PLANS

      During 1995, the Company completed a private placement of securities in
      which it sold 1,435,999 shares of common stock and 287,200 warrants to
      purchase common stock for cash proceeds of $3,245,358. During 1996,
      warrants to purchase 44,248 shares of common stock were canceled and the
      remaining warrants to purchase 242,952 shares of common stock were
      exercised.

      The Company completed a public offering of securities in May 1996, in
      which it sold 2,650,000 shares of common stock for proceeds, net of
      underwriter's fees and other offering expenses, of $8,015,268. In
      connection with this offering, warrants to purchase 250,000 shares of the
      Company's common stock were issued to the underwriters. The Company has
      reserved 250,000 shares of its common stock for the exercise of these
      warrants. These warrants became fully vested on May 14, 1997, are
      exercisable at an exercise price of $4.20 per share, and expire on May 15,
      2002.

      The Company has four fixed option plans. They are the 1987 Stock Option
      Plan (the 1987 Plan), the 1989 Incentive Stock Plan (the 1989 Plan), the
      1996 Stock Option Plan (the 1996 Plan), and the 1991 Directors' Stock
      Option Plan (the Directors Plan), under which 2,650,000, 1,453,536,
      2,000,000, and 300,000 shares have been reserved for issuance,
      respectively. As of December 31, 1998, -0- shares, -0- shares, 709,687
      shares, and 104,000 shares remained available for future grant under the
      plans, respectively. The exercise price of all granted options under these
      plans must be at least equal to fair market value of the common stock on
      the date of grant, except that the exercise price for all nonstatutory
      stock options granted under the 1996 Plan must be at least equal to the
      fair market value of the common stock on the date of grant for grants made
      to certain of the Company's executive officers and at least 85 percent of
      the fair market value of the common stock on the date of grant for all
      other persons. For all plans except the Directors Plan, the number of
      shares, option price, and dates the options become exercisable and expire
      are determined by the Board of Directors on an option-by-option basis.
      Under the Directors Plan, directors are granted options annually to
      acquire 10,000 shares each which become exercisable on the first
      anniversary of the date of grant.


                                      F-11


<PAGE>   47



      A summary of the activity under the Plans follows:
<TABLE>
<CAPTION>

                                                    YEARS ENDED DECEMBER 31,
                                       1998                    1997                       1996
                             ------------------------  --------------------     -----------------------
                                           WEIGHTED-                WEIGHTED-                  WEIGHTED-
                              NUMBER        AVERAGE       NUMBER     AVERAGE      NUMBER        AVERAGE
                                OF         EXERCISE         OF      EXERCISE        OF         EXERCISE 
                              SHARES        PRICE         SHARES      PRICE       SHARES        PRICE
                             ---------    -----------  -----------  ----------  ----------    -----------
<S>                          <C>          <C>          <C>           <C>         <C>           <C>     
Options outstanding at
beginning of year            3,031,269       $2.59       2,536,469     $2.60     1,739,045       $1.92
Options granted              2,193,710        1.20         764,000      2.85     1,163,975        3.42
                             ---------                   ---------               ---------                 

                             5,224,979                   3,300,469               2,903,020         
                             ---------                   ---------               ---------                 

Options exercised               45,576         .80         112,795       .39       115,661         .57
Options canceled             1,999,341        2.62         156,405      2.34       250,890        2.67
                             ---------                   ---------               ---------                 

                             2,044,917                     269,200                 366,551            
                             ---------                   ---------               ---------                 

Options outstanding at
end of year                  3,180,062       $1.41       3,031,269     $2.59     2,536,469       $2.60
                             =========                   =========               =========              

Options exercisable
at end of year               1,930,931       $1.54       1,493,895     $2.39       907,189       $2.00

Weighted-average fair
    value of options
    granted during
    the year                     $1.28                       $1.24                   $1.90                

</TABLE>

        On October 9, 1998, the Board of Directors authorized a stock option
        repricing amendment. Option holders electing to participate in the
        repricing of options were required to surrender one option for every
        four options held. Under the repricing amendment, 1,829,480 options were
        surrendered in exchange for 1,372,110 re-priced options. The exercise
        price of the re-priced options is equal to the fair market value of the
        Company's common stock on October 8, 1998. Directors' and outside
        consultants' options were excluded from the repricing. Under certain
        conditions of the amendment, some of the re-priced options are not
        exercisable until October 9, 1999.




                                             F-12


<PAGE>   48



The following table summarizes information about fixed stock options outstanding
at December 31, 1998:
<TABLE>
<CAPTION>

                                           OPTIONS OUTSTANDING                         OPTIONS EXERCISABLE
                             ----------------------------------------------       ----------------------------
                                                                                  AVERAGE NUMBER      WEIGHTED-
                RANGE OF       NUMBER        WEIGHTED-AVERAGE     WEIGHTED-         EXERCISABLE        AVERAGE
                EXERCISE     OUTSTANDING        REMAINING         EXERCISE              AT            EXERCISE
                 PRICES      AT 12/31/98     CONTRACTUAL LIFE      PRICE             12/31/98           PRICE
               ----------    -----------     ----------------    ----------       --------------   -------------
<S>                          <C>             <C>                 <C>               <C>              <C>  
               $0.09-0.42        122,926          4.5 yrs.         $0.15             122,926            $0.15
                     0.88        453,500          9.5               0.88                 625             0.88
                     1.00      1,355,609          8.6               1.00             815,712             1.00
                1.01-1.99        765,742          5.7               1.61             652,302             1.63
                     2.00         42,000          3.4               2.00              42,000             2.00
                2.01-3.00        342,785          3.3               2.78             206,681             2.76
                3.01-6.50         97,500          2.2               4.50              90,685             4.59
                             ===========                                         ===========
               $0.09-6.50      3,180,062          7.0              $1.41           1,930,931            $1.54
                             ===========                                         ===========
</TABLE>

      The Company accounts for these plans and its Employee Stock Purchase Plan
      ("ESPP") under APB 25, under which no compensation cost has been
      recognized. Had compensation cost for these plans and the ESPP been
      determined consistent with SFAS No. 123, the Company's net income (loss)
      and income (loss) per share would have changed to the following pro forma
      amounts:
<TABLE>
<CAPTION>

                                                         1998           1997           1996
                                                       ----------    ----------     -----------
<S>                                   <C>             <C>            <C>            <C>        
        Net income (loss)             As reported        $425,030     $(907,466)    $(4,659,083)
                                      Pro forma       (1,417,158)    (1,622,314)     (5,393,559)
        Basic and diluted income      As reported             .02         (0.04)          (0.23)
         (loss) per share             Pro forma            (0.06)         (0.07)          (0.27)
</TABLE>

      Pro forma net income (loss) reflects only options granted in 1998, 1997,
      and 1996. Therefore, the effect that calculating compensation cost for
      stock-based compensation under SFAS 123 has on the pro forma net loss as
      shown above may not be representative of the effects on reported net
      losses or net income for future years.

      The fair value of each option was estimated as of the date of the grant
      using the Black-Scholes option pricing model. In determining the pro forma
      figures, the following weighted average assumptions were used for grants
      in 1998, 1997, and 1996, respectively: risk free interest rate of 4.5
      percent, 6.5 percent, and 6.2 percent; expected dividend yield of 0
      percent; expected life of 6.14, 3.07, and 3.15 years; and expected
      volatility of 109 percent, 74 percent, and 77 percent.

      The Company also has an employee stock purchase plan (the ESPP), whereby
      qualified employees are allowed to purchase limited amounts of the
      Company's common stock at the lesser of 85 percent of the market value of
      the stock at the beginning or end of the offering period. The Company has
      reserved 550,000 shares of common stock for future purchases by full-time
      employees under the ESPP. The Company issued 83,385, 94,033, and 45,253
      shares in 1998, 1997, and 1996, respectively, and issued 284,338 shares
      cumulatively, through December 31, 1998 under this plan.



                                      F-13


<PAGE>   49





      In September 1997, the Board of Directors approved the adoption of a
      Shareholders Rights Plan (the Rights Plan). The Rights Plan provides for
      the distribution of a preferred stock purchase right (Right) as a dividend
      to shareholders of record of the Company's common stock as of October 15,
      1997. This Right entitles stockholders to acquire stock in the Company or
      in an acquirer at a discounted price in the event that a person or group
      acquires 15 percent or more of the Company's outstanding voting stock or
      announces a tender offer that would result in ownership of 15 percent or
      more of the Company's stock. Each right entitles the registered holder to
      purchase from the Company 1/1000th of a share of Series A Participating
      Preferred Stock at a price of $2.00 per 1/1000th of a preferred share,
      subject to adjustment. The Rights may only be exercised on the occurrence
      of certain events related to a tender offer as described above. The Rights
      will expire on September 19, 2007. The Rights may be redeemed by the
      Company at $0.01 per right at any time on or before the tenth day
      following acquisition by a person or group of 15 percent or more of the
      Company's stock.

      (7)      INCOME TAXES

      The Company has reported no income tax expense or benefit for the years
      ended December 31, 1998, 1997, and 1996, due to net operating losses and
      net operating loss carryforwards. The difference between the expected tax
      benefit and actual tax benefit is primarily attributable to the effect of
      these net operating losses and net operating loss carryforwards being
      offset by an increase or decrease in the Company's valuation allowance.

      The tax effects of temporary differences that give rise to significant
      portions of the deferred tax assets at December 31, 1998 and 1997, are
      presented below:

<TABLE>
<CAPTION>
                                                                             1998           1997
                                                                        ------------   ------------
        Deferred tax assets:

<S>                                                                     <C>            <C>    
        Allowance for doubtful accounts                                 $    45,153    $    66,368

        Inventories, principally due to additional costs
           inventoried for tax purposes pursuant to the Tax Reform   
           Act of 1986, and reserves for obsolescence                       129,538        121,378
        Equipment, principally due to differences in depreciation           155,928        117,741
        Accrued expenses                                                     75,628        119,621
        Research activities credit carryforward                             695,000        559,765
        Net operating loss carryforwards                                 15,531,945     15,692,647
        Other                                                                30,050         32,849
                                                                        ------------   ------------
        Total gross deferred tax assets                                  16,663,242     16,710,369
        Less valuation allowance                                         16,663,242     16,710,369
        Net deferred tax assets                                         $    --        $    --
                                                                        ===========    ============
</TABLE>




                                             F-14


<PAGE>   50



      The valuation allowance for deferred tax assets as of January 1, 1997 was
      $16,061,871. The net change in the valuation allowance for the years ended
      December 31, 1998 and 1997, is a decrease of $47,127 and an increase of
      $648,498, respectively.

      Subsequently, recognized tax benefits relating to the valuation allowance
      for deferred tax assets as of December 31, 1998 will be allocated as an
      income tax benefit to be reported in the statement of operations.

      At December 31, 1998, the Company has net operating loss and research
      activities credit carryforwards to offset future income for federal income
      tax purposes approximately as follows:
<TABLE>
<CAPTION>

                                 NET OPERATING LOSS
                                  CARRYFORWARD FOR        RESEARCH
                                 REGULAR INCOME TAX  ACTIVITIES CREDIT
          EXPIRING                    PURPOSES          CARRYFORWARD
         ------------           ------------------    --------------
<S>                             <C>                   <C>    
         2006                          $2,965,000         $    --
         2007                          11,309,000         201,000
         2008                           8,185,000          33,000
         2009                           7,885,000         127,000
         2010                           6,038,000          37,000
         2011                           4,691,000          68,000
         2012                             568,000         193,000
         2018                                  --          36,000
                                ------------------  --------------
                                      $41,641,000        $695,000
                                ==================  ==============
</TABLE>

      As a result of a 1994 merger, the Company underwent a greater than 50
      percent change of ownership under the rules of the Tax Reform Act of 1986.
      The maximum amount of the remaining net operating loss carryforwards
      available to offset future income in a given year is limited to the
      product of the Company's value on the date of ownership change and the
      federal long-term tax-exempt rate, plus any limited carryforward not
      utilized in prior years. Net operating losses of approximately $17,168,000
      incurred after the merger are not subject to the change in ownership
      limitation.

 (8)  COLLABORATIVE AND LICENSING AGREEMENTS

      During 1998, the Company had the following collaborative development and
      licensing agreements:

      (a)     SENKO Medical Instrument Manufacturing Co. Ltd. (SENKO) -
              Effective April 5, 1994, the Company entered into an agreement
              licensing its proprietary siloxane coating technology to SENKO,
              in exchange for an initial payment and continuing royalties. The
              Company assisted in the construction and startup of the coating
              system in SENKO'S manufacturing facility in Japan. In May 1996,
              the Company received an order from SENKO to build a second fiber
              coating system for use by SENKO. On April 9, 1998, InnerDyne
              entered into another agreement with SENKO licensing the
              Company's proprietary biocompatible coating technology in
              exchange for an initial payment and continuing royalties.

      (b)     Boston Scientific Corporation (BSC) - Effective April 17, 1996,
              the Company entered into an agreement with BSC covering the
              potential application and use of the Company's proprietary
              biocompatible coating technologies with BSC's stents, grafts,
              vena cava filters, and other implantable medical devices. As
              part of this agreement, BSC purchased 166,667 shares of the
              Company's common stock for $500,000.



                                             F-15


<PAGE>   51




               Boston Scientific Corporation notified InnerDyne in August 1998
               that it had decided to proceed with the transfer of technology
               for the application and use of InnerDyne's proprietary
               biocompatible coating technology with Boston Scientific's stents,
               grafts, vena cava filters, and other implantable medical devices.
               The transfer of the technology required under the Agreement is
               expected to be completed during 1999, though the Company may
               continue to conduct related research if requested by Boston
               Scientific.

        (c)    United States Surgical Corporation (USSC) - Effective December
               20, 1996, the Company entered into an agreement which granted
               USSC exclusive worldwide sales and marketing rights for its
               EnAbl(TM) Thermal Ablation System. In exchange for initial
               license fees, milestone payments, and royalties based upon future
               sales, USSC gained the right to complete development and
               manufacture, and to market the technology on a worldwide basis,
               and the Company agreed not to compete in USSC's intended field of
               application.

               On June 4, 1998, InnerDyne, announced the signing of an agreement
               with U.S. Surgical Corporation covering the licensing of its
               proprietary siloxane coating technology for use by U.S. Surgical
               to enhance the performance of selected products used in M.I.S.
               procedures, for which the Company would receive license fees.

               On August 20, 1998, InnerDyne received notification from U.S.
               Surgical that it did not intend to continue development of the
               EnAble(TM) device.

(9)   EMPLOYEE BENEFIT PLAN

               The Company has a deferred savings plan which qualifies under
               Internal Revenue Code Section 401(k). All full-time employees,
               who are 21 or older and have completed 30 days of service, are
               eligible to participate. For 1998 the Company made matching
               contributions of 10 percent of employee contributions. For 1997,
               the Company did not make any matching contributions. The Company
               matching contributions for future years are at the discretion of
               the Board of Directors.





                                      F-16


<PAGE>   52



                          INDEPENDENT AUDITORS' REPORT




The Board of Directors and Stockholders
InnerDyne, Inc.:


        Under date of January 29, 1999, we reported on the balance sheets of
InnerDyne, Inc. as of December 31, 1998 and 1997, and the related statements of
operations, stockholders' equity, and cash flows for each of the years in the
three-year period ended December 31, 1998. In connection with our audits of the
aforementioned financial statements, we also audited the related financial
statement schedule. This financial statement schedule is the responsibility of
the Company's management. Our responsibility is to express an opinion on this
financial statement schedule based on our audits.

        In our opinion, such financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly, in
all material respects, the information set forth therein.

                                                                     KPMG LLP



San Francisco, California
January 29, 1999



                                      F-17


<PAGE>   53




                                                                     Schedule II
                                       INNERDYNE, INC.

                              VALUATION AND QUALIFYING ACCOUNTS

                        Years ended December 31, 1998, 1997, and 1996

                                    (Dollars in thousands)

<TABLE>
<CAPTION>

                                             Balance at      Additions     Receivables
Allowance for doubtful receivables            beginning      charged to     charged to     Balance at
                                               of year        expense       allowance     end of year
                                             ----------     -----------   ------------    -----------
<S>                                          <C>            <C>           <C>             <C>    

Year ended December 31, 1998                $   177,930      $   26,469     $ (83,345)       $121,054
                                            ===========      ==========     =========        ========

Year ended December 31, 1997                $   159,165      $   45,687     $ (26,922)       $177,930
                                            ===========      ==========     =========        ========
 
Year ended December 31, 1996                $    73,290      $  108,566     $ (22,691)       $159,165
                                            ===========      ==========     =========        ========

                                             Balance at      Additions     Receivables
Reserve for obsolete inventory                beginning      charged to     charged to     Balance at
                                               of year        expense       allowance     end of year
                                             ----------     -----------   ------------    -----------

Year ended December 31, 1998                $   240,362      $ 130,587      $ (85,949)       $285,000
                                            ===========      ==========     =========        ========

Year ended December 31, 1997                $   120,217      $  185,203     $ (65,058)       $240,362
                                            ===========      ==========     =========        ========


Year ended December 31, 1996                $    59,460      $  238,517     $(177,760)       $120,217
                                            ===========      ==========     =========        ========

                                            Balance at
Deferred tax asset valuation                 beginning                                    Balance at
  allowance                                   of year         Additions     Reductions    end of year
                                            -----------      ----------      --------     -----------

Year ended December 31, 1998                $16,710,369      $       --      $(47,127)    $16,663,242
                                            ===========      ==========      ========     ===========

Year ended December 31, 1997                $16,061,871      $  648,498      $     --     $16,710,369
                                            ===========      ==========      ========     ===========
                                      
Year ended December 31, 1996                $14,192,219      $1,869,652      $     --     $16,061,871
                                            ===========      ==========      ========     ===========

</TABLE>





                                      F-18


<PAGE>   54





                                          SIGNATURES

        Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.



                                          INNERDYNE, INC.

Date: March 30, 1999                      By: /s/ WILLIAM G. MAVITY
                                          ----------------------------------
                                          William G. Mavity
                                          President and Chief Executive Officer


<PAGE>   55

                                                                    EXHIBIT 24.1
                                POWER OF ATTORNEY

        KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints William G. Mavity and Robert A. Stern, or
either of them, 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 each of said attorneys-in-fact, or his
substitute or substitutes, may do or cause to be done by virtue hereof.

        Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons in the capacities and
on the dates indicated.
<TABLE>
<CAPTION>

                     SIGNATURE                                   TITLE                            DATE
                     ---------                                   -----                            ----

<S>                                          <C>                                            <C>
       /s/ WILLIAM G. MAVITY                 President, Chief Executive Officer and
       ------------------------------------- Director (Principal Executive Officer)          March 30, 1999
       William G. Mavity

       /s/ ROBERT A. STERN                   Vice President  and Chief Financial Officer     March 30, 1999
       ------------------------------------- (Principal Financial and Accounting Officer)
       Robert A. Stern

       /s/ ROBERT M. CURTIS 
       ------------------------------------- Director                                        March 30, 1999
       Robert M. Curtis

       /s/ EDWARD W. BENECKE
       ------------------------------------- Director                                        March 30, 1999
       Edward W. Benecke

       /s/EUGENE J. FISCHER                                                                  March 30, 1999
       ------------------------------------- Director
       Eugene J. Fischer

       /s/GUY P. NOHRA                                                                       March 30, 1999
       ------------------------------------- Director
       Guy P. Nohra

       /s/STEVEN N. WEISS                                                                    March 30, 1999
       ------------------------------------- Director
       Steven N. Weiss
</TABLE>
<PAGE>   56





EXHIBIT INDEX
<TABLE>
<CAPTION>

               EXHIBIT          DESCRIPTION
               NUMBER

<S>                             <C>
               3.1(7)           Restated Certificate of Incorporation of Registrant.
               3.2(2)           Bylaws of Registrant.
               10.1*(4)         1987 Stock Option Plan, as amended.
               10.2*(8)         1991 Directors' Stock Option Plan, as amended.
               10.3*(8)         1991 Employee Stock Purchase Plan, as amended.
               10.4(1)          Purchase Agreement (Series C) dated as of June 26, 1990, as
                                amended.
               10.6(1)          Form of Indemnification Agreement between the Registrant and
                                its officers and directors.
               10.7*(1)         Defined Contribution "401(k)" Plan as amended January 1, 1990.
               10.9(2)          Lease dated June 1989 between the Registrant and William J.
                                Lowenberg.
               10.13*(3)        Letter Agreement with William G. Mavity.
               10.14*(4)        Consulting Agreement with Robert M. Curtis dated January 12,
                                1994.
               10.16(5)         Lease Extension with BSL Associates.
               10.17(5)         Lease Agreements with QED Associates.
               10.18(5)(9)      Licensing Agreement with SENKO Medical Instrument Mfg. Co.,
                                Ltd.
               10.19*(5)        InnerDyne Medical, Inc. 1989 Incentive Stock Plan.
               10.20*(5)        Interventional Thermodynamics Inc. 401(k) Plan.
               10.22(6)(9)      License and Development Agreement dated as of August 25, 1994
                                by and among InnerDyne, Inc., InnerDyne Medical, Inc. and
                                CooperSurgical, Inc.
               10.23(7)         Loan and Security Agreement and Collateral
                                Assignment, Patent Mortgage and Security
                                Agreement dated as of February 23, 1995 between
                                the Registrant and Silicon Valley Bank.
               10.24(8)         Common Stock and Warrant Purchase Agreement
                                dated as of June 2, 1995 by and among the
                                Registrant and the purchasers named therein,
                                including form of Common Stock Warrant.
               10.25(10)        Amendment to Loan and Security Agreement dated
                                as of February 29, 1996 between the Registrant
                                and Silicon Valley Bank.
               10.26*(10)       1996 Stock Option Plan.
               10.27(9)(10)     Licensing, Development and Manufacturing Agreement dated as of
                                February 2, 1996 between the Registrant and
                                EndoTex Interventional Systems, Inc.
               10.28(9)(10)     National Contract dated October 1995 between the Registrant
                                and Surgical Care Affiliates, Inc.
               10.29(9)(10)     License Agreement dated as of January 1, 1996
                                between the Registrant and Alliance of
                                Children's Hospitals, Inc.
               10.31*(10)       Letter Agreement with Robert A. Stern dated January 10, 1996.
               10.32*(11)       Change of Control Agreement dated as of September 12, 1996
                                between the Registrant and William G. Mavity.
               10.33(9)(11)     License Agreement dated as of December 20, 1996 by and among
                                the Registrant and United States Surgical Corporation.
               10.34(9)(11)     License, Supply and Distribution Agreement dated as of January
                                6, 1997 by and between the Registrant and
                                Sherwood Medical Company.
               10.35*(11)       Letter Agreement with Daniel J. Genter dated March 13, 1996.
               10.36(11)        Amendment to Loan and Security Agreement dated as of February
                                4, 1997 between the Registrant and Silicon Valley Bank.
               10.37*(11)       Form of Senior Management Change of Control Agreement.
</TABLE>
<PAGE>   57
 
<TABLE>
<S>                            <C>        
              10.38(12)         Loan modification Agreement dated as of June 18, 1998 by and
                                between the Registrant and Silicon Valley
               10.39(13)        Termination of License, Supply and Distribution Agreement by
                                and between the Registrant and Sherwood Medical Company dated
                                March 12, 1998.
               10.40+           Letter Agreement with United States Surgical Corporation dated
                                May 26, 1998
               10.41+           Letter Agreement with Boston Scientific dated July 29, 1998
               10.42+           Letter Agreement with United States Surgical Corporation dated
                                August 14, 1998
               10.43            Third Addendum to the Lease with QED Associates dated August
                                31, 1998.
               23.1             Consent of Independent Certified Public Accountants.
               24.1             Power of Attorney
               27.1             Financial Data Schedule.
</TABLE>

* Management compensatory plan or arrangement.
+ Confidential treatment requested as to certain portions of this Exhibit.

(1) Incorporated by reference to exhibits filed in response to Item 16(a),
"Exhibits," of the Registrant's Registration Statement on Form S-1, as amended
(File No. 33-44361), filed December 4, 1991.

(2) Incorporated by reference to exhibits filed in response to Item 14(a)(3),
"Exhibits," of the Registrant's Annual Report on Form 10-K for the year ended
December 31, 1992.

(3) Incorporated by reference to exhibits filed in response to Item 6, "Exhibits
and Reports on Form 8-K," of the Registrant's Quarterly Report on Form 10-Q for
the quarterly period ended September 30, 1993.

(4) Incorporated by reference to exhibits filed in response to Item 21,
"Exhibits and Financial Statement Schedules," of the Registrant's Registration
Statement on Form S-4, as amended (File No. 33-74624), filed January 31, 1994.

(5) Incorporated by reference to exhibits filed in response to Item 6, "Exhibits
and Reports on Form 8-K," of the Registrant's Quarterly Report on Form 10-QSB
for the quarterly period ended June 30, 1994.

(6) Incorporated by reference to exhibits filed in response to Item 6 "Exhibits
and Reports on Form 8-K," of the Registrant's Quarterly Report on Form 10-QSB
for the quarterly period ended September 30, 1994.

(7) Incorporated by reference to exhibits filed in response to Item 13, "Exhibit
List and Reports on Form 8-K," of the Registrant's Annual Report on Form 10-KSB
for the year ended December 31, 1994.

(8) Incorporated by reference to exhibits filed in response to Item 6, "Exhibits
and Reports on Form 8-K" of the Registrant's Quarterly Report on Form 10-QSB for
the quarterly period ended June 30, 1995.

(9) Confidential treatment granted for portions of this exhibit by order of the
Securities and Exchange Commission.

(10) Incorporated by reference to exhibits filed in response to Item 13,
"Exhibit List and Reports on Form 8-K," of the Registrant's Annual Report on
Form 10-KSB for the year ended December 31, 1995.

(11) Incorporated by reference to exhibits filed in response to Item 14,
"Exhibits, Financial Statement Schedules and Reports on Form 8-K," of the
Registrant's Annual Report on Form 10-K for the year ended December 31, 1996.


<PAGE>   58



               (12) Incorporated by reference to exhibits filed in response to
               Item 6, "Exhibits and Reports on Form 8-K," of the Registrant's
               Quarterly Report on Form 10-Q for quarterly
               period ended June 30, 1998.

               (13) Incorporated by reference to exhibits filed in response to
               Item 14. "Exhibits, Financial Statement Schedules and Reports on
               Form 8-K," of the Registrant's Annual Report on Form 10-K for the
               year ended December 31, 1997.

(b)     Reports on Form 8-K: None