|U.S. SECURITIES AND EXCHANGE
COMMISSION
WASHINGTON, D.C. 20549                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
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|FORM 10-K                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF
THE
SECURITIES EXCHANGE ACT OF 1934                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|For fiscal year ended December 31,
2000                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Commission file number: 0-22340                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|PALOMAR MEDICAL TECHNOLOGIES, INC
(Exact name of registrant as specified in its charter)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|Delaware
(State or other jurisdiction of incorporation or organization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|82 Cambridge Street, Burlington, Massachusetts 01803
(Address of principal executive offices)(781) 993-2300
(Issuer ́s telephone number, including area code)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Securities registered pursuant to Section 12 (b) of the Act:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Title of each class
Not Applicable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, $.01 par value                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|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 report(s)), and (2) has
been subject to such filing requirements for the past 90 days.
YesXNo                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Check if there is no
disclosure of delinquent filers in response to Item 405 of Regulation S-K
contained in this form, and no disclosure will 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|As of March 1, 2001, 10,326,616 shares of common stock were
outstanding. The aggregate market value of the voting shares (based upon the closing price reported by
Nasdaq on March 1, 2001) of Palomar Medical Technologies, Inc., held by nonaffiliates was $11,683,394.
For purposes of this disclosure, shares of common stock held by entities
and individuals who own 5% or more of the outstanding common stock, as reported in Amendment No. 6 to a
Schedule 13G/A filed on February 1, 2001, Schedule 13G as reported on February 9, 2001 and Amendment No. 7 to a Schedule 13D/A
filed on February 28, 2001 and shares of common stock held by each officer and director have been excluded in that such
persons may be deemed to be affiliates as that term is defined under the Rules and Regulations of the
Securities Exchange Act of 1934. This determination of affiliate status is not necessarily conclusive.
|DOCUMENTS INCORPORATED BY REFERENCE                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Portions of the definitive proxy statement to be filed prior
to April 30, 2001, pursuant to Regulation 14A of the
Securities Exchange Act of 1934 are incorporated by reference into Part III of this Form 10-K                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Transitional Small Business Disclosure Format:
YesNoX                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
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|INDEX                                                                                         |        
|Item                                                                                          |        
|                                                                                             
|PART I                                                                                        |        
|                                                                                             
|Item 1. Business                                                                              |        
|                                                                                             
|(a) Introduction                                                                              |        
|(b) Financial Information About Industry Segments                                             |        
|(c) Description of Business                                                                   |        
|(d) Financial Information About Exports by Domestic Operations                                |        
|                                                                                             
|Item 2. Properties                                                                            |        
|                                                                                             
|Item 3. Legal Proceedings                                                                     |        
|                                                                                             
|Item 4. Submission of Matters to a Vote of Security Holders                                   |        
|                                                                                             
|PART II                                                                                       |        
|                                                                                             
|Item 5. Market for Registrants Common Equity and Related Stockholder Matters                 |        
|                                                                                             
|Item 6. Selected Financial Data                                                               |        
|                                                                                             
|Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations |        
|                                                                                             
|(a) Overview                                                                                  |        
|(b) Results                                                                                   |        
|(c) Liquidity and Capital Resources                                                           |        
|(d) Year 2000 Impact                                                                          |        
|(e) Recently Issued Accounting Standard                                                       |        
|                                                                                             
|Item 7A. Quantitative and Qualitative Disclosures About Market Risk                           |        
|                                                                                             
|Statement Under the Private Securities Litigation Reform Act                                  |        
|                                                                                             
|Risk Factors                                                                                  |        
|                                                                                             
|Item 8. Financial Statements                                                                  |        
|                                                                                             
|Report of Independent Public Accountants                                                      |        
|Consolidated Balance Sheets as of December 31, 1999 and 2000                                  |        
|Consolidated Statements of Operations for the years ended December 31, 1998, 1999 and 2000    |        
|Consolidated Statements of Stockholders Equity (Deficit) for the years ended                 |        
|December 31, 1998, 1999 and 2000                                                              |        
|Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1999 and 2000    |        
|Notes to Consolidated Financial Statements                                                    |  
;
|                                                                                             
|Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosures    |        

|
|

|PART III                                                                 |  | 48 | 
|------------------------------------------------------------------------ |  | -- | 
|                                                                        
|Item 10. Directors and Executive Officers of the Registrant              |  | 48 | 
|                                                                        
|Item 11. Executive Compensation                                          |  | 48 | 
|                                                                        
|Item 12. Security Ownership of Certain Beneficial Owners and Management  |  | 48 | 
|                                                                        
|Item 13. Certain Relationships and Related Transactions                  |  | 48 | 
|                                                                        
|PART IV                                                                  |  | 49 | 
|                                                                        
|Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K |  | 49 | 
|                                                                        
|(a) Index to Consolidated Financial Statements and Schedules             |  | 49 | 
|(b) Reports on Form 8-K                                                  |  | 49 | 
|(c) Exhibits                                                             |  | 50 | 
|                                                                        
|SIGNATURES                                                               |  | 53 | 

|PART I
Item 1.    Business.


(a)            Introduction


Palomar Medical
Technologies, Inc. was organized in 1987 to design, manufacture and market lasers,
delivery systems and related disposable products for use in medical procedures. In
December 1992, the Company went public. Subsequently, the Company pursued an aggressive
acquisition program, acquiring companies in its core laser business as well as others,
principally in the electronics industry, in order to spread risk and bolster operating
assets, among other reasons. By the beginning of 1997, the Company had more than a dozen
subsidiaries. At the same time, having obtained FDA clearance to market its EpiLaser®ruby
laser hair removal laser system in March 1997, the Company was well positioned to focus
on what it believed was at that time the most promising product in its core laser
business. Hence, under the direction of a new Board and management team, the Company
undertook an ambitious program in 1997, completed in May of 1998, of exiting from all
non-core businesses and investments and focusing only on those businesses which it
believes hold the greatest promise for maximizing stockholder value. The Companys
exclusive focus is now the use of lasers in dermatology and cosmetic procedures, with an
emphasis on laser hair removal and research and development relating to that and other
cosmetic laser products. On December 7, 1998, the Company entered into an Agreement and
Plan of Reorganization (the Agreement) with Coherent, Inc (Coherent)
to sell all of the issued and outstanding common stock of Palomars Star Medical
Technologies, Inc. (Star) subsidiary. The Company completed the sale of Star
to Coherent on April 27, 1999. Currently, the Company has two operating subsidiaries,
Palomar Medical Products, Inc. (PMP) and Esthetica Partners, Inc. (formerly
Cosmetic Technology International, Inc). In early 2000, the Company opened a research and
development division in Livermore, California (Palomar West). PMP, located at
the Companys headquarters in Burlington, Massachusetts, oversees the manufacture
and sale of the Companys laser systems currently on the market. Esthetica, also
based in Burlington, Massachusetts, places the Companys lasers in clinical and
cosmetic settings. Palomar West was established to expand product development in
dermatology, including laser treatment of tattoos, pigmented lesions, and leg veins. (See
Item 7. Managements Discussion and Analysis of Financial Condition and
Results of Operations Overview.)

(b)            Financial Information About Industry Segments


The Company conducts
business in one industry segment, medical products and services. In 1998, the Company
completed the program, begun in 1997, of divesting all of its non-core electronics
subsidiaries. (See Item 7. Managements Discussion and Analysis of Financial
Condition and Results of Operations Overviewand Note 12 to Financial
Statements.)


(c)            Description of Business


(i)            Principal Products


Hair
Removal/Vascular Lasers


Using its core ruby laser
technology, originally developed for tattoo removal and pigmented lesions, Palomar
developed a long pulse ruby laser, the EpiLaser®, that is specifically configured to
allow the appropriate wavelength, energy level and pulse duration to be absorbed
effectively by the hair follicle without being absorbed by the surrounding tissue. That,
combined with the patented cooling handpiece, allows for safe and effective hair removal.
In March 1997, Palomar was the first company to receive FDA clearance to sell and market
a ruby laser (the EpiLaser®system) in the U.S. for hair removal.


In December 1997 and
January 1998 respectively, Palomar was also the first company to receive FDA clearance
for a diode laser for hair removal and for leg vein treatment, the LightSheerdiode
laser system manufactured by Star. The LightSheerwas the first generation of high
powered diode lasers designed for hair removal. These diode lasers also incorporate the
patented contact-cooling system licensed exclusively to Palomar. High-powered diode laser
systems are compact, solid-state lasers that are significantly smaller than most current
systems, and relatively easy to install and service.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|During 1998, Palomar
introduced its second generation ruby laser, the Palomar E2000hair removal laser
system, a product that is superior to hair removal lasers currently available in a number
of respects, including speed and efficacy. The Palomar E2000has also received FDA
clearance for hair removal.


Studies using Palomars
laser hair removal process demonstrated significant permanent reduction of hair following
treatment with the EpiLaser®and the Palomar E2000. The first treatment causes a
portion of the hair (typically the hair in the growth mode) to be reduced in size, color
and/or quantity (based on studies followed for up to three years) and causes significant
growth delay (three to six months) of most of the rest of the hair. Since the partial
re-growth tends to occur in synchrony, the follow-up treatment is often more effective
than the first treatment. The EpiLaser®and the Palomar E2000were the first hair
removal lasers on the market that were cleared by the FDA for permanent hair
reduction labeling.


During 2000, Palomar
received FDA clearance to market and sell the Palomar SLP1000diode laser system.
The Palomar SLP1000is a high-powered diode laser that delivers energy over a
relatively long time period using a technology called (Super Long Pulse Technology).
The SLP1000diode laser system is the first diode laser using Super Long Pulse
Technology to provide hair removal and vascular treatments to virtually all skin types.
Furthermore, the Palomar SLP1000diode laser system is the first laser system
utilizing interchangeable hand pieces to provide hair removal or vascular treatments. In
addition to the Palomar SLP1000diode laser systems broad treatment range, it
is compact and easy to use. These proprietary delivery systems are essential to providing
safe and effective treatment. This new generation of lasers promises to be much gentler
to the skin, capable of treating a wide range of skin types, and cheaper to produce than
current systems on the market


Market surveys report
that the great majority of women in the United States employ one or more techniques for
temporary hair removal from various parts of the body, including waxing, depilatories,
tweezing, shaving, and electrolysis. The market for laser-based hair removal is in its
early stages. Benefits of Palomars laser hair removal process, as compared to other
hair removal methods currently available, include significant long term cosmetic
improvement, treatment of larger areas in each treatment session, a procedure that is
relatively painless and non-invasive, reduced risk of scarring, no risk of
cross-contamination, and higher success rates.



Tattoo
Removal/Pigmented Lesion Laser


The Company also sells a
Q-switched ruby laser for tattoo removal and treating pigmented lesions, the RD-1200.
The RD-1200has been on the market for ten years. Intense competition in the medical
device industry and market saturation for this type of laser have reduced RD-1200sales
over the last five years. In addition, there are less expensive products now available
for this purpose. Palomar expects sales of this product to continue in 2001 at a low
volume to foreign countries where the advantages of the ruby laser for treatment of
pigmented lesions is especially important. Palomar West is developing technology for this
market that is expected to be less expensive than current products on the market.


Distribution and
Service


Palomar has changed its
distribution method over the past few years to address changes in the market conditions
and composition of its product line. The Company has hired a number of direct sales
representatives in anticipation of new products to be introduced during 2001. The Company
further intends to tailor distribution methods to different geographic regions and may
include a combination of exclusive and non-exclusive distributors, independent
representatives and a direct sales force. Palomar sells and services products through
distributors internationally. In the United States, Palomar provides service through its
own service organization.


(ii)            Products Under Development


The Company is engaged in
developing products for the dermatology and cosmetic market. Products under development
include hair removal lasers, tattoo and pigmented lesion lasers, leg vein lasers, acne
treatment lasers and fat reduction lasers. The core research, including in vitro, in
vivo, and clinical research, is a joint effort between scientists and researchers at the
Company and at our research partner Massachusetts General Hospital (MGH).
Product development is performed by scientists and engineers at the Companys
headquarters and in our Livermore, California facility. The Company splits its efforts
between new products for existing markets such as hair removal, leg vein treatment and
tattoo removal, and new products for new markets, such as acne treatment and fat
reduction.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(iii)            Production and Sources and Availability of Materials


Palomars
manufacturing operations are currently located in Burlington, Massachusetts.
Manufacturing consists of the assembly and testing of components purchased from outside
suppliers and contract manufacturers. Palomar maintains control of and manufactures most
key components in-house. The entire fully assembled system is subjected to a rigorous set
of tests prior to shipment to the customer or distributor.


Palomar depends and will
depend upon a number of outside suppliers for components used in its manufacturing
process. Palomar has also contracted with a key overseas supplier of a major component of
the Super Long Pulse Technology. The component is matched with a specific delivery system
developed by Palomar and is incorporated into a full system. Most of Palomars
components and raw materials are available from a number of qualified suppliers. Ruby
rods for the ruby lasers are available through only one qualified supplier. To date, the
Company has not experienced, nor does it expect to experience, any significant delays in
obtaining component parts or raw materials. Palomar has expanded its manufacturing
capabilities to satisfy projected demand. Palomar has the approval for the CE Mark for
the EpiLaser®and E2000laser systems, and has obtained ISO 9001 registration.

(iv)            Patents and Licenses


Certain products of the
Company and methods for the use of such products are largely proprietary. The Company
believes that patent protection of its technology and products that result from the
Companys research and development efforts is important to the possible
commercialization of the Companys technology. The Company continually attempts to
protect its proprietary technology by obtaining patent protection and relying on trade
secret laws and non-disclosure and confidentiality agreements with its employees and
third parties that have access to its proprietary technology.


The Company believes it
owns, or has the right to use, the basic patents covering its products. However, each
year there are many patents granted worldwide related to lasers and their applications.
In the past, the Company has been able to obtain patent licenses for patents related to
its products on commercially reasonable terms. The failure to obtain a key patent license
from a third party could cause the Company to incur liabilities for patent infringement
and, in the extreme case, to discontinue manufacturing products that infringe upon the
patent. Management believes that none of the Companys current products infringe
upon a valid claim of any patents owned by third parties, where the failure to license
the patent would have a material and adverse effect on the Companys financial
position or results of operations.



The Company has not been
notified that it is currently infringing on any patents nor has it been the subject of
any patent infringement action. Defense of a claim of infringement is costly and could
have a material adverse effect on the Companys business, even if the Company were
to prevail. (See Item 7. Risk Factors.)


In August 1995, the
Company entered into an agreement with MGH whereby MGH agreed to conduct clinical trials
on a laser treatment for hair removal/reduction developed at MGHs Wellman
Laboratories of Photomedicine. In July 1999, the Company amended this agreement to extend
its exclusive research relationship for an additional five years. In addition to photo
thermal removal or reduction of hair, the agreement has been expanded to include research
and development in the fields of non-invasive electromagnetic targeting of subcutaneous
fat, and treatment of sebaceous glands and related skin disorders (e.g., acne) using
infrared light (hereinafter referred to, respectively, as hair removal,fat
removal,and acne treatment,for simplicity).


MGH has filed a number of
patents surrounding technology involving laser hair removal. These patents expire on
February 1, 2015. MGH licenses these patents exclusively to Palomar. Palomar, in turn,
has the right to sublicense these patents to others. Palomar also has the right to
exclusively license in the fields of hair removal, fat removal, and acne treatment any
other patents arising out of MGHs Palomar-funded clinical trials. As consideration
for this license, the Company is obligated to pay MGH royalties on products and services
covered by valid patents licensed to the Company. Palomar has sublicensed to competitors
these two MGH patents.
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|(v) Seasonal Influences


There is no significant
seasonal influence on the Companys sales.


(vi) Working Capital


There are no special
inventory requirements, return rights, or credit terms extended to customers that would
have a material adverse effect on the Companys working capital.


(vii) Dependence on a Single Sales Agent


The Company is not
dependent on a Single Sales Agent. Sales pursuant to the Companys Sales Agency,
Development and License Agreement with Coherent accounted for approximately 60% of the
Companys total revenues in fiscal 1999 and 89% in fiscal 1998. The Sales Agency
Agreement terminated upon the closing of the sale of Star in April 1999.


(viii) Backlog


The Companys
backlog of firm orders for its continuing operations at December 31, 2000 and December
31, 1999, was approximately $606,000 and $885,000 respectively.


(ix) Government Contracts


Not applicable.


(x) Competition


The markets in which the
Company is engaged are subject to keen competition and rapid technological change. To
Palomars knowledge, at least ten other companies have received market clearance
from the FDA for laser hair removal and another company has received FDA clearance to
market a laser-like system using filtered intense light to remove hair. The Companys
former subsidiary, Star, was sold to Coherent on April 27, 1999 and now competes with
Palomar in the hair removal market as well. The Company expects that other hair removal
devices will be developed and/or introduced in 2001, making laser hair removal a
competitive application within the cosmetic laser marketplace. The Company also expects
that there may be further consolidation of companies within the laser hair removal
industry via acquisitions, partnering arrangements or joint ventures. The Companys
products will also compete with other hair removal products and methods. The Company
competes primarily on the basis of technology, product performance, price, quality,
reliability, distribution and customer service and support. To remain competitive, the
Company will be required to continue to develop new products and periodically enhance its
existing products. (See Item 7. Risk Factors.)


(xi) Research and Development


Palomars research
and development goals in the field of laser hair removal are to design systems that (1) permit
more rapid treatment of large areas, (2) have high gross margins, and (3) are
manufactured at a lower cost, thus addressing broader markets. Further, Palomar aims to
address dermatology and cosmetic procedure markets other than hair, including the fields
of acne treatment and fat removal covered in its expanded research agreement with
Massachusetts General Hospital.


During fiscal 2000, 1999
and 1998, the Company incurred approximately $7,851,000, $8,022,000, $7,029,000,
respectively, on research and development programs. Due to the intense competition and
rapid technological changes in the laser industry, the Company believes that it must
continue to improve and refine its existing products and services, and develop new
applications for its technology. (See Item 7. Risk Factorsand Note 4 to
Financial Statements.)
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(xii) Environmental Protection
Regulations
The Company believes that
compliance with federal, state and local environmental regulations will not have a
material adverse effect on its capital expenditures, earnings or competitive position.


(xiii) Number of Employees


As of December 31, 2000,
the Company and its divisions and subsidiaries employed 91 people, 8 independent
contractors and 2 temporary employees.


(d) Financial Information About Exports by Domestic
Operations


Aggregate export sales
for the Companys continuing operations were approximately $17.4 million for 1998,
$8.4 million for 1999 and $3.9 million for 2000. The 1998 and 1999 export sales consisted
primarily of the LightSheerand the 2000 export sales consisted primarily of the
SLP1000 (See Notes 2(i) and 3 to Financial Statements.)

Item 2.   Properties.


The Company occupies
approximately 44,000 square feet of office, manufacturing and research space in
Burlington, Massachusetts under a lease expiring in August 2009. The Company occupies
approximately 4,000 square feet of research space in Livermore, California under a lease
expiring in December 2001. The Company believes that these facilities are in good
condition and are suitable and adequate for its current operations.

Item 3.   Legal Proceedings.


On March 11, 1999, the
United States District Court for the Southern District of New York granted plaintiffs
leave to amend their complaint in the action styled Varljen v. H.J. Meyers, Inc., et. al.
to join the Company, its former chief executive officer and current chief operating
officer as defendants. On March 17, 1999, the Second Amended Class Action Complaint in
Varljen was served upon the Company and its current chief operating officer, alleging
that the Company and the former and current officer violated the federal securities laws
in various public disclosures that the Company made directly and indirectly during the
period from February 1, 1996 to March 26, 1997. Palomar and the Varljen plaintiffs
reached an agreement in principle pursuant to which Palomar and its insurance carrier
would pay plaintiffs $5 million in settlement of all their claims. Of this amount,
Palomar would contribute up to $1 million in Palomar Common stock and $1.375 million in
cash, and its insurance carrier the remaining $2.625 million in cash. This settlement
agreement was approved by the court on November 6, 2000. A final judgement of dismissal
with prejudice was entered by the court on November 6, 2000. All payments required by
Palomar under the settlement agreement have been made except for the delivery of 358,547
shares of Palomar Common stock, which is the balance of the shares owed under the
settlement agreement. These shares will be delivered in 2001 upon receipt of instruction
from plaintiffs counsel.


The Company is involved
in other legal and administrative proceedings and claims of various types. While any
litigation contains an element of uncertainty, management, in consultation with the
Companys general counsel, at present believes that the outcome of each such other
proceeding or claim which is pending or known to be threatened, or all of them combined,
will not have a material adverse effect on the Company.

(See Item 7. "Risk Factors.")Item 4.    Submission of Matters to a Vote of Security Holders.Not applicable.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART II

Item 5.    Market for Registrant's Common Equity and Related Stockholder Matters.


The Companys common
stock is currently traded on the National Association of Securities Dealers Automated
Quotation System (Nasdaq) under the symbol PMTI. The following table sets forth the high
and low bid prices quoted on Nasdaq for the common stock for the periods indicated. Such
quotations reflect inter-dealer prices, without retail markup, markdown or commission and
do not necessarily represent actual transactions.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 |                  
|-------------------------------- | -----------------
|                                 | Fiscal Year Ended
|                                 | December 31, 1999
|                                 |                  
|                                 | High             
|                                 |                  
|Quarter Ended March 31, 1999     | 1.0938           
|Quarter Ended June 30, 1999      | 5.1875           
|Quarter Ended September 30, 1999 | 4.9375           
|Quarter Ended December 31, 1999  | 2.1563           
|                                

|                                 |                                   
|-------------------------------- | ----------------------------------
|                                 | Fiscal Year EndedDecember 31, 2000
|                                 |                                   
|                                 | High                              
|                                 |                                   
|Quarter Ended March 31, 2000     | 5.1250                            
|Quarter Ended June 30, 2000      | 3.2188                            
|Quarter Ended September 30, 2000 | 3.3750                            
|Quarter Ended December 31, 2000  | 2.8750                            
|                                

|As of March 1, 2001, the
Company had 1,682 holders of record of common stock. This does not include
holdings in street or nominee names.


The Company has not paid
dividends to its common stockholders since its inception and does not plan to pay
dividends to its common stockholders in the foreseeable future. The Company intends to
retain substantially all earnings to finance the operations of the Company. The Company
may buy back shares of its common stock on the open market from time to time.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Item 6.   Selected Financial Data.


The following table sets
forth selected consolidated financial and other information (in thousands except per
share data) on a consolidated historical basis for the Company and its subsidiaries as of
and for each of the fiscal years in the five year period ended December 31, 2000.
Pursuant to Accounting Principles Board Opinion (APB) No. 30, Reporting the
Results of Operations Reporting the Effects of Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, the
consolidated financial statements of the Company have been reclassified to reflect the
dispositions of its subsidiaries that comprise the electronics segment. This table should
be read in conjunction with the Consolidated Financial Statements of the Company and the
Notes thereto included elsewhere in this Annual Report on Form 10-K.

Selected Financial Data

(in thousands, except per share data)
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                 | Year ended December 31, 2000 |          |           |           
|------------------------------------------------ | ---------------------------- | -------- | --------- | ----------
|                                                 | 1996                         | 1997     | 1998      | 1999      
|                                                 |                              |          |           |           
|Statement of Operations Data:                    |                              |          |           |           
|Revenues                                         | $ 17,607                     | $ 20,995 | $ 44,514  | $ 24,251  
|Gross Profit                                     | 3,437                        | 939      | 21,463    | 8,741     
|Operating Expenses (Income)                      | 26,548                       | 42,867   | 30,897    | (24,297)  
|Income (Loss) from Operations                    | (23,110)                     | (41,929) | (9,434)   | 33,038    
|Net Income (Loss) from Continuing Operations     | (20,798)                     | (58,369) | (9,967)   | 25,501    
|Cumulative effect of change in accounting method | --                           | --       | --        | --        
|Net Loss from Discontinued Operations            | (17,066)                     | (27,435) | (2,624)   | (435)     
|Net Income (Loss)                                | (37,864)                     | (85,804) | (12,591)  | 25,066    
|Basic Net Income (Loss) Per Common Share:       
|Continuing Operations                            | $  (5.88)                    | $(12.52) | $  (1.26) | $     2.48
|Cumulative effect of change in accounting method | --                           | --       | --        | --        
|Discontinued Operations                          | (4.55)                       | (5.47)   | (0.29)    | (0.04)    
|                                                 |                              |          |           |           
|Total Basic Net Income (Loss) Per Common Share   | $(10.43)                     | $(17.99) | $  (1.55) | $    2.44 
|Basic Weighted Average Number of                
|Common Shares Outstanding                        | 3,738                        | 5,015    | 8,981     | 10,153    
|                                                 |                              |          |           |           
|Diluted Net Income (Loss) Per Common Share:     
|Continuing Operations                            | $  (5.88)                    | $(12.52) | $  (1.26) | $     2.39
|Cumulative effect of change in accounting method | --                           | --       | --        | --        
|Discontinued Operations                          | (4.55)                       | (5.47)   | (0.29)    | (0.04)    
|                                                 |                              |          |           |           
|Total Diluted Net Income (Loss) Per Common Share | $(10.43)                     | $(17.99) | $  (1.55) | $     2.35
|Diluted Weighted Average Number of              
|Common Shares Outstanding                        | 3,738                        | 5,015    | 8,981     | 10,776    
|                                                 |                              |          |           |           
|Balance Sheet Data:                             
|Working Capital                                  | $ 15,203                     | $(7,269) | $(6,004)  | $ 18,347  
|Total Assets                                     | 67,533                       | 28,968   | 23,526    | 34,843    
|Long-term Debt                                   | 14,665                       | 12,446   | 3,150     | 1,622     
|Stockholder's Equity (Deficit)                   | 38,077                       | (6,184)  | (6,463)   | 17,093    
|                                                

|Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations.



(a) Overview


We are a researcher and
developer of proprietary laser systems for hair removal and other cosmetic laser systems
and are the first company to obtain clearance from the FDA for using laser systems for
permanent hair reduction.Hundreds of Palomar laser hair removal systems have
been installed in physician practices worldwide. Through Palomars research
partnership with Massachusetts General Hospitals Wellman Laboratories, new
indications are being tested to further advance the laser hair removal market and other
cosmetic laser applications including fat reduction and acne treatment.


On December 7, 1998, the
Company entered into an Agreement and Plan of Reorganization (the Agreement)
with Coherent to sell all of the issued and outstanding common stock of Palomars
Star subsidiary. The Company completed the sale of Star to Coherent on April 27, 1999.
The total purchase price for all of the issued and outstanding capital stock of Star was
$65 million, paid in cash. The purchase price was paid to the stockholders of Star in
proportion to their holdings of Star capital stock. On the date of sale, Palomar owned
82.46% of Star. Palomar received net proceeds of $49,736,023, of which $3,254,907 was
held in escrow until April 27, 2000 as security for any claims which Coherent may have
had under the Agreement. During 2000, in connection with the lapse of the escrow period,
the Company recognized a deferred gain of $2,439,556, net of certain commitments and
contingencies related to the sale.


As a result of the above
transaction, the Company is able to fund its operations for the short term. However, the
successful introduction and marketing of new products will become critical to the Companys
long-term success. For the year ended December 31, 1999, gross revenues associated with
Stars LightSheersystem comprised 60% of the Companys total revenues.
This revenue base will need to be replaced with revenues from the SLP1000 and other
products that the Company intends to introduce in 2001. There can be no assurance that
the Palomar SLP 1000 or the Companys future products will achieve market
acceptance or generate sufficient margins. Broad market acceptance of laser hair removal
is critical to the Companys success. The Company recognizes the need and intends to
broaden its product line by developing cosmetic laser products other than hair removal
lasers.


In the third and fourth
quarters of 1997, the Board of Directors authorized management to focus the Company on
its core laser products and services business, principally related to laser hair removal,
and to proceed with a restructuring plan to reorganize the Company and divest its
electronic subsidiaries, Dynaco Corp., Dynamem, Inc., Comtel Electronics, Inc., and Nexar
Technologies, Inc. (collectively, the "Electronic Subsidiaries"), and other non-core
businesses. As a result, the Company has simplified its organization and now conducts
business in only two locations, Burlington, Massachusetts and Livermore, California.
Prior to the restructuring, the Company conducted business in over a dozen different
locations.


Pursuant to Accounting Principles
Board Opinion (APB) No. 30, Reporting the Results of Operations 
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions, the
consolidated financial statements of the Company have been presented to reflect
the dispositions of the Electronic Subsidiaries. Accordingly, the revenues, cost
and expenses, assets and liabilities and cash flows of the Electronics
Subsidiaries have been reported as discontinued operations in these consolidated
financial statements (see Note 12 to the Financial Statements).



(b) Results

(i)   REVENUES AND GROSS PROFIT: Year Ended December 31, 2000 
               Compared to Year Ended December 31, 1999


For the year ended
December 31, 2000, the Companys revenues decreased to $13.2 million as compared to
$24.3 million for the year ended December 31, 1999. The decrease in the Companys
revenues of $11.1 million, or 46% from the year ended December 31, 1999, was mainly due
to the reduction of $14.5 million in sales volume associated with the elimination of
LightSheersales in connection with the sale of Star to Coherent on April 27, 1999,
as discussed above. There was an additional decrease of $1.7 million due to declining
sales of the Palomar E2000, offset by an increase of $3.7 million from the Palomar SLP
1000 introduced in June of 2000. Royalties received by the Company increased by $1.4
million.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Gross profit for the year
ended December 31, 2000 was $2.6 million (20% of revenues) compared to $8.7 million (36%
of revenues) for the year ended December 31, 1999. The decrease in gross profit and gross
profit percentage was due to the fact that the Company sold Star and its LightSheerlaser
system to Coherent on April 27, 1999, as discussed above.

(ii)    OPERATING AND OTHER EXPENSES: Year Ended December 31, 2000 
                 Compared to Year Ended December 31, 1999



Research and development
costs decreased slightly to $7.9 million for the year ended December 31, 2000 from $8.0
million for the year ended December 31, 1999. Research and development expenses as a
percentage of revenues totaled 60% for the year ended December 31, 2000 and 33% for the
year ended December 31, 1999. The continued spending on research and development reflects
the Companys commitment to research and development of devices and delivery systems
for cosmetic and medical applications using a variety of lasers, while continuing
dermatology research utilizing the Companys ruby and diode lasers. Palomars
research and development goals in the field of laser hair removal are to design systems
that (1) permit more rapid treatment of large areas, (2) have high gross
margins, and (3) are manufactured at a lower cost, thus addressing broader markets.
Management believes that research and development expenditures will remain constant over
the next year as the Company continues product development and clinical trials for
additional applications for its lasers and delivery systems in the cosmetic and
dermatological markets. The Company entered into an amendment to its existing Clinical
Trial Agreement with Massachusetts General Hospital, pursuant to which it will fund a
minimum of $475,000 per year for research until August 1, 2004. The funding will be in
the fields of photo thermal removal or reduction of hair, non-invasive electromagnetic
targeting of subcutaneous fat, and treatment of sebaceous glands and related skin
disorders (e.g., acne) using infrared light. In return, the Company will obtain exclusive
license rights to patents arising from Palomar funded research in these fields (referred
to, respectively, as hair removal,fat removal,and acne
treatment,for simplicity).


Sales and marketing
expenses decreased to $3.2 million (24% of revenues) for the year ended December 31, 2000
from $6.6 million (27% of revenues) for the year ended December 31, 1999. The decrease in
sales and marketing expenses as a percentage of revenues is a result of the Companys
sale of Star to Coherent, which accounted for significant commission expense. New
distribution channels include direct sales by the Company and other distribution
channels, and the associated sales and marketing expenses for the SLP 1000are less
than the commission earned by Coherent, the Companys previous distributor. The
Company will continue to expand its own direct sales force to complement these sales
channels. The Company anticipates that, in comparison to the commission previously paid
to Coherent as a percentage of revenues, its future sales and marketing costs as a
percentage of revenues will decrease.


General and
administrative expenses decreased to $3.9 million (29% of revenues) for the year ended
December 31, 2000 as compared to $5.1 million (21% of revenues) for the year ended
December 31, 1999. This decrease for the year ended December 31, 2000 is attributable to
the sale of the Companys Star subsidiary and due to the Companys
restructuring and consolidation of administrative functions.


Costs related to goodwill
and asset write-off were the result of impaired past generation products being phased
out, and, accordingly, we wrote off $522,000 of goodwill and $224,000 of equipment.


Costs related to
solicitation of proxies in connection with the Companys 1999 Annual Meeting of
Stockholders were $625,000 for the year ended December 31, 1999 as a result of a proxy
contest launched by a dissident stockholder group.


Settlement costs were
$2.5 million for the year ended December 31, 1999 and are attributable to lawsuits and
claims against the Company. (See Note 10(c) to Financial Statements.)


Gain from the sale of a
subsidiary was $47.1 million for the year ended December 31, 1999 due to the Company
completing the sale of Star on April 27, 1999. The Company recognized a deferred gain of
$2.4 million, net of certain commitments and contingencies related to the sale for the
year ended December 31, 2000.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Interest expense
decreased to $155,000 for the year ended December 31, 2000 from $597,000 for the year
ended December 31, 1999. As a result of the sale of Star, which generated $49.7 million
in cash, the Company used a portion of these proceeds to pay down certain of its
outstanding debt during the second quarter of 1999.


Interest income decreased
slightly to $1.2 million for the year ended December 31, 2000 as compared to $1.3 for the
year ended December 31, 1999. This amount represents interest earned on the balance of
the funds received from the sale of Star, which are invested in high-grade corporate and
government notes and bonds and will be used to fund future operations and research and
development efforts.


Redemption expense was
$6.2 million for the year ended December 31, 1999. This amount reflects a redemption
expense as a result of a settlement agreement between Palomar and certain European banks
that had held 4.5% Swiss franc denominated subordinated convertible debentures originally
totaling $7.7 million and due in 2003. Under the terms of this agreement, which resolved
a lawsuit, Palomar agreed to rescind its conversion notices issued in November 1997.
Through these conversion notices, Palomar converted the subordinated debentures into
130,576 shares of the Companys common stock. Since the conversion date, the Company
had treated these shares as issued and outstanding. Under the terms of this compromise,
the Company agreed to pay a total of $6.7 million to the European banks, of which $5.7
million has been paid as of December 31, 2000. The balance of $1.0 million is due in
2001. Accordingly, the Company has recorded a charge to operations of $6.2 million as of
December 31, 1999. This amount represents the total amount due to the European banks less
the fair market value of the redemption of the common shares previously considered
outstanding by the Company.


Other income decreased
slightly to $380,000 for the year ended December 31, 2000. This amount compares to
$411,000 for the year ended December 31, 1999.


The Company recognized an
income tax benefit of $226,000 for the year ended December 31, 2000 as compared to a $2.5
million expense for the year ended 1999 as a result of the sale of Star.


The Company adopted
Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No.
101, Revenue Recognition in Financial Statements. As a result of adopting SAB 101, the
Company now records royalty income when received rather than when earned. In accordance
with SAB No. 101, the Company recorded the impact of adopting SAB No. 101 as a cumulative
catch-up adjustment to income in the current years statement of operations,
effective January 1, 2000.


The loss from
discontinued operations of $435,000 for the year ended December 31, 1999 was due to a
settlement related to the operations of a former subsidiary.

(iii)        REVENUES AND GROSS PROFIT: Year Ended December 31, 1999 
                     Compared to Year Ended December 31, 1998


For the year ended
December 31, 1999, the Companys revenues decreased to $24.3 million, as compared to
$44.5 million for the year ended December 31, 1998. The decrease in the Companys
revenues of $20.2 million, or 45% from the year ended December 31, 1998, was mainly due
to the reduction in sales volume of $21.1 million associated with the elimination of
LightSheersales in connection with the sale of Star to Coherent on April 27, 1999,
as discussed above. There was an additional decrease of $2.1 million due to declining
sales of other cosmetic lasers, offset by an increase of $3.0 million consisting of
royalties received by the Company from Coherent. The Company anticipates that sales
volumes from its E2000 hair removal laser system introduced during the first quarter
of 1999 will not be substantial, and will need to be supplemented with additional new
products. The decrease in sales volume associated with other cosmetic laser product
revenue was principally due to declining sales of the Companys EpiLaser®ruby
laser hair removal system. Palomar introduced its second generation long pulse ruby laser
for hair removal, the Palomar E2000, during the first quarter of 1999. In March of
1999, the Company obtained FDA clearance to market and sell its Palomar E2000 in the
United States for permanent hair reduction.The Company generated revenues of
$2.3 million on the Palomar E2000 during the year ended December 31, 1999.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Gross profit for the year
ended December 31, 1999 was $8.7 million (36% of revenues) compared to $21.5 million (48%
of revenues) for the year ended December 31, 1998. The decrease in gross profit and gross
profit percentage was due the fact that the Company sold Star and its LightSheerto
Coherent on April 27, 1999, as discussed above. The LightSheer provided a significantly
higher gross profit than the Companys EpiLaser®and other cosmetic products. The
Company anticipates that its gross profit percentage from sales of the Palomar E2000
will be significantly less than the gross profit from its former LightSheerproduct,
unless and until the Palomar E2000 achieves volume production and further manufacturing
efficiencies and overcomes product introduction issues.

(iv)         OPERATING AND OTHER EXPENSES: Year Ended December 31, 
                      1999, Compared to Year Ended December 31, 1998


Research and development
costs increased to $8.0 million for the year ended December 31, 1999, from $7.0 million
for the year ended December 31, 1998. Research and development expenses as a percentage
of revenues totaled 33% for the year ended December 31, 1999 and 16% for the year ended
December 31, 1998. The continued spending on research and development reflects the Companys
commitment to research and development of devices and delivery systems for cosmetic and
medical applications using a variety of lasers, while continuing dermatology research
utilizing the Companys ruby and diode lasers. Palomars research and
development goals in the field of laser hair removal are to design systems that (1) permit
more rapid treatment of large areas, (2) have high gross margins, and (3) are
manufactured at a lower cost, thus addressing broader markets. Management believes that
research and development expenditures will remain constant over the next year as the
Company continues product development and clinical trials for additional applications for
its lasers and delivery systems in the cosmetic and dermatological markets. The Company
recently entered into an amendment to its existing Clinical Trial Agreement with
Massachusetts General Hospital, pursuant to which it will fund a minimum of $475,000 per
year over the next five years for research. The funding will be in the fields of photo
thermal removal or reduction of hair, non-invasive electromagnetic targeting of
subcutaneous fat, and treatment of sebaceous glands and related skin disorders (e.g.,
acne) using infrared light. In return, the Company will obtain exclusive license rights
in these fields. Research and development as a percentage of revenues is expected to
increase until the Company introduces other products currently in development.


Sales and marketing
expenses decreased to $6.6 million (27% of revenues) for the year ended December 31,
1999, from $15.1 million (34% of revenues) for the year ended December 31, 1998. The
decrease in sales and marketing expenses as a percentage of revenues is a result of the
Companys sale of Star to Coherent, which incurred significant commission expense.
New distribution channels include direct sales by the Company and other distribution
channels, and the associated sales and marketing expenses for the E2000are less
than the commission earned by Coherent, the Companys previous distributor. The
Company will continue to expand its own direct sales force to complement these sales
channels. The Company anticipates that, in comparison to the commission previously paid
to Coherent as a percentage of revenues, its future sales and marketing costs as a
percentage of revenues will decrease.


General and
administrative expenses decreased to $5.1 million (21% of revenues) for the year ended
December 31, 1999, as compared to $8.9 million (20% of revenues) for the year ended
December 31, 1998. This decrease for the year ended December 31, 1999 is attributable to
a $3.5 million reduction due to the sale of the Companys Star subsidiary and due to
the Companys restructuring and consolidation of administrative functions.


Costs related to
solicitation of proxies in connection with the Companys 1999 Annual Meeting of
Stockholders were $625,000 for the year ended December 31, 1999 as a result of a proxy
contest launched by a dissident shareholder group.


Settlement costs were
$2.5 million for the year ended December 31, 1999 and are attributable to lawsuits and
claims against the Company.


Gain from the sale of a
subsidiary was $47.1 million for the year ended December 31, 1999 due to the Company
completing the sale of Star on April 27, 1999. The Company has deferred gain recognition
of $3.1 million of the proceeds from this sale pending the resolution in 2000 of certain
commitments and contingencies related to the sale.


Redemption expense was
$6.2 million for the year ended December 31, 1999. This amount reflects a redemption
expense as a result of a settlement agreement between Palomar and certain European banks
that had held 4.5% Swiss Franc denominated subordinated convertible debentures originally
totaling $7.7 million and due in 2003. Under the terms of this agreement, which resolved
a lawsuit, Palomar agreed to rescind its conversion notices issued in November 1997.
Through these conversion notices, Palomar converted the subordinated debentures into
130,576 shares of the Companys common stock. Since the conversion date, the Company
had treated these shares as issued and outstanding. Under the terms of this compromise,
the Company agreed to pay a total of $6.7 million to the European banks, of which $4.5
million has been paid as of December 31, 1999. The balance of $2.2 million is due through
2001. Accordingly, the Company has recorded a charge to operations of $6.2 million. This
amount represents the total amount due to the European banks less the fair market value
of the redemption of the common shares previously considered outstanding by the Company.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Interest expense
decreased to $597,000 for the year ended December 31, 1999, from $1.3 million for the
year ended December 31, 1998. This 54% decrease is primarily the result of a decrease in
convertible debenture financings and the use of conventional financing. Also, operations
did not require as much financing in 1999 as compared to 1998 as a result of lower
working capital needs. As a result of the sale of Star, which generated $49.7 million in
cash, the Company anticipates that interest expense will decline significantly due to use
of a portion of these proceeds to pay down certain of its outstanding debt during the
second quarter of 1999.


Net gain on trading
securities represents a realized gain of approximately $703,000 for the year ended
December 31, 1998 related to the Companys investment in a publicly traded company
that was sold during 1998. The Company did not have any marketable trading securities as
of December 31, 1999.


Interest income increased
to $1.3 million for the year ended December 31, 1999, as compared to $33,000 for the year
ended December 31, 1998. This amount represents interest earned on the balance of the
funds received from the sale of Star which are invested in high-grade corporate and
government notes and bonds and will be used to fund future operations and research and
development efforts.


Other income increased to
$411,000 for the year ended December 31, 1999. This amount compares to $21,000 for the
year ended December 31, 1998. The increase is primarily due to $231,000 of foreign
currency gain from the Swiss franc convertible debentures.


The Company projected
income taxes of $2.5 million in 1999 as a result of the sale of Star as the Company was
not able to fully offset the taxable income with net operating loss carryforwards.


The loss from
discontinued operations for the year ended December 31, 1999 was $435,000, compared to a
loss of $2.6 million for the year ended December 31, 1998. The loss from discontinued
operations incurred during 1999 was due to a settlement related to the operations of
Dynaco. The loss from discontinued operations incurred during 1998 was due to disposing
of the Companys electronics business segment, consisting of the manufacture and
sale of personal computers, high density flexible electronic circuitry and memory
modules. (See Note 12 to Financial Statements)



(c)   Liquidity and Capital Resources


On April 27, 1999,
Palomar completed the sale of Star to Coherent for $65 million. On the date of the sale,
Palomar owned 82.46% of Star. Palomar received net proceeds of $49,736,023, of which
$3,254,907 was held in escrow until April 27, 2000, as security for any claims Coherent
may have had under the Agreement.


In addition, the Company
receives an ongoing royalty from Coherent for all licensed products sold by Coherent that
incorporate certain patented technology or use certain patented methods currently
licensed by the Company on an exclusive basis from MGH. Palomar has also sublicensed
these patents to two additional competitors. Portions of these royalty proceeds are
remitted to MGH.


The Company used a
portion of the proceeds of the Star sale to pay down certain aspects of its outstanding
debt during 1999. The balance of the funds has been invested in high-grade corporate and
municipal notes and bonds to fund future operations and research and development efforts.
Accordingly, the Company will generate additional interest income.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Company is a holding
company with no significant operations. Operations are carried out at the subsidiary
level, and consist primarily of research and development. To date, the Companys
operating subsidiaries have required cash advances from the Company to fund their
operations. As of December 31, 2000, the Company had $15.4 million in cash, cash
equivalents and available-for-sale investments. With the Companys current cash
position, the Company believes that its financial position will meet its ongoing cash
flow requirements and can fund operating losses at its subsidiaries for at least the next
12 months. The successful introduction and marketing of new products currently under
development will be critical to funding operations beyond 2001.


During the year ended
December 31, 1999, under a settlement agreement, the Company agreed to pay a total of
$6.7 million to the European banks that had held 4.5% convertible debentures originally
totaling $7.7 million due in 2003. The Company has paid $5.7 million to these banks
through December 31, 2000. The balance of $1.0 million is due in 2001.


During 1999, the Company
entered into a 10-year lease agreement for its operating facility in Burlington,
Massachusetts. The annual commitment under this agreement is $860,000 for the first five
years of the agreement and $950,000 thereafter.


In July 1999, the Company
entered into an amendment to extend its exclusive research agreement with MGH for an
additional five years. In addition to laser hair removal, the agreement has been expanded
to include research and development in the fields of fat removal and acne treatment.
Under the terms of this agreement, the Company is obligated to pay MGH $475,000 on an
annual basis for clinical research through August 1, 2004.


The Company anticipates
that capital expenditures for 2001 will total $400,000, consisting primarily of
machinery, equipment, computers and peripherals. The Company expects to finance these
expenditures with cash on hand and equipment leasing lines, if available.

d)     Year 2000 Impact


We have not yet
experienced any problems with our computer systems relating to distinguishing
twenty-first century dates from twentieth century dates, which generally are referred to
as Year 2000 problems. We are also not aware of any material Year 2000 problems with our
clients or vendors. Accordingly, we do not anticipate incurring material expenses or
experiencing any material operational disruptions as a result of any Year 2000 problems.



(e)     Recently Issued Accounting Standard


In June 1999, the
Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 137, Accounting for Derivative Instruments and Hedging
Activities Deferral of the Effective Date of FASB Statement No. 133, which defers
the effective date of SFAS No. 133 to all fiscal quarters of all fiscal years beginning
after June 15, 2000. SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for hedging
activities. It requires entities to recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments at fair
value. The adoption of this new accounting standard is not expected to have a material
impact on the Companys financial statements.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In December 1999, the SEC released Staff
Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements.This
bulletin summarizes some views of the staff on applying accounting principles generally
accepted in the United States to revenue recognition in financial statements. (See Note 2)


In March 2000, the FASB
issued Interpretation No. 44, Accounting for Certain Transactions Involving Stock
Compensation an Interpretation of APB Opinion No. 25. This interpretation clarifies
the application of Accounting Principles Board (APB) Opinion No. 25 in certain
situations, as defined. The interpretation is effective July 1, 2000, but covers certain
events occurring during the period after December 15, 1998 but before the effective date.
The adoption of this new accounting interpretation did not have a material impact on the
Companys financial statements.

Item 7A.        Quantitative And Qualitative Disclosures About Market Risk.

(i)         Derivative Financial Instruments, Other Financial Instruments, and 
                    Derivative Commodity Instruments.


SFAS No. 107 requires
disclosure about fair value of financial instruments. Financial instruments consist of
cash equivalents, investments, accounts receivable, accounts payable and long-term debt
obligations. The fair value of these financial instruments approximates their carrying
amount as of December 31, 2000. All of the Companys investments are considered cash
equivalent money market accounts and debt securities which are considered
available-for-sale investments and are carried at market value, with the difference
between cost and market value, net of related tax effects, recorded as a separate
component of stockholders(deficit) equity. Accordingly, the Company has no
quantitative information concerning the market risk of participating in such investments.

(ii)         Primary Market Risk Exposures.


The Companys
primary market risk exposures are in the areas of interest rate risk and foreign currency
exchange rate risk. The Companys investment portfolio of cash equivalents and debt
securities is subject to interest rate fluctuations, but the Company believes this risk
is immaterial because of the short-term nature of these investments.


The Companys
significant exposure to currency exchange rate fluctuations is specifically related to
its Swiss franc convertible debentures. The impact of exchange rate movements on these
debentures was immaterial for the year ended December 31, 2000. The Company has mitigated
its potential exposure related to such debentures by entering into forward contracts
which have been designated as cash flow hedges for the final two remaining payments due
in 2001. The Companys other exposure to currency exchange rate fluctuations has
been and is expected to continue to be modest since it sells its products in United
States dollars.


Statement Under the Private Securities Litigation Reform Act


In addition to the other
information in this Annual Report on Form 10-K, the following cautionary statements
should be considered carefully in evaluating the Company and its business. Statements
contained in this Form 10-K that are not historical facts (including, without limitation,
statements concerning products under development, the timing of new product
introductions, financing of future operations, and the Companys research
partnership with MGH) and other information provided by the Company and its employees
from time to time may contain certain forward-looking information, as defined by (i) the
Private Securities Litigation Reform Act of 1995 (the Reform Act) and (ii)
releases by the SEC. The risk factors identified below, among other factors, could cause
actual results to differ materially from those suggested in such forward-looking
statements. Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date hereof. The Company undertakes no obligation
to release publicly the results of any revisions to these forward-looking statements that
may be made to reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events. The cautionary statements below are being made
pursuant to the provisions of the Reform Act and with the intention of obtaining the
benefits of safe harbor provisions of the Reform Act.

RISK FACTORS


Our future revenue depends on our successfully developing and
marketing new products.


We face rapidly changing
technology and continuing improvements in cosmetic laser technology. In order to be
successful, we must continue to make significant investments in research and development
in order to develop in a timely and cost-effective manner new products that meet changing
market demands, to enhance existing products, and to achieve market acceptance for such
products. We have in the past experienced delays in developing and marketing new products
and enhancing existing products. Furthermore, some of our new products under development
are based on unproven technology and/or technology with which the Company has no previous
experience. As a result of the sale of Star to Coherent, our future revenue will be
almost entirely dependent on sales of newly introduced products. Sales to date for the
Companys current products have been minimal and the Companys future products
may not achieve market acceptance or generate sufficient margins. In addition, the market
for this type of hair removal laser may already be saturated. At present, broad market
acceptance of laser hair removal is critical to our success. We intend to diversify our
product line by developing cosmetic laser products other than hair removal lasers, but
there can be no assurance that we will be able to successfully implement such strategy in
a timely fashion or at all.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We face intense competition from companies with superior
financial, marketing and other resources.


The laser hair removal
industry is highly competitive and companies frequently introduce new products. We
compete in the development, manufacture, marketing and servicing of hair removal lasers
with numerous other companies, some of which have substantially greater financial,
marketing and other resources than we do. As a result, some of our competitors are able
to sell hair removal lasers at prices significantly below the prices at which we sell our
hair removal lasers. In addition, as a result of the Star sale, Coherent, our former
exclusive distributor and one of the largest and best financed laser companies, is now
our competitor and we have to find new ways to distribute our products. We currently have
no significant direct or indirect sales force in place for our new products under
development. Our laser products also face competition from alternative medical products
and procedures, such as electrolysis and waxing, among others. We may not be able to
differentiate our products from the products of our competitors, and customers may not
consider our products to be superior to competing products or medical procedures,
especially if competitive products and procedures are offered at lower prices. Our
competitors may develop products or new technologies that make our products obsolete or
less competitive.


Our quarterly operating results have decreased as a result of
the Star sale, and that may hurt the price of our common stock.


Almost all of our
revenues in 1999 were attributable to sales of the LightSheer diode laser system
manufactured by Star. Therefore, as a result of the Star sale, our revenues have declined
significantly. If our operating results fall below the expectations of investors or
public market analysts, the price of our common stock could decline.


We could be delisted from NASDAQ.


For continued listing on
The NASDAQ SmallCap Market, a company must maintain a minimum bid price of $1.00 per
share. A company must also maintain a minimum requirement of net tangible assets of $2
million or market capitalization of $35 million or net income (in latest fiscal year or 2
of the last 3 fiscal years) of $500,000. In March 1999, NASDAQ held a hearing regarding
our continued listing on The NASDAQ SmallCap Market in light of the fact that our common
stock had traded below the $1.00 minimum bid price requirement for longer than 30 trading
days. As a result of our reverse stock split, we regained compliance with the minimum bid
price requirement before that date, and are now in compliance with all of NASDAQs
requirements for continued listing on The NASDAQ SmallCap Market. However, there can be
no assurance that we will remain in compliance with NASDAQs criteria for continued
listing or that we will remain listed on NASDAQ. The delisting of our common stock would
likely reduce the liquidity of our common stock and our ability to raise capital. If our
common stock is delisted from The NASDAQ SmallCap Market, it will likely be quoted on the
pink sheetsmaintained by the National Quotation Bureau, Inc. or NASDAQs
OTC Bulletin Board. These listings can make trading more difficult for stockholders.


We depend on a number of vendors for critical components in our
current and future products.


We develop laser systems
that incorporate third-party components as part of the overall systems. Some of these
items are custom made or otherwise not readily available on the market. We purchase some
of these components from small, specialized vendors that are not well capitalized. A
disruption in the delivery of these key components could have an adverse effect on our
business. In 2001, we anticipate that we will be substantially dependent on an overseas
third-party manufacturer over whom we do not have absolute control to provide us with
critical components for our Super Long Pulse diode laser.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our lasers are subject to numerous medical device regulations.
Compliance is expensive and time-consuming. Our new products may not be able to
obtain the necessary clearances in order to sell them.


All of our current
products are laser medical devices. Laser medical devices are subject to FDA regulations
regulating clinical testing, manufacturing, labeling, sale, distribution and promotion of
medical devices. Before a new laser medical device can be introduced into the market, we
must obtain clearance from the FDA. Compliance with the FDA clearance process is
expensive and time-consuming, and we may not be able to obtain such clearances in a
timely fashion or at all.


Our products are subject to
similar regulations in our major international markets. Complying with these
regulations is necessary for our strategy of expanding the markets for and sales
of our products into these countries. These approvals may necessitate clinical
testing, limitations on the number of sales and controls of end user purchase
price, among other things. In certain instances, these constraints can delay
planned shipment schedules as design and engineering modifications are made in
response to regulatory concerns and requests. In addition, there can be no
assurance that we will obtain such approvals in timely fashion or at all.


We are dependent on third-party researchers.


We are substantially
dependent upon third-party researchers over whom we do not have absolute control to
satisfactorily conduct and complete research on our behalf and to grant us favorable
licensing terms for products, which they may develop. At present, our principal research
partner is the Wellman Laboratories of Photomedicine at Massachusetts General Hospital.
We provide research funding, laser technology and optics know-how in return for licensing
rights with respect to specific medical applications and patents. Our success will be
highly dependent upon the results of this research. We cannot be sure that such research
agreements will provide us with marketable products in the future or that any of the
products developed under these agreements will be profitable for us.


Our common stock could be further diluted as the result of
outstanding convertible securities, warrants and options.


In the past, we have
issued convertible securities, such as debentures, preferred stock and warrants, in order
to raise money. We have also issued options and warrants as compensation for services and
incentive compensation for our employees and directors. We have a substantial number of
shares of common stock reserved for issuance upon the conversion and exercise of these
securities. These outstanding convertible securities, options and warrants could affect
the rights of our stockholders, and could adversely affect the market price of our common
stock.


Our proprietary technology has only limited protections.


Our business could be
materially and adversely affected if we are not able to adequately protect our
intellectual property rights. We rely on a combination of patent, trademark and trade
secret laws, license and confidentiality agreements to protect our proprietary rights. We
generally enter into non-disclosure agreements with our employees and customers and
restrict access to, and distribution of, our proprietary information. Nevertheless, we
may be unable to deter misappropriation of our proprietary information, detect
unauthorized use and take appropriate steps to enforce our intellectual property rights.
Our competitors also may independently develop technologies that are substantially
equivalent or superior to our technology. Although we believe that our services and
products do not infringe the intellectual property rights of others, we cannot prevent
someone else from asserting a claim against us in the future for violating their
intellectual property rights. In addition, costly and time-consuming lawsuits may be
necessary to enforce patents issued or licensed exclusively to us, to protect our trade
secrets and/or know-how or to determine the enforceability, scope and validity of othersintellectual
property rights.


The medical laser
industry is characterized by frequent litigation regarding patent and other intellectual
property rights. Because patent applications are maintained in secrecy for a period of
time, we can conduct only limited searches to determine whether our technology infringes
any patents or patent applications. Any claims for patent infringement could be
time-consuming, result in costly litigation and diversion of technical and management
personnel, cause shipment delays, require us to develop non-infringing technology or to
enter into royalty or licensing agreements. Although patent and intellectual property
disputes in the laser industry have often been settled through licensing or similar
arrangements, costs associated with such arrangements may be substantial and often
require the payment of ongoing royalties, which could have a negative impact on gross
margins. There can be no assurance that necessary licenses would be available to us on
satisfactory terms, or that we could redesign our products or processes to avoid
infringement, if necessary. Accordingly, an adverse determination in a judicial or
administrative proceeding or failure to obtain necessary licenses could prevent us from
manufacturing and selling some of our products. This could have a material adverse effect
on our business, results of operations and financial condition.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our charter documents and Delaware law may discourage potential
takeover attempts.


Our Second Restated
Certificate of Incorporation and our By-laws contain provisions that could discourage
takeover attempts or make more difficult the acquisition of a substantial block of our
common stock. Our By-laws require a stockholder to provide to the Secretary of the
Company advance notice of director nominations and business to be brought by such
stockholder before any annual or special meeting of stockholders, as well as certain
information regarding such nomination and/or business, the stockholder and others known
to support such proposal and any material interest they may have in the proposed
business. They also provide that a special meeting of stockholders may be called only by
the affirmative vote of a majority of the Board of Directors. These provisions could
delay any stockholder actions that are favored by the holders of a majority of the
outstanding stock of the Company until the next stockholdersmeeting. In addition,
the Board of Directors is authorized to issue shares of common stock and preferred stock
that, if issued, could dilute and adversely affect various rights of the holders of
common stock and, in addition, could be used to discourage an unsolicited attempt to
acquire control of the Company.


The Company is also
subject to the anti-takeover provisions of Section 203 of the Delaware General
Corporation Law, which prohibits the Company from engaging in a business combinationwith
an interested stockholderfor a period of three years after the date of the
transaction in which the person becomes an interested stockholder, unless the business
combination is approved in a prescribed manner. The application of Section 203 may limit
the ability of stockholders to approve a transaction that they may deem to be in their
best interests. These provisions of our Second Restated Certificate of Incorporation,
By-laws and the Delaware General Corporation Law could deter certain takeovers or tender
offers or could delay or prevent certain changes in control or management of the Company,
including transactions in which stockholders might otherwise receive a premium for their
shares over the then current market prices.


As with any new products, there is substantial risk that the
marketplace may not accept or be receptive to the potential benefits of our
products.


Market acceptance of our
current and proposed products will depend, in large part, upon our or any marketing
partners ability to demonstrate to the marketplace the advantages of our products
over other types of products. There can be no assurance that the marketplace will accept
applications or uses for our current and proposed products or that any of our current or
proposed products will be able to compete effectively.


We may not be able to successfully collect licensing royalties.


At present, material
portions of our revenues consist of royalties from licensing both our own patents and
patents licensed to us on an exclusive basis by Massachusetts General Hospital. However,
there can be no assurance that we will be able to obtain valuable patent rights.
Moreover, there can be no assurance that, even if we do obtain such patent rights and are
able to license them to third parties, we will derive a significant revenue stream from
such licenses.


We face risks associated with pending litigation.


We are involved in
disputes with third parties. Such disputes have resulted in litigation with such parties.
We have incurred, and likely will continue to incur, legal expenses in connection with
such matters. There can be no assurance that such litigation will result in favorable
outcomes for us. Any adverse result in litigation could have a material adverse effect on
our business, financial condition and results of operations.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We may not be able to retain our key executives and research and
development personnel.


As a small company with
less than 100 employees, our success depends on the services of key employees in
executive and research and development positions. The loss of the services of one or more
of these employees could have a material adverse effect on our business.


We face a risk of financial exposure to product liability claims
in the event that the use of our products results in personal injury.


Our products are and will
continue to be designed with numerous safety features, but it is possible that patients
could be adversely affected by use of one of our products. Further, in the event that any
of our products prove to be defective, we may be required to recall and redesign such
products. Although we have not experienced any material losses due to product liability
claims to date, there can be no assurance that we will not experience such losses in the
future. We maintain general liability insurance in the amount of $1 million per
occurrence and $2 million in the aggregate and maintain umbrella coverage in the
aggregate amount of $25 million; however, there can be no assurance that such coverage
will continue to be available on terms acceptable to us or that such coverage will be
adequate for liabilities actually incurred. In the event we are found liable for damages
in excess of the limits of our insurance coverage or if any claim or product recall
results in significant adverse publicity against us, our business, financial condition
and results of operations could be materially and adversely affected. In addition,
although our products have been and will continue to be designed to operate in a safe
manner, and although we attempt to educate medical personnel with respect to the proper
use of our products, misuse of our products by medical personnel over whom we cannot
exert control may result in the filing of product liability claims or in significant
adverse publicity against us.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Item 8. Financial Statements.
|-----------------------------

|PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES                                             |   
|----------------------------------------------------------------------------------------------- | --
|                                                                                                |   
|INDEX TO CONSOLIDATED FINANCIAL STATEMENTS                                                      |   
|                                                                                                |   
|                                                                                               
|Report of Independent Public Accountants                                                        | 20
|                                                                                               
|Consolidated Balance Sheets as of December 31, 1999 and 2000                                    | 21
|                                                                                               
|Consolidated Statements of Operations for the Years Ended December 31, 1998,                   
|1999 and 2000                                                                                   | 22
|                                                                                               
|Consolidated Statement of Stockholders' Equity (Deficit) for the Years Ended December 31, 1998,
|1999 and 2000                                                                                   | 23
|                                                                                               
|Consolidated Statements of Cash Flows for the Years Ended December 31, 1998,                   
|1999 and 2000                                                                                   | 24
|                                                                                               
|Notes to Consolidated Financial Statements                                                      | 25
|                                                                                               

|REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To Palomar Medical Technologies, Inc:


We have audited the
accompanying consolidated balance sheets of Palomar Medical Technologies, Inc. (a
Delaware corporation) and subsidiaries as of December 31, 1999 and 2000 and the related
consolidated statements of operations, stockholdersequity (deficit) and cash flows
for each of the three years in the period ended December 31, 2000. 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
auditing standards generally accepted in the United States. 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 Palomar Medical Technologies, Inc. and subsidiaries as of December
31, 1999 and 2000 and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 2000 in conformity with accounting
principles generally accepted in the United States.


As explained in Note 2(h)
to the consolidated financial statements, effective January 1, 2000, the Company changed
its method of accounting for revenue recognition for royalties through the adoption of
Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      |  | 
|--------------------- |  | 
|ARTHUR ANDERSEN LLP   |  | 
|Boston, Massachusetts |  | 
|January 30, 2001      |  | 

|PALOMAR MEDICAL
TECHNOLOGIES, INC. AND SUBSIDIARIES


CONSOLIDATED BALANCE
SHEETS
|---------------------------------------------------------------------------------

|                                                                       | December 31,1999 | December 31,2000
|---------------------------------------------------------------------- | ---------------- | ----------------
|
|Current
Assets:                                                        |                  |                 
|Cash and cash equivalents                                              |                  | $  2,712,466    
|Available-for-sale investments, at market
value                        |                  | 22,505,996      
|Accounts receivable, net of allowance for doubtful
accounts of         |                 
|approximately
$207,000 and $306,000 in 1999 and
2000, respectively     |                  | 1,879,612       
|Inventories                                                            |                  | 1,899,591       
|Receivable from sale of subsidiary (Note
1)                            |                  | 3,330,976       
|Other current assets                                                   |                  | 729,301         
|                                                                      
|Total current
assets                                                   |                  | 33,057,942      
|                                                                      
|                                                                       |                 
|Property and Equipment,
Net                                            |                  | 991,432         
|                                                                      
|                                                                       |                 
|Other
Assets:                                                          |                 
|Cost in excess of net assets acquired, net of
accumulated amortization |                  | 631,026         
|Other assets                                                           |                  | 162,468         
|                                                                      
|Total other
assets                                                     |                  | 793,494         
|                                                                      
|                                                                       |                  | $34,842,868     
|                                                                      

|LIABILITIES AND
STOCKHOLDERS' EQUITY
|------------------------------------

|                                                               |  |                
|-------------------------------------------------------------- |  | ---------------
|Current
Liabilities:                                           |  |                
|Current portion of long-term debt                              |  | $     1,122,008
|Accounts payable                                               |  | 659,280        
|Accrued liabilities                                            |  | 6,371,553      
|Accrued income taxes                                           |  | 2,500,000      
|Deferred revenue                                               |  | 918,642        
|Deferred gain from sale of subsidary (Note
1)                  |  | 3,139,556      
|                                                              
|Total current
liabilities                                      |  | 14,711,039     
|                                                              
|Long-Term Debt, Net of Current
Portion                         |  | 1,622,008      
|                                                              
|Preferred Stock Accrued
Dividends and Interest                 |  | 1,417,184      
|                                                              
|Commitments and Contingencies
(Note 10)                        | 
|                                                              
|Stockholders'
Equity:                                          | 
|Preferred stock, $.01 par value-                               | 
|Authorized -
1,500,000 shares                                  | 
|Issued and
outstanding -                                       | 
|6,000
shares                                                   | 
|at December
31, 1999 and 2000, respectively                    | 
|(Liquidation
preference of $7,785,450 as of December 31, 2000) |  | 60             
|Common stock, $.01 par value-                                  | 
|Authorized -
45,000,000 shares                                 | 
|Issued -
11,034,493 shares and 11,074,393 shares               | 
|at December
31, 1999 and 2000, respectively                    |  | 110,345        
|Additional paid-in capital                                     |  | 162,275,613    
|Accumulated deficit                                            |  | (141,550,040   
|Unrealized loss on available-for-sale
investments              |  | (67,943        
|Less: Treasury stock - 1,002,615 and 763,835
shares at cost    | 
|at December
31, 1999 and 2000, respectively                    |  | (3,675,398     
|                                                              
|Total
stockholders' equity                                     |  | 17,092,637     
|                                                              
|                                                               |  | $   34,842,868 
|                                                              

|The accompanying notes
are an integral part of these consolidated financial statements.
|---------------------------------------------------------------------------------------

|PALOMAR MEDICAL
TECHNOLOGIES, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS
|-------------------------------------------------------------------------------------------

|                                                          | Years Ended December 31,
|--------------------------------------------------------- | ------------------------
|
|Product Revenues                                          |                         
|Royalty Revenues                                          |                         
|                                                         
|Total Revenues                                            |                         
|                                                          |                         
|Cost of product revenues                                  |                         
|Cost of royalty revenues                                  |                         
|                                                         
|Total Cost of Revenues                                    |                         
|                                                         
|Gross profit                                              |                         
|                                                         
|                                                          |                         
|Operating Expenses
(Income)                               |                         
|Research and
development                                  |                         
|Sales and marketing                                       |                         
|General and
administrative                                |                         
|Goodwill and asset write-off (Note
2)                     |                         
|Costs incurred for proxy
contest                          |                         
|Restructuring and asset write-off
(Note 13)               |                         
|Settlement and litigation
costs                           |                         
|Gain from sale of subsidiary (Note
1)                     |                         
|                                                         
|Total
operating expenses (income)                         |                         
|                                                         
|Income
(loss) from operations                             |                         
|                                                          |                         
|Interest
Expense                                          |                         
|                                                          |                         
|Interest Income                                           |                         
|                                                          |                         
|Net Gain on Trading
Securities                            |                         
|                                                          |                         
|Swiss Franc Redemption (Note
9)                           |                         
|                                                          |                         
|Other Income, Net                                         |                         
|                                                         
|                                                          |                         
|                                                          |                         
|Income (Loss) from Continuing
Operations                  |                         
|Before Provision (Benefit) from Income
Taxes              |                         
|                                                         
|Provision (Benefit) for Income
Taxes                      |                         
|                                                         
|Net Income (Loss) from Continuing
Operations              |                         
|                                                          |                         
|Cumulative Effect of Change in
Accounting Method (Note 2) |                         
|                                                          |                         
|Loss from Discontinued Operations (Note
12)               |                         
|Loss from operations                                      |                         
|Loss on dispositions,
net                                 |                         
|                                                         
|Net Loss from Discontinued
Operations                     |                         
|                                                         
|Net
Income (Loss)                                         |                         
|                                                         
|                                                          |                         
|Basic Net Income (Loss) Per
Share:                        |                         
|Continuing Operations                                     |                         
|Cumulative effect of change in
accounting method          |                         
|Discontinued Operations                                   |                         
|                                                         
|Total
Basic Net Income (Loss) Per Share                   |                         
|                                                         
|                                                          |                         
|Basic Weighted Average Number of Shares
Outstanding       |                         
|                                                          |                         
|                                                         
|Diluted Net Income (Loss) Per
Share:                      |                         
|Continuing Operations                                     |                         
|Cumulative effect of change in
accounting method          |                         
|Discontinued Operations                                   |                         
|                                                         
|Total
Diluted Net Income (Loss)  Per Share                |                         
|                                                          |                         
|                                                         
|Diluted Weighted Average Number of
Shares Outstanding     |                         
|                                                         

|The accompanying notes
are an integral part of these consolidated financial statements.
|---------------------------------------------------------------------------------------

|PALOMAR MEDICAL
TECHNOLOGIES, INC. AND SUBSIDIARIES




CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
|-----------------------------------------------------------------------------------------------------------------

|                                                                                        | Preferred Stock | Common Stock | Treasury Stock | Additional    |   | Unrealized (Loss) Gain | TotalStockholders'
|--------------------------------------------------------------------------------------- | --------------- | ------------ | -------------- | ------------- | - | ---------------------- | ------------------
|
|Balance, December
31, 1997                                                              |                 | 16,397       |                | $        164  |   | 6,541,800              |                   
|Issuance of common stock pursuant to warrants, options and
Employee Stock Purchase Plan |                 |             |                |              |   | 27,459                 |                   
|Issuance of common stock for 1997 employer 401(k) matching
contribution                 |                 |             |                |              |   | 44,555                 |                   
|Conversion of preferred stock                                                           |                 | (5,888       | )              | (59           | ) | 984,526                |                   
|Conversion of convertible debentures                                                    |                 |             |                |              |   | 1,005,095              |                   
|Issuance of common stock, net of investment banking
fees                                |                 |             |                |              |   | 1,457,143              |                   
|Redemption of preferred stock                                                           |                 | (3,516       | )              | (36           | ) |                       |                   
|Fair value of warrants issued for investment banking
services                           |                 |             |                |              |   |                       |                   
|Common stock issued for advisory services                                               |                 |             |                |              |   | 14,286                 |                   
|Costs incurred related to the issuance of common
stock                                  |                 |             |                |              |   |                       |                   
|Preferred stock dividends and penalties                                                 |                 |             |                |              |   |                       |                   
|Net loss                                                                                |                 |             |                |              |   |                       |                   
|                                                                                       
|Balance, December 31,
1998                                                              |                 | 6,993        |                | $          69 |   | 10,074,864             |                   
|                                                                                       
|Issuance of stock for  Employee Stock Purchase
Plan                                     |                 |             |                |              |   | 10,118                 |                   
|Issuance of common stock for 1998 employer 401(k) matching
contribution                 |                 |             |                |              |   | 32,561                 |                   
|Conversion of preferred stock                                                           |                 | (340         | )              | (3            | ) | 74,905                 |                   
|Conversion of convertible debentures                                                    |                 |             |                |              |   | 377,760                |                   
|Redemption of preferred stock                                                           |                 | (653         | )              | (6            | ) |                       |                   
|Redemption of common stock related to Swiss Franc convertible
debentures                |                 |              |                |               |   |                       |                   
|Purchase of stock for treasury                                                          |                 |              |                |              |   |                        |                   
|Issuance of escrow shares to treasury                                                   |                 |              |                |              |   | 464,285                |                   
|Costs incurred related to the issuance of common
stock                                  |                 |             |                |              |   |                       |                   
|Unrealized loss on available-for-sale
investments                                       |                 |              |                |              |   |                       |                   
|Preferred stock dividends                                                               |                 |             |                |              |   |                       |                   
|Net  income                                                                             |                 |             |                |              |   |                       |                   
|                                                                                       
|Balance, December 31,
1999                                                              |                 | 6,000        |                | $          60 |   | 11,034,493             |                   
|                                                                                       
|Issuance of stock for  Employee Stock Purchase
Plan                                     |                 |             |                |              |   |                       |                   
|Issuance of stock for 1999 employer 401(k) matching
contribution                        |                 |             |                |              |   |                       |                   
|Exercise of stock options                                                               |                 |             |                |              |   | 39,900                 |                   
|Fair value of warrants issued for investment banking
services                           |                 |             |                |              |   |                       |                   
|Costs incurred from issuance of treasury stock for
settlement                           |                 |             |                |              |   |                       |                   
|Unrealized gain on available-for-sale
investments                                       |                 |              |                |              |   |                       |                   
|Costs incurred related to the issuance of common
stock                                  |                 |             |                |              |   |                       |                   
|Preferred stock dividends                                                               |                 |             |                |              |   |                       |                   
|Net  loss                                                                               |                 |             |                |              |   |                       |                   
|                                                                                       
|Balance, December 31,
2000                                                              |                 | 6,000        |                | $          60 |   | 11,074,393             |                   
|                                                                                       

|The accompanying notes
are an integral part of these consolidated financial statements.
|---------------------------------------------------------------------------------------

|PALOMAR MEDICAL TECHNOLOGIES, INC. AND
SUBSIDIARIES


CONSOLIDATED STATEMENTS OF CASH
FLOWS
|-------------------------------------------------------------------------------------------

|                                                                                                                           | Year Ended December 31,
|-------------------------------------------------------------------------------------------------------------------------- | -----------------------
|
|Cash Flows from
Operating Activities:                                                                                      |                        
|Net income (loss)                                                                                                          |                        
|Less:  Net loss from
discontinued operations                                                                               |                        
|                                                                                                                          
|Net income (loss) from continuing operations                                                                               |                        
|                                                                                                                          
|Adjustments to reconcile net income (loss) from
continuing            operations to net cash used in operating activities- |                        
|Depreciation and
amortization                                                                                              |                        
|Gain from sale of subsidiary                                                                                               |                        
|Restructuring, goodwill and
asset write-off costs                                                                          |                        
|Inventory
write-off                                                                                                        |                        
|Noncash interest expense related
to debt                                                                                   |                        
|Unrealized gain on marketable
securities                                                                                   |                        
|Unrealized foreign currency
exchange loss on foreign debt                                                                  |                        
|Redemption of common stock held
by Swiss Franc              debenture
holders                                              |                        
|Fair value of warrants issued
for investment banking services                                                              |                        
|Changes in assets and
liabilities, net of effects from sale
of subsidiary                                                  |                        
|Net
sale of marketable trading securities                                                                                  |                        
|Accounts
receivable                                                                                                        |                        
|Inventories                                                                                                                |                        
|Receivable
from sale of subsidiary                                                                                         |                        
|Other
current assets                                                                                                       |                        
|Accounts
payable                                                                                                           |                        
|Accrued
liabilities                                                                                                        |                        
|Accrued
income taxes                                                                                                       |                        
|Deferred
revenue                                                                                                           |                        
|Deferred
gain from sale of subsidiary                                                                                      |                        
|                                                                                                                          
|Net
cash used in operating activities                                                                                      |                        
|                                                                                                                          
|                                                                                                                           |                        
|Cash Flows from Investing
Activities:                                                                                      |                        
|Purchases of property and equipment                                                                                        |                        
|Purchases of available-for-sale investments                                                                                |                        
|Proceeds from sale of available-for-sale
investments                                                                       |                        
|Proceeds from the sale of subsidiary, net of cash on
hand $288,000                                                         |                        
|Proceeds from sale of building                                                                                             |                        
|Decrease (increase) in other assets                                                                                        |                        
|                                                                                                                          
|Net
cash provided by (used in) investing activities                                                                        |                        
|                                                                                                                          
|                                                                                                                           |                        
|Cash Flows from Financing
Activities:                                                                                      |                        
|Proceeds from notes payable and advances from
distributor                                                                  |                        
|Redemption
of convertible debentures                                                                                       |                        
|Proceeds from the issuance
of common stock                                                                                 |                        
|Proceeds from exercise of warrants, stock
options                                                                          |                        
|and Employee Stock Purchase
Plan                                                                                           |                        
|Costs incurred related to issuance of common
stock                                                                         |                        
|Proceeds
from line of credit                                                                                               |                        
|Payments
on line of credit                                                                                                 |                        
|Payment
on Swiss Franc convertible debentures                                                                              |                        
|Purchase of stock for treasury                                                                                             |                        
|Payment on note payable                                                                                                    |                        
|Redemption of preferred stock                                                                                              |                        
|                                                                                                                          
|Net
cash provided by (used in) financing activities                                                                        |                        
|                                                                                                                          
|Net increase (decrease) in cash and
cash equivalents                                                                       |                        
|Net cash provided by (used in)
discontinued operations                                                                     |                        
|Cash and cash equivalents, beginning of
the period                                                                         |                        
|                                                                                                                          
|Cash and cash equivalents, end of the
period                                                                               |                        
|                                                                                                                          
|                                                                                                                           |                        
|Supplemental Disclosure of
Cash Flow Information:                                                                          |                        
|Cash paid for interest                                                                                                     |                        
|                                                                                                                          
|                                                                                                                           |                        
|Supplemental Disclosure
of Noncash Financing and Investing Activities:                                                     |                        
|Conversion of convertible debentures and related
accrued                                                                   |                        
|interest, net of financing
fees                                                                                            |                        
|                                                                                                                           |                        
|                                                                                                                          
|                                                                                                                           |                        
|Conversion of preferred stock                                                                                              |                        
|                                                                                                                          
|                                                                                                                           |                        
|                                                                                                                           |                        
|Issuance of common stock for 1997, 1998 and 1999
employer              401(k) matching
contribution                        |                        
|                                                                                                                          
|                                                                                                                           |                        
|Unrealized loss (gain) on available-for-sale
investments                                                                   |                        
|                                                                                                                          
|                                                                                                                           |                        
|Issuance of common stock for advisory services performed
in 1997                                                           |                        
|                                                                                                                          
|                                                                                                                           |                        
|Accrued dividends and interest on preferred
stock                                                                          |                        
|                                                                                                                          
|                                                                                                                           |                        
|Costs incurred from the issuance of treasury stock for
settlement                                                          |                        
|                                                                                                                          

|The accompanying notes
are an integral part of these consolidated financial statements.
|---------------------------------------------------------------------------------------

|PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





1) Organization and Operations


Palomar Medical
Technologies, Inc. and subsidiaries are engaged in the commercial sale and development of
cosmetic and medical laser systems and services. During the year ended December 31, 1997,
the Company began execution of a plan to dispose of its electronics segment (see Note
12). The Company substantially completed the divestiture program in May of 1998.


The Companys
medical laser products are in various stages of development; accordingly, the success of
future operations is subject to a number of risks similar to companies in similar stages
of development. Principal among these risks are the need for successful development and
marketing of the Companys products, the need for regulatory approval, the need to
achieve profitable operations, competition from substitute products and larger companies,
the need for successful funding of future operations, and dependence on key individuals.


On December 7, 1998, the
Company entered into an Agreement and Plan of Reorganization (the Agreement)
with Coherent to sell all of the issued and outstanding common stock of Star, Palomars
majority-owned subsidiary, to Coherent. The Company owned substantially all of the issued
and outstanding common shares of Star. However, options outstanding granted to Palomar
and employees of Star to purchase shares of Stars common stock remained outstanding
prior to the consummation of this sale. When all of the outstanding options under Stars
Stock Option Plan were exercised, the Company owned 82.46% of Stars common stock
and the employees collectively owned 17.54%. This sale was approved by a majority of the
stockholders of Palomar on April 21, 1999. On April 27, 1999, the Company completed the
sale of Star to Coherent and received net proceeds of $49,736,023. Additionally,
$3,254,907 was held in escrow until April 27, 2000 as security for any claims that
Coherent may have had under the Agreement. During 2000, in connection with the lapse of
the escrow period, the Company recognized a deferred gain of $2,439,556, net of certain
commitments and contingencies related to the sale.

 The gain on the sale of Star for 1999 is calculated as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                             |            
|------------------------------------------------------------ | -----------
|Cash Received, Net of $965,000 Bonuses Due to Star Employees | $48,771,023
|Plus: Net Liabilities Divested                               | 1,165,482  
|                                                             |            
|Gain on Sale Before Expenses                                 | 49,936,505 
|Less: Expenses                                               | 2,845,628  
|                                                             |            
|Net Gain on Sale of Subsidiary                               | $47,090,877
|                                                            
|                                                            

|Under the terms of
the Agreement, the Company will receive an ongoing royalty of 7.5% from Coherent on the
sale of any products by Coherent that incorporate certain patented technology or use
certain patented methods currently licensed by the Company on an exclusive basis from
Massachusetts General Hospital (MGH). Portions of these royalty proceeds are
remitted to MGH. For the years ended December 31, 1999 and 2000, the Company recognized
royalty revenue from Coherent of $1,837,250 and $3,836,875, respectively and a cost of
royalty to MGH of $734,900 and $1,534,750, respectively.



(2) Summary of Significant Accounting Policies


The accompanying
consolidated financial statements reflect the application of certain accounting policies
described below and elsewhere in the Notes to Consolidated Financial Statements.



(a) Principles of Consolidation


The accompanying
consolidated financial statements reflect the consolidated financial position, results of
operations and cash flows of the Company and all wholly owned and majority-owned
subsidiaries. All investments of which the Company owns less than 20% of the common stock
are accounted for using the cost method. All intercompany transactions have been
eliminated in consolidation.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b) Management Estimates


The preparation of
financial statements in conformity with accounting principles generally accepted in the
United States 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.

(c) Investments


The Company accounts for
marketable debt securities in accordance with Statement of Financial Accounting Standards
(SFAS) No. 115, Accounting for Certain Investments in Debt and Equity
Securities. The Companys marketable debt securities, all of which have maturities
within one year, are considered available-for-sale investments in the accompanying
balance sheets and are carried at market value, with the difference between cost and
market value, net of related tax effects, recorded as a separate component of stockholdersequity.
The aggregate market value, cost basis, and gross unrealized losses of available-for-sale
investments are as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     
|---------------------
|                     
|                     
|                     
|Market Value         
|                     
|Cost Basis           
|                     
|Gross Unrealized Loss
|                     

|Available-for-sale
investments in the accompanying balance sheet at December 31, 2000 include debt
securities of $5,868,213. Actual maturities may differ from contractual maturities as a
result of the Companys intent to sell these securities prior to maturity and as a
result of call features of the securities that enable either the Company, the issuer, or
both to redeem these securities at an earlier date. Unrealized holding gains totaling
$65,107 on such debt securities were recorded in stockholdersequity during the
twelve months ended December 31, 2000.(d)   Inventories
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Inventories
are stated at the lower of cost (first-in, first-out) or market. At December 31, 1999 and 2000, inventories consist of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------

|               
|---------------
|               
|               
|               
|Raw materials  
|Work-in-process
|Finished goods 
|               
|               
|               
|               

|(e) Depreciation and Amortization


The Company provides for depreciation and
amortization on property and equipment using the straight-line method by charging to operations amounts that
allocate the cost of the assets over their estimated lives.

At December 31, 1999 and 2000, property and equipment consist of the following:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                               |             
|------------------------------ | ------------
|                               | December 31,
|                               | 1999        
|                              
|Machinery and equipment        | $1,062,774  
|Furniture and fixtures         | 1,006,125   
|Leasehold improvements         | 139,046     
|                               |             
|                               | 2,207,945   
|Less: Accumulated depreciation
|and amortization               | 1,216,513   
|                               |             
|                               | $991,432    
|                              
|                              

|During 2000, the Company
determined that the carrying value of certain equipment related to past generation
products being phased out had been impaired and, accordingly, wrote-off $223,715 of such
equipment.



(f) Cost in Excess of Net Assets Acquired



The costs in excess of
net assets for acquired businesses were being amortized on a straight-line basis over
five to seven years. Amortization expense for the years ended December 31, 1998, 1999,
and 2000 amounted to approximately $602,000, $252,000 and $0 respectively, and is
included in general and administrative expenses in the consolidated statements of
operations.


The Company assesses the
relizability of intangible assets in accordance with SFAS No. 121, Accounting
for the Impairment Of Long-Lived Assets And For Long-Lived Assets To Be Disposed
Of. Under SFAS No. 121, the Company is required to assess the valuation of its
long-lived assets, including intangible assets, based on the estimated
undiscounted cash flows to be generated by such assets. During the year ended
December 31, 2000, the Company made a determination that goodwill related to
certain past generation products being phased out had been impaired and,
accordingly, wrote-off $522,089 of such goodwill.



(g) Deferred Financing Costs


The Company incurred
financing costs related to several issuances of convertible debentures. Deferred
financing costs are amortized by a charge to interest expense over the period that the
debt is outstanding. Any remaining unamortized deferred financing costs are charged to
additional paid-in-capital upon conversion (see Note 9(a)).



(h) Revenue Recognition


The Company recognizes
product revenues upon shipment and acceptance. Provisions are made at the time of revenue
recognition for any applicable warranty costs expected to be incurred. Revenues from
services are recognized in the period the services are provided.


During the quarter ended
June 30, 2000, the Company adopted Securities and Exchange Commission (SEC) Staff
Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial
Statements. As a result of adopting SAB No. 101, the Company now recognizes royalty
revenues when received rather than when earned. In accordance with SAB No. 101, the
Company recorded the impact of adopting SAB No. 101 as a cumulative catch-up adjustment
to income in the current years statement of operations, effective January 1, 2000.
The impact of adopting SAB No. 101 for the twelve months ended December 31, 2000 was to
increase net income before the cummulative effect of change in accounting method by
approximately $140,000 ($0.01 per share), respectively. Restated results of operations
for the quarter ended March 31, 2000 as a result of adopting SAB No. 101 are as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|                  
|------------------
|                  
|                  
|                  
|                  
|Revenues          
|Gross Profit      
|Operating Loss    
|Net Loss          
|Net Loss Per Share
|                  
|                  

|If SAB 101 had been adopted effective
January 1, 1999, the Company would have reported the following pro forma results:
|-----------------------------------------------------------------------------------------------------------------------

|                                 
|---------------------------------
|                                 
|                                 
|                                 
|                                 
|                                 
|Revenues                         
|Income from continuing operations
|Net income                       
|Net income per share - basic     
|Net income per share - diluted   
|                                 
|                                 

|No proforma results were reported for 1998 since royalty revenue was not recognized during this period.


(i)   Significant Sales Agent


For the years ended
December 31, 1998 and 1999, Coherent acted as the sales agent for products sold to the
Company's customers that represented 89% and 60% of product revenues, respectively. At
December 31, 1999, Coherent accounted for 60% of accounts receivable. Coherent was the
Company's exclusive worldwide distributor of laser systems until the sale of Star in
April 1999. International sales (including sales for which Coherent was the sales agent)
for the years ended December 31, 1998 and 1999 were approximately 39% and 35%,
respectively, of total revenues.


(j)   Research and Development Expenses


The Company charges research and
development expenses to operations as incurred.

(k)   Net Income (Loss) per Common Share



Basic net income (loss)
per share is determined by dividing net income (loss), adjusted for preferred stock
dividends, by the weighted average common shares outstanding during the period. Diluted
net income (loss) per share is determined by dividing net income (loss), adjusted for
preferred stock dividends, by the diluted weighted average shares outstanding during the
period. Diluted weighted average shares reflect the dilutive effect, if any, of common
stock options and warrants based on the treasury stock method and the assumed conversion
of all convertible debt obligations and convertible preferred stock. The calculations of
basic and diluted weighted average shares outstanding are as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|                                    
|------------------------------------
|                                    
|                                    
|                                    
|Basic weighted average common       
|shares outstanding                  
|Potential common shares pursuant to:
|Stock options and warrants          
|Convertible preferred stock         
|Convertible debentures              
|                                    
|Diluted weighted average common     
|Shares outstanding                  
|                                    
|                                    

|The Company's basic adjusted net income (loss) per
share from continuing operations for the years ended
1998, 1999 and 2000 is as follows:
|------------------------------------------------------------------------------------------------------------------------------------------

|                               
|-------------------------------
|                               
|                               
|                               
|Net income (loss) from         
|continuing operations          
|Preferred stock dividends      
|                               
|Adjusted net income (loss) from
|continuing operations          
|                               

|For the years ended 1998,
1999 and 2000, potential common shares related to 4,064,432, 3,687,262 and 4,796,329,
respectively, of outstanding stock options, stock warrants and convertible debt and
equity securities, respectively, were not included in diluted weighted average shares
outstanding as they were antidilutive.


(l)   Concentration of Credit Risk



SFAS No. 105, Disclosure
of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial
Instruments with Concentrations of Credit Risk, requires disclosure of any significant
off-balance-sheet and credit risk concentrations. Financial instruments that subject the
Company to credit risk consist primarily of cash, cash equivalents, available-for-sale
investments, and accounts receivable. The Company places its cash, cash equivalents and
available-for-sale investments in established financial institutions. The Company has no
significant off-balance-sheet risk or concentration of credit risk, such as foreign
exchange contracts, options contracts or other foreign hedging arrangements. The Company
maintains an allowance for potential credit losses. The Companys accounts
receivable credit risk is not concentrated within any one geographic area. The Company
has not experienced significant losses related to receivables from any individual
customers or groups of customers in any specific industry or by geographic area. Due to
these factors, no additional credit risk beyond amounts provided for collection losses is
believed by management to be inherent in the Companys accounts receivable.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(m)   Disclosures
About Fair Value of Financial Instruments




SFAS No. 107, Disclosure
About Fair Value of Financial Instruments, requires disclosure of an estimate of the fair
value of certain financial instruments. At December 31, 1999 and 2000, financial
instruments consisted principally of cash, cash equivalents, available-for-sale
investments, accounts receivable, accounts payable and long-term debt. The fair value of
financial instruments pursuant to SFAS No. 107 approximated their carrying values at
December 31, 1999 and 2000. Fair values have been determined through information obtained
from market sources and management estimates.

(n)   Comprehensive Income (Loss)


The Company adopted SFAS
No. 130, Reporting Comprehensive Income, effective January 1, 1998. SFAS No. 130
establishes standards for reporting and presentation of comprehensive income (loss) and
its components in the financial statements. The components of the Company's comprehensive
loss are as follows:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                            
|--------------------------------------------
|                                            
|                                            
|                                            
|                                            
|Net income (loss)                           
|Unrealized gain (loss) on available-for-sale
|Investments                                 
|                                            
|Comprehensive income (loss)                 
|                                            

|(o) Recent Accounting Pronouncements


In June 1999, the
Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 137, Accounting for Derivative Instruments and Hedging
Activities Deferral of the Effective Date of FASB Statement No. 133, which defers
the effective date of SFAS No. 133 to all fiscal quarters of all fiscal years beginning
after June 15, 2000. SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for hedging
activities. It requires entities to recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments at fair
value. The adoption of this new accounting standard is not expected to have a material
impact on the Companys financial statements.





In December 1999, the
Securities and Exchange Commission (SEC) released Staff Accounting Bulletin (SAB) No.
101, Revenue Recognition in Financial Statements. This bulletin summarizes some views of
the staff on applying accounting principles generally accepted in the United States to
revenue recognition in financial statements.


In March 2000, the FASB
issued Interpretation No. 44, Accounting for Certain Transactions Involving Stock
Compensation an Interpretation of APB Opinion No. 25. This interpretation clarifies
the application of Accounting Principles Board (APB) Opinion No. 25 in certain
situations, as defined. The interpretation is effective July 1, 2000, but covers certain
events occurring during the period after December 15, 1998 but before the effective date.
The adoption of this new accounting interpretation did not have a material impact on the
Companys financial statements.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) Segment and Geographic Information


The Company has adopted
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS
No. 131 establishes standards for reporting information regarding operating segments in
annual financial statements and requires selected information for those segments to be
presented in interim financial reports issued to stockholders. SFAS No. 131 also
establishes standards for related disclosures about products and services and geographic
areas. Operating segments are identified as components of an enterprise about which
separate discrete financial information is available for evaluation by the chief
operating decision maker, or decision making group, in making decisions how to allocate
resources and assess performance. The Companys chief decision-maker, as defined
under SFAS No. 131, is a combination of the Chief Executive Officer and the Chief
Financial Officer. To date, the Company has viewed its operations and manages its
business as principally one segment, cosmetic laser sales, and the Companys
long-lived assets are located in facilities in the United States. Associated services are
not significant. As a result, the financial information disclosed herein represents all
of the material financial information related to the Companys principal operating
segment.


The following table represents
percentage of product revenue by geographic destination for 1998, 1999 and 2000:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                
|----------------
|                
|                
|United States   
|Japan           
|Europe          
|Asia/Pacific    
|Canada          
|Latin America   
|Australia/Africa
|                
|Total           
|                

|(4) Research and Development


In August 1995, the
Company entered into an agreement with MGH whereby MGH agreed to conduct clinical trials
on a laser treatment for hair removal/reduction developed at MGHs Wellman
Laboratories of Photomedicine. Effective February 14, 1997, the Company amended the 1995
agreement with MGH. Under the terms of this amendment, the Company agreed to provide MGH
with a grant of approximately $204,000 to perform research and evaluation in the field of
hair removal. In July 1999, the Company entered an amendment to extend its exclusive
research agreement for an additional five years. In addition to laser hair removal, the
agreement has been expanded to include research and development in the fields of fat
removal and acne treatment. Palomar has the right to exclusively license, on royalty
terms to be negotiated, Palomar-funded inventions in the relevant fields. Under the terms
of this agreement, the Company will pay MGH $475,000 on an annual basis for clinical
research through August 2004.



(5) Income Taxes


The Company provides for
income taxes under the liability method in accordance with the provisions of SFAS No.
109, Accounting for Income Taxes. At December 31, 2000, the Company had available,
subject to review and possible adjustment by the Internal Revenue Service, a federal net
operating loss carryforward of approximately $87.0 million to be used to offset future
taxable income, if any. This net operating loss carryforward will begin to expire in
2012. The Internal Revenue Code contains provisions that limit the net operating loss
carryforwards due to changes in ownership, as defined by the Internal Revenue Code.
During 1999, the Company completed an analysis of its availability to utilize its net
operating loss carryforwards in connection with the sale of Star to Coherent (see Note
1). The Company estimates that it has net operating losses of approximately $37.9 million
that are not subject to limitation under the Internal Revenue Code. The Company has a net
deferred tax asset of approximately $35.0 million, comprised mainly of the net operating
tax carryforwards discussed above, and the tax effect of certain expenses and reserves
not currently deductible. However, the Company has placed a full valuation allowance
against the deferred tax asset, due to uncertainty relating to the Companys ability
to realize the asset.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|A reconciliation of the
federal statutory rate to the Companys effective tax rate is as follows:
|-------------------------------------------------------------------------------------------------

|                                              
|----------------------------------------------
|                                              
|                                              
|                                              
|Income tax provision at federal statutory rate
|Decrease in tax resulting from-               
|Net operating loss utilization                
|Other                                         
|Increase in valuation allowance               
|                                              
|Provision (benefit) for income taxes          
|                                              

|(6)     401(k)Plan


The Company has a 401(k)
Plan, which covers substantially all
employees who have attained the age of 18 and are employed at year-end. Employees may
contribute up to 15% of their salary, as defined, subject to restrictions defined by the
Internal Revenue Service. At the Company's discretion, the Company may make a
matching contribution, in cash or the Company's common stock up to 50% of all employee contributions in each plan year.
The Company contributions vest over a three-year period from date of hire.


During 1999 and 2000, the
Company matched in Company stock 50% of all employee contributions by issuing 32,561 shares of its common stock
and 99,843 shares of treasury stock, respectively, to the 401(k) Plan in satisfaction of its
employer match for the 1998 and 1999 employee contributions. For the year ended December 31, 2000, the Company
has accrued $180,000 for the 2000 match. The number of shares of common stock reserved for issuance under the 401(k)
Plan is 300,000 and as of the end of the fiscal year 103,997 shares of common stock remained available
for issuance thereunder.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7)     Quarterly Results of
Operations (Unaudited)


The following table
presents a condensed summary of quarterly results of operations for the years ended
December 31, 1999 and 2000 (in thousands, except per share data).
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                       
|-----------------------
|                       
|                       
|                       
|                       
|                       
|                       
|Total revenues         
|Gross profit           
|Loss from continuing   
|operations             
|Net loss per share from
|continuing operations: 
|Basic and Diluted      
|                       

|                           
|---------------------------
|                           
|                           
|                           
|                           
|                           
|Total revenues             
|Gross profit (loss)        
|Income (loss) from         
|continuing operations      
|Net income (loss) per share
|from continuing operations:
|Basic                      
|Diluted                    

|(8)     Accrued Liabilities

At December 31, 1999 and 2000, accrued liabilities consisted of the following:
|-----------------------------------------------------------------------------------------------------------

|                              |             
|----------------------------- | ------------
|                              | December 31,
|                              |             
|                              | 1999        
|                              |             
|Payroll and employee benefits | $   782,912 
|Royalties                     | 1,265,825   
|Settlement costs              | 2,500,000   
|Warranty                      | 711,606     
|Professional Fees             | 516,501     
|Other                         | 594,709     
|                             
|Total                         | $6,371,553  
|                             
|                             

|(9)    Long-Term Debt

       At December 31, 1999 and 2000, long-term debt consisted of the following:
|-------------------------------------------------------------------------------------------------------

|                                              
|----------------------------------------------
|                                              
|                                              
|                                              
|Dollar-denominated convertible debentures     
|Swiss franc-denominated convertible debentures
|                                              
|                                              
|Less - Current maturities                     
|                                              
|                                              
|                                              

(a)      Convertible Debentures

|The following table summarizes the issuance
and conversion of convertible debentures for the years ended December 31, 1999 and 2000.
|------------------------------------------------------------------------------------------------------------------------------------

|                                                           |         |                    |             |               |     
|---------------------------------------------------------- | ------- | ------------------ | ----------- | ------------- | ----
|                                                           |         |                    |             | Common Shares |     
|                                                           | Initial | Amount Outstanding | Issued Upon |               |     
|                                                           | Face    | December 31,       | Conversion  |              
|                                                           | Value   | 1999               | 2000        | 1999          | 2000
|                                                          
|6% Series due March 13, 2002                               |         | $   500,000        |             | $   500,000   |     
|6%, 7% and 8% Series due September 30, 2002                |         | 7,000,000          |             | --            |     
|4.5% Series denominated in Swiss francs Due March 31, 2001 |        
|and June 30, 2001                                          |         | 7,669,442          |             | 2,244,016     |     
|                                                          
|                                                           |         | $15,169,442        |             | $2,744,016    |     
|                                                          

|On March 13, 1997,
the Company issued $500,000 of 6% convertible debentures due March 13, 2002. The
convertible debentures have a conversion price of $11.00. The debentureholder may convert
no more than one-third of the debenture in any 30-day period. The Company has accounted
for these debentures at face value.


On September 30, 1997,
the Company issued $7 million of convertible debentures due September 30, 2002. The
debentures bear interest at a rate of 6% for the first 179 days, 7% for days 180 through
269 and 8% thereafter. During the year ended December 31, 1998, the Company redeemed
$2,196,667 of these convertible debentures, including accrued interest of $196,667.
During the year ended December 31, 1999, the debentureholders converted the remaining
$1,650,000 of principal plus $176,483 of accrued interest, into 377,760 shares of the
Companys common stock.


On July 3, 1996, the
Company raised approximately $7,669,000 through the issuance of 9,675 units in a
convertible debenture financing. These units are traded on the Luxembourg Stock Exchange
and consist of a convertible debenture due July 3, 2003 denominated in 1,000 Swiss
francs, and a warrant to purchase 24 shares of the Companys common stock at $16.50
per share. The warrants are non-detachable and may be exercised only if the related
debentures are simultaneously converted, redeemed or purchased. Interest on the
convertible debentures accrued at a rate of 4.5% per annum and was payable quarterly in
Swiss francs. The convertible debentures were convertible by the holder, or the Company,
commencing October 1, 1996 at a conversion price equal to 100% to 77.5% of the applicable
conversion price, calculated as defined. The Company ascribed a value of $1,917,360 to
the discount conversion feature of the convertible debenture. This amount was being
amortized to interest expense over the life of the Swiss franc convertible debenture.
During 1997, the Company redeemed 300 units of this convertible debenture financing for
$195,044.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|On October 16, 1997, the
Company brought a declaratory judgment action in the United States District Court against
certain of the Swiss franc debenture holders. Prior to this suit, those debenture holders
had alleged that the Company was in breach of certain protective covenants and, on
October 22, 1997, they brought suit based on these claims. On November 13, 1997, the
Company exercised its right to convert 9,375 units into 130,576 shares of common stock
and cash of approximately $36,000. The unamortized discount totaling approximately
$1,784,000 was amortized to interest expense upon conversion. The Company accounted for
these debentures as converted as of December 31, 1998.


During the year ended
December 31, 1999, the Company recorded a redemption expense of $6,167,369 as a result of
a compromise agreement between Palomar and certain European banks that had held the Swiss
franc debentures. Under the terms of this April 21, 1999 agreement, which resolved a
lawsuit, Palomar agreed to rescind its conversion notices issued in November 1997. Under
the terms of the agreement, the Company agreed to pay a total of approximately $6,742,717
to the European banks, of which $5,790,875 had been paid as of December 31, 2000. The
remaining amounts due under this obligation are due through 2001. Accordingly, the
Company has recorded a charge to operations of $6,167,369 during the year ended December
31, 1999. This amount represents the total amount due to the European banks less the fair
market value of the redemption of the common shares ($575,348) previously considered
outstanding by the Company.


The Company incurred
deferred financing costs of approximately $769,000 relating to the issuance of
convertible debentures during the year ended December 31, 1997. During the years ended
December 31, 1998, 1999 and 2000, the Company amortized approximately $64,000, $39,000
and $0 to interest expense, respectively. During the years ended December 31, 1998, 1999
and 2000, the Company charged approximately $374,000, $20,000 and $0, respectively, of
unamortized deferred financing costs to additional paid-in-capital.

(b)    Revolving Line of Credit with a Bank


The Company had a $10
million revolving line of credit with a bank. This line of credit was to mature on March 31,
2000 and bore interest at the banks prime rate. Borrowings under this line of
credit were secured by substantially all assets of the Company and were limited to 80% of
qualified accounts receivable. A director of Palomar had guaranteed all borrowings under
this line of credit. In connection with this guarantee, the Company issued this director
warrants to purchase 28,571 shares of common stock at $10.50 per share. These warrants
were valued at approximately $69,000. This amount was amortized to interest expense over
the term of the revolving line of credit. The Company repaid all amounts outstanding
under this line of credit on April 27, 1999, and cancelled the line of credit.



(c)     Notes Payable to Coherent


In May and June 1998 and
February 1999, the Company borrowed $3,000,000, $1,000,000 and $750,000, respectively,
from the Companys then worldwide distributor, Coherent. These notes accrued
interest at 8.5% per annum and were collateralized by Stars inventory. Coherent
assumed this debt in connection with its purchase of all of the issued and outstanding
common stock of Star on April 27, 1999.



(10) Commitments and Contingencies



(a)     Operating Leases


The Company has entered
into various operating leases for its corporate office, research facilities, and
manufacturing operations. These leases have monthly rent ranging from approximately
$4,000 to $81,000, which is adjusted annually, for certain other costs, such as
inflation, taxes and utilities, and expire through August 2009.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Future minimum payments under the
Companys operating leases at December 31, 2000 are approximately
as follows:
|---------------------------------------------------------------------------------------------------------------

|            
|------------
|Year Ended  
|December 31,
|            
|2001        
|2002        
|2003        
|2004        
|2005        
|Thereafter  
|            
|            
|            

|(b)     Royalties


The Company is required
to pay a royalty under a license agreement with MGH (see Note 4). For the years ended
December 31, 1998, 1999 and 2000, approximately $1,332,000, $2,085,000 and $2,078,000 of
royalty expense, respectively, was incurred under this agreement. These amounts are
included in cost of revenues in the accompanying consolidated statements of operations.


A former employee and
previous owner of one of the Companys subsidiaries was paid a 1% commission on the
net sales of certain lasers, as defined in his severance agreement, through March 31,
2000. Accordingly, the company paid commissions for the years ended December 31, 1998,
1999 and 2000 of $250,000, $218,000 and $10,000, respectively.



(c)    Litigation


In 1997, the Company
brought a declaratory judgment action against the holders and the indenture trustee of
the Companys 4.5% Subordinated Convertible Debentures due 2003, denominated in
Swiss francs (the Swiss Franc Debentures). Just after this suit, certain of
the debenture holders (the Asserting Holders) filed suit against the Company
alleging that the Company was in breach of certain protective covenants under the
indenture. The Asserting Holders claimed that the Company had breached certain protective
indenture covenants and that the Asserting Holders were entitled to immediate payment of
their indebtedness under the Swiss Franc Debentures. As of November 13, 1997, the Company
notified the holders of the Swiss Franc Debentures that it had caused conversion of all
of the Swiss Franc Debentures into an aggregate of 130,576 shares of the Companys
common stock. Since the conversion date, the Company had treated these shares as issued
and outstanding. In July 1999, Palomar and certain European banks entered into a
settlement agreement whereby Palomar agreed to rescind its conversion notices issued in
November 1997. Under the terms of this compromise, the Company agreed to pay a total of
approximately $6.7 million to the European banks, of which $5.7 million has been paid as
of December 31, 2000. The balance of $1.0 million is due through 2001. In 1998, the
Company recorded a charge to operations of approximately $6.2 million representing the
total amount due to the European banks less the fair market value of the redemption of
the common shares previously considered outstanding by the Company.


On March 17, 1999, the
Company and a former and current officer were added as defendants in the class action of
Varljen v. H.J. Meyers, Inc., et al. In February 2000, Palomar and the Varljen plaintiffs
reached an agreement in principle pursuant to which Palomar and its insurance carrier
would pay plaintiffs $5 million in settlement of all their claims. Of this amount,
Palomar would contribute up to $1 million in stock and $1.375 million in cash, all of
which had been accrued as of December 31, 1999, and its insurance carrier would
contribute the remaining $2.625 million in cash. This settlement agreement was approved
by the court on November 6, 2000. A final judgement of dismissal with prejudice was
entered by the court on November 6, 2000. All payments required by Palomar under the
settlement agreement have been made, including the delivery of 89,000 shares of Palomar
Common stock. The delivery of 358,547 shares of Palomar Common stock, which is the
balance of the shares owed under the settlement agreement, will be delivered in 2001 upon
receipt of instruction from plaintiffs counsel. These 358,547 shares of Palomar
Common stock have been considered outstanding for purposes of determining net loss per
share for the year ended December 31, 2000.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Company is involved
in other legal and administrative proceedings and claims of various types. While any
litigation contains an element of uncertainty, management, in consultation with the
Companys general counsel, presently believes that the outcome of each such other
proceedings or claims which are pending or known to be threatened, or all of them
combined, will not have a material adverse effect on the Company.


(d)    Distribution Agreement


On November 17, 1997, the
Company entered into an exclusive distribution, sales and service agreement with
Coherent, an established, worldwide laser company. Under this agreement, Coherent had the
exclusive right to sell the EpiLaser®and the LightSheerdiode laser system and
future generation products worldwide. The Company paid Coherent a per unit commission,
adjusted for certain events, as defined. During 1998 and 1999, the Company incurred
approximately $14,108,000 and $4,702,000, respectively, of commission expense related to
this agreement, which is included in sales and marketing expense in the accompanying
consolidated statement of operations. Upon execution of this agreement, Coherent made a
lump sum payment of $3.5 million and received a warrant to purchase 142,857 shares of the
Companys common stock at a share price of $36.75. The valuation of the warrant
using the Black-Scholes option pricing model was approximately $380,000. The value was
credited to additional paid-in capital during the year ended December 31, 1997. The
remaining amount of $3,120,000, was included in deferred revenue, and originally
amortized to revenue over the three year life of the agreement. On April 27, 1999, in
connection with the Companys completion of the sale of Star to Coherent, as
discussed in Note 1, the distribution agreement was terminated and replaced with a one
year non-exclusive distribution agreement that enabled Coherent to sell the Companys
ruby-based laser products. The Company amortized the remaining amounts in deferred
revenue related to Coherent over the one-year non-exclusive period ending April 27, 2000.


(e)   Employment Agreements



The Company and its
subsidiaries have employment agreements with certain executive officers that provide for
annual bonuses to the officers and expire on various dates through 2001. Each of these
agreements provides for 12 months severance upon termination of employment and certain
payments upon change of control.



(11) Stockholders Equity



(a) Common Stock


During 1998, the Company
sold 1,457,142 shares of common stock to a group of investors for $10,200,000. In
addition, the Company issued callable warrants with a three-year term to these investors
to purchase 1,457,142 shares of common stock at an exercise price of $21.00 per share.
The callable warrants are not exercisable for the first six months after issuance and
thereafter are callable by the Company if the closing price of the Companys common
stock equals or exceeds $35.00 for 10 consecutive trading days. Under the terms of this
private placement, the Company is obligated to pay the investors a fee of 5% per annum
(payable quarterly) of the dollar value invested in the Company as long as the investors
continue to hold their common stock in their name at the Companys transfer agent.
During 1998, 1999 and 2000, the Company paid $283,125, $383,050 and $287,675,
respectively, related to this fee. This amount has been charged to additional paid-in
capital. During 1998, the Company also paid $360,000 for investment banking fees related
to the issuance of these common shares. The Company netted this amount against the
proceeds through a reduction in additional paid-in capital.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|On April 21, 1999, a
majority of the Companys stockholders approved an amendment to the Companys
Certificate of Incorporation to effect a plan of recapitalization that resulted in a
one-for-seven reverse split of the Companys common stock. The Companys
authorized capital stock was also reduced to 45,000,000 shares of common stock and
1,500,000 shares of preferred stock. All shares and per share amounts of common stock for
all periods presented have been retroactively adjusted to reflect the reverse stock
split.

(b) Preferred Stock


The Company is authorized
to issue up to 1,500,000 shares of preferred stock, $.01 par value. As of December 31,
1999 and 2000, preferred stock authorized, issued and outstanding consists of the
following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                          
|--------------------------------------------------------------------------
|                                                                          
|                                                                          
|Redeemable convertible preferred stock, Series F, $.01 par value per share
|Authorized, issued and outstanding - 6,000 shares                         
|(liquidation preference of $7,785,450 at December 31, 2000)               
|                                                                          

|The Series F redeemable convertible
preferred stock (Series F Preferred), together with any accrued but unpaid
dividends, may be converted into common stock at 80% of the average closing bid price for
the 10 trading days preceding the conversion date, but in no event less than $21.00 or
more than $112.00. This conversion floor was decreased by the two parties from the
original price to $49.00. The conversion price for the Series F Preferred is adjustable
for certain dilutive events, as defined. The Series F Preferred may be redeemed at the
Companys option, with no less than 10 daysand no more than 30 daysnotice
or when the stock price exceeds $117.60 per share for 60 consecutive trading days, at an
amount equal to the amount of liquidation preference determined as of the applicable
redemption date. The Series F Preferred has a liquidation preference equal to $1,000 per
share of redeemable convertible preferred stock, plus accrued but unpaid dividends and
accrued but unpaid interest. The Series F Preferred stockholders do not have any voting
rights except on matters affecting the Series F Preferred. Dividends are payable quarterly at 8% per annum in arrears on
March 31, June 30, September 30 and December 31. Dividends not paid on the
payment date, whether or not such dividends have been declared, will bear
interest at the rate of 10% per annum until paid. As of December 31, 2000, there
is $1,785,450 of unpaid accrued dividends and interest.


During the third quarter
of 1996, the Company issued 10,000 shares of Series G redeemable convertible preferred
stock (Series G Preferred) for $10 million, less associated financing costs.
The Series G Preferred together with any accrued but unpaid dividends, was convertable
into common stock at 85% of the average closing bid price for the five trading days
preceding the conversion date, but in no event less than $.07. The Series G Preferred
was redeemable at the Companys option at any time, with no less than 15 daysand
no more than 20 daysnotice, at an amount equal to the sum of (a) the amount of
liquidation preference determined as of the applicable redemption date plus (b) $176.50.
Dividends were payable quarterly at 7% per annum in arrears on January 1, April 1, July 1
and October 1. As of December 31, 1999, all of the Series G Preferred had been redeemed or converted.


During the first and
second quarters of 1997, the Company issued 16,000 shares of Series H redeemable
convertible preferred stock (Series H Preferred) for $16 million, less
associated financing costs of $1 million. The Series H Preferred accrued dividends at
rates varying from 6% to 8% per annum, as defined. The Series H Preferred, together with
any accrued but unpaid dividends, was convertable into common stock at 100% of the
average stock price for the first 179 days from the closing date, 90% of the average
stock price, as defined, for the following 90 days and 85% of the average stock price, as
defined, thereafter. The conversion price was adjustable for certain dilutive events. The
holders were restricted for the first 209 days following the closing date to converting
no more than 33% of the Series H Preferred in any 30 day period (or 34% in the last 30
day period). Under certain conditions, the Company had the right to redeem the Series H
Preferred. The Company had ascribed a value of $2,823,529 to the discount conversion
feature of the Series H Preferred, which was amortized as an adjustment to earnings
available to common stockholders over the most favorable conversion period attainable to
the holders (270 days from the date of issuance). As of December 31, 1999, all of the
Series H Preferred had been redeemed or converted.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|During the year ended
December 31, 1998, the following shares of preferred stock, accrued premiums, dividends,
interest, and other related costs were converted into shares of common stock as follows:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|         
|---------
|         
|Preferred
|Stock    
|Series   
|         
|G        
|H        
|         
|         
|         

|In addition to the 598,378 shares of common stock issued related
to the Series H Preferred conversion, the Company redeemed 3,516 shares of Series H
Preferred for $4,387,434 in 1998. This amount includes accrued dividends and interest
totaling $771,876.

During the year ended December 31, 1999, the following shares of preferred stock, accrued premium,
dividends, interest and other related costs were converted into shares of common stock as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|         
|---------
|         
|Preferred
|Stock    
|Series   
|         
|G        
|         
|         

|In addition to the 74,905 shares of common stock issued related to the Series G Preferred conversion,
the Company redeemed 403 shares of Series G Preferred and 250 shares of Series H Preferred for $902,396 in 1999,
including related accrued dividends and interest of $121,009.

(c)   Stock Option Plans and Warrants

(i)   Stock Options


The Company has several
Stock Option Plans (the "Plans") that provide for the issuance of a maximum of 4,778,571
shares of common stock, which may be issued as incentive stock options ("ISOs") or
nonqualified options. Under the terms of the Plans, ISOs may not be granted at less than
the fair market value on the date of grant (and in no event less than par value); in
addition, ISO grants to holders of 10% of the combined voting power of all classes of
Company stock must be granted at an exercise price of not less than 110% of the fair
market value at the date of grant. Pursuant to the Plans, options are exercisable at
varying dates, as determined by the Board of Directors, and have terms not to exceed 10
years (five years for 10% or greater stockholders). The Board of Directors, at its
discretion, may convert the optionee's ISOs into nonqualified options at any time prior
to the expiration of such ISOs.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The following table summarizes all stock
option activity of the Company for the years ended December 31, 1998, 1999 and 2000:
|-----------------------------------------------------------------------------------------------------------------------------

|                                                                      
|----------------------------------------------------------------------
|                                                                      
|                                                                      
|                                                                      
|                                                                      
|Outstanding, December 31, 1997                                        
|Granted                                                               
|Canceled                                                              
|                                                                      
|Outstanding, December 31, 1998                                        
|Granted                                                               
|Canceled                                                              
|                                                                      
|Outstanding, December 31, 1999                                        
|Granted                                                               
|Exercised                                                             
|Canceled                                                              
|                                                                      
|Outstanding, December 31, 2000                                        
|                                                                      
|Exercisable, December 31, 1998                                        
|                                                                      
|Exercisable, December 31, 1999                                        
|                                                                      
|Exercisable, December 31, 2000                                        
|                                                                      
|Available for future issuances under the Plans as of December 31, 2000
|                                                                      
|                                                                      

|The ranges of exercise prices for
options outstanding and options exercisable at December 31, 2000 are as follows:
|------------------------------------------------------------------------------------------------------------------

|               
|---------------
|               
|Range of       
|Exercise Prices
|               
|$1.38 - $1.63  
|1.97           
|2.06 - 2.88    
|3.19 - 3.22    
|4.88 - 5.06    
|10.50          
|               
|$1.38 - $10.50 
|               

|The Company accounts for its
stock-based compensation plans under APB Opinion No. 25, Accounting for Stock
Issued to Employees. In October 1995, the FASB issued SFAS No. 123, Accounting
for Stock-Based Compensation, which is effective for fiscal years beginning
after December 15, 1995. SFAS No. 123 established a fair-value-based method of
accounting for stock-based compensation plans. The Company has adopted the
disclosure-only alternative under SFAS No. 123, which requires disclosure of the
pro forma effects on earnings per share as if SFAS No. 123 had been adopted, as
well as certain other information. Under Emerging Issues Task Force (EITF)
96-18, the fair value of the non-employee equity issuances will be marked to
market over the vesting term of the stock options and warrants.


During the year ended
December 31, 1998, a total of 312,128 options to purchase common stock were repriced to
above the fair market value of the underlying common stock to $10.50 per share.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Company has computed the pro forma disclosures required under SFAS
No. 123 for all stock options granted to employees of the Company in the years ended
December 31, 1998, 1999 and 2000 using the Black-Scholes option pricing model prescribed
by SFAS No. 123.


The assumptions used to
calculate the SFAS No. 123 pro forma disclosure and the resulting grant date fair values
for the years ended December 31, 1998, 1999 and 2000 for the Company are as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                               
|-----------------------------------------------
|                                               
|                                               
|                                               
|Risk-free interest rate                        
|Expected dividend yield                        
|Expected lives                                 
|Expected volatility                            
|Grant date fair value of options granted during
|the period                                     
|                                               

|The weighted average fair-value
and weighted average exercise price of options granted by the Company for the
years ended December 31, 1998, 1999 and 2000 are as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                   
|---------------------------------------------------
|                                                   
|                                                   
|Weighted average exercise price for options:       
|Whose exercise price exceeded fair market value at 
|the date of grant                                  
|Whose exercise price was equal to fair value at the
|date of grant                                      
|Weighted average fair market value for options:    
|Whose exercise price exceeded fair market value at 
|the date of grant                                  
|Whose exercise price was equal to fair market value
|at the date of grant                               
|                                                   

|(ii) Warrants


The following table summarizes all
warrant activity of the Company for the years ended December 31, 1998, 1999 and
2000:
|----------------------------------------------------------------------------------------------------------------------------------------

|                              
|------------------------------
|                              
|                              
|                              
|                              
|Outstanding, December 31, 1997
|Granted                       
|Exercised                     
|Canceled                      
|                              
|Outstanding, December 31, 1998
|Granted                       
|Canceled                      
|                              
|Outstanding, December 31, 1999
|Granted                       
|Canceled                      
|                              
|Outstanding, December 31, 2000
|                              
|Exercisable, December 31, 1998
|                              
|Exercisable, December 31, 1999
|                              
|Exercisable, December 31, 2000
|                              

|During the year ended December 31,
1998, a total of 185,714 warrants to purchase common stock were repriced to
above the then current fair market values of the underlying common stock. These
repriced exercise prices ranged from $10.50 to $14.00 per share.


The ranges of exercise prices for
warrants outstanding and exercisable at December 31, 2000 are as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     |                      |                  |                  |             |                 
|-------------------- | -------------------- | ---------------- | ---------------- | ----------- | ----------------
|Warrants Outstanding | Warrants Exercisable
|                    
|                     | Weighted Average     |                 
|Range of             | Warrants             | Remaining        | Weighted Average | Warrants    | Weighted Average
|Exercise Prices      | Outstanding          | Contractual Life | Exercise Price   | Exercisable | Exercise Price  
|                    
|$1.97                | 60,000               | 9.08 years       | $1.97            | -           | $-              
|2.81 - 3.50          | 383,000              | 5.97 years       | 3.37             | 363,000     | 3.40            
|10.50                | 54,283               | 1.13 years       | 10.50            | 54,283      | 10.50           
|21.00 - 22.75        | 1,544,264            | 2.23 years       | 21.04            | 1,544,264   | 21.04           
|35.00 - 66.50        | 440,291              | 0.36 years       | 49.88            | 440,291     | 49.88           
|84.00 - 105.00       | 89,721               | 0.52 years       | 94.17            | 89,721      | 94.17           
|                    
|$1.97-105.00         | 2,571,559            | 2.54 years       | $25.23           | $2,491,559  | 25.97           
|                    

|The Company has computed the pro
forma disclosures required under SFAS No. 123 for all warrants granted in the
years ended December 31, 1998, 1999 and 2000 using the Black-Scholes option
pricing model prescribed by SFAS No. 123.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The weighted-average assumptions
used to calculate the SFAS No. 123 pro forma disclosure for the years ended
December 31, 1998, 1999 and 2000 for the Company are as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                
|------------------------------------------------
|                                                
|                                                
|                                                
|Risk-free interest rate                         
|Expected dividend yield                         
|Expected lives                                  
|Expected volatility                             
|Grant date fair value of warrants granted during
|the period                                      
|                                                
|                                                

|The weighted average fair value
and weighted average exercise price of warrants granted by the Company for the
years ended December 31, 1998, 1999 and 2000 are as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                       
|-------------------------------------------------------
|                                                       
|                                                       
|                                                       
|Weighted average exercise price for warrants:          
|Whose exercise price exceeded fair market value at date
|of grant                                               
|Whose exercise price was less than fair market value at
|date of grant                                          
|Whose exercise price was equal to fair market value at 
|date of grant                                          
|Weighted average fair value for warrants:              
|Whose exercise price exceeded fair market value at date
|of grant                                               
|Whose exercise price was less than fair market value at
|date of grant                                          
|Whose exercise price was equal to fair market value at 
|date of grant                                          
|                                                       

|(iii) Pro Forma Disclosure



The pro forma effect on the Company of
applying SFAS No. 123 for all options and warrants to purchase common stock of the
Company would be as follows:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                      
|------------------------------------------------------
|                                                      
|                                                      
|Pro forma net income (loss) from continuing operations
|Pro forma basic net income (loss) per share from      
|continuing operations                                 
|Pro forma diluted net income (loss) per share from    
|continuing operations                                 
|                                                      

|(d)      Reserved Shares
|------------------------

|At December 31, 2000, the Company has
reserved shares of its common stock for the following:
|--------------------------------------------------------------------------------------------

|                            
|----------------------------
|                            
|Warrants                    
|Stock option plans          
|Convertible debentures      
|Convertible preferred stock 
|Employee stock purchase plan
|Employee 401(k) plan        
|                            
|Total                       
|                            

|(e) Employee Stock Purchase Plan


In June 1996, the Board
of Directors established the Palomar Medical Technologies, Inc. 1996 Employee Stock
Purchase Plan (the Purchase Plan). Under the Purchase Plan, all employees are
eligible to purchase the Companys common stock at an exercise price equal to 85% of
the fair market value of the common stock with a lookback provision of three months. The
Purchase Plan provides for issuance of up to approximately 140,000 shares. During the
years ended December 31, 1998, 1999 and 2000, employees purchased 9,315, 14,199 and
30,937 shares, respectively, of the Companys common stock for approximately
$50,000, $46,000 and $53,000, respectively, pursuant to the Purchase Plan.


(12) Discontinued Operations


During the fourth quarter
of 1997, the Companys Board of Directors approved a plan to dispose of the Companys
electronics business segment. The electronics segment consisted of the manufacture and
sale of personal computers, high-density flexible electronics circuitry and memory
modules. The Company substantially completed this plan in May 1998.


During 1997 and 1998, the
Company reduced its ownership in Nexar through the sale of common stock to private
investors. As of December 31, 1998, the Company beneficially owned 2,406,080 shares of
Nexars common stock, representing approximately 19% ownership interest and had no
other significant obligations related to Nexar, other than the guaranty to GFL Advantage
Fund Limited (GFL) discussed below.


During 1998, the Company
recorded a charge to discontinued operations of $1,524,966 as a result of managements
decision to write-down the carrying value of its investment in Nexar.


On December 31, 1997 the
Company entered into an Exchange Agreement and sold 500,000 shares of Nexars common
stock to GFL for $2 million. Under the terms of the Exchange Agreement, Palomar
guaranteed GFL a minimum selling price of $5.00 per share with respect to 400,000 shares
of Nexars common stock over a two-year time period. The deferred liability related
to this transaction totaled $1,680,171 and represents the total amount due to GFL after
GFL sold its 400,000 common shares of Nexar stock. The Company paid this deferred
obligation on May 3, 1999.


The other entities that
were included in the electronics business segment are Dynaco Corp. (Dynaco)
and Dynacos wholly owned subsidiaries Comtel Electronics, Inc. (Comtel)
and Dynamem, Inc. (Dynamem). On December 9, 1997, the Company entered into a
two-phase stock purchase agreement with Biometric Technologies Corporation (BTC).
BTC was formed jointly by Dynacos President and its Chairman of the Board. The
first phase was consummated on December 9, 1997 and consisted of the sale of all of the
issued and outstanding common stock of Comtel and Dynamem in exchange for $3,654,000,
payable in two installments. The first installment was a $850,000 unsecured promissory
note that was due on February 15, 1998. The second installment was a $2.8 million
unsecured promissory note due in 48 monthly installments, beginning February 1, 1999.
This promissory note was fully reserved by the Company during 1997, as its ultimate
collectibility was believed to be uncertain. As of December 31, 2000, the Company has not
received any amounts due on these notes.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|As part of the first
phase, the Company entered into a Loan and Subscription Agreement with a creditor of
Comtel, Coast Business Credit, for $3,233,000. This promissory note represented the
settlement of amounts owed the creditor by Comtel and guaranteed by Palomar. Principal
and interest payments were being made over 24 months, beginning December 31, 1997, and
interest accrued at the banks prime rate plus 2.25%. This promissory note had been
collateralized by 464,285 shares of the Companys common stock that were held in
escrow. The Company also guaranteed up to $2.5 million of Comtels borrowings from
this creditor until November 30, 1999. The stockholders of BTC had personally guaranteed
to the Company payment for any amounts borrowed under this line of credit in excess of
approximately $1.5 million in the event that the Company would have been obligated to
honor this guarantee.


BTC did not make the
first installment on February 1, 1998, and on October 7, 1998 the Company and BTC agreed
to reduce the principal balances of the $850,000 note and the $2.8 million note to a
total of $1 million. BTC paid $500,000 during 1998, with the balance due April 5, 1999.
BTC did not make its final principal payment on April 5, 1999, and on April 16, 1999
amended the agreement, resulting in payment of $100,000, a release of Palomar from its
obligation to Coast Business Credit and a promissory note for $400,000 due on March 31,
2001. The amended note is guaranteed by the principal stockholders of BTC.


In connection with the
disposition of Comtel, the Company also restructured all assets and investments related
to a significant customer of Comtel into a $4 million note receivable. This receivable
was fully reserved by the Company during 1997, as its ultimate collectibility is
uncertain. To date, no amounts have been received under this restructured note receivable
from the customer, nor does the Company anticipate receiving any amounts from this note
receivable in the foreseeable future.


In the second phase, BTC
agreed to purchase all of the issued and outstanding stock of Dynaco. During phase two,
BTC had the option of selling Dynaco to a third party if agreed to by the Company and
BTC. Consistent with the terms of the agreement with BTC, the Company entered into a
Stock Purchase Agreement with Quick Turn Circuits, Inc. (QTC) on May 26, 1998
pursuant to which QTC purchased 100% of the issued and outstanding shares of common stock
of Dynaco for $3.2 million.


As of December 31, 1997,
the Company accrued for the estimate of Dynacos 1998 operating loss through the
anticipated disposition date of approximately $850,000. Through the date of disposition
of Dynaco, the Company recognized additional operating losses totaling $1,090,885. During
1998, the Company recorded a loss on disposition of $8,329 related to the ultimate sale
of Dynaco to QTC.


During 1999, the Company
paid and settled a lawsuit related to the operations of Dynaco for $435,000.


Pursuant to Accounting
Principles Board (APB) Opinion No. 30, Reporting the Results of Operations
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions, (APB No. 30) the
consolidated financial statements of the Company have been presented to reflect the
dispositions of the aforementioned subsidiaries that comprise the electronics segment in
accordance with APB 30. Accordingly, revenues, expenses, and cash flows of the
electronics segment have been excluded from the respective captions in the accompanying
consolidated statements of operations and consolidated statements of cash flows. The
net operating losses of these entities have been reported as
Net Loss from Discontinued Operationsin the accompanying consolidated
statements of operations; and the net cash flows of these entities have been reported as
Net Cash Provided by (Used in) Discontinued Operationsin the accompanying
consolidated statements of cash flows.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The following summarizes the results of the
discontinued operations:
|--------------------------------------------------------------------

|                                     
|-------------------------------------
|                                     
|                                     
|                                     
|                                     
|Revenues                             
|Net loss from discontinued operations
|                                     
|                                     

|(13) Restructuring And Asset Write Off


On January 1, 1998, the
Company sold substantially all of the business assets and liabilities of Palomar
Technologies, Ltd., a foreign manufacturer, to a publicly traded company. The Company
received cash of approximately $200,000 and was relieved of obligations related to the
building lease and all employment agreements of approximately $69,000, resulting in a net
gain of approximately $131,000.



(14) Valuation And Qualifying Accounts


The roll forward of the Allowance for
Doubtful Accounts is as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                 
|-----------------
|                 
|                 
|                 
|                 
|December 31, 1998
|                 
|December 31, 1999
|                 
|December 31, 2000
|                 

|The roll forward of the Restructuring
Accrual is as follows:
|------------------------------------------------------------

|                 
|-----------------
|                 
|                 
|                 
|                 
|December 31, 1998
|                 
|December 31, 1999
|                 
|December 31, 2000
|                 

|Item 9.      Changes in and Disagreements with Accountants on Accounting and
                   Financial Disclosures.

Not applicable.
|---------------------------------------------------------------------------------------------------------------------------------------

|PART III
Item 10.      Directors and Executive Officers of the Registrant.


The information
concerning directors required under this item is incorporated herein by reference from
the material contained under the heading Election of Directorsin the
Registrants definitive proxy statement to be filed with the Securities and Exchange
Commission pursuant to Regulation 14A, not later than 120 days after the close of the
fiscal year. The information concerning delinquent filers pursuant to Item 405 of
Regulation S-K is incorporated herein by reference from the material contained under the
heading Section 16(a) Beneficial Ownership Reporting Compliancein the
Registrants definitive proxy statement to be filed with the Securities and Exchange
Commission pursuant to Regulation 14A, not later than 120 days after the close of the
fiscal year.

Item 11.       Executive Compensation.



The information required
under this item is incorporated herein by reference from the material contained under the
heading Executive Compensationin the Registrants definitive proxy
statement to be filed with the Securities and Exchange Commission pursuant to Regulation
14A, not later than 120 days after the close of the fiscal year.

Item 12.       Security Ownership of Certain Beneficial Owners and Management.




The information required
under this item is incorporated herein by reference from the material contained under the
heading Stock Ownershipin the Registrants definitive proxy statement to
be filed with the Securities and Exchange Commission pursuant to Regulation 14A, not
later than 120 days after the close of the fiscal year.

Item 13.       Certain Relationships and Related Transactions.




The information required
under this item is incorporated herein by reference from the material contained under the
heading Relationship with Affiliatesin the Registrants definitive proxy
statement to be filed with the Securities and Exchange Commission pursuant to Regulation
14A, not later than 120 days after the close of the fiscal year.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART IV

Item 14.      Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a)      Index to Consolidated Financial Statements.



The following
Consolidated Financial Statements of the Company and its subsidiaries are filed as part
of this report on Form 10-K:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Reports of Independent Public Accountants                              | 20
| | ---------------------------------------------------------------------- | --
|
|
| | Consolidated Balance Sheets -                                         
| | December 31, 2000 and December 31, 1999                                | 21
|
|
| | Consolidated Statements of Operations -                               
| | Years ended December 31, 2000, December 31, 1999 and December 31, 1998 | 22
|
|
| | Consolidated Statements of Stockholders' Equity (Deficit) -           
| | Years ended December 31, 2000, December 31, 1999 and December 31, 1998 | 23
|
|
| | Consolidated Statements of Cash Flows -                               
| | Years ended December 31, 2000, December 31, 1999 and December 31, 1998 | 24
|
|
| | Notes to Consolidated Financial Statements                             | 25

|(b)      Reports on Form 8-K.

      Not applicable.
|----------------------------------------------------

|(c)      Exhibits.


The following exhibits required to
be filed herewith are incorporated by reference to the filings previously made
by the Company where so indicated below.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

|^^^3(i).1 |  | Certificate of Designation, as filed with the Delaware Secretary of State on April 21, 1999.
|--------- |  | --------------------------------------------------------------------------------------------

|^3(i).2 |  | Second Restated Certificate of Incorporation, as filed with the Delaware Secretary of State on
January 8, 1999.
|------- |  | ---------------------------------------------------------------------------------------------------------------

|^^^^3(ii) |  | Bylaws, as amended.
|--------- |  | -------------------

|^4.1 |  | Common Stock Certificate.
|---- |  | -------------------------

|^^4.2. |  | Rights Agreement Between Palomar Medical Technologies, Inc. and American Stock Transfer & Trust
Company, dated as of April 20, 1999
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------

|##4.3 |  | Form of 4.5% Convertible Debenture (denominated in Swiss Francs) due July 3, 2003.
|----- |  | ----------------------------------------------------------------------------------

|####4.4 |  | First Allonge and Amendment to 4.5% Subordinated Convertible Debenture
|------- |  | ----------------------------------------------------------------------

|##4.5 |  | Form of 6% Convertible Debenture due March 13, 2002.
|----- |  | ----------------------------------------------------

|<4.6 |  | Second Amended 1991 Stock Option Plan.
|---- |  | --------------------------------------

|<4.7 |  | Second Amended 1993 Stock Option Plan.
|---- |  | --------------------------------------

|<4.8 |  | Second Amended 1995 Stock Option Plan
|---- |  | -------------------------------------

|<4.9 |  | Second Amended 1996 Stock Option Plan.
|---- |  | --------------------------------------

|<4.10 |  | Third Amended 1996 Employee Stock Purchase Plan.
|----- |  | ------------------------------------------------

|*4.11 |  | Form of Stock Option Grant under the 1991, 1993 and 1995 Amended Stock Option Plans.
|----- |  | ------------------------------------------------------------------------------------

|##4.12 |  | Form of Stock Option Agreement under the 1996 Amended Stock Option Plan.
|------ |  | ------------------------------------------------------------------------

|#4.13 |  | Form of Company Warrant to Purchase Common Stock.
|----- |  | -------------------------------------------------

|###10.1 |  | Employment Agreement, dated as of May 15, 1997, between the Company and Louis P. Valente.
|------- |  | -----------------------------------------------------------------------------------------

|<10.2 |  | Amendment No. 1 to Key Employment Agreement between the Company and Louis P. Valente dated May 15,
1999.
|----- |  | --------------------------------------------------------------------------------------------------------

|####10.3 |  | Amendment No. 2 to Key Employment Agreement between the Company and Louis P. Valente dated February
1, 2000
|-------- |  | -----------------------------------------------------------------------------------------------------------

|<10.4 |  | Amended and Restated Employment Agreement between the Company and Joseph P. Caruso dated June 30,
1999.
|----- |  | -------------------------------------------------------------------------------------------------------

|####10.5 |  | Amendment No. 1 to Amended and Restated Employment Agreement between the Company and Joseph P.
Caruso, dated February 1, 2000.
|-------- |  | ------------------------------------------------------------------------------------------------------------------------------

|
|

|<10.6 |  | Lease for premises at 82 Cambridge Street, Burlington, Massachusetts, dated June 17, 1999.
|----- |  | ------------------------------------------------------------------------------------------

|###10.7 |  | License Agreement between the Company and Massachusetts General Hospital, dated August 18, 1995.
|------- |  | ------------------------------------------------------------------------------------------------

|###10.8 |  | First Amendment to License Agreement between the Company and Massachusetts General Hospital, dated
August 18, 1995.
|------- |  | -------------------------------------------------------------------------------------------------------------------

|###10.9 |  | Second Amendment to License Agreement between the Company and Massachusetts General Hospital,
dated August 18, 1995.
|------- |  | --------------------------------------------------------------------------------------------------------------------

|-10.10 |  | The Company's 401(k) Plan.
|------ |  | --------------------------

|**10.11 |  | Agreement and Plan of Reorganization by and among Coherent, Inc., Medical Technologies,
Acquisition, Inc., Palomar Medical Technologies, Inc., Star Medical Technologies, Inc., Robert E.
Grove, James Z. Holtz and David C. Mundinger, dated as of December 7, 1998.
|------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|<<10.12 |  | Amendment No. 1 to Key Employment Agreement between the Company and Joseph P. Caruso dated June 8,
2000
|------- |  | -------------------------------------------------------------------------------------------------------

|21 |  | List of Subsidiaries.
|-- |  | ---------------------

|23 |  | Consent of Arthur Andersen LLP.
|-- |  | -------------------------------

|^ |  | Previously filed as an exhibit to Form 8-K, filed on April 21, 1999 and incorporated herein by
reference.
|- |  | ---------------------------------------------------------------------------------------------------------

|^^ |  | Previously filed as an exhibit to Form 10-K for the period ended December 31, 1998, filed on
March 30, 1999 and incorporated herein by reference.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------

|^^^ |  | Previously filed as an exhibit to Form 10-Q for the period ended March 31, 1999, filed on May 17,
1999 and incorporated herein by reference.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------

|^^^^ |  | Previously filed as an exhibit to Form 8-K, filed on December 16, 1999 and incorporated herein by
reference.
|---- |  | ------------------------------------------------------------------------------------------------------------

|* |  | Previously filed as an exhibit to Amendment No. 4 to Form S-1 Registration Statement No. 33-47479
filed on October 5, 1992, and incorporated herein by reference.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

|** |  | Previously filed as an exhibit to the Company's Definitive Proxy Statement for the period ended
December 31, 1998 filed on March 12, 1999, and incorporated herein by reference.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|# |  | Previously filed as an exhibit to the Company's Annual Report on Form 10-KSB for the year ended
December 31, 1995, and incorporated herein by reference.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

|## |  | Previously filed as an exhibit to the Company's Annual Report on Form 10-KSB for the year ended
December 31, 1996, and incorporated herein by reference.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

|### |  | Previously filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended
December 31, 1998, and incorporated herein by reference.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|#### |  | Previously filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended
December 31, 1999, and incorporated herein by reference.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

|- |  | Previously filed as an exhibit to Form S-8 Registration Statement No. 33-97710 filed on October
4, 1995, and incorporated herein by reference.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

|< |  | Previously filed as an exhibit Form 10-Q for the period ended June 30, 1999, and incorporated
herein by reference.
|- |  | ------------------------------------------------------------------------------------------------------------------

|<< |  | Previously filed as an exhibit Form 10-Q for the period ended June 30, 2000, and incorporated
herein by reference.
|-- |  | ------------------------------------------------------------------------------------------------------------------

|SIGNATURES


Pursuant to the
requirements of the Securities Act of 1934, the Registrant certifies that it has caused
this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in
the Town of Burlington in the Commonwealth of Massachusetts on March 26, 2001.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | PALOMAR MEDICAL TECHNOLOGIES, INC.By: /s/ Louis P. Valente
Louis P. ValenteChief Executive Officer
| |  | ----------------------------------------------------------------------------------------------------------------

|Pursuant to the
requirements of the Securities Act of 1934, this Report has been signed by the following
persons on behalf of the Registrant in the capacities and on the dates indicated.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Name                     | Capacity                              | Date          
|------------------------ | ------------------------------------- | --------------
|                        
|/s/ Louis P. Valente     | Chief Executive Officer and Chairman  | March 26, 2001
|                        
|                        
|                        
|Louis P. Valente        
|                        
|/s/ Joseph P. Caruso     | President and Chief Operating Officer | March 26, 2001
|                        
|Joseph P. Caruso         | (Principal Financial Officer and     
|                        
|                         | Principal Accounting Officer)        
|                        
|/s/ Jeanne Cohane        | Director                              | March 26, 2001
|                        
|Jeanne Cohane           
|                        
|/s/ Nicholas P. Economou | Director                              | March 26, 2001
|                        
|Nicholas P. Economou    
|                        
|/s/ A. Neil Pappalardo   | Director                              | March 26, 2001
|                        
|A. Neil Pappalardo      
|                        
|/s/ James G. Martin      | Director                              | March 26, 2001
|                        
|James G. Martin         

|
|