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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, 1999, 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 $96,301,670 as of February 29, 2000, 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 22,248,449 shares of issuer's Common Stock issued and outstanding as
of February 29, 2000.


                       DOCUMENTS INCORPORATED BY REFERENCE

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        Parts of the Proxy Statement for Registrant's 2000 Annual Meeting of
Stockholders to be held on June 20, 2000 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. In 1997, an estimated 85% of the
approximately 820,000 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 conversion to minimally invasive
approaches, including the treatment of gynecological disorders and the diagnosis
and



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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 1.4 million general surgery and gynecology 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 outpace increases in
total surgical procedures for the balance of the decade.

M.I.S. Access Devices

        A trocar is the conventional device used by surgeons to access a
possible treatment site in an M.I.S. procedure. A trocar is traditionally 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 1998 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 caused by
contact with trocar cutting surfaces.

        Another device commonly used in minimally invasive 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 1998
approximately 4.7 million minimally invasive vascular procedures were performed
worldwide. In addition, approximately 1.2 million interventional radiology
procedures utilizing minimally invasive vascular access were performed in 1998.

        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.

        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

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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 1999 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 malignant tumor site, and is used
to 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 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 employing I-125, Pd-103, and
Ir-192 are the most common isotope-related methods used in therapy for solid
focal 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.

        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.



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        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.

        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 line of minimally invasive surgical access
devices. 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.

        As of December 31, 1999 more than 30 peer reviewed papers or
presentations have been published or presented, with the conclusion that patient
safety is enhanced when the Step product is used. A recent paper presented in
November 1999 at the American Association of Gynecological Laparoscopy Annual
Meeting involved more than 8,000 procedures and more than 21,000 Step
insertions. The study concluded that, based on a comparison to a control group
where standard access devices of various types were used, an adverse event was
ten times more likely with conventional trocars versus InnerDyne's product.

        Short Step(TM) 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 freestanding 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 continue to help the Company expand awareness and sales of
its Step product line for use in the pediatric environment.



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        Reposable Step(TM). 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(TM). 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(TM). 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(TM). 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. Three
additional buying group agreements were signed in 1999, adding approximately
2,150 hospitals and surgery centers to those covered by agreements. 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 & Technology. 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 1997 and continued
testing the product concept in conjunction with cardiology advisors in early
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, and
limited domestic use evaluations have been ongoing throughout 1999. An
additional related 510(k) application was filed with the FDA in August 1999,
primarily to update labeling involving the most current version of the radially
expanding vascular access (REVAS) product. If clinical benefits are confirmed in
continuing usage with the most recent product version, the Company will explore
alternative methods of distribution in the interventional vascular marketplace
and may launch a radial dilation vascular access device in the United States in
2000 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 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. InnerDyne expects to continue expending development
resources through the first half of 2000 to determine the feasibility



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of introducing an intra-organ access device based on its proprietary radially
expanding dilation technology.

        The Company has also evaluated the potential use of its proprietary
radial dilation technology to gain access for urologic procedures, and a related
510(k) pre-market notification was submitted to and cleared by the FDA in
mid-1999. The Company is completing the development process for a new product
intended to facilitate percutaneous access to the kidney and bladder, and
expects to initiate expanded human clinical evaluation of the product in the
first half of 2000. If this evaluation yields positive results, the Company may
initiate distribution of a urological access product in 2000.

        There can be no assurance that current or future new product
developments will generate product opportunities that can be commercially sold
in sufficient quantities; failure to achieve commercial success with any or all
new product applications could have a material adverse impact on the Company's
profitability and operations.

        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 impact 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.

        During 1997 and early 1998, InnerDyne committed resources to an
investigation of the market opportunity for a radially dilatable access device
for arthroscopic procedures. Clinical evaluation of an FDA cleared arthroscopic
access product indicated that clinical benefits of the technology in this market
were not sufficient to warrant further investment, and the project was
terminated.

Thermal Ablation Technology

        The Company has developed proprietary technology 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
that 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 received
notification from U. S. Surgical that the 1996 Agreement was being terminated.
The Company does not presently intend to proceed with commercial development of
this technology.

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



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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. InnerDyne will complete the stent-based
studies using rhenium-188 for the treatment of restenosis in early 2000. Though
the preliminary results hold promise there is no assurance that the Company can
attract a corporate stent partner that will license the technology under
acceptable terms, if at all.

        In the fourth quarter of 1999 the company began to shift resources to
investigate a proprietary therapeutic coating which may potentially provide a
proprietary drug-based treatment for restenosis. If preliminary promising
results of this investigation are confirmed in further animal investigations,
the Company may increase associated resources, and endeavor to attract a
corporate partner interested in the technology. There can be no assurances that
the results of this further investigation will be positive, or that a corporate
partner will be interested in licensing or developing this technology on
acceptable terms, if at all.

        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 help control cancer growth and
limit cancer recurrence. The advantage of localized radiotherapy over other
therapies is the ability to 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 may 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 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 will be completed in
early 2000.

        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.

        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.



                                       7
<PAGE>   9

        In June 1999, the Company announced that the National Institutes of
Health awarded the Company a Small Business Innovation Research ("SBIR") phase 1
research grant to support development of a new form of cancer treatment. The
InnerDyne technology allows for the concurrent delivery of drugs and radiation
through the use of implantable devices that are absorbed by the body after
delivering their therapeutic payloads. The absorbable devices will differ from
both current brachytherapy and drug-delivery sources, and could potentially
provide a highly efficient and flexible treatment mechanism for the handling of
focal 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 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, in exchange for an initial payment and
continuing material purchases, 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.
If SENKO continues to use the Company's technologies, royalties would be
received through 2004.

        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, license fees and
future 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 was completed during
1999.

        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
constructed a custom coating system and provided coated product samples for
testing by U.S. Surgical in exchange for payment of initial license fees and
capital equipment costs. If 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 some 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 may be coated with drugs and/or isotopes using InnerDyne's
proprietary technology. 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. However, there can be no assurance
that additional agreements with third parties, if any, will be on acceptable
terms.

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, 1999, 1998, and 1997 were
approximately $2.8 million, $2.9 million, and $3.3 million, respectively. The
decrease in 1999 was primarily the result of lower expenses related to new
product development programs, including costs associated with development,
clinical trials and regulatory submissions. The decrease in 1998 was primarily
the result of a reduction in reimbursed development expenses related to the
EnAbl thermal ablation system.



                                       8
<PAGE>   10

As of December 31, 1999, the Company had 21 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, developing other access products based on
InnerDyne's proprietary radial dilation technology, and advancing InnerDyne's
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.

        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.

        In early 1999, InnerDyne announced that it was 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 bio-absorbable 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 June 1999, the Company announced that the National Institutes of
Health awarded the Company a Small Business Innovation Research ("SBIR") phase 1
research grant to support development of a new form of cancer treatment. The
InnerDyne technology allows for the concurrent delivery of drugs and radiation
through the use of implantable devices that are absorbed by the body after
delivering their therapeutic payloads. The absorbable devices will differ from
both current brachytherapy and drug-delivery sources, and could potentially
provide a highly efficient and flexible treatment mechanism for the handling of
focal cancers.

        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; with Shearwater Polymers covering that company's manufacture and sale
of products utilizing the Company's proprietary polyethylene oxide compound; 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.

        In September 1999, the Company licensed to William Cook Europe A/S
(Cook) a Rotatably Actuated Constricting Catheter Valve on a non-exclusive basis
for use in the treatment of aortic aneurysms. The agreement requires that Cook
pay InnerDyne a licensing fee in two installments and annual minimum royalty
payments.

        In December 1999, InnerDyne licensed to Alung Technologies, Inc. certain
assets related to the Company's earlier development of an implantable lung
assist product, and associated technologies. Under the terms of the agreement,
InnerDyne is to receive a license fee, payable in two installments in the fourth
quarter of 1999 and 2000.

        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 and to attract corporate partners interested in licensing
its coating technologies. 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.




                                       9
<PAGE>   11

SALES AND MARKETING

        The Company is presently 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 management employees manage these 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. Three additional buying group agreements were
signed in 1999, adding approximately 2,150 hospitals to those covered by prior
agreements. Management has approached other buying groups, and is optimistic
that additional agreements may be signed.

        In selected foreign countries, local distributors purchase products from
the Company for subsequent resale to their respective countries' 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. In 1999, orders were received
from distributors in 26 countries. Management hopes to make additional progress
in this regard during 2000 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 quality systems
regulations ("QSR"), ISO 9000 standards 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.

        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


                                       10
<PAGE>   12

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 customers' 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, 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 ongoing. 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 raw material supply 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 and divert
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,



                                       11
<PAGE>   13

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 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.
The U.S. Surgical unit of Tyco International Ltd. ("U.S. Surgical") 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 Ethicon Endosurgery Division of Johnson
and Johnson ("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. 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 or their parent companies. 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 or their parent companies.

        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 or their parent companies' 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 has also pursued
and has been awarded purchasing contracts with a number of buying groups. Such
agreements can, in some situations, allow the Company's products to compete on
an equal footing with those of its larger competitors, reducing the degree of
leverage represented by the size and volume of its competitors' product
offerings.

        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."




                                       12
<PAGE>   14

GOVERNMENT REGULATION

        Clinical testing, manufacture and sale of the Company's products,
including the Step product line, the vascular access 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 or mandate 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 QSR'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) pre-market notification or FDA
approval of a Premarket Approval ("PMA") application. 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)
pre-market clearance, but can take longer. 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 require a new 510(k) submission. There can be no
assurance that the Company will obtain 510(k) pre-market clearance within a
reasonable time frame, or at all, for any of the devices or modifications for
which it may file a 510(k).

        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 PMA's. 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 can 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 PMA's. 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 IRB's without the need for



                                       13
<PAGE>   15

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.

        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.(TM)") 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, urological, and arthroscopic
applications. 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 existing clearances 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) notifications.
There can be no assurance; however, that the FDA would agree with any of the
Company's determinations not to submit new 510(k) notification for any of these
changes or would not require the Company to submit new 510(k) notification for
any of the changes made to the device. If the FDA requires the Company to submit
a new 510(k) notification for any device modification, the Company may be
prohibited from marketing the modified device until the 510(k) notification 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 QSR 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 QSR requirements, MDR requirements and other
applicable regulations. Failure of the Company to maintain satisfactory QSR
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 implemented changes to the QSR requirements that may
increase the cost of compliance. 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 an identifying CE Mark signifying this certification 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.



                                       14
<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 future
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, 1999, the Company had 130 full-time and 2 temporary and
part-time employees. Of the 130 full-time employees on December 31, 1999, 69
were involved in manufacturing operations, 21 in research and development and
regulatory/clinical affairs (including 6 in biocompatible coatings development),
9 in administration, and 31 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.

EXECUTIVE OFFICERS OF THE COMPANY

        The Company has corporate officers that are not executive officers. As
of March 17, 2000, 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               50               President, Chief Executive Officer and Director

         Robert A. Stern                 43               Vice President and Chief Financial Officer

         Daniel J. Genter                63               Senior Vice President, Sales and Marketing
</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.
degree 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.



                                       15
<PAGE>   17

        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 previously 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.

        In January 2000 Michael J. Orth, former Vice President, Research and
Development, left InnerDyne to join a private medical technology company located
in Northern California.

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 2005.

        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 was 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, 1999.




                                       16
<PAGE>   18

                                     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>
                     FISCAL 1998                                          HIGH                  LOW
                     -----------                                          ----                  ---
<S>                                                                     <C>                   <C>
         First quarter ended March 31, 1998                              3-1/2                 2-1/16
         Second quarter ended June 30, 1998                              3-3/4                 2-3/8
         Third quarter ended September 30, 1998                          2-7/8                 7/8
         Fourth quarter ended December 31, 1998                          1-11/16               31/32

                     FISCAL 1999
         First quarter ended March 31, 1999                              4                     1 1/8
         Second quarter ended June 30, 1999                              2 3/8                 1 3/8
         Third quarter ended September 30, 1999                          3 3/4                 1 7/8
         Fourth quarter ended December 31, 1999                          4 1/4                 2 3/4
</TABLE>

        As of February 4, 2000, there were 295 stockholders of record; however;
the Company believes it has at least 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 4 of
Notes to Financial Statements.

        During 1999, the Company issued and sold (without payment of any selling
commission to any person) the following unregistered securities: In March 1999,
June 1999, and October 1999, the Company issued 10,909 shares, 1,582 shares, and
4,154 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 of operations data for the years
ended December 31, 1999, 1998, and 1997 and the balance sheet data as of
December 31, 1999 and 1998 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,
1996 and 1995,



                                       17
<PAGE>   19

and the balance sheet data as of December 31, 1997, 1996, and 1995 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,
                                                                  -------------------------------------------------------------
Statement of Operations Data:                                       1999        1998          1997         1996          1995
                                                                  -------      -------      -------       -------       -------
<S>                                                               <C>           <C>          <C>            <C>           <C>
              Revenues                                            $20,416       17,610       15,664         9,086         5,275
              Net income/(loss)                                   $ 1,480          425         (907)       (4,659)       (5,627)
                                                                  =======      =======      =======       =======       =======
              Net income/(loss) per diluted share                 $   .06          .02         (.04)         (.23)         (.32)
                                                                  =======      =======      =======       =======       =======
         BALANCE SHEET DATA:
              Total assets                                        $13,146       11,089       11,319        11,362         5,370
              Long-term debt, excluding current installments      $   233          349          649           630           187
</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, 1999, 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 ("M.I.S.") procedures. The Company also 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
$1,480,000 on revenues of $20.4 million, $425,000 on revenues of $17.6 million,
and a loss of $907,000 on revenues of $15.7 million, for the fiscal years ended
December 31, 1999, 1998, and 1997, respectively. As of December 31, 1999,
InnerDyne had an accumulated deficit of approximately $50.3 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 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. 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.



                                       18
<PAGE>   20

        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. The U.S. Surgical unit of Tyco International Ltd.
("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. The
Ethicon Endosurgery Division of Johnson and Johnson ("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. 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, or their parent companies.
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 or their parent companies.

        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 continue 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 recent 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 and consolidation among existing market participants, 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 InnerDyne's family of
Step products, and InnerDyne 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."

        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 2000, the Company expects to
commercially introduce an intra-organ product, a urology product, and possibly a
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



                                       19
<PAGE>   21

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 quality systems 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 9000
certification, InnerDyne now undergoes periodic audits by a regulatory body.
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
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


                                       20
<PAGE>   22

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 number of international distributors, there can be no
assurance that the Company will be able to build or maintain 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.

        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 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."



                                       21
<PAGE>   23

        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 a 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 PMA's. 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 PMA's. 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, urological, and arthroscopic applications. 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 marketed in the United States are required to adhere to
applicable regulations setting forth detailed quality systems regulations, 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.



                                       22
<PAGE>   24

        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 QSR requirements, MDR requirements and other
applicable regulations. Failure of the Company to maintain satisfactory QSR
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 customers' 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 ongoing.
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 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 is
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 payors. The Company intends to
continue 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 and maintain 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 a substantial 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.



                                       23
<PAGE>   25

        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 medical device
industry generally or general market conditions may have a significant effect on
the market price of the Company's 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.

        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




                                       24
<PAGE>   26

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.

RESULTS OF OPERATIONS

        Total revenues of $20,415,733 were realized during the year ended
December 31, 1999, compared to total revenues of $17,610,237 in 1998 and
$15,664,365 in 1997. Total revenues are comprised of revenues from product sales
and licensing, contract and grant revenues. Revenues from product sales
increased to $20,015,690 in 1999 from $16,268,375 in 1998 and $12,149,395 in
1997, reflecting increased sales of the Step device in each year. Licensing,
contract and grant revenues were $400,043, $1,341,862, and $3,514,970 in 1999,
1998 and 1997, 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. The decrease in licensing and contract revenue in
1999, versus 1998, primarily reflects reduced milestone payments and licensing
fees resulting from coatings agreements with third parties, including SENKO,
Boston Scientific, and U. S. Surgical. The decrease in licensing and contract
revenues in 1998, versus 1997, primarily reflects reduced revenues resulting
from subsequently terminated agreements with Sherwood Davis and Geck and U.S.
Surgical, the latter relating to the EnAble thermal ablation 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 $19,066,787 in 1999 compared to
$17,357,916 in 1998 and $16,789,068 in 1997. Expenses in 1999 and 1998 grew
because of increased costs of product sales on higher sales volume, 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 product sales was $5,740,209 in 1999 compared to $5,631,031 in
1998, and $5,070,946 in 1997. Cost of product 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 product sales will continue to increase in absolute
dollars in future periods, cost of product sales as a percentage of revenue is
expected to decrease in 2000 if sales and production volumes increase as
expected.

        Research, development, regulatory and clinical expenses were $2,805,688
in 1999 compared to $2,908,929 in 1998 and $3,292,775 in 1997. 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 1999 vs. 1998 was
the result of programs implemented to control cost, while the decrease in 1998
vs. 1997 was primarily the result of lower reimbursed research costs associated
with the EnAbl thermal ablation system. The Company anticipates that research,
development, regulatory and clinical expenditures may increase in future periods
depending upon the type and number of new product and technology development
programs that the Company chooses to undertake.

        Sales and marketing expenses were $8,326,303 compared to $6,824,228 in
1998 and $6,161,934 in 1997. 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. A portion of
the increase in 1999 is the additional sales and marketing expenditure related
to the Company's efforts to leverage expanded safety claims cleared by the FDA
in January 1999. InnerDyne expects that sales and marketing expenses will
continue to increase in absolute dollars.



                                       25
<PAGE>   27

        General and administrative expenses in 1999 were $2,194,587 compared to
$1,993,728 in 1998 and $2,263,413 in 1997. 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 increase in 1999 reflected higher lease expenses at the Company's
Sunnyvale and Salt Lake City facilities as well as higher costs associated with
legal, accounting, insurance and other general corporate expenses. The decrease
in expenses in 1998 related primarily to negotiating lower insurance premiums,
as well as reduced professional services and consulting costs. The Company
anticipates that general and administrative expenses will increase in absolute
dollars to support expanding operations.

        Interest income was $286,437 in 1999, $293,227 in 1998, and $327,943 in
1997, reflecting a decrease in the average cash and equivalent balances
outstanding during each year, and changing returns earned on the Company's cash
and equivalent balances. Interest expense was $105,896 in 1999, $120,061 in
1998, and $117,338 in 1997. The changes in interest expense were primarily the
result of a decrease in debt incurred to finance equipment to support operations
of the Company.

        Primarily for the reasons outlined above, InnerDyne earned net income of
$1,480,375 or $.07 per share on a basic and $.06 on a diluted basis in 1999,
$425,030 or $.02 per share on both a basic and diluted basis in 1998, and
incurred a net loss of $907,466 or $.04 per share on both a basic and diluted
basis in 1997.

LIQUIDITY AND CAPITAL RESOURCES

        From its inception to December 31, 1999, the Company has incurred a
cumulative deficit of approximately $50.3 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, 1999, cash and cash equivalents totaled $6,862,313
compared to $5,757,538 at December 31, 1998. The Company had $412,765, $359,739,
and $427,276 in capital expenditures in the years ended December 31, 1999, 1998,
and 1997, respectively. Working capital totaled $10,007,116 at December 31,
1999, and the Company had long-term debt, excluding current installments,
totaling $232,797 relating to financing of equipment.

        In April 1999, 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 April 23, 2000 on a revolving credit basis at prime
plus .25% 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 36-month term
loans bearing interest at prime plus .25%. As of December 31, 1999, the Company
had drawn $639,989 for financing of working capital needs on the revolving line
of credit, secured by certain accounts receivable, and had borrowed $517,613
under the equipment advance line with Silicon Valley Bank for the financing of
capital expenditures. Debt balances as of December 31, 1999 on the Company's
balance sheet also include 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



                                       26
<PAGE>   28

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 2000, 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, 1999, InnerDyne had short-term investments of
$6,172,374. 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, 1999 rates would cause the fair market value of
these short-term investments to change by an immaterial amount. The Company has
the ability to hold these investments until maturity, and therefore, the value
of these investments is not expected to be affected to any significant degree by
sudden changes in market interest rates. Declines in interest rates over time
will, however, reduce interest income. The Company has not used derivative
financial instruments.

        InnerDyne does not own any equity investments. Therefore, the Company is
not currently exposed to any direct equity price risk.

        All InnerDyne revenues are realized in U.S. dollars; therefore,
management believes that the Company currently is not subject to significant
direct foreign currency exchange rate risk.

FOREIGN CURRENCY RISK

        International revenues represented less than 10% of total revenues in
1999. 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. 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 1999 was not
material.


                                       27
<PAGE>   29

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

        See pages F-1 through F-22.

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

        None.







                                       28
<PAGE>   30

                                    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 June 20, 2000, 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.




                                       29
<PAGE>   31

                                     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-22.
                Schedule II - Valuation and Qualifying Accounts - See page F-22.

                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

                3.1(7)       Restated Certificate of Incorporation of
                             Registrant.



<TABLE>
<CAPTION>
               EXHIBIT
                NUMBER                    DESCRIPTION
                ------                    -----------
<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 Cooper Surgical, 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.
</TABLE>




                                       30
<PAGE>   32


<TABLE>
<S>                         <C>
                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.

                10.38.1(12)  Amended and Restated Loan and Security Agreement
                             dated as of June 19, 1997 by and between the
                             Registrant and Silicon Valley Bank.

                10.38.2(13)  Loan Modification Agreement dated as of June 18,
                             1998 by and between the Registrant and Silicon
                             Valley Bank.

                10.38.3      Loan Modification Agreement dated as of April 23,
                             1999 by and between the Registrant and Silicon
                             Valley Bank.

                10.38.4(16)  Loan Modification Agreement dated as of June 28,
                             1999 by and between the Registrant and Silicon
                             Valley Bank.

                10.39(14)    Termination of License, Supply and Distribution
                             Agreement by and between the Registrant and
                             Sherwood Medical Company dated March 12, 1998.

                10.40(9)(15) Letter Agreement with United States Surgical
                             Corporation dated May 26, 1998.

                10.41(9)(15) Letter Agreement with Boston Scientific dated
                             July 29, 1998.

                10.42(9)(15) Letter Agreement with United States Surgical
                             Corporation dated August 14, 1998.

                10.43(15)    Third Addendum to the Lease with QED Associates
                             dated August 31, 1998.

                10.44        Letter Notice to Extend BSL Associates Lease from
                             Registrant dated April 2, 1999.

                10.45*       Letter Agreement with Daniel E. Genter dated August
                             15, 1999.

                10.46*       Defined Contribution "401(k)" Plan as amended
                             January 1, 1999.

                23.1         Consent of Independent Certified Public
                             Accountants.

                24.1         Power of Attorney (contained on signature page).

                27.1         Financial Data Schedule.
</TABLE>


                *       Management compensatory plan or arrangement.

                (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.



                                       31
<PAGE>   33

                (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.

                (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 the
                        quarterly period ended June 30, 1997.

                (13)    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.

                (14)    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.

                (15)    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, 1998.

                (16)    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 June 30, 1999.

        (b)     Reports on Form 8-K: None




                                       32
<PAGE>   34


                                 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>






                                      F-1

<PAGE>   35

                          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, 1999 and 1998, and the related statements of operations,
stockholders' equity, and cash flows for each of the years in the three-year
period ended December 31, 1999. 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, 1999 and 1998, and the results of its operations and its cash
flows for each of the years in the three-year period ended December 31, 1999, in
conformity with generally accepted accounting principles.


                                                      /s/KPMG LLP


Salt Lake City, Utah
January 20, 2000


                                      F-2
<PAGE>   36

                                 InnerDyne, INC.

                                 Balance Sheets

                           December 31, 1999 and 1998



<TABLE>
<CAPTION>
                                    Assets                                             1999                1998
                                                                                   ------------       ------------
<S>                                                                                <C>                <C>
Current assets:
Cash and cash equivalents                                                          $  6,862,313       $  5,757,538
      Accounts receivable, less allowance for doubtful
         accounts of $140,181 in 1999 and $121,054 in 1998  (note 4)                  3,524,228          2,670,811
      Interest and other receivables                                                    170,110            383,726
      Inventories (note 3)                                                            1,602,143          1,202,982
      Prepaid expenses                                                                  197,874            213,831
                                                                                   ------------       ------------
                  Total current assets                                               12,356,668         10,228,888
                                                                                   ------------       ------------
Equipment and leasehold improvements:
      Equipment (note 4)                                                              4,056,037          3,677,624
      Leasehold improvements                                                            241,789            209,245
                                                                                   ------------       ------------
                                                                                      4,297,827          3,886,869
      Less accumulated depreciation and amortization                                 (3,575,981)        (3,072,749)
                                                                                   ------------       ------------
                  Net equipment and leasehold improvements                              721,846            814,120
Deposits and long term assets                                                            67,167             45,695
                                                                                   ------------       ------------
                                                                                   $ 13,145,681       $ 11,088,703
                                                                                   ============       ============
Liabilities and Stockholders' Equity
Current liabilities:
      Line of credit (note 4)                                                      $    639,989       $    300,000
      Current installments of long-term debt (note 4)                                   284,816            391,040
      Accounts payable                                                                  234,911            260,132
      Accrued payroll                                                                   135,400            346,879
      Accrued commissions                                                               356,706            300,000
      Other accrued expenses                                                            697,730            473,165
                                                                                   ------------       ------------
                  Total current liabilities                                           2,349,552          2,071,216
Long-term debt, excluding current installments (note 4)                                 232,797            348,723
Stockholders' equity (note 6):
      Preferred stock, $.01 par value.  Authorized 1,000,000 shares; no
         shares issued and outstanding at December 31, 1999 and 1998                         --                 --
      Common stock, $.01 par value.  Authorized 40,000,000 shares; issued and
         outstanding 22,153,620 shares at December 31, 1999 and
         21,891,388 shares at December 31, 1998                                         221,536            218,914
      Additional paid-in capital                                                     60,618,436         60,206,865
      Accumulated deficit                                                           (50,276,640)       (51,757,015)
                                                                                   ------------       ------------
                  Net stockholders' equity                                           10,563,332          8,668,764

                  Commitments (notes 4, 5, and 6)                                  ------------       ------------
                                                                                   $ 13,145,681       $ 11,088,703
                                                                                   ============       ============
</TABLE>


See accompanying notes to financial statements.


                                      F-3
<PAGE>   37

                                 InnerDyne, INC.

                            Statements of Operations

                  Years ended December 31, 1999, 1998, and 1997




<TABLE>
<CAPTION>
                                                                     1999             1998             1997
                                                                 ------------     ------------     ------------
<S>                                                              <C>              <C>              <C>
Revenues:

      Product sales                                              $ 20,015,690     $ 16,268,375     $ 12,149,395

      Licensing, contract, and grant revenue (note 8)                 400,043        1,341,862        3,514,970
                                                                 ------------     ------------     ------------
                  Total revenues                                   20,415,733       17,610,237       15,664,365
Costs and expenses:

      Cost of product sales                                         5,740,209        5,631,031        5,070,946

      Research, development, regulatory, and clinical               2,805,688        2,908,929        3,292,775

      Sales and marketing                                           8,326,303        6,824,228        6,161,934

      General and administrative                                    2,194,587        1,993,728        2,263,413
                                                                 ------------     ------------     ------------
                  Total costs and expenses                         19,066,787       17,357,916       16,789,068
                                                                 ------------     ------------     ------------
                  Operating profit (loss)                           1,348,946          252,321       (1,124,703)
Other income (expense):

      Interest income                                                 286,437          293,227          327,943

      Interest expense                                               (105,896)        (120,061)        (117,338)

      Gain (loss) on asset disposal                                     3,500             (457)           6,632
                                                                 ------------     ------------     ------------
                  Total other income                                  184,041          172,709          217,237
                                                                 ------------     ------------     ------------
                  Income (loss) before taxes                        1,532,987          425,030         (907,466)
      Income tax expense (note 7)                                     (52,612)              --               --
                                                                 ------------     ------------     ------------
                  Net income (loss)                              $  1,480,375          425,030         (907,466)
                                                                 ============     ============     ============
Net income (loss) per share:
                  Basic                                          $       0.07             0.02            (0.04)
                                                                 ============     ============     ============
                  Diluted                                        $       0.06             0.02            (0.04)
                                                                 ============     ============     ============

Weighted average basic and diluted common shares outstanding:
                  Basic                                            21,978,913       21,814,271       21,671,604
                                                                 ============     ============     ============

                  Diluted                                          23,252,792       22,271,919       21,671,604
                                                                 ============     ============     ============
</TABLE>



See accompanying notes to financial statements.



                                      F-4
<PAGE>   38

InnerDyne, INC.

                       Statements of Stockholders' Equity

                  Years ended December 31, 1999, 1998, and 1997




<TABLE>
<CAPTION>
                                                                               Additional                               Net
                                                                Common          paid-in         Accumulated       stockholders'
                                                                stock           capital           deficit            equity
                                                             -----------       ----------       -----------       -------------
<S>                                                           <C>              <C>              <C>                 <C>
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)
                                                             -----------       ----------       -----------       -----------

Balances at December 31, 1997                                    217,549       60,000,046       (52,182,045)        8,035,550

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
Issuance of shares upon exercise of stock options and
  under employee stock purchase plan                               2,456          353,593                --           356,049
Compensation for options issued to non-employee options               --           17,888                --            17,888
Issuance of shares for services rendered                             166           40,090                --            40,256
Net income                                                            --               --         1,480,375         1,480,375
                                                             -----------       ----------       -----------       -----------

Balances at December 31, 1999                                $   221,536       60,618,436       (50,276,640)       10,563,332
                                                             ===========       ==========       ===========       ===========

</TABLE>



See accompanying notes to financial statements.



                                       F-5
<PAGE>   39

                                 InnerDyne, INC.
                            Statements of Cash Flows

                  Years ended December 31, 1999, 1998, and 1997



<TABLE>
<CAPTION>
                                                                                         1999           1998           1997
                                                                                     -----------    -----------    -----------
<S>                                                                                  <C>            <C>            <C>
Cash flows from operating activities:
        Net income (loss)                                                            $ 1,480,375    $   425,030    $  (907,466)
        Adjustments to reconcile net income (loss) to net cash provided by
           (used in) operating activities:
           Depreciation and amortization of equipment and leasehold improvements         505,039        530,903        596,426
           Provision for doubtful accounts                                                15,198         26,469         45,687
           Provision for obsolete inventory                                              113,149        130,587        185,203
           Loss (gain) on asset disposal                                                  (3,500)           457         (6,632)
           Common stock issued for services rendered                                      58,144         19,257         15,000
           Increase in accounts receivable, interest,
           and other receivables                                                        (654,999)      (457,434)    (1,094,541)
           Decrease (increase) in inventories                                           (512,310)       120,697       (480,371)
           Decrease (increase) in prepaid expenses and deposits                           (5,515)       (97,010)        35,654
           Increase (decrease) in accounts payable                                       (25,221)      (229,470)       187,656
           Increase (decrease) in accrued payroll, commissions, and other expenses        69,792       (384,292)       357,459
                                                                                     -----------    -----------    -----------
                    Net cash provided by (used in) operating activities                1,040,152         85,194     (1,065,925)
                                                                                     -----------    -----------    -----------
Cash flows from investing activities:
        Capital expenditures                                                            (412,765)      (359,739)      (427,276)
Proceeds from disposal of equipment and
leasehold improvements                                                                     3,500          1,500          9,550
                                                                                     -----------    -----------    -----------
                      Net cash used in investing activities                             (409,265)      (358,239)      (417,726)
                                                                                     -----------    -----------    -----------
Cash flows from financing activities:
           Proceeds from issuance of long-term debt                                      178,645         58,467        284,639
           Proceeds from line of credit                                                  339,989             --             --
           Proceeds from issuance of common stock, net                                   356,049        188,927        199,162
           Additional expenses related to 1996 public offering                                --             --        (30,432)
           Principal payments on long-term debt                                         (400,795)      (308,308)      (148,506)
                                                                                     -----------    -----------    -----------
                      Net cash provided by (used in) financing activities                473,888        (60,914)       304,863
                                                                                     -----------    -----------    -----------
Net increase (decrease) in cash and cash equivalents                                   1,104,775       (333,959)    (1,178,788)
Cash and cash equivalents at beginning of year                                         5,757,538      6,091,497      7,270,285
                                                                                     ===========    ===========    ===========
Cash and cash equivalents at end of year                                             $ 6,862,313    $ 5,757,538    $ 6,091,497
                                                                                     ===========    ===========    ===========

Supplemental Disclosure of Cash Flow Information:
Cash paid for interest                                                               $   120,061    $   113,874    $   117,338
Cash paid for income taxes                                                           $     4,962    $     6,187    $     1,226
</TABLE>



See accompanying notes to financial statements


                                      F-6
<PAGE>   40


(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 at the date of
                acquisition to be cash equivalents. Cash equivalents consist of
                money market funds and commercial paper of $6,169,437 and
                $6,008,650 at December 31, 1999 and 1998, 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 are 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.





                                      F-7
<PAGE>   41


        (e)     REVENUE RECOGNITION

                Revenues are recognized upon shipment of products. Additionally,
                the Company recognizes revenue from its collaborative
                development and licensing agreements as related development
                costs are incurred and from its license fees and milestone
                payments as agreed-upon events occur. Cash received in advance
                of the performance of the related development is recorded as
                deferred income.


        (f)     RESEARCH AND DEVELOPMENT COSTS

                Research and development costs are expensed as incurred.


        (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 1999, 1998, and 1997, is summarized
                as follows:


<TABLE>
<CAPTION>
                                                                                      1999             1998              1997
                                                                                   ----------       ----------       ----------
<S>                                                                                <C>              <C>              <C>
                    Basic weighted average number of common
                      shares outstanding during the period                         21,978,913       21,814,271       21,671,604

                    Weighted-average number of dilutive common stock options
                      outstanding during the period                                 1,273,879          457,648               --
                                                                                   ----------       ----------       ----------

                    Diluted weighted average number of common and
                      common equivalent shares outstanding during the period       23,252,792       22,271,919       21,671,604
                                                                                   ==========       ==========       ==========
</TABLE>

                Potential common shares of 2,048,719, 2,741,347, and 3,031,267
                outstanding during the years ended December 31, 1999, 1998, and
                1997, 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.



                                      F-8
<PAGE>   42

        (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.


        (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 SFAS No. 131, Disclosures About Segments of an Enterprise
                and Related Information.




                                      F-9
<PAGE>   43

        (l)     COMPREHENSIVE INCOME (LOSS)

                The Company adopted SFAS No. 130, Reporting Comprehensive
                Income, effective January 1, 1998. SFAS No. 130 establishes
                standards for reporting and display of comprehensive income
                (loss) and its components in financial statements. For the years
                ended December 31, 1999, 1998, and 1997 comprehensive income
                (loss) was equal to the net income (loss) as presented in the
                accompanying statements of operations.




        (m)     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.


(3)     INVENTORIES

        Inventories consist of the following:


<TABLE>
<CAPTION>
                                                        1999               1998
                                                    -----------        -----------
<S>                                                 <C>                    <C>
                 Raw materials and supplies         $ 1,339,016            936,191
                 Finished goods                         583,126            551,791
                 Reserve for obsolescence              (319,999)          (285,000)
                                                    -----------        -----------
                                                    $ 1,602,143          1,202,982
                                                    ===========        ===========
</TABLE>



                                      F-10
<PAGE>   44

(4)     LONG-TERM DEBT AND LINE OF CREDIT

           Long-term debt consists of the following:


<TABLE>
<CAPTION>
                                                                                 1999           1998
                                                                               --------       --------
<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 2003                            $517,613        739,763
        Less current installments                                               284,816        391,040
                                                                               --------       --------
                          Long-term debt, excluding current installments       $232,797        348,723
                                                                               ========       ========
</TABLE>

        The aggregate maturities of long-term debt for the years subsequent to
        December 31, 1999 are as follows: 2000, $284,816; 2001, $121,076; 2002,
        $89,466; and 2003, $22,055.

        The Company may borrow up to $2,000,000 through April 23, 2000 on a
        revolving line of credit with a commercial bank at prime plus
        one-quarter of one percent (8.5 percent at December 31, 1999) 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 one-quarter of one percent. As of
        December 31, 1999, the Company had drawn $639,989 for financing of
        working capital needs on the revolving line of credit, secured by
        certain accounts receivable, and had borrowed $517,613 for the financing
        of fixed assets. The loans are subject to certain covenants and
        conditions.


(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 $526,569 in 1999, $369,054
        in 1998, and $421,317 in 1997.



                                      F-11
<PAGE>   45

        Future minimum lease payments under noncancelable operating leases (with
        initial or remaining lease terms in excess of one year) as of December
        31, 1999 are:

<TABLE>
<CAPTION>
         Years ending December 31:
<S>                                                          <C>
              2000                                           $  525,732
              2001                                              519,477
              2002                                              534,857
              2003                                              517,455
              2004                                               98,784
                                                             ----------
              Total minimum lease payments                   $2,196,305
                                                             ==========
</TABLE>

(6)     CAPITAL STOCK AND STOCK BASED COMPENSATION PLANS

        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
        underwriters 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, 1999, zero shares, zero shares, 177,200
        shares, and 102,000 shares remained available for future grant under the
        plans. 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-12
<PAGE>   46

        A summary of the activity under the plans follow:



<TABLE>
<CAPTION>
                                                                   Years ended December 31,
                                    -----------------------------------------------------------------------------------------
                                       1999                          1998                            1997
                                    -------------------------       -------------------------       -------------------------
                                                     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                3,180,062           $1.41       3,031,269         $  2.59       2,536,469          $ 2.60
Options granted                       701,900            2.29       2,193,710            1.20         764,000            2.85
                                    ---------                       ---------                       ---------
                                    3,881,962                       5,224,979                       3,300,469
                                    ---------                       ---------                       ---------

Options exercised                     120,399            1.45          45,576             .80         112,795             .39
Options canceled                      208,511            2.04       1,999,341            2.62         156,405            2.34
                                    ---------                       ---------                       ---------
                                      328,910                       2,044,917                         269,200
                                    ---------                       ---------                       ---------

Options outstanding
at end of year                      3,553,052            1.52       3,180,062            1.41       3,031,269            2.59
                                    =========                       =========                       =========
Options exercisable
at end of year                      2,404,562            1.42       1,930,931            1.54       1,493,895          $ 2.39
Weighted-average
fair value of options granted
during the year                     $    2.36              --       $    1.28                          $ 1.24
</TABLE>

        On October 9, 1998, the Board of Directors authorized a stock option
        repricing amendment. Option holder's 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 repriced options. The exercise
        price of the repriced options is equal to the fair market value of the
        Company's common stock on that date. Directors and outside consultant's
        options were excluded from the repricing.



                                      F-13
<PAGE>   47


           The following table summarizes information about fixed stock options
           outstanding at December 31, 1999:


<TABLE>
<CAPTION>
                                            OPTIONS OUTSTANDING                               OPTIONS EXERCISABLE
                               ---------------------------------------------------      --------------------------------
                                                 WEIGHTED-
                                NUMBER             AVERAGE               WEIGHTED-        NUMBER               WEIGHTED-
          RANGE OF             OUTSTAND-          REMAINING              AVERAGE        EXERCISABLE             AVERAGE
          EXERCISE              ING AT           CONTRACTUAL             EXERCISE            AT                 EXERCISE
           PRICES              12/31/99              LIFE                 PRICE           12/31/99               PRICE
         ----------            --------          -----------             ---------      -----------            ---------
<S>                          <C>                  <C>                    <C>             <C>                     <C>
         $0.09-0.14              26,535            2.5 yrs.               $0.13              26,535               $0.13
          0.14-0.21              95,461            3.9                     0.15              95,461                0.15
          0.43-1.00           1,684,243            7.9                     0.97           1,271,224                0.98
          1.01-1.52             530,461            5.7                     1.47             434,625                1.49
          1.53-3.00           1,118,452            6.1                     2.29             503,168                2.33
          3.01-4.52              59,900            3.5                     3.83              35,549                3.79
          4.53-6.50              38,000            1.1                     5.32              38,000                5.32
                              ---------                                                 -----------
         $0.09-6.50           3,553,052            6.7                    $1.52           2,404,562               $1.42
                              =========                                                 ===========
</TABLE>

        The Company accounts for these plans and its 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>
                                                                            1999              1998             1997
                                                                          ---------        -----------     -----------
<S>                                                <C>                  <C>                <C>             <C>
         Net income (loss)                          As reported         $1,480,375            425,030        (907,466)
                                                    Pro forma             (105,199)        (1,417,158)     (1,622,314)

         Basic income (loss) per share              As reported              0.07               0.02             (0.04)
                                                    Pro forma               (0.00)             (0.06)            (0.07)

         Diluted income (loss) per share            As reported              0.06               0.02             (0.04)
                                                    Pro forma               (0.00)             (0.06)            (0.07)
</TABLE>

        The effect that calculating compensation cost for stock-based
        compensation under SFAS No. 123 has on the pro forma net income (loss)
        as shown above may not be representative of the effects on reported net
        income or net losses 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 1999, 1998, and 1997, respectively: risk free interest rate of
        5.63 percent, 4.5 percent, and 6.5 percent; expected dividend yield of
        zero percent; expected life of 6.5, 6.14, and 3.07 years; and expected
        volatility of 77 percent, 109 percent, and 74 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



                                      F-14
<PAGE>   48

        employees under the ESPP. The Company issued 125,188, 83,385, and 94,033
        shares in 1999, 1998, and 1997, respectively, and issued 409,526 shares
        cumulative through December 31, 1999 under this plan.

        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 or 1997 due to net operating losses and net
        operating loss carryforwards. The difference between the expected tax
        benefit and actual tax benefit for 1997 is primarily attributable to the
        effect of these net operating loss carryforwards being offset by an
        increase or decrease in the Company's valuation allowance.

           Income taxes for 1999 are summarized as follows:

<TABLE>
<S>                                                   <C>
         Current:
               U.S. Federal                            $25,778
               State and local                          26,834
                                                       -------
                            Total current               52,612
                                                       -------
         Deferred:
               U.S. Federal                                 --
               State and local                              --
                                                       -------
                            Total deferred                  --
                                                       -------
                            Total income tax expense   $52,612
                                                       =======
</TABLE>



                                      F-15
<PAGE>   49

        Income tax expense for 1999 and 1998 differs from the amounts computed
by applying the U.S. federal income tax rate of 34 percent to income before
taxes as a result of the following:

<TABLE>
<CAPTION>
                                                                              1999                1998
                                                                            ---------          ---------
<S>                                                                          <C>                 <C>
         Computed "expected" tax expense                                     $521,216            144,510
               Increase (reduction) in income taxes resulting from:
               State taxes net, of federal tax benefit                         18,149                 --
               Change in federal valuation allowance                         (254,431)           (30,693)
               Meals and entertainment expense                                 12,417             22,323
               Research and experimentation tax credit                       (230,830)          (135,235)
               Other                                                          (13,909)              (905)
                                                                            ---------          ---------
                                                                              $52,612                 --
                                                                            =========          =========
</TABLE>

        The tax effects of temporary differences that give rise to significant
        portions of the deferred tax assets at December 31, 1999 and 1998, are
        presented below:

<TABLE>
<CAPTION>
                                                                                       1999                 1998
                                                                                    -----------         -----------
<S>                                                                                 <C>                 <C>
         Deferred tax assets:
               Allowance for doubtful accounts                                          $52,288              45,153
               Inventories, principally due to additional costs inventoried
                  for tax purposes pursuant to the Tax Reform
                  Act of 1986, and reserves for obsolescence                            148,269             129,538
               Equipment, principally due to differences in depreciation                190,846             155,928
               Accrued expenses                                                         101,147              75,628
               Research activities credit carryforward                                  925,830             695,000
               Net operating loss carryforwards                                      14,886,824          15,531,945
               Other                                                                     52,735              30,050
                                                                                    -----------         -----------
                           Total gross deferred tax assets                           16,357,939          16,663,242
                           Less valuation allowance                                  16,357,939          16,663,242
                                                                                    -----------         -----------
                           Net deferred tax assets                                  $        --                  --
                                                                                    ===========         ===========
</TABLE>



                                      F-16
<PAGE>   50

        The valuation allowance for deferred tax assets as of January 1, 1998
        was $16,710,369. The net change in the valuation allowance for the years
        ended December 31, 1999 and 1998, was a decrease for both years of
        $305,303 and $47,127, respectively.

        Subsequently, recognized tax benefits relating to the valuation
        allowance for deferred tax assets as of December 31, 1999, will be
        allocated as an income tax benefit to be reported in the accompanying
        financial statements.

        At December 31, 1999, 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               RESEARCH
                                     FOR REGULAR                ACTIVITIES
                                      INCOME TAX                  CREDIT
          EXPIRING                     PURPOSES                CARRYFORWARD
          --------                -----------------            ------------
<S>                                  <C>                          <C>
            2006                      $1,239,000                        --
            2007                      11,309,000                   201,137
            2008                       8,184,000                    32,906
            2009                       7,885,000                   126,971
            2010                       6,039,000                    36,794
            2011                       4,691,000                    68,440
            2012                         568,000                   192,764
            2018                              --                   158,451
            2019                              --                   108,367
                                     -----------               -----------
                                     $39,915,000                   925,830
                                     ===========               ===========
</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

        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. The Company'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 the Company
        to engage in certain areas of product development,



                                      F-17
<PAGE>   51


        manufacturing, and marketing. In addition, these third parties may have
        the unilateral right to terminate any such arrangement without
        significant penalty. The following is a description of significant
        current collaborative 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, the Company
                entered into another agreement with SENKO licensing the
                Company's proprietary biocompatible coating technology in
                exchange for an initial payment and continuing royalties. If
                SENKO continues to use the Company's technologies, royalties
                would be received through 2004.

        (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, provided initial research
                support, license fees, and future royalty payments.

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

        (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,
                manufacture, and market technology on a worldwide basis, and the
                Company agreed not to compete in USSC's intended field of
                application.

                On June 4, 1998, the Company announced the signing of an
                agreement with USSC covering the licensing of its proprietary
                siloxane coating technology for use by USSC to enhance the
                performance of selected products used in MIS procedures, for
                which the Company received an initial license fee and certain
                capital equipment costs. If the testing confirms that coated
                samples meet USSC's requirements, the Company will receive a
                final license fee payment and will assist in the transfer of the
                system. Coincidental with transfer and system startup, a royalty
                payment period would begin.

                On August 20, 1998, the Company received notification from USSC
                that the December 20, 1996 agreement was being terminated. The
                Company does not presently intend to proceed with commercial
                development of this product.



                                      F-18
<PAGE>   52
        (d)     California Cancer Research Program (CRP) - In January 1999, the
                Company 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
                devises. The commercial objective of this project is to develop
                bio-absorbable 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 propriety InnerDyne technology for
                potential use in the treatment of site-specific prostate,
                breast, and neurological cancers.

        (e)     The National Institute of Health - In June 1999, the Company
                announced that it had been awarded a Small Business Innovation
                Research (SBIR) Phase 1 research grant, to support development
                of a new form of cancer treatment. The Company's technology
                allows for the concurrent delivery of drugs and radiation
                through the use of implantable devices that are absorbed by the
                body after delivering their therapeutic payloads. The absorbable
                devices will differ from both current brachytherapy and
                drug-delivery sources, and could potentially provide a highly
                efficient and flexible treatment mechanism for the handling of
                focal cancers.

        (f)     William Cook Europe A/S (Cook) - In September 1999, the Company
                licensed to William Cook Europe a rotatably actuated
                constricting catheter valve on a nonexclusive basis for the use
                in the treatment of aortic aneurysms. The agreement requires
                that Cook pay the Company a licensing fee in two installments
                and annual minimum royalty payments.

        (g)     Alung Technologies (Alung) - In December 1999, the Company
                licensed to Alung Technologies, Inc. certain assets related to
                the Company's earlier development of an implantable lung assist
                product, and associated technologies. Under the terms of the
                Agreement, the Company is to receive a license fee, payable in
                two installments in the fourth quarter of 1999 and 2000.



                                      F-19
<PAGE>   53


(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 the years ending December 31, 1999, 1998, and 1997, the
        Company made matching contributions of $52,557, $28,412, and $-0-,
        respectively. The Company's matching contributions for future years are
        at the discretion of the Board of Directors.

(10)    DISCLOSURE ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS

        The carrying value for certain short-term financial instruments that
        mature or reprice frequently at market rates, approximates fair value.
        Such financial instruments include: cash and cash equivalents, accounts
        receivable, interest and other receivables, inventories, prepaid
        expenses, accounts payable, and accrued and other liabilities. The
        carrying value of the line of credit and long-term debt approximates
        fair market value.


(11)    RECENT ACCOUNTING PRONOUNCEMENTS

        The Financial Accounting Standards Board issued SFAS No. 133, Accounting
        for Derivatives Instruments and Hedging Activities, in 1998. SFAS No.
        133 establishes accounting and reporting standards for derivative
        instruments, including certain derivative instruments embedded in other
        contracts (collectively referred to as derivatives), and for hedging
        activities. It requires that an entity recognize all derivatives as
        either assets or liabilities in the balance sheets and measure those
        instruments at fair value. For a derivative not designated as a hedging
        instrument, changes in the fair value of the derivative are recognized
        in earnings in the period of change. The Company must adopt SFAS No. 133
        in 2001. The Company does not believe the adoption of SFAS No. 133 will
        have a material effect on the financial position or results of
        operations of the Company.

        On December 3, 1999, the SEC staff issued Staff Accounting Bulletin No.
        101, Revenue Recognition in Financial Statements (SAB 101). SAB 101
        summarizes certain of the staff's views in applying generally accepted
        accounting principles to revenue recognition in financial statements.
        The Company will incorporate the guidance of SAB 101 in the first
        quarter of fiscal 2001. Management has not yet determined the impact
        that SAB 101 will have on the financial position or results of
        operations of the Company.




                                      F-20
<PAGE>   54


                          INDEPENDENT AUDITORS' REPORT



The Board of Directors and Stockholders
InnerDyne, Inc.:


Under date of January 20, 2000, we reported on the balance sheets of InnerDyne,
Inc. as of December 31, 1999 and 1998, and the related statements of operations,
stockholders' equity, and cash flows for each of the years in the three-year
period ended December 31, 1999. 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.




Salt Lake City, Utah
January 20, 2000



                                      F-21
<PAGE>   55

                                                                     Schedule II



                                 INNERDYNE, INC.

                        Valuation and Qualifying Accounts

                  Years ended December 31, 1999, 1998, and 1997

                             (Dollars in thousands)



<TABLE>
<CAPTION>
                                                                                        Receivables
                                           Balance at             Additions              recovered
                                           beginning              charged to            (charged to               Balance at
                                            of year                expense               allowance)               end of year
                                           ---------              ----------            -----------               -----------
<S>                                        <C>                     <C>                    <C>                     <C>
Allowance for doubtful receivables:
Year ended December 31, 1999                $121,054                $15,198                $  3,929                $140,181
                                           =========               ========               =========                ========
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
                                           =========               ========               =========                ========
</TABLE>


<TABLE>
<CAPTION>
                                           Balance at             Additions              Inventory
                                           beginning              charged to             charged to               Balance at
                                            of year                expense                 reserve                end of year
                                           ----------             ----------             ----------               -----------
<S>                                         <C>                    <C>                     <C>                     <C>
Reserve for obsolete inventory:
Year ended December 31, 1999                $285,000               $113,149                $(78,150)               $319,999
                                           =========               ========               =========                ========
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
                                           =========               ========               =========                ========
</TABLE>


<TABLE>
<CAPTION>
                                          Balance at
                                           beginning                                                            Balance at
                                            of year                Additions             Reductions            end of year
                                          ------------            ----------            -----------            -----------
<S>                                        <C>                    <C>                     <C>                  <C>
Deferred tax asset valuation allowance:
Year ended December 31, 1999               $16,663,242            $       --              $(305,303)           $16,357,939
                                          ============            ==========            ===========            ===========
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
                                          ============            ==========            ===========            ===========
</TABLE>





                                      F-22
<PAGE>   56

                                   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 20, 2000                    By: /s/ WILLIAM G. MAVITY
                                        ---------------------------------------
                                        William G. Mavity
                                        President and Chief Executive Officer




                                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 20, 2000
William G. Mavity


/s/ ROBERT A. STERN                      Vice President  and Chief Financial Officer
----------------------------------       (Principal Financial and Accounting Officer)                   March 20, 2000
Robert A. Stern


/s/ ROBERT M. CURTIS
----------------------------------       Director                                                       March 20, 2000
Robert M. Curtis


/s/ EDWARD W. BENECKE
----------------------------------       Director                                                       March 20, 2000
Edward W. Benecke


/s/ EUGENE J. FISCHER
----------------------------------       Director                                                       March 20, 2000
Eugene J. Fischer


/s/ JOHN A. HINDS
----------------------------------       Director                                                       March 20, 2000
John A. Hinds


/s/ STEVEN N. WEISS
----------------------------------       Director                                                       March 20, 2000
Steven N. Weiss
</TABLE>




<PAGE>   57


EXHIBIT INDEX



<TABLE>
<CAPTION>
        EXHIBIT
        NUMBER        DESCRIPTION
        -------       -----------
<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 Cooper Surgical, 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>   58


<TABLE>
<S>                  <C>
        10.38.1(12)   Amended and Restated Loan and Security Agreement dated as
                      of June 19, 1997 by and between the Registrant and Silicon
                      Valley Bank.

        10.38.2(13)   Loan Modification Agreement dated as of June 18, 1998 by
                      and between the Registrant and Silicon Valley Bank.

        10.38.3       Loan Modification Agreement dated as of April 23, 1999 by
                      and between the Registrant and Silicon Valley Bank.

        10.38.4(16)   Loan Modification Agreement dated as of June 28, 1999 by
                      and between the Registrant and Silicon Valley Bank.

        10.39(14)     Termination of License, Supply and Distribution Agreement
                      by and between the Registrant and Sherwood Medical Company
                      dated March 12, 1998.

        10.40(9)(15)  Letter Agreement with United States Surgical Corporation
                      dated May 26, 1998

        10.41(9)(15)  Letter Agreement with Boston Scientific dated July 29,
                      1998

        10.42(9)(15)  Letter Agreement with United States Surgical Corporation
                      dated August 14, 1998

        10.43(15)     Third Addendum to the Lease with QED Associates dated
                      August 31, 1998.

        10.44         Letter Notice to Extend BSL Associates Lease from
                      Registrant dated April 2, 1999.

        10.45*        Letter Agreement with Daniel Genter dated August 15, 1999.

        10.46*        Defined Contribution "401(k)" Plan as amended January 1,
                      1999.

        23.1          Consent of Independent Certified Public Accountants.

        24.1          Power of Attorney (contained in signature page.)

        27.1          Financial Data Schedule.
</TABLE>


        *       Management compensatory plan or arrangement.

        (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.



<PAGE>   59


        (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 the quarterly period ended
                June 30, 1997.

        (13)    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.

        (14)    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..

        (15)    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, 1998.

        (16)    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
                June 30, 1999.

(b)     Reports on Form 8-K: None