<PAGE>

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

                                    Form 10-K

(Mark One)
|X|   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
      ACT OF 1934. For the fiscal year ended December 31, 1997.

                                       or

|_|   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: 000-27956

                               Physiometrix, Inc.
             (Exact name of registrant as specified in its charter)

             Delaware                                    77-0238187
      (State or other jurisdiction of                 (I.R.S. employer
      incorporation or organization)                  identification no.)

             Five Billerica Park,
     101 Billerica Ave., N. Billerica, MA               01862
      (Address of principal executive offices)        (Zip code)

       Registrant's telephone number, including area code: (978) 670-2422

        Securities registered pursuant to Section 12(b) of the Act: None

           Securities registered pursuant to Section 12(g) of the Act:

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

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

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

      The aggregate value of voting stock held by non-affiliates of the
Registrant was approximately $8,396,386 as of January 31, 1998, based upon the
average of the high and low prices of the Registrant's Common Stock reported for
such date on the Nasdaq National Market. Shares of Common Stock held by each
executive officer and director and by each person who owns 5% or more of the
outstanding Common Stock have been excluded in that such persons may be deemed
to be affiliates. The determination of affiliate status is not necessarily a
conclusive determination for other purposes. As of January 31, 1998, the
Registrant had outstanding 5,667,075 shares of Common Stock.

                       DOCUMENTS INCORPORATED BY REFERENCE

      Certain information is incorporated into Part III of this report by
reference to the Proxy Statement for the Registrant's 1998 annual meeting of
stockholders to be filed with the Securities and Exchange Commission pursuant to
Regulation 14A not later than 120 days after the end of the fiscal year covered
by this Form 10-K.


<PAGE>

                               Physiometrix, Inc.

                                      INDEX

                                                                            Page
                                                                          Number
                                                                          ------
PART I.........................................................................1

      Item 1   BUSINESS .......................................................1
      Item 2   PROPERTIES ....................................................20
      Item 3   LEGAL PROCEEDINGS .............................................21
      Item 4   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ...........21

PART II.......................................................................22

      Item 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND
                RELATED STOCKHOLDER MATTERS...................................22
      Item 6   SELECTED FINANCIAL DATA .......................................23
      Item 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                AND RESULTS OF OPERATIONS.....................................24
      Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ...................26
      Item 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
                ACCOUNTING AND FINANCIAL DISCLOSURE...........................26

PART III......................................................................27

      Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ............27
      Item 11. EXECUTIVE COMPENSATION ........................................28
      Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
                MANAGEMENT ...................................................28
      Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ................28

PART IV.......................................................................29

      Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
                ON FORM 8-K ..................................................29


<PAGE>

                                      PART I

Item 1.

Introduction

      Physiometrix designs, develops, manufactures and markets noninvasive,
advanced medical products incorporating proprietary materials, electronics
technology and software for use in neurological monitoring applications during
surgical and diagnostic procedures. The Company sells its products to hospitals,
clinics and physicians' offices domestically and internationally. The Company's
current principal product focus is its electronic neurology monitoring products
consisting of the Equinox EEG system, which the Company introduced in February
1997, and the Patient State Analyzer, an innovative system for monitoring brain
activity during anesthesia, which is currently in clinical trials. The Company's
initial products, which were commercially introduced in 1994, are its innovative
e-net headpiece and disposable HydroDot biosensors, which are based upon the
Company's proprietary HydroGel technology, and its custom electronics. These
products are packaged as the HydroDot NeuroMonitoring System, which was
developed and is sold for brain monitoring applications, such as clinical
electroencephalograph ("EEG") procedures. The system is marketed and sold as a
safer, lower cost alternative to current EEG data collection technology. The
system connects and interfaces to the standard input on all conventional EEG
instruments currently in use worldwide, yet offers reduced patient setup time,
more reliable data readings, and enhanced patient comfort and safety.

      Equinox EEG System. The Equinox EEG System uses the Company's HydroDot
NeuroMonitoring System or traditional electrodes to collect EEG data and the
NeuroLink, the Company's data acquisition interface which utilizes a proprietary
high speed analog-to-digital converter to process the data. The Equinox EEG
System transmits the digitized EEG data to a standard personal computer for
analysis and networking by a proprietary fiber optic interface developed by the
Company. The combination of the HydroDot NeuroMonitoring System, the NeuroLink,
and the fiber optic interface is designed to provide health care providers with
a fully integrated EEG system at a lower cost, with enhanced results and
improved patient safety and comfort than the currently available EEG
instruments. The Company received FDA 510(k) clearance for the Equinox in
December 1996 and commenced commercial sales of the Equinox in February 1997.

      Patient State Analyzer. The Patient State Analyzer is being developed by
the Company to provide a simplified, user friendly analysis of patient brain
activity during surgical procedures involving general anesthesia. Currently,
such monitoring is used only during about 3% of all such procedures, primarily
during high risk interventions such as cardiology and neurology surgeries. At
present, brain monitoring can only be accomplished through traditional EEG
techniques involving lengthy setups and the use of flammable materials and
cumbersome equipment. Traditional EEG devices also require a neurologist to
interpret their data output. As a result, anesthesiologists are reluctant to use
EEG monitoring during other surgical procedures, despite the potential benefits
offered by brain monitoring such as improved patient safety, shorter patient
recovery times, and lower overall costs per procedure. The Patient State
Analyzer will incorporate the Company's HydroDot NeuroMonitoring System, the
NeuroLink, and the Equinox EEG technology. In addition, the Company is
developing the final component of the Patient State Analyzer, a proprietary
software module which will process EEG data and provide an easy to read signal
to anesthesiologists regarding patient's brain activity.

      The Company believes that monitoring patients' brain activity during
surgery with the Patient State Analyzer will improve patient safety and lower
costs per surgical procedure by better controlling the amount of anesthesia
administered during surgeries. This will reduce the amount of postoperative
recovery time required, and eliminate the requirement of a neurologist or
specialized technologists to interpret EEG results during surgery. The Company
believes that these benefits create the opportunity for the Patient State
Analyzer to become the standard of care during all surgical interventions using
general anesthesia. The Company plans to resubmit a 510(k) clearance application
to the FDA for the Patient State Analyzer in late 1998, and is working with
clinical investigators at several institutions, including Harvard Medical
School, in the development of the system.


<PAGE>

      The Company has developed additional neurology products utilizing the
Company's proprietary materials and electronics technology. For clinicians
desiring the benefits of the HydroDot biosensors but who do not wish to use
the e-net because they prefer a procedure setup similar to that used with
conventional cup electrodes, the Company has developed the HydroSpot. The
HydroSpot is a hydrogelled disposable biosensor attached to a reusable lead
wire and is offered as an alternative to the conventional cup electrodes
typically employed in EEG procedures. In addition to routine EEG procedures,
the HydroSpot has potential application for long term EEG monitoring and
several other applications including the evaluation of carpal tunnel syndrome.

      The Company will not be able to market the Patient State Analyzer or other
potential products in the United States unless and until it obtains clearance or
approval from the FDA and there can be no assurance that the Company will obtain
FDA clearance for such products on a timely basis, if at all.

      This Report on Form 10-K contains certain forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. Actual events or results may differ
materially from those projected in the forward-looking statements as a result of
the factors described herein and in the documents incorporated herein by
reference. Such forward-looking statements include, but are not limited to,
statements concerning (i) business strategy; (ii) products under development;
(iii) other products; (iv) marketing and distribution; (v) research and
development; (vi) manufacturing; (vii) competition; (viii) government
regulation; (ix) third-party reimbursement; and (x) operating and capital
requirements.


                                      -2-
<PAGE>

      The table below summarizes the products currently offered by the Company,
the products under development by the Company, the markets served by these
products and their present development and/or commercialization status:

--------------------------------------------------------------------------------
                                                               Development/
                                                            Commercialization
          Product                  Description                   Status
--------------------------------------------------------------------------------

Patient State Analyzer      Intraoperative EEG           Under development
                            monitoring system
                            (incorporates proprietary
                            software under
                            development, OR e-net and
                            NeuroLink electronics)

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

Equinox EEG System          Complete EEG monitoring      Commerical Sales
                            system (incorporates
                            HydroDot NeuroMonitoring
                            System and proprietary
                            NeuroLink electronics)

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

NeuroLink                   Multichannel data            Commercial sales
                            acquisition interface
                            between the patient and
                            EEG instrument; also
                            incorporates digital
                            signal processing
                            capability

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

HydroDot NeuroMonitoring
System
- e-net                     EEG headpiece                Commercial sales

- Small e-net               EEG headpiece for children   Commercial sales

- OR e-net                  EEG headpiece for            Commercial sales
                            operating room
                            applications (designed
                            for use with Patient State
                            Analyzer)

- HydroDot biosensors       Disposable  biosensors for   Commercial sales
                            use with e-nets


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

HydroSpot biosensors        Disposable biosensors        Commercial sales
                            attached to lead wires
--------------------------------------------------------------------------------


                                      -3-
<PAGE>

Industry Overview

      EEG Market

      An EEG procedure measures neurophysiological activity by measuring the
intensity and pattern of electrical signals generated by the brain. Undulations
in the recorded electrical signals are called brain waves, and the entire record
of electrical rhythms and other electrical activity (ongoing background signals
and event related transients) of the brain is an EEG. EEGs are widely used to
assist in the diagnosis of epilepsy, brain tumors, physiological disorders and
other brain abnormalities. Because the electrical waves produced by an injured
or abnormal brain will differ in predictable ways from waves produced by a
normal brain, an EEG exam should disclose and help diagnose brain abnormalities
and injuries.

      Although EEG based brain monitoring has been performed for over 70 years,
it is only recently that medical professionals have begun to recognize the
benefits of EEGs as a broad based diagnostic tool. This should be contrasted
with the field of cardiac monitoring in which medical professionals have long
been aware of the benefits of such monitoring, and have integrated
electrocardiogram ("ECG") procedures into both preventive and diagnostic health
care. As a result, medical device and instrument companies have concentrated on,
and provided improved technology for, the cardiac monitoring market. However,
EEG technology has remained virtually unchanged since its inception.

      Industry studies estimate that over 12 million EEG examinations are
performed worldwide annually. The Company believes that the annual market for
EEG devices, including replacement EEG instruments, electrodes and related
supplies, is approximately $125 million. The Company's HydroDot NeuroMonitoring
System and its components target this market.

      There are approximately 48 million surgical interventions performed
annually worldwide under general anesthesia, representing a neuromonitoring
market opportunity estimated in excess of $1 billion. The Company is developing
the Patient State Analyzer to address this market. Currently, anesthesiologists
measure heart, breathing rates, as well as other physiological changes, to
monitor the effect of anesthesia on patients. However, the brain, the organ
which anesthetic drugs affect the earliest, is generally not directly monitored.
Nevertheless, in several types of surgical procedures, including high risk
cardiology and vascular surgical procedures, brain monitoring is recognized by
clinicians as particularly important. Routine monitoring of brain functions
during surgery can result in earlier detection of abnormalities that, if left
undetected, could result in serious surgical and post surgical complications.
Such monitoring can also potentially reduce costs and postoperative recovery
times by enabling a reduction in the amount of anesthesia used during the
surgical procedure, which would enable patients to emerge from the effects of
the anesthesia and be ambulatory more quickly following the procedure. Today,
such monitoring can only be accomplished through the use of conventional EEG
procedures, which require the use of collodion, a flammable, toxic gel material,
for attachment of electrodes as well as cumbersome EEG equipment in the close
confines of the operating room environment. In addition, anesthesiologists are
typically not familiar with conventionally produced EEG test results, and a
neurologist must therefore be on hand to interpret EEG test information. The
Company believes that the availability of a low cost, easy to use monitoring
device such as the Patient State Analyzer could substantially increase brain
monitoring during surgical procedures involving general anesthesia.

      Current EEG Procedure

      Currently, to perform a typical EEG exam, the technician must measure,
mark, clean and abrade 20 spots on the scalp. After these procedures are
completed, 20 disc shaped electrodes are placed on the points identified on the
scalp. Collodion is typically used during this process. Abrasion of the skin is
necessary in order to provide a sufficiently low impedance signal (typically
less than 5,000 ohms) to the EEG monitor. Electrodes can be misplaced, resulting
in inaccurate readings, and can fall off, necessitating that the technician
restart the recording. At the end of the procedure, cleanup of the collodion
used to affix the electrodes to the scalp requires the use of toxic solvents and
is both time consuming and unpleasant for the patient. In addition, incomplete
sterilization of the cup electrodes can result in increased risk of infection
for the patient. These difficulties in patient setup and cleanup also contribute
to reduced


                                      -4-
<PAGE>

operating efficiencies in the EEG laboratory. The current method for performing
EEGs also suffers from several functional deficiencies, including difficulty in
achieving effective electrical contact between the patient and the device, the
possibility of electrode movement or displacement during the EEG examination,
creation of salt bridges, or unwanted electrical circuits between electrodes,
that result in a high level of EEG signal interference. The consequences of
these deficiencies include poor signal quality making diagnoses questionable, a
need to administer repeat tests and signal format that is not conducive to
advanced diagnostic analytical techniques. The Company believes that these
deficiencies have limited the growth of EEG monitoring.

      A traditional EEG procedure takes an average of about 60 minutes, of which
about 30 minutes is made up of actual recording time. The traditional EEG is
extremely sensitive to patient movement, sweating, electrical interference and
muscle tension; any of these may make a tracing uninterpretable. For most of the
actual recording, the patient will lie calmly with their eyes closed. Additional
studies which most laboratories routinely perform include recording during
hyperventilation and photic simulation with a repetitive flash. For many
tracings, subjects are encouraged to fall asleep, if they can. Some laboratories
induce sleep with oral chloral hydrate.

      In response to the inherent inadequacies of traditional methods for
performing EEGS, one manufacturer has introduced a device, which it calls
ElectroCap. This product uses an enclosed "bathing cap" type format, in which
the electrodes are encased in a headpiece that is much like a rubber bathing
cap. The Company believes the ElectroCap suffers from several disadvantages,
including the requirement for many different sized caps for different head
sizes, difficulty in placing electrodes because the technician cannot see the
electrode positioning due to the cap, and the closed design of the cap which is
uncomfortably hot and confining for the patient. In addition, to improve signal
quality, the patient's scalp must be aggressively abraded with a blunt needle
which is a painful, awkward and potentially infectious procedure.

The Physiometrix Solution

      The Physiometrix HydroDot NeuroMonitoring System has been developed to
address and seek to overcome the deficiencies of current methods of performing
EEGS. The HydroDot System incorporates innovative product features that improve
clinical efficacy, patient comfort and allow the EEG laboratory to perform EEG
procedures more efficiently. Physiometrix' e-net is a proprietary, flexible,
open net matrix that fits over the patient's head and uses disposable, soft
hydrogel biosensors that are inserted into the matrix at predetermined locations
that correspond to points on the scalp where conventional cup electrodes would
otherwise be affixed manually. In effect, the e-net serves as a template to
automatically position the HydroDot biosensors for the EEG procedure. The e-net
fits a majority of adult head sizes. The elasticity of the e-net ensures
accurate placement of the HydroDot biosensors and the maintenance of
proportionality between electrodes. The Company also sells a smaller version of
the e-net which, together with the adult sized e-net, enables over 95% of head
sizes to be accommodated. The proprietary hydrogel electrode material is
adhesive, but does not leave a residue. In contrast to conventional EEG methods,
time consuming and often painful scalp preparation is not required to achieve a
low impedance signal. The hair is simply parted and the HydroDot biosensors are
pressed into the sockets on the e-net. For testing environments in which there
is the potential for hostile electrical interference, the e-net can connect to
an adjacent analog to digital interface module that digitizes the electrode
signal, transmits the digital data via a fiber optic link to the instrument
location, where it is converted back into an analog form acceptable to the EEG
input electronics. This data transmission procedure virtually eliminates ambient
noise that is present in most EEGs (especially electronic noise in the intensive
care unit, operating room and emergency room) as a result of the "antennae"
effect from using wire leads to transmit electrical data, and can be used with
any EEG instrument.

      The e-net reduces average EEG setup times by approximately 75 percent (6
to 8 minutes versus 30 minutes), in addition to providing a high quality and
accurate signal. The HydroDot NeuroMonitoring System offers the following
advantages over traditional modalities:

      -     Electrode positioning is fast, easy, accurate and reproducible; time
            consuming measurements are avoided.


                                      -5-
<PAGE>

      -     Patient preparation time is greatly reduced and the use of toxic,
            flammable substances is avoided.

      -     Patient comfort is enhanced because patients can move around
            untethered; the open e-net structure provides ventilation and the
            patient is not encumbered by a large number of wires.

      -     Adhesive qualities of the hydrogel provide excellent skin contact
            without slippage, eliminate salt bridges and prevent electrodes from
            falling off the scalp.

      -     Biosensors ensure reproducible signal quality and minimize
            collection of electrical interference from the environment.

      -     Risk of infection is reduced through the use of disposable
            biosensors and reduced need for scalp abrasion.

      The Company believes that the Equinox EEG System and the Patient State
Analyzer, will enable it to offer new and enhanced system solutions for the
neurology monitoring market. The Equinox EEG System could significantly increase
the number of neurologists performing EEGs by reducing the capital costs
involved in EEG monitoring. Currently, only approximately one-third of the
nearly 10,000 neurologists in the United States perform EEGs due in large part
to the capital costs associated with EEG devices.

      The Company believes that the availability of a low-cost, easy to use
monitoring device such as the Patient State Analyzer, could substantially
increase brain monitoring during surgery and has the potential to become the
standard of care in brain monitoring during administration of general
anesthesia.

Business Strategy

      The Company's objective is to become the leader in the design, development
and commercialization of brain monitoring technology. Key elements of the
Company's strategy including the following:

      -     Design and Develop Innovative, Proprietary Products for the
            Neurology and Surgical Market. Physiometrix plans to capitalize on
            the growing recognition among medical professionals of EEG
            monitoring as a diagnostic tool and the need for a low-cost, easy to
            use and reliable method of brain monitoring. The Company intends to
            remain focused on the development and marketing of products for
            neurology and surgery including products that are designed to expand
            the use of neurological monitoring. The Company has substantial
            design and development expertise in the neurological monitoring
            field and will seek to position itself at the forefront of
            innovation in this industry.

      -     Diversify Product Offerings to Increase Market Penetration. The
            Company seeks to offer a range of products, including hardware and
            disposable products designed to simplify EEG procedures and
            encourage broader use of EEG monitoring. The Company believes that
            it will be able to significantly expand its penetration of the
            neurology and surgery markets with the Equinox EEG System and
            through the introduction of the Patient State Analyzer.

      -     Broaden Marketing Channels. The Company will seek to implement a
            broad based marketing strategy, using direct sales personnel and
            distributors in the United States and distributors and others
            internationally. The Company's current products are also being
            marketed through a neurology monitoring company. In addition, the
            Company will need to select a distribution partner to market the
            Patient State Analyzer to anesthesiologists, hospital
            administrators, and, to a lesser extent, managed care centers.

      -     Outsource Manufacturing to Control Costs. The Company will seek to
            outsource many manufacturing processes to qualified contract
            manufacturers to control costs, maintain quality and reduce capital


                                      -6-
<PAGE>

            investment, while retaining control over key proprietary processes
            for certain components of its products.

Products and Technology

      Current Products

      Equinox EEG System. The Equinox EEG System is a low cost, general
purpose, digital, EEG platform with software and hardware optimized for both
desktop and portable systems utilizing the Company's EEG signal acquisition
technology. The Equinox EEG System is offered at a price significantly lower
than currently available EEG instruments. The Company believes that the
Equinox EEG System's portability will facilitate greater EEG access to remote
areas both domestically and internationally. The incorporation of personal
computer technology allows networking, analysis and transmission of EEG data.
In addition, the use of the Company's NeuroLink product and the HydroDot
NeuroMonitoring System provides the EEG data acquisition front end link to
the standard personal computer platform which underlies the Equinox EEG
System. The Equinox EEG System received FDA 510(k) clearance in December 1996
and commercial sales of the Equinox commenced in February 1997.

      NeuroLink. The NeuroLink is a cost effective "front end" link from the
patient to the EEG machine and is integrated into both the Equinox EEG System
and the Patient State Analyzer. The NeuroLink is an optically isolated,
instrumentation grade, 32 channel data acquisition system that provides a quick
interface capability to the Company's e-net. The NeuroLink allows the physician
or EEG technician to check calibration and individual electrode impedances
immediately upon preparation of the patient for the EEG procedure. Because the
NeuroLink incorporates a fiber optic link between the patient and the EEG
instrument, recordings are free from 60 hertz interference, a particular problem
in operating rooms and other critical care settings.

      e-net. The e-net is an open handed headpiece designed to position and hold
the HydroDot disposable biosensors symmetrically against the scalp during an EEG
study. The e-net is manufactured from a proprietary elastic material and
positions 20 biosensors according to the internationally recognized 10-20 System
on head sizes varying from 48 to 62 centimeters in circumference. The 10-20
System is a standard, universal methodology for marking and measuring the
patient's scalp for electrode placement in EEG procedures.

      The e-net is held in place by adjustable straps, one at the back of the
neck and the other around the chin. These strap positions minimize interaction
between head motion and electrode position. The open handed design of the e-net
allows access to the scalp for parting the hair and for placing additional
biosensors on the patient. The expandable, shielded wire leads on the outside of
the e-net are combined into a single connector that interfaces to the straight
cable. The e-net is reusable with an expected lifetime of up to 200
applications. The elastic material is shielded by a fabric sheath and the wires
are covered in a protective jacket and ultrasonically welded to the biosensor
sockets. The disposable biosensors snap out of the e-net after it is removed and
the entire e-net may be sterilized in disinfectant solution. Its key competitive
features are elastic proportionality, increased patient comfort, standardized
placement of biosensors, elimination of measurements, open handed design,
integrated wiring, and durability. The e-net is currently sold separately for
$250.00 or as a starter kit with a half case of HydroDot biosensors (enough for
approximately 10 EEG procedures) and a straight cable for connection to EEG
machines for $495.00.

      Small e-net. Because the HydroDot NeuroMonitoring System is much less
traumatic to patients than traditional EEG procedures, it is much easier to use
on children. Physiometrix' small e-net, introduced in March 1995, enables
technicians to use the HydroDot NeuroMonitoring System on children.


                                      -7-
<PAGE>

      OR e-net. The Company has developed the OR e-net, which is specially
designed so that it can be used during surgical procedures in which blood flow
to the brain could be compromised. Typically, hospitals have had to rely on
collodion as an adhesive for their operating room procedures to secure the metal
cup electrodes. Many institutions have banned collodion from operating room use
because it is highly flammable. As a result, the Company believes that the
HydroDot NeuroMonitoring System can potentially replace many products currently
available for such uses.

      HydroDot Disposable Biosensors. The HydroDot biosensors are disposable and
are used in lieu of conventional cup electrodes to acquire EEG signals from a
patient. The biosensors are packaged in ready-to-use sealed trays of 24 sensors.
Minimal skin preparation and no collodion is required when the sensors are
inserted into the sockets on the e-net. When the e-net is removed after
completion of an EEG examination, the sensors leave no residue on the scalp. The
HydroDot biosensors provide high signal quality through the incorporation of a
silver/silver chloride reference and an adhesive proprietary hydrogel material
that conforms to the scalp. Because the HydroDot biosensors are disposable, they
can be used on patients with contagious diseases and discarded, thereby reducing
the risk of spreading infectious disease. Their key competitive features are
ease of use, reduced risk of infection, cleanliness, improved signal quality and
increased safety. The HydroDot biosensors are sold in 20-tray cases for $180.00.

      HydroSpot. The Company has developed the HydroSpot biosensor for those
technicians who want the benefits of the HydroDot biosensors, but do not wish to
use the e-net because they prefer a procedure setup similar to that used with
conventional cup electrodes. The HydroSpot is a hydrogelled disposable biosensor
attached to a reusable lead wire and will be offered as an alternative to the
conventional cup electrodes typically employed in EEG procedures. In addition to
routine EEG procedures, the HydroSpot has potential application for long term
EEG monitoring and several other applications including evoked potentials and
nerve conduction velocity studies which are often used in evaluation of carpal
tunnel syndrome patients.

      The HydroDot NeuroMonitoring System represents a new method for EEG
monitoring, and market acceptance of the system will be dependent upon, among
other things, the willingness of physicians, EEG technicians and others to adopt
use of this new system. Market acceptance will also be dependent upon the
Company's ability to convince potential users of the system of its anticipated
cost and efficacy advantages. In addition, the HydroDot NeuroMonitoring System
may not be suitable for patients that have experienced severe head trauma
because the physician may not wish to surround the patient's head with the
e-net. However, the Company's HydroSpot biosensors, which do not require use of
the eNet, could be used for such patients. [In addition, clinical experience
with the HydroDot NeuroMonitoring System indicates that the system may be less
effective with, or may not be suitable for use with, patients with long or thick
hair. This may adversely affect market acceptance of the HydroDot system.]

      Products Under Development

      Patient State Analyzer. Physiometrix is developing the Patient State
Analyzer ("PSA") for brain monitoring in the operating room. The PSA is expected
to utilize a single use Disposable Appliance to record EEG for continuous
analysis by the PSA. The PSA is being designed to extract data known to be
sensitive to the functional level of each region of the brain, the adequacy of
blood supply and the interaction of each region with neighboring regions on the
opposite side of the brain. Based on such measurements, statistical procedures
will be used to deliver an analysis of the data into a measurement called a
"self-norm," to provide a base for monitoring the effects of anesthesia.

      The PSA will record "self-norms" both prior to and immediately after
the administration of anesthesia. During intraoperative procedures, the PSA
will constantly monitor data and its relationship to those two endpoints and
alert the anesthesiologist as to changes in the patient's state of
consciousness. The PSA will provide the anesthesiologist with a readout
regarding the patient's ideal anesthetized state. Normal neurological
function for the patient will be determined by recording a brief EEG
immediately prior to anesthesia and a subsequent brief EEG as soon as the
patient has reached an optimal anesthetized state.


                                      -8-
<PAGE>

      The PSA will consist of portions of the Company's Equinox EEG hardware
with a single use version of the e.Net place of the standard e-net and an 8
channel preamplifier input. Software will include testing electrode impedance,
amplifier calibration, EEG collection, quantitative analysis after artifact
removal (brain wave abnormalities resulting from external stimulation, eye
blinking or muscle movement), display and storage. The capability to construct
group norms for a particular procedure will be provided, so the user can build
criteria for the typical patient.

      The Company expects that the PSA will be developed in two phases. The
first phase will include the development and implementation of proprietary
software for displaying changes in the patient's level of consciousness. The
development system platform will consist of a standard personal computer and a
NeuroLink fiber optic interface card. The second phase will consist of trials
seeking to validate the effectiveness and safety of the PSA during operating
conditions using six different anesthetic agents. Each agent will be evaluated
in 20 cases. The software is planned for development in a modular fashion. The
Company expects that it will include a data acquisition module, signal
processing module, artifact removal module, signal analysis module, a data
storage module and a user interface module. By developing a system software
specification defining the use of software modules, development time and cost
for new Physiometrix products is expected to be reduced.

      The Patient State Analyzer represents a new approach for brain monitoring
during surgery. Market acceptance of this product will be dependent upon, among
other things, the willingness of physicians, EEG technicians and others to adopt
use of these products. Market acceptance will also be dependent upon the
Company's ability to convince potential users of this product of its cost and
efficacy advantages.

      The Patient State Analyzer is currently in clinical trials in the United
States. The Company intends to resubmit a 510(k) clearance application to the
FDA for the Patient State Analyer in late 1998 and is working with leading
neurologists and anesthesiologists at several institutions, including Harvard
Medical School, in the development of the system.

Marketing and Distribution

      The Company's initial sales and marketing strategy is to focus on
neurologists in the United States and in other markets targeted by the Company.
In the United States, there are approximately 10,000 neurologists, and industry
studies estimate that over 6 million EEG examinations are performed in the
United States annually, with approximately 80 percent of these procedures being
performed in approximately 3,650 high volume clinics. The Company seeks to
emphasize to neurologists and neurological technicians the cost saving potential
of the HydroDot NeuroMonitoring System. A cost justification analysis performed
at a leading children's hospital indicated that use of the HydroDot
NeuroMonitoring System provided measurable time and cost savings and resulted in
the adoption of the HydroDot System at the hospital at which the study was
performed.

      Physiometrix currently employs a small direct sales force in the United
States with the goal of expanding adoption of the HydroDot System. In addition,
the system is being actively promoted by a leading manufacturer of EEG machines:
known as TECA Corp. ("TECA"). The Company has begun an active program to train
the sales organizations of its marketing partners. This includes field training
of sales, service and applications staffs as well as in house training of
telemarketing and customer support personnel.

      The Company intends, in connection with the planned commercial
introduction of the Patient State Analyzer, to select a distribution partner
with substantial experience and capabilities in sales of capital equipment to
hospitals, anesthesiologists and other potential users of such system. The
Company currently does not intend to increase significantly its sales force to
market the Patient State Analyzer.

      Because the Company has only recently reached product commercialization,
Physiometrix has to date focused its sales effort domestically. The Company
anticipates utilizing specialty medical device distributors for international
sales.


                                      -9-
<PAGE>

Research and Development

      Physiometrix research and development activities are performed by the
Company's internal research and development staff, whose activities are
augmented by the use of outside consultants for particular projects and areas of
specialization. The Company has retained consultants for hardware and software
design and clinical evaluation and development of the Patient State Analyzer.
The Company's future research and development efforts are expected to be focused
on completion of development of the Patient State Analyzer, improving its
existing products as well as development of new products for the neurology
market.

      Research and development expenses for the years ended December 31, 1995,
1996 and 1997 were $392,413, $1,189,336, and $2,500,601 respectively, none of
which was customer funded.

Manufacturing

      The Company manufactures its products at its facilities in North
Billerica, Massachusetts. Production occurs in approximately 5,000 square feet
of space utilizing standard production equipment for most processes and
proprietary equipment for several specialized operations. The Company's
production area includes a segregated area where temperature can be controlled
and maintained for the production of the HydroDot biosensors. The Company
intends to increase outsourcing of manufacturing to contract manufacturers for
certain components in order to reduce cost and capital requirements and improve
quality, while retaining control over certain proprietary manufacturing
processes.

      The Company manufactures its products in conformance with FDA's GMPs, and
intends to comply with ISO 9001 standards when required in order to continue to
produce products for sale in Europe. Any failure by the Company to remain in
compliance with the GMPs or comply with ISO 9001 standards could have a material
adverse effect on the Company's business, financial condition and results of
operation.

      The Company purchases components from various suppliers and relies on
single sources for several parts. To date, the Company has not experienced any
significant adverse affects resulting from shortages of components. Delays
associated with any future part shortages, particularly as the Company scales up
its manufacturing activities, would have a material adverse effect on the
Company's business, financial condition and results of operations.

      The Company currently manufactures its HydroDot NeuroMonitoring Systems
and NeuroLink and Equinox in limited quantities. The Company does not have
experience in manufacturing its products in commercial quantities. Manufacturers
often encounter difficulties in scaling up production of products, including
problems involving production yields, quality control and assurance, component
supply and lack of qualified personnel. Difficulties encountered by the Company
in scaling up manufacturing could have a material adverse effect on its
business, financial condition and results of operations.

Competition

      Competition in the market for neurological monitoring devices is intense
and may increase. The Company's products compete against conventional EEG
monitoring devices and related EEG monitoring products. Traditional EEG
electrodes are manufactured by a variety of companies. Nicolet, Nihon Kohden
America, Inc. and TECA are leading providers of EEG supplies through their
respective catalogs. Many of the Company's competitors have substantially
greater name recognition and financial resources than the Company and also have
greater resources and expertise in the areas of research and development,
obtaining regulatory approvals, manufacturing, marketing and sales. There can be
no assurance that the Company's competitors will not succeed in developing and
marketing products and technologies that are more effective than those developed
and marketed by the Company or that would render the Company's products and
technologies obsolete or noncompetitive. Additionally, there can be no assurance
that the Company will be able to compete effectively against its competitors in
the areas of manufacturing, marketing and sales.


                                      -10-
<PAGE>

      The Company believes that the primary competitive factors in the market
for neurological monitoring devices are the ability to provide products that can
improve clinical efficacy, reduce patient setup time, and contribute to
improvement of laboratory operating efficiencies. The Company believes that the
innovations it has developed in the field of neurology monitoring can
potentially afford it a competitive advantage.

      The Company commercially introduced the Equinox EEG System in February
1997 and anticipates that, due to the number of companies competing for sales of
EEG machines, the Company will encounter increased price competition. Several of
the Company's competitors are offering EEG systems with limited capabilities at
sale prices below those of full featured EEG instruments, and other competitors
are also developing their own low cost systems. Accordingly, the Company may be
subject to increased price competition as well as other competitive factors in
the future.

Patents and Proprietary Rights

      The Company's policy is to protect its proprietary position by, among
other methods, filing United States and foreign patent applications to
protect technology, inventions and improvements that are important to its
business. The Company has nine issued United States patents and four United
States patent applications pending in the areas of biosensor material
compositions, electrode configurations, diagnostic systems and
system-to-instrument data links.

      The patent positions of medical device companies, including those of the
Company, are uncertain and involve complex and evolving legal and factual
questions. The coverage sought in a patent application either can be denied or
significantly reduced before or after the patent is issued. Consequently, there
can be no assurance that any patent applications will result in the issuance of
patents, or that the Company's issued or any future patents will provide
significant protection or commercial advantage or will not be circumvented by
others. Since patent applications are secret until patents are issued in the
United States or corresponding applications are published in international
countries, and since publication of discoveries in the scientific or patent
literature often lags behind actual discoveries, the Company cannot be certain
that it was the first to make the inventions covered by each of its pending
patent applications or that it was the first to file patent applications for
such inventions. There can be no assurance that patents held by or licensed to
the Company or any patents that may be issued as a result of the Company's
pending or future patent applications will be of commercial benefit, afford the
Company adequate protection from competing products or technologies or will not
be challenged by competitors or others or declared invalid. Also, there can be
no assurance that the Company will have the financial resources to defend its
patents from infringement or claims of invalidity.

      In the event a third party has also filed a patent application relating to
an invention claimed in a Company patent application, the Company may be
required to participate in an interference proceeding declared by the United
States Patent and Trademark Office ("US PTO") to determine priority of
invention, which could result in substantial uncertainties and costs to the
Company, even if the eventual outcome is favorable to the Company. There can be
no assurance that any patents issued to the Company would be held valid by a
court of competent jurisdiction.

      The Company relies upon trade secret protection for certain unpatented
aspects of other proprietary technology. There is no assurance that others will
not independently develop or otherwise acquire substantially equivalent
proprietary information or techniques, others will not otherwise gain access to
the Company's proprietary technology or disclose such technology, or the Company
can meaningfully protect its trade secrets.

      The Company typically requires its employees and consultants to execute
appropriate confidentiality and proprietary information agreements upon the
commencement of employment or consulting relationship with the Company. These
agreements generally provide that all confidential information developed or made
known to the individual by the Company during the course of the individual's
relationship with the Company, is to be kept confidential and not disclosed to
third parties, except in specific circumstances. The agreements generally
provide that all inventions conceived by the individual in the course of
rendering services to the Company shall be the exclusive property of the
Company; however, certain of the Company's agreements with consultants, who
typically are employed on a full time basis by academic institutions or
hospitals, do not contain assignment of invention provisions. There can


                                      -11-
<PAGE>

be no assurance, however, that these agreements will provide meaningful
protection or adequate remedies for the Company in the event of unauthorized
use, transfer or disclosure of such information or inventions.

Government Regulation

      United States

      The Company's HydroDot NeuroMonitoring System (including its family of
e-nets, and HydroDot biosensors, HydroSpot, Equinox EEG System, Patient State
Analyzer and other potential products are and will be regulated in the United
States as medical devices by the FDA under the Federal Food, Drug, and Cosmetic
Act ("FDC Act") and require premarket clearance or approval by the FDA prior to
commercialization. In addition, certain material changes or modifications to
medical devices also are subject to FDA review and clearance or approval.
Pursuant to the FDC Act, the FDA regulates the research, testing, manufacture,
safety, labeling, storage, record keeping, advertising, distribution and
production of medical devices in the United States. Noncompliance with
applicable requirements can result in warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or premarket
approval for devices, and criminal prosecution. Medical devices are classified
into one of three classes, Class I, II or III, on the basis of the controls
deemed by FDA to be necessary to reasonably ensure their safety and
effectiveness. Class I devices are subject to general controls (e.g., labeling,
premarket notification and adherence to Good Manufacturing Practices ("GMP").
Class II devices are subject to general controls and to special controls (e.g.,
performance standards, postmarket surveillance, patient registries, and FDA
guidelines). Generally, Class III devices are those which must receive premarket
approval by the FDA to ensure their safety and effectiveness (e.g., life
sustaining, life supporting and implantable devices, or new devices which have
not been found substantially equivalent to legally marketed devices), and
require clinical testing to ensure safety and effectiveness and FDA approval
prior to marketing and distribution. FDA also has the authority to require
clinical testing of Class I and Class II devices. A premarket approval ("PMA")
application must be filed if the proposed device is not substantially equivalent
to a legally marketed predicate device or if it is a Class II device for which
FDA has called for such applications.

      If human clinical trials of a device are required and if the device
presents a "significant risk," the manufacturer or the distributor of the device
is required to file an investigational device exemption ("IDE") application
prior to commencing human clinical trials. The IDE application must be supported
by data, typically including the results of animal and, possibly, mechanical
testing. If the IDE application is approved by FDA, human clinical trials may
begin at a specific number of investigational sites with a maximum number of
patients, as approved by the agency. Sponsors of clinical trials are permitted
to sell those devices distributed in the course of the study provided such costs
do not exceed recovery of the costs of manufacture, research, development and
handling. The clinical trials must be conducted under the auspices of an
independent institutional review board ("IRB") established pursuant to FDA
regulations.

      Generally, before a new device can be introduced into the market in the
United States, the manufacturer or distributor must obtain FDA clearance of a
510(k) notification or approval of a PMA application. If a medical device
manufacturer or distributor can establish that a device is "substantially
equivalent" to a legally marketed Class I or Class II device, or to a Class II
device for which FDA has not called for PMAs, the manufacturer or distributor
may seek clearance from FDA to market the device by filing a 510(K)
notification. The 510(k) notification may need to be supported by appropriate
data establishing the claim of substantial equivalence to the satisfaction of
FDA. FDA recently has been requiring a more rigorous demonstration of
substantial equivalence.

      Following submission of the 510(k) notification, the manufacturer or
distributor may not place the device into commercial distribution until an order
is issued by FDA. No law or regulation specifies the time limit by which FDA
must respond to a 510(k) notification. At this time, FDA typically responds to
the submission of a 510(k) notification within 150 to 200 days. An FDA order may
declare that the device is substantially equivalent to another legally marketed
device and allow the proposed device to be marketed in the United States. FDA,
however, may determine that the proposed device is not substantially equivalent
or require further information, including clinical data, to make a


                                      -12-
<PAGE>

determination regarding substantial equivalence. Such determination or request
for additional information could delay market introduction of the products that
are the subject of the 510(k) notification.

      If a manufacturer or distributor of medical devices cannot establish that
a proposed device is substantially equivalent to a legally marketed device, the
manufacturer or distributor must seek premarket approval of the proposed device
through submission of a PMA application. A PMA application must be supported by
extensive data, including preclinical and clinical trial data, as well as
extensive literature to prove the safety and effectiveness of the device.
Following receipt of a PMA application, if FDA determines that the application
is sufficiently complete to permit a substantive review, FDA will "file" the
application. Under the FDC Act, FDA has 180 days to review a PMA application,
although the review of such an application more often occurs over a protracted
time period, and generally takes approximately two years or more from the date
of filing to complete.

      The PMA application approval process can be expensive, uncertain and
lengthy. A number of devices for which premarket approval has been sought have
never been approved for marketing. The review time is often significantly
extended by FDA, which may require more information or clarification of
information already provided in the submission. During the review period, an
advisory committee likely will be convened to review and evaluate the
application and provide recommendations to FDA as to whether the device should
be approved. In addition, FDA will inspect the manufacturing facility to ensure
compliance with FDA's GMP requirements prior to approval of an application. If
granted, the approval of the PMA application may include significant limitations
on the indicated uses for which a product may be marketed.

      The Company received clearance of 510(k) premarket notification from the
FDA to market the HydroDot NeuroMonitoring System, HydroSpot and Equinox EEG
System for EEG monitoring and the EP System for certain external defibrillation
applications and RF return during electrosurgical procedures where a combination
of defibrillation and RF return indications is required. The Company believes
that the Patient State Analyzer and other potential products currently under
development will be subject to FDA clearance by 510(k) notification, however,
the FDA may require the Company to submit a PMA application for such products.
There can be no assurance that the Company will be able to obtain necessary
510(k) clearance or PMA application approval to market the Patient State
Analyzer or any other products, on a timely basis, if at all, and delays in
receipt or failure to receive such clearances or approvals, the loss of
previously received clearances or approvals, or failure to comply with existing
or future regulatory requirements could have a material adverse effect on the
Company's business, financial condition and results of operations.

      The Company is also required to register as a medical device manufacturer
with the FDA and state agencies and to list its products with the FDA. As such,
the Company will be inspected by both FDA and state agencies for compliance with
the FDA's GMP and other applicable regulations. These regulations require that
the Company manufacture its products and maintain its documents in a prescribed
manner with respect to manufacturing, testing and control activities. Further,
the Company is required to comply with various FDA requirements for design,
safety, advertising and labeling. The Company has not yet undergone an FDA GMP
inspection.

      The Company is required to provide information to the FDA on death or
serious injuries alleged to have been associated with the use of its medical
devices, as well as product malfunctions that would likely cause or contribute
to death or serious injury if the malfunction were to recur. In addition, the
FDA prohibits an approved device from being marketed for unapproved
applications. If the FDA believes that a company is not in compliance with the
law, it can institute proceedings to detain or seize products, issue a recall,
enjoin future violations and assess civil and criminal penalties against the
company, its officers and its employees. Failure to comply with the regulatory
requirements could have a material adverse effect on the Company's business,
financial condition and results of operations.

      The advertising of most FDA regulated products is subject to both FDA and
Federal Trade Commission jurisdiction. The Company also is subject to regulation
by the Occupational Safety and Health Administration and by other governmental
entities.


                                      -13-
<PAGE>

      Regulations regarding the manufacture and sale of the Company's products
are subject to change. The Company cannot predict what impact, if any, such
changes might have on its business, financial condition or results of
operations.

      International

      International sales of the Company's products are subject to the
regulatory agency product registration requirements of each country. The
regulatory review process varies from country to country. The Company has relied
on its international distributors to obtain necessary foreign regulatory
approvals for sales of its products overseas. The Company also intends to seek
any necessary additional regulatory approvals in certain European countries and
in Japan in connection with future marketing and sales efforts in these
countries. The Company anticipates that it will rely on OEM partners and
distributors for assistance in obtaining any future international regulatory
approvals. There can be no assurance, however, that the Company will secure
additional international OEM partners or distributors or that international
regulatory approvals, if sought, will be obtained on a timely basis or at all.

      In connection with future sales in the European market, the Company
anticipates that it will implement policies and procedures which will allow the
Company's manufacturing and quality assurance processes to receive ISO 9001
certification. ISO 9001 standards for quality operations have been developed to
ensure that companies know, on a worldwide basis, the standards of quality to
which they will be held. The European Union has promulgated rules which require
that medical products receive by mid 1998 the CE mark, an international symbol
of quality and compliance with applicable European medical device directives.
Failure to receive CE mark certification will prohibit the Company from selling
its products in Europe. There can be no assurance that the Company will be
successful in meeting certification requirements. ISO 9001 certification is one
of the CE mark certification requirements.

Third Party Reimbursement

      In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices such as the Company's products,
generally rely on third party payors, principally federal Medicare, state
Medicaid and private health insurance plans, to reimburse all or part of the
cost of therapeutic and diagnostic catheterization procedures. Reimbursement for
neurophysiological monitoring procedures performed using devices that have
received FDA clearance or approval has generally been available in the United
States. The Company anticipates that in a capitated payment system, such as the
DRG system utilized by Medicare and many managed care systems used by private
health care payors , the cost of the Company's products will be incorporated
into the overall cost of the procedure and that there will be no separate,
additional reimbursement for the Company's products.

      Internationally, future market acceptance of the Company's products may be
dependent in part upon the availability of reimbursement within prevailing
health care payment systems. Reimbursement and health care payment systems in
international markets vary significantly by country. The main types of health
care payment systems in international markets are government sponsored health
care and private insurance. There can, however, be no assurance that
reimbursement for procedures performed using the Company's products will be
available in international markets under either governmental or private
reimbursement systems.

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

Product Liability and Insurance


                                      -14-
<PAGE>

      The Company's business involves the risk of product liability claims. The
Company has not experienced any product liability claims to date. Although the
Company maintains product liability insurance with coverage limits of $2 million
per occurrence and an annual aggregate maximum of $3 million, there can be no
assurance that product liability claims will not exceed such insurance coverage
limits, which could have a material adverse effect on the Company, or that such
insurance will be available on commercially reasonable terms or at all.

Employees

      As of December 31, 1997, the Company had 48 full time employees. Of
these employees, 11 were engaged in research and development activities, 11
in manufacturing and manufacturing engineering, seven in quality assurance
and regulatory affairs, 14 in sales and marketing and five in general and
administrative functions. No employees are covered by collective bargaining
agreements, and the Company believes it maintains good relations with its
employees.

Additional Risk Factors

      Dependence Upon HydroDot NeuroMonitoring System, Equinox EEG System and
Future Products. The Company received 510(k) premarket notification clearance
from the FDA in October 1993 to market the HydroDot NeuroMonitoring System and
in December 1996 to market the Equinox EEG System. The HydroDot NeuroMonitoring
System is currently the Company's principal commercial product and is expected
to account for most of the Company's revenue through 1997. The Company
commercially introduced the HydroDot NeuroMonitoring System in August 1994 and
the Equinox EEG System in February 1997. There can be no assurance that the
Company will be able to manufacture these products in commercial quantities at
acceptable costs, or that it will be able to market such systems successfully.
Increases in international sales of these products will require the Company to
obtain foreign regulatory approvals and secure "OEM" partners or establish
foreign distribution capability. If these products are not commercially
successful, the Company's business, financial condition and results of
operations would be materially adversely affected.

      The Company is developing the Patient State Analyzer, which will require
further development and regulatory approvals before it can be marketed in the
United States or internationally. There can be no assurance that the Company's
development efforts will be successful or that the Patient State Analyzer or any
other product developed by the Company will be safe or effective, capable of
being manufactured in commercial quantities at acceptable costs, approved by
regulatory authorities or successfully marketed. If the Patient State Analyzer
is not successfully commercialized, the Company's business, financial condition
and results of operations would be materially adversely affected.

      Uncertainty of Market Acceptance. The Company's HydroDot
NeuroMonitoring System represents a novel method to monitor
neurophysiological activity. The Equinox EEG System is being offered as a
lower cost alternative to other EEG systems currently marketed. The Patient
State Analyzer is being designed primarily to monitor the effects of
anesthesia on a patient during medical procedures by analyzing such patient's
neurophysiological activity and alerting the anesthesiologist of changes in
this activity. There can be no assurance that these products or any other
products developed by the Company will gain any significant degree of market
acceptance among physicians, patients and health care payors, even if the
necessary international and United States regulatory approvals are obtained
and distribution channels are established. The Company believes that
recommendations and endorsements by physicians will be essential for market
acceptance of the HydroDot NeuroMonitoring System, Equinox EEG System,
Patient State Analyzer and other products developed by the Company, and there
can be no assurance that any such recommendations or endorsements will be
obtained. Physicians will not use the Company's products unless they
determine, based on clinical data and other factors, that these products are
an attractive alternative to other means of monitoring neurophysiological
activity and that the clinical benefits to the patient and cost savings
achieved through use of these products outweigh the cost of switching to such
products from other commercially available alternatives. In addition,
clinical experience with the HydroDot NeuroMonitoring System indicates that
the system may be less effective with, or may not be suitable for use with,
patients with long or thick hair. This may adversely affect market acceptance
of the HydroDot system. Acceptance among physicians will depend upon the
Company's ability to train neurologists,

                                      -15-
<PAGE>

anesthesiologists and other potential users of the Company's products and the
willingness of such users to learn new patient monitoring methods. Market
acceptance will also be dependent upon acceptance of the Company's products by
hospital administrators and will require the Company to provide evidence to such
administrators of the cost effectiveness and clinical utility of the Company's
products. Failure of the Company's products to achieve significant market
acceptance would have a material adverse effect on the Company's business,
financial condition and results of operations.

      Limited Operating History and Commercial Scaleup Risk. The Company has a
limited history of operations. Since its inception in January 1990, the Company
has been primarily engaged in research and development of neurophysiological
monitoring products. The Company has sold a small number of units of the
HydroDot NeuroMonitoring System and it has generated only limited revenues from
commercial sales and does not have experience in manufacturing, marketing or
selling its products in quantities necessary for achieving profitability.
Whether the Company can successfully manage the transition to a larger scale
commercial enterprise will depend upon the successful development of its
manufacturing capability, the development of its marketing and distribution
network, obtaining foreign regulatory approvals for the HydroDot NeuroMonitoring
System, obtaining domestic and foreign regulatory approvals for the Equinox EEG
System, Patient State Analyzer and other potential products and strengthening
its financial and management systems, procedures and controls. With respect to
the Company's proposed Patient State Analyzer System, the Company will need to
develop a sales and marketing effort targeted towards anesthesiologists, rather
than neurologists to whom the Company has previously marketed its products.
Failure to make such a transition successfully would have a material adverse
effect on the Company's business, financial condition and results of operations.
In addition, there can be no assurance that the Company will achieve significant
revenues from either domestic or international sales or achieve or sustain
profitability in the future.

      History of Losses and Expectation of Future Losses; Fluctuations in
Operating Results. The Company has experienced significant operating losses
since inception and, as of December 31, 1997, had an accumulated deficit of
approximately $18.4 million. The development and commercialization of the
Company's current products and other new products, if any, will require
substantial development, clinical, regulatory and other expenditures. The
Company expects its operating losses to continue for at least the next few years
as it continues to expend substantial resources to expand marketing and sales
activities, scale up manufacturing capabilities, increase research and
development and support regulatory and reimbursement approvals. Results of
operations may fluctuate significantly from quarter to quarter and will depend
upon numerous factors, including actions relating to regulatory and
reimbursement matters, the extent to which the Company's products gain market
acceptance, introduction of alternative means for neurophysiological monitoring
and competition.

      Limited Manufacturing, Marketing and Sales Experience. The Company has
only limited experience in manufacturing the HydroDot NeuroMonitoring System and
has not yet manufactured it in commercial quantities. As a result, the Company
has no experience manufacturing its products in volumes necessary for the
Company to achieve significant commercial sales, and there can be no assurance
that reliable, high volume manufacturing can be achieved at a commercially
reasonable cost. If the Company encounters any manufacturing difficulties,
including problems involving product yields, quality control and assurance,
supplies of components or shortages of qualified personnel, it could have a
material adverse affect on its business, financial condition and results of
operations.

      The Company has only sold a small number of its HydroDot NeuroMonitoring
Systems in the United States since it obtained 510(k) clearance in October 1993
and does not have experience marketing and selling such products in commercial
quantities. The Company markets and sells its HydroDot NeuroMonitoring System
and Equinox EEG System and intends to market and sell its Patient State Analyzer
and other potential products in the United States through a direct sales force
and distribution partners, and there can be no assurance that such direct sales
force and distribution partners will effectively market and sell the Company's
products.

      Through its distributors, the Company has obtained the regulatory
approvals, if any, required to market and sell its products in certain foreign
markets. However, regulatory requirements vary by region, and compliance with
such regulations may be costly and time consuming. There can be no assurance
that the Company will obtain the necessary


                                      -16-
<PAGE>

regulatory approvals or successfully sell its products in any additional
foreign markets. Additionally, international revenues are subject to a number
of risks, including generally greater difficulties in accounts receivables
collections, financial instability of distributors, failure of distributors
to promote effectively products, longer payment cycles, exposure to foreign
currency fluctuations, and political and economic instability.

      If the Company secures the necessary regulatory approvals to sell the
Patient State Analyzer or any other potential products in the United States or
in foreign markets, the Company would have to establish a separate marketing and
sales capability for those products. This would require significant effort and
expense and would be subject to all the risks attendant to establishing a
marketing and sales capability for its current products, including its HydroDot
NeuroMonitoring System and Equinox EEG System. Failure by the Company to
successfully market its products domestically or internationally would have a
material adverse effect on the Company's business, financial condition and
results of operations.

      Risks of International Sales. A number of risks are inherent in
international operations and transactions, and the Company will be subject to
such risks to the extent it engages in international sales. International
sales and operations may be limited or disrupted by the imposition of
government controls, changes in regulatory requirements or interpretations
thereof, export license requirements, political instability, trade
restrictions, changes in tariffs, financial instability of distributors,
collectibility of receivables, differences in purchasing systems for medical
products, and difficulties in staffing, coordinating and managing
international operations. Additionally, the Company's business, financial
condition and results of operations may be adversely affected by fluctuations
in international currency exchange rates as well as constraints on the
Company's ability to maintain or increase prices. There can be no assurance
that the Company will be able to commercialize successfully its current or
future products in any international market.

      Government Regulation. The manufacture and sale of medical devices,
including the HydroDot NeuroMonitoring System, Equinox EEG System, Patient State
Analyzer and other potential products, are subject to extensive regulation by
numerous governmental authorities in the United States, principally the FDA and
corresponding state agencies, and in other countries. In the United States, the
Company's products are regulated as medical devices and are subject to the FDA's
premarket clearance or approval requirements. The process of obtaining FDA and
other required regulatory approvals is lengthy, expensive and uncertain,
frequently requiring from one to several years from the date of FDA submission
if premarket approval is obtained at all.

      Regulatory approvals, if granted, may include significant limitations on
the indicated uses for which the product may be marketed. In addition, to obtain
such approvals, the FDA and certain foreign regulatory authorities impose
numerous other requirements with which medical device manufacturers must comply.
FDA enforcement policy strictly prohibits the marketing of approved medical
devices for unapproved uses. In addition, product approvals could be withdrawn
for failure to comply with regulatory standards or the occurrence of unforeseen
problems following the initial marketing. The Company will be required to adhere
to applicable FDA regulations regarding GMP and similar regulations in other
countries, which include testing, control and documentation requirements.
Ongoing compliance with GMP and other applicable regulatory requirements will be
monitored through periodic inspections by federal and state agencies and by
comparable agencies in other countries. Failure to comply with applicable
regulatory requirements, including marketing products for unapproved uses, could
result in, among other things, warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, refusal of the government to grant premarket clearance or premarket
approval for devices, withdrawal of approvals and criminal prosecution. Changes
in existing regulations or adoption of new governmental regulations or policies
could prevent or delay regulatory approval of the Company's products. Certain
material changes to medical devices also are subject to FDA review and clearance
or approval.

      Sales of medical devices outside of the United States are subject to
international regulatory requirements that vary from country to country. The
time required to obtain approval for sale internationally may be longer or
shorter than that required for FDA approval, and the requirements may differ. In
Europe, the Company will be required to obtain the certifications necessary to
enable the "CE" mark to be affixed to the Company's products by late 1998 in
order to sell products commercially in member countries of the European Union.
The Company has not obtained these


                                      -17-
<PAGE>

certifications, and there can be no assurance it will be able to do so in a
timely manner. Many other countries in which the Company intends to operate
either do not currently regulate medical devices or have minimal registration
requirements; however, these countries may develop more extensive regulations in
the future that could affect the Company's ability to market its products. In
addition, significant costs and requests for additional information may be
encountered by the Company in its efforts to obtain regulatory approvals. Any
such events could substantially delay or preclude the Company from marketing its
products in the United States or internationally.

      There can be no assurance that the Company will be able to obtain the
certifications necessary for affixation of the CE mark on the Company's products
or other necessary regulatory approvals or clearances on a timely basis or at
all, and delays in receipt of or failure to receive such approvals or
clearances, the loss of previously obtained approvals, or failure to comply with
existing or future regulatory requirements would have a material adverse effect
on the Company's business, financial condition and results of operations.

      Intense Competition, Technological Advances and Risk of Obsolescence.
Competition in the market for neurophysiological monitoring devices is intense
and could increase. The Company believes its principal competition will come
from existing providers of EEG equipment and electrodes. Most of the Company's
competitors have significantly greater financial, technical, research,
marketing, sales, distribution and other resources than the Company, as well as
greater name recognition. There can be no assurance that the Company's
competitors will not succeed in developing or marketing technologies and
products that are more effective or commercially attractive than any that are
being developed or marketed by the Company, or that such competitors will not
succeed in obtaining regulatory approval, introducing or commercializing any
such products prior to the Company. Such developments could have a material
adverse effect on the Company's business, financial condition and results of
operations.

      Reliance on Patents and Protection of Proprietary Technology. The
Company's ability to compete effectively will depend in part on its ability to
develop and maintain proprietary aspects of its technology. There can be no
assurance that the Company's issued patents or any patents that may be issued as
a result of the Company's United States or international patent applications
will offer any degree of protection. There can be no assurance that any patents
that may be issued to the Company or any of the Company's patent applications
will not be challenged, invalidated or circumvented in the future. In addition,
there can be no assurance that competitors, many of which have substantial
resources and have made substantial investments in competing technologies, will
not seek to apply for and obtain patents that will prevent, limit or interfere
with the Company's ability to make, use or sell its products either in the
United States or in international markets.

      The medical device industry has been characterized by extensive litigation
regarding patents and other intellectual property rights, and companies in the
medical device industry have employed intellectual property litigation to gain a
competitive advantage. There can be no assurance that the Company will not in
the future become subject to patent infringement claims and litigation or
interference proceedings declared by the USPTO to determine the priority of
inventions. The defense and prosecution of intellectual property suits, USPTO
interference proceedings and related legal and administrative proceedings are
both costly and time consuming. Litigation may be necessary to enforce patents
issued to the Company, to protect trade secrets or knowhow owned by the Company
or to determine the enforceability, scope and validity of the proprietary rights
of others.

      Any litigation or interference proceedings will result in substantial
expense to the Company and significant diversion of effort by the Company's
technical and management personnel. An adverse determination in litigation or
interference proceedings to which the Company may become a party could subject
the Company to significant liabilities to third parties or require the Company
to seek licenses from third parties. Costs associated with licensing or similar
arrangements that may be involved in statement of intellectual property
disputes, including patent disputes, may be substantial and could include
ongoing royalties. Furthermore, there can be no assurance that necessary
licenses would be available to the Company on satisfactory terms if at all.
Adverse determinations in a judicial or administrative proceeding or failure to
obtain necessary licenses could prevent the Company from manufacturing and
selling its products, which would have a material adverse effect on the
Company's business, financial condition and results of operations.


                                      -18-
<PAGE>

      In addition to patents, the Company relies on trade secrets and
proprietary know how, which it seeks to protect, in part, through appropriate
confidentiality and proprietary information agreements. These agreements
generally provide that all confidential information developed or made known to
the individual by the Company during the course of the individual's relationship
with the Company, is to be kept confidential and not disclosed to third parties,
except in specific circumstances. The agreements generally provide that all
inventions conceived by the individual in the course of rendering services to
the Company shall be the exclusive property of the Company; however, certain of
the Company's agreements with consultants, who typically are employed on a full
time basis by academic institutions or hospitals, do not contain assignment of
invention provisions. There can be no assurance that proprietary information or
confidentiality agreements with employees, consultants and others will not be
breached, that the Company would have adequate remedies for any breach, or that
the Company's trade secrets will not otherwise become known to or independently
developed by competitors.

      Uncertainty Relating to Third Party Reimbursement. In the United States,
health care providers, such as hospitals and physicians, that purchase medical
devices such as the Company's products, generally rely on Third Party payors,
principally federal Medicare, state Medicaid and private health insurance plans,
to reimburse all or part of the cost of therapeutic and diagnostic procedures.
Reimbursement for neurophysiological monitoring procedures performed using
devices that have received FDA clearance or approval has generally been
available in the United States. The Company anticipates that in a capitated
payment system, such as the DRG system utilized by Medicare and many managed
care systems used by private health care payors, the cost of the Company's
products will be incorporated into the overall cost of the procedure and that
there will be no separate, additional reimbursement for the Company's products.

      Internationally, future market acceptance of the Company's products may be
dependent in part upon the availability of reimbursement within prevailing
health care payment systems. Reimbursement and health care payment systems in
international markets vary significantly by country. The main types of health
care payment systems in international markets are government sponsored health
care and private insurance. There can, however, be no assurance that
reimbursement for procedures performed using the Company's products will be
available in international markets under either governmental or private
reimbursement systems.

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

      Product Liability and Recall Risk, Limited Insurance Coverage. The
manufacture and sale of medical products entail significant risk of product
liability claims or product recalls. There can be no assurance that the
Company's existing or future insurance coverage limits are or would be adequate
to protect the Company from any liabilities it might incur in connection with
the sale of its products. In addition, the Company may require increased product
liability coverage as its products are commercialized. Such insurance is
expensive and in the future may not be available on acceptable terms, if at all.
A successful product liability claim or series of claims brought against the
Company in excess of its insurance coverage, or a recall of the Company's
products, could have a material adverse effect on the Company's business,
financial condition and results of operations.

      Dependence Upon Key Suppliers. Physiometrix purchases components used in
its products from various suppliers and relies on single sources for several
components. To date, the Company has not experienced significant component
shortages. Delays associated with any future component shortages could have a
material adverse effect on the Company's business, financial condition and
results of operations, particularly as the Company scales up its manufacturing
activities in support of international commercial sales and United States
commercial sales.


                                      -19-
<PAGE>

      Dependence Upon Key Personnel and Medical Advisors. The Company is
dependent upon a number of key management and technical personnel. The loss of
the services of one or more key employees would have a material adverse effect
on the Company. The Company has no employment agreements with any of its key
personnel. The Company's success will also depend on its ability to attract and
retain additional highly qualified management and technical personnel. The
Company faces intense competition for qualified personnel, many of whom are
often subject to competing employment offers, and there can be no assurance that
the Company will be able to attract and retain such personnel. There can be no
assurance that the proceeds of the Company's $1 million key person life
insurance policy on John A. Williams, its President and Chief Executive Officer,
would be sufficient to compensate the Company in the event of his loss.
Furthermore, the Company relies on the services of several medical and
scientific consultants, all of whom are employed on a full time basis by
hospitals or academic or research institutions. Such consultants are therefore
not available to devote their full time or attention to the Company's affairs.

      Uncertainty Relating to New Product Development. The Company's strategy
involves the design and development of new products. Products under development
include the Patient State Analyzer. The Company's future revenues, and any
future profitability of the Company, will depend upon the successful completion
of development of and commercial introduction of this product. The product
development process is time consuming and costly, and there can be no assurance
that product development will be successfully completed, that necessary
regulatory approvals or clearances will be granted by the FDA on a timely basis,
or at all, or that any new products developed and introduced by the Company will
achieve market acceptance. Failure by the Company to develop, obtain necessary
regulatory clearances or approvals for, or successfully market, new products,
including in particular the Patient State Analyzer, would have a material
adverse effect on the Company's business, financial condition and results of
operations.

      Uncertainty Related to Health Care Reform. Political, economic and
regulatory influences are subjecting the health care industry in the United
States to fundamental change. Although Congress has failed to pass comprehensive
health care reform legislation to date, the Company anticipates that Congress,
state legislatures and the private sector will continue to review and assess
alternative health care delivery and payment systems. Potential approaches that
have been considered include mandated basic health care benefits, controls on
health care spending through limitations on the growth of private health
insurance premiums and Medicare and Medicaid spending, the creation of large
insurance purchasing groups, price controls and other fundamental changes to the
health care delivery system. Legislative debate is expected to continue in the
future, and market forces are expected to demand reduced costs. The Company
cannot predict what impact the adoption of any federal or state health care
reform measures, future private sector reform or market forces may have on its
business.

      Possible Volatility of Stock Price. The stock market has from time to time
experienced significant price and volume fluctuations that are unrelated to the
operating performance of particular companies. These broad market fluctuations
may adversely affect the market price of the Company's Common Stock. In
addition, the market price of the Company's Common Stock is likely to be highly
volatile. Factors such as fluctuations in the Company's operating results,
announcements of technological innovations or new products by the Company or its
competitors, FDA and international regulatory actions, actions with respect to
reimbursement matters, developments with respect to patents or proprietary
rights, public concern as to the safety of products developed by the Company or
others, changes in health care policy in the United States and internationally,
changes in stock market analysts' recommendations regarding the Company, other
medical device companies or the medical device industry generally or general
market conditions may have a significant effect on the market price of the
Common Stock. In addition, it is possible that in a future fiscal quarter, the
Company's results of operations will fail to meet the expectations of stock
market analysts and investors and, in such event, the market price of the
Company's Common Stock would be materially and adversely affected.

Item 2.   PROPERTIES

      The Company leases an approximately 12,000 square foot facility in North
Billerica, Massachusetts. This facility includes manufacturing, laboratory and
office space. The facility is leased through December 14, 1999. The Company
believes these facilities will be adequate to meet its current and reasonably
anticipated future requirements.


                                      -20-
<PAGE>

Item 3. LEGAL PROCEEDINGS

      The Company is not party to any legal proceedings.

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

      Not applicable.


                                      -21-


<PAGE>

                                     PART II

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

      The Company's Common Stock is traded on the Nasdaq National Market (ticker
symbol). The number of record holders of the Company's Common Stock at January
31, 1998 was 105. The Company has not paid any dividends since its inception and
does not intend to pay any dividends in the foreseeable future.

      The Company completed an initial public offering of 2,000,000 shares of
Common Stock in April 1996. Prior to the initial public offering, the Company's
Common Stock was not publicly traded.

      Quarterly high and low stock prices are as follows:

<TABLE>
<CAPTION>


-----
                        Quarter Ended                       High      Low
                                                            ----      ---
       <S>                                              <C>        <C>
       March 31, 1997 ...............................     $4-3/8     $3-1/4
       June 30, 1997.................................     $4-1/4     $2-5/8
       September 30, 1997............................     $3-3/8     $2-3/8
       December 31, 1997.............................     $3         $2


-----
<CAPTION>

                        Quarter Ended                       High      Low
                                                            ----      ---
       <S>                                              <C>        <C>
       June 30, 1996 (from April 30, 1996)...........     $12-1/4     $7-3/4
       September 30, 1996............................    $7-15/16     $4-3/4
       December 31, 1996.............................     $6-5/16         $3

</TABLE>

                                      22
<PAGE>

Item 6.     SELECTED FINANCIAL DATA

      The selected financial data presented below with respect to the Company's
statements of operations for each of the three years in the period ended
December 31, 1997 and with respect to the Company's balance sheets at December
31, 1996 and 1997 are derived from Financial Statements of the Company and the
Notes thereto included elsewhere in this Form 10-K that have been audited by
Ernst & Young LLP, independent auditors, and is qualified by reference to such
Financial Statements. The data set forth with respect to the Company's
operations for the fiscal years ended December 31, 1993 and December 31, 1994
and with respect to the Company's balance sheets at December 31, 1993, December
31, 1994 and December 31, 1995 are derived from audited financial statements
which are not included herein. The selected financial data set forth below is
qualified in its entirety by, and should be read in conjunction with,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Financial Statements of the Company and the Notes thereto
included elsewhere in this Form 10-K.

<TABLE>
<CAPTION>
                                                                                  Year Ended December 31,
                                                             1993           1994            1995            1996           1997
<S>                                                    <C>             <C>             <C>             <C>             <C>
Statements of Operations Data:
Revenues ...........................................   $         --    $     72,677    $    321,835    $    413,698    $  1,006,381
Costs and expenses:
  Cost of goods sold ...............................             --         622,765       1,164,268       1,189,510       1,925,316
  Research and development .........................        917,574         741,068         392,413       1,189,336       2,500,601
  Selling, general and administrative ..............      1,163,641       1,756,515       1,575,481       1,652,596       2,739,423
                                                       ------------    ------------    ------------    ------------    ------------
                                                          2,081,215       3,120,348       3,132,162       4,031,442       7,165,340
                                                       ------------    ------------    ------------    ------------    ------------

Operating loss .....................................     (2,081,215)     (3,047,671)     (2,810,327)     (3,617,744)     (6,158,959)
Interest income ....................................         10,987          61,712          75,465         683,461         788,878
Interest expense ...................................        (25,611)        (56,551)        (36,876)        (90,090)        (23,016)
                                                       ------------    ------------    ------------    ------------    ------------

Net loss ...........................................   $ (2,095,839)   $ (3,042,510)   $ (2,771,738)   $ (3,024,373)   $ (5,393,097)
                                                       ============    ============    ============    ============    ============

Loss per common share (Pro Forma in 1995) ..........                                   $       (.83)   $       (.80)   $       (.96)
                                                                                       ============    ============    ============
Shares used in computing net loss per common
share (pro forma in 1995)* .........................                                      3,338,974       3,766,494       5,615,360
                                                                                       ============    ============    ============

*See Footnote 1 in Financial Statements

<CAPTION>
                                                                                          December 31,
                                                       1993            1994            1995                1996            1997
<S>                                                    <C>             <C>             <C>             <C>             <C>
Balance Sheet Data:
Cash, cash equivalents
  and short-term investments .......................   $    105,747    $  3,019,483    $    432,126    $ 18,146,248    $ 11,588,286
Working capital (deficit) ..........................        (50,184)      2,662,202        (214,710)     16,990,259      11,555,124
Total assets .......................................        346,970       3,575,565       1,048,000      19,151,982      13,376,170
Notes payable to stockholders, net of
  current portion ..................................        223,986         176,420          82,089              --              --
Accumulated deficit ................................     (4,162,466)     (7,204,976)     (9,976,714)    (13,001,087)    (18,394,184)
Total stockholders' equity (deficit) ...............        (46,849)      2,814,877          46,944      17,575,615      12,310,052
</TABLE>


                                       23
<PAGE>

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

     The following discussion of the financial condition and results of
operations of Physiometrix, Inc. should be read in conjunction with the
Financial Statements and related Notes thereto included elsewhere in this Form
10-K. This Report on Form 10-K contains certain forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. Actual events or results may differ
materially from those projected in the forward-looking statements as a result of
the factors described herein and in the documents incorporated herein by
reference. Such forward-looking statements include, but are not limited to,
statements concerning (i) business strategy; (ii) products under development;
(iii) other products; (iv) marketing and distribution; (v) research and
development; (vi) manufacturing; (vii) competition; (viii) government regulation
especially as it relates to FDA approvals; (ix) third-party reimbursement and
(x) operating and capital requirements.

Overview

     Since its inception in January 1990, Physiometrix has been engaged
primarily in the design and development and more recently the manufacture and
sale of noninvasive, advanced medical products. The Company's products which
incorporate proprietary materials and electronics technology are used in
neurological monitoring applications. The Company's initial products are its
e-net headpiece and disposable HydroDot biosensors and custom electronics, which
are packaged as the HydroDot NeuroMonitoring System. The Company also has two
additional neurological monitoring products, the Equinox EEG System which was
commercially introduced in February 1997 and the Patient State Analyzer, which
is currently in clinical trials. The Company believes that the Patient State
Analyzer will be subject to FDA 510(k) clearance notification. However, the FDA
may require the Company to submit a premarket approval ("PMA") application for
this product. There can be no assurance that the Company will be able to obtain
necessary 510(k) clearance or PMA application approval to market the Patient
State Analyzer or any other products on a timely basis, if at all.

     Physiometrix has a limited history of operations and has experienced
significant operating losses since its inception. As of December 31, 1997, the
Company had an accumulated deficit of approximately $18.4 million. The HydroDot
NeuroMonitoring System and Equinox are currently the Company's principal
commercial products and is expected to account for most of the Company's revenue
through 1998. The Company anticipates that its operating results will fluctuate
on a quarterly basis for the foreseeable future due to several factors,
including actions relating to regulatory and reimbursement matters, the extent
to which the Company's products gain market acceptance, introduction of
alternative means for neurophysiological monitoring and competition. Results of
operations will also be affected by the progress of clinical trials and in house
development activities, and the extent to which the Company establishes
distribution channels for its products domestically and internationally. There
can be no assurance the Company will achieve significant commercial revenues or
profitability.

Results of Operations

     Years Ended December 31, 1997 and 1996

     Revenues were $1,006,000 in 1997, a $592,000 increase over 1996. This was
primarily the result of increased Equinox sales, which was introduced in early
1997.

     Cost of goods sold were $1,925,000 in 1997, an increase of $735,000 over
1996. This is due to increased sales and overhead costs associated with the
increased levels of manufacturing.

     Research and development expenses were $2,501,000 in 1997, a $1,312,000
increase from 1996. This is primarily due to the increased personnel and
consulting costs for the development of the Company's Equinox and Patient State
Analyzer (PSA) including clinical trial costs for the PSA.


                                       24
<PAGE>

     Selling, general and administrative expenses were $2,739,000 in 1997, an
increase of $1,086,000 over 1996. This was primarily the result of increased
sales and marketing expenses associated with the Equinox product introduction.

     Interest income was $789,000 in 1997, an increase of $106,000 over 1996.
This was the result of investing the cash proceeds from the Company's initial
public offering.

     Interest expense was $23,000 in 1997, a $67,000 decrease from 1996. This
was primarily the result of the Company paying off $500,000 in borrowings under
a revolving credit facility.

     The Company has experienced operating losses since inception and therefore
has not paid any federal income taxes since its inception. The Company accounts
for income taxes under Statement of Financial Accounting Standards No. 109 ("FAS
No. 109"). Realization of deferred tax assets is dependent on future earnings,
if any, the timing and amount of which are uncertain. Accordingly, valuation
allowances, in amounts equal to the net deferred tax assets as of December 31,
1997 and 1996, have been established in each period to reflect these
uncertainties.

     At December 31, 1997, the Company had federal net operating loss
carryforwards of $12,700,000 and federal and state tax credit carryforwards of
$284,000, that will expire in varying amounts through 2012, if not utilized.
Utilization of net operating loss and tax credit carryforwards will be subject
to substantial annual limitations provided by the Internal Revenue Code of 1986,
as amended. The annual limitation may result in the expiration of net operating
loss and tax credit carryforwards before full utilization.

     Years Ended December 31, 1996 and 1995

     Revenues were $414,000 in 1996 and $322,000 in 1995. The $92,000 increase
in 1996 versus 1995 was primarily the result of increased biosensor sales. The
$249,000 increase in 1995 versus 1994 was the result of a full year of sales of
the Company's HydroDot NeuroMonitoring System and the introduction of the
NeuroLink in 1995.

     Cost of goods sold were $1,190,000 in 1996 and $1,164,000 in 1995. Cost of
goods sold increased only $26,000 in 1996 versus 1995 due to lower material
costs and no increase in overhead costs. The $541,000 increase in 1995 versus
1994 was due to increased material costs and increased personnel and other costs
associated with the scale up of manufacturing.

     Research and development expenses were $1,189,000 and $392,000 in 1996 and
1995, respectively. The $797,000 increase from 1995 to 1996 is primarily due to
the increased personnel costs for the development of the Company's Equinox and
Patient State Analyzer (PSA) including clinical trial costs for the PSA. The
$349,000 decrease from 1994 to 1995 reflects the Company's emphasis on scaling
up production and a resulting shift of resources from research and development
into manufacturing.

     Selling, general and administrative expenses were $1,653,000 in 1996 and
$1,575,000 in 1995. The increase of only $78,000 in 1996 versus 1995 was
primarily the result of lower facility and overhead costs. The decrease of
$182,000 from 1994 to 1995 was due primarily to lower consulting expenses
associated with manufacturing process development.

     Interest income was $684,000 and $75,000 in 1996 and 1995, respectively.
The increase of $609,000 in 1996 was the result of investing the cash proceeds
from the Company's initial public offering.

     Interest expense was $90,000 and $37,000 in 1996 and 1995, respectively.
The $53,000 increase in 1996 was primarily the result of the Company incurring
$500,000 in borrowings under a revolving credit facility.

     The Company has experienced operating losses since inception and therefore
has not paid any federal income taxes since its inception. The Company accounts
for income taxes under Statement of Financial Accounting Standards


                                       25
<PAGE>

No. 109 ("FAS No. 109"). Realization of deferred tax assets is dependent on
future earnings, if any, the timing and amount of which are uncertain.
Accordingly, valuation allowances, in amounts equal to the net deferred tax
assets as of December 31, 1996 and 1995, have been established in each period to
reflect these uncertainties.

Liquidity and Capital Resources

     In April 1996, the Company completed an initial public offering of
2,000,000 shares of common stock at $11.00 per share. Net proceeds to the
Company were approximately $19,780,000. At December 31, 1997, the Company's
cash, cash equivalents and short-term investments were $11,588,000 as compared
to $18,146,000 at December 31, 1996.

     The Company's operating activities used cash of $5,634,000 in 1997 as
compared to $2,581,000 in 1996. The $3,053,000 increase in net cash used was
primarily the result of an increased net loss of the company, accounts
receivable and inventory.

     The Company's financing activities used cash of $549,000 in 1997 as
compared to $20,629,000 provided in 1996. The 1997 financing activities included
a repayment of the line of credit of $541,000 and payment to stockholders of
$82,000 for equipment financing. Financing activities in 1996 consisted
principally of $19.8 million in proceeds from the Company's initial public
offering.

      Net cash provided by investing activities in 1997 was $14,959,000, as
compared with $18,151,000 used in 1996. The increase was due to the proceeds
received from maturity of available for sale securities.

      The Company's principal source of liquidity at December 31, 1997 consisted
of cash, cash equivalents and short term investments of $11,588,000. The Company
believes that its capital resources will be sufficient to meet the Company's
operating and capital requirements at least through 1998. The Company's future
liquidity and capital requirements will depend on numerous factors, including
progress of the Company's clinical trials, actions relating to regulatory
approvals, the cost and timing of expansion of marketing, sales, manufacturing
and product development activities, the extent to which the Company's products
gain market acceptance and competitive developments. The Company may in the
future seek to raise additional funds through bank facilities, debt equity
offerings or other sources of capital. There can be no assurance that additional
financing, if required, will be available on satisfactory terms, if at all.

      The Company has begun to review its computer system for Year 2000
compliance and has designed a plan to test whether their systems will conform to
Year 2000 requirements. The Company is expensing all costs associated with these
systems changes and does not anticipate that these costs will have a material
impact on its financial position or results from operations. Although management
does not expect Year 2000 issues to have a material impact on its business or
results of operations, there can be no assurance that there will be no
interruptions or other limitations of system functionality.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      The Independent Auditors' Report, Financial Statements and
Notes to Financial Statements begin on page F-1.

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

      Not applicable.


                                       26
<PAGE>

                                    PART III

      Certain information required by Part III is omitted from this Report on
Form 10-K in that the Registrant will file a definitive proxy statement within
120 days after the end of its fiscal year pursuant to Regulation 14A with
respect to the 1998 Annual Meeting of Stockholders (the "Proxy Statement") to be
held May 21, 1998 and certain information included therein is incorporated
herein by reference.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

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

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

              Name                  Age                Position

       John A. Williams             50      President, Chief Executive Officer
                                            and Director

       E. Stuart Tuthill            47      Vice President of Sales and
                                            Marketing

       Tibor L. Foldvari, Ph.D.     62      Senior Vice President of Research,
                                            Development and Clinical Affairs

       Daniel W. Muehl              35      Vice President of Finance &
                                            Administration and Chief Financial
                                            Officer

      John A. Williams joined the Company in December 1993 and has served as a
member of the Board of Directors and as the Company's President and Chief
Executive Officer. Prior to that time, Mr. Williams served as President of Bruel
and Kjaer Medical, a medical device company, from 1990 to 1993. Mr. Williams was
Vice President of Sales and Marketing at Medtronic/AMI, a medical device
company, from 1988 to 1990 and Vice President of Sales and Marketing, Worldwide
at Merrimack Laboratories from 1983 to 1987.

      E. Stuart Tuthill joined the Company in March 1994 as Vice President of
Sales and Marketing. Prior to that time, Mr. Tuthill served as Director of Sales
at Bruel and Kjaer Medical from 1989 to 1994. Mr. Tuthill also served as
National Sales Manager at Medtronic/AMI, a medical device company, from 1986 to
1988.

      Tibor L. Foldvari, Ph.D. joined the Company in January 1998 as Senior Vice
President of Research, Development and Clinical Affairs. Dr. Foldvari served as
Director, Advanced Technology at Johnson & Johnson Professional Inc. from 1990
to 1994 and Vice President Research, Development and Engineering at Nellcor,
Inc. from 1988 to 1990. Dr. Foldvari received his B.S. and M.S. in Electrical
Engineering, and his Ph.D. in Bioengineering from Massachusetts Institute of
Technology.

      Daniel W. Muehl joined the Company in February 1998 as Vice President of
Finance & Administration and Chief Financial Officer. Previously, Mr. Muehl was
Chief Operating Officer and Chief Financial Officer at Number Nine Visual
Technology from 1995 to 1998 and served in various finance positions at
Powersoft Corporation and Medical Care America from 1991 to 1995. Mr. Muehl is a
Certified Public Accountant and served his public accountancy with Ernst &
Young LLP and Laventhol and Horwath from 1985 to 1991.


                                       27
<PAGE>

Item 11. EXECUTIVE COMPENSATION

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


Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

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


Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

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


                                       28
<PAGE>

                                     PART IV

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

     (a)  1.   Financial Statements

               The following Financial Statements of Physiometrix, Inc. and
               Report of Ernst & Young LLP, Independent Auditors are in this
               Form 10-K.

                                                                            Page

               Report of Ernst & Young LLP, Independent Auditors.            F1
               Balance Sheets, December 31, 1996 and 1997.                   F2
               Statements of Operations, Years Ended December 31, 1995,
               1996 and 1997.                                                F3
               Statements of Cash Flows, Years Ended December 31, 1995,
               1996 and 1997.                                                F4
               Statements of Stockholders' Equity, Years Ended December
               31, 1995, 1996 and 1997.                                      F5
               Notes to Financial Statements.                                F6

          2.   Financial Statement Schedules

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

          3.   Exhibits

               Refer to (c) below.

     (b)  Reports on Form 8-K

          The Company was not required to and did not file any reports on Form
          8-K during the year ended December 31, 1997.

     (c)  Exhibits

          Exhibit                           Description
            No.

            3.1(1)  Restated Certificate of Incorporation of the Company.
            3.2(1)  Bylaws of the Company, as amended.
            4.1(1)  Specimen Common Stock Certificate.
            4.2(1)  Form of Warrant Agreement between the Company and Cruttendon
                    Roth Incorporated, with form of Warrant attached.
           10.1(1)  Form of Indemnification Agreement between the Company and
                    each of its directors and officers.
           10.2(1)  1991 Incentive Stock Plan and Form of Stock Option Agreement
                    thereunder.
           10.3(2)  1996 Director Option Plan.
           10.4(2)  1996 Employee Stock Purchase Plan and forms of agreements
                    thereunder.
           10.5(1)  Lease dated October 11, 1994 between the Company and Yvon
                    Cormier, Trustee of YCEE Investment Trust, for a facility
                    located at Five Billerica Park, 101 Billerica Avenue, North
                    Billerica, Massachusetts  01862.
           10.6(1)  Restated Shareholder Rights Agreement dated June 24, 1994
                    between the Company and certain holders of the Company's
                    securities.
              23.1  Consent of Ernst & Young LLP, Independent Auditors.


                                       29
<PAGE>

          Exhibit                            Description
            No.

              24.1  Power of Attorney. Reference is made to page F-12
              27.1  Financial Data Schedule - 1997 Year End
              27.2  Financial Data Schedule - 1996 Four Columns
              27.3  Financial Data Schedule - 1997 Three Columns

----------

    (1) Filed as an Exhibit to the Company's Registration Statement of Form S-1
        (File No. 3302138) and incorporated herein by reference.

    (2) Filed as an Exhibit to the Company's Registration Statement on Form
        S-8 (File No. 333-16525) and incorporated herein by reference.
                                      30

<PAGE>


                         REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Physiometrix, Inc.

     We have audited the accompanying balance sheets of Physiometrix, Inc. as of
December 31, 1996 and 1997, and the related statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Physiometrix, Inc. at
December 31, 1996 and 1997, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1997, in conformity
with generally accepted accounting principles.


                                                          /s/ ERNST & YOUNG LLP

Boston, Massachusetts
February 20, 1998


                                       F-1
<PAGE>

                               PHYSIOMETRIX, INC.
                                 BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                          December 31
                                                                     1996             1997
                           ASSETS
<S>                                                             <C>             <C>
Current assets:
   Cash and cash equivalents................................    $    328,331    $  9,104,147
   Short-term investments ...................................     17,817,917       2,484,139
   Accounts receivable, net of allowances of $20,000 in
      1996 and $25,000 in 1997 for doubtful accounts ........         38,196         311,194
   Inventories, net .........................................        279,789         640,131
   Prepaid expenses .........................................        102,393          81,631
                                                                ------------    ------------
Total current assets ........................................     18,566,626      12,621,242
Equipment, net ..............................................        492,838         662,410
Due from officer ............................................         84,000          84,000
Other assets ................................................          8,518           8,518
                                                                ------------    ------------

Total assets................................................    $ 19,151,982    $ 13,376,170
                                                                ============    ============
            LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
   Accounts payable .........................................   $    691,690    $    621,353
   Accrued expenses .........................................        261,107         444,765
   Demand note payable ......................................        541,334
   Current portion of notes payable to stockholder ..........         82,236
                                                                ------------    ------------
Total current liabilities ...................................      1,576,367       1,066,118
Commitments and contingencies
Stockholders' equity ........................................
   Preferred stock: $.001 par value; 10,000,000 shares
   authorized:
   Common stock: $.001 par value, 50,000,000 shares
   authorized; 5,580,324 shares in 1996 and 5,640,825
   shares in 1997 issued and outstanding ....................          5,580           5,641
Additional paid-in capital ..................................     30,571,122      30,698,595
Accumulated deficit .........................................    (13,001,087)    (18,394,184)
                                                                ------------    ------------
Total stockholders' equity ..................................     17,575,615      12,310,052
                                                                ------------    ------------
Total liabilities and stockholders' equity ..................   $ 19,151,982    $ 13,376,170
                                                                ============    ============
</TABLE>

                             See accompanying notes


                                       F-2
<PAGE>

                               PHYSIOMETRIX, INC.
                            STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                            Year ended  December 31,
                                                    1995          1996           1997

<S>                                            <C>            <C>            <C>
Revenues ...................................   $   321,835    $   413,698    $ 1,006,381

Costs and expenses:
   Cost of goods sold ......................     1,164,268      1,189,510      1,925,316
   Research and development ................       392,413      1,189,336      2,500,601
   Selling, general and administrative .....     1,575,481      1,652,596      2,739,423
                                               -----------    -----------    -----------

                                                 3,132,162      4,031,442      7,165,340
                                               -----------    -----------    -----------

Operating loss .............................    (2,810,327)    (3,617,744)    (6,158,959)
Interest income ............................        75,465        683,461        788,878
Interest expense ...........................       (36,876)       (90,090)       (23,016)
                                               -----------    -----------    -----------

Net loss ...................................   $(2,771,738)   $(3,024,373)   $(5,393,097)
                                               ===========    ===========    ===========

Loss per common share (Pro Forma in 1995) ..   $      (.83)   $      (.80)   $      (.96)
                                               ===========    ===========    ===========
Shares used in computing net loss per common
share (pro forma in 1995) ..................     3,338,974      3,766,494      5,615,360
                                               ===========    ===========    ===========
</TABLE>

                             See accompanying notes


                                       F-3
<PAGE>

                               PHYSIOMETRIX, INC.
                            STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                           Year ended December 31,
                                                                                     1995            1996             1997
                                                                                     ----            ----             ----
<S>                                                                             <C>             <C>              <C>
Operating Activities:
Net loss ..................................................................     $(2,771,738)    $ (3,024,373)    $ (5,393,097)

Adjustments to reconcile net loss to net cash used in operating activities:
   Depreciation and amortization ..........................................          96,342          114,640          205,456
   Stock compensation .....................................................              --               --           53,000
   Loss on disposal of equipment ..........................................          22,433              325               --
   Changes in operating assets and liabilities:
      Accounts receivable .................................................         (42,736)          52,716         (272,998)
      Inventories .........................................................         (42,111)        (107,927)        (360,342)
      Prepaid expenses and other assets ...................................           6,839          (60,236)          20,762
      Accounts payable and accrued expenses ...............................           1,453          443,844          113,321
                                                                                -----------      -----------     ------------
Net cash used in operating activities .....................................      (2,729,518)      (2,581,011)      (5,633,898)
Investing activities:
Purchase of equipment .....................................................        (106,747)        (334,178)        (375,028)
Proceeds from sale of equipment ...........................................           6,188              800               --
Purchase of available-for-sale securities .................................              --     (150,684,912)    (127,696,952)
Proceeds from maturity of available-for-sale securities ...................              --      132,866,995      143,030,730
                                                                                -----------      -----------     ------------

Net cash provided by (used in) investing activities .......................        (100,559)     (18,151,295)      14,958,750
Financing activities:
Proceeds from (payments on) demand note ...................................              --          541,334         (541,334)
Proceeds from notes payable to stockholders ...............................         308,972          380,428
Principal payments on notes payable to
stockholders ..............................................................         (70,057)        (100,895)         (82,236)
Proceeds from issuance of common stock ....................................           3,805       19,807,644           74,534
                                                                                -----------     ------------     ------------
Net cash provided by (used in) financing activities .......................         242,720       20,628,511         (549,036)
                                                                                -----------     ------------     ------------
Net increase (decrease) in cash and cash quivalents .......................      (2,587,357)        (103,795)       8,755,816
Cash and cash equivalents at beginning of year ............................       3,019,483          432,126          328,331
                                                                                -----------     ------------     ------------

Cash and cash equivalents at end of year ..................................     $   432,126     $    328,331     $  9,104,147
                                                                                ===========     ============     ============
</TABLE>

                              See accompanying notes


                                       F-4
<PAGE>

                               PHYSIOMETRIX, INC.
                       STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                    Preferred Stock              Common Stock             Additional

                                                 Shares          Amount         Shares        Amount     Paid-in-Capital

<S>                                           <C>             <C>            <C>              <C>         <C>
Balance at December 31, 1994 .............     4,027,662      $   4,028         40,674        $   41      $10,015,784
   Issuance of common stock upon
       exercise of options ...............                                      93,480            93            3,412
   Issuance of warrants ..................                                                                        300
   Net loss ..............................
                                             -----------      ---------     ----------       -------      -----------

Balance at December 31, 1995  ............     4,027,662          4,028        134,154           134       10,019,496
   Issuance of common stock pursuant
       to initial public offering, net of
       issuance costs of $671,160 ........                                   2,000,000         2,000       19,776,841
   Conversion of preferred stock to
       common stock pursuant to initial
       public offering ...................    (4,027,662)        (4,028)     3,222,130         3,222              806
   Conversion of bridge loan financing
       to common stock pursuant to initial
       public offering ...................                                      62,672            63          689,337
   Deferred compensation related to
       stock options granted .............                                                                     56,000
   Issuance of common stock upon
       exercise of options ...............                                     161,368           161           28,157
   Issuance of warrants ..................                                                                        485
   Net loss...............................
                                             -----------      ---------     ----------       -------      -----------
Balance at December 31, 1996 .............                                   5,580,324         5,580       30,571,122
   Issuance of common stock upon
       exercise of options ...............                                      35,861            36           10,088
   Issuance of Common Stock under
       Employee Stock Purchase Plan ......                                      24,640            25           64,385
   Stock compensation ....................                                                                     53,000
   Net loss ..............................
                                             -----------      ---------     ----------       -------      -----------
Balance at December 31, 1997 .............                    $              5,640,825       $ 5,641      $30,698,595
                                             ===========      =========     ==========       =======      ===========
</TABLE>

<TABLE>
<CAPTION>

                                               Accumulated        Total
                                                                Stockholders'
                                                 Deficit          Equity
<S>                                          <C>              <C>
Balance at December 31, 1994 .............   $ (7,204,976)    $ 2,814,877
   Issuance of common stock upon
       exercise of options ...............                          3,505
   Issuance of warrants ..................                            300
   Net loss ..............................     (2,771,738)     (2,771,738)
                                             ------------     -----------
Balance at December 31, 1995  ............     (9,976,714)         46,944
   Issuance of common stock pursuant
       to initial public offering, net of
       issuance costs of $671,160 ........                     19,778,841
   Conversion of preferred stock to
       common stock pursuant to initial
       public offering ...................
   Conversion of bridge loan financing
       to common stock pursuant to initial
       public offering ...................                        689,400
   Deferred compensation related to
       stock options granted .............                         56,000
   Issuance of common stock upon
       exercise of options ...............                         28,318
   Issuance of warrants ..................                            485
   Net loss...............................     (3,024,373)     (3,024,373)
                                             ------------     -----------
Balance at December 31, 1996 .............    (13,001,087)     17,575,615
   Issuance of common stock upon
       exercise of options ...............                         10,124
   Issuance of Common Stock under
       Employee Stock Purchase Plan ......                         64,410
   Stock compensation ....................                         53,000
   Net loss ..............................     (5,393,097)     (5,393,097)
                                             ------------     -----------
Balance at December 31, 1997 .............   $(18,394,184)    $12,310,052
                                             ============     ===========

</TABLE>


                                       F-5
<PAGE>

                               PHYSIOMETRIX, INC.
                          NOTES TO FINANCIAL STATEMENTS

1.    Company Description and Summary of Significant Accounting Policies

The Company

      Physiometrix, Inc. (the "Company") is engaged in the development,
manufacturing and marketing of medical devices for use in neurological
monitoring applications during surgical and diagnostic procedures.

Use of Estimates

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

Cash and Short-term Investments

      Cash equivalents consist principally of United States Treasury bills and
certificates of deposit with maturities of three months or less at the date of
purchase. In addition, the Company has certain investments in commercial paper,
U.S. government agencies and debt securities, which do not meet the definition
of cash equivalents and have been classified as short-term investments. These
securities are considered available-for-sale securities. The estimated fair
value is equal to the cost of the securities and due to the nature of the
securities, there are no unrealized gains or losses at the balance sheet dates.

Concentrations of Credit Risk

      The Company places its cash investments in high quality short-term,
interest-bearing investment grade securities including U.S. Treasury securities
and high grade corporate notes. By policy, the Company limits the amount of
credit exposure in any one financial instrument or institution. One customer
accounted for 34% of accounts receivable and 10% of revenue at December 31,
1997. Two customers each accounted for approximately 12% of revenue in 1996 and
one customer accounted for 22% of revenue in 1995.

Inventories

      Inventories are stated at the lower of cost (first-in, first-out) or
market.

Equipment

      Equipment is recorded at cost and is depreciated using the straight line
method over its estimated useful life of five years.

Revenue Recognition

      The Company recognizes revenue for product sales upon shipment, net of
allowances for discounts and estimated returns which are also provided for at
the time of shipment


                                       F-6
<PAGE>

Stock - Based Compensation

      The Company has elected to follow Accounting Principles Board Opinion No.
25 ("APB 25"), "Accounting for Stock Issued to Employees" and related
interpretations in accounting for its stock-based compensation plans, rather
than the alternative fair value accounting method provided for under Financial
Accounting Standards Board Statement No. 123 ("Statement 123"), "Accounting for
Stock-Based Compensation," as this alternative requires the use of option
valuation models that were not developed for use in valuing employee stock
options. Under APB 25, where the exercise price of options granted under these
plans equals the market price of the underlying stock on the date of grant, no
compensation expense is required.

Net Loss Per Common Share

      In 1997, the Financial Accounting Standards Board issued Statement No.
128, Earnings per Share. Statement No 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. Pursuant to the previous requirements of the Securities and
Exchange Commission (SEC), common shares and common share equivalents issued by
the Company during the twelve-month period prior to the initial public offering
of the Company's common stock had been included in the calculations as if they
were outstanding for all periods prior to the offering in April 1996 whether or
not they were anti-dilutive. In February 1998, the SEC issued Staff Accounting
Bulletin 98 which, among other things, conformed prior SEC requirements to
Statement 128 and eliminated inclusion of such shares in the computation of
earnings per share. All earnings per share amounts for all periods have been
presented and where appropriate, restated to conform to the Statement 128 and
SEC requirements.

Accounting Pronouncements

      In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," and SFAS No. 131, "Disclosures About Segments of an Enterprise and
Related Information." Both SFAS No. 130 and SFAS No. 131 are effective for
fiscal years beginning after December 15, 1997. The Company believes that the
adoption of these new accounting standards will not have a material impact on
the Company's financial statement.

2.    Inventories

      Inventories consist of the following at December 31:

<TABLE>
<CAPTION>

                                                         1996         1997
     <S>                                                 <C>          <C>
      Raw materials.................................     $ 149,032    $ 405,446
      Work in progress..............................        78,726       67,391
      Finished goods................................        52,031      167,294
                                                         ---------    ---------
                                                         $ 279,789    $ 640,131
                                                         =========    =========

</TABLE>

                                       F-7
<PAGE>

3.    Equipment

      Equipment, net consists of the following at December 31:

<TABLE>
<CAPTION>
                                                  1996             1997
       <S>                                       <C>              <C>
       Computer equipment ................       $ 362,746        $  602,726
       Machinery and equipment ...........         414,831           549,879
                                                 ---------        ----------
                                                   777,577         1,152,605

       Accumulated depreciation ..........        (284,739)         (490,195)
                                                 ---------        ----------

                                                 $ 492,838        $  662,410
                                                 =========        ==========
</TABLE>

4.    Accrued Expenses

      Accrued expense consist of the following at December 31:

<TABLE>
<CAPTION>
                                                   1996              1997
       <S>                                       <C>              <C>
       Payroll .............................     $ 115,036        $  169,056
       Professional fees ...................        65,731           141,425
       Other ...............................        80,340           134,284
                                                 ---------        ----------

                                                 $ 261,107        $  444,765
                                                 =========        ==========
</TABLE>

5.    Financing Arrangements

      The Company had a credit agreement with a lending institution which
allowed for borrowings up to $500,000, accrued interest at 12.5% and expired in
March 1997. The line of credit was collatoralized by a $500,000 certificate of
deposit. Borrowings outstanding were $541,334 at December 31, 1996. There were
no borrowings outstanding at December 31, 1997. The Company made a final payment
of $53,000 to a stockholder for equipment financing in 1997. Interest paid
approximated interest expense in 1995, 1996 and 1997.

6.    Leases

      The Company leases its administrative and manufacturing facility under a
non-cancelable operating lease which expires in December 1999. Future minimum
operating lease payments as of December 31, 1997 are as follows:

<TABLE>
       <S>                                              <C>
       1998...........................................  $ 103,630

       1999...........................................    103,630
                                                        ---------
       Total minimum lease payments...................  $ 207,260
                                                        =========
</TABLE>
      Total rent expense was approximately $165,000 in 1995, $ 96,000 in 1996
and $115,000 in 1997.


                                       F-8
<PAGE>

7.    Stockholders' Equity

      The Company is authorized to issue 10,000,000 shares of preferred stock,
$.001 par value, in one or more series, each of such series to have such rights
and preferences, including voting rights, dividends rights, conversion rights,
redemption privileges and liquidation preferences, as shall be determined by the
Board of Directors.

      The Company has warrants outstanding to purchase 100,000, 6,000 and 52,227
shares of common stock at $13.20, $11.00 and $6.60 per share respectively,
expiring in 2001. At December 31, 1997, 1,479,790 shares of common stock have
been reserved for issuance upon exercise of common stock warrants and stock
options.

8.    Employee Benefit Plans

      Stock Option Plans

      The Company's 1991 Incentive Stock Plan (the Plan) provides for the
issuance of incentive and nonstatutory common stock options to employees,
officers and consultants. The Plan provides for the granting of up to 1,500,000
options to purchase shares of the Company's common stock. Except for
nonstatutory options, the exercise price of the options granted under the Plan
may not be less than 100% of the fair market value of the common stock subject
to the option on the date of grant as determined by the Board of Directors.
Generally, options granted under the Plan vest over a four-year period and
expire ten years from the date of grant.

      The Company's 1996 Director Option Plan (The Director Plan) provides that
each nonemployee director who becomes a director will be granted a nonstatutory
option to purchase 15,000 shares of common stock at its then fair market value.
Annually thereafter, each nonemployee director will be granted a nonstatutory
option to purchase 5,000 shares of common stock as its then fair market value.
All options will vest ratably over four years and expire ten years after date of
grant. A total of 150,000 shares of common stock are available for grant under
the Director Plan.

      A summary of option activity for the two plans is as follows:

<TABLE>
<CAPTION>

                                        1995         1996          Weighted         1997     Weighted
                                                                    Average                   Average
                                                                   Exercise                  Exercise
                                                                     Price                     Price
<S>                                  <C>             <C>             <C>       <C>             <C>
Outstanding at beginning of year         606,000          748,228    $  .30         685,681    $1.03

Granted ........................         266,388          109,400      4.59         246,100     2.78
Canceled .......................         (30,680)         (10,597)      .33         (48,359)    1.97
Exercised ......................         (93,480)        (161,350)      .11         (35,861)     .28
                                         -------         --------                   -------
Outstanding at end of year .....         748,228          685,681    $ 1.03         847,561    $1.51
                                         =======          =======    ======         =======    =====
Price Range at end of year .....     $.04 - $.63     $.04 - $6.25              $.04 - $6.25
                                     ===========     ============              ============
Exercisable at end of year .....         281,016          327,493    $  .55         513,668    $1.03
                                                                     ======         =======    =====
                                     ===========     ============
Available for grant at end of
year ...........................          59,374          671,743                   474,002
                                     ===========     ============                   =======
</TABLE>

                                     F-9


<PAGE>

      The following table presents weighted average price and life information
about significant option groups outstanding at December 31, 1997:

<TABLE>
<CAPTION>

      Exercise          Options          Options
      Price             Outstanding      Exercisable
  <S>                   <C>              <C>
    $.04 - $.63         514,434          425,051
  $2.38 - $6.25         333,127           88,617
                        -------          -------
                        847,561          513,668
</TABLE>

The weighted average contractual life of options outstanding at December 31,
1996 and 1997 was 8.1 years and 7.9 years, respectively. The weighted average
fair value of options granted in 1996 was $3.03 and $2.38 in 1997.

      Pro forma information regarding net loss and net loss per share was
computed in accordance with Statement 123, and has been determined as if the
Company has accounted for its employee stock options granted subsequent to
December 31, 1994 under the fair value method of that Statement. The fair value
for these options was estimated at the date of grant using a Black-Scholes
option pricing model with the following weighted-average assumptions for 1995,
1996 and 1997, risk-free interest rate of 5.91%, dividend yield of 0%,
volatility factor of the expected market price of the Company's common stock of
118% and a weighted-average expected life of the option of 5.5 years. The
Company has determined that the pro forma net loss per share as computed under
Statement 123 is not materially different from the net loss per share as
currently disclosed under APB 25.

      Employee  Stock Purchase Plan

      Under the 1996 Employee Stock Purchase Plan ("the Purchase Plan") eligible
employees may purchase common stock at a price per share equal to 85% of the
lower of the fair market value of the common stock at the beginning of the
offering period or end of each six month purchase period. Participation in the
offering is limited to 20% of the employees compensation or $25,000 in any
purchase period. The first offering commenced on December 1, 1996 and the
Purchase Plan will terminate April 2006. A total of 150,000 shares of common
stock has been reserved for issuance under the Purchase Plan.

      401(k) Savings Plan

      The 401(k) Savings Plan ("Savings Plan") allows all employees that have
attained the age of 21 to make annual, tax-deferred contributions of up to 15%
of their eligible compensation. Annually, the Company may make discretionary
matching contributions based upon a percentage of the employees' contributions.
The Company made no such contributions to the Savings Plan in 1997, 1996 or
1995.


                                     F-10
<PAGE>

9.    Income Taxes

      Since the Company has incurred only losses since inception, and due to the
degree of uncertainty related to the use of the loss carryforwards, the Company
has fully reserved this benefit. At December 31, 1997, the Company had tax net
operating loss carryforwards of approximately $12.7 million available to offset
federal taxable income. The Company also has research and development tax credit
carryforwards of approximately $284,000 available to offset federal and state
income taxes. Both carryforwards expire in varying amounts through 2012. The
Company also had approximately $11.4 million in net operating loss carryforwards
to offset state taxable income. This carryforward expires in varying amounts
through 2002. In accordance with Section 382 of the Internal Revenue Code, the
use of the above carryforwards will be subject to annual limitations based upon
ownership changes of the Company's stock which have occurred.

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets as of December 31 are as follows:

<TABLE>
<CAPTION>
                                                          1996          1997
       <S>                                             <C>         <C>
       Net operating loss carryforwards............... $3,621,000   $5,004,000

       Research and development costs.................  1,077,000    1,831,000
       Research and development tax credits...........    196,000      284,000
       Other..........................................    172,000      134,000
                                                       ----------   ----------
                                                        5,066,000    7,253,000
       Valuation allowance............................ (5,066,000)  (7,253,000)
                                                       ----------   ----------
       Net deferred tax asset......................... $   --       $   --
                                                       ==========   ==========
</TABLE>

      The valuation allowance increased by $2,187,000 in 1997 due primarily to
the unbenefitted net operating loss incurred in 1997. The tax net operating loss
carryforward differs from the accumulated deficit principally due to temporary
differences in the recognition of certain revenue and expense items for
financial and tax reporting purposes, consisting primarily of research and
development costs.

10.   Related Party Transactions

      Certain of the Company's legal services, principally related to patent
matters, are provided by a firm which is affiliated with a director/shareholder.
Payments to this company amounted to approximately $26,200, $51,000 and $23,900
in 1995, 1996 and 1997, respectively.

      The Company has a loan outstanding to an officer in the amount of $84,000
at December 31, 1997 which is due periodically from 1999 to 2002. The loan
accrued interest at the applicable federal rate (6.31% at December 31, 1997).


                                      F-11
<PAGE>

                                   SIGNATURES

      Pursuant to the requirements of the Securities Act, the Registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.

                                    Physiometrix, Inc.


                                    By:       /s/ JOHN A. WILLIAMS
                                        ---------------------------------------
                                                  John A. Williams
                                        President and Chief Executive Officer

      KNOW ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints John A. Williams and Daniel W. Muehl,
jointly and severally, his or her attorneys in fact, and each with the power of
substitution, for him or her in any and all capacities, to sign any amendments
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said attorneys in
fact, or his or her substitute or substitutes, may do or cause to be done by
virtue thereof.

      Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated.

          Signature                          Title                         Date

<TABLE>
   <S>                       <C>                                       <C>
   /s/ JOHN A. WILLIAMS      President, Chief Executive Officer and    March 31, 1998
--------------------------   Director (Principal Executive Officer)
       John A. Williams


   /s/ DANIEL W. MUEHL       Vice President and Chief Financial        March 31, 1998
--------------------------   Officer (Principal Financial and
      Daniel W. Muehl        Accounting Officer)


   /s/ THOMAS BARUCH         Director                                  March 31, 1998
--------------------------
       Thomas Baruch


   /s/ JAMES E. NICHOLSON    Director                                  March 31, 1998
--------------------------
    James E. Nicholson


   /s/ JAMES A. SAALFIELD    Director                                  March 31, 1998
--------------------------
    James A. Saalfield


   /s/ THOMAS J. TOY         Director                                  March 31, 1998
--------------------------
        Thomas J. Toy
</TABLE>

                                      F-12
<PAGE>

                                  EXHIBIT INDEX

     (c)  Exhibits

--------
          Exhibit                           Description
            No.

            3.1(1) Restated Certificate of Incorporation of the Company.
            3.2(1) Bylaws of the Company, as amended.
            4.1(1) Specimen Common Stock Certificate.
            4.2(1) Form of Warrant Agreement between the Company and Cruttendon
                   Roth Incorporated, with form of Warrant attached.
           10.1(1) Form of Indemnification Agreement between the Company and
                   each of its directors and officers.
           10.2(1) 1991 Incentive Stock Plan and Form of Stock Option Agreement
                   thereunder.
           10.3(2) 1996 Director Option Plan.
           10.4(2) 1996 Employee Stock Purchase Plan and forms of agreements
                   thereunder.
           10.5(1) Lease dated October 11, 1994 between the Company and Yvon
                   Cormier, Trustee of YCEE Investment Trust, for a facility
                   located at Five Billerica Park, 101 Billerica Avenue, North
                   Billerica, Massachusetts  01862.
           10.6(1) Restated Shareholder Rights Agreement dated June 24, 1994
                   between the Company and certain holders of the Company's
                   securities.
              23.1 Consent of Ernst & Young LLP, Independent Auditors.
              24.1 Power of Attorney. Reference is made to page F-12.
              27.1 Financial Data Schedule - 1997 Year-End
              27.2 Financial Data Schedule - 1996 - Four Columns
              27.3 Financial Data Schedule - 1997 - Three Columns
------------------

               (1) Filed as an Exhibit to the Company's Registration
                   Statement on Form S-1 (File No. 33302138) and incorporated
                   herein by reference.

               (2) Filed as an Exhibit to the Company's Registration
                   Statement on Form S-8 (File No. 33316525) and incorporated
                   herein by reference.