## ** **

## **UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-KSB**

 

| **ý**                                  | ** ** | **Annual report pursuant to section 13 or 15(d) of the  Securities Exchange Act of 1934.**                                                                              |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                  | ** ** | **For  the fiscal year ending June 30, 2004.**                                                                                                                          |
| ** **                                  |
| **Or**                                      |
|                                        |       |                                                                                                                                                                         |
| **o**                                       | ** ** | **Transition report pursuant to Section 13 or 15(d) of  the Securities Exchange Act of 1934.**                                                                          |
| ** **                                  | ** ** | **For  the transition period from             to           .** |
|                                        |       |                                                                                                                                                                         |
| **Commission  file number  000-25839** |

 

**IMPLANT SCIENCES CORPORATION**

(Exact name ofregistrant as specified in its charter)

 
| **Massachusetts**                                                | ** ** | **04-2837126**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |       | (IRS Employer  Identification number) |
|                                                             |       |                                  |
| **107  Audubon Road, #5 Wakefield, MA**                          | ** ** | **01880**                             |
| (Address of  Principal Executive Offices)                        |       | (Zip Code)                            |

 

**781-246-0700**

(Registrant’sTelephone Number, Including Area Code)

 

Securities registeredpursuant to Section 12(b) of the Act:

 

| **Title of Each Class**       | ** ** | **Name of Each Exchange on Which Registered** |
|-------------------------------|------------|-----------------------------------------------|
| Common Stock, $.10 par  value |       | American Stock  Exchange                      |
| Warrants                      |       | American Stock  Exchange                      |

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.

YES  ý           NO  o

 

Check if there isno disclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB.

No Disclosure  ý

 

State issuer’srevenues for its most recent fiscal year: $8,566,000

 

The aggregatemarket value of the voting stock held by non-affiliates of the registrant wasapproximately $67,994,000 as of August 31, 2004 (based on the closingprice for such stock as of August 31, 2004).

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock:

 

| **Class**                     | ** ** | **Outstanding at August 31, 2004** |
|-------------------------------|------------|-----------------------------------------|
| Common Stock,  $.10 par value |       | 8,444,251                               |

 

 

----

 

**PART 1**

 

**SPECIAL NOTE ONFORWARD LOOKING STATEMENTS**

 

*Inaddition to historical information, this Annual Report on Form 10-KSB containsforward looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  The words“believe,” “expect,” “anticipate,” “project,” “estimate,” “forecast,” and similarexpressions, among others, identify forward looking statements.  The forward-looking statements are subject tocertain risks and uncertainties that could cause actual results to differmaterially from those reflected in such forward-looking statements.  Factors that might cause such a differenceinclude, but are not limited to, those discussed in the sections entitled“Business”, “Risk Factors”, and “Managements Discussion and Analysis ofFinancial Condition and Results of Operations.” Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s opinions only as of thedate thereof.  We undertake no obligationto revise or publicly release the results of any revision of theseforward-looking statements.  Readersshould carefully review the risk factors described in the Annual Report and inother documents that we file from time to time with the Securities and ExchangeCommission.*

 

**ITEM 1.  OURBUSINESS**

 

Implant Sciences Corporation (the “Company”),incorporated in August 1984, has over the past twenty years, developedcore technologies using ion implantation and thin film coatings for medicaldevice applications and has proprietary processes and equipment for themanufacture of medical devices for radiation therapy.  This technology has been applied to themanufacture of radioactive prostate seeds using a dry fabrication process whichwe believe is more cost-effective and less hazardous than conventionalprocesses which use radioactive wet chemistry. Our I-Plant seeds are made radioactive in a nuclear reactor prior toshipment to customers.  We believe thatthe opportunities for radioactive prostate seeds will continue to grow as anattractive alternative to other methods of treatment.  Research and development on the radioactiveprostate seed commenced in approximately June 1998.  We received Food and Drug Administration510(k) clearance to market our I-PlantTM Iodine-125 radioactive seedfor the treatment of prostate cancer in May 1999.  From approximately May 1999 throughAugust 2000, we expended resources in the building of a productionfacility to manufacture and sell the radioactive prostate seeds.  We recognized our first sales of radioactiveprostate seeds in the first half of fiscal 2001.  The transition from research and developmenton the radioactive prostate seeds to FDA approval and commercialization of thisproduct represents a critical stage in our growth from a provider of ionimplantation services for semiconductor and orthopedic applications to amanufacturer and seller of product in the form of radioactive prostate seeds.

 

We have expanded our radiation therapy products toinclude a radiation delivery system to provide breast cancer treatment.  This treatment called accelerated partialbreast irradiation therapy following lumpectomy can be completed in five daysrather than seven weeks of daily treatments using external beam radiation.  We believe this system will become thetreatment of choice for women following lumpectomy.

 

The Company is also developing a new device for the treatmentof ocular melanoma using brachytherapy. This new product, funded by theNational Cancer Institute, we believe, will provide a better distribution ofradiation within the tumor while providing less discomfort for the patient.  The Company also has numerous other radiationtherapy devices in various stages of development including devices for biliaryduct cancer, brain cancer and intravascular radiation therapy.

 

We are also applying our ion implantation technologiesto modify surfaces to reduce polyethylene wear generation in orthopedic jointimplants, manufactured by the Stryker-Orthopaedics Division of StrykerCorporation.  We also supply ionimplantation services to numerous semiconductor manufacturers, researchlaboratories and universities.  We currentlyhave twenty-three issued United States patents and six United States patentspending covering these technologies and processes.

 

Since May 1999, we have been performing research todevelop a trace explosives detector, which could be used to detect hidden bombsin airports and other public places. This technology is yet another application of our ion sourcetechnology.  In November 2001, wedeveloped a portable prototype and, in December 2001, we demonstrated itto an independent third party.  Followingthis demonstration, management decided to pursue the technology and to preparefor submission, a cooperative research and development agreement (CRADA) to theTSA by June 2002.  This CRADA wasreceived by the company in August 2002. At present, we are developing both portable and bench-top systems foruse in airports and Department of Defense facilities.  Prototype units have been transported to theDepartment of Defense and Department of Transportation facilities fordemonstration and evaluation.  See“Current and Future Products.”  Wecurrently have one issued United States patent and seven United

 

2

----

 

States patents pending covering these technologies and processes.

 

**Technologies**

 

*General. *Weuse two core technologies, ion implantation and thin film coatings, to provideenhanced surfaces to various medical implants and semiconductor products.  With respect to each core technology, we havedeveloped proprietary processes and equipment for the purpose of improving oraltering the surfaces of medical implants and semiconductor wafers.

 

Ion implantation and thin film coatings are techniquesfirst developed in the 1970’s to improve the functional surface properties ofmetals, ceramics and polymers, such as friction, wear, wetability andhardness.  Ion implantation was initiallydeveloped as a means to dope semiconductors in the fabrication of integratedcircuits.  The accuracy, cleanliness andcontrollability of this process have made it the standard for semiconductormanufacturing.  Ion implantation isgenerally preferred over other surface modification methods because it does notdelaminate, does not require high temperatures and does not deform or alter thedimensions of the treated surface.

 

Thin film coatings were initially developed tointerconnect transistors on semiconductor chips.  Thin films modify surfaces by layering adesired metal or ceramic coating on the substrate material.  Common thin film coating techniques includechemical vapor deposition and physical vapor deposition.

 

*Ion Implantation. *Ion implantation is a process by which ions(electrically charged atoms) are accelerated to high velocity in a vacuum anddirected toward a substrate or target material. The atoms become embedded just below the surface of the materialproducing an alloy composed of the atoms and the substrate material in thenear-surface region of the target material. This surface alloy may have new mechanical, electrical, chemical,optical and other properties.  We believeour proprietary technology, including high current ion sources and specializedcomponent holding fixtures, provides higher ion implant doses and higher beampower and yields superior surface characteristics at lower cost thancommercially available equipment.

 

Ion implantation can be used to embed single isotopesof radioactive or non-radioactive elements into components.  We are using our proprietary equipment tomanufacture radioactive seed implants for the treatment of prostate cancer andother carcinomas which can be manufactured without expensive cyclotrons orlinear accelerators and without hazardous radioactive wet chemistry, themethods currently employed by existing suppliers.  We have twenty-three United States patentsand six United States patents pending on our processes.  We also believe we can cost-effectivelyimplant ions of therapeutic radioisotopes including phosphorous-32,palladium-103 or ytterbium-90 into a device such as a coronary stent used toreduce restenosis following balloon angioplasty.

 

*Thin Film Coating.*A thin filmcoating is grown upon a substrate in a vacuum by the gradual deposition ofatoms on the substrate.  Our proprietaryunbalanced magnetron sputtering process results in coatings that are extremelydense and free of voids, yielding good contrast and sharp edges under x-ray orfluoroscopic examination. These coatings usually consist of gold or platinumfor radiopaque applications.  Ourproprietary manufacturing process allows for efficient utilization of preciousmetals and for cost effective recovery and recycling of these preciousmetals.  We are also developing processesto coat stents, guidewires and catheters used in interventional cardiologyprocedures with substances, usually gold or platinum, that allow those stents,guidewires and catheters to be visible under x-ray observation during aprocedure.  We believe other techniquesfor applying thin film coatings are less desirable for medical deviceapplications because of their inability to apply a dense coating, whilecontinuing to be flexible and adhering to the substrate.

 

*TraceExplosives Detection.*We have developed an instrument, whichcan detect the vapor from trace amounts of explosive compounds includingplastic explosives such as RDX, the compound commonly found in C4explosives.  The system works by ionizingexplosive molecules in an air sample and then detecting the ionized moleculesof the explosive using ion mobility spectrometry.  The instrument has successfully detectedmolecules of five different types of explosives in the air at the parts pertrillion concentrations.  We believe thistechnology will provide commercial systems with improved sensitivity andcapabilities than equipment presently available.

 

**Medical Products**

 

*Prostate Cancer Seeds*

 

*General. *Thealternatives generally presented to patients diagnosed with early stageprostate cancer are surgical removal of the prostate (radical prostatectomy) orexternal beam radiation.  Both techniquesfrequently have significant side effects including impotence andincontinence.  Brachytherapy has been anincreasingly popular treatment technique whereby radioactive seeds (each ofwhich is approximately half the size of a grain of rice) are permanentlyimplanted into the prostate.  Thistechnique allows the delivery of highly concentrated yet confined

 

3

----

 

doses of radiation directly to the prostate. Surrounding healthytissues and organs are spared significant radiation exposure.  Advances in transrectal ultrasound andcatscan imaging equipment provide detailed and precise measurements of prostatesize and shape, for seed distribution and placement.

 

*Prostate Seeds. *We have developed, and been granted two United Statespatents covering radioactive seeds, implants and methods of manufacturingradioactive seed implants by a proprietary process.  We have received Food and Drug Administration510(k) clearance to market our I-PlantTM Iodine-125 radioactive seedfor the treatment of prostate cancer. These seeds are used primarily in the treatment of prostate cancer.  Our 510(k) clearance permits treatment of anylocalized tumors treatable by temporary or permanent brachytherapy.  A twelve-year study conducted by theNorthwest Hospital, Seattle, Washington shows that this treatment has atwelve-year disease-free survival rate equal to surgical removal of theprostate and may be superior to other early stage treatments, with asubstantial reduction in the negative side effects, impotence and incontinence,frequently associated with surgery and external beam radiation treatment.  The National Cancer Institute and AmericanCancer Society have reported that sexual potency after implantation ofradioactive seeds has been 86% to 92%, which compares with rates of 10% to 40%for radical prostectomies and 40% to 60% for external beam radiationtherapy.  Our production method,involving a proprietary dry fabrication process, does not use radioactive wetchemistry.  On July 28, 1999 wereceived our Radioactive Sealed Source Registration Certificate, a NuclearRegulatory Commission requirement administered by the Commonwealth ofMassachusetts as a Nuclear Regulatory Commission Agreement State.  These seeds have been on sale in the U.S. forfour years.

 

*Manufacturing. *Management believes that the Company’s manufacturingprocess results in lower capital equipment and manufacturing assembly costs andis less hazardous than the manufacturing processes used by ourcompetitors.  Other radioactive prostateseed manufacturers use radioactive wet chemistry during seed assembly forIodine-125 products.  Our dry process,for which we have patents issued and pending, uses a dry fabrication process,and we believe it requires fewer personnel and yields faster throughput.  Following seed core assembly we send our seedcores to a nuclear reactor for activation. Using this dry fabrication process,seed cores can be fabricated and inventoried in large quantities and activatedonly when ordered.  Due to the shorthalf-life of Iodine-125 (approximately 60 days), the competition must assembleand ship seeds on a tight schedule so they can be implanted into thepatient at the appropriate radioactive strength.  We maintain multiple source vendors for ourraw materials supplies in the construction of our radioactive prostate seedsincluding Trace Sciences International, Isoflex USA, Inc., Specialty GlassProducts, United Silica Products, Uniform Tube Corporation, and Fraen MachiningCorporation.  In addition, we maintainmultiple nuclear reactor sources capable of activating the radioactive prostateseeds, including Studsvik Nuclear Corporation and NRG Petten.

 

*Sales.*  On February 2,2000, we signed a distribution agreement with MED-TEC.  Under this agreement, MED-TEC has agreed toact as our exclusive distributor for our Iodine-125 radioactive seed for thetreatment of prostate cancer in the United States, the District of Columbia,and Puerto Rico.  The agreement wasterminated by mutual consent and was replaced by another agreement onJuly 31, 2003 defining an orderly transition, transfer of customers to theCompany’s direct sales force and a covenant by MED-TEC not to compete for 36months.  The Company agreed to payMED-TEC approximately $39,000 per month over the 28 months, beginningSeptember 2003, in connection with this agreement.  Since August 2003, the Company has beenbuilding its own direct sales force to sell prostate seeds.

 

*Breast Cancer Radiation Treatment*

 

*General*.  Early state breast cancer is commonly treatedby lumpectomy followed by a course of 35 sessions of external beam radiation tothe whole breast over a seven week term. Over the past several years, Accelerated Partial Breast Irradiation(APBI) has been increasing in popularity with patients because it can becompleted in four to five days on an outpatient basis and has shown equalefficacy with good cosmetic outcomes. Approximately 600 to 1000 patients have already been treated using thisnew temporary brachytherapy technique. Currently this treatment is performed using a conventional HDR (HighDose Radiation) system using an iridium -192 radioactive source.  An important drawback of the currently usediridium -192 source is that the treatments must be performed in a heavilyconcrete shielded room to prevent the very penetrating iridium -192 gamma raysirradiating people in hallways and adjacent rooms.  Approximately 10% of the U.S. hospitalscurrently have such dedicated HDR concrete shielded rooms for brachytherapy.  The Company has developed a new lower energysource, ytterbium -169 which can deliver the same therapeutic dose to thelumpectomy cavity and does not require a concrete shielded treatment room.  The procedure can be done in an ordinarytreatment room with some portable shielding around the patient.

 

4

----

 

*Breast Brachytherapy System.*

 

The Company has developed a specially constructedsource wire tipped with a proprietary ytterbium -169 source of sufficientstrength to compete with iridium -192 but does not present the same radiationexposure to the hospital staff.  Thetreatment will be done by delivering this source into the breast cavity using aconventional afterloader system.  Thebreast cavity can be irradiated using the interstitial needle techniquepioneered by Dr. Kuske or by the MammositeÔapplicator manufactured by Proxima Therapeutics. The Company believes that thissource wire is a device that needs a 510(k) pre-market notification from theFDA and does not require clinical trials prior to commercial sales.

 

*Manufacturing. *The Company will manufacture the ytterbium -169 sourcematerial in-house using several nuclear reactors as subcontractors.  The Yb-169 source wire is designed to fit allafterloader systems presently on the market.

 

*Sales. *Thesource wires and service contracts will be sold by our direct sales force.  This new product will be purchased by theRadiation Oncology Department of hospitals which is the same customer ourexisting prostate seed salesmen call on.

 

*Orthopedic Total Joint Replacements*

 

*General. *Weprovide surface engineering technology to manufacturers of orthopedic hip andknee total joint replacements.  Themajority of existing hip and knee joint replacements are made of a cobaltchromium femoral component that articulates against a polyethylenecomponent.  While offering excellentbiocompatibility and superior wear resistance over prior alloys and designs andpotentially longer average life than prior alloys, cobalt chromium devicesstill suffer from particle generation where the metal and polyethylenecomponents articulate against each other. This particle generation has been identified as a primary cause ofimplant loosening due to osteolysis requiring repeat surgery.

 

*Orthopedics. *We implant cobalt chromium components of total jointreplacements manufactured by our customers with nitrogen ions.  Nitrogen ion implantation of these componentsreduces polyethylene wear by modifying the native oxide present in cobaltchromium alloys.  Laboratory tests andclinical studies have shown that nitrogen ion-implanted cobalt chromiumcomponents offer superior performance over untreated components, significantlyreducing wear and slowing the incidence of osteolysis which ultimately leads torevision surgery.

 

*Manufacturing. *We believe we now operate one of the highestbeam-current ion implanters used in the medical field.  This equipment has higher throughput andlower cost than equipment with a lower beam-current.  For our new second-generation orthopediccoating, this equipment can provide a ceramic coating with superiorcharacteristics due to its patented “blended interface” process.  We maintain multiple source vendors for ourgas supplies, the primary raw material used in the ion implantation process inproviding this service, including Praxair and Wesco.

 

*Sales. *Wecurrently implant cobalt chromium components of total joint replacements madeby our customers with nitrogen ions and are developing ceramic ion implantationtechniques for total joint replacements. We receive untreated cobalt chromium total joint replacements from ourcustomers and implant them at our facility. We then invoice and ship the implanted total joint replacements to ourcustomers.  We maintain one majorcustomer which accounted for 19% and 24% of total revenues in the year endedJune 30, 2004 and 2003, respectively.

 

*Markets. *Osteoarthritisis a natural result of the aging process and is the predominant cause of theneed for joint replacement.  We believethat longer life expectancy as well as the growth in the number of people overage 50 will cause the demand for total joint replacement to increase.  According to the American Academy ofOrthopedic Surgeons, the hip and knee total joint replacement market wasestimated to be 650,000 procedures in the United States.  We treat approximately 60,000 units each yearusing our ion implantation process for the Stryker-Orthopaedics Division ofStryker Corporation.  Our research hasshown that our ceramic coatings can decrease wear debris generation bytwo-thirds, which we believe will reduce osteolysis and thereby reduce the needfor revision surgery.

 

*Interventional Devices*

 

*General*.  In cooperation with certain devicemanufacturers and with the support of government research contracts and grants,we are in the process of developing a number of devices to be used inintravascular radiation therapy.  Amongthese devices are temporary brachytherapy systems stents, guidewires andcatheters containing radiopaque markers. Coronary stents are made of metals which are not radiopaque and in manycases must be coated with dense precious metals for increased visibility thatis critical to their guiding, positioning, manipulation and

 

5

----

 

placement.

 

*Temporary Coronary Brachytherapy Systems*

 

*General*.  With the support of a government researchgrant, we have begun an initiative on a catheter-based brachytherapy systemdevice for the prevention of restenosis, reclosure of the artery, followingballoon angioplasty.  The catheter isbeing designed to deliver localized radiation to the patient’s artery, usingIodine-125, a soft gamma ray emitter mounted on the tip of a deliverycatheter.  Using our patented coretechnology for the I-PlantTM seed we are developing a proprietaryprocess to produce radioactive sources of sufficient strength to be used in thevascular system.  We expect that the useof this soft gamma ray isotope within the catheterization laboratory will allowthe physician and staff to remain at the patient’s side during the treatment,which is currently not an option with other gamma ray emitters.  We anticipate that this soft gamma ray shouldalso make the procedure more acceptable to the physician, compared to othersystems currently in clinical development.

 

*Radiopaque Coatings. *We have developedproprietary methods for applying radiopaque coatings onto a variety of medicaldevices manufactured by our customers in order to increase the visibility ofsuch devices during interventional cardiology and other catheter-basedprocedures.  These biocompatible coatingsare deposited using a proprietary unbalanced magnetron sputtered coatingprocess.  The resulting coating isextremely dense and free of voids yielding good contrast and sharp edges underx-ray or fluoroscopic examination.  Weuse this process to coat stents, guidewires and catheters.  For a fractional increase in themanufacturing cost of a stent, we believe our coatings can provide significantadded value and enhanced performance. Our thin film coatings are being evaluated by certain customers forstents, guidewires and catheters.

 

**Security Products**

 

*Trace Explosives Detection Equipment*

 

We are developing several explosive detection systemsthat could be used in airports, public and government buildings, and sportingevent facilities.  The systems use ourproprietary technology, which includes the use of laser beams in combinationwith ion mobility spectrometry, to electronically detect minute quantities ofexplosive vapor molecules in the air.

 

This project has been ongoing since approximately May1999.  This project was undertaken inresponse to the interest in ion beam phenomena by our research personnel whoare constantly researching new applications for this technology.  The development of new applications istypically funded through government grants or internal funding.  Originally, we funded a research anddevelopment program for the electronic detection system to produce enough datato write grant proposals for the Department of Defense to detect unexplodedbombs and mines.

 

The Department of Transportation has stated that theU.S. could spend between $1.9 billion and $2.5 billion on equipment for thedetection of bulk and trace amounts of explosives.  However, we do not know how much will beallocated to each of trace and bulk equipment or how much allocated toequipment for the detection of trace amounts of explosives will be allocated todevices like ours.

 

In June 2000, we developed our first experimentaldevice, which demonstrated sensitivity to the explosive TNT.  In June 2001, we developed asecond-generation prototype with increased sensitivity and selectivity.  This device was able to detect and specify anincreasing number of compounds within various explosive materials.  The explosives that have been tested to dateare TNT, RDX, PETN, EGDN, and DNT. RDX is the primary component of C3 and C4explosives, such as Datasheet and Semtex, as well as certain types of blackpowder explosives.  We believe theseexplosives represent the majority of the explosives presently used in terroristactivities.  After the attack on theWorld Trade Center occurred on September 11, 2001, management made thedecision to continue the internal funding of the project rather than awaitfunding through government grants.  InDecember 2001, we successfully demonstrated our working prototype of theelectronic detection system to the FAA. Our electronic detection system has been subjected to controlled testingby third parties and successfully detected a sample of C4.  As a result of the successful demonstration,we believed it was appropriate to further pursue the commercial development ofour electronic detection system device. We are developing a pre-production electronic detection system whichwill form the basis of a commercial unit and we will submit it to theTransportation Security Administration for evaluation when ready.

 

The electronic detection system detects microscopicquantities of explosive molecules in the air. The device does not use any radioactive materials and does not produce adanger to personnel operating the device or scanned by the device.  The device is a sensor that receives signalsthat are already in the environment.  Twocompanies market trace electronic detection systems (Ion Track Instruments, asubsidiary of General Electric, and Smiths Plc, a U.K. publicly heldcompany).  Both of these competitors useIon Mobility Spectrometry in their

 

6

----

 

respective devices for the detection and classification of explosivemolecules.  Additionally, both of thesecompetitors use Nickel-63, a radioactive source, to ionize the explosivevapors.  Our electronic detection systemalso uses Ion Mobility Spectrometry technology to detect and classify explosivesmolecules, however, our electronic detection system uses a laser beam to ionizethe explosive molecules.  The laseryields greater sensitivity than Nickel-63 and has the potential to detectexplosives without physically rubbing or swiping the outside of a container orluggage.  Currently, the trace electronicdetection systems require the operator to physically rub or swipe the articlesto be tested.  The swab or cloth is thenplaced into the electronic detection system, heated to evaporate some of theexplosive particles, and then directs these vapors into the Ion MobilitySpectrometry device.  Our electronicdetection system uses a sensor that does not require physical contact to screenthe article to detect trace residues and detects the explosives from thevapor alone.  Since our device does notuse a radioactive source, management believes it is safer than trace explosivesresidue detection systems currently in use.

 

We have tested for false positives and false negativesby using numerous non-explosive organic vapors. The accepted testing methodology for false positives requires testing ona commercially available electronic detection system and is usually performedin the context of a specific application, such as baggage screening, personnelscreening, locating bombs in buildings, and cargo or auto screening.  The official false positive and falsenegative testing must be done by an independent third party agency, however,such independent testing has not yet been performed.

 

Consistent with our policy to protect our proprietarytechnologies, we have submitted eight preliminary patent applications to theUnited States Patent and Trademark Office. These patent applications will cover specific design configurations thatare responsible for our improved vapor detection sensitivity.  One application, a patent covering theoverall system design, was allowed by the U.S. Patent and Trademark Office inAugust 2004.

 

We are developing several versions of the systems toserve various markets.  We are developinga table-top unit, which can be used to screen passengers and carry-on baggagein airports.  We are developing aportable system, which can be used to replace bomb-sniffing dogs to clearbuildings, aircrafts, or ships where hidden bombs are believed to exist.  And we are also developing a device to detectlandmines.  We plan to first market thesesystems to U.S. government agencies for use in airports, government buildingsand in the field.  We have signed aCooperative Research and Development Agreement with an agency of the Departmentof Transportation which will permit the Company and the government to exchangecritical test data and for the Company to deliver a certain number of units tothe Department of Transportation for independent evaluation and field testing.

 

The electronic detection system does not change ourcurrent operational and spending focus. Our operations and spending continue to focus on the sales of oursemiconductor, medical coatings and prostate seed products.  Additionally, we continue to fund researchand development through government grants in accordance with the provisions ofthe respective grant awards.  We mayrequire additional funding in order to advance the commercial development ofthe electronic detection system.  We willattempt to obtain such financing by: (i) government grants, (ii) the exercise of the redeemable common stockpurchase warrants and/or (iii) private financing.  However, there can be no assurance that wewill be successful in our attempts to raise such additional financing, or (iv)through joint ventures or from exclusive distributors.

 

**Semiconductor Products**

 

*Semiconductor Ion Implantation*

 

We supply ion implantation services to numeroussemiconductor manufacturers, research laboratories, and researchuniversities.  Ion implantation ofelectronic dopants into silicon, the process by which silicon is turned into asemiconductor, is an integral part of the integrated circuit fabricationprocess. While many of our customers have their own ion implantation equipment,they often use our services and specialized expertise for research and newproduct development because they do not want to interfere with production orbecause they are unable to perform the services themselves.

 

In June 2003, we installed two Axcelis MC3 semiconductor ionimplanters within a new 1000 square foot class-100 clean room. These arestate-of-the-art implantation machines, which are totally automated and can ionimplant silicon wafers up to 30 cm (12 inches) in diameter. The Companybelieves it is the only semiconductor ion implantation service company whichcan accommodate twelve-inch wafers and is one of only two in the U.S. that canimplant eight-inch wafers.

 

The Company believes that these two machines and thenew clean room facilities will enable the Company to expand its semiconductorimplantation services to include high volume production customers as well asthe

 

7

----

 

existing R & D and pilot production customers.  These facilities were completed inSeptember 2003 and are currently servicing customers.

 

**Marketing and Sales**

 

Our marketing and sales methods vary according to thecharacteristics of each of our main business areas.  Foreign sales have comprised less than fivepercent of our total revenues.  Sales andmarketing to the medical device markets are directed by our Director ofBrachytherapy Sales and Director of Operations – Contract Manufacturing.  The Director of Brachytherapy Sales isassisted by regional sales representatives. Our Director of Semiconductor Sales and Marketing handles semiconductorimplant services.  Our Director ofExplosives Detection is responsible for sales and marketing our traceexplosives technology. The Company may enter into a distributorship agreementpursuant to which another company may distribute our security products. Thesolicitation and proposal process for research and development contracts andgrants are conducted by our President, our Chief Scientist, and our scientificstaff.

 

During the year ended June 30, 2003, we utilizeda distributor for the sale of our prostate seeds.  Beginning July 31, 2003, we entered intoan agreement with our former distributor and began to market this productourselves.

 

During the years ended June 30, 2004 and 2003, werecorded product revenues related to medical products of approximately$4,451,000 and $4,474,000, respectively, and product revenues related tosemiconductor sales of approximately $958,000 and $876,000, respectively.  During the years ended June 30, 2004 and2003, two customers, MED-TEC and the Stryker-Orthopaedics Division of StrykerCorporation accounted for 55% and 95% of the total medical product revenues,respectively.

 

We also recorded government and other contractrevenues of $3,157,000 and 1,346,000, for the years ended June 30, 2004and 2003, respectively.  During the yearsended June 30, 2004 and 2003, government contract funding was receivedfrom the Department of Defense, the National Institutes of Health, theEnvironmental Protection Agency, and Transportation Security Administration.

 

*Medical Sales and Marketing*

 

In the business of ion implantation for total jointreplacements, we concentrate on identifying and serving leadingmanufacturers.  Where possible, weattempt to become the sole provider of devices or surface engineering servicesto each such manufacturer.  Our marketingand sales efforts require considerable direct contact and typically involve aprocess of customer education in the merits of our technology.  We accomplish this by first researchingcustomer needs, delivering scientific papers at orthopedic and biomaterialconferences, and through presentations at customer sites.  Our internal research and government researchgrants are an integral part of the marketing process.  Our patent portfolio is also very importantin this process.

 

To promote sales of our radiopaque coatings, we attendtrade shows, use press releases, and our website atwww.implantsciences.com.  Once acustomer’s interest is established, the sales process proceeds with an initialdemonstration project funded by the customer. A set of developmental runs are then performed to determine projectfeasibility and to roughly optimize a parameter set for deposition.  After testing of samples generated andconsidering cost estimates for production quantities, the customer mayauthorize us to proceed to pilot production.

 

In pilot production, typically, several hundred unitsare produced in a manner equivalent to the envisioned full productionmethod.  Pilot production may be done onan existing piece of equipment with customer/device specific fixturing, or aprototype machine depending on the complexity of the process and device.  Samples made in pilot production arefabricated into complete devices and used by the customer for further testing,clinical studies, FDA submissions, and marketing and sales efforts.

 

*Semiconductor Sales and Marketing*

 

Since semiconductor ion implantation is a standardprocess in all integrated circuit fabrication, customers usually know what theywant and little education is necessary. Our services are promoted and sold through trade shows, advertising intrade magazines, direct mailings, press releases, and our website atwww.implantscisences.com.  Most sales arebetween $600 and $2,500 per order, take less than one day to complete, and theentire sales effort is often conducted by telephone.  Most of our sales in this area are foroutsourced customer-specified ion implantation services, which the customer’sown ion implantation department is unable or unwilling to perform.

 

8

----

 

*Government Contracts*

 

Research and development contracts from the U.S.government must be won through a competitive proposal process which undergoespeer review.  We are in frequent contactwith the National Institutes of Health, the Department of Defense, theDepartment of Energy and other agencies at technical conferences to stayinformed of the government’s needs.  Webelieve our management and senior scientific staff have earned a strongreputation with these and other agencies. To date we have been awarded research and development contracts by theNational Institute of Health, the Department of Defense, the National ScienceFoundation, the National Aeronautics and Space Administration, theEnvironmental Protection Agency and the Department of Homeland Security.

 

**Research and Development**

 

Our technical staff consists of fifteen scientists andengineers, including six with Ph.D. degrees, and nine with Bachelor Degrees orwith expertise in physical sciences and engineering.  All of our existing and planned products relyon proprietary technologies developed in our research and developmentlaboratories.  Our research anddevelopment efforts may be self-funded, funded by corporate partners or byawards under the Small Business Innovative Research program of the U.S.government.  Under the Small BusinessInnovative Research program, we retain the right to patent anything developedpursuant to the program, however, the U.S. government retains a royalty freelicense to use the technology.  We haveobtained over $10 million in U.S. government grants and contracts over the past16 years.  Each research and developmentagreement with our corporate partners defines the rights to theseagreements.  Since September 2000, nocorporate partner has funded research and development programs.

 

We spent approximately $3,841,000 and $2,027,000 onresearch and development in the fiscal years ended June 30, 2004 and 2003,respectively.  Approximately $2,210,000and $1,216,000 of these research and development activities represents researchand development costs that were directly sponsored by customers in the form ofgovernment contracts and grants during 2004 and 2003, respectively.

 

**Patents and Proprietary Technology**

 

It is our policy to protect our proprietary positionby, among other methods, filing United States and foreign patent applications.We currently have twenty-three (23) issued United States patents and fourteen(14) United States patent applications pending, one of which we have receivednotification of allowance from the US Patent and Trademark office inAugust 2004.  Of the twenty-three(23) patents issued, five (5) are of material importance to us and are in thefield of brachytherapy.  These five (5)material patents expire in the years 2017 through 2020.

 

We have exclusive rights inter-alia under patentscovering the following technologies: (i) methods of rendering coronary stentsradioactive, (ii) a radioactive, radiopaque stent device, (iii) methods ofgrowing ceramic coatings on orthopedic implants, (iv) methods of generating ionbeams and (v) an iodine-125 radioactive prostate seed.  In addition, we also have patents pending on(i) a palladium-103 radioactive prostate seed, (ii) vascular brachytherapydevices, and (iii) drug eluting stents.

 

We intend to seek further patents on our technologies,if appropriate.  However, there can be noassurance that patents will issue for any of our pending or future applicationsor that any claim allowed from such applications will be of sufficient scope orstrength, or be issued in all countries where we sell our products andservices, to provide meaningful protection or any commercial advantage to us.

 

We also rely on unpatented proprietary technology,trade secrets and know-how and we do not know if others will independentlydevelop substantially equivalent proprietary information, techniques orprocesses, that such technology or know-how will not be disclosed or that wecan meaningfully protect our rights to such unpatented proprietary technology,trade secrets or know-how.  Although wehave entered into non-disclosure agreements with our employees and consultants,we cannot be sure such non-disclosure agreements will provide adequate protectionfor our trade secrets or other proprietary know-how.

 

**Government Regulation and Environmental Matters**

 

Medical devices incorporating our technologies, suchas radioactive prostate seeds and interventional cardiology devices, aresubject to FDA regulation.  The burden ofsecuring FDA clearance or approval for these core business medical devicesrests with our medical device manufacturers or licensees.  We have received Food and Drug Administration510(k) clearance to market our I-PlantTM Iodine-125 radioactive seedfor the treatment of prostate cancer.

 

In the 510(k) clearance procedure, a company must showthat its new product is “substantially equivalent” to a medical device that iscurrently approved for use.  This processrequires an application to the FDA for 510(k) clearance.  If the FDA determines that a product is infact substantially equivalent to a product that has already been

 

9

----

 

approved for use, the FDA grants 510(k) clearance for the sale of thenew product.  This process is quicker andless expensive than obtaining approval for an entirely new product.  We obtained 510(k) clearance for our I-PlantTMprostate seed product in May 1999.  Allof our presently contemplated new medical products only require a 510 (k)clearance.

 

Our medical device manufacturing facility operatesunder the FDA Quality Control Regulations. Our facility, located in Wakefield, Massachusetts, was registered withthe FDA in July 2000 prior to the introduction and commercial sales of ourradioactive prostate seed product.  Ourfacility is subject to the FDA’s inspection at any time. The FDA has inspectedImplant Sciences’ medical manufacturing facilities and found its Quality Systemto meet their requirements.  The FDAregulates the medical device industry and has the authority to demandcorrective action(s) for any deficiencies in adherence to Quality SystemRegulations, order product recalls, and can require that a factory ceaseoperations until it is brought into compliance with these regulations.  Implant Sciences’ Quality Systems Managerensures adherence to the FDA’s Quality System Regulations as well as to the ISO9001 standard.

 

In addition to FDA regulation, certain of ouractivities are regulated by, and require approvals from, other federal andstate agencies.  For example, aspects ofour operations require the approval of the Massachusetts Department of PublicHealth and registration with the Department of Labor and Industries.

 

In order to ship our radioactive prostate seed productfrom our facility, we are required to obtain a radioactive sealed sourceregistration from the Massachusetts Department of Health, Labor andIndustries.  We obtained this certificateprior to the commencement of the commercial sales of our radioactive prostateseed product in the first half of fiscal 2001. This certificate requires no maintenance or renewal as long as thedesign of the radioactive prostate seed is not changed.  The Massachusetts Department of Health, Laborand Industries can, however, terminate this certification in the event of anaccident that would require a redesign of the product.  On July 28, 1999, we received ourRadioactive Sealed Source Registration Certificate, a Nuclear RegulatoryCommission requirement, administered by the Commonwealth of Massachusetts as aNuclear Regulatory Commission Agreement State.

 

The State Radiation Control Program issued to us alicense to manufacture and distribute our radioactive prostate seedproduct.  The State Radiation ControlProgram performs periodic inspections of our facility.  Since the commencement of commercial sales ofour radioactive prostate seed product in the first half of fiscal 2001, theState Radiation Control Program has performed two (2) annual inspections of thefacility and identified no violations or deficiencies.

 

Furthermore, our use, management, transportation, anddisposal of certain chemicals and wastes are subject to regulation by severalfederal and state agencies depending on the nature of the chemical or wastematerial.  Certain toxic chemicals andproducts containing toxic chemicals require special reporting to the UnitedStates Environmental Protection Agency and/or its state counterparts.  We are not aware of any specificenvironmental liabilities that we could incur. Our future operations may require additional approvals from federaland/or state environmental agencies.

 

**Competition**

 

In radioactive products, such as prostate seedimplants, radioactive brachytherapy devices and coronary stents, we expect tocompete with Oncura Corp., Theragenics Corp., and North American Scientific,Inc.  Of these, Oncura Corp, TheragenicsCorp. and North American Scientific, Inc., serve substantially the entireradioactive prostate seed market.  Thenumber and types of procedures being performed on the prostate are increasinglydrawing new entrants into the market.  Webelieve that competition, and, in turn, pricing pressures, may increase.  Many of our competitors have substantiallygreater financial, technical and marketing resources than we do.

 

Many medical device manufacturers have developed orare engaged in efforts to develop internal surface modification technologiesfor use on their own products.  Mostcompanies that market surface modification to the outside marketplace aredivisions of organizations with businesses in addition to surfacemodification.  Many of our existing andpotential competitors (including medical device manufacturers pursuing coatingsolutions through their own research and development efforts) havesubstantially greater financial, technical and marketing resources than we do.

 

With respect to ion implantation of orthopedicimplants, we primarily compete with Spire Corporation.  Competition within the orthopedic implantindustry is primarily conducted on the basis of service and productdesign.  Price competition has abatedsomewhat in the case of first time and more youthful patients where higher-costand more durable reconstructive devices are preferred.  We attempt to differentiate ourselves fromour competition

 

10

----

 

by providing what we believe are high value-added solutions to surfacemodification.  We believe that theprimary factors customers consider in choosing a particular surfacemodification technology are performance, ease of manufacturing, ability toproduce multiple properties from a single process, compliance withmanufacturing regulations, customer service pricing, turnaround time, and theability to work with a variety of materials. We believe that our process competes favorably with respect to thesefactors. We believe that the cost and time required to acquire equipment andtechnical engineering talent, as well as to obtain the necessary regulatoryapprovals, significantly reduces the likelihood of a manufacturer changing thecoating process it uses after a device has been approved for marketing.

 

Our primary competition in the semiconductor industryconsists of two companies:  InnovionCorporation and Core Systems, Inc.  Thesecompanies are both located in Silicon Valley, California and primarily servethe silicon wafer production needs of semiconductor factories in their localarea, although Core Systems does research and development implantsnationwide.  We primarily serve both eastand west coast factories with silicon production and research and developmentlaboratories worldwide.

 

In the trace explosives detection industry, Ion TrackDivision of General Electric and the Barringer Division of Smiths Plc.  are our two primary competitors.  These two companies also use ion mobilityspectrometry, however, they use a radioactive Nickel-63 source to ionize theexplosive molecules.  This technologydiffers from our technology because we use a laser to ionize the explosive moleculesin the air.  We believe our technologyprovides our device with greater capabilities.

 

Many of our competitors and potential competitors havesubstantially greater capital resources than we do and also have greaterresources and expertise in the areas of research and development, obtainingregulatory approvals, manufacturing and marketing.  There can be no assurance that ourcompetitors and potential competitors will not succeed in developing, marketingand distributing technologies and products that are more effective than thosedeveloped and marketed by us or that would render our technology and productsobsolete or noncompetitive. Additionally, there is no assurance that we will be able to competeeffectively against such competitors and potential competitors in terms ofmanufacturing, marketing and sales.

 

**Product Liability and Insurance**

 

Our business entails the risk of product liabilityclaims.  Although we have not experiencedany product liability claims to date, there can be no assurance that suchclaims will not be asserted or that we will have sufficient resources tosatisfy any liability resulting from such claims.  We have acquired product liability insurancecoverage.  There can be no assurance thatproduct liability claims will not exceed such insurance coverage limits, thatsuch insurance will continue to be available on commercially reasonable termsor at all, or that a product liability claim would not materially adverselyaffect the business, financial condition or our results of operations.

 

**Employees**

 

As of June 30, 2004, we had 75 full timeemployees.  We believe we maintain goodrelations with our employees.  None ofour employees is represented by a union or covered by a collective bargaining agreement.

 

**ITEM 2.****     PROPERTIES**

 

We operate out of a 50,919 square foot leased facilityin Wakefield, Massachusetts.  Thefacility is located approximately 15 miles north of Boston.  Our current lease expires inDecember 2008.  This facility housesall of our research and development, manufacturing and administrative offices.

 

I**TEM 3.****     LEGAL PROCEEDINGS**

 

From time to time, we are subject to various claims,legal proceedings and investigations covering a wide range of matters thatarise in the ordinary course of our business activities.  Each of these matters is subject to variousuncertainties.  On the basis ofinformation presently available, we are not currently aware of any legalproceedings or claims that we believe are likely to have a material effect onour financial position or results of operations.

 

**ITEM 4.****     SUBMISSION OF MATTERS TO AVOTE TO SECURITY HOLDERS**

 

No matters were submitted to a vote of securityholders during the fourth quarter of fiscal year ended June 30, 2004.

 

11

----

 

**PART II**

 

**ITEM 5.****     MARKET FOR REGISTRANT’SCOMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

**Market Price**

 

As ofJune 30, 2004, our common stock, $0.10 par value, was traded on theAmerican Stock Exchange under the symbol IMX. The following sets forth the range of high and low closing sales priceson the American Stock Exchange

 
| ** **                                 | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------|------------|----------|------------|---------|------------|
| **Fiscal  Year Ended June 30, 2003:** |       |     |       |    |       |
| Quarter ended  September 30           |       | $        | 13.30      |    | $          | 5.00 |   |
| Quarter ended  December 31            |       | 6.00     |       | 3.93    |       |
| Quarter ended  March 31               |       | 4.15     |       | 2.10    |       |
| Quarter ended  June 30                |       | 5.68     |       | 3.16    |       |
|                                       |       |     |       |    |       |
| **Fiscal  Year Ended June 30, 2004:** |       |     |       |    |       |
| Quarter ended  September 30           |       | $        | 8.17       |    | $          | 5.10 |   |
| Quarter ended  December 31            |       | 9.33     |       | 6.72    |       |
| Quarter ended  March 31               |       | 14.95    |       | 9.49    |       |
| Quarter ended  June 30                |       | 16.54    |       | 10.24   |       |

 

At September 30, 2004, the closing sales price ofour common stock was $10.80.

 

**Dividends**

 

We have neverdeclared or paid any cash dividends on our common stock.  We currently anticipate that we will retainall future earnings for the expansion and operation of our business, and do notanticipate paying cash dividends in the foreseeable future.

 

**Sales of Unregistered Securities**

 

On August 28,2003, we issued 200,000 shares of Series B 5% Cumulative Convertible PreferredStock (“Series B”) having a stated value of $10 per share pursuant to aSecurities Purchase Agreement executed on August 28, 2003 with the LaurusMaster Fund, Ltd. (“Laurus”).  Wereceived $2,000,000 in gross proceeds, less a management fee and placementagent fee of approximately $100,000 and related transaction costs estimated tobe an additional $73,000.  The terms ofthe Series B provide for repayment of outstanding principal and accruedinterest in either cash or with shares of our common stock, at our option overa 16 month period beginning December 1, 2003, pursuant to an amortizationschedule.  However, if the closing pricefor any of the 11 trading days preceding a Repayment Date was less than $6.00,the Company would be required to pay such Monthly Amount in cash at 105% of themonthly obligation.  If the payment ofthe Monthly Amount is made in common stock, the fixed conversion price is$5.50.  We also issued to Laurus awarrant to purchase 25,000 shares of common stock at $6.88 per share and 45,000shares of common stock at $8.25 per share. The Securities Purchase Agreement also provides for a security interestin substantially all of our assets.  TheSecurities Purchase Agreement also provides Laurus a right of first refusal onfuture financing arrangements during the Term. In the event Laurus declines to exercise its right of first refusal, ithereby agrees to enter into such documentation as shall be reasonable requestedby the Company in order to subordinate its rights under the Series B PreferredStock to the subsequent financier.  Nofinancial covenants exist.  We willutilize the proceeds of this financing to commercialize our explosivesdetection system and for general working capital purposes.  The securities were sold pursuant to anexemption contained in Rule 506.  As ofJune 30, 2004, all shares of Series B Preferred Stock and related accrueddividends had been converted into 371,336 shares of common stock.

 

OnNovember 25, 2003, we issued 250,000 shares of Series C 5% CumulativeConvertible Preferred Stock (“Series C”) having a stated value of $10 pershare, pursuant to a Securities Purchase Agreement executed onNovember 25, 2003 with the Laurus Master Fund, Ltd. We received $2,500,000in gross proceeds, less a management and placement agent fee of approximately$125,000, and related transaction costs of approximately $86,000.  The terms of the Series C provide forrepayment with shares of our common stock or in cash, pursuant to

 

12

----

 

an amortization schedule. Repayment of the Series C commences on March 31, 2004.  We have the sole option to determine whetherto satisfy payment of the monthly amount in full on each repayment date eitherin cash or in shares of common stock, or a combination of both.  If the payment of the monthly amount is madein common stock, the fixed conversion price is $6.75.  We also issued to Laurus a warrant topurchase 50,000 shares of common stock at $8.44 per share and 50,000 shares ofcommon stock at $10.13 per share.  TheSecurities Purchase Agreement also provides for a security interest in substantiallyall of our assets and provides Laurus a right of first refusal on futurefinancing arrangements during the Term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it hereby agrees to enter into such documentation asshall be reasonable requested by us in order to subordinate its rights underthe Series C to the subsequent financier. We will utilize the proceeds of this financing to purchase an ionimplanter and for general working capital purposes.  The securities were sold pursuant to anexemption contained in Rule 506. As of June 30, 2004, 118,125 shares ofSeries C Preferred Stock had been converted into 175,000 shares of commonstock.

 

On June 17,2004, we issued 468,604 shares of our common stock at $10.67 per share, in aprivate placement with the following four investors: Truk Opportunity Fund LLC;Truk International Fund LP; Basso Multi-Strategy Holding Fund Ltd; Basso EquityOpportunity Holding Fund Ltd.  We received$5,000,000 in gross proceeds, less placement agent fees of approximately$250,000 and related transaction costs of approximately $60,000.  The stock was issued at a 15% discount of itsfair market value on the date of issuance.

 

In connection withthe common stock transaction, we issued warrants to the investors to purchase117,152 shares of common stock at an exercise price of $14.43 per share, whichare exercisable through June 16, 2009. In addition, the investors have rights to purchase up to 215,330 sharesof common stock at a price of $11.61 per share, which are exercisable for aperiod commencing on June 17, 2004 and ending on the earlier of (i) 100days after July 26, 2004, the effective date of the registration statementor (ii) February 16, 2005.  We alsoissued warrants to the placement agent to purchase 15,936 shares of our commonstock at an exercise price of $14.43 per share, which are exercisable unitJune 16, 2009.  Should the investorsexercise these additional investment rights, the placement agent will receivean additional warrant for 7,968 shares at an exercise price of $12.55 pershare.  The securities were sold pursuantto an exemption contained in Rule 506.

 

**ITEM6.****  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

Over the pasttwenty years, Implant Sciences Corporation has developed core technologiesusing ion implantation and thin film coatings for medical device applicationsand has proprietary processes and equipment for the manufacture of medicaldevices for radiation therapy.  Thistechnology has been applied to the manufacture of our I-Plant radioactiveprostate seeds using a dry fabrication process which we believe is morecost-effective and less hazardous than conventional processes which useradioactive wet chemistry.  We believethat the opportunities for radioactive prostate seeds will continue to grow asan attractive alternative to other methods of treatment.  We have expanded our radiation therapyproducts to include a radiation delivery system, currently under development,to provide breast cancer treatment using accelerated partial breast irradiationtherapy.  We believe this system willbecome the treatment of choice for women following lumpectomy.  The Company is also developing a new devicefor the treatment of ocular melanoma using brachytherapy, which we believe willprovide a better distribution of radiation within the tumor while providingless discomfort for the patient.  TheCompany also has numerous other radiation therapy devices in various stages ofdevelopment including devices for biliary duct cancer, brain cancer andintravascular radiation therapy.

 

We are alsoapplying our ion implantation technologies to modify surfaces to reducepolyethylene wear generation in orthopedic joint implants, manufactured by theStryker-Orthopaedics Division of Stryker Corporation.  We also supply ion implantation services tonumerous semiconductor manufacturers, research laboratories and universities.

 

Since May 1999, wehave been performing research to develop a trace explosives detector, whichcould be used to detect hidden bombs in airports and other public places.  This technology is yet another application ofour ion source technology.  At present,we are developing both portable and bench-top systems for use in airports andDepartment of Defense facilities. Prototype units have been transported to the Department of Defense andDepartment of Transportation facilities for demonstration and evaluation.  We currently have one issued United Statespatent and seven United States patents pending covering these technologies andprocesses.

 

13

----

 

**RESULTSOF OPERATIONS**

 

The following is a discussion and analysis of thefinancial condition and results of operation of the Company for the years endedJune 30, 2004 and 2003.  It shouldbe read in conjunction with the financial statements and notes theretoappearing elsewhere herein.

 

*Year Ended June 30, 2004 vs. June 30, 2003*

 

*Revenues.*  Total revenuesfor the year ended June 30, 2004 were $8,566,000 as compared to $6,696,000for the comparable prior year period, an increase of $1,870,000 or 28%.  The increase is attributable primarily torevenue recognized from the performance of government research and developmentcontracts.  The revenue recognized fromgovernment contract and other increased by $1,811,000 or 135%, from $1,346,000in 2003 to $3,157,000 in 2004.  Thisincrease is primarily a result of new government contracts to develop explosivesdetection products using our Laser Ion Mobility Spectrometry (“IMS”)technology.  While the revenue from thesales of our radioactive prostate seeds increased by $113,000 or 4%, from$2,631,000 to $2,744,000 in 2003 and 2004, respectively, the actual seed volumedecreased by 18%.  The decrease in seedvolume was offset by an increase in the average seed price due to the valueadded items offered to our customers, such as preloaded needles with strandedor unstranded seeds.  Management believesthat this trend of decreased volume may continue.  This is due in part to competition in themarketplace and continued downward pressure.

 

In thefirst quarter of fiscal 2004, the Company entered into a new agreement withMED-TEC, our former exclusive distributor of I-Plant prostate seeds to replacethe original Distributor Agreement, which had expired.  This new agreement outlined an orderlytransition of the direct sales responsibilities for the I-Plant prostate seedto the Company.  MED-TEC also agreed notto compete with the Company for a period of three years.  Implant Sciences is paying MED-TEC an averageof approximately $39,000 per month over 28 months, beginning September 1,2003.

 

Revenuesfrom medical and industrial coatings were $1,731,000 as compared to $1,832,000for the prior year, a decline of $101,000 or 6%.  The decrease in revenues from medical andindustrial coatings is due primarily to a $95,000 decrease in medical coatingsales resulting from certain customers pursuing different product processes notrequiring radiopacity and the completion of a research and development programfor a customer in fiscal 2003.  Themedical coating revenue has been very stable. We are currently constructing a new piece of capital equipment toincrease our processing capacity and revenue. This is expected to be completed within the next nine months.  The sales of our semiconductor servicesincreased $82,000 or 9% in the year ended June 30, 2004.

 

Combined sales to our two major customers, the UnitedStates government and the Stryker-Orthopaedics Division of Stryker Corporation,accounted for 53% and 45% of gross revenues in the years ended June 30,2004 and 2003, respectively.  Our salesto these customers increased as a percentage of total revenues as a result ofthe growth in our government contract and grant revenue.  Our government contract and grant revenueaccounted for 35% and 20% of revenue for the years ended June 30, 2004 and2003, respectively.  This increase is a resultof our receiving several new grants and contracts, primarily related to our explosivesdetection product development.  Our grantrevenues, principally Small Business Innovative Research programs, fluctuatedue to: (a) our desire to obtain external funding for our research anddevelopment efforts; (b) the availability of government funding; and (c) thetime required to obtain approval of a grant application.  We have been successful in obtaining SmallBusiness Innovative Research grants in fiscal 2004 and 2003.  We expect to continue to seek continuation orreplacement of our existing Small Business Innovative Research grants in fiscal2005.

 

*Cost of Product and Contract Research Revenues*.  Cost of revenues for the year endedJune 30, 2004 was $6,186,000 as compared to $5,363,000 for the comparableprior year period, an increase of $823,000 or 15%.  The overall increase in cost is primarily aresult of the expenses relating to the performance of the many new governmentcontracts and grants awarded in the year ended June 30, 2004.  This represents an overall improvement ingross margin of 40%, from 20% in 2003 to 28% in 2004.  Cost of product revenues for the year endedJune 30, 2004 was $3,976,000 as compared to $4,147,000 for the comparableprior year period, a decrease of $171,000 or 4%.  This results in improved gross margins of 26%for the year ended June 30, 2004 as compared to 22% for the comparableprior year period.  The improvement inthe gross margin from product revenue is attributable to higher prices earnedon prostate seed sales and improved utilization in our semiconductorbusiness.  Cost of government contractsand other for the year ended June 30, 2004 was $2,210,000 as compared to$1,216,000 for the comparable prior year period, an increase of $994,000 or82%.  This increase is primarily relatedto the costs associated with the increase in contract research revenue, whichwas funded by the U.S. government. During fiscal 2004 and 2003, we utilized Small Business InnovativeResearch grants as a source of funding for our research and developmentefforts.  Our obligation with respect tothese grants is to perform the research on a best-efforts basis.  Periodically, we may

 

14

----

 

continue our research and development efforts related to these projectsat our own expense.  This cost isconsidered company-funded research and development.

 

*Research and Development*.  Research and development expense for the yearended June 30, 2004 was $1,631,000 as compared to $1,776,000 for thecomparable prior year period, a decrease of 145,000 or 8%.  These expenses include $300,000 and $141,000of stock-based compensation expense, respectively.  The decrease is the result of the increasedgovernment contract and grant awards which allowed us to decrease Companyfunded research and development expenses. The Company continues to work in the areas of explosives and toxicsubstance detection, temporary brachytherapy and radioactive prostate seedproduct compliments.

 

*Selling, General and Administrative*.  Selling, general and administrative expensesfor the year ended June 30, 2004 were $4,634,000 as compared to $2,326,000for the comparable prior year period, an increase of  $2,308,000 or 99%.  Included in selling, general andadministrative costs for the year ended June 30, 2004 was approximately$1,279,000 related to stock-based compensation and $383,000 of amortizationexpense relating to the MED-TEC non-compete agreement as compared to $167,000and $0, respectively, for the comparable prior year period.  Accordingly, selling, general andadministrative expenses for the year ended June 30, 2004, net of thecharges for stock-based compensation and amortization expense, were $2,972,000as compared to $2,159,000 for the comparable prior year period, an increase of$813,000 or 38%.  This increase isprimarily related to the expenses associated with the addition of four (4)regional sales representatives to promote the sales of our I-Plant radioactiveseed as well as a Director of Marketing for our trace detectiontechnology.  In addition, travel to tradeshows and advertising expenses increased as we continue to market theseproducts.

 

*Other Income and Expenses, Net*.  For the year ended June 30, 2004, werecorded other expense, net, of $127,000 as compared to $0, in the comparableprior year period.  The increase in otherexpense, net, is primarily attributable the interest expense relating theAxcelis financing combined with the losses realized from the investment inCorNova and the impairment of the Epsilon Medical investment.

 

*NetLoss.*  Net loss for theyear ended June 30, 2004 was $4,012,000 as compared with $2,769,000 forthe comparable prior year period, an increase in net loss of $1,243,000 or45%.  Net loss for June 30, 2004includes an approximate charge of $1,668,000 related to stock-based compensationas compared to $308,000 in the comparable prior year period.  Accordingly, the net loss for the year endedJune 30, 2004, before giving effect to the charge for stock-basedcompensation is $2,433,000 as compared to $2,461,000 for the comparable prioryear period.  This decrease in net lossis attributable, in part, to the marked increase in government contract andgrant revenue received relating to the continued development work in the areasof explosives and toxic substance detection, temporary brachytherapy andradioactive prostate seed product compliments.

 

Additionally, during the fiscal year endedJune 30, 2004, we recognized approximately $2,527,000 as a preferreddistribution, which included accretion of dividends, the beneficial conversionfeature and amortization of warrants for each of the Series A, B, and CPreferred Stock, in the amounts of $564,000, $1,287,000 and $638,000,respectively, and $38,000 relating to the estimated fair value of the extensionof certain warrants issued in connection with our initial public offering.  During the year ended June 30, 2003, werecognized approximately $891,000 as a preferred distribution, which includedthe accretion of dividends, the beneficial conversion feature and theamortization of warrants for the Series A Preferred Stock in the amount of$696,000 and $195,000 relating to estimated fair value of the extension ofcertain warrants issued in connection with our initial public offering.  The effect of these transactions had nooverall effect on stockholders’ equity or cash, but increased net loss pershare applicable to common shareholders by $0.35 and $0.14 per share for theyears ended June 30, 2004 and 2003, respectively.  The basic and diluted net loss per shareapplicable to common shareholders for the period ended June 30, 2004 was($0.90) per share as compared to ($0.58) per share for the comparable prioryear period, an increase in net loss applicable to common shareholders pershare of $0.32 or 55%.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

As of June 30, 2004, we had approximately$6,906,000 in the form of cash and cash equivalents.  During the year ended June 30, 2004,operating activities used cash of approximately $2,647,000.  Net cash used by operating activitiesprimarily reflects the $4,012,000 net loss and an $8,000 increase in inventory,a $171,000 decrease in accounts payable, stock-based compensation of$1,668,000, and depreciation and amortization of $1,263,000.  During the year ended June 30,****2004, investing activities used cash of approximately$500,000, which was primarily attributable to $355,000 used in the purchases ofproperty and equipment.  During the yearended June 30,

 

15

----

 

2004, financing activities provided approximately $9,094,000 incash.  Net cash provided by financingactivities primarily includes proceeds from the exercise of stock options andwarrants in the approximate amount of $1,661,000, proceeds from the issuance ofSeries B and Series C in the amount of $4,100,000 and the proceeds from aprivate placement of $4,689,000.  Netcash provided by financing was also offset by payments on our long term debt of$1,579,000.

 

On October 7, 2002, the Company issued 250,000shares of Series A 7% Cumulative Convertible Preferred Stock (“Series A”)having a stated value of $10 per share, pursuant to a Securities PurchaseAgreement executed on October 7, 2002 with the Laurus Master Fund, Ltd(Laurus). The Company received $2,500,000 in gross proceeds, less a managementand placement agent fee of approximately $300,000, and related transactioncosts of approximately $101,000.  .  The Company also granted the investor asecurity interest in substantially all of the Company’s assets.  In connection with the issuance of the SeriesA, the investor received a warrant to purchase 55,000 shares of the Company’scommon stock.  The common stock purchasewarrant may be exercised at any time and is valid for five years from the dateof issuance at an exercise price of $6.23 per share.

 

In accordance with the provisions of Emerging IssuesTask Force (EITF) Issue 00-27, “Application of EITF Issue No. 98-5 ‘Accountingfor Convertible Securities with Beneficial Conversion Features of ContingentlyAdjustable Conversion Ratios’, to Certain Convertible Securities”, which becameeffective in November 2000, the allocated value of the Series A containeda beneficial conversion feature calculated based on the difference between theeffective conversion price of the proceeds allocated to the Series A and the fairmarket value of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $537,000. The discount was being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to the mandatoryredemption date of April 7, 2004 or the actual conversion date, whicheveris earlier.

 

The Company valued the Series A at issuance at$1,434,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $2,099,000 ($401,000of issuance costs incurred), amount allocated to warrants of $128,000, and theamount of the discount related to the value of beneficial conversion feature of$537,000.  The Company was accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $2,500,000 at April 7, 2004, or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend during the period ofredemption.

 

As of June 30, 2004, all amounts were fully accretedand the principal balance of the Series A has been fully converted.  All Series A shares have been converted into672,458 shares of common stock.  Duringthe years ended June 30, 2004 and 2003, approximately $564,000 and$696,000, respectively, were accreted.

 

On August 28,2003, the Company issued 200,000 shares of Series B 5% Cumulative ConvertiblePreferred Stock (“Series B”) having a stated value of $10 per share, pursuantto a Securities Purchase Agreement executed on August 28, 2003 with Laurus..  The Company received $2,000,000 ingross proceeds, less a management and placement agent fee of approximately$108,000, and related transaction costs of approximately $70,000.  The terms of the Series B provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  The Company alsoissued to Laurus a warrant to purchase 25,000 shares of common stock at $6.88per share and 45,000 shares of common stock at $8.25 per share.  The Securities Purchase Agreement alsoprovides for a security interest in substantially all of the Company’s assetsand provides Laurus a right of first refusal on future financing arrangementsduring the Term of the agreement.

 

In accordance with the provisions of EITF Issue 00-27,the allocated value of the Series B contained a beneficial conversion featurecalculated based on the difference between the effective conversion price ofthe proceeds allocated to the Series B and the fair market value of the commonstock at the date of issuance.  Thediscount arising from the beneficial conversion feature aggregated$826,000.  The discount was beingamortized and recorded as a preferred dividend during the period from theissuance of the preferred stock to the mandatory redemption date ofMarch 1, 2005, or the actual conversion date, whichever is earlier.

 

The Company valued the Series B at issuance to be$812,000 based on the relative fair market values of the financial instrumentsissued in connection with this placement, net of offering costs, and thebeneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $1,822,000 ($178,000of issuance costs incurred), amount allocated to warrants of $184,000, and theamount of the discount related to the value of beneficial conversion feature of$826,000.  The

 

16

----

 

Company accreted these discounts on the carrying value of the preferredstock to its redemption value of $2,000,000. The accretion of these amounts was being recorded as a preferreddividend in the period of redemption.  Asof June 30, 2004, all amounts were fully accreted and the principalbalance of the Series B has been fully converted.  During the year ended June 30, 2004, theCompany accrued approximately $63,000 of dividends. All Series B shares andrelated accrued dividends had been converted into 371,336 shares of commonstock.  During the year endedJune 30, 2004, approximately $1,287,000 was accreted. 

 

OnNovember 25, 2003, the Company issued 250,000 shares of Series C 5%Cumulative Convertible Preferred Stock (“Series C”) having a stated value of$10 per share, pursuant to a Securities Purchase Agreement executed on November 25,2003 with Laurus .  The Company received$2,500,000 in gross proceeds, less a management and placement agent fee ofapproximately $125,000, and related transaction costs of approximately $86,000.  The terms of the Series C provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  Repayment of theSeries C commenced on March 31, 2004. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both.  If the payment of the monthly amount is madein common stock, the fixed conversion price is $6.75.  The Company also issued to Laurus a warrantto purchase 50,000 shares of common stock at $8.44 per share and 50,000 sharesof common stock at $10.13 per share.  TheSecurities Purchase Agreement also provides for a security interest insubstantially all of the Company’s assets and provides Laurus a right of firstrefusal on future financing arrangements during the Term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, Laurus hereby agrees to enter into such documentationas shall be reasonably requested by the Company in order to subordinate itsrights under the Series C agreement to the subsequent financier.  The Company is utilizing the proceeds of thisfinancing to purchase an ion implanter and for general working capitalpurposes.

 

In accordance with the provisions of EITF Issue 00-27,the allocated value of the Series C contained a beneficial conversion featurecalculated based on the difference between the effective conversion price ofthe proceeds allocated to the Series C and the fair market value of the commonstock at the date of issuance.  Thediscount arising from the beneficial conversion feature aggregated$700,000.  The discount is being accretedand recorded as a preferred dividend during the period from the issuance of thepreferred stock to the mandatory redemption date of June 1, 2005, or theactual conversion date, whichever is earlier using the effective interestmethod.

 

The Company valued the Series C at issuance to be$1,284,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $2,289,000 ($211,000of issuance costs incurred), the amount allocated to warrants of $305,000, andthe amount of the discount related to the value of beneficial conversionfeature of $700,000.  The Company isaccreting these discounts on the carrying value of the preferred stock to itsredemption value of $2,500,000 through June 1, 2005, or the actualconversion date, whichever is earlier. The accretion of these amounts is being recorded as a preferred dividendin the period of redemption.

 

As of June 30, 2004, 118,125 shares of Series Cwere converted into 175,000 shares of common stock at the price of $6.75 pershare.  The outstanding principal atJune 30, 2004, is $1,318,750. During the year ended June 30, 2004,approximately $638,000 was accreted. During the year ended June 30, 2004, the Company accruedapproximately $64,000 of dividends.

 

We are developing several explosive detection systemsthat could be used in airports, public and government buildings, and sportingevent facilities.  The systems use ourproprietary Laser IMS technology, which includes the use of laser beams incombination with ion mobility spectrometry, to electronically detect minutequantities of explosive vapor molecules in the air.  This project has been ongoing since approximatelyMay 1999.  In November 2001, wedeveloped a portable prototype and in December 2001 we demonstrated it tothe U.S. Department of Transportation. Following this demonstration, we decided to pursue the technology.  At present, we are developing both portableand bench-top systems for use in airports and Department of Defensefacilities.  Prototype units have beentransported to the Department of Defense and Department of Transportationfacilities for demonstration and evaluation.

 

This project is currently being undertaken by both ourinternal scientists and outside contractors. The development of new applications is typically funded throughgovernment grants or internal funding. Originally, we funded a research and development program for theelectronic detection system to produce enough data to write grant proposals forthe Department of Defense to detect unexploded bombs and mines.  Since March 2000, we have

 

17

----

 

received seven contracts totaling $1,789,000 for detection of toxic chemicalsor explosives from agencies such as the Departments of the Army, Air Force,Marine Corps and Navy; as well as the National Institutes of Health and theDepartment of Homeland Security.  Inaddition, on August 12, 2002, we signed a Cooperative Research andDevelopment Agreement with an agency of the Department of Homeland Securitywhich will permit us and the government to exchange critical test data and forus to deliver a certain number of units to the Department of Homeland Securityfor independent evaluation and field testing.

 

In June 2000, we developed our first generationdevice, which demonstrated sensitivity to the explosive TNT.  In June 2001, we developed a secondgeneration prototype with increased sensitivity and selectivity.  This device can detect and specify anincreasing number of compounds within various explosive materials.  The explosives that have been tested to dateare TNT, RDX, PETN, EGDN, and DNT.  RDXis the primary component of C3 and C4 explosives, such as Datasheet and Semtex,as well as certain types of black powder explosives.  We believe these explosives represent themajority of the explosives presently used in terrorist activities.  After the attack on the World Trade Centeroccurred on September 11, 2001, management made the decision to continuethe internal funding of the project rather than await funding throughgovernment grants.  Our electronicdetection system has been subjected to controlled testing by third parties andsuccessfully detected C4.  As a result ofthe successful demonstration, we believed it was appropriate to further pursuethe commercial development of our electronic detection system device.

 

Consistent with our policy to protect our proprietarytechnologies, we have submitted six patent applications to the United StatesPatent and Trademark Office.  Thesepatent applications will cover specific design configurations that areresponsible for our improved vapor detection sensitivity.

 

We are developing several versions of our explosivesdetection systems, including: (i) a table-top unit, which can be used to screenpassengers and carry-on baggage in airports; and (ii) a portable system, whichcan be used to replace bomb-sniffing dogs to clear buildings, aircrafts, orships where hidden bombs are believed to exist. We received $600,000 from the U.S. Navy in November 2002 forfurther development of the portable device. This device was delivered to the U.S. Navy for testing in May 2003.  Tests were successfully completed and inDecember 2003, the U. S. Navy awarded the Company an additional $1,300,000to turn this prototype into a manufacturable unit and deliver three units fortesting.    We plan to first market thesesystems to U.S. government agencies for use in airports, government buildingsand facilities.

 

Although our operations and spending continue to focuson the sales of our semiconductor, contract manufacturing, medical coatings andprostate seed products, we are currently expending significant resources in thedevelopment of our explosives detection devices.  We continue to fund as much research anddevelopment as possible through government grants in accordance with theprovisions of the respective grant awards. We will require additional funding in order to advance the commercialdevelopment of the explosives detection system. We will attempt to obtain such financing by: (i) government grants, (ii)the exercise of the redeemable common stock purchase warrants, (iii) privatefinancing, or (iv) strategic partnerships. However, there can be no assurance that we will be successful in ourattempts to raise such additional financing.

 

We will require substantial funds for further researchand development, regulatory approvals and continued expansion ofcommercial-scale manufacturing capabilities, and the marketing of ourproducts.  Our capital requirementsdepend on numerous factors, including but not limited to, the progress of ourresearch and development programs; the cost of filing, prosecuting, defendingand enforcing any intellectual property rights; competing technological andmarket developments; changes in our development of commercialization activitiesand arrangements; and the purchase of additional facilities and capitalequipment.

 

As of June 30, 2004, we were conducting ouroperations with approximately $6,906,000 in cash and cash equivalents.  We estimate such amounts combined with ourcash flow from operations will be sufficient to fund our working capital in thenext twelve months.  Future expendituresfor research and product development, especially relating to outside testing,are discretionary and, accordingly, can be adjusted, as can certain selling,general and administrative expenses, based on the availability of cash.

 

The Company’s future minimum payments undercontractual obligations related to capital leases, operating leases and termnotes as of June 30, 2004 are as follows:

 

18

----

 
| ** **                | ** ** | **Capital  Leases** | ** ** | **Operating  Lease** | ** ** | **Axcelis  Technologies,  Inc. (1)** | ** ** | **MED-TEC (2)** | ** ** | **Total** | ** ** |
|---------------------------|------------|---------------------|------------|----------------------|------------|--------------------------------------|------------|-----------------|------------|-----------|------------|
| Year ending June 30: |       |                |       |                 |       |                                 |       |            |       |      |       |
| 2005                      |       | $                   | 4,000      |                 | $          | 557,000                              |       | $               | 97,000     |      | $          | 394,000 |   | $ | 1,052,000 |   |
| 2006                      |       | 5,000               |       | 609,000              |       |                                 |       | 212,000         |       | 826,000   |       |
| 2007                      |       | 1,000               |       | 610,000              |       |                                 |       |            |       | 611,000   |       |
| 2008                      |       |                |       | 611,000              |       |                                 |       |            |       | 611,000   |       |
| 2009                      |       |                |       | 306,000              |       |                                 |       |            |       | 306,000   |       |
|                      |       |                |       |                 |       |                                 |       |            |       |      |       |
| Total                     |       | $                   | 10,000     |                 | $          | 2,693,000                            |       | $               | 97,000     |      | $          | 606,000 |   | $ | 3,406,000 |   |

 

----

(1)  Should theCompany fail to pay the balance in full, Axcelis has the right to recover thesystem from the Company.  As ofSeptember 30, 2004, this obligation has been paid in full.

 

(2) Relates to MED-TEC payment obligation (See Note 15of financial statements).

 

On June 30, 2004, weentered into an employment agreement with Dr. Anthony J. Armini, the Company’sPresident and CEO, with an initial term of three years and an automatic renewalfor a successive period of three years, unless the we or Dr. Armini give theother party not less than three months written notice of non-renewal.  Under this employment agreement, Dr. Armini servesas our president and chief executive officer at a base salary of up to$210,000.  In addition, Dr. Armini mayparticipate in our employee fringe benefit plans or programs generallyavailable to employees of comparable status and position.  We are entitled to terminate his employmentfor any material breach of his employment agreement at any time upon at least30 days written notice.  In the event weterminate Dr. Armini’s employment without cause, we will pay him 12 monthssalary.  Under his employment agreement,he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Dr.Armini is subject to a non-competition provision.

 

On June 30, 2004, we entered into an employmentagreement Dr. Stephen Bunker, the Company’s Vice President and Chief Scientist,with an initial term of three years and an automatic renewal for a successiveperiod of three years, unless the we or Dr. Bunker give the other party notless than three months written notice of non-renewal.  Under this employment agreement, Dr. Bunkerserves as our vice president and chief executive scientist at a base salary ofup to $150,000.  In addition, Dr. Bunkermay participate in our employee fringe benefit plans or programs generallyavailable to employees of comparable status and position.  We are entitled to terminate his employmentfor any material breach of his employment agreement at any time upon at least30 days’ written notice.  In the event weterminate Dr. Bunker’s employment without cause, we will pay him 12 monthssalary.  Under his employment agreement,he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Dr.Bunker is subject to a non-competition provision.

 

*Critical Accounting Policies*

 

Our significantaccounting policies are described in Note 2 to the financial statementsincluded in Item 7 of our Form 10-KSB as of June 30, 2004.  Our discussion and analysis of our financialcondition and results of operations are based upon the financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities.  On an on-going basis,we evaluate our estimates, including those related to bad debts, productreturns, inventories, investments, intangible assets and warrantyobligations.  We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. In the past, actual results have not been materially different from ourestimates.  However, results may differfrom these estimates under different assumptions or conditions.  There has been no change to our criticalaccounting policies during the year ended June 30, 2004.

 

The Company hasidentified the following as critical accounting policies, based on thesignificant judgments

 

19

----

 

and estimates used in determining the amounts reported in its financialstatements:

 

•                  *Revenue Recognition –Product and Government Contract Revenues*

 

The Companyrecognizes revenue when there is persuasive evidence of an arrangement with thecustomer which states a fixed and determinable price and terms, delivery of theproduct has occurred or the service performed in accordance with the terms ofthe sale, and collectibility of the sale is reasonably assured.

 

Government contract revenue under cost-sharingresearch and development agreements is recognized as eligible research anddevelopment expenses are incurred.  TheCompany’s obligation with respect to these agreements is to perform theresearch on a best-efforts basis.  Forgovernment contracts with a deliverable, revenue is recognized on a percentageof completion basis.

 

•                  *Accounts Receivable and Allowance for DoubtfulAccounts*

 

The Company maintains allowances for estimated losses resulting fromthe inability of its customers to make required payments.  Judgments are used in determining theallowance for doubtful accounts and are based on a combination of factors.  Such factors include historical collectionexperience, credit policy and specific customer collection issues.  In circumstances where the Company is awareof a specific customer’s inability to meet its financial obligations to us(e.g., bankruptcy filings), we record a specific reserve for bad debts againstamounts due to reduce the net recognized receivable to the amount we reasonablybelieve will be collected.  We performongoing credit evaluations of our customers and continuously monitor collectionsand payments from our customers.  Whileactual bad debts have historically been within our expectations and theprovisions established, we cannot guarantee that we will continue to experiencethe same bad debt rates that we have in the past.  A significant change in the liquidity orfinancial position of any of our customers could result in the uncollectibilityof the related accounts receivable and could adversely impact our operatingcash flows in that period.

 

•                  *Sales Returns and Allowances*

 

The Company records reductions to revenue for estimated customerreturns and allowances. We record estimated allowances against revenues in thesame period the revenue is recorded. These estimates are based upon historical analysis of our credit memodata and other known factors for pricing and disputes that arise in the normalcourse of business.  To date, allowanceshave not been significant.  Actualreturns may differ significantly from our estimates if factors such as economicconditions or competitive conditions differ from our expectations.

 

•                  *Inventories*

 

We value our inventories at lower of cost or market.  Cost is determined by the first-in, first-out(FIFO) method, including material, labor and factory overhead.  In assessing the ultimate realization ofinventories, management judgment is required to determine the reserve forobsolete or excess inventory.  Inventoryon hand may exceed future demand either because the product is excess, orbecause the amount on hand is more than can be used to meet future need.  We provide for the total value of inventoriesthat we determine to be obsolete or excess based on criteria such as customerdemand and changing technologies.  AtJune 30, 2004, our inventory consisted of:

 
| Raw materials      |   | $       | 308,000 |   |
|--------------------|--------|---------|---------|--------|
| Work-in-progress   |   | 97,000  |    |
| Finished goods     |   | 157,000 |    |
| Inventory  Reserve |   | (81,000 | )       |
|               |   | $       | 481,000 |   |

 

•                  *Warranties*

 

We provide for the estimated cost of product warranties at the timerevenue is recognized.  We record anestimate for warranty related costs at the time of sale based on our actualhistorical return rates and repair costs. While our warranty costs have historically been within our expectationsand

 

20

----

 

the provisions established, we cannot guarantee that we will continueto experience the same warranty return rates or repair costs that we have inthe past.  A significant increase inwarranty return rates or costs to repair our products could have a materialadverse impact on our operating results for the period or periods in which suchreturns or additional costs materialize.

 

•                  *Valuation of Certain Marketable Equity Securities*

 

The Company currently classifies its investment securities asavailable-for-sale securities. Pursuant to Statement of Financial AccountingStandards (SFAS) No. 115, “Accounting for Certain Investments in Debt andEquity Securities” such securities are measured at fair market value in thefinancial statements with unrealized gains or losses recorded in accumulatedother comprehensive income until the securities are sold or otherwise disposedof.  However, in accordance with SFAS No.115, a decline in fair market value below cost that is other than temporary isaccounted for as a realized loss.  Todate, we have not experienced any realized losses.

 

•      *Income Taxes*

 

The income tax accounting process involves estimating our actualcurrent exposure together with assessing temporary differences resulting fromdiffering treatment of items for tax and accounting purposes.  These differences result in the recognitionof deferred tax assets and liabilities. We must then record a valuation allowance to reduce our deferred taxassets to the amount that is more likely than not to be realized.

 

Significant management judgment is required in determining ourprovision for income taxes, our deferred tax assets and liabilities and anyvaluation allowance recorded against deferred tax assets.  We have recorded a full valuation allowanceagainst our deferred tax assets of $6,359,000 as of June 30, 2004, due touncertainties related to our ability to utilize these assets.  The valuation allowance is based on ourestimates of taxable income and the period over which our deferred tax assetswill be recoverable.  In the event thatactual results differ from these estimates or we adjust these estimates infuture periods we may need to adjust our valuation allowance which couldmaterially impact our financial position and results of operations.

 

Recent Accounting Pronouncements

 

In December 2003, the Securities and Exchange Commission (“SEC”)published Staff Accounting Bulletin (“SAB”) No. 104, “RevenueRecognition.”  SAB No. 104 was effectiveupon issuance.  The adoption of SAB No.104 did not have an effect on the Company’s financial position, results ofoperations, or cash flows. 

 

**ITEM 7.****                             FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

Our Financial Statementsand Related Report of Independent Registered Public Accounting Firm arepresented in the following pages.  TheFinancial Statements filed in this Item 7 are as follows:

 

21

----

 
|                                                                                                                                 | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------------|----------|
| Report  of Independent Registered Public Accounting Firm                                                                        | 23       |
| Balance  Sheet as of June 30, 2004                                                                                              | 24       |
| Statements  of Operations for the years ended June 30, 2003 and 2004                                                            | 25       |
| Statements  of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the  years ended June 30, 2003 and 2004 | 26       |
| Statements  of Cash Flows for the years ended June 30, 2003 and 2004                                                            | 28       |
| Notes to Financial  Statements                                                                                                       | 30       |

 

22

----

 

**Report of Independent Registered Public Accounting Firm**

 

The Board of Directors and Stockholders

Implant Sciences Corporation:

 

We have audited the accompanying balance sheet of Implant SciencesCorporation as of June 30, 2004 and the related statements of operations,stockholders’ equity and comprehensive income (loss) and cash flows for each ofthe two years in the period ended June 30, 2004.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the financial position of Implant SciencesCorporation at June 30, 2004, and the results of its operations and itscash flows for each of the two years in the period ended June 30, 2004, inconformity with accounting principles generally accepted in the United Statesof America.

 

 
|                    | /s/ BDO Seidman, LLP |   |
|-------------------------|----------------------|--------|
|                    |                 |
|                    |                 |
| Boston, Massachusetts   |                 |
| September 21, 2004 |                 |

 

23

----

 

**IMPLANTSCIENCES CORPORATION**

**BALANCE SHEET**

 
| ** **                                                                                                                                          | ** ** | **June 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                          |       |                    |       |
| Current assets:                                                                                                                                     |       |                    |       |
| Cash and cash  equivalents (Note 2)                                                                                                                 |       | $                       | 6,906,000  |   |
| Accounts  receivable, less allowance of $89,000 (Note 2)                                                                                            |       | 709,000                 |       |
| Accounts  receivable, unbilled (Notes 2 and 7)                                                                                                      |       | 1,434,000               |       |
| Inventories  (Notes 2 and 3)                                                                                                                        |       | 481,000                 |       |
| Investments -  available for sale securities (Note 9)                                                                                               |       | 419,000                 |       |
| Prepaid expenses  and other current assets (Note 16)                                                                                                |       | 140,000                 |       |
| Total current  assets                                                                                                                               |       | 10,089,000              |       |
|                                                                                                                                                |       |                    |       |
| Property and  equipment, net (Notes 2, 4 and 10)                                                                                                    |       | 4,308,000               |       |
| Amortizable  intangible assets, net (Note 15)                                                                                                       |       | 625,000                 |       |
| Investment in  unconsolidated subsidiary (Note 6)                                                                                                   |       | 63,000                  |       |
| Other  non-current assets                                                                                                                           |       | 139,000                 |       |
|                                                                                                                                                |       |                    |       |
| Total assets                                                                                                                                        |       | $                       | 15,224,000 |   |
|                                                                                                                                                |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                      |       |                    |       |
| Current  liabilities:                                                                                                                               |       |                    |       |
| Current  maturities of long-term debt and obligations under capital lease (Notes 10  and 15)                                                        |       | $                       | 101,000    |   |
| Payable to  Med-Tec (Note 15)                                                                                                                       |       | 394,000                 |       |
| Accrued expenses  (Note 5)                                                                                                                          |       | 740,000                 |       |
| Deferred revenue                                                                                                                                    |       | 23,000                  |       |
| Total current  liabilities                                                                                                                          |       | 1,836,000               |       |
|                                                                                                                                                |       |                    |       |
| Long-term  liabilities:                                                                                                                             |       |                    |       |
| Long-term debt  and obligations under capital lease, net of current maturities (Notes 10 and  15)                                                   |       | 6,000                   |       |
| Payable to  Med-Tec, net of current amount (Note 15)                                                                                                |       | 212,000                 |       |
| Total  liabilities                                                                                                                                  |       | 2,054,000               |       |
|                                                                                                                                                |       |                    |       |
| Commitments and  Contingencies (Note 10)                                                                                                            |       |                    |       |
|                                                                                                                                                |       |                    |       |
| Convertible  preferred stock (Note 12):  5,000,000  shares authorized                                                                          |       |                    |       |
| 7% Series A  Cumulative Redeemable Convertible Preferred Stock, $10 stated value; 250,000  shares designated; no shares issued and outstanding      |       | —                  |       |
| 5% Series B  Cumulative Redeemable Convertible Preferred Stock, $10 stated value; 200,000  shares designated; no shares issued and outstanding      |       | —                  |       |
| 5% Series C  Cumulative Redeemable Convertible Preferred Stock; $10 stated value; 250,000  shares designated; 131,875 shares issued and outstanding |       | 670,000                 |       |
|                                                                                                                                                |       |                    |       |
| Stockholders’  equity (Note 13):                                                                                                               |       |                    |       |
| Common stock,  $0.10 par value; 20,000,000 shares authorized; 8,370,338 shares issued and  outstanding as of June 30, 2004                     |       | 837,000                 |       |
| Additional  paid-in capital                                                                                                                         |       | 31,360,000              |       |
| Accumulated  deficit                                                                                                                                |       | (19,527,000             | )          |
| Deferred  compensation                                                                                                                              |       | (449,000                | )          |
| Accumualted  other comprehensive income                                                                                                             |       | 313,000                 |       |
| Treasury stock,  3,103 common shares, at cost (Note 6)                                                                                              |       | (34,000                 | )          |
| Total  stockholders’ equity                                                                                                                    |       | 12,500,000              |       |
|                                                                                                                                                |       |                    |       |
| Total  liabilities and stockholders’ equity                                                                                                    |       | $                       | 15,224,000 |   |

 

The accompanying notesare an integral part of these financial statements.

 

24

----

 

**IMPLANT SCIENCES CORPORATION**

**STATEMENTSOF OPERATIONS**

 
| ** **                                                                                                                                                                  | ** ** | **Years Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2003**                      | ** ** | **2004** | ** ** |
| Revenues:                                                                                                                                                                   |       |                          |       |   |   |
| Product  revenues:                                                                                                                                                          |       |                          |       |   |   |
| Medical                                                                                                                                                                     |       | $                             | 4,474,000  |   | $ | 4,451,000 |   |
| Semiconductor                                                                                                                                                               |       | 876,000                       |       | 958,000 |   |
| Total product  revenues                                                                                                                                                     |       | 5,350,000                     |       | 5,409,000 |   |
| Government  contracts and other (Note 7)                                                                                                                                    |       | 1,346,000                     |       | 3,157,000 |   |
| Total revenues                                                                                                                                                              |       | 6,696,000                     |       | 8,566,000 |   |
|                                                                                                                                                                        |       |                          |       |   |   |
| Costs of  revenues:                                                                                                                                                         |       |                          |       |   |   |
| Cost of product  revenues (includes $0 and $89,000 of non-cash stock-based compensation for  the years ended June 30, 2003 and 2004, respectively)                     |       | 4,147,000                     |       | 3,976,000 |   |
| Cost of  government contracts and other                                                                                                                                     |       | 1,216,000                     |       | 2,210,000 |   |
| Total costs of  revenues                                                                                                                                                    |       | 5,363,000                     |       | 6,186,000 |   |
|                                                                                                                                                                        |       |                          |       |   |   |
| Gross margin                                                                                                                                                                |       | 1,333,000                     |       | 2,380,000 |   |
|                                                                                                                                                                        |       |                          |       |   |   |
| Operating  expenses:                                                                                                                                                        |       |                          |       |   |   |
| Research and  development (includes $141,000 and $300,000 of non-cash stock-based  compensation for the years ended June 30, 2003 and 2004, respectively)              |       | 1,776,000                     |       | 1,631,000 |   |
| Selling, general  and administrative (includes $167,000 and $1,279,000 of non-cash stock-based  compensation for the years ended June 30, 2003 and 2004, respectively) |       | 2,326,000                     |       | 4,634,000 |   |
| Total operating  expenses                                                                                                                                                   |       | 4,102,000                     |       | 6,265,000 |   |
|                                                                                                                                                                        |       |                          |       |   |   |
| Loss from  operations                                                                                                                                                       |       | (2,769,000                    | )          | (3,885,000 | ) |
|                                                                                                                                                                        |       |                          |       |   |   |
| Other income  (expenses):                                                                                                                                                   |       |                          |       |   |   |
| Interest income                                                                                                                                                             |       | 27,000                        |       | 23,000 |   |
| Interest expense                                                                                                                                                            |       | (25,000                       | )          | (135,000 | ) |
| Gain on sale of  equipment                                                                                                                                                  |       | —                        |       | 35,000 |   |
| Equity losses in  unconsolidated subsidiaries (Note 6)                                                                                                                      |       | (2,000                        | )          | (50,000 | ) |
| Total other  income (expense)                                                                                                                                               |       | —                        |       | (127,000 | ) |
|                                                                                                                                                                        |       |                          |       |   |   |
| Net loss                                                                                                                                                                    |       | (2,769,000                    | )          | (4,012,000 | ) |
|                                                                                                                                                                        |       |                          |       |   |   |
| Preferred  distribution, dividends and accretion (Note 12)                                                                                                                  |       | (891,000                      | )          | (2,527,000 | ) |
|                                                                                                                                                                        |       |                          |       |   |   |
| Net loss per  share applicable to common shareholders                                                                                                                       |       | $                             | (3,660,000 | ) | $ | (6,539,000 | ) |
|                                                                                                                                                                        |       |                          |       |   |   |
|                                                                                                                                                                        |       |                          |       |   |   |
|                                                                                                                                                                        |       |                          |       |   |   |
|                                                                                                                                                                        |       |                          |       |   |   |   |   |
|                                                                                                                                                                        |       |                          |       |   |   |
| Net loss  applicable to common shareholders, basic and diluted                                                                                                              |       | $                             | (0.58      | ) | $ | (0.90 | ) |
|                                                                                                                                                                        |       |                          |       |   |   |
| Weighted average  common shares outstanding used in computing basic and diluted loss per share                                                                              |       | 6,310,748                     |       | 7,317,677 |   |

 

The accompanying notesare an integral part of these financial statements.

 

25

----

 

**IMPLANTSCIENCES CORPORATION**

**STATEMENTSOF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENVIS INCOME (LOSS)**

**FOR THE YEARS ENDED JUNE 30, 2003 AND 2004**

 
| ** **                                                                                                                                                          | ** ** | **Common Stock**      | ** ** | ** ** | ** ** | ** **                       | ** ** | ** **              | ** ** | ** **                | ** ** | **Treasury Stock**                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                             | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|----------------------------------|------------|-------------------------|------------|---------------------------|------------|-----------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                                          | ** ** | **Number of  shares** | ** ** | **Amount** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated Deficit** | ** ** | **Deferred Compensation** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Notes  Receivable  from  Employees** | ** ** | **Total  Stockholders’  Equity** | ** ** | **Comprehensive  (Loss)** | ** ** |
| Balance at June 30, 2002                                                                                                                                       |       | 6,200,901             |       | $          | 620,000    |                             | $          | 13,630,000              |       | $                         | (9,328,000 | )                                             | $          | (9,000     | )          | $          | 45,000     |                                   |       | — |   | $ | — |   | $ | (138,000 | ) | $ | 4,820,000 |   | $ | (2,149,000 | ) |
|                                                                                                                                                                |       |                  |       |       |       |                             |       |                    |       |                      |       |                                          |       |       |       |       |       |                                   |       |   |   |   |   |
| Issuance of common stock pursuant to exercise of stock options                                                                                                      |       | 23,000                |       | 3,000      |       | 97,000                           |       |                    |       |                      |       |                                          |       |       |       |       |       | (85,000                                | )          | 15,000 |   |   |   |
| Issuance of common stock pursuant to exercise of warrants                                                                                                           |       | 2,000                 |       | —     |       | 18,000                           |       |                    |       |                      |       |                                          |       |       |       |       |       |                                   |       | 18,000 |   |   |   |
| Issuance of common stock pursuant to employee stock purchase plan                                                                                                   |       | 5,934                 |       | 1,000      |       | 30,000                           |       |                    |       |                      |       |                                          |       |       |       |       |       |                                   |       | 31,000 |   |   |   |
| Issuance of common stock pursuant to private financing agreement, net  of issuance costs                                                                            |       | 8,721                 |       | —     |       | 41,000                           |       |                    |       |                      |       |                                          |       |       |       |       |       |                                   |       | 41,000 |   |   |   |
| Value of beneficial conversion feature and common stock warrants  issued in connection with the issuance of the 7% Series A Cumulative  Convertible Preferred Stock |       |                  |       |       |       | 665,000                          |       |                    |       |                      |       |                                          |       |       |       |       |       |                                   |       | 665,000 |   |   |   |
| Accretion of the beneficial conversion feature and common stock  warrants in connection with the 7% Series A Cumulative Convertible Preferred  Stock                |       |                  |       |       |       |                             |       | (533,000                | )          |                      |       |                                          |       |       |       |       |       |                                   |       | (533,000 | ) |   |   |
| Conversion of 7% Series A Cumulative Convertible Preferred Stock and  related accrued dividends into common stock                                                   |       | 409,600               |       | 41,000     |       | 1,035,000                        |       | (116,000                | )          |                      |       |                                          |       |       |       |       |       |                                   |       | 960,000 |   |   |   |
| Accretion and dividends paid on Series A Preferred Stock                                                                                                            |       |                  |       |       |       | 47,000                           |       | (47,000                 | )          |                      |       |                                          |       |       |       |       |       |                                   |       | — |   |   |   |
| Stock-based compensation associated with warrants and nonqualified  stock options issued to nonemployees                                                            |       |                  |       |       |       | 306,000                          |       |                    |       | 2,000                     |       |                                          |       |       |       |       |       |                                   |       | 308,000 |   |   |   |
| Unrealized gain on available for sale securities                                                                                                                    |       |                  |       |       |       |                             |       |                    |       |                      |       | 72,000                                        |       |       |       |       |       |                                   |       | 72,000 |   | 72,000 |   |
| Value of IPO warrant extension (Note 13)                                                                                                                            |       |                  |       |       |       | 195,000                          |       | (195,000                | )          |                      |       |                                          |       |       |       |       |       |                                   |       | — |   |   |   |
| Net loss                                                                                                                                                            |       |                  |       |       |       |                             |       | (2,769,000              | )          |                      |       |                                          |       |       |       |       |       | —                                 |       | (2,769,000 | ) | (2,769,000 | ) |
| Balance at June 30, 2003                                                                                                                                       |       | 6,650,156             |       | 665,000    |       | 16,064,000                       |       | (12,988,000             | )          | (7,000                    | )          | 117,000                                       |       | —     |       | —     |       | (223,000                               | )          | 3,628,000 |   | (2,697,000 | ) |
|                                                                                                                                                                     |            |                       |            |            |            |                                  |            |                         |            |                           |            |                                               |            |            |            |            |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanyingnotes are an integral part of these financial statements.

 

26

----

 
| ** **                                                                                                                                           | ** ** | **Common Stock**      | ** ** | ** ** | ** ** | ** **                       | ** ** | ** **               | ** ** | ** **                 | ** **  | **Treasury Stock**                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                             | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|----------------------------------|------------|--------------------------|------------|----------------------------|-------------|-----------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                           | ** ** | **Number of  shares** | ** ** | **Amount** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Deferred  Compensation** | ** **  | **Accumulated  Other  Comprehensive  Income** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Notes  Receivable  from  Employees** | ** ** | **Total  Stockholders'  Equity** | ** ** | **Comprehensive  (Loss)** | ** ** |
| ** **                                                                                                                                           | ** ** | ** **            | ** ** | ** ** | ** ** | ** **                       | ** ** | ** **               | ** ** | ** **                 | ** **  | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at June 30, 2003                                                                                                                        |       | 6,650,156             |       | $          | 665,000    |                             | $          | 16,064,000               |       | $                          | (12,988,000 | )                                             | $          | (7,000     | )          | $          | 117,000    |                                   | —     |   | $ | — |   | $ | (223,000 | ) | $ | 3,628,000 |   | $ | (2,697,000 | ) |
| Issuance of common stock pursuant to exercise of stock options                                                                                       |       | 138,635               |       | 14,000     |       | 516,000                          |       |                     |       |                       |        |                                          |       |       |       |       |       |                                   |       | 530,000 |   |   |   |
| Issuance of common stock pursuant to exercise of warrants                                                                                            |       | 186,120               |       | 19,000     |       | 1,083,000                        |       |                     |       |                       |        |                                          |       |       |       |       |       |                                   |       | 1,102,000 |   |   |   |
| Issuance of common stock pursuant to employee stock purchase plan                                                                                    |       | 7,135                 |       | 1,000      |       | 28,000                           |       |                     |       |                       |        |                                          |       |       |       |       |       |                                   |       | 29,000 |   |   |   |
| Issuance of common stock pursuant to private financing agreement, net  of issuance costs of $310,000                                                 |       | 468,604               |       | 47,000     |       | 4,642,000                        |       |                     |       |                       |        |                                          |       |       |       |       |       |                                   |       | 4,689,000 |   |   |   |
| Conversion of 7% Series A Cumulative Convertible Preferred Stock and  related accrued dividends into common stock                                    |       | 301,143               |       | 30,000     |       | 1,501,000                        |       | (32,000                  | )          |                       |        |                                          |       |       |       |       |       |                                   |       | 1,499,000 |   |   |   |
| Conversion of 5% Series B Cumulative Convertible Preferred Stock and  related accrued dividends into common stock                                    |       | 371,336               |       | 37,000     |       | 2,057,000                        |       | (63,000                  | )          |                       |        |                                          |       |       |       |       |       |                                   |       | 2,031,000 |   |   |   |
| Issuance of common stock to consultants in exchange for services                                                                                     |       | 11,205                |       | 1,000      |       | 109,000                          |       |                     |       |                       |        |                                          |       |       |       |       |       |                                   |       | 110,000 |   |   |   |
| Accretion and dividends on 7% Series A Cumulative Convertible Preferred  Stock                                                                       |       |                  |       |       |       |                             |       | (532,000                 | )          |                       |        |                                          |       |       |       |       |       |                                   |       | (532,000 | ) |   |   |
| Accretion of the beneficial conversion feature and common stock  warrants in connection with the 5% Series B Cumulative Convertible Preferred  Stock |       |                  |       |       |       | 1,009,000                        |       | (1,224,000               | )          |                       |        |                                          |       |       |       |       |       |                                   |       | (215,000 | ) |   |   |
|                                                                                                                                                 |       |                  |       |       |       |                             |       |                     |       |                       |        |                                          |       |       |       |       |       |                                   |       |   |   |   |   |
| Accretion of the beneficial conversion feature and common stock  warrants in connection with the 5% Series C Cumulative Convertible Preferred  Stock |       |                  |       |       |       | 1,005,000                        |       | (638,000                 | )          |                       |        |                                          |       |       |       |       |       |                                   |       | 367,000 |   |   |   |
| Conversion of 5% Series C Cumulative Convertible Preferred Stock                                                                                     |       | 175,000               |       | 17,000     |       | 1,164,000                        |       |                     |       |                       |        |                                          |       |       |       |       |       |                                   |       | 1,181,000 |   |   |   |
| Repayment of notes receivable from employees                                                                                                         |       |                  |       |       |       |                             |       |                     |       |                       |        |                                          |       |       |       |       |       | 223,000                                |       | 223,000 |   |   |   |
| Investment in unconsolidated subsidiaries (Note 6)                                                                                                   |       | 10,344                |       | 1,000      |       | 112,000                          |       |                     |       |                       |        | (6,000                                        | )          | 3,103      |       | (34,000    | )          |                                   |       | 73,000 |   | (6,000 | ) |
| Fair value associated with warrants and nonqualified stock options  issued to nonemployees                                                           |       | —                |       | —     |       | 992,000                          |       |                     |       | 2,000                      |        |                                          |       |       |       |       |       |                                   |       | 994,000 |   |   |   |
| Stock-based compensation associated with warrants and nonqualified  stock options issued to employees below fair market value                        |       | 50,660                |       | 5,000      |       | 1,040,000                        |       |                     |       | (444,000                   | )           |                                          |       |       |       |       |       |                                   |       | 601,000 |   |   |   |
| Unrealized gain on available for sale securities                                                                                                     |       |                  |       |       |       |                             |       |                     |       |                       |        | 202,000                                       |       |       |       |       |       |                                   |       | 202,000 |   | 202,000 |   |
| Value of underwriter IPO unit warrant extension (Note 13)                                                                                            |       |                  |       |       |       | 38,000                           |       | (38,000                  | )          |                       |        |                                          |       |       |       |       |       |                                   |       | — |   |   |   |
| Net loss                                                                                                                                             |       |                  |       |       |       |                             |       | (4,012,000               | )          |                       |        |                                          |       |       |       |       |       |                                   |       | (4,012,000 | ) |   |   |
| Balance at June 30, 2004                                                                                                                        |       | 8,370,338             |       | $          | 837,000    |                             | $          | 31,360,000               |       | $                          | (19,527,000 | )                                             | $          | (449,000   | )          | $          | 313,000    |                                   |       | 3,103 |   | $ | (34,000 | ) | $ | — |   | $ | 12,500,000 |   | $ | (2,501,000 | ) |
|                                                                                                                                                      |            |                       |            |            |            |                                  |            |                          |            |                            |             |                                               |            |            |            |            |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanyingnotes are an integral part of these financial statements.

 

27

----

 

**IMPLANT SCIENCESCORPORATION**

**STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                                               | ** ** | **Years Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                               | ** ** | **2003**                      | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities:**                                                                               |       |                          |       |   |   |
| Net loss                                                                                                                 |       | $                             | (2,769,000 | ) | $ | (4,012,000 | ) |
|                                                                                                                     |       |                          |       |   |   |
| Adjustments to  reconcile net loss to net cash used in operating activities:                                             |       |                          |       |   |   |
| Depreciation and  amortization                                                                                           |       | 800,000                       |       | 1,263,000 |   |
| Stock-based  compensation expense                                                                                        |       | 308,000                       |       | 1,668,000 |   |
| Equity loss in  unconsolidated subsidiaries                                                                              |       | 2,000                         |       | 50,000 |   |
| Changes in  operating assets and liabilities:                                                                            |       |                          |       |   |   |
| Accounts  receivable                                                                                                     |       | 138,000                       |       | (1,365,000 | ) |
| Inventories                                                                                                              |       | (21,000                       | )          | (8,000 | ) |
| Prepaid expenses  and other current assets                                                                               |       | 39,000                        |       | (102,000 | ) |
| Accounts payable                                                                                                         |       | 176,000                       |       | (171,000 | ) |
| Accrued expenses                                                                                                         |       | (110,000                      | )          | 30,000 |   |
| Net cash used in  operating activities                                                                                   |       | (1,437,000                    | )          | (2,647,000 | ) |
|                                                                                                                     |       |                          |       |   |   |
| **Cash  flows from investing activities:**                                                                               |       |                          |       |   |   |
| Purchase of  property and equipment                                                                                      |       | (478,000                      | )          | (355,000 | ) |
| Investment - available  for sale securities                                                                              |       | —                        |       | (40,000 | ) |
| Increase in  other non-current assets                                                                                    |       | (26,000                       | )          | (105,000 | ) |
| Net cash used in  investing activities                                                                                   |       | (504,000                      | )          | (500,000 | ) |
|                                                                                                                     |       |                          |       |   |   |
| **Cash  flows from financing activities:**                                                                               |       |                          |       |   |   |
| ** **                                                                                                               |       |                          |       |   |   |
| Proceeds from  issuance of common stock in connection with the exercise of options and the  Employee Stock Purchase Plan |       | 46,000                        |       | 559,000 |   |
| Proceeds from  warrant exercise                                                                                          |       | 18,000                        |       | 1,102,000 |   |
| Proceeds from  issuance of 7% Series A Cumulative Convertible Preferred Stock, net of issuance  costs                    |       | 2,099,000                     |       | — |   |
| Proceeds from  issuance of 5% Series B Cumulative Convertible Preferred Stock, net of  issuance costs                    |       | —                        |       | 1,818,000 |   |
| Proceeds from  issuance of 5% Series C Cumulative Convertible Preferred Stock, net of  issuance costs                    |       | —                        |       | 2,282,000 |   |
| Repayments of  long-term debt and capital lease obligations                                                              |       | (276,000                      | )          | (1,579,000 | ) |
| Payments of  preferred stock dividends                                                                                   |       | (42,000                       | )          | — |   |
| Repayments of  notes receivable from employees                                                                           |       | —                        |       | 223,000 |   |
| Proceeds from  issuance of common stock in connection with private placement, net of  issuance costs                     |       | 41,000                        |       | 4,689,000 |   |
| Net cash  provided by financing activities                                                                               |       | 1,886,000                     |       | 9,094,000 |   |
|                                                                                                                     |       |                          |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                                                                    |       | (55,000                       | )          | 5,947,000 |   |
| Cash and cash  equivalents, beginning                                                                                    |       | 1,014,000                     |       | 959,000 |   |
| Cash and cash  equivalents, ending                                                                                       |       | $                             | 959,000    |   | $ | 6,906,000 |   |

 

The accompanying notesare an integral part of these financial statements.

 

28

----

 
| ** **                                                                                                                | ** ** | **Years Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                | ** ** | **2003**                      | ** ** | **2004** | ** ** |
| **Supplemental  disclosures of cash flow information:**                                                                   |       |                          |       |   |   |
| Interest paid                                                                                                             |       | $                             | 10,000     |   | $ | 135,000 |   |
|                                                                                                                      |       |                          |       |   |   |
| **Noncash  Investing and Financing Activity:**                                                                            |       |                          |       |   |   |
| Fixed assets  acquired in exchange for equipment financing                                                                |       | $                             | 1,300,000  |   | $ | — |   |
| Issuance of  Series A warrants                                                                                            |       | $                             | 128,000    |   | $ | — |   |
| Noncash  beneficial conversion feature - Series A                                                                         |       | $                             | 537,000    |   | $ | — |   |
| Stock options  exercised for note receivable from shareholder                                                             |       | $                             | 85,000     |   | $ | — |   |
| Value of IPO  warrant extension (Note 13)                                                                                 |       | $                             | 195,000    |   | $ | 38,000 |   |
| Issuance of  Series B warrants                                                                                            |       | $                             | —     |   | $ | 184,000 |   |
| Noncash  beneficial conversion feature - Series B                                                                         |       | $                             | —     |   | $ | 826,000 |   |
| Issuance of  Series C warrants                                                                                            |       | $                             | —     |   | $ | 305,000 |   |
| Noncash  beneficial conversion feature - Series C                                                                         |       | $                             | —     |   | $ | 700,000 |   |
| Conversion of 7%  Series A Cumulative Convertible Preferred stock and accrued dividends into  common stock                |       | $                             | 1,076,000  |   | $ | 1,531,000 |   |
| Conversion of 5%  Series B Cumulative Convertible Preferred stock and accrued dividends into  common stock                |       | $                             | —     |   | $ | 2,064,000 |   |
| Conversion of  5% Series C Cumulative Convertible  Preferred stock and accrued dividends into common stock           |       | $                             | —     |   | $ | 1,181,000 |   |
| Accretion of 7%  Series A Cumulative Convertible Preferresd Stock, dividends, beneficial  conversion feature and warrants |       | $                             | 696,000    |   | $ | 564,000 |   |
| Accretion of 5%  Series B Cumulative Convertible Preferred Stock, dividends, beneficial  conversion feature and warrants  |       | $                             | —     |   | $ | 1,287,000 |   |
| Accretion of 5%  Series C Cumulative Convertible Preferred Stock, dividends, beneficial  conversion feature and warrants  |       | $                             | —     |   | $ | 638,000 |   |
| Value of  intangible asset acquired in exchange for long-term note payable                                                |       | $                             | —     |   | $ | 1,007,000 |   |

 

The accompanying notesare an integral part of these financial statements.

 

29

----

 

**1.****              Description of Business**

 

ImplantSciences Corporation (the “Company”) develops products for the medical deviceand explosives detection industry using ion implantation and thin film coatingsof radioactive and non-radioactive materials. The Company has received Food and Drug Administration 510(k) clearanceto market its I-Plantä Iodine-125radioactive seed for the treatment of prostate cancer.  The Company also has under developmentinterventional cardiology devices and temporary coronary brachytherapy systemsfor the prevention of restenosis (reclosure of the artery after balloonangioplasty).  The Company also modifiesthe surface characteristics of orthopedic joint implants to reduce polyethylenewear and thereby increasing the life of the implant and provides ionimplantation of electronic dopants for the semiconductor industry.  Additionally, the Company continues todevelop explosives detection systems to be used in the detection of traceresidues of explosives.

 

Whilethe Company strives to bring new products to market, it is subject to a numberof risks similar to other technology-based companies, including risks relatedto: (a) its dependence on key individuals and collaborative research partners;(b) competition from substitute products and larger companies; (c) its abilityto develop and market commercially usable produces and obtain regulatoryapproval for its products under development; and (d) its ability to obtain thesubstantial additional financing necessary to adequately fund the development,commercialization and marketing of its products.  For the year ended June 30, 2004, the Companyreported a net loss of $4,012,000 and used $2,647,000 in cash fromoperations.  As of June 30, 2004, theCompany had an accumulated deficit of approximately $19,527,000.  Management continually evaluates plans toreduce its operating expenses and increase its cash flow from operations.  Failure of the Company to achieve its projectionsmay require the Company to seek additional financing.  There can be no guarantee that financing, ifrequired, will be available at commercially favorable terms.  Management believes that its working capitalat June 30, 2004 and cash flows generated during the year then ended will besufficient to finance its operations through at least the next twelve months. 

 

**2.****              Summary of Significant AccountingPolicies**

 

*Cash, Cash Equivalents, and Investments*

 

The Company considersany  securities with maturities of 90days or less at the time of investment to be cash equivalents.

 

The Company accounts forinvestments in accordance with  Statementof Financial Accounting Standards (“SFAS”) No. 115, “Accounting for CertainInvestments in Debt and Equity Securities.” Under SFAS No. 115, securities purchased in order to be held forindefinite periods of time and not intended at the time of purchase to be helduntil maturity are classified as available-for-sale securities.  At June 30, 2004, these securities consistedof common stock in CardioTech, a related party (See Note 9).  This common stock is recorded at fair marketvalue with any unrealized gains and losses reported as a separate component ofequity in other accumulated comprehensive income (loss).

* *

*Comprehensive Income (Loss)*

 

The Company hasaccumulated other comprehensive income resulting from the unrealized gain on aninvestment in marketable securities of CardioTech International Inc.(Note 9) and the recognition of the unrealized gain of the Company's shareof CardioTech and the Company's stock owned by CorNova (Note 6), which isrecorded as a separate component of equity in other accumulated comprehensiveincome (loss).

* *

*Financial Instruments*

 

The estimated fair  values of the Company’s financialinstruments, which at June 30, 2004 include cash equivalents, investments inavailable for sale securities, accounts receivable, accounts payable, long-termdebt, and 5% Series C Cumulative Convertible Preferred Stock, approximatestheir carrying  values due to theirshort-term nature or market variable rates of interest.

 

30

----

 

*Inventories*

 

Inventories consist ofraw materials, work-in-process and finished goods.  Work-in-process and finished goods includeslabor and overhead, and are stated at the lower of cost (first in, first out)or market.

 

*Property and Equipment and Capital Lease*

 

Equipmentand leasehold improvements are stated at cost. Equipment is depreciated using the straight-line method over theestimated useful lives of the assets, ranging from five to seven years.  Capitalized leases and leasehold improvementsare amortized based upon the lesser of the term of the lease or the useful lifeof the asset and such expense is included in depreciation expense.  Expenditures for repairs and maintenance arecharged to expense as incurred.

 
|                                                       |   | **Estimated Lives** |                                                                              |
|------------------------------------------------------------|--------|---------------------|-----------------------------------------------------------------------------------|
| Machinery and  equipment                                   |   |                | 5 - 7 years                                                                       |   |
| Computers and  software                                    |   |                | 3 - 5 years                                                                       |   |
| Leasehold  improvements and equipment under capital leases |   |                | Lesser of the remaining  life of the lease or the useful life of the improvement. |   |
|                                                       |   |                |                                                                              |   |
| Furniture and  fixtures                                    |   |                | 7 years                                                                           |   |
| Motor vehicles                                             |   |                | 7 years                                                                           |   |

 

*WarrantyCosts*

 

The Company accrueswarranty costs in the period the related revenue is recognized.  Warranty costs and related accruals are notmaterial to operating results.

 

*Income Taxes*

 

The liability method isused to account for income taxes. Deferred tax assets and liabilities are determined based on differencesbetween the financial reporting and income tax bases of assets and liabilities as well as net operating loss and taxcredit carry forwards and are measured using the enacted tax rates and lawsthat will be in effect when the differences reverse.  Deferred tax assets may be reduced by avaluation allowance to reflect the uncertainty associated with their ultimaterealization.

 

*Patent Costs*

 

As of June 30, 2004,there were 23 patents issued.  TheCompany expenses patent costs as incurred.

 

*Impairmentof Long-Lived Assets*

 

In accordancewith  SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” the Company reviews the carryingvalues of its long-lived assets for possible impairment whenever events orchanges in circumstances indicate that the carrying amounts of the assets maynot be recoverable.

 

The Company believes thatthe carrying value of  its long-livedassets is fully realizable at June 30, 2004.

 

*Concentration of Credit Risk and Major Customers*

 

The Company grants creditto its customers, primarily large corporations in the medical device and  semiconductor industries and the U.S.government.  The Company performsperiodic credit evaluations of customer financial conditions and generally doesnot require collateral.  Receivables aregenerally due within thirty days.  Creditlosses have historically been minimal, which is consistent with management’sexpectations.  Reserves are provided forestimated amounts of accounts receivable which may not be collected.  Financial instruments that potentiallysubject the Company to concentration of credit risk consist of tradereceivables.

 

The Company hasthree  major customers with revenues inexcess of 10% of the Company’s total revenues for the years ended June 30, 2003and 2004, respectively. that accounted for the following annual revenue:

 
| ** ** | ** ** | **Years Ended June 30,** | ** ** |
|------------|------------|--------------------------|------------|
| ** ** | ** ** | **2003**                 | ** ** | **2004** | ** ** |
|       |       |                     |       |   |   |
| Company A  |       | $                        | 1,346,000  |   | $ | 2,969,000 |   |
| Company B  |       | 1,628,000                |       | 1,585,000 |   |
| Company C  |       | 2,631,000                |       | 883,000 |   |
|            |            |                          |            |  |  |  |  |

 

31

----

 

At June 30, 2004, these customers accounted for thefollowing amounts of accounts receivable:

 

| ** **    | ** ** | **Year Ended June 30,** | ** ** |
|---------------|------------|-------------------------|------------|
|          |       | **2004**                |       |
| Company A     |       | $                       | —     |   |
| Company B     |       | 222,000                 |       |
| Company C (1) |       | 1,534,000               |       |
|               |            |                         |            |  |

 

----

(1) Contains billed andunbilled revenue.

 

*EmployeeStock-Based Compensation*

 

The Company accounts forits employee stock based compensation arrangements under the provisions ofAccounting  Principles Board (APB)Opinion No. 25, “Accounting for Stock Issued to Employees,” rather than thealternative fair value accounting method provided for under SFAS No. 123,“Accounting for Stock-Based Compensation.”

 

The Company has electedto use the disclosure-only provisions of SFAS No. 123 and SFAS No. 148,“Accounting for Stock-Based Compensation-Transition and Disclosure.”  Had compensation expense for stock optiongrants to employees been determined based on the fair value method at the grantdates for awards under the stock option plans consistent with the methodprescribed by SFAS No. 123, the Company’s net loss would have increased to thepro forma amounts indicated as follows:

 
| ** **                                                                                                             | ** ** | **Years Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                                             | ** ** | **2003**                 | ** ** | **2004** | ** ** |
| Net loss applicable  to common shareholders, as reported                                                               |       | $                        | (3,660,000 | ) | $ | (6,539,000 | ) |
|                                                                                                                   |       |                     |       |   |   |
| Add:  Stock-based employee compensation expense  included in reported net loss                                    |       | 16,000                   |       | 295,000 |   |
|                                                                                                                   |       |                     |       |   |   |
| Deduct:  Total stock-based employee compensation  expense determined under fair value based method for all awards |       | (870,000                 | )          | (856,000 | ) |
|                                                                                                                   |       |                     |       |   |   |
| Pro forma net  loss                                                                                                    |       | $                        | (4,514,000 | ) | $ | (7,100,000 | ) |
|                                                                                                                   |       |                     |       |   |   |
| Basic and diluted  Loss per share applicable to common shareholders:                                                   |       |                     |       |   |   |
| As reported                                                                                                            |       | $                        | (0.58      | ) | $ | (0.90 | ) |
| Pro forma                                                                                                              |       | $                        | (0.71      | ) | $ | (0.97 | ) |

 

32

----

 

The Company has computedthe pro forma disclosures for stock options granted to employees using theBlack-Scholes option pricing model prescribed by SFAS No. 123.  In addition, deferred compensation has beenrecorded relating to stock options issued below fair market value.  The assumptions used during each of the twoyears ended June 30, 2004 were as follows:

 

| ** **                                    | ** ** | **June 30,**      | ** ** |
|-----------------------------------------------|------------|-------------------|------------|
| ** **                                    | ** ** | **2003**          | ** ** | **2004** | ** ** |
| Risk free  interest rate                      |       | 2.27% - 4.65%     |       | 2.87% - 6.69% |   |
| Expected  dividend yield                      |       | 0%                |       | 0% |   |
| Expected lives  (years)                       |       | 5 – 10 years |       | 5 – 10 years |   |
| Expected  volatility                          |       | 45% - 98%         |       | 47% - 68% |   |
| Weighted-average  fair value of option grants |       |              | $3.60      |   |   | $6.75 |   |
|                                               |            |                   |            |  |  |  |  |

 

 

*Revenue Recognition*

 

The Company recognizesrevenue when there is persuasive evidence of an arrangement with the customerwhich states a fixed or determinable price and terms, delivery of the producthas occurred or the service performed in accordance with the terms of the sale,and collectibility of the sale is reasonably assured.  The Company provides for estimated returns atthe time of shipment based on historical data.

 

Contract revenue undercost-sharing research and development agreements is recognized as eligibleresearch and development expenses are incurred. The Company’s obligation with respect to these agreements is to performthe research on a best-efforts basis. For contracts with a deliverable, revenue is recognized on a percentageof completion basis.

 

The Company utilized adistributor for the sale of its prostate seeds for a portion of the year,before transitioning to a direct sales force. Under the terms of the sale of prostate seeds, the customer had theright to return product previously purchased, subject to certain conditions,and was entitled to certain price protection. Due to the limited timeframe under which these rights were exercisableby the customer, the Company was able to estimate the financial impact of eachof these provisions upon shipment.  Additionally the Company recorded a provision for an estimate of theactual sales returns and price discounts each period.

 

The Company accounts forshipping and handling fees passed on to its customers as revenues.  The corresponding costs are recorded as costsof revenues.

 

33

----

 

*Accounts Receivable*

 

Contract revenue undercost sharing research and development agreements is recognized as eligibleexpenses are incurred.  Invoicing ofresearch and development contracts occurs in accordance with the terms of thecontract.  Revenue recognized butunbilled is recorded as unbilled accounts receivable.  At June 30, 2004 unbilled accounts receivablerepresented approximately 67% of total accounts receivable.  Generally, there are no prerequisitesnecessary to bill.

 

*Research and Development Costs*

 

All costs of research anddevelopment activities are expensed as incurred.  The Company performs research and developmentfor itself and under contracts with others, primarily the U.S. government.  In addition, periodically,  the Company may continue  its research on  such projects at  its own expense.  These costs are considered Company fundedresearch and development.

 

The Company funded andcustomer reimbursed research and development costs were as follows:

 

| ** **                      | ** ** | **June 30,** | ** ** |
|---------------------------------|------------|--------------|------------|
| ** **                      | ** ** | **2003**     | ** ** | **2004** | ** ** |
|                            |       |         |       |   |   |
| Company funded                  |       | $            | 811,000    |   | $ | 1,631,000 |   |
| Customer funded                 |       | 1,216,000    |       | 2,210,000 |   |
|                            |       |         |       |   |   |
| Total research  and development |       | $            | 2,027,000  |   | $ | 3,841,000 |   |

 

*Earnings (Loss) per Share*

 

Basic earnings (loss) pershare is computed based only on the weighted average number of common sharesoutstanding during the period. Diluted earnings per share is computed by usingthe weighted average number of common shares outstanding during the period,plus the dilutive effects of shares issuable through the exercise of stockoptions (common stock equivalents) unless their inclusion would beantidilutive.  In calculating dilutedearnings per share, the dilutive effect of stock options and warrants iscomputed using the average market price for the period.  Basic and diluted net loss per shareavailable for common shareholders is the same for all periods presented asoutstanding common stock options and warrants have been excluded because theyare antidilutive.

The Company had thefollowing potential dilutive securities outstanding on June 30, 2003: (i)options and warrants to purchase 953,500 and 1,551,775 shares, respectively, ofthe Company's common stock at weighted average prices of $4.87 and $8.44 pershare, respectively, and (ii) Series A Preferred Stock convertible into anaggregate of 551,471 shares of the Company's common stock.  Such potential dilutive securities were notincluded in the calculation of diluted loss per share in 2003 because theinclusion thereof would be antidilutive.

 

The Company had thefollowing potential dilutive securities outstanding on June 30, 2004: (i)options and warrants to purchase 1,162,065 and 1,876,803 shares, respectively,of the Company’s common stock at weighted average exercise prices of $5.55 and$9.72 per share, respectively, and (ii) Series C Preferred Stock convertibleinto an aggregate of 195,370 shares of the Company’s common stock.  Such potential dilutive securities were notincluded in the calculation of diluted loss per share in 2004 because theinclusion thereof would be antidilutive. 

 

*Recent Accounting Pronouncements*

 

 In December 2003, theSecurities and Exchange Commission (“SEC”) published Staff Accounting Bulletin(“SAB”) No. 104, “Revenue Recognition.” SAB No. 104 was effective upon issuance. The adoption of SAB No. 104 did not have a material effect on theCompany’s financial position, results of operations, or cash flows.

 

*Use of Estimates*

 

The preparation of thesefinancial statements in conformity with accounting principles generallyaccepted in the United States of America, requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting periods.  Some of the moresignificant estimates include allowance for doubtful accounts, allowance forsales returns, inventory valuation, and warranty reserves.  Management’s estimates are based on the factsand circumstances available at the time estimates are made, past historicalexperience, risk of loss, general economic conditions and trends andmanagement’s assessments of the probable future outcome of these matters.  Consequently, actual results could differfrom such estimates.  

 

34

----

 

 

**3.****              Inventories**

 

Inventories at June 30,2004 consist of the following:

 
| Raw materials    |   | $      | 308,000 |   |
|------------------|--------|--------|---------|--------|
| Work-in-progress |   | 97,000 |    |
| Finished goods   |   | 76,000 |    |
|             |   |   |    |
|             |   | $      | 481,000 |   |

 

The reserve for excess and obsolete inventory was$81,000 as of June 30, 2004. 

 

**4.****              Property and Equipment**

 

Propertyand equipment at June 30, 2004 consists of the following**:**

 
|                                             |   |       |      |   |
|--------------------------------------------------|--------|------------|-----------|--------|
| Machinery  and equipment                         |   | $          | 7,269,000 |   |
| Computers and  software                          |   | 452,000    |      |
| Leasehold  improvements                          |   | 322,000    |      |
| Furniture and  fixtures                          |   | 161,000    |      |
| Motor vehicles                                   |   | 33,000     |      |
| Equipment under  capital leases                  |   | 32,000     |      |
|                                             |   | 8,269,000  |      |
| Less:  Accumualted depreciation and amortization |   | (3,961,000 | )         |
|                                             |   |       |      |
|                                             |   | $          | 4,308,000 |   |

 

The Company recorded depreciation expense ofapproximately $745,000 and $866,000 for the years ended June 30, 2003 and 2004,respectively. Capitalized leases and leasehold improvements are amortized basedupon the lesser of the term of the lease or the useful life of the asset andsuch expense is included in depreciation expense.

 

35

----

 

**5.     Accrued Expenses**

 

Accrued expenses at June30, 2004 consist of the following:

 
| Accrued compensation  and benefits      |   | $       | 397,000 |   |
|-----------------------------------------|--------|---------|---------|--------|
| Accrued legal,  accounting and printing |   | 80,000  |    |
| Subcontractor  costs                    |   | 118,000 |    |
| Accrued  utilities                      |   | 17,000  |    |
| Accrued  dividends                      |   | 63,000  |    |
| Other                                   |   | 65,000  |    |
|                                    |   |    |    |
|                                    |   | $       | 740,000 |   |

 

**6.****              Investment in Unconsolidated Subsidiaries**

 

On October 6, 1999, theCompany acquired 38% of the outstanding shares of Epsilon Medical, Inc. inexchange for $50,000 in cash.  TheCompany accounted for its investment in Epsilon Medical, Inc. under the equitymethod and the carrying amount of their investment is adjusted to reflect theCompany’s share of all gains and losses. For the year ended June 30, 2003, the Company recognized its share ofequity losses in Epsilon Medical, Inc. of approximately $2,000.  As of June 30, 2004, the Company determinedthis investment was permanently impaired. Accordingly, the Company recognized approximately $35,000, the netinvestment at June 30, 2004, as a loss on this investment.

 

InMarch 2004, the Company entered into an Exchange & Venture Agreement withCardioTech International, Inc. (“CardioTech”), a public company and relatedparty of the Company (Note 9) and CorNova, Inc. (“CorNova”).  CorNova is a start-up company, incorporatedas a Delaware corporation on October 12, 2003. CorNova’s focus will be the development and marketing of innovativeinterventional cardiology products.  Inconnection with the agreement, in March 2004, the Company and CardioTech issued10,344 and 12,931 shares, respectively, of their respective common stock (the“Contributory Shares”) bearing an aggregate fair market value of $113,000 and$76,000, respectively, as of the date of issuance.  In exchange, the Company and CardioTech eachreceived 1,500,000 shares of CorNova’s common stock, which represents a 30%ownership position for each party, and a position on the Board of Directors.

 

Uponthe event of CorNova securing additional financing in the minimum amount of$1,000,000 and up to a maximum amount of $3,000,000 (the “Series A Financing”),CardioTech and Implant will each issue additional shares of their common stock(the “Investment Shares”), where the number of Investment Shares to be issuedwill be equal to twenty-five percent (25%), of the gross proceeds of the SeriesA Financing divided by the respective five (5) day average of the closingprices of the common stock of CardioTech and Implant as published in the WallStreet Journal on the dates immediately preceding each relevant closing of theSeries A Financing.  This additionalfinancing did not take place as of June 30, 2004.

 

Boththe Contributory Shares and the Investment Shares (collectively, the“Securities”) are restricted securities within the meaning of Rule 144 of theSecurities and Exchange Commission under the Securities Act of 1933, as amended(the “Securities Act”) and none of the Securities may be sold except pursuantto an effective registration statement under the Securities Act or under thesecurities laws of any state, or in a transaction exempt from registrationunder the Securities Act.

 

TheCompany is accounting for this investment under the equity method under APBOpinion No. 18, “The Equity Method of Accounting for Investments in CommonStock.”  As of June 30, 2004, 10,344shares have been issued to CorNova by the Company, 3,103 of which have beencategorized as treasury stock in the accompanying balance sheet.  These shares represent 30% of the sharesissued.  For the year ended June 30,2004, the Company recognized approximately $15,000 of other expenserepresenting the Company’s portion of CorNova’s net loss.  The Company also recorded approximately$6,000 as an unrealized loss, which is included in accumulated othercomprehensive income for the year ended June 30, 2004.  This unrealized loss relates to the Company’sportion of the decline in value of the Contributory Shares issued to CorNova.

 

7.               **Research and Development Arrangements**

 

The Company is therecipient of several grants under the U.S. Government’s Small BusinessInnovative Research (SBIR) Program. These grants from the National Institute of Health are firm-fixed pricedcontracts and generally range in length from six to twenty-four months.  Contracts received from the Department ofDefense are both firm-fixed price and cost-plus type programs and also range fromsix to twenty-four months.  Revenuesunder such arrangements were approximately $1,346,000 and $2,969,000 for theyears ended June 30, 2003 and 2004, respectively.  Unbilled accounts receivable relating to such

 

36

----

 

arrangements was approximately $1,434,000 at June 30,2004.

 

**8.****              Cooperative Research and DevelopmentAgreement**

 

In August 2002, theCompany executed a Cooperative Research and Development Agreement with anagency of the Department of Homeland Security (TSA) for its trace explosivesdetection prototypes.  Under theagreement, the Company will submit these prototypes for testing andevaluation.  In addition, the TSA willsupply the Company with test protocols and current and anticipated performancecriteria needed for commercial approval and as a mechanism for future fundingfrom the TSA.  The Company is accountingfor the revenues related to this agreement under the percentage of completionmethod of accounting and has recognized approximately $846,000 during the yearended June 30, 2004.

 

**9.****              Related Party Transactions**

 

SFAS No. 57, “RelatedParty Disclosures,” specifies the nature of information that should bedisclosed in financial statements regarding related party transactions.  CardioTech, a publicly traded company whosecommon stock trades under the symbol CTE on the American Stock Exchange, is arelated party with the Company by virtue of its significant businessrelationships.

 

Certain directors of theCompany hold positions as directors of CardioTech.  The CEO and Chairman of the Board ofDirectors of the Company is also a director of CardioTech.  The CEO and Chairman of the Board ofDirectors of CardioTech is also a director of the Company.

 

InMarch 2000, the Company entered into a joint research agreement with CardioTechto develop a proprietary porous polymer biocompatible coating technology as aplatform for the Company’s proprietary radioactive brachytherapytechnology.  In consideration for thisagreement, the Company agreed to pay $150,000 in cash and purchase 100,000 sharesof CardioTech stock at a price of $1.00 per share.  As of June 30, 2004, the Company haspurchased these shares, the fair market value of which is $419,000 and isrecorded as investments in available for sale securities in the accompanyingbalance sheet.

 

InJanuary 2004, a director of the Company entered into a Sales RepresentativeAgreement with the Company to sell radioactive prostate seeds.  In April 2004, this director resigned fromthe Company’s Board of Directors to pursue this opportunity and eliminate anypossible conflict.

 

In March 2004 the Companyentered into an Exchange & Venture Agreement with CardioTech and CorNova(Note 6).  The Company’s CEO and theChairman of the Audit Committee are also on the Board of Directors of CorNova.

 

**10.****       Commitments and Contingencies**

 

(a)  Capital and Operating Leases

 

TheCompany has an operating lease for its manufacturing, research and office spacewhich expires on December 31, 2008.  TheCompany has an option to extend the lease for five additional years.  Under the terms of the lease, the Company isresponsible for its proportionate share of real estate taxes and operatingexpenses relating to this facility. Total rental expense, including maintenance and real estate taxexpenses, for the fiscal years ended June 30, 2003 and 2004 was $583,000 and$644,000, respectively.

 

Includedin property and equipment at June 30, 2004 is equipment recorded under acapital lease with a net book value of $2,000. Amortization of assets under capital lease obligations is included indepreciation expense.

 

Futureminimum rental payments required under capital leases and operating leases withnoncancelable terms in excess of one year at June 30, 2004, together with thepresent value of net minimum lease payments are as follows:

 

37

----

 
| ** **                                   | ** ** | **Capital Lease** | ** ** | **Operating Lease** | ** ** |
|----------------------------------------------|------------|-------------------|------------|---------------------|------------|
|                                         |       |              |       |                |       |
| Year ending June  30:                        |       |              |       |                |       |
| 2005                                         |       | $                 | 4,000      |                | $          | 557,000 |   |
| 2006                                         |       | 5,000             |       | 609,000             |       |
| 2007                                         |       | 1,000             |       | 610,000             |       |
| 2008                                         |       | —            |       | 611,000             |       |
| 2009                                         |       | —            |       | 306,000             |       |
| Net minimum  lease payments                  |       | 10,000            |       | $                   | 2,693,000  |   |
|                                         |       |              |       |                |       |
| Less:  Finance charges                  |       | —            |       |                |       |
| Present value of  net minimum lease payments |       | 10,000            |       |                |       |
|                                         |       |              |       |                |       |
| Less:  current portion                  |       | 4,000             |       |                |       |
|                                         |       |              |       |                |       |
| Long term  portion                           |       | $                 | 6,000      |                |       |   |
|                                         |       |              |       |                |       |   |

 

(b)  Employment Agreements

 

On June 30, 2004, weentered into an employment agreement with Dr. Anthony J. Armini, the Company’sPresident and CEO, with an initial term of three years and an automatic renewalfor a successive period of three years, unless the we or Dr. Armini give theother party not less than three months written notice of non-renewal. Underthis employment agreement, Dr. Armini serves as our president and chiefexecutive officer at a base salary of up to $210,000. In addition, Dr. Arminimay participate in our employee fringe benefit plans or programs generallyavailable to employees of comparable status and position. We are entitled toterminate his employment for any material breach of his employment agreement atany time upon at least 30 days written notice. In the event we terminate Dr.Armini’s employment without cause, we will pay him 12 months salary. Under hisemployment agreement, he is subject to restrictive covenants, includingconfidentiality provisions. Also, during his employment and for a period of twoyears after the term of the employment agreement, Dr. Armini is subject to anon-competition provision.

 

On June 30, 2004, weentered into an employment agreement Dr. Stephen Bunker, the Company’s VicePresident and Chief Scientist, with an initial term of three years and anautomatic renewal for a successive period of three years, unless the we or Dr.Bunker give the other party not less than three months written notice ofnon-renewal. Under this employment agreement, Dr. Bunker serves as our vicepresident and chief executive scientist at a base salary of up to $150,000. Inaddition, Dr. Bunker may participate in our employee fringe benefit plans orprograms generally available to employees of comparable status and position. Weare entitled to terminate his employment for any material breach of hisemployment agreement at any time upon at least 30 days’ written notice. In theevent we terminate Dr. Bunker’s employment without cause, we will pay him 12months salary. Under his employment agreement, he is subject to restrictivecovenants, including confidentiality provisions. Also, during his employmentand for a period of two years after the term of the employment agreement, Dr.Bunker is subject to a non-competition provision.

 

(c)  Other

 

From time to time, theCompany is subject to various claims, legal proceedings and investigationscovering a wide range of matters that arise in the ordinary course of itsbusiness activities.  Each of thesematters is subject to various uncertainties. On the basis of information presently available, the Company is notcurrently aware of any legal proceedings or claims that the Company believesare likely to have a material effect on the Company’s financial position orresults of operations.

 

**11.  Income Taxes**

 

A reconciliation of the federal statutory rate to the Company’seffective tax rate for the years ended June 30, 2003 and 2004 is as follows:

 
| ** **                                                | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Income tax  provision (benefit) at federal statutory rate |       | (34.0    | )%         | (34.0    | )%         |
| Increase (decrease)  in tax resulting from                |       |     |       |     |       |
| State tax  provision, net of federal benefit              |       | (6.3     | )%         | (8.0     | )%         |
| Non-deductible  expenses                                  |       | 4.6      | %          | .3       | %          |
| Credits and  other, net                                   |       | (3.1     | )%         | (0.3     | )%         |
| Change in  valuation allowance                            |       | 38.8     | %          | 45.9     | %          |
| Effective income  tax rate                                |       | —   | %          | —   | %          |

 

38

----

 

 

Significantcomponents of the Company’s net deferred tax asset as of June 30, 2004, are asfollows:

 

***Deferred Tax Components***

 
| Deferred tax  assets:                            |   |       |      |
|--------------------------------------------------|--------|------------|-----------|
| Net operating  loss and tax credit carryforwards |   | $          | 6,181,000 |   |
| Accrued expenses                                 |   | 134,000    |      |
| Book over tax  patent costs                      |   | 71,000     |      |
| Stock-based  compensation                        |   | 545,000    |      |
| Depreciation                                     |   | (590,000   | )         |
| Equity  investments                              |   | 18,000     |      |
| Total deferred  tax assets                       |   | 6,359,000  |      |
| Valuation  allowance                             |   | (6,359,000 | )         |
| Net deferred tax  asset                          |   | $          | —    |   |

 

Avaluation allowance has been established for the Company’s tax assets as theiruse is dependent on the generation of sufficient future taxable income, whichcannot be predicted at this time. Included in the valuation allowance is approximately $545,000 related tocertain operating loss carryforwards resulting from the exercise of employeestock options, the tax benefit of which, when recognized, will be accounted foras a credit to additional paid in capital rather than a reduction in incometax.

 

AtJune 30, 2004, the Company has the following unused net operating loss and taxcredit carryforwards available to offset federal and state taxable income, bothof which expire at various times through 2024.

 

| ** ** | ** ** | **Net Operating  Loss** | ** ** | **Research & Development  Credits** | ** ** |
|------------|------------|-------------------------|------------|-----------------------------------------|------------|
|       |       |                    |       |                                    |       |
| Federal    |       | $                       | 14,345,000 |                                    | $          | 219,000 |   |
|       |       |                    |       |                                    |       |
| State      |       | $                       | 13,995,000 |                                    | $          | 315,000 |   |

 

The Company’sfederal net operating loss carryforwards are subject to review and possibleadjustment by the Internal Revenue Service and are subject to certainlimitations in the event of cumulative changes in the ownership interest ofsignificant stockholders over a three-year period in excess of 50%.

 

**12.Convertible Preferred Stock**

 

*7% SeriesA Cumulative Convertible Preferred Stock*

 

On October 7, 2002, theCompany issued 250,000 shares of Series A 7% Cumulative Convertible PreferredStock (“Series A”) having a stated value of $10 per share, pursuant to aSecurities Purchase Agreement executed on October 7, 2002 with the LaurusMaster Fund, Ltd. (Laurus).  The Companyreceived $2,500,000 in gross

 

39

----

 

proceeds, less a management and placement agent fee ofapproximately $300,000, and related transaction costs of approximately$101,000.  The terms of the Series Aprovide for repayment of outstanding principal and accrued dividends in eithercash or with shares of the Company’s common stock, at the Company’s option,over a 14 month period beginning February 1, 2003.  If the Company elects to convert into sharesof the Company’s common stock, the common stock will be valued at $5.19 pershare.  However, if the closing price ofthe Company’s common stock for any of the 11 trading days prior to a monthly repaymentdate is less than $5.70, the common stock will be valued at the greater of 83%of the average of the three lowest closing prices during the 30 trading daysimmediately preceding the repayment date or $2.02 and Laurus Master Fund, Ltd.will be permitted to convert such part of the monthly payment, up to the amountthe Company elected to repay, into shares of common stock.  Any part of the monthly amount not convertedinto common stock shall be paid in cash on the following monthly repaymentdate.  The Company also granted theinvestor a security interest in substantially all of the Company’s assets.  In connection with the issuance of the SeriesA, the investor received a warrant to purchase 55,000 shares of the Company’scommon stock.  The common stock purchasewarrant may be exercised at any time and is valid for five years from the dateof issuance at an exercise price of $6.23 per share.

 

In accordance with theprovisions of Emerging Issues Task Force (EITF) Issue 00-27, “Application ofEITF Issue No. 98-5 ‘Accounting for Convertible Securities with BeneficialConversion Features of Contingently Adjustable Conversion Ratios’, to CertainConvertible Securities”, which became effective in November 2000, the allocatedvalue of the Series A contained a beneficial conversion feature calculatedbased on the difference between the effective conversion price of the proceedsallocated to the Series A and the fair market value of the common stock at thedate of issuance.  The discount arisingfrom the beneficial conversion feature aggregated $537,000.  The discount is being amortized and recordedas a preferred dividend during the period from the issuance of the preferredstock to the mandatory redemption date of April 7, 2004 or the actualconversion date, whichever is earlier.

 

The Company valued theSeries A at issuance at $1,434,000 based on the relative fair market values ofthe financial instruments issued in connection with this placement, net ofoffering costs and the beneficial conversion feature.  The amounts recorded in the financial statementsrepresent the amounts attributed to the sale of the preferred stock, net cashproceeds of $2,099,000 ($401,000 of issuance costs incurred), amount allocatedto warrants of $128,000, and the amount of the discount related to the value ofbeneficial conversion feature of $537,000. The Company was accreting these discounts on the carrying value of thepreferred stock to its redemption value of $2,500,000 at April 7, 2004, or theactual conversion date, whichever is earlier. The accretion of these amounts is being recorded as a preferred dividendin the period of redemption.

 

As of June 30, 2004, allamounts were fully amortized and the principal balance of the Series A has beenpaid in full.  All Series A shares hadbeen converted into 672,458 shares of common stock.  During the years ended June 30, 2003 and2004, approximately $696,000 and $564,000, respectively, was amortized.

 

*5%Series B Cumulative Convertible Preferred Stock*

 

On August 28, 2003, theCompany issued 200,000 shares of Series B 5% Cumulative Convertible PreferredStock (“Series B”) having a stated value of $10 per share, pursuant to aSecurities Purchase Agreement executed on August 28, 2003 with the LaurusMaster Fund, Ltd.  The Company received $2,000,000in gross proceeds, less a management and placement agent fee of approximately$108,000, and related transaction costs of approximately $70,000.  The terms of the Series B provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  Repayment of theSeries B commenced on December 1, 2003. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both.  However, if the closing price for any of the11 trading days preceding a repayment date is less than $6.00, the Companywould be required to pay such monthly amount in cash at 105% of the monthlyobligation.  If the payment of themonthly amount is made in common stock, the fixed conversion price is$5.50.  The Company also issued to Laurusa warrant to purchase 25,000 shares of common stock at $6.88 per share and45,000 shares of common stock at $8.25 per share.  The Securities Purchase Agreement also providesfor a security interest in substantially all of the Company’s assets andprovides Laurus a right of first refusal on future financing arrangementsduring the Term of the agreement.  In theevent Laurus declines to exercise its right of first refusal, it hereby agreesto enter into such documentation as shall be reasonable requested by theCompany in order to

 

40

----

 

subordinate its rights under the Series B to thesubsequent financier.  The Companyutilized the proceeds of this financing to commercialize its explosivesdetection system and for general working capital purposes.

 

In accordance with theprovisions of EITF Issue 00-27, the allocated value of the Series B contained abeneficial conversion feature calculated based on the difference between theeffective conversion price of the proceeds allocated to the Series B and thefair market value of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $826,000. The discount is being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to the mandatoryredemption date of March 1, 2005, or the actual conversion date, whichever isearlier.

 

The Company valued theSeries B at issuance to be $812,000 based on the relative fair market values ofthe financial instruments issued in connection with this placement, net ofoffering costs and the beneficial conversion feature.  The amounts recorded in the financialstatements represent the amounts attributed to the sale of the preferred stock,net cash proceeds of $1,822,000 ($178,000 of issuance costs incurred), amountallocated to warrants of $184,000, and the amount of the discount related tothe value of beneficial conversion feature of $826,000.  The Company is accreting these discounts onthe carrying value of the preferred stock to its redemption value of $2,000,000at March 1, 2005, or the actual conversion date, whichever is earlier.  The accretion of these amounts is beingrecorded as a preferred dividend in the period of redemption.

 

As of June 30, 2004, allamounts were fully amortized and the principal balance of the Series B has beenpaid in full.  All Series B shares andaccrued dividends had been converted into 371,336 shares of common stock.During the year ended June 30, 2004, approximately $1,287,000 was amortized.

 

*5% Series C CumulativeConvertible Preferred Stock*

 

On November 25, 2003, theCompany issued 250,000 shares of Series C 5% Cumulative Convertible PreferredStock (“Series C”) having a stated value of $10 per share, pursuant to aSecurities Purchase Agreement executed on November 25, 2003 with the LaurusMaster Fund, Ltd.  The Company received$2,500,000 in gross proceeds, less a management and placement agent fee ofapproximately $125,000, and related transaction costs of approximately$86,000.  The terms of the Series Cprovide for repayment with shares of the Company’s common stock or in cash, pursuantto an amortization schedule.  Repaymentof the Series C commences on March 31, 2004. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both, unless the closing price ofthe Company's common stock, for any of the eleven trading days preceding arepayment date was less than $7.35, wherein the Company will be required to paysuch monthly amount in cash.  If thepayment of the monthly amount is made in common stock, the fixed conversionprice is $6.75.  The Company also issuedto Laurus a warrant to purchase 50,000 shares of common stock at $8.44 pershare and 50,000 shares of common stock at $10.13 per share.  The Securities Purchase Agreement also providesfor a security interest in substantially all of the Company’s assets andprovides Laurus a right of first refusal on future financing arrangementsduring the Term of the agreement.  In theevent Laurus declines to exercise its right of first refusal, it hereby agreesto enter into such documentation as shall be reasonable requested by theCompany in order to subordinate its rights under the Series C to the subsequentfinancier.  The Company will utilize theproceeds of this financing to purchase an ion implanter and for general workingcapital purposes.

 

In accordance with theprovisions of EITF Issue 00-27, the allocated value of the Series C contained abeneficial conversion feature calculated based on the difference between theeffective conversion price of the proceeds allocated to the Series C and thefair market value of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $700,000. The discount is being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to the mandatoryredemption date of June 1, 2005, or the actual conversion date, whichever isearlier using the effective interest method.

 

The Company valued theSeries C at issuance to be $1,284,000 based on the relative fair market valuesof the financial instruments issued in connection with this placement, net ofoffering costs and the beneficial conversion feature.  The amounts recorded in the financialstatements represent the amounts attributed to the sale of the preferred stock,net cash proceeds of $2,289,000 ($211,000 of issuance costs incurred), theamount allocated to warrants of $305,000, and the amount of the discountrelated to the value of beneficial conversion feature of $700,000.  The Company is accreting these discounts onthe carrying value of the preferred stock to its redemption value of $2,500,000at June 1, 2005, or the actual conversion date, whichever is earlier.  The accretion of these amounts is beingrecorded as a preferred dividend in the period of redemption.  During the

 

41

----

 

year ended June 30, 2004, approximately $638,000 wasamortized.

 

As of June 30, 2004,118,125 shares of Series C were converted into 175,000 shares of common stockat the price of $6.75 per share.  Theoutstanding principal at June 30, 2004, is $1,318,750.  For the year ended June 30, 2004, the Companyaccrued approximately $64,000 of dividends.

 

**13.  Stockholders’ Equity**

 

(a)  IPO Units

 

InJune 1999, the Company issued 1,138,000 Units, consisting of one share ofcommon stock, and one redeemable common stock purchase warrant (the “IPOWarrants”) in connection with its initial public offering.  Each Unit carries the right to purchase one shareof common stock at $9.00, and is redeemable by the Company at $0.20 per warrantif the closing bid price of the common stock averages in excess of $10.50 for aperiod of 20 consecutive trading days. On March 28, 2002, the Company extended the expiration date of the IPOWarrants from June 23, 2002 to June 30, 2003. The Company did not receive any consideration from the holders of thewarrants accordingly, the Company recognized this transaction as a preferred distributionbased upon the estimated fair value of the extension of approximately$530,000.  On April 15, 2003, the Companyagain extended the expiration date of the IPO Warrants from June 30, 2003 toJune 30, 2005.  The Company did notreceive any consideration from the holders of the warrants, accordingly, theCompany recognized the value of this transaction as a preferred distributionbased upon the estimated fair value of the extension of approximately $195,000for the year ended June 30, 2003.  TheCompany also issued to the Representative of the Underwriters, for nominalconsideration, the Representative’s Warrants to purchase 100,000 shares ofcommon stock and 100,000 redeemable warrants at an exercise price of$12.00.  The expiration date of the Representative’sWarrants was extended from June 22, 2004 to December 22, 2004.  The Company did not receive any considerationfrom the holders of the warrants, accordingly, the Company recognized the valueof this transaction as a preferred distribution based upon the estimated fairvalue of the extension of approximately $38,000 for the year ended June 30,2004.  During the year ended June 30,2004, 400 of the IPO warrants and 69,030 the Representative’s Warrants ofredeemable warrants were exercised, and the balance expired.  As of June 30, 2004, 1,064,700 IPO warrantsremain outstanding, and 29,101 of the Representative’s Warrants remainoutstanding.

 

 (b) Option Activity

 

InSeptember 1998, the Company adopted the 1998 Stock Option Plan (the “1998Plan”).  The 1998 Plan provides for thegrant of incentive stock options and nonqualified stock options to employeesand affiliates.  The exercise price ofthe options equals 100% of the fair market value on the date of the grant.  Options expire ten years from the date of theoption grant and vest ratably over a three-year period commencing with thesecond year.  A total of 280,000 optionswere reserved for issuance under the 1998 Plan. Upon adoption of the 1998 Plan, the 1992 Stock Option Plan wasterminated.  No new stock options will begranted under the 1992 Stock Option Plan, which has been superseded by the 1998Plan.  In December 2000, the Companyadopted the 2000 Incentive and Non Qualified Stock Option Plan (the “2000Plan”).  The 2000 Plan provides for thegrant of incentive stock options and nonqualified stock options to employeesand affiliates.  The exercise price ofthe options equals 100% of the fair market value on the date of the grant or110% of the fair market value for greater than 5% beneficial owners of theCompany stock.  Options expire betweenfive and ten years from the date of the option grant and have variable vestingperiods.  A total of 1,000,000 optionsare reserved for issuance under the 2000 Plan. As of June 30, 2004, a total of 8,503 and 0 stock options are availablefor issuance under the 1998 and 2000 stock option Plans, respectively.  As of June 30, 2004, the Company’s Board ofDirectors approved the issuance of 500,000 options to employees under the 2000Plan.  During the year ended June 30,2004, 38,800 options were granted by the Company prior to shareholderapproval.  These grants are subject toshareholder approval.  Shareholderapproval fixes the measurement date at which time the Company may recorddeferred compensation related to the difference between the fair market valueof the options upon approval and the exercise price of options.  These amounts, if any, will be expensed overthe related vesting period.

 

InDecember 2003, the stockholders of the Company approved an increase in the 2000Incentive and Non-Qualified Stock Option Plan from 600,000 shares to 1,000,000shares.  Prior to the approval of thisincrease, the Company granted options to employees, subject to shareholderapproval.  The Company recordedapproximately $739,000 of deferred compensation expense relating to these stockoptions, which represents the difference between the exercise price of theoptions and the fair market value of the stock on the date of shareholderapproval. This deferred compensation will be recorded as compensation expense

 

42

----

 

over the related vestingperiod, $295,000 of which was recorded as non-cash compensation during the yearended June 30, 2004.

 

InSeptember 1998, the Company adopted the 1998 Employee Stock Purchase Plan (the“Plan”).  The Plan provides a methodwhereby employees of the Company will have an opportunity to acquire anownership interest in the Company through the purchase of shares of CommonStock of the Company through payroll deductions.  After 12 months of employment, an employee iseligible to participate and can defer up to 10% of their wages into this Plan,with a maximum of $25,000 in any calendar year. The purchase price of the Common Stock is calculated at the lower of 85%of the closing price of the stock on the first day of the plan period or thelast day of the plan period.  The periodsare January 1 to June 30 and July 1 to December 31.  Fractional shares are not issued.  Participants may withdraw at any time bygiving written notice to the Company and will be credited the amounts ofdeferrals in their account.  The maximumnumber of shares eligible to be issued under the Plan is 141,000.  As of June 30, 2003, a total of 122,442shares are available for issuance under the Plan.

 

Thefollowing table presents the activity of the 1992, 1998 and 2000 Stock OptionPlans for the years ended June 30, 2003, and 2004:

 
| ** **                                                      | ** ** | **2003**   | ** ** | **2004**                                | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|
| ** **                                                      | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Outstanding at  beginning of period                             |       | 434,700    |       | $                                       | 6.23       |   | 953,500 |   | $ | 4.87 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Granted                                                         |       | 545,800    |       | 3.60                                    |       | 352,200 |   | 6.75 |   |
| Exercised                                                       |       | (23,000    | )          | 4.33                                    |       | (138,635 | ) | 3.77 |   |
| Canceled                                                        |       | (4,000     | )          | 9.12                                    |       | (5,000 | ) | 7.74 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Outstanding at  end of period                                   |       | 953,500    |       | $                                       | 4.87       |   | 1,162,065 |   | $ | 5.55 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Options  exercisable at end of period                           |       | 665,560    |       | $                                       | 4.91       |   | 669,665 |   | $ | 4.90 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Weighted-average  fair value of options granted during the year |       |       |       | $                                       | 3.60       |   |   |   | $ | 6.75 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |   |   |

The following tablepresents weighted average price and life information about significant optionsgroups outstanding at June 30, 2004:

 
| ** **                    | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                        | ** ** |
|-------------------------------|------------|-------------------------|------------|----------------------------------------------------------------|------------|
| **Range of Exercise  Prices** | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Remaining  Contractual  Life (in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $1.00 - $1.37                 |       | 61,800                  |       | 1.92                                                           |       | $ | 1.37 |   | 61,800 |   | $ | 1.37 |   |
| $2.10 - $2.31                 |       | 89,165                  |       | 7.58                                                           |       | 2.15 |   | 89,165 |   | 2.15 |   |
| $3.16 - $5.26                 |       | 427,900                 |       | 7.81                                                           |       | 4.20 |   | 249,450 |   | 4.30 |   |
| $6.33 - $9.50                 |       | 554,000                 |       | 3.51                                                           |       | 5.01 |   | 260,900 |   | 8.10 |   |
| $10.90 - $14.00               |       | 29,200                  |       | 7.70                                                           |       | 10.41 |   | 8,350 |   | 12.61 |   |
|                          |       | **1,162,065**           | ** ** | **5.35**                                                       | ** ** | **$** | **5.53** | ** ** | **669,665** | ** ** | **$** | **5.33** | ** ** |
|                          |       | ** **              | ** ** | ** **                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |

(c)  Warrants

 

In August 2003, inconnection with the issuance of Series B, the Company issued to Laurus awarrant to purchase 25,000 shares of common stock at an exercise price of $6.88per share and an additional warrant to purchase 45,000 shares of common stockat an exercise price of $8.25.  Thesewarrants were

 

43

----

 

fully vested upon issuance and expire 5 years from thedate of grant.  The warrants wererecorded as a discount on the preferred stock at their estimated fair value ofapproximately $184,000.  The Company hasaccreted the discount as a preferred distribution during the year ended June30, 2004.

 

In August 2003, theCompany issued a warrant to a consultant to purchase 2,000 shares of commonstock at an exercise price of $5.24 and, in May 2004, an additional warrant topurchase 8,000 shares at the same exercise price, in exchange forservices.  This warrant was fully vestedupon issuance and expires 5 years from the date of grant.  The fair value of these warrants wasapproximately $63,000 and was recorded as compensation expense in theaccompanying statement of operations during the year ended June 30, 2004

 

In November 2003, inconnection with the issuance of Series C, the Company issued to Laurus awarrant to purchase 50,000 shares of common stock at an exercise price of $8.44per share and an additional warrant to purchase 50,000 shares of common stockat an exercise price of $10.13.  Thesewarrants were fully vested upon issuance and expire 5 years from the date ofgrant.  The warrants were recorded as adiscount on the preferred stock at their estimated fair value of approximately$305,000.  The Company has accretedapproximately $143,000 of the discount as a preferred distribution during theyear ended June 30, 2004.

 

In June 2004, inconnection with a private placement (Note 17), the Company issued to TrukOpportunity Fund LLC, Truk International Fund LP, Basso Multi-Strategy FundLTD, Basso Equity Opportunity Holding Fund LTD and Pacific Wave Partners LTDwarrants to purchase a total of 133,088 shares of common stock at an exerciseprice of $14.43.  These warrants werefully vested upon issuance and expire 5 years from the date of grant.

 

During 2004, the Company issued a warrant to an investor relationscompany to purchase 250,000 shares of common stock at an exercise price of$14.00, in exchange for services.  Thiswarrant was fully vested upon issuance and expired on June 30, 2004.  The fair value of this warrant wasapproximately $230,000 and was recorded as compensation expense in theaccompanying statement of operations for the year ended June 30, 2004.  In June 2004, the Company issued thisinvestor relations company another warrant to purchase 150,000 shares of commonstock at an exercise price of $14.00, in exchange for continued services.  These warrants were fully vested uponissuance and expire 3 years from the date of grant.  The fair value of these warrants wasapproximately $638,000 and was recorded as compensation expense in theaccompanying statement of operations during the year ended June 30, 2004.

 

During 2004, the Company issued other warrants to various advisors andindividuals in exchange for services to purchase a total of 10,000 shares ofcommon stock at exercise prices ranging from $9.95 to $10.25.  The fair value of these warrants wasapproximately $58,000 and was recorded as compensation expense in theaccompanying statement of operations during the year ended June 30, 2004.

 

TheCompany estimated the fair value of the warrants issued during 2004 using theBlack-Scholes option-pricing model. The Company estimated the fair value of thewarrants using the following input assumptions:

 
| Volatility               |   | 63.0% - 67.5%      |   |
|--------------------------|--------|--------------------|--------|
| Dividend yield           |   | 0%                 |   |
| Risk-free  interest rate |   | 0.94% - 4.50%      |   |
| Expected lives           |   | 3 months - 5 years |   |

 

The following table presents the weighted average exercise price ofwarrants outstanding at June 30, 2004:

 

44

----

Warrants Outstanding and Exercisable
| **Range  of Exercise  Prices** | ** ** | **Number of  Warrant Shares** | ** ** | **Weighted  Average Exercise  Price** | ** ** |
|--------------------------------|------------|-------------------------------|------------|---------------------------------------|------------|
|                           |       |                          |       |                                  |       |
| $2.40 - $3.31                  |       | 105,310                       |       | $                                     | 3.28       |   |
|                           |       |                          |       |                                  |       |
| $5.24 - $6.88                  |       | 90,000                        |       | $                                     | 6.30       |   |
|                           |       |                          |       |                                  |       |
| $8.25 - $12.00                 |       | 1,314,375                     |       | $                                     | 9.22       |   |
|                           |       |                          |       |                                  |       |
| $12.45 - $14.43                |       | 367,118                       |       | $                                     | 14.17      |   |
| Total                          |       | 1,876,803                     |       | $                                     | 9.72       |   |

(d)  Notes Receivable

During the year endedJune 30, 2004, loans previously made to the Company’s chief executive officerand to an employee for a total of approximately $223,000, relating to theexercise of stock options, which were recorded as a reduction of stockholders’equity, were paid in full.    

**14. 401k Plan**

The Company has a definedcontribution retirement plan which contains a 401(k) Plan.  All employees who are 21 years of age and whohave completed three months of service during which they worked at least 1,000hours are eligible for participation in the plan.  The Company makes discretionary contributionsto the 401(k) plan.  During the yearsended June 30, 2003 and 2004, the Company made no contributions to the plan.  

**15.  Long-term Debt and Payable toMed-Tec**

*MED-TEC Payment Obligation*

On July 31, 2003, theCompany entered into an agreement with its former exclusive distributor ofprostate seeds, to release each other from further obligations under theoriginal Distributor Agreement.  The new agreement conveys to the Companydirect marketing and sales capabilities to sell its I-Plant Seed brachytherapyseeds for use in the treatment of prostate cancer.  In connection withthis, the Company’s former exclusive distributor will work cooperatively totransition customers and marketing materials directly to the Company.  Thedistributor also agreed not to compete with the Company for a period of threeyears.  The agreement requires the Company to pay the distributor anaverage of approximately $39,000 per month over the 28 months, beginning September1, 2003.  The present value of this payment obligation was recorded asapproximately $1,007,000, using a rate of 10.24%.  This amount was recorded as an intangibleasset and is being amortized over its estimated useful life of 29 months. During the year ended June 30, 2004, approximately $383,000 of amortizationexpense was recognized, which is included in selling, general andadministrative expenses in the accompanying statement of operations.  As of June 30, 2004, the outstandingprincipal balance is approximately $606,000, of which $394,000 and $212,000become due during the years ended June 30, 2005 and 2006, respectively. For the year ended June 30, 2004, the Company recorded approximately $68,000 ofinterest expense relating to this transaction.

*Axcelis Lease Financing*

In June, 2003, theCompany purchased a MC3, mass-analyzed ion implanter and wafer handlingend-station (the “System”) from Axcelis Technologies, Inc. (“Axcelis”) for aprice of $1,300,000.  The Company hadfinanced the System with Axcelis via monthly installments of approximately$43,000 beginning July 2003 and continuing through December 31, 2003.   This agreement bore interest at prime plus6.25%.  In December 2003, the Companyamended this agreement to extend the payment period through June 30, 2004.  This refinancing provided for a lump sumpayment of approximately $571,000 in December 2003 and monthly installments ofapproximately $98,000 beginning January 2004 and continuing through June 30,2004.  Title for the equipment remainedwith Axcelis until the system was paid in full. The value of the equipment is included in property and equipment.  As of June 30, 2004, the unpaid principalbalance of this equipment is approximately $97,000, which becomes due duringthe year ended June 30, 2005 and is included in current maturities of long-termdebt in the accompanying balance sheet. During July 2004, this debt was paid in full.  

**16. Bay Area MRI**

In March2004, the Company entered into a consulting agreement with Christopher Lang andBay Area MRI to assist the Company in the sale of radioactive prostateseeds.  As compensation for consulting services, the Company may berequired to pay commissions of up to $600,000 ($300,000 in cash and $300,000 inshares of common stock).  During the year ended June 30, 2004, the Companyissued 3,205 shares of restricted common stock, bearing an aggregate fairmarket value of approximately $37,500 and advanced $50,000 of cash commissions.As of June 30, 2004, these amounts are classified as prepaid commissions, whichwill be amortized to expense when incurred.  For the year ended June 30,2004, 

45

----

 

approximately$4,000 was amortized. Future commissions will be paid quarterly, up to amaximum of $300,000 in cash and $300,000 of common stock based on servicesprovided.

 

**17. ****PrivatePlacement**

 

On June 17, 2004,the Company issued 468,604 shares of common stock at $10.67 per share, in aprivate placement with the following four investors: Truk Opportunity Fund LLC;Truk International Fund LP; Basso Multi-Strategy Holding Fund Ltd; Basso EquityOpportunity Holding Fund Ltd.  TheCompany received $5,000,000 in gross proceeds, less placement agent fees andrelated transaction costs of approximately $310,000. 

 

In connection with thetransaction, we issued warrants to the investors to purchase 117,152 shares ofcommon stock at an exercise price of $14.43 per share, which are exercisableuntil June 16, 2009.  In addition, theinvestors have rights to purchase up to 215,330 shares of common stock at aprice of $11.61 per share, which are exercisable for a period commencing onJune 17, 2004 and ending on the earlier of (i) 100 days after July 26, 2004,the effective date of the registration statement filed on July 14, 2004 or (ii)February 16, 2005.  We also issuedwarrants to the placement agent to purchase 15,936 shares of our common stockat an exercise price of $14.43 per share, which are exercisable unit June 16,2009.  Should the investors exercisethese additional investment rights, the placement agent will receive anadditional warrant for 7,968 shares at an exercise price of $12.55 per share.

 

**18.  Financial Information by Segment**

 

Under SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” operating segments are defined as componentsof an enterprise about which separate financial information is available thatis evaluated regularly by the chief operating decision maker, or decisionmaking group, in deciding how to allocate resources and in assessingperformance.  The Company’s chiefoperating decision making group is composed of the chief executive officer andmembers of senior management. The Company’s reportable segments are:  Medical, Semiconductor and Explosives.  

 

Gross margin is themeasure that management uses when evaluating the Company's segments, therefore,operating expenses are excluded from the financial information below.

 

The revenues andexpenses related to these segments for the years ended June 30, 2003 and 2004,respectively, are:  

 
| ** **   | ** ** | **Year Ended June 30, 2003** | ** **      |
|--------------|------------|------------------------------|-----------------|
| ** **   | ** ** | **Medical**                  | ** **      | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
|         |       |                         |            |   |   |   |   |   |   |
| Revenue      |       | $                            |  4,594,000 |   | $ |  1,258,000 |   | $ |  844,000 |   | $ | 6,696,000 |   |
| COGS         |       | (3,884,000                   | )               | (992,000 | ) | (487,000 | ) | (5,363,000 | ) |
| Gross Margin |       | $                            | 710,000         |   | $ |  266,000 |   | $ |  357,000 |   | $ |  1,333,000 |   |

 

 
| ** **   | ** ** | **Year Ended June 30, 2004** | ** ** |
|--------------|------------|------------------------------|------------|
| ** **   | ** ** | **Medical**                  | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
|         |       |                         |       |   |   |   |   |   |   |
| Revenue      |       | $                            | 4,957,000  |   | $ | 1,022,000 |   | $ | 2,587,000 |   | $ | 8,566,000 |   |
| COGS         |       | (3,822,000                   | )          | (1,280,000 | ) | (1,084,000 | ) | (6,186,000 | ) |
| Gross Margin |       | $                            | 1,135,000  |   | $ | (258,000 | ) | $ | 1,503,000 |   | $ | 2,380,000 |   |

 

 

**ITEM 8          Changes In and Disagreements WithAccountants on Accounting and Financial Disclosure**

 

# ***ITEM8A.  CONTROLS AND PROCEDURES***

 

EVALUATION OF OUR DISCLOSURE CONTROLS AND INTERNAL CONTROLS

 

As of the end of the period covered by this Annual Report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (“Disclosure Controls”) and our internal controls and procedures 

 

46

----

 

for financial reporting (“Internal Controls”). This evaluation (the “Controls Evaluation”) was done under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”). Rules adopted by the SEC require that in this section of the Annual Report, we present the conclusions of our CEO and the CFO about the effectiveness of our Disclosure Controls and Internal Controls based on and as of the date of the Controls Evaluation.

 

CEO AND CFO CERTIFICATIONS

 

Appearing as exhibits to this Annual Report are “Certifications” of the CEO and the CFO. The Certifications are required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (the “Section 302 Certifications”). This section of the Annual Report contains information concerning the Controls Evaluation referred to in the Section 302 Certifications and this information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.

 

DISCLOSURE CONTROLS AND INTERNAL CONTROLS

 

Disclosure Controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (“Exchange Act”), such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1) our transactions are properly authorized, recorded and reported; and (2) our assets are safeguarded against unauthorized or improper use, to permit the preparation of our financial statements in conformity with generally accepted accounting principles.

 

LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS

 

Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our Internal Controls will prevent all errors and fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. 

 

 

SCOPE OF THE CONTROLS EVALUATION

 

The CEO/CFO evaluation of our Disclosure Controls and Internal Controls included a review of the controls’ objectives and design, the controls’ implementation by us and the effect of the controls on the information generated for use in this Annual Report. In the course of the Controls Evaluation, management sought to identify data errors, controls problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation will be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our Quarterly Reports on Form 10-QSB and Annual Report on Form 10-KSB. The overall goals of these various review and evaluation activities are to monitor our Disclosure Controls and Internal Controls and to make modifications as necessary; our intent in this regard is that the Disclosure Controls and the Internal Controls will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant.

 

Among other matters, management sought in its evaluation to determine whether there were any “significant deficiencies” or “material weaknesses” in our Internal Controls, or whether we had identified any acts of fraud involving personnel who have a significant role in our Internal Controls. In the professional auditing literature, “significant deficiencies” are referred to as “reportable conditions”; these are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. A “material weakness” is defined in the auditing literature as a particularly serious reportable condition 

 

47

----

 

where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions.

 

In accordance with SEC requirements, the CEO and CFO note that, during the fiscal year covered by this Annual Report it was discovered that there was an error in calculation of the fair value of certain warrants issued to non-employees and warrants issued in connection with the Series B and Series C preferred stock issuance, which were used to determine charges to our statement of operations during the three and nine months ended March 31, 2004.  Our chief executive officer and chief financial officer concluded that the weakness that lead to these errors did not constitute a material weakness in internal control.  These amounts were corrected as of August 31, 2004 and the financial statements for the third quarter of fiscal 2004 were restated accordingly.  Management concluded that our disclosure controls and procedures were effective because the errors were inadvertent and isolated.  In addition, our reporting and disclosure procedures were modified to correct this situation and those people who made the inadvertent errors were appropriately educated and additional review procedures were implemented.

 

CONCLUSIONS

 

Based upon the Controls Evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this Annual Report, except as described in the following paragraphs, our Disclosure Controls are effective to ensure that material information relating to our company is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our Internal Controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles.

 

Subsequent to March 31, 2004 and in connection with our year-end audit, it was discovered that there was an error in the calculation of the fair value of certain warrants issued to non-employees and warrants issued in connection with the Series B and Series C preferred stock issuances, which were used to determine charges to our statement of operations during the three and nine months ended March 31, 2004.  Our chief executive officer and chief financial officer concluded that the weakness that led to these errors did not constitute a material weakness in internal control.  These amounts were corrected as of August 31, 2004 and the financial statements for the third quarter of fiscal 2004 were restated accordingly.  Management concluded that our disclosure controls and procedures were effective because the errors were inadvertant and isolated.  In addition, our reporting and disclosure procedures were modified to correct this situation and those people who made the inadvertant errors were properly educated and additional review procedures were implemented.

 

Our independent auditors have reported to our Audit Committee certain matters involving internal controls that our independent auditors considered to be a reportable condition, but not a material weakness, under standards established by the American Institute of Certified Public Accountants. The reportable condition relates to the June 30, 2004 financial close process, including financial statement account analysis.  This reportable condition resulted from inadequate staffing and supervision over the review and financial statement close function. The reportable condition lead, in the audit process, to the identification and resolution of accounting matters and substantiation and evaluation of certain account balances and financial information.

The reportable condition has been discussed in detail among management, our Audit Committee and our independent auditors, and we are committed to addressing and resolving these matters fully and promptly, by putting in place the personnel, processes, technology and other resources appropriate to support our financial close processes. As part of this commitment, we have begun the process to identify and hire additional personnel to assist with the financial close process in the second quarter of fiscal year 2005.

 

 

## **PART III**

**ITEM9.****                             Directors, Executive Officers, Promoters andControl Persons; Compliance with Section 16(a) of the Exchange Act.**

** **

Section 16(a) of theSecurities Exchange Act of 1934, as amended, requires our officers, directorsand persons who beneficially own more than 10% of a registered class of ourequity securities (“ten percent stockholders”) to file reports of ownership andchanges in ownership with the Securities and Exchange Commission.  Officers, directors and ten percentstockholders are charged by the SEC regulations to furnish us with copies ofall Section 16(a) forms they file.

 

Based solely upon a review of Forms 3, 4, and 5 andamendments thereto furnished to us during the past 

 

48

----

 

fiscal year, and, ifapplicable, written representations that Form 5 was not required, we believethat all Section 16(a) filing requirements applicable to our officers,directors and ten percent stockholders were fulfilled.  

 
| **Name**                    | ** ** | **Age**    | ** ** | **Position**                                                  | ** ** | **Position Since** |
|-----------------------------|------------|------------|------------|---------------------------------------------------------------|------------|--------------------|
| ** **                  | ** ** | ** ** | ** ** | ** **                                                    | ** ** | ** **         |
| Anthony J. Armini (1)       |       | 66         |       | President, Chief Executive Officer and Chairman of  the Board |       | 1984               |
|                        |       |       |       |                                                          |       |               |
| Stephen N. Bunker (1)       |       | 61         |       | Vice President and Chief Scientist, Director                  |       | 1987               |
|                        |       |       |       |                                                          |       |               |
| John J. Munro, III (1)      |       | 55         |       | Vice President, Brachytherapy Products                        |       | 2001               |
|                        |       |       |       |                                                          |       |               |
| Diane J. Ryan (1)           |       | 44         |       | Vice President Finance and Chief Financial Officer            |       | 2003               |
|                        |       |       |       |                                                          |       |               |
| Michael Szycher (3)         |       | 65         |       | Director                                                      |       | 1999               |
|                        |       |       |       |                                                          |       |               |
| David B. Eisenhaure (3) (4) |       | 58         |       | Director                                                      |       | 2002               |
|                        |       |       |       |                                                          |       |               |
| Gerald Entine (3) (4) (5)   |       | 61         |       | Director                                                      |       | 2004               |

 

----

(1)               ExecutiveOfficer

(3)               Memberof the Audit Committee for the fiscal year ended June 30, 2004

(4)                                              Member of the Compensation Committee for thefiscal year ended June 30, 2004.  

(5)                                              Mr. Entine was appointed to serve on ourBoard of Directors on May 7, 2004.

 

*Dr.Anthony J. Armini* has been our President, Chief ExecutiveOfficer, and Chairman of the Board of Directors since our incorporation.  From 1972 to 1984, prior to our founding, Dr.Armini was Executive Vice President at Spire Corporation.  From 1967 to 1972, Dr. Armini was a SeniorScientist at McDonnell Douglas Corporation. Dr. Armini received his Ph.D. in nuclear physics from the University ofCalifornia, Los Angeles in 1967.  Dr.Armini is the author of twenty two patents and fourteen publications in thisfield.  Dr. Armini has over thirty yearsof experience working with cyclotrons and linear accelerators, the productionand characterization of radioisotopes, and over twenty years experience withion implantation in the medical and semiconductor fields.  Dr. Armini has been on the Board of Directorsof CardioTech International, Inc., a publicly traded company of which Dr.Szycher is President and Chief Executive Officer, since October 2000.

 

*Dr.Stephen N. Bunker* has served as our Vice President and ChiefScientist since 1987 and a Director since 1988. Prior to joining us, from 1972 to 1987, Dr. Bunker was a Chief Scientistat Spire Corporation.  From 1971 to 1972,Dr. Bunker was an Engineer at McDonnell Douglas Corporation.  Dr. Bunker received his Ph.D. in nuclearphysics from the University of California, Los Angeles in 1969.  Dr. Bunker is the author of eleven patents inthe field of implant technology.

 

*John J. Munro, III* has been our Vice President ofBrachytherapy Products since 2001.  FromMarch 2000 until December 2000, he served as our Director of BrachytherapyProducts and from November 1999 until March 2000 as our Project Manager ofTemporary Brachytherapy.  From August1998 until October 1999, he served as Chief Executive Officer of GammaMed, USA,Inc and from July 1997 until August 1998 Mr. Munro was the Director of SourceOperations at CIS-US, Inc.  Mr. Munro isthe author of two patents.    

 

*DianeJ. Ryan*has served as our Vice President of Finance and ChiefFinancial Officer since May 2003.  Ms.Ryan has been employed with Implant Sciences Corporation since March 1989.  From March 2003 to May 2003, she was theCorporate Controller of the Company.  Ms.Ryan graduated from Salem State College with a B.S. in Business Administrationand a minor in management.  

 

*Dr. Michael Szycher* joined our Board of Directors inDecember 1999.  He has been President andChief Executive Officer and Director of CardioTech International, Inc., apublicly traded manufacturer of medical devices and biocompatible polymerssince 1996.  From 1988 to 1996, Dr.Szycher was Chairman and Chief Technology Officer of Polymedica Industries.  Dr. Szycher is a recognized authority onpolyurethanes and blood compatible 

 

49

----

 

polymers.  He is the editor of six books on varioussubjects in blood compatible materials and devices and the author of eightyoriginal research articles.  

 

*Dr. David B. Eisenhaure* has served on our board of directorssince November 2002.  He has been thePresident, Chief Executive Officer and Chairman of the Board of SatConTechnology Corporation since 1985.  From1974 until 1985, Mr. Eisenhaure was associated with the Charles Stark DraperLaboratory, Incorporated and with its predecessor, the Massachusetts Instituteof Technology’s Instrumentation Laboratory, from 1967 to 1974.  Mr. Eisenhaure also holds an academic positionat M.I.T., as a lecturer in the Department of Mechanical Engineering.  Mr. Eisenhaure serves on the board ofdirectors of Mechanical Technology Incorporated and Beacon Power.  He holds a S.B., S.M. and an Engineer’s Degreein Mechanical Engineering from M.I.T.  

 

*Dr. Gerald Entine*has served on our board since May 2004. He is the President of RadiationMonitoring Devices, Inc. of Watertown, Massachusetts, which he founded in 1974.RMD, Inc. is a manufacturer of radiation detectors and diagnosticinstrumentation used in medical and industrial applications. Dr. Entine, whoreceived his Ph.D. in Physics from the University of California in Berkeley,has also been the Principal Investigator on numerous research grants from theNational Institutes of Health, NASA, DOE and the National Science Foundation. 

** **

**ITEM10.****                      ExecutiveCompensation**

 

The following table sets forth the aggregate cashcompensation paid by us with respect to the three fiscal years ended June 30,2002, 2003 and 2004 to our executive officers

 

**SUMMARYCOMPENSATION TABLE**

 
| ** **                          | ** ** | ** ** | ** ** | ** **                         | ** ** | **Long-Term**                   | ** ** |
|-------------------------------------|------------|------------|------------|------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | ** ** | ** ** | ** **                         | ** ** | ** **                      | ** ** | ** ** | ** ** | **Compensation** | ** ** |
| ** **                          | ** ** | ** ** | ** ** | ** **                         | ** ** | **Awards**                      | ** ** |
| ** **                          | ** ** | ** ** | ** ** | **Annual Compensation**            | ** ** | **Shares  Underlying  Options** | ** ** |
| ** **                          | ** ** | ** ** | ** ** | **Other Annual  Compensation ($)** |
| **Name and Principal Position**     | ** ** | **Year**   | ** ** | **Salary($)**                      | ** ** | **Bonus ($)**                   | ** ** | **(1)** | ** ** | **Granted(#)** | ** ** |
| Anthony J.  Armini**                |       | 2004       |       | $                                  | 166,693    |                            | *$         | 59,700 |   | $ | 12,260 |   | 50,000 |   |
| President, Chief  Executive Officer |       | 2003       |       | $                                  | 176,202    |                            | $          | 75,000 |   | $ | 14,965 |   | 62,200 |   |
| and Chairman of  the Board          |       | 2002       |       | $                                  | 182,533    |                            | $          | 25,000 |   | $ | 10,993 |   | — |   |
|                                |       |       |       |                               |       |                            |       |   |   |   |   |
| Stephen N.  Bunker**                |       | 2004       |       | $                                  | 114,228    |                            | *$         | 23,150 |   | $ | 1,049 |   | 50,000 |   |
| Vice President,                     |       | 2003       |       | $                                  | 82,932     |                            | —     |   | $ | 1,316 |   | 57,300 |   |
| Chief Scientist  and Director       |       | 2002       |       | $                                  | 126,539    |                            | —     |   | $ | 5,759 |   | — |   |
|                                |       |       |       |                               |       |                            |       |   |   |   |   |
| Diane J. Ryan**                     |       | 2004       |       | $                                  | 93,102     |                            | *$         | 25,050 |   | $ | 812 |   | 50,000 |   |
| Vice President  Finance and         |       | 2003       |       | $                                  | 75,421     |                            | $          | 2,750 |   | $ | 783 |   | 49,000 |   |
| Chief Financial  Officer            |       | 2002       |       | —                             |       | —                          |       | — |   | — |   |
|                                |       |       |       |                               |       |                            |       |   |   |   |   |
| John J. Munro,  III**               |       | 2004       |       | $                                  | 118,974    |                            | *$         | 24,050 |   | $ | 1,103 |   | 50,000 |   |
| Vice President  of Sales and        |       | 2003       |       | $                                  | 123,841    |                            | $          | 2,500 |   | $ | 942 |   | 22,700 |   |
| Marketing                           |       | 2002       |       | $                                  | 125,976    |                            | $          | 500 |   | $ | 1,361 |   | 30,000 |   |

 

----

*   Includes the issuance of restricted stock,none of which has been sold as of September 30, 2004.

* *Executive Officer

 

(1)                      Other annual compensation consists oflife and disability insurance premiums and 401(k) plan benefits paid by us onbehalf of these executive officers.

 

50

----

 

**Employment Agreements**

** **

*Anthony J. Armini.*  On June 30, 2004, we entered into anemployment agreement, with an initial term of three years and an automaticrenewal for a successive period of three years, unless the we or Dr. Arminigive the other party not less than three months written notice ofnon-renewal.  Under this employmentagreement, Dr. Armini serves as our president and chief executive officer at abase salary of up to $210,000.  Inaddition, Dr. Armini may participate in our employee fringe benefit plans orprograms generally available to employees of comparable status andposition.  We are entitled to terminatehis employment for any material breach of his employment agreement at any timeupon at least 30 days written notice.  Inthe event we terminate Dr. Armini’s employment without cause, we will pay him12 months salary.  Under his employmentagreement, he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Dr.Armini is subject to a non-competition provision.

 

*Stephen N. Bunker.*  On June 30, 2004, we entered into anemployment agreement, with an initial term of three years and an automaticrenewal for a successive period of three years, unless the we or Dr. Bunkergive the other party not less than three months written notice ofnon-renewal.  Under this employmentagreement, Dr. Bunker serves as our vice president and chief executivescientist at a base salary of up to $150,000. In addition, Dr. Bunker may participate in our employee fringe benefitplans or programs generally available to employees of comparable status andposition.  We are entitled to terminatehis employment for any material breach of his employment agreement at any timeupon at least 30 days’ written notice. In the event we terminate Dr. Bunker’s employment without cause, we willpay him 12 months salary.  Under hisemployment agreement, he is subject to restrictive covenants, includingconfidentiality provisions.  Also, duringhis employment and for a period of two years after the term of the employmentagreement, Dr. Bunker is subject to a non-competition provision.

 

**DirectorCompensation**

 

Our directors who are our employees do not receive anycompensation for service on the board of directors.  Directors who are not our employees, are paida yearly stipend of $2,500 and are reimbursed for reasonable travel expensesincurred in connection with attendance at board and committee meetings.

 

Under the 2000 incentive and nonqualified stock optionplan, each director who is not our employee, automatically receives an annualgrant of options to purchase shares of our common stock at an exercise priceequal to the closing price of the common stock on that date for each year ofservice.  Each such option will have a termof five years and will vest in full on the date of the grant.

## ** **

**Stock Plan**

 

In September 1998, the Company adopted the 1998 StockOption Plan (the “1998 Plan”).  The 1998Plan provides for the grant of incentive stock options and nonqualified stockoptions to employees and affiliates.  Theexercise price of the options equals 100% of the fair market value on the dateof the grant.  Options expire ten yearsfrom the date of the option grant and vest ratably over a three-year periodcommencing with the second year.  A totalof 280,000 options were reserved for issuance under the 1998 Plan.  Upon adoption of the 1998 Plan, the 1992Stock Option Plan was terminated.  No newstock options will be granted under the 1992 Stock Option Plan, which has beensuperseded by the 1998 Plan.  In December2000, the Company adopted the 2000 Incentive and Non Qualified Stock OptionPlan (the “2000 Plan”).  The 2000 Planprovides for the grant of incentive stock options and nonqualified stockoptions to employees and affiliates.  Theexercise price of the options equals 100% of the fair market value on the dateof the grant.  Options expire betweenfive and ten years from the date of the option grant and have variable vestingperiods.  A total of 1,000,000 optionswere reserved for issuance under the 2000 Plan. As of June 30, 2004, a total of 8,503 and 0 stock options are availablefor issuance under the 1998 and 2000 stock option plans, respectively.

 

The Board ofDirectors administers the Stock Plan. Subject to the provisions of the StockPlan, the Board of Directors has the authority to select the optionees orrestricted stock recipients and determine the terms of the options orrestricted stock granted, including: (i) the number of shares, (ii) optionexercise terms, (iii) the exercise or purchase price (which in the case of anincentive stock option cannot be less than the market price of the Common Stockas of the date of grant), (iv) type and duration of transfer or otherrestrictions and (v) the time and form of payment for restricted stock and uponexercise of options. Generally, an option is not transferable by the optionholder except by will or by the laws of descent and distribution. Also,generally, no option may be exercised more than 60 days following terminationof 

 

51

----

 

employment, 90days in cases of retirement.  However, inthe event that termination is due to death or disability, the option isexercisable for a period of 180 days following such termination.

 

In September 1998, the Company adopted the 1998Employee Stock Purchase Plan (the “Plan”). The Plan provides a method whereby employees of the Company will have anopportunity to acquire an ownership interest in the Company through thepurchase of shares of Common Stock of the Company through payrolldeductions,  After 12 months ofemployment, an employee is eligible to participate and can defer up to 10% oftheir wages into this Plan.  The purchaseprice of the Common Stock is calculated at the lower of 85% of the closingprice of the stock on the first day of the plan period or the last day of theplan period and are issued twice a year. The periods are January 1 to June 30 and July 1 to December 31.  Fractional shares are not issued.  Participants may withdraw at any time bygiving written notice to the Company and will be credited the amounts ofdeferrals in their account.  The maximumnumber of shares eligible to be issued under the Plan is 141,000.  As of June 30, 2004, a total of 122,442shares are available for issuance.    

## ** **

## **OPTION GRANTS IN FISCAL 2004**

 

The following table sets forth certain informationregarding stock options held as of June 30, 2004 by the executive officers.

 
| ** **                                | ** ** | **Number of  Securities  Underlying  Options** | ** ** | **% of Total Granted  to Employees in** | ** ** | **Exercise**     | ** ** | **Expiration** | ** ** |
|-------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------|------------|------------------|------------|----------------|------------|
| **Name  and Principal Position**          | ** ** | **Granted**                                    | ** ** | **Fiscal Year**                         | ** ** | **Price ($/Sh)** | ** ** | **Date**       | ** ** |
| ** **                                | ** ** | ** **                                     | ** ** | ** **                              | ** ** | ** **       | ** ** | ** **     | ** ** |
| Anthony J.  Armini                        |       | 50,000                                         |       | 13                                      | %          | $                | 6.96       |           | 8/22/08    |   |
| President and  Chief Executive Officer    |       |                                           |       |                                    |       |             |       |           |       |
|                                      |       |                                           |       |                                    |       |             |       |           |       |
| Stephen N.  Bunker                        |       | 50,000                                         |       | 13                                      | %          | $                | 6.33       |           | 8/22/13    |   |
| Vice President and  Chief Scientist       |       |                                           |       |                                    |       |             |       |           |       |
|                                      |       |                                           |       |                                    |       |             |       |           |       |
| John J. Munro,  III                       |       | 50,000                                         |       | 13                                      | %          | $                | 6.33       |           | 8/22/13    |   |
| Vice President  of Brachytherapy Products |       |                                           |       |                                    |       |             |       |           |       |
|                                      |       |                                           |       |                                    |       |             |       |           |       |
| Diane J. Ryan                             |       | 50,000                                         |       | 13                                      | %          | $                | 6.33       |           | 8/22/13    |   |
| Vice President  Finance and               |       |                                           |       |                                    |       |             |       |           |       |
| Chief Financial  Officer                  |       |                                           |       |                                    |       |             |       |           |       |

 

**AGGREGATEOPTIONS EXERCISEABLE IN LAST FISCAL YEAR**

**AND FISCAL YEAR END OPTION VALUES**

 
| ** **                                | ** ** | **Number of Securities  Underlying Unexercised  Options at June 30, 2004** | ** ** | **Value of Unexercised  In-the-Money Options  at June 30, 2004 (1)** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Name and Principal Position**           | ** ** | **Exercisable**                                                            | ** ** | **Unexercisable**                                                    | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| Anthony J.  Armini                        |       | 135,700                                                                    |       | 66,500                                                               |       | $ | 552,157 |   | $ | 308,105 |   |
| President, Chief  Executive Officer       |       |                                                                       |       |                                                                 |       |   |   |   |   |
| and Chairman of  the Board                |       |                                                                       |       |                                                                 |       |   |   |   |   |
|                                      |       |                                                                       |       |                                                                 |       |   |   |   |   |
| Stephen N.  Bunker                        |       | 40,800                                                                     |       | 66,500                                                               |       | $ | 276,978 |   | $ | 339,605 |   |
| Vice President  and Chief Scientist       |       |                                                                       |       |                                                                 |       |   |   |   |   |
|                                      |       |                                                                       |       |                                                                 |       |   |   |   |   |
| John J. Munro,  III                       |       | 42,850                                                                     |       | 64,850                                                               |       | $ | 188,141 |   | $ | 289,594 |   |
| Vice President  of Brachytherapy Products |       |                                                                       |       |                                                                 |       |   |   |   |   |
|                                      |       |                                                                       |       |                                                                 |       |   |   |   |   |
| Diane J. Ryan                             |       | 58,000                                                                     |       | 75,000                                                               |       | $ | 191,913 |   | $ | 411,167 |   |
| Vice President  Finance and               |       |                                                                       |       |                                                                 |       |   |   |   |   |
| Chief Financial  Officer                  |       |                                                                       |       |                                                                 |       |   |   |   |   |

 

52

----

 

----

(1) As of June 30, 2004, the market value of a shareof common stock was $11.02.

No shares were exercised by Executive Officers infiscal year ended June 30, 2004.

** **

**Equity Compensation Plan Disclosure**

 

The followingtable sets forth certain information as of June 30, 2004 regarding securitiesauthorized for issuance under our equity compensation plans.

 
| **Plan  Category**                                          | ** ** | **Number of securities  to be issued upon   exercise of outstanding   options, warrants and   rights** | ** ** | **Weighted-average   exercise price of   outstanding options, warrants and rights** | ** ** | **Number of securities    remaining available for   future issuance under   equity compensation  plans** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
|                                                        |       |                                                                                                   |       |                                                                                |       |                                                                                                     |       |
| Equity  Compensation Plans Approved by Security Holders     |       | 953,500                                                                                                |       | $                                                                                   | 4.87       |                                                                                                     | 355,703    |   |
|                                                        |       |                                                                                                   |       |                                                                                |       |                                                                                                     |       |
| Equity  Compensation Plans Not Approved by Security Holders |       | —                                                                                                 |       | —                                                                              |       | —                                                                                                   |       |
|                                                        |       |                                                                                                   |       |                                                                                |       |                                                                                                     |       |
| Total                                                       |       | 953,500                                                                                                |       | $                                                                                   | 4.87       |                                                                                                     | 355,703    |   |

 

**ITEM11.****                      SecurityOwnership of Certain Beneficial Owners and Management**

 

The following table setsforth information as of August 31, 2004, with respect to the beneficialownership of our common stock of each director and nominee for director, eachnamed executive officer in the executive compensation table above, all of ourdirectors and current officers as a group, and each person known by us to be abeneficial owner of five percent or more of our common stock.  This information is based upon informationreceived from or on behalf of the individuals named therein.

 
| **Name  of Beneficial Owner**               | ** ** | **Number of Shares  Beneficially Owned (1)** | ** ** | **Percent of  Class (2)** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|
| Anthony J.  Armini (3)                      |       | 1,377,155                                    |       | 14.4                      | %          |
| Stephen N.  Bunker (4)                      |       | 678,715                                      |       | 7.5                       | %          |
| Diane Ryan (5)                              |       | 73,639                                       |       |                      | *          |
| John Munro (6)                              |       | 69,059                                       |       |                      | *          |
| Michael Szycher  (7)                        |       | 26,000                                       |       |                      | *          |
| David Eisenhaure  (8)                       |       | 21,000                                       |       |                      | *          |
| Gerald Entine  (9)                          |       | 10,000                                       |       |                      |       |
| All Directors  and Officers as a group (10) |       | 2,255,568                                    |       | 25.6                      | %          |

 

53

----

 

----

* Less than 1%.

 

(1)                      Unless otherwise noted, each person identified possesses sole votingand investment power over the shares listed.

 

(2)                      The calculation of percent of class is based on 8,444,251 shares ofcommon stock issued and outstanding as of August 31, 2004

 

(3)                      Includes 160,533 options exercisable within 60 days of the date hereof.

 

(4)                      Includes 48,967 options exercisable within 60 days of the date hereof.

 

(5)                      Includes 48,999 options exercisable within 60 days of the date hereof.

 

(6)                      Includes 61,867 options exercisable within 60 days of the date hereof.

 

(7)                      Includes 24,000 options exercisable within 60 days of the date hereof.

 

(8)                      Includes 20,000 options exercisable within 60 days of the date hereof.

 

(9)                      Includes 10,000 options exercisable within 60 days of the date hereof.

 

(10)                Includes374,366 options exercisable within 60 days of the date hereof

 

**ITEM12.****                      CertainRelationships and Related Transactions**

 

Certain of our directors hold positions asdirectors of CardioTech.  Our CEO andChairman of the Board of Directors is also a director of CardioTech.  The CEO and Chairman of the Board ofDirectors of CardioTech is also our director. 

 

In March 2000, the Companyentered into a joint research agreement with CardioTech to develop aproprietary porous polymer biocompatible coating technology as a platform forthe Company’s proprietary radioactive brachytherapy technology.  In consideration for this agreement, theCompany agreed to pay $150,000 in cash and purchase 100,000 shares ofCardioTech stock at a price of $1.00 per share. As of June 30, 2004, the Company has purchased these shares, the fairmarket value of which is $419,000 and is recorded as investments in availablefor sale securities in the accompanying balance sheet.

 

54

----

 

of $1.00 per share.  As of June 30, 2004, the fair market value ofthe CardioTech shares held as investment is $419,000.  CardioTech is a publicly traded company whosecommon stock trades under the symbol CTE on the American Stock Exchange.

 

In March 2004 the Company entered into an Exchange & VentureAgreement with CardioTech International, Inc. (“CardioTech”), a public companyand related party of the Company, and CorNova, Inc. (“CorNova”).  CorNova is a start-up company incorporated asa Delaware corporation on October 12, 2003. CorNova’s focus will be the development and marketing of innovativeinterventional cardiology products.  Inconnection with the agreement, in March 2004, the Company and CardioTech issued10,344 and 12,931 shares, respectively, of their respective common stock (the“Contributory Shares”) bearing an aggregate fair market value of $113,000 and$76,000, respectively, as of the date of the issuance.  In exchange, the Company and CardioTech eachreceived 1,500,000 shares of CorNova’s common stock, which represents a 30%ownership position for each party.  OurCEO and the Chairman of our Audit Committee are also on the Board of Directorsof CorNova.

 

In January 2004, a director of the Company entered into a SalesRepresentative Agreement with the Company to sell radioactive prostateseeds.  In April 2004, this directorresigned from the Company’s Board of Directors to pursue this opportunity andeliminate any possible conflict.

 

55

----

 

**ITEM13.****                      EXHIBITINDEX**

 

The followingare filed as part of this Form 10-KSB

 
| **Exhibit  No.** | ** ** | **Ref.  No.** | ** ** | ** **                                                                                                                           |
|------------------|------------|---------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|
|             |       |          |       |                                                                                                                                 |
| 3.2              |       | 1             |       | By-Laws of the Company                                                                                                               |
| 3.3              |       | 1             |       | Articles of Amendment to the Articles of  Organization of the Company, dated June 9, 1999                                            |
| 3.4              |       | 1             |       | Restated Articles of Organization of the  Company, dated June 9. 1999                                                                |
| 3.5              |       | 5             |       | Certificate of Vote of Directors  establishing Series A 7% Cumulative Convertible Preferred Stock, dated  October 7, 2002            |
| 3.6              |       | 10            |       | Certificate of Vote of Directors  establishing Series B 5% Cumulative Convertible Preferred Stock, dated August  26, 2003            |
| 3.7              |       | 1             |       | Certificate of Vote of Directors  establishing Series C 5% Cumulative Convertible Preferred Stock, dated  November 25, 2003.         |
| 4.1              |       | 2             |       | Specimen certificate for the Common  Stock of the Company                                                                            |
| 4.2              |       | 2             |       | Specimen certificate for the Redeemable  Warrants of the Company                                                                     |
| 4.3              |       | 3             |       | Specimen certificate for the Units of  the Company                                                                                   |
| 4.4              |       | 5             |       | Specimen Certificate of the Series A 7%  Cumulative Convertible Preferred Stock                                                      |
| 10.3             |       | 1             |       | 1992 Stock Option Plan                                                                                                               |
| 10.31            |       | 1             |       | Form of Stock Option Agreement under the  1992 Stock Option Plan                                                                     |
| 10.32            |       | 1             |       | 1998 Incentive and Nonqualified Stock  Option Plan                                                                                   |
| 10.33            |       | 2             |       | Form of Incentive Stock Option under the  1998 Incentive and Nonqualified Stock Option Plan                                          |
| 10.34            |       | 2             |       | Form of Nonqualified Stock Option under  the 1998 Incentive and Nonqualified Stock Option Plan                                       |
| 10.35            |       | 2             |       | Form of Nonqualified Stock Option for  Non-Employee Directors under the 1998 Incentive and Nonqualified Stock Option  Plan           |
| 10.54            |       | 4             |       | Research and Development Agreement,  dated March 13, 2000, by and between Implant Sciences Corporation and  Cardiotech International |
| 10.55            |       | 4             |       | Amendment to Distributorship Agreement  between Med-Tec Iowa, Inc., and Implant Sciences Corporation dated 26 January  2000          |
| 10.69            |       | 5             |       | Securities Purchase Agreement between  Implant Sciences Corporation and Laurus Master Fund, Ltd. Dated October 7,  2002              |
| 10.69.1          |       | 6             |       | Amendment #1 to Item 10.69                                                                                                           |
| 10.70            |       | 5             |       | Security Agreement between Implant  Sciences Corporation and Laurus Master Fund, Ltd. Dated October 7, 2002.                         |
| 10.71            |       | 5             |       | Common Stock Purchase Warrant for 55,000  shares issued to Laurus Master Fund, Ltd. Dated October 7, 2002.                           |
| 10.72            |       | 6             |       | Securities Purchase Agreement between  Implant Sciences Corporation and Laurus Master Fund, Ltd, Dated August 28,  2003.             |
| 10.73            |       | 6             |       | Security Agreement between Implant  Sciences Corporation and Laurus Master Fund, Ltd. Dated August 28, 2003.                         |

 

56

----

 
| **Exhibit  No.** | ** ** | **Ref.  No.** | ** ** | ** **                                                                                                                                                                   |
|------------------|------------|---------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.74            |       | 6             |       | Common Stock Purchase Warrant for 70,000  shares issued to Laurus Master Fund, Ltd. Dated August 28, 2003.                                                                   |
| 10.75            |       | 7             |       | Securities Purchase Agreement between  Implant Sciences Corporation and Laurus Master Fund, Ltd, Dated November 25,  2003.                                                   |
| 10.76            |       | 7             |       | Security Agreement between Implant  Sciences Corporation and Laurus Master Fund, Ltd. Dated November 25, 2003.                                                               |
| 10.77            |       | 7             |       | Common Stock Purchase Warrant for  100,000 shares issued to Laurus Master Fund, Ltd. Dated November 25, 2003.                                                                |
| 10.78            |       | 8             |       | Exchange and Venture agreement between  Implant Sciences Corporation, CardioTech International, and CorNova, Inc.  dated March 5, 2004.                                      |
| 10.78            |       | 9             |       | Form of Securities Purchase Agreement  between Implant Sciences and certain investors                                                                                        |
| 10.79            |       | 9             |       | Form of Warrant dated June, 17, 2004                                                                                                                                         |
| 10.80            |       | 9             |       | Form of Additional Investors Rights  Agreement dated June 17, 2004 between Implant Sciences and certain investors                                                            |
| 10.81            |       | 9             |       | Form of Registration Rights Agreement  dated June 17, 2004 between Implant Sciences and certain investors                                                                    |
| 10.82            |       |          |       | Employment Agreement with Anthony J.  Armini, dated June 30, 3004                                                                                                            |
| 21.1             |       |          |       | Subsidiaries of the Company                                                                                                                                                  |
| 23.1             |       |          |       | Consent of BDO Seidman, LLP, independent  registered public accounting firm                                                                                                  |
| 31.1             |       |          |       | Certification of Chief Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                         |
| 31.2             |       |          |       | Certification of the Chief Financial  Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                     |
| 32.1             |       |          |       | Certification of the Chief Executive  Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|             |       | 1             |       | Previously filed in the Registration  Statement on Form SB-2 (Registration No. 333-64499) filed on September 29,  1998, and is incorporated herein by reference.             |
|             |       | 2             |       | Previously filed in Amendment No. 1 to  the Registration Statement, filed on December 21, 1998, and is incorporated  herein by reference.                                    |
|             |       | 3             |       | Previously filed in Amendment No. 2 to  the Registration Statement, filed on February 11, 1999, and is incorporated  herein by reference.                                    |
|             |       | 4             |       | Previously filed in Quarterly Report on  Form 10-QSB for the quarter ended March 31, 2001, filed on May 11, 2000, and  is incorporated herein by reference.                  |
|             |       | 5             |       | Previously filed in the Annual Report on  Form 10 KSB for the fiscal year ended June 30, 2002 filed on October 15, 2002  and is incorporated herein by reference             |
|             |       | 6             |       | Previously filed in the Annual Report on  Form 10 KSB for the fiscal year ended June 30, 2003 filed on September 29,  2003 and is incorporated herein by reference           |
|             |       | 7             |       | Previously filed on Form 8-K on December  12, 2003, and is incorporated herein by reference                                                                                  |
|             |       | 8             |       | Previously filed on Form 8-K on March  18, 2004, and is incorporated herein by reference                                                                                     |
|             |       | 9             |       | Previously filed on Form S-3  on July 14, 2004, and is incorporated  herein by reference                                                                                |

 

57

----

 

**ITEM14.    PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 
| ** **               | ** ** | **June 30,** | ** ** |
|--------------------------|------------|--------------|------------|
| ** **               | ** ** | **2003**     | ** ** | **2004** | ** ** |
|                     |       |         |       |   |   |
| Audit fees               |       | $            | 77,000     |   | $ | 75,000 |   |
| Quarterly reviews*       |       | 8,000        |       | 25,500 |   |
| Financing  related fees* |       | 10,000       |       | 20,650 |   |
| Other fees               |       | 2,000        |       | 3,000 |   |
| Tax preparation  fees    |       | —       |       | — |   |
| Total                    |       | $            | 97,000     |   | $ | 124,150 |   |

 

----

*  Audit-related fees

 

The Company’s Audit Committee must pre-approve allaudit services to be provided to the Company, whether provided by the principalauditor or other firms, and all other services (review, attest and non-audit)to be provided to the Company by the independent auditor, provided, however,that *de minimis*non-auditservices may instead be approved in accordance with applicable SEC rules.  The Company’s principal financial andaccounting officer communicates to both the Chairman of the Audit Committee andthe auditing services firm any services requested to be provided.  After receiving a fee quote for services fromthe service provider, a letter from the Chairman of the Audit Committee isprepared and submitted to the service provider as evidence of approval of therequested services.

 

58

----

 

**SIGNATURES**

 

In accordance with Section 13 or 15(d) of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                   |   | Implant Sciences Corporation        |
|------------------------|--------|-------------------------------------|
|                   |   |                                |
| Date: October 11, 2004 |   | /s/ Anthony J. Armini               |   |
|                   |   | Anthony J. Armini                   |
|                   |   | President, Chief Executive Officer, |
|                   |   | Chairman of the Board of Directors  |
|                   |   | (Principal Executive Officer)       |

 

In accordance with the Exchange Act, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| Date: October 11, 2004        |   | /s/ Anthony J. Armini                        |   |
|-------------------------------|--------|----------------------------------------------|--------|
|                          |   | Anthony J. Armini                            |
|                          |   | President, Chief Executive Officer,          |
|                          |   | Chairman of the Board of Directors           |
|                          |   | (Principal Executive Officer)                |
|                          |   |                                         |
|                          |   |                                         |
| Date: October 11, 2004        |   | /s/ Diane J. Ryan                            |   |
|                          |   | Diane J. Ryan                                |
|                          |   | VP Finance and CFO                           |
|                          |   | (Principal Financial and Accounting Officer) |
|                          |   |                                         |
|                          |   |                                         |
| Date: October 11, 2004        |   | /s/ Stephen N. Bunker                        |   |
|                          |   | Stephen N. Bunker                            |
|                          |   | Vice President and Chief Scientist,          |
|                          |   | Director                                     |
|                          |   |                                         |
| Date:  October  11, 2004 |   | /s/ Michael Szycher                          |   |
|                          |   | Michael Szycher, Director                    |
|                          |   |                                         |
|                          |   |                                         |
| Date:  October  11, 2004 |   | /s/ David Eisenhaure                         |   |
|                          |   | David Eisenhaure, Director                   |
|                          |   |                                         |
|                          |   |                                         |
| Date:  October  11, 2004 |   | /s/ Gerald Entine                            |   |
|                          |   | Gerald Entine, Director                      |

 

59

----